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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
---------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004.
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE TRANSITION PERIOD FROM _________ TO _________
COMMISSION FILE NUMBER 1-10139
NETEGRITY, INC.
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 04-2911320
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)
201 JONES ROAD
WALTHAM, MA 02451
(Address of Principal Executive Offices) (Zip Code)
(781) 890-1700
(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such other shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
As of October 25, 2004 there were 38,817,961 shares of Common Stock
outstanding, exclusive of treasury shares.
QUARTERLY REPORT ON FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2004
TABLE OF CONTENTS
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003 (unaudited)...................... 3
Condensed Consolidated Statements of Operations for the three months ended September 30, 2004 and 2003 (unaudited).... 4
Condensed Consolidated Statements of Operations for the nine months ended September 30, 2004 and 2003 (unaudited).... 5
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003 (unaudited).... 6
Notes to Condensed Consolidated Financial Statements.................................................................. 7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.............................. 15
Item 3. Quantitative and Qualitative Disclosures About Market Risk......................................................... 31
Item 4. Controls and Procedures............................................................................................ 31
PART II OTHER INFORMATION.................................................................................................. 32
Item 6. Exhibits........................................................................................................... 32
SIGNATURES................................................................................................................. 33
2
PART I. - FINANCIAL INFORMATION
NETEGRITY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------ ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents .................................................................. $ 12,357 $ 20,123
Short-term available-for-sale securities ................................................... 55,526 51,557
Accounts receivable--trade, net of allowances of $1,039 at September 30, 2004 and $829 at
December 31, 2003 ......................................................................... 16,149 14,340
Prepaid expenses and other current assets .................................................. 2,808 2,513
Restricted cash ............................................................................ 126 538
------------ ------------
Total Current Assets ...................................................................... 86,966 89,071
Long-term available-for-sale securities ..................................................... 21,349 19,401
Property and equipment, net ................................................................. 4,371 4,848
Restricted cash ............................................................................. 1,354 767
Goodwill .................................................................................... 34,503 34,503
Other intangible assets, net ................................................................ 5,970 7,500
Other assets ................................................................................ 1,148 1,134
------------ ------------
Total Assets .............................................................................. $ 155,661 $ 157,224
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable--trade .................................................................... $ 1,532 $ 1,415
Accrued compensation and benefits .......................................................... 5,461 5,947
Other accrued expenses ..................................................................... 6,928 16,273
Deferred revenue ........................................................................... 20,123 18,503
------------ ------------
Total Current Liabilities ................................................................. 34,044 42,138
------------ ------------
Commitments and Contingencies
STOCKHOLDERS' EQUITY:
Common stock, voting, $.01 par value; 135,000 shares authorized; 38,474 shares
issued and 38,436 shares outstanding at September 30, 2004; 37,577 shares
issued and 37,539 shares outstanding at December 31, 2003 ................................. 385 375
Additional paid-in capital .................................................................. 229,704 226,019
Accumulated other comprehensive loss ........................................................ (153) (137)
Accumulated deficit ......................................................................... (108,136) (110,971)
Loan to officer ............................................................................. (99) (116)
------------ ------------
121,701 115,170
Less--Treasury stock, at cost: 38 shares .................................................... (84) (84)
------------ ------------
Total Stockholders' Equity .................................................................. 121,617 115,086
------------ ------------
Total Liabilities and Stockholders' Equity .................................................. $ 155,661 $ 157,224
============ ============
The accompanying notes are an integral part of the condensed
consolidated financial statements.
3
NETEGRITY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE THREE MONTHS
ENDED SEPTEMBER 30,
----------------------------
2004 2003
------------- ------------
Revenues:
Software licenses .......................................................................... $ 8,668 $ 11,404
Services ................................................................................... 11,325 8,144
Other ...................................................................................... 310 849
------------ ------------
Total revenues ............................................................................ 20,303 20,397
------------ ------------
Cost of Revenues:
Cost of software licenses .................................................................. 223 483
Non-cash cost of software licenses ......................................................... 510 --
Cost of services ........................................................................... 3,868 2,791
Cost of other .............................................................................. 212 567
------------ ------------
Total cost of revenues .................................................................... 4,813 3,841
------------ ------------
Gross profit ................................................................................ 15,490 16,556
Selling, general and administrative expenses ................................................ 10,341 10,857
Research and development expenses ........................................................... 5,817 5,381
------------ ------------
Income (loss) from operations ............................................................... (668) 318
Other income, net ........................................................................... 312 404
------------ ------------
Income (loss) before provision for income taxes ............................................. (356) 722
Provision for income taxes .................................................................. -- 63
------------ ------------
Net income (loss) ........................................................................... $ (356) $ 659
============ ============
Net income (loss) per share:
Basic and diluted ......................................................................... $ (0.01) $ 0.02
Weighted average shares outstanding:
Basic ..................................................................................... 38,393 34,621
Diluted ................................................................................... 38,393 38,006
The accompanying notes are an integral part of the condensed
consolidated financial statements.
4
NETEGRITY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
----------------------------
2004 2003
------------ ------------
Revenues:
Software licenses .......................................................................... $ 35,110 $ 30,536
Services ................................................................................... 31,194 23,274
Other ...................................................................................... 1,355 2,130
------------ ------------
Total revenues ............................................................................ 67,659 55,940
------------ ------------
Cost of Revenues:
Cost of software licenses .................................................................. 764 1,350
Non-cash cost of software licenses ......................................................... 1,530 5,398
Cost of services ........................................................................... 10,531 8,539
Cost of other .............................................................................. 932 1,319
------------ ------------
Total cost of revenues .................................................................... 13,757 16,606
------------ ------------
Gross profit ................................................................................ 53,902 39,334
Selling, general and administrative expenses ................................................ 33,995 31,845
Research and development expenses ........................................................... 17,665 15,292
------------ ------------
Income (loss) from operations ............................................................... 2,242 (7,803)
Other income, net ........................................................................... 921 1,195
------------ ------------
Income (loss) before provision for income taxes ............................................. 3,163 (6,608)
Provision for income taxes .................................................................. 328 122
------------ ------------
Net income (loss) ........................................................................... $ 2,835 $ (6,730)
============ ============
Net income (loss) per share:
Basic and diluted ......................................................................... $ 0.07 $ (0.20)
Weighted average shares outstanding:
Basic ..................................................................................... 37,999 34,453
Diluted ................................................................................... 40,646 34,453
The accompanying notes are an integral part of the condensed
consolidated financial statements.
5
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
----------------------------
2004 2003
------------ ------------
OPERATING ACTIVITIES:
Net income (loss) ........................................................................... $ 2,835 $ (6,730)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization .............................................................. 3,845 8,767
Provision for doubtful accounts ............................................................ 506 622
Non-cash interest expense .................................................................. 1,283 509
Gain on sale of marketable securities ...................................................... (18) (42)
Changes in operating assets and liabilities:
Accounts receivable - trade ................................................................ (1,888) 3,184
Prepaid expenses and other current assets .................................................. 285 448
Other assets ............................................................................... (14) 2
Accounts payable - trade ................................................................... 117 524
Accrued compensation and benefits .......................................................... (486) 94
Other accrued expenses ..................................................................... (1,444) (1,631)
Deferred revenue ........................................................................... 1,620 1,710
------------ ------------
Net cash provided by operating activities ................................................... 6,641 7,457
------------ ------------
INVESTING ACTIVITIES:
Proceeds from sales of marketable securities ................................................ 15,449 17,577
Proceeds from maturities of marketable securities ........................................... 33,779 19,921
Purchases of marketable securities .......................................................... (56,590) (60,196)
Purchases of property and equipment ......................................................... (1,838) (1,912)
Cash used for acquisition, net of cash acquired ............................................. (8,497) --
Restricted cash ............................................................................. (586) 303
------------ ------------
Net cash used for investing activities ...................................................... (18,283) (24,307)
------------ ------------
FINANCING ACTIVITIES:
Proceeds from issuance of common stock under stock plans .................................... 3,694 1,119
Proceeds from repayment of loan to officer .................................................. 17 --
------------ ------------
Net cash provided by financing activities ................................................... 3,711 1,119
------------ ------------
Effect of exchange rate changes on cash and cash equivalents ................................ 165 29
------------ ------------
Net change in cash and cash equivalents ..................................................... (7,766) (15,702)
Cash and cash equivalents at beginning of period ............................................ 20,123 25,707
------------ ------------
Cash and cash equivalents at end of period .................................................. $ 12,357 $ 10,005
============ ============
The accompanying notes are an integral part of the condensed
consolidated financial statements.
