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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM JANUARY 1, 1998 TO DECEMBER 31, 1998
COMMISSION FILE NUMBER 1-8722
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THE MACNEAL-SCHWENDLER CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 95-2239450
(State or other jurisdiction of incorporation or (I.R.S. Employer Identification No.)
organization)
815 COLORADO BOULEVARD, 90041
LOS ANGELES, CALIFORNIA (Zip Code)
(Address of principal executive offices)
Registrant's telephone number including area code: (323) 258-9111
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Securities registered pursuant to Section 12(b) of the Act:
NAME OF EACH EXCHANGE ON WHICH
TITLE OF EACH CLASS REGISTERED
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Common Stock par value $.01 per share New York Stock Exchange
7 7/8% Convertible Subordinated Debentures
due August 18, 2004 New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: NONE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes 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. / /
As of April 5, 1999 the approximate aggregate market value of The
MacNeal-Schwendler Corporation's voting stock held by nonaffiliates was
$81,762,000.
As of April 5, 1999 there were outstanding 13,770,447 shares of Common Stock
of The MacNeal-Schwendler Corporation.
Documents incorporated by reference: None
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FORM 10K
TABLE OF CONTENTS
PAGE
Business................................................................................................... 1
Properties................................................................................................. 11
Legal Proceedings.......................................................................................... 11
Submission of Matters to a Vote of Security Holders........................................................ 11
Market for Registrant's Common Stock and Related Shareholder Matters....................................... 12
Selected Financial Data.................................................................................... 12
Management's Discussion and Analysis of Financial Condition and Results of Operations...................... 13
Quantitative and Qualitative Disclosures about Market Risk................................................. 25
Financial Statements and Supplementary Data................................................................ 27
Changes In and Disagreements With Accountants on Accounting and Financial Disclosure....................... 53
Directors and Executive Officers of the Registrant......................................................... 53
Executive Compensation..................................................................................... 55
Security Ownership of Certain Beneficial Owners and Management............................................. 61
Certain Relationships and Related Transactions............................................................. 62
Exhibits, Financial Statement Schedules and Reports on Form 8-K............................................ 63
PART I
ITEM 1. BUSINESS.
The MacNeal-Schwendler Corporation ("MSC" or the "Company") was incorporated
in Delaware in 1994. Since its inception in 1963, MSC has been engaged in
computer-aided engineering ("CAE"), including the development and marketing of
software for use principally by engineers and designers in industry, research
laboratories and universities. In the last three years, MSC has expanded its
scope to focus on providing engineering solutions through strategic consulting,
software integration, and customization services in addition to engineering
software sales. MSC's principal software products are MSC.NASTRAN and
MSC.PATRAN.
On January 29, 1999, MSC decided to change its fiscal year from a year
beginning February 1 and ending January 31, to a calendar year. All references
to fiscal year 1998 mean the year ended December 31, 1998. Additionally, all
financial information for prior periods has been restated to coincide with the
new fiscal year, therefore any references to a fiscal year mean the twelve
months ended December 31 of that year.
In the current computer-aided manufacturing environment, designs are
simulated before manufacturing has begun. MSC.NASTRAN is a basic CAE analysis
software program that determines a product's stresses and deformations.
MSC.PATRAN is an interactive CAE environment that facilitates the use of
geometric data from popular computer-aided design ("CAD") systems such as CATIA,
Pro/ENGINEER, and Unigraphics in a variety of commercial analysis programs
including MSC.NASTRAN. MSC.Working Model is linked to popular mid-range CAD
systems such as SolidWorks, Autodesk's Mechanical Desktop, and SolidEdge, and
answers the questions "Will it break?" and "Will it work?" by providing stress
and motion analysis capabilities. CAE analysis is used to simulate the
performance of a design prior to its physical manufacture, replacing
time-consuming and costly physical testing of prototypes and permitting a
substantial increase in the number of design trade-offs and design cycles.
Mechanical simulation helps manufacturers design and build better products
faster and more efficiently. Engineers use MSC's simulation software worldwide
in several industries, including aerospace, automotive, shipbuilding, consumer
products and electronic packaging.
MSC develops educational tools designed to train users of its products as an
extension of its software business. Training seminars are conducted in local
languages on a frequent basis at the MSC Institute of Technology in Costa Mesa,
California, at MSC 's Los Angeles headquarters, at MSC's offices worldwide, and
at client sites. In addition, MSC now provides a broad range of engineering
software consulting services. A typical consulting assignment might include all
or some of the following activities:
- - design/analysis process reengineering planning, where we suggest an improved
process state and provide a roadmap of changes to be made to achieve that
improved state.
- - reengineering implementation, where we implement the recommended changes,
often introducing new software tools and analysis techniques. The software may
be our own or those of third parties. Often process change includes
integration with the customer's Product Data Management (PDM) system.
- - software customization, where we modify our software products to match
particular features of the client's process or methodology.
- - proprietary software commercialization, where we commercialize proprietary
software programs to reduce the client's support costs, increase the sources
of input for technological advance and/or increase access to the software for
the client's supply chain.
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The following is a detailed discussion of each of MSC's major CAE products:
MSC.NASTRAN
MSC.NASTRAN is a descendant of NASTRAN-TM-, a computer program owned by the
United States Government and leased to others. MSC has improved upon NASTRAN
since NASTRAN was first released in 1970 and the current capabilities and scope
of MSC.NASTRAN are substantially greater than those of NASTRAN. MSC has been
selling MSC.NASTRAN since 1971. Pursuant to a 1982 agreement with the National
Aeronautics and Space Administration, MSC acquired the perpetual rights to
commercially use those elements of NASTRAN which are embodied in MSC.NASTRAN.
See "--Intellectual Property Rights" below. However, certain of MSC's
competitors sell other variations of NASTRAN-TM-.
MSC.NASTRAN is based upon the "finite element method" (FEM) of analysis.
With FEM analysis, complex structures are divided into small elements, which
form a finite element model, which is then subjected to computer analysis.
MSC.NASTRAN is used to analyze structures in order to determine, among other
things, their strength, safety and performance characteristics. For example, in
the aerospace industry, MSC.NASTRAN is employed to determine the stress
distribution in the major parts of an aircraft, such as engines, wings, fuselage
and tail. A computer analysis could be applied to improve the design of aircraft
by suggesting the removal of material where stresses are low and the addition of
material where stresses are high, while reducing the usage of physical
prototypes and other testing. With this knowledge, aircraft can be made both
stronger and lighter. The same principles have been applied to improve the
design of jets, rockets, engines, automobiles, trucks, tires, ships, farm
equipment, heavy industrial equipment, nuclear containment vessels, helicopters,
spacecraft and other products and structures.
Because MSC.NASTRAN has been designed in a modular way, new features can be
added and obsolete features replaced without disrupting the other modules of the
system. As a result, major changes in computer hardware have been systematically
accommodated. For example, the program has been adapted to be used on a variety
of computer types, from supercomputers to PC's. MSC believes that the continued
development and maintenance of MSC.NASTRAN, together with the modular design
features of that program, have prevented, and will continue to prevent, its
obsolescence, although no assurance can be given that future changes in hardware
or breakthroughs in software design will not result in the obsolescence of the
program.
MSC.PATRAN
MSC.PATRAN provides finite element modeling, analysis data integration,
analysis simulation, and results evaluation capabilities to simulate product
performance early in the design-for-manufacture process. All of the functions of
MSC.PATRAN may be integrated, automated and tailored to the user's specific
requirements using a powerful programming command language.
MSC.PATRAN system provides three fundamental functions:
- - MSC.PATRAN CORE SOFTWARE--The core of the MSC.PATRAN software enables the
engineer to visualize the design, preprocess the design into a computer model
for engineering analysis, and postprocess the results of the analysis into a
graphical representation. The software interfaces with many popular CAD
programs and many analysis packages such as MSC.NASTRAN.
- - APPLICATION MODULES--Through a series of modules that can be added to the core
software, engineers can perform analysis on stress, thermal mechanisms and
dynamics, fluid flow, solid modeling, and fatigue. Some of these application
modules have been developed by third parties and are marketed under joint
development or marketing agreements.
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- - INTERFACES--MSC.PATRAN uses a series of interfaces that allow it to interact
with programs developed by other companies in the CAD/CAE industry. These
interfaces either involve direct links into other software or translate data
to and from other software so that it can be processed within MSC.PATRAN.
MSC.WORKING MODEL
MSC.Working Model, MSC's newest product line, was created by the acquisition
of Knowledge Revolution (see"--Mergers and Acquisitions"). The two principal
products are:
- - MSC.Working Model Motion, to simulate motion such as falling and colliding
objects, pistons, conveyor belts, rotating machinery, and other moving
mechanical systems. This simulation answers the question "Will it work?"
- - MSC.Working Model FEA, to simulate stress, deformation, and vibration. This
simulation answers the question "Will it break?"
These products run on Microsoft Windows-based PCs and are closely linked to
mid-range, desktop-based CAD programs such as SolidWorks, Auto Desk's Mechanical
Desktop, and SolidEdge.
OTHER
In addition, MSC has a variety of other products, none of which account for
more than 5% of the Company's revenue, including MSC.DYTRAN, MSC.MVISION,
MSC.SuperModel and MSC.SuperForge.
RESEARCH AND DEVELOPMENT
MSC continually expends significant amounts on the development and
maintenance of its suite of CAE software products, as well as on new product
research and development. During the years ended December 31, 1998, 1997, and
1996, approximately $25,266,000, $22,723,000, and $31,259,000, respectively, was
expended for software research and development. Of the amounts expended,
$11,600,000 in 1998, $12,545,000 in 1997, and $8,075,000 in 1996 were included
in software costs capitalized. Effective January 1, 1999 the Company has changed
the estimated useful life of its capitalized software assets from three and four
years to two and three years. The Company has always estimated the expected life
of these assets based on the release cycle of its products. The Company believes
that as software production cycles decrease, amortization periods should also
decrease in order to coincide with each version's revenue stream. The Company is
making this change prospectively.
MSC's development activities have historically involved adding new
capabilities to its family of CAE programs or converting those programs for use
on new computer platforms. These activities are intended to prevent
technological obsolescence and assure MSC's clients the maximum flexibility in
selecting computer hardware. MSC considers the feasibility, cost and the size of
the market for a MSC software program for a particular computer when determining
whether to undertake development activity to adapt the program for a particular
computer.
Maintenance of MSC software products includes system integration, quality
assurance testing, error correction, and modifications to accommodate changes to
computer system software. Given the maturity of MSC's software, most maintenance
efforts stem from continuing new developments. Maintenance costs are expensed as
incurred.
