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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ________ to ___________
Commission file number: 00-15997
FILENET CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 95-3757924
(State or other jurisdiction of (I.R.S. Employer
corporation or organization Identification No.)
3565 Harbor Boulevard, Costa Mesa, CA 92626
(Address of principal executive offices) (Zip code)
(714) 327-3400 .
(Registrant's telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the Registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer as defined in Rule
12b-2 of the Securities Exchange Act of 1934:
Yes |X| No |_|
As of November 13, 2003, there were 37,558,098 shares of the Registrant's common stock
outstanding.
FILENET CORPORATION
Index
Page
Number
PART I. FINANCIAL INFORMATION.......................................... 3
Item 1. Unaudited Condensed Consolidated Financial Statements ........ 3
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations .................................. 19
Item 3. Quantitative and Qualitative Disclosures about Market Risk..... 38
Item 4. Controls and Procedures........................................ 40
PART II. OTHER INFORMATION.............................................. 40
Item 1. Legal Proceedings.............................................. 40
Item 6. Exhibits and Reports on Form 8-K............................... 40
SIGNATURE ............................................................... 41
INDEX TO
EXHIBITS ............................................................... 42
2
PART I. FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements
FILENET CORPORATION
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
September 30, December 31,
2003 2002
ASSETS
Current assets:
Cash and cash equivalents $ 162,271 $ 130,154
Short-term investments 33,545 29,188
Accounts receivable, net 43,941 44,839
Inventories, net 1,244 2,568
Prepaid expenses and other current assets 14,130 13,317
Deferred income taxes 802 802
Total current assets 255,933 220,868
Property, net 28,359 34,641
Long-term investments 21,705 25,864
Goodwill 24,676 16,907
Intangible assets, net 8,169 3,029
Deferred income taxes 20,047 21,792
, Other assets 4,322 4,935
Total assets $ 363,211 $ 328,036
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable 10,484 7,706
Customer deposits 6,248 2,962
Accrued compensation and benefits 23,549 20,729
Unearned maintenance revenue 45,024 38,945
Other accrued liabilities 13,174 15,224
Total current liabilities 98,479 85,566
Unearned maintenance revenue and other liabilities 2,009 3,565
Commitments and contingencies (Note 9)
Stockholders' equity:
Preferred stock - $0.10 par value; 7,000,000 shares
authorized; none issued and outstanding
Common stock - $0.01 par value; 100,000,000 shares
authorized; 37,922,123 issued and 36,824,123
shares outstanding at September 30, 2003; and
37,014,512 shares issued and 35,916,512 shares
outstanding at December 31, 2002 218,339 206,676
Retained earnings 58,452 53,178
Accumulated other comprehensive income(loss) 499 (6,382)
Treasury stock, at cost; 1,098,000 shares (14,567) (14,567)
Net stockholders' equity 262,723 238,905
Total liabilities and stockholders' equity $ 363,211 $ 328,036
See accompanying notes to unaudited condensed consolidated financial statements.
3
FILENET CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
Three Months Ended Sept 30, Nine Months Ended Sept 30,
2003 2002 2003 2002
Revenue:
Software $ 35,320 $ 30,538 $ 104,397 $ 96,128
Customer support 41,162 37,838 121,024 111,682
Professional services and education 12,162 12,751 36,095 43,078
Hardware 745 1,975 2,039 6,682
Total revenue 89,389 83,102 263,555 257,570
Costs:
Software 3,800 2,484 10,416 7,239
Customer support 9,660 9,604 28,144 29,499
Professional services and education 10,586 11,361 32,001 38,003
Hardware 827 1,337 2,882 4,847
Total cost of revenue 24,873 24,786 73,443 79,588
Gross Profit 64,516 58,316 190,112 177,982
Operating expenses:
Sales and marketing 34,405 32,338 103,660 97,388
Research and development 19,049 17,764 58,031 53,993
In-process research and development - - - 400
General and administrative 8,241 7,455 24,393 24,248
Total operating expenses 61,695 57,557 186,084 176,029
Operating income 2,821 759 4,028 1,953
Other income, net 632 1,045 3,297 3,874
Income before income taxes 3,453 1,804 7,325 5,827
Provision for income taxes 967 415 2,051 1,340
Net income $ 2,486 $ 1,389 $ 5,274 $ 4,487
Earnings per share:
Basic $ 0.07 $ 0.04 $ 0.15 $ 0.13
Diluted $ 0.06 $ 0.04 $ 0.14 $ 0.12
Weighted-average shares outstanding:
Basic 36,588 35,629 36,234 35,511
Diluted 38,494 36,445 37,471 36,803
See accompanying notes to unaudited condensed consolidated financial statements.
4
FILENET CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS
(In thousands)
Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
Net income $ 2,486 $ 1,389 $ 5,274 $ 4,487
Other comprehensive income:
Foreign currency translation adjustments 1,582 156 6,942 5,147
Unrealized gains on securities:
Unrealized holding gains(loss) (23) 12 (61) 26
Total other comprehensive income 1,559 168 6,881 5,173
Comprehensive income $ 4,045 $ 1,557 $ 12,155 $ 9,660
See accompanying notes to unaudited condensed consolidated financial statements.
5
FILENET CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Nine Months Ended
September 30,
2003 2002
Cash flows from operating activities:
Net income $ 5,274 $ 4,487
Adjustments to reconcile net income to net cash
provided by operating activities:
Purchased in-process research and development - 400
Depreciation and amortization 14,759 16,160
Loss on sale of fixed assets 14 13
Provision for doubtful accounts 52 354
Deferred income taxes 1,746 16
Stock option income tax benefit 2,129 -
Changes in operating assets and liabilities,
net of the effects of acquisitions:
Accounts receivable 2,871 (5,526)
Inventories 1,373 417
Prepaid expenses and other current assets 2,423 (3,100)
Accounts payable 2,026 (861)
Accrued compensation and benefits 1,840 3,918
Customer deposits and advances 3,264 (1,781)
Unearned maintenance revenue 2,916 6,870
Income taxes payable (1,590) (1,199)
Other (3,304) (4,213)
Net cash provided by operating activities 35,793 15,955
Cash flows from investing activities:
Capital expenditures (6,809) (8,592)
Proceeds from sale of property 129 44
Note receivable from officer - (1,900)
Cash paid for acquisitions, net of cash acquired (8,073) (9,359)
Purchases of marketable securities (81,354) (103,529)
Proceeds from sales and maturities of marketable 77,805 94,621
securities
Net cash used in investing activities (18,302) (28,715)
Cash flows from financing activities:
Proceeds from issuance of common stock 9,485 3,875
Principal payments on capital lease obligations (5) (1,293)
Net cash provided by financing activities 9,480 2,582
Effect of exchange rate changes on cash and cash 5,146 4,138
equivalents
Net increase in cash and cash equivalents 32,117 (6,040)
Cash and cash equivalents, beginning of year 130,154 107,502
Cash and cash equivalents, end of period 162,271 101,462
Supplemental cash flow information:
Interest paid 36 65
Income taxes paid $ 2,221 $ 2,897
See accompanying notes to unaudited condensed consolidated financial statements.
6
FILENET CORPORATION
Notes To Condensed Consolidated Financial Statements
(Unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited interim condensed consolidated financial
statements of FileNet Corporation (the "Company" or "FileNet") reflect all
adjustments (consisting of normal recurring adjustments) necessary to
present fairly the financial position of the Company at September 30, 2003,
the results of its operations and its comprehensive operations for the
three and nine months ended September 30, 2003 and 2002, and its cash flows
for the nine months ended September 30, 2003 and 2002. Certain information
and footnote disclosures normally included in financial statements have
been condensed or omitted pursuant to rules and regulations of the
Securities and Exchange Commission (the "SEC"), although the Company
believes that the disclosures in the condensed consolidated financial
statements are adequate to ensure the information presented is not
misleading. These condensed consolidated financial statements should be
read in conjunction with the consolidated financial statements and notes
thereto contained in the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 2002 filed with the SEC on March 28, 2003.
The results of operations for the interim periods are not necessarily
indicative of the operating results for the year, or any other future
period.
2. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 141, "Business
Combinations," which was effective immediately. SFAS No. 141 requires that
the purchase method of accounting be used for all business combinations
initiated after June 30, 2001 and it eliminated the pooling-of-interests
method. The adoption of this standard did not have a significant impact on
the Company's consolidated financial statements. The Company's acquisition
of certain assets and certain liabilities of eGrail, Inc. in April 2002,
and the acquisition of Shana Corporation in April 2003 were accounted for
in compliance with this pronouncement (See Note 3 for details).
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets," which the Company adopted January 1, 2002. SFAS No. 142 requires
that goodwill and other intangible assets with indefinite useful lives no
longer be amortized, but instead be tested for impairment at least annually
and written down when impaired. SFAS No. 142 requires purchased intangible
assets other than goodwill to be amortized over their useful lives, unless
these lives are determined to be indefinite. In accordance with this
Standard, the Company does not amortize goodwill and indefinite life
intangible assets but evaluates their carrying value annually or when
events or circumstances indicate that their carrying value may be impaired.
As of the first day of July of each year, goodwill is tested for impairment
by determining if the carrying value of each reporting unit exceeds its
fair value. We engaged an independent valuation firm to determine the
business enterprise value for each of our three reporting units and to
perform an impairment analysis as of July 1, 2003 in accordance with SFAS
142. The analysis indicated there was no impairment of goodwill in any of
the three reporting units. As of September 30, 2003, no impairment of
goodwill has been recognized. If estimates change, a materially different
impairment conclusion could result.
