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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 .
FORM 10-K
(Mark One)
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period for _____________ to _______________.
Commission File No. 0-15997
FILENET CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 95-3757924
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3565 Harbor Boulevard
Costa Mesa, California 92626
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (714) 327-3400
Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act: Common Stock, $0.01
par value
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 disclosure of delinquent filers pursuant
to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of the Registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. [x]
Indicate by check mark whether the registrant is an accelerated filer as
defined by Rule 12b-2 of the Securities Exchange Act of 1934: Yes [x] No [ ]
Based on the closing sale price as of June 30, 2002, the aggregate market
value of the 36,323,178 shares of common stock of the Registrant held by
non-affiliates of the Registrant on such day was $653,853,204. For purposes of
such calculation, only executive officers, board members and beneficial owners
of more than 10% of our outstanding common stock are deemed to be affiliates.
The number of shares outstanding on the Registrant's common stock was
38,535,087 at March 12, 2004.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive proxy statement, to be delivered in
connection with the Registrant's 2004 Annual Meeting of Stockholders, are
incorporated by reference into Part III of this Report.
FILENET CORPORATION
2003 ANNUAL REPORT ON FORM 10-K
For the Year Ended December 31, 2002
TABLE OF CONTENTS
Page
PART I
Item 1. Business..............................................................3
Item 2. Properties...........................................................19
Item 3. Legal Proceedings....................................................19
Item 4. Submission of Matters to a Vote of Security Holders..................19
PART II
Item 5. Market for the Registrant's Common Stock and Related Stockholder
Matters..............................................................20
Item 6. Selected Financial Data..............................................21
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations................................................22
Item 7a. Quantitative and Qualitative Disclosures About Market Risk...........39
Item 8. Financial Statements and Supplementary Data..........................40
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.................................................40
Item 9a. Controls and Procedures..............................................40
PART III
Item 10. Directors and Executive Officers of the Registrant..................41
Item 11. Executive Compensation..............................................41
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters.........................................41
Item 13. Certain Relationships and Related Transactions......................41
Item 14. Principal Accountant Fees and Services..............................41
PART IV
Item 15. Financial Statement Schedule, Reports on Form 8-K, and Exhibits.....42
Signatures....................................................................46
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Forward-Looking Statements
In addition to historical information, this Annual Report on Form 10-K
contains forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995, Section 21E of the Securities 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. These forward-looking
statements involve risks and uncertainties, including those discussed herein and
in the notes to our financial statements for the year ended December 31, 2003,
certain sections of which are incorporated herein by reference as set forth in
Items 7 and 8 of this report. The actual results that we achieve may differ
materially from any forward-looking statements, which reflect management's
opinions only as of the date hereof. We undertake no obligation to revise or
publicly release the results of any revisions to these forward-looking
statements. Readers should carefully review the section entitled "Risk Factors"
and other documents we file from time to time with the Securities and Exchange
Commission. Our business, financial condition, operating results and prospects
can be impacted by a number of factors, including but not limited to those set
forth in the section entitled "Risk Factors" and elsewhere in this report, any
one of which could cause our actual results to differ materially from recent
results or from our anticipated future results.
PART I
Item 1. Business
FileNet Corporation ("FileNet") was incorporated on July 30, 1982. We
develop, market, sell and support a software platform and framework for
Enterprise Content Management. Enterprise Content Management, or ECM, refers to
the broad range of functions used by organizations of all types, including
businesses and governmental agencies, to control and track the information, or
content, that is important to the organization's operations, whether that
information is used internally, such as sales data or product specifications, or
externally, such as content provided to customers through a Web site. The
content our software manages includes, but is not limited to: Web pages, word
processing documents, spreadsheets, HTML, XML, PDF, document images, email
messages and other electronic content. ECM also refers to processing,
communicating and gathering information within the organization and from third
parties, such as processing payments or applications for services. Our software
offers customers the ability to configure, design, build and deploy ECM
solutions to meet the needs of their particular business or organization. These
solutions allow customers to manage content throughout their organizations,
automate and streamline their business processes, and provide the broad-spectrum
of connectivity needed to support their critical and everyday decision-making.
We operate globally and sell our products and services to our customers
through a direct sales force, system integrators, resellers and value added
distributors. We invest significantly in product development to improve our
existing products and to increase our product offerings. We also offer
professional services for the implementation of these software solutions, as
well as 24 hours a day, 7 days a week technical support and services to our
customers on a global basis.
Available Information
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.
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Fiscal 2003 Developments and Strategy
During fiscal 2003, we focused our development efforts on enhancing and
integrating the capabilities of our FileNet P8 architecture and bringing this
architecture to market. FileNet P8 provides our customers with the ability to
easily configure, design, build and deploy a variety of ECM solutions to meet a
broad range of content management and business process management needs within a
single scalable framework. Also during the year, we acquired the technology of
the Shana Corporation and ramped up our third party offshore development
efforts. The Shana acquisition brought us advanced eForms management technology.
Offshore development augments our current development capacity with a low cost
and high quality alternative to internal development.
During fiscal 2002, we acquired the technology of eGrail, which brought us
advanced Web content management technology. During fiscal 2000, we acquired the
technology of Application Partners Incorporated, which brought us eService
applications technology.
With the introduction of the FileNet P8 ECM architecture in early 2003, we
provide the following capabilities:
o a unified architecture for content types;
o unified object oriented Application Programming Interfaces to
facilitate rapid application development;
o common user and management interface across the entire architecture;
o portal integration to leverage a customer's existing applications;
o connectivity to customer enterprise applications via an Enterprise
Application Integration capability and FileNet Virtual Content
Management, which provides the ability to interact with external
content and events; and
o enhanced Business Process Management capabilities including process
simulation and analytics allowing customers to optimize business
processes on a real-time basis.
We have packaged our ECM capabilities into five FileNet suites that include
the Business Process Manager, Content Manager, Web Content Manager, Image
Manager and Forms Manager. Each suite provides specific functionality to meet
customer requirements. When our customers purchase a FileNet ECM solution they
have the ability to add-on additional FileNet capabilities as needed, allowing
them flexibility to acquire only the functionality they need. The integration of
the suites allows for a lower total cost of ownership by reducing support costs
and application development times.
We intend to continue to leverage our development capabilities and
substantial worldwide distribution and service network to deliver on our unified
platform strategy. We also intend to continue our strategy of investing in
product enhancements, new product developments, new partnerships, and strategic
acquisitions.
Markets and Customers
We believe the FileNet P8 architecture offers our customers the ability to
scale their ECM solutions to the enterprise-level and offers the flexibility to
manage demanding content challenges, complex business processes, and integration
with an organization's existing systems. The FileNet P8 architecture is designed
to provide our customers with a way to manage their enterprise content, which
can provide greater process control and consistency throughout the enterprise.
Our customers include many of the Global 2000 organizations and are
typically those enterprises and government agencies that have complex business
processes that capture, manage, store, and share large volumes of digital
content. As of December 31, 2003, our software has been licensed to more than
4,000 customers worldwide.
Our software solutions are effective for a variety of applications such as
mortgage loan servicing, customer relationship management, insurance claims
processing, regulatory compliance, accounts payable and receivable, and for any
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business operation that processes significant amounts of electronic information
or content in their day-to-day operations. Additionally, our software products
can address ad hoc business processes at the enterprise, departmental, and
workgroup levels to improve overall enterprise productivity, and can integrate
with industry-standard productivity and enterprise applications such as Lotus
Notes, Microsoft Office, SAP, Siebel, and others.
We market our products in more than 90 countries around the world through a
direct sales force and through our ValueNet business partner program. The
ValueNet program brings together value-added resellers, independent software
vendors, system integrators, consultants and service providers to deliver a
broad range of solutions and services to our customers worldwide. Furthermore,
our strategic alliances with other industry leaders contribute to our efforts in
product development, customer satisfaction, and worldwide market penetration.
More than 250 firms operate under the ValueNet program and combine our software
products with industry-specific, value-added services and applications to
provide turnkey ECM solutions for customers. Our FileNet ECM solutions are
applicable in a variety of industries, however our key vertical markets are
insurance, financial services, government, manufacturing, telecommunications,
and utilities.
Using our standard software products, customers generally build
applications that address their particular needs. Very often these applications
can involve a significant change in the way a customer operates. Consequently,
our sales cycle, or the time from initial customer contact to completed product
sale, can be lengthy, and our quarterly sales typically include a mix of medium
sized sales with a smaller number of large orders. We typically ship our
products within a short period of time after acceptance of orders, which is
common in the computer software industry.
