<PAGE> 1
As Filed with the Securities and Exchange Commission on November 12, 1999
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1999
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 No. 000-26937
QUEST SOFTWARE, INC.
------------------------------------------------------
(Exact name of Registrant as specified in its charter)
CALIFORNIA 33-0231678
- ------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
8001 IRVINE CENTER DRIVE
IRVINE, CALIFORNIA 92618
---------------------------------------- ----------
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (949) 754-8000
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 [ ]
The number of shares outstanding of the Registrant's Common Stock, no par
value, as of November 8, 1999 was 38,811,000.
<PAGE> 2
QUEST SOFTWARE, INC.
FORM 10-Q
INDEX
<TABLE>
<CAPTION>
PAGE NUMBER
-----------
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 1999 (unaudited)
and December 31, 1998.........................................................2
Consolidated Statements of Operations for the Three and Nine
Months Ended September 30, 1999 and 1998 (unaudited)..........................3
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 1999 and 1998 (unaudited).................................4
Notes to Consolidated Financial Statements (unaudited)...............................5
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations...........................................................................8
Item 3. Qualitative and Quantitative Disclosure about Market Risk...........................21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings...................................................................23
Item 2. Changes in Securities and Use of Proceeds...........................................23
Item 4. Submission of Matters to a Vote of Security Holders.................................24
Item 5. Other information...................................................................24
Item 6. Exhibits and Reports on Form 8-K....................................................24
Signatures
</TABLE>
<PAGE> 3
PART I
FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
QUEST SOFTWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------ ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents ............................................ $ 43,358 $ 8,981
Short-term marketable securities ..................................... 9,250 --
Accounts receivable, net ............................................. 13,359 7,443
Prepaid expenses and other current assets ............................ 1,122 720
Prepaid income taxes ................................................. 329 --
Deferred income taxes ................................................ 198 198
------------ ------------
Total current assets .............................................. 67,616 17,342
Property and equipment, net .......................................... 3,864 1,388
Long-term marketable securities ...................................... 2,903 --
Purchased technology and software licenses, net ...................... 591 527
Deferred income taxes ................................................ 267 267
Other assets ......................................................... 393 121
------------ ------------
Total assets ...................................................... $ 75,634 $ 19,645
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable ..................................................... $ 1,168 $ 1,468
Accrued compensation ................................................. 3,731 1,937
Other accrued expenses ............................................... 4,598 2,243
Deferred support revenue ............................................. 10,547 7,298
Deferred license revenue ............................................. 4,046 1,625
------------ ------------
Total current liabilities ......................................... 24,090 14,571
------------ ------------
Shareholders' equity:
Preferred stock, no par value, 5,000 authorized; no shares issued
or outstanding .................................................... -- --
Common stock, no par value, 75,000 shares authorized; 38,811
and 44,538 issued and outstanding at September 30, 1999
and December 31, 1998, respectively ............................... 84,374 4,241
Retained earnings .................................................... 303 3,991
Notes receivable from sale of common stock ........................... (3,069) (3,158)
Capital distribution in excess of basis in common stock .............. (30,064) --
------------ ------------
Total shareholders' equity ........................................ 51,544 5,074
------------ ------------
Total liabilities and shareholders' equity ........................ $ 75,634 $ 19,645
============ ============
</TABLE>
See accompanying notes to the consolidated financial statements.
2
<PAGE> 4
QUEST SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- --------------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Revenues:
Licenses ................................... $ 13,995 $ 6,190 $ 35,360 $ 15,770
Services ................................... 4,313 2,544 11,237 6,999
---------- ---------- ---------- ----------
Total revenues ......................... 18,308 8,734 46,597 22,769
Cost of revenues:
Licenses ................................... 734 1,081 2,138 2,585
Services ................................... 1,154 609 2,892 1,653
---------- ---------- ---------- ----------
Total cost of revenues ................. 1,888 1,690 5,030 4,238
---------- ---------- ---------- ----------
Gross profit ................................... 16,420 7,044 41,567 18,531
Operating expenses:
Sales and marketing ........................ 8,321 3,169 20,479 7,540
Research and development ................... 4,502 1,928 10,536 5,557
General and administrative ................. 2,787 980 6,776 3,050
Compensation and other costs ............... 186 -- 961 --
---------- ---------- ---------- ----------
Total operating expenses ............... 15,796 6,077 38,752 16,147
---------- ---------- ---------- ----------
Income from operations ......................... 624 967 2,815 2,384
Other income, net .............................. 278 106 360 225
---------- ---------- ---------- ----------
Income before income tax provision ............. 902 1,073 3,175 2,609
Income tax provision ........................... 380 446 1,339 1,083
---------- ---------- ---------- ----------
Net income ..................................... 522 627 1,836 1,526
Preferred stock dividends ...................... 250 -- 590 --
---------- ---------- ---------- ----------
Net income applicable to common shareholders.... $ 272 $ 627 $ 1,246 $ 1,526
========== ========== ========== ==========
Basic and diluted net income per share ......... $ 0.01 $ 0.01 $ 0.03 $ 0.03
Weighted average shares:
Basic ...................................... 34,449 44,538 40,108 44,172
Diluted .................................... 40,421 44,538 42,537 44,172
</TABLE>
See accompanying notes to the consolidated financial statements.
3
<PAGE> 5
QUEST SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------------
1999 1998
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net income ..................................................................... $ 1,836 $ 1,526
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization .............................................. 1,617 1,326
Compensation expense associated with stock option grants ................... 246 --
Accrued interest receivable from shareholders .............................. (142) (118)
Deferred income taxes ...................................................... -- (1,251)
Changes in assets and liabilities, net of effects of acquisitions:
Accounts receivable ...................................................... (5,916) 1,181
Income taxes receivable .................................................. -- 122
Prepaid expenses and other current assets ................................ (731) (790)
Other assets ............................................................. (262) 17
Accounts payable ......................................................... (300) (133)
Accrued compensation ..................................................... 1,794 1,338
Other accrued expenses ................................................... 2,362 1,687
Deferred revenue ......................................................... 5,670 1,056
---------- ----------
Net cash provided by operating activities .............................. 6,174 5,961
Cash flows used in investing activities:
Purchases of property and equipment ............................................ (3,437) (729)
Purchases of software licenses ................................................. (234) (5)
Purchases of marketable securities ............................................. (12,153) --
Cash paid for acquisitions ..................................................... (496) --
---------- ----------
Net cash used in investing activities ...................................... (16,320) (734)
Cash flows from financing activities:
Proceeds from note payable ..................................................... 10,000 --
Repayment of note payable ...................................................... (10,000) --
Proceeds from issuance of preferred stock ...................................... 25,000 --
Redemption of preferred stock .................................................. (10,000) --
Dividends paid on redeemable preferred stock ................................... (590) --
Proceeds from issuance of common stock, net .................................... 64,858 --
Repurchase of common stock ..................................................... (35,000) --
Proceeds from the exercise of stock options .................................... 33 --
Repayment of note payable to related party ..................................... (8) (6)
Payment on notes receivable from shareholders for purchase of common stock ..... 230 --
---------- ----------
Net cash provided by (used in) financing activities ........................ 44,523 (6)
---------- ----------
Net increase in cash and cash equivalents .......................................... 34,377 5,221
Cash and cash equivalents, beginning of period ..................................... 8,981 2,096
---------- ----------
Cash and cash equivalents, end of period ........................................... $ 43,358 $ 7,317
========== ==========
Supplemental disclosures of consolidated cash flow information:
Cash paid during the year for:
Interest ....................................................................... $ 256 $ 5
Income taxes ................................................................... $ 1,812 $ 1,430
Supplemental schedule of noncash investing and financing activities:
Note receivable from shareholders for purchase of common stock ................. $ -- $ 750
Conversion of Series A Redeemable Preferred Stock into common stock ............ 15,000 --
Accrued interest receivable from shareholders .................................. 142 118
Issuance of common stock for technology rights ................................. $ -- $ 66
</TABLE>
See accompanying notes to the consolidated financial statements.