In August 2001, the FASB issued SFAS No. 144, "Accounting for Impairment or
Disposal of Long-Lived Assets." This Statement addresses financial
accounting and reporting for the impairment of long-lived assets and for
the disposal of long-lived assets and discontinued operations. SFAS No. 144
superseded SFAS No. 121, "Accounting for the Impairment of Long-Lived
7
Assets and for Long-Lived Assets to Be Disposed Of," and is effective for
fiscal years beginning after December 15, 2001. The adoption of this
Standard on January 1, 2002 did not have a material impact on the Company's
consolidated financial position and results of operations.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which addresses financial
accounting and reporting for costs associated with exit or disposal
activities and supersedes Emerging Issues Task Force ("EITF") Issue 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." SFAS No. 146 requires that costs associated with exit or
disposal activities be recognized when they are incurred rather than at the
date of a commitment to an exit or disposal plan. SFAS No. 146 also
establishes that the liability should initially be measured and recorded at
fair value. The Company adopted the provisions of SFAS No. 146 for exit or
disposal activities initiated after December 31, 2002. The adoption of the
provisions of SFAS No. 146 in the three and nine months ended September 30,
2003 did not have a material impact on the Company's consolidated results
of operations or financial position.
In November 2002, the FASB issued FASB Interpretation No. ("FIN") 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees and Indebtedness of Others," an
interpretation of FASB Statement Nos. 5, 57 and 107, and rescission of FIN
34, "Disclosure of Indirect Guarantees of Indebtedness of Others." FIN 45
elaborates on the disclosures to be made by the guarantor in its interim
and annual financial statements about its obligations under certain
guarantees that it has issued. It also requires that a guarantor recognize,
at the inception of a guarantee, a liability for the fair value of the
obligation undertaken in issuing the guarantee. The provisions related to
recognizing a liability at inception of the guarantee for the fair value of
the guarantor's obligations does not apply to product warranties or to
guarantees accounted for as derivatives. The initial recognition and
measurement provisions of this interpretation are applicable on a
prospective basis to guarantees issued or modified after December 31, 2002,
while the disclosure requirements are effective for financial statements
for interim or annual periods ending after December 15, 2002. The adoption
of the recognition provisions of FIN 45 in the three and nine months ended
September 30, 2003 did not have a material impact on the Company's
consolidated results of operations or financial position.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation Transition and Disclosure." This statement amends SFAS No.
123, "Accounting for Stock-Based Compensation," to provide alternative
methods of transition for a voluntary change to the fair value based method
of accounting for stock-based employee compensation. In addition, this
statement amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial statements about
the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The transition guidance and
annual disclosure provisions of SFAS No. 148 are effective for fiscal years
ending after December 15, 2002. The interim disclosure provisions are
effective for financial reports containing financial statements for interim
periods beginning after December 15, 2002. The adoption of SFAS No. 148 did
not have a material impact on the Company's consolidated results of
operations or financial position.
8
The following table summarizes the Company's net income (loss) and net income
(loss) per share on a pro forma basis had compensation cost for the Company's
stock-based compensation plans been determined based on the provisions of SFAS
No. 123, for the three and nine months ended September 30, 2003 and 2002:
Three Months Ended Nine Months Ended
September 30, September 30,
(In thousands, except per share amounts) 2003 2002 2003 2002
Net income, as reported $ 2,486 $ 1,389 $ 5,274 $ 4,487
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards, net
of related tax effects (1,636) (1,987) (5,732) (6,547)
Pro forma net income (loss) 850 (598) (458) (2,060)
Earnings per share:
Basic earnings per share - as reported $ 0.07 $ 0.04 $ 0.15 $ 0.13
Basic earnings (loss) per share - pro forma 0.02 (0.02) (0.01) (0.06)
Diluted earnings per share - as reported 0.06 0.04 0.14 .12
Diluted earnings (loss) per share - pro forma $ 0.02 $ (0.02) $ (0.01) $ (0.06)
Pro forma compensation cost of shares issued under the Employee Qualified Stock
Purchase Plan is measured based on the discount from market value on the date of
purchase in accordance with SFAS No. 123. For purposes of computing proforma net
income, the Company estimates the fair value of each option grant and employee
stock purchase plan right on the date of grant using the Black-Scholes
option-pricing model. The Black-Scholes option-pricing model was developed for
use in estimating the value of traded options that have no vesting restrictions
and are fully transferable, while the options issued by the Company are subject
to both vesting and restrictions on transfer. In addition, option-pricing models
require input of highly subjective assumptions including the expected stock
price volatility. The Company uses projected data for expected volatility and
expected life of its stock options based upon historical data.
The assumptions used to value the option grants and the purchase rights are
stated as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
Expected term (in years) 2-5 2-5 2-5 2-5
Expected volatility 63% 70% 63 - 66% 70%
Risk free interest rates 3.15% 2.16 - 4.81% 3.15% 2.16 - 4.81%
Expected dividend 0% 0% 0% 0%
9
In January 2003, the FASB issued FIN 46, "Consolidation of Variable Interest
Entities." In general, a variable interest entity is a corporation, partnership,
trust, or any other legal structure used for business purposes that either (a)
does not have equity investors with voting rights or (b) has equity investors
that do not provide sufficient financial resources for the entity to support its
activities. FIN 46 requires a variable interest entity to be consolidated by a
company if that company is subject to a majority of the risk of loss from the
variable interest entity's activities or entitled to receive a majority of the
entity's residual returns or both. The consolidation requirements of FIN 46
apply immediately to variable interest entities created after January 31, 2003.
The consolidation requirements apply to older entities in the first fiscal year
or interim period beginning after June 15, 2003. Certain of the disclosure
requirements apply in all financial statements issued after January 31, 2003,
regardless of when the variable interest entity was established. The Company
does not have any variable interest entities as of September 30, 2003. The
adoption of FIN 46 did not have a material impact on the Company's consolidated
results of operations or its financial position.
In April 2003, FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 (1) clarifies under
what circumstances a contract with an initial net investment meets the
characteristics of a derivative discussed in paragraph 6(b) of Statement 133,
(2) clarifies when a derivative contains a financing component, (3) amends the
definition of an underlying derivative to conform it to language used in FIN 45,
and (4) amends certain other existing pronouncements, which will collectively
result in more consistent reporting of contracts as either derivatives or hybrid
instruments. SFAS No. 149 is effective for contracts and hedging relationships
entered into or modified after June 30, 2003. The adoption of SFAS No. 149 did
not have a material impact on the Company's consolidated financial statements or
financial position.
In May 2003, FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both debt and equity and requires
an issuer to classify the following instruments as liabilities in its balance
sheet:
o a financial instrument issued in the form of shares that is
mandatorily redeemable and embodies an unconditional obligation that
requires the issuer to redeem it by transferring its assets at a
specified or determinable date or upon an event that is certain to
occur;
o a financial instrument, other than an outstanding share, that embodies
an obligation to repurchase the issuer's equity shares, or is indexed
to such an obligation, and requires the issuer to settle the
obligation by transferring assets; and
o a financial instrument that embodies an unconditional obligation that
the issuer must settle by issuing a variable number of its equity
shares if the monetary value of the obligation is based solely or
predominantly on (1) a fixed monetary amount, (2) variations in
something other than the fair value of the issuer's equity shares, or
(3) variations inversely related to changes in the fair value of the
issuer's equity shares.
SFAS No. 150 is effective for financial instruments entered into or modified
after May 31, 2003 and is effective for all other financial instruments as of
the first interim period beginning after June 15, 2003. SFAS No. 150 is to be
implemented by reporting the cumulative effect of a change in accounting
principle. The adoption of SFAS No. 150 did not have a material impact on the
Company's consolidated financial statements or financial position.
Reclassifications. Certain reclassifications have been made to prior-years'
balances to conform to the current-year's presentation.
10
3. ACQUISITIONS
On April 2, 2002, the Company acquired certain assets and assumed certain
liabilities of eGrail, Inc. ("eGrail"), a Web content management company.
This strategic acquisition provides additional Web Content Management
("WCM") software application capabilities that expand the Company's
position in the Enterprise Content Management ("ECM") market, which
contributed to the purchase price that resulted in goodwill. The purchase
price for the acquisition consisted of $9.0 million in cash consideration
and direct acquisition costs of $359,000.
On April 2, 2003, the Company completed a stock purchase acquisition of
Shana Corporation ("Shana"), an electronic forms management company. This
strategic acquisition provides technology and experience to expand the
Company's ECM offering with Enterprise Forms Management capability, which
contributed to the purchase price and resulted in goodwill. The purchase
price for the acquisition consisted of $8.55 million in cash consideration,
less $938,000 of acquired cash, plus $184,000 in acquisition expenses and
$277,000 paid for Non-Compete Agreements.
In accordance with SFAS No. 141, "Business Combinations," these
acquisitions were accounted for under the purchase method of accounting.
The purchase price was allocated as follows:
eGrail, Inc. Shana Corp.
April 2, 2002 April 2, 2003
(In thousands)
Net tangible assets $ 581 $ 2,725
Patents 24 -
Acquired technology 3,300 4,000
Technical manuals and design documents - 600
Customer maintenance relationships - 800
In-process research and development 400 -
Non-Compete Agreements - 277
Liabilities assumed (739) (2,494)
Goodwill 5,793 3,103
Total purchase price $ 9,359 $ 9,011
Less cash acquired - (938) .
Net cash paid $ 9,359 $ 8,073
The Company allocated the purchase price for these acquisitions based on
fair value. Statement of Financial Accounting Concepts No. 7 defines fair
value as the amount at which an asset (or liability) could be bought or
sold in a current transaction between willing parties, that is, other than
in a forced or liquidation sale.