6
NETEGRITY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Basis of Presentation and Principles of Consolidation
The accompanying unaudited condensed consolidated financial statements
include the accounts and operations of Netegrity, Inc. and its wholly owned
subsidiaries ("Netegrity", (the "Company", "we" or "our") and have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission regarding interim financial reporting. Accordingly, they do not
include all of the information and notes required by accounting principles
generally accepted in the United States of America for complete financial
statements and thus should be read in conjunction with the audited consolidated
financial statements included in our Annual Report on Form 10-K filed on March
1, 2004. In the opinion of management, the accompanying unaudited condensed
consolidated financial statements contain all adjustments, consisting only of
those of a normal recurring nature, necessary for a fair presentation of the
Company's financial position, results of operations and cash flows at the dates
and for the periods indicated. The results of operations for the three and nine
months ended September 30, 2004 are not necessarily indicative of the results
expected for the remainder of the year ending December 31, 2004.
All significant intercompany accounts and transactions have been
eliminated in consolidation.
(b) Revenue Recognition
Our revenues are primarily generated from the sale of perpetual licenses
for our proprietary SiteMinder, IdentityMinder Web Edition, IdentityMinder
eProvision and TransactionMinder products and related services. We generate our
services revenues from consulting and training services performed for customers
and from the maintenance and support of our products. As described below,
significant management judgments and estimates must be made and used in
connection with the revenues recognized in any accounting period. Management
analyzes various factors in making these judgments and estimates, including
specific terms and conditions of a transaction, historical experience, credit
worthiness of customers and current market and economic conditions. Changes in
judgments based upon these factors could impact the timing and amount of
revenues and cost recognized.
We generally license our software products on a perpetual basis. We apply
the provisions of Statement of Position No. 97-2, "Software Revenue
Recognition," as amended by Statement of Position No. 98-9, "Software Revenue
Recognition, with Respect to Certain Transactions," to all transactions
involving the sale of software products. We recognize revenues from the sale of
software licenses when persuasive evidence of an arrangement exists, the product
has been delivered, the fees are fixed or determinable and collection of the
resulting receivable is reasonably assured. This policy is applicable to all
sales, including sales to resellers and end users. We typically do not offer a
right of return on our products.
For all sales, we use a license agreement signed by both parties and/or a
purchase order with binding terms and conditions as evidence of an arrangement.
For arrangements with multiple obligations (for example, software license,
undelivered maintenance and support, training and consulting), we allocate
revenues to each component of the arrangement using the residual value method
based on the fair value of the undelivered elements. We defer revenue from the
arrangement equivalent to the fair value of the undelivered elements. Fair value
for each component is either the price we charge when the same component is sold
separately or the price established by the members of our management who have
the relevant authority to set prices for an element not yet sold separately.
At the time of the transaction, we assess whether the fee associated with
the transaction is fixed or determinable based on the payment terms associated
with the transaction. If a significant portion of the fee is due after our
normal payment terms, which are generally 30 to 90 days from invoice date, we
account for the fee as not being fixed or determinable. In those cases, we
recognize revenues as the fees become due. In addition, we assess whether
collection is probable based on the credit worthiness of the customer. Initial
credit worthiness is assessed through Dun & Bradstreet or similar credit rating
agencies. Credit worthiness for follow-on transactions is assessed through a
review of the transaction history with the customer. We do not typically request
collateral from our customers. If we determine that collection of a fee is not
reasonably assured, we defer the fee and recognize revenues at the time
collection becomes reasonably assured, which is generally upon receipt of cash.
7
Installation by Netegrity is not considered essential to the functionality
of our products as these services do not alter the product capabilities, do not
require specialized skills and may be performed by the customer or other
vendors. Revenues for maintenance and support are recognized ratably over the
term of the support period. Revenues from consulting and training services
generally are recognized as the services are performed.
(c) Cash and Cash Equivalents
Cash and cash equivalents include cash, money market investments and other
highly liquid investments with original maturities of three months or less.
(d) Restricted Cash
Long-term restricted cash at September 30, 2004 represents three time
deposits held at financial institutions. The first, in the amount of $774,000,
is held in connection with the lease of the Company's headquarter office space
and has an expiration date of March 2005; however, it has a clause that provides
that the time deposit will be automatically renewed. The second, in the amount
of $140,000, is held in connection with the lease of the Company's office space
in Israel and has an expiration date of June 2006. The third, in the amount of
$566,000, is held in connection with a prepaid maintenance contract, has an
expiration date of December 2012 and is reduced ratably over the term of the
contract.
(e) Marketable Securities
Investments, which primarily consist of debt securities, are accounted for
under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting
for Certain Investments in Debt and Equity Securities" issued by the Financial
Accounting Standards Board (FASB). Pursuant to the provisions of SFAS No. 115,
the Company has classified its investment portfolio as "available-for-sale".
"Available-for-sale" securities include debt securities that are being held for
an unspecified period of time and may be used for liquidity or other corporate
purposes and are recorded at fair value. Unrealized gains and losses on
available-for-sale securities are reported as a separate component of
accumulated other comprehensive income (loss) in stockholders' equity, net of
related taxes.
(f) Other Intangible Assets, net
The Company accounts for purchased technology and software development
costs in accordance with SFAS No. 86, "Accounting for the Costs of Computer
Software to Be Sold, Leased, or Otherwise Marketed". Under SFAS No. 86, the
Company is required to test for recoverability of its capitalized software costs
as of each balance sheet date or an interim period if events and circumstances
indicate that the carrying amount may not be recoverable. Impairment is recorded
as the excess of the unamortized cost over the expected future net realizable
value of the products.
Software development costs subsequent to the establishment of
technological feasibility are capitalized and amortized to non-cash cost of
software. Based on the Company's product development process, technological
feasibility is established upon completion of all planning, designing, coding
and testing activities. Such costs are amortized over the estimated life of the
product. During the three and nine months ended September 30, 2004, costs
incurred by the Company between completion of all planning, designing, coding
and testing activities and the point at which the product is ready for general
release were insignificant and, therefore, no such costs have been capitalized
during this time period.
(g) Goodwill
The Company reviews the valuation of goodwill in accordance with SFAS No.
142 "Goodwill and Other Intangible Assets." Under the provisions of SFAS No.
142, goodwill is required to be tested for impairment annually in lieu of being
amortized. This testing is done in the fourth quarter of each year. Furthermore,
goodwill is required to be tested for impairment on an interim basis if an event
or circumstance indicates that it is more likely than not that an impairment
loss has been incurred. An impairment loss is recognized to the extent that the
carrying amount of goodwill exceeds its implied fair value. Impairment losses
are recognized in operations. The Company's valuation methodology for assessing
impairment requires management to make judgments and assumptions based on
historical experience and projections of future operating performance.
Management predominantly uses third party valuation reports to assist in its
determination of the fair value. If these assumptions differ materially from
future results, the Company may record impairment charges in the future.
8
(h) Comprehensive Income (Loss)
Comprehensive income (loss) is defined as the change in equity of a
business enterprise during a period from transactions and other events and
circumstances from non-owner sources, including foreign currency translation
adjustments and unrealized gains and losses on marketable securities held as
"available-for-sale". The components of comprehensive income (loss) were as
follows (in thousands):
FOR THE THREE FOR THE NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income (loss) ...................................................... $ (356) $ 659 $ 2,835 $ (6,730)
Net unrealized holding gain (loss) arising during the period, net
of related tax effects ............................................... 163 (84) (162) (136)
Reclassification adjustment for net realized (gains) losses, included
in net income (loss), net of related tax effects ..................... 4 -- (18) (42)
---------- ---------- ---------- ----------
167 (84) (180) (178)
Net unrealized foreign currency translation adjustment arising during
the period, net of related tax effects ............................... 18 18 164 29
---------- ---------- ---------- ----------
Comprehensive income (loss) ............................................ $ (171) $ 593 $ 2,819 $ (6,879)
========== ========== ========== ==========
The components of accumulated other comprehensive income (loss) as of
September 30, 2004 and December 31, 2003 were as follows (in thousands):
SEPTEMBER 30, 2004 DECEMBER 31, 2003
------------------ -----------------
Net unrealized holding loss ................................ $ (268) $ (88)
Net unrealized foreign currency translation adjustment ..... 115 (49)
------------ ------------
Accumulated other comprehensive loss ....................... $ (153) $ (137)
============ ============
(i) Earnings (Loss) Per Share
Basic earnings (loss) per share (EPS) is calculated by dividing net income
(loss) by the weighted average number of shares outstanding during the period.
Diluted EPS is calculated by dividing net income (loss) by the weighted average
number of shares outstanding plus the dilutive effect, if any, of outstanding
stock options and warrants using the "treasury stock" method. During periods of
net loss, diluted net loss per share does not differ from basic net loss per
share since potential shares of common stock from stock options and warrants are
anti-dilutive and therefore are excluded from the calculation. The following
table presents the calculation for both basic and diluted EPS (in thousands,
except per share data):
FOR THE THREE FOR THE NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ -----------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income (loss) ...................................................... $ (356) $ 659 $ 2,835 $ (6,730)
---------- ---------- ---------- ----------
Basic weighted average shares outstanding .............................. 38,393 34,621 37,999 34,453
Dilutive effect of stock options and warrants .......................... -- 3,385 2,647 -
---------- ---------- ---------- ----------
Diluted shares outstanding ............................................. 38,393 38,006 40,646 34,453
========== ========== ========== ==========
Basic and diluted EPS .................................................. $ (0.01) $ 0.02 $ 0.07 $ (0.20)
Outstanding options and warrants to purchase a total of approximately 2.4
million and 1.9 million shares of common stock for the three and nine months
ended September 30, 2004, respectively, and a total of 222,000 and 394,000
shares of common stock for the three and nine months ended September 30, 2003,
respectively, were excluded in the computation of diluted EPS because the effect
on EPS was anti-dilutive.
