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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 1998
[_] 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: 0-26130
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LEGATO SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 94-3077394
(State of incorporation) (I.R.S. Employer
Identification No.)
3210 Porter Drive
Palo Alto, California 94304
(Address of principal executive offices)
(650) 812-6000
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Preferred Share Purchase Rights
Common Stock, $.0001 par value
(Title of each class)
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Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of the voting stock held by non-affiliates of
the registrant as of January 22, 1999 was approximately $2,149,795,153. Shares
of Common Stock held by each officer and director have been excluded in that
such persons may be deemed to be affiliates. This determination of affiliate
status is not necessarily a conclusive determination for other purposes.
The number of shares outstanding of the registrant's common stock as of
January 22, 1999 was 37,661,841.
DOCUMENTS INCORPORATED BY REFERENCE
Part III--Portions of the registrant's definitive Proxy Statement to be
issued in conjunction with the registrant's Annual Meeting of Stockholders to
be held on May 20, 1999.
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LEGATO SYSTEMS, INC.
FORM 10-K ANNUAL REPORT
FOR THE FISCAL YEAR ENDED
DECEMBER 31, 1998
Table of Contents
PART I
Item 1. Business....................................................... 3
Item 2. Properties..................................................... 24
Item 3. Legal Proceedings.............................................. 24
Item 4. Submission of Matters to a Vote of Security Holders............ 24
Item 4a. Executive Officers of the Registrant........................... 24
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters........................................................ 26
Item 6. Selected Consolidated Financial Data........................... 27
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................... 28
Item 8. Consolidated Financial Statements and Supplementary Data....... 36
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure........................................... 36
PART III
Item 10. Directors and Executive Officers of the Registrant............. 57
Item 11. Executive Compensation......................................... 57
Item 12. Security Ownership of Certain Beneficial Owners and
Management..................................................... 57
Item 13. Certain Relationships and Related Transactions................. 57
PART IV
Item 14. Exhibits, Financial Statement Schedule and Reports on Form 8-
K.............................................................. 58
Signatures............................................................... 62
2
PART I
ITEM 1. BUSINESS
The discussion in this report on Form 10-K contains forward-looking
statements that involve risks and uncertainties. The statements contained in
this Report that are not purely historical are forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended,
and Section 21E of the Securities Exchange Act of 1934, as amended, including
statements on our expectations, beliefs, intentions or strategies regarding
the future. All forward-looking statements included in this document are based
on information available to us on the date hereof. We assume no obligation to
update any such forward-looking statements. Our actual results could differ
materially from those indicated in such forward-looking statements. Factors
that could cause or contribute to such differences include, but are not
limited to fluctuations in quarterly operating results, uncertainty in future
operating results, product concentration, competition, and other risks
discussed in this item under the heading "Risk Factors" and the risks
discussed in our other Securities and Exchange Commission filings.
Legato Systems, Inc. was incorporated in Delaware in September 1988. We
develop, market and support network storage management software products for
heterogeneous client/server computing environments and large scale
enterprises. We believe we are currently a technology leader in the network
storage management software market because of the scalability, heterogeneity,
performance, ease of use and central administration of our software products.
Our NetWorker family of products supports many storage management server
platforms and accommodates a variety of clients, servers, applications,
databases and storage devices. Our long term strategy is to create an
integrated set of solutions centered around storage management that enhance
and simplify network computing as a whole.
We utilize multiple distribution channels, including direct sales,
resellers and original equipment manufacturers ("OEMs"), as a part of our
strategy to achieve comprehensive coverage in the market. We license our
source code to leading computer system and software suppliers, including:
. Amdahl;
. Banyan;
. Compaq (Digital);
. Compaq (Tandem);
. Data General;
. NEC;
. Siemens Nixdorf;
. Silicon Graphics; and
. Sun Microsystems.
These leading computer system and software suppliers port the products to
their proprietary platforms, sell the products through their direct and
indirect distribution channels and provide primary support for the products
after installation. These relationships enable us to reach a broad customer
base, while reducing development, support and product costs. We have also
established strategic partnerships with Hewlett-Packard, Netscape and Oracle.
Background
Our NetWorker software has been designed to address the emerging
requirements of storage management in client/server computing environments.
NetWorker employs a client/server architecture in which a server centralizes
storage management services for a wide variety of clients, including servers
and desktop computers.
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NetWorker provides a cost-effective storage management solution that scales to
support large networks, supports heterogeneous client/server computing
environments, accomplishes storage management tasks within stringent time
constraints, reduces the cost of network administration and employs an easy-
to-use graphical user interface. The core elements of the our solution
include:
. Scalability;
. Heterogeneity;
. Performance;
. Ease of use; and
. Central Administration.
Scalability. Our storage management architecture, also referred to as
Enterprise Storage Management Architecture ("ESMA"), is designed to be
scalable so that it can grow with an expanding network and accommodate a wide
range of storage management needs. Our storage server family can be configured
or expanded to meet the storage requirement needs of a changing and dynamic
network. Our architecture is modular, so that clients, servers and storage
devices can be upgraded or added without requiring redesign of the entire
system. An existing server can be quickly upgraded to a more powerful server
with minimal modification. Furthermore, our architecture can adapt to growing
networks with its ability to easily add clients to a given storage management
server. For example, a single NetWorker storage management server has been
employed to manage data located on hundreds of clients ranging from desktop
computers to large file servers.
Heterogeneity. Our storage management solutions are designed to support a
wide range of servers, clients, applications, databases and storage devices.
Servers, clients, applications, databases and storage devices supported by our
BusinesSuite products include:
. DB2;
. Informix;
. Lotus Notes;
. Microsoft Exchange;
. Microsoft SQL;
. Oracle;
. SAP R/3; and
. Sybase.
Our family of storage management server products operates on the following
platforms:
. NetWare;
. Windows NT;
. UNIX systems (AIX, DEC, Dynix/ptx, HP-UX, Irix and Solaris); and
. UNIX systems and Windows NT offered by our OEMs.
Server and desktop computer clients supported include:
. DOS;
. Macintosh;
. NetWare;
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. OS/2;
. UNIX;
. Vines;
. Windows; and
. Windows NT.
Storage devices supported include most popular tape drives, and optical and
tape robotic storage devices. All NetWorker server platforms inter-operate
with all supported clients. As a result, customers can mix and match clients
and servers as necessary to meet their specific requirements. In addition,
NetWorker's interoperability enables the flexibility to change storage
management server platforms, without disrupting any client systems.
Performance. Organizations usually need to accomplish storage management
functions (which tend to consume network bandwidth as large amounts of data
are transferred over the network) during a network's off-peak hours. Our
NetWorker storage management server can process data from many clients in
parallel, allowing high volumes of network data to be managed within stringent
time constraints. NetWorker is designed to take advantage of improvements in
the physical environment to deliver higher performance. As networks employ
higher-speed computers, faster and increased capacity storage devices and
higher bandwidth networking technologies, NetWorker can exploit these
capabilities to move data quickly.
Ease of Use. Our storage management solutions have been designed to be easy
to use for both network administrators and end users. Our architecture permits
a network administrator to perform the storage management function for the
entire network either from the storage server or a client. The network
administrator can access our products through a number of graphical user
interfaces, including Windows, Windows NT and Motif. Network administrators
can also automate their storage operations by adding robotic storage
libraries, further reducing the need for human intervention. Finally, our
architecture supports a simple user interface that permits end users to access
or recover copies of their files without the need for intervention by the
network administrator.
Central Administration. Our Global Enterprise Management Systems
("G.E.M.S.") product allows information system organizations the ability to
globally manage hundreds and even thousands of NetWorker storage servers.
G.E.M.S. provides services such as policy management, software distribution,
universal licensing and advanced media management and can be integrated with
management frameworks including CA Unicenter, HP Openview, Sun Enterprise
Manager and Tivoli TME.
Our acquisition of Software Moguls, Inc, a developer of advanced backup-
retrieval products for Window NT and UNIX environments, in 1998, and our
pending acquisitions of Qualix Group, Inc. (dba FullTime Software, Inc.), a
developer of distributed, enterprise-wide, cross-platform, adaptive computing
solutions, and Intelliguard Software, Inc., a developer of standards-based
storage management solutions for storage area networks, are intended to enable
us to continue to provide customers with storage management technologies to
protect their data with ease and confidence. The research and development
resources and product lines from the acquisition of Software Moguls, Inc., and
pending acquisitions of FullTime Software, Inc. and Intelliguard Software,
Inc., potentially provides us with opportunities to enhance the core elements
of our enterprise storage management solution. (See Risk Factors also.)
Architecture
The most basic function of a storage management system is data protection.
The process of data protection involves making backup copies of data stored on
hard disks onto low-cost, high capacity removable media such as tapes and
optical disks.
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Our architecture provides reliable data protection services. Data may be
managed according to the application that produces it. For example, a
relational database may be frequently updated. To back up this kind of
database efficiently, it is necessary to understand how the database is
constructed, so that a consistent copy of the database can be made while it is
undergoing change and while the database is "on-line." Our architecture can
accommodate the data produced by different applications because of its
Application Specific Module ("ASM") technology. Each ASM can be tailored to
the specific storage management needs of a particular kind of application
data, and all ASMs are implemented using a modular architecture designed to
permit new ASMs to be easily integrated into our storage offerings.
Once data is read from the client's hard disk, it is transmitted to the
storage management software that resides on the storage server using industry-
standard communications protocols such as TCP/IP and SPX/IPX. A high-
performance, integrated database is fundamental to the storage management
server engine. This database has two roles: to keep track of where the storage
management server has stored the data, and to keep track of what data is
stored. Our architecture makes it possible for clients to query the database
as to what data is under management and for clients to access this data
themselves. This enables novice users to directly access the system, thereby
reducing the burden on network administrators.
One of the most critical ways our architecture achieves its ability to
accommodate an increasing number of clients while retaining high performance
is by implementing parallel data transfers from the clients to the storage
management server in the same way that adding more tellers to serve customers
allows a bank to process more transactions in the same amount of time. When an
additional client's data is managed, it may be scheduled for processing by the
storage management server at the same time as the data from other clients.
