Summary of ACME PACKET INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Cautionary Statement
This Quarterly Report on Form 10-Q, including the information incorporated by reference herein, contains, in addition to historical information, forward-looking statements. We may, in some cases, use words such as "project," "believe," "anticipate," "plan," "expect," "estimate," "intend," "continue," "should," "would," "could," "potentially," "will," "may" or similar words and expressions that convey uncertainty of future events or outcomes to identify these forward-looking statements. Forward-looking statements in this Quarterly Report on Form 10-Q may include statements about:
• our ability to integrate Covergence Inc. and the benefits to our stockholders;

• our ability to attract and retain customers;

• our financial performance;

• our development activities;

• our position in the session border controller market;

• the effect of the worldwide markets and related economic crisis on purchases of our products;

• the expectations about our growth;

• the demand for and the growth of worldwide revenues for session border controllers;

• the benefit of our products, services, or programs;

• our ability to establish and maintain relationships with key partners and contract manufacturers;

• the advantages of our technology as compared to that of our competitors;

• our ability to establish and maintain intellectual property rights;

• our ability to retain and hire necessary employees and appropriately staff our operations;

• our expectations regarding the realization of recorded deferred tax assets; and

• our cash needs.

The outcome of the events described in these forward-looking statements is subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from the results anticipated by these forward-looking statements. These important factors include our financial performance, our ability to attract and retain customers, our development activities and those factors we discuss in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K under the caption "Risk Factors." You should read these factors and the other cautionary statements made in this Quarterly Report on Form 10-Q as being applicable to all related forward-looking statements wherever they appear in this Quarterly Report on Form 10-Q. These risk factors are not exhaustive and other sections of this Quarterly Report on Form 10-Q may include additional factors which could adversely impact our business and financial performance.
Overview
Acme Packet, Inc. is the leading provider of session border controllers, or SBCs, that enable service providers and enterprises to deliver secure and high quality interactive communications-voice, video and other real-time multimedia sessions-across defined border points where internet protocol networks connect, known as network borders. Our products support multiple applications in service provider, enterprise and contact center networks; from voice-over-internet-protocol, or VoIP, trunking to hosted enterprise and residential services to fixed-mobile convergence. Our products satisfy critical security, service assurance and regulatory requirements in wireline, cable and wireless networks, and support multiple protocols and multiple border points. As of September 30, 2009, 910 end user customers in 100 countries have deployed our products. We sell or license our products and support services through our direct sales force and approximately 60 distribution partners, including many of the largest networking and telecommunications equipment vendors throughout the world.
Our headquarters are located in Burlington, Massachusetts. We maintain sales offices in Burlington, Massachusetts; Madrid, Spain; Seoul, Korea; Tokyo, Japan; and Ipswich, United Kingdom. We also have sales personnel in Argentina, Australia, Belgium, Brazil, Canada, China, Croatia, Czech Republic, France, Germany, Hong Kong, India, Italy, Jordan, Malaysia, Mexico, the Netherlands, New Zealand, Peru,