9
(j) Stock-Based Compensation
The Company accounts for its stock option plans under the recognition and
measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related Interpretations. No stock-based compensation cost is
reflected in net income (loss) for these plans, as all options granted under
these plans had exercise prices equal to the fair market value of the underlying
common stock on the date of grant. The following table illustrates the effect on
net income (loss) and earnings (loss) per share if the Company had applied the
fair value recognition provisions of FASB Statement No. 123, "Accounting for
Stock Based Compensation," to stock based compensation (in thousands, except per
share data):
FOR THE THREE FOR THE NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income (loss), as reported ........................................... $ (356) $ 659 $ 2,835 $ (6,730)
Add: Stock-based employee compensation expense not included in reported
net income (loss), net of related tax effects .......................... (1,987) (1,255) (5,973) (8,278)
---------- ---------- ---------- ----------
Pro-forma net loss ....................................................... $ (2,343) $ (596) $ (3,138) $ (15,008)
========== ========== ========== ==========
Earnings (loss) per share:
Basic and diluted--as reported ......................................... $ (0.01) $ 0.02 $ 0.07 $ (0.20)
Basic and diluted--pro-forma ........................................... $ (0.06) $ (0.02) $ (0.08) $ (0.44)
At the annual meeting of stockholders held in May 2004, the Company's
stockholders approved the 2004 Stock Incentive Plan (the "2004 Plan") pursuant
to which 4.0 million shares of common stock are reserved for issuance to the
Company's or its subsidiaries' employees, officers, directors, consultants and
advisors. The 2004 Plan provides for the grant of incentive stock options,
non-statutory stock options, restricted stock, stock appreciation rights and
other stock based awards.
(k) Recent Accounting Pronouncements
In December 2003, the Financial Accounting Standards Board (FASB) revised
Interpretation No. 46, Consolidation of Variable Interest Entities, an
Interpretation of ARB No. 51 (FIN 46R), which addresses how a business
enterprise should evaluate whether it has a controlling interest in an entity
through means other than voting rights and accordingly should consolidate the
entity. FIN 46R replaces FASB Interpretation No. 46, which was issued in January
2003. Before concluding that it is appropriate to apply the voting interest
consolidation model to an entity, an enterprise must first determine that the
entity is not a variable interest entity or a special purpose entity. FIN 46R
became effective in March 2004 and the adoption of this statement did not have a
material impact on the Company's financial position or results of operations.
In November 2003, the Emerging Issues Task Force (EITF) of the FASB
reached a consensus on certain disclosure provisions under Issue No. 03-1, "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments." The disclosure provisions indicate that certain quantitative and
qualitative disclosures are required for debt and marketable equity securities
classified as available-for-sale or held-to-maturity under SFAS Nos. 115 and 124
that are impaired at the balance sheet date but for which an
other-than-temporary impairment has not been recognized. The EITF has not
reached a consensus on the proposed models for evaluating impairment of equity
securities and debt securities. The consensus on the required quantitative and
qualitative disclosures is effective for fiscal years ending after December 15,
2003. The adoption of the disclosure provisions of this Issue during the fourth
quarter of 2003 did not have a material impact on the Company's financial
position or results of operations. In September 2004, the FASB approved the
issuance of FASB Staff Positions EITF 03-1-1, which delays the effective date
for the application and measurement provisions of EITF 03-1 to investments in
securities that are impaired.
NOTE 2: ACQUISITION
Business Layers
On December 30, 2003, the Company acquired Business Layers, Inc., a
Delaware corporation (Business Layers) and a provider of provisioning solutions,
through a merger of Business Layers and a subsidiary of the Company. As a result
of the acquisition, Business Layers became a wholly-owned subsidiary of the
Company. The aggregate consideration for the acquisition of $42.5 million
included approximately $15.0 million in cash, reimbursement of $920,000 in
acquisition costs and 2,556,940 shares of the Company's common stock valued at
approximately $26.6 million. A portion of the purchase price consideration,
comprised of approximately 358,000 shares of Netegrity common stock and
approximately $400,000 of cash, has been placed in escrow for up to one year
from the acquisition date to secure the indemnification obligations of certain
former employees and the stockholders of Business Layers under the merger
agreement. The acquisition was accounted for using the purchase method of
accounting. The results of operations of Business Layers from the acquisition
date are included in the Company's consolidated results of operations for the
three and nine months ended September 30, 2004.
In connection with the acquisition, the Company initiated an overall
integration plan that included the elimination of redundant headcount and
facilities. The Company accrued approximately $1.4 million of costs related to
the integration plan, consisting of approximately $545,000 of facilities costs
and approximately $888,000 for planned workforce reductions primarily of
duplicative selling, general and administrative employees. The Company paid the
majority of these costs during the nine months ended September 30, 2004,
although the facilities costs will not be paid in full until April 2006.
10
The Company engaged a third-party appraiser to conduct a valuation of the
intangible assets and to assist in the determination of useful lives for such
assets. Based on the appraisal, approximately $7.5 million of the purchase price
was allocated to developed technology and $3.8 million was allocated to
in-process research and development, which was expensed upon closing of the
transaction. The amount allocated to developed technology is being amortized
over its estimated useful life ranging from two to five years. Amortization
expense was $510,000 for the three months ended September 30,2004 and $1.5
million for the nine months ended September 30, 2004. Accumulated amortization
as of September 30, 2004 was $1.5 million.
The valuation of in-process research and development was determined using
the income method. Revenue and expense projections for the in-process research
and development project were prepared by management. The value was determined
using the present value of the cash flows from the projections using a 30%
discount rate. The technologies under development were completed by June 30,
2004.
In accordance with SFAS No. 142, the total goodwill of approximately $34.5
million related to the acquisition will not be amortized. In lieu of being
amortized, goodwill is required to be tested for impairment annually in the
fourth quarter or on an interim basis if an event or circumstance indicates that
it is more likely than not that an impairment loss has been incurred.
NOTE 3: OPERATING SEGMENTS AND GEOGRAPHICAL INFORMATION
Based on the information provided to the Company's chief operating
decision maker for purposes of making decisions about allocating resources and
assessing performance, the Company's continuing operations have been classified
into a single segment. The Company primarily operates in the United States of
America, Europe, the Middle East and Asia Pacific. Revenues (based on the
location of the customer) and long-lived assets by geographic region are as
follows (in thousands):
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
----------------------- -----------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Revenues:
United States of America ............................................. $ 13,812 $ 15,432 $ 46,625 $ 42,676
Europe and the Middle East ........................................... 4,147 3,887 15,854 8,613
Asia Pacific ......................................................... 965 893 2,956 4,258
Canada ............................................................... 1,379 185 2,224 393
---------- ---------- ---------- ----------
Total ................................................................ $ 20,303 $ 20,397 $ 67,659 $ 55,940
========== ========== ========== ==========
SEPTEMBER 30, DECEMBER 31,
------------- ------------
2004 2003
------------- ------------
Long-Lived Assets:
United States of America .................................................................. $ 44,180 $ 46,365
Europe and the Middle East ................................................................ 1,664 1,407
Asia Pacific .............................................................................. 146 211
Canada .................................................................................... 2 2
------------ ------------
Total ..................................................................................... $ 45,992 $ 47,985
============ ============
11
NOTE 4: RELATED PARTY TRANSACTIONS
LOAN TO OFFICER
The condensed consolidated balance sheets as of September 30, 2004 and
December 31, 2003 include $99,000 and $116,000, respectively, in a loan to an
officer of Netegrity issued in connection with the exercise of stock options in
1996. The loan is reflected as a reduction of stockholders' equity in the
accompanying condensed consolidated balance sheets. The loan is payable upon
demand and bears interest at 7% per annum. The loan was originally represented
by a secured note; however, in May 2002, the note was amended such that it
became a full recourse unsecured note. This loan will be repaid upon the
consummation of the merger contemplated by the agreement and plan of merger
entered into with Computer Associates on October 6, 2004 (see note 6).
MARKETING SERVICES
During the three and nine months ended September 30, 2004 the Company paid
approximately $34,000 and $97,000, respectively, and during the three and nine
months ended September 30, 2003, the Company paid approximately $32,000 and
$74,000, respectively, to a company for marketing services. The principal
shareholder of that Company is the son-in-law of a former member of the
Company's Board of Directors whose term expired in May 2004. The Company has
similar arrangements with other marketing services firms and believes the
arrangement was entered into on substantially the same terms and conditions as
its arrangements with such other firms.