MSC has recently increased its expenditure for software development. This
increase resulted primarily from changes within the Company's product management
in staffing and staff mix related to a strategic revision in product development
activity. This shift in strategy de-emphasizes features upgrades for specific
products and promotes the development of technologies and integrated software
solutions for targeted
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customers. The Company's total development cost before software capitalization
was 20% of revenue for 1998 which remains consistent with management's target of
20% of total annual revenues.
SALES AND MARKETING
MSC markets its products through advertising in trade publications,
participation in industry trade shows and exhibits, training seminars conducted
worldwide, its existing client base through complementary marketing agreements
with computer hardware manufacturers and through the Internet. MSC uses its own
dedicated sales force as well as value added resellers ("VARs") for domestic
marketing.
Foreign marketing is generally conducted in the same manner as U.S.
marketing, the basic licensing agreements are substantially the same. Prices for
agreements originating with MSC's German subsidiary are generally stated in
German Marks and agreements originating within Japan are generally stated in
Japanese Yen. Agreements with customers in Asia-Pacific outside of Japan are
denominated in US dollars. The agreements stated in foreign currencies are
subject to currency fluctuations.
REVENUE POLICY. The Company provides a variety of licensing alternatives
for the use of its software products. MSC's software products have been
primarily offered on an annual non-cancelable, pre-paid license basis. An annual
non-cancelable, pre-paid license is set at a fixed rate for the period and
provides for payment in advance of use. Prior to October 1, 1998, license
revenue was recognized at the time of sale, while maintenance revenue,
representing approximately 15% of the revenue from a non-cancelable, pre-paid
license, was recognized ratably over the term of the maintenance period.
Effective October 1, 1998, MSC adopted the Accounting Standards Executive
Committee (AcSEC) of the American Institute of Certified Public Accountants
(AICPA) Statement of Position 98-9 pursuant to which revenue will be recognized
ratably over the life of the contract for a non-cancelable, pre-paid annual
license. In recent years, demand has also increased for paid up licenses for
engineering software products. A paid up license provides significant revenue at
the original time of sale of the product, with smaller payments for maintenance
following the time of sale. The growth of paid up licenses creates higher
earnings volatility since larger amounts of revenue are recognized at one time
instead of over a period of time. Service revenue was less than 7% of revenue in
1998. See Note 1 of Notes to Consolidated Financial Statements for additional
information with respect to the Company's revenue recognition policy.
SALES/SUPPORT OFFICES. MSC maintains North American sales and client
support offices in Los Angeles, CA; Costa Mesa, CA; San Mateo, CA; Dallas, TX;
Atlanta, GA; Dayton, OH; Detroit, MI; Boston, MA; and Seattle, WA areas. In
addition, sales and support personnel work out of numerous home offices
throughout the United States. The Los Angeles office also serves as MSC's
headquarters. Sales and/or technical support representatives who have
engineering backgrounds and experience using MSC products staff the other
offices. These representatives market MSC's products, provide training in their
use, respond to user support calls and provide solutions for CAE analysis
throughout North America.
MSC's products are marketed, distributed and supported outside of North
America through a network of foreign subsidiary offices. MSC's wholly-owned
European subsidiary headquartered in Munich, Germany, manages its own network of
wholly-owned subsidiaries in the United Kingdom, Italy, Spain, France, Norway,
and The Netherlands. Other sales offices are located in Moscow, Russia,
Fribourg, Switzerland and Brno, Czech Republic. In the Asia-Pacific, sales and
service are handled through MSC's wholly-owned subsidiary in Tokyo, Japan, with
a branch office in Osaka, Japan, as well as other sales and services offices in
Taipei, Taiwan and Beijing, People's Republic of China.
Representative arrangements are also utilized in several European and Asia
Pacific countries as well as in India, Australia, and parts of Latin America.
POST CONTRACT SUPPORT. Client service is an integral aspect of MSC's
marketing program. The Company maintains toll-free numbers and a "hot line"
service for its clients. MSC has invested in advanced "call center" technology
to improve its capabilities.
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User manuals, training and quality assurance are also essential to MSC's
marketing program. MSC's user manuals are comprehensive and updated on a regular
basis. A staff of writers and editors manage the design, writing, editing and
preparation of user manuals as well as of training materials and promotional
literature. MSC conducts formal training for clients, ranging from three-day
introductory courses to intensive courses on specialized subjects for
experienced users. On site courses for clients are provided for larger user
organizations.
MSC also hosts annual users' conferences in the United States, Europe, Asia
Pacific, Australia, and Latin America to gather data on client needs, new
engineering applications, and new trends in computing technology.
CUSTOMERS
MSC's products are marketed internationally to clients from aerospace,
automotive, other manufacturers and universities. These categories of clients
accounted for 39%, 24%, 34% and 3%, respectively, of MSC's revenues for 1998.
In 1998, foreign export sales accounted for approximately 57% of gross
revenues, most of which were attributable to Europe (32%) and Asia-Pacific
(22%). The balance was attributable to Canada and South America. The operating
margins derived from MSC's foreign export sales do not materially differ from
its domestic operations. See Notes 11 and 12 of Notes to Consolidated Financial
Statements for additional information with respect to MSC's foreign operations.
No customer accounts for more than 10% of MSC's consolidated revenues.
BACKLOG
MSC does not maintain backlog statistics for its products because software
is generally available for delivery upon execution of a licensing agreement or
contract. Backlog for consulting services work is currently not material.
INTELLECTUAL PROPERTY RIGHTS
MSC, MSC., MSC.ARIES, MSC.PATRAN, MSC.MVISION and MSC.DYTRAN are registered
trademarks of MSC. Working Model is a registered trademark of MSC's wholly-owned
subsidiary, Knowledge Revolution, Inc. NASTRAN is a registered trademark of
NASA. MSC.NASTRAN is an enhanced proprietary version of NASTRAN.
MSC.NASTRAN, MSC.NASTRAN for Windows, MSC.SuperModel, MSC.InCheck,
MSC.SuperForge, MSC.NVH Manager, MSC.DropTest, MSC.FEA, MSC.FATIGUE, MSC.Working
Knowledge, MSC.CONSTRUCT, and MSC.AMS are trademarks of MSC. Knowledge
Revolution is a trademark of MSC's subsidiary, Knowledge Revolution, Inc.
Registration on certain of these trademarks is pending. Most of MSC's trademarks
have also been registered in foreign countries. MSC believes that it could
successfully defend the use of its trademarks, whether registered or pending
registration, under federal or common law existing in the State of California.
In addition, MSC maintains federal statutory copyright protection with
respect to its software programs and products and has registered copyrights on
all documentation and manuals related to these programs and maintains trade
secret protection on its software products.
MERGERS AND ACQUISITIONS
In late December 1998, Knowledge Revolution ("KR") merged with and into a
wholly-owned subsidiary of the Company (the "KR Merger"). In the KR Merger, MSC
paid to shareholders and holders of options and warrants of KR approximately
$19,200,000 and became the sole owner of all of the
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outstanding shares of capital stock of KR. The acquisition was treated as a
purchase for accounting purposes and, accordingly, the operating results of KR
have been reflected in MSC's consolidated financial statements since the date of
acquisition. Following consummation of the KR Merger, the operations of KR
continue to be operated as the Working Knowledge division of MSC. KR is the
world's leading developer and distributor of 2D and 3D-motion simulation
software for design engineers and analysts.
The total purchase price was allocated to the assets and liabilities of KR
based on their approximate fair market value. The appraisal of the acquired
business included $6,000,000 of purchased in-process research and development,
which was related to three products under development. This valuation represents
the five-year after tax cash flow of this in-process technology using a discount
rate of 28%. The acquired technology had not yet reached technological
feasibility and had no future alternative uses. Accordingly, it was written off
at the time of the acquisition. The remaining purchase price was allocated as
follows: $800,000 to net tangible assets, $9,890,000 to identified intangible
assets, including $5,200,000 of value-added reseller distribution channel,
$4,300,000 of developed technology, and $390,000 of assembled work force, and
$2,510,000 to goodwill.
COMPETITION
MSC competes in highly competitive markets including the development and
marketing of software for use principally by engineers and designers in
industry, research laboratories, and universities. MSC believes it is a leading
supplier of software and services to the CAE markets in which it competes.
MSC believes that MSC.NASTRAN is the leading program for engineering
analysis worldwide based upon capability, functionality, international
acceptance, and sales volume and that MSC.PATRAN is the standard CAE environment
for manufacturers worldwide, based upon its enhanced usability, direct CAD
access, intelligent use of geometry, automated finite element modeling, and
completeness of analysis integration. MSC believes that MSC.Working Model Motion
is the unit volume leader for desktop-based motion simulation, based principally
on its ease of use and on its association with leading university textbook
publishers that bundle our software with their texts.
MSC must continue to offer attractive prices and performance capabilities in
order to retain existing clients and further extend its markets. See "Research
and Development" and "Marketing" above. MSC competes primarily based upon
product quality, service, price, and technological innovation.
EMPLOYEES
At December 31, 1998, MSC and its subsidiaries employed approximately 745
persons, of whom 425 were involved in technical activities, 179 in sales and
marketing and 141 in administration. Of these employees, 312 hold advanced
degrees. As part of its restructuring, MSC reduced the number of employees by
75, approximately 10% of its workforce. MSC's business is dependent in part upon
its ability to attract and retain highly skilled personnel who are in great
demand. MSC has no contracts with labor organizations and believes its relations
with its employees are good.
6
EXECUTIVE OFFICERS OF THE REGISTRANT
The table below sets forth certain information with regard to executive
officers who are not also directors of MSC. MSC is not aware of any arrangement
or understanding between these persons and any other persons pursuant to which
the executive officers were selected as such. MSC is not aware of any family
relationships between these executive officers and any other executive officers.
Louis A. Greco................... 51 Chief Financial Officer (March 1983-present) and Corporate Secretary
(December 1985-present).
James B. Archer.................. 50 Senior Vice President of Worldwide Product Development (February
1998-present); Vice President of Product Development (August
1997-January 1998); Director of Object Technology at IBM (1994-July
1997).
Kenneth D. Blakely............... 44 Senior Vice President, General Manager Mechanical Solutions Division
(January 1999-present); Senior Vice President of International
Operations and General Manager of Aerospace Business Unit (February
1998-December 1998); Vice President and General Manager of Aerospace
Business Unit (March 1996-January 1998); Vice President of Marketing
(January 1995-February 1996); Department Director of Production and
Support (March 1993-December 1994); Section Manager of Technical Product
Planning and Support (January 1992-February 1993); Department Director
of Product Management and Support (June 1991-December 1991); MSC.NASTRAN
Program Manager (October 1989-May 1991).
