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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

R

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 31, 2014

OR

£

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________________ to _________________________

 

Commission file number  0-22823

QAD Inc.

(Exact name of Registrant as specified in its charter)

100 Innovation Place, Santa Barbara, California  93108

(Address of principal executive offices)

(805) 566-6000

(Registrant's telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such 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 R  No £.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes R  No £.

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.  (Check One):

 

Large accelerated filer £	Accelerated filer R
Non-accelerated filer £  (Do not check if a smaller reporting company)	Smaller reporting company £

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes £  No R.

As of August 31, 2014, there were 12,860,103 shares of the Registrant's Class A common stock outstanding and 3,188,353 shares of the Registrant's Class B common stock outstanding.

 

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QAD INC.

INDEX

 

EXHIBIT 31.1

EXHIBIT 31.2

EXHIBIT 32.1

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PART I

ITEM 1 – FINANCIAL STATEMENTS

QAD INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

See Accompanying Notes to Condensed Consolidated Financial Statements.

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QAD INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

(in thousands, except per share data)

(unaudited)

See Accompanying Notes to Condensed Consolidated Financial Statements.

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QAD INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See Accompanying Notes to Condensed Consolidated Financial Statements.

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QAD INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1.	BASIS OF PRESENTATION AND RECENT ACCOUNTING PRONOUNCEMENTS

Basis of Presentation

In the opinion of management, the accompanying unaudited Condensed Consolidated Financial Statements fairly present the financial information contained therein. These statements have been prepared in accordance with generally accepted accounting principles ("GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In management's opinion, all necessary adjustments, consisting of normal, recurring and non-recurring adjustments, have been included in the accompanying Condensed Consolidated Financial Statements to present fairly the financial position and operating results of QAD Inc. ("QAD" or the "Company"). The Condensed Consolidated Financial Statements do not include all disclosures required by accounting principles generally accepted in the United States of America for annual financial statements and should be read in conjunction with the audited financial statements and related notes included in the Company's Annual Report on Form 10-K for the year ended January 31, 2014. The Condensed Consolidated Financial Statements include the results of the Company and its wholly owned subsidiaries. The results of operations for the three and six months ended July 31, 2014 are not necessarily indicative of the results to be expected for the year ending January 31, 2015.

Recent Accounting Pronouncements

In July 2013, the FASB issued ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists ("ASU 2013-11"), which requires an unrecognized tax benefit to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, similar tax loss, or a tax credit carryforward. To the extent the tax benefit is not available at the reporting date under the governing tax law or if the entity does not intend to use the deferred tax asset for such purpose, the unrecognized tax benefit should be presented as a liability and not combined with deferred tax assets. ASU 2013-11 was effective for and adopted by the Company in the first quarter of fiscal 2015 and was applied prospectively to unrecognized tax benefits that existed at the effective date. The adoption of ASU 2013-11 impacted the Company's financial statement presentation and disclosures, but otherwise did not impact the Company's condensed consolidated results of operations or cash flows.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers ("ASU 2014-09"). ASU 2014-09 provides principles for recognizing revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will be effective for the Company's fiscal year beginning February 1, 2017. Early adoption is not permitted. The standard permits the use of either the retrospective or cumulative transition method. The Company is currently evaluating the accounting, transition and disclosure requirements of the standard and cannot currently estimate the financial statement impact of adoption.

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2.	COMPUTATION OF NET INCOME (LOSS) PER SHARE

The following table sets forth the computation of basic and diluted net income (loss) per share:

Potential common shares consist of the shares issuable upon the release of restricted stock units ("RSUs") and the exercise of stock appreciation rights ("SARs"). The Company's unvested RSUs are not considered participating securities as they do not have rights to dividends or dividend equivalents prior to release. In addition, the Company's unexercised SARs are not considered participating securities as they do not have rights to dividends or dividend equivalents prior to exercise.

The following table sets forth the number of potential common shares not included in the calculation of diluted net income (loss) per share because their effects were anti-dilutive:

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3.	FAIR VALUE MEASUREMENTS

When determining fair value, the Company uses a three-tier value hierarchy which prioritizes the inputs used in measuring fair value. Whenever possible, the Company uses observable market data. The Company relies on unobservable inputs only when observable market data is not available. Classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. The assessment of the significance of a particular item to the fair value measurement in its entirety requires judgment, including the consideration of inputs specific to the asset or liability.

 

·

Level 1 - Money market mutual funds are recorded at fair value based upon quoted market prices.

·

Level 2 - The asset or liability related to the interest rate swap is recorded at fair value based upon a valuation model that uses relevant observable market inputs at quoted intervals, such as forward yield curves.

·

Level 3 - The contingent liability associated with the acquisition of CEBOS is recorded at fair value based on significant inputs that are not observable in the market. This measure includes an assessment of the probability of achieving certain milestones and discounting the amount of each potential payment based on expected timing of the payment. Key assumptions include a discount rate of 4.6%, probability of achieving profitability and probability of achieving product development goals. There is one remaining future payment due April 2015 which consists of a guaranteed payment of $0.3 million and $0.5 million contingent upon certain milestones.

The following table sets forth the financial assets, measured at fair value, as of July 31, 2014 and January 31, 2014:

 

Money market mutual funds are classified as part of "Cash and equivalents" in the accompanying Condensed Consolidated Balance Sheets. In addition, the amount of cash and equivalents, including cash deposited with commercial banks, was $20 million and $19 million as of July 31, 2014 and January 31, 2014, respectively.

The Company's line of credit and notes payable both bear a variable market interest rate commensurate with the Company's credit standing. Therefore, the carrying amounts outstanding under the line of credit and note payable reasonably approximate fair value based on Level 2 inputs.

There have been no transfers between fair value measurements levels during the six months ended July 31, 2014.

