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SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission File Number: 0-20981

Document Sciences Corporation

Registrant’s telephone number, including area code: (760) 602-1400

Securities registered pursuant to Section 12(b) of the Act: None

     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 þ         No o

     Indicate by check mark if 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 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.    o

     As of February 28, 2002, there were 3,869,364 shares of the Registrant’s common stock outstanding and the aggregate market value of such shares held by non-affiliates of the Registrant (based upon the closing sale price of such shares on The Nasdaq National Market on February 28, 2002) was $7,375,355. Shares of common stock held by each executive officer and director and by each entity that owns 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

DOCUMENTS INCORPORATED BY REFERENCE

     Part III incorporates certain information by reference from Registrant’s definitive proxy statement pursuant to Schedule 14A for its 2001 Annual Meeting of Stockholders to be held on April 23, 2002, which proxy statement will be filed no later than 120 days after the close of Registrant’s fiscal year ended December 31, 2001.

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A WARNING ABOUT FORWARD-LOOKING STATEMENTS

      We make forward-looking statements in this Annual Report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our financial condition, operations, plans, objectives and performance. Additionally, when we use the words “believe,” “expect,” “anticipate,” “estimate” or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance. This could cause our results or performance to differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this document, along with the following possible events or factors:

	•	national, international, regional and local economic, competitive and regulatory conditions and developments;
	•	the market for document automation software;
	•	market acceptance of enhancements to our existing products and introduction of new products;
	•	continued expansion of our professional services;
	•	maintaining our relationships with Xerox Corporation; and
	•	other uncertainties, all of which are difficult to predict and many of which are beyond our control.

      Foreseeable risks and uncertainties are described elsewhere in this report and in detail under “Item 1. Business — Risk Factors.” You are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this Annual Report. We undertake no obligation to publicly release the results of any revision of the forward-looking statements.

PART I

Item 1.     Business

      Document Sciences Corporation develops, markets and supports a family of document automation software used in high volume print and transactional electronic publishing applications. Document automation has become increasingly important as more companies realize the benefits of producing personalized documents that include the precise layout of regulated content, personal financial data and in-context, one-to-one marketing information. Our document automation software (our Autograph family of products) enables personalized publishing solutions for many industries including insurance, managed healthcare, financial services, commercial print services, government, telecommunications and manufacturing. Our products facilitate an important form of communication between organizations and their customers by employing enterprise database assets to produce high-quality, highly-personalized documents that are ready to print on demand, to email or to distribute over the web using HTML or Adobe Systems’ (Adobe) PDF® technology. Our Autograph products are licensed to approximately 600 customers worldwide who collectively produce over one billion customized pages per month. Our highly portable Autograph software platform enables cost-effective, just-in-time, on demand, high volume or transactional publishing that is high quality and fully automated. Our software products are used across a wide array of computing environments from client/server PC and Unix configurations to large mainframe computer systems.

Company Formation

      We were incorporated in Delaware in October 1991 as a wholly owned subsidiary of Xerox Corporation (Xerox). Following our initial public offering of stock in September 1996, Xerox ownership was reduced to approximately 62%. As a result of our tender offer and our exercise of an option to purchase additional shares from Xerox in April 2001, Xerox’s ownership interest has been reduced to 19.9%. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”.

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Products

      Our Autograph family of products currently addresses two major functional areas within the enterprise content and document automation arena: Document Composition and Assembly and Regulated Content Management. All of our software products can be complemented by our professional services organization.

      We generally license our products for one year, for an initial license fee, after which an annual renewal license and support fee, usually 15% of the initial license fee, is required for continued use. We have two additional licensing models whereby we offer perpetual licenses for our products, as well as three-year term licenses, after which the license may be renewed for additional three-year terms, or converted for perpetual use. We also provide three-year maintenance agreements that are usually in an amount equal to 15% per year of the initial license fee. The list price for a three-year license fee for CompuSet, our core product, is currently $90,000 for a mainframe installation and ranges down to $45,000 for a PC NT server installation. Options currently range from $2,000 to $50,000. A typical new account sale through our direct channel is approximately $100,000 for software licenses and $75,000 for professional services.

     Document Composition and Assembly

      Composition and Assembly. CompuSet software automates document composition and assembly using corporate data and variable content. CompuSet consists of a rule-based language and a robust composition engine that provides high-speed content composition and assembly of complex personalized documents at a high level of quality. Corporate data and variable content are marked with CompuSet tags which, in turn, are defined in logically separate CompuSet style specifications. The CompuSet tags are conceptually and syntactically similar to HTML or XML tags, the current web standards for content tagging, and the CompuSet style specifications are conceptually similar to CSS and XSL, the current web standards for style definition. Without requiring any real-time user interaction, CompuSet transforms the tagged data, the style specifications and the variable content into high-quality electronic documents that are assembled and composed at rates in excess of 50 pages per second, depending on the computing platform configuration and the complexity of the document. The document composition features are rich and extensive, including the automatic generation of multi-dimensional dynamic data driven graphics and the support of full color text and images. The composition and assembly process can be optimized for print, email and/or web presentation media for multi-channel distribution.