Dave Baszucki.................... 36 Vice President, General Manager Working Knowledge Division (January
1999-present); President and Founder, Knowledge Revolution Inc. (August
1989-December 1998).
Dr. Dan Bryce.................... 41 Vice President, General Manager, Engineering-e.com Division (April
1999-present); Chief Information Officer (February 1998-March 1999);
Department Director (July 1995-January 1998); Manager of Parametric
Modeling Task Force (1994-June 1995).
Richard C. Murphy................ 35 Vice President, the Americas (January 1999- present); Vice President and
General Manager of Growth Industries Business Unit (February
1997-December 1998); Vice President and General Manager of General
Manufacturing Unit (September 1996-January 1997); Department Director of
North American Sales and Support (March 1996-August 1996); Regional
Office Manager of North American Sales and Sales Support (February
1994-February 1996); Sales Representative of North American Sales and
Sales Support (April 1991-January 1994).
Masaru Tateishi.................. 53 Vice President, Asia-Pacific (February 1995-present); General Manager of
MSC Japan (March 1993-January 1995); General Manager of MSC Hong Kong
(August 1986-February 1993).
Dr. Christopher St. John......... 52 Vice President, Europe (April 1997-present); Director of European
Engineering Services (January 1995-March 1997); Manager of U.K.
Engineering Services (January 1991-December 1994).
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FORWARD LOOKING STATEMENTS
The forward-looking statements in this report, including statements
concerning projections of the Company's future results, operating profits and
earnings, are based on current expectations and are subject to risks and
uncertainties that could cause actual results to differ materially from those
expressed or implied by those statements. The risks and uncertainties include
but are not limited to:
- - the timely development and market acceptance of new versions of the Company's
software products;
- - the successful integration of Knowledge Revolution and the prospects of the
new Working Knowledge Division;
- - timely development of CAE technologies which, among other things, must
accommodate industry trends such as increasing computing power and increased
usage of workstations;
- - fluctuations of the U.S. dollar versus foreign currencies;
- - economic conditions in Asia-Pacific, Europe and the U.S.;
- - the Company's ability to reduce costs without adversely impacting revenues;
- - successful involvement of international and domestic business partners in
creating mechanical engineering solutions;
- - the Company's ability to attract, motivate and retain salespeople, programmers
and other key personnel;
- - continued demand for its products, including MSC.NASTRAN, MSC.PATRAN,
MSC.DYTRAN, MSC.MVISION, MSC.NASTRAN for Windows, MSC.InCheck, and Working
Knowledge products; and
- - Year 2000 issues.
Subsequent written and oral forward-looking statements attributable to MSC
or persons acting on its behalf are hereby expressly qualified in their entirety
by the cautionary statements in this section of this report.
RISK FACTORS
HISTORICAL RESULTS OF OPERATIONS AND FINANCIAL POSITION OF THE COMPANY ARE NOT
NECESSARILY INDICATIVE OF FUTURE FINANCIAL PERFORMANCE.
MSC derives most of its revenue from selling software products and services
to high end users of the product design markets. Our revenue growth and our
ability to match spending levels with revenue growth rates will directly impact
our future operating results. Historically, a significant portion of our revenue
has been generated from shipments in the last month of a quarter. In addition,
higher volumes of orders have been experienced in the fourth quarter. The
concentration of orders makes projections of quarterly financial results
difficult. In addition, over 50% of our revenues are derived from international
markets and are denominated in foreign currencies. As a result, our financial
results could be impacted by weakened general economic conditions in various
parts of the world, differing technological advances or preferences, volatile
foreign exchange rates, and government trade restrictions in any country in
which we do business.
RISK ASSOCIATED WITH EXPENSE MANAGEMENT.
MSC plans its operating expense levels, in part, on expected revenue growth.
Our expense levels, however, are generally committed in advance and, in the near
term, we are able to change only a relatively small portion of our expenses. As
a result, our ability to convert operating outlays into expected revenue growth
at profitable margins will impact our future operating results. If our future
revenues are less than expected, our net income may be disproportionately
affected since expenses are relatively fixed.
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RISKS OF COMPETITION.
The software industry is highly competitive. The entire industry may
experience pricing and margin pressure which could adversely affect our
operating results and financial position. Our success depends on our ability to
continue to develop, enhance and market new products to meet our customers'
sophisticated needs within competitive pricing structures and in a timely
manner. Shortened product development cycles may impact product quality,
performance, reliability, ease of use, functionality, breadth and integration.
Our success also depends, in part, on our ability to (1) attract and retain
technical and other key employees who are in great demand, (2) protect the
intellectual property rights of our products, and (3) continue key relationships
with product development partners.
Some of our current and possible future competitors have greater financial,
technical, marketing and other resources than we do, and some have
well-established relationships with our current and potential customers. It is
also possible that alliances among competitors may emerge and rapidly acquire
significant market share or that competition will increase as a result of
software industry consolidation. Increased competition may result in price
reductions, reduced profitability and loss of market share, any of which could
have a material adverse effect on our business, financial condition and results
of operations.
RISKS RELATED TO STOCK MARKET VOLATILITY.
The trading price of our stock, like other software and technology stocks,
is subject to significant volatility. If our revenues or earnings fail to meet
securities analysts' expectations, there could be an immediate and significant
adverse impact on the trading price of our stock. In addition, broader market
factors unrelated to our performance may affect our stock price.
RISKS RELATED TO DEPENDENCE ON CORE PRODUCTS.
We currently earn a significant portion of our revenues from sales and
maintenance of a core group of analysis and design software derived primarily
from our MSC.NASTRAN and MSC.PATRAN products. As a result, any factor adversely
affecting sales of these core products could have a material adverse effect on
our business. Our future performance will depend upon successful development,
introduction and customer acceptance of new products or enhanced versions of our
existing products. We can give no assurance that we will continue to be
successful in marketing our current products or any new or enhanced products
that we may develop in the future. In addition, competitive pressures or other
factors may result in price erosion that could have a material adverse effect on
our business, financial condition and results of operations.
RISKS RELATED TO DEPENDENCE ON CERTAIN INDUSTRIES.
We primarily market our products to aerospace, automotive and other
industrial customers. For the year ended December 31, 1998, aerospace clients
accounted for 39% and automotive clients accounted for 24% of our revenues,
respectively. Changes in capital spending by, and cyclical trends affecting,
these customers may adversely affect our offerings to these industries. In
addition, these types of customers tend to adhere to a technology choice for
long periods (i.e., an entire development cycle). As a result, a lost
opportunity with a given customer may not again become a new opportunity for
several years.
RISKS RELATED TO INTERNATIONAL ACTIVITIES.
Revenues from foreign export sales represented approximately 57% of our
gross revenue in 1998. Risks inherent in our international business activities
include the following:
- - imposition of government controls
- - foreign exchange fluctuations, as many of our agreements originating with our
German and Japanese subsidiaries are stated in foreign currencies
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- - export license requirements
- - restrictions on the export of critical technology or other trade restrictions
- - foreign political and economic instability
- - ineffective copyright and trade secret protection under foreign law
- - changes in regulatory practices, tariffs and taxes
- - difficulties in staffing and managing international operations
- - longer accounts receivable payment cycles
- - burdens of complying with a wide variety of foreign laws and regulations
See also "Euro Conversion" in Management's Discussion and Analysis of
Financial Condition and Results of Operations.
Unfavorable economic and political conditions in the Asian markets have
recently impacted our international results. The decrease in reported revenues
from our Asia-Pacific region is due primarily to the economic turmoil the region
experienced during the past year and is not an indication of a reduction in the
Company's market share from the region. 16% of the Company's total revenue for
1998 is directly related to the Japanese market, while 6% is from the
Asia-Pacific region outside of Japan. In light of the continued economic turmoil
in the region we remain cautious about MSC's Asia-Pacific prospects. We can give
no assurance that the economic crisis and currency issues currently being
experienced in the Asian markets will not have a material adverse effect on our
future international sales and, consequently, on our business, financial
condition and results of operations.
RISKS RELATED TO CERTAIN ANTI-TAKEOVER PROVISIONS.
Certain provisions of our Certificate of Incorporation and Restated Bylaws
could make it more difficult for a third party to acquire control of us, even if
the change in control would be beneficial to stockholders. These provisions
include the following:
- - division of our board of directors into three classes, with each class serving
a staggered three-year term
- - vesting of exclusive authority in the board, the Chairman of the Board and the
president (except as otherwise required by law) to call special meetings of
stockholders
- - elimination of stockholder voting by consent
- - removal of directors for cause only
- - ability of the board to authorize the issuance of preferred stock in series
- - vesting of exclusive authority in the board to determine the size of the board
(subject to certain limited exceptions) and to fill vacancies thereon
- - advance notice requirements for stockholder proposals and nominations for
election to the board
In addition to the above provisions, we have recently adopted a new
stockholder rights plan. Such plan entitles our stockholders, if an entity
acquires more than 20% of our stock or in the event of a squeeze-out merger,(1)
to purchase either our common stock or the common stock of the merged entity at
one-half of
- ------------------------
(1) A "squeeze-out merger" is a merger transaction in which a minority interest
in a corporation is intentionally eliminated or reduced. This is often
accomplished by setting up the merger transaction to provide such holders of
minority interests with effectively no choice but to accept cash (as opposed
to interests in the continuing entity) in exchange for their shares.
10
such stock's market value. Until ten days after the announcement of the
acquisition of such a 20% interest, we may redeem the rights for a nominal
amount.
ITEM 2. PROPERTIES.
MSC's offices are leased under agreements expiring at various times over the
next one to ten years. MSC's principal offices are in Los Angeles, California
and Costa Mesa, California, and include 56,690 square feet and 81,178 square
feet, respectively, under leases expiring in 2005 and 2002, respectively. As
part of its restructuring, MSC is exploring the possibility of relocating its
headquarters and combining its principal offices into one office prior to the
end of the current leases. Management believes that such a move could provide
cost savings as well as enhance productivity by having key personnel in one
office. MSC also leases its other offices throughout the United States and
internationally. See Note 15 of Notes to Consolidated Financial Statements of
this report for additional information regarding MSC's lease obligations.
ITEM 3. LEGAL PROCEEDINGS.
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of shareholders during the last quarter
of MSC's fiscal year ended December 31, 1998.
11
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS.