SOFTWARE LICENSE AGREEMENT
On June 30, 2004, the Company entered into a software license agreement
with a third party under which the Company purchased software for its internal
use. The Vice President of Client Services of this third party is the brother of
an officer of Netegrity. The Company has licensed software under similar terms
and conditions with other software providers and believes the arrangement was
entered into on substantially the same terms and conditions as its arrangements
with such other firms. The Company paid approximately $80,000 in the third
quarter of 2004 under this agreement.
NOTE 5: COMMITMENTS AND CONTINGENCIES
The Company has commitments that expire at various times through 2010.
Non-cancelable operating leases shown below are primarily for facility costs for
the Company's corporate headquarters, customer service, research and development
and world-wide sales offices. Other contractual obligations shown below
primarily consist of minimum guaranteed payments to a software service provider
for various development projects. (in thousands)
2004 (three months ending).................................................................................. $ 1,299
2005........................................................................................................ 2,674
2006........................................................................................................ 2,328
2007........................................................................................................ 2,223
2008........................................................................................................ 1,389
Thereafter.................................................................................................. 712
----------
$ 10,625
Included in the operating lease commitments above is approximately
$337,000 related to excess facilities which have been accrued in purchase
accounting related to the Company's acquisition of Business Layers and are
payable through April 2006.
12
The Company incurred total operating lease expense, primarily related to
certain facilities and equipment under non-cancelable operating leases, of
approximately $752,000 for the three months ended September 30, 2004, and $2.3
million for the nine months ended September 30, 2004, and approximately $1.0
million for the three months ended September 30, 2003, and $3.0 million for the
nine months ended September 30, 2003.
In April 2002, the Company entered into an agreement with a system
integrator to assist the Company in the development and launch of one of its
products. Under the terms of the agreement, as consideration for the system
integrator's time in assisting with the development of the product, the Company
agreed to promote the system integrator as an integrator of the developed
product. The Company's obligation under the agreement would have been considered
satisfied once the system integrator received consulting revenues totaling
approximately $3.9 million from the Company's customers, or by the expiration
date of the agreement. The agreement expired in May 2004. No royalties were due
to the system integrator under this agreement during its term.
In August 2002, the Company entered into a five year non-cancelable
operating lease for an office building for its corporate headquarters. The
Company occupied the new facility in March 2003. In connection with the lease
agreement, the Company delivered to the landlord an irrevocable, unconditional,
negotiable letter of credit in the amount of $774,000 as a security deposit.
In February 2004, the Company entered into an agreement with a software
service provider located in India under which the Company has guaranteed to pay
this software service provider a minimum of $4.0 million annually for various
product development projects. The initial term of this agreement expires in
December 2004. As of September 30, 2004, approximately $3.5 million had been
paid to this software service provider.
In June 2004, the Company entered into a letter of credit with a financial
institution. The letter of credit in the amount of $566,000, which is held in
connection with a prepaid customer maintenance contract, has an expiration date
of December 2012 and is reduced ratably over the term of the contract.
In September 2004, the Company received a letter from a customer of its
subsidiary Business Layers GmbH ("BLG"), making a claim for rescission of its
contract with BLG for alleged breach of such contract under German law. The
customer has requested compensation in the amount of approximately 2.2 million
Euro plus interest, reserving a right to assert additional unspecified damages.
The customer may also assert an additional claim for pre-paid maintenance fees
in the amount of approximately 575,000 Euro. The Company has notified the
indemnification representatives for the Business Layer's escrow that the Company
intends to seek indemnification for any damages incurred relating to this claim,
subject to the limitations of the escrow and the Business Layers merger
agreement.
The Company enters into standard indemnification agreements with its
business partners and customers in the ordinary course of business. Pursuant to
these agreements, the Company agrees to repair or replace the product, pay
royalties for a right to use, or reimburse the indemnified party for actual
damages awarded by a court against the indemnified party for an intellectual
property infringement claim by a third party with respect to products. The term
of these indemnification agreements is generally perpetual. The maximum
potential amount of future payments the Company could be required to make under
these indemnification agreements is unlimited. The Company has never incurred
costs to defend lawsuits or settle claims related to these indemnification
agreements. As a result, the Company believes the estimated fair value of these
agreements is minimal. Accordingly, the Company had no liabilities recorded for
these agreements as of September 30, 2004.
The Company enters into standard indemnification agreements with its
customers, whereby the Company indemnifies them for certain damages, such as
personal property damage, which may be incurred in connection with consulting
services performed at a customer location by the Company's employees or
subcontractors. The potential amount of future payments the Company could be
required to make under these indemnification agreements is unlimited. However,
the Company has general and umbrella insurance policies that enable it to
recover a portion of any amounts paid. The Company has never incurred costs to
defend lawsuits or settle claims related to these indemnification agreements. As
a result, the Company believes the estimated fair value of these agreements is
minimal. Accordingly, the Company has no liabilities recorded for these
agreements as of September 30, 2004.
The Company generally warrants for ninety days from delivery to a customer
that its software products will perform free from material errors which prevent
performance in accordance with user documentation. Additionally, the Company
warrants that its consulting services will be performed consistent with
generally accepted industry standards. The Company has never incurred
significant expense under its product or service warranties. As a result, the
Company believes the estimated fair value of these agreements is minimal.
Accordingly, the Company has no liabilities recorded for these agreements as of
September 30, 2004.
13
The Company has entered into employment and executive retention agreements
with certain employees and executive officers which, among other things, include
certain severance and change of control provisions. The consummation of the
merger contemplated by the agreement and plan of merger entered into with
Computer Associates on October 6, 2004 (see note 6) would constitute a change in
control under such agreements. The Company has also entered into agreements
whereby the Company indemnifies its officers and directors for certain events or
occurrences while the officer or director is, or was, serving at the Company's
request in such capacity.
From time to time, the Company is involved in litigation relating to
claims arising out of the Company's operations in the normal course of business.
The Company is not presently a party to any legal proceedings, the adverse
outcome of which, in the Company's opinion, would have a material adverse effect
on the Company's results of operations or financial position.
NOTE 6. SUBSEQUENT EVENT
On October 6, 2004, Computer Associates International, Inc., a Delaware
corporation ("Computer Associates"), and the Company entered into an Agreement
and Plan of Merger (the "Agreement") pursuant to which the Company would merge
with a wholly owned subsidiary of Computer Associates and become a wholly owned
subsidiary of Computer Associates. If the merger is completed, at the effective
time of the merger, each issued and outstanding share of common stock, par value
$0.01 per share, of Netegrity will be converted into the right to receive $10.75
in cash. The Agreement has been approved by Netegrity's Board of Directors, and
the transactions contemplated by the Agreement are subject to the approval of
Netegrity's stockholders, any required antitrust clearance, any required
international regulatory approvals and other customary closing conditions and is
expected to be completed in the fourth quarter of 2004.
In connection with the execution of the Agreement, certain directors,
executive officers and stockholders of Netegrity executed agreements with
Computer Associates and the Company to vote their shares of Netegrity Common
Stock in favor of the proposed merger and against any other proposal or offer to
acquire Netegrity (the "Stockholder Agreements"). The shares subject to the
Stockholder Agreements represent in the aggregate approximately 12% of the
outstanding shares of Netegrity Common Stock.
The Company expects to incur expenses of approximately $5.0 million
related to the merger with Computer Associates. These merger-related expenses
include investment banking fees, and legal and professional fees.
A contingent termination fee of $13.0 million plus reimbursement of up to
$2.0 million of Computer Associates' expenses related to the transaction is
payable by the Company to Computer Associates in the event that the Agreement is
terminated as a result of certain events as detailed in the Agreement.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements about our plans,
objectives, expectations and intentions. You can identify these statements by
words such as "expect," "anticipate," "intend," "plan," "believe," "seek,"
"estimate," "may," "will" and "continue" or similar words. You should read
statements that contain these words carefully. They discuss our future
expectations, contain projections of our future results of operations or our
financial condition or state other forward-looking information, and may involve
known and unknown risks over which we have no control. You should not place
undue reliance on forward-looking statements. We cannot guarantee any future
results, levels of activity, performance or achievements. Moreover, we assume no
obligation to update forward-looking statements or update the reasons actual
results could differ materially from those anticipated in forward-looking
statements, except as required by law. The factors discussed in the sections
captioned "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Certain Factors that May Affect Future Results," in
this report identify important factors that may cause our actual results to
differ materially from the expectations we describe in our forward-looking
statements.
OVERVIEW
Netegrity's objective is to be a leading provider of enterprise security
software solutions specifically for managing user identities and access. Our
identity and access management product line provides companies a secure way to
make corporate information assets and resources available online. We believe
open, protected access is essential as companies seek to leverage the Web to
grow their businesses.
With Netegrity identity and access management products, companies are able
to securely use the Web -- Internet, Intranet or Extranet -- to meet the
information access needs of partners, suppliers, customers and employees.
Netegrity solutions are designed to enable businesses to ensure that the right
people have the right access to the right information across a variety of
applications, business systems and computing architectures. This enables more
business to be securely conducted online, providing opportunities to improve
customer service and productivity, increase sales of products and services and
enhance business partnerships.