4
<PAGE> 6
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1. BASIS OF PRESENTATION
The accompanying unaudited interim consolidated financial statements of
Quest Software, Inc., a California corporation (the "Company" or "Quest"), for
the three and nine months ended September 30, 1999 and 1998, respectively,
reflect all adjustments (consisting of normal recurring accruals) which, in the
opinion of management, are necessary for a fair presentation of the results for
the interim periods presented. These financial statements have been prepared in
accordance with generally accepted accounting principles of interim financial
information and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for complete financial
statements.
These financial statements should be read in conjunction with the
Company's annual audited financial statements for the year ended December 31,
1998, which are included in the Company's Registration Statement on Form S-1
(Reg. No. 333-80543) filed with the Securities and Exchange Commission in
connection with its initial public offering.
Operating results for the three and nine month periods ended September
30, 1999 are not necessarily indicative of the results that may be expected for
the full year ending December 31, 1999.
NEW ACCOUNTING PRONOUNCEMENTS:
For the year ended December 31, 1998, the Company adopted SFAS No. 130,
Reporting Comprehensive Income. There was no difference between the net income
and the comprehensive net income for the three months and nine months ended
September 30, 1999.
The Company has adopted SFAS No. 131, Disclosures About Segments of an
Enterprise and Related Information. In accordance with SFAS No. 131, the Company
has disclosed in Note 7 certain information about operating segments and certain
information about the Company's revenue types.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, which the Company is required to adopt
effective in its fiscal year 2001. SFAS No. 133 will require the Company to
record all derivatives on the balance sheet at fair value. The Company does not
currently engage in hedging activities but will continue to evaluate the effects
of adopting SFAS No. 133.
2. RELATED-PARTY TRANSACTIONS
In April 1999, the Company repurchased and cancelled 14,820 shares of
common stock from a shareholder of the Company at a price of $2.36 per share.
The Company also entered into a severance agreement with the shareholder whereby
the shareholder will receive $200 per year through 2001 and provides for use of
a company car and related expenses and medical benefits. The Company recorded
approximately $715 of expense related to the agreement in April 1999, which is
included in compensation and other costs in the accompanying consolidated
financial statements.
3. NET INCOME PER SHARE AND PRO FORMA NET INCOME PER SHARE
The Company computes net income per share in accordance with SFAS No.
128, Earnings per Share. Basic earnings per share is computed by dividing net
income available to common shareholders by the weighted average number of
common shares outstanding for the period. Diluted earnings per share reflects
the potential dilution of securities by including other common stock
equivalents, including stock options, in the weighted average number of common
shares outstanding for a period, if dilutive.
Pro forma net income per share, which would reflect the conversion of
the Series A Preferred Stock to common stock as if it occurred at the beginning
of each period presented, would not have been different from the basic and
diluted net income per share amounts presented herein.
5
<PAGE> 7
4. TERM NOTE
In connection with the repurchase of common stock from a shareholder in
April 1999, the Company borrowed $10,000 under a term note with a bank. In
August 1999 the Company repaid the $10,000 term note and all accrued interest
using a portion of the net proceeds from its initial public offering (Note 5).
5. SHAREHOLDERS' EQUITY
In April 1999, the Company issued 2,667 shares of Series A Preferred
Stock for $15,000 and 1,778 shares of Series B Redeemable Preferred stock
(Series B) for $10,000. The proceeds along with the $10,000 in term debt raised
in April 1999 (Note 4) were used to repurchase and cancel 14,820 shares of
common stock from a shareholder for $35,000.
In August 1999, the Company raised $64,858 from an initial public
offering of 4,400 shares and the underwriters exercising their over-allotment
option of 660 shares net of underwriting discounts and commissions and related
expenses. The Company used a portion of the net proceeds to redeem all 1,778
outstanding shares of Series B Preferred Stock for $10,000 and pay all accrued
preferred dividends of $590.
6. STOCK OPTION PLANS
The following table summarizes information about stock options
outstanding as of September 30, 1999:
<TABLE>
<CAPTION>
Number of Options
Number of Excercisable as
Shares Price per Share of September 30, 1999
--------- ----------------- ---------------------
<S> <C> <C> <C>
Balance at January 1, 1999 3,366,600 $ 1.00- $ 2.37
Granted 2,039,525 2.37- 37.00
Excercised (32,973) 1.00- 1.00
Canceled (363,795) 1.00- 12.00
---------
Balance at September 30, 1999 5,009,357 $ 1.00- $ 37.00 576,904
=========
</TABLE>
7. OPERATING SEGMENT DATA
Operating segments are defined as components of an enterprise about
which separate financial information is available that is evaluated regularly by
the Company's chief operating decision maker, or decision making group, in
deciding how to allocate resources and in assessing performance. The operating
segments of the Company are managed separately because each segment represents a
strategic business unit that offers different products or services.
The Company's reportable operating segments include Licenses and
Services. The Software Licenses operating segment develops and markets the
Company's software products. The Services segment provides after-sale support
for software products and fee-based training and consulting services related to
the Company's products.
The Company does not separately allocate operating expenses to these
segments, nor does it allocate specific assets to these segments. Therefore,
segment information reported includes only revenues, cost of sales and gross
profit as this information and the geographic information described below are
the only information provided to the chief operating decision maker.