Thus, one slow client need not slow down the entire storage management
process. Our architecture achieves this parallelism by writing multiple client
data streams to the tape simultaneously. This allows the full bandwidth of the
tape drive to be used as the data from many clients can be delivered to the
tape drive in the same amount of time as the data from one client. As a
result, one high-capacity tape drive can be shared effectively by more than
one client on the network, and therefore, it may not be necessary to purchase
several tape drives to accomplish data protection in the required amount of
time.
An increasingly important function of the architecture to some end users is
to facilitate the management of data according to its criticality. As an
example, a set of quarterly reports may be grouped together and filed away.
This data may not need to be accessed on a regular basis, but may need to be
retrievable for a period of years because of certain regulatory requirements.
This class of data is termed "archive" data, because it may be filed away for
future reference and need not be kept on-line. When archived data is needed,
it must be explicitly retrieved, typically from offsite storage. It is also
possible to archive data in such a way that it appears to be on-line, when it
in reality is stored elsewhere. This process is referred to as "hierarchical
storage management." The indexing technology embedded within our storage
products is designed to support the management of protected, archived, and
hierarchically managed data.
To reduce the burden on expensive administrative staff, our architecture
allows the storage management server to be managed remotely, from an easy-to-
use, graphical user interface familiar to the administrator. The use of a
common administrative protocol developed by us greatly facilitates the
development of diverse user interfaces that support remote administration. Our
family of storage management products can also automate a wide range of
storage management functions and can employ robotic storage devices to remove
the need for human intervention to retrieve a particular piece of removable
storage media.
Products
Our family of storage management server software--NetWorker--provides
network storage management services for a wide variety of platforms. NetWorker
consists of two basic components: a client module that accesses the data being
managed, and a server module that performs the protection, management and
control of network data. Typically, the server module is selected to run on
the platform most familiar to the administrative staff in an organization; the
client modules are selected according to the type of computers installed on
the
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network. Our server software is available for NetWare, Windows NT and several
UNIX platforms, including Compaq (Digital), HP, IBM, Silicon Graphics and Sun
versions of UNIX. A number of applications and enhancements options are
available for the storage server.
The base NetWorker server product provides data protection services for
clients and includes client software for the same platform as the NetWorker
server, as well as support for a set of popular non-robotic storage devices.
In multiple platform environments, client software for dissimilar platforms
must be purchased. The following client packages are currently available:
. ClientPak for UNIX, which supports a diverse set of UNIX clients;
. ClientPak for PC Desktops, which supports OS/2, Windows 95, Windows 98
and Windows NT;
. ClientPak for Windows NT, which supports Window NT workstation and
Windows NT Server;
. ClientPak for MPE/iX, which supports HP3000 MPE/iX systems;
. ClientPak for NetWare, which supports NetWare; and
. ClientPak for Macintosh, which supports MacOS.
The base NetWorker server product for Windows NT, UNIX and NetWare is also
available through the following offerings, which support a variety of
Networker options:
. Workgroup Edition--a storage management solution for small networks in
corporate environments. Workgroup Edition provides support for up to four
client connections and two storage devices;
. Network Edition--an enterprise-strength storage management solution for
distributed networks. Network Edition supports up to ten clients, as well
as options that add client connections, expand client platform coverage,
and deliver advanced data management services; and
. Power Edition--a storage management solution for customers with very
large servers, clusters, or the requirement to drive high-speed devices.
Power Edition features enhanced architecture to increase throughput while
minimizing use of system resources and supports all standard Networker
options.
NetWorker for UNIX is licensed by the number of clients to be supported and
has the following storage management server options available:
. Archive--the ability to archive data;
. Autochanger--the ability to employ tape and optical jukeboxes of varying
capacities;
. BusinesSuite--the ability to utilize a family of add-on modules tailored
for databases and business applications;
. Client Connections--the ability to increase the number of clients of the
storage management server beyond the ten supported by the base product;
. High Speed Device Support--the ability to utilize high speed devices;
. Silo Support--the ability to leverage mainframe-class storage silos;
. SNMP Modules--the ability to integrate with leading system management
offerings; and
. Storage Nodes--the ability to perform very high-speed backup locally
which is managed centrally.
NetWorker for Windows NT is Microsoft BackOffice certified and licensed by
the number of clients to be supported and it has the following storage
management server options available:
. Archive--the ability to archive data;
. Autochanger--the ability to employ tape and optical jukeboxes of varying
capacities;
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. BusinesSuite--the ability to utilize a family of add-on modules tailored
for databases and business applications such as SQL Server and Exchange
Server;
. Client Connections--the ability to increase the number of clients of the
storage management server beyond the ten supported by the base product;
. Open File Manager--the ability to protect open files;
. Silo Support--the ability to leverage mainframe-class storage silos;
. SNMP Module--the ability to integrate with leading system management
offerings; and
. Storage Nodes--the ability to perform very high-speed backup locally
which is managed centrally.
NetWorker for NetWare is licensed by the number of clients to be supported
and has the following storage management server options available:
. Archive--the ability to archive data;
. Autochanger--the ability to employ tape and optical jukeboxes of varying
capacities; and
. Client Connections--the ability to increase the number of clients of the
storage management server beyond the ten supported by the base product.
NetWorker server software has an entry end user list price from $1,000 to
$19,500, while a fully configured NetWorker system can have an end user list
price of over $100,000.
Our G.E.M.S. product complements the NetWorker family of products by
providing an approach to managing enterprise-wide storage from Java-enabled
Web browsers via a central console. G.E.M.S allows systems administrators to
centrally configure, control, and manage storage in geographically dispersed
areas. The main features of G.E.M.S. include policy-based administration,
software management and flexible software licensing across the enterprise.
G.E.M.S. provides system administrators the ability to control multiple data
zones managed by NetWorker servers.
Sales and Marketing
Our strategy is to deploy a comprehensive sales, marketing and support
infrastructure to meet the storage management needs of users of complex
client/server networks worldwide. We use multiple distribution channels to
reach end user customers, which range in size from individual corporate
departments or small businesses to large multinational corporations. Network
storage management software may be utilized in a broad range of industries.
The range of distribution channels includes:
. Direct sales;
. Resellers; and
. OEMs.
Direct Sales
We have established a dedicated sales force to penetrate large enterprise-
wide opportunities. As storage management applications increase in strategic
importance to major enterprises, we have recognized the need to establish even
closer relationships with our largest corporate clients. Customers
participating in our enterprise sales program have an assigned salesperson and
an executive contact, participate in our technical exchange program and work
closely with us to develop large projects for installations over a period of
time. An enterprise sales representative coordinates business partner
activities across the customer's enterprise and closely monitors customer
satisfaction.
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Resellers
We have established regional sales offices to increase the effectiveness of
and support to our channel partners.
North America Enterprise Solution Partners. Our North America Enterprise
Solution Partners program provides a significant source of revenue in North
America. The Enterprise Solution Partners program enables third-party
integrators specializing in storage management and client/server network
solutions to provide end user customers with complete solutions, including
systems and storage hardware, complementary software and our software. The
reseller is responsible for managing the sales and installation process in
each customer situation. In large, complex opportunities, our support
personnel work with the reseller to provide technical support. This approach
enables us to cost effectively achieve broader market coverage, while
maintaining close contact with end user customers in order to obtain input on
product direction and to monitor customer satisfaction. We provide sales and
pre-sale technical support to business partners and end user customers from
our headquarters in Palo Alto and from regional offices in the following
metropolitan areas:
. Atlanta;
. Boston;
. Chicago;
. Dallas;
. Denver;
. Los Angeles;
. New York;
. Seattle;
. Toronto; and
. Washington, D.C.
North America Distributor Program. To further expand coverage in the
marketplace, we sell our products to large regional and national distributors
who sell the products to resellers with expertise in integrating network
solutions for end users. We provide support to these network solutions
resellers. We currently have relationships with various major distributors,
including Access Graphics, Gates/Arrow, Ingram Micro and TechData.
International Reseller and Distributor Programs. We have similar reseller
and distributor programs internationally. We currently operate sales offices
in the following countries to support resellers and distributors throughout
various regions of the world:
. Australia;
. Belgium;
. China;
. France;
. Germany;
. Italy;
. Japan;
. Netherlands;
. Poland;
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. South Africa;
. Sweden;
. Switzerland; and
. United Kingdom.
International product sales were $42.5 million in 1998, $21.7 million in
1997 and $11.6 million in 1996, representing 30 percent of total revenue in
1998, 26 percent in 1997 and 20 percent in 1996. The majority of international
sales during these periods were made in Europe and Canada. We believe that
international markets present an attractive growth opportunity and are
expanding the scope of our international operations. We have engaged, and
intend to add international resellers and distributors in targeted countries
and are developing joint marketing programs with certain resellers and
distributors. In order to facilitate penetration in certain markets, we, along
with cooperation from certain international distributors, are in the process
of localizing certain products to targeted languages.
We also rely significantly on our resellers for the marketing and
distribution of our products. Our agreements with resellers are generally not
exclusive and in many cases may be terminated by either party without cause.
Many of our resellers carry our competitors' product lines. We cannot
guarantee that these resellers will give a high priority to the marketing of
our products or that they will continue to carry our products. Events or
occurrences of this nature could seriously harm our business, operating
results and financial condition.
OEMs
Source Code OEM Program. Our source code OEM program generates significant
royalty revenue. Under this program, we license our software products, in
source code form, to leading computer system and software suppliers from which
we receive an initial license fee and ongoing royalty revenue. The OEM partner
is then responsible for porting our software to its unique operating system
environment, testing it, selling it through the OEM partner's direct sales
force and distribution channels and providing the primary customer support
after installation. The OEM partners generally have exclusive rights to the
products on their proprietary platforms (subject to certain minimum royalty
obligations), but, in certain cases, work cooperatively to incorporate their
enhancements into our storage products on an ongoing basis. The benefit of
this approach for end users is that they can acquire our family of storage
management products as part of a complete systems solution from a single
vendor, with such vendor providing a single point of contact for customer
support. The benefit to us has been access to our OEM partners' customer
bases, both in North America and overseas, without a commensurate investment
in fixed expense. We currently have source code OEM agreements in place with
several computer system and software suppliers, including:
. Amdahl;
. Banyan;
. Compaq (Digital);
. Compaq (Tandem);
. Data General;
. Fujitsu-ICL;
. Nihon-Unisys;
. NEC;
. Siemens Nixdorf;
. Silicon Graphics;
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. Sony;
. Sun Microsystems; and
. Unisys.