The Company's common stock is listed for trading on the New York Stock
Exchange under symbol MNS. The following table sets forth through December 31,
1998, the high and low prices as reported on the NYSE for the period shown:
SALES PRICES
--------------------
HIGH LOW
--------- ---------
Calendar Year 1998
Fourth quarter........................................................... $ 7.25 $ 5.19
Third quarter............................................................ 9.81 5.88
Second quarter........................................................... 12.00 9.25
First quarter............................................................ 12.31 9.06
Calendar Year 1997
Fourth quarter........................................................... $ 13.13 $ 8.94
Third quarter............................................................ 13.25 10.31
Second quarter........................................................... 11.13 9.13
First quarter............................................................ 10.13 7.63
As of April 5, 1999 there were 367 record holders of the Company's Common
Stock. The Company eliminated its dividend in September of 1996 and does not
anticipate paying a dividend in the foreseeable future. The price of the Common
Stock on April 5, 1999 was $5.94.
On December 30, 1998, in connection with a marketing arrangement with Kubota
Solid Technology Corporation ("KSTC"), the Company issued warrants to purchase
54,054 shares of the Company's common stock at $6.94 per share for an aggregate
exercise price of $375,000. The warrants are non-transferable, have a five-year
term and become exercisable two years after the date of issuance. The warrants
were valued using the Black-Scholes valuation method at $144,324. The exercise
price was equal to the fair market value of the common stock on the date of
purchase. The transaction was a private placement involving one offeree and one
purchaser exempt from registration under section 4(2) of the Securities Act of
1933. See Note 14 of Notes to Consolidated Financial Statements for additional
information with respect to warrants issued by the Company.
ITEM 6. SELECTED FINANCIAL DATA.
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------------------------
1998* 1997 1996 1995 1994**
---------- ---------- ---------- ---------- ----------
IN THOUSANDS, EXCEPT PER SHARE AMOUNTS
Revenue.............................................. $ 125,397 $ 132,804 $ 132,081 $ 127,374 $ 90,682
Operating income (loss).............................. (10,041) 18,963 18,685 22,648 (31,059)
Net income (loss).................................... (12,979) 9,887 9,711 12,743 (33,466)
Basic earnings (loss) per share...................... (0.95) 0.73 0.72 0.97 (2.50)
Diluted earnings (loss) per share.................... (0.95) 0.73 0.72 0.90 (2.50)
Cash dividends declared per share.................... -- -- 0.22 0.48 0.64
Total assets......................................... 138,829 129,053 119,786 114,704 113,600
Convertible long-term debt........................... 56,574 56,574 56,574 56,574 56,574
- ------------------------
* Reflects a reduction in revenue of $9,398,000 related to the change in how
the Company recognizes revenue, an in-process research and development
charge of $6,000,000 related to the acquisition of Knowledge Revolution,
impairment charges of $8,164,000 in cost of revenue and restructuring and
other impairment charges of $2,365,000.
** Reflects an in-process research and development charge of $35,000,000 and a
restructuring charge of $8,962,000 related to the acquisition of PDA
Engineering.
12
The selected financial data for the five years ended December 31, 1998, are
derived from the Company's audited Financial Statements. The selected financial
data should be read in conjunction with Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations, the Consolidated
Financial Statements of the Company and the related Notes to Consolidated
Financial Statements.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
RECENT DEVELOPMENTS
ACCOUNTING CHANGES
In January 1999, the Company changed its reporting period from a January 31
fiscal year-end to a December 31 calendar year-end basis. As part of this
change, the Company elected to present restated financial results on a calendar
year-end basis for all reported prior periods.
In the fourth quarter of 1998, the Accounting Standards Executive Committee
(AcSEC) of the American Institute of Certified Public Accountants (AICPA) issued
Statement of Position (SOP) 98-9 "Modification of SOP 97-2, Software Revenue
Recognition with Respect to Certain Transactions" which retained the restrictive
definition of what qualified for vendor specific objective evidence (VSOE) of
fair value for allocating a contract fee among the various elements of an
arrangement. VSOE must be known for all undelivered elements of an arrangement,
such as post-sales customer support (PCS). As permitted, the Company adopted the
provisions of SOP 98-9 effective October 1, 1998 and, accordingly, revenue on
non-cancelable and prepaid lease agreements is recognized monthly over the term
of the agreement, beginning in the fourth quarter of 1998, since the VSOE of
fair value required under SOP 97-2 to allocate the contract fee to the
undelivered PCS element of the arrangements is not available. This resulted in a
decrease in revenues that otherwise would have been recognized in the fourth
quarter since only a portion of the revenues related to annual lease agreements
was recognized. The revenue reduction was $9,398,000 compared to the amount of
revenue that would have been recognized under SOP 97-2. This revenue will be
recognized ratably over primarily the first three quarters of 1999. The effect
of this change for the fourth quarter of 1998 and subsequent periods is outlined
in the following table:
CY98 Q4 CY99 Q1 CY99 Q2 CY99 Q3 CY99 Q4 BEYOND
------------- ------------ ------------ ------------ ---------- ----------
Revenues........................
The Americas.................. $ (5,583,000) $ 1,665,000 $ 1,648,000 $ 1,622,000 $ 427,000 $ 221,000
Europe........................ (3,067,000) 904,000 866,000 846,000 390,000 61,000
Asia-Pacific.................. (748,000) 398,000 137,000 122,000 44,000 47,000
------------- ------------ ------------ ------------ ---------- ----------
Consolidated.................. $ (9,398,000) $ 2,967,000 $ 2,651,000 $ 2,590,000 $ 861,000 $ 329,000
------------- ------------ ------------ ------------ ---------- ----------
------------- ------------ ------------ ------------ ---------- ----------
Future quarters will also reflect the deferral of revenue associated with
non-cancelable and prepaid annual lease arrangements entered into in those
quarters under SOP 98-9. Because SOP 98-9 does not permit restatements of prior
periods and because there are annual license renewals in every month of the
year, the entire effect of this change in revenue recognition will not be fully
recognized in reported revenue on a quarterly basis until the fourth quarter of
1999. The year 2000 will be the first reported year that will reflect a full
twelve months of revenue under this method of revenue recognition for annual
licenses.
ASSET IMPAIRMENT AND RESTRUCTURING
The Company has consistently followed the policy of capitalizing software
development costs related to product development in accordance with the
guidelines established under Statement of Financial Accounting Standard (SFAS)
No. 86, "Accounting For the Costs of Computer Software to Be Sold, Leased or
Otherwise Marketed". Capitalized software costs are then amortized over a period
of time (expected
13
useful life) that is estimated to equate to the term during which meaningful
revenue from the related product is expected to be recognized. Previously
capitalized product development costs and projected revenues are reviewed
quarterly to determine if any impairment in value has occurred that would
require an adjustment in the carrying value or change in expected useful lives
under the guidelines established in SFAS No. 86 and SFAS No. 121, "Accounting
for the Impairment of Long Lived Assets and for Long Lived Assets to be Disposed
of." The Company recognizes impairment losses on long lived assets when
indicators of impairment are present and the undiscounted cash flows estimated
to be generated by those assets are less than the assets' carrying amounts.
Accordingly, during the fourth quarter of 1998, the Company recognized non-cash
pre-tax charges of $7,771,000 related to the write off of the net book value of
certain previously capitalized software development costs and $393,000 of other
impairment charges recorded in cost of revenues and a non-cash pre-tax charge of
$1,670,000 recorded as part of restructuring and other impairment charges
related to the write off of previously reported goodwill from the acquisition of
Silverado Software & Consulting. Refer to Note 3 in Notes to Consolidated
Financial Statements.
On February 3, 1999 the Company announced a new organizational structure
following a re-evaluation of its business strategy. The Company will now
emphasize the expansion of the software business into new markets and
value-added integration services. The new structure is designed to better serve
the existing customer base and at the same time address expanding growth
opportunities. The reorganization plan provides for a 10% reduction in the
Company's worldwide workforce (which is approximately 75 positions), and the
consolidation of 15 field offices. These changes will result in pre-tax charges
of approximately $5,900,000 in the first quarter of 1999. The charges consist of
severance costs of $3,200,000, costs related to facility consolidations of
$2,200,000 and other charges of $500,000. The Company anticipates these charges
will provide a reduction in its annual operating costs. The restructuring
liability at December 31, 1998 represents $695,000 of severance charges for
certain employee terminations that occurred in December 1998. The restructuring
and other impairment charges for 1998 of $2,365,000 include the severance cost
and the goodwill write-off discussed above.
ACQUISITION
In late December 1998, the Company acquired all of the outstanding stock of
Knowledge Revolution (KR). KR is the world's leading developer and distributor
of 2D and 3D-motion simulation software for design engineers and analysts. This
acquisition has allowed the Company to increase its product offerings to deliver
tools and expertise to the mid-range and desktop markets. The Company acquired
KR for approximately $19,200,000 in cash and the acquisition has been accounted
for under the purchase method of accounting. The total purchase price was
allocated to the assets and liabilities of KR based on their approximate fair
market value. A significant portion of the purchase price was identified in an
independent appraisal, using proven valuation procedures and techniques, as
intangible assets. The appraisal of the acquired business included $6,000,000 of
purchased in-process research and development (IPR&D). This acquired technology
had not yet reached technological feasibility and had no alternative future
uses. Accordingly, it was written off at the time of the acquisition. The
remaining purchase price was allocated as follows: $800,000 to net tangible
assets, $4,300,000 to developed technology, $5,200,000 to their value-added
reseller network, $390,000 to their assembled work force, and $2,510,000 to
goodwill. Goodwill and identified intangibles are being amortized between three
and ten years.
On the date of its acquisition, KR's technology was classified between core
or developed technology and IPR&D. Four KR products, one released and the others
under development, were identified and their reliance on the developed
technology and IPR&D was determined. The reliance on IPR&D ranged from 0% to 90%
on these products. IPR&D was further segmented into classifications of completed
and to-be-completed based on three criteria: (1) the estimated time required to
complete the development, (2) the estimated cost to complete and (3) the
complexity involved in overcoming technological obstacles that must be resolved
during development. The completion of development at the time of acquisition
ranged
14
from 39% to 72%. Management estimates the cost to complete this development
effort to be approximately $1,300,000 and the release of these products during
the second and third quarters of 1999.
These R&D valuations represent the five-year after tax cash flow of this
technology using a discount rate of 23% for developed technology and 28% for
IPR&D respectively. The discount rate is based upon the acquiring Company's
weighted average cost of capital (WACC) of 22%. This WACC was derived by
considering various factors to quantify the risk above a risk-free rate of
return of approximately 5%. The discount rate selected for the IPR&D was
determined to be significantly higher than the WACC due to the fact that the
technology had not yet reached technological feasibility as of the date of
acquisition.