Derivative Instruments

The Company entered into an interest rate swap in May 2012 to mitigate the exposure to the variability of one month LIBOR for its floating rate debt described in Note 6 "Debt" within these Notes to Condensed Consolidated Financial Statements. The fair value of the interest rate swap is reflected as an asset or liability in the Condensed Consolidated Balance Sheets and the change in fair value is reported in "Other (income) expense, net" in the Condensed Consolidated Statements of Operations and Comprehensive Income. The fair value of the interest rate swap is estimated as the net present value of projected cash flows based upon forward interest rates at the balance sheet date.

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The fair values of the derivative instrument at July 31, 2014 and January 31, 2014 were as follows (in thousands):

The change in fair value of the interest rate swap recognized in the Condensed Consolidated Statement of Operations and Comprehensive Income for the six months ended July 31, 2014 and 2013 was $0.1 million and $(0.7) million, respectively.

4.	CAPITALIZED SOFTWARE COSTS

Capitalized software costs and accumulated amortization at July 31, 2014 and January 31, 2014 were as follows:

 

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(1)

Capitalized software development costs include the impact of foreign currency translation.

Acquired software technology costs relate to technology purchased as a result of the Company's fiscal 2013 acquisitions of DynaSys and CEBOS. In addition to the acquired software technology, the Company has capitalized costs related to translations and localizations of QAD Enterprise Applications.

Amortization of capitalized software costs was $0.6 million for each of the six months ended July 31, 2014 and 2013. Amortization of capitalized software costs is included in "Cost of license fees" in the accompanying Condensed Consolidated Statements of Operations and Comprehensive Income.

The following table summarizes the estimated amortization expense relating to the Company's capitalized software costs as of July 31, 2014:

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5.	GOODWILL AND INTANGIBLE ASSETS

Goodwill

The changes in the carrying amount of goodwill for the six months ended July 31, 2014 were as follows:

The Company performed its annual goodwill impairment review during the fourth quarter of fiscal 2014. The analysis compared the Company's market capitalization to its net assets as of the test date, November 30, 2013. As the market capitalization significantly exceeded the Company's net assets, there was no indication of goodwill impairment for fiscal 2014. The Company monitors the indicators for goodwill impairment testing between annual tests. No adverse events occurred during the six months ended July 31, 2014, that would cause the Company to test goodwill for impairment.

Intangible Assets

(1)	Customer relationships include the impact of foreign currency translation.

The Company's intangible assets are related to the DynaSys and CEBOS acquisitions completed in fiscal 2013. Intangible assets are included in "Other assets, net" in the accompanying Condensed Consolidated Balance Sheets. As of July 31, 2014, all of the Company's intangible assets were determined to have finite useful lives, and therefore were subject to amortization.

Amortization of intangible assets was $0.4 million for each of the six months ended July 31, 2014 and July 31, 2013. The following table summarizes the estimated amortization expense relating to the Company's intangible assets as of July 31, 2014:

6.

DEBT

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Note Payable

Effective May 30, 2012, QAD Ortega Hill, LLC entered into a variable rate credit agreement (the "2012 Mortgage") with Rabobank, N.A., to refinance a pre-existing mortgage. The 2012 Mortgage has an original principal balance of $16.1 million and bears interest at the one month LIBOR rate plus 2.25%. One month LIBOR was 0.15% at July 31, 2014. The 2012 Mortgage matures in June 2022 and is secured by the Company's headquarters located in Santa Barbara, California. In conjunction with the 2012 Mortgage, QAD Ortega Hill, LLC entered into an interest rate swap with Rabobank, N.A. The swap agreement has an initial notional amount of $16.1 million and a schedule matching that of the underlying loan that synthetically fixes the interest rate on the debt at 4.31% for the entire term of the 2012 Mortgage. The terms of the 2012 Mortgage provide for QAD Ortega Hill, LLC to make net monthly payments of $88,100 consisting of principal and interest and one final payment of $11.7 million. The unpaid balance as of July 31, 2014 was $15.3 million.

Credit Facility

The Company has an unsecured credit agreement with Rabobank, N.A. (the "Facility"). The Facility provides a commitment through July 15, 2014 for a $20 million line of credit for working capital or other business needs. The Company pays a commitment fee of 0.25% per annum of the daily average of the unused portion of the $20 million Facility. Borrowings under the Facility bore interest at a rate equal to one month LIBOR plus 0.75%. On July 11, 2014, the Company entered into an amendment to the Facility. The amendment extended the maturity of the Facility from July 15, 2014 to July 15, 2017. The amendment did not provide for any change in the interest rate or debt covenants. At July 31, 2014, the effective borrowing rate would have been 0.90%.

The Facility provides that the Company maintain certain financial and operating ratios which include, among other provisions, minimum liquidity on a consolidated basis of $25 million in cash and equivalents at all times, a current ratio (calculated using current liabilities excluding deferred revenue) of not less than 1.3 to 1.0 determined at the end of each fiscal quarter, a leverage ratio of not more than 1.5 to 1.0 determined at the end of each fiscal quarter, and a debt service coverage ratio of not less than 1.5 to 1.0 determined at the end of each fiscal year. The Facility also contains customary covenants that could restrict the Company's ability to incur additional indebtedness.

As of July 31, 2014, there were no borrowings under the Facility and the Company was in compliance with all financial covenants.

7.	ACCUMULATED OTHER COMPREHENSIVE LOSS

The components of accumulated other comprehensive loss, net of taxes, were as follows:

During the first six months of fiscal 2015 there were no reclassifications from accumulated other comprehensive loss.