The valuation of the eGrail assets included $400,000 of in-process research
and development, which was expensed upon acquisition because technological
feasibility had not been established and no future alternative uses
existed. New product development underway at eGrail at the time of the
acquisition included the next generation of their WCM product that was in
the early stages of design and only 5% complete at the date of the
acquisition. The cost to complete the project was estimated at
approximately $3.0 million to occur over a 12-month period. As of March 31,
2003 the project was complete and the Company incurred approximately $4.8
million of research and development expenses related to the project. The
acquired technology of $3.3 million was assigned a useful life of five
years and patents of $24,000 were assigned a useful life of two years. The
remaining purchase price of $6.0 million was primarily allocated to
tangible assets and goodwill. Goodwill of $5.8 million was tax deductible
for this asset purchase.
11
The acquisition of Shana resulted in acquired technology, technical manuals
and design documents, and customer maintenance relationships. Since Shana
had recently completed Version 4.1 of its eForms product, there was no
in-process research and development underway at the time of the
acquisition. Shana's technology manuals and design documents are the
"roadmaps" for the eForms technology and will be used by FileNet in its
product development. Recurring maintenance revenues are expected and
estimable for Shana's customers based on the older and newer versions of
eForms technology. The acquired technology of $4.0 million, the technical
manuals and design documents of $600,000, and the customer maintenance
relationships of $800,000 were assigned a useful life of five years. The
remaining purchase price of $3.6 million was allocated primarily to
goodwill.
In accordance with SFAS No. 142, goodwill for both the eGrail and Shana
acquisitions will not be amortized and was reviewed for impairment as part
of the annual analysis performed in July. (See Note No. 4.) Although the
goodwill stemming from the Shana stock purchase is non-deductible for
Canadian tax purposes, a Section 338(g) election will result in the
reduction of taxable income for U.S. tax purposes on this transaction.
Actual results of operations of the acquired eGrail business, as well as
assets and liabilities of the acquired eGrail business, are included in the
unaudited condensed consolidated financial statements from the date of
acquisition. The pro forma results of operations data for the nine-month
periods ended September 30, 2002 presented below assumes that the eGrail
acquisition had been made at the beginning of fiscal 2002. The pro forma
data is presented for informational purposes only and is not necessarily
indicative of the results of future operations nor of the actual results
that would have been achieved had the acquisition taken place at the
beginning of fiscal 2002. No pro forma information has been presented for
the Shana acquisition, as the result did not have a material impact on the
financial statements of the Company during the reporting period.
Nine Months Ended
September 30,
2003 Actual 2002 Pro Forma
(In thousands)
Revenue $ 263,555 $ 258,322
Net income 5,274 2,634
Earnings per share:
Basic $ 0.15 $ 0.07
Diluted $ 0.14 $ 0.07
4. GOODWILL AND PURCHASED INTANGIBLE ASSETS
In acquisitions accounted for using the purchase method, goodwill is
recorded for the difference, if any, between the aggregate consideration
paid for an acquisition and the fair value of the net tangible and
identified intangible assets acquired. SFAS No. 142 requires a periodic
review of goodwill and indefinite life intangibles for possible impairment.
(See Note No.2) Intangible assets with definite lives must be amortized
over their estimated useful lives. Shana goodwill and intangible assets
were recorded in the financial statements of the Company's Canadian
subsidiary and a portion of the goodwill and intangible assets for previous
acquisitions was allocated to the financial statements of the Company's
Ireland subsidiary. This results in fluctuations in foreign exchange
translation gains and losses. The following table represents the balance of
goodwill as of December 31, 2002 and the changes in goodwill for the nine
months ended September 30, 2003:
12
Goodwill (in thousands)
Balance as of December 31, 2002 $ 16,907
Goodwill acquired during the period 3,103
Adjustments 3,498
Foreign currency gain 1,168
Balance as of September 30, 2003 $ 24,676
Adjustments to goodwill included $1.7 million for the write-off of a
prepaid royalty and the recognition of a $1.7 million deferred tax asset.
Prior to the Shana acquisition, FileNet licensed the eForms technology from
Shana under an agreement that resulted in a prepaid royalty. The remaining
balance of this prepaid royalty fee was considered additional investment in
Shana and was allocated to goodwill. A deferred tax asset was recorded
under purchase accounting for the estimated future tax effects of the
identified intangibles with a corresponding entry to goodwill of $1.7
million.
Acquired technology, technical manuals and design documents, customer
maintenance relationships, non-compete agreements and patents are the
Company's only intangible assets subject to amortization under SFAS No.
142. These assets were recorded in connection with the acquisition of
assets of eGrail in April 2002 and the acquisition of Shana in April 2003,
and are comprised of the following as of December 31, 2002 and September
30, 2003:
Intangible Assets Subject to Amortization
Foreign
Balance as of December 31, 2002 Accumulated Currency
(In thousands) Gross Amortization Fluctuation Net
Acquired technology and other intangibles $ 3,468 $ (532) $ 79 $ 3,015
Non-compete agreements - - - -
Patents 25 (12) 1 14
Total $ 3,493 $ (544) $ 80 $ 3,029
Foreign
Balance as of September 30, 2003 Accumulated Currency
(In thousands) Gross Amortization Fluctuation Net
Acquired technology and other intangibles $ 8,868 $ (1,705) $ 756 $ 7,919
Non-compete agreements 277 (58) 27 246
Patents 25 (23) 2 4
Total $ 9,170 $ (1,786) $ 785 $ 8,169
NOTE - other intangibles include technical manuals and customer maintenance
relationships.
13
Acquired technology, technical manuals and design documents, and customer
maintenance relationships are being amortized over a useful life of five
years, patents are being amortized over a useful life of two years, and the
non-compete agreements are being amortized over a period of between two and
three years. Amortization expense for amortizing intangible assets was
approximately $500,000 and $1,177,000 for the three and nine months ended
September 30, 2003, and $176,000 and $344,000 for the three and nine months
ended September 30, 2002. We determined that these assets were not impaired
as of September 30, 2003.
Estimated future amortization expense (excluding foreign exchange effect)
of purchased intangible assets as of September 30, 2003 is as follows (in
thousands):
Fiscal Year Amount
2003 (remaining 3 months) $ 514
2004 2,041
2005 2,008
2006 1,942
2007 1,368
2008 296
Total Amortization Expense $ 8,169
5. EARNINGS PER SHARE
Basic earnings per share are computed by dividing net income for the period
by the weighted-average number of common shares outstanding during the
period. Diluted earnings per share is computed by dividing net income by
the weighted-average number of common shares outstanding plus the dilutive
effect of outstanding stock options and shares issuable under the employee
stock purchase plan using the treasury stock method. The number of dilutive
options excluded from the basic EPS calculation for the three and nine
months ended September 30, 2003 were 1,906,000 and 1,237,000 shares,
compared to 816,000 and 1,292,000 for the comparable periods in 2002. The
following table sets forth the computation of basic and diluted earnings
per share for the three and nine months ended September 30, 2003 and 2002:
Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
(In thousands, except per share amounts)
Net Income $ 2,486 $ 1,389 $ 5,274 $ 4,487
Shares used in computing
basic earnings per share 36,588 35,629 36,234 35,511
Dilutive effect of stock plans 1,906 816 1,237 1,292
Shares used in computing
diluted earnings per share 38,494 36,445 37,471 36,803
Earnings per basic share $ .07 $ .04 $ .15 $ .13
Earnings per diluted share $ .06 $ .04 $ .14 $ .12
14
6. ACCUMULATED OTHER COMPREHENSIVE LOSS
Accumulated other comprehensive income for the nine months ended September
30, 2003 is comprised of the following:
Foreign
Currency Unrealized Accumulated Other
Translation Holding Comprehensive
(In thousands) Adjustment Gain(Loss) Gain(Loss)
Balance, December 31, 2002 $ (6,448) $ 66 $ (6,382)
Nine month period changes 6,942 (61) 6,881
Balance, September 30, 2003 $ 494 $ 5 $ 499
7. OPERATING SEGMENT DATA
The Company has prepared operating segment information in accordance with
SFAS No. 131, "Disclosures About Segments of An Enterprise and Related
Information," to report components that are evaluated regularly by the
Company's chief operating decision maker, or decision-making group, in
deciding how to allocate resources and in assessing performance. The
Company is organized geographically and by line of business. The line of
business management structure is the primary basis upon which financial
performance is assessed and resources allocated.
The Company's reportable operating segments include Software, Customer
Support, Professional Services and Education, and Hardware. The Software
operating segment develops and markets the Company's Enterprise Content,
Business Process and Forms Management software products. The Customer
Support segment provides after-sale support for software, as well as
providing software upgrades when and if available pursuant to the Company's
right to new versions program. The Professional Services and Education
segment provides fee-based implementation and technical services related to
the Company's software products, and also provides training. The Hardware
operating segment manufactures and markets the Company's line of Optical
Storage And Retrieval ("OSAR") libraries.
The financial results of the segments reflect allocation of certain
functional expense categories consistent with the basis and manner in which
Company management internally disaggregates financial information for the
purpose of assisting in making internal operating decisions, which is not
the same as generally accepted accounting principles reporting. The Company
evaluates performance based on stand-alone segment operating results after
these allocations have been made to each segment.
Because the Company does not evaluate performance based on the return on
assets at the operating segment level, assets are not tracked internally by
segment. Therefore, segment asset information is not presented.