Our global customer support operation offers software maintenance and
technical support services for our products worldwide. These technical support
programs offer a wide range of services including the right to new versions of
our software, extended phone support coverage, on-site technical consultants, a
technical account management program, and software development kit support.
Our professional services operation offers business and technical
consulting services and training to both end-users of our products and to
ValueNet partners on our standard software products. These professional services
are marketed by our direct sales force and through the ValueNet business partner
program, with a focus on FileNet centric enterprise system implementation and
the delivery of ECM applications.
Industry Segments and Geographic Information
For the purposes of Statement of Financial Accounting Standards ("SFAS")
No. 131, "Disclosures About Segments of an Enterprise and Related Information,"
we have provided a breakdown of our sales, operating results and other
information using the management approach in Note 16 of the "Notes to
Consolidated Financial Statements" under Item 8, "Financial Statements and
Supplementary Data." Using the management approach, our principle reportable
operating segments include Software, Customer Support, Professional Services and
Education, and Hardware. A summary of our sales by geographic location is
incorporated herein by reference in Note 16 of the "Notes to Consolidated
Financial Statements" under Item 8, "Financial Statements and Supplementary
Data."
5
Software Products and Solutions
FileNet P8
The FileNet P8 architecture offers our customers enterprise-level
scalability and flexibility to handle demanding content challenges, complex
business processes, and integration to existing systems. The FileNet P8
architecture provides a framework for functional expansion to provide enhanced
content and process management across an enterprise through five pre-packaged
suites, each emphasizing a different aspect of the ECM solution set, with
functions grouped in a logical order that are designed to meet a customer's
individual ECM needs. Each suite can be implemented by a customer individually,
but remains expandable to include all FileNet ECM capabilities. FileNet ECM
solutions are designed to manage content; allowing organizations to capture,
create, use, and activate that content in order to make decisions faster and
bring control and consistency to business processes, to improve efficiency and
address compliance requirements.
FileNet Suites
Business Process Manager
FileNet Business Process Manager is an ECM solution that is designed to
help organizations increase process performance, reduce cycle times, and improve
productivity by managing the flow of work through automating, streamlining, and
optimizing complex processes associated with business operations. The operations
of many businesses involve gathering information and making decisions based on
that information, and many of these decisions, or the steps leading up to them,
can be automated to increase efficiency and create a more standardized approach
to these decisions throughout the business organization. Examples of customer
business processes that may benefit from our Business Process Manager solution
include: insurance companies that have automated policy underwriting and claims
processing decisions, financial services companies that have streamlined the
loan origination and servicing processes, and government agencies that have
automated case management and tax processing functions. The Business Process
Manager can provide an interface for gathering necessary information and either
make decisions based on automated criteria or direct that information to the
appropriate decision-maker in an efficient and consistent basis. Additionally,
the Business Process Manager suite provides real-time and historical tracking of
processes combined with analysis and simulation capabilities allowing customers
to optimize their processes. This product is standards based, flexible and can
be customized to a wide range of industry requirements.
Content Manager
FileNet Content Manager is an ECM solution that combines content management
with process management capabilities to help organizations manage complex
documents to control, share, and access critical business information. Content
Manager is designed to assist with all steps in the content life cycle, from
creation and tracking to storing and controlling access to relevant information.
It activates content by allowing an organization to make content available to
the right place at the right time - to support the business decision-making
process at any level in the organization. The Content Manager's secure and
scalable environment integrates directly with desktop and business applications
so business users can collaborate on the creation and management of content,
while controlling access as necessary.
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Web Content Manager
FileNet Web Content Manager is designed to combine easy-to-use Web site
development capabilities with integrated process capabilities for managing the
creation, approval and publication of Web content and complex documents to
multiple Web sites, in multiple formats, and in multiple languages. The Web
Content Manager allows centralized control of Web site content and appearance
while allowing particular content to be directly created and updated by
organization members without specialized Web expertise, through the use of
controlled templates and other tools. Web Content Manager can control large
amounts of dynamic Web content across globally distributed sites and provides
integrated process management capabilities to help ensure secure and accurate
Web content publication.
Image Manager
FileNet Image Manager is designed to be highly scalable and provides rapid
access for end-users to fixed objects, or content that is not intended to be
modified, such as scanned documents, faxes, email and rich media. It is designed
to securely and permanently store large volumes of critical business information
and to safeguard critical content from disaster and misuse while making it more
accessible to thousands of users. Among other applications, FileNet Image
Manager has been used by organizations such as municipal court systems to scan,
track and provide access to important case documents.
Forms Manager
FileNet Forms Manager is designed to provide customers the ability to
design, deploy and process electronic forms (eForms) across their enterprise.
FileNet Forms Manager enables customers to transform cumbersome paper forms into
fully interactive eForms that directly connect to their business applications.
FileNet Forms Manager provides a rich and intuitive design environment that
enables general business users to create, deploy and process eForms and
associated data without extensive Web development or JavaScript experience.
FileNet Forms Manager integrates with a customer's existing infrastructure to
enable forms to be widely accessible by supporting a variety of operating
systems and browsers. It enables users to view forms in a business process and
supports digital signatures and tracking for audit trails to help in meeting
regulatory compliance requirements.
FileNet ECM Technology
The FileNet P8 architecture includes the following technology for aiding in
the development of ECM solutions:
Content Engine provides software services for managing content and other
business-related data, collectively referred to as objects. In addition to
managing documents and any customer defined objects, the Content Engine manages
a broad range of enterprise content including workflow definitions, stored
searches, publishing templates, entry templates, Web content management
templates, analytics reports, and simulation scenarios.
Process Engine is the component for design, execution and tracking of processes.
It manages processes and their associations with documents, data, and lifecycle
information residing in the Content Engine. It also tracks and records the
status of work in progress. The Process Engine drives processes, associates
information, manages work-to-do, sends notifications, sets milestones, provides
reporting and tracking capabilities, and provides the most up-to-date
information to all participants.
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Enterprise Application Integration provides connectors for integrating process
and content with enterprise applications. In addition, FileNet offers an
optional EAI server through an OEM agreement for IBM Websphere InterChange
Server, Adaptors and Collaborations. The connectors provided by FileNet provide
integration with enterprise applications such as SAP R/3, Siebel, and Clarify as
well as technologies such as XML, Web Service, JMS, and MQSeries.
FileNet P8 Workplace is an end-user application that provides a Web-based
interface to FileNet P8. It is designed to allow users to locate business
content, initiate new transactions, check status and track a wide variety of
processes and information across multiple storage locations or systems. A
customizable environment, FileNet P8 Workplace is designed to enable employees,
partners and customers to manage work processes through a simple interface.
Content Provider for FileNet P8 Workplace provides virtual content management
(VCM) access to content stored in third party repositories including content
management repositories from IBM, EMC/Documentum, and OpenText among others,
through the FileNet P8 Workplace. It is designed to eliminate the need for
custom integrations, which can be expensive, time consuming and require ongoing
maintenance for customers. FileNet's VCM capabilities are provided as a result
of a reseller business agreement with FileNet partner, Venetica.
Web Content Manager ("WCM") is an application that provides Web content
management capabilities that leverage the core content and process management
capabilities provided in the platform.
Java2 Platform Enterprise Edition ("J2EE") Support provides J2EE application
components and system components that operate in J2EE Platform Products
(application servers) such as BEA WebLogic and IBM WebSphere. In addition,
FileNet applications leverage the J2EE application model to build multi-tier
applications that deliver the scalability, accessibility, and manageability
required by enterprise applications.
Web Application Toolkit provides a framework for developing web applications
that run in a J2EE environment. The toolkit is used by several FileNet P8
applications, including Workplace, Solution Templates, and the Web Content
Manager.
Image Services Resource Adapter ("ISRA") is designed to enable organizations to
connect content stored in the FileNet Image Manager's Image Services repository
to custom J2EE applications. The ISRA delivers the functionality required to
access Image Services content within a J2EE Web application. It was specifically
designed for Image Services customers who have standardized on a Java
development and implementation environment for Web applications.
Portal Integrations provide commonly required content and process functionality
within 3rd party portal products. FileNet provides portal integration for BEA
WebLogic, IBM WebSphere and mySAP portals. Additionally, customers and partners
can create their own portlets using FileNet's Java Application Programming
Interfaces. In addition, FileNet distributes the source code for the portlets so
that customers and partners can modify and extend the capabilities if desired.
