<PAGE>
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 SEPTEMBER 30, 2000
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: 1-11859
PEGASYSTEMS INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
MASSACHUSETTS 04-2787865
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
101 MAIN STREET
CAMBRIDGE, MA 02142-1590
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(617) 374-9600
(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 X No
------- -------
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
There were 29,438,310 shares of the Registrant's common stock, $.01 par value
per share, outstanding on November 8, 2000.
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<TABLE>
<CAPTION>
PEGASYSTEMS INC. AND SUBSIDIARIES
INDEX TO FORM 10-Q
PAGE
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<S> <C>
PART I - FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets at September 30, 2000
and December 31, 1999 3
Condensed Consolidated Statements of Operations for the three- and nine-
month periods ended September 30, 2000 and September 30, 1999 4
Condensed Consolidated Statements of Cash Flows for the nine-
month periods ended September 30, 2000 and September 30, 1999 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 11
Item 3. Quantitative and Qualitative Disclosures About Market Risk 19
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 19
Item 2. Changes in Securities and Use of Proceeds 20
Item 3. Defaults upon Senior Securities 20
Item 4. Submission of Matters to a Vote of Security Holders 20
Item 5. Other Information 20
Item 6. Exhibits and Reports on Form 8-K 20
SIGNATURES 21
</TABLE>
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Page 3 OF 21
FORM 10-Q
PEGASYSTEMS INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE-RELATED AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
SEPTEMBER 30, December 31,
2000 1999
-------------------- -------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $25,258 $30,004
Trade and installment accounts receivable, net of
allowance for doubtful accounts of $1,034 in
2000 and $1,026 in 1999 34,192 40,716
Prepaid expenses and other current assets 2,499 1,676
-------------------- -------------------
Total current assets 61,949 72,396
Long-term license installments 43,488 36,744
Equipment and improvements, net 6,127 8,335
Purchased software and other assets, net 5,705 7,516
-------------------- -------------------
Total assets $117,269 $124,991
==================== ===================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses $13,987 $13,643
Accrued litigation settlement 12,681 --
Deferred revenue 2,449 8,765
Current portion of capital lease obligations 212 198
-------------------- -------------------
Total current liabilities 29,329 22,606
Deferred income taxes 1,000 1,000
Capital lease obligations, net of current portion 93 253
Other long-term liabilities 60 87
-------------------- -------------------
Total liabilities 30,482 23,946
Commitments and contingencies (Note F)
Stockholders' Equity:
Preferred stock, $.01 par value, 1,000,000 shares
authorized; no shares issued and outstanding -- --
Common stock, $.01 par value, 45,000,000 shares authorized;
29,327,570 shares and 28,995,821 shares issued and
outstanding in 2000 and 1999, respectively 293 290
Additional paid-in capital 90,123 88,941
Deferred compensation (5) (18)
Stock warrant 2,897 2,897
Retained (deficit) earnings (6,243) 9,079
Accumulated comprehensive loss (278) (144)
-------------------- -------------------
Total stockholders' equity 86,787 101,045
-------------------- -------------------
Total liabilities and stockholders' equity $117,269 $124,991
==================== ===================
</TABLE>
See notes to condensed consolidated financial statements.
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Page 4 OF 21
PEGASYSTEMS INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPT 30, SEPT 30,
2000 1999 2000 1999
-------------- ----------------- --------------- -------------------
<S> <C> <C> <C> <C>
REVENUE:
Software license $12,946 $ 6,274 $28,210 $ 21,419
Services 9,718 14,235 33,740 35,502
-------------- ----------------- --------------- -------------------
Total revenue 22,664 20,509 61,950 56,921
-------------- ----------------- --------------- -------------------
COST OF REVENUE:
Cost of software license 585 586 1,756 1,757
Cost of services 11,127 7,129 28,064 23,769
-------------- ----------------- --------------- -------------------
Total cost of revenue 11,712 7,715 29,820 25,526
-------------- ----------------- --------------- -------------------
GROSS PROFIT 10,952 12,794 32,130 31,395
OPERATING EXPENSES:
Research and development 3,557 5,134 11,425 15,364
Selling and marketing 5,853 3,932 17,449 14,851
General and administrative 3,039 2,804 8,244 8,068
Litigation settlement, net of insurance -- -- 14,088 --
recovery
-------------- ----------------- --------------- -------------------
Total operating expenses 12,449 11,870 51,206 38,283
-------------- ----------------- --------------- -------------------
(LOSS) INCOME FROM OPERATIONS (1,497) 924 (19,076) (6,888)
Installment receivable interest income 900 900 2,743 2,565
Other interest income, net 451 274 1,339 601
Other income (expense), net -- 346 (179) 481
-------------- ----------------- --------------- -------------------
(LOSS) INCOME BEFORE PROVISION FOR (146) 2,444 (15,173) (3,241)
INCOME TAXES
Provision for income taxes 100 -- 150 --
-------------- ----------------- --------------- -------------------
NET (LOSS) INCOME ($246) $ 2,444 ($15,323) ($3,241)
============== ================= =============== ===================
(LOSS) EARNINGS PER SHARE:
Basic ($0.01) $0.08 ($0.53) ($0.11)
============== ================= =============== ===================
Diluted ($0.01) $0.08 ($0.53) ($0.11)
============== ================= =============== ===================
WEIGHTED AVERAGE NUMBER OF COMMON AND
COMMON EQUIVALENT SHARES OUTSTANDING:
Basic 29,454 28,861 29,173 28,858
============== ================= =============== ===================
Diluted 29,454 31,043 29,173 28,858
============== ================= =============== ===================
</TABLE>
See notes to condensed consolidated financial statements.
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Page 5 OF 21
PEGASYSTEMS INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPT 30,
2000 1999
-------------- ----------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ($15,323) ($3,241)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Depreciation and amortization 4,700 5,161
Provision for doubtful accounts 190 2,060
Issuance of compensatory stock option - 85
Changes in operating assets and liabilities:
Trade and installment accounts receivable (410) 15,490
Prepaid expenses and other current assets (823) 87
Other long term assets 56 (222)
Accounts payable and accrued expenses 344 (1,441)
Accrued litigation settlement 12,681 -
Deferred revenue (6,316) (13,756)
Other long term liabilities (27) 127
-------------- ----------------
Net cash provided by operating activities (4,928) 4,350
-------------- ----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of equipment and improvements (723) (1,792)
-------------- ----------------
Net cash used in investing activities (723) (1,792)
-------------- ----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments of capital lease obligation (146) (77)
Exercise of stock options 785 423
Sale of stock under employee stock purchase plan 400 414
-------------- ----------------
Net cash provided by financing activities 1,039 760
-------------- ----------------
Effect of exchange rate on cash and cash equivalents (134) 281
-------------- ----------------
NET (DECREASE) INCREASE IN CASH AND CASH
EQUIVALENTS (4,746) 3,599
-------------- ----------------
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 30,004 24,806
-------------- ----------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $25,258 $28,405
============== ================
</TABLE>
See notes to condensed consolidated financial statements.
