<PAGE>
CONFIDENTIAL PAGE 1 11/11/98
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 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, 1998
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 0-24081
EVOLVING SYSTEMS, INC.
(Exact Name of Registrant as Specified in its Charter)
DELAWARE 84-1010843
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
9777 MT. PYRAMID COURT, ENGLEWOOD, COLORADO 80112
(Address of Principal Executive Offices) (Zip Code)
(303) 802-1000
(Registrant's Telephone Number, Including Area Code)
Indicate by check 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 filed such reports, and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
----- -----
As of September 30, 1998, there were outstanding 11,618,557 shares of
Registrant's Common Stock (par value $0.001 per share).
<PAGE>
CONFIDENTIAL PAGE 2 11/11/98
EVOLVING SYSTEMS, INC.
PART 1 FINANCIAL INFORMATION PAGE
Item 1. Financial Statements
Balance Sheets
September 30, 1998 (unaudited) and December 31, 1997........ 3
Statements of Operations
for the three-month and nine month periods ended
September 30, 1998 and 1997 (unaudited)..................... 4
Condensed Statements of Cash Flow
for the nine month periods ended September 30, 1998 and
1997 (unaudited)............................................ 5
Notes to Financial Statements..................................... 5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................. 7
PART II OTHER INFORMATION............................................... 13
Item 1. Legal Proceedings................................................. 13
Item 2. Changes in Securities............................................. 13
Item 3. Defaults on Senior Securities..................................... 13
Item 4. Submission of Matters to a Vote of Security Holders............... 13
Item 5. Other Information................................................. 13
Item 6. Exhibits and Reports on Form 8-K.................................. 13
SIGNATURES................................................................. 13
<PAGE>
CONFIDENTIAL PAGE 3 11/11/98
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
EVOLVING SYSTEMS, INC.
BALANCE SHEETS
(IN THOUSANDS EXCEPT SHARE AND PER SHARE DATA)
Sept. 30 Dec. 31,
1998 1997
-------- --------
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 24,623 $ 1,171
Certificates of deposit -- 131
Contract receivables, net 8,784 13,344
Unbilled work-in-process 4,402 841
Prepaid and other current assets 1,501 1,077
-------- --------
Total current assets 39,310 16,584
Property and equipment, net 8,312 9,803
Deferred tax asset 1,769 1,276
Other assets 217 216
-------- --------
Total assets $ 49,608 $ 27,859
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term obligations $ 2,329 $ 3,178
Accounts payable 1,556 2,047
Accrued liabilities 1,310 1,195
Unearned revenue and customer deposits 1,454 6,054
-------- --------
Total current liabilities 6,649 12,474
Long-term obligations 400 13,287
Deferred income taxes 414 400
-------- --------
Stockholders' equity:
Preferred stock, $.001 par value,
2,000,000 shares authorized, no shares
issued -- --
Series A preferred stock, $.001 par value;
0 and 8,160 shares authorized, issued and
outstanding at September 30, 1998 and
December 31, 1997 (liquidation preference
$6,250 per share) -- --
Common stock, $.001 par value; 4,930,000
non-voting shares authorized; 1,620,760
non-voting shares issued and outstanding
as of December 31, 1997; 25,000,000 voting
shares authorized; 11,573,890 voting shares
issued and outstanding as of September 30, 1998 12 2
Additional paid-in-capital 50,413 2,423
Deferred compensation (684) (992)
Retained earnings (deficit) (7,596) 265
-------- --------
Total stockholders' equity 42,145 1,698
-------- --------
Total liabilities and
stockholders' equity $ 49,608 $ 27,859
======== ========
The accompanying notes are an integral part of the financial statements.
<PAGE>
CONFIDENTIAL PAGE 4 11/11/98
EVOLVING SYSTEMS, INC.
STATEMENTS OF OPERATIONS
(IN THOUSANDS EXCEPT PER SHARE DATA)
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended Sept 30, Nine Months Ended Sept 30,
-------------------------- --------------------------
Revenue: 1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
License fees and related $ 434 $ 6,912 $ 9,090 $14,482
services
Other services 5,711 4,755 19,765 15,552
------- ------- ------- -------
Total revenue 6,145 11,667 28,855 30,034
------- ------- ------- -------
Cost of revenue:
License fees and related 1,927 1,550 6,331 5,069
services
Other services 4,870 5,561 13,848 14,033
------- ------- ------- -------
Total cost of revenue 6,797 7,111 20,179 19,102
------- ------- ------- -------
Gross margin (652) 4,556 8,676 10,932
Operating expenses:
Sales and marketing 1,247 1,396 4,238 3,436
General and administrative 2,267 2,072 6,119 6,345
Research and development 1,934 506 5,775 1,166
------- ------- ------- -------
Restructuring 361 361
------- -------
Total operating expenses 5,809 3,974 16,493 10,947
------- ------- ------- -------
Income (loss) from operations (6,461) 582 (7,817) (15)
Other (income) expense, net (293) 310 199 1,079
------- ------- ------- -------
Income (loss) before income taxes (6,168) 272 (8,016) (1,094)
Provision for (benefit from) income taxes 234 (601) (948)
------- ------- ------- -------
Income (loss) before Extraordinary item (6,168) 38 (7,415) (146)
Extraordinary item, net of applicable income taxes (446)
-------
Net income (loss) $(6,168) $ 38 $(7,861) $ (146)
======= ======= ======= =======
BASIC EARNINGS PER COMMON SHARE:
Income (loss) before extraordinary item (.53) .02 (1.12) (.09)
Extraordinary item (.07)
-------
Net income (loss) per common share $ (.53) $ .02 $ (1.19) $ (.09)
======= ======= ======= =======
DILUTED EARNINGS PER COMMON SHARE:
Income (loss) before extraordinary item (.53) (1.12) (.09)
Extraordinary item (.07)
-------
Net income (loss) per common share $ (.53) $ .02 $ (1.19) $ (.09)
======= ======= ======= =======
Basic shares outstanding 11,602 1,570 6,613 1,553
Diluted shares outstanding 11,602 9,025 6,613 1,553
</TABLE>
The accompanying notes are an integral part of the financial statements.