In valuing both the developed technology and IPR&D, the initial focus was on
the revenue contribution generated by each of the products. Revenue estimates
were based on the following: (1) aggregate revenue growth rates for the business
as a whole, (2) individual product revenues, (3) growth rates for related
products, (4) anticipated product development and introduction schedules, (5)
product sales cycles and (6) the estimated useful life of a product's underlying
technology. The aggregate product revenue amounts were estimated and segregated
between the developed technology and IPR&D. Operating expenses were deducted
from the revenue estimates to arrive at operating income. Operating expenses
included cost of revenue, selling and marketing, and general and administrative
expenses but no non-cash charges such as depreciation and amortization. Certain
adjustments were made to operating income to derive the after-tax cash flow.
These adjustments included the calculation of an applicable tax expense and an
appropriate charge for the use of contributory assets necessary to generate
revenue and operating income associated with the subject intangible assets.
Management believes that the Company is positioned to complete development
of these KR products and expand the Company's market share in the growing
mid-range and desktop markets. However, there is risk associated with the
completion, marketing and ultimate sale of these products. There is no assurance
that any product will meet with either technological or commercial success. The
substantial delay or outright failure of these products could adversely impact
the Company's financial condition. Refer to Notes 3 and 4 in Notes to
Consolidated Financial Statements.
1998 VS. 1997
The Company reported revenue of $125,397,000 in 1998, compared to revenue of
$132,804,000 in 1997, a decrease of $7,407,000 or 6%. Revenue growth in 1998 was
adversely affected by the change in the Company's revenue recognition policy
effective October 1, 1998 and the strength of the U.S. Dollar compared to
foreign currencies in which the Company operates. Revenue in the current year
would have been approximately $127,374,000, if translated using prior year
foreign currency translation rates. Revenue would have been $134,795,000, if
recorded under previous revenue recognition policies, because the adoption of
SOP 98-9 in the fourth quarter of 1998 deferred $9,398,000 into subsequent
periods or $9,485,000, if valued using prior year foreign currency translation
rates. Software license revenue and maintenance fees account for 93% of total
reported revenue for the year ended December 31, 1998 and 96% for the year ended
December 31, 1997, with service revenue making up the difference.
Software license revenue consists of licensing fees, which are fees charged
for the right to use the Company's or a third parties' software. Maintenance and
services revenues include PCS and consulting services. PCS includes training,
telephone support, bug fixes and upgrade privileges on a when and-if available
basis. Services range from installation and basic consulting to software
modification and customization to meet specific customer needs. Software is sold
through monthly, annual or longer lease arrangements and through paid-up license
arrangements whereby the customer purchases a perpetual license for the use of
the Company's software.
15
The following table illustrates revenue by geographic region and the related
growth rates in functional currencies:
1998 FUNCTIONAL CURRENCY GROWTH RATE
% OF -----------------------------------------------------
TOTAL REVENUE WITH REVENUE CHANGE WITHOUT REVENUE CHANGE
--------------- ------------------------ ---------------------------
The Americas.................... 46% (3% ) 6%
Europe.......................... 32% 8% 16%
Asia-Pacific.................... 22% (17% ) (15% )
The increase in reported revenues in Europe resulted from higher volumes of
software licenses and related maintenance revenue. The decrease in reported
revenues from our Asia-Pacific region is due primarily to the economic turmoil
the region experienced during the past year and is not an indication of a
reduction in the Company's market share from the region. 16% of the Company's
total revenue for 1998 is directly related to the Japanese market, while 6% is
from the Asia-Pacific region outside of Japan. In light of the continued
economic turmoil in the region the Company remains cautious about its
Asia-Pacific prospects.
Of the 93% and 96% of the Company's revenues in 1998 and 1997, respectively,
that consisted of software license and maintenance revenue, approximately 79% in
1998 and 78% in 1997 of this revenue is derived from annual renewable leases and
recurring maintenance fees with the remaining 21% in 1998 and 22% in 1997
related to paid-up licenses.
The Company is exposed to the impact of foreign currency fluctuations. The
following table details the effect of the currency rate changes on revenue for
1998 and the risk of change in 1999. The trend exchange rate was determined by
prorating the rate change between 1997 and 1998 and is used to illustrate the
sensitivity to foreign currency fluctuations. The trend rate is for illustration
purposes only and may or may not reflect the actual translation rate in the
future period.
CY 1998 CY 1998 CY 1998
USING 1997 USING 1998 USING 98/97
EXCHANGE EXCHANGE TREND
REVENUES RATES RATES EXCHANGE RATE
- -------------------------------------------- ------------- ------------- ----------------
Europe...................................... $40,436,000 $39,875,000 $ 39,314,000
Asia-Pacific................................ 28,529,000 27,113,000 25,880,000
------------- ------------- ----------------
Total Revenue............................. $68,965,000 $66,988,000 $ 65,194,000
------------- ------------- ----------------
------------- ------------- ----------------
Exchange Rates:
$/DM...................................... 0.577 0.569 0.561
Yen/$..................................... 121.75 130.81 139.87
Operating expenses of $135,438,000 in 1998 includes both restructuring and
impairment costs in addition to on-going operating costs necessary for the
operation of the business, and represents an increase of $21,597,000, or 19%
from the $113,841,000 reported in 1997. Operating expenses included
restructuring and impairment costs and other unusual items consisting of: (1) a
$8,164,000 non-cash charge included in cost of revenues, (2) a $6,000,000
in-process research and development charge, (3) restructuring and other
impairment costs of $2,365,000 and (4) a gain from the reversal of a $1,157,000
of Post Retirement Health Care liability resulting from the termination of the
Post Retirement Health Care Plan. Without these charges and the gain, operating
expenses totaled $120,066,000 in 1998, an increase of $6,225,000 or 5% from the
$113,841,000 reported in 1997. This increase was primarily attributable to: (1)
a $3,325,000 increase in cost of revenue exclusive of the $3,200,000
reclassification of post-sales customer support expense, (2) a $3,488,000
increase in research and development cost including a $2,543,000 increase in the
gross research and development investment and a $945,000 decrease in capitalized
software costs, offset by (3) a $588,000 decrease in selling, general and
administrative expenses exclusive of the $3,200,000
16
reclassification of post-sales customer support expense and the gain from the
reversal of $1,157,000 of Post Retirement Health Care liability.
In accordance with the AICPA Statement of Financial Accounting Standards
(SFAS) No. 86, "Accounting for the Costs of Computer Software to be Sold,
Leased, or Otherwise Marketed," cost of revenue expense includes period expenses
directly related to revenue as well as the amortization of capitalized software
costs. Research and development expense is reported net of the amount
capitalized.
Cost of revenue of $46,255,000 in 1998 includes impairment costs in addition
to on-going operating costs necessary for the operation of the business. Cost of
revenue as a percent of revenue was 37% and 24% for 1998 and 1997, respectively
or 30% and 24% exclusive of the impairment charges. Impairment costs included a
charge of $7,771,000 against capitalized software and $393,000 of other non-cash
impairment charges. Capitalized software amortization decreased slightly to
$11,974,000 in 1998 from $12,043,000 in the prior year. Cost of revenues,
excluding these impairment charges was $38,091,000 for 1998 compared to
$31,566,000 for 1997, an increase of $6,525,000 or 21%. This increase resulted
from: (1) a $3,200,000 reclassification of post-sales customer support expense
from sales and marketing in 1998 and (2) a $3,300,000 increase in labor and
related costs. During 1998, the Company reclassified $3,200,000 of sales and
marketing expense to cost of revenue for post-sales customer support costs. The
increase in labor and related costs were related to increases in staffing and
the utilization of development and sales resources to support maintenance and
consulting activities. Royalty expense is also included in cost of revenue and
paid to third parties under various agreements. The Company does not consider
any royalty expense related to individual agreements to be material.
Gross margin, which is revenue less cost of revenue, was negatively impacted
by the Company's change in its revenue recognition policy and the increase in
its costs of revenue noted above. Gross margin was $79,142,000 or 63% of
revenues for the year ended December 31, 1998 as compared to $101,238,000 or 76%
of revenues for the year ended December 31, 1997 representing a decrease of
$22,096,000.
Research and development expense for the year ended December 31, 1998 was
$13,666,000 compared to $10,178,000 for the year ended December 31, 1997
representing an increase of $3,488,000, or 34%. The increase is the result of an
increase of $2,543,000 in the total gross investment in research and development
activities and a decrease of $945,000 in the amount of research and development
expenditures capitalized under SFAS 86.
The total gross investment in research and development activities for the
year amounted to $25,266,000 or 20% of current year revenue, compared to
$22,723,000, or 17% of revenue in the prior year. The total increase in the
gross research and development investment was $2,543,000, or 11%. This increase
resulted primarily from changes within the Company's product management in
staffing and staff mix related to a strategic revision in product development
activity. This shift in strategy de-emphasizes features upgrades for specific
products and promotes the development of technologies and integrated software
solutions for targeted customers. The Company's total development cost before
software capitalization was 20% of revenue for 1998 which remains consistent
with management's target of 20% of total annual revenues.
Capitalized software development costs were $11,600,000 in 1998 compared to
$12,545,000 in 1997, a decrease of $945,000, or 8%. The amount of product
development capitalized in any given period is a function of many factors
including the number of products under development at any point in time as well
as their stage of development. The Company's product development process is
continually under review to improve efficiency, product quality, and reduce time
to market. Due to the continual change in the product development process there
can be no assurance that the level of development capitalized in future periods
will be comparable to current capitalized levels.
Selling, general, and administrative expense was $64,884,000 in 1998
compared to $69,829,000 in 1997, a decrease of 7%. The $4,945,000 decrease was
primarily due to: (1) $3,200,000 of post-sales customer
17
support costs included in cost of revenue, and (2) a reduction of Post
Retirement Health Care expense of $280,000 and a gain from the reversal of a
$1,157,000 of Post Retirement Health Care liability resulting from the
termination of the Post Retirement Health Care Plan.
As with revenue, the Company's expenses are impacted by foreign currency
fluctuations. The following table details the effect of the currency rate
changes on operating expense for 1998 and the risk of change in 1999. The trend
exchange rate was determined by prorating the rate change between 1997 and 1998
and is used to illustrate the risk of foreign currency fluctuations. The trend
rate is for illustration purposes only and may or may not reflect the actual
translation rate in the future period.