Solution Templates are a set of predefined objects and processes for use in
developing industry specific solutions. Built on the FileNet P8 architecture, a
Solution Template provides working code that can be configured and extended to
build complete applications. A Solution Template is not a turnkey application;
rather, it can be thought of as an application development template. By
providing much of the application's core infrastructure, it can reduce the
length of the solution development and deployment cycle.
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Stand-Alone Products
In addition to the FileNet P8 product suites and development tools the
following FileNet software products are available to our customers as
stand-alone products that provide some of the functionality available through
the full FileNet P8 architecture, and were formally available under the Panagon
and/or Brightspire brands.
FileNet eProcess Services is a Web browser-based process management product.
eProcess Services enables an organization to create and manage high-volume,
mission-critical automated business processes in a dynamic Web environment. Our
Web-based user interface, built-in eProcess applications, Web server components,
and XML architecture provide scalable connectivity of business processes for
employees, business partners, and customers.
FileNet Web Services combines a full-featured, Web browser-based client system
that allows access to content without the need to locally download information
or content. FileNet Web Services also combines a comprehensive Web-based
application development tool kit, and Web server components, and is designed to
support complex and mission critical ECM and Business Process Management
activities. This application provides a complete set of content management
functionality, allowing users to check in, check out, search and browse, share,
revise, and change properties for content stored in a FileNet repository, all
from a Web browser.
FileNet Content Services is a repository for creating, accessing, managing,
securing, and updating electronic documents and content. Content Services is
designed to allow a business to manage enterprise content from creation, to
secure delivery, to revision and re-use.
FileNet WorkFlo Services is FileNet's eProcess workflow engine. WorkFlo
Services, combined with eProcess Services, is designed to enable customers to
automate and access critical business processes and associated content. WorkFlo
Services can be used to create applications that reflect the way business
processes are performed within the particular customer's organization, and is a
critical enabling technology for the automation of business processes via the
Web. It allows organizations to control and modify their work processes to meet
their evolving needs, and integrates the flow of information between software
applications within a company's business processes. WorkFlo Services supports
multiple client, server and applications development environments, such as Java
and COM, and integrates with leading business process re-engineering products
for reduced implementation time.
FileNet Integrated Document Management ("IDM") Desktop is a Microsoft Windows
client software application designed to allow users to view, manage, revise,
share, and distribute content across an enterprise for ad hoc or mission
critical use. IDM Desktop allows users to manage content directly from within
Microsoft Office and Lotus Notes applications.
FileNet Image Services is an image and object server designed to allow
businesses to manage the high-speed acquisition, distribution, and access of
content and objects of all types.
FileNet Report Manager is an online statement and report management system.
Report Manager is designed to allow organizations the ability to capture, store
and access legacy print data streams within ECM applications by storing,
accessing, mining, and analyzing computer-generated reports, statements and
forms.
FileNet Capture addresses document and content capture needs. Available in
high-volume Capture Professional or small department Capture Desktop versions,
Capture is designed to acquire digital and paper-based content into FileNet ECM
repositories for enterprise-wide use and online access.
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FileNet Application Connector for SAP software is a document and data archiving
application certified by SAP, designed for use with the SAP R/3 Enterprise
Resource Planning ("ERP") application suite.
Hardware
We also manufacture and market an Optical Storage And Retrieval ("OSAR")
library product based on 12-inch, 30 gigabyte, and optical disk technology for
storage management of business critical content. Hardware is no longer a
strategic focus for the Company.
Services, Support, and Manufacturing
We operate service and support organizations on a global basis to provide
both pre-sales and post-sales services to ensure successful implementation of
our products and customer satisfaction. Due to the highly configurable nature of
our products, many of our product sales are coupled with contracts for
continuing support services.
Our worldwide Customer Service and Support organization provides
comprehensive support capabilities including electronic and real-time phone
support and global call tracking for customers and partners on support programs.
System engineers deliver support coverage on multiple platforms with 24-hour
call handling. Our Web site offers the ability to open cases, search our
knowledge base and review related status reports.
Support programs may be customized and enhanced with optional fee-based
services. These options include after hours phone coverage, on-site technical
consultants to assist with upgrades and FileNet product installations, and
FileNet Software Development Kit support for development teams building
applications using our products.
Our manufacturing facilities in Costa Mesa, California and Dublin, Ireland,
conduct software manufacturing and distribution, localization, integration, test
and quality control.
Professional Services and Education
Our worldwide professional services organization provides consulting,
development, architecture and other technical services and training services to
our licensed customers and authorized ValueNet Partners and Global System
Integrators. These services are provided through in-house employees and through
a network of qualified partners. Our worldwide professional services
organization offers a comprehensive methodology to architect, install,
integrate, customize and deploy our solutions. These services range from the
management of large-scale implementations of our products to prepackaged
standard services such as software installation, but do not include
modifications to the standard software. Our educational curriculum includes
training courses for end users, application developers and system administrators
through media-based and instructor-led training.
Research and Development
We have made and expect to continue to make substantial investments in
research and development, primarily through internal and offshore development
activities, third party licensing agreements and through technology
acquisitions. Our development efforts focus on our unified FileNet P8 ECM
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architecture as we continue to develop and enhance our ECM capabilities.
Additionally, we license and embed third party software that enhances the
functionality of our products through a variety of agreements with the producers
of this software. Expenditures for research and development were $77.0 million;
$71.7 million and $68.8 million for the years ended December 31, 2003, 2002, and
2001, respectively.
We expect to continue to look for technology acquisitions that offer us
additional product know-how or domain knowledge where appropriate and will
continue to embed third party technology that enhances our product line. We
intend to continue to invest significantly in internal and offshore development
with a focus on developing new functionality in Enterprise Content Management
and Business Process Management technology that provide a richer competitive
product offering to our customers.
Competition
The market for our products is highly competitive and competition will
continue to intensify as the ECM market consolidates. We compete with a large
number of Enterprise Content Management, Web content management, business
process management, workflow, document imaging, and electronic document
management companies. IBM is the largest company that competes directly with
FileNet in the content and process management market. Documentum, a key
competitor in the Content Management market, was acquired by the EMC
Corporation, a large storage technology company, during 2003. EMC becomes a
FileNet competitor offering both content management and storage management
capabilities. Numerous smaller software vendors also compete in each product
area. We also experience competition from systems integrators who configure
hardware and software into customized systems.
Large infrastructure vendors such as Oracle Corporation and Microsoft
Corporation have developed products or plan to offer products in the content
management market. Software vendors such as Tibco Software, Inc., Savvion, Inc.
and Pegasystems, Inc., each with a different core product foundation, have
approached the business process management market from their individual market
segments and may compete more intensely with us in the future. It is also
possible that new competitors or alliances among competitors may emerge and
rapidly acquire significant market share. We also expect that competition will
increase as a result of software industry consolidations.
We believe that the principal competitive factors affecting the market for
our software products and services include vendor and product reputation;
product quality, performance and price; the availability of software products on
multiple platforms; product scalability; product integration with other
enterprise applications; software functionality and features; software ease of
use; and the quality of professional services, customer support services and
training. The relative importance of each of these factors depends upon the
specific customer involved.
Certain of our competitors and potential competitors may have greater
resources, larger sales and marketing teams, broader product lines and more
experience developing software than we do. Increased competition may result in
price reductions, reduced gross margins and loss of market share, any of which
could have a material adverse effect on our business, financial condition or
results of operations.
Trademarks
FileNet, WorkFlo Services, ValueNet, OSAR, Watermark, Panagon, Acenza,
Brightspire, Document Warehouse, and FileNet Workgroup are trademarks or
registered trademarks of FileNet Corporation that may be referenced in this Form
10K. All other brands or product names are trademarks of their respective
companies.
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Patents and Licenses
As of December 31, 2003, FileNet Corporation has four issued and seven
pending U.S. patents. Our subsidiary, 3565 Acquisition LLC, has one issued U.S.
patent and one pending U.S. patent application. Another subsidiary, Shana
Corporation, has one issued U.S. patent and two pending U.S. patent
applications. We have applied for and may in the future apply for patent
protection in foreign countries.
We have also entered into non-exclusive license arrangements with a number
of organizations, including IBM, Verity, Stellent and Oracle that permit our
resellers and us to grant sublicenses and provide support to end-users of our
systems to use software developed by these third party vendors.
Employees
As of December 31, 2003 we had 1,720 full-time employees, of which 456 were
employed in research and development; 436 in sales; 113 in marketing; 210 in
education and professional services; 261 in customer support; 68 in operations;
and 176 in administration. No employees are represented by labor unions, and we
have never experienced a work stoppage. We believe that we enjoy good employee
relations.
