PERITUS SOFTWARE SERVICES INC
10-Q, 2000-05-15
COMPUTER PROGRAMMING SERVICES
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549


FORM 10-Q

 

(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2000 OR
   
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO
   
COMMISSION FILE NUMBER 000-22647
   
PERITUS SOFTWARE SERVICES, INC.
(Exact Name of Registrant as Specified in Its Charter)
   

Massachusetts

04-3126919

(State or Other Jurisdiction of Incorporation or Organization)

(I.R.S. Employer Identification No.)

   

112 Turnpike Road, Suite 111, Westborough, Massachusetts

01581-2860

(Address of Principal Executive Offices)

(Zip Code)

   
(508) 870-0963
(Registrant's Telephone Number, Including Area Code)
   
Not Applicable
(Former Name, Former Address and Former Fiscal Year, If Changed Since Last Report)
   

          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 o

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

Title of Class

Shares outstanding
at May 8, 2000

Common Stock, $.01 par value
27,319,903
   

PERITUS SOFTWARE SERVICES INC.
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2000

TABLE OF CONTENTS

      Page
Part I. Financial Information
3
     
  Item 1. Financial Statements
    Consolidated Balance Sheet as of March 31, 2000 and December 31, 1999
3
    Consolidated Statement of Operations for the Three Months Ended March 31, 2000 and 1999
4
    Consolidated Statement of Cash Flows for the Three Months Ended March 31, 2000 and 1999
5
    Notes to Unaudited Consolidated Financial Statements
6
  Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
9
  Item 3. Quantitative and Qualitative Disclosures about Market Risk
17
     
Part II. Other Information
     
  Item 1. Legal Proceedings
19
  Item 2. Changes in Securities and Use of Proceeds
19
  Item 6. Exhibits and Reports on Form 8-K
19
    Signatures
20

     From time to time, information provided by the Company or statements made by its employees may contain ''forward-looking'' statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words ''believes'', ''anticipates'', ''plans'', ''expects'', and similar expressions are intended to identify forward-looking statements.

     This Quarterly Report on Form 10-Q may contain forward looking statements which involve risks and uncertainties. The Company's actual results could differ materially from the results discussed in such statements. Certain factors that could cause such a difference include, without limitation, the risks specifically described in the Company's Annual Report on Form 10-K for the year ended December 31, 1999 and other public documents filed by the Company with the Securities and Exchange Commission (the ''Commission''), which factors are incorporated herein by reference, the factors listed below in "Factors That May Affect Future Results" and other factors such as product or services demand and market acceptance risks, product development and services capacity, commercialization and technological difficulties, capacity and supply constraints or difficulties and the effect of general business or economic conditions. The Company's forward-looking statements do not reflect the impact of any future transactions or strategic alliances. From time to time, the Company may also provide oral or written forward-looking statements in other materials it releases to the public. The Company does not assume any obligation to update any of the forward-looking statements it makes.

2

 

PART I. FINANCIAL INFORMATION

Item 1.       Financial Statements

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED BALANCE SHEET

(In thousands, except share-related data)

ASSETS

March 31,
2000

  December 31,
1999

 
(unaudited)
Current assets:
Cash and cash equivalents
$
6,866
$
2,475
Accounts receivable, net of allowance for doubtful accounts of $25
306
532
Costs and estimated earnings in excess of billings on uncompleted contracts
190
281
Prepaid expenses and other current assets
176
248


Total current assets
7,538
3,536
Property and equipment, net
516
702
Intangible and other assets, net
42
55


$
8,096
$
4,293


LIABILITIES AND STOCKHOLDERS' EQUITY

 
Current liabilities:
Current portion of capital lease obligations
$
13
$
13
Accounts payable
47
11
Customer advances
296
296
Billings in excess of costs and estimated earnings on uncompleted contracts
197
253
Deferred revenue
127
195
Other accrued expenses and current liabilities
805
1,128


Total current liabilities
1,485
1,896
Capital lease obligations
21
25


Total liabilities
1,506
1,921


Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized; 27,309,903 and
17,173,975 shares issued and outstanding at March 31, 2000 and December 31, 1999,
respectively
273
172
Additional paid-in capital
113,206
105,279
Accumulated deficit
(106,881
)
(103,071
)
Accumulated other comprehensive loss
(8
)
(8
)


Total stockholders' equity
6,590
2,372


$
8,096
$
4,293


The accompanying notes are an integral part of these unaudited consolidated financial statements.

3

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED STATEMENT OF OPERATIONS

(In thousands, except per share related data)

(unaudited)

Three Months
Ended
March 31,

2000

1999

Revenue:      
  Outsourcing services   809   $ 1,853  
  License   644     1,359  
  Other services   112     1,455  
       
   
 
        Total revenue   1,565     4,667  
       
   
 
Cost of revenue:            
  Cost of outsourcing services   510     1,923  
  Cost of license       96  
  Cost of other services   70     1,028  
       
   
 
        Total cost of revenue   580     3,047  
       
   
 
Gross profit   985     1,620  
       
   
 
Operating expenses:            
  Sales and marketing   57     1,050  
  Research and development   325     470  
  General and administrative   472     1,776  
  Restructuring charge       291  
  Gain on sale of assets   (24 )    
       
   
 
        Total operating expenses   830     3,587  
       
   
 
Profit (Loss) from operations   155     (1,967 )
Interest income, net   35     8  
Cost of strategic investment   (4,000 )    
       
   
 
    Net loss $ (3,810 ) $ (1,959 )
       
   
 
Net loss per share:            
  Basic $ (0.19 ) $ (0.12 )
       
   
 
  Diluted $ (0.19 ) $ (0.12 )
       
   
 
Weighted average shares outstanding:            
    Basic   19,708     16,345  
       
   
 
   Diluted   19,708     16,345  
       
   
 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

4

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)

(Unaudited)

Three Months Ended
March 31,

2000

1999

Increase (Decrease) in Cash and Cash Equivalents            
Cash flows from operating activities:
  Net loss $ (3,810 ) $ (1,959 )
  Adjustments to reconcile net loss to net cash provided by (used for) operating activities:
  Depreciation and amortization   153     433  
  Gain on asset sale   (24 )    
  Cost of strategic investment   4,000      
      Changes in assets and liabilities:
    Accounts receivable   226     2,093  
    Costs and estimated earnings in excess of billings on uncompleted contracts   91     33  
    Prepaid expenses and other current assets   72     264  
    Other assets   13     (223 )
    Accounts payable   36     (105 )
    Customer advances       289  
    Billings in excess of costs and estimated earnings on uncompleted contracts   (56 )   373  
    Deferred revenue   (68 )   (779 )
    Other accrued expenses and current liabilities excluding accrued restructuring
  (323 )   (200 )
    Accrued restructuring       (282 )
         
   
 
        Net cash provided by (used for) operating activities   310     (63 )
         
   
 
Cash flows from investing activities:
  Sale (purchase) of short-term investments       (607 )
  Proceeds from sale of property and equipment   57     64  
  Purchases of property and equipment       (34 )
         
   
 
           Net cash provided by (used for) investing activities   57     (577 )
         
   
 
Cash flows from financing activities:
  Restricted cash       569  
  Principal payments on long-term debt       (269 )
  Principal payments on capital lease obligations   (4 )   (30 )
  Proceeds from exercise of stock options   28      
  Proceeds from issuance of common stock, net of issuance costs   4,000      
         
   
 
          Net cash provided by financing activities   4,024     270  
         
   
 
Effects of exchange rates on cash and cash equivalents       (1 )
         
   
 
Net increase (decrease) in cash and cash equivalents   4,391     (371 )
Cash and cash equivalents, beginning of period   2,475     2,809  
         
   
 
Cash and cash equivalents, end of period $ 6,866     2,438  
         
   
 
Supplemental disclosure of cash flows:
     Cash paid for income taxes $   $ 5  
     Cash paid for interest       7  

The accompanying notes are an integral part of these unaudited consolidated financial statements.