CY 1998 CY 1998 CY 1998
USING 1997 USING 1998 USING 98/97
EXCHANGE EXCHANGE TREND
LOCAL OPERATING EXPENSES* RATES RATES EXCHANGE RATE
- -------------------------------------------- ------------- ------------- ----------------
Europe.................................... $25,030,000 $24,683,000 $ 24,336,000
Asia-Pacific.............................. 12,353,000 11,497,000 10,752,000
------------- ------------- ----------------
Total Local Operating Expense............... $37,383,000 $36,180,000 $ 35,088,000
------------- ------------- ----------------
------------- ------------- ----------------
Exchange Rates:
$/DM...................................... 0.577 0.569 0.561
Yen/$..................................... 121.75 130.81 139.87
- ------------------------
* Does not include U.S. based cost incurred on behalf of the International
Operations.
Operating income or loss, including software capitalization and
amortization, restructuring costs and impairment charges was a loss of
$10,041,000 in 1998 compared to income of $18,963,000 in 1997. The $29,004,000
decrease in operating income is primarily attributable to the decrease in gross
margin of $22,096,000, an increase in research and development expense of
$3,488,000, offset by a decrease in selling, general and administrative expense
of $4,945,000. The 1998 operating loss includes both effects of the Company's
adoption of SOP 98-9 in the fourth quarter of 1998 that deferred $9,398,000 of
revenue into subsequent periods and restructuring and impairment costs in
addition to on-going operating costs necessary for the operation of the
business. Restructuring and impairment costs included (1) a $8,164,000 non-cash
charge included in cost of revenues, (2) a $6,000,000 in-process research and
development charge, (3) restructuring and other impairment costs of $2,365,000
and (4) a gain from the reversal of a $1,157,000 Post Retirement Health Care
liability resulting from the termination of the Post Retirement Health Care
Plan. Without the effect of adoption of SOP 98-9, these charges and the gain,
operating income, including software capitalization and amortization would have
been $14,729,000 in 1998 compared to $18,963,000 in 1997, a decrease of 22%.
Debenture interest reflects the interest on the convertible subordinated
debentures issued as part of the acquisition of PDA Engineering in 1994.
Interest payments are due on March 15 and September 15 of each year until the
debentures are converted or redeemed.
Other income was $1,322,000 in 1998 compared to income of $474,000 in 1997.
The fluctuation is primarily attributable to an increase in interest and
investment income from $940,000 in 1997 to $1,651,000 in 1998, a change in
foreign exchange gains and losses from a loss of $502,000 in 1997 to a gain of
$295,000 in 1998 and a $110,000 decrease in gains and losses on the sale of
property, plant and equipment. The Company anticipates that interest and
investment income will decrease in 1999 as a result of the decrease in cash
balances following the acquisition of Knowledge Revolution. Other income also
includes other non-operating income.
The effective tax rate for the year was a benefit of 1% compared to a
provision of 34% in 1997. The expected benefit in 1998 was reduced due to
foreign losses not benefited, and certain non-deductible charges related to the
write off of the Silverado Software & Consulting goodwill and acquired
in-process technology of Knowledge Revolution.
18
Net loss was ($12,979,000) in 1998 compared to net income of $9,887,000 in
1997, a decrease of $22,866,000. The decline in net income was less than the
operating income decline due to an increase of $848,000 of other income for
1998. Net income in 1998 was unfavorably affected by fluctuations in functional
currencies used in the Company's international operations. The fluctuation of
the U.S. Dollar versus these currencies could continue to have an unfavorable
effect throughout 1999 and future years. The effect of foreign currency
translation on net income in 1998 was immaterial.
1997 VS. 1996
The Company reported revenue of $132,804,000 for 1997, compared to revenue
of $132,081,000 for 1996, a 1% increase. The 1997 revenue growth was adversely
affected by the strength of the U.S. Dollar compared to foreign currencies in
which the company operates. Revenue in the current year would have been
approximately $141,050,000 or 7% more than 1996, if valued using prior year
foreign currency translation rates. Software license revenue and maintenance
fees account for 96% of total reported revenue for 1997 and 1996, with service
revenue making up the difference.
Software revenue consists of licensing fees, which are fees charged for the
right to use the software, and maintenance fees, which provide for support and
upgrade privileges, which are generally 15% of the license fees. In accordance
with SOP 91-1, "Software Revenue Recognition" issued in 1991 revenue associated
with support and upgrade privileges was consistently deferred and recognized
over the term of the license agreement in 1997 and 1996.
The following table illustrates revenue by geographic region and the related
growth rates in functional currencies:
% OF 1997 FUNCTIONAL CURRENCY
TOTAL REVENUE GROWTH RATE
--------------- ----------------------------
The Americas......................................... 46% 7%
Europe............................................... 28% 7%
Asia-Pacific......................................... 26% 11%
The increase in reported revenues in Asia-Pacific resulted from higher
volumes of software licenses and related maintenance revenue. 17% of the
Company's total revenue in 1997 was directly related to the Japanese market,
while 9% was from the Asia-Pacific region outside of Japan.
Of the 96% of the Company's revenues in both 1997 and 1996, that consisted
of software license and maintenance revenue, approximately 78% in 1997 and 80%
in 1996 of this revenue is derived from annual renewable leases and recurring
maintenance fees with the remaining 22% in 1997 and 20% in 1996 related to
paid-up licenses.
The Company is exposed to the impact of foreign currency fluctuations. The
following table details the effect of the currency rate changes on revenue for
1997:
CY 1997 CY 1997
USING 1996 USING 1997
EXCHANGE EXCHANGE
REVENUES RATES RATES
- --------------------------------------------------------------- ------------- -------------
Europe......................................................... $43,235,000 $37,514,000
Asia-Pacific................................................... 37,489,000 34,964,000
------------- -------------
Total Revenue................................................ $80,724,000 $72,478,000
------------- -------------
------------- -------------
Exchange Rates:
$/DM......................................................... 0.665 0.577
Yen/$........................................................ 109.50 121.75
In addition to the currency impact, 1997 revenue growth was also adversely
affected by the sale of the electromagnetic product line in July 1996, which
contributed revenues of $2,459,000 in 1996.
19
Operating expense of $113,841,000 in 1997 increased by less than 1% from
$113,396,000 reported in 1996. The increase was attributable to an increase of
$11,140,000 in cost of revenue, an increase of $2,445,000 in selling, general
and administrative expense, offset by a decrease of $13,006,000 in the net cost
of research and development.
In accordance with the SFAS 86, cost of revenue expense includes period
expenses directly related to revenue as well as the amortization of capitalized
software costs. Research and development expense is reported net of the amount
capitalized.
Cost of revenue was $31,566,000 for 1997 compared to $20,426,000 for 1996,
an increase of $11,140,000, or 55%. Cost of revenue as a percent of revenue was
24% and 15% for 1997 and 1996, respectively. This increase included $4,507,000
of additional amortization of capitalized software and a $6,633,000 increase in
other costs of revenue. Capitalized software amortization increased to
$12,043,000 in 1997 from $7,536,000 in the prior year. The change in other costs
of revenue was due to: (1) a $4,166,000 increase in sales commissions to third
parties, (2) a $3,249,000 increase in labor and related costs related to
increases in staffing and the utilization of development and sales resources to
support maintenance and consulting activities, offset by (3) a $417,000 decrease
in product, packaging and delivery costs and offset by (4) a $365,000 decrease
in royalty expense. Royalty expense is also included in cost of revenue and paid
to third parties under various agreements. The Company does not consider any
royalty expense related to individual agreements to be material.
Gross margin, which is revenue less cost of revenue, was $101,238,000 or 76%
of revenues for the year ended December 31, 1997 as compared to $111,655,000 or
85% of revenues for the year ended December 31, 1996 representing a decrease of
$10,417,000. The decrease is due to the Company's increase in its costs of
revenue noted above.
Research and development expense in 1997 was $10,178,000 compared to
$23,184,000 for the year ended December 31, 1996 representing a decrease of
$13,006,000, or 56%. The decrease is the result of a decrease of $8,536,000 in
the total gross investment in research and development activities and by an
increase of $4,470,000 in the amount of research and development expenditures
capitalized under SFAS 86.
The total gross investment in research and development activities for the
year amounted to $22,723,000, or 17% of current year revenue, compared to
$31,259,000, or 24% of revenue in the prior year. The total decrease in the
gross research and development investment between the years was $8,536,000, or
27%. This decrease resulted primarily from changes within the Company's product
management in staffing and staff mix related to a strategic revision in product
development activity. This shift in strategy de-emphasizes features upgrades for
specific products and promotes the development of integrated software solutions
for targeted customers. The changes are in line with the Company's goals and
objectives for research and development.
Capitalized software development costs were $12,545,000 in 1997 compared to
$8,075,000 in 1996, an increase of $4,470,000, or 55%. The amount of product
development capitalized in any given period is a function of many factors
including the number of products under development at any point in time as well
as their stage of development. The Company's product development process is
continually under review to improve efficiency, product quality, and reduce time
to market. Due to the continual change in the product development process there
can be no assurance that the level of development capitalized in future periods
will be comparable to current capitalized levels.
Selling, general, and administrative expense in 1997 was $69,829,000
compared to $67,384,000 in 1996, an increase of less than 4%. The increase
relates primarily to expanded worldwide staffing requirements in the sales and
distribution area and was part of the change in customer focus implemented
during 1997.
20
As with revenue, the Company is exposed to the impact of foreign currency
fluctuations related to expenses. The following table details the effect of the
currency rate changes on operating expense for 1997:
CY 1997 CY 1997
USING 1996 USING 1997
EXCHANGE EXCHANGE
LOCAL OPERATING EXPENSES* RATES RATES
- --------------------------------------------------------------- ------------- -------------
Europe....................................................... $24,648,000 $21,386,000
Asia-Pacific................................................. 15,066,000 13,550,000
------------- -------------
Total Local Operating Expense.................................. $39,714,000 $34,936,000
------------- -------------
------------- -------------
Exchange Rates:
$/DM......................................................... 0.665 0.577
Yen/$........................................................ 109.50 121.75
- ------------------------
* Does not include U.S. based cost incurred on behalf of the International
Operations.
Operating income, including software capitalization and amortization was
$18,963,000 in 1997 compared to $18,685,000 in 1996, an increase of 1%. The
$278,000 increase in operating income is primarily attributable to the decrease
in research and development expense of $13,006,000 offset by a decrease in the
Company's gross margin of $10,417,000 and an increase in selling, general and
administrative expense of $2,445,000.
Debenture interest reflects the interest on the convertible subordinated
debentures issued as part of the acquisition of PDA Engineering in 1994.
Interest payments are due on March 15 and September 15 of each year until the
debentures are converted or redeemed.
Other income was $474,000 in 1997 compared to income of $157,000 in 1996.