6
<PAGE> 8
Operating segment data for the three months and nine months ended
September 30, 1999 and 1998, respectively was as follows:
<TABLE>
<CAPTION>
LICENSES SERVICES TOTAL
---------- ---------- ----------
<S> <C> <C> <C>
Third quarter ended September 30, 1999:
Revenues $ 13,995 $ 4,313 $ 18,308
Cost of revenues 734 1,154 1,888
---------- ---------- ----------
Gross profit $ 13,261 $ 3,159 $ 16,420
========== ========== ==========
Third quarter ended September 30, 1998:
Revenues $ 6,190 $ 2,544 $ 8,734
Cost of revenues 1,081 609 1,690
---------- ---------- ----------
Gross profit $ 5,109 $ 1,935 $ 7,044
========== ========== ==========
Nine months ended September 30, 1999:
Revenues $ 35,360 $ 11,237 $ 46,597
Cost of revenues 2,138 2,892 5,030
---------- ---------- ----------
Gross profit $ 33,222 $ 8,345 $ 41,567
========== ========== ==========
Nine months ended September 30, 1998:
Revenues $ 15,770 $ 6,999 $ 22,769
Cost of revenues 2,585 1,653 4,238
---------- ---------- ----------
Gross profit $ 13,185 $ 5,346 $ 18,531
========== ========== ==========
</TABLE>
8. SUBSEQUENT EVENTS
During November 1999, Quest entered into an agreement to acquire all of
the outstanding stock and all stock options of MBR Technologies, Inc. (MBR) in
exchange for $10,000 in Quest common stock and $1,500 in cash subject to certain
reductions. The Company expects that a significant portion of the purchase price
will be allocated to intangible assets. Quest will account for the transaction
using purchase accounting and expects to close the acquisition by November 30,
1999 subject to the approval by the shareholders of MBR and other customary
closing conditions.
During November 1999, Quest entered into an agreement to acquire all of
the outstanding stock and all stock options of Foglight Software (Foglight) in
exchange for 1,300 shares of Quest common stock subject to adjustments and
reductions. The Company expects that a significant portion of the purchase price
will be allocated to intangible assets. Quest will account for the transaction
using purchase accounting and expects to close the acquisition during December
1999 subject to the approval by the shareholders of Foglight and other customary
closing conditions.
7
<PAGE> 9
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements in this report, including statements regarding the
Company's strategy, financial performance and revenue sources, are
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of
1934, as amended, and Section 27A of the Securities Act of 1933, as amended, and
are subject to the safe harbors created by those sections. These forward-looking
statements are based on current expectations and entail various risks and
uncertainties that could cause actual results to differ materially from those
expressed in such forward-looking statements. The Company's actual results could
differ materially from the results anticipated in these forward-looking
statements as a result of certain factors set forth under "Risk Factors" and
elsewhere in this report. Readers are urged to carefully review and consider the
various disclosures made by the Company in this report and in the Company's
other reports filed with the SEC, including the Company's Registration Statement
on Form S-1 (No. 333-80543) and the related prospectus dated August 13, 1999, as
filed with the SEC, that attempt to advise interested parties of certain risks
and factors that may affect the Company's business. Readers are cautioned not to
place undue reliance on these forward-looking statements to reflect events or
circumstances occurring after the date hereof. The following discussion should
be read in conjunction with the Company's consolidated financial statements and
notes thereto.
OVERVIEW
We provide application and information availability software solutions
that enhance the performance and reliability of an organization's e-business,
packaged and custom applications and enable the delivery of information across
the extended enterprise.
We derive our revenues primarily from the sale of software licenses and
related annual maintenance fees. Pricing of our software licenses is based on
the number of servers, workstations and/or users of our products. Annual
maintenance contracts may be purchased separately by customers at their
discretion.
We recognize software license revenues when a non-cancellable license
agreement has been signed with a customer, the software is shipped, no
significant post delivery vendor obligations remain and collection is deemed
probable. Maintenance revenues are recognized ratably over the contract term,
which is typically one year. Revenues for consulting services are recognized as
such services are performed.
We market our software and services primarily through our direct sales
organization in the United States, the United Kingdom, Germany and Australia. We
intend to expand our international sales activities as part of our business
strategy. All of our current international revenues are derived from the
operations of our three wholly-owned subsidiaries in Australia, the United
Kingdom and Germany. Our international subsidiaries conduct business in the
currency of the country in which they operate, exposing us to currency
fluctuations and currency transaction losses or gains which are outside of our
control. Historically fluctuations in foreign currency exchange rates have not
had a material effect on our business. We have not to date conducted any hedging
transactions to reduce our risk to currency fluctuations.
In the development of new products and enhancements of existing
products, the technological feasibility of the software is not established until
substantially all product development is complete. Historically, our software
development costs eligible for capitalization have been insignificant and all
costs related to internal research and development have been expensed as
incurred.
8
<PAGE> 10
RESULTS OF OPERATIONS
The following table sets forth certain consolidated statements of
operations data as a percentage of total revenues for the periods indicated:
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
------------------------ ------------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Revenues:
Licenses 76% 71% 76% 69%
Services 24 29 24 31
---------- ---------- ---------- ----------
Total revenues 100 100 100 100
Cost of revenues:
Licenses 4 12 5 12
Services 6 7 6 7
---------- ---------- ---------- ----------
Total cost of revenues 10 19 11 19
---------- ---------- ---------- ----------
Gross profit 90 81 89 81
Operating expenses:
Sales and marketing 45 37 43 33
Research and development 25 22 23 24
General and administrative 15 11 15 13
Compensation and other costs 1 -- 2 --
---------- ---------- ---------- ----------
Total operating expenses 86 70 83 70
---------- ---------- ---------- ----------
Income from operations 4 11 6 11
Other income, net 1 1 1 1
---------- ---------- ---------- ----------
Income before income tax provision 5 12 7 12
Income tax provision 2 5 3 5
---------- ---------- ---------- ----------
Net income 3% 7% 4% 7%
========== ========== ========== ==========
</TABLE>
THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 1999 AND 1998, RESPECTIVELY
REVENUES
Revenues are derived from the sale of software licenses and related
services. Total revenues for the three and nine months ended September 30, 1999
were $18.3 million and $46.6 million, respectively, an increase of 110% and
105%, respectively, from the comparable periods of 1998. International revenues
for the three and nine months ended September 30, 1999 were $3.7 million and
$10.0 million, respectively, an increase of 123% and 161%, respectively, from
the comparable periods of 1998.
LICENSES
Licenses revenues for the three and nine months ended September 30, 1999
were $14.0 million and $35.4 million, respectively, an increase of 126% and
124%, respectively, from the comparable periods of 1998. The increases resulted
both from the 169% increase in the size of our worldwide sales organization
since September 30, 1998 as well as the availability of new products. Products
available in the first nine months of 1999 which were not available in 1998
included Schema Manager, I/Watch and TOAD along with the Vista Plus interface
module for SAP R/3. Licenses revenues represented 76% of total revenues for the
three and nine months of 1999 compared to 71% and 69%, respectively, in the
comparable periods of 1998. International licenses revenues for the three and
nine months ended September 30, 1999 were $2.9 million and $8.1 million,
respectively, an increase of 118% and 172%, respectively, from the comparable
periods of 1998.
9
<PAGE> 11
SERVICES
Services revenues for the three and nine months ended September 30, 1999
were $4.3 million and $11.2 million, respectively, an increase of 70% and 61%,
respectively, from the comparable periods of 1998. Services consist primarily of
annual maintenance contracts for technical support and product enhancements.