5

PERITUS SOFTWARE SERVICES, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

1. Basis of Presentation and Current Financial Condition

     The accompanying unaudited consolidated financial statements include the accounts of Peritus Software Services, Inc. and its subsidiaries (the ''Company'') and have been prepared by the Company without audit in accordance with the Company's accounting policies, as described in the Company's Annual Report on Form 10-K for the year ended December 31, 1999, as filed with the Securities and Exchange Commission (''SEC''). In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, and consist only of those of a normal recurring nature, necessary for a fair presentation of the Company's financial position, results of operations and cash flows at the dates and for the periods indicated. While the Company believes that the disclosures presented are adequate to make the information not misleading, these financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company's 1999 Annual Report on Form 10-K. The operating results for the three months ended March 31, 2000 are not necessarily indicative of the results to be expected for the full year ending December 31, 2000.

     The Company's consolidated financial statements have been presented on the basis that it is a going concern, which contemplates continuity of operations, realization of assets and the satisfaction of liabilities in the ordinary course of business. The Company experienced a net loss of $3,810,000 for the quarter ended March 31, 2000, and net losses of $2,583,000 and $26,673,000 in the years ended December 31, 1999 and 1998, respectively.

     On March 27, 2000, Rocket Software, Inc. ("Rocket"), a privately held company, invested $4,000,000 in the Company in exchange for 10,000,000 shares ($.40 per share) of restricted common stock (37% of outstanding stock after the investment). The Company granted Rocket certain registration rights with respect to the shares. The Company recorded a $4,000,000 non-cash charge related to the investment in the quarter ended March 31, 2000. The charge represented the difference between the quoted market price on the commitment date and the price paid by Rocket. Under certain sections of the Internal Revenue Code, a change in ownership of greater than 50% within a three-year period places an annual limitation on the Company's ability to utilize its existing net operating loss and research and development tax credit carry-forwards. The investment by Rocket triggered the limitation. Based on the Company's current forecasted cash expenditures, its cash on hand prior to the Rocket investment and the $4,000,000 invested by Rocket, the Company expects to have sufficient cash to finance its operations through the year 2000. The Company's future beyond the year 2000 is dependent upon its ability to achieve a break-even cash flow or raise additional financing. There can be no assurances that the Company will be able to do so.

2. Legal Proceedings

      The Company and certain of its officers and directors were named as defendants in purported class action lawsuits filed in the United States District Court for the District of Massachusetts by Robert Downey on April 1, 1998, by Scott Cohen on April 7, 1998, by Timothy Bonnett on April 9, 1998, by Peter Lindsay on April 17, 1998, by Harry Teague on April 21, 1998, by Jesse Wijntjes on April 29, 1998, by H. Vance Johnson and H. Vance Johnson as Trustee for the I.O.R.D. Profit-Sharing Plan on May 6, 1998, by John B. Howard, M.D. on May 21, 1998 and by Helen Lee on May 28, 1998 (collectively, the "complaints"). The complaints principally alleged that the defendants violated federal securities laws by making false and misleading statements and by failing to disclose material information concerning the Company's December 1997 acquisition of substantially all of the assets and assumption of certain liabilities of the Millennium Dynamics, Inc. ("MDI") business from American Premier Underwriters, Inc., thereby allegedly causing the value of the Company's common stock to be artificially inflated during the purported class periods. In addition, the Howard complaint alleged violation of federal securities laws as a result of the Company's purported failure to disclose material information in connection with the Company's initial public offering on July 2, 1997, and also named Montgomery Securities, Inc., Wessels, Arnold & Henderson, and H.C. Wainwright & Co., Inc. as defendants. The complaints further alleged that certain officers and/or directors of the Company sold stock in the open market during the class periods and sought unspecified damages.

      On or about June 1, 1998, all of the named plaintiffs and additional purported class members filed a motion for the appointment of several of those individuals as lead plaintiffs, for approval of lead and liaison plaintiffs' counsel and for consolidation of the actions. The Court granted the motion on June 18, 1998.

      On January 8, 1999, the plaintiffs filed a Consolidated Amended Complaint applicable to all previously filed actions. The Consolidated Amended Complaint alleged a class period of October 22, 1997 through October 26, 1998 and principally claimed that the Company and three of its former officers violated federal securities law by purportedly making false and misleading statements (or omitting material information) concerning the MDI acquisition and the Company's revenue during the proposed class period, thereby allegedly causing the value of the Company's common stock to be artificially inflated. Previously stated claims against the Company and its underwriters alleging violations of the federal securities laws as a result of purportedly inadequate or incorrect disclosure in connection with the Company's initial public offering were not included in the Consolidated Amended Complaint. The Company and the individual defendants filed motions to dismiss the Consolidated Amended Complaint on March 5, 1999. Oral arguments on the motions were held on April 21, 1999 and the Court granted the Company's and the individual defendants' motions to dismiss the Consolidated Amended Complaint pursuant to an order dated June 1, 1999. The plaintiffs appealed the Court's order of dismissal. The Company contested the appeal and supported the Court's order of dismissal. In December, 1999, the parties agreed to settle the lawsuit. The Company received final approval on February 28, 2000 from the Court of the settlement of the action. The $2.8 million settlement became effective and the appeal period expired on March 29, 2000. The settlement was funded entirely by the Company's directors and officers liability insurer and the Company and the individual defendants received a full release and dismissal of all claims brought by the class during the class period.

      On or about April 28, 1999, the Company filed a lawsuit in the United States District Court for the District of Massachusetts against Micah Technology Services, Inc. and Affiliated Computer Services, Inc. (collectively, "Micah"). The lawsuit principally alleges that Micah breached its contract with the Company by failing to pay for services performed by the Company under such contract. The lawsuit further alleges that since Micah was unjustly enriched by the services performed by the Company, the Company is entitled to recovery based on quantum meruit, and that Micah engaged in unfair and/or deceptive trade practices or acts in violation of Massachusetts General Laws ("M.G.L.") Chapter 93A by allowing the Company to perform services when Micah did not pay for such services. The lawsuit seeks unspecified damages on the breach of contract and quantum meruit claims and double or triple damages on the Chapter 93A claim. Micah has denied the Company's allegations and has filed a counterclaim against the Company principally alleging fraud, negligent misrepresentations, breach of contract and that the Company engaged in unfair and/or deceptive trade practices or acts in violation of M.G.L. Chapter 93A by its misrepresentations and breach of contract. The Company denied the allegations contained in Micah's counterclaim and intends to contest the counterclaim vigorously. The parties are still in the initial discovery phase of the litigation. A non-binding mediation hearing was held on March 17, 2000 and no settlement was reached.

