(13) Stock Based Compensation

Overview

We issue stock-based awards to certain of our employees and our Board of Directors pursuant to our 2000 Stock Incentive Plan, as amended, (the “Plan”) and our 2001 Employee Stock Purchase Plan (the “ESPP”) and recognize related stock-based compensation for both equity and liability-classified stock-based awards in our consolidated financial statements. The Plan provides for the granting to employees and consultants of Comtech (including prospective employees and consultants): (i) incentive and non-qualified stock options, (ii) restricted stock units (“RSUs”), (iii) RSUs with performance measures (which we refer to as “performance shares”), (iv) restricted stock, (v) stock units (reserved for issuance to non-employee directors) and share units (reserved for issuance to employees) (collectively, “share units”) and (vi) stock appreciation rights (“SARs”), among other types of awards. Our non-employee directors are eligible to receive non-discretionary grants of stock-based awards, subject to certain limitations. The aggregate number of shares of common stock which may be issued, pursuant to the Plan, may not exceed 8,962,500. Stock options granted may not have a term exceeding ten years or, in the case of an incentive stock award granted to a stockholder who owns stock representing more than 10.0% of the voting power, no more than five years. We expect to settle all outstanding awards under the Plan and ESPP with new shares, except for SARs which may only be settled with cash.

As of October 31, 2013, we had granted stock-based awards pursuant to the Plan representing the right to purchase and/or acquire an aggregate of 6,874,264 shares (net of 2,695,240 expired and canceled awards), of which an aggregate of 3,830,652 have been exercised or converted into common stock, substantially all of which related to stock options.

As of October 31, 2013, the following stock-based awards, by award type, were outstanding:



	October 31, 2013
Stock options	2,870,620
Performance shares	121,986
RSUs and restricted stock	37,326
Share units	6,680
SARs	7,000
Total	3,043,612

Our ESPP, approved by our shareholders on December 12, 2000, provides for the issuance of 675,000 shares of our common stock. Our ESPP is intended to provide our eligible employees the opportunity to acquire our common stock at 85% of fair market value at the date of issuance. Through October 31, 2013, we have cumulatively issued 526,517 shares of our common stock to participating employees in connection with our ESPP.

Stock-based compensation for awards issued is reflected in the following line items in our Condensed Consolidated Statements of Operations:



	Three months ended October 31,
	2013			2012
Cost of sales	$	53,000		$	45,000
Selling, general and administrative expenses	771,000			601,000
Research and development expenses	123,000			99,000
Stock-based compensation expense before income tax benefit	947,000			745,000
Estimated income tax benefit	(346,000		)	(264,000		)
Net stock-based compensation expense	$	601,000		$	481,000

Stock-based compensation for equity-classified awards is measured at the date of grant, based on an estimate of the fair value of the award and is generally expensed over the vesting period of the award. Stock-based compensation for liability-classified awards is determined the same way, except that the fair value of liability-classified awards is re-measured at the end of each reporting period until the award is settled, with changes in fair value recognized pro-rata for the portion of the requisite service period rendered. At October 31, 2013, unrecognized stock-based compensation of $10,374,000, net of estimated forfeitures of $853,000, is expected to be recognized over a weighted average period of 3.3 years. Total stock-based compensation capitalized and included in ending inventory at both October 31, 2013 and July 31, 2013 was $72,000. Included in accrued expenses at October 31, 2013 and July 31, 2013 is $4,000 and $1,000, respectively, relating to the potential cash settlement of liability-classified SARs.

Stock-based compensation expense, by award type, is summarized as follows:



	Three months ended October 31,
	2013			2012
Stock options	$	648,000		573,000
Performance shares	177,000			86,000
ESPP	45,000			53,000
RSUs and restricted stock	68,000			32,000
Share units	6,000			6,000
Equity-classified stock-based compensation expense	944,000			750,000
Liability-classified stock-based compensation expense (SARs)	3,000			(5,000	)
Stock-based compensation expense before income tax benefit	947,000			745,000
Estimated income tax benefit	(346,000		)	(264,000	)
Net stock-based compensation expense	$	601,000		481,000

ESPP stock-based compensation expense primarily relates to the 15% discount offered to employees participating in the ESPP.