Strategic Partner Program. The Strategic Partner program is an alternative
to the source code OEM program for major system providers who wish to offer
our products along with theirs, but prefer not to make an investment in
enhancing the base Legato product. For example, SunSoft, a private label
reseller, licenses the object code for the standard Legato products and sells
and supports the products under the SunSoft logo as described above for the
source code OEM program. We also have established strategic partnerships with
Hewlett-Packard, Informix, Netscape and Oracle.
The source code OEMs and strategic partner programs accounted for
approximately $19.2 million in 1998, $16.7 million in 1997 and $12.9 million
in 1996. We are currently investing, and intend to continue to invest
resources to develop this channel, which could seriously harm our operating
margins if such efforts are not successful. We cannot guarantee that we will
be successful in our efforts to increase the revenue represented by this
channel. We are dependent upon our OEMs' ability to develop new products,
applications and product enhancements on a timely and cost-effective basis
that will meet changing customer needs and respond to emerging industry
standards and other technological changes. We cannot guarantee that our OEMs
will effectively meet these technological challenges. These OEMs are not
within our control, may incorporate into their products the technologies of
other companies in addition to those of ours and are not obligated to purchase
products from us. We cannot guarantee that any OEM will continue to carry our
products, and the inability to recruit, or the loss of, important OEMs could
seriously harm our business, operating results and financial condition.
One customer, SunSoft, accounted for approximately 11 percent of total
revenue, or $9.0 million in 1997 and $5.9 million in 1996. No one customer
accounted for more than 10 percent of total revenue in 1998.
Corporate Marketing
We support our resellers and OEMs with extensive marketing programs
designed to establish our image in key markets and to generate end user
demand. We participate in trade shows and advertise in key network systems
publications and on the Internet. Leads are qualified by our inside sales
staff and provided to our channel partners. Additionally, resellers and
distributors are provided with promotional and educational materials and can
qualify for market development funding for specific promotional activities
tailored for their solutions and geography.
Customer Service and Support
We employ systems engineers who work closely with our direct sales
personnel to assist resellers and end users with pre-sales and post-sales
support matters. In addition, we employ a centralized support organization,
which provides customers with technical support, education, training and
consulting services.
Technical Support. We offer product update services and help desk services.
Product updates services may be purchased pre-bundled with our software
products or separately once the products are registered. Customers may
purchase additional product update services and help desk service offerings on
an as needed basis or on an annual basis. Product update service customers
receive updates, enhancements and improvements to supported software,
operating systems' support, on-line support services and opportunities to
participate in special programs we offer. Annual fees for product update
services are generally equivalent to 15 percent of the current list price of
the products under license to such customers.
Generally, help desk service customers may receive telephone or electronic
support from 6 a.m. to 6 p.m. Pacific time, Monday through Friday. We also
offer premium help-desk service, which includes a one year
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contract covering seven-day, 24-hour technical support, monthly telephone
reviews of technical issues with a designated backline engineer and a
designated technical support manager for escalation management. Depending on
the type of help desk service desired, the pricing ranges from $500 to $2,500
for per-incident help desk service and from $1,000 to more than $30,000 for
annual support agreements. The customer service and support organization
consists of an experienced staff of technical support engineers providing
telephone and electronic support via electronic mail, facsimile and CompuServe
from our offices in Palo Alto, California and Toronto, Canada. Our sales and
customer support organizations work closely together to ensure overall
customer satisfaction.
In recent years, our installed base of customers has significantly
increased, as have the number of customers purchasing software support
contracts. From time to time, we receive customer complaints about the
timeliness and accuracy of customer support. Although we plan to add customer
support personnel in order to address current customer support needs and
intend to closely monitor progress in this area, we cannot guarantee that
these efforts will be successful.
Education and Training. We offer education and training to end users and
resellers. Training classes are offered through in-house facilities at our
offices in Palo Alto, as well as at off-site locations. We also provide on-
site training services upon request by customers. Fees for education and
training services are charged separately from our software products. Although
we intend to add education and training personnel in order to meet customer
needs, we cannot guarantee that these efforts will be successful. If our
efforts are not successful, it could seriously harm our business, operating
results and financial condition.
Consulting. Our consultants are available to work closely with customers'
information systems organizations. These consulting services generally consist
of assisting customers in setting up more complex installations or tailoring
our software products to achieve higher performance or a higher degree of
automation. Fees for consulting services are charged separately from our
software products. While we continue to allocate resources in order to provide
customers with additional value-added services, we cannot guarantee that these
efforts will be successful. Although we intend to add consulting personnel in
order to meet customer needs, we cannot guarantee that these efforts will be
successful. If our efforts are not successful, it could seriously harm our
business, operating results and financial condition.
Research and Development
Since our inception, we have made substantial investments in product
development. In addition, we receive the benefits of additional testing and
product enhancements from each source code OEM's development group. Our future
success will depend upon our ability to develop and introduce new software
products, including new releases, applications and enhancements, on a timely
basis that keep pace with technological developments and emerging industry
standards and address the increasingly sophisticated needs of our customers.
In particular, our strategy is to continue to leverage the NetWorker
architecture to enhance the functionality of the product through new releases,
applications and product enhancements to meet the ongoing storage management
requirements of our customers. We cannot guarantee that we will be successful
in developing and marketing new products that respond to technological change
or evolving industry standards, that we will not experience difficulties that
could delay or prevent the successful development, introduction and marketing
of these new products, or that our new products will adequately meet the
requirements of the marketplace and achieve market acceptance. If we are
unable, for technological or other reasons, to develop and introduce new
products in a timely manner in response to changing market conditions or
customer requirements, our business, operating results and financial condition
will be seriously harmed.
Also, some of our competitors currently offer certain of these potential
new products. Due to the complexity of client/server software and the
difficulty in gauging the engineering effort required to produce these
potential new products, such potential new products are subject to significant
technical risks. We cannot guarantee that such potential new products will be
introduced on a timely basis or at all.
12
As part of the our ongoing development process, we released several new
versions of NetWorker during 1998, and intend to release additional versions
of NetWorker. In addition, we released several new products that support the
base NetWorker software, including:
. SmartMedia--an open media management application that provides standard
interfaces for applications, robotic library control, drive control, and
administration;
. NetWorker Storage Node for MPE/iX--enables local data backup and restore
capabilities;
. NetWorker Remote--provides data protection and disaster recovery for
Windows-based desktops and laptops; and
. NetWorker Hierarchical Storage Manager Client--optimizes online disk
requirements by allowing data to be migrated from the primary storage
medium to other near-line storage.
We cannot guarantee that these and future new products will achieve market
acceptance. The lack of market acceptance for these and future new products
will seriously harm our business, operating results and financial condition.
We have research and development centers in the following locations:
. Palo Alto, California;
. Seattle, Washington;
. Eden Prairie, Minnesota; and
. Burlington, Canada.
Total expenses for research and development were $21.8 million in 1998,
$14.8 million in 1997 and $9.5 million in 1996. We anticipate that we will
continue to commit substantial resources to research and development in the
future. To date, our development efforts have not resulted in any capitalized
software development costs.
Competition
We operate in the enterprise storage management market, which is intensely
competitive, highly fragmented and characterized by rapidly changing
technology and evolving standards. Competitors vary in size and in the scope
and breadth of the products and services offered. Our major competitors
include:
Novell NetWare and Windows NT platforms:
Computer Associates (Cheyenne Software)
Seagate (Palindrome and Arcada)
Sun Solaris/SunOS platform:
Computer Associates (Legent/Lachman)
EMC2 (Epoch)
Peripheral Devices (Delta Microsystems)
Spectra Logic
Veritas
AIX platform and the HP-UX platform:
IBM
Hewlett Packard
13
We expect to encounter new competitors as we enter new markets. In
addition, many of our existing competitors are broadening their platform
coverage. We also expect increased competition from systems and network
management companies, especially those that have historically focused on the
mainframe market and are broadening their focus to include the client/server
market. In addition, since there are relatively low barriers to entry in the
software market, we expect additional competition from other established and
emerging companies. We also expect that competition will increase as a result
of future software industry consolidations. Increased competition could harm
us by causing, among other things:
. Price reductions;
. Reduced gross margins; and
. Loss of market share.
Many of our current and potential competitors have longer operating
histories and have substantially greater financial, technical, sales,
marketing and other resources, as well as greater name recognition and a
larger customer base, than we have. As a result, certain current and potential
competitors can respond more quickly to new or emerging technologies and
changes in customer requirements. They can also devote greater resources to
the development, promotion, sale and support of their products. In addition,
current and potential competitors may establish cooperative relationships
among themselves or with third parties. If so, new competitors or alliances
among competitors may emerge and rapidly acquire significant market share. In
addition, network operating system vendors could introduce new or upgrade
existing operating systems or environments that include functionality offered
by our products. If so, our products could be rendered obsolete and
unmarketable. For all the foregoing reasons, we may not be able to compete
successfully, which would seriously harm our business, operating results and
financial condition.
Employees
As of December 31, 1998, we had a total of 660 employees. Of the total, 243
were in sales and marketing, 193 in research and development, 97 in technical
support, 83 in finance and administration, 34 in consulting and educational
services and 10 in operations. Our future success depends, in significant
part, upon the continued service of our key technical and senior management
personnel and our continuing ability to attract and retain highly qualified
technical and managerial personnel. Competition for such personnel is intense,
and we cannot guarantee that we can retain our key technical and managerial
employees or that we can attract, assimilate or retain other highly qualified
technical and managerial personnel in the future. None of our employees are
represented by a labor union. We have not experienced any work stoppages and
consider our relations with our employees to be good.
Risk Factors
In addition to the other information in this Report, the following risk
factors should be considered carefully in evaluating our business and us:
Our Quarterly Operating Results Are Volatile.
Our quarterly operating results have varied in the past and may vary in the
future. Our quarterly operating results may vary depending on a number of
factors, many of which are outside of our control, including:
. The size and timing of orders for our products;
. Increased competition;
. Market acceptance of our new products, applications and product
enhancements or those of our competitors;
. Changes in our pricing policies or those of our competitors;
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. Our ability to timely develop, introduce and market new products,
applications and product enhancements;
. Ability to integrate acquired businesses;
. Our ability to control costs;
. Quality control of products sold;
. Lengthy sales cycles, particularly with enterprise license transactions;
. Success in expanding sales and marketing programs;
. Technological changes in our markets;
. The mix of sales among our channels;
. Deferrals of customer orders in anticipation of new products,
applications or product enhancements;
. Market readiness to deploy our products for distributed computing
environments;
. Changes in our strategy or that of our competitors;
. Customer budget cycles and changes in these budget cycles;
. Foreign currency and exchange rates;
. Acquisition costs or other non-recurring charges in connection with the
acquisition of companies, products or technologies;
. Personnel changes; and
. General economic factors.