8.	INCOME TAXES

During the first quarter of fiscal year 2015 QAD adopted ASU 2013-11. The new standard requires the netting of unrecognized tax benefits against deferred tax assets for a loss or credit that would apply in settlement of the uncertain tax position. As a result, the Company netted $1.4 million of its uncertain tax benefits against $1.4 million of deferred tax assets on its Condensed Consolidated Balance Sheets. The total amount of unrecognized tax benefits (before netting) was $2.7 million at July 31, 2014. This amount includes penalties and interest. The entire amount of unrecognized tax benefits, if recognized, would impact the Company's effective tax rate. This liability is classified as long-term unless the liability is expected to conclude within twelve months of the reporting date. In the next twelve months, due to potential settlements with domestic tax authorities related to tax credits and lapse of statute of limitations an estimated $0.8 million of unrecognized tax benefits may be recognized.

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The Company's policy is to recognize interest and penalties, if any, related to unrecognized tax benefits as a component of income tax expense. As of July 31, 2014, the Company has accrued approximately $0.3 million of interest and penalty expense relating to unrecognized tax benefits.

The Company files U.S. federal, state, and foreign tax returns that are subject to audit by various tax authorities. The Company is currently under audit in:

·

India for the fiscal years ended March 31, 1998, 1999,  2008, 2009, 2010 and 2012

·

California for the fiscal year ended 2004

·

Minnesota for the fiscal years ended 2010, 2011, 2012, 2013

During the first six months of fiscal year 2015 the Company settled audits in the following locations:

·

South Africa for the fiscal year ended 2008

·

Thailand for the fiscal year ended January 2012

·

India for the fiscal year ended March 31, 2011

·

France for the fiscal years ended 2011, 2012 and 2013

·

City of Wilmington, Delaware for the calendar years  2009, 2010, 2011, 2012, 2013

No material adjustments were made as a result of such settlements.

9.	STOCKHOLDERS' EQUITY

Dividends

The following table sets forth the dividends that were declared by the Company during the first six months of fiscal 2015:

10.	STOCK-BASED COMPENSATION

The Company's equity awards consist of SARs and RSUs. For a description of the Company's stock-based compensation plans, see Note 13 "Stock-Based Compensation" in Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended January 31, 2014.

Stock-Based Compensation

The following table sets forth reported stock-based compensation expense for the three and six months ended July 31, 2014 and 2013:

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Option/SAR Information

The weighted average assumptions used to value SARs granted in the six months ended July 31, 2014 and 2013 are shown in the following table:

(1)	The expected life of SARs granted under the stock-based compensation plans is based on historical vested SAR exercise and post-vest forfeiture patterns and includes an estimate of the expected term for SARs that were fully vested and outstanding.

(2)	The risk-free interest rate is based on the U.S. Treasury yield for a term consistent with the expected life of SARs in effect at the time of grant.

(3)	The Company estimates the volatility of its common stock at the date of grant based on the historical volatility of the Company's common stock for a period equivalent to the expected life of the SARs, which it believes is representative of the expected volatility over the expected life of the SARs.

(4)	The Company expects to continue paying quarterly dividends at the same rate as the six months ending on July 31, 2014.

The following table summarizes the activity for outstanding SARs for the six months ended July 31, 2014:

(1)	The expected-to-vest SARs are the result of applying the pre-vesting forfeiture rate assumptions to total outstanding SARs.

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the aggregate difference between the closing stock price of the Company's common stock based on the last trading day as of July 31, 2014, and the exercise price for in-the-money SARs) that would have been received by the holders if all SARs had been exercised on July 31, 2014. The total intrinsic value of SARs exercised in the six months ended July 31, 2014 was $4.7 million.

The number of SARs exercised includes shares withheld on behalf of employees to satisfy minimum statutory tax withholding requirements. During the three months ended July 31, 2014, the Company withheld 35,000 shares for payment of these taxes at a value of $0.7 million. During the six months ended July 31, 2014, the Company withheld 73,000 shares for payment of these taxes at a value of $1.5 million.

At July 31, 2014, there was approximately $6.7 million of total unrecognized compensation cost related to unvested SARs. This cost is expected to be recognized over a weighted-average period of approximately 3.0 years.

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RSU Information

The estimated fair value of RSUs was calculated based on the closing price of the Company's common stock on the date of grant, reduced by the present value of dividends foregone during the vesting period.

The following table summarizes the activity for RSUs for the six months ended July 31, 2014:

(1)	The number of RSUs released includes shares withheld on behalf of employees to satisfy statutory tax withholding requirements.

The Company withholds, at the employee's election, a portion of the released shares as consideration for the Company's payment of applicable employee income taxes. During the three months ended July 31, 2014, the Company withheld 42,000 shares for payment of these taxes at a value of $0.9 million.  During the six months ended July 31, 2014, the Company withheld 44,000 shares for payment of these taxes at a value of $1.0 million.

Total unrecognized compensation cost related to RSUs was approximately $6.8 million as of July 31, 2014. This cost is expected to be recognized over a weighted-average period of approximately 3.3 years.

11.	COMMITMENTS AND CONTINGENCIES

Indemnifications

The Company sells software licenses and services to its customers under written agreements. Each agreement contains the relevant terms of the contractual arrangement with the customer and generally includes certain provisions for indemnifying the customer against losses, expenses and liabilities from damages that may be awarded against the customer in the event the Company's software is found to infringe upon certain intellectual property rights of a third party. The agreements generally limit the scope of and remedies for such indemnification obligations in a variety of industry-standard respects.

The Company believes its internal development processes and other policies and practices limit its exposure related to the indemnification provisions of the agreements. For several reasons, including the lack of prior indemnification claims and the lack of a monetary liability limit for certain infringement cases under the agreements, the Company cannot determine the maximum amount of potential future payments, if any, related to such indemnification provisions.

Legal Actions

The Company is subject to various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on the Company's consolidated results of operations, financial position or liquidity.