The estimated income tax benefit, as shown in the above table, was computed using income tax rates expected to apply when the awards are settled and results in a deferred tax asset which is netted in our long-term deferred tax liability in our Condensed Consolidated Balance Sheet. The actual income tax benefit recognized for tax reporting is based on the fair market value of our common stock at the time of settlement and can significantly differ from the estimated income tax benefit recorded for financial reporting.

The following table provides the components of the actual income tax benefit recognized for tax deductions relating to the settlement of stock-based awards:



	Three months ended October 31,
	2013		2012
Actual income tax benefit recorded for the tax deductions relating to the settlement of stock-based awards	$	54,000	1,000
Less: Tax benefit initially recognized on settled stock-based awards vesting subsequent to the adoption of accounting standards that require us to expense stock-based awards, excluding income tax shortfalls	41,000		1,000
Excess income tax benefit recorded as an increase to additional paid-in capital	13,000		—
Less: Tax benefit initially disclosed but not previously recognized on settled equity-classified stock-based awards vesting prior to the adoption of accounting standards that require us to expense stock-based awards, excluding income tax shortfalls	13,000		—
Excess income tax benefit from settled equity-classified stock-based awards reported as a cash flow from financing activities in our Condensed Consolidated Statements of Cash Flows	$	—	—

As of October 31, 2013 and July 31, 2013, the amount of hypothetical tax benefits related to stock-based awards, recorded as a component of additional paid-in capital, was $18,072,000 and $19,981,000, respectively. These amounts represent the initial hypothetical tax benefit of $8,593,000 determined upon adoption of ASC 718 (which reflects our estimate of cumulative actual tax deductions for awards issued and settled prior to the August 1, 2005), adjusted for actual excess income tax benefits or shortfalls since that date. During the three months ended October 31, 2013 and 2012, we recorded $1,911,000 and $2,897,000, respectively, as a net reduction to additional paid-in capital and accumulated hypothetical tax benefits, which primarily represents the reversal of unrealized deferred tax assets associated with certain vested equity-classified stock-based awards that expired during the respective periods.

Stock Options

The following table summarizes the Plan's activity (including SARs) during the three months ended October 31, 2013:



	Awards (in Shares)		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value
Outstanding at July 31, 2013	3,047,910		$	29.94
Granted	247,000		27.23
Expired/canceled	(413,240	)	45.66
Exercised	(4,050	)	19.54
Outstanding at October 31, 2013	2,877,620		$	27.46	5.66	$	7,426,000

Exercisable at October 31, 2013	1,499,240		$	27.18	3.22	$	4,313,000

Vested and expected to vest at October 31, 2013	2,776,031		$	27.44	5.57	$	7,207,000

Stock options (including SARs) outstanding as of October 31, 2013 have exercise prices ranging between $13.19-$35.79. The total intrinsic value relating to stock options exercised during the three months ended October 31, 2013 and 2012 was $41,000 and $350,000, respectively. Stock options granted during the three months ended October 31, 2013 had exercise prices equal to the fair market value of our common stock on the date of grant, a contractual term of ten years and a vesting period of five years. There were no stock options granted during the three months ended October 31, 2012. There were no SARs granted or exercised during the three months ended October 31, 2013 and 2012. The estimated per-share weighted average grant-date fair value of stock options granted during the three months ended October 31, 2013 was $5.47 which was determined using the Black-Scholes option pricing model, and included the following weighted average assumptions:



Expected dividend yield	4.04	%
Expected volatility	32.89	%
Risk-free interest rate	1.38	%
Expected life (years)	5.44