The fluctuation is primarily attributable to an increase in interest and
investment income from $750,000 in 1996 to $940,000 in 1997 and an increase in
foreign exchange gains from a loss of $397,000 in 1996 to a loss of $502,000 in
1997. Other income also includes gains and losses on sales of assets and other
non-operating income.
The effective tax rate for the year was 34% compared to 32.5% in 1996. This
change reflects a decrease of $419,000 in income tax expense on a year to year
basis.
Net income was $9,887,000 in 1997 compared to $9,711,000 in 1996, an
increase of 2%. The increase in net income was less than the operating income
increase due to an increase in the Company's other income for 1997. Net income
in 1997 was unfavorably affected by fluctuations in functional currencies used
in the Company's international operations. The fluctuation of the U.S. Dollar
versus these currencies could continue to have an unfavorable effect in future
years. The effect of foreign currency translation on net income using the 1997
tax rate of 34% was an unfavorable variance of approximately $2,300,000 if
valued using prior year foreign currency translation rates.
COMPANY TRENDS
On February 3, 1999 the Company announced a new organizational structure
following a re-evaluation of its business strategy. The Company will now
emphasize the expansion of the software business into new markets and
value-added integration services. The new structure is designed to better serve
the existing customer base and at the same time address expanding growth
opportunities.
The new organization includes the Working Knowledge Division, the result of
the Company's acquisition of KR in December 1998. KR is the world's leading
developer and distributor of 2D and 3D-motion simulation software for design
engineers and analysts. The acquisition of KR created the Company's newest
product line, MSC.Working Model. MSC.Working Model is linked to popular
mid-range CAD systems such as SolidWorks, Autodesk's Mechanical Desktop, and
SolidEdge, and answers the questions "Will it break?" and "Will it work?" by
providing stress and motion analysis capabilities. The Company expects that
these changes to its organizational structure will allow the Company to continue
its leadership in the high-end market and deliver tools and expertise to the
mid-range and desktop markets.
21
During March 1999, the Company created the Engineering-e.com group. This group
will provide a full-service engineering software and solutions marketplace on
the Internet. Additionally, Engineering-e.com will provide the e-commerce
channel for selected Company products.
OPERATING PATTERN
The change in year-end to December 31 and the adoption of SOP 98-9 in the
fourth quarter of 1998 both have a significant effect on the operating pattern
of the Company. The month of January has historically been the largest revenue
month of the year with the highest volume of renewals.
Under SOP 98-9 the Company will be recognizing its software lease revenue on
a monthly basis over the term of the licenses. This change will reduce the
volatility of the revenue stream for interim accounting periods of the Company.
In addition, because the SOP does not permit restatements of prior periods and
because there are annual license renewals in every month of the year, the entire
effect of this change in revenue recognition will not be fully recognized in
reported revenue on a quarterly basis until the fourth quarter of 1999. The year
2000 will be the first reported year that will reflect a full twelve months of
revenue under this method of revenue recognition for annual licenses.
The Company anticipates that revenue for 1999 will also be affected by
having a full-year of operations of the Working Knowledge Division, which was
created in December 1998.
Effective January 1, 1999 the Company has changed the estimated useful life
of its capitalized software assets from three and four years to two and three
years. The Company has always estimated the expected life of these assets based
on the release cycle of its products. The Company believes that as software
production cycles decrease, amortization periods should also decrease in order
to coincide with a version's revenue stream. The Company is making this change
prospectively. Due to the continual change in the product development process
there can be no assurance that the level of development capitalized in future
periods will be comparable to current capitalized levels. Therefore the effect
of this change is not determinable.
LIQUIDITY AND CAPITAL RESOURCES
Working capital needed to finance the Company's growth in the past has been
provided by cash on hand and cash flow from operations. Management believes that
cash generated from operations and the unused portion of its line of credit will
continue to provide sufficient capital for normal working capital needs in the
foreseeable future. Net cash provided by operating activities was $27,197,000
and $18,769,000 in 1998 and 1997, respectively. The Company's working capital at
December 31, 1998 was $21,736,000, compared to $39,053,000 at December 31, 1997.
Cash outlays in conjunction with the $6,595,000 restructuring charge
anticipated in the first quarter of 1999 are estimated to be $948,000. These
outlays are to be completed by the end of 1999, excluding certain lease
commitments that may continue through January 2000.
The Company expended approximately $19.2 million of cash in connection with
the acquisition of KR. The acquisition adversely affected the Company's working
capital position and its cash reserves.
At March 31, 1999, the Company had an agreement with its principal bank for
a $15,000,000 unsecured line of credit. The Company drew down on its line of
credit in the amount of $10,800,000 late in the fourth quarter of 1998 in lieu
of having to liquidate a portion of its securities held for sale portfolio. The
line of credit bears interest at the bank's prime rate of interest with an
option to fix the rate at LIBOR plus 1.9% for a period of 179 days. The interest
rate was fixed under the LIBOR option at December 31, 1998 at 7% with interest
payments due monthly. The line of credit matures in July 2000. The Company is in
violation of certain covenants under the line of credit at December 31, 1998 and
March 31, 1999. The Company is in the process of negotiating a new line of
credit agreement.
The Company issued convertible subordinated debentures in August 1994, in
connection with its PDA acquisition, in the aggregate amount of approximately
$56,608,000. The debentures bear interest at 7 7/8%
22
with interest payments due semi-annually in March and September. Debenture
interest payments were made in both March 1998 and September 1998 totaling
$4,456,000. The amount of interest expense will decrease if the debentures are
converted into common stock. The debentures mature in August 2004 and are
convertible into common stock at a price of $15.15 per share.
Management expects to continue to invest a substantial portion of the
Company's revenues in the development of new computer software technologies and
products and the enhancement of certain existing products. The Company expended
a total of $25,266,000 and $22,723,000 for the year ended December 31, 1998 and
1997, respectively, on development efforts, of which $11,600,000 and
$12,545,000, respectively, were capitalized. Product development costs and the
capitalization rate may vary depending, in part, on the number of products and
the stage of development of the products in process.
During 1998 and 1997, the Company acquired $6,003,000 and $3,993,000,
respectively, of new property and equipment. Capital expenditures included
upgrades in computer equipment in order to keep current with technological
advances and upgrades of facilities worldwide. The Company's capital
expenditures vary from year to year, as required by business needs. The Company
intends to continue to expand the capabilities of its computer equipment used in
the development and support of its proprietary software products. Management
expects expenditures for property and equipment in 1999 and 2000 to be
consistent with those for 1998.
In 1998, the Company's Board of Directors had authorized the repurchase of
common stock in the open market for up to a total aggregate amount of
$3,000,000. The Company repurchased approximately $2,226,000 of common stock in
1998 before this authorization was rescinded.
On March 9, 1998, the Company entered into a joint-development and marketing
arrangement with Kubota Solid Technology Corporation (KSTC). This arrangement
allows KSTC to purchase warrants with an aggregate exercise price of up to
$3,000,000 to purchase shares of the Company's common stock. The exercise price
is equal to the fair market value of the common stock on the date of issuance of
the warrants. The warrants are non-transferable, have a five-year term and
become exercisable two years after the date of issuance. The arrangement also
provides KSTC with marketing rights to a specific technology being developed.
For the year ended December 31, 1998, the Company has recorded $944,000 of
service revenue related to the development effort and marketing rights provided
under the arrangement and issued warrants to KSTC valued at $556,000 to purchase
185,843 shares of the Company's common stock. The warrants were recorded at fair
value under the Black Scholes valuation method. The warrants issued have
exercise prices ranging between $6.188 per share and $11.375 per share. KSTC has
the right to purchase additional warrants with an aggregate exercise price of
$1,500,000 through December 31, 1999 under the arrangement.
The Company has no obligation under the arrangement to produce a
commercially viable product or technology or to refund any monies contributed by
KSTC.
In September 1998, the Company acquired all of the stock of Silverado
Software & Consulting, Inc., (SSC) for approximately 222,200 shares of common
stock valued at $6.9375 per share or $1,542,000, a promissory note of $331,000
due March 2000 and cash of $936,000 for a total purchase price of $2,809,000.
Net assets acquired included cash and securities available for sale of
approximately $945,000. There was no net cash outlay for the SSC acquisition
because the cash and securities available for sale received in the purchase
approximated the cash paid.
The Company sold its Electromagnetic Business Unit (EBU) to Ansoft
Corporation for $5,600,000 in July 1996, which did not result in a material
effect on earnings. The sale of the unit did not materially affect 1996 net
income compared to prior years because of the relatively small size compared to
the Company's overall operations. However, the sale did significantly improve
both the Company's cash position and its cash used in investing activities,
compared to prior years.
23
During the middle of 1996, the Company eliminated its quarterly dividend in
order to reinvest more of its earnings into its operations. Dividend payments
were made on the Company's common stock in the aggregate amounts of $5,111,000
in the year ended December 31, 1996. The Company does not plan to reinstate the
payment of dividends in the foreseeable future.
IMPACT OF YEAR 2000
The Company has determined that the purchased software applications and
internally developed software applications that are used internally are Year
2000 compliant. The Company has initiated formal communications with all its
significant suppliers and large customers to determine the extent to which the
Company's internal applications and other interface systems are vulnerable to
those third parties' failure to remediate their own Year 2000 issues. The
Company has assessed that potential problems associated with embedded technology
do not represent a significant area of risk relative to Year 2000 readiness due
to the nature of Company's operations and its use of non-information technology
systems (i.e. embedded technology such as microcontrollers). The Company's
operations do not include capital-intensive equipment with embedded
microcontrollers. However, there is no guarantee that other systems or equipment
of other companies on which the Company's systems rely will be timely converted
and would not have an adverse effect on the Company's systems.
The Company expects to complete its contingency planning for the most
reasonably likely worst case scenarios by August 1999. Depending on the systems
affected, these plans could include: (1) accelerated replacement of affected
equipment or software, (2) short to medium-term use of back-up equipment and
software, (3) increased work hours for Company personnel or use of contract
personnel to correct on an accelerated schedule any Year 2000 issues which arise
or to provide manual workarounds for information systems or (4) other similar
approaches. If the Company is required to implement any of these contingency
plans, such plans could have a material adverse effect on the Company's
business, financial condition or results of operations.
During 1998, the Company made significant progress in its' Year 2000
compliance testing on the software that is sold to customers. The tests certify
that our currently supported products will operate and correctly process dates
over a supported date range which extends from before January 1, 2000 and
encompasses a time period reasonably suitable for the intended use of the
product. Substantially all of the Company's products licensed after January 1,
1998 are Year 2000 compliant. Compliance letters for each product containing
Year 2000 compliance details are posted at the Company's web site at URL
http://www.mscsoftware.com. The Company's policy, in accordance with GAAP, is to
expense as incurred the cost of maintenance and modification to existing
systems, and to capitalize the cost of any new software or hardware and amortize
that cost over the assets' estimated useful lives. The incremental cost of the
modifications to achieve compliance was immaterial to operating results.
