PCTI PCTEL Inc

Liquidity and Capital Resources

Liquidity and Capital Resources Overview

At December 31, 2016, our cash, cash equivalents, and investments were approximately $33.3 million and we had working capital of approximately $55.2 million.  Our primary source of liquidity is cash provided by operations, with short term swings in liquidity supported by a significant balance of cash and short-term investments.  The balance has fluctuated with cash from operations, acquisitions and divestitures, payment of dividends and the repurchase of our common shares.

Within operating activities, we are historically a net generator of operating funds from our income statement activities and a net user of operating funds for balance sheet expansion.  We expect this historical trend to continue in the future.

Within investing activities, capital spending historically ranges between 2.0% and 5.0% of our revenues and the primary use of capital is for manufacturing and engineering development requirements.  Our capital expenditures during the year ended December 31, 2016 was approximately 2.0% of revenues. We historically have significant transfers between investments and cash as we rotate our large cash balances and short-term investment balances between money market funds, which are accounted for as cash equivalents, and other investment vehicles.  We have a history of supplementing our organic revenue growth with acquisitions of product lines or companies, resulting in significant uses of our cash and short-term investment balances from time to time.  We expect the historical trend for capital spending and the variability caused by moving money between cash and investments and periodic merger and acquisition activity to continue in the future.

Within financing activities, we have historically generated funds from the exercise of stock options and proceeds from the issuance of common stock through the Employee Stock Purchase Plan (“ESPP”) and have historically used funds to repurchase shares of our

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common stock through our share repurchase programs and through quarterly dividends.  Whether this activity results in our being a net user of funds ver sus a net generator of funds is largely dependent on our stock price during any given year.

Operating Activities:

We generated $10.4 million of funds from operating activities during the year ended December 31, 2016.  Adjustments related to non-cash items within net income were $23.0 million for the year ended December 31, 2016 as the deferred tax provision was $8.2 million,  impairment expense was $5.8 million, amortization and depreciation was $5.5 million, and stock-based compensation was $4.0 million.  Within the balance sheet, we generated cash of $2.9 million from the reduction of inventories and $1.7 million from the reduction of accounts receivable.  Inventories decreased $2.9 million due to lower inventories for Connected Solutions as a result of improved processes for forecasting and reductions in minimum order quantities for purchases.  Accounts receivable generated cash primarily due to more favorable timing of revenues with the fourth quarter 2016 compared to the fourth quarter 2015.  We used $0.4 million for payroll taxes related to stock-based compensation. The tax payments related to our stock issued for restricted stock awards.

We generated $9.1 million of funds from operating activities during the year ended December 31, 2015.  Adjustments related to non-cash items within net income were $8.1 million for the year ended December 31, 2015 as amortization and depreciation was $7.1 million and stock-based compensation was $1.9 million.  Within the balance sheet, we generated cash of $8.3 million from accounts receivable, of which $5.4 million related to the collection of opening balance sheet accounts receivable for Nexgen.  We also generated cash from accounts receivable because revenues for the quarter ended December 31, 2015 were $3.3 million lower than the quarter ended December 31, 2014.  We used $1.9 million for the payout of the executive deferred compensation plan, and we used $1.5 million to pay annual 2014 accruals, including short-term incentive plan bonuses and sales commissions.  Inventories increased $1.4 million due to higher inventories for Connected Solutions. Inventories increased because of the transition of additional production to China from the U.S. and because of increased safety stock.  We used $0.4 million for payroll taxes related to stock-based compensation. The tax payments related to our stock issued for restricted stock awards.