Risk Factors
Except for the historical information and discussions contained herein,
statements contained in this Form 10-K 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 annual 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 IT spending trends;
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;
12
o the length of our sales cycle;
o the level of software sales and price competition;
o the timing of new software introductions and software enhancements by
us and our competitors; or,
o seasonality in technology purchases.
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 with the consolidation of the
ECM market. 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. In 2003, EMC
Corporation, a data storage hardware company, acquired one of our
competitors, Documentum. Other large, well-capitalized hardware firms
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 its 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
13
markets we serve. Accordingly, it is possible that new competitors or alliances
among competitors may emerge and rapidly acquire significant market share.
Increased competition may result in price reductions, reduced gross margins and
loss of market share that could result in reduced revenue.
A significant portion of our revenue is derived internationally and we are
subject to many risks internationally, which could put our revenue at risk.
Historically, we have derived approximately 28% of our total revenue from
international sales through our worldwide network of subsidiaries and channel
partners. International business is subject to certain risks including, but not
limited to, the following:
o political and economic instability;
o tariffs and trade barriers;
o varying technical standards and requirements for localized products;
o reduced protection for intellectual property rights in certain
countries;
o difficulties in staffing and maintaining foreign operations;
o difficulties in managing foreign distributors;
o multiple overlapping tax regimes;
o currency restrictions and currency exchange fluctuations;
o the burden of complying with a wide variety of complex foreign laws,
regulations and treaties;
o spreading our management resources to cover multiple countries; or,
o longer collection cycles and higher risk of non-collection and bad
debt expense.
Any of these factors could reduce the amount of revenue we realize from our
international operations in the future.
The market for content management solutions may not grow as we anticipate,
and may decline, and our products may not gain acceptance within this market,
resulting in reduced revenue. Our future financial performance will depend
primarily on the continued growth of the markets for our software products and
services as well as our ability to capture a larger share of those markets. Our
primary product offerings address the new and emerging market for content
management solutions. This market is developing rapidly, and while we believe
this market is growing and will continue to grow, particularly as new
regulations are introduced that focus on controlling the flow of information
within organizations to ensure compliance with disclosure and other obligations,
there can be no assurance that these markets will continue to grow as we
anticipate, or that our products and solutions will gain acceptance within these
markets. If the markets we serve, particularly the market for enterprise content
management solutions, fail to grow or grow more slowly than we currently
anticipate, or if our products and solutions do not gain acceptance within these
markets, our business, financial condition and operating results would be
harmed.
We must execute on our strategy of offering a unified platform and
framework for Enterprise Content Management that gains customer acceptance or
our revenue may suffer. This strategy may require us to develop and maintain
relations with technology partners. If we fail to successfully execute on our
integrated product solution strategy or if we fail to maintain or establish
relationships with technology partners, or if release dates of any future
products or enhancements are delayed, or if these products or enhancements fail
to achieve market acceptance when released, our business operating results and
financial condition could be materially harmed. In the past, we have experienced
delays in the release dates of enhancements and new releases to our products and
we cannot assure that we will not experience significant future delays in
product introduction. From time to time, either our competitors or we may
announce new software products, capabilities or technologies that have the
potential to replace or shorten the life cycles of our existing software
products. We cannot assure that announcements of currently planned or other new
software products will not cause customers to delay their purchasing decisions
in anticipation of such software products, and such delays could have a material
adverse effect on our business and operating results.
14
We must develop and sell new products to keep up with rapid technological
change in order to achieve future revenue growth and profitability. The market
for our software and services is characterized by rapid technological
developments, evolving industry standards, changes in customer requirements and
frequent new product introductions and enhancements. Our ability to continue to
sell products will be dependent upon our ability to continue to enhance our
existing software and services offerings, develop and introduce, in a timely
manner, new software products incorporating technological advances and respond
to customer requirements. In addition, our ability to generate revenues from the
sale of customer support, education and professional services is substantially
dependent on our ability to generate new sales of our software products. We may
not be successful in developing, marketing and releasing new products or new
versions of our products that respond to technological developments, evolving
industry standards or changing customer requirements. We may also experience
technical difficulties that could delay or prevent the successful development,
introduction and sale of these products and enhancements. In the past, we have
experienced delays in the release dates of enhancements and new releases to our
products and we cannot assure that we will not experience significant future
delays in product introduction. From time to time, our competitors or we may
announce new software products, capabilities or technologies that have the
potential to replace or shorten the life cycles of our existing software
products. We cannot assure that announcements of currently planned or other new
software products will not cause customers to delay their purchasing decisions
in anticipation of such software products, and such delays could have a material
adverse effect on our sales.
We are dependent upon customers concentrated in a small number of
industries. A significant decline in one of those industries could result in
reduced revenue. Our customers are concentrated in the insurance, financial
services, government, manufacturing, telecommunications and utilities
industries. We may not be successful in obtaining significant new customers in
different industry segments and we expect that sales of our products to a
limited number of customers in a limited number of industry segments will
continue to account for a large portion of our revenue in the future. If we are
not successful at obtaining significant new customers or if a small number of
customers cancel or delay their orders for our products, then our business and
our prospects could be harmed. Consolidation within the financial services and
insurance industry could further reduce our customers and future prospects. As
many of our significant customers are concentrated in a small number of industry
segments, if business conditions in one of those industry segments decline, then
orders for our products from that segment may decrease, which could negatively
impact our business, financial condition and operating results and cause the
price of our common stock to fall.
We must devote substantial resources to software development, and we may
not realize revenue from our development efforts for a substantial period of
time. Introducing new products that rapidly address changing market demands
requires a continued high level of investment in research and development. Our
research and development expenses were $77.0 million, or 21% of total revenue,
for 2003 and $ 71.7 million, or 21% of total revenue, for 2002. The majority of
our investment in new and existing market opportunities must be made prior to
our ability to generate revenue from these new opportunities. These investments
of money and resources must be made based on our prediction of new products and
services that the market needs and will accept. As a result, our operating
results could be adversely affected if our predictions of market demand are
incorrect and we are not able to realize the level of revenues we expect from
new products or if that revenue is significantly delayed.
We are increasing our use of third party software developers and may have
difficulty enforcing or managing our agreements with them, which could delay new
product introductions and reduce revenue. To help manage costs, we have
contracted with third party software development companies overseas,
particularly in India, where labor costs are lower, to perform an increasing
portion of our software development and software localization work. As a result,
15
we will become increasingly dependent on these third party developers for
continued development and maintenance of several of our key products. If any of
these third party developers were to terminate their relationship with us, our
efforts to develop new products and improve existing products could be
significantly delayed and our ability to provide product support to our
customers could be impaired. In addition, since the majority of these third
party developers are located outside the United States, our ability to enforce
our agreements with them may be limited.
We must retain and attract key executives and personnel who are essential
to our business, which could result in increased personnel expenses. Our success
depends to a significant degree upon the continued contributions of our key
management, as well as other marketing, technical and operational personnel. The
loss of the services of one or more key employees could have a material adverse
effect on our operating results. We do not have employment agreements with any
of the members of our United States-based senior management. We do have
employment contracts with members of our international management that commit
them to a notification period.
We believe our future success will depend in large part upon our ability to
attract and retain additional highly skilled management, technical, marketing,
product development and operational personnel and consultants. There is
competition for such personnel; particularly software developers, professional
services consultants and other technical personnel. We cannot assure that in the
future we will be successful in attracting and retaining such personnel.
If our products contain errors, we could incur unplanned expenses and
delays that could result in reduced revenue, lower profits, and harmful
publicity. Software, services and products, as complex as those we sell, are
susceptible to errors or failures, especially when first introduced or deployed.
Our software products are often intended for use in applications that are
critical to a customer's business. As a result, our customers may rely on the
effective performance of our software to a greater extent than the market for
software products generally. Despite internal testing and testing by current and
potential customers, new products or enhancements may contain undetected errors
or performance problems that are discovered only after a product has been
installed and used by customers. Errors or performance problems could cause
delays in product introduction and shipments or could require design
modifications, either of which could lead to a loss in or delay of revenue.
These problems could cause a diversion of development resources, harm our
reputation or result in increased service or warranty costs, or require the
payment of monetary damages. While our license agreements with customers
typically contain provisions designed to limit our exposure to potential product
liability claims, it is possible that such limitation of liability provisions
may not be effective under the laws of certain jurisdictions.