We derive our revenues from our core products, SiteMinder, IdentityMinder
Web Edition, IdentityMinder eProvision and TransactionMinder, which offer a
single source solution for integrated, centralized identity management, user
access and administration and account provisioning/de-provisioning. Our solution
supports a broad range of technology environments, and aims to ensure that
companies optimize their existing information technology investments while
incorporating new technologies. We also offer various levels of consulting and
support services that enable our customers to successfully implement our
products in their organizations.
Our products are generally sold on a perpetual license basis. Customers
typically place an initial order for a limited number of users and purchase
additional users as their need for our products within their enterprise
increases. We believe that our product line synergies and the strength of our
customer base create opportunities to sell additional products to existing
customers. Customers also enter into an annual support agreement for their
software license at the time of initial purchase and typically renew this
support agreement annually. Our support agreement entitles customers to software
license updates, telephone support and online support.
We believe sales of our products will be driven by customers' desire for a
comprehensive single-source identity access management solution whose key
benefits include reduced costs by reducing information technology complexity,
increased employee productivity, increased revenue potential by improving
customer service online, expanded business opportunities by creating real-time
business networks and support for regulatory compliance and risk mitigation. As
a result, we expect that companies will spend their discretionary information
technology dollars on technology that will help them drive revenue and reduce
costs while mitigating risk. The combined impact of the high growth potential of
the identity and access management market, our broadened product portfolio and
the focus of our direct sales resources on larger companies in selected
industries has enabled us to continue to drive business through our installed
base while at the same time adding new customers.
15
Some of our products contain technology that is licensed from third
parties. Our cost of software licenses consists primarily of royalty fees that
we pay for the licensed technologies as well as product fulfillment costs.
Non-cash cost of software licenses include amortization of acquired software.
Cost of services includes salaries and related expenses for our consulting,
training and technical support services organizations, and the associated cost
of training facilities.
Our professional services group provides customers with project
management, deployment, architecture and design, custom development services and
training. Our customers typically pay for professional services at an hourly
rate for the time it takes us to complete the project. We strive to maintain
effective staffing levels and to limit the amount of turnover of our
professional services staff. If we are not successful in maintaining effective
staffing levels, our ability to achieve our service revenue and profitability
objectives may be adversely affected.
The majority of our sales are made directly with customers. Our direct
sales to customers in countries outside of the United States are denominated in
U.S. dollars and local currency, with the majority of our sales denominated in
U.S. dollars. Our sales through indirect distribution channels are generally
denominated in U.S. dollars. For countries outside of the United States, we
generally pay our operating expenses in local currency. Where we do invoice
customers in local currency, we are exposed to foreign exchange rate
fluctuations from the time the contract is signed until collection occurs. We
are also exposed to foreign currency fluctuations between the time we collect in
U.S. dollars and the time we pay our operating expenses in local currency.
Fluctuations in currency exchange rates could affect the profitability and cash
flows in U.S. dollars of our products sold in international markets. To date,
these fluctuations have not been significant.
Our future revenues and operating results may also fluctuate from quarter
to quarter based on the number and size of license deals and the size and scope
of the professional service projects in which we are engaged. In addition,
license revenues from a large customer deal may constitute a significant portion
of our total revenues in a particular quarter. Any such deal may result in
increased royalty payments and commission expenses. Any decline in our revenues
will have a significant impact on our financial results, particularly because a
significant portion of our operating costs, such as personnel, rent and
depreciation, are fixed in advance of a particular quarter. As a result, despite
cost savings realized to date, our costs for services personnel, sales and
marketing and general and administrative could increase as a percentage of
revenue, thereby adversely affecting our operating results.
On October 6, 2004, we and Computer Associates entered into a merger
agreement, pursuant to which, if the merger is completed, at the effective time
of the merger, each outstanding share of our common stock will be converted into
the right to receive $10.75 in cash and we will become a wholly owned subsidiary
of Computer Associates. The merger agreement has been approved by our Board of
Directors, and the transactions contemplated by the merger agreement are subject
to the approval of our stockholders, any required antitrust clearance, any
required international regulatory approvals and other customary closing
conditions and is expected to be completed in the fourth quarter of 2004. See
Note 6 to the accompanying Condensed Consolidated Financial Statements for
additional information.
CRITICAL ACCOUNTING POLICIES AND SIGNIFICANT JUDGMENTS AND ESTIMATES
Our discussion and analysis of our financial condition and results of
operations are based on our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements requires
our management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements as well as the reported
revenues and expenses during the reporting periods. On an ongoing basis, our
management evaluates its estimates and judgments, including those related to
revenue recognition, accounts receivable reserves, valuation of long-lived and
intangible assets, goodwill, in-process research and development, and income
taxes. Our management bases its estimates on historical experience and on
various other factors that it believes to be reasonable under the circumstances,
the results of which form the basis for making judgments about the carrying
value of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different
assumptions or conditions.
There have been no significant changes in our critical accounting policies
during the nine months ended September 30, 2004 as compared to what was
previously disclosed in Management's Discussion and Analysis of Financial
Condition and Results of Operations included in our Annual Report on Form 10-K
for the year ended December 31, 2003.
16
RESULTS OF OPERATIONS
THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THE THREE AND
NINE MONTHS ENDED SEPTEMBER 30, 2003
The following discussion reviews the results of operations for the three
months ended September 30,2004 (the "2004 Quarter") and the nine months ended
September 30, 2004 (the "2004 Period") compared to the three months ended
September 30, 2003 (the "2003 Quarter") and the nine months ended September 30,
2003 (the "2003 Period").
REVENUES ($ IN MILLIONS)
THREE MONTHS ENDED
-----------------------------------------
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
------------------- -------------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
--------- -------- --------- -------- ------------ ------------
Software licenses $ 8.7 43% $ 11.4 56% $ (2.7) (24)%
Services 11.3 56% 8.1 40% 3.2 40%
Other 0.3 1% 0.9 4% (0.6) (67)%
--------- --- --------- --- --------- ---
Total revenues $ 20.3 100% $ 20.4 100% $ (0.1) 0%
========= === ========= === ========= ===
NINE MONTHS ENDED
------------------------------------------
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
-------------------- --------------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
--------- ---------- --------- ---------- ------------ ------------
Software licenses $ 35.1 52% $ 30.5 55% $ 4.6 15%
Services 31.2 46% 23.3 42% 7.9 34%
Other 1.4 2% 2.1 3% (0.7) (33)%
--------- --- --------- --- -------- ---
Total revenues $ 67.7 100% $ 55.9 100% $ 11.8 21%
========= === ========= === ======== ===
Revenues. Total revenues in the 2004 Quarter were relatively consistent
with the same period in the prior year. The small decrease in total revenues was
primarily due to a decrease in software license revenues offset by an increase
in service revenue, which includes consulting, training, maintenance and
support. Total revenues for the 2004 Period increased as compared to the same
period in the prior year. This increase was due to an increase in software
license revenues from the sale of our SiteMinder product, as well as sales
generated by our new product offerings, IdentityMinder Web Edition,
IdentityMinder eProvision and TransactionMinder and from the sale of our service
offerings.
Software license revenues decreased in the 2004 Quarter as compared to the
same period in the prior year. During the 2004 Quarter we closed 91 deals, 17
(or 19%) of which were with new customers. This compares to 109 deals closed in
the 2003 Quarter, 30 (or 28%) of which were with new customers. The average deal
size in the 2004 Quarter was $107,000 as compared to an average deal size of
$123,000 in the 2003 Quarter. The decrease in software license revenue as well
as the decrease in the number of deals and the average size of those deals was
primarily due to a longer than anticipated sales cycle in the 2004 Quarter,
particularly on a couple of large deals. This resulted in some deals not closing
in the 2004 Quarter as expected. Overall, during the 2004 Period we closed 296
deals, 63 (or 21%) of which were with new customers. This compares to 263 deals
closed in the 2003 Period, 81 (or 31%) of which were with new customers. The
average deal size in the 2004 Period was $139,000 which was consistent with the
average deal size in the 2003 Period.
Services revenues increased in both the 2004 Quarter and the 2004 Period
as compared to the same periods in the prior year, primarily due to an increase
in maintenance revenue and to a lesser extent an increase in consulting and
training revenue. The increase in maintenance revenue of $2.3 million in the
2004 Quarter and $5.8 million in the 2004 Period, as compared to the same
periods in the prior year, is attributable (1) to an increase in the license
revenue base, (2) a significant number of maintenance renewals by our existing
customer base, some of which were delayed renewals from the fourth quarter of
2003 and the first half of 2004 and (3) an increase in the sale of our
specialized, on-site support services. Consulting revenue increased by $900,000
in the 2004 Quarter and $1.8 million in the 2004 Period, as compared to the same
periods in the prior year, primarily due to increased demand for our design and
17
architecture services resulting in higher utilization rates of our professional
services employees. Training revenue increased by $22,000 in the 2004 Quarter
and $342,000 in the 2004 Period, as compared to the same periods in the prior
year, primarily due to increased focus on selling our training courses to our
new and existing customers, particularly our customers outside of the United
States.