15
Operating segments data for the three and nine months ended September 30,
2003 and 2002 are as follows:
In thousands Three months ended Nine months ended
September 30, September 30,
2003 2002 2003 2002
Software
Revenue $ 35,320 $ 30,538 $ 104,397 $ 96,128
Operating loss (15,028) (14,822) (46,891) (40,272)
Customer Support
Revenue $ 41,162 $ 37,838 $ 121,024 $ 111,682
Operating income 17,885 16,156 51,889 44,343
Professional Services and Education
Revenue $ 12,162 $ 12,751 $ 36,095 $ 43,078
Operating loss 13 (742) (553) (2,421)
Hardware
Revenue $ 745 $ 1,975 $ 2,039 $ 6,682
Operating income (loss) (49) 167 (417) 303
Total
Revenue $ 89,389 $ 83,102 $ 263,555 $ 257,570
Operating income 2,821 759 4,028 1,953
8. STOCK OPTIONS
The following is a summary of stock option transactions regarding all stock option plans for the three
months ended September 30, 2003:
Weighted-Average
Number of Exercise
Options Price
Balance, June 30, 2003 8,587,463 $ 15.22
Granted (weighted-average fair value of $9.19) 202,900 19.97
Exercised (457,298) 11.58
Canceled (104,900) 15.64
Balance, September 30, 2003 8,228,165 $ 15.53
16
The following table summarizes information concerning outstanding and exercisable stock options at
September 30, 2003:
Options Outstanding Options Exercisable
Weighted-Average
Remaining Weighted-Average Weighted-Average
Range of Exercise Number Contractual Exercise Number Exercise
Price Outstanding Life (Years) Price Exercisable Price
$ 1.39 - 9.00 1,420,896 4.12 $ 7.97 1,420,646 $ 7.97
9.17 - 12.86 1,655,694 7.62 11.97 790,612 11.21
12.97 - 14.19 1,551,055 7.59 13.47 751,516 13.59
14.39 - 18.45 1,534,449 7.52 16.77 781,122 16.60
19.53 - 24.88 1,438,979 6.97 22.52 1,089,018 22.78
25.00 - 41.84 627,092 5.81 28.14 555,878 28.22
$ 1.39 - 41.84 8,228,165 6.74 $ 15.53 5,388,792 $ 15.56
9. COMMITMENTS AND CONTINGENCIES
Leases
The Company leases its corporate offices, sales offices, development and
manufacturing facilities, and other equipment under non-cancelable
operating leases, some of which have renewal options and generally provide
for escalation of the annual rental amount. Amounts related to deferred
rent are recorded in other accrued liabilities on the consolidated balance
sheet. Future annual minimum lease payments under all non-cancelable
operating leases with an initial term in excess of one year as of September
30, 2003 were as follows:
(In thousands)
2003 (remaining 3 months) $ 3,670
2004 12,388
2005 10,775
2006 9,993
2007 9,325
2008 8,197
Thereafter 6,548
Total $ 60,896
Product Warranties
The Company provides a 90-day warranty for its hardware products against
defects in materials and workmanship and for its software products against
substantial nonconformance to the published documentation at time of
delivery. For hardware products the Company accrues warranty costs based on
historical trends in product return rates and the expected material and
labor costs to provide warranty services. For software products, the
Company records the estimated cost of technical support during the warranty
period. A provision for these estimated warranty costs is recorded at the
time of sale or license. If the Company were to experience an increase in
warranty claims compared with historical experience, or costs of servicing
warranty claims were greater than the expectations on which the accrual had
been based, gross margins could be adversely affected.
17
The following table represents the warranty activity and balance for the
nine months ended September 30, 2003 and 2002:
(In thousands) 2003 2002
Beginning balance at January 1 $ 728 $ 772
Additions 678 856
Deductions (916) (904)
Ending balance at September 30 $ 490 $ 724
Guarantees and Indemnities
In November 2002, the FASB issued FIN 45, "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others." The initial recognition and initial measurement
provisions apply on a prospective basis to guarantees issued or modified
after December 15, 2002. The disclosure requirements are effective for
financial statements of interim and annual periods ending after December
15, 2002.
The Company has made guarantees and indemnifications, under which it may be
required to make payments to a guaranteed or indemnified party, in relation
to certain transactions. In connection with the sales of its products, the
Company provides intellectual property indemnities to its customers.
Guarantees and indemnities to customers in connection with product sales
and service generally are subject to limits based upon the amount of the
related product sales or service. Payment by the Company is conditioned
upon the other party filing a claim pursuant to the terms and conditions of
the agreement. The Company may challenge this claim and may also have
recourse against third parties for certain payments made by the Company.
Predicting the maximum potential future payment under these agreements is
not possible due to the unique facts and circumstances involved with each
agreement. Historically, the Company has made no payments under these
agreements.
In connection with certain facility leases and other performance
guarantees, the Company has guaranteed payments on behalf of some of its
subsidiaries. To provide subsidiary guarantees, the Company obtains
unsecured bank guarantees from local banks. These bank guarantees totaled
an equivalent of approximately $1.3 million issued in local currency in
Europe and Asia as of September 30, 2003. Approximately $0.4 million of the
$1.3 million is secured by cash deposit.
The Company indemnifies its directors and officers to the maximum extent
permitted under the laws of the State of Delaware.
The Company has not recorded a liability for the guarantees and indemnities
described above in the accompanying consolidated balance sheet and the
maximum amount of potential future payments under such guarantees and
indemnities is not determinable, other than as described above. The
Company's product warranty liability as of September 30, 2003 is disclosed
in this item under the heading "Product Warranties."
10. LEGAL PROCEEDINGS
In the normal course of business, the Company is subject to ordinary
routine litigation and claims incidental to business. While the results of
litigation and claims cannot be predicted with certainty, management
believes that the final outcome of these matters will not have a materially
adverse effect on the Company's consolidated results of operations or
financial condition.
18
11. FOREIGN CURRENCY TRANSACTIONS
As of September 30, 2003, the Company had forward foreign exchange
contracts outstanding totaling approximately $ 0.9 million in 10
currencies. These contracts were opened on the last business day of the
quarter and mature within three months. Accordingly, the fair value of such
contracts is zero at September 30, 2003.
12. RELATED-PARTY TRANSACTIONS
In July 2001, the Compensation Committee of the Company's Board of
Directors ("the Board") entered into discussions with Lee Roberts, the
Company's Chief Executive Officer, regarding a secured loan by the Company
to Mr. Roberts to enable him to purchase a home in Orange County,
California. In July 2001, the Compensation Committee forwarded its
recommendation to the Board to approve, in principle, a secured loan, in
the amount of $1.2 million to Mr. Roberts. In September 2001, the
Compensation Committee approved, in principle, an increase in the
previously requested loan amount to $1.9 million, subject to review of
final loan documents and approval of the Board. In May 2002, the
Compensation Committee reviewed proposed loan documentation for a secured
loan to Mr. Roberts and forwarded its recommendation to the Board to
approve the loan on the terms set forth in the loan documents. The loan
documents provided that the loan would be secured by the real estate
purchased by Mr. Roberts. Subsequently, on June 5, 2002, the Board approved
the loan documents and the loan. As of September 30, 2003, FileNet has an
outstanding secured note receivable from Mr. Roberts in the amount of $1.9
million that relates to the above-referenced loan and is included in other
assets on the consolidated balance sheet. The note bears interest at 2.89%
per annum. Accrued interest on the principal balance of this note is
payable annually beginning February 15, 2003 and on each February 15th
thereafter until the entire principal balance becomes due. Accrued interest
as of September 30, 2003 was approximately $34,000. The entire outstanding
principal balance of this note and any accrued interest is due and payable
at the earliest of (a) June 7, 2005, (b) one year after termination of Mr.
Roberts' employment by the Company, or (c) ninety (90) days after voluntary
termination of employment by Mr. Roberts. Imputed interest for the
difference between the stated interest rate of the note and a fair value
interest rate of 7% was recorded as compensation expense and a discount
that is being amortized over the term of the note to interest income using
the effective interest method. The loan to Mr. Roberts is permitted under
Section 13 of the Securities Exchange Act of 1934, as amended by Section
402 of the Sarbanes-Oxley Act on July 30, 2002, because it was outstanding
on July 30, 2002. However, its terms cannot be renewed or materially
modified in the future.
John Savage, a member of the Board of Directors and the Audit Committee of
the Board, is Managing Partner of Alliant Partners, which acted as
financial advisor to eGrail in connection with our acquisition of assets
from eGrail and was paid approximately $500,000 by eGrail. Accordingly,
John Savage recused himself from all discussions related to the acquisition
of eGrail assets by the Company and abstained from voting on the
transaction.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995,
Section 21E of the Securities and Exchange Act of 1934, as amended, and
Section 27A of the Securities Act of 1933, as amended, and is subject to
the safe harbors created by those sections. Words such as "anticipates,"
"expects," "intends," "plans," "believes," "seeks," "estimates," "may,"
"will" and variations of these words or similar expressions are intended to
identify forward-looking statements. In addition, any statements that refer
to expectations, projections or other characterizations of future events or
19
circumstances, including any underlying assumptions, are forward-looking
statements. These statements are not guarantees of future performance and
are subject to risks, uncertainties and assumptions that are difficult to
predict. Therefore, our actual results could differ materially and
adversely from those expressed in any forward-looking statements as a
result of various factors. We undertake no obligation to revise or publicly
release the results of any revisions to these forward-looking statements.
Readers should carefully review the risk factors described below under the
heading "Risk Factors That May Affect Future Results" and in other
documents we file from time to time with the Securities and Exchange
Commission, including our Annual Report on Form 10-K for the fiscal year
ended December 31, 2002. Our filings with the Securities and Exchange
Commission, including our Annual Reports on Form 10-K, Quarterly Reports on
Form 10-Q, Current Reports on Form 8-K and amendments to those filings,
pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of
1934, are available free of charge at www.filenet.com, when such reports
are available at the Securities and Exchange Commission Web site.