Maintenance fees are generally renewable annually at the customer's option and
the fees are recognized over the term of each agreement. The increase in
services for the three and nine months of 1999 reflected increases in the
installed base of customers that purchased maintenance. Services revenues
represented 24% of total revenues for the three and nine months of 1999 compared
to 29% and 31%, respectively, in the comparable periods of 1998. International
services revenues for the three and nine months ended September 30, 1999 were
$825,000 and $1.9 million, respectively, an increase of 142% and 121%,
respectively, from the comparable periods of 1998.
COST OF LICENSES
Cost of licenses includes amortization of purchased technology and
software licenses, product media, printing and duplication costs, and royalties
to former owners of acquired technologies. Cost of licenses for the three and
nine months ended September 30, 1999 were $734,000 and $2.1 million,
respectively, a decrease of 32% and 17%, respectively, from the comparable
periods of 1998. This decrease was principally a result of a decrease in
royalties of $300,000 and $443,000 respectively, a decrease in amortization of
purchased technology and software licenses of $141,000 and $311,000,
respectively, offset in part by an increase in product media, duplication costs
and printing compared to the comparable periods of 1998. These costs as a
percentage of license revenues in the three and nine months ended September 30,
1999 were 5% and 6%, respectively, compared to 17% and 16%, respectively, in the
comparable periods of 1998. The decreases for the three and nine months of 1999
as a percentage of licenses revenues resulted from increased licenses revenues
without a corresponding increase in amortization of technology rights and
software licenses which do not vary by the number of licenses sold. We do not
expect the cost of licenses revenues to increase as a percentage of licenses
based upon our current amortization projections and existing royalty
obligations.
COST OF SERVICES
Cost of services includes salaries and related costs for customer
support personnel. Cost of services for the three and nine months ended
September 30, 1999 were $1.2 million and $2.9 million, respectively, an increase
of 90% and 75%, respectively, from the comparable periods of 1998. The increases
were primarily due to a 38% increase in the number of customer support personnel
required to manage and support our growing customer base as well as the
increased number of product offerings since September 30, 1998. Also
contributing to the increased costs were related training and travel expenses
associated with the increase in Company service personnel. These costs as a
percentage of services revenues in the three and nine months ended September 30,
1999 were 27% and 26%, respectively, compared to 24% in the respective periods
of 1998. We expect the cost of services to increase in absolute dollars for the
foreseeable future as additional customer support personnel are retained.
OPERATING EXPENSES
SALES AND MARKETING
Sales and marketing expenses consist primarily of salaries, commissions
earned by sales personnel, recruiting costs, trade show, travel and
entertainment and other marketing communications costs such as advertising and
promotion. Sales and marketing expenses for the three and nine months ended
September 30, 1999 were $8.3 million and $20.5 million, respectively, an
increase of 163% and 172%, respectively, from the comparable periods of 1998.
The increases reflect the increase in salaries and related expenses due to the
173% increase in our sales and marketing organization personnel since September
30, 1998 and an increase in sales commissions due to revenue growth. Sales and
marketing expenses as a percentage of total revenues in the three and nine
months ended September 30, 1999 were 45% and 43%, respectively, compared to 37%
and 33%, respectively, in the comparable periods of 1998. We expect that sales
and marketing expenses will continue to increase in absolute dollars for the
foreseeable future as commissions increase with expected increases in revenues
and as we continue to expand the size of our sales and marketing organization.
10
<PAGE> 12
RESEARCH AND DEVELOPMENT
Research and development expenses consist primarily of salaries and
benefits for software developers, software product managers and quality
assurance personnel and payments to outside software development contractors.
Research and development expenses for the three and nine months ended September
30, 1999 were $4.5 million and $10.5 million, respectively, an increase of 134%
and 90%, respectively, from the comparable periods of 1998. The increases were
primarily related to a 195% increase in the number of software developers since
September 30, 1998, both in our domestic and Australian development operations.
These expenses as a percentage of total revenues in the three and nine months
ended September 30, 1999 were 25% and 23%, respectively, compared to 22% and
24%, respectively, in the comparable periods of 1998. We expect that research
and development expenses will continue to increase in absolute dollars for the
foreseeable future as additional development personnel are hired.
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of salaries,
benefits and related costs for our executive, finance, administrative and
information services personnel. General and administrative expenses for the
three and nine months ended September 30, 1999 were $2.8 million and $6.8
million, respectively, an increase of 184% and 122%, respectively, from the
comparable periods of 1998. The increases were due to a number of factors
including an increase in salaries and related expenses due to a 104% increase in
headcount necessary to support our expanding operations, costs to move the
Company's corporate office and increases in professional fees, and depreciation.
These expenses as a percentage of total revenues in the three and nine months
ended September 30, 1999 were 15% for both periods compared to 11% and 13%,
respectively, in the comparable periods of 1998. We expect that general and
administrative expenses will continue to increase in absolute dollars for the
foreseeable future as a result of the continued expansion of administrative
staff and expenses associated with being a public company, including annual and
other public reporting costs, directors' and officers' liability insurance
premiums, investor relations programs and professional services fees.
COMPENSATION AND OTHER COSTS
Compensation and other costs for the three and nine months ended
September 30, 1999 were $186,000 and $961,000, respectively, compared to no
costs incurred in the comparable periods of 1998. The increase in these costs
for the three months ended September 30, 1999 was attributable to compensation
costs related to the grant of stock options below fair market value. The
year-to-date increase is due to $715,000 related to a severance package provided
to a previous shareholder in April 1999, which will be paid out over a three
year period, and $246,000 in compensation costs related to the grant of stock
options below fair market value.
OTHER INCOME, NET
Other income, net is comprised of interest income, interest expense and
foreign currency transaction gains and losses. Other income, net for the three
and nine months ended September 30, 1999 were $278,000 and $360,000,
respectively, an increase of 162% and 60%, respectively, from the comparable
periods of 1998. Other income, net increased for the three and first nine months
of 1999 due primarily to increases in interest income from larger cash and
marketable securities balances related to the proceeds from our initial public
offering.
PROVISION FOR INCOME TAXES
Provision for income taxes for the three and nine months ended September
30, 1999 were $380,000 and $1.3 million, respectively. Our effective income tax
rate was 42% for the three and nine months ended September 30, 1999 and for the
comparable periods of 1998.
NET INCOME
Net income for the three and nine months ended September 30, 1999 were
$522,000 and $1,836,000, respectively, a decrease of 17% and an increase of 20%,
respectively, from the comparable periods of 1998 for the reasons noted above.
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NET INCOME APPLICABLE TO COMMON SHAREHOLDERS
Net income applicable to common shareholders for the three and nine
months ended September 30, 1999 consists of net income of $522,000 and
$1,836,000, less $250,000 and $590,000 of cumulative dividends paid on the
Series B Redeemable Preferred Stock which was redeemed in the third quarter
using a portion of the proceeds from the Company's initial public offering.
INFLATION
Inflation has not had a significant effect on our results of operations
or financial position for the quarter and nine months ended September 30, 1999
or the comparable periods of 1998.