Other revenues, which are derived from our Firewall legacy business,
decreased in both the 2004 Quarter and the 2004 Period as compared to the same
periods in the prior year due to our decision during the second quarter of 2004
to reallocate the resources previously used in this business in order to focus
them on our core identity and access management business. While we plan to
support the existing Firewall customers through the end of their current support
term, we will no longer sell these products.
GROSS PROFIT ($ IN MILLIONS)
THREE MONTHS ENDED
--------------------------------------
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
------------------ ------------------
GROSS GROSS $ CHANGE % CHANGE
$ PROFIT % $ PROFIT % 2003 TO 2004 2003 TO 2004
------- -------- ------- -------- ------------ ------------
Gross profit - software licenses $ 7.9 91% $ 10.9 96% $ (3.0) (28)%
Gross profit - services 7.5 66% 5.4 66% 2.1 39%
Gross profit - other 0.1 32% 0.3 33% (0.2) (67)%
------- ------- ------
Total gross profit $ 15.5 76% $ 16.6 81% $ (1.1) (7)%
======= == ======= == ====== ===
NINE MONTHS ENDED
--------------------------------------
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
------------------ ------------------
GROSS GROSS $ CHANGE % CHANGE
$ PROFIT % $ PROFIT % 2003 TO 2004 2003 TO 2004
------ ---------- ------- -------- ------------ ------------
Gross profit - software licenses $ 32.8 93% $ 23.8 78% $ 9.0 38%
Gross profit - services 20.7 66% 14.7 63% 6.0 41%
Gross profit - other 0.4 29% 0.8 38% (0.4) (50)%
------- ------- ------
Total gross profit $ 53.9 80% $ 39.3 70% $ 14.6 37%
======= == ======= == ====== ==
Gross profit. Gross profit is calculated as revenues less cost of
revenues. Cost of revenues includes, among other things, royalties due to third
parties for technology included in our products, amortization of capitalized
software, product fulfillment costs, salaries and related expenses for our
consulting, education and technical support services organizations, and the
associated cost of training facilities. Historically, we have realized overall
gross profit margins of between 60% and 80%. The wide range in these percentages
is the result of significant software amortization expenses being included in
certain periods. Gross profit margins on license revenue in periods where there
has not been significant amortization of capitalized software are typically in
excess of 90% and gross profit margins on services revenue are typically in
excess of 50%.
The decrease in gross profit on software licenses in the 2004 Quarter as
compared to the same period in the prior year is due to a decrease in software
license revenue and an increase in the cost of software licenses, which includes
non-cash cost of software licenses. Non-cash cost of software licenses in the
2004 Quarter increased by approximately $500,000 related to the amortization of
capitalized software acquired from Business Layers. These capitalized software
assets are being amortized over their estimated useful lives of two to five
years. The increase in gross profit on software licenses in the 2004 Period as
compared to the same period in the prior year is due to an increase in software
license revenue and a significant decrease in the non-cash cost of software
licenses. Non-cash cost of software licenses in the 2004 Period was $1.5
million, a $3.9 million decrease as compared to the same period in the prior
year due to the purchased software related to the portal technology, which was
recorded in connection with the acquisition of DataChannel, and was fully
amortized as of June 30, 2003. This decrease was slightly offset by the
amortization of capitalized software acquired from Business Layers.
Gross profits on our services revenue are primarily driven by gross
profits on maintenance and professional services revenue. We experienced an
increase in gross profit on services revenues in both the 2004 Quarter and 2004
Period as compared to the same periods in the prior year as a result of an
increase in service revenue partially offset by an increase in the corresponding
cost of providing these services. The cost of maintenance revenue increased
slightly due to an investment in the technical support organization in order to
enhance overall customer satisfaction. The cost of professional services revenue
also increased resulting from the increase in salary and related expenses,
commissions and the use of outside consultants.
Gross profits on Other, which is derived from our Firewall legacy
business, decreased in both the 2004 Quarter and the 2004 Period as compared to
the same periods in the prior year due to a decrease in revenue from this
business attributable to our decision during the second quarter of 2004 to
reallocate the resources previously used in this business in order to focus them
on our core
18
identity and access management business. While we plan to support the existing
Firewall customers through the end of their current support term, we will no
longer sell these products.
OPERATING EXPENSES ($ IN MILLIONS)
THREE MONTHS ENDED
----------------------------------------
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
------------------- -------------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
------ ---------- ------ ---------- ------------ ------------
Selling, general and administrative expenses $ 10.3 51% $ 10.9 53% $ (0.6) (6)%
Research and development expenses 5.8 29% 5.4 26% 0.4 7%
------ ------ -------
Total operating expenses $ 16.1 80% $ 16.3 80% $ (0.2) (1)%
====== == ====== == ======= ==
NINE MONTHS ENDED
----------------------------------------
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
------------------- -------------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
------ ---------- ------ ---------- ------------ ------------
Selling, general and administrative expenses $ 34.0 50% $ 31.8 57% $ 2.2 7%
Research and development expenses 17.7 26% 15.3 27% 2.4 16%
------ ------ ------
Total operating expenses $ 51.7 76% $ 47.1 84% $ 4.6 10%
====== == ====== == ====== ==
Selling, General and Administrative Expenses. Selling, general and
administrative expenses consist primarily of salaries and other related costs
for selling, administrative and marketing personnel, sales commissions, travel,
legal and accounting services, public relations, marketing materials, trade
shows and certain facilities-related expenses. The decrease in selling, general
and administrative expenses in the 2004 Quarter as compared to the same quarter
in the prior year was primarily attributable to decreased commission expense
resulting from lower software license revenue, a decrease in bad debt expense, a
reversal of an accrual for sales tax and a decrease in depreciation expense.
This decrease was slightly offset by an increase in salary and related expenses
as a result of the acquisition of Business Layers, an increase in legal and
accounting expenses related to the proposed merger with Computer Associates and
an increase in accounting and consulting expenses related to our efforts to
comply with the requirements of Sarbanes-Oxley. The increase in the 2004 Period
as compared to the same period in the prior year was due to an increase in
salary and related expenses and transition related expenses as a result of the
acquisition of Business Layers and an increase in accounting and consulting
expenses related to our efforts to comply with the requirements of
Sarbanes-Oxley. These increases were partially offset by reduced insurance
expenses and facility-related expenses, including office rent, depreciation and
utilities, primarily resulting from the consolidation of field offices and the
move of our corporate headquarters to a new facility in March 2003.
Research and Development Expenses. Research and development expenses
consist primarily of personnel and outside contractor costs to support product
development. The increase in research and development expenses in both the 2004
Quarter and 2004 Period as compared to the same periods in the prior year was
primarily due to an increase in salary and related expenses incurred as a result
of the addition of approximately 30 research and development employees located
in Israel that were added as part of the acquisition and integration of Business
Layers in December 2003.
Other Income, Net. The decrease in Other income, net, in both the 2004
Quarter and the 2004 Period as compared to the same periods in the prior year
was primarily attributable to lower interest income earned due to lower average
cash, cash equivalents and marketable securities balances in the 2004 Quarter
and 2004 Period. Our cash and investment balances decreased as a result of cash
payments made as part of the purchase price for Business Layers. Our investment
portfolio is generally comprised of highly liquid, high quality investments, and
therefore we do not expect significant fluctuations in other income as a result
of changes in investment yields.
Provision for Income Taxes. The provision for income taxes was $0 for the
2004 Quarter and $328,000 for the 2004 Period, as compared with a provision of
approximately $63,000 for the 2003 Quarter and approximately $122,000 for the
2003 Period. The 2004 Period provision reflects estimated federal alternative
minimum taxes and foreign taxes on income generated in the 2004 Period. Our
policy is to provide for income taxes in our interim financial statements at an
effective rate based upon our estimate of full year earnings and projected tax
expense. We have recorded a full valuation allowance against deferred tax assets
as of September 30, 2004 due to uncertainties related to our ability to utilize
some of our deferred tax assets, primarily consisting of certain net operating
losses carried forward, before they expire.
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LIQUIDITY AND CAPITAL RESOURCES
In the current and prior years, we have primarily funded our operations
with cash flows generated from operations and the proceeds of our equity
issuances. We invest our cash primarily in instruments that are highly liquid,
investment grade securities. As of September 30, 2004, we had cash and cash
equivalents totaling $12.4 million, short-term marketable securities of $55.5
million and working capital of $52.9 million, compared to cash and cash
equivalents totaling $20.1 million, short-term marketable securities of $51.6
million and working capital of $46.9 million as of December 31, 2003. In
addition, we had long-term marketable securities totaling $21.3 million as of
September 30, 2004 and $19.4 million as of December 31, 2003.