      Document Output and Merge. The CompuSet Emitters transform CompuSet generated output into a number of popular Page Description Languages (PDLs) for subsequent printing, electronic distribution and/or archive storage for future retrieval and viewing. These PDLs provide device-specific instructions for rendering text, forms, images and graphics into finished documents. The Emitters also condition the PDLs for transport over a variety of high-speed printing interfaces and for support of various finishing devices. The PDL formats currently supported are Xerox’ Metacode®, International Business Machines Corporation’s (IBM) AFPDS®, Hewlett-Packard Company’s PCL® and Adobe’s PostScript® and PDF. This part of the Autograph architecture is extensible and new Emitters can be developed as necessary. In 2001, we significantly extended our architecture with the release of Output Processing. Output Processing enables inline output stream manipulation including stream splitting, merging, resequencing, sorting, bundling and barcoding. These features are necessary for postal optimization, for the support of finishing equipment without further post-processing and for multi-channel applications that require both print and electronic (email) distribution. In addition, several additional Emitter extensions were released, including support for Creo’s Variable Print Specification® (VPS), enabling high-volume full-color production on Xerox DocuColor products, as well as additional extensions for IBM’s AFPDS® and Adobe’s PDF®.

      Rapid Application Development Tools. The Visual CompuSet application development tools run on Microsoft Corporation’s (Microsoft) Windows® and simplify variable document application design and prototyping. Visual CompuSet uses a Windows® version of CompuSet that supports all of the composition features of the NT, Unix and mainframe CompuSet production engines to ensure exact design for all supported production platforms. Visual CompuSet includes a variety of content Importer, Merge, Font and Emitter tools necessary for basic application development. The content Importers accept externally generated

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      Data Preparation Tool. The Data Preparation Tool (DPT) is a Visual CompuSet product extension that enables users to map, capture, edit and tag corporate data and variable content from a wide variety of sources, including flat files and popular relational databases. It provides an easy-to-use GUI that enables the description of a complex variable data environment including any related data processing and tagging instructions. Using a data description, it automatically generates a COBOL data-tagging program that is compatible with mainframe COBOL compilers and with Acucorp’s AcuCobol® runtime products on Unix and NT platforms. DPT eliminates the need to manually develop and maintain custom programs for capturing, processing and tagging corporate data used to drive personalized document assembly and composition. DPT is the production engine for applications that are developed using our fully integrated design tool, Visual CompuSet Professional Edition.

      Visual CompuSet Professional Edition. Visual CompuSet Professional Edition (VCPro) significantly augments the capabilities of the Visual CompuSet and DPT products through the addition of an interactive Document Designer component that is tightly integrated with the DPT GUI. VCPro users can define their data environment with DPT and can directly associate their data and variable content elements with CompuSet style specifications such as sections, paragraphs, tabular elements, images, photographs and data-driven graphics. The VCPro Document Designer GUI features WYSIWYG interaction and drag-and-drop operability. The feature set is optimized for the generation of high-value investment and financial statements. In 2001, we released VCPro Web Designer, a new product option that enables the parallel development of HTML portal applications using the same DPT data environment as a related print application. In a single GUI, users are able to design an application for both print and real-time web distribution. For example, an investment statement designed for traditional print distribution can be easily web-enabled for on-demand interactive web access. The web-enabled application can be integrated into a corporate web portal that provides personalized customer access to individual account information. VCPro Web Designer eliminates the need to develop and maintain duplicate application development environments for both web and print.

     Regulated Content Management

      Our Autograph regulated content management products provide solutions for the creation, revision and management of document content used in several types of regulated document automation applications. They consist of the Document Library Service (DLS) Server and Client products, DLS Express, DLS eCor and DLSCOM. Unlike other general-purpose content management products, our Autograph DLS products are tailored for regulated document applications.

      DLS Server and Client. DLS Server manages the document content creation process required in complex, regulated text-intensive documents, such as proposals, contracts, policies and customer correspondence. Our DLS products use a client server architecture for accessing data and files stored on mainframes or NT network servers. DLS Client manages the text content created with Microsoft Word® and stored in HTML. The DLS text content is tracked and managed in a multi-authoring environment that supports access security, content searching, revision control and approval workflow. In addition to content creation and management, DLS Client enables the definition of complex assembly and business rules required for interactive or automated document assembly and composition using Microsoft Word® and/or CompuSet. DLS supports a criteria-based content selection mechanism for generating a Microsoft Word® document or a CompuSet tagged file, based on application volume requirements. The personalized document assembly can occur in a high volume fashion on a server or in a just in time, on-demand fashion on a local DLS Client computer.

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      DLS Express. DLS Express augments the flexibility of our DLS product line by incorporating web support. DLS Express enables the dynamic creation and fulfillment of web-ready documents using HTML and/or Adobe’s PDF®. These web documents can be created on-demand through a variety of web server applications including Advanced Server Pages (ASP). Dynamic web browser form input can be routed to the DLS Express server to automatically assemble and generate a customized web-ready document for local browser viewing or for local printing. Target web fulfillment applications for DLS Express include sales proposal and contract automation for insurance and other financial agents.