Overview
FileNet Corporation develops, markets, sells and supports Enterprise
Content Management ("ECM") software to enable organizations to improve
operational efficiency and leverage their content, process and connectivity
resources to make decisions faster. In the first quarter of 2003, we
introduced FileNet P8, our new architecture that provides a unified
platform and framework for ECM. The FileNet P8 architecture is designed to
provide an integrated solution for our customers to easily configure,
design, build and deploy a variety of enterprise-wide ECM applications to
meet a broad range of content management needs within a single scalable
framework. We also offer professional services and training for the
implementation of these software solutions, as well as 24 hours a day,
seven days a week technical support and services to our customers on a
global basis.
Critical Accounting Policies and Estimates
The consolidated financial statements of FileNet are prepared in conformity
with accounting principles generally accepted in the United States of
America. The consolidated financial statements include our accounts and the
accounts of our wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated. 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 at the date of
the financial statements and the reported amounts of revenue and expenses
during the reporting period. Actual amounts could differ from estimates.
The significant accounting policies we believe are most critical to aid in
fully understanding and evaluating our reported financial results include
the following:
Revenue Recognition. FileNet accounts for the licensing of software in
accordance with the American Institute of Certified Accountants ("AICPA")
Statement of Position ("SOP") 97-2, "Software Revenue Recognition." We
enter into contracts for the sale of our products and services.
The majority of these contracts relate to single elements and contain
standard terms and conditions. However, there are agreements that contain
multiple elements or non-standard terms and conditions. Contract
interpretation is sometimes required to determine the appropriate
accounting, including how the price should be allocated among the
deliverable elements and when to recognize revenue.
Software license revenue generated from sales through direct and indirect
channels, which do not contain multiple elements, are recognized upon
shipment and passage of title of the related product, if the requirements
of SOP 97-2, are met. If the requirements of SOP 97-2, including evidence
of an arrangement, delivery, fixed or determinable fee, collectibility or
vendor specific evidence about the value of an element are not met at the
date of shipment, revenue is not recognized until these elements are known
or resolved. Fees are deemed to be fixed and determinable for transactions
20
with a set price that is not subject to refund or adjustment and payment is
due within 90 days from the invoice date. Software license revenue from
channel partners is recognized when the product is shipped and sale by the
channel partner to a specified end user is confirmed.
For arrangements with multiple elements, we allocate revenue to each
element of a transaction based upon its fair value as determined in
reliance on vendor specific objective evidence. This evidence of fair value
for all elements of an arrangement is based on the normal pricing and
discounting practices for those products and services when sold separately.
If fair value of any undelivered element cannot be determined objectively,
we defer the revenue until all elements are delivered, services have been
performed or until fair value can objectively be determined.
Customer support contracts are renewable on an annual basis and provide
after-sale support for our software, as well as software upgrades under the
our right to new versions program, on a when-and-if-available basis.
Revenue from post-contract customer support is recognized ratably over the
term of the arrangement, which is typically 12 months.
Professional services revenue consists of consulting and implementation
services provided to end users of our software products and technical
consulting services provided to our resellers. Consulting engagements
average from one to three months. We do not make changes to the standard
software code in the field. Revenue from these services and from training
classes is recognized as such services are delivered and accepted by the
customer. Revenue and cost is recognized using the percentage-of-completion
method for fixed-price consulting contracts. However, revenue and profit
are subject to revision as the contract progresses and anticipated losses
on fixed-price professional services contracts are recognized in the period
when they become known.
Allowance for Doubtful Accounts and Sales Returns. We evaluate the
creditworthiness of our customers prior to order fulfillment, and we
perform ongoing credit evaluations of our customers to adjust credit limits
based on payment history and the customer's current creditworthiness. We
constantly monitor collections from our customers and maintain an allowance
for estimated credit losses that is based on historical experience and on
specific customer collection issues. While credit losses have historically
been within our expectations and the provisions established in our
financial statements, we cannot guarantee that we will continue to
experience the same credit loss rates that we have in the past. Since our
revenue recognition policy requires customers to be creditworthy, our
accounts receivable are based on customers whose payment is reasonably
assured. Our accounts receivable are derived from sales to a wide variety
of customers.
We do not believe a change in liquidity of any one customer or our
inability to collect from any one customer would have a material adverse
impact on our consolidated financial position. Based on historical
experience, we also maintain a sales return allowance for the estimated
amount of potential returns. While product returns have historically been
minimal and within our expectations and the allowances established by us,
we cannot guarantee that we will continue to experience the same return
rates that we have in the past.
Goodwill and Other Intangible Assets. Goodwill is recorded at cost and is
not amortized. In June 2001, the FASB issued SFAS No. 142, "Goodwill and
Other Intangible Assets," which we adopted January 1, 2002. SFAS No. 142
requires that goodwill and other intangible assets with indefinite useful
lives no longer be amortized, but instead be tested for impairment at least
annually and written down when impaired. On the first day of July of each
year, goodwill is tested for impairment by determining if the carrying
value of each reporting unit exceeds its fair value. We also periodically
evaluate whether events and circumstances have occurred which indicate that
the carrying value of goodwill may not be recoverable. The Company engaged
an independent valuation firm to determine the business enterprise value
for each of our three reporting units and to perform an impairment analysis
as of July 1, 2003 in accordance with SFAS 142. The analysis indicated
21
there was no impairment of goodwill in any of the three reporting units. As
of September 30, 2003, no impairment of goodwill has been recognized. If
estimates change, a materially different impairment conclusion could
result.
Long-Lived Assets. Property, plant and equipment, intangible assets, and
capitalized software costs are recorded at cost less accumulated
depreciation or amortization. They are amortized using the straight-line
method over estimated useful lives of generally three to six years. The
determination of useful lives and whether or not these assets are impaired
involves judgment and are reviewed for impairment whenever events or
circumstances indicate that the carrying amount of such assets may not be
recoverable. We evaluate the carrying value of long-lived assets and
certain identifiable intangible assets for impairment of value based on
undiscounted future cash flows resulting from the use of the asset and its
eventual disposition. While we have not experienced impairment of
intangible assets in prior periods, we cannot guarantee that there will not
be impairment in the future.
Deferred Income Taxes. Deferred income taxes reflect the net tax effects of
temporary differences between the carrying amounts of assets and
liabilities for financial reporting purposes and the amounts used for
income tax purposes. We maintain a valuation allowance against a portion of
the deferred tax asset due to uncertainty regarding the future realization
based on historical taxable income, projected future taxable income, and
the expected timing of the reversals of existing temporary differences. If
we operate at a loss or are unable to generate sufficient future taxable
income we could be required to increase the valuation allowance against all
or a significant portion of our deferred tax assets which would result in a
substantial increase to our effective tax rate and could result in a
material adverse impact on our operating results. Conversely, if we
continues to generate profits and ultimately determines that it is more
likely than not that all or a portion of the remaining deferred tax assets
will be utilized to offset future taxable income, the valuation allowance
could be decreased or eliminated all together, thereby resulting in a
substantial temporary decrease to our effective tax rate and an increase to
additional paid in capital.
Research and Development Costs. We expense research and development costs
as incurred. No amounts are required to be capitalized in accordance with
SFAS No. 86, "Accounting for the Costs of Computer Software to be Sold,
Leased, or Otherwise Marketed," because our software is substantially
completed concurrently with the establishment of technological feasibility.
22
Results of Operations
The following table sets forth certain consolidated statements of
operations data as a percentage of total revenue for the periods indicated:
Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
Revenue:
Software 39.5% 36.7% 39.6% 37.3%
Customer support 46.1 45.5 45.9 43.4
Professional services and education 13.6 15.4 13.7 16.7
Hardware 0.8 2.4 0.8 2.6
Total revenue 100.0 100.0 100.0 100.0
Cost of revenue:
Software 4.3 3.0 4.0 2.8
Customer support 10.8 11.5 10.7 11.4
Professional services and education 11.8 13.7 12.1 14.8
Hardware 0.9 1.6 1.1 1.9
Total cost of revenue 27.8 29.8 27.9 30.9
Gross Profit 72.2 70.2 72.1 69.1
Operating expenses:
Sales and marketing 38.5 38.9 39.3 37.8
Research and development 21.3 21.4 22.0 21.0
In-process research and development - - - 0.1
General and administrative 9.2 9.0 9.3 9.4
Total operating expenses 69.0 69.3 70.6 68.3
Operating income 3.2 .9 1.5 .8
Other income, net 0.7 1.3 1.3 1.5
Income before income tax 3.9% 2.2% 2.8% 2.3%
23
Revenue
Total revenue for the three months ended September 30, 2003 was $89.4
million compared to $83.1 million for the three months ended September 30,
2002, an increase of $6.3 million, or 8%. Total revenue for the nine months
ended September 30, 2003 was $263.6 million compared to $257.6 million for
the nine months ended September 30, 2002, an increase of $6.0 million, or
2%. International revenue for the three and nine months ended September 30,
2003 was 24% and 29% of total revenue, compared to 29% and 28% for the
three and nine months ended September 30, 2002. The increases in total
revenue for the three-month and nine-month periods ended September 30, 2003
as compared to the same periods in 2002, resulted from increases in
software and customer support revenue partially offset by decreases in
professional services and hardware revenue. These trends are more fully
discussed and explained below.
Software: Software revenue consists of fees earned from the licensing of
our software products to customers. Software revenue increased $4.8
million, or 16%, to $35.3 million for the three months ended September 30,
2003, from $30.5 million for the three months ended September 30, 2002.
Software revenue increased $8.3 million, or 9%, to $104.4 million for the
nine months ended September 30, 2003, from $96.1 million for the nine
months ended September 30, 2002. Software revenue represented 40% and 37%
of total revenue for the three months ended September 30, 2003 and
September 30, 2002, respectively. Software revenue represented 37% of total
revenue for the nine months ended September 30, 2003 and September 30,
2002, respectively.