Our Future Operating Results Are Uncertain.
We cannot predict our future revenue with any significant degree of
certainty for several reasons including the following:
. Product revenue in any quarter is substantially dependent on orders
booked and shipped in that quarter, since we operate with virtually no
order backlog;
. We do not recognize revenue on sales to domestic distributors until the
products are sold through to end-users;
. The storage management market is rapidly evolving;
. Our sales cycles vary substantially from customer to customer, in large
part because we are becoming increasingly dependent upon larger company-
wide enterprise license transactions to corporate customers. Such
transactions include product license, service and support components and
take a long time to complete;
. The timing of large orders can significantly affect revenue within a
quarter; and
. License and royalty revenue are difficult to forecast. Our royalty
revenue is dependent upon product license sales by OEMs of their products
that incorporate our software. Accordingly, these royalty revenue is
subject to OEMs' product cycles, which are also difficult to predict.
Fluctuations in licensing activity from quarter to quarter further impact
royalty revenue, because initial license fees generally are non-recurring
and recognized upon the signing of a license agreement.
Our expense levels are relatively fixed and are based, in part, on our
expectations of our future revenue. Consequently, if revenue levels fall below
our expectations, our net income will decrease because only a small portion of
our expenses varies with our revenue.
We believe that period-to-period comparisons of our results of operations
are not meaningful and should not be relied upon as indications of future
performance. Our operating results will be below the expectations of
15
public market analysts and investors in some future quarter or quarters. Our
failure to meet such expectations would likely seriously harm the market price
of our common stock.
Our Market is Highly Competitive.
We operate in the enterprise storage management market, which is intensely
competitive, highly fragmented and characterized by rapidly changing
technology and evolving standards. Competitors vary in size and in the scope
and breadth of the products and services offered. Our major competitors
include:
Novell NetWare and Windows NT platforms:
Computer Associates (Cheyenne Software)
Seagate (Palindrome and Arcada)
Sun Solaris/SunOS platform:
Computer Associates (Legent/Lachman)
EMC2 (Epoch)
Peripheral Devices (Delta Microsystems)
Spectra Logic
Veritas
AIX platform and the HP-UX platform:
IBM
Hewlett Packard
We expect to encounter new competitors as we enter new markets. In
addition, many of our existing competitors are broadening their operating
systems platform coverage. We also expect increased competition from systems
and network management companies, especially those that have historically
focused on the mainframe computer market and are broadening their focus to
include the client/server computer market. In addition, since there are
relatively low barriers to entry in the software market, we expect additional
competition from other established and emerging companies. We also expect that
competition will increase as a result of future software industry
consolidations. Increased competition could harm us by causing, among other
things:
. Price reductions;
. Reduced gross margins; and
. Loss of market share.
Many of our current and potential competitors have longer operating
histories and have substantially greater financial, technical, sales,
marketing and other resources, as well as greater name recognition and a
larger customer base, than we have. As a result, certain current and potential
competitors can respond more quickly to new or emerging technologies and
changes in customer requirements. These competitors can also devote greater
resources to the development, promotion, sale and support of their products.
In addition, current and potential competitors may establish cooperative
relationships among themselves or with third parties. If so, new competitors
or alliances among competitors may emerge and rapidly acquire significant
market share. In addition, network operating system vendors could introduce
new or upgrade existing operating systems or environments, that include the
same functions offered by our products. If so, our products could be rendered
obsolete and unmarketable. For all of these reasons, we may not be able to
compete successfully, which would seriously harm our business, operating
results and financial condition.
16
We Depend on Our Networker Product Line.
We currently derive, and expect to continue to derive, a substantial
majority of our revenue from our NetWorker software products and related
services. A decline in the price of or demand for NetWorker, or failure to
achieve broad market acceptance of NetWorker, would seriously harm our
business, operating results and financial condition. We cannot reasonably
predict NetWorker's remaining life for several reasons, including:
. The recent emergence of our market;
. The effect of new products, applications or product enhancements;
. Technological changes in the network storage management environment in
which NetWorker operates; and
. Future competition.
We Must Respond to Rapid Technological Changes with New Product Offerings.
The markets for our products are characterized by:
. Rapid technological changes;
. Changing customer needs;
. Frequent new software product introductions; and
. Evolving industry standards.
The introduction of products embodying new technologies and the emergence
of new industry standards could render our existing products obsolete and
unmarketable.
To be successful, we need to develop and introduce new software products on
a timely basis that:
. Keep pace with technological developments and emerging industry
standards; and
. Address the increasingly sophisticated needs of our customers.
We may:
. Fail to develop and market products that respond to technological changes
or evolving industry standards;
. Experience difficulties that could delay or prevent the successful
development, introduction and marketing of these products; or
. Fail to develop products that adequately meet the requirements of the
marketplace or achieve market acceptance
.If so, our business, operating results and financial condition would be
seriously harmed.
We currently plan to introduce and market several new products in the next
twelve months. Some of the our competitors currently offer certain of these
potential new products. Such potential new products are subject to significant
technical risks. We may fail to introduce such potential new products on a
timely basis or at all. In the past, we have experienced delays in the
commencement of commercial shipments of our new products. Such delays caused
customer frustration and resulted in delay or lost product revenue. If
potential new products are delayed or do not achieve market acceptance, our
business, operating results and financial condition would be seriously harmed.
In the past, we have also experienced delays in purchases of our products by
customers who were anticipating our new product launches. Our business,
operating results and financial condition would be seriously harmed if
customers defer material orders in anticipation of new product introductions.
17
Software products as complex as those we offer may contain undetected
errors or failures when first introduced or released as new versions. We have
in the past discovered software errors in certain of our new products after
their introduction. We experienced delays or lost revenue during the period
required to correct these shipments, despite testing by us and by our current
and potential customers. This may result in loss of or delay in market
acceptance of our products, which would seriously harm our business, operating
results and financial condition.
We Rely on Enterprise-Level License Transactions.
In the past, we marketed our products at the department level of corporate
customers. Within the last year, we developed strategies to pursue larger
enterprise license transactions with corporate customers. We may fail to
successfully market our products in larger enterprise license transactions.
Such failure would seriously harm our business, operating results and
financial condition. Our operating results are sensitive to the timing of such
orders. Such orders are difficult to manage and predict, because:
. The sales cycle is typically lengthy, generally lasting three to six
months, and varies substantially from transaction to transaction;
. They often include product license, service and support components;
. They typically involve significant technical evaluation and commitment of
capital and other resources; and
. Customers' internal procedures frequently cause delays in orders. Such
internal procedures include approval of large capital expenditures,
implementation of new technologies within their networks, and testing new
technologies that affect key operations.
Due to the large size of enterprise transactions, if orders forecasted for a
specific transaction for a particular quarter are not realized in that
quarter, our operating results for that quarter may be seriously harmed.
Historically, we have not had a separate large enterprise or national
accounts sales force and only within the last eighteen months have we begun to
develop direct sales groups focused on these larger accounts. To succeed in
the national accounts market, we will be required to continue to transition
our existing sales forces into enterprise-level sales groups and attract and
retain qualified personnel. New personnel will require training to obtain
knowledge of product attributes for our products. We may not be successful in
creating the necessary sales organization or in attracting, retaining or
training these individuals. To succeed in the enterprise and national accounts
market will require, among other things, establishing and continuing to
develop relationships and contacts with senior technology officers at these
accounts. Our business, financial condition and results of operations would be
seriously harmed if our sales force is not successful in these efforts.
We Rely on Indirect Sales Channels.
We rely significantly on our distributors, systems integrators and value
added resellers (collectively, "resellers") for the marketing and distribution
of our products. Our agreements with resellers are generally not exclusive and
in many cases may be terminated by either party without cause. Many of our
resellers carry product lines that are competitive with ours. These resellers
may not give a high priority to the marketing of our products. Rather, they
may give a higher priority to other products, including the products of
competitors, or may not continue to carry our products. Events or occurrences
of this nature would seriously harm our business, operating results and
financial condition. In addition we may not be able to retain any of our
current resellers or successfully recruit new resellers. Any such changes in
our distribution channels would seriously harm our business, operating results
and financial condition.
Our strategy is also to increase the proportion of our customers licensed
through OEMs. We may fail to achieve this strategy. We are currently
investing, and intend to continue to invest resources to develop this channel.
Such investments could seriously harm our operating margins. We depend on our
OEMs' abilities to develop new products, applications and product enhancements
on a timely and cost-effective basis that will meet
18
changing customer needs and respond to emerging industry standards and other
technological changes. Our OEMs may not effectively meet these technological
challenges. These OEMs:
. Are not within our control;
. May incorporate into their products the technologies of other companies
in addition to, or to the exclusion of, our technologies; and
. Are not obligated to purchase our products. In addition, our OEMs
generally have exclusive rights to our technology on their respective
platforms, subject to certain minimum royalty obligations.
Our OEMs may not continue to carry our products. The inability to recruit,
or the loss of, important OEMs would seriously harm our business, operating
results and financial condition.
We Depend on International Revenue.
Our continued growth and profitability will require further expansion of
our international operations. To successfully expand international operations,
we must:
. Establish additional foreign operations;
. Hire additional personnel, and
. Recruit additional international resellers.
This will require significant management attention and financial resources
and could seriously harm our operating margins. If we fail to further expand
our international operations in a timely manner, our business, operating
results and financial condition could be seriously harmed. In addition, we may
fail to maintain or increase international market demand for our products. Our
international sales are currently denominated in U.S. dollars. An increase in
the value of the U.S. dollar relative to foreign currencies could make our
products more expensive and, therefore, potentially less competitive in those
markets. In some markets, localization of our products is essential to achieve
market penetration. We may incur substantial costs and experience delays in
localizing our products. We may fail to generate significant revenue from
localized products.