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Poland, Russia, Singapore, South Africa, Sweden, Taiwan, Thailand and throughout the United States. In the short-term we expect to selectively add personnel to provide additional geographic sales and technical support coverage. Industry Background
Service providers traditionally have delivered voice and data services over two separate networks: the Public Switched Telephone Network, or PSTN, and the internet. The PSTN provides high reliability and security but is costly to operate and is limited in its ability to support high bandwidth video and other interactive multimedia services. The internet is capable of cost-effectively transmitting any form of traffic that is internet protocol (IP)-based, including interactive voice, video and data, but it transmits only on a best-efforts basis, because all forms of traffic have the same priority. Therefore, the internet attempts to deliver all traffic without distinction, which can result in significantly varying degrees of service quality for the same or similar types of traffic transmissions. Internet-based services are also subject to disruptive and fraudulent behavior, including identity theft, viruses, unwanted and excessively large input data, known as SPAM, and the unauthorized use and attempts to circumvent or bypass security mechanisms associated with those services, known as hacking.
Service providers are migrating to a single IP network architecture to serve as the foundation for their next-generation voice, video and data service offerings. In order to provide secure and high quality interactive communications on a converged IP network, service providers must be able to manage and integrate the communications flows that comprise communication sessions for applications such as interactive video and VoIP, which allows the routing of voice conversations over the Internet.
Prior to the advent of the SBC, IP network infrastructure equipment, such as softswitches, routers and data firewalls, was able to initiate and route undifferentiated data but lacked the ability to target specifically the management of interactive communication sessions. We believe that there is significant demand for SBCs that can facilitate the delivery of secure and high quality real-time interactive communications across all IP network borders. Infonetics Research, a market research and consulting firm specializing in networking and IP communications, projects that the cumulative worldwide addressable market opportunity for SBCs over the next 4 years from 2010 to 2013 will be $1.0 billion in the service provider market and $742 million in the enterprise market.
We see rapidly emerging opportunities for our solutions within large enterprises, contact centers, and wireless service providers. We believe that enterprise IP telephony (IPT) is now mainstream, and that unified communications (UC) - or the integration of interactive voice, video, messaging and collaboration applications over IP - will soon follow. Both are critical components of enterprise IT strategies to improve business agility, increase employee efficiency and responsiveness, build customer satisfaction and loyalty, and reduce overhead costs. We believe that these components are indispensable tools for success in a newly-competitive global marketplace. The full-scale deployment of enterprise IPT has revealed deficiencies in network and security infrastructure originally deployed for data. Consequently, we believe that enterprises will likely be adding further controls to their IPT/UC infrastructure to improve its security, extend its application reach, meet service level commitments, optimize capital and operating costs, and comply with relevant commercial and government regulations. Enterprises are deploying SBCs to successfully deliver network security, availability, and performance as well as to achieve control over the four key borders within their IPT/UC infrastructure - IP trunking, private network, internet, and hosted services interconnect borders. We believe that the majority of large enterprises today having already deployed IP PBXs are about to rapidly embrace SIP trunking to reduce costs and set the foundation for enabling end-to-end IP communication.
Within today's modern contact center, the migration of voice services from time-division multiplexing, or TDM, to IP is now well underway. This migration is essential to the contact center's strategic goals: meeting customers' growing service expectations, achieving ever-higher performance and quality metrics, improving agent retention rates, growing revenues and reducing capital and operating costs. However, existing network and security infrastructure that was originally deployed for TDM voice services and data applications have demonstrated deficiencies for IP interactive communications. We believe that contact center strategists are deploying SBCs to assert control over the four critical IP network borders found in most contact centers: its connections to IP trunking service providers, to managed private IP networks, to the public internet, and to virtual contact center locations. With SBCs to reinforce these borders in five key functional areas-security, application reach, SLA assurance, cost optimization, and regulatory compliance-contact centers can successfully and safely navigate the transition to an IP infrastructure. Our early customers within this market have included the contact center operations of our Tier-1 service providers throughout North America, Europe, as well as Central and Latin America.
Key Financial Highlights
Some of our key financial highlights for the third quarter of 2009 include the following:
• Net revenues were $36.3 million for the third quarter 2009 compared to $28.4 million in the same period of 2008.

• Net income for the third quarter of 2009 was $3.6 million compared to $2.0 million in the same period of 2008.

• Net income per share was $0.06 on a diluted basis for the third quarter of 2009 compared to $0.03 per share on a diluted basis in the same period of 2008.

• Cash flows from operating activities were $4.1 million for the third quarter of 2009 compared to $2.5 million in the same period of 2008.

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The Acme Packet Strategy
Principal elements of our strategy include:
• Continuing to satisfy the evolving border requirements of large service providers, enterprises, government and contact centers. Our SBC deployments in the wireline, wireless and cable networks of Tier-1 and other large service providers, as well as in enterprises and contact centers, position us to gain valuable knowledge that we can use to expand and enhance our products' features and functionality.

• Exploiting new technologies to enhance product performance and scalability. We will seek to leverage new technologies as they become available to increase the performance, capacity and functionality of our product family, as well as to reduce our costs.