Cash provided by operating activities for the 2004 Period was $6.6
million. This resulted primarily from income of $2.8 million, which included
non-cash charges for depreciation and amortization of $3.8 million, and an
increase in deferred revenue of $1.6 million, partially offset by an increase in
accounts receivable of $1.9 million and a decrease in other accrued expenses of
$1.4 million. Deferred revenue increased as a result of increased revenue and
strong maintenance renewals in the first nine months of 2004. Accrued expenses
decreased due to lower commission amounts payable. Finally, while we continued
to experience strong collection results in the 2004 Period, accounts receivable
increased due to the increase in revenue, the timing of when deals are invoiced
and the volume of maintenance renewals. The increase in accounts receivable
resulted in an increase of our day's sales outstanding to 73 days in the quarter
ended September 30, 2004 from 53 days in the quarter ended December 31, 2003.
Cash used for investing activities was $18.3 million for the 2004 Period.
Investing activities consisted primarily of $8.5 million of net cash used for
the payment of the remaining purchase consideration and transaction costs
associated with the acquisition of Business Layers and the purchases of
marketable securities of approximately $56.6 million, offset by sales and
maturities of marketable securities of approximately $49.2 million.
Cash provided by financing activities in the period ended September 30,
2004 was $3.7 million, primarily related to proceeds received from the exercise
of stock options in the 2004 Period and the issuance of shares in connection
with our employee stock purchase plan during May 2004.
Any increase or decrease in our accounts receivable balance and accounts
receivable days outstanding (calculated as net accounts receivable divided by
revenue per day) affects our cash flow from operations and liquidity. Our
accounts receivable and accounts receivable days outstanding may increase due to
changes in factors such as the timing of when sales are invoiced and the length
of our customers' payment cycles. We also record deferred maintenance billings
as accounts receivable, and the timing of these billings can affect the accounts
receivable days outstanding, as it did in the 2004 Period. Historically,
international and indirect customers pay at a slower rate than domestic and
direct customers do. An increase in revenues generated from international
customers may increase our accounts receivable balance and accounts receivable
days outstanding. Due to the current economic climate, we may observe an
increase in the length of our customers' payment cycles and, as a result, our
day's sales outstanding may increase in future periods. To the extent that our
accounts receivable balance increases, we may incur increased bad debt expense
and will be subject to greater general credit risks.
We anticipate our short-term cash requirements to primarily include the
continued funding of our operating expenses and to a lesser extent the funding
of capital expenditures. We believe that our existing cash and cash equivalent
balances together with our marketable securities will be sufficient to meet
these requirements for at least the next twelve months in the event that our
proposed merger with Computer Associates is not consummated. We anticipate our
long-term cash requirements to primarily include the funding of acquisitions or
investments in businesses, technologies, products or services that are
complementary to our business.
COMMITMENTS AND CONTRACTUAL OBLIGATIONS
In April 2002, we entered into an agreement with a system integrator to
assist us in the development and launch of one of our products. Under the terms
of the agreement, as consideration for the system integrator's time in assisting
with the development of the product, we agreed to promote the system integrator
as an integrator of the developed product. Our obligation under the agreement
would have been considered satisfied once the system integrator received
consulting revenues totaling approximately $3.9 million from our customers, or
by the expiration date of the agreement. The agreement expired in May 2004. No
royalties were due to the system integrator under this agreement during its
term.
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In February 2004, we entered into an agreement with a software service
provider located in India under which we have guaranteed to pay this software
service provider a minimum of $4.0 million annually for various product
development projects. The initial term of this agreement expires in December
2004. As of September 30, 2004, approximately $3.5 million had been paid to this
software service provider.
In August 2002, we entered into a five year non-cancelable operating lease
for an office building for our corporate headquarters. We occupied the new
facility in March 2003. In connection with the lease agreement, we delivered to
the landlord an irrevocable, unconditional, negotiable letter of credit in the
amount of $774,000 as a security deposit.
In June 2004, we entered into a letter of credit with a financial
institution. The letter of credit in the amount of $566,000, which is held in
connection with a prepaid customers maintenance contract, has an expiration date
of December 2012 and is reduced ratably over the term of the contract.
We enter into standard indemnification agreements with our business
partners and customers in the ordinary course of business. Pursuant to these
agreements, we agree to repair or replace the product, pay royalties for a right
to use, or reimburse the indemnified party for actual damages awarded by a court
against the indemnified party for an intellectual property infringement claim by
a third party with respect to our products. The term of these indemnification
agreements is generally perpetual. The maximum potential amount of future
payments we could be required to make under these indemnification agreements is
unlimited. We have never incurred costs to defend lawsuits or settle claims
related to these indemnification agreements. As a result, we believe the
estimated fair value of these agreements is minimal. Accordingly, we have no
liabilities recorded for these agreements as of September 30, 2004.
We enter into standard indemnification agreements with our customers,
whereby we indemnify them for certain damages, such as personal property damage,
which may be incurred in connection with consulting services performed at a
customer location by our employees or subcontractors. The potential amount of
future payments we could be required to make under these indemnification
agreements is unlimited. However, we have general and umbrella insurance
policies that enables us to recover a portion of any amounts paid. We have never
incurred costs to defend lawsuits or settle claims related to these
indemnification agreements. As a result, we believe the estimated fair value of
these agreements is minimal. Accordingly, we have no liabilities recorded for
these agreements as of September 30, 2004.
We generally warrant for ninety days from delivery to a customer that our
software products will perform free from material errors which prevent
performance in accordance with user documentation. Additionally, we warrant that
our consulting services will be performed consistent with generally accepted
industry standards. We have never incurred significant expense under our product
or service warranties. As a result, we believe the estimated fair value of these
agreements is minimal. Accordingly, we have no liabilities recorded for these
agreements as of September 30, 2004.
We have entered into employment and executive retention agreements with
certain employees and executive officers which, among other things, include
certain severance and change of control provisions. We have also entered into
agreements whereby we indemnify our officers and directors for certain events or
occurrences while the officer or director is, or was, serving at our request in
such capacity.
From time to time, we are involved in litigation relating to claims
arising out of our operations in the normal course of business. We are not
presently a party to any legal proceedings, the adverse outcome of which, in our
opinion, would have a material adverse effect on our results of operations or
financial position.
In September 2004, we received a letter from a customer of Business Layers
GmbH (BLG) making a claim for rescission of their contract with BLG for alleged
breach of its contract under German law. The customer has requested compensation
in the amount of approximately 2.2 million Euro plus interest, reserving a right
to assert additional unspecified damages. The customer may also assert an
additional claim for pre-paid maintenance fees in the amount of approximately
575,000 Euro. We have notified the indemnification representatives for the
Business Layer's escrow that we intend to seek indemnification for any damages
incurred relating to this claim, subject to the limitations of the escrow and
the Business Layers merger agreement.
On October 6, 2004, we entered into an Agreement and Plan of Merger (the
"Agreement") with Computer Associates International, Inc., a Delaware
corporation ("Computer Associates") pursuant to which we would merge with a
wholly owned subsidiary of Computer Associates and become a wholly owned
subsidiary of Computer Associates. If the merger is completed, at the effective
time of the merger, each outstanding share of our common stock will be converted
into the right to receive $10.75 in cash. The Agreement has been approved by our
Board of Directors, and the transactions contemplated by the Agreement are
subject to the
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approval of our stockholders, any required antitrust clearance, any required
international regulatory approvals and other customary closing conditions and is
expected to be completed in the fourth quarter of 2004. We expect to incur
expenses of approximately $5.0 million related to the merger with Computer
Associates. These merger-related expenses include investment banking fees, and
legal and professional fees. A contingent termination fee of $13.0 million plus
reimbursement of up to $2.0 million of Computer Associates' expenses related to
the transaction is payable by us to Computer Associates in the event that the
Agreement is terminated as a result of certain events as detailed in the
Agreement.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
We caution you that the following important factors, among others, in the
future could cause our actual results to differ materially from those expressed
in forward-looking statements made by us or on our behalf in filings with the
Securities and Exchange Commission, press releases, communications with
investors and oral statements. Any or all of our forward-looking statements in
this Quarterly Report on Form 10-Q and in any other public statements we make
may turn out to be wrong. They can be affected by inaccurate assumptions we
might make or by known or unknown risks and uncertainties. Many factors
mentioned in the discussion below will be important in determining future
results. Consequently, no forward-looking statement can be guaranteed. Actual
future results may vary materially. We undertake no obligation to update any
forward-looking statements, whether as a result of new information, future
events or otherwise. You are advised, however, to consult any further disclosure
we make in our reports filed with the Securities and Exchange Commission.
IF THE PROPOSED MERGER WITH COMPUTER ASSOCIATES IS NOT COMPLETED, OUR BUSINESS
AND STOCK PRICE COULD BE ADVERSELY AFFECTED.