Acquisitions of companies or technologies may result in disruptions to our
business and diversion of management attention, which could cause our financial
performance to suffer. As part of our business strategy, we frequently evaluate
strategic acquisition opportunities. For example, we recently completed the
acquisitions of eGrail and Shana. We anticipate that our future growth may
depend in part on our ability to identify and acquire complementary businesses,
technologies or product lines. Acquisitions involve significant risks and could
divert management's attention from the day-to-day operations of our ongoing
business. Additionally, such acquisitions may include numerous other risks,
including, but not limited to, the following:
o difficulties in the integration of the operations, products and
personnel of the acquired companies;
o the incurrence of debt;
o liabilities and risks that are not known or identifiable at the time
of the acquisition;
o difficulties in retaining the acquired company's customer base;
o valuations of acquired assets or businesses that are less than
expected; or
o the potential loss of key personnel of the acquired company.
16
If we fail to successfully manage future acquisitions or fully integrate
future acquired businesses, products or technologies with our existing
operations, we may not receive the intended benefits of the acquisitions and
such acquisitions may harm our business and financial results.
Our business is highly automated for the execution of marketing, selling
and technical support functions. We depend on the integrity of our information
systems network connectivity to perform these business functions. Significant
business interruption could occur at our Costa Mesa headquarters facility due to
a natural disaster such as earthquake, which could cause a prolonged power
outage and the inability for key personnel to perform their job functions.
Protection of our intellectual property and other proprietary rights is
limited, which could result in the use of our technology by competitors or other
third parties. There is risk of third-party claims of infringement, which could
expose us to litigation and other costs. Our success depends, in part, on our
ability to protect our proprietary rights to the technologies used in our
principal products. We rely on a combination of copyrights, trademarks, trade
secrets, patents, confidentiality procedures and contractual provisions to
protect our proprietary rights in our software products. We cannot assure that
our existing or future copyrights, trademarks, trade secrets, patents or other
intellectual property rights will have sufficient scope or strength to provide
meaningful protection or a commercial advantage to us. Intellectual property
rights often cannot be enforced without engaging in litigation, which involves
devotion of significant resources, can divert management attention and has
uncertain outcomes. In addition, the laws of some foreign countries do not
protect our proprietary rights to the same extent, as do the laws of the United
States. Any inability to protect our intellectual property may harm our business
and competitive position.
We may, from time to time, be notified that we are infringing certain
patent or intellectual property rights of others, which could expose us to
litigation and other costs. While there are no material actions currently
pending against us for infringement of patent or other proprietary rights of
third parties, we cannot assure that third parties will not initiate
infringement actions against us in the future. Combinations of technology
acquired through past or future acquisitions and our technology will create new
software products and technology that also may give rise to claims of
infringement. Infringement actions can result in substantial costs and diversion
of resources, regardless of the merits of the actions. If we were found to
infringe upon the rights of others, we cannot assure that we could redesign the
infringing products to avoid further infringement or that we could obtain
necessary licenses to use the infringed rights on acceptable terms, or at all.
Additionally, significant damages for past infringement could be assessed or
future litigation relative to any such licenses or usage could occur. An adverse
disposition of any claims or the advent of litigation arising out of any claims
of infringement could result in significant costs or reduce our ability to
market any affected products.
We depend on certain strategic relationships in order to license
third-party products and revenue related to these products could be at risk if
we were unable to maintain these relationships. In order to expand the
distribution of our products and broaden our product offerings, we have
established strategic relationships with a number of indirect channel partners
and other consultants that provide marketing and sales opportunities for us. We
have entered into key formal and informal agreements with other companies such
as IBM CrossWorlds, Microsoft Corporation, SAP AG, Siebel Systems Inc, Sun
Microsystems, Inc., BEA Systems Inc., EMC Corporation, ILOG Corporation,
Arbortext, Inc., Venetica Corporation and Verity, Inc. Certain of these
agreements have minimum purchase requirements and/or require prepayments which
usage is limited to a specific timeframe, while others do not have minimum
purchase requirements and/or are cancelable at will. We cannot assure that these
companies will not reduce or discontinue their relationships with, or support
of, FileNet and our products. Our failure to maintain these relationships, or to
establish new relationships in the future, could harm our business, financial
condition and results of operations.
17
We currently license certain software from third parties, including
software that is integrated with internally developed software and used in our
products to perform key functions. We would be unable to sell theses products if
we do not maintain these licenses, which would result in reduced revenue. In the
past, we have had difficulty renewing certain licenses. The failure to continue
to maintain these licenses would prohibit us from selling certain products. We
cannot assure that such third parties will remain in business, that they will
continue to support their software products or that their software products will
continue to be available to us on acceptable terms. The loss or inability to
maintain any of these software licenses could result in shipment delays or
reductions in software shipments until equivalent software can be developed,
identified, licensed, and integrated. In addition, it is possible that as a
consequence of a merger or acquisition transaction involving one of these third
parties, certain restrictions could be imposed on our business that had not been
imposed prior to the transaction. This could adversely affect our sales.
Our stock price has been and may continue to be volatile causing
fluctuations in the market price of our stock, which would impact shareholder
value. The trading price of our common stock has fluctuated in the past and is
subject to significant fluctuations in response to the following factors, among
others, some of which are beyond our control:
o variations in quarterly operating results;
o fluctuations in our order levels;
o announcements of technological innovations or new products or product
enhancements by us or our competitors;
o key management changes;
o changes in accounting regulations;
o changes in joint marketing and development programs;
o developments relating to patents or other intellectual property rights
or disputes;
o developments in our relationships with our customers, resellers and
suppliers;
o our announcements of significant contracts, acquisitions, strategic
partnerships or joint ventures;
o general conditions in the software and computer industries;
o fluctuations in general stock market prices and volume, which are
particularly common among highly volatile securities of Internet and
software companies;
o acquisitions in the past have been primarily cash based transactions.
Future acquisitions may include stock, which could dilute EPS and
possibly reduce shareholder value;
o we may not be able to hedge all foreign exchange risk due to the
significant fluctuation of the Euro to the US Dollar and our ability
to predict the mix of sales orders denominated in the Euro at the end
of each fiscal quarter;
o reduced stock value may restrict our access to equity financing to
fund further acquisitions using stock;
o industry analyst opinions may increase our stock price volatility and
reduce shareholder value; and,
o other general economic and political conditions.
In recent years, the stock market, in general, has experienced extreme
price and volume fluctuations that have affected the market price for many
companies in industries similar to ours. Some of these fluctuations have been
unrelated to the operating performance of the affected companies. These market
fluctuations may decrease the market price of our common stock in the future.
18
Item 2. Properties
We currently lease 300,238 square feet of office, development and
manufacturing space in Costa Mesa, California and 91,128 square feet of office
and development space in Kirkland, Washington. In addition, we lease 24,500
square feet of office and manufacturing space in Dublin, Ireland and 10,000
square feet of office and development space in Edmonton, Alberta, Canada. We
also lease sales and support offices in 29 locations in the United States, 18
locations in Europe, 3 locations in Australia, 2 other locations in Canada, and
4 locations in Asia. We believe that the Costa Mesa, Dublin, Kirkland and
Edmonton facilities will be adequate for our anticipated development and
manufacturing needs through 2004.
Item 3. Legal Proceedings
In the normal course of business, we are subject to ordinary routine
litigation and claims incidental to our business. While the results of
litigation and claims cannot be predicted with certainty, we believe that the
final outcome of existing litigation and claims matters will not have a
materially adverse effect on our consolidated results of operations or financial
conditions.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended December 31, 2003.
19
PART II
Item 5. Market for the Registrant's Common Stock and Related Stockholder
Matters
Our common stock is traded on the NASDAQ National Market under the symbol
"FILE". The following are the high and low sale prices from January 1, 2002
through December 31, 2003, as reported by NASDAQ:
High Low
Year Ended December 31, 2003
4th Quarter $ 27.75 $ 19.50
3rd Quarter 22.65 15.00
2nd Quarter 19.65 10.19
1st Quarter 14.18 10.39
Year ended December 31, 2002
4th Quarter $ 14.23 $ 8.64
3rd Quarter 15.50 10.09
2nd Quarter 17.98 11.35
1st Quarter 23.10 16.01
The closing price of our common stock at December 31, 2003 was $27.08. As
of March 12, 2004 we estimate that there will be approximately 475 stockholders
of record on March 16, 2004 (record date for 2004 Annual Meeting of
Stockholders).
We have not paid any dividends on our common stock. We currently intend to
retain earnings for use in our business and do not anticipate paying cash
dividends in the foreseeable future.
20
Item 6. Selected Financial Data
The following table summarizes selected financial data and should be read
in conjunction with our consolidated financial statements and the notes thereto,
and Item 7, Management's Discussion and Analysis of Financial Condition and
Results of Operations. The selected consolidated statements of operations and
balance sheet data as of and for each of the five years in the period ended
December 31, 2003 have been derived from our audited financial statements.