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Page 6 OF 21
PEGASYSTEMS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2000
NOTE A - BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of
Pegasystems Inc. (the "Company") presented herein have been prepared in
accordance with the Securities and Exchange Commission's rules and regulations
regarding interim financial reporting. In the opinion of management, all
adjustments (consisting of normal recurring accruals) considered necessary for a
fair presentation have been included. Operating results for the three- and
nine-month periods ended September 30, 2000 are not necessarily indicative of
the results that may be expected for the full year ending December 31, 2000. The
Company suggests that these condensed consolidated financial statements be read
in conjunction with the consolidated financial statements and notes thereto for
the year ended December 31, 1999, included in the Company's 1999 Annual Report
on Form 10-K/A filed with the Securities and Exchange Commission ("SEC".)
NOTE B - REVENUE RECOGNITION
The Company's revenue is derived from two sources: software license fees and
services fees. Software license fees are generally payable on a monthly basis
under license agreements, which generally have a five-year term and may be
renewed for additional years at the customer's option. The present value of
future license payments is generally recognized as revenue upon customer
acceptance. A portion of the fee from each arrangement is deferred and
recognized as interest income over the license term. In the case of software
license agreement renewals, license fee revenue is recognized upon the
commencement of the new license terms.
The Company's services revenue is comprised of fees for maintenance,
implementation, training and consulting services. Software license customers are
offered the option to enter into an annual maintenance contract requiring the
customer to pay a monthly maintenance fee renewable on a year-to-year basis.
Prepaid maintenance fees are deferred based on the estimated fair value of all
the elements of the arrangement and are recognized ratably over the term of the
maintenance agreement. The Company's software implementation agreements
typically require the Company to provide a specified level of implementation
services for a specified fee, typically with additional implementation services
available at an hourly rate. Implementation fees for time and material projects
are recognized as incurred. Implementation fees for fixed price projects are
recognized once the fair value of services and any other elements to be
delivered under the arrangement can be determined. Costs associated with fixed
price contracts are expensed as incurred. Prior to the point at which the fair
value of the elements of a contract can be determined, revenue recognition is
limited to amounts equal to costs incurred during the reporting period,
resulting in no gross profit. Once the fair values of the elements of a contract
are apparent, profit associated with the services elements will begin to be
recognized. Training and consulting fees are generally recognized as the
services are provided.
The Company has adopted the provisions of the American Institute of Certified
Public Accountants Statement of Position 98-9, "Modification of SOP 97-2,
Software Revenue Recognition, With Respect to Certain Transactions." While such
adoption did not have a material impact on the financial statements of the
Company included in this report on Form 10-Q, it may in the future cause a
greater portion of contract revenue to be classified as services revenue rather
than license revenue.
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NOTE C - EARNINGS (LOSS) PER SHARE
<TABLE>
<CAPTION>
(in thousands, except per share data) Three Months Ended Nine Months Ended
Sept 30, Sept 30,
2000 1999 2000 1999
------------ ----------- ------------- ------------
<S> <C> <C> <C> <C>
Basic
Net (loss) income ($246) $2,444 ($15,323) ($3,241)
============ =========== ============= ============
Weighted average common shares outstanding 29,454 28,861 29,173 28,858
============ =========== ============= ============
Basic (loss) earnings per share ($0.01) $0.08 ($0.53) ($0.11)
============ =========== ============= ============
Diluted
Net (loss) income ($246) $2,444 ($15,323) ($3,241)
============ =========== ============= ============
Weighted average common shares outstanding 29,454 28,861 29,173 28,858
Effect of :
Assumed exercise of stock options -- 2,182 -- --
------------ --------- ----------- ------------
Weighted average common shares outstanding,
Assuming dilution 29,454 31,043 29,173 28,858
============ =========== ============= ============
Diluted (loss) earnings per share ($0.01) $0.08 ($0.53) ($0.11)
============ =========== ============= ============
</TABLE>
Basic earnings (loss) per share is computed based on the weighted average number
of common shares outstanding during the period. Diluted earnings (loss) per
share includes, to the extent inclusion of such shares would be dilutive to
earnings per share, the effect of outstanding options and warrants, computed
using the treasury stock method. For the three-month periods ended September 30,
2000 and 1999, 6,790,825 and 823,626 potential shares, respectively, have been
excluded from the calculation, as such effect would be anti-dilutive. For the
nine-month periods ended September 30, 2000 and 1999, 4,761,074 and 3,874,863
potential shares, respectively, have been excluded from the calculation, as
their effect would be anti-dilutive.
As stated in Note G to Notes to Consolidated Financial Statements, the
Company entered into an agreement with a director of the Company pursuant to
which such director has agreed to purchase 500,000 shares (the "Shares") of
the Company's common stock for $2,345,000 from the escrow fund proposed to be
established in connection with the settlement of the Chalverus Case (See Note
F to Notes to Consolidated Financial Statements.) The Shares have been
treated as though issued in August 2000 for purposes of determining weighted
average common shares outstanding for computing basic loss per share, even
though they were not actually issued as of September 30, 2000, because the
Company was obligated in August 2000 to issue the Shares either to the Fund
or directly to the director.
NOTE D - COMPREHENSIVE INCOME (LOSS)
The components of the Company's comprehensive income (loss) are as follows:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
Sept 30, Sept 30
(IN THOUSANDS) 2000 1999 2000 1999
----------- -------------- -------------- ------------ ------------------
<S> <C> <C> <C> <C>
Net (loss) income ($246) $2,444 ($15,323) ($3,241)
-------------- -------------- ------------ ------------------
Other Comprehensive (Loss)
Foreign currency translation adjustments,
net of income taxes (58) 17 (134) 281
-------------- -------------- ------------ ------------------
Comprehensive (loss) income ($304) $2,461 ($15,457) ($2,960)
============== ============== ============ ==================
</TABLE>
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NOTE E-NEW ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative
Instruments and Hedging Activities". In June 2000, the FASB issued SFAS No. 138,
which amends certain provisions of SFAS 133 to clarify four areas causing
difficulties in implementation. The amendment included expanding the normal
purchase and sale exemption for supply contracts, permitting the offsetting of
certain intercompany foreign currency derivatives and thus reducing the number
of third party derivatives, permitting hedge accounting for foreign-currency
denominated assets and liabilities, and redefining interest rate risk to reduce
sources of ineffectiveness. The Company will adopt SFAS 133 and the
corresponding amendments under SFAS 138 on January 1, 2001. SFAS 133, as amended
by SFAS 138, is not expected to have a material impact on the Company's
financial position or results of operation.