       On April 13, 2000, without admitting or denying any findings, the Company consented to the issuance of an administrative cease and desist Order with the Securities and Exchange Commission concerning its previously announced revenue restatements in the first and second quarters of 1998, the third quarter of 1997 and the year ended December 31, 1997. The Order requires the Company to cease and desist from committing future violations of the public company reporting, record keeping and internal control provisions of the Securities Exchange Act of 1934.    

        In addition to the matters noted above, the Company is from time to time subject to legal proceedings and claims which arise in the normal course of its business. In the opinion of management, the amount of ultimate liability with respect to these other actions, currently known, will not have a material adverse effect on the Company's financial position or results of operations.

6

3. Comprehensive Income (Loss)

     Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.

     For the three months ended March 31, 2000 and 1999, the Company's comprehensive loss consisted of the following:

Three Months
Ended March 31,

 
2000

 
1999

 
Net loss $
(3,810,000
) $
(1,959,000
)
Translation adjustment  
 —
   
(1,000
)
 
 
 
  $
(3,810,000
) $
(1,960,000
)
 
 
 

4. Recently Issued Accounting Standards

     In March 2000, the Financial Accounting Standard Board ("FASB") issued FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation, -an interpretation of APB Opinion 25" ("FIN 44"). FIN 44 clarifies the application of APB No. 25 and, among other issues, clarifies the following: the definition of an employee for purposes of applying APB Opinion No. 25; the criteria for determining whether a plan qualifies as a non-compensatory plan; the accounting consequence of various modifications to the terms of previously fixed stock options or awards; and the accounting for an exchange of stock compensation awards in a business combination. FIN 44 is effective July 1, 2000, but certain conclusions in FIN 44 cover specific events that occurred after either December 15, 1998 or January 12, 2000. At this time, the Company does not expect the application of FIN 44 to have a material impact on its financial position or results of operations.

5. Segment, Geographic, and Product Information

     The Company operates in one reportable segment under SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," due to its centralized structure and single industry segment: software maintenance, tools and services. The Company currently derives its revenue from software maintenance outsourcing services, software and methodology licensing and other services.

Information by geographic area for the three months ended at March 31, 2000 and 1999 is summarized below (in thousands):

 

  Outsourcing Services   License Revenue   Other Services Revenue   Long-lived  
  Unaffiliated
  Affiliated
  Unaffiliated
  Affiliated
  Unaffiliated
  Affiliated
  Assets
 
March 31, 2000                
United States   $   809     $   644     $   112     $   516  
Foreign                
   
 
 
 
 
 
 
 
    $   809     $   644     $   112     $   516  
   
 
 
 
 
 
 
 
March 31, 1999  
United States   $1,853     $1,359     $1,455     $3,523  
Foreign               202  
   
 
 
 
 
 
 
 
    $1,853   $     —   $1,359   —-   $1,455     $3,725  
   
 
 
 
 
 
 
 

 

7

     The geographic classification of revenue is determined based on the country in which the legal entity providing the services is located. Revenue from no single foreign country was greater than 10% of the consolidated revenues of the Company in the quarters ended March 31, 2000 and 1999.

8

Item 2. Management's Discussion And Analysis Of Financial Condition And Results Of Operations

Overview and Current Financial Condition

          Peritus Software Services, Inc. ("Peritus" or the "Company") was incorporated in Massachusetts in August 1991. The Company provides solutions consisting of software products and services that enable organizations to improve the productivity, quality and effectiveness of their information technology, systems maintenance, or "software evolution" functions. The Company derives its revenue from software maintenance outsourcing services, software and methodology licensing and other services.

          In the second half of 1998 and in 1999, the overall market for the year 2000 tools and services of Peritus contracted dramatically, resulting in substantial financial losses. In response, the Company substantially reduced its workforce in September and December of 1998 and again in April of 1999. During the second and third quarters of 1999, the Company also settled its leases for its facilities in Cincinnati, Ohio, Lisle, Illinois and Billerica, Massachusetts and took other efforts to reduce its fixed costs. As a result of the Company's degraded financial condition, the Company began encountering major obstacles in obtaining new outsourcing business. Since most outsourcing engagements are multi-year and involve critical applications, prospective new clients, although interested in the capabilities and technology of the Company, were reluctant or unwilling to commit to contracts. Despite the significant reduction in the overall cost structure as a result of the foregoing actions, the Company was unable to achieve a cash flow break-even position in the year ended December 31, 1999.

          On March 27, 2000, Rocket Software, Inc. ("Rocket"), a privately held company, invested $4,000,000 in the Company in exchange for 10,000,000 shares ($.40 per share) of restricted common stock (37% of outstanding stock after the investment). The Company granted Rocket certain registration rights with respect to the shares. Based on the Company's current forecasted cash expenditures, its cash on hand prior to the Rocket investment and the $4,000,000 invested by Rocket, the Company expects to have sufficient cash to finance its operations through the year 2000. The Company's future beyond the year 2000 is dependent upon its ability to achieve a break-even cash flow or raise additional financing. There can be no assurances that the Company will be able to do so.

          The Company's current strategy is to continue to service its existing outsourcing customers and to renew expiring contracts. At the same time, the Company is pursuing new business through the licensing of, and associated consulting and training for, its outsourcing methodology (technology transfer services) and SAM Relay and SAM Workbench tools. The Company anticipates using the proceeds from the Rocket investment to fund additional investments in sales and marketing, research and development (particularly the enhancement of the Company's SAM Workbench tool) and other general corporate purposes. The Company also plans to develop other service offerings.

Three Months Ended March 31, 2000 Compared To Three Months Ended March 31, 1999

     Revenue

          Total revenue decreased 66.5% to $1,565,000 in the three months ended March 31, 2000 from $4,667,000 in the three months ended March 31, 1999. This decrease in revenue was primarily due to a decrease in other services and outsourcing revenues and, to a lesser extent, in the licensing of the Company's software products and tools.

          The Company anticipates that total revenue for the year 2000 will be substantially below the level achieved in 1999.

           Outsourcing Services. Outsourcing services revenue decreased 56.3% to $809,000 in the three months ended March 31, 2000 from $1,853,000 in the three months ended March 31, 1999. As a percentage of total revenue, outsourcing services revenue increased to 51.7% in the three months ended March 31, 2000 from 39.7% for the three months ended March 31, 1999. The increase in outsourcing services revenue as a percentage of total revenue reflects the decreased contribution of other services revenue to total revenue during the three months ended March 31, 2000 when compared to the same period in the prior year. The decrease in outsourcing services revenue in absolute dollars in the three months ended March 31, 2000, compared to March 31, 1999, was attributable to recording lower amounts of revenue under existing outsourcing engagements due to reduced workload or contract terminations. During the first quarter of 2000, a contract with one client reached the end of its term and was not renewed. During the first quarter of 2000, outsourcing services revenue attributable to the client was $216,000. The Company did not sign any new outsourcing contracts during the first quarter of 2000.