(Per thousands, except per share amounts)
Fiscal Years Ended December 31, 2003 2002 2001 2000 1999
Consolidated statements of operations data:
Revenue:
Software $ 149,214 $ 132,508 $ 119,014 $ 204,872 $ 183,316
Service 212,833 206,806 201,568 174,291 148,162
Hardware 2,458 7,703 14,028 21,199 16,630
Total revenue 364,505 347,017 334,610 400,362 348,108
Cost of revenue:
Cost of software revenue 13,800 10,565 7,522 14,643 16,986
Cost of service revenue 81,462 89,016 102,292 101,976 86,377
Cost of hardware revenue 3,669 5,995 10,211 13,559 9,078
Total cost of revenue 98,931 105,576 120,025 130,178 112,441
Gross profit 265,574 241,441 214,585 270,184 235,667
Operating expenses:
Research and development 77,050 71,735 68,838 57,914 54,307
Selling and marketing 144,975 132,109 136,124 135,513 133,374
General and administrative 32,466 31,656 33,381 29,428 24,356
Restructuring and in-process
research and development - 400 - 2,984 -
Total operating expenses 254,491 235,900 238,343 225,839 212,037
Operating income (loss) 11,083 5,541 (23,758) 44,345 23,630
Other income, net 4,084 5,209 2,503 5,406 3,409
Income (loss) before income taxes 15,167 10,750 (21,255) 49,751 27,039
Provision (benefit) for
income taxes 4,247 2,478 (4,633) 11,204 7,362
Net income (loss) $ 10,920 $ 8,272 $ (16,622) $ 38,547 $ 19,677
Earnings (loss) per share:
Basic 0.30 0.23 (0.47) 1.13 0.61
Diluted 0.29 0.23 (0.47) 1.05 0.59
Weighted average shares outstanding:
Basic 36,532 35,590 35,117 34,155 32,125
Diluted 38,089 36,709 35,117 36,765 33,360
Consolidated balance sheet data:
Working capital $ 189,326 $ 135,302 $ 144,750 $ 155,483 $ 101,777
Total assets 391,848 328,036 301,639 324,093 243,398
Stockholders' equity 289,148 238,905 215,825 224,957 150,458
Note: Service revenue and costs include both Customer Support and Professional
Services and Education. Certain reclassifications have been made to the prior
years' selected financial data to conform to the current year's presentation. In
November 2001, the FASB announced Emerging Issues Task Force ("EITF") Topic No.
D-103, "Income Statement Characterization of Reimbursements Received for
Out-of-Pocket Expense Incurred." The EITF required companies to characterize
reimbursements received for out-of-pocket expenses as revenues in the statement
of operations. Application of this EITF required that comparative financial
statements for prior periods be reclassified to comply with the guidance. We
adopted this EITF as of January 1, 2002 and have reclassified our prior-period,
consolidated financial statements to conform to this EITF.
21
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
This Annual Report on Form 10-K 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 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 factors described under the heading "Risk
Factors" and in other documents we file from time to time with the Securities
and Exchange Commission. 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.
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 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.
22
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 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. 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. Professional
services are not required for the software to function. We do not make changes
to the standard software code in the field.
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 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.
The following table represents the account balances for these provisions
and the changes for each of the periods presented. Deductions to these
provisions are the result of customer bad debt write-offs or product returns.
Additions to the provision are based on estimated credit losses related to
specific customer collection issues and are also based on historical experience.
(In thousands)
Additions
Balance at Charged to Balance
Beginning Revenue and at End
of Period Expenses Deductions of Period
Year ended December 31, 2003:
Allowance for doubtful accounts
and sales returns $ 4,232 $ 653 $ 968 $ 3,917
Year ended December 31, 2002:
Allowance for doubtful accounts
and sales returns $ 3,567 $ 1,752 $ 1,087 $ 4,232
Year ended December 31, 2001:
Allowance for doubtful accounts
and sales returns $ 5,518 $ 1,482 $ 3,433 $ 3,567
23
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 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. 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 December 31, 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 five 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
(related to domestic operations) 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 continue to generate
profits and ultimately determine 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. The Company is currently
assessing its valuation allowance related to our deferred tax assets. As of
December 31, 2003, we have a net tax deferred asset of approximately $26.6
million and valuation allowance of approximately $24.3 million. We will continue
weighing various factors throughout the year to assess the need for any
valuation allowance. Recoverability of the deferred tax assets is dependent on
continued profitability from operations. Should our level of profitability
continue as expected, we would likely remove the entire valuation allowance in
2004. We would realize a one-time, non-cash benefit by decreasing our tax
expense (causing an increase in earnings) by approximately $10.0 million to
$14.0 million. Additionally, we would record a non-cash charge to increase
additional reported paid-in capital by approximately $9.0 million.
24
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.
Overview
FileNet develops and markets software that helps our customers address
their electronic content and business process management requirements.
Electronic content is unstructured data with various object characteristics and
attributes. Electronic content includes, but is not limited to: Web content,
forms, word documents and scanned images that are not easily managed by
relational databases. We market these enterprise software solutions to primarily
Global 2000 customers in the banking, insurance, government, utilities and
telecom industries located in North America, Europe and Asia.
We have experienced a turbulent business environment during the last three
years. During this period we have witnessed dramatically reduced spending on
information technology. Only during the last half of 2003 have we seen
accelerated spending on information technology from our customers. We derive
approximately seventy two percent of our revenue from the United States market
and approximately twenty eight percent from international markets. The U.S.
economy is showing early indications of moderate expansion while growth in
Europe remains sluggish. Growth in Asia is expanding rapidly - but represents a
much smaller base of business for us compared to the United States market. We
operate in an international economy and are subject to the inherent risks of
foreign exchange, regulatory compliance, intellectual property infringement and
interest rate risk. We believe the electronic content management market will
out-perform average information technology spending based on industry analysts'
opinions and our own customers' statements regarding their IT investment
priorities in the next several years.
There was a significant consolidation in the electronic content management
market space during 2003. Several competitors that previously offered only point
solutions to specific content management problems now provide a suite of
solutions rendering them as more viable competitors to us. These competitors
must now integrate these various point solutions, based on several different
technologies, into an application that a prospective customer could consider
deploying on an enterprise-wide basis. We have taken a different approach by
focusing primarily on internal development to provide an integrated solution. We
have, however, acquired certain specific third party technologies that enhance
our products' capabilities. For example, we acquired and integrated Web content
and electronic forms technologies into our FileNet P8 framework during 2002 and
2003.
We face several challenges in executing our strategy of growth and
profitability in the future. Our strategy is to:
o Leverage the investment we have made in research and development
through increased software license sales,
o Continue to sell our software to customers who will deploy multiple
applications across their enterprises based on the FileNet P8
architecture,
o Manage our research and development expenditures through a balanced
approach of internal development, offshore development, and third
party licensing and technology acquisitions,
o Increase our marketing and sales productivity to effectively and
efficiently address each vertical market and each account segment, and
o Maintain high customer satisfaction levels to ensure continued renewal
of maintenance contracts.
25
We believe we are well positioned for continued growth and profitability if
we can execute our business strategy.
Results Of Operations
The following table sets forth certain consolidated statement of operations
data as a percentage of total revenue for the periods indicated:
(As a percentage of total revenue)
December 31, 2003 2002 2001
Revenue:
Software 40.9% 38.2% 35.6%
Customer support 45.2 43.2 39.6
Professional services and education 13.2 16.4 20.6
Hardware 0.7 2.2 4.2
Total revenue 100.0 100.0 100.0
Cost of revenue:
Software 3.8 3.1 2.2
Customer support 10.7 11.1 12.7
Professional services and education 11.6 14.5 17.9
Hardware 1.0 1.7 3.1
Total cost of revenue 27.1 30.4 35.9
Gross profit 72.9 69.6 64.1
Operating expenses:
Research and development 21.1 20.8 20.6
Selling and marketing 39.8 38.1 40.6
General and administrative 8.9 9.1 10.0
Total operating expenses 69.8 68.0 71.2
Operating income (loss) 3.1 1.6 (7.1)
Other income, net 1.1 1.5 0.7
Income (loss) before tax 4.2% 3.1% (6.4)%
Revenue
As more fully discussed below, total revenue increased by 5.0% in 2003
compared to 2002 and by 3.7% in 2002 compared to 2001. The increase in total
revenue during both of these periods is primarily attributable to an increase in
demand for our software products as well as the growth in customer support
revenue partially offset by lower professional services and hardware revenue.