The Securities and Exchange Commission has released Staff Accounting Bulletin
No. 101, "Revenue Recognition in Financial Statements," which sets forth its
views regarding how revenue should be recognized in financial statements. The
Company's revenue recognition practices are in conformity with accounting
standards generally accepted in the United States of America, and the Company
does not expect that this bulletin will have a material impact on the Company's
financial position or results of operation.
NOTE F - COMMITMENTS AND CONTINGENCIES
COMPANY LITIGATION
CLASS ACTION LITIGATION
The Company has been involved in two matters involving litigation related to
restatements of its financial statements (the Chalverus Case and the Gelfer
Case). As described below, the Company has reached agreements with the
plaintiffs to settle both cases and recorded a charge of $14.1 million (net of
insurance reimbursements of $4.3 million) against operations in the quarter
ended June 30, 2000, reflecting the estimated cost of the settlements and
remaining legal costs.
CHALVERUS CASE
As a result of complaints filed in 1997 and 1998 in the United States District
Court of Massachusetts, which were subsequently consolidated into a single
complaint, (the "Amended Complaint" or the "Chalverus Case"), the Company has
been engaged in litigating matters related to a restatement of its financial
statements in 1997. The Amended Complaint alleged that the Company and two
officers caused the issuance of false and misleading financial statements for
the fiscal quarter ended June 30, 1997 by inappropriately including $5 million
in revenue from a series of contracts with First Data Resources, Inc. The
Amended Complaint alleged that as a result of the inclusion of such revenue in
the Company's financial statements for that quarter, the market price of the
Company's common stock was artificially inflated, causing damage to purchasers
of the Company's common stock.
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Page 9 OF 21
The parties have agreed in writing to a settlement of the litigation, pursuant
to which the Company will pay $5.25 million in shares of its common stock or in
cash, at the Company's option, for the benefit of a stipulated class defined to
include all purchasers of the Company's common stock between July 29, 1997 and
October 29, 1997, inclusive, and the action will be dismissed with prejudice.
The parties' settlement is subject to notice to class members and to approval by
the United States District Court of Massachusetts (the "Court"). The Court has
set December 18, 2000 as the date to consider such approval hearing.
GELFER CASE
In December 1998, a complaint also purporting to be a class action was filed
with the Court after the Company's announcement on November 24, 1998 that it may
be recording revenue adjustments to prior periods. In April 1999, the plaintiffs
filed their First Amended Class Action Complaint (the "Gelfer Complaint") in
that action following the January 20, 1999 restatement. The Gelfer Complaint
involves the Company and two officers and alleges violations of the Exchange
Act. The Complaint was filed on behalf of a purported class of persons who
purchased the Company's common stock between April 2, 1998 through November 23,
1998.
The parties entered a settlement by which the Company will pay a total of $12.25
million, of which at least $4.5 million is a cash payment and the remaining
$7.75 million is a payment in shares of its common stock or in cash, at the
Company's option. The settlement is for the benefit of stipulated class defined
to include all purchasers of the Company's common stock between April 2,1998 and
November 23,1998, inclusive, and the action will be dismissed with prejudice.
The parties' settlement is subject to notice to class members and further
approval by the Court.
ERNST & YOUNG CASE
On June 9, 2000, the Company and two of its officers filed a complaint against
Ernst & Young LLP and Alan B. Levine (a former partner of Ernst & Young LLP) in
a Massachusetts state court. The complaint alleges that the defendants committed
professional malpractice, breached contractual and fiduciary duties owed to the
Company, and issued false and misleading public statements in connection with
accounting advice that Ernst & Young LLP rendered to the Company regarding the
revenues in question in the Chalverus Case discussed above. The Company seeks
compensatory damages, including contribution, for losses and other costs
incurred in connection with the Chalverus Case. The defendants have moved to
dismiss the complaint on the grounds that the matter should be arbitrated.
FORMAL ORDER OF PRIVATE INVESTIGATION
In May 1999, the Boston office of the SEC issued a Formal Order of Private
Investigation of the Company and unidentified individuals, currently or formerly
associated with the Company, concerning past accounting matters, financial
reports, and other public disclosures and trading activity in the Company's
securities during 1997 and 1998. The Company is cooperating fully with the
investigation.
NOTE G - SALE OF STOCK
In August 2000, the Company entered into an agreement with a director of the
Company pursuant to which such director has agreed to purchase 500,000 shares
(the "Shares") of the Company's common stock for $2,345,000 from the escrow
fund (the "Fund") proposed to be established in connection with the
settlement of the Chalverus Case (See Note F to Notes to Consolidated
Financial Statements). However, if (i) the case does not settle on or before
December 31, 2000, (ii) the Fund is not established in connection with the
settlement of the case, (iii) the court before which the case is pending does
not approve the settlement on or before December 31, 2000 or (iv) the Fund
does not sell
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the shares to such director, then the director has agreed to purchase, and
the Company has agreed to sell, such number of shares at the same price. The
Shares have been treated as though issued in August 2000 for purposes of
determining weighted average common shares outstanding for computing basic
loss per share, even though they were not actually issued as of September 30,
2000, because the Company was obligated in August 2000 to issue the Shares
either to the Fund or directly to the director.
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Page ll of 21
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The Company's business has historically experienced a lack of predictable
revenues. The timing of revenue recognition is related to the completion of
implementation services and acceptance of the licensed software by the customer,
the timing of which has proven to be difficult to predict accurately.
In 1999, there was a reduction in the size of the Company's sales force of
almost 50%. Given the intense competition for qualified sales personnel and the
significant amount of time required to train new sales personnel, this reduction
may adversely affect the Company's ability to meet its future sales goals. In
addition, because of the reduced size of the Company's sales force, the Company
is more focused on closing larger but fewer license transactions than in the
past. This may increase the volatility in the Company's quarterly operating
results.
The Company's independent public accountants have identified in connection with
their audits of the Company's 1997, 1998, and 1999 financial statements material
weaknesses in the Company's internal control environment. See Note 1 to the
Consolidated Financial Statements included in the Company's 1999 Annual Report
on Form 10-K/A.