           License. License revenue decreased 52.6% to $644,000 in the three months ended March 31, 2000, or 41.2% of total revenue, compared to $1,359,000, or 29.1% of total revenue, in the three months ended March 31, 1999. The decrease in license revenue for 2000 in absolute dollars was primarily attributable to a decrease in year 2000 related licensed revenue from end users and value added integrators. The Company will continue to pursue licenses of its outsourcing technology and SAM Relay and SAM Workbench tools and future revenue is dependent on the success of such efforts. The $644,000 of license revenue in the quarter ended March 31, 2000 was attributable to paid-up license revenue from two customers.

          Other Services. Other services revenue decreased 92.3% to $112,000 in the three months ended March 31, 2000 from $1,455,000 in the three months ended March 31, 1999. As a percentage of total revenue, other services revenue decreased to 7.2% in the three months ended March 31, 2000 from 31.2% in the three months ended March 31, 1999. The decrease in other services revenue in absolute dollars was primarily attributable to a decrease in direct delivery, consulting and client support services relating to the Company's year 2000 products and services. Future revenue from other services is dependent on the Company's success in licensing its methodology, and its SAM Workbench and SAM Relay tools, which would generate maintenance, consulting and training revenue. Future revenue from other services is also dependent on the development of other successful offerings.

     Cost of Revenue

          Cost of Outsourcing Services Revenue. Cost of outsourcing services revenue consists primarily of salaries, benefits and overhead costs associated with delivering outsourcing services to clients. The cost of outsourcing services revenue decreased 73.5% to $510,000 in the three months ended March 31, 2000 from $1,923,000 for the three months ended March 31, 1999. Cost of outsourcing services revenue as a percentage of outsourcing services revenue decreased to 63.0% in the three months ended March 31, 2000 from 103.8% in the three months ended March 31, 1999. Costs in 1999 were negatively impacted by expenditures in anticipation of and to generate new business that did not materialize. In addition, the Company incurred costs in connection with an agreement with Micah Technology Services, Inc. ("Micah") for which it received no payments. The Company has filed a lawsuit against Micah to attempt to recover amounts due under such agreement. See "Part II-Item 1. Legal Proceedings."

          Cost of License Revenue. Cost of license revenue consists primarily of amortization of expense of intangibles related to the acquisition of Millennium Dynamics, Inc. ("MDI") and salaries, benefits and related overhead costs associated with license-related materials packaging and freight. Cost of license revenue was $0 in the three months ended March 31, 2000. Cost of license revenue was $96,000, or 7.1% of license revenue, in the three months ended March 31, 1999. The decrease in cost of license revenue was primarily related to the termination (in the fourth quarter of 1999) of amoritization expense of intangibles related to the MDI acquisition.

          Cost of Other Services Revenue. Cost of other services revenue consists primarily of salaries, benefits and related overhead costs associated with delivering other services to clients. Cost of other services revenue decreased 93.2% to $70,000 in the three months ended March 31, 2000 from $1,028,000 in the three months ended March 31, 1999. Cost of other services revenue as a percentage of other services revenue decreased to 62.5% in the three months ended March 31, 2000 from 70.7% in the three months ended March 31, 1999. Costs decreased in absolute dollars in the three months ended March 31, 2000 due to reduced staffing for the Company's client support, training and consulting organizations related to fewer customers for the Company's year 2000 products and services, including year 2000 renovations and renovation quality evaluation ("RQE") services.

     Operating Expenses

          Sales and Marketing. Sales and marketing expenses consist primarily of salaries, commissions and related overhead costs for sales and marketing personnel; sales referral fees to third parties; advertising programs; and other promotional activities. Sales and marketing expenses decreased 94.6% to $57,000 in the three months ended March 31, 2000 from $1,050,000 in the three months ended March 31, 1999. As a percentage of total revenue, sales and marketing expenses decreased to 3.6% in the three months ended March 31, 2000 from 22.5% in the three months ended March 31, 1999. The decrease in expenses in absolute dollars and as a percentage of revenue was primarily attributable to dramatically reduced staffing, commissions and promotional activities. The Company plans to increase its sales resources and marketing efforts in the future.

           Research and Development. Research and development expenses consist primarily of salaries, benefits and related overhead costs for engineering and technical personnel and outside engineering consulting services associated with developing new products and enhancing existing products. Research and development expenses decreased 30.9% to $325,000 in the three months ended March 31, 2000 from $470,000 in the three months ended March 31, 1999. As a percentage of total revenue, research and development expenses increased to 20.8% in the three months ended March 31, 2000 from 10.1% in the three months ended March 31, 1999. The decrease in research and development expenses in absolute dollars was primarily attributable to reduced staffing. The Company plans to continue maintenance of and enhancements to its existing products (particularly the enhancement of the Company's SAM Workbench tool) and may selectively develop new products or services.

           General and Administrative. General and administrative expenses consist primarily of salaries and related costs for the finance and accounting, human resources, legal services, information systems and other administrative departments of the Company, as well as contracted legal and accounting services. General and administrative expenses decreased 73.4% to $472,000 in the three months ended March 31, 2000 from $1,776,000 in the three months ended March 31, 1999. As a percentage of total revenue, general and administrative expenses decreased to 30.2% in the three months ended March 31, 2000 from 38.1% in the three months ended March 31, 1999. The decrease in general and administrative expenses in absolute dollars was primarily due to the reductions in staffing, the cost of excess space, and legal and accounting fees incurred in the three months ended March 31, 2000.

     Restructuring Charge

          On March 29, 1999, the Company announced its intention to restructure and recorded a charge of $291,000 consisting of severance payments associated with the termination of 40 employees. The Company had no restructuring charges in the three months ended March 31, 2000.

  Gain on the Sale of Assets

            The gain on the sale of assets in the quarter ended March 31, 2000 represented the excess of the sales proceeds over the net book value of the fixed assets of the Company's India subsidiary that were sold during the quarter.   

  Cost of Strategic Investment

          On March 27, 2000, Rocket, a privately held company, invested $4,000,000 in the Company in exchange for 10,000,000 shares ($.40 per share) of restricted common stock (37% of outstanding stock after the investment). The Company recorded a non-cash charge of $4,000,000 for the cost of this strategic investment equal to the difference between the purchase price per share of $0.40 and the market price per share of $0.80 on March 27, 2000.

     Interest Income (Expense), Net

          Interest income and expense consists primarily of interest income from cash balances, partially offset by interest expense on debt. The Company had interest income, net, of $35,000 in the three months ended March 31, 2000 compared to interest income, net, of $8,000 in the three months ended March 31, 1999. This change in interest income (expense), net, was primarily attributable to increased interest income from higher interest bearing balances and higher bank rates as well as lower interest expense.

     Provision for Income Taxes

          The Company's income tax provision was zero in each of the three months ended March 31, 2000 and 1999. The Company did not record a tax provision or benefit in either period due to losses incurred.

Liquidity and Capital Resources

     The Company has financed its operations and capital expenditures primarily with the proceeds from sales of the Company's convertible preferred stock and common stock, borrowings, and advance payments for services from clients. The Company's cash balances were $6,866,000 and $2,475,000 at March 31, 2000 and December 31, 1999, respectively. The Company's working capital was $6,053,000 and $1,640,000 at March 31, 2000 and December 31, 1999, respectively.