LIQUIDITY AND CAPITAL RESOURCES
We have funded our business to date primarily from cash generated by our
operations. We also completed our initial public offering in August 1999 which
generated net proceeds of $64.9 million. Our sources of liquidity as of
September 30, 1999 consisted principally of cash and cash equivalents of $43.4
million, $9.3 million in high grade corporate and government short-term
marketable securities, and $2.9 million in high grade corporate and government
long-term marketable securities.
Net cash provided by operating activities was $6.2 million and $6.0
million for the nine months ended September 30, 1999 and 1998, respectively. The
increase in 1999 was primarily due to increases in net income, depreciation and
amortization, deferred revenue resulting from additional service contracts and
accrued expenses, offset by an increase in accounts receivable resulting from
increased sales.
Investing activities have consisted of purchases of property and
equipment, marketable securities and the acquisition of technology and software
licenses. Capital expenditures totaled $3.4 million and $729,000 in the nine
months ended September 30, 1999 and 1998, respectively. Purchases of marketable
securities were $12.2 million for the nine months ended September 30, 1999.
Purchases of technology and software licenses were $234,000 and $5,000 for the
nine months ended September 30, 1999 and 1998, respectively.
Financing activities provided $44.5 million and used $6,000 for the nine
months ended September 30, 1999 and 1998, respectively. In April 1999, we raised
$25.0 million through the sale of preferred stock and an additional $10.0
million in term debt from a commercial bank in order to purchase shares of
common stock from a former shareholder for $35.0 million. In August 1999, we
raised $64.9 million from our initial public offering of 4,400,000 shares and
the underwriters exercising their over-allotment option of 660,000 shares net of
underwriting discounts and commissions and related expenses. We used a portion
of the net proceeds to redeem all outstanding shares of Series B Preferred Stock
for $10.0 million and all accrued preferred dividends of $590,000 and repay
$10.0 million of outstanding term debt from a commercial bank and all accrued
and unpaid interest thereon.
The Company believes that our existing cash, cash equivalents and
investments on hand, together with the cash we expect to generate from
operations, will be sufficient to meet our capital needs for at least the next
12 months. However, it is possible that we may need to raise additional funds to
fund our activities beyond the next year. We could raise such funds by selling
more stock to the public or to selected investors, or by borrowing money. In
addition, even though we may not need additional funds, we may still elect to
sell additional equity securities or obtain credit facilities for other reasons.
We may not be able to obtain additional funds on favorable terms, or at all. If
we raise additional funds by issuing additional securities, the ownership
percentages of existing shareholders would be reduced.
YEAR 2000 READINESS
Many currently installed computer systems and software products are
unable to distinguish between twentieth century dates and twenty-first century
dates because such systems were developed using two digits rather than four to
determine the applicable year. This error could result in system failures or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices or engage
in similar normal business activities. As a result, many companies' software and
computer systems may need to be upgraded or replaced to comply with such "Year
2000 Readiness" requirements.
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STATE OF READINESS OF OUR OPERATIONS
Our business is dependent on the operation of numerous systems that
could potentially be affected by Year 2000-related problems. Those systems
include, among others:
- the software products we sell to customers;
- hardware and software systems used by us in our operations,
including our
- proprietary software systems as well as software supplied by third
parties;
- communications networks such as our client/server network, the
Internet and our private intranet;
- the hardware and software systems of our customers and suppliers;
and
- non-information technology systems and services, such as utilities,
telephone systems and building systems.
To date, we have completed the identification and testing of the
material systems used in our business. During the identification process there
were some systems identified as non-compliant. We have undertaken the task of
bringing these systems into compliance and anticipate be completed by November
30, 1999.
READINESS OF OUR PRODUCTS
Based on our review of the use of dates within our products, each of the
current versions of our products was found to be Year 2000 compliant - that is,
they are capable of adequately distinguishing 21st century dates from 20th
century dates when used in accordance with the related documentation, and
subject to the Year 2000 compliance of the underlying system of the host machine
and any other software used in conjunction with our products.
Earlier versions of certain of our products and certain other
discontinued products were not Year 2000 compliant when they were sold. However,
we currently make available versions of our non-discontinued software that is
Year 2000 compliant for customers that have current maintenance contracts with
us.
RISKS
Although we have not been a party to any litigation or arbitration
proceeding to date involving our products or services related to Year 2000
compliance issues, we may in the future be required to defend our products or
services in such proceedings, or to negotiate resolutions of claims based on
Year 2000 issues. The costs of defending and resolving Year 2000-related
disputes, regardless of the merits of such disputes, and any liability for Year
2000-related damages, including consequential damages, could have a material
adverse effect on our business, results of operations and financial condition.
Success of our Year 2000 compliance efforts may depend on the success of
our customers in dealing with their Year 2000 issues. Our products are generally
integrated into enterprise systems involving sophisticated hardware and complex
software products which may not be Year 2000 compliant. In addition, third party
applications in which our products are embedded, or for which our products are
separately licensed, may not comply with Year 2000 requirements, which may have
an adverse impact on or demand for our products. In some cases even certain
earlier Year 2000 compliant versions of our software, while compatible with
earlier, non-Year 2000 compliant versions of other software products with which
our software is integrated, are not compatible with certain more recent Year
2000 compliant versions of such other software providers. While we do not
believe we have any obligation under these circumstances given that these
customers are using older versions of our software products, there can be no
assurance that we will not be subject to claims or complaints by our customers.
CONTINGENCY PLAN
To date, we have not encountered any material Year 2000 problems with
the hardware and software systems we use in our operations. However, we could
experience material adverse effects on our business if we fail to identify all
Year 2000 dependencies in our systems and in the systems of our suppliers,
customers and financial institutions. We do not presently have a comprehensive
contingency plan for handling Year 2000 problems that are
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not detected and corrected prior to their occurrence, but we expect to continue
developing such a plan, to the extent possible, throughout 1999. Despite our
efforts, we may not identify and remediate all significant Year 2000 problems on
a timely basis, remediation efforts may involve significant time and expense,
and unremediated problems may have a material adverse effect on our business.
See "Risk Factors - Year 2000 issues present technological risks and could cause
disruption of our business."
COSTS
To date, we have not incurred any material costs directly associated
with our Year 2000 compliance efforts, except for compensation expense
associated with our salaried employees who have devoted some of their time to
our Year 2000 assessment and remediation efforts. Moreover, to date, other
projects, including our new product development efforts, have not been delayed
due to our Year 2000 efforts. We do not expect the total cost of Year 2000
problems to be material to our business, financial condition and operating
results.
