WITNESS SYSTEMS INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2004
o	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 000-29335

WITNESS SYSTEMS, INC.
(Exact Name of Registrant as Specified in its Charter)

Delaware (State or Other Jurisdiction of Incorporation or Organization)		23-2518693 (I.R.S. Employer Identification No.)
300 Colonial Center Parkway Roswell, Georgia (Address of Principal Executive Offices)		30076 (Zip Code)

Registrant's telephone number, including area code 770-754-1900

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 ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class		Outstanding at October 29, 2004
Common Stock, par value $.01 per share		24,301,304

WITNESS SYSTEMS, INC.

FORM 10-Q

INDEX

		Page
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Condensed Consolidated Balance Sheets at September 30, 2004 and December 31, 2003	3
	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2003	4
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003	5
	Notes to the Condensed Consolidated Financial Statements	6
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	40
Item 4.	Controls and Procedures	40
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	41
Item 2.	Changes in Securities and Use of Proceeds	41
Item 6.	Exhibits	41
SIGNATURES		42

PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements

WITNESS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
(unaudited)

			September 30, 2004			December 31, 2003
ASSETS
Current assets:
	Cash and cash equivalents		$	36,417		$	30,717
	Investments			26,530			10,155
	Accounts receivable, net of allowance for doubtful accounts of $2,677 at September 30, 2004 and $2,584 at December 31, 2003			27,694			31,707
	Prepaid and other current assets			4,906			3,311

		Total current assets		95,547			75,890
Intangible assets, net				11,907			20,083
Property and equipment, net of accumulated depreciation of $10,931 at September 30, 2004 and $7,556 at December 31, 2003				6,057			6,141
Other assets				1,399			2,177

			$	114,910		$	104,291

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
	Accounts payable		$	4,601		$	3,648
	Accrued expenses			15,942			23,579
	Deferred revenue			23,179			19,966

		Total current liabilities		43,722			47,193
Other long-term liabilities				4,129			3,906
Deferred income taxes				119			3,197

		Total liabilities		47,970			54,296

Stockholders' equity:
	Preferred stock, $.01 par value; 10,000,000 shares authorized; (50,000 shares of which have been designated as Series A Junior Participating Preferred Stock), no shares issued or outstanding			—			—
	Common stock, $.01 par value; 50,000,000 shares authorized; 24,160,563 and 22,169,672 shares issued and outstanding at September 30, 2004 and December 31, 2003, respectively			242			222
	Additional paid-in capital			106,109			94,293
	Accumulated deficit			(43,579	)		(48,506	)
	Accumulated other comprehensive income			4,168			3,986

		Total stockholders' equity		66,940			49,995
Commitments and contingencies

			$	114,910		$	104,291

See accompanying notes to condensed consolidated financial statements.

WITNESS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(unaudited)

			Three Months Ended September 30,						Nine Months Ended September 30,
			2004			2003			2004		2003
Revenue:
	Product		$	13,925		$	11,000		$	41,965	$	31,987
	Services			21,332			16,897			60,662		42,464

		Total revenue		35,257			27,897			102,627		74,451

Cost of revenue:
	Product			2,737			2,410			10,361		7,539
	Services			8,036			6,524			24,335		16,724

		Total cost of revenue		10,773			8,934			34,696		24,263

		Gross profit		24,484			18,963			67,931		50,188
Operating expenses:
	Selling, general and administrative			16,422			15,402			47,663		42,385
	Research and development			5,470			4,804			15,308		13,310
	Merger-related costs			152			1,602			675		6,179
	Acquired in-process research and development			—			—			—		7,840

		Operating income (loss)		2,440			(2,845	)		4,285		(19,526	)
Interest and other income, net				435			321			743		1,187

		Income (loss) before provision for income taxes		2,875			(2,524	)		5,028		(18,339	)
(Benefit) provision for income taxes				(68	)		8			101		198

		Net income (loss)	$	2,943		$	(2,532	)	$	4,927	$	(18,537	)

Net income (loss) per share:
		Basic	$	0.12		$	(0.11	)	$	0.21	$	(0.84	)

		Diluted	$	0.11		$	(0.11	)	$	0.19	$	(0.84	)

Weighted-average common shares outstanding:
		Basic		23,631			22,040			23,035		21,947

		Diluted		26,202			22,040			25,745		21,947

See accompanying notes to condensed consolidated financial statements.