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     The Company's operating activities provided cash of $310,000 and used cash of $63,000 during the three months ended March 31, 2000 and 1999, respectively. The cash provided during the three months ended March 31, 2000 was primarily caused by a net loss of $3,810,000 (less the non-cash cost of the strategic investment of $4,000,000 by Rocket, depreciation and amortization expense of $153,000, and the gain from the sale of assets of $24,000). Other sources were a decrease in accounts receivable of $226,000, a decrease in costs and estimated earnings in excess of billings on uncompleted contracts of $91,000, a decrease in prepaid expenses and other current assets of $72,000, an increase in accounts payable of $36,000, and a decrease in other assets of $13,000. These amounts were partially offset by a decrease in other accrued liabilities of $323,000, a decrease in deferred revenue of $68,000, and a decrease in billings in excess of costs and estimated earnings on uncompleted contracts of $56,000.

     The Company's investing activities provided cash of $57,000 and used cash of $577,000 during the three months ended March 31, 2000 and 1999, respectively. Proceeds from the sale of property and equipment in the three months ended March 31, 2000 consisted of the proceeds from the sale of the remaining assets of the Company's India subsidiary.

     The Company's financing activities provided cash of $4,024,000 and $270,000 during the three months ended March 31, 2000 and 1999, respectively. Financing activities in the three months ended March 31, 2000 primarily reflect an increase from the proceeds of issuance of new common stock of $4,000,000 and the exercise of stock options of $28,000, partially offset by payments on capital lease obligations of $4,000.

     The Company has an accounts receivable purchase agreement with a lender to permit borrowing against certain acceptable receivables at a rate of 80% of the face amount of such receivables up to a maximum of $4,000,000. In exchange for such agreement, the Company granted the lender security interest on substantially all of its assets. There were no borrowings outstanding under the agreement at March 31, 2000.

     On March 27, 2000, Rocket, a privately held company, invested $4,000,000 in the Company in exchange for 10,000,000 shares ($.40 per share) of restricted common stock (37% of outstanding stock after the investment). The Company granted Rocket certain registration rights with respect to the shares. Based on the Company's current forecasted cash expenditures, its cash on hand prior to the Rocket investment and the $4,000,000 invested by Rocket, the Company expects to have sufficient cash to finance its operations through the year 2000. The Company's future beyond the year 2000 is dependent upon its ability to achieve a breakeven cash flow or raise additional financing. There can be no assurances that the Company will be able to do so.

     To date, the Company has not invested in derivative securities or any other financial instruments that involve a high level of complexity or risk. Excess cash has been, and the Company contemplates that it will continue to be, invested in interest-bearing, investment grade securities.

Foreign Currency

     Assets and liabilities of the Company's majority-owned foreign subsidiary are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at average exchange rates for the period. Accumulated net translation adjustments are included in stockholders' equity.

Inflation

     To date, inflation has not had a material impact on the Company's results of operations.

Recently Issued Accounting Standards

     In March 2000, the Financial Accounting Standard Board ("FASB") issued FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation, -an interpretation of APB Opinion 25" ("FIN 44"). FIN 44 clarifies the application of APB No. 25 and, among other issues, clarifies the following: the definition of an employee for purposes of applying APB Opinion No. 25; the criteria for determining whether a plan qualifies as a non-compensatory plan; the accounting consequence of various modifications to the terms of previously fixed stock options or awards; and the accounting for an exchange of stock compensation awards in a business combination. FIN 44 is effective July 1, 2000, but certain conclusions in FIN 44 cover specific events that occurred after either December 15, 1998 or January 12, 2000. At this time, the Company does not expect the application of FIN 44 to have a material impact on its financial position or results of operations.

Factors That May Affect Future Results

     Failure to Achieve Cash Flow Breakeven/Strategic Initiatives

           The Company's ability to achieve a cash flow breakeven position is critical for achieving financial stability. There can be no assurance that the Company will achieve a cash flow breakeven position in the future.

     Financing

          There can be no assurance that the Company will be able to obtain additional funds in the future through equity and/or debt financings or borrow against its accounts receivable financing agreement.

     Over the Counter Listing

          Trading of the common stock is conducted in the over-the-counter market which could make it more difficult for an investor to dispose of, or obtain accurate quotations as to the market value of, the common stock. In addition, there are additional sales practice requirements on broker-dealers who sell such securities to persons other than established customers and accredited investors. For transactions covered by this rule, the broker-dealer must make a special suitability determination for the purchaser and must have received the purchaser's written consent to the transaction prior to sale. In addition, if the trading price of the common stock is below $5.00 per share, trading in the common stock would also be subject to the requirements of certain rules promulgated under the Securities Exchange Act of 1934, which require additional disclosure by broker-dealers in connection with any trades involving a stock defined as a penny stock (generally any non-NASDAQ equity security that has a market price of less than $5.00 per share, subject to certain exceptions). Such rules require the delivery, prior to any penny stock transaction, of a disclosure schedule explaining the penny stock market and the risks associate therewith, and impose various sales practice requirements on broker-dealers who sell penny stocks to persons other than established customers and accredited investors (generally institutions). For these types of transactions, the broker-dealer must make a special suitability determination for the purchaser and have received the purchaser's written consent to the transaction prior to sale. The additional burdens imposed upon broker-dealers by such requirements may discourage broker-dealers from effecting transactions in the common stock, which could severely limit the market liquidity of the common stock and the ability of purchasers in this offering to sell the common stock in the secondary market.

     Risk of Current Strategy

          In the past, the Company generated significant revenues from marketing and selling products and services that addressed the year 2000 problem. The demand for such products and services has ended and the Company no longer actively markets and sells year 2000 products and services. The Company's current strategy is to continue to service its existing outsourcing customers and to renew expiring contracts. At the same time, the Company is pursuing new business through the licensing of, and associated consulting and training for, its outsourcing methodology (technology transfer services) and SAM Relay and SAM Workbench tools. The Company plans to continue maintenance of and enhancements to its existing products (particularly the enhancements of the Company's SAM Workbench tool) and may selectively develop new products or services. The Company is planning to increase its sales resources and marketing efforts in the future. There can be no assurance that this current strategy will generate revenues sufficient for the Company to achieve a cash flow breakeven position.

     Potential Fluctuations in Quarterly Performance

          The Company's revenue and operating results have varied significantly in the past and are likely to vary significantly from quarter to quarter in the future. The Company's quarterly operating results may continue to fluctuate due to a number of factors, including the timing, size and nature of the Company's individual outsourcing, technology transfer, insourcing and licensing transactions; unforeseen difficulties in performing such transactions; the performance of the Company's value added integrators and distributors; the timing of the introduction and the market acceptance of new services, products or product enhancements by the Company or its competitors; the relative proportions of revenue derived from license fees and professional services; changes in the Company's operating expenses; personnel changes; foreign currency exchange rates and fluctuations in economic and financial market conditions.

          The timing, size and nature of individual outsourcing, technology transfer, insourcing and licensing transactions are important factors in the Company's quarterly operating results. Many such transactions involve large dollar amounts, and the sales cycle for these transactions is often lengthy and unpredictable. In addition, the sales cycle associated with these transactions is subject to a number of uncertainties, including clients' budgetary constraints, the timing of clients' budget cycles and clients' internal approval processes. There can be no assurance that the Company will be successful in closing such large transactions on a timely basis or at all. Most of the Company's outsourcing engagements are performed on a fixed-price basis and, therefore, the Company bears the risk of cost overruns and inflation. A significant percentage of the Company's revenue derived from these engagements is recognized on the percentage-of-completion method, which requires revenue to be recorded over the term of a client contract. A loss is recorded at the time when current estimates of project costs exceed unrecognized revenue. The Company's operating results may be adversely affected by inaccurate estimates of contract completion costs.