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12.	BUSINESS SEGMENT INFORMATION

The Company markets its products and services worldwide, primarily to companies in the manufacturing industry, including automotive, consumer products, food and beverage, high technology, industrial products and life sciences industries. The Company sells and licenses its products through its direct sales force in four geographic regions: North America; Europe, the Middle East and Africa ("EMEA"); Asia Pacific; and Latin America and through distributors where third parties can extend sales reach more effectively or efficiently. The North America region includes the United States and Canada. The EMEA region includes Europe, the Middle East and Africa. The Asia Pacific region includes Asia and Australia. The Latin America region includes South America, Central America and Mexico. The Company's Chief Operating Decision Maker, the Chief Executive Officer, reviews the consolidated results within one operating segment.

License and subscription revenues are assigned to the geographic regions based on both the proportion of users in each region and sales effort. Maintenance revenue is allocated to the region where the end user customer is located. Services revenue is assigned based on the region where the services are performed.

(1)	Sales into Canada accounted for 2% of North America total revenue for both the three and six months ended July 31, 2014 and for 2% and 3% of North America total revenue for the three and six months ended July 31, 2013, respectively.

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ITEM 2 – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995. Any statements contained herein that are not statements of historical fact should be construed as forward looking statements, including statements that are preceded or accompanied by such words as "may," "believe," "could," "anticipate," "would," "might," "plan," "expect," "intend" and words of similar meaning or the negative of these terms or other comparable terminology. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in Part I, Item 1A entitled "Risk Factors" within our Annual Report on Form 10-K for the year ended January 31, 2014. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's opinions only as of the date hereof and are subject to risks, uncertainties and assumptions about our business. We undertake no obligation to revise or update or publicly release the results of any revision or update to these forward-looking statements except as required by applicable securities laws. Readers should carefully review the risk factors and other information described in other documents we file from time to time with the Securities and Exchange Commission ("SEC").

INTRODUCTION

The following discussion should be read in conjunction with the information included within our Annual Report on Form 10-K for the year ended January 31, 2014, and the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q.

CRITICAL ACCOUNTING POLICIES

Our condensed consolidated financial statements are prepared applying certain critical accounting policies. The SEC defines "critical accounting policies" as those that require application of management's most difficult, subjective, or complex judgments. Critical accounting policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or subject to variations and may significantly affect our reported results and financial position for the period or in future periods. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on our future financial condition and results of operations. Our financial statements are prepared in accordance with U.S. GAAP, and they conform to general practices in our industry. We apply critical accounting policies consistently from period to period and intend that any change in methodology occur in an appropriate manner. Accounting policies currently deemed critical, including a) revenue recognition; b) accounts receivable allowances for bad debt and sales returns; c) capitalized software development costs; d) impairment assessments on goodwill and intangible assets; e) business combinations; f) valuation of deferred tax assets and tax contingency reserves; and g) stock-based compensation are further discussed in the Annual Report on Form 10-K for the fiscal year ended January 31, 2014. There have been no significant changes to our accounting policies and estimates as discussed in our Annual Report on Form 10-K for the fiscal year ended January 31, 2014.

BUSINESS OVERVIEW

QAD Inc. ("QAD", the "Company", "we" or "us") is a global provider of enterprise software solutions for manufacturers. We deliver our solutions both in the cloud and on-premise. We provide ongoing support to our customers which ensures they have access to the latest features of our software. We provide professional services to assist customers in deploying, upgrading and optimizing our software so they can maximize the benefit they receive from our solutions in their operating environment. We provide our solutions to global manufacturing companies in the automotive, consumer products, food and beverage, high technology, industrial products and life sciences industries.  Around the world more than 2,000 manufacturing companies use QAD solutions in their businesses. We were founded in 1979, incorporated in California in 1986 and reincorporated in Delaware in 1997.

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At the core of our solutions is our enterprise resource planning ("ERP") suite called QAD Enterprise Applications or MFG/PRO. Our ERP suite is also deployed in the cloud as QAD Cloud ERP. QAD Enterprise Applications supports the core business processes of our global manufacturing customers, including key functions in the following areas: financials, customer management, manufacturing, demand and supply chain planning, supply chain execution, transportation management, service and support, enterprise asset management, analytics, enterprise quality management, interoperability, process and performance, and internationalization. We also focus on the foundation and technology of our applications, such as user interface and usability.

Many companies are implementing cloud-based solutions to support their business. This trend continues to gain momentum, and the demand for cloud ERP is growing. With cloud-based systems, customers benefit from the ability to connect to the solution over the Internet or a private network, while not having to provide their own hardware or manage the operation of the infrastructure that supports the system. In addition, support services and license updates are included in the monthly subscription fee.

QAD customers are able to combine on-premise and cloud-based solutions in a blended deployment. In this model a customer may have some sites deployed in the cloud and some on-premise, delivering similar functionality and user experiences to all end-users. This blended deployment is a key differentiator for QAD and makes it easier for existing customers to expand their footprint and migrate progressively to the cloud as needed to meet their business needs.

We have four principal sources of revenue:

·

License purchases of our Enterprise Applications;

·

Subscription to our Enterprise Applications through our Cloud offering in a SaaS model as well as other hosted Internet applications;

·

Maintenance and support, including technical support, training materials, product enhancements and upgrades;

·

Professional services, including implementations, technical and application consulting, training, migrations and upgrades.

We operate primarily in the following four geographic regions: North America, Latin America, EMEA and Asia Pacific. In the first six months of fiscal 2015, approximately 42% of our total revenue was generated in North America, 35% in EMEA, 16% in Asia Pacific and 6% in Latin America. The majority of our revenue is generated from global customers who have operations in multiple countries throughout the world. License and subscription revenues are assigned to the geographic regions based on both the proportion of users in each region and sales effort. Maintenance revenue is allocated to the region where the end user is located. Services revenue is assigned based on the region where the services are performed. A significant portion of our revenue and expenses are derived from international operations which are primarily conducted in foreign currencies. As a result, changes in the value of foreign currencies relative to the U.S. dollar have impacted our results of operations and may impact our future results of operations. At July 31, 2014, we employed approximately 1,600 employees worldwide, of which 590 employees were based in North America, 480 employees in EMEA, 460 employees in Asia Pacific and 70 employees in Latin America.