<PAGE>
CONFIDENTIAL PAGE 5 11/11/98
EVOLVING SYSTEMS, INC.
CONDENSED STATEMENTS OF CASH FLOW
(IN THOUSANDS)
(unaudited)
<TABLE>
<CAPTION>
Nine Months Ended September 30,
-------------------------------
1998 1997
-------- --------
OPERATING ACTIVITIES:
<S> <C> <C>
Net loss $ (7,861) $ (146)
Adjustments to reconcile net (loss) to net cash
provided by (used in) operating activities:
Provision for uncollectable contract receivables -- 413
Amortization of deferred compensation 308 134
Depreciation and amortization 3,135 2,886
Change in operating assets and liabilities:
Contract receivables 4,560 (3,381)
Unbilled work-in-process (3,561) (25)
Prepaid and other assets (293) (1,139)
Accounts payable (376) 498
Accrued liabilities (479) (582)
Unearned revenue and customer deposits (4,600) 5,574
-------- --------
Net cash provided by (used in) operating activities (9,167) 4,232
INVESTING ACTIVITIES:
Purchases of property and equipment (1,645) (2,080)
-------- --------
Net cash used in investing activities (1,645) (2,080)
FINANCING ACTIVITIES:
Repayment of long-term obligations (13,787) (2,263)
Sales of stock 48,051 61
-------- --------
Net cash provided by (used in) financing activities 34,264 (2,202)
-------- --------
Net increase in cash and cash equivalents 23,452 (50)
Cash and cash equivalents at beginning of period 1,171 3,184
-------- --------
Cash and cash equivalents at end of period $ 24,623 $ 3,134
======== ========
</TABLE>
The accompanying notes are an integral part of the financial statements.
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS
(Unaudited)
(1) BASIS OF PRESENTATION
Interim Financial Statements. The accompanying financial statements of
Evolving Systems, Inc. (the "Company") have been prepared pursuant to the rules
and regulations of the Securities and Exchange Commission ("SEC"). Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to such rules and regulations. However, the
Company believes that the disclosures are adequate to make the information
presented not misleading. The unaudited financial statements included herein
have been prepared on the same basis as the annual financial statements and
reflect all adjustments, which include only normal recurring adjustments,
necessary for a fair presentation in accordance with generally accepted
accounting principles. The results for the period ended September 30, 1998 are
not necessarily indicative of the results to be expected for any subsequent
quarter or full fiscal year. These financial statements should be read in
conjunction with the audited financial statements and the notes thereto for the
year ended December 31, 1997 included in the Company's Registration Statement on
Form S-1 (No. 333-43973), which was declared effective by the SEC on May 11,
1998.
<PAGE>
CONFIDENTIAL PAGE 6 11/11/98
Use of Estimates. The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Actual results could differ from those estimates.
(2) EARNINGS (LOSS) PER COMMON SHARE
The Company was required to adopt Statement of Financial Accounting Standards
("SFAS") No. 128, "Earnings Per Share," in its financial statements effective
retroactively to 1997. Prior period earnings per common share ("EPS") were
restated to conform with the new statement. Basic EPS was computed by dividing
net income (loss) by the weighted average number of common shares outstanding
during the period. Diluted EPS was computed using the weighted average number of
common shares plus all dilutive potential common shares outstanding during the
period unless the effect of the potential common shares is anti-dilutive.
The following is the reconciliation of the numerators and denominators of the
basic and diluted EPS computations (in thousands, except per share data):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
<S> <C> <C> <C> <C>
Basic earnings per share:
Net income (loss) $(6,168) $ 38 $(7,861) $ (146)
Weighted average common shares outstanding 11,602 1,570 6,613 1,553
Basic net income (loss) per common share $ (.53) $ .02 $ (1.19) $ (.09)
Effect of dilutive securities:
Options and warrants --- 1,335 --- ---
Preferred Stock --- 6,120 --- ---
------ ------ ------ -----
Diluted weighted average common shares outstanding 11,602 9,025 6,613 1,553
Diluted net income (loss) per common share $ (.53) $ .00 $ (1.19) $ (.09)
</TABLE>
In February 1998, the Company effected a one-for-two reverse stock split. All
references in the financial statements to shares, share prices, and per share
amounts have been adjusted retroactively for all periods presented to reflect
the stock split. During the quarter ended September 30, 1998, the Company
repriced 361,976 options to purchase common stock at $2.75 per share.
Subsequently, the company repriced an additional 238,230 options to purchase
common stock at $2.75 on November 5, 1998.
(3) INITIAL PUBLIC OFFERING
In May 1998, the Company effected an initial public offering on Form S-1. In
connection with the offering, the Company issued 3,798,000 shares of common
stock, including shares issued to cover the Underwriters' (as hereinafter
defined) over-allotment option, and received net proceeds of approximately $48
million. In addition, all of the Preferred Stock was converted into common stock
upon the closing of the initial public offering.
(4) RESTRUCTURING
During the three months ended September 30, 1998, in response to continued
reductions in purchases of the Company's products and services, the Company
completed voluntary separation plans for several individuals in conjunction with
the consolidation of and deletion of several functions. In connection with
these actions, a restructuring charge of $361,481 was recorded and paid in the
three months ended September 30, 1997. This charge related solely to severance
and benefits.