      DLS eCor and DLSCOM. DLS eCor and DLSCOM further augment our DLS technology capabilities by providing a rich feature-set that is targeted at enterprise-wide correspondence applications. DLS eCor enables the on-demand generation of customer correspondence through corporate call centers. DLS eCor is web-based and features an integrated Java editor that can be used to make additional manual or exception changes to pre-assembled customer correspondence. DLS eCor supports an email-based change tracking, approval and workflow process to ensure document integrity and compliance. DLSCOM is a component product version that enables the deployment of our DLS technology in a Microsoft COM/ DCOM environment. With DLS eCor and/or DLSCOM, customers can integrate our DLS products into a Customer Relationship Management (CRM) system or electronic CRM system of their choice.

     Autograph for the Enterprise

      Our products generally are licensed initially for a single document automation application. Regulated content applications such as policies and contracts are typically implemented using our DLS products whereas statement applications are typically implemented using our VCPro products. In each case, document production is driven through our CompuSet products. A growing number of customers are licensing our entire Autograph product suite for use across multiple applications throughout their enterprise.

Professional Services

      In addition to our software products, we provide a comprehensive suite of professional services that can assist customers in the implementation of mission-critical document automation applications. Our professional services include on-site software installation, consulting services, customer training programs and telephone support. Our consulting services focus on assisting in the sale of high margin initial software licenses by providing project management, requirements analysis, application design and application development services. In addition to consulting services, we provide introductory and advanced-level education classes in CompuSet, Visual CompuSet, DPT, VCPro and DLS at our headquarters in San Diego, our offices in Milwaukee and Washington DC and at customer sites. We believe our professional services enable customers to use our document automation products rapidly and effectively. Our professional services and support organizations employed a staff of 41 as of December 31, 2001.

Sales and Marketing

      Our sales and marketing organization targets vertical industry markets that require document automation and high volume, high quality document personalization. We currently license our products using a combination of direct sales and alternative channels. In the United States, we market our products primarily through a direct sales force that manages our existing base of corporate accounts, as well as targets new accounts in select market segments. Our sales account executives are provided with pre-sales technical support through qualified solution analysts. Account executives and solution analysts are located throughout the United States to provide optimal coverage. Outside of the United States, we distribute our software products through value added resellers (VARs) such as Xerox Canada, Ltd. in Canada, Fuji Xerox Co., Ltd. in Australia and Xerox do Brazil, Ltd. in Brazil. Our subsidiary, Document Sciences Europe, markets our products in Europe, Africa and the Middle East by providing VAR channel management and support and by defining European market and product requirements. Our European VARs are principally Xerox Europe affiliates who re-market our products. Our revenues from export transactions with Xerox affiliates were $4.6 million, $4.7 million and $3.7 million in 1999, 2000 and 2001, respectively. Our sales and marketing organization employed a staff of 36 as of December 31, 2001.

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      We intend to increase both our product offerings and markets through joint marketing, sales and distribution and development relationships with other major companies. Current relationships include formal and informal marketing and sales alliances with IBM, Xerox, American Management Systems, Inc. and Edgewater Technology, Inc. These relationships provide qualified sales leads for our products and extend our sales coverage and networking capabilities. In addition, we also support partner relationships with complimentary technology companies such as Siebel Systems, Inc., Sybase, Inc. and Oracle Corporation. We participate in joint marketing events with our key partners whenever appropriate and feasible. Furthermore, we actively market our products and solutions at major trade shows, through focused regional seminars and through a variety of web marketing mechanisms, including webinars.

Research and Development

      We are continuing to enhance our web functionality across all of our major product offerings. We engage customers in a formal requirements analysis that is based on the Quality Function Deployment (QFD) process. The QFD process is a formal procedure for interviewing customers, identifying their needs and prioritizing specific product features. As a result, we have identified a number of customer requirements for the production of regulated, electronic documents for the future. Our major development initiatives in 2002 address several of these key requirements brought to our attention through our QFD process.

      In general, our product development strategy is based on delivering document automation solutions for specific types of documents in one or more vertical markets or industries. A cross-functional team is responsible for delivering each focused offering. We use a documented business planning and product delivery process to guide our product development and delivery activities. We also employ iterative and rapid prototyping development methodologies.

      Our recent product offerings continue to build on our existing Autograph family of products. These well-established products are maintained by teams that respond to customer requests for defect corrections and feature enhancements. By building on our existing products, we maximize our reuse of existing software and expertise and we enable our customers to purchase these new offerings as upgrades to their existing product configurations.

      Future new product offerings are being developed as components that adhere to open standards for large-scale systems integration. Furthermore, these product offerings will be supporting open tagged data and content standards such as XML. By developing products using open standards, we can expand the delivery of our products through large systems integrators and other channels.

      We can make no assurance that we will be successful in developing, introducing and marketing future new products on a timely and cost-effective basis, if at all, or that such future new products will achieve market acceptance. See “Risk Factors — Our growth depends on market acceptance of enhancements to our existing products and our introduction of new products.”

      We expect to continue enhancing our existing products and to develop future new products, particularly as they relate to multi-channel content automation applications. Our research and development expenditures have grown substantially since our inception. Such expenditures, not including amounts capitalized, were $5.3 million, $5.3 million and $5.9 million in 1999, 2000 and 2001, respectively. Our development organization employed a staff of 40 as of December 31, 2000. We also utilize outside consulting and development firms and employ independent contractors as needed to supplement our permanent development staff.