RESULTS OF OPERATIONS
As of January 1, 1999, the Company refined its method of classifying costs and
expenses by directly charging costs to their appropriate functional
classification.
During the third quarter of 1999, the Company further refined its methodology of
classifying costs and expenses. Results for the first six months of 1999 have
been reclassified to conform with the current methodology.
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED TO THREE AND NINE MONTHS
ENDED SEPTEMBER 30, 1999
REVENUE
Total revenue for the three-month period ended September 30, 2000 (the
"2000 Three Month Period") increased 10.5% to $22.7 million from $20.5 million
for the three-month period ending September 30, 1999 (the "1999 Three Month
Period"). Total revenue for the nine-month period ended September 30, 2000 (the
"2000 Nine Month Period") increased 8.8% to $62.0 million from $56.9 million for
the nine-month period ended September 30, 1999 (the "1999 Nine Month Period").
The increase in total revenue was due to an increase in software license
revenue, partially offset by a decrease in services revenue.
Software license revenue for the 2000 Three Month Period increased 106.3% to
$12.9 million from $6.3 million for the 1999 Three Month Period. Software
license revenue for the 2000 Nine Month Period increased 31.7% to $28.2 million
from $21.4 million for the 1999 Nine Month Period. The increases were due
primarily to a rise in software license renewals and acceptances by new and
existing customers and less allocation of a portion of license revenue to
services revenue in accordance with generally accepted accounting principles.
Services revenue for the 2000 Three Month Period decreased 31.7% to $9.7
million from $14.2 million for the 1999 Three Month Period. The decrease was
due primarily to the reduction of revenue recognized from previously deferred
projects and a reduced allocation of software license revenue to services
revenue under generally accepted accounting principles. Services revenue for
the 2000 Nine Month Period decreased 5.0% to $33.7 million from $35.5 million
for the 1999 Nine Month Period. The decrease in service revenue for the 2000
Nine Month Period was primarily attributable to a reduced allocation of
software license revenue to services revenue in accordance with generally
accepted accounting principles, partially offset by an increase in
maintenance revenue during the nine months ended September 30, 2000.
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COST OF REVENUE
Cost of software license revenue for the 2000 Three and Nine Month Periods and
the 1999 Three and Nine Month Periods remained constant at $0.6 million and $1.8
million, respectively. Cost of software license relates to the amortization
associated with a stock purchase warrant issued by the Company in June 1997, and
the Company's acquisition of First Data Resources Corporation's ESP software
product. These costs are being amortized through December 31, 2002. Cost of
software license as a percentage of license revenue for the 2000 Three Month
Period decreased to 4.5% from 9.3% in the 1999 Three Month Period. Cost of
software license as a percentage of license revenue for the 2000 Nine Month
Period decreased to 6.2% from 8.2% in the 1999 Nine Month Period. The lower
percentages are due to the increase in license revenue.
Cost of services consists primarily of the costs of providing implementation,
consulting, maintenance, and training services. Cost of services for the 2000
Three Month Period increased 56.1% to $11.1 million from $7.1 million for the
1999 Three Month Period. Cost of services for the 2000 Nine Month Period
increased 18.1% to $28.1 million from $23.8 million for the 1999 Nine Month
Period. Cost of services as a percentage of services revenue increased to
114.5% for the 2000 Three Month Period from 50.1% for the 1999 Three Month
Period. Cost of services as a percentage of services revenue increased to
83.2% for the 2000 Nine Month Period from 67.0% for the 1999 Nine Month
Period. Services gross profit in the 1999 Three Month and Nine Month Periods
had been favorably impacted due to recognition of service revenue that had
been previously deferred; the costs associated with the deferred revenue had
been recognized in prior periods. During the 2000 Three Month and Nine Month
Periods, service margins declined due to a lower recovery rate on hours
worked and costs associated with increased staffing - such as compensation,
benefits, travel, and facilities. The lower recovery was also due to
investing in field deployment of an eCRM template for new and existing
customers, investing in partnership relationships, as well as a lower
allocation of license revenue to service revenue as required by generally
accepted accounting principles.
OPERATING EXPENSES
Research and development expenses for the 2000 Three Month Period decreased
30.7% to $3.6 million from $5.1 million for the 1999 Three Month Period.
Research and development expenses for the 2000 Nine Month Period decreased 25.6%
to $11.4 million from $15.4 million for the 1999 Nine Month Period. As a
percentage of total revenue, research and development expenses decreased to
15.7% for the 2000 Three Month Period from 25.0% for the 1999 Three Month
Period. As a percentage of total revenue, research and development expenses
decreased to 18.4% for the 2000 Nine Month Period from 27.0% for the 1999 Nine
Month Period. These decreases were due to decreased staffing costs - such as
compensation, benefits, and travel. These cost reductions are not indicative of
management's commitment to research and development projects. Management
believes that the current level of staffing will enable the Company to
successfully innovate.
Selling and marketing expenses for the 2000 Three Month Period increased 48.9%
to $5.9 million from $3.9 million for the 1999 Three Month Period. Selling and
marketing expenses for the 2000 Nine Month Period increased 17.5% to $17.4
million from $14.9 million for the 1999 Nine Month Period. As a percentage of
total revenue, selling and marketing expenses increased to 25.8% for the 2000
Three Month Period from 19.2% for the 1999 Three Month Period. As a percentage
of total revenue, selling and marketing expenses increased to 28.2% for the 2000
Nine Month Period from 26.1% for the 1999 Nine Month Period. These increases
were due to additional costs associated with marketing programs such as trade
shows and additional employee related costs- such as compensation, benefits, and
travel.
General and administrative expenses for the 2000 Three Month Period increased
8.4% to $3.0 million from $2.8 million for the 1999 Three Month Period. General
and administrative expenses for the 2000 Nine Month Period increased 2.2% to
$8.2 million from $8.1 million for the 1999 Nine Month Period. These increased
costs were due to costs associated with increased staffing - such as
compensation, benefits, and travel. As a percentage of total revenue, general
and administrative expenses decreased to 13.4% for the 2000 Three Month Period
from 13.7% for the 1999 Three Month Period. As a percentage of total revenue,
general and administrative expenses decreased to 13.3% for the 2000 Nine Month
Period from 14.2% for the 1999 Nine Month Period. These decreases were due
primarily to the increase in software license revenue.