The increase in software revenue is the result of a combination of larger
transactions, continued sales of additional software licenses to existing
customers in our key vertical industries of financial services and
insurance, and heightened demand for our content management and business
process product offerings. We believe enterprise content management
continues to be a priority for companies in our key vertical industries. If
overall economic conditions strengthen and if technology spending increases
as a consequence of this improvement, we anticipate that demand for our
software products, particularly in our key vertical industries, will result
in an increase.
Customer Support: Customer support revenue consists of revenue from
software maintenance contracts, "fee for service" revenue and the sale of
spare parts and supplies. Customer support revenue increased $3.3 million,
or 9%, to $41.1 million for the three months ended September 30, 2003 from
$37.8 million for the three months ended September 30, 2002. Customer
support revenue increased $9.3 million, or 8%, to $121.0 million for the
nine months ended September 30, 2003 from $111.7 million for the nine
months ended September 30, 2002. Customer support revenue represented 46%
and 45% of total revenue for the three months ended September 30, 2003 and
September 30, 2002, respectively. Customer support revenue represented 46%
of total revenue for the nine months ended September 30, 2003 compared to
43% for the comparable period of 2002.
The increase in customer support revenue was primarily due to the growth in
our base of customers who receive ongoing maintenance as a result of new
and add-on customer software sales made during the three months ended
September 30, 2003. Our solutions tend to be mission critical applications
for our customers and consequently we have experienced a high rate of
renewal on maintenance contracts from our customer base. However, over time
the growth rate for customer support revenue is dependent on our success in
achieving software revenue growth and high rates of customer satisfaction.
Professional Services and Education: Professional services and education
revenue is generated primarily from consulting and implementation services
provided to end users of our software products, technical consulting
services provided to our resellers and training services provided to end
users and resellers. Professional services are performed on a time and
material basis or under a fixed price contract. Professional services and
education revenue decreased $0.6 million, or 5%, to $12.2 million for the
24
three months ended September 30, 2003 from $12.8 million for the three
months ended September 30, 2002. Professional services and education
revenue decreased $7.0 million, or 16%, to $36.1 million for the nine
months ended September 30, 2003 from $43.1 million for the nine months
ended September 30, 2002. Professional services and education revenue
represented 14% and 15% of total revenue for the three months ended
September 30, 2003 and September 30, 2002, respectively. Professional
services and education revenue represented 14% of total revenue for the
nine months ended September 30, 2003 compared to 17% for the comparable
period in 2002.
Professional services revenue and education revenue is dependent on the
level and the nature of software sales over time. Generally, software sales
for new customer system implementations will generate larger professional
service consulting engagements and training enrollments than sales of
additional licenses to existing customer installations. In our recent
quarters, software revenue has been characterized by repeat purchases for
additional software licenses that do not require large-scale professional
services engagements. Additionally, the professional service market in
general has experienced significant pricing pressure resulting in reduced
revenue. These factors have reduced professional services and education
revenue. However, as more fully discussed in the software revenue section,
if software sales increase to our installed base and new customers, we
would expect that demand for consulting and education would increase over
the next several quarters.
Hardware: Hardware revenue is generated primarily from the sale of 12-inch
Optical Storage And Retrieval ("OSAR") libraries. Hardware revenue
decreased $1.3 million, or 65%, to $0.7 million for the three months ended
September 30, 2003 from $2.0 million for the three months ended September
30, 2002. Hardware revenue decreased $4.7 million, or 70%, to $2.0 million
for the nine months ended September 30, 2003 from $6.7 million for the nine
months ended September 30, 2002. Hardware revenue represented slightly less
than 1% of total revenue for the three months ended September 30, 2003,
compared to 2% for the comparable period of 2002. Hardware revenue
represented less than 1% of total revenue for the nine months ended
September 30, 2003, compared to 3% for the comparable period of 2002. The
decline in hardware revenue reflects that hardware is not a strategic focus
for us, and we expect hardware revenue to continue to decrease in the
future.
Cost of Revenue
Total cost of revenue increased $0.1 million, or less than 1%, to $24.9
million for the three months ended September 30, 2003, from $24.8 million
for the comparable period in 2002. Total cost of revenue decreased $6.2
million, or 8%, to $73.4 million for the nine months ended September 30,
2003, from $79.6 million for the comparable period in 2002. The decrease
for the nine-month period is primarily due to the decrease in the cost of
professional services and education revenue and hardware revenue as more
fully discussed below.
Software: Cost of software revenue includes royalties paid to third
parties, amortization expense for acquired technology and other intangible
assets, partner commissions, software media costs, and the cost to
manufacture and distribute software. The cost of software revenue increased
$1.3 million, or 52%, to $3.8 million for the three months ended September
30, 2003 from $2.5 million for the three months ended September 30, 2002.
The cost of software revenue increased $3.2 million, or 44%, to $10.4
million for the nine months ended September 30, 2003 from $7.2 million for
the nine months ended September 30, 2002. The costs of software revenue
represented 11% and 8% of the related software revenue for the three months
ended September 30, 2003 and September 30, 2002, respectively. The costs of
software revenue represented 10% and 8% of the related software revenue for
the nine months ended September 30, 2003 and September 30, 2002,
respectively.
The increase in cost of software revenue for the three and nine month
periods of 2003, as compared to the same periods in 2002, is due primarily
to higher partner commission expense and the additional amortization
expense of acquired technology and other intangible assets associated with
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the acquisitions of eGrail in April 2002 and Shana in April 2003. We
anticipate cost of software revenue as a percentage of software revenue to
remain comparable to current levels in future periods, however additional
technology acquisitions or unexpected increases in third party royalty
costs could increase cost of software revenue in the future.
Customer Support: Cost of customer support revenue includes costs of
customer support personnel, cost of supplies and spare parts, and the cost
of third-party hardware maintenance. The cost of customer support revenue
increased $0.1 million, or 1%, to $9.7 million for the three months ended
September 30, 2003 from $9.6 million for the three months ended September
30, 2002. The cost of customer support revenue decreased $1.4 million, or
5%, to $28.1 million for the nine months ended September 30, 2003 from
$29.5 million for the nine months ended September 30, 2002. These costs
represented 23% and 25% of the related customer support revenue for the
three months ended September 30, 2003 and 2002, respectively. These costs
represented 23% and 26% of the related customer support revenue for the
nine months ended September 30, 2003 and 2002, respectively.
The decrease in cost of customer support revenue as a percentage of
customer support revenue was primarily due to automation and process
improvements that allowed growth in the customer and revenue base without a
proportional increase in support personnel and cost. The decrease in cost
of customer support revenue for nine months ended September 30, 2003
compared to the same period in 2002 is primarily attributable to lower
variable compensation expense and lower supplies cost. Going forward, we
expect cost of customer support revenue to remain relatively stable in the
near term.
Professional Services and Education: Cost of professional services and
education revenue consists primarily of costs of professional services
personnel, training personnel, and third-party independent consultants. The
cost of professional services and education revenue decreased $0.8 million,
or 7%, to $10.6 million for the three months ended September 30, 2003 from
$11.4 million for the three months ended September 30, 2002. The cost of
professional services and education revenue decreased $6.0 million, or 16%,
to $32.0 million for the nine months ended September 30, 2003 from $38.0
million for the nine months ended September 30, 2002. These costs
represented 87% and 89% of the related professional services and education
revenue for the three months ended September 30, 2003 and 2002,
respectively. These costs represented 89% and 88% of the related
professional services and education revenue for the nine months ended
September 30, 2003 and 2002, respectively.
The decrease in cost of professional services and education revenue in 2003
compared to 2002 was primarily attributable to a reduction in the use of
third-party independent consultants, as well as lower variable compensation
expense; all directly related to the decrease in professional services and
education revenue. We expect professional services and education costs as a
percentage of professional services and education revenue to vary from
period to period, depending on the utilization rates of internal resources
and the mix between the use of internal resources and third-party
independent consultants.
Hardware: Cost of hardware revenue includes the cost of assembling and
distributing our OSAR library products, the cost of hardware integration
personnel, and warranty costs. The cost of hardware revenue decreased $0.5
million, or 38%, to $0.8 million for the three months ended September 30,
2003 from $1.3 million for the three months ended September 30, 2002. The
cost of hardware revenue decreased $1.9 million, or 40%, to $2.9 million
for the nine months ended September 30, 2003 from $4.8 million for the nine
months ended September 30, 2002. The decrease in cost of hardware revenue
is directly related to the decrease in sales of OSAR library products. The
increase in costs as a percentage of sales reflects the fixed operating
costs relative to reduced sales volume. This operating segment is not a
strategic focus for us.
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Operating Expenses
Sales and Marketing: Sales and marketing expense consists primarily of
salaries and benefits, sales commissions and other expenses related to the
direct and indirect sales force, various marketing expenses and the cost of
other market development programs. Sales and marketing expense increased
$2.1 million, or 6%, to $34.4 million for the three months ended September
30, 2003 from $32.3 million for the three months ended September 30, 2002,
and represented 38% and 39% of total revenue for these respective periods.
Sales and marketing expense increased $6.3 million, or 6%, to $103.7
million, 6%, for the nine months ended September 30, 2003 from $97.4
million for the nine months ended September 30, 2002, and represented 39%
and 38% of total revenue for these respective periods.
The increase in sales and marketing expense in the quarter ended September
30, 2003 and during the first nine months of 2003 was primarily due to
investment in our sales and marketing capabilities that include targeted
contact and campaign management for specific industries, and channel
partner development expenses associated with the launch of our FileNet P8
product. This increase was partially offset by reduced variable
compensation expense. We expect sales and marketing expense to be at
approximately 39% of revenue in the near-term due to the continuing
investment in demand generation capabilities for targeted customers through
our direct and indirect sales channels.