PURCHASING PATTERNS OF OUR CUSTOMERS
We believe that purchasing patterns of customers and potential customers
may be affected by Year 2000 issues as companies expend significant resources to
correct or upgrade their current software systems for Year 2000 compliance or
defer additional software purchases until after 2000. As a result, some
customers and potential customers may have more limited budgets available to
purchase software products such as those offered by us, and others may choose to
refrain from changes in their information technology environment until after
2000. Still other companies are accelerating purchases of software products
prior to 2000, causing an increase in short-term demand which may, in turn,
cause a corresponding decrease in long-term demand for software products. To the
extent Year 2000 issues cause significant change in, delay in, or cancellation
of, decisions to purchase our products or services, our business could be
materially adversely affected.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard, or SFAS, No. 133, Accounting for Derivative
Instruments and Hedging Activities. SFAS No. 133 establishes methods for
derivative financial instruments and hedging activities related to those
instruments, as well as other hedging activities. Because we do not currently
hold any derivative instruments and do not currently engage in hedging
activities, we expect that the adoption of SFAS No. 133 will not have a material
impact on our financial position or results of operations. We will be required
to implement SFAS No. 133 for the year ending December 31, 2001.
In December 1998, the AICPA issued SOP 98-9, Modification of SOP 97-2,
Software Revenue Recognition, with respect to Certain Transactions. SOP 98-9
amends SOP 97-2 and SOP 98-4 extending the deferral of the application of
certain provisions of SOP 97-2 amended by SOP 98-4 through fiscal years
beginning on or before March 15, 1999. All other provisions of SOP 98-9 are
effective for transactions entered into in fiscal years beginning after March
15, 1999. We do not expect the adoption of SOP 98-9 to have a material effect on
our results of operations or financial condition.
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RISK FACTORS
The following information should be read in conjunction with the
consolidated historical financial information and the notes thereto included in
Item 1 of this report and Management's Discussion and Analysis of Financial
Condition and Results of Operations contained in the Company's Registration
Statement on Form S-1 as filed with the Securities and Exchange Commission on
June 11, 1999.
RISKS RELATED TO OUR BUSINESS
OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE IN FUTURE PERIODS, AND, AS
A RESULT, WE MAY FAIL TO MEET EXPECTATIONS OF INVESTORS AND ANALYSTS, CAUSING
OUR STOCK PRICE TO FLUCTUATE OR DECLINE
Our revenues and operating results may vary significantly from quarter
to quarter due to a number of factors. These factors include the following:
- the size and timing of customer orders. See "- The size and timing
of our customer orders may vary significantly from quarter to
quarter which could cause fluctuations in our revenues."
- increased expenses, whether related to sales and marketing, product
development or administration;
- our ability to attain market acceptance of new products and services
and enhancements to our existing products;
- delays in introducing new products;
- new product introductions by competitors; lack of order backlog;
- changes in our pricing policies or the pricing policies of our
competitors;
- costs related to acquisitions of technologies or businesses;
- the timing of releases of new versions of third-party software
products that our products support, including, without limitation,
product releases by Oracle; and
- the amount and timing of expenditures related to expansion of our
operations.
See "- Customer focus and spending on Year 2000 remediation make it
difficult to predict the buying patterns of our customers during the third and
fourth quarters of 1999."
THE SIZE AND TIMING OF OUR CUSTOMER ORDERS MAY VARY SIGNIFICANTLY FROM QUARTER
TO QUARTER WHICH COULD CAUSE FLUCTUATIONS IN OUR REVENUES
In any given quarter, sales of some of our products have involved large
financial commitments from a relatively small number of customers, and
cancellation or deferral of these large contracts would reduce our revenues. In
addition, the sales cycles for Vista Plus and SharePlex have been up to six
months and often require pre-purchase evaluation periods and customer education.
These relatively long sales cycles may cause significant periodic variation in
our license revenues. Also, we have often booked a significant portion of our
orders in the last month of a quarter and delays in the closing of orders near
the end of a quarter could cause quarterly revenues to fall short of anticipated
levels. Finally, while a portion of our revenues each quarter is recognized from
previously deferred revenue, our quarterly performance will depend primarily
upon entering into new contracts to generate revenues for that quarter.
MANY OF OUR PRODUCTS ARE DEPENDENT ON ORACLE'S TECHNOLOGIES AND IF ORACLE'S
TECHNOLOGIES LOSE MARKET SHARE OR BECOME INCOMPATIBLE WITH OUR PRODUCTS, THE
DEMAND FOR OUR PRODUCTS COULD SUFFER
We believe that our success has depended in part, and will continue to
depend in part for the foreseeable future, upon our relationship with Oracle and
our status as a complementary software provider for Oracle's database and
application products. Many versions of our principal products, including
SharePlex, SQLab Xpert, and SQL Navigator, are designed specifically to be used
with Oracle databases. Although a number of our products work with other
environments, our competitive advantage consists in substantial part on the
integration between our products and Oracle's products, and our extensive
knowledge of Oracle's technology. Currently, a significant portion of our total
revenues are derived from products that specifically support Oracle-based
products. If Oracle
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for any reason decides to promote technologies and standards that are not
compatible with our technology, or if Oracle loses market share for its database
products, our business, operating results and financial condition would be
materially adversely affected.
MANY OF OUR PRODUCTS ARE VULNERABLE TO DIRECT COMPETITION FROM ORACLE
We currently compete with Oracle in the market for database management
solutions. We expect that Oracle's commitment to and presence in the database
management product market will increase in the future and therefore
substantially increase competitive pressures. We believe that Oracle will
continue to incorporate database management technology into its server software
offerings, possibly at no additional cost to its users. We believe that Oracle
will also continue to enhance its database management technology. Furthermore,
Oracle could attempt to increase its presence in this market by acquiring or
forming strategic alliances with our competitors, and Oracle may be in better
position to withstand and respond to the current factors impacting this
industry. Oracle has a longer operating history, a larger installed base of
customers and substantially greater financial, distribution, marketing and
technical resources than we do. In addition, Oracle has well-established
relationships with many of our present and potential customers. As a result, we
may not be able to compete effectively with Oracle in the future which could
materially adversely affect our business, operating results and financial
condition.
OUR ABILITY TO INCREASE OUR REVENUES DEPENDS ON OUR ABILITY TO EXPAND OUR
INDIRECT SALES CHANNELS
Our ability to increase revenues in the future substantially depends on
our ability to expand our indirect sales channel.
In certain domestic and international markets we may miss sales
opportunities if we are unable to enter into successful relationships with
locally based resellers. In the future, we intend to augment our current limited
indirect sales distribution methods through additional third-party distribution
arrangements and, therefore, we will likely become more dependent on these type
of relationships. There can be no assurance that we will successfully augment
these arrangements or that the expansion of indirect sales distribution methods
will increase revenues.
OUR PAST AND FUTURE GROWTH MAY STRAIN OUR MANAGEMENT, ADMINISTRATIVE,
OPERATIONAL AND FINANCIAL INFRASTRUCTURE
We have recently experienced a period of rapid growth in our operations
that has placed and will continue to place a strain on our management,
administrative, operational and financial infrastructure. During this period, we
have experienced an increase in the number of our employees, increasing demands
on our operating and financial systems and personnel, and an expansion in the
geographic coverage of our operations. Our ability to manage our operations and
growth requires us to continue to improve our operational, financial and
management controls, and reporting systems and procedures. In addition, we will
be required to hire additional management, financial, and sales and marketing
personnel to manage our expanding operations. If we are unable to manage this
growth effectively, our business, operating results and financial condition may
be materially adversely affected.