<PAGE>
Page 13 OF 21
LITIGATION SETTLEMENT
The Company has been involved in two matters involving litigation related to
restatements of its financial statements (the Chalverus Case and the Gelfer
Case). The Company has reached agreements in principle with the plaintiffs in
both matters and has recorded a charge of $14.1 million (net of insurance
reimbursements of $4.3 million) in the quarter ended June 30, 2000, reflecting
the estimated cost of the settlements and the remaining legal costs. See Note F
of Notes to Consolidated Financial Statements for additional information.
INSTALLMENT RECEIVABLE INTEREST INCOME
Installment receivable interest income, which consists of the portion of all
license fees under long-term software license agreements that is attributable to
the time value of money, remained constant at $0.9 million for the 2000 Three
Month Period and the 1999 Three Month Period. Installment receivable interest
income increased 6.9% to $2.7 million for the 2000 Nine Month Period from $2.6
million for the 1999 Nine Month Period. This change was primarily due to the
increase in the Company's installment receivable balance.
INTEREST INCOME, NET
Interest income, net increased 64.6% to $0.5 million for the 2000 Three Month
Period from $0.3 million for the 1999 Three Month Period. Interest income, net
increased 122.8% to $1.3 million for the 2000 Nine Month Period from $0.6
million for the 2000 Nine Month Period. These increases were due primarily to
additional interest income generated on cash and cash equivalents due to a
larger average cash balance.
OTHER INCOME (EXPENSE), NET
Other income (expense), net, which consists primarily of reseller development
funds received from third-party resellers of computer hardware products and
unrealized currency exchange gains or losses on foreign denominated accounts
receivable, was zero for the 2000 Three Month Period and $0.3 million of net
income for the 1999 Three Month Period. Other income, net, decreased 137.2% to
$0.2 million net expenses for the 2000 Nine Month Period from $0.5 million net
income for the 1999 Nine Month Period. The decrease was due primarily to a
larger unrealized currency exchange losses for foreign denominated accounts
receivable.
PROVISION FOR INCOME TAXES
The tax provision for the 2000 Three and Nine Month Periods consisted of foreign
taxes in the amount of $0.1 million and $0.2 million respectively. There was no
tax provision for the 1999 Three and Nine Month Periods. No benefit was recorded
for domestic losses incurred due to uncertainty regarding eventual utilization
of these losses.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has funded its operations primarily through
cash flow from operations, bank borrowings, and proceeds from the Company's
public stock offerings.
At September 30, 2000, the Company has cash and cash equivalents of
approximately $25.3 million and working capital of approximately $32.6 million.
The Company's approach of charging license fees payable in installments over the
term of its license has historically deferred the receipt of cash and limits the
availability of working capital in the short term while having a stabilizing
effect on cash and working capital for the longer term.
Net cash used by operating activities for the 2000 Nine Month Period was $4.9
million, as compared to $4.4 million of net cash provided during the 1999 Nine
Month Period. This change was primarily due to an increase
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in operating expense during the 2000 Nine Month Period and the additional
collection of long term outstanding receivables during the 1999 Nine Month
Period.
Net cash used in investing activities was approximately $0.7 million during the
2000 Nine Month Period, as compared to $1.8 million for the 1999 Nine Month
Period. This change was primarily due to fewer purchases of property and
equipment, consisting mainly of computer hardware and software, and furniture
and fixtures.
Net cash provided by financing activities was $1.0 million during the 2000 Nine
Month Period, as compared, to $0.8 million used in the 1999 Nine Month Period.
The increase in cash provided was primarily due to additional stock option
exercises and the sale of stock under the Company's Employee Stock Purchase
Plan.
The Company anticipates, assuming the entry of Final Judgment in the
Chalverus Case, that it will pay out $5 million in either cash or an amount
in shares of the Company's common stock of equivalent value during the fourth
quarter of 2000. (See Note F to Notes to Consolidated Financial Statements.)
The Company anticipates, assuming the entry of Final Judgment in the Gelfer
Case, that it will pay out $7.75 million in either cash or an amount in
shares of the Company's common stock of equivalent value during the fourth
quarter of 2000. (See Note F to Notes to Consolidated Financial Statements.)
The Company has paid $4.5 million in accordance with the Gelfer settlement
and $250,000 in accordance with the Chalverus settlement during the third
quarter of 2000. The Company received $4.3 million in insurance settlement
during the second Quarter of 2000.
The Company has entered into an agreement with a director of the Company
pursuant to which such director has agreed to purchase 500,000 shares of the
Company's common stock for $2,345,000 from the escrow fund (the "Fund")
proposed to be established in connection with the settlement of the Chalverus
Case (See Note F to Notes to Consolidated Financial Statements). However, if
(i) the case does not settle on or before December 31, 2000, (ii) the Fund is
not established in connection with the settlement of the case, (iii) the
court before which the case is pending does not approve the settlement on or
before December 31, 2000 or (iv) the Fund does not sell the shares to such
director, then the director has agreed to purchase, and the Company has
agreed to sell, such number of shares at the same price.
The Company believes that current cash and cash equivalents will be
sufficient to fund the Company's operations for the near term. There can be
no assurance that additional capital which may be required to support further
revenue growth will not be required or that any such required additional
capital will be available on reasonable terms, if at all, at such time as
required by the Company.
INFLATION
Inflation has not had a significant impact on the Company's operating results to
date, and the Company does not expect it to have a significant impact in the
future. The Company's license and maintenance fees are typically subject to
annual increases based on recognized inflation indexes.
FORWARD-LOOKING STATEMENTS
This report on Form 10-Q contains certain forward-looking statements. 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
generality of the foregoing, the words "believes", "anticipates", "plans"
"expects", and similar expressions are intended to identify forward-looking
statements. There are a number of important factors that could cause the
Company's actual results to differ materially from those indicated by
forward-looking statements made in this report and presented elsewhere by
management from time to time. Some of the important risks and uncertainties that
may cause the Company's operating results to differ materially and adversely are
discussed below.
THE COMPANY IS PRESENTLY A DEFENDANT IN TWO PRIVATE SECURITIES LITIGATION
MATTERS. The Company has entered into a memorandum of understanding with
plaintiffs' counsel in each of these cases with respect to proposed settlements,
the financial impact of which are reflected in the Company's financial
statements contained in this report on Form 10-Q. The proposed settlements are
contingent, however, on final court approval. The failure to settle either of
these cases on the proposed terms could result in the Company being required to
pay substantial damages or higher settlement costs, incurring substantial
defense costs and suffering diversion of management time and attention, any of
which could have a material adverse effect on the Company's financial position
or results of operation.