Competition

      The market for document automation products is intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. We target document intensive organizations that require the ability to produce large quantities of personalized documents in paper or electronic form. We face direct and indirect competition from a broad range of competitors who offer a variety of products and solutions to our current and potential customers. Our principal competition currently comes from systems developed in-house by the internal MIS departments of large

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      It is also possible that we will face competition from new competitors. These include large independent software companies offering personal computer-based application software solutions, such as Microsoft and Adobe, and from large corporations providing database and content management software solutions, such as Oracle Corporation. In addition, Xerox or IBM, either directly or through affiliated entities, could become large competitors. Moreover, as the market for document automation software develops, a number of these or other companies with significantly greater resources could attempt to enter or increase their presence in the document automation market by either acquiring or forming strategic alliances with our competitors or by increasing their focus on the industry. 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 our current and prospective customers. 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, any of which could have a material adverse effect on our business, operating results and financial condition.

Patents and Proprietary Rights

      Our success is dependent, in part, on our ability to protect our proprietary technology. We rely primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. We seek to protect our software, documentation and other written materials under trade secret and copyright laws. However, these afford only limited protection. We presently have no patents or patent applications pending. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. See “Risk Factors — Our growth is dependent upon successfully protecting our proprietary rights.”

      In addition, we also rely on certain software that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. There can be no assurances that such firms will remain in business, that they will continue to support their products or that their products will otherwise continue to be available to us on commercially reasonable terms. The loss or inability to maintain any of these software licenses could result in delays or reductions in product shipments until equivalent software can be developed, identified, licensed and integrated, which would adversely affect our business, operating results and financial condition.

Customers

      We derived 19% of our revenues through Xerox and its affiliates in 2001. As a result, discontinuation of agreements and other business transactions that may adversely impact our relationship with Xerox could have a material adverse effect on our business, operating results and financial condition.

Employees

      As of December 31, 2001, we had 130 employees including 41 in professional services, 36 in sales and marketing, 40 in research and development and 13 in finance and administration. None of our employees are represented by labor unions. We have experienced no work stoppages and believe our relationship with our employees is good. Competition for qualified personnel in the industry in which we compete is intense. We

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Financial Information about Segments and Geographic Areas

      The information regarding revenues and operating profit by reportable segments and revenues from unaffiliated customers by geographic region is set forth at the end of the Annual Report under the heading “Notes to Consolidated Financial Statements — 3. Segment Information,” and is incorporated herein by reference.

RISK FACTORS

      The following is a discussion of certain factors which currently impact or may impact our business, operating results and/or financial condition. Anyone making an investment decision with respect to our common stock or other securities is cautioned to carefully consider these factors. If any of the following risks actually occur, our business, future operating results and financial condition could be materially adversely affected. In such case, the trading price of our common stock could decline and you may lose all or part of your investment.

Our quarterly results fluctuate significantly and we may not be able to grow our business.

      Our total revenues and operating results can vary, sometimes substantially, from quarter to quarter, and we expect them to vary significantly in the future. Our revenues and operating results are difficult to forecast, and our future results will depend upon many factors, including the following:

	•	the demand for our products;
	•	the level of product and price competition we face;
	•	the length of our sales cycle;
	•	the size and timing of individual license transactions;
	•	the delay or deferral of customer implementations;
	•	the budget cycles of our customers;
	•	our success in expanding our direct sales force or indirect distribution channels;
	•	the timing of our new product introductions and enhancements, as well as those of our competitors;
	•	our mix of products and services;
	•	our level of international sales;
	•	the activities of and acquisitions by our competitors;
	•	our timing of new hires;
	•	changes in foreign currency exchange rates;
	•	our ability to develop and market new products and to control costs; and
	•	general domestic and international economic conditions.

      Our initial license fee revenue mainly depends on when orders are received and shipped. However, because of our sales model, our customers’ implementation schedule and the complexity of the implementation process, revenue from some software shipments may not be recognized in the same quarter as when shipment occurs. Our operating expenses are primarily based on anticipated revenue levels. Since a high percentage of those expenses are relatively fixed, a delay in the recognition of revenue from license transactions could cause significant variations in operating results from quarter to quarter and we may sustain losses as a result. If such expenses precede increased revenues, our operating results would be materially adversely affected.

      As a result of these factors, results from operations for any quarter are subject to significant variation, and we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and

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We currently derive a significant portion of our revenues through Xerox.

      We currently have a variety of contractual and informal relationships with Xerox and its affiliates, including a cooperative marketing agreement, a transfer and license agreement and various distribution agreements. We rely on these relationships and agreements for a significant portion of our total revenues. In 2001, revenues derived from relationships with Xerox and affiliates of Xerox accounted for approximately $5.2 million, $5.2 million and $4.1 million in 1999, 2000 and 2001, respectively, representing 21%, 23% and 19% of our total revenues, respectively.

      Furthermore, there can be no assurance that existing and potential customers will continue to do business with us because of these relationships or our historical ties with Xerox and its affiliates. Although we intend to continue our existing business relationships with Xerox, our strategy is to lessen our dependence on Xerox. However, there can be no assurance that we will be able to do so and, because of our current level of dependence on Xerox, there can be no assurance that our move to become more independent will not adversely affect our business, operating results and financial condition. Our failure to maintain these relationships, particularly with Xerox and its affiliates, or to establish new relationships in the future, could have a material adverse effect on our business, operating results and financial condition.