Additional risks inherent in our international business activities
generally include:
. Significant reliance on our distributors and other resellers who do not
offer our products exclusively;
. Unexpected changes in regulatory requirements;
. Tariffs and other trade barriers;
. Lack of acceptance of localized products, if any, in foreign countries;
. Longer accounts receivable payment cycles;
. Difficulties in managing international operations;
. Potentially adverse tax consequences, including restrictions on the
repatriation of earnings;
. The burdens of complying with a wide variety of foreign laws; and
. The risks related to the recent global economic turbulence and adverse
economic circumstances in Asia.
The occurrence of such factors could seriously harm our international sales
and, consequently, our business, operating results and financial condition.
We Must Manage Our Growth and Expansion.
We have recently experienced a period of significant expansion of our
operations that has placed a significant strain upon our management systems
and resources. In addition, we have recently hired a significant number of
employees, and plan to further increase our total headcount. We also plan to
expand the geographic scope of our customer base. This expansion has resulted
and will continue to result in substantial demands on our management
resources.
19
From time to time, we receive customer complaints about the timeliness and
accuracy of customer support. We plan to add customer support personnel in
order to address current customer support needs. If we are not successful in
hiring such personnel, our business, operating results and financial condition
could be seriously harmed. Our ability to compete effectively and to manage
future expansion of our operations, if any, will require us to (a) continue to
improve our financial and management controls, reporting systems and
procedures on a timely basis, and (b) expand, train and manage our employees.
Our failure to do so would seriously harm our business, operating results and
financial condition.
We Must Integrate Recent Acquisitions.
On August 6, 1998, we acquired Software Moguls, Inc. ("SMI"), a developer
of advanced backup-retrieval products for the Windows NT and UNIX
environments. On October 25, 1998, we entered into a definitive agreement to
acquire Qualix Group, Inc. (dba FullTime Software, Inc.), a developer of
distributed, enterprise-wide, cross-platform, adaptive computing solutions.
The acquisition is expected to be completed by the end of the first quarter or
April of 1999, subject to the satisfaction of standard closing conditions,
including shareholder approval. On January 28, 1999, we entered into a
definitive agreement to acquire Intelliguard Software, Inc., a developer of
standards-based storage management solutions for storage area networks. The
acquisition is expected to be completed by the end of the first quarter or
April of 1999, subject to the satisfaction of standard closing conditions,
including regulatory approval and shareholder approval. We may make additional
acquisitions in the future. Acquisitions of companies, products or
technologies entail numerous risks, including:
. An inability to successfully assimilate acquired operations and products;
. Diversion of management's attention;
. Loss of key employees of acquired companies;
. Substantial transaction costs; and
. Substantial additional costs charged to operations as a result of the
failure to consummate acquisitions.
Some of the products we acquired may require significant additional
development before they can be marketed and may not generate revenue at levels
we anticipate. Moreover, our future acquisitions may result in dilutive
issuances of our equity securities, the incurrence of debt, large one-time
write-offs and the creation of goodwill or other intangible assets that could
result in amortization expense. We cannot guarantee that our efforts to
consummate acquisitions or integrate acquisitions will be successful. If our
efforts are not successful, it could seriously harm our business, financial
condition and results of operations.
We Rely on Our Key Personnel.
Our future performance depends on the continued service of our key
technical and senior management personnel. None of the our key technical or
senior management personnel is bound by an employment agreement. The loss of
the services of one or more of our officers or other key employees could
seriously harm our business, operating results and financial condition.
Our future success also depends on our continuing ability to attract and
retain highly qualified technical and managerial personnel. Competition for
such personnel is intense, and we may fail to retain our key technical and
managerial employees or attract, assimilate or retain other highly qualified
technical and managerial personnel in the future.
We Depend on Growth in the Storage Management Market.
All of our business is in the storage management market. The storage
management market is still an emerging market. Our future financial
performance will depend in large part on continued growth in the number of
organizations adopting company-wide storage and management solutions for their
client/server computing environments. The market for enterprise storage
management may not continue to grow. If this market fails to grow or grows
more slowly than we currently anticipate, our business, operating results and
financial condition would be seriously harmed.
20
We Are Affected by General Economic and Market Conditions.
During recent years, segments of the computer industry have experienced
significant economic downturns characterized by:
. Decreased product demand;
. Product overcapacity;
. Price erosion;
. Work slowdowns; and
. Layoffs.
Our operations may experience substantial fluctuations from period-to-
period as a consequence of such industry patterns, general economic conditions
affecting the timing of orders from major customers, and other factors
affecting capital spending. The occurrence of such factors could seriously
harm our business, operating results or financial condition.
Protection of Our Intellectual Property is Limited.
Our success depends significantly upon proprietary technology. To protect
our proprietary rights, we rely on a combination of:
. Patents;
. Copyright and trademark laws;
. Trade secrets;
. Confidentiality procedures; and
. Contractual provisions.
We seek to protect our software, documentation and other written materials
under patent, trade secret and copyright laws, which afford only limited
protection. However,
. We may not develop proprietary products or technologies that are
patentable;
. Any issued patent may not provide us with any competitive advantages or
may be challenged by third parties; or
. The patents of others may seriously impede our ability to do business.
Despite our efforts to protect our proprietary rights, unauthorized parties
may attempt to copy aspects of our products or to obtain and use information
that we regard as proprietary. Policing unauthorized use of our products is
difficult, and software piracy can be expected to be a persistent problem. In
licensing our products, other than in enterprise license transactions, we rely
on "shrink wrap" licenses that are not signed by licensees. Such licenses may
be unenforceable under the laws of certain jurisdictions. In addition, the
laws of some foreign countries do not protect our proprietary rights to as
great an extent as do the laws of the United States. Our means of protecting
our proprietary rights may not be adequate. Our competitors may independently
develop similar technology, duplicate our products or design around patents
issued to us or other intellectual property rights of ours.
From time to time, we have received claims that we are infringing third
parties' intellectual property rights. In the future, we may be subject to
claims of infringement by third parties with respect to current or future
products, trademarks or other proprietary rights. We expect that software
product developers will increasingly be subject to infringement claims as the
number of products and competitors in our industry segment grows and the
21
functionality of products in different industry segments overlaps. Any such
claims, with or without merit, could be time-consuming, result in costly
litigation, cause product shipment delays or require us to enter into royalty
or licensing agreements with third parties. If such royalty or licensing
agreements, if required, are not available on terms acceptable to us, our
business, operating results and financial condition would be seriously harmed.
Defects in Our Products Would Harm Our Business.
Our products can be used to manage data critical to organizations. As a
result, the sale and support of products we offer may entail the risk of
product liability claims. A successful product liability claim brought against
us could seriously harm our business, operating results and financial
condition.
Year 2000 Issues Could Affect Our Business.
Many currently installed computer systems and software products include
coding to accept only two digit entries in the date code field. These date
code fields will need to accept four digit entries to distinguish 21st century
dates from 20th century dates. Our computer systems and/or software will need
to be upgraded to comply with such "Year 2000" requirements. Systems that do
not properly recognize such information could generate erroneous data or cause
a system to fail. Significant uncertainty exits the software industry
concerning the potential effects associated with such problems.
We have conducted Year 2000 compliance reviews for current versions of our
products. The reviews include:
. Assessment;
. Implementation;
. Validation testing; and
. Contingency planning.
We respond to customer concerns about our products on a case-by-case basis.
Although we believe our software products are Year 2000 compliant, our
software products may not contain all the necessary software routines and
programs for the accurate calculation, display, storage and manipulation of
data involving dates. Failures of the our software products to contain all the
necessary software routines and programs for the accurate calculation,
display, storage and manipulation of data involving dates would seriously harm
our business, operating results and financial condition.
We have tested software obtained from third parties that is incorporated
into our products, and seek assurances from vendors that licensed software is
Year 2000 compliant. Despite such testing and assurances, products
incorporated into our products may contain undetected errors or defects
associated with Year 2000 date functions. Known or unknown errors or defects
in our products may result in:
. Delay or loss of revenue;
. Diversion of development resources;
. Damage to our reputation; or
. Increased service and warranty costs.
22
The occurrence of any of the foregoing could seriously harm our business,
operating results, or the financial condition.
To the extent information is publicly available, we have assessed the Year
2000 compliance status of our customers. If our current or future customers
fail to achieve Year 2000 compliance or if they divert technology expenditures
to address Year 2000 compliance problems, our business, results of operations,
or financial condition could be seriously harmed.
We believe the software and hardware we use internally comply with Year
2000 requirements. During 1998, we replaced or upgraded much of our internal
use hardware and software. In addition, we are not aware of any material
operational issues or costs associated with preparing our internal use
software and hardware for the Year 2000. However, serious, unanticipated
negative consequences, including material costs caused by undetected errors or
defects in the technology used in our internal systems may occur. The
occurrence of any of the foregoing could seriously harm our business,
operating results or financial condition.
We have funded our Year 2000 compliance review from operating cash flows
and have not separately accounted for these costs in the past. We will incur
additional amounts related to the Year 2000 compliance review including:
. Administrative personnel to manage the review; and
. Outside contractors to provide technical advice and technical support for
our products, product engineering, and customer satisfaction.
We are developing contingency plans to be implemented as part of our
efforts to identify and correct Year 2000 problems. Depending on the systems
affected, these plans include:
. Accelerated replacement of affected equipment or software;
. Short to medium-term use of backup equipment and software;
. Increased work hours for our personnel or use of contract personnel to
correct (on an accelerated schedule) any Year 2000 problems that arise or
to provide manual workarounds for information systems; and
. Other similar approaches
If we are required to implement any of these contingency plans, it would
seriously harm our business, financial condition and operating results. Our
ability to achieve Year 2000 compliance and the level of incremental costs
associated therewith, could be seriously impacted by, among other things:
. The availability and cost of programming and testing resources;
. Vendors' ability to modify proprietary software; and
. Unanticipated problems identified in the ongoing compliance review.
Our Trading Price is Volatile.
The market price of our common stock may decrease significantly. A number
of factors could significantly affect the market price of our common stock
including:
. Quarterly fluctuations in financial results or results of other software
companies;
. Changes in our revenue growth rates or those of our competitors growth
rates;
. Announcements that our revenue or income are below analysts'
expectations;
. Changes in analysts' estimates of our performance or industry
performance;
23
. Announcements of new products by our competitors or by us;
. Developments with respect to our patents, copyrights, or proprietary
rights or those of our competitors;
. Sales of large blocks of our common stock;
. Conditions in the financial markets in general;
. General business conditions and trends in the distributed computing
environment and software industry;
. Deferred purchases of our products as a result of customers needs to
expend available resources to become Year 2000 compliant;
. Costs and resources required to address potential Year 2000 problems
relating to our products or our internal use software and hardware; and
. Changes in prices of our products.