(5) CONTINGENCIES
In June, 1998, four class action lawsuits were filed in the U.S. District
Court for the District of Colorado against the Company and certain of its
officers and directors and, in two cases, the Company's Underwriters on behalf
of purchasers of the Company's common stock between May 12, 1998 and June 17,
1998. In October 1998, these cases were consolidated, class action status was
certified, and the class period was extended to July 23, 1998. The lawsuit seeks
an unspecified amount of damages and allege that the defendants disseminated
false and misleading statements about the Company's business, finances and
future prospects. The Company believes it has meritorious legal defenses with
respect to these suits
<PAGE>
CONFIDENTIAl PAGE 7 11/11/98
and intends to vigorously defend against these actions. However, the Company is
currently unable to (a) determine the ultimate outcome of the complaints, (b)
determine whether resolution of this matter will have a material adverse impact
on the Company's financial position or results of operations, or (c) reasonably
estimate the amount of loss, if any, which may result from resolution of this
matter. Motions to dismiss are pending before the Court.
The Company is, from time to time, subject to certain other claims,
assertions or litigation by outside parties as part of its ongoing business
operations. The outcome of any such contingencies are not expected to have a
material adverse effect on the financial condition, operations or cash flows of
the Company.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
---------------------------------------------------------------
RESULTS OF OPERATIONS
---------------------
GENERAL
- -------
Evolving Systems, Inc. is a leading provider of selected software
solutions and services that enable telecommunications carriers to address the
technical challenges to their operational support systems created by the
industry's rapidly changing competitive and regulatory environment. The Company
also provides custom software development services to leading telecommunications
companies.
The Company adopted the provisions of Statement of Position 97-2,
"Software Revenue Recognition," for transactions entered into after January 1,
1998. The Company derives revenue from license fees and services under the terms
of both fixed price and time and materials contracts. License fees and related
services revenue consists of revenue from contracts that generally provide for
both licenses and services or development fees related to the Company's standard
software products. Other services revenue consists of revenue from custom
programming, systems integration of third-party products, annual maintenance
contracts and training.
License fees and related services revenue is generally recognized
using the percentage-of-completion method of accounting. The percentage-of-
completion for each contract is determined based on the ratio of direct labor
hours incurred to total estimated direct labor hours. Amounts billed in advance
of services being performed are recorded as unearned revenue. Unbilled work in-
progress represents revenue earned but not yet billable under contract terms and
all such amounts are expected to be billed and collected during the succeeding
twelve months.
Services revenue provided under fixed price contracts is generally
recognized using the percentage-of-completion method of accounting described
above. Revenue from other services provided pursuant to time-and-materials
contracts is recognized as the services are performed.
Annual maintenance revenue is recorded as deferred revenue and is
recognized ratably over the service period, which is generally 12 months.
Revenue from training services is recognized as the training services are
performed. When maintenance or training services are bundled with the original
license fee arrangement, their fair value is deferred and recognized during the
period such services are provided.
The Company may encounter budget and schedule overruns on fixed-price
contracts caused by increased material, labor, or overhead costs. Adjustments
to cost estimates are made in the periods in which the facts requiring such
revisions become known. Estimated losses, if any, are recorded in the period in
which current estimates of total contract revenue and contract cost indicate a
loss.
On May 15, 1998, the Company completed an initial public offering of
Common Stock that was managed by Goldman, Sachs & Company, BancAmerica Robertson
Stephens, Hambrecht & Quist, and UBS Securities, (the "Underwriters"). On May
11, 1998 the Commission declared effective the Company's Registration Statement
on Form S-1 (Registration Statement No. 333-43973), which should be read in
conjunction with this document for further information regarding the Company's
business, risk factors, and accounting policies.
RESULTS OF OPERATIONS
- ---------------------
The following table presents, for the periods indicated, certain items
in the Company's unaudited statement of operations reflected as a percentage of
total revenue.
<PAGE>
CONFIDENTIAL PAGE 8 11/11/98
<TABLE>
<CAPTION>
Three Months Sept 30, Nine Months Ended Sept 30,
-------------------- --------------------------
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Revenue:
License fees and related services 7.1% 59.2% 31.5% 48.2%
Other services 92.9 40.8 68.5 51.8
------ ------ ------ ------
Total revenue 100.0 100.0 100.0 100.0
Cost of revenue:
License fees and related services 31.4 13.3 21.9 16.9
Other services 79.3 47.6 48.0 46.7
------ ------ ------ ------
Total cost of revenue 110.6 60.9 69.9 63.6
Gross margin (10.6) 39.1 30.1 36.4
Operating expenses:
Sales and marketing 20.3 12.0 14.7 11.4
General and administrative 36.9 17.8 21.2 21.1
Research and development 31.5 4.3 20.0 3.9
Restructuring 5.9 1.3
------ ------ ------ ------
Total operating expenses 94.5 34.1 57.2 36.4
Income (loss) from operations (105.1) 5.0 (27.0) (0.1)
Other (income) expense, net (4.7) 2.7 0.7 3.6
Income (loss) before income taxes (100.4) 2.3 (27.7) (3.7)
Provision for (benefit from) income taxes 0.0 2.0 (2.0) (3.2)
------ ------ ------ ------
Income (loss) before extraordinary item (100.4) 0.3 (25.7) (0.5)
Extraordinary item 0.0 (1.5)
------ ------ ------ ------
Net income (loss) (100.4)% 0.3% (27.2)% (0.5)%
====== ====== ====== ======
</TABLE>
THE THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 1997
REVENUE. Total revenue decreased approximately $5.5 million or 47% to $6.2
million in the three months-ended September 30,1998 from $11.7 million in the
three months ended September 30, 1997. License fees and related services
revenue decreased by $6.5 million or 94% to $434,000 in the three months ended
September 30, 1998 from $6.9 million in the three months ended September 30,
1997, reflecting the completion in prior months of certain major LNP projects in
1998 and, conversely, the acceleration of the LNP market in mid 1997. Other
services revenue increased by $956,000 or 20% to $5.7 million in the three
months ended September 30, 1998 from $4.8 million in the three months ended
September 30, 1997, reflecting growth in consulting and custom programming
projects with long-standing customers in 1998 and the adverse impact in 1997 of
delays in signing significant contracts that were concluded in the following
quarter. As a percentage of total revenue other services revenue increased to
93% for the three months ended September 30, 1998 from 41% for the three months
ended September 30, 1997.