      Xerox has strategic alliances and other business relationships with other companies who supply software and services used in high volume electronic publishing applications and who now or in the future may be our competitors. There can be no assurance that Xerox or one of its affiliated companies will not engage in business that directly competes with us. In addition, Xerox has ongoing internal development activities that could in the future lead to products that compete with us. Xerox could in the future expand these relationships or enter into additional ones and, as a result, our business could be materially adversely affected.

Our growth is dependent upon successfully protecting our proprietary rights.

      We rely on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. Despite these precautions, it may be possible for unauthorized third parties to copy portions of our products or use information we consider proprietary. Policing unauthorized use of our products is difficult and, while we are unable to determine the extent to which piracy of our software products exists, software piracy can be expected to be a persistent problem. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. We cannot assure you that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology.

      We are not aware of any infringement of our products upon the proprietary rights of third parties. However, we cannot assure you that third parties will not claim infringement by us with respect to current or future products. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results and financial condition.

Our growth is dependent upon successfully focusing our distribution channels.

      We intend to streamline our worldwide sales and distribution channels by focusing on key target industry market segments where our current and planned products enjoy a significant competitive advantage and a current, high market demand. We also plan on leveraging our existing relationships with Xerox, IBM and their channels and affiliates by launching targeted joint marketing and value added reseller programs and by

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Maintaining our professional services expertise is necessary for our future growth.

      We are continuing our focus on the consulting services component of our professional services to assist customers in the planning and implementation of enterprise-wide, mission-critical document automation applications. This strategy is dependent on retaining and hiring professionals to perform these consulting services. Should we be unable to maintain the necessary services workforce, our business and financial condition could be materially adversely affected.

Our growth depends on our ability to compete successfully against current and future competitors.

      The market for document automation products is intensely competitive. We face competition from a broad range of competitors, many of whom have greater financial, technical and marketing resources than we do. Our principal competition currently comes from systems developed in-house by the internal MIS departments of large organizations and direct competition from numerous software vendors, including Docucorp International, Inc., Metavente and Group 1 Software, Inc. We believe that the principal competitive factors affecting our market include product performance and functionality, ease of use, scalability, operating across multiple computer and operating system platforms, product and company reputation, client service and support and price. Although we believe that we currently compete favorably with respect to such factors, we cannot assure you that we will be able to maintain our competitive position against current and future competitors, especially those with greater financial, technical and marketing resources than us, or that we will be successful in the face of increasing competition from new products, new solutions introduced by existing competitors or by new companies entering the market.

Our growth depends on market acceptance of enhancements to our existing products and our introduction of new products.

      Our future business, operating results and financial condition will depend upon market acceptance of our existing products, as well as our ability to respond to emerging industry standards and practices and to develop new products that address the future needs of our target markets. Our Autograph family of products has been applied mainly to document automation applications producing paper-based documents. We have started to extend our core technology to the Internet, intranets and commercial on-line services. However, we cannot assure you that we will be successful in developing, introducing and marketing new products or product enhancements, including new products or the extension of existing products for the Internet, intranets and commercial on-line services, on a timely and cost effective basis, if at all. In addition, we cannot assure you that our new products and product enhancements will adequately meet the requirements of the marketplace or achieve market acceptance. Delays in our commercial shipments of new products or enhancements may result in client dissatisfaction and a delay or loss of product revenues.

      If for technological or other reasons we are unable to develop and introduce new products or enhancements of existing products in a timely manner in response to changing market conditions or client requirements, then our business, operating results and financial condition will be materially adversely affected. In addition, we cannot assure you that our existing products, new products or new versions of our existing products will achieve market acceptance. In order to provide our customers with integrated product solutions, our future success will also depend in part upon our ability to maintain and enhance relationships with our technology partners.

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A longer than expected sales cycle may affect our revenues and operating results.

      The licensing of our software products often involves an enterprise-wide decision making process by potential customers. Sales cycles generally range from three to twelve months in order to educate potential customers regarding the use and benefits of our products. In addition, the implementation of our products by customers involves a significant commitment of their resources over an extended period of time and is commonly associated with substantial customer business process reengineering efforts. For these and other reasons, our sales and customer implementation cycles are subject to a number of significant delays over which we have little or no control. Any delay in the sale or customer implementation of a limited number of license transactions could have a material adverse effect on our business and financial condition and cause our operating results to vary significantly from quarter to quarter.

Our operating results are substantially dependent on sales of a small number of products in highly concentrated industries.

      We derived 66% of our initial license revenue from CompuSet and related CompuSet option products in 2001. In 2001, our initial license fees from DLS and Electronic Document Viewing products comprised 33% and 1%, respectively. As a result, factors that may adversely impact the pricing of or demand for CompuSet and related products, such as competition from other products, negative publicity or obsolescence of the hardware or software environments in which our products run, could have a material adverse effect on our business, operating results and financial condition. Our financial performance will continue to depend significantly on the successful development, introduction and customer acceptance of new and enhanced versions of our CompuSet software and related products.

      Our revenues are derived from sales to a small number of industries. Licenses to end users in the insurance, finance and commercial print services industries accounted for 82%, 90% and 97% of initial license revenues in 1999, 2000 and 2001, respectively.