          The Company's expense levels are based, in part, on its expectations as to future revenue and are fixed, to a large extent, in the short term. As a result, the Company has been and may continue to be unable to adjust spending in a timely manner to compensate for any further unexpected revenue shortfall. Accordingly, any significant shortfall in revenue, in addition to those already experienced in relation to the Company's expectations, would have an immediate and material adverse effect on the Company's business, financial condition and results of operations.

          Due to all of the foregoing factors, the Company believes that period-to-period comparisons of its operating results are not necessarily meaningful and that such comparisons cannot be relied upon as indicators of future performance. There can be no assurance that future revenue and operating results will not continue to vary substantially. It is also possible that in a quarter the Company's operating results will be below the expectations of public market analysts and investors. In either case, the price of the Company's Common Stock has been and could continue to be materially adversely affected.

     Need to Develop Additional Products and Services

          In the past, the Company generated significant revenue from, and devoted significant resources to, products and services that address the year 2000 problem. The demand for such products and services has ended and the Company no longer actively markets and sells year 2000 products and services. The Company's current strategy is to continue to service its existing outsourcing customers and to renew expiring contracts. At the same time, the Company is pursuing new business through the licensing of and associated consulting and training for, its outsourcing methodology (technology transfer services) and SAM Relay and SAM Workbench tools. The Company plans to continue maintenance of and enhancements to its existing products (particularly the enhancements of the Company's SAM Workbench Tool) and may selectively develop new products or services. There can be no assurance that the Company will be able to grow or maintain its outsourcing business or sell its other products or services. The failure to diversify, develop and sell additional products and services (and/or sell existing products or services) would have a material adverse effect on the Company's business, financial condition and results of operations.

     Concentration of Clients

          The Company's revenue is highly concentrated among a small number of clients. During the year ended December 31, 1999, revenue from three clients accounted for 40.5% of the year's revenue, with one client representing 21.7%. The contracts for two of these three clients (representing 18.8% of the revenue for the year ended December 31, 1999) terminated in November 1999 and March 2000. During the quarter ended March 31, 2000, $644,000 of license revenue was attributable to paid-up license revenue from two customers. The loss of, or a significant reduction in revenue from, any of the Company's major clients could have a material adverse impact on the Company's business, financial condition and results of operations. In addition, with such a large percentage of the Company's revenue attributable to a small number of clients, the loss of one or more major clients could have a material adverse impact on the Company's liquidity.

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     Competition

          The market for the Company's products and services is intensely competitive and is characterized by rapid changes in technology and user needs and the frequent introduction of new products. In addition, the Company faces competition in the software maintenance outsourcing services market and the software maintenance tools market. A number of the Company's competitors are more established, benefit from greater name recognition and have substantially greater financial, technical and marketing resources than those of the Company. As a result, there can be no assurance that the Company's products and services, will compete effectively with those of their respective competitors.

     Competitive Market for Technical Personnel

          The Company depends, to a significant extent, on its ability to attract, train, motivate and retain highly skilled software professionals, particularly project managers, software engineers and other senior technical personnel. The Company believes that there is a shortage of, and significant competition for, software development professionals with the skills and experience necessary to perform the services offered by the Company. The Company's ability to develop new products and services, maintain and renew existing engagements and obtain new business depends, in large part, on its ability to hire and retain technical personnel with the IT and other skills that keep pace with continuing changes in software evolution, industry standards and technologies, client preferences and the Company's business strategy. The inability to hire additional qualified personnel could impair the Company's ability to satisfy its client base and to develop new products and services, requiring an increase in the level of responsibility for both existing and new personnel. There can be no assurance that the Company will be successful in retaining current or future employees.

     Fixed-Price, Fixed-Time Contracts

          Part of the Company's business is to offer its outsourcing and technology transfer services on fixed-price, fixed-time frame contracts, rather than contracts in which payment to the Company is determined solely on a time-and-materials basis. These contracts are terminable by either party generally upon prior written notice. Although the Company uses its proprietary tools and methodologies and its past project experience to reduce the risks associated with estimating, planning and performing the fixed-price projects, the Company's standard outsourcing and technology transfer agreements provide for a fixed-fee based on projected reductions in a client's maintenance costs and increases in a client's maintenance productivity. The Company's failure to estimate accurately the resources, costs and time required for a project or its failure to complete its contractual obligations within the time frame committed could have a material adverse effect on the Company's business, financial condition and results of operations.

     Potential for Contract Liability

          The Company's products and services relating to software maintenance, involve key aspects of its clients' computer systems. A failure in a client's system could result in a claim for substantial damages against the Company, regardless of the Company's responsibility for such failure. The Company attempts to limit contractually its liability for damages arising from negligent acts, errors, mistakes or omissions in rendering its products and services. Despite this precaution, there can be no assurance that the limitations of liability set forth in its contracts would be enforceable or would otherwise protect the Company from liability for damages. Additionally, the Company maintains general liability insurance coverage, including coverage for errors and omissions. However, there can be no assurance that such coverage will continue to be available on acceptable terms, or will be available in sufficient amounts to cover one or more large claims, or that the insurer will not disclaim coverage as to any future claim. The successful assertion of one or more large claims against the Company that exceed available insurance coverage or changes in the Company's insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on the Company's business, financial condition and results of operations. Furthermore, litigation, regardless of its outcome, could result in substantial cost to the Company and divert management's attention from the Company's operations. Any contract liability claim or litigation against the Company could, therefore, have a material adverse effect on the Company's business, financial conditions and results of operations.

     Software Errors or Bugs

          The Company's software products and tools are highly complex and sophisticated and could from time to time contain design defects or software errors that could be difficult to detect and correct. Errors, bugs or viruses may result in loss of or delay in market acceptance, a failure in a client's system or loss or corruption of client data. Although the Company has not experienced material adverse effects resulting from any software defects or errors, there can be no assurance that, despite testing by the Company and its clients, errors will not be found in new products, which errors could have a material adverse effect upon the Company's business, financial condition and results of operations.

     Limited Protection of Proprietary Rights

          The Company relies on a combination of patent, copyright, trademark and trade secret laws and license agreements to establish and protect its rights in its software products and proprietary technology. In addition, the Company currently requires its employees and consultants to enter into nondisclosure and assignment of invention agreements to limit use of, access to and distribution of its proprietary information. There can be no assurance that the Company's means of protecting its proprietary rights in the United States or abroad will be adequate. The laws of some foreign countries may not protect the Company's proprietary rights as fully or in the same manner as do the laws of the United States. Also, despite the steps taken by the Company to protect its proprietary rights, it may be possible for unauthorized third parties to copy aspects of the Company's products, reverse engineer, develop similar technology independently or obtain and use information that the Company regards as proprietary. Furthermore, there can be no assurance that others will not develop technologies similar or superior to the Company's technology or design around the proprietary rights owned by the Company.