We generated $8.0 million of funds from operating activities during the year ended December 31, 2014.  Cash from operations consisted of approximately $13.3 million of cash generated from our income statement, offset by approximately $5.3 million of cash used within our balance sheet.  Within our income statement activities, we used $1.0 million for payroll taxes related to stock-based compensation.  The tax payments related to our stock issued for restricted stock awards.  On the balance sheet, we used cash of $5.3 million due to higher accounts receivable.  Accounts receivable increased due to higher revenues during the quarter ended compared to quarter ended December 31, 2013 and due to the timing of revenues with the quarters.  Revenues were $3.4 million higher for the three months ended December 31, 2014 versus the comparable period in 2013.  We used cash of $1.9 million from the increase of inventories.  Our inventories were higher for RF Solutions due to the introduction of new products, and our inventories were higher for Connected Solutions to meet the demand for shipments in the first quarter 2015. We generated cash of $1.1 million within the balance sheet due to higher accounts payable.  Accounts payable increased due to increases in inventories and due to the timing of vendor purchases during the year ended December 31, 2014 compared to the year ended December 31, 2013.

Investing Activities:

Our investing activities provided $4.3 million of cash during the year ended December 31, 2016.  Redemptions and maturities of our short-term investments during the year provided $80.5 million in cash and we rotated $74.3 million of cash into new short-term investments. We used $1.9 million for capital expenditures during the year ended December 31, 2016.

Our investing activities used $7.7 million of cash during the year ended December 31, 2015.  We used $20.5 million for the purchase of the Nexgen business in February 2015. We funded the acquisition from our cash and from investments that matured during January and February 2015.  During the year ended December 31, 2015, redemptions and maturities of our short-term investments provided $45.0 million in cash and we rotated $30.1 million of cash into new short-term investments. We used $2.1 million for capital expenditures during the year ended December 31, 2015.

Our investing activities used $6.0 million of cash during the year ended December 31, 2014 as we used $3.5 million of cash for investments and used $2.5 million for capital expenditures.  Redemptions and maturities of our investments in short-term bonds during the year ended December 31, 2014 provided $55.1 million in funds.  We rotated $58.6 million of cash into new short-term bonds during the year ended December 31, 2014.

Financing Activities:

We used $6.9 million in cash for financing activities during the year ended December 31, 2016. We used $4.1 million to repurchase shares in the stock repurchase program and $3.5 million for cash dividends paid quarterly during 2016.  We received $0.6 million in proceeds from the purchase of shares through our ESPP.

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We used $14.7 million in cash for financing activities during the year ended December 31, 2015. We used $12.1 million to repurchase shares in the stock repurchase program and $3.6 million for cash dividends paid quarterly during 2015.  We received $1.0 million in proceeds from the purchase of shares through our ESPP and the exercise of stock options.

We used $3.3 million in cash for financing activities during the year ended December 31, 2014.  We paid $3.0 million for quarterly cash dividends and used $1.6 million to repurchase shares in the stock repurchase program.  We received $1.3 million in proceeds from the purchase of shares through our ESPP and the exercise of stock options.

As of December 31, 2016, we had obligations through 2021 for capital leases of $241 related to office and manufacturing equipment.  See Note 7 of the consolidated financial statements for more information on capital leases.

We have a liability related to uncertain positions for income taxes of $0.9 million at December 31, 2016.  We do not know when this obligation will be paid.

Off-Balance Sheet Arrangements

None.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements in accordance with generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the period reported.  By their nature, these estimates and judgments are subject to an inherent degree of uncertainty.  Management bases its estimates and judgments on historical experience, market trends, and other factors that are believed to be reasonable under the circumstances.  Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition - We recognize revenue when the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, price is fixed and determinable, and collectability is reasonably assured.  We recognize revenue for sales of products when title transfers, which is predominantly upon shipment from the factory.  For products shipped on consignment, we recognize revenue upon delivery from the consignment location.  Revenue recognition is also based on estimates of product returns, allowances, discounts, and other factors.  These estimates are based on historical data.  We believe that the estimates used are appropriate, but differences in actual experience or changes in estimates may affect future results.  We recognize revenue for our network engineering services under the completed performance method.  Most services occur in one week or less, and revenue is generally recognized when the engineering reports are completed and issued to the customer.