COST OF REVENUE. Total cost of revenue decreased by $314,000 or 4% to $6.8
million in the three months ended September 30, 1998 from $7.1 million in the
three months ended September 30, 1997. As a percentage of total revenue costs
increased from 61% of revenue in the three months ended September 30, 1997 to
111% of revenue due to the decline in revenue in the three months ended
September 30, 1998. Cost of license fees and related services increased by
$377,000 or 24% to $1.9 million for the three months ended September 30, 1998
from $1.6 million for the three months ended September 30, 1997. As a
percentage of total revenue, cost of license fees and related services increased
to 31% for the three months ended September 30, 1998 from 13% in the three
months ended September 30, 1997. The cost increase in license fees and related
services in absolute dollar terms reflects the cost of third party software
incorporated in license products as well as increases in personnel assigned to
systems integration efforts. Cost of other services decreased by $691,000 or 12%
to $4.9 million for the three months ended September 30, 1998 from $5.6 million
for the three months ended September 30, 1997. Other services cost levels were
favorably impacted by efficiencies and expense controls initiated in late 1997
which allowed for workforce reductions. The Company experienced a negative total
gross margin in the three months ended September 30, 1998 due to the shortfall
in revenues previously discussed and a largely fixed cost of goods based on
staffing. The Company's expense levels are based in significant part on its
expectations regarding future revenues. The Company's revenue is difficult to
forecast because the market for the Company's products and services is rapidly
evolving, and the Company's sales cycle and the size and timing of significant
contracts vary substantially among customers. Accordingly, the Company may be
unable to adjust spending in cost of revenue or operating areas in a timely
manner to compensate for any unexpected shortfall in revenue.
SALES AND MARKETING. Sales and marketing expenses decreased by $149,000 or 11%
to $1.2 million in the three months ended September 30, 1998 from $1.4 million
in the three months ended September 30, 1997. As a percentage of revenue, sales
and marketing increased to 20% of revenue in the three months ended September
30, 1998 from 12% in the three months ended September 30, 1997. This percentage
increase reflects decreased revenue over the prior period. In absolute dollar
terms, the reduction in expense reflects cost containment on discretionary
marketing efforts.
<PAGE>
CONFIDENTIAL PAGE 9 11/11/98
GENERAL AND ADMINISTRATIVE. General and administrative expenses increased by
$195,000 or 9% to $2.3 million in the three months ended September 30, 1998 from
$2.1 million in the three months ended September 30, 1997. As a percentage of
revenue, general and administrative expenses increased to 36% in the three
months ended September 30, 1998 from 18% in the three months ended September 30,
1997. The increase in absolute dollars is attributable to increased legal
defense and other outside consultant services in the three months ended
September 30, 1998. During the quarter ended September 30, 1998, the Company
repriced 361,976 options to purchase common stock at $2.75 per share for all
employees except officers. Subsequently, on November 5, 1998, the Company
repriced 238,230 options to purchase common stock at $2.75 for Company officers
which was higher than the quoted market price at that time.
RESEARCH AND DEVELOPMENT. Research and development expenses increased by $1.4
million, or 282%, to $1.9 million in the three months ended September 30, 1998
from $506,000 in the three months ended September 30, 1997. As a percentage of
revenue, research and development expenses increased to 32% in the three months
ended September 30, 1998 from 4% in the three months ended September 30, 1997,
reflecting both absolute dollar increases in spending due to staff increases
related to MetOSS product development projects, and percentage increases due to
lower revenue levels.
RESTRUCTURING. During the three months ended September 30, 1998, in response to
continued reductions in purchases of the Company's products and services, the
Company completed voluntary separation plans for several individuals in
conjunction with the consolidation of and deletion of several functions. In
connection with these actions, a restructuring charge of $361,481 or $.03 per
basic share was recorded. This charge related solely to severance and benefits.
OTHER (INCOME) EXPENSE, NET. Other (income) expense, net reflected increased
income by $603,000, or 195%, to $293,000 in the three months ended September 30,
1998 from $310,000 expense in the three months ended September 30, 1997. This
expense results principally from interest expense related to funding the
Company's operations and the decrease from prior periods reflects the repayment
of most outstanding long term debt and line of credit advances following the
company's initial public offering in May, 1998 as well as interest income on the
Company's cash subsequent to the offering
PROVISION FOR (BENEFIT FROM) INCOME TAXES. The Company recorded no income tax
benefit relating to its operating loss of $6.2 million for the three months
ended September 30, 1998 compared to a tax provision of $234,000 for the three
months ended September 30, 1997. The Company deems it inappropriate to book
such benefits until the market for the Company's products and services
stabilizes and projected operating results reflect greater certainty of
profitability and the ability to realize such benefits.