26
Revenue by Geography. The following table sets forth total revenue by
geography and as a percentage of total revenue for the periods indicated:
Revenue by Geography
(In thousands)
% Increase/ % Increase/
Year ended December 31, 2003 decrease 2002 decrease 2001
Total United States
Revenue $ 257,100 2.2% $ 251,447 2.7% $ 244,902
Europe 83,817 7.5% 77,953 8.1% 72,117
Asia / Pacific 12,171 22.7% 9,916 24.4% 7,968
Canada 7,971 42.8% 5,581 (17.8%) 6,787
Other 3,446 62.5% 2,120 (25.2%) 2,836
Total International Revenue 107,405 12.4% 95,570 6.5% 89,708
Total Revenue $ 364,505 5.0% $ 347,017 3.7% $ 334,610
United States Revenue 71% 72% 73%
International Revenue 29% 28% 27%
Total Revenue Contribution 100% 100% 100%
International revenue represents approximately 29% of total revenue and
grew more rapidly than domestic revenue in both 2003 and 2002. Europe is our
largest international market and total revenues in Europe grew by 16% during the
period from 2001 to 2003. Asia is a much smaller market, but produced revenue
growth of 53% during the period from 2001 to 2003. We made significant
investments in the Asia Pacific region to support the revenue growth that we
believe will continue to increase in countries such as China and India. We
expect international revenue to continue to represent a significant percentage
of total revenue. However, international revenues will be adversely affected if
the U.S. dollar strengthens against certain major international currencies or if
international economic conditions remain relatively weak.
27
Revenue by Reporting Segment. The following table sets forth total revenue by
reporting segment and as a percentage of total revenue for the periods
indicated:
Revenue by Reporting Segment
(In thousands)
% Increase/ % Increase/
Year ended December 31, 2003 (Decrease) 2002 (Decrease) 2001 .
Software $ 149,214 12.6% $ 132,508 11.3% $ 119,014
Customer Support 164,772 10.0 149,847 13.2 132,382
Professional Services and
Education 48,061 (15.6) 56,959 (17.7) 69,186
Hardware 2,458 (68.0) 7,703 (45.1) 14,028
Total Revenue $ 364,505 5.0% $ 347,017 3.7% $ 334,610
Software 40.9% 38.2% 35.6%
Customer Support 45.2 43.2 39.6
Professional Services and
Education 13.2 16.4 20.6
Hardware .7 2.2 4.2
Total Revenue Contribution 100.0% 100.0% 100.0%
Software. Software revenue consists of fees earned from the licensing of
our software products to our customers. Software revenue increased by 12.6% in
2003 compared to 2002, and by 11.3% in 2002 compared to 2001. The increase in
software revenue during both periods was primarily due to an increase in demand
for enterprise content management and business process management solutions.
Additionally, our existing customers primarily drove this demand in our key
vertical industries of banking, insurance and government. We saw these customers
increase usage of existing applications and new applications of our software. We
believe the IT spending environment improved during the past two fiscal years
and more significantly during the last half of 2003 as we experienced the return
of larger software deployments by some of our customers. We believe these trends
will continue in 2004 with a moderate, but steady improvement in IT spending on
enterprise content management and business process management software.
Customer Support. Customer support revenue consists of revenue from
software maintenance contracts, "fee for service" revenues and the sale of spare
parts and supplies. Maintenance contracts entitle our customers to receive
technical support, bug fixes and upgrades to new versions of software releases
when and if available. Customer support revenue increased by 10.0% in 2003
compared to 2002 and by 13.2% in 2002 compared to 2001. These increases in
customer support revenue reflect an increase in our overall customer installed
base combined with a high rate of renewal in the existing customer base.
Customer support revenue is directly related to the sale of software licenses in
prior periods. Customer support revenue grew more slowly in both 2003 and 2002
compared to the growth rate in previous years as a result of reduced software
sales growth in 2001 and 2002 and software support pricing pressure. A
prolonged economic slowdown negatively affects the growth rate of customer
support revenue as this revenue stream is directly related to software revenue
growth over time. However, we believe we will continue to experience a high rate
of renewal on maintenance contracts, as our customers tend to deploy mission
critical applications using our software to manage content.
Professional Services and Education. Professional services and education
revenue is generated primarily from consulting and implementation services to
end users of our software products, technical consulting services provided to
our resellers, and training services. No modifications are made to our standard
base product code once the software has been sold. Professional services are
28
generally performed on a time and material basis. Professional services and
education revenue decreased by 15.6% in 2003 compared to 2002 and by 17.7% in
2002 compared to 2001. The decrease during the last two years is reflective of
the economic slow down that began in 2001, resulting in fewer and smaller
consulting engagements and increased pricing pressures. Professional services
revenue and education revenue is dependent on the level and the nature of
software sales in prior years - particularly new customer sales. Professional
services revenue was strong in 2001 as a result of strong software sales in 2000
to new customers. However, with the decline in software revenue in 2001,
professional services revenue in 2002 started to decrease and this trend
continued into 2003. Another contributing factor to the decrease in professional
services revenue for the past two years is that software revenue has been
characterized by repeat purchases for additional software licenses that do not
require large-scale professional services engagements. We believe we will
experience a moderate, but steady improvement in professional services and
education revenue in 2004 based on the software revenue trends we experienced
during the last half of 2003.
Hardware. Hardware revenue is generated primarily from the sale of our
12-inch OSAR libraries. Hardware revenue decreased by 68.1% in 2003 compared to
2002 and by 45.1% in 2002 compared to 2001. The decline in hardware revenue
reflects that hardware is not a strategic focus for us.
Cost of Revenue
Cost of Revenue by Reporting Segment. The following table sets forth total
cost of revenue by reporting segment and as a percentage of total cost of
revenue by reporting segment for the periods indicated:
Cost of Revenue by Reporting Segment
(In thousands)
% Increase/ % Increase/
Year ended December 31, 2003 (Decrease) 2002 (Decrease) 2001
Software $ 13,800 30.6% $ 10,565 40.5% $ 7,522
Customer Support 39,116 1.3 38,608 (8.9) 42,396
Professional Services and
Education 42,346 (16.0) 50,408 (15.8) 59,896
Hardware 3,669 (38.8) 5,995 (41.3) 10,211
Total Cost of Revenue $ 98,931 (6.3)% $ 105,576 (12.0)% $ 120,025
Software 9.2% 8.0% 6.3%
Customer Support 23.7 25.8 32.0
Professional Services and 88.1 88.5 86.6
Education
Hardware 115.0 77.8 72.8
Total Cost of Revenue as a %
of Segment Revenue 27.1% 30.4% 35.9%
Software. Cost of software revenue includes royalties paid to third parties
for technology embedded in our products to enhance features and functionality,
amortization of acquired technology, media costs, and the cost to manufacture
and distribute software. The cost of software revenue as a percent of software
revenue increased by 1.2% in 2003 compared to 2002 and by 1.7% in 2002 compared
to 2001. The increase in cost of software revenue during both periods is
primarily the result of an increase in royalty costs due to increased
utilization of new third party software products and the amortization of
acquired technology resulting from the eGrail acquisition in April 2002 and the
29
Shana acquisition in April 2002. Going forward we anticipate cost of software
revenue to be approximately 10% of cost of revenue as we continue to integrate
third-party technology with our products.
Customer Support. Cost of customer support revenue includes the cost of
customer support personnel, facility and technology infrastructure expenses in
our call centers, supplies and spare parts. The cost of customer support revenue
as a percent of customer support revenue decreased by 2.0% in 2003 compared to
2002 and by 6.2% in 2002 compared to 2001. These reductions in cost of customer
support revenue are attributable to employee reductions and efficiency
improvements in the delivery of technical support. We expect the cost of
customer support revenue to remain at approximately 25% of customer support
revenue for the near future.
Professional Services and Education. Cost of professional services and
education revenue consists primarily of the costs of professional services
personnel, training personnel, and third-party contractors. The cost of
professional services and education revenue, as a percent of professional
services and education revenue, decreased by 0.4% in 2003 compared to 2002 and
increased by 1.9% in 2002 compared to 2001. The reduction in the use of external
third party independent consultants and lower variable compensation for internal
employees contributed to maintaining essentially flat operating costs as a
percent of professional services and education revenue during both periods. 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 internal and
external service providers.