SUMMARY OF THE FIRST SIX MONTHS OF FISCAL 2015

Total revenue for the first six months of fiscal 2015 increased by 11% to $141.5 million compared to the prior year period. The two primary drivers of our revenue growth were subscription revenue from our cloud offering and professional services revenue.  Excluding the effect of foreign exchange fluctuations, we expect that total revenue generally will continue to increase in fiscal 2015 due to continued services implementation and upgrade projects, the high percentage of customers that renew their maintenance contracts and continued growth in cloud revenue.

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Our success in closing license deals for existing customers, new customers that are affiliates of existing customers and customers that have employees with historical experience working with QAD tends to be higher than with new customers that have no QAD affiliations. As a result, we place increased focus on these opportunities. A majority of our license revenue is generated from existing customers and their affiliates. We believe global economic volatility will continue to shape customers' and prospects' buying decisions, making it difficult to forecast sales cycles for our products and the timing of large software license sales.  In addition, as we focus on our cloud sales we may experience a correspondingly negative effect on license revenue.

Subscription Revenue. Growing our cloud model, which generates subscription revenue, and offering our products as software-as-a-service ("SaaS") continues to be a key strategic and growth initiative for us. In the first six months of fiscal 2015, subscription revenue increased by 49% to $12.6 million compared to the prior year period. Our cloud customers include a mix of new user implementations of our cloud product and existing customers who have converted from our on-premise model. Subscription revenue is generally billed on a quarterly basis and recognized ratably over the term of the agreement, typically 12 to 36 months.  We expect cloud revenue in fiscal 2015 to grow at a rate above 40%.

 

Maintenance Revenue. We offer support services 24 hours a day, seven days a week in addition to providing software upgrades, which include additional or improved functionality, when and if available. In the first six months of fiscal 2015, maintenance revenue increased by 4% to $72.2 million compared to the prior year period. Maintenance revenue fluctuations are influenced by: (1) new license revenue growth; (2) annual renewal of support contracts; (3) increase in customers through acquisitions; (4) fluctuations in currency rates; (5) adjustments to revenue as a result of revenue recognition rules; and (6) customer conversions to QAD Cloud ERP. The vast majority of our customers renew their annual support contracts. Over the last three years, our annual revenue renewal rate of customers subscribing to maintenance has been greater than 90%. Maintenance revenue is generally billed on an annual basis and recognized ratably over the term of the agreement, typically twelve months.  Our maintenance revenue is negatively impacted by customers that transition to QAD Cloud ERP.  When customers transition to our cloud solution they no longer pay for maintenance as those services are included as a component of our subscription offering.

 

Although our professional services are optional, many of our customers use these services for some of their planning, implementation, or related needs. Professional services are typically rendered under time and materials-based contracts with services typically billed on an hourly basis. Professional services are sometimes rendered under fixed-fee based contracts with payments due on specific dates or milestones.

 

Professional services revenue growth is contingent upon license and subscription revenue growth and customer upgrade cycles, which are influenced by the strength of general economic and business conditions and the competitive position of our software products. We use our partners and subcontractors to supplement our internal resources. This allows us to quickly respond to demand fluctuations while somewhat mitigating low utilization in slow times. We believe this also helps us extend our global reach by keeping a higher number of partners engaged and knowledgeable about our product.

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Cash Flow and Financial Condition. In the first six months of fiscal 2015, we generated cash flows from operating activities of $5.5 million. Our cash and equivalents at July 31, 2014 totaled $75.3 million, with the only debt on our balance sheet consisting of $15.3 million related to the mortgage of our headquarters. Our primary uses of cash have been funding investment in research and development and funding operations to drive revenue and earnings growth. In addition, we use cash for dividend payments, acquisitions, share repurchase programs and other equity related transactions.

 

In fiscal 2015, we anticipate that our priorities for use of cash will be growing our cloud business in addition to developing sales and services resources and continued investment in research and development to drive and support growth and profitability. We will continue to evaluate acquisition opportunities that are complementary to our product footprint, solutions delivery, technology direction and the growth of our cloud solution. We will also continue to assess share repurchases and dividend payments. We do not anticipate additional borrowing requirements in fiscal 2015.

 

RESULTS OF OPERATIONS

We operate in several geographical regions as described in Note 12 "Business Segment Information" within Notes to Condensed Consolidated Financial Statements. In order to present our results of operations without the effects of changes in foreign currency exchange rates, we provide certain financial information on a "constant currency basis", which is in addition to the actual financial information presented in the following tables. In order to calculate our constant currency results, we apply the current foreign currency exchange rates to the prior period results.

Revenue

Total Revenue. On a constant currency basis, total revenue was $73.1 million and $66.1 million for the second quarter of fiscal 2015 and 2014, respectively, representing a $7.0 million, or 11%, increase from the same period last year. When comparing categories within total revenue at constant rates, our current quarter results included increases across all revenue categories. Revenue outside the North America region as a percentage of total revenue was 58% for the second quarter of both fiscal 2015 and fiscal 2014. Total revenue increased in all our regions during the second quarter of fiscal 2015 when compared to the same quarter last year. Our products are sold to manufacturing companies that operate mainly in the following six industries: automotive, consumer products, food and beverage, high technology, industrial products and life sciences. Given the similarities between food and beverage and consumer products as well as between high technology and industrial products, we aggregate them for management review. Revenue by industry for the second quarter of fiscal 2015 was approximately 29% in automotive, 21% in consumer products and food and beverage, 32% in high technology and industrial products and 18% in life sciences. In comparison, revenue by industry for the second quarter of fiscal 2014 was approximately 28% in automotive, 22% in consumer products and food and beverage, 34% in high technology and industrial products and 16% in life sciences.