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Accounts Receivable a nd Allowance for Doubtful Accounts - Accounts receivable are recorded at invoiced amount.  We extend credit to our customers based on an evaluation of a customer’s financial condition and collateral is generally not required.  We maintain an allowance for doubtful accounts for estimated uncollectible accounts receivable.  The allowance is based on our assessment of known delinquent accounts, historical experience, and other currently available evidence of the collectability and the aging of accounts receiva ble.  Although management believes the current allowance is sufficient to cover existing exposures, there can be no assurance against the deterioration of a major customer’s creditworthiness, or against defaults that are higher than what has been experienc ed historically.

Excess and Obsolete Inventory - We maintain reserves to reduce the value of inventory to the lower of cost or market and reserves for excess and obsolete inventory.  Reserves for excess inventory are calculated based on our estimate of inventory in excess of normal and planned usage. Obsolete reserves are based on our identification of inventory where carrying value is above net realizable value.  We believe the accounting estimate related to excess and obsolete inventory is a critical accounting estimate because it requires us to make assumptions about future sales volumes and product mix, both of which are highly uncertain.  Changes in these estimates can have a material impact on our financial statements.

Warranty Costs - We offer repair and replacement warranties of primarily five years for antenna products and scanning receiver products.  Our warranty reserve is based on historical sales and costs of repair and replacement trends.  We believe that the accounting estimate related to warranty costs is a critical accounting estimate because it requires us to make assumptions about matters that are highly uncertain, including future rates of product failure and repair costs.  Changes in warranty reserves could be material to our financial statements.

Stock-based Compensation - We recognize stock-based compensation expense for all equity awards in accordance with fair value recognition provisions.  Under the fair value provisions, we recognize stock-based compensation expense net of an estimated forfeiture rate, recognizing compensation cost only for those awards expected to vest over requisite service periods of the awards.  Stock-based compensation expense and disclosures are dependent on assumptions used in calculating such amounts.  These assumptions include risk-free interest rates, expected term of the stock-based compensation instrument granted, volatility of stock and option prices, expected time between grant date and date of exercise, attrition, performance, and other factors.  These factors require us to use judgment.  Our estimates of these assumptions typically are based on historical experience and currently available market place data.  While management believes that the estimates used are appropriate, differences in actual experience or changes in assumptions may affect our future stock-based compensation expense and disclosures.

Income Taxes - Income taxes are accounted for under the asset and liability method.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Our operations have international subsidiaries located in China, United Kingdom and Israel, as well as an international branch office located in Hong Kong.  The complexities that arise from operating in several different tax jurisdictions inevitably lead to an increased exposure to worldwide taxes.  Should review of the tax filings result in unfavorable adjustments to our tax returns, the operating results, cash flows, and financial position could be materially and adversely affected.

We are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities.  A change in the assessment of the outcomes of such matters could materially impact our consolidated financial statements.  The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax regulations.  We recognize liabilities for anticipated tax audit issues based on our estimate of whether, and the extent to which, additional taxes may be required.  If we ultimately determine that payment of these amounts is unnecessary, then we reverse the liability and recognize a tax benefit during the period in which we determine that the liability is no longer necessary.  We also recognize tax benefits to the extent that it is more likely than not that our positions will be sustained if challenged by the taxing authorities.  To the extent we prevail in matters for which liabilities have been established, or are required to pay amounts in excess of our liabilities, our effective tax rate in a given period may be materially affected.  An unfavorable tax settlement would require cash payments and may result in an increase in our effective tax rate in the year of resolution.  A favorable tax settlement would be recognized as a reduction in our effective tax rate in the year of resolution.

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Valuation Allowances for Deferred Tax Assets - We establish an income tax valuation allowance when available evidence indicates that it is more likely than not that all or a portion of a deferred tax asset will not be realized.  In assessing the need for a valuation allowance, we consider the amounts and timing of expected future deductions or carryforwards and sources of taxable income that may enable utilization.  We maintain an existing valuatio n allowance until sufficient positive evidence exists to support its reversal.  Changes in the amount or timing of expected future deductions or taxable income may have a material impact on the level of income tax valuation allowances.  Our assessment of t he realizability of the deferred tax assets requires judgment about our future results.  Inherent in this estimation is the requirement for us to estimate future book and taxable income and possible tax planning strategies.  These estimates require us to e xercise judgment about our future results, the prudence and feasibility of possible tax planning strategies, and the economic environment in which we do business.  It is possible that the actual results will differ from the assumptions and require adjustme nts to the allowance.  Adjustments to the allowance would affect future net income.