THE NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THE NINE MONTHS ENDED
SEPTEMBER 30, 1997
REVENUE. Total revenue decreased approximately $1.2 million or 4% to $28.9
million in the nine months-ended September 30,1998 from $30.0 million in the
nine months ended September 30, 1997. License fees and related services revenue
decreased by $5.4 million or 37% to $9.1 million in the nine months ended
September 30, 1998 from $14.5 million in the nine months ended September 30,
1997, reflecting LNP product strength in the first three months of 1998. Other
services revenue increased by $4.2 million or 27% to $19.8 million in the nine
months ended September 30, 1998 from $15.6 million in the nine months ended
September 30, 1997, reflecting strength in consulting and custom development
projects with long-standing customers in 1998 and the adverse impact of delays
in signing significant contracts in the second and third quarters of 1997. As a
percentage of total revenue, other services revenue increased to 69% for the
nine months ended September 30, 1998 from 52% for the nine months ended
September 30, 1997.
COST OF REVENUE. Cost of revenue increased $1.1 million or 6% to $20.2 million
in the nine months ended September 30, 1998 from $19.1 million in the nine
months ended September 30, 1997. License fees and related services cost
increased by $1.3 million or 25% to $6.3 million for the nine months ended
September 30, 1998 from $5.0 million for the nine months ended September 30,
1997. Increased third party software costs as well as increased dedicated
staffing for LNP product is reflected in this increase. Other services cost
decreased $185,000 or 1% to $13.8 million in the nine months ended September 30,
1998 from $14.0 million in the nine months ended September 30, 1997. This
decrease in other services cost was due to expense controls instituted in prior
periods of 1998.
SALES AND MARKETING. Sales and marketing expenses increased by $802,000 or 23%
to $4.2 million in the nine months ended September 30, 1998 from $3.4 million in
the nine months ended September 30, 1997. As a percentage of revenue, sales and
marketing expenses increased to 15% of revenue in the nine months ended
September 30, 1998 from 11% in the nine months ended September 30, 1997. This
increase reflects the absolute dollar spending increase related to personnel
increases and promotional expenses in 1998.
GENERAL AND ADMINISTRATIVE. General and administrative expenses decreased by
$226,000 or 4% to $6.1 million in the nine months ended September 30, 1998 from
$6.3 million in the nine months ended September 30, 1997. As a percentage of
revenue, general and administrative expenses remained constant at 21% in the
nine months ended September 30, 1998 and in the nine months ended September 30,
1997. This decrease in absolute dollars is attributable to lower salary, bonus,
and equipment costs; the constancy in percentage of revenue is attributable to
lower revenue levels.
RESEARCH AND DEVELOPMENT. Research and development expenses increased by $4.6
million, or 395%, to $5.8 million in the nine months ended September 30, 1998
from $1.2 million in the nine months ended September 30, 1997. As a percentage
of revenue, research and development expenses increased to 20% in the nine
months ended September 30, 1998 from 4% in the nine months ended September 30,
1997, reflecting absolute dollar increases in spending due to staff increases
related to MetOSS product development projects.
<PAGE>
CONFIDENTIAL PAGE 10 11/11/98
RESTRUCTURING. During the three months ended September 30, 1998, in response to
continued reductions in purchases of the Company's products and services, the
Company completed voluntary separation plans for several individuals in
conjunction with the consolidation of and deletion of several functions. In
connection with these actions, a restructuring charge of $361,481 or $.03 per
basic share was recorded. This charge related solely to severance and benefits.
A similar charge was not recorded in the nine months ended September 30, 1997.
OTHER (INCOME) EXPENSE, NET. Other (income) expense, net decreased by $880,000,
or 82%, to $199,000 in the nine months ended September 30, 1998 from $1.1
million in the nine months ended September 30, 1997. This expense is
principally interest expense related to funding the Company's operations and
reflects the payoff of the majority of outstanding long term debt and line of
credit advances following the company's initial public offering in May 1998, as
well as interest income on the Company's cash investments subsequent to the
offering.
PROVISION FOR (BENEFIT FROM) INCOME TAXES. The Company recorded a net income
tax benefit of $601,000 for the nine months ended September 30, 1998. This
compares to a tax benefit of $948,000 for the nine months ended September 30,
1997. The Company recorded no income tax benefit relating to its operating loss
of $6.2 million for the three months ended September 30, 1998 compared to a tax
provision of $234,000 for the three months ended September 30, 1997. The
Company deems it inappropriate to book such benefits until the market for the
Company's products and services stabilizes and projected operating results
reflect greater certainty of profitability and the ability to realize such
benefits.
EXTRAORDINARY ITEM. The Company recorded an extraordinary item of $446,000 net
of taxes relating to early retirement penalties and the write off of capitalized
debt issue costs resulting from the repayment of debt associated with completion
of the Company's initial public offering during the nine months ended September
30, 1998. The Company recorded a tax benefit of $220,000 relating to the
extraordinary item recorded in the nine months ended September 30, 1998. A
similar charge was not recorded in the nine months ended September 30, 1997.
LIQUIDITY AND CAPITAL RESOURCES.
The Company has historically financed its operations through a combination
of cash flow from operations and borrowings. On May 15, 1998, the Company
completed its initial public offering of common stock and subsequently repaid
most outstanding borrowings. At September 30, 1998, the Company's principal
sources of liquidity included $24.6 million in cash and cash equivalents, a
$10.0 million secured bank line of credit and an equipment term loan agreement
of $1.5 million, both of which expire in September 1999. As of September 30,
1998, the Company had no outstanding balance under the line of credit and
$330,000 outstanding with respect to the equipment term loan agreement. The
Company is required under the credit line to comply with certain financial
covenants regarding tangible net worth, performance ratios relating to
profitability, debt, asset performance, and working capital. At September 30,
1998, the Company was not in compliance with such covenants, however, waivers
have been subsequently obtained.