Research and Development: Research and development expense primarily
consists of costs of personnel to support product development. Research and
development expense increased $1.2 million to $19.0 million, 7%, for the
three months ended September 30, 2003 from $17.8 million for the three
months ended September 30, 2002, and represented 21% of total revenue for
these respective periods. Research and development expense increased $4.0
million to $58.0 million, for the nine months ended September 30, 2003 from
$54.0 million for the nine months ended September 30, 2002, and represented
22% and 21% of total revenue for these respective periods.
The increase year over year in the first nine months of 2003 is the result
of increased third party development expense and increased headcount. We
are transitioning our development labor base from purely direct personnel
to a mix of internal and third party developers. Third party developers
tend to be located in lower labor cost countries. Over time, we believe we
will be able to lower our per developer cost through the use of these third
party resources. However, in the near term, some duplicate expenses will be
incurred as our development programs are transitioned to third party
developers. Third party development costs for the nine months ended
September 30, 2003 was $2.4 million compared to $1.3 million for the same
period in 2002. Research and development employee headcount totaled 464 for
the period ended September 30, 2003 compared to 459 for the same period in
2002. Increased internal headcount resulted in higher compensation,
benefits and relocation costs related to the eGrail and Shana acquisitions
in April of 2002 and 2003, respectively. This increase was partially offset
by a decrease in variable compensation expense.
Our research and development efforts are focused on enhancing and
maintaining our enterprise content management capabilities within the
FileNet P8 product line. These efforts will focus on enhancements to our
FileNet P8 platform, Business Process Management, Web Content Management
and the development of integrated records management and other
capabilities. We intend to complement internal development with third-party
software through OEM agreements and may execute additional technology
acquisitions. We expect that competition for qualified technical personnel
will remain strong and may result in higher levels of compensation expense
for us in the future. We believe that research and development
expenditures, including compensation of technical personnel, are essential
to maintaining our competitive position. We expect research and development
expense to be at approximately 21% of revenue in the near term.
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In-process Research and Development: There has been no in-process research
and development expensed during 2003. The acquisition of the eGrail assets
acquired in April 2002 included $400,000 of in-process research and
development, which was expensed upon acquisition because technological
feasibility had not been established and no future alternative uses,
existed.
General and Administrative: General and administrative expense consists
primarily of personnel costs for finance, information technology, legal,
human resources and general management, and the cost of outside
professional services. General and administrative expense increased $0.7
million, or 9%, to $8.2 million, for the three months ended September 30,
2003 from $7.5 million for the three months ended September 30, 2002, and
represented 9% of total revenue for these respective periods. General and
administrative expense increased $0.1 million, or less than 1%, to $24.4
million for the nine months ended September 30, 2003 from $24.3 million for
the nine months ended September 30, 2002, and represented 9% of total
revenue for these respective periods.
General and administrative expense was essentially unchanged during the
first nine months of 2003 compared to the first nine months of 2002 due to
cost containment programs that have been in effect over the last eighteen
months. We expect general and administrative expenses to remain at
approximately 9% of revenue for the near term.
Amortization of Purchased Intangible Assets
The April 2002 purchase of eGrail assets resulted in intangible assets
comprised of acquired technology of $3.3 million and patents of $24,000,
with assigned useful lives of five years and two years, respectively. The
April 2003 purchase of Shana resulted in $5.7 million of intangible assets;
comprised of acquired technology of $4.0 million, customer maintenance
relationships of $800,000 and technology manuals and design documents of
$600,000. All intangible assets for the Shana acquisition were assigned a
useful life of five years. Non-compete agreements with former executives of
Shana were valued at $277,000 and were assigned a useful life of between
two and three years.
Other Income, Net
Other income, net, consists primarily of interest income earned on our cash
and cash equivalents, short and long-term investments, and other items
including foreign exchange gains and losses, the gain (loss) on sale of
fixed assets, and interest expense. Other income, net was $0.6 million for
the three months ended September 30, 2003 compared to other income, net of
$1.0 million for the three months ended September 30, 2002. Other income,
net was $3.3 million for the nine months ended September 30, 2003 compared
to other income, net of $3.8 million for the nine months ended September
30, 2002. Other income decreased slightly between comparable periods due to
reduced investment earnings between comparable periods partially offset by
foreign exchange gains.
Income Taxes
Our combined federal, state and foreign annual effective tax rate for the
three months ended September 30, 2003, is 28% compared to 23% for the
comparable period in 2002. The combined federal, state and foreign annual
effective tax rate for the nine months ended September 30, 2003, is 28%
compared to 23% for the comparable period in 2002. The provision for income
taxes differs from the tax computed at the federal statutory income tax
rate due primarily to earnings considered as permanently reinvested in
foreign operations. The increased tax rate in 2003 was primarily due to the
mix of income earned by our domestic operations versus the foreign
subsidiaries.
We have a deferred net tax asset of approximately $22.6 million and a
valuation allowance of approximately $23.8 million as of September 30,
2003. FileNet management will continue weighing various factors throughout
the year to assess the recoverability of its recorded deferred assets and
28
the need for any valuation allowance against such amounts. Recoverability
of the deferred tax assets is dependent on profitability from operations
going forward. If we were to reverse the entire valuation allowance in the
future, we would record a non-cash charge to increase additional reported
paid in capital by approximately $9.0 million, and tax expense would
decrease (causing an increase in earnings) by approximately $10.0 million
to $14.0 million.
Liquidity and Capital Resources
At September 30, 2003, combined cash, cash equivalents and investments
totaled $217.5 million, an increase of $32.3 million from December 31,
2002.
Cash provided by operating activities during the nine months ended
September 30, 2003 totaled $35.8 million and resulted primarily from:
additions to net income for depreciation and amortization expense of $14.8
million, net income of $5.3 million, an increase of $3.3 million in
customer deposits and advances, an increase in unearned maintenance revenue
related to prepaid maintenance contracts of $2.9 million and a decrease in
accounts receivable of $2.9 million. The increase in unearned maintenance
revenue is primarily the result of the growth in our base of annual support
contracts resulting from new customer sales and sales of additional
products to the existing base. Additionally, a significant number of
maintenance contracts renew early in the year and are amortized ratably
throughout the year resulting in a lower balance in unearned maintenance by
December 31.
For the nine months ended September 30, 2003, cash used for investing
activities totaled $18.3 million and included: Shana acquisition of $8.1
million, capital expenditures of $6.8 million and a net purchase of
marketable securities of $3.5 million.
Cash provided by financing activities totaled $9.5 million and was a result
of proceeds received from the exercise of employee stock options and stock
purchases under the employee stock purchase plan.
On June 27, 2003, our $5.0 million multi-currency revolving line of credit
expired in accordance with its terms and was not renewed because the cost
of carrying the line did not justify the level of usage. We believe we will
be able to meet our bank guarantee needs through our existing bank
relationships in the United States and internationally.
Contractual cash obligations of significance include operating leases for
our corporate offices, sales offices, development and manufacturing
facilities, non-cancelable operating leases for other equipment, some of
which have renewal options and generally provide for escalation of the
annual rental amount. (See Note No. 9 to the Notes to Unaudited Condensed
Consolidated Financial Statements for additional details.)
We believe that our present cash balances together with internally
generated funds and credit lines will be sufficient to meet our working
capital and capital expenditure needs for at least the next 12 months.
Other Financial Instruments
We conduct business on a global basis in several currencies. Accordingly,
we are exposed to movements in foreign currency exchange rates. We enter
into forward foreign exchange contracts to minimize the short-term impact
of currency fluctuations on monetary assets and liabilities denominated in
currencies other than the functional currency of the relevant entity. We do
not enter into foreign exchange forward contracts for trading purposes.
Gains and losses on these contracts, which equal the difference between the
forward contract rate and the prevailing market spot rate at the time of
valuation, are recognized as other income in the consolidated statements of
operations. We open new hedge contracts on the last business day of each
quarter that will mature at the end of the following quarter. The
counterparties to these contracts are major financial institutions. We use
29
commercial rating agencies to evaluate the credit quality of the
counterparties and do not anticipate nonperformance by any counterparties.
We do not anticipate a material loss resulting from any credit risks
related to any of these institutions.
Recently Adopted Accounting Pronouncements
In June 2001, the FASB issued SFAS No. 141, "Business Combinations," which
was effective immediately. SFAS No. 141 requires that the purchase method
of accounting be used for all business combinations initiated after June
30, 2001 and it eliminated the pooling-of-interests method. The adoption of
this standard did not have a significant impact on our consolidated
financial statements. Our April 2002 acquisition of certain assets and
certain liabilities of eGrail, Inc. and our April 2003 acquisition of Shana
Corporation were accounted for in compliance with this pronouncement (See
Note No. 3 to the Notes to the Unaudited Condensed Consolidated Financial
Statements for details).
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets," which we adopted January 1, 2002. SFAS No. 142 requires that
goodwill and other intangible assets with indefinite useful lives no longer
be amortized, but instead be tested for impairment at least annually and
written down when impaired. SFAS No. 142 requires purchased intangible
assets other than goodwill to be amortized over their useful lives, unless
these lives are determined to be indefinite. In accordance with this
standard, we do not amortize goodwill and indefinite life intangible assets
but evaluate their carrying value annually or when events or circumstances
indicate that their carrying value may be impaired. As of the first day of
July of each year, goodwill is tested for impairment by determining if the
carrying value of each reporting unit exceeds its fair value. We engaged an
independent valuation firm to determine the business enterprise value for
each of our three reporting units and to perform an impairment analysis as
of July 1, 2003 in accordance with SFAS 142. The analysis indicated there
was no impairment of goodwill in any of the three reporting units. As of
September 30, 2003, no impairment of goodwill has been recognized. If
estimates change, a materially different impairment conclusion could
result.