In addition, the stock market may experience extreme price and volume
fluctuations, which may affect the market price for the securities of
technology companies without regard to their operating performance or any of
the factors listed above. These broad market fluctuations may seriously harm
the market price of our common stock. In the past, securities class action
litigation has often been brought against a company following periods of
volatility in the market price of such company's securities. Such litigation
may occur in the future with respect to us and could result in substantial
costs and diversion of management's attention and resources, which could
seriously harm our business, financial condition and results of operations.
ITEM 2. PROPERTIES
Our principal administrative, marketing and research and development
facility are located in approximately 96,000 square feet of space in Palo
Alto, California. This facility is leased through September 2006. Our
principal sales office is located in approximately 52,500 square feet of space
in Sunnyvale, California. This office is leased through February 2007. We also
currently lease other domestic offices throughout the United States, as well
as international offices in Australia, Belgium, Canada, England, France,
Germany, Holland, Italy, Hong Kong, Japan, Poland, Switzerland and Sweden.
ITEM 3. LEGAL PROCEEDINGS
We are engaged in certain legal and administrative proceedings incidental
to our business, the outcome of which, individually or in the aggregate, are
not expected to seriously harm our business, results of operations or
financial condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We did not submit any matters to a vote of security holders during the
fourth quarter of the fiscal year ended December 31, 1998.
ITEM 4a. EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below are biographical summaries of our executive officers as of
December 31, 1998:
Louis C. Cole, 55, joined Legato Systems, as President, Chief Executive
Officer and a Director in June 1989. Since April 1995, Mr. Cole has also
served as Chairman of the Board. Before joining Legato, from March 1987 until
July 1988, Mr. Cole served as Executive Vice President responsible for all
operating divisions of Novell, Inc. ("Novell"), a manufacturer of computer
networking and software products. Mr. Cole serves as a director of Inference
Corp., Qualix Group, Inc. (doing business as Fulltime Software, Inc.) and
Rogue Wave Software, all publicly held software companies. Mr. Cole holds a
B.S. in mathematics and education from Pennsylvania State University at
Edinboro.
24
Kent D. Smith, 49, has served as Executive Vice President and Chief
Operating Officer of Legato Systems, since May 1996. He served as Executive
Vice President of Customer Operations from March 1995 to May 1996. Before
joining Legato, from March 1994 until March 1995, Mr. Smith served as Vice
President of Emerging Markets at VeriFone, Inc. ("VeriFone"), a transaction
automation company. Prior to joining VeriFone, Mr. Smith held a range of sales
and marketing positions in the United States and overseas with IBM Corporation
("IBM"), a publicly held manufacturer of computers and related products, from
1974 to 1994. Mr. Smith holds a B.A. in German from California State
University at Fullerton and an M.B.A. from the University of Southern
California.
Stephen C. Wise, 44, joined Legato Systems, Inc., in September 1996 as
Senior Vice President of Finance and Administration and Chief Financial
Officer. Before joining Legato, Mr. Wise served as Senior Vice President,
Finance of Novell from December 1994 to September 1997. He was Vice President
and Corporate Controller of Novell from January 1991 to December 1994 and was
Vice President, Accounting and Planning from January 1990 to January 1991. Mr.
Wise holds a B.S. in Accounting from San Jose State University and an M.B.A.
from Santa Clara University.
Nora M. Denzel, 36, joined Legato Systems, in January 1997 as Senior Vice
President of Product Operations. Before joining Legato, Ms. Denzel served as
the director of IBM's storage management software products and held a range of
operations, development and marketing positions with IBM from 1984 to 1996.
Ms. Denzel holds a B.S. in Computer Science from the State University of New
York and an M.B.A. from Santa Clara University.
John Ferraro, 37, joined Legato Systems, in December 1997 as Senior Vice
President of Worldwide Sales Operations. Before joining Legato, Mr. Ferraro
held the position of Vice President of Sales for Unison Software, a network
management software company, where he was responsible for developing the North
America sales organization on both a direct and channel basis from December
1994 to December 1997. Prior to that, Mr. Ferraro's experience includes seven
years in sales and management at Computer Associates, as Vice President of the
Systems Management division. Mr. Ferraro holds a B.S. in Accounting from the
University of Colorado.
James Chappell, 38, joined Legato Systems, in June 1992. Since August 1998,
he has served as our Vice President of Business Development. From June 1992 to
July 1998, Mr. Chappell held various sales and marketing management positions
with Legato, including general manager, manager of strategic businesses and
director of worldwide channel marketing. Prior to joining Legato, Mr. Chappell
served as President of The Connectivity Lab, a data communications consulting
firm, from March 1989 to March 1991. Mr. Chappell holds a B.S. in Computer
Science from Cal Poly University, San Luis Obispo, California.
25
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
Our common stock is traded on the Nasdaq National Market under the symbol
LGTO. The following table sets forth the high and low closing sales prices of
our common stock from January 1, 1996 through December 31, 1998. Such prices
represent prices between dealers, do not include retail mark-ups, mark-downs
or commissions and may not represent actual transactions.
Share prices have been adjusted to reflect the two-for-one splits of our
common stock, which were effected July 5, 1996 and April 17, 1998.
High Low
------ ------
Fiscal 1996
First Quarter................................................ $10.75 $ 5.82
Second Quarter............................................... $13.75 $ 8.75
Third Quarter................................................ $24.00 $ 9.13
Fourth Quarter............................................... $23.50 $13.38
Fiscal 1997
First Quarter................................................ $16.44 $ 8.07
Second Quarter............................................... $12.44 $ 5.50
Third Quarter................................................ $17.88 $ 8.69
Fourth Quarter............................................... $23.32 $16.13
Fiscal 1998
First Quarter................................................ $29.94 $20.06
Second Quarter............................................... $39.50 $25.75
Third Quarter................................................ $54.75 $35.13
Fourth Quarter............................................... $65.94 $30.25
As of January 22, 1999, there were approximately 91 holders of record of
our common stock. We believe that a significant number of beneficial owners of
our common stock hold shares in street name.
We have never paid a cash dividend on our common stock and do not intend to
pay cash dividends on our common stock in the foreseeable future.
26
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
Five Year Summary
December 31,
-----------------------------------------
1998 1997 1996 1995 1994(2)
-------- -------- ------- ------- -------
(in thousands, except per share amounts)
Revenue............................ $143,178 $ 83,885 $56,774 $32,531 $16,405
Gross profit....................... 125,978 74,186 51,209 28,498 14,403
Income from operations............. 39,996 21,046 13,614 7,576 1,574
Net income......................... 27,708 14,012 8,922 6,033 1,773
Net income per share--basic (1).... 0.75 0.40 0.27 0.30 0.23
Shares used in per share
calculations--basic (1)........... 36,894 35,070 33,348 20,174 7,700
Net income per share--diluted (1).. 0.69 0.37 0.24 0.20 0.08
Shares used in per share
calculations--diluted (1)......... 40,005 37,976 37,793 30,469 23,672
Cash, cash equivalents and
investments....................... 118,623 71,991 57,787 50,218 4,031
Working capital.................... 115,556 70,817 52,228 39,090 3,113
Total assets....................... 186,865 114,791 84,569 60,390 8,274
Retained earnings (accumulated
deficit).......................... 54,690 26,982 12,971 4,138 (2,643)
Total stockholders' equity......... 144,465 93,309 69,398 51,346 4,145
- --------
(1) See Note 1 of Notes to Consolidated Financial Statements
(2) Selected financial data has not been restated because we did not consider
the operating results of Software Moguls, Inc. for 1994 material to us.
27
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The discussion in this report on Form 10-K contains forward-looking
statements that involve risks and uncertainties. The statements contained in
this Report that are not purely historical are forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended,
and Section 21E of the Securities Exchange Act of 1934, as amended, including
statements regarding our expectations, beliefs, intentions or strategies
regarding the future. All forward-looking statements included in this document
are based on information available to us on the date hereof, and we assume no
obligation to update any such forward-looking statements. Our actual results
could differ materially from those discussed. Factors that could cause or
contribute to such differences include, but are not limited to, those
discussed elsewhere in item 1 under the heading "Risk Factors", as well as
those discussed elsewhere in this Report, and the risks discussed in our other
Securities and Exchange Commission filings.
Results of Operations
Overview
We develop, market and support network storage management software products
for heterogeneous client/server computing environments and large scale
enterprises. Our NetWorker family of software products, from which we derive a
substantial majority of our revenue, support many storage management server
platforms and can accommodate a variety of servers, clients, applications,
databases and storage devices. We license our products through resellers and
directly to end users primarily located in North America, Europe and Asia
Pacific. We also license our source code to original equipment manufacturers
("OEMs") in exchange for initial licensing fees and receive ongoing royalties
from the OEMs' product sales. Substantially all of the OEMs are large computer
system and software suppliers located in the United States, Europe and Asia
Pacific.
We acquired Software Moguls, Inc. in August 1998 primarily for its product
offerings and research and development team. We do not expect Software Moguls,
Inc. to have a significant impact on our results of operations.
28
Selected elements of our consolidated financial statements are shown below
for the last three years as a percentage of total revenue and as a percentage
change from year to year.