At March 31, 1998, the Company had senior promissory notes payable to
stockholders in the amount of $6.8 million bearing semi-annual interest payments
at a rate of 9% beginning April 1996, and principal repayments of $1.6 million
due semi-annually beginning in 2000. The Company also had notes payable to
stockholders in the amount of $5.1 million bearing annual interest payments of
7.25%, with the principal due in 2006. Following the Company's initial public
offering in May, 1998, these notes and accrued interest obligations were
retired.
Net cash used in operating activities was $9.2 million in the nine months
ended September 30, 1998 compared to a positive contribution of $4.2 million in
the nine months ended September 30, 1997. The main contributors to the usage of
cash by operations in the nine months ended September 30, 1998 were an increase
in unbilled work-in-process by $3.5 million reflecting milestone extensions
which must be met prior to final invoicing and a decline in customer deposits
and unearned revenue by $4.6 million, primarily the result of the completion of
several large LNP projects. Receivables provided cash of $4.6 million during
this period reflecting increased collections on major accounts. In the nine
months ended September 30, 1997, the cash contribution by operations was largely
the result of an increase of $5.6 million in customer deposits and unearned
revenue due to large LNP contracts entered into during that period.
Net cash used in investing activities during the nine months ended
September 30, 1998 and September 30, 1997 was $1.6 million and $2.2 million
respectively in the area of equipment and facilities to support operations.
Financing activities provided $34.3 million in cash in the nine months
ended September 30, 1998 compared to using $2.0 million in the nine months ended
September 30, 1997. The Company's initial public offering generated
approximately $48 million and all outstanding debt of the Company except for
capital lease obligations was repaid during the three months ended June 30,
1998.
The Company believes that its current cash and short-term investments,
together with anticipated cash flow from operations and its existing credit
facilities and the net proceeds from the initial public offering will be
sufficient to meet its working capital and capital expenditure requirements for
at least the next twelve months. Thereafter, the Company may require additional
funds to support such activity through public or private equity financing or
from other sources. There can be no assurance that additional financing will be
available at all or that if available, such financing will be obtainable on
terms favorable to the Company and would not be dilutive.
<PAGE>
CONFIDENTIAL PAGE 11 11/11/98
FACTORS THAT MIGHT AFFECT OPERATING RESULTS.
The Company's operating results have fluctuated significantly in the past
and are likely to continue to fluctuate significantly in the future.
Fluctuations in operating results may result in volatility in the price of the
Company's Common Stock. There can be no assurance that the Company will be
profitable in the future or that the Company's level of profitability will not
vary significantly between quarters. These quarterly fluctuations may result
from a number of factors, including the magnitude, timing and signing of new
contracts; the Company's rate of progress under such contracts; the timing of
customer and market acceptance of the Company's product and service offerings;
actual or anticipated changes in government laws and regulations related to the
telecommunications market or judicial or administrative actions with respect to
such laws or regulations; the nature and pace of enforcement of the
Telecommunications Act of 1996; changes in management; product lifecycles; the
Company' success in building a product-based business; the mix of products and
services sold; changes in demand for the Company's products and services; the
timing of third-party contractors' delivery of software and hardware; budgeting
cycles of the Company's customers; changes in the renewal rate of support
agreements; the timing and amount of expenditures made by the Company for
research and development and sales, general and administrative expenses;
competition by existing and emerging competitors in the telecommunications
software markets; the Company's success in developing and marketing new
products, controlling costs, attracting and retaining qualified personnel and
expanding its sales and marketing programs; regional office expansion; software
defects and other product quality problems; changes in the Company's strategy;
the extent of industry consolidation; expansion into international markets, and
general economic conditions.
A significant portion of the Company's revenue has been and is expected to
continue to be derived from a small number of customers. Accordingly, the loss
of any significant customer, delays in delivery or acceptance of any of the
Company's products or delays in the performance of services could have a
material adverse effect on the Company's business, financial condition and
results of operations. Historically, the Company has generally recognized both
license fees and service fee revenue under its customer contracts using the
percentage-of-completion method. The Company is broadening its strategy to
include the development and sale of software products. To the extent that the
Company is successful in doing so, the Company expects that it may be able to
record future revenue from license fees upon the delivery of a software product
to a customer. The Company's ability to recognize revenue on software licenses
as packaged software solutions at the time of delivery depends on its ability to
engage third parties to implement its software and to separately license the
software and separately sell implementation services, as well as technical
factors and customer expectations and requirements. There can be no assurance
that the Company will be able to achieve or maintain a sales model that allows
the Company to record license fees when software products are delivered to
customers. Software companies that account for revenue from license fees upon
delivery of software products may be exposed to increased risk of quarterly
fluctuations. To the extent that this pattern develops at the Company, any
failure or delay in the delivery of orders during any given quarter could have a
material adverse effect on the Company's business, financial condition and
results of operations. The timing of revenue recognition from the Company's
contracts has caused, and may continue to cause, material fluctuations in the
Company's operating results, particularly on a quarterly basis.
The Company's expense levels are based in significant part on its
expectations regarding future revenue. The Company's revenue is difficult to
forecast because the market for the Company's products and services is rapidly
evolving, and the Company's sales cycle and the size and timing of significant
contracts vary substantially among customers. Accordingly, the Company may be
unable to adjust spending in a timely manner to compensate for any unexpected
shortfall in revenue. Any significant shortfall from anticipated levels of
demand for the Company's products and services could have a material adverse
effect on the Company's business, financial condition and results of operations.