In August 2001, the FASB issued SFAS No. 144, "Accounting for Impairment or
Disposal of Long-Lived Assets." This statement addresses financial
accounting and reporting for the impairment of long-lived assets and for
the disposal of long-lived assets and discontinued operations. SFAS No. 144
superseded SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of," and is effective for
fiscal years beginning after December 15, 2001. The adoption of this
standard did not have a material impact on our consolidated financial
position and results of operations.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which addresses financial
accounting and reporting for costs associated with exit or disposal
activities and supersedes EITF Issue 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146
requires that costs associated with exit or disposal activities be
recognized when they are incurred rather than at the date of a commitment
to an exit or disposal plan. SFAS No. 146 also establishes that the
liability should initially be measured and recorded at fair value. We
adopted the provisions of SFAS No. 146 for exit or disposal activities
initiated after December 31, 2002. The adoption of this standard did not
have a material impact on our consolidated financial position and results
of operations.
In November 2002, the FASB issued FIN 45, "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees and
Indebtedness of Others," an interpretation of FASB Statement Nos. 5, 57 and
107, and rescission of FIN 34, "Disclosure of Indirect Guarantees of
Indebtedness of Others." FIN 45 elaborates on the disclosures to be made by
the guarantor in its interim and annual financial statements about its
obligations under certain guarantees that it has issued. It also requires
that a guarantor recognize, at the inception of a guarantee, a liability
for the fair value of the obligation undertaken in issuing the guarantee.
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The provisions related to recognizing a liability at inception of the
guarantee for the fair value of the guarantor's obligations does not apply
to product warranties or to guarantees accounted for as derivatives. The
initial recognition and measurement provisions of this interpretation are
applicable on a prospective basis to guarantees issued or modified after
December 31, 2002, while the disclosure requirements are effective for
financial statements for interim or annual periods ending after December
15, 2002. The adoption of the recognition of provisions of FIN 45 in the
three and nine months ended September 30, 2003 did not have a material
impact on our consolidated results of operations or financial position.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation Transition and Disclosure," an amendment of SFAS No. 123. This
statement amends SFAS No. 123, "Accounting for Stock-Based Compensation,"
to provide alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee
compensation. In addition, this statement amends the disclosure
requirements of SFAS No. 123 to require prominent disclosures in both
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on
reported results. The transition guidance and annual disclosure provisions
of SFAS No. 148 are effective for fiscal years ending after December 15,
2002. The interim disclosure provisions are effective for financial reports
containing financial statements for interim periods beginning after
December 15, 2002. The adoption of SFAS No. 148 did not have a material
impact on our consolidated results of operations or financial position.
In January 2003, the FASB issued FIN 46, "Consolidation of Variable
Interest Entities." In general, a variable interest entity is a
corporation, partnership, trust, or any other legal structure used for
business purposes that either (a) does not have equity investors with
voting rights or (b) has equity investors that do not provide sufficient
financial resources for the entity to support its activities. FIN 46
requires a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable
interest entity's activities or entitled to receive a majority of the
entity's residual returns or both. The consolidation requirements of FIN 46
apply immediately to variable interest entities created after January 31,
2003. The consolidation requirements apply to older entities in the first
fiscal year or interim period beginning after June 15, 2003. Certain of the
disclosure requirements apply in all financial statements issued after
January 31, 2003, regardless of when the variable interest entity was
established. We do not have any variable interest entities as of September
30, 2003. The adoption of FIN 46 did not have a material impact on our
consolidated results of operations or financial position.
In April 2003, FASB issued SFAS No. 149, "Amendment of Statement No. 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 (1) clarifies
under what circumstances a contract with an initial net investment meets
the characteristic of a derivative discussed in paragraph 6(b) of Statement
No. 133, (2) clarifies when a derivative contains a financing component,
(3) amends the definition of an underlying derivative to conform it to
language used in FIN 45, and (4) amends certain other existing
pronouncements, which will collectively result in more consistent reporting
of contracts as either derivatives or hybrid instruments. SFAS No. 149 is
effective for contracts and hedging relationships entered into or modified
after June 30, 2003. The adoption of SFAS No. 149 did not have a material
impact on our consolidated financial statements or financial position.
In May 2003, FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." SFAS No.
150 establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both debt and equity and
requires an issuer to classify the following instruments as liabilities in
its balance sheet:
o a financial instrument issued in the form of shares that is
mandatorily redeemable and embodies an unconditional obligation
that requires the issuer to redeem it by transferring its assets
at a specified or determinable date or upon an event that is
certain to occur;
31
o a financial instrument, other than an outstanding share, that
embodies an obligation to repurchase the issuer's equity shares,
or is indexed to such an obligation, and requires the issuer to
settle the obligation by transferring assets; and
o a financial instrument that embodies an unconditional obligation
that the issuer must settle by issuing a variable number of its
equity shares if the monetary value of the obligation is based
solely or predominantly on (1) a fixed monetary amount, (2)
variations in something other than the fair value of the issuer's
equity shares, or (3) variations inversely related to changes in
the fair value of the issuer's equity shares.
SFAS No. 150 is effective for financial instruments entered into or
modified after May 31, 2003 and is effective for all other financial
instruments as of the first interim period beginning after June 15, 2003.
SFAS No. 150 is to be implemented by reporting the cumulative effect of a
change in accounting principle. The adoption of SFAS No. 150 did not have a
material impact on our consolidated financial statements or financial
position.
Other Matters
Environmental Matters. We are not aware of any issues related to environmental
matters that have, or are expected to have, a material affect on our business.
Risk Factors That May Affect Future Results
Except for the historical information and discussions contained herein,
statements contained in this Form 10-Q may constitute "forward looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. These statements are based on current expectations and assumptions that
involve a number of risks, uncertainties and other factors that could cause
actual results to differ materially from recent results or from our anticipated
future results. We operate in a rapidly changing economic and technological
environment that presents numerous risks. Prospective and existing investors are
strongly urged to carefully consider the various cautionary statements and risks
set forth in this quarterly report and our other public filings. Many of these
risks are beyond our control and are driven by factors that we cannot predict.
The following discussion highlights some of these risks.
Our quarterly operating results may fluctuate in future periods and are not
predictable and, as a result, we may fail to meet expectations of investors and
analysts, causing our stock price to fluctuate or decline. Our operating results
have fluctuated in the past and we anticipate our future operating results will
continue to fluctuate due to many factors, some of which are largely beyond our
control. Consequently, our prior operating results should not necessarily be
considered indicative of future operating results.
Factors, which may cause our operating results to fluctuate, include, but are
not limited to, the following:
o the industry-wide slow down in IT spending;
o general domestic and international economic and political conditions;
o the discretionary nature of our customers' budget and purchase cycles
and the absence of long-term customer purchase commitments;
o the tendency to realize a substantial percentage of our revenue in the
last weeks, or even days, of each quarter;
o the potential for delays or deferrals of customer orders;
o the size, complexity and timing of individual transactions;
o the length of our sales cycle;
o the level of software product sold and price competition;
o the timing of new software introductions and software enhancements by
us and our competitors; or,
o seasonality in technology purchases.
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The decision to implement our products is subject to each customer's resources
and budget availability. Our quarterly sales generally include a mix of medium
sized orders, along with several large individual orders, and as a result, the
loss or delay of an individual large order could have a significant impact on
our quarterly operating results and revenue. Our operating expenses are based on
projected revenue trends and are generally fixed. Therefore, any shortfall from
projected revenue may cause significant fluctuations in operating results from
quarter to quarter. As a result of these factors, revenue and operating results
for any quarter are subject to fluctuations and are not predictable with any
significant degree of accuracy. Therefore, we believe that period-to-period
comparisons of our results of operations should not be relied upon as
indications of future performance. Moreover, such factors could cause our
operating results in a given quarter to be below the expectations of public
market analysts and investors. In either case, the price of our common stock
could decline materially.
The markets in which we operate are highly competitive and we cannot be
sure that we will be able to continue to compete effectively, which could result
in lost market share and reduced revenue. The markets we serve are highly
competitive and we expect competition to intensify. We have multiple competitors
and there may be future competitors, some of which have or may have
substantially greater sales, marketing, development and financial resources. As
a consequence, our present or future competitors may be able to develop software
products comparable or superior to those offered by us, offer lower priced
products or adapt more quickly than we do to new technologies or evolving
customer requirements.
Other competitive risks include, but are not limited to:
o We anticipate significant future consolidation as the software
industry matures. Large well-established software firms like Oracle,
IBM and Adobe may enter our market by adding content management
features to their existing suite of products. EMC Corporation, a data
storage hardware company, has announced its intention to acquire
Documentum. Other large, well-capitalized hardware firms like Sun
Microsystems may enter our market by acquiring our competitors to
pursue revenue growth opportunities;
o Many of our competitors are also our distribution channel partners.
For example, IBM competes with us in the content management market,
but also implements our software solutions through the IBM Global
Services business unit. This type of vertical integration of software
development and system integration capabilities may be viewed by our
customers as a key competitive advantage;
o Some of our competitors are also our key technology suppliers. For
example, IBM's Crossworlds business unit supplies a key technology for
our business process management software. Our inability to license
future releases of key technology from these competitive vendors could
limit the technical capabilities of our products.
We cannot predict new competitors entering our market through acquisitions or
other alliances. In order to be successful in the future, we must respond to
technological change, customer requirements and competitors' current software
products and innovations. We may not be able to compete effectively in our
target markets. In addition, current and potential competitors have established
or may establish cooperative relationships among themselves or with third
parties to increase the ability of their products to address the needs of the
markets we serve. A