• Investing in quality and responsive support. As we broaden our product platform and increase our product capabilities, we will continue to provide comprehensive service and support targeted at maximizing customer satisfaction and retention.

• Facilitating and promoting service interconnects among our customers. We intend to increase demand for our products by helping our customers to extend the reach of their services and, consequently, to increase the value of their services to their customers.

• Leveraging distribution partnerships to enhance market penetration. We will continue to invest in training and tools for our distribution partners' sales, systems engineering and support organizations, in order to improve the overall efficiency and effectiveness of these partnerships.

• Actively contributing to architecture and standards definition processes. We will utilize our breadth and depth of experience with SBC deployments to contribute significantly to organizations developing standards and architectures for next-generation IP networks.

Factors That May Affect Future Performance
• Integration of Covergence Inc. As part of our growth strategy, our acquisition of Covergence will allow Covergence's software-based SBCs to complement our existing Net-Net family of custom hardware-based SBCs by extending our low-end product range to address the needs of small and remote enterprise locations. Whether we realize the anticipated benefits from this transaction will depend in part upon the integration of the acquired business, the performance of the acquired products, capacities of the technologies acquired as well as the personnel hired in connection therewith. Accordingly, our results of operations could be adversely affected from transaction-related charges, amortization of intangible assets and charges for impairment of long-term assets. While we believe that we have established appropriate and adequate procedures and processes to mitigate these risks, there can be no assurance that this transaction will be successful.

• Global Macroeconomic Conditions. We believe that the capital budgets of some of our core customers - service providers, enterprises and contact centers - may be affected by the current worldwide economic downturn, including uncertainty in the global financial markets. For example, during 2008 we had a significant increase in our allowance for doubtful accounts primarily related to the bankruptcy proceedings of one of our distribution partners. Our ability to generate revenue from these core customers is dependent on the status of such capital budgets. Should the current uncertainty in these areas continue, our revenues could be adversely impacted.

• Gross Margin. Our gross margin has been, and will continue to be, affected by many factors, including (a) the demand for our products and services, (b) the average selling price of our products, which in turn depends in part on the mix of product configurations sold, (c) the level of software license upgrades, (d) new product introductions, (e) the mix of sales channels through which our products are sold, and (f) the costs of manufacturing our hardware products and the provision of our related support services. Customers license our software in various configurations depending on each customer's requirements for session capacity, feature groups and protocols. The product software configuration mix will have a direct impact on the average selling price of the system sold. Systems with higher software content (higher session capacity and a larger number of feature groups) will generally have a higher average selling price than those systems sold with lower software content. If customers begin to purchase systems with lower software content, this may have a negative impact on our gross margins.

• Competition. The market for SBCs is competitive and constantly evolving. While we believe we are currently the market leader, we expect competition to persist and intensify in the future as the SBC market grows. Our primary competitors generally consist of start-up vendors, such as Genband, and more established network and component companies such as Cisco Systems, Inc. and Huawei Technologies Co., Ltd. We also compete with some of the companies with which we have distribution partnerships, such as Sonus Networks Inc. and Telefonaktiebolaget LM Ericsson. We believe we compete successfully with all of these companies based upon our experience in interactive communications networks, the breadth of our applications and standards support, the depth of our border control

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features, the demonstrated ability of our products to interoperate with key communications infrastructure elements, and our comprehensive service and support. We also believe our products are priced competitively with other market offerings. As the SBC market opportunity grows, we expect competition from additional networking and IP communications equipment suppliers, including our distribution partners.

• Evolution of the SBC Market. The market for SBCs is in its early stages and is still evolving, and it is uncertain whether these products will continue to achieve and sustain high levels of demand and market acceptance. Our success will depend, to a substantial extent, on the willingness of interactive communications service providers and enterprises to continue to implement SBCs.