Based on all of the foregoing, the Company believes that future revenue,
expenses and operating results are likely to vary significantly from quarter to
quarter. As a result, quarter-to-quarter comparisons of operating results are
not necessarily meaningful or indicative of future performance. Furthermore, the
Company believes it is likely that in some future quarter the Company's
operating results will be below the expectations of public market analysts or
investors. In such event, or in the event that adverse conditions prevail, or
are perceived to prevail, with respect to the Company's business or generally,
the market price of the Company's Common Stock would likely be materially
adversely affected.
These results should be read in conjunction with the risk factors defined
in the Company's Registration Statement on Form S-1 (No. 333-43973) which was
declared effective by the SEC on May 11, 1998. Statements contained in this Form
10-Q with respect to future revenue and expenses are "forward-looking
statements" within the meaning of Section 21E of the Securities Exchange Act of
1934, as amended. Actual results may differ. Among the factors that could cause
actual results to differ are the following: (i) the Company's dependence on the
rapidly evolving telecommunications industry, (ii) delays in enforcement and
implementation of the Telecommunications Act of 1996; (iii) customer's
acceptance of Local Number Portability Products, (iv) delays associated with
customers' internal approval and contracting procedures, procurement practices,
and testing and acceptance process; (v) changes in management; and (vi) rapid
technological change and intense competition in the Company's industry.
IMPACT OF THE YEAR 2000 ISSUE
Many currently installed computer systems and software products are coded
to accept only two digit entries in the date code field. These date code fields
will need to accept four digit entries to distinguish 21st century dates from
20th
<PAGE>
CONFIDENTIAL PAGE 12 11/11/98
century dates. As a result, computer systems and/or software used by many
companies may need to be upgraded to comply with such Year 2000 requirements.
Significant uncertainty exists in the software industry concerning the potential
effects associated with such compliance.
The Company is impacted by the Year 2000 issue in its internal operations.
As a developer and supplier of telecommunications software, the Company is also
at risk with respect to the Year 2000 in connection with the software the
Company provides to its customers. Finally, Year 2000 issues may have an effect
upon the buying decisions of the Company's customers, which could result in
either a positive or negative impact on the Company's revenue.
The Company has formed a Year 2000 project team to assessing its state of
readiness with respect to Year 2000 issues and to implement corrective actions
and contingency plans. This project team is in the process of inventorying items
that will be affected by Year 2000 compliance, assigning priorities to
identified items, assessing the Year 2000 compliance of items determined to be
material to the Company, repairing or replacing materials items that are found
not be Year 2000 compliant, testing Company developed software and third party
provided software, and designing contingency plans. The Company expects the Year
2000 projects to be successfully completed during the remainder of 1998 and
through 1999. The following graph should be used as an approximate guide of the
Company's activities to date in regard to this problem.
<TABLE>
<S> <C> <C> <C> <C> <C>
PHASE: AWARENESS ASSESSMENT RENOVATION VALIDATION IMPLEMENTATION
Products and services --------------------------->
Third Party Suppliers ---------------->
Customers: ------->
Evolving Systems Internal:
IT-Software ---------------------------------------->
IT-Hardware ---------------->
Non-IT Hardware ---------------->
Suppliers ------->
</TABLE>
The Company is currently performing Year 2000 compliance assessment and testing
using its own personnel. Depending upon availability of the Company's personnel,
the Company may elect to hire third party consultants to assist the Company with
its Year 2000 compliance activities.
Products: The Company currently offers software products that are designed to be
Year 2000 compliant and the Company's current contracts with its customers
require that the Company warrant Year 2000 capability. Although the Company has
designed its products to be Year 2000 capable and has tested third-party
software that is incorporated with the Company's products, there can be no
assurance that the Company's software products, particularly when such products
incorporate third-party software, contain all necessary date code changes. The
Company is continuing its review of its products to ensure compliance and
anticipates ongoing testing of its products through the balance of 1998 and into
1999 as new releases of the Company's products are made available to the
Company's customers. The Company's primary products subject to Year 2000 issues
are the Company's Local Number Portability products. Preliminary testing of
these products was conducted in early 1998, and ongoing testing is planned. This
additional testing may be accomplished with the assistance of third party
providers of Year 2000 products and services in order to provide independent
third-party verification of Year 2000 readiness.
Custom Software and Services: The Company provides custom software and related
services for a number of customers. These customers have engaged the Company to
perform Year 2000 compliance tests on such software and services. As of
September 30, 1998, the Company successfully completed Year 2000 tests on
several software solutions. The Company expects to continue performing Year 2000
tests for such customers. The Company's relationship with its customers and the
Company's exposure to liability may be impacted if the Company fails to
adequately address Year 2000 issues in its products and/or custom software
solutions. This could have a material adverse effect on the Company's business,
results of operation and financial condition.
Customers: The Company offers software products and services to
telecommunications carriers and telecommunication companies. Currently, the
Company is assisting several of these customers in the evaluation of their
software and systems to be compliant with Year 2000 requirements. As these
companies products and services are largely dependent on integrated software and
hardware networks as described above, there can be no assurance that assessment
and remediation will have been completed by all such customers within the
appropriate timeframe. As a result, the Company's business with these customers
could be negatively or positively influenced by these customers financial and
operational results and consequent decisions regarding the purchase of the
Company's products and services. Such a disruption of buying patterns could
cause a material adverse effect on the Company's business, results of operations
and financial condition.