      Our future success will depend on our ability to continue to successfully market our products in these and other industries. We cannot assure you that we will continue to be successful in developing and marketing CompuSet products and related services. Our failure to do so would have a material adverse effect on our business, operating results and financial condition.

We may be exposed to risks associated with international operations.

      Our revenues from export sales, including sales through our foreign subsidiary, accounted for 25%, 28% and 21% of our total revenues in 1999, 2000 and 2001, respectively.

      Our wholly owned subsidiary, Document Sciences Europe, markets and supports our products in Europe. We license our products in Europe through VAR’s and to a much lesser extent, direct sales. Our VARs are principally Xerox affiliates who re-market our products. Revenues generated through European resellers were $3.7 million, $3.9 million and $2.7 million in 1999, 2000 and 2001, respectively. In Canada, Australia and Brazil, we distribute our products through Xerox Canada, Ltd., Fuji Xerox Co., Ltd. and Xerox do Brazil, Ltd., respectively. Revenues generated by these Xerox affiliates were $2.4 million, $2.4 million and $2.1 million in 1999, 2000 and 2001, respectively. In order to successfully expand export sales, we may need to establish additional foreign operations, hire additional personnel and develop relationships with additional international resellers. If we are unable to do so in a timely manner, our growth in international export sales could be limited and our business, operating results and financial condition could be materially adversely affected. In addition, we cannot assure you that we will be able to maintain or increase international market demand for our products.

      Additional risks inherent in our international business activities include:

	•	currency fluctuations;
	•	unexpected changes in regulatory requirements;
	•	tariffs and other trade barriers;

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	•	our limited experience in localizing products for foreign countries;
	•	lack of acceptance of our localized products in foreign countries;
	•	longer accounts receivable payment cycles;
	•	difficulties in managing our international operations;
	•	potentially adverse tax consequences including restrictions on the repatriation of earnings; and
	•	the burdens of complying with a wide variety of foreign laws.

      A portion of our business is conducted in currencies other than the U.S. Dollar, primarily the Euro. Although exchange rate fluctuations have not had a significant impact on us, fluctuations in the value of the currencies in which we conduct our business relative to the U.S. Dollar could cause currency transaction gains and losses in future periods. We do not currently engage in currency hedging transactions, and we cannot assure you that fluctuations in currency exchange rates in the future will not have a material adverse impact on our international revenues, business, operating results and financial condition.

Our business is dependent on the market for document automation software.

      The market for document automation software is intensely competitive, highly fragmented and subject to rapid change. We cannot assure you that the market for document automation software will grow or that, if it does grow, organizations will adopt our products. We have spent, and intend to continue to spend, significant resources educating potential customers about the benefits of our products. However, we cannot assure you that such expenditures will enable our products to achieve further market acceptance. Moreover, if the document automation software market fails to grow or grows more slowly than we currently anticipate, our business, operating results and financial condition would be materially adversely affected.

      In addition, the commercial market for document automation of electronic documents designed for use with the Internet, intranets and commercial on-line services has only recently begun to develop, and the success of our products designed for these markets will depend in part on the compatibility of our products with such services. It is difficult to predict whether the demand for related products and services will increase or decrease in the future. Since the increased commercial use of the Internet, intranets and commercial on-line services could require substantial modification and customization of certain of our products and services as well as the introduction of new products and services, we cannot assure you that we will be able to effectively or successfully compete in this market.

Our ability to manage future change will affect our business.

      Our ability to compete effectively and to manage future change will require us to continue to improve our financial and management controls, reporting systems and procedures on a timely basis and to expand, train and manage our work force. We cannot assure you that we will be able to do so successfully. Our failure to do so could have a material adverse effect on our business, operating results and financial condition.

Our executive officers and certain key personnel are critical to our business, and these officers and key personnel may not remain with us in the future.

      Our future performance depends significantly upon the continued service of our key technical, sales and senior management personnel. Only our President and Chief Executive Officer and our Chief Scientist have signed employment agreements with us. The loss of the services of one or more of our executive officers or key personnel could have a material adverse effect on our business, operating results and financial condition. Our future success also depends on our continuing ability to attract and retain highly qualified product development, sales and management personnel. Competition for such personnel is intense, and there can be no assurance that we will be able to retain our key employees or that we will be able to attract, assimilate or retain other highly qualified product development, sales and managerial personnel in the future.

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Our failure to adequately limit our exposure to product liability claims may adversely affect us.

      Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. However, it is possible that the limitation of liability provisions contained in our license agreements may not be effective under the laws of certain jurisdictions. Although we have not experienced any product liability claims to date, sale and support of our products may entail the risk of such claims in the future. A successful product liability claim brought against us or a claim arising as a result of our professional services could have a material adverse effect upon our business, operating results and financial condition.

Our products may suffer from defects or errors.

      Our software products are complex and may contain undetected defects or errors when first introduced or as new versions are released. As a result, we could lose or delay recognition of revenues as a result of software errors or defects. In addition, our products are typically intended for use in applications that may be critical to a customer’s business. As a result, we expect that our customers and potential customers have a greater sensitivity to product defects than the general market for software products. Although our business has not been adversely affected by any such errors to date, we cannot assure you that, despite testing by us and by current and potential customers, errors will not be found in our new products or releases. If these errors are discovered after the commencement of commercial shipments, it could result in any of the following:

	•	loss of revenue or delay in market acceptance;
	•	diversion of our development resources;
	•	damage to our reputation; or
	•	increased service and warranty costs.