THE COMPANY IS BEING INVESTIGATED BY THE SECURITIES AND EXCHANGE COMMISSION. In
May of 1999, the Boston office of the SEC issued a Formal Order of Private
Investigation of the Company
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and, as a result, the Company and certain individuals, currently or formerly
associated with the Company, are presently being investigated by the SEC
concerning past accounting matters, financial reports and other public
disclosures and trading activity in the Company's securities during 1997 and
1998. Such investigation may result in the SEC imposing fines on the Company or
taking other measures that may have a material adverse impact on the Company's
financial position or results of operations. In addition, regardless of the
outcome of the investigation, it is likely that the Company will incur
substantial defense costs and that such investigation will cause a diversion of
management time and attention. Finally, the negative publicity resulting from
the investigation has made and may continue to make it more difficult for the
Company to close sales, which in turn could have a material adverse impact on
the Company's financial position or results of operations.
THE COMPANY CONTINUED TO HAVE MATERIAL WEAKNESSES IN ITS FINANCIAL CONTROL
ENVIRONMENT. The Company's independent public accountants have identified in
connection with their audits of the Company's 1997, 1998, and 1999 financial
statements material weaknesses in the Company's internal control environment. In
connection with the completion of the 1999 audit, they informed the Company that
their management letter would include a recommendation to, among other things,
strengthen the resources of the Company's finance organization to improve
financial accounting and internal controls. Although the Company is actively
seeking to hire additional qualified personnel into such organization, these
efforts have proved to be difficult and there can be no assurance that the
Company will be successful in these efforts in the near term. The inability to
hire such personnel could have a material adverse impact on the Company's
reputation and on its financial condition and results of operations.
THE COMPANY'S STOCK PRICE HAS BEEN VOLATILE. Quarterly results have and are
likely to fluctuate significantly. The market price of Pegasystems' common stock
has been and may continue to be highly volatile. Factors that are difficult to
predict, such as quarterly revenues and operating results, statements and
ratings by financial analysts, overall market performance and the outcome of
litigation, will have a significant effect on the price for shares of
Pegasystems' common stock. Revenues and operating results have varied
considerably in the past from period to period and are likely to vary
considerably in the future. The Company plans product development and other
expenses based on anticipated future revenue. If revenue falls below
expectations, financial performance is likely to be adversely affected because
only a small portion of expenses vary with revenue. As a result,
period-to-period comparisons of operating results are not necessarily meaningful
and should not be relied upon to predict future performance.
THE TIMING OF LICENSE REVENUES IS RELATED TO THE COMPLETION OF IMPLEMENTATION
SERVICES AND PRODUCT ACCEPTANCE BY THE CUSTOMER, THE TIMING OF WHICH HAS BEEN
DIFFICULT TO PREDICT ACCURATELY. There can be no assurance that Pegasystems will
be profitable on an annual or quarterly basis or that earnings or revenues will
meet analysts' expectations. Fluctuations may be particularly pronounced because
a significant portion of revenues in any quarter is attributable to product
acceptance or license renewal by a relatively small number of customers.
Fluctuations also reflect a policy of recognizing license fee revenue upon
product acceptance or license renewal in an amount equal to the present value of
the total committed license payment due during the term. Customers generally do
not accept products until the end of a lengthy sales cycle and an implementation
period, typically ranging from one to six months but in some cases significantly
longer. Risks over which the Company has little or no control, including
customers' budgets, staffing allocation, and internal authorization reviews, can
significantly affect the sales and acceptance cycles. Changes dictated by
customers may delay product implementation and revenue recognition. The
Company's business and financial and operating results have experienced and may
continue to experience significant seasonality.
THE COMPANY WILL NEED TO DEVELOP NEW PRODUCTS, EVOLVE EXISTING ONES, AND ADAPT
TO TECHNOLOGICAL CHANGE. Technological developments, customer requirements,
programming languages and industry standards change frequently in the Company's
markets. As a result, success in current markets and new markets will depend
upon the Company's ability to enhance current products, to develop and introduce
new products that meet customer needs, keep pace with technological changes,
respond to competitive products, and achieve market acceptance. Product
development requires substantial investments for research, refinement and
testing. There can be no assurance that the Company will
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have sufficient resources to make necessary product development investments.
Pegasystems may experience difficulties that will delay or prevent the
successful development, introduction or implementation of new or enhanced
products. Inability to introduce or implement new or enhanced products in a
timely manner would adversely affect future financial performance. The Company's
products are complex and may contain errors. Errors in products will require the
Company to ship corrected products to customers. Errors in products could cause
the loss of or delay in market acceptance or sales and revenue, the diversion of
development resources, injury to the Company's reputation, or increased service
and warranty costs which would have an adverse effect on financial performance.
THE COMPANY HAS HISTORICALLY SOLD TO THE FINANCIAL SERVICES MARKET. This market
is consolidating rapidly, and faces uncertainty due to many other factors. The
Company has historically derived a significant portion of its revenue from
customers in the financial services market, and its future growth depends, in
part, upon increased sales to this market. Competitive pressures, industry
consolidation, decreasing operating margins within this industry, currency
fluctuations, geographic expansion and deregulation affect the financial
condition of the Company's customers and their willingness to pay. In addition,
customers' purchasing patterns are somewhat discretionary. As a result, some or
all of the factors listed above may adversely affect the demand by customers.
The financial services market is undergoing intense domestic and international
consolidation. In recent years, several customers have been merged or
consolidated. Future mergers or consolidations may cause a decline in revenues
and adversely affect the Company's future financial performance.
THE COMPANY'S GROWTH STRATEGY REQUIRES EXPANSION INTO NEW VERTICAL MARKETS. The
results of this strategy are uncertain. A critical part of the Company's growth
strategy is to continue selling products to markets other than financial
services, such as insurance, telecommunications, and health care. The Company
will need to hire additional personnel with expertise in these other markets and
otherwise invest in people and technologies to facilitate this expansion.
Deterioration in economic or market conditions generally may also adversely
affect the demand by customers in these other markets. There can be no assurance
that the Company will be successful in selling products to these other markets
or in continuing to attract and retain personnel with the necessary industry
expertise. Inability to effectively penetrate these other markets could have an
adverse effect on future financial performance.
IF EXISTING CUSTOMERS DO NOT RENEW THEIR LICENSES, THE COMPANY'S FINANCIAL
RESULTS MAY SUFFER. A significant portion of total revenue has been attributable
to license renewals. While historically a significant number of customers have
renewed their licenses, there can be no assurance that a significant number of
customers will continue to renew expiring licenses. A decrease in license
renewals absent offsetting revenue from other sources would have a material
adverse effect on future financial performance. In addition, possible transition
to a prepaid extended term license may have a material adverse impact on the
amount of license renewal revenues in future periods.