Finally, the Company is also subject to external forces that might generally
affect industry and commerce, such as utility or manufacturing company Year 2000
compliance failures and related service and production interruptions.
Furthermore, the purchasing patterns of analysts and designers may be affected
by Year 2000 issues as companies expend significant resources to correct their
current systems for Year 2000 compliance. The Company does not currently have
any information about the Year 2000 status of its customers. However, these
expenditures may result in constant or reduced revenues, which could have a
material adverse effect on the Company's business, results of operations, and
financial condition.
Based on the actions taken to date as discussed above, the Company is
reasonably certain that it has or will identify all Year 2000 issues that could
materially adversely affect its business and operations. The cost of this study
has been immaterial.
EURO CONVERSION
On January 1, 1999, eleven of the fifteen member countries of the European
Union (the "participating countries") established fixed conversion rates between
their existing sovereign currencies (the "legacy
24
currencies") and the Euro currency, adopting the Euro as their common legal
currency on that date. The legacy currencies are scheduled to remain legal
tender in the participating countries as denominations of the Euro between
January 1, 1999 and January 1, 2002. During this transition period, public and
private parties may pay for goods and services using either the Euro or the
participating country's legacy currency on a "no compulsion, no prohibition"
basis whereby recipients must accept Euros or the legacy currency as offered by
the payer. A currency translation process known as triangulation dictates how
legacy currencies are converted to the Euro and other legacy currencies.
Beginning January 1, 2002, the participating countries will issue new
Euro-denominated bills and coins and replace the legacy currencies as legal
tender in cash transactions by July 1, 2002.
Because the Company conducts a significant portion of its business in Europe
through its wholly owned German subsidiary, its business and operations will be
affected by the Euro conversion. Management is addressing the Euro conversion,
but its impact on future operating results is uncertain. Management expects the
conversion to decrease pressure for pricing in legacy currencies in the
participating countries. However, the Company also does business in many
non-participating countries including the United Kingdom. This could lead to an
increase in cross-border competition, which could affect its allocation of
resources within Europe, and eventually the Company's labor cost.
The Company is implementing an upgrade to its management information system
which includes the ability to simultaneously record transactions in Euros,
perform the prescribed currency conversion computations and convert legacy
currency amounts to Euro. The impact of the conversion on the Company's currency
risk and taxable income is not expected to be significant. In regard to
contracts denominated in legacy currencies, management has not identified any
third party or customer contracts whose performance might be considered
unenforceable due to a currency substitution. Software lease and maintenance
contracts are typically renewed on an annual basis.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued Statement No.
133, Accounting for Derivative Instruments and Hedging Activities, which is
required to be adopted in years beginning after June 15, 1999. Because of the
Company's minimal use of derivatives, management does not anticipate that the
adoption of the new Statement will have a significant effect on earnings or the
financial position of the Company.
INFLATION
Inflation in recent years has not had a significant effect on the Company's
business.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company is exposed to the impact of foreign currency fluctuations and
interest rate changes.
FOREIGN CURRENCY RISK As discussed above, international revenues are 57% of
the Company's total revenues. International sales are made mostly from the
Company's two foreign sales subsidiaries in Germany and Japan and are typically
denominated in the local currency of each country. These subsidiaries also incur
most of their expenses in the local currency. Accordingly, all foreign
subsidiaries use the local currency as their functional currency.
The Company's international business is subject to risks typical of an
international business, including, but not limited to differing economic
conditions, changes in political climate, differing tax structures, other
regulations and restrictions, and foreign exchange rate volatility. Accordingly,
the Company's future results could be materially adversely impacted by changes
in these or other factors.
The Company's exposure to foreign exchange rate fluctuations arises in part
from inter-company accounts in which cash from sales of the Company's foreign
subsidiaries costs are transferred back to the United States. These
inter-company accounts are typically denominated in the functional currency of
the foreign subsidiary in order to centralize foreign exchange risk with the
parent company in the United
25
States. The Company is also exposed to foreign exchange rate fluctuations as the
financial results of foreign subsidiaries are translated into U.S. Dollars in
consolidation. As exchange rates vary, these results, when translated, may vary
from expectations and adversely impact overall expected profitability. The
effect of foreign exchange rate fluctuations on the Company in 1998 was not
material.
The Company enters into forward exchange contracts to hedge certain
anticipated repayments of its inter-company debt with its foreign subsidiaries.
The forward exchange contracts do not qualify as a hedge for financial reporting
purposes and, accordingly, unrealized gains or losses based on the current
forward foreign exchange rates are reflected directly in income. At December 31,
1998, the Company had two forward exchange contracts maturing in January and
February 1999 to exchange a total of 4,000,000 Deutsche Marks for U.S. Dollars
in the amount of approximately $2,500,000. At December 31, 1997, the Company had
two forward exchange contracts maturing in January and February 1998 to exchange
a total of 4,000,000 Deutsche Marks for U.S. Dollars in the amount of
approximately $2,400,000. The unrealized gains were immaterial at December 31,
1998 and 1997.
INTEREST RATE RISK The Company's exposure to market rate risks for changes
in interest rates relate to both the Company's investment portfolio and its
outstanding borrowings under its line of credit. Refer to Note 5 of Notes to the
Consolidated Financial Statements.
The Company has not used derivative financial instruments in its investment
portfolio. The Company invests its excess cash primarily in debt instruments of
U.S. municipalities and other high-quality issuers and, by policy, limits amount
of credit exposure to any one issuer. The Company protects and preserves its
invested funds by limiting default, market and reinvestment risk. The following
table is a summary of available-for-sale securities:
FAIR MARKET VALUE FAIR MARKET VALUE
----------------- % RATE ----------------- % RATE OF
DECEMBER 31, 1998 OF RETURN DECEMBER 31, 1997 RETURN
----------------- ----------- ----------------- -----------
DOLLARS IN THOUSANDS
Municipal securities............ $ 15,782 5.8% $ 15,752 4.6%
Other debt securities........... 699 6.4% 331 5.9%
------- -------
$ 16,481 $ 16,083
------- -------
------- -------
Investments in both fixed rate and floating rate interest earning
instruments carries a degree of interest rate risk. Fixed rate securities may
have their fair market value adversely impacted due to a rise in interest rates,
while floating rate securities may produce less income than expected if interest
rates fall. Due in part to these factors, the Company's future investment income
may fall short of expectations due to changes in interest rates or the Company
may suffer losses in principal if forced to sell securities which have declined
in market value due to changes in interest rates.
The Company's line of credit is available at the variable interest rate of
prime, with an option to fix the rate at LIBOR plus 1.9% for a period of 179
days. As of December 31, 1998, the Company's balance was $10,800,000.
26
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
THE MACNEAL-SCHWENDLER CORPORATION
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
ASSETS
1998 1997
------------ ------------
Current assets:
Cash and cash equivalents........................... $ 10,822,000 $ 10,846,000
Securities available for sale....................... 16,481,000 16,083,000
Accounts receivable, net............................ 39,674,000 38,204,000
Deferred tax charges................................ 6,288,000 3,416,000
Other current assets................................ 7,866,000 7,073,000
------------ ------------
Total current assets............................ 81,131,000 75,622,000
Property and equipment, net........................... 8,895,000 8,526,000
Capitalized software costs, net....................... 21,034,000 27,866,000
Goodwill, net......................................... 11,146,000 10,076,000
Other intangibles, net................................ 12,850,000 4,071,000
Other assets.......................................... 3,773,000 2,892,000
------------ ------------
$138,829,000 $129,053,000
------------ ------------
------------ ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable.................................... $ 3,159,000 $ 2,066,000
Line of credit...................................... 10,800,000 --
Accrued liabilities:
Compensation and related expenses................. 6,412,000 6,135,000
Contribution to profit sharing plan............... 1,796,000 2,791,000
Restructuring reserve............................. 695,000 --
Other............................................. 14,302,000 13,947,000
Deferred income..................................... 20,903,000 10,267,000
Income taxes payable................................ 1,328,000 1,363,000
------------ ------------
Total current liabilities....................... 59,395,000 36,569,000
Deferred income taxes................................. 5,173,000 7,765,000
Convertible Subordinated Debentures................... 56,574,000 56,574,000
Commitments and contingencies
Shareholders' equity:
Preferred Stock, $0.01 par value, 10,000,000 shares
authorized; no shares outstanding in 1998 and
1997.............................................. -- --
Common Stock, $0.01 par value, 100,000,000 shares
authorized; 13,710,700 and 13,570,400 issued and
outstanding in 1998 and 1997, respectively........ 32,310,000 31,052,000
Retained earnings (deficit)......................... (11,404,000) 1,575,000
Other comprehensive income (loss)................... (3,219,000) (4,482,000)
------------ ------------
Total shareholders' equity...................... 17,687,000 28,145,000
------------ ------------
$138,829,000 $129,053,000
------------ ------------
------------ ------------
See accompanying notes.
27
THE MACNEAL-SCHWENDLER CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
1998 1997 1996
-------------- -------------- --------------
Revenues:
Software licenses............................................. $ 89,077,000 $ 102,889,000 $ 107,000,000
Software maintenance and services............................. 36,320,000 29,915,000 25,081,000
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Total revenues.............................................. 125,397,000 132,804,000 132,081,000
Operating expenses:
Cost of revenue............................................... 46,255,000 31,566,000 20,426,000
Amortization of goodwill and other intangibles................ 2,268,000 2,268,000 2,402,000
Research and development...................................... 13,666,000 10,178,000 23,184,000
Selling, general, and administrative.......................... 64,884,000 69,829,000 67,384,000
Acquired in-process technology................................ 6,000,000 -- --
Restructuring and other impairment charges.................... 2,365,000 -- --
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Total operating expenses.................................... 135,438,000 113,841,000 113,396,000
Operating income (loss)......................................... (10,041,000) 18,963,000 18,685,000
Debenture interest.............................................. 4,456,000 4,456,000 4,456,000
Other income, net............................................... (1,322,000) (474,000) (157,000)
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Income (loss) before income taxes............................... (13,175,000) 14,981,000 14,386,000
Provision (benefit) for income taxes............................ (196,000) 5,094,000 4,675,000
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Net income (loss)............................................... $ (12,979,000) $ 9,887,000 $ 9,711,000
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Basic earnings (loss) per share................................. $ (0.95) $ 0.73 $ 0.72
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