Hardware. Cost of hardware revenue includes the cost of assembling our OSAR
library products, the cost of hardware integration personnel, warranty costs and
distribution costs. The cost of hardware revenue decreased by 38.8% in 2003
compared to 2002 and decreased by 41.3% in 2002 compared to 2001. The
year-to-year decreases in absolute dollars are directly related to decreased
hardware revenue. Hardware cost as a percent of hardware revenue has not
decreased proportionally because fixed costs have not decreased at the same rate
as hardware revenue. Hardware is no longer a strategic focus for us.
Operating Expenses
Total Operating Expenses. The following table sets forth total operating
expense by function and as a percentage of total revenue for the periods
indicated:
Operating Expenses .
% Increase/ % Increase/
Year ended December 31, 2003 (Decrease) 2002 (Decrease) 2001
Research and Development $ 77,050 7.4% $ 71,735 4.2% $ 68,838
Marketing and Sales 144,975 9.7 132,109 (2.9) 136,124
General and Administrative 32,466 2.6 31,656 (5.2) 33,381
In-process R and D - 400 -
Total Operating Expenses $ 254,491 7.9% $ 235,900 (1.0)% $ 238,343
Research and Development 21.1% 20.8% 20.6%
Marketing and Sales 39.8 38.1 40.6
General and Administrative 8.9 9.1 10.0
Operating Expense as a % of
Revenue 69.8% 68.0% 71.2%
30
Research and Development. Our research and development efforts are focused
on enhancing and maintaining our Enterprise Content Management capabilities
within the FileNet P8 product line. These efforts focus on existing products and
developing additional capabilities to our FileNet P8 platform and suites such as
Business Process Management, Web Content Management, Records Management, Team
Collaboration and other capabilities.
We seek to achieve our development objectives through both internal and
external resources, and by obtaining third party technology to enhance product
capabilities through licensing agreements and acquisitions. During 2002 we
initiated a program involving offshore development in lower labor cost
countries. During 2003 we expanded this offshore development effort to include
both product sustainment and product development activities. During 2003 we
acquired Shana to integrate their electronics forms capabilities into our
products. During 2002 we acquired eGrail to integrate their web content
management capabilities into our products. (See Note 3 to the Notes to the
Consolidated Financial Statements.)
Our research and development expense consists primarily of personnel costs
for software developers; third party contracted development efforts and related
facilities costs. Research and development expense increased by 7.4% in 2003
compared to 2002 and by 4.2% in 2002 compared to 2001. The number of research
and development personnel was 456 in 2003, 430 in 2002 and 425 in 2001.
The majority of the $5.3 million increase in research and development
expenses from 2002 to 2003 is attributable to the acquisition of Shana, the full
year cost of the eGrail development team, extensive investment development
efforts to enhance content management with new capabilities and increased
offshore development expense. Increased numbers of internal employees resulted
in higher compensation, benefits and relocation costs related to the integration
of the eGrail and Shana acquisitions in April of 2002 and 2003, respectively.
The majority of the $2.9 million increase in research and development expenses
from 2001 to 2002 is primarily attributable to the acquisition of eGrail that
resulted in additional facility and employee expenses. This acquisition resulted
in an increase in compensation expense primarily due to increased numbers of
personnel as well as an increase in consulting costs due to the expanded use of
contractors.
We intend to complement internal development with offshore development as
well as with third-party software through OEM agreements and may execute
additional technology acquisitions. Over time, we believe we will be able to
lower our per developer cost through the use of offshore resources. However, in
the near term, some duplicate expenses will be incurred as our development
programs are transitioned to offshore developers. Offshore development costs for
the 12 months ended December 31, 2003 was $3.1 million compared to $1.3 million
for 2002. 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.
Selling and Marketing. We sell our products through a direct sales force
and our indirect channel sales partners. Our selling and marketing expense
consists primarily of salaries, benefits, sales commissions and other expenses
related to the direct and indirect sales force and personnel cost for marketing
and market development programs.
Selling and marketing expense increased by 9.7% in 2003 compared to 2002
and decreased by 2.9% in 2002 compared to 2001. The number of sales and
marketing employees was 549 in 2003 compared to 541 in 2002. Marketing personnel
increased by 30 employees while sales personnel decreased by 22 employees,
yielding the net increase of 8 employees during 2003. This shift in sales and
marketing capacity was predicated on our customer engagement initiative, which
31
we implemented in 2002 and 2003. This initiative prescribed a smaller direct
sales force, increased channel partner business and increased marketing
personnel with deep vertical industry knowledge and demand generation
capabilities.
The increase in sales and marketing expense of $12.9 million reflects a
higher salary mix as well as higher variable compensation associated with higher
revenue in 2003 compared to 2002. Personnel related expenses including salaries
and benefits increased $4.6 million year over year. Higher software revenue in
2003 resulted in higher commission expense of $3.4 million. Travel, training,
recruitment and marketing programs related to the FileNet P8 product release in
2003 accounted for the balance of the increase. The decrease in absolute dollars
from 2001 to 2002 was primarily due to a 54% reduction in recruitment expenses,
as well as a 10% reduction in sales commission expense. Charges in 2001 for
severance of $2.9 million related to workforce reductions and $218,000 for
facility consolidation costs, primarily in sales, also contributed to the higher
costs in 2001 compared to 2002 and led to reduced costs in 2002.
We expect selling and marketing expense to remain at approximately 40% of
revenue in the near-term.
General and Administrative. Our general and administrative expense consists
primarily of salaries, benefits, and other expenses related to personnel costs
for finance, information technology, legal, human resources and general
management; and the cost of outside professional services.
General and administrative expense increased slightly by 2.6% in 2003
compared to 2002 and decreased by 5.2% in 2002 compared to 2001. General and
administrative expenses remained relatively stable when comparing 2003 to 2002
and 2001 - primarily as a result of expense controls.
We expect general and administrative expense to remain at approximately 9%
of revenue in the near-term.
Purchased In-Process Research and Development. There was no in-process
research and development expense associated with our April 2003 acquisition of
Shana. Our eGrail acquisition in April 2002 of certain assets and certain
liabilities of eGrail resulted in an allocation of $400,000 to in-process
research and development. The allocation was determined through established
valuation techniques in the high-technology industry by an independent
third-party appraiser. In-process research and development 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 Web Content
Management 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 twelve-month period. However,
actual costs upon 100% completion at March 31, 2003 were $4.7 million. There was
no in-process research and development expense during 2001.
Amortization of Goodwill. There was no amortization of goodwill expense
during 2003 and 2002 as we ceased amortizing goodwill and assembled workforce
beginning January 1, 2002 based on the adoption of SFAS No. 142. In connection
with our acquisition of certain assets from API on May 18, 2000, the purchase
price amount allocated to goodwill of $14.6 million was being amortized in
operating expenses over a useful life of five years and assembled workforce of
$386,000 was being amortized over a useful life of three years. Assembled
workforce no longer meets the definition of a separately identified intangible
asset under the provisions of SFAS No. 141, "Business Combinations," and the
un-amortized balance of $182,000 at December 31, 2001 was reclassified as
goodwill at January 1, 2002. SFAS No. 142 was also effective for business
combinations that occurred after June 30, 2001. Accordingly, goodwill of $5.8
32
million that was recorded in April 2002 in connection with the eGrail
acquisition and goodwill of $3.6 million that was recorded in April 2003 in
connection with the Shana acquisition is not amortized.
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. 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 December 31, 2003, no
impairment of goodwill has been recognized. If estimates change, a materially
different impairment conclusion could result.
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, technology manuals and design
documents of $600,000 and non-compete agreements of $277,000. All intangible
assets for the Shana acquisition were assigned a useful life of five years.
Non-compete agreements with former executives of Shana were assigned a useful
life of between two and three years. We determined that these assets were not
impaired at December 31, 2003. Amortization of patents are reported as research
and development expense, amortization of non-compete agreements are reported as
general and administrative expense, while acquired technology, customer
maintenance relationships and technical manuals and design documents are
reported as cost of revenue.
Interest, Other Income and Expenses, 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 and interest expense. Other income, net of other expenses, was $4.1
million in 2003, $5.2 million in 2002 and $2.5 million in 2001. The decrease in
2003 from 2002 of $1.1 million was primarily attributable to a lower net foreign
exchange gain of approximately $700,000 due to a significant weakening of the
dollar against the Euro in 2003, and reduced interest income of approximately
$400,000 due to a lower weighted-average interest rate in 2003 compared to 2002.
The weighted average interest rate earned on cash, cash equivalents and
investments was 1.39% in 2003, 1.98% in 2002 and 2.49% in 2001. Other expense in
2001 included a $3.5 million litigation settlement charge.
Provision for Income Taxes. The provision for income taxe