Expected dividend yield is the expected annual dividend as a percentage of the fair market value of our common stock on the date of grant, based on our Board's annual dividend target at the time of grant, which, as of October 31, 2013, was $1.10 per share. We estimate expected volatility by considering the historical volatility of our stock, the implied volatility of publicly-traded call options on our stock, the implied volatility of call options embedded in our 3.0% convertible senior notes and our expectations of volatility for the expected life of stock options. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for an instrument which closely approximates the expected term. The expected term is the number of years we estimate that awards will be outstanding prior to exercise and is determined by employee groups with sufficiently distinct behavior patterns. Assumptions used in computing the fair value of stock-based awards reflect our best estimates, but involve uncertainties relating to market and other conditions, many of which are outside of our control. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by recipients of stock-based awards.

Performance Shares, RSUs, Restricted Stock and Share Unit Awards

The following table summarizes the Plan's activity relating to performance shares, RSUs, restricted stock and share units:



	Awards (in Shares)		Weighted Average Grant Date Fair Value		Aggregate Intrinsic Value
Outstanding at July 31, 2013	102,334		$	25.80
Granted	68,167		24.58
Converted to common stock	(4,509	)	26.25
Outstanding at October 31, 2013	165,992		$	25.28	$	4,983,000

Vested at October 31, 2013	12,335		$	26.84	$	370,000

Vested and expected to vest at October 31, 2013	158,953		$	25.29	$	4,772,000

Performance shares granted to employees prior to fiscal 2014 vest over a 5.3 year period, beginning on the date of grant if pre-established performance goals are attained, and are convertible into shares of our common stock generally at the time of vesting, on a one-for-one basis for no cash consideration. The performance shares granted to employees during the three months ended October 31, 2013 vest over a three-year performance period that ends on July 31, 2016, if pre-established performance goals are attained or as specified pursuant to the Plan and related agreement. As of October 31, 2013, the number of outstanding performance shares included in the above table, and the related compensation expense, assume achievement of the pre-established goals at a target level. During the three months ended October 31, 2013, our Board of Directors determined that the pre-established performance goals for 35,003 performance shares granted in fiscal 2012 had been attained and, as a result, the first tranche of 6,996 performance shares vested and converted into 3,496 net shares of our common stock, after reduction for 1,013 shares retained to satisfy minimum tax withholding and 2,487 shares for deferral requirements.

RSUs and restricted stock granted to non-employee directors have a vesting period of three years and are convertible into shares of our common stock generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain circumstances. RSUs granted to employees have a vesting period of five years and are convertible into shares of our common stock generally at the time of vesting, on a one-for-one basis for no cash consideration.

Share units are vested when issued and are convertible into shares of our common stock generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain circumstances.

No RSUs, restricted stock or share units granted to date have been converted into common stock.

The fair value of performance shares, RSUs, restricted stock and share units is determined using the closing market price of our common stock on the date of grant, less the present value of any estimated future dividend equivalents such awards are not entitled to receive. RSUs and performance shares granted in fiscal 2012 are not entitled to dividend equivalents. RSUs, performance shares and restricted stock granted in fiscal 2013 and 2014 are entitled to dividend equivalents unless forfeited before vesting occurs; however, performance shares granted in fiscal 2013 and 2014 are not entitled to such dividend equivalents until our Board of Directors has determined that the pre-established performance goals have been met. Share units granted prior to fiscal 2014 are not entitled to dividend equivalents. Share units granted in fiscal 2014 are entitled to dividend equivalents while the underlying shares are unissued.

Dividend equivalents are subject to forfeiture, similar to the terms of the underlying stock-based awards, and are payable in cash generally at the time of conversion of the underlying shares into our common stock. As of October 31, 2013 and July 31, 2013, accrued dividend equivalents were $32,000 and $7,000, respectively. Such amounts were recorded as a reduction to retained earnings.