WITNESS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(unaudited)

					Nine Months Ended September 30,
					2004			2003
Cash flows from operating activities:
	Net income (loss)				$	4,927		$	(18,537	)
	Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
		Acquired in-process research and development charge				—			7,840
		Amortization of intangible assets				5,028			3,887
		Depreciation and amortization on property and equipment				2,398			2,800
		Provision for doubtful accounts				516			2,679
		Other				413			266
		Changes in operating assets and liabilities:
			Accounts receivable			3,763			(1,414	)
			Prepaid and other assets			(285	)		255
			Accounts payable and accrued expenses			(7,645	)		(5,539	)
			Deferred revenue			3,214			5,018

				Net cash provided by (used in) operating activities		12,329			(2,745	)

Cash flows from investing activities:
	Capital expenditures					(2,185	)		(1,562	)
	Purchases of investments					(20,804	)		(3,105	)
	Proceeds from maturities of investments					3,000			4,888
	Proceeds from sales of investments					968			26,938
	Acquisition of Eyretel plc, net of cash acquired of $38,814					—			(21,496	)
	Purchase of other business assets					—			(2,385	)

				Net cash (used in) provided by investing activities		(19,021	)		3,278

Cash flows from financing activities:
	Proceeds from exercise of stock options and stock purchase plan					11,389			586
	Repayment of note receivable from stockholder					—			484
	Stock repurchases					—			(734	)

				Net cash provided by financing activities		11,389			336

	Effect of exchange rate changes on cash					1,003			1,526

				Net increase in cash and cash equivalents		5,700			2,395
Cash and cash equivalents at beginning of year						30,717			36,391

Cash and cash equivalents at end of year					$	36,417		$	38,786

Supplemental cash flow information:
	Cash paid for interest				$	—		$	86

	Cash paid for income taxes				$	203		$	15

Non-cash investing activities:
	Purchase of other business assets with short-term borrowings				$	—		$	1,000

See accompanying notes to condensed consolidated financial statements.

WITNESS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2004
(unaudited)

1. Basis of Presentation

Business—Witness Systems, Inc. ("Witness") provides an integrated contact center performance optimization software suite that enables global enterprises to capture customer intelligence and optimize workforce performance. Our solution is comprised of business-driven and/or full-time customer interaction recording, performance analysis and e-learning management applications that are designed to enhance the quality of customer interactions across multiple communications media, including the telephone, e-mail and the Internet.

We are headquartered in Roswell, Georgia with offices in the United States, Australia, Brazil, Canada, China, Germany, Japan, Mexico, the Netherlands, Singapore and the United Kingdom. We were originally incorporated in 1988 in Georgia and were reincorporated in Delaware in 1997. We have been a publicly traded company since February 2000.

Principles of Consolidation—The unaudited interim condensed consolidated financial statements include the financial statements of Witness Systems, Inc. and its wholly-owned subsidiaries. During the first quarter of 2003, we acquired Eyretel plc ("Eyretel"), a U.K.-based provider of compliance and recording solutions for customer contact centers. We began consolidating Eyretel's results on March 22, 2003, the date we assumed majority ownership of Eyretel. All significant intercompany balances and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.

The financial statements included herein have been prepared in accordance with the requirements of Form 10-Q and, therefore, do not include all information and footnotes required by generally accepted accounting principles in the United States of America. However, in the opinion of management, all adjustments necessary for a fair presentation of the results of operations for the relevant periods have been made. Results for the interim periods are not necessarily indicative of the results to be expected for the year. These financial statements should be read in conjunction with the summary of significant accounting policies and the notes to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003, as amended and filed with the U.S. Securities and Exchange Commission.

Use of Estimates—The preparation of these financial statements requires us to make certain estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

2. Revenue Recognition and Deferred Revenue

We recognize revenue in accordance with Statement of Position ("SOP") 97-2, Software Revenue Recognition, and SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions. Revenue is primarily derived from licensing software and providing related services including maintenance. During the nine months ended September 30, 2004 and 2003, we also had $5.5 million and $4.3 million, respectively, in hardware revenue, which commenced upon the acquisition of Eyretel. Product revenue, which includes software and hardware, is recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is fixed or determinable, collection is probable and vendor specific objective evidence ("VSOE") exists to allocate revenue to the undelivered elements of the

arrangement. We report hardware revenue gross in accordance with Emerging Issues Task Force ("EITF") No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, because the factors indicating gross reporting outweigh the factors indicating net reporting. We recognize revenue using the residual method of accounting since we have VSOE of fair value for maintenance and professional services, but not for the software and hardware elements of the order. Under the residual method, services revenue, including maintenance and professional services, is deferred at an amount equal to its fair value until those elements are delivered. Consequently, product revenue for the software and hardware may be recognized (i) upon delivery of those products when we have VSOE on the related maintenance and professional services sold and (ii) at an amount representing the difference between the total order amount and the amount deferred.

Services revenue includes installation, training, consulting, maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services is recognized upon performance of the related services and is offered and billed as separate elements of contracts. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses. The functionality of the software and any hardware sold is not dependent on installation and training services and customization is not required to enable our customers to use our products. Maintenance is offered as a separate element and the majority of contracts include the right to unspecified upgrades on a when-and-if available basis. Maintenance revenue is deferred and recognized ratably over the term of the related contract.