Impairment Reviews of Goodwill – We perform an annual impairment test of goodwill as of the end of the first month of the fiscal fourth quarter (October 31st), or at an interim date if an event occurs or if circumstances change that would indicate that an impairment loss may have been incurred. In performing our annual impairment test, we first perform a qualitative assessment to determine whether it is more likely that not that the fair value of a reporting unit is less than its carrying value, including goodwill.  If our qualitative assessment is indicative of possible impairment, then a two-step quantitative fair value assessment is performed at the reporting unit level. In the first step, the fair value of each reporting unit is compared with its carrying value.  If the fair value exceeds the carrying value, then goodwill is not impaired and no further testing is performed.  The second step is performed if the carrying value exceeds the fair value.  The implied fair value of goodwill is then compared against the carrying value of goodwill to determine the amount of impairment.

The process of evaluating the potential impairment of goodwill is subjective because it requires the use of estimates and assumptions in determining a reporting unit’s fair value. We calculate the fair value of each reporting unit by using the income approach based on the present value of future discounted cash flows. The discounted cash flow method requires us to use estimates and judgments about the future cash flows of the reporting units. Although we base cash flow forecasts on assumptions that are consistent with plans and estimates we use to manage the underlying reporting units, there is significant judgment in determining the cash flows attributable to these reporting units, including markets and market share, sales volumes and mix, research and development expenses, tax rates, capital spending, discount rate and working capital changes. Cash flow forecasts are based on reporting unit operating plans for the early years and business projections in later years. We believe the accounting estimate related to the valuation of goodwill is a critical accounting estimate because it requires us to make assumptions that are highly uncertain about the future cash flows of our reporting units.

While the use of historical results and future projections can result in different valuations for a business, it is a generally accepted valuation practice to apply more than one valuation technique to establish a range of values for a business. Since each technique relies on different inputs and assumptions, it is unlikely that each technique would yield the same results. However, it is expected that the different techniques would establish a reasonable range. In determining the fair value, we weigh the two methods equally because we believe both methods have an equal probability of providing an appropriate fair value.

Impairment Reviews of Finite-Lived Intangible Assets - We evaluate the carrying value of finite-lived intangible assets and other long-lived assets for impairment whenever indicators of impairment exist. We test finite-lived intangible assets for recoverability using undiscounted cash flows. Although we base cash flow forecasts on assumptions that are consistent with plans and estimates we use to manage the underlying reporting units, there is significant judgment in determining the cash flows attributable to these reporting units, including markets and market share, sales volumes and mix, research and development expenses, capital spending and working capital changes. Cash flow forecasts are based on operating plans and business projections. We compare the tax-affected undiscounted cash flows to the carrying value of the asset group. If the carrying value exceeds the sum of the undiscounted cash flows of the asset group, we would assess the fair value of the intangible assets in the group to determine if an impairment charge should be recognized in the financial statements.

We believe the accounting estimate related to the valuation of intangible assets is a critical accounting estimate because it requires us to make assumptions about future sales prices and volumes for products that involve new technologies and applications where customer acceptance of new products or timely introduction of new technologies into their networks are uncertain. The recognition of impairment could be material to our financial statements.

Recent Accounting Pronouncements

In January 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-04, Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”).  ASU 2017-04 eliminates Step 2 as part of the goodwill impairment test.  The amount of the impairment charge to be recognized would now be the amount by which the carrying value exceeds the reporting unit’s fair value.  The loss to be recognized cannot exceed the amount of

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goodwill allocated to that reporting unit.  The amendments in ASU 2017-04 are effective for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019.  Early adoption is permitted for interim and annual goodwill impairment tests performed on testing dates after January 1, 2017.  We are evaluating the provisions of ASU 2017-04 and its impact on our consolidated financial statements and related disclosures.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. This ASU addresses the following eight specific cash flow issues: Debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies (including bank-owned life insurance policies); distributions received from equity method investees; beneficial interests in securitization transactions; and separately identifiable cash flows and application of the predominance principle. This guidance will be effective for us on January 1, 2018. We do not expect the adoption of this ASU to have a material impact on our consolidated financial statements.