          The Company has entered into license agreements with clients that allow these clients access to and use of the Company's AutoEnhancer/2000, Vantage YR 2000 software, SAM Relay and RQE Tools source code for certain purposes. Access to the Company's source code may increase the likelihood of misappropriation or misuse by third parties.

          There can be no assurance that any patent will be issued pursuant to any pending patent applications or that, if granted, such patents would survive a legal challenge to their validity or provide meaningful or significant protection to the Company. In addition, the Company may decide to abandon a patent application if, among other things, it determines that continued prosecution of an application would be too costly, the technologies, processes or methodologies are not critical to the Company's business in the foreseeable future or it is unlikely that a patent will issue with regard to a particular application. Certain of the Company's technology incorporated in some of its products may infringe on patents held by others. Any infringement claim or litigation against the Company could have a material adverse effect on the Company's business, financial condition and results of operations.

          The Company maintains trademarks and service marks to identify its various service offerings, products and software. Although the Company has registered certain trademarks and service marks with the United States Patent and Trademark Office ("PTO") and has several trademark and service mark applications pending in the United States and foreign jurisdictions, not all of the applications have been granted and, even if granted, there can be no assurance that a particular trademark or service mark will survive a legal challenge to its validity or provide meaningful or significant protection to the Company. In addition, the Company has abandoned the applications of certain trademarks or service marks that it believes are not critical to its business in the future. In some cases, entities other than the Company are using certai

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different manner than a third party. There may be some risk of infringement claims against the Company in the event that a service or product of the Company is too similar to that of another entity that is using a similar mark.

     Dependence on Third-Party Technology

          The Company's proprietary software is currently designed, and may in the future be designed, to work on or in conjunction with certain third-party hardware and/or software products. If any of these current or future third-party vendors were to discontinue making their products available to the Company or to licensees of the Company's software or to increase materially the cost to the Company or its licensees to acquire, license or purchase the third-party vendors' products, or if a material problem were to arise in connection with the ability of the Company to design its software to properly use or operate with third-party hardware and/or software products, the Company would be required to redesign its software to function with or on alternative third-party products or attempt to develop internally a replacement for the third-party products. In such an event, interruptions in the availability or functioning of the Company's software and delays in the introduction of new products and services may occur until equivalent technology is obtained. There can be no assurance that an alternative source of suitable technology would be available or that the Company would be able to develop an alternative product in sufficient time or at a reasonable cost. The failure of the Company to obtain or develop alternative technologies or products on a timely basis and at a reasonable cost could have a material adverse effect on the Company's business, financial condition and results of operations.

 

     Rapid Technological Change

          The market for the Company's products and services is characterized by rapidly changing technology, evolving industry standards and new product introductions and enhancements that may render existing products obsolete. As a result, the Company's market position could erode further due to unforeseen changes in the features and functionality of competing products. The process of developing products and services such as those offered by the Company is extremely complex and is expected to become increasingly complex and expensive in the future with the introduction of new platforms and technologies. There can be no assurance that the Company will develop any new products or services in a timely fashion or that the Company's current or future products or services will satisfy the needs of its target market.

     Potential Adverse Effects of Anti-Takeover Provisions; Possible Issuance of Preferred Stock

          The Company's Amended and Restated Articles of Organization and Amended and Restated By-laws contain provisions that may make it more difficult for a third party to acquire, or discourage acquisition bids for, the Company. For instance, the Company's Amended and Restated By-laws provide that special meetings of stockholders may be called only by the President, the Board of Directors or the holders of at least 80% of the voting securities of the Company. In addition, the Massachusetts General Laws provide that stockholders may take action without a meeting only by the unanimous written consent of all stockholders. The Company's Board of Directors is also divided into three classes, as nearly equal in size as possible, with staggered three-year terms. The Company is also subject to an anti-takeover provision of the Massachusetts General Laws which prohibits, subject to certain exceptions, a holder of 5% or more of the outstanding voting stock of the Company from engaging in certain activities with the Company, including a merger, stock or asset sale. The foregoing provisions could limit the price that certain investors might be willing to pay in the future for shares of the Company's Common Stock. In addition, shares of the Company's Preferred Stock may be issued in the future without further stockholder approval and upon such terms and conditions, and having such rights, privileges and preferences, as the Board of Directors may determine. The rights of the holders of Common Stock will be subject to, and may be adversely affected by, the rights of any holders of Preferred Stock that may be issued in the future. The issuance of Preferred Stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire, or discouraging a third party from acquiring, a majority of the outstanding voting stock of the Company.

Year 2000 Matters

         To date, the Company has not experienced any material problems with its internal computer systems relating to the inability of such systems to recognize appropriate dates associated with the year 2000. The Company is also not aware of any material year 2000 problems experienced by customers that have licensed the Company's products or have received its services, or vendors that have provided products or services to the Company. Accordingly, the Company does not presently anticipate incurring material expenses or damages or experiencing any material operational disruptions as a result of any year 2000 problems. However, there can be no assurance that the Company may not experience unanticipated expenses or damages or be adversely impacted by any year 2000 problems.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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          As of March 31, 2000, the Company was exposed to market risks which primarily included changes in U.S. interest rates. The Company maintains a significant portion of its cash and cash equivalents in financial instruments with purchased maturities of three months or less. These financial instruments are subject to interest rate risk and will decline in value if interest rates increase. Due to the short duration of these financial instruments, an immediate increase in interest rates would not have a material effect of the Company's financial condition or results of operations.

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PART II. OTHER INFORMATION

Item 1.       Legal Proceedings

      The Company and certain of its officers and directors were named as defendants in purported class action lawsuits filed in the United States District Court for the District of Massachusetts by Robert Downey on April 1, 1998, by Scott Cohen on April 7, 1998, by Timothy Bonnett on April 9, 1998, by Peter Lindsay on April 17, 1998, by Harry Teague on April 21, 1998, by Jesse Wijntjes on April 29, 1998, by H. Vance Johnson and H. Vance Johnson as Trustee for the I.O.R.D. Profit-Sharing Plan on May 6, 1998, by John B. Howard, M.D. on May 21, 1998 and by Helen Lee on May 28, 1998 (collectively, the "complaints"). The complaints principally alleged that the defendants violated federal securities laws by making false and misleading statements and by failing to disclose material information concerning the Company's December 1997 acquisition of substantially all of the assets and assumption of certain liabilities of the Millennium Dynamics, Inc. business from American Premier Underwriters, Inc., thereby allegedly causing the value of the Company's common stock to be artificially inflated during the purported class periods. In addition, the Howard complaint alleged violation of federal securities laws as a result of the Company's purported failure to disclose material information in connection with the Company's initial public offering on July 2, 1997, and also named Montgomery Securities, Inc., Wessels, Arnold & Henderson, and H.C. Wainwright & Co., Inc. as defendants. The complaints further alleged that certain officers and/or directors of the Company sold stock in the open market during the class periods and sought unspecified damages.

      On or about June 1, 1998, all of the named plaintiffs and additional purported class members filed a motion for the appointment of several of those individuals as lead plaintiffs, for approval of lead and liaison plaintiffs' counsel and for consolidation of the actions. The Court granted the motion on June 18, 1998.