• Research and Development. To continue to achieve market acceptance for our products, we must effectively anticipate and adapt, in a timely manner to customer requirements and must offer products that meet changing customer demands. Prospective customers may require product features and capabilities that our current products do not have. The market for SBCs is characterized by rapid technological change, frequent new product introductions, and evolving industry requirements. We intend to continue to invest in our research and development efforts, which we believe are essential to maintaining our competitive position.

• Managing Growth. We significantly expanded our operations in 2008 and the first nine months of 2009. During the period from September 30, 2008 through September 30, 2009, we increased the number of our employees and full-time independent contractors by 17%, from 377 to 440. In connection with the acquisition of Covergence, we added 39 employees during April 2009. We anticipate that further expansion of our infrastructure and headcount will be required to achieve planned expansion of our product offerings, projected increases in our customer base and anticipated growth in the number of product deployments. In the future, we expect to continue to carefully manage the increase of our operating expenses based on our ability to expand our revenues, the expansion of which could occur organically or through future acquisitions.

Revenue
We derive product revenue from the sale of our Net-Net hardware and the licensing of our Net-Net software. We generally recognize product revenue at the time of product delivery, provided all other revenue recognition criteria have been met. For arrangements that include customer acceptance or other material non-standard terms, we defer revenue recognition until after delivery, assuming all other criteria for revenue recognition have been met.
We generate maintenance, support and service revenue from (a) maintenance associated with software licenses, (b) technical support services for our product software, (c) hardware repair and maintenance services,
(d) implementation, training and consulting services and (e) reimbursable travel and other out-of-pocket expenses. We offer our products and services indirectly through distribution partners and directly through our sales force. Our distribution partners include networking and telecommunications equipment vendors throughout the world. Our distribution partners generally purchase our products after they have received a purchase order from their customers and do not maintain an inventory of our products in anticipation of sales to their customers. Generally, the pricing offered to our distribution partners will be lower than to our direct customers. The product configuration, which reflects the mix of session capacity and requested features, determines the price for each SBC sold. Customers can purchase our SBCs in either a standalone or high availability configuration and can license our software in various configurations, depending on the customers' requirements for session capacity, feature groups and protocols. The product software configuration mix will have a direct impact on the average selling price of the system sold. As the market continues to develop and grow, we expect to experience increased price pressure on our products and services. We believe that our revenue and results of operations may vary significantly from quarter to quarter as a result of long sales and deployment cycles, variations in customer ordering patterns, and the application of complex revenue recognition rules to certain transactions. Some of our arrangements with customers include clauses under which we may be subject to penalties for failure to meet specified performance obligations. We have not incurred any such penalties to date. Cost of Revenue
Cost of product revenue consists primarily of (a) third party manufacturers fees for purchased materials and services, combined with Company expenses for
(b) salaries, wages and related benefits, (c) related overhead, (d) provision for inventory obsolescence and (e) amortization of intangible assets. Cost of maintenance, support and service revenue consists primarily of
(a) salaries, wages and related benefits (b) related overhead, (c) billable and non-billable travel, lodging, and other out-of-pocket expenses, and (d) contract services for repairs and warranty services.