On October 6, 2004, we entered into an Agreement and Plan of Merger (the
"Agreement") with Computer Associates International, Inc., a Delaware
corporation ("Computer Associates") pursuant to which we would merge with a
wholly owned subsidiary of Computer Associates and become a wholly owned
subsidiary of Computer Associates. If the merger is completed, at the effective
time of the merger, each outstanding share of our common stock will be converted
into the right to receive $10.75 in cash. The Agreement has been approved by our
Board of Directors, and the transactions contemplated by the Agreement are
subject to the approval of our stockholders, any required antitrust clearance,
any required international regulatory approvals and other customary closing
conditions and is expected to be completed in the fourth quarter of 2004. We
expect to incur expenses of approximately $5.0 million related to the merger
with Computer Associates. These merger-related expenses include investment
banking fees, and legal and professional fees. A contingent termination fee of
$13.0 million plus reimbursement of up to $2.0 million of Computer Associates'
expenses related to the transaction is payable by us to Computer Associates in
the event that the Agreement is terminated as a result of certain events as
detailed in the Agreement.
Our business and stock price could be adversely affected if the merger with
Computer Associates is not completed as a result of several factors, including,
but not limited to, the following:
- our customers, prospective customers and investors in general may view
this failure as a poor reflection on our business or prospects;
- customers or prospective customers may have delayed their purchase
commitments until the merger was complete and the product integration
plan and roadmap was clarified or may have chosen to not purchase at
all;
- certain of our suppliers, distributors, and other business partners may
have sought to change or terminate their relationships with us as a
result of the proposed merger;
- our key employees may have sought other employment opportunities; and
- our management team may have been distracted from day to day operations
as a result of the proposed transaction with Computer Associates.
ALTHOUGH WE ARE NOW PROFITABLE, WE HAVE INCURRED SUBSTANTIAL LOSSES IN THE PAST
AND MAY NOT CONTINUE TO BE PROFITABLE IN THE FUTURE.
In recent years, we have incurred substantial operating losses. While we
were profitable for the nine months ended September 30, 2004, we generated an
operating loss during the third quarter of 2004 and we cannot predict if we will
maintain profitability for any substantial period of time. To achieve operating
profitability on a quarterly and annual basis, we will need to continue to
increase our
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revenues, particularly our license revenues. Failure to maintain levels of
profitability as expected by investors may adversely affect the market price of
our common stock. We had an accumulated deficit of $108.1 million as of
September 30, 2004.
OUR QUARTERLY RESULTS MAY FLUCTUATE WIDELY.
Our quarterly revenues and operating results are difficult to predict and
may continue to fluctuate significantly from quarter to quarter for several
reasons, including, but not limited to, the following:
- customers choosing to delay their purchase commitments or purchase
in smaller than expected quantities due to our pending merger with
Computer Associates, a general slowdown in the economy or in
anticipation of the introduction of new products by us or our
competitors;
- market acceptance of our SiteMinder, IdentityMinder Web Edition,
IdentityMinder eProvision and TransactionMinder products;
- the timing and size of orders from our customers, including the
tendency for a significant amount of our sales to occur in the final
two weeks of each fiscal quarter;
- increased dependency on large transactions as more customers make
enterprise wide purchased of our products;
- our ability to obtain follow-on sales from existing customers;
- the long sales and deployment cycle of our products;
- our ability to hire and retain personnel, particularly in
development, services and sales and marketing;
- the loss of or changes in key management personnel;
- the timing of the release of new versions of our SiteMinder,
IdentityMinder Web Edition, IdentityMinder eProvision and
TransactionMinder or other products;
- pricing pressures that result in increased discounts or changes in
our or competitors' pricing policies;
- changes in our operating expenses;
- the development of our direct and indirect distribution channels;
- integration issues with acquired technology and businesses; and
- general economic conditions.
In addition, because our revenues from services, particularly maintenance
revenues, are largely correlated with our software revenues, a decline in
software revenues could also cause a decline in our services revenues in the
same quarter or in subsequent quarters. Other factors, many of which are outside
our control, could also cause variations in our quarterly revenues and operating
results.
Most of our expenses, such as employee compensation and rent, are
relatively fixed. As a result, any shortfall in revenues in relation to our
expectations could cause significant changes in our operating results from
quarter to quarter and could result in future losses.
OUR SUCCESS WILL DEPEND ON OUR ABILITY TO MARKET OUR PRODUCTS AND RELATED
SERVICES SUCCESSFULLY.
Our revenues are primarily generated from the sale of perpetual licenses
for our proprietary SiteMinder, IdentityMinder Web Edition, IdentityMinder
eProvision, TransactionMinder and related services. Broad market acceptance of
our products will depend on the continued development of a market for identity
and access management, the education of our customers on the use of business
23
software applications in general and the relevance of our products specifically.
Market acceptance of our products, and customer demand for the services they
provide, may not develop.
We have released several new product offerings in the past 18 months. If
we fail to gain market acceptance for these products, our business, operating
results and financial position could be materially adversely affected.
Additionally, with the continued constraints in information technology spending
in all industries we will need to be successful in conveying the value of our
products to customers who may be hesitant to replace a "homegrown" system due to
the costs involved with switching to a purchased solution.
Our ability to succeed in the market for our products depends in part on
our ability to provide support services on a 24 hour per day, seven day per week
basis. Any damage or disruptions to our service centers, including our service
centers in Malaysia and Israel, whether as a result of employee attrition, acts
of terrorism, language barriers, or some other cause, could seriously impact our
ability to provide the necessary service to our customers and fulfill our
service contracts.
OUR SUCCESS IS DEPENDENT ON OUR ABILITY TO ENHANCE OUR PRODUCT LINES AND DEVELOP
NEW PRODUCTS.
We believe our success is dependent, in large part, on our ability to
enhance and broaden our product lines to meet the evolving needs of the business
market. Our success also depends on the ability of our customers to link our
software to their existing systems and applications through various connectors
and agents that we have developed. We may not be able to efficiently integrate
recently acquired technologies into our products or provide the most effective
connector or agent. We may be unable to respond effectively to technological
changes or new industry standards or developments. Product development cycles
are unpredictable and, in the past, we have delayed the introduction of several
new product versions due to delays in development.
We have arrangements with a third party located in India to perform certain
testing of our products, as well as internationalization and porting of our
products to new platforms, and with third party software vendors who provide
software which is embedded in our products. Any adverse change in our
relationship with these third parties could result in delays in the release of
our products. In the future, we could be adversely affected and be at a
competitive disadvantage if we incur significant delays or are unsuccessful in
enhancing our product lines or developing new products, or if any of our
enhancements or new products experience higher than anticipated error rates or
do not gain market acceptance.
As we continue to release new versions of our existing software, we may be
required to assist customers in migrating to the latest version once we announce
the end of life of the previous version. Additionally, we may be required to
assist Business Layers customers in migrating to more standardized versions of
the provisioning product. We could be adversely affected if we experience
significant migration issues and a decline in customer satisfaction related to
such transitions.
OUR ACQUISITION OF BUSINESS LAYERS AND OTHER COMPANIES MAY INCREASE THE RISKS WE
FACE.
We recently acquired Business Layers. In the future, we may pursue other
acquisitions to obtain complementary products, services and technologies. These
acquisitions may not produce the revenues, earnings or business synergies that
we anticipate, and an acquired product, service or technology might not perform
as we expect. In pursuing any acquisition, our management could spend
significant time and effort in identifying and completing the acquisition. We
will have to devote significant management resources to integrate with our
existing businesses the business we acquired from Business Layers and any other
business we might acquire. We might not be able to successfully transfer the
knowledge of the employees or integrate the operations of acquired businesses,
including Business Layers. As a result of acquisitions, we might assume
contracts and other agreements that subject us to burdensome liabilities,
including obligations to indemnify third parties, or impose unfavorable terms on
us, including significant royalty obligations and termination fees. We may not
be able to renegotiate these agreements. To pay for an acquisition, we might use
our stock or cash. Alternatively, we might borrow money from a bank or other
lender. If we use our stock, our stockholders would experience dilution of their
ownership interests. If we use cash or debt financing, our financial liquidity
will be reduced.
OUR PERFORMANCE DEPENDS ON OUR ABILITY TO WIN BUSINESS AND OBTAIN FOLLOW-ON
SALES IN PROFITABLE SEGMENTS.
Customers typically place small initial orders for our products to allow
them to evaluate our products' performance. A key element of our strategy is to
pursue more significant follow-on sales after these initial installations. Our
financial performance depends on successful initial deployments of our products
that, in turn, lead to follow-on sales. If the initial deployments of our
products are not successful or if our customers do not remain satisfied with our
products and services, we may be unable to obtain follow-on sales. In
24
addition, even if initial deployments are successful, we cannot assure you that
customers will choose to make follow-on purchases, which could have a material
adverse effect on our ability to generate revenues.
WE FACE SIGNIFICANT COMPETITION FROM OTHER TECHNOLOGY COMPANIES AND WE MAY NOT
BE ABLE TO COMPETE EFFECTIVELY.
The market for identity and access management is highly competitive. We expect
the level of competition to increase as a result of the anticipated growth of
the identity and access management market. Our primary competitor in the
identity and access management market is the Tivoli Division of IBM. We also
compete against traditional security and software companies, such as Oblix, RSA
and Novell, and stack vendors such as Sun MicroSy