Deferred revenue consists of amounts collected from customers for products and services that have not met the criteria for revenue recognition.

3. Net Income (Loss) Per Share

The following is a reconciliation of the numerator and denominator used in the calculation of basic and diluted net income (loss) per share (in thousands, except per share data):

			Three months ended September 30,					Nine months ended September 30,
			2004		2003			2004		2003
Net income (loss)			$	2,943	$	(2,532	)	$	4,927	$	(18,537	)

	Weighted average shares of common stock and common stock equivalents outstanding:
	Basic			23,631		22,040			23,035		21,947
	Dilutive effect of stock options computed using the treasury stock method			2,571		—			2,710		—

		Diluted common shares outstanding		26,202		22,040			25,745		21,947

Net income (loss) per share:
	Basic		$	0.12	$	(0.11	)	$	0.21	$	(0.84	)

	Diluted		$	0.11	$	(0.11	)	$	0.19	$	(0.84	)

We have excluded all outstanding stock options from the calculation of historical diluted net loss per common share for the three and nine months ended September 30, 2003 because we reported a loss in both periods and all such securities were anti-dilutive. The total number of shares excluded from the calculations of diluted net loss per common share for the three and nine months ended September 30, 2003 was 933,051 and 613,052, respectively, using the treasury stock method. For the three months ended September 30, 2004 and 2003, 843,659 and 5,095,887 stock options, respectively, and for the nine months ended September 30, 2004 and 2003, 1,027,343 and 4,329,781 stock options, respectively, were excluded from the computation of diluted earnings per share because they had exercise prices that exceeded the average fair market value of our common stock during those periods, and therefore had an anti-dilutive effect.

4. Stock-Based Compensation

We generally do not record compensation expense for options granted to our employees because all options granted under our stock option plans have an exercise price equal to the market value of the underlying common stock on the date of grant. As permitted under SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, and SFAS No. 123, Accounting for Stock-Based Compensation, we have elected to continue to apply the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and have adopted the disclosure requirements of SFAS No. 123. The following table illustrates the effect on net income (loss) and net income (loss) per share if we had applied the fair value method as prescribed by SFAS No. 123 (in thousands, except per share data):

			Three months ended September 30,						Nine months ended September 30,
			2004			2003			2004			2003
Reported net income (loss)			$	2,943		$	(2,532	)	$	4,927		$	(18,537	)
Add back: Stock-based employee compensation expense included in reported net income (loss)				44			23			44			69
Deduct: Total stock-based compensation expense determined under fair value based method for all awards				(2,458	)		(1,862	)		(6,082	)		(5,689	)

Pro forma net income (loss)			$	529		$	(4,371	)	$	(1,111	)	$	(24,157	)

Net income (loss) per share:
	Reported:
		Basic	$	0.12		$	(0.11	)	$	0.21		$	(0.84	)

		Diluted	$	0.11		$	(0.11	)	$	0.19		$	(0.84	)

	Pro forma:
		Basic	$	0.02		$	(0.20	)	$	(0.05	)	$	(1.10	)

		Diluted	$	0.02		$	(0.20	)	$	(0.05	)	$	(1.10	)

As of September 30, 2004, there were 1.7 million shares available for future grants under our stock option plans.

5. Comprehensive Income (Loss)

Total comprehensive income (loss) and accumulated other comprehensive income consisted of the following (in thousands):

		Three months ended September 30,						Nine months ended September 30,
		2004			2003			2004			2003
Net income (loss)		$	2,943		$	(2,532	)	$	4,927		$	(18,537	)
Other comprehensive income (loss):
	Unrealized net holding gain (loss) on investments		70			—			(96	)		(165	)
	Foreign currency translation adjustments		(164	)		250			278			1,428

Total comprehensive income (loss)		$	2,849		$	(2,282	)	$	5,109		$	(17,274	)

	September 30, 2004			December 31, 2003
Cumulative foreign currency translation adjustments	$	4,272		$	3,994
Unrealized net holding loss on investments		(104	)		(8	)

Total accumulated other comprehensive income	$	4,168		$	3,986

6. Eyretel Acquisition

During the first quarter of 2003, we acquired a controlling interest in Eyretel. We paid 25 pence per share for a total purchase price of approximately £35.3 million, or $55.3 million, excluding shares owned by Eyretel's employee stock option trust at the time of acquisition. The acquisition was intended to extend our presence in international markets and to expand our product line by adding a full-time compliance recording solution. We commenced the consolidation of Eyretel's results on March 22, 2003, the date we assumed majority ownership of Eyretel. The acquisition was accounted for using the purchase method of accounting.

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