WE MAY NEED TO RAISE ADDITIONAL CAPITAL IN THE FUTURE, AND ADDITIONAL FUNDS MAY
NOT BE AVAILABLE ON TERMS ACCEPTABLE TO US.
We believe that the cash, cash equivalents and investments on hand and
the cash we expect to generate from operations will be sufficient to meet our
capital needs for at least the next 12 months. However, it is possible that we
may need to raise additional funds to fund to fund our activities beyond the
next year. In addition, we may require additional capital to consummate
acquisitions of other businesses, products, or technologies. We could raise
these funds by selling more stock to the public or to selected investors, or by
borrowing money. In addition, even though we may not need additional funds, we
may still elect to sell additional equity securities or obtain credit facilities
for other reasons. We may not be able to obtain additional funds on favorable
terms, or at all. If adequate funds are not available, we may be required to
curtail our operations significantly or to obtain funds through arrangements
with strategic partners or others that may require us to relinquish rights to
certain technologies or potential markets. If we raise additional funds by
issuing additional equity securities, the ownership percentages of existing
shareholders would be reduced.
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It is possible that our future capital requirements may vary materially
from those now planned. The amount of capital that we will need in the future
will depend on many factors, including: planned growth, hiring, infrastructure
and facility needs or to consummate acquisitions of other businesses, products
or technologies.
WE MAY NOT GENERATE INCREASED BUSINESS FROM OUR CURRENT CUSTOMERS WHICH COULD
SLOW OUR REVENUE GROWTH IN THE FUTURE
Most of our customers initially make a purchase of our products for a
single department or location. Many of these customers may choose not to expand
their use of our products. If we fail to generate expanded business from our
current customers, our business, operating results and financial condition could
be materially adversely affected. In addition, as we deploy new modules and
features for our existing products or introduce new products, our current
customers may choose not to purchase this new functionality or these new
products. Moreover, if customers elect not to renew their maintenance
agreements, our service revenues would be materially adversely affected.
BECAUSE THE MARKET FOR E-BUSINESS SOLUTIONS IS NEW AND EVOLVING, WE CANNOT
ACCURATELY PREDICT THE FUTURE GROWTH RATE OF THIS MARKET OR ITS ULTIMATE SIZE
We are increasingly focusing our selling efforts on providing
application and information availability solutions for e-business applications
and we expect such sales to constitute an increasing portion of our future
revenue growth. We believe that most companies currently are not yet aware of
our products and capabilities within this evolving market, and, as a result,
such companies have not deployed our solutions. While we have devoted
significant resources to promoting awareness of our products and the problems
these products address for this evolving market, these efforts may not be
sufficient to build market awareness of the need for our products. Failure of a
significant market for e-business application and information availability
products to develop, or failure of our products to achieve broad market
acceptance, could have a material adverse effect on our business, operating
results and financial condition.
WE EXPECT TO INCUR SIGNIFICANT INCREASES IN OUR OPERATING EXPENSES IN THE
FORESEEABLE FUTURE, WHICH MAY AFFECT OUR FUTURE PROFITABILITY
We intend to substantially increase our operating expenses for the
foreseeable future as we:
- increase our sales and marketing activities, including expanding our
direct sales and telesales forces;
- increase our research and development activities;
- expand our general and administrative activities; and
- expand our customer support organizations.
Accordingly, we will be required to significantly increase our revenues
in order to maintain profitability. These expenses will be incurred before we
generate any revenues by this increased spending. If we do not significantly
increase revenues from these efforts, our business and operating results would
be negatively impacted.
ACQUISITIONS OF COMPANIES OR TECHNOLOGIES MAY RESULT IN DISRUPTIONS TO OUR
BUSINESS AND DIVERSION OF MANAGEMENT ATTENTION
We have in the past made and we expect to continue to make acquisitions
of complementary companies, products or technologies. If we make any
acquisitions, we will be required to assimilate the operations, products and
personnel of the acquired businesses and train, retain and motivate key
personnel from the acquired businesses. We may be unable to maintain uniform
standards, controls, procedures and policies if we fail in these efforts.
Similarly, acquisitions may subject us to liabilities and risks that are not
known or identifiable at the time of the acquisition or may cause disruptions in
our operations and divert management's attention from day-to-day operations,
which could impair our relationships with our current employees, customers and
strategic partners. We may have to incur debt or issue equity securities to pay
for any future acquisitions. The issuance of equity securities for any
acquisition could be substantially dilutive to our shareholders. In addition,
our profitability may suffer because of acquisition-related costs or
amortization costs for acquired goodwill and other intangible assets. In
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consummating acquisitions, we are also subject to risks of entering geographic
and business markets in which we have no or limited prior experience. If we are
unable to fully integrate acquired businesses, products or technologies with our
existing operations, we may not receive the intended benefits of acquisition.
OUR INTERNATIONAL OPERATIONS AND OUR PLANNED EXPANSION OF OUR INTERNATIONAL
OPERATIONS EXPOSES US TO CERTAIN RISKS
Substantially all of our current international revenues are derived from
the operations of our three wholly-owned subsidiaries in Australia, the United
Kingdom and Germany. As a result, we face increasing risks from doing business
on an international basis, including, among others:
- difficulties in staffing and managing foreign operations;
- longer payment cycles;
- seasonal reductions in business activity in Europe;
- increased financial accounting and reporting burdens and
complexities;
- potentially adverse tax consequences;
- delays in localizing our products;
- compliance with a wide variety of complex foreign laws and treaties;
- reduced protection for intellectual property rights in some
countries; and
- licenses, tariffs and other trade barriers.
In addition, because our international subsidiaries conduct business in
the currency of the country in which they operate, we are subject to currency
fluctuations and currency transaction losses or gains which are outside of our
control.
We plan to expand our international operations as part of our business
strategy. The expansion of our existing international operations and entry into
additional international markets will require significant management attention
ad financial resources and will place additional burdens on our management,
administrative, operational and financial infrastructure. We cannot be certain
that our investments in establishing facilities in other countries will produce
desired levels of revenue or profitability. In addition, we have sold our
products internationally for only a few years and we have limited experience in
developing localized versions of our products and marketing and distributing
them internationally. As our international operations expand, our exposure to
exchange rate fluctuations will increase as we use an increasing number of
foreign currencies. We have not yet entered into any hedging transactions to
date to mitigate our expense to currency fluctuations.
OUR FUTURE SUCCESS DEPENDS IN PART ON THE ACCEPTANCE OF OUR VISTA PLUS PRODUCT
Our operating results for the nine months ended September 30, 1999 were
dependent in part upon the commercial success of our Vista Plus product line and
we expect a significant portion, but not a majority, of our licensing revenues
for the foreseeable future to come from sales of these products. As a result,
any future growth of Quest for the foreseeable future will depend on the
continued commercial success of these products. Our future financial performance
will also depend in part on the successful development, introduction and
customer acceptance of new and enhanced versions of Vista Plus products. In the
future we may not be successful in marketing our existing products or any new or
enhanced products or services.