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On a constant currency basis, total revenue was $141.5 million and $128.0 million for the first six months of fiscal 2015 and 2014, respectively, representing a $13.5 million, or 11%, increase from the same period last year. When comparing categories within total revenue at constant rates, our results for the first six months of fiscal 2015 included increases across all revenue categories. Revenue outside the North America region as a percentage of total revenue was 58% for the first six months of fiscal 2015, as compared to 57% in the same period of the prior fiscal year.  Total revenue increased in our North America, EMEA and Latin America regions and remained relatively flat in our Asia Pacific region during the first six months of fiscal 2015 when compared to the same six months last year.  Revenue by industry for the first six months of fiscal 2015 was approximately 29% in automotive, 23% in consumer products and food and beverage, 33% in high technology and industrial products and 15% in life sciences. In comparison, revenue by industry for first six months of fiscal 2014 was approximately 28% in automotive, 22% in consumer products and food and beverage, 34% in high technology and industrial products and 16% in life sciences.

License Revenue. On a constant currency basis, license revenue was $9.0 million and $8.8 million for the second quarter of fiscal 2015 and 2014, respectively, representing a $0.2 million, or 2%, increase from the same period last year. License revenue increased in our EMEA region, remained flat in our Latin America region and decreased in our Asia Pacific and North America regions during the second quarter of fiscal 2015 when compared to the same quarter last year.  One of the metrics that management uses to measure license revenue performance is the number of customers that have placed sizable license orders in the period. During the second quarter of fiscal 2015, five customers placed license orders totaling more than $0.3 million and no orders exceeded $1.0 million. This compared to the second quarter of fiscal 2014 when six customers placed license orders totaling more than $0.3 million and no orders exceeded $1.0 million.

On a constant currency basis, license revenue was $15.6 million and $15.0 million for the first six months of fiscal 2015 and 2014, respectively, representing a $0.6 million, or 4%, increase from the same period last year. License revenue increased in our EMEA region, remained flat in our Latin America region and decreased in our North America and Asia Pacific regions during the first six months of fiscal 2015 when compared to the same period last year. During the first six months of fiscal 2015, seven customers placed license orders totaling more than $0.3 million and no orders exceeded $1.0 million. This compared to the first six months of fiscal 2014 when eight customers placed license orders totaling more than $0.3 million, and no orders exceeded $1.0 million. Although our license billings for the first six months of fiscal 2015 were relatively consistent when compared to the prior year period, our license revenue in the current period benefited from recognition of deals that were deferred in prior periods for accounting purposes.

Subscription Revenue. On a constant currency basis, subscription revenue was $6.4 million and $4.5 million for the second quarter of fiscal 2015 and 2014, respectively, representing a $2.0 million, or 44%, increase from the same period last year. Subscription revenue increased in our North America and EMEA regions and remained relatively flat in our Latin America and Asia Pacific regions during the second quarter of fiscal 2015 when compared to the same quarter last year. The increase in subscription revenue was primarily due to sales of our QAD Cloud ERP product offering to new customers, QAD customers converting from on-premise and additional users and modules purchased from our existing cloud customers. We expect the growth rate of subscription revenue in the future to be primarily attributable to growth in sales of our QAD Cloud ERP product offering.

On a constant currency basis, subscription revenue was $12.6 million and $8.5 million for the first six months of fiscal 2015 and 2014, respectively, representing a $4.1 million, or 48%, increase from the same period last year.  Subscription revenue increased in our North America, Latin America and EMEA regions and remained relatively flat in our Asia Pacific region during the first six months of fiscal 2015 when compared to the same period last year. The increase in subscription revenue was primarily due to additional revenue related to our QAD Cloud ERP product offering.  Currently, a majority of our QAD Cloud ERP revenue is in the North America region. We expect the growth of subscription revenue in the future to be primarily attributable to growth in our QAD Cloud ERP product offering.

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Maintenance and Other Revenue. On a constant currency basis, maintenance and other revenue was $36.1 million and $34.6 million for the second quarter of fiscal 2015 and 2014, respectively, representing a $1.5 million, or 4%, increase from the same period last year. Maintenance and other revenue increased in our EMEA, Latin America and Asia Pacific regions and remained relatively flat in our North America region during the second quarter of fiscal 2015 when compared to the same quarter last year. The increase in maintenance and other revenue was primarily related to price increases, new customers, new users and new modules in excess of cancellations.

On a constant currency basis, maintenance and other revenue was $72.2 million and $69.7 million for the first six months of fiscal 2015 and 2014, respectively, representing a $2.5 million, or 4%, increase from the same period last year. Maintenance and other revenue increased in all our regions during the first six months of fiscal 2015 when compared to the same period last year. The increase in maintenance and other revenue was primarily related to price increases, new customers, new users and new modules in excess of cancellations.

We track our rate of contract renewals by determining the number of customer sites with active contracts as of the end of the previous reporting period and compare this to the number of customers that renewed, or are in the process of renewing, their maintenance contracts as of the current period end. Our maintenance contract renewal rate has remained in excess of 90% for the second quarters of both fiscal 2015 and 2014.

Professional Services Revenue. On a constant currency basis, professional services revenue was $21.5 million and $18.2 million for the second quarter of fiscal 2015 and 2014, respectively, representing a $3.3 million, or 18%, increase from the same period last year. Professional services revenue increased in our North America, EMEA and Asia Pacific regions and remained relatively flat in our Latin America region during the second quarter of fiscal 2015 compared to the same quarter last year. The increase in services revenue was primarily due to higher revenue generated from implementation and upgrade projects. Services revenue recognized from cloud customers was between 15% and 20% of total services revenue in each period. The number of engagements and the average revenue per engagement were both higher in the second quarter of fiscal 2015 than in the same period of last year as a result of increased cloud subscriptions and license sales.