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Gross Profit
Our gross profit has been, and will be, affected by many factors, including
(a) the demand for our products and services, (b) the mix between product and service revenue, (c) the average selling price of our products, which in turn depends, in part, on the mix of product configurations sold, (d) new product introductions, (e) the mix of sales channels through which our products are sold, (f) the volume and costs of manufacturing of our hardware products and
(g) personnel and related costs for manufacturing, support and services. Operating Expenses
Operating expenses consist of sales and marketing, research and development, and general and administrative expenses. Personnel-related costs are the most significant component of each of these expense categories. During the period from September 30, 2008 through September 30, 2009, we increased the number of our employees and full-time independent contractors by 16%, from 322 to 373. In addition to the 33 employees added through the acquisition of Covergence in April 2009. We expect to selectively hire new employees in the short-term to support our expected growth.
Sales and marketing expense consists primarily of (a) salaries and related personnel costs, (b) commissions, (c) travel, lodging and other out-of-pocket expenses, (d) marketing programs such as trade shows and (e) other related overhead. Commissions are recorded as expense when earned by the employee. We expect sales and marketing expense to increase in absolute dollars as we expand our sales force to continue to increase our revenue and market share. However, we anticipate that sales and marketing expense will decrease as a percentage of total revenue in the future.
Research and development expense consists primarily of (a) salaries and related personnel costs, (b) payments to suppliers for design and consulting services, (c) prototype and equipment costs relating to the design and development of new products and enhancement of existing products, (d) quality assurance and testing and (e) other related overhead. To date, all of the costs related to our research and development efforts have been expensed as incurred. We intend to continue to invest in our research and development efforts, which we believe are essential to maintaining our competitive position. We expect research and development expense to increase in absolute dollars. However, we anticipate that research and development expense will decrease as a percentage of total revenue in the future.
General and administrative expense consists primarily of (a) salaries, wages and personnel costs related to our executive, finance, human resource and information technology organizations, (b) accounting and legal professional fees, (c) expenses associated with uncollectible accounts and (d) other related overhead. We expect general and administrative expense to increase in absolute dollars as we invest in infrastructure to support continued growth and incur ongoing expenses related to being a publicly traded company, including increased audit and legal fees, costs of compliance with securities and other regulations, investor relations expense, and higher insurance premiums. Stock-Based Compensation
Cost of revenue and operating expenses include stock-based compensation expense. We expense share-based payment awards with compensation cost for share-based payment transactions measured at fair value. For the three months ended September 30, 2009 and 2008, we recorded expense of $2.8 million and $2.0 million, respectively, and for the nine months ended September 30, 2009 and 2008, we recorded expense of $7.7 million and $5.3 million, in connection with share-based payment awards. Based on share-based awards outstanding as of September 30, 2009, a future expense of non-vested options of $26.4 million is expected to be recognized over a weighted-average period of 2.96 years.
In July 2009, our board of directors approved an offer (the Offer) to our employees, excluding members of our board of directors and our Section 16 officers, to exchange option grants that had (i) an exercise price greater than or equal to the higher of (a) $11.42 and (b) a price at least 10% higher than the closing price of our common stock on the expiration date of the Offer; (ii) were granted under the Acme Packet, Inc. 2006 Equity Incentive Plan; and
(iii) were held by eligible option holders. Eligible participants were all persons who were employees (including employees on an expatriate assignment) hired on or before 5:00 p.m., Eastern Daylight Savings Time, on July 8, 2009 and who remained employees us through the date on which the new options were granted, and included certain independent contractors who continued to provide services to us through the date on which the new options are granted. The Offer expired on August 5, 2009, and upon the expiration, we exchanged the tendered options that had exercise prices equal to or greater than $11.42 per share for new options. The tendered options that were exchanged for new option were cancelled on the expiration date of the Offer. As a result, an aggregate of 1,222,500 options, with exercise prices ranging from $11.97 to $18.36 per share, were cancelled and exchanged for 945,317 options with an exercise price per share of $8.98. The new options began to vest on the new option grant date, whereby 25% of the new options vesting on the first anniversary of the new option grant date, and the remainder vesting ratably on a quarterly basis over the final three years of the vesting period. On the date of the exchange, the estimated fair value of the new options did not exceed the estimated fair value of the exchanged stock options calculated immediately prior to the exchange. As such, there was no incremental stock-based compensation expense associated with the new options, and we did not record additional compensation expense related to the exchange. We will continue to recognize the remaining compensation expense related to the exchanged options over the vesting period of the new options.

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Other Income (Expense), Net
Other income (expense) consists primarily of interest income earned on cash balances. We historically have invested our cash in money market funds. Other income (expense) also includes (losses) gains from foreign currency translation adjustments of our international subsidiaries. The functional currency of our international operations in Europe and Asia is the U.S. dollar. Accordingly, all assets and liabilities of these international subsidiaries are re-measured into U.S. dollars using the exchange rates in effect at the balance sheet date. Revenue and expenses of these international subsidiaries are re-measured into U.S. dollars at the average rates in effect during the period. Any differences resulting from the re-measurement of assets, liabilities and operations of the . . .