% Increase
-----------------
% of Total
Revenue
Years Ended
December 31, 1998 1997
------------------- Compared Compared
1998 1997 1996 to 1997 to 1996
----- ----- ----- -------- --------
Revenue:
Product licenses....................... 77.2% 79.1% 81.9% 67% 43%
Service and support.................... 22.8 20.9 18.1 87 71
----- ----- ----- --- ----
Total revenue........................ 100.0 100.0 100.0 71 48
Cost of revenue:
Product licenses....................... 3.0 3.4 3.7 49 38
Service and support.................... 9.0 8.1 6.1 89 96
----- ----- ----- --- ----
Gross profit......................... 88.0 88.5 90.2 70 45
Operating expenses:
Research and development............... 15.2 17.6 16.8 48 55
Sales and marketing.................... 36.1 34.9 31.9 76 62
General and administrative............. 7.5 9.5 12.3 35 14
Amortization of intangibles............ 0.8 1.3 1.9 -- 2
Merger-related expenses................ 0.5 -- -- 100 --
In-process research and development.... -- -- 3.3 -- (100)
----- ----- ----- --- ----
Total operating expenses............. 60.1 63.3 66.2 62 41
----- ----- ----- --- ----
Income from operations................... 27.9 25.2 24.0 90 55
Interest income, net..................... 2.9 2.6 3.2 95 19
Provision for income taxes............... 11.5 11.0 11.5 80 41
----- ----- ----- --- ----
Net income............................... 19.3% 16.8% 15.7% 98% 57%
===== ===== ===== === ====
Revenue
Total revenue was $143.2 million in 1998, $83.9 million in 1997 and $56.8
million in 1996. Total revenue increased 71 percent from 1997 to 1998 and 48
percent from 1996 to 1997. Total revenue increased primarily as a result of
the continued acceptance of our Networker family of products, increased sales
of service and support contracts, as well as increased royalty revenue.
Product License Revenue. Product license revenue was $110.5 million in
1998, $66.4 million in 1997 and $46.5 million in 1996. Product license revenue
increased 67 percent from 1997 to 1998 and 43 percent from 1996 to 1997.
Product license revenue increased primarily as a result of the continued
market acceptance of our products. Product license revenue also increased as a
result of product sales to large-scale enterprises. The increase in our number
of sales and marketing personnel, as well as sales programs helped to increase
the market acceptance of our products and product sales. Our sales and
marketing personnel increased from 85 employees in 1996 to 243 employees in
1998. We recognize product revenue upon shipment if a signed contract exists,
the fee is fixed and determinable, collection of resulting receivables is
probable and product returns are reasonably estimable, except for sales to
domestic distributors, which are recognized upon sale by the domestic
distributors to end-users. We recognize revenue from domestic distributors
upon sale by the distributor to end-users since these distributors have
unlimited rights of return and we historically have not been able to make
reasonable estimates of product returns from these distributors. Product
license revenue also includes royalty payments received from product sales by
OEMs, which were $19.2 million in 1998, $16.7 million in 1997 and $12.9
million in 1996. We recognize product revenue from royalty payments upon
receipt of quarterly royalty reports from OEMs related to their product sales
for the previous quarter. Prior growth rates of our product license revenue
are not indicative of future product license revenue growth rates and may not
be sustainable in the future.
29
Service and Support Revenue. Service and support revenue was $32.7 million
in 1998, $17.5 million in 1997 and $10.3 million in 1996. Service and support
revenue increased 87 percent from 1997 to 1998 and 71 percent from 1996 to
1997. Service and support revenue increased primarily as a result of the
growth in the number of registered customers electing to subscribe to support
contracts and to renew software support contracts after the initial one-year
term. Our increase in internal staffing for software support helped to
increase new sales and renewals of our software support contracts. Our
increase in internal staffing for education and consulting services resulted
in increased sales of the education and consulting services we offer. Our
technical support personnel increased from 68 employees in 1996 to 97
employees in 1998. Our consulting and education services personnel increased
from 19 employees in 1997 to 34 employees in 1998. We collect fees for ongoing
customer support and product updates in advance and recognize this support
revenue ratably over the period of the contract. For education and consulting
services, we recognize revenue when such services are performed. Prior growth
rates of our software service and support revenue are not indicative of future
software service and support revenue growth rates and may not be sustainable
in the future.
International product license revenue accounted for 30 percent of total
revenue in 1998, 24 percent in 1997 and 20 percent in 1996. International
license revenue increased primarily as a result of the continued market
acceptance of our products overseas. An increase in the number of
international sales offices and international distributors and resellers
marketing our products helped increase the market acceptance of our products
overseas. The majority of international sales during these periods were made
in Europe and Canada. We established sales offices in Canada and the
Netherlands during 1996, sales offices in Japan and Sweden during 1997 and
sales offices in Belgium, Hong Kong, Italy, Poland and Switzerland during
1998. We believe that our continued growth and profitability will require
further expansion of our international operations. In order to successfully
expand international sales in 1999 and subsequent periods, we must continue to
establish additional foreign operations, hire additional personnel and recruit
additional international resellers. Expansion and management of our
international operations will require significant management attention and
financial resources and could seriously harm certain operating results if such
efforts are not successful. To the extent that we are unable to effect these
additions in a timely manner, our growth, if any, in international revenue
will be limited, and our business, operating results and financial condition
could be seriously harmed. In addition, we cannot guarantee that we will be
able to maintain or increase international market demand for our products. Our
international sales are currently denominated in U.S. dollars. An increase in
the value of the U.S. dollar relative to foreign currencies could make our
products more expensive and, therefore, potentially less competitive in those
markets. In some markets, localization of our products is essential to achieve
market penetration. We may incur substantial costs and experience delays in
localizing our products, and we cannot guarantee that any localized product
will ever generate significant revenue.
Gross Profit
Gross profit was $126.0 million in 1998, $74.2 million in 1997 and $51.2
million in 1996, representing 88.0 percent of total revenue in 1998, 88.5
percent in 1997 and 90.2 percent in 1996. Gross profit consists of product
license and service and support revenue less related costs.
Gross profit from product license revenue was $106.2 million in 1998, $63.5
million in 1997 and $44.4 million in 1996, representing 96.1 percent of
product license revenue in 1998, 95.6 percent in 1997 and 95.5 percent in
1996. Gross profit from product license revenue increased 67 percent from 1997
to 1998 and 43 percent from 1996 to 1997. Gross profit from product license
revenue consists of product license revenue less the related costs. Related
costs of revenue consist primarily of product media, documentation and
packaging. Gross profit from product license revenue as a percentage of
product license revenue increased primarily as a result of the costs of
revenue for product licenses increasing at a slower rate than product license
revenue.
Gross profit from service and support revenue was $19.8 million in 1998,
$10.7 million in 1997 and $6.8 million in 1996, representing 60.5 percent of
the service and support revenue in 1998, 61.1 percent in 1997 and
30
66.1 percent in 1996. Gross profit from service and support revenue increased
85 percent from 1997 to 1998 and 58 percent from 1996 to 1997. Gross profit
from service and support revenue as a percentage of service and support
revenue decreased primarily as a result of the increased costs incurred to
continue our investment in developing new services and support offerings. The
continued investment consists of additional costs associated with supporting a
larger installed base of products, as well as costs to provide higher support
levels to customers. Costs of service and support revenue consist primarily of
personnel-related costs incurred in providing telephone support, consulting
services, and training to customers, costs of providing software updates and
costs of education and consulting materials.
Operating Expenses
Research and Development. Research and development expenses consist
primarily of personnel-related costs. Research and development expenses were
$21.8 million in 1998, $14.8 million in 1997 and $9.5 million in 1996,
representing 15.2 percent of total revenue in 1998, 17.6 percent in 1997 and
16.8 percent in 1996. Research and development expenses increased 48 percent
from 1997 to 1998 and 55 percent from 1996 to 1997. The increases in research
and development expenses in absolute dollars primarily reflect increased
staffing and associated support for engineers necessary to expand and enhance
our product line. The number of research and development personnel increased
from 102 employees in 1996 to 193 employees in 1998. Research and development
expenses as a percentage of total revenue decreased primarily as a result of
research and development expenses increasing at a slower rate than the
increase in total revenue. We believe that research and development expenses
will continue to increase in absolute dollars as we continue to invest in
developing new products, applications, and product enhancements.
Sales and Marketing. Sales and marketing expenses consist primarily of
salaries and commissions for sales and marketing personnel and promotional
expenses. Sales and marketing expenses were $51.7 million in 1998, $29.3
million in 1997 and $18.1 million in 1996, representing 36.1 percent of total
revenue in 1998, 34.9 percent in 1997 and 31.9 percent in 1996. Sales and
marketing expenses increased 76 percent from 1997 to 1998 and 62 percent from
1996 to 1997. The increases in sales and marketing expenses were primarily
attributable to the growth of our sales force and associated support personnel
from 85 employees in 1996 to 243 employees in 1998. Sales and marketing
expenses also increased from 1996 to 1998 as a result of additional marketing
and promotional activities to increase awareness of our products. We believe
that sales and marketing expenses will increase in absolute dollars as we
continue to expand our sales and marketing staff.
General and Administrative. General and administrative expenses include
personnel and other costs of our finance, human resources, facilities,
information systems and other administrative departments. General and
administrative expenses were $10.8 million in 1998, $8.0 million in 1997 and
$7.0 million in 1996, representing 7.5 percent of total revenue in 1998, 9.5
percent in 1997 and 12.3 percent in 1996. General and administrative expenses
increased 35 percent from 1997 to 1998 and 14 percent from 1996 to 1997. The
decreases in general and administrative expenses as a percentage of total
revenue were attributable to leveraging general and administrative expenses
over a larger revenue base. General and administrative expenses increased at a
slower rate than our rate of increase for revenue. The increases in absolute
dollars of general and administrative expenses from 1996 to 1998 were
primarily attributable to increased staffing and related costs required to
manage and support our expansion. General and administrative personnel
increased from 45 employees in 1996 to 83 employees in 1998. We expect that
general and administrative expenses will increase in absolute dollars as we
continue to expand our operations.
Amortization of Intangibles. Amortization of intangibles was $1.1 million
for each of 1998, 1997 and 1996. We recorded the related intangibles following
an acquisition in the first quarter of 1996. We amortize these intangibles on
a straight-line basis over five years.
Merger-Related Expenses. In connection with the our acquisition of Software
Moguls, Inc. during the third quarter of 1998, we incurred merger-related
expenses of $645,000, consisting primarily of investment bankers', attorneys'
and accountants' fees. We did not incur any merger-related expenses for 1997
and 1996.
31
In-process Research and Development. We did not incur any in-process
research and development costs during 1998 or 1997. In 1996, we incurred in-
process research and development costs of $1.8 million related to an
acquisition in the first quarter of 1996. (See Note 5 of the Notes to the
Consolidated Financial Statements)
Interest Income, Net
Interest income, net, was $4.2 million in 1998. Interest income, net, was
$2.2 million in 1997 and $1.8 million in 1996. The increase in interest income
relates primarily to interest earned from the increased cash balances.