On a constant currency basis, professional services revenue was $41.1 million and $34.7 million for the first six months of fiscal 2015 and 2014, respectively, representing a $6.4 million, or 18%, increase from the same period last year. Professional services revenue increased in our North America, EMEA and Asia Pacific regions and decreased in our Latin America region during the first six months of fiscal 2015 when compared to the same period last year.  The increase in services revenue was primarily due to higher revenue generated from implementation and upgrade projects. Services revenue recognized from cloud customers was between 15% and 20% of total services revenue in each period.

Cost of Revenue

 

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Cost of license fees includes license royalties, amortization of capitalized software and fulfillment. Cost of maintenance, subscription and other includes personnel costs of fulfilling maintenance and subscription contracts, stock-based compensation for those employees, travel expense, professional fees, hosting costs, royalties, direct material and an allocation of information technology and facilities costs. Direct material charges include the cost of fulfilling maintenance and subscription contracts, hardware, costs associated with transferring our software to electronic media, printing of user manuals and packaging materials. Cost of professional services includes personnel costs of fulfilling service contracts, stock-based compensation for those employees, third-party contractor expense, travel expense for services employees and an allocation of information technology and facilities costs.

Total Cost of Revenue. On a constant currency basis, total cost of revenue (combined cost of license fees, cost of maintenance, subscription and other and cost of professional services) was $33.2 million for the second quarter of fiscal 2015 and $29.0 million for the second quarter of fiscal 2014; and as a percentage of total revenue was 45% and 44% for the second quarter of fiscal 2015 and 2014, respectively. The non-currency related increase in cost of revenue of $4.2 million, or 14%, in the second quarter of fiscal 2015 compared to the second quarter of fiscal 2014 was primarily due to higher personnel and hosting costs associated with higher subscription revenue and higher personnel and subcontractor costs associated with higher professional services revenue.

On a constant currency basis, total cost of revenue (combined cost of license fees, cost of maintenance, subscription and other and cost of professional services) was $64.7 million for the first six months of fiscal 2015 and $57.6 million for the first six months of fiscal 2014; and as a percentage of total revenue was 46% and 45% for the first six months of fiscal 2015 and 2014, respectively. The non-currency related increase in cost of revenue of $7.1 million, or 12%, for the first six months of fiscal 2015 compared to the first six months of fiscal 2014 was primarily due to higher personnel and hosting costs associated with higher subscription revenue and higher personnel and subcontractor costs associated with higher professional services revenue.

Cost of License Fees.  On a constant currency basis, cost of license fees was $1.2 million and $1.1 million for the second quarter of fiscal 2015 and fiscal 2014, respectively, representing an increase of $0.1 million, or 9%. The non-currency related increase in cost of license fees of $0.1 million in the second quarter of fiscal 2015 compared to the second quarter of fiscal 2014 was due to higher royalty expense associated with higher license billings.  Cost of license fees as a percentage of license revenue was fairly consistent at 13% and 12% for the second quarter of fiscal 2015 and 2014, respectively.

On a constant currency basis, cost of license fees was $2.1 million and $2.0 million for the first six months of fiscal 2015 and 2014, respectively, representing an increase of $0.1 million, or 5%. The non-currency related increase in cost of license fees of $0.1 million for the first six months of fiscal 2015 compared to the first six months of fiscal 2014 was due to slightly higher royalties.  Cost of license fees as a percentage of license revenue was fairly consistent at 13% and 14% for the first six months of fiscal 2015 and fiscal 2014, respectively.

Cost of Maintenance, Subscription and Other.  On a constant currency basis, cost of maintenance, subscription and other was $12.5 million and $11.1 million for the second quarter of fiscal 2015 and fiscal 2014, respectively, representing an increase of $1.4 million, or 13%. The non-currency related increase in cost of maintenance, subscription and other of $1.4 million in the second quarter of fiscal 2015 compared to the second quarter of fiscal 2014 was primarily due to higher subscription costs, which included higher hosting costs of $0.7 million and higher personnel costs of $0.5 million as a result of increased headcount of 19 people; both of which are to support the growth in our cloud business. Cost of maintenance, subscription and other as a percentage of maintenance, subscription and other revenue was 29% for the second quarters of both fiscal 2015 and 2014.

On a constant currency basis, cost of maintenance, subscription and other was $24.4 million and $22.1 million for the first six months of fiscal 2015 and fiscal 2014, respectively, representing an increase of $2.3 million, or 10%. The non-currency related increase in cost of maintenance, subscription and other of $2.3 million for the first six months of fiscal 2015 compared to the first six months of fiscal 2014 was primarily due to higher subscription costs, which included higher hosting costs of $1.4 million and higher personnel costs of $0.8 million as a result of increased headcount of 19 people; both of which are to support the growth in our cloud business. Cost of maintenance, subscription and other as a percentage of maintenance, subscription and other revenues was 29% and 28% in the first six months of fiscal 2015 and fiscal 2014, respectively.

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Cost of Professional Services.  On a constant currency basis, cost of professional services was $19.6 million and $16.9 million for the second quarter of fiscal 2015 and fiscal 2014, respectively, representing an increase of $2.7 million, or 16%. The non-currency related increase in cost of professional services of $2.7 million in the second quarter of fiscal 2015 compared to the second quarter of fiscal 2014 was primarily due to higher subcontractor costs of $1.1 million, higher personnel costs of $0.5 million as a result of increased headcount of 25 people and higher travel of $0.4 million. In addition, the increase in cost of professional services included $0.4 million of personnel costs from other departments to help support the increase in services engagements. Cost of professional services as a percentage of professional services revenue was 91% and 93% for the second quarter of fiscal 2015 and 2014, respectively.