In June 2016, the FASB issued Accounting Standards Update No. 2016-13 ("ASU 2016-13") regarding ASC Topic 326, "Financial Instruments - Credit Losses," which modifies the measurement of expected credit losses of certain financial instruments. The amendments will be effective for us on January 1, 2020.   We are currently evaluating this guidance and the impact it will have on our consolidated financial statements .

In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. ASU No. 2016-09 affects all entities that issue share-based payment awards to their employees. ASU No. 2016-09 simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows, including recognizing all excess tax benefits and tax deficiencies as income tax expense or benefit in the income statement rather than in additional paid-in capital. ASU No. 2016-09 is effective for financial statements issued for annual reporting periods beginning after December 15, 2016 and interim periods within those years.  Upon adoption, we anticipate recognizing deferred tax assets for all excess tax benefits that had not been previously recognized. This will be accomplished through a cumulative-effect adjustment to retained earnings of approximately $0.6 million.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which amends existing guidance to require lessees to recognize assets and liabilities on the balance sheet for the rights and obligations created by long-term leases and to disclose additional quantitative and qualitative information about leasing arrangements. This ASU also provides clarifications surrounding the presentation of the effects of leases in the income statement and statement of cash flows. This guidance will be effective for us on January 1, 2019. We are currently evaluating this guidance and the impact it will have on our consolidated financial statements and related disclosures.

In November 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes, to simplify the presentation of deferred income taxes. The amendments in this update require that deferred tax assets and liabilities be entirely classified as noncurrent within the statement of financial position. Effective December 31, 2015, we early adopted the balance sheet classification of deferred taxes on a prospective basis. The guidance requires deferred tax assets and liabilities to be classified as noncurrent rather than split between current and noncurrent. Approximately $1.8 million in current deferred tax assets was reclassified to long-term deferred tax assets at December 31, 2015.

In July 2015, the FASB issued ASU No. 2015-11, Simplifying the Measurement of Inventory. ASU 2015-11 simplifies the subsequent measurement of inventory by requiring inventory to be measured at the lower of cost and net realizable value.  ASU 2015-11 applies only to inventories for which cost is determined by methods other than last-in first-out and the retail inventory method.  ASU 2015-11 is effective for public companies for annual reporting periods beginning after December 15, 2016, and interim periods within those fiscal years.  We are currently evaluating the impact of ASU 2015-11 and have preliminarily concluded that it will not have a significant impact on our consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” which introduces a new revenue recognition model in which an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. This ASU also requires disclosures sufficient to enable users to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers, including qualitative and quantitative disclosures about contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. This guidance will be effective for us on January 1, 2018. The FASB has also issued the following standards which clarify ASU 2014-09 and have the same effective date as the original standard: ASU 2016-20,

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Technical Corrections and Improvements to Topic 606, ASU No. 2016-12, Narrow-Scope Improvements and Pr actical Expedients, ASU 2016-10, Identifying Performance Obligations and Licensing and ASU 2016-08, Principal versus Agent Considerations.

We will commence our assessment of ASU 2014-09 during the first quarter of 2017 and develop a project plan to guide the implementation. This project plan includes analyzing the standard’s impact on our contract portfolio, comparing our historical accounting policies and practices to the requirements of the new standard and identifying potential differences from applying the requirements of the new standard to its contracts. We will draft an updated accounting policy, evaluate new disclosure requirements and identify and implement appropriate changes to our business processes, systems and controls to support recognition and disclosure under the new standard.  We expect to adopt this new standard using the modified retrospective method that will result in a cumulative effect adjustment as of the date of adoption. We are currently evaluating this guidance and the impact it will have on the consolidated financial statements.