<PAGE>
CONFIDENTIAL PAGE 13 11/11/98
Evolving Systems' Internal Operations:
IT Software: The Company utilizes off-the-shelf and custom software developed
internally and by third parties. The Company's ERP (enterprise resource
planning) systems as well as its internal communication software has been
replaced within the past three years by new systems that are certified by their
vendors to be date code compliant. Another non-compliant subsystem is scheduled
to be replaced early 1999. All such upgrades were undertaken to increase
efficiency and effectiveness of the Company's operations and were not approved
primarily for the reasons of date code compliance. The Company has initiated
correspondence with suppliers and is continuing to review what actions will be
required to make all software systems used internally Year 2000 compliant as
well as to mitigate its vulnerability to problems with the systems used by its
suppliers and other third parties. To the extent the Company does not receive
adequate responses by March 31, 1999, the Company will develop contingency
plans. To the extent that such software and systems do not comply with Year 2000
requirements, or that the Company's contingency plans are not effective, there
can be no assurance that potential systems interruptions or the cost necessary
to update such software will not have a material adverse effect on the Company's
business, financial condition and results of operations.
IT Hardware: The Company utilizes off-the-shelf hardware in its processing and
network operations. Such equipment either has been certified to be date code
compliant or correspondence with suppliers in progress to validate such
condition.
Non-IT Hardware: The Company will initiate correspondence with suppliers to
review what actions will be required to make all embedded systems date code
compliant in the facilities it occupies. The costs associated with such actions
is not expected to have a material effect on the Company's business, results
operations or financial condition.
Suppliers: The Company will initiate correspondence with service suppliers to
review what actions will be undertaken to make all embedded systems date code
compliant. Such actions include a review of vendor contracts and formal
communication with suppliers to request certification that products are Year
2000 compliant. The total cost and time associated with the impact of Year 2000
compliance cannot presently be estimated. The costs associated with such actions
is not expected to have a material effect on the Company's business, results of
operations or financial condition.
The Company does not, at this time, have a formal contingency plan in the event
of the failure of remediation efforts with regard to its internal operations.
Such a plan can only be developed after a full assessment of potential points of
failure. Following the completion of the assessment phase in all areas, the
Company anticipates the development of such a plan as part of the Company's
ongoing Year 2000 compliance effort.
COSTS: The costs of the Company's Year 2000 compliance efforts are being funded
with cash flows from operations. To date, these costs have been associated with
the reallocation of internal staff hours to Year 2000 project related efforts
and not been material. As additional evaluation and testing is performed,
particularly on the Company's products if independent third party vendors are
engaged by the Company, these costs are likely to increase significantly. As
ongoing testing is performed, modifications to the Company's products may be
required. The total costs that the Company incurs in connection with the Year
2000 problems will be influenced by the Company's ability to successfully
identify Year 2000 systems' flaws, the nature and amount of programming required
to fix the affected programs, the related labor and/or consulting costs for such
remediation, and the ability of third parties with whom the Company's has
business relationships to successfully address their own Year 2000 concerns. As
a result of these, and other unforeseen factors, the Company does not have
sufficient information at this time to determine the full extent of the
additional costs associated with Year 2000 compliance, and, thus to determine
whether the consequences of Year 2000 readiness will have a material impact on
the Company's business, results of operation and financial condition.
THE DISCUSSION OF THE COMPANY'S EFFORTS AND MANAGEMENT'S EXPECTATIONS RELATING
TO YEAR 2000 COMPLIANCE CONTAIN FORWARD-LOOKING STATEMENTS AND ARE BASED ON
MANAGEMENT'S BEST ESTIMATES OF FUTURE EVENTS. MANAGEMENT BELIEVES THAT IT IS
NOT POSSIBLE TO DETERMINE WITH COMPLETE CERTAINTY THAT ALL YEAR 2000 PROBLEMS
AFFECTING THE COMPANY HAVE BEEN IDENTIFIED OR CORRECTED. RISKS TO COMPLETING
THE PLAN INCLUDE THE AVAILABILITY OF RESOURCES, THE COMPANY'S ABILITY TO
DISCOVER AND CORRECT THE POTENTIAL YEAR 2000 PROBLEMS WHICH COULD HAVE IMPACT ON
THE COMPANY AND ITS PRODUCTS, THE ABILITY OF THE COMPANY AND ITS SUPPLIERS TO
BRING THEIR SOFTWARE AND SYSTEMS INTO COMPLIANCE AND UNANTICIPATED PROBLEMS
IDENTIFIED IN THE ONGOING COMPLIANCE REVIEW.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In June, 1998, four class action lawsuits were filed in the United
States District Court of the District Court of Colorado against the Company and
certain of its officers and directors. The actions were purportedly brought on
behalf of purchasers of the Company's common stock between May 12, 1998 and June
17, 1998. In October 1998 these actions were consolidated, the class was
certified and the class period was extended to July 23, 1998. The claims allege
violations of Sections 11 and 12 of the Securities Act of 1933 and Sections
10(b) and 20(a) of the Securities Exchange Act of 1934. The actions seek
unspecified compensatory and punitive damages, interest, attorneys' fees and
other costs. The Company
<PAGE>
CONFIDENTIAL PAGE 14 11/11/98
believes that it has meritorious defenses to both actions and intends to
vigorously defend the actions. Motions to dismiss are pending before the court.
Item 2. Changes in Securities
None
Item 3. Defaults on Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
On January 28, 1998, the Company solicited the written consent of its
security holders with respect to (a) Election of Directors; (b) One-for-two
reverse stock split; (c) Amendments to Articles of Incorporation; (d) Amendment
of the Company's Stock Option Plan; (e) Adoption of the Company's Employee Stock
Purchase Plan; (f) Adoption of Amended and Restated Bylaws; and (g) Approval of
Standard Indemnification Agreement. 8,160 shares of Series A Preferred Stock
were voted in favor of such proposal, no shares of Series A Preferred Stock were
voted against such proposal.
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
10.27 Financial Data Schedule
(b) Reports on Form 8-K
None
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.
Date: 11/13/98 /s/ David R. Johnson
--------------------
David R. Johnson
Chief Financial Officer
(Principal Financial and Accounting Officer)
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