On a constant currency basis, cost of professional services was $38.2 million and $33.5 million for the first six months of fiscal 2015 and 2014, respectively, representing an increase of $4.7 million, or 14%. The non-currency related increase in cost of professional services of $4.7 million in the first six months of fiscal 2015 compared to the first six months of fiscal 2014 was due to higher subcontractor costs of $1.6 million, higher personnel costs of $1.1 million as a result of increased headcount of 25 people, higher travel of $0.6 million and higher bonuses of $0.4 million. In addition, the increase in cost of professional services included $1.0 million of personnel costs from other departments to help support the increase in services engagements. Cost of professional services as a percentage of professional services revenues was 93% and 97% for the first six months of fiscal 2015 and fiscal 2014 respectively.

Sales and Marketing

Sales and marketing expense includes salaries, benefits, bonuses, stock-based compensation and travel expense for our sales and marketing employees in addition to costs of programs aimed at increasing revenue, such as trade shows, user group events, advertising and various sales and promotional programs. Sales and marketing expense also includes personnel costs of order processing, sales agent fees and an allocation of information technology and facilities costs.

On a constant currency basis, sales and marketing expense was $17.4 million and $16.0 million for the second quarter of fiscal 2015 and fiscal 2014, respectively, representing an increase of $1.4 million, or 9%. The non-currency related increase in sales and marketing expense of $1.4 million in the second quarter of fiscal 2015 compared to the second quarter of fiscal 2014 was due primarily to higher travel expense of $0.8 million, higher commissions and sales bonuses of $0.6 million and higher salaries and related expense of $0.5 million as a result of 11 additional sales employees; partially offset by lower severance of $0.2 million and lower professional fees of $0.2 million. Some of the increase in commissions is related to our cloud business. Our policy is to expense commissions in the period when the sale occurs; so when cloud sales are booked we incur the expense without the related revenue in the period.

On a constant currency basis, sales and marketing expense was $33.9 million and $32.1 million for the first six months of fiscal 2015 and 2014, respectively, representing an increase of $1.8 million, or 6%. The non-currency related increase in sales and marketing expense of $1.8 million for the first six months of fiscal 2015 compared to the first six months of fiscal 2014 was primarily due to higher travel expense of $1.0 million and higher commissions and sales bonuses of $0.7 million, which were mainly driven by higher revenue including orders partially recognized in the first six months of fiscal 2015 from new cloud subscriptions. Our policy is to expense commissions in the period when the sale occurs; so when cloud sales are booked we incur the expense without the related revenue in the period. In addition, sales and marketing expense increased due to higher salaries and related expense of $0.8 million as a result of 11 additional sales employees. These increases in sales and marketing expense were partially offset by lower severance of $0.4 million, lower allocated information technology and facilities costs of $0.1 million and lower professional fees of $0.1 million. In addition, sales and marketing expense was reduced by $0.3 million of personnel costs related to staff which supported our services engagements.

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Research and Development

Research and development is expensed as incurred and consists primarily of salaries, benefits, bonuses, stock-based compensation, training and travel expense for research and development employees, and professional services, such as fees paid to software development firms and independent contractors. Research and development expense also includes an allocation of information technology and facilities costs, and is reduced by reimbursements from joint development projects.

On a constant currency basis, research and development expense was $10.9 million and $10.5 million for the second quarter of fiscal 2015 and fiscal 2014, respectively, representing an increase of $0.4 million, or 4%. The non-currency related increase in research and development expense of $0.4 million in the second quarter of fiscal 2015 compared to the second quarter of fiscal 2014 was due primarily to a reduction of our joint development reimbursements of $0.3 million. There were no significant joint development arrangements in the second quarter of fiscal 2015.

On a constant currency basis, research and development expense was $22.1 million and $21.3 million for the first six months of fiscal 2015 and 2014, respectively, representing an increase of $0.8 million, or 4%. The non-currency related increase in research and development expense of $0.8 million for the first six months of fiscal 2015 compared to the first six months of fiscal 2014 was primarily due to higher bonuses of $0.4 million and higher salaries and related expense of $0.3 million.

General and Administrative

General and administrative expense includes salaries, benefits, bonuses, stock-based compensation and travel expense for our finance, human resources, legal and executive personnel. General and administrative expense also includes professional fees for accounting and legal services, bad debt expense and an allocation of information technology and facilities costs and is reduced by capitalized costs related to an internal systems upgrade project.

On a constant currency basis, general and administrative expense was $9.3 million and $8.5 million for the second quarter of fiscal 2015 and fiscal 2014, respectively, representing an increase of $0.8 million, or 9%. The non-currency related increase in general and administrative expense of $0.8 million in the second quarter of fiscal 2015 compared to the second quarter of fiscal 2014 was primarily due to higher professional fees of $0.4 million, higher bonuses of $0.2 million, higher stock compensation expense of $0.2 million and higher salaries and related expense of $0.2 million partially offset by lower severance of $0.3 million.

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On a constant currency basis, general and administrative expense was $18.2 million and $16.4 million for the first six months of fiscal 2015 and 2014, respectively, representing an increase of $1.8 million, or 11%. The non-currency related increase in general and administrative expense of $1.8 million for the first six months of fiscal 2015 compared to the first six months of fiscal 2014 was primarily due higher professional fees of $0.7 million, higher bonuses of $0.4 million, higher stock compensation expense of $0.3 million, higher salaries and related expense of $0.3 million and higher costs related to an internal systems upgrade of $0.2 million, partially offset by lower severance of $0.3 million.

Amortization of Intangibles from Acquisitions

Amortization of intangibles from acquisitions was $0.2 million for both the second quarters of fiscal 2015 and 2014, and $0.4 million for the first six months of both fiscal 2015 and 2014. Amortization expense for all periods was due to the intangible assets acquired in our fiscal 2013 acquisitions of DynaSys and CEBOS.

Other Expense (Income)