      On January 8, 1999, the plaintiffs filed a Consolidated Amended Complaint applicable to all previously filed actions. The Consolidated Amended Complaint alleged a class period of October 22, 1997 through October 26, 1998 and principally claimed that the Company and three of its former officers violated federal securities law by purportedly making false and misleading statements (or omitting material information) concerning the MDI acquisition and the Company's revenue during the proposed class period, thereby allegedly causing the value of the Company's common stock to be artificially inflated. Previously stated claims against the Company and its underwriters alleging violations of the federal securities laws as a result of purportedly inadequate or incorrect disclosure in connection with the Company's initial public offering were not included in the Consolidated Amended Complaint. The Company and the individual defendants filed motions to dismiss the Consolidated Amended Complaint on March 5, 1999. Oral arguments on the motions were held on April 21, 1999 and the Court granted the Company's and the individual defendants' motions to dismiss the Consolidated Amended Complaint pursuant to an order dated June 1, 1999. The plaintiffs appealed the Court's order of dismissal. The Company contested the appeal and supported the Court's order of dismissal. In December, 1999, the parties agreed to settle the lawsuit. The Company received final approval on February 28, 2000 from the Court of the settlement of the action. The $2.8 million settlement became effective and the appeal period expired on March 29, 2000. The settlement was funded entirely by the Company's directors and officers liability insurer and the Company and the individual defendants received a full release and dismissal of all claims brought by the class during the class period.

      On or about April 28, 1999, the Company filed a lawsuit in the United States District Court for the District of Massachusetts against Micah Technology Services, Inc. and Affiliated Computer Services, Inc. (collectively, "Micah"). The lawsuit principally alleges that Micah breached its contract with the Company by failing to pay for services performed by the Company under such contract. The lawsuit further alleges that since Micah was unjustly enriched by the services performed by the Company, the Company is entitled to recovery based on quantum meruit, and that Micah engaged in unfair and/or deceptive trade practices or acts in violation of Massachusetts General Laws ("M.G.L.") Chapter 93A by allowing the Company to perform services when Micah did not pay for such services. The lawsuit seeks unspecified damages on the breach of contract and quantum meruit claims and double or triple damages on the Chapter 93A claim. Micah has denied the Company's allegations and has filed a counterclaim against the Company principally alleging fraud, negligent misrepresentations, breach of contract and that the Company engaged in unfair and/or deceptive trade practices or acts in violation of M.G.L. Chapter 93A by its misrepresentations and breach of contract. The Company denied the allegations contained in Micah's counterclaim and intends to contest the counterclaim vigorously. The parties are in the initial discovery phase of the litigation. A non-binding mediation hearing was held on March 17, 2000 and no settlement was reached.

       On April 13, 2000, without admitting or denying any findings, the Company consented to the issuance of an administrative cease and desist Order with the Securities and Exchange Commission concerning its previously announced revenue restatements in the first and second quarters of 1998, the third quarter of 1997 and the year ended December 31, 1997. The Order requires the Company to cease and desist from committing future violations of the public company reporting, record keeping and internal control provisions of the Securities Exchange Act of 1934.

       In addition to the matters noted above, the Company is from time to time subject to legal proceedings and claims which arise in the normal course of its business. In the opinion of management, the amount of ultimate liability with respect to these other actions, currently known, will not have a material adverse effect on the Company's financial position or results of operations.

Item 2.      

Changes in Securities and Use of Proceeds

       On March 27, 2000, the Company issued and sold 10,000,000 shares of Peritus common stock, $.01 par value per share, to Rocket Software, Inc. for $4,000,000 in cash. These shares were offered and sold in reliance upon Rule 506 under the Securities Act of 1933, as amended, relating to sales by an issuer not involving a public offering. Rocket Software represented to the Company, among other things, that it is an "accredited investor" as defined in Rule 501(a) under the Securities Act. On April 4, 2000, the Company filed a Notice of Sale of Securities Pursuant to Regulation D on Form D with the Securities and Exchange Commission. No underwriters were involved in the sale of these shares.       

Item 6.       Exhibits And Reports On Form 8-K

       (a) Exhibits:

     Documents listed below, except for documents identified by footnotes, are being filed as exhibits herewith. Documents identified by footnotes, if any, are not being filed herewith and, pursuant to Rule 12b-32 of the General Rules and Regulations promulgated by the Commission under the Securities Exchange Act of 1934 (the ''Exchange Act''), reference is made to such documents as previously filed as exhibits with the Commission. The Company's file number under the Exchange Act is 000-22647.

Exhibit 10.1
  1997 Director Stock Option Plan as Amended and Restated
10.2(1)   Addendum to Employment Agreement between the Company and John Giordano
dated January 21, 2000.
10.3(1)  

Amended Employment Agreement between the Company and John Giordano dated
January 21, 2000.  

10.4(1)   Asset Purchase Agreement dated as of January 31, 2000, as amended, by and among Peritus Software  Services (India) Private Limited, LTP (India) Pvt. Ltd. and Lisle Technology Partners L.L.C.
10.5(1)    Common Stock Purchase Agreement dated as of March 27, 2000 by and between the Company and Rocket Software, Inc.
10.6(1)    Registration Rights Agreement dated as of March 27, 2000 by and between
the Company and Rocket Software, Inc.   
Exhibit 27
  Financial Data Schedule
       (1)    Incorporated by reference to the Registrant's Annual Report on Form 10-K dated
March 30, 2000

       (b) Reports on Form 8-K:

       A Current Report Form 8-K dated March 27, 2000 was filed by the Company on March 29, 2000. The Company reported under item 5 (Other Events) that Rocket Software, Inc. ("Rocket"), a privately held software company, invested $4,000,000 in Peritus. Under terms of the agreement, Rocket invested $4,000,000 in cash in exchange for 10,000,000 restricted shares of Peritus common stock ($0.40 per share). The shares represented approximately 37% of the total shares outstanding after the investment and the Company granted Rocket certain registration rights with respect to the shares.

19

SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: May 15, 2000

  Peritus Software Services, Inc.
   
  By:   /s/ John D. Giordano
 
  John D. Giordano
President, Chief Executive Officer and Chief
Financial Officer
(Principal Financial Officer)
   
   
  Peritus Software Services, Inc.
   
  By:   /s/ Patrick Manning
 
  Patrick Manning
Corporate Controller
(Principal Accounting Officer)
   

20

Peritus Software Services, Inc.
FORM 10-Q
For the Quarterly Period Ended March 31, 2000
Exhibit Index

Exhibit No.
 
Description
10.1
  1997 Director Stock Option Plan as Amended and Restated
10.2(1)   Addendum to Employment Agreement between the Company and John Giordano dated January 21, 2000.
10.3(1)  

Amended Employment Agreement between the Company and John Giordano dated
January 21, 2000.  

10.4(1)   Asset Purchase Agreement dated as of January 31, 2000, as amended, by and among Peritus Software  Services (India) Private Limited, LTP (India) Pvt. Ltd. and Lisle Technology Partners L.L.C.
10.5(1)       Common Stock Purchase Agreement dated as of March 27, 2000 by and between the Company and Rocket Software, Inc.
10.6(1)     Registration Rights Agreement dated as of March 27, 2000 by and between the Company and Rocket Software, Inc.   
27
Financial Data Schedule
       (1)     Incorporated by reference to the Registrant's Annual Report on Form 10-K dated March 30, 2000
                   


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