THE COMPANY DEPENDS ON CERTAIN KEY PERSONNEL AND MUST BE ABLE TO ATTRACT AND
RETAIN QUALIFIED PERSONNEL IN THE FUTURE. The business is dependent on a number
of key, highly skilled technical, managerial, consulting, sales and marketing
personnel, including Mr. Trefler, the Company's Chief Executive Officer. The
loss of key personnel could adversely affect financial performance. The Company
does not have any significant key-man life insurance on any officers or
employees and does not plan to put any in place. The Company's success will
depend in large part on the ability to hire and retain qualified personnel. The
number of potential employees who have the extensive knowledge of computer
hardware and operating systems needed to develop, sell and maintain its products
is limited, and competition for their services is intense and there can be no
assurance that the Company will be able to attract and retain such personnel. If
the Company is unable to do so, the Company's business, operating results, and
financial condition could be materially adversely affected.
THE MARKET FOR THE COMPANY'S OFFERINGS IS INCREASINGLY AND INTENSELY
COMPETITIVE, RAPIDLY CHANGING, AND HIGHLY FRAGMENTED. The market for customer
relationship management software and related consulting and training services is
intensely competitive and highly fragmented. The Company currently encounters
significant competition from internal information
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systems departments of potential or existing customers that develop custom
software. It also competes with companies that target the customer interaction
and workflow markets and professional services organizations that develop custom
software in conjunction with rendering consulting services. Competition for
market share and pressure to reduce prices and make sales concessions are likely
to increase. Many competitors have far greater resources and may be able to
respond more quickly and efficiently to new or emerging technologies,
programming languages or standards or to changes in customer requirements or
preferences. Competitors may also be able to devote greater managerial and
financial resources to develop, promote and distribute products and provide
related consulting and training services. There can be no assurance that the
Company will be able to compete successfully against current or future
competitors or that the competitive pressures faced by the Company will not
materially adversely affect its business, operating results, and financial
condition.
THE COMPANY MUST MANAGE INCREASED BUSINESS COMPLEXITY AND GROWTH EFFECTIVELY.
The business has grown in size, geographic scope and complexity and product
offerings and the customer base have expanded. This growth and expansion have
placed, and are expected to continue to place, a significant strain on
management, operations and capital needs. Continued growth will require the
Company to hire, train and retrain many employees in the United States and
abroad, particularly additional sales and financial personnel. The Company will
also need to enhance its financial and managerial controls and reporting
systems. There can be no assurance that the Company will attract and retain the
personnel necessary to meet its business challenges. Failure to manage growth
effectively may adversely affect future financial performance.
THE COMPANY SUFFERED RECENT ATTRITION IN ITS SALES FORCE. In 1999, there was a
reduction in the size of the Company's sales force of almost 50%. Given the
intense competition for qualified sales personnel and significant amount of time
required to train new sales personnel, this reduction may adversely affect the
Company's ability to meet its future sales goals. In addition, because of the
reduced size of the Company's sales force, the Company is more focused on
closing larger but fewer license transactions than in the past. This may
increase the volatility in the Company's quarterly operating results.
THE COMPANY RELIES ON CERTAIN THIRD PARTY RELATIONSHIPS. The Company has a
number of relationships with third parties that are significant to sales,
marketing and support activities and product development efforts. The Company
relies on relational database management system applications and development
tool vendors, software and hardware vendors, and consultants to provide
marketing and sales opportunities for the direct sales force and to strengthen
the Company's products through the use of industry-standard tools and utilities.
The Company also has relationships with third parties that distribute its
products. In particular, the Company relies on its relationship with First Data
Corporation for the distribution of products to the credit card and mutual fund
markets. There can be no assurance that these companies, most of which have
significantly greater financial and marketing resources, will not develop or
market products that compete with those of the Company in the future or will not
otherwise end their relationships with or support of the Company.
THE COMPANY MAY FACE PRODUCT LIABILITY AND WARRANTY CLAIMS. The Company's
license agreements typically contain provisions intended to limit the nature and
extent of the Company's risk of product liability and warranty claims. There is
a risk that a court might interpret these terms in a limited way or could hold
part or all of these terms to be unenforceable. Also, there is a risk that these
contract terms might not bind a party other than the direct customer.
Furthermore, some of the Company's licenses with its customers are governed by
non-U.S. law, and there is a risk that foreign law might give the Company less
or different protection. Although the Company has not experienced any material
product liability claims to date, a product liability suit or action claiming a
breach of warranty, whether or not meritorious, could result in substantial
costs and a diversion of management's attention and the Company's resources.
THE COMPANY FACES RISKS FROM OPERATIONS AND CUSTOMERS BASED OUTSIDE OF THE U.S.
Sales to customers headquartered outside of the United States represented
approximately 21.4%, 22.6%,
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and 16.5% of the Company's total revenue in 1999, 1998, and 1997, respectively.
The Company, in part through its wholly-owned subsidiaries based in the United
Kingdom, Singapore, Sweden, Canada, and Australia, markets products and renders
consulting and training services to customers based in Canada, the United
Kingdom, France, Switzerland, Ireland, Luxembourg, Mexico, Sweden, Australia,
Austria, Hong Kong and Singapore. The Company has established offices in
continental Europe and in Australia. The Company believes that its continued
growth will necessitate expanded international operations requiring a diversion
of managerial attention and financial resources. The Company anticipates hiring
additional personnel to accommodate international growth, and the Company may
also enter into agreements with local distributors, representatives, or
resellers. If the Company is unable to do one or more of these things in a
timely manner, the Company's growth, if any, in its foreign operations will be
restricted, and the Company's business, operating results, and financial
condition could be materially and adversely affected.
In addition, there can be no assurance that the Company will be able to maintain
or increase international market demand for its products. Most of the Company's
international sales are denominated in U.S. dollars. Accordingly, any
appreciation of the value of the U.S. dollar relative to the currencies of those
countries in which the Company distributes its products may place the Company at
a competitive disadvantage by effectively making its products more expensive as
compared to those of its competitors.