      If any of these events occur, it would have a material adverse effect upon our business, operating results and financial condition.

Item 2.     Properties

      We lease approximately 21,300 square feet for our principal administrative, sales, marketing, training and research and development facility in Carlsbad, California. This lease expires on February 28, 2005. Our subsidiary in France occupies approximately 2,200 square feet of office space with a renewable lease expiring on April 15, 2004. In addition, our regional office in Milwaukee, Wisconsin occupies approximately 7,500 square feet of office space pursuant to a lease expiring on March 31, 2003. Sales representatives and field technical support personnel operate from their homes.

Item 3.     Legal Proceedings

      In the ordinary course of business, we may become involved in legal proceedings from time to time. As of February 22, 2002, we were not a party, nor was our property subject, to any material pending legal proceedings.

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 fiscal year 2001.

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PART II

Item 5.     Market for Registrant’s Common Equity and Related Stockholder Matters

      Our common stock is traded on The Nasdaq National Market under the symbol “DOCX.” The following table sets forth the range of high and low sales prices of our common stock for the periods indicated, as reported on The Nasdaq National Market System. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions.

      We had 3,867,906 shares outstanding and 103 record holders of our common stock as of February 27, 2002. We did not make any sales of unregistered stock in 1999, 2000 or 2001. We have not paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future.

Item 6.     Selected Financial Data

      The following table presents selected financial data of Document Sciences Corporation. This historical data should be read in conjunction with the Consolidated Financial Statements and the related notes thereto in Item 8 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

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Item 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

      We develop, market and support a family of document automation software used in high volume electronic publishing applications. We were incorporated in Delaware in October 1991 as a wholly owned subsidiary of Xerox Corporation. Following our initial public offering of stock in September 1996, Xerox ownership was reduced to approximately 62%. As a result of our tender offer and our exercise of an option to purchase additional shares from Xerox in April 2001, Xerox’s ownership interest has been reduced to 19.9%.

Critical Accounting Policies

      We believe the following represent our critical accounting policies:

      Revenue Recognition. We recognize revenue in accordance with SOP 97-2, Software Revenue Recognition and SAB No. 101, Revenue Recognition in Financial Statements. Initial license fees are recognized when a contract exists, the fee is fixed and determinable, software delivery has occurred and collection of the receivable is deemed probable. Revenues generated from consulting services are recognized as the related services are performed. However, when such consulting services are deemed to be essential to the functionality of the delivered software product, revenue from the entire arrangement is recognized on a percentage of completion method or not until the contract is completed in accordance with SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, and ARB No. 45, Long-Term Construction-Type Contracts.

      Our operating expenses are primarily based on anticipated revenue levels. Since a high percentage of those expenses are relatively fixed, a delay in the recognition of revenue from license transactions could cause significant variations in operating results from quarter to quarter and we may sustain losses as a result. Since revenue may not be recognized in the same quarter as when shipment occurs and if such fixed expenses precede these revenues, our operating results would be materially adversely affected.

      Computer Software Costs. In accordance with SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, costs incurred in the research and development of new software products and significant enhancements to existing software products are expensed as incurred until the technological feasibility of the product has been established. After technological feasibility has been established, direct production costs, including programming and testing, are capitalized until general release of the product.

      Capitalized costs of software to be sold, licensed or otherwise marketed are amortized using the greater of the amount computed using the ratio of current period product revenues to estimated total product revenues or the straight-line method over the remaining estimated economic lives of the products. It is possible that estimated total product revenues, the estimated economic life of the product, or both, will be reduced in the future. As a result, the carrying amount of capitalized software costs may be reduced in the future, which could cause our operating results in future periods to be adversely affected.

Results of Operations for the Years Ended December 31, 1999, 2000 and 2001

     Revenues

      Total revenues were $24.3 million, $22.6 million and $22.1 million in 1999, 2000 and 2001, respectively, representing decreases of 7% from 1999 to 2000 and 2% from 2000 to 2001. Our revenues are divided into three categories based upon the sources from which they are derived: initial license fees, annual renewal license and support fees, and services and other revenues. Initial license fees consist primarily of license fees for the first year of use of our products. Annual renewal license and support fees consist of license fees for the continued use and support of our licensed products. Services and other revenues consist of fees for consulting, application development and training services performed by us as well as miscellaneous other operational revenues.

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      We sell our products principally through our direct sales force domestically, and internationally through distributors and value added resellers (VARs). Revenues from export sales and sales through our foreign subsidiary were $6.1 million, $6.3 million and $4.7 million in 1999, 2000 and 2001, respectively, representing an increase of 3% from 1999 to 2000 and a decrease of 25% from 2000 to 2001. Revenue from export sales were 25%, 28% and 21% of total revenues in 1999, 2000 and 2001, respectively. The decrease from 2000 to 2001 was the result of lower initial license fees in all regions. The increase from 1999 to 2000 was primarily the result of increased revenues through our Xerox affiliates in Australia and Europe.

      We have entered into distributorship agreements with various Xerox foreign affiliates to remarket our products internationally. Our revenues from these agreements were $4.6 million, $4.7 million and $3.7 million in 1999, 2000 and 2001, respectively. The decrease from 2000 to 2001 was the result of lower initial license fees in all regions. The increase from 1999 to 2000 was primarily the result of increased revenues through our Xerox affiliates in Australia and Europe.