Provision for Income Taxes
The provision for income taxes was $16.5 million in 1998, $9.2 million in
1997 and $6.5 million in 1996, with an effective rate of 37 percent in 1998,
40 percent in 1997 and 42 percent in 1996. The decrease in the effective rate
from 1998 to 1997 was primarily attributable to the acquisition of Software
Moguls, Inc. which was an S-corporation for income tax purposes, and
therefore, did not record a provision for or benefit from income taxes. If the
losses of Software Moguls, Inc., had been reflected in our financial
statements in 1997, the effective tax rate would have been 37 percent. (See
Note 8 of the Notes to the Consolidated Financial Statements) The decrease in
the effective tax rate from 1996 to 1997 was primarily a result of the
reinstatement of the federal research and experimental tax credit. We
anticipate that the tax rate for 1999 may increase primarily as a result of
the expected statutory expiration of the research and development credit and
impact of non-deductible merger expenses.
Liquidity and Capital Resources
Our cash, cash equivalents and investments totaled $118.6 million at
December 31, 1998 and represented 63 percent of total assets. Cash and cash
equivalents increased $46.2 million during 1998. Cash and cash equivalents are
highly liquid investments with original maturities of ninety days or less.
Investments consist mainly of short-term and long-term municipal securities.
At December 31, 1998, we had no long-term debt and stockholders' equity was
$144.5 million.
We have financed our operations to date primarily by cash from operations
and sales of common stock. Net cash provided by operating activities was $48.0
million in 1998. Net cash provided from operations in 1998 consisted primarily
of net income of $27.7 million plus the tax benefit from exercise of stock
options of $12.8 million, depreciation and amortization of $5.9 million and
the change in operating assets and liabilities of $4.6 million, offset by $3.6
million attributable to the change in net deferred tax assets. Net cash
provided by operating activities was $16.7 million in 1997. Net cash provided
from operations in 1997 consisted primarily of net income of $14.0 million
plus the tax benefit from stock options of $5.0 million and depreciation and
amortization of $3.9 million, offset by the change in operating assets and
liabilities of $5.9 million. Net cash provided by operating activities was
$17.2 million in 1996. Net cash provided from operations in 1996 consisted
primarily of net income of $8.9 million plus the tax benefit from exercise of
stock options of $7.1 million, depreciation and amortization of $2.1 million,
the write-off of in-process research and development of $1.8 million, offset
by the change in operating assets and liabilities of $1.9 million and the
change in net deferred tax assets of $1.3 million. Accounts payable and
accrued liabilities increased during 1998 and 1997 because of increased
purchases to support the growth in our operations. Accrued compensation and
benefits increased during 1998 and 1997 primarily as a result of the growth in
the number of employees worldwide. Accounts receivable and deferred revenue
increased during 1998 and 1997 because of increasing sales of our product
licenses as well as service and support contracts.
Net cash used in investing activities was $12.2 million in 1998. Net cash
used in investing activities was $14.5 million in 1997 and $21.3 million in
1996. Net cash used in investing activities primarily reflected net purchases
of marketable securities and property and equipment. Purchases of property and
equipment increased during 1998 and 1997 to support the growth in our
operations.
32
Net cash provided by financing activities was $10.5 million in 1998. Net
cash provided by financing activities was $4.9 million in 1997 and $1.9
million in 1996. Net cash provided by financing activities consisted primarily
of proceeds received from the issuance of our common stock.
We believe our current cash balances and cash flow from operations, if any,
will be sufficient to meet our working capital and capital expenditure
requirements for at least the next twelve months.
Year 2000 Compliance
Many currently installed computer systems and software products include
coding to accept only two digit entries in the date code field. These date
code fields will need to accept four digit entries to distinguish 21st century
dates from 20th century dates. Our computer systems and/or software will need
to be upgraded to comply with such "Year 2000" requirements. Systems that do
not properly recognize such information could generate erroneous data or cause
a system to fail. Significant uncertainty exists in the software industry
concerning the potential effects associated with such problems.
We have conducted Year 2000 compliance reviews for current versions of our
products. The reviews include:
. Assessment;
. Implementation;
. Validation testing; and
. Contingency planning.
We respond to customer concerns about our products on a case-by-case basis.
Although we have performed validation testing to ensure our products are Year
2000 compliant and believe our software products are Year 2000 compliant, our
software products may not contain all the necessary software routines and
programs for the accurate calculation, display, storage and manipulation of
data involving dates. Failures of our software products to contain all the
necessary software routines and programs for the accurate calculation,
display, storage and manipulation of data involving dates would seriously harm
our business, operating results and financial condition.
We have tested software obtained from third parties that is incorporated
into our products, and seek assurances from vendors that licensed software is
Year 2000 compliant. Despite such testing and assurances, products
incorporated into our products may contain undetected errors or defects
associated with Year 2000 date functions. Known or unknown errors or defects
in our products may result in:
. Delay or loss of revenue;
. Diversion of development resources;
. Damage to our reputation; or
. Increased service and warranty costs.
The occurrence of any of the foregoing could seriously harm our business,
operating results, or financial condition.
To the extent information is publicly available, we have assessed the Year
2000 compliance status of our customers. If our current or future customers
fail to achieve Year 2000 compliance or if they divert technology expenditures
to address Year 2000 compliance problems, our business, results of operations,
or financial condition could be seriously harmed.
We believe the software and hardware we use internally comply with Year
2000 requirements. During 1998, we replaced or upgraded much of our internal
use hardware and software. In addition, we are not aware of any
33
material operational issues or costs associated with preparing our internal
use software and hardware for the Year 2000. However, serious, unanticipated
negative consequences, including material costs caused by undetected errors or
defects in the technology used in our internal systems may occur. The
occurrence of any of the foregoing could seriously harm our business,
operating results or financial condition.
We have funded our Year 2000 compliance review from operating cash flows
and have not separately accounted for these costs in the past. We will incur
additional amounts related to the Year 2000 compliance review including:
. Administrative personnel to manage the review; and
. Outside contractors to provide technical advice and technical support for
our products, product engineering, and customer satisfaction.
We are developing contingency plans to be implemented as part of our
efforts to identify and correct Year 2000 problems. Depending on the systems
affected, these plans include:
. Accelerated replacement of affected equipment or software;
. Short to medium-term use of backup equipment and software;
. Increased work hours for our personnel or use of contract personnel to
correct (on an accelerated schedule) any Year 2000 problems that arise or
to provide manual workarounds for information systems; and
. Other similar approaches
If we are required to implement any of these contingency plans, it could
seriously harm our business, financial condition and operating results. Our
ability to achieve Year 2000 compliance and the level of incremental costs
associated therewith, could be seriously impacted by, among other things:
. The availability and cost of programming and testing resources;
. Vendors' ability to modify proprietary software; and
. Unanticipated problems identified in the ongoing compliance review.
Financial Risk Management
As a global concern, we face exposure to adverse movements in foreign
currency exchange rates. These exposures may change over time as business
practices evolve and could seriously harm our financial results. All of our
international sales are currently denominated in U.S. dollars. An increase in
the value of the U.S. dollar relative to foreign currencies could make our
products more expensive and, therefore, reduce the demand for our products.
Reduced demand for our products could seriously harm our financial results.
Currently, we do not hedge against any foreign currencies and as a result,
could incur unanticipated gains or losses.
We maintain an investment portfolio of various issuers, types and
maturities. Our investment portfolio consists of both fixed and variable rate
financial instruments. These securities are classified as available-for-sale,
and consequently, are recorded on the balance sheet at fair value with
unrealized gains or losses reported as a separate component of stockholders'
equity, net of taxes. At any time, a sharp rise in interest rates could
seriously harm the fair value of our investment portfolio. Conversely,
declines in interest rates could seriously harm interest earnings of our
investment portfolio. Currently, we do not hedge these interest rate
exposures.
34
The table below presents principal amounts and related weighted average
interest rates by year of maturity for our investment portfolio.
1999 2000 2001 2002 2003 Thereafter Total
------- ----- ---- ---- ---- ---------- -------
Municipal securities......... $22,575 8,797 -- -- -- -- $31,372
Average interest rate....... 4.9% 5.2% -- -- -- -- 4.8%
Auction rate receipts........ $ 5,800 -- -- -- -- -- $ 5,800
Average interest rate....... 3.8% -- -- -- -- -- 3.8%
Recent Pronouncements
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, or SFAS 133, Accounting for Derivative Instruments and Hedging
Activities. SFAS 133 establishes new standards of accounting and reporting for
derivative instruments and hedging activities. SFAS 133 requires that all
derivatives be recognized at fair value in the balance sheet, and that the
corresponding gains or losses be reported either in the statement of
operations or as a component of comprehensive income, depending on the type of
hedging relationship that exists. SFAS 133 will be effective for fiscal years
beginning after June 15, 1999. Currently, we do not hold derivative
instruments or engage in hedging activities.
In March 1998, the Accounting Standards Executive Committee, or AcSEC,
released Statement of Position 98-1, or SOP 98-1, Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use. SOP 98-1 requires
companies to capitalize certain costs of computer software developed or
obtained for internal use, provided that those costs are not research and
development. SOP 98-1 is effective for fiscal years beginning after December
15, 1998. We are evaluating the requirements of SOP 98-1 and the effects, if
any, on our current policies on accounting for software costs.
In December 1998, AcSEC released Statement of Position 98-9, or SOP 98-9,
Modification of SOP 97-2, "Software Revenue Recognition" with Respect to
Certain Transactions. SOP 98-9 amends SOP 97-2 to require that an entity
recognize revenue for multiple element arrangements by means of the "residual
method" when (1) there is vendor-specific objective evidence (VSOE) of the
fair values of all the undelivered elements that are not accounted for by
means of long-term contract accounting, (2) VSOE of fair value does not exist
for one or more of the delivered elements, and (3) all revenue recognition
criteria of SOP 97-2 (other than the requirement for VSOE of the fair value of
each delivered element) are satisfied.
The provisions of SOP 98-9 that extend the deferral of certain paragraphs
of SOP 97-2 became effective December 15, 1998. These paragraphs of SOP 97-2
and SOP 98-9 will be effective for transactions that are entered into in
fiscal years beginning after March 15, 1999. Retroactive application is
prohibited. We are evaluating the requirements of SOP 98-9 and the effects, if
any, on our current revenue recognition policies.
35
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements
Consolidated Balance Sheets at Dece