Additional risks inherent in the Company's international business activities
generally include unexpected changes in regulatory requirements, increased
tariffs and other trade barriers, the costs of localizing products for local
markets and complying with local business customs, longer accounts receivable
patterns and difficulties in collecting foreign accounts receivable,
difficulties in enforcing contractual and intellectual property rights,
heightened risks of political and economic instability, the possibility of
nationalization or expropriation of industries or properties, difficulties in
managing international operations, potentially adverse tax consequences
(including restrictions on repatriating earnings and the threat of "double
taxation"), enhanced accounting and internal control expenses, and the burden of
complying with a wide variety of foreign laws. There can be no assurance that
one or more of these factors will not have a material adverse effect on the
Company's foreign operations, and, consequentially, the Company's business,
operating results, and financial condition.
THE COMPANY FACES RISKS RELATED TO INTELLECTUAL PROPERTY CLAIMS OR APPROPRIATION
OF ITS INTELLECTUAL PROPERTY RIGHTS. The Company relies primarily on a
combination of copyright, trademark and trade secrets laws, as well as
confidentiality agreements to protect its proprietary rights. In October 1998,
the Company was granted a patent by the United States Patent and Trademark
Office relating to the architecture of the Company's systems. There can be no
assurance that such patent will not be invalidated or circumvented or that
rights granted thereunder or the description contained therein will provide
competitive advantages to the Company's competitors or others. Moreover, despite
the Company's efforts to protect its proprietary rights, unauthorized parties
may attempt to copy aspects of the Company's products or to obtain the use of
information that the Company regards as proprietary. In addition, the laws of
some foreign countries do not protect the Company's proprietary rights to as
great an extent as do the laws of the United States. There can be no assurance
that the Company's means of protecting its proprietary rights will be adequate
or that the Company's competitors will not independently develop similar
technology.
The Company is not aware that any of its products infringe the proprietary
rights of third parties. There can be no assurance, however, that third parties
will not claim infringement by the Company with respect to current or future
products. The Company expects that software product developers will increasingly
be subject to infringement claims as the number of products and competitors in
the Company's industry segment grows and the functionality of products in
different industry segments overlaps. Any such claims, with or without merit,
could be time-consuming, result in costly litigation, cause product shipment
delays, or require the Company to enter into royalty or licensing agreements.
Such royalty or licensing agreements, if required, may not be available on terms
acceptable to the Company or at all, which could have a material adverse effect
upon the Company's business, operating results, and financial condition.
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Page 19 OF 21
PEGASYSTEMS INC.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk represents the risk of loss that may affect the Company due to
adverse changes in financial market prices and rates. The Company's market risk
exposure is primarily the result of fluctuations in foreign exchange rates. The
Company has not entered into derivative or hedging transactions to manage risk
in connection with such fluctuations.
Certain of the Company's international sales are denominated in foreign
currencies. The price in dollars of products sold outside the United States in
foreign currencies will vary as the value of the dollar fluctuates against such
foreign currencies. Although the Company's sales denominated in foreign
currencies in 1999 and the nine months ended September 30, 2000 were not
material, there can be no assurance that such sales will not be material in the
future and that there will not be increases in the value of the dollar against
such currencies that will reduce the dollar return to the Company on the sale of
its products in such foreign currencies.
PART II - OTHER INFORMATION:
Item 1. Legal Proceedings
COMPANY LITIGATION
CLASS ACTION LITIGATION
The Company has been involved in two matters involving litigation related to
restatements of its financial statements (the Chalverus Case and the Gelfer
Case). As described below, the Company has reached agreements with the
plaintiffs to settle both cases and has recorded a charge of $14.1 million (net
of insurance reimbursements of $4.3 million) against operations in the quarter
ended June 30, 2000, reflecting the estimated cost of the settlements and
remaining legal costs.
CHALVERUS CASE
As a result of complaints filed in 1997 and 1998 in the United States District
Court of Massachusetts, which were subsequently consolidated into a single
complaint, (the "Amended Complaint" or the "Chalverus Case"), the Company has
been engaged in litigating matters related to a restatement of its financial
statements in 1997. The Amended Complaint alleged that the Company and two
officers caused the issuance of false and misleading financial statements for
the fiscal quarter ended June 30, 1997 by inappropriately including $5 million
in revenue from a series of contracts with First Data Resources, Inc. The
Amended Complaint alleged that as a result of the inclusion of such revenue in
the Company's financial statements for that quarter, the market price of the
Company's common stock was artificially inflated, causing damage to purchasers
of the Company's common stock.
The parties have agreed in writing to a settlement of the litigation, pursuant
to which the Company will pay $5.25 million in shares of its common stock or in
cash, at the Company's option, for the benefit of a stipulated class defined to
include all purchasers of the Company's common stock between July 29, 1997 and
October 29, 1997, inclusive, and the action will be dismissed with prejudice.
The parties' settlement is subject to notice to class members and to approval by
the United States District Court of Massachusetts (the "Court"). The Court has
set December 18, 2000 as the date to consider such approval hearing.
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Page 20 OF 21
GELFER CASE
In December 1998, a complaint also purporting to be a class action was filed
with the Court after the Company's announcement on November 24, 1998 that it may
be recording revenue adjustments to prior periods. In April 1999, the plaintiffs
filed their First Amended Class Action Complaint (the "Gelfer Complaint") in
that action following the January 20, 1999 restatement. The Gelfer Complaint
involves the Company and two officers and alleges violations of the Exchange
Act. The Complaint was filed on behalf of a purported class of persons who
purchased the Company's common stock between April 2, 1998 through November 23,
1998.
The parties entered a settlement by which the Company will pay a total of $12.25
million, of which at least $4.5 million is a cash payment and the remaining
$7.75 million is a payment in shares of its shares of its common stock or in
cash, at the Company's option. The Ssettlement is for the benefit of stipulated
class defined to include all purchasers of the Company's common stock between
April 2,1998 and November 23,1998, inclusive, and the action will be dismissed
with prejudice. The parties' settlement is subject to notice to class members
and further approval by the Court.
FORMAL ORDER OF PRIVATE INVESTIGATION
In May 1999, the Boston office of the SEC issued a Formal Order of Private
Investigation of the Company and unidentified individuals, currently or formerly
associated with the Company, concerning past accounting matters, financial
reports, and other public disclosures and trading activity in the Company's
securities during 1997 and 1998. The Company is cooperating fully with the
investigation.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
10.1 Letter Agreement Between the Company and Alexander V. d'Arbeloff dated
August 23, 2000
27.1 Financial Data Schedule
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Page 21 OF 21
PEGASYSTEMS INC.
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.
PEGASYSTEMS INC.
Date: November 13, 2000 /s/ James P. O'Halloran
------------------------------
James P. O'Halloran
Treasurer and Chief Financial Officer
(principal financial officer and
chief accounting officer)