      Initial license fees. Initial license fees were $10.4 million, $10.3 million and $8.2 million in 1999, 2000 and 2001, respectively, representing decreases of 1% from 1999 to 2000 and 20% from 2000 to 2001. The decreases in 2001 and 2000 were largely the result of fewer sales and fewer new customers from our foreign resellers. Initial license revenues were 43%, 46% and 37% of total revenues in 1999, 2000 and 2001, respectively.

      Annual renewal license and support fees. Annual renewal license fees were $7.6 million, $8.6 million and $8.7 million in 1999, 2000 and 2001, respectively, representing increases of 13% from 1999 to 2000 and 1% from 2000 to 2001. The increase in 2001 was largely offset by the impact of discontinuing support for certain products and platforms. These increases in license renewal and support fees were principally due to an increase in the installed base of users of our software products. Annual license fees were 31%, 38% and 39% of total revenues in 1999, 2000 and 2001, respectively.

      Services and other. Revenues from services and other were $6.3 million, $3.7 million and $5.2 million in 1999, 2000 and 2001, respectively, representing a decrease of 41% from 1999 to 2000 and an increase of 41% from 2000 to 2001. The increase in 2001 is due to the delivery of consulting services needed to implement new product sales made since the fourth quarter of 2000 as well as significant services to existing customers. The decrease in 2000 was principally due to the mix of software sold, which only required minimal consulting services at implementation. Revenues from services and other were 26%, 16% and 24% of total revenues in 1999, 2000 and 2001, respectively.

     Cost of Revenues and Operating Expenses

      Cost of initial license fees. Costs of initial license fees were $1.4 million, $1.6 million and $1.5 million in 1999, 2000 and 2001, respectively, representing 13%, 16% and 18% of initial license fees in 1999, 2000 and 2001, respectively. Cost of initial license fees includes documentation, reproduction costs, product packaging and media, employment costs for installation and distribution personnel, the cost of third party software and amortization of previously capitalized software development costs. The decrease in 2001 compared to 2000 was due to lower sales and a decrease in the amortization of software. The increase in 2000 compared to 1999 was primarily the result of expensing the remainder of the capitalized software costs of VCPro 2.0 due to the 4th quarter 2000 release of VCPro 3.0.

      Cost of annual renewal license and support fees. Costs of annual license fees were $947,000, $1.3 million and $1.5 million 1999, 2000 and 2001, respectively, representing 13%, 15% and 17% of annual license fees in 1999, 2000 and 2001, respectively. Costs of annual renewal license fees consist principally of the employment-related costs for our technical support staff. The increase in 2001 compared to 2000 was due to additional technical support personnel necessary to support our increasing customer base. The increase in 2000 compared to 1999 was due to the implementation of a new technical support database and additional technical support personnel necessary to support our increasing customer base.

      Cost of services and other. Costs of services and other were $3.6 million, $2.5 million and $3.0 million in 1999, 2000 and 2001, respectively, representing 58%, 68% and 58% of services and other revenue in 1999, 2000

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      Research and development. Research and development expenses were $4.7 million, $4.2 million and $5.2 million in 1999, 2000 and 2001, respectively, representing a decrease of 11% from 1999 to 2000 and an increase of 24% from 2000 to 2001. Research and development expenses consist primarily of the employment-related costs of personnel associated with developing new products, enhancing existing products, testing software products and developing product documentation. As a percentage of total revenue, research and development expenses were 19%, 18% and 24% in 1999, 2000 and 2001, respectively. We anticipate that we will continue to direct significant resources to the development and enhancement of our products. In connection with a development services and referral agreement effective January 16, 2002, we have signed a two-year agreement with Objectiva Software Solutions, Inc. to provide us development services, which could range up to $3.1 million.

      We capitalized software development costs of $643,000, $1.2 million and $717,000 in 1999, 2000 and 2001, respectively. Some of the new products started in 2001 have yet to reach technological feasibility. The amount of software development costs to be capitalized in the future may change if the time between the establishment of technological feasibility of a product and its general release changes.

      Selling and marketing. Selling and marketing expenses were $7.7 million, $8.4 million and $7.2 million in 1999, 2000 and 2001, respectively, representing an increase of 9% from 1999 to 2000 and a decrease of 14% from 2000 to 2001. Selling and marketing expenses consist primarily of salaries, commissions, marketing programs and related costs for pre- and post-sales activity. The decrease in 2001 was primarily due to fewer personnel and decreased commissions due to decreased initial license fees. The increase in 2000 was primarily due to increased marketing expenditures on advertising, promotion activities and trade shows. Selling and marketing expenses were 32%, 37% and 32% of total revenues in 1999, 2000 and 2001, respectively.

      General and administrative. General and administrative expenses were $4.6 million, $5.0 million and $3.4 million in 1999, 2000 and 2001, respectively, representing an increase of 9% from 1999 to 2000 and a decrease of 32% from 2000 to 2001. General and administrative expenses consist of employment-related costs for finance, administration and human resources, allowance for doubtful accounts and general corporate management expenses, including legal and audit fees. The decrease in 2001 was primarily due to decreased personnel and outside consultant costs. The increas