FAILURE TO DEVELOP STRATEGIC RELATIONSHIPS COULD HARM OUR BUSINESS BY DENYING US
SELLING OPPORTUNITIES AND OTHER BENEFITS
Our current collaborative relationships may not prove to be beneficial
to us, and they may not be sustained. We also may not be able to enter into
successful new strategic relationships in the future, which could have a
material adverse effect on our business, operating results and financial
condition. From time to time, we have collaborated with other companies,
including Hewlett-Packard and Oracle and certain regional offices of a number of
the national accounting firms that provide system integration services, in areas
such as product development, marketing, distribution and implementation. We
could lose sales opportunities if we fail to work effectively with these
parties. Moreover, we expect that maintaining and enhancing these and other
relationships will become a more
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meaningful part of our business strategy in the future. However, many of our
current partners are either actual or potential competitors with us. In
addition, many of these third parties also work with competing software
companies and we may not be able to maintain these existing relationships, due
to the fact that these relationships are informal or, if written, are terminable
with little or no notice.
OUR PROPRIETARY RIGHTS MAY BE INADEQUATELY PROTECTED, AND THERE IS RISK OF
INFRINGEMENT CLAIMS OR INDEPENDENT DEVELOPMENT OF COMPETING TECHNOLOGY THAT
COULD HARM OUR COMPETITIVE POSITION
Our success and ability to compete are dependent on our ability to
develop and maintain the proprietary aspects of our technology. We rely on a
combination of trademark, trade secret, copyright law and contractual
restrictions to protect the proprietary aspects of our technology.
Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy aspects of our products or to obtain and use
information that we regard as proprietary. Litigation may be necessary in the
future to enforce our intellectual property rights, to protect our trade
secrets, and to determine the validity and scope of the proprietary rights of
others. Any such resulting litigation could result in substantial costs and
diversion of resources.
Our means of protecting our proprietary rights may prove to be
inadequate and competitors may independently develop similar or superior
technology. Policing unauthorized use of our products is difficult, and we
cannot be certain that the steps we have taken will prevent misappropriation of
our technology, particularly in foreign countries where the laws may not protect
our proprietary rights as fully as in the United States. We also believe that,
because of the rapid rate of technological change in the software industry,
trade secret and copyright protection are less significant than factors such as
the knowledge, ability and experience of our employees, frequent product
enhancements and the timeliness and quality of customer support services.
Our success and ability to compete are also dependent on our ability to
operate without infringing upon the proprietary rights of others. Third parties
may claim infringement by us of their intellectual property rights. In the event
of a successful claim of product infringement against us and our failure or
inability to either license the infringed or similar technology or develop
alternative technology on a timely basis, we may incur substantial licensing
fees, be liable for infringement damage, or be unable to market our products.
On May 25, 1999, Mobius Management Systems, Inc. filed a lawsuit against
us in the United States District Court for the District of New Jersey. The
complaint alleges, among other things, that we misappropriated unspecified trade
secrets belonging to Mobius. The suit seeks injunctive relief and unspecified
damages.
OUR BUSINESS WILL SUFFER IF OUR SOFTWARE CONTAINS ERRORS
The software products we offer are inherently complex. Despite testing
and quality control, we cannot be certain that errors will not be found in
current versions, new versions or enhancements of our products after
commencement of commercial shipments. Significant technical challenges also
arise with our products because our customers purchase and deploy our products
across a variety of computer platforms and integrate it with a number of
third-party software applications and databases. If new or existing customers
have difficulty deploying our products or require significant amounts of
customer support, our operating margins could be harmed. Moreover, we could face
possible claims and higher development costs if our software contains undetected
errors or if we fail to meet our customers' expectations. As a result of the
foregoing, we could experience:
- loss of or delay in revenues and loss of market share;
- loss of customers;
- damage to our reputation;
- failure to achieve market acceptance;
- diversion of development resources;
- increased service and warranty costs;
- legal actions by customers against us which could, whether or not
successful, increase costs and distract our management; and
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- increased insurance costs.
In addition, a product liability claim, whether or not successful, could
harm our business by increasing our costs and distracting our management.
WE INCORPORATE SOFTWARE LICENSED FROM THIRD PARTIES INTO SOME OF OUR PRODUCTS
AND ANY SIGNIFICANT INTERRUPTION IN THE AVAILABILITY OF THESE THIRD-PARTY
SOFTWARE PRODUCTS OR DEFECTS IN THESE PRODUCTS COULD REDUCE THE DEMAND FOR, OR
PREVENT THE SHIPPING OF, OUR PRODUCTS
Our SQL Navigator, TOAD and Vista Plus products contain components
developed and maintained by third-party software vendors. For example, we
incorporate software licensed from Inso Corporation and Artifex Software into
add-on options for our Vista Plus products. We expect that we may have to
incorporate software from third-party vendors in our future products. We may not
be able to replace the functionality provided by the third-party software
currently offered with our products if that software becomes obsolete, defective
or incompatible with future versions of our products or is not adequately
maintained or updated. Any significant interruption in the availability of these
third-party software products or defects in these products could harm our sales
unless and until we can secure an alternative source. Although we believe there
are adequate alternate sources for the technology licensed to us by Inso and
Artifex, such alternate sources may not provide us with the same functionality
as that currently provided to us. Further, we may experience a delay in
obtaining an alternate source for the file viewing technology licensed to us by
Inso if our license with Inso becomes unavailable for any reason.
RISKS RELATED TO OUR INDUSTRY
YEAR 2000 ISSUES PRESENT TECHNOLOGICAL RISKS AND COULD CAUSE DISRUPTION TO OUR
BUSINESS
We are in the process of our Year 2000 review program for the systems we
use to run our business. The Year 2000 problem could affect these systems
causing a disruption in our business as well as divert management's attention
from ordinary business activities. In addition, there can be no assurance that
third parties that we rely upon for services will resolve their Year 2000
problems. If our present efforts to address Year 2000 issues are not successful,
or if third parties upon which we rely to conduct our business do not
successfully address such issues, our business, operating results and financial
condition would be materially adversely affected. We are unable to reasonably
estimate the duration and extent of any such unanticipated interruption to our
business caused by the Year 2000, or quantify the effect it may have on our
future operating results. We have not yet developed a comprehensive contingency
plan to address these issues but we intend to continue developing such a plan,
to the extent possible, throughout 1999. Please refer to our discussion in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Year 2000" for further information.
Quest believes that the following consequences are possible in a
"reasonable worst case" Year 2000 scenario:
- costly business disputes and claims for pricing adjustments,
damages, product returns and warranty obligations related to our
products, any of which could cause a delay in receipt of revenues
from our customers;
- a significant number of operational inconveniences and
inefficiencies for Quest and its customers that will divert
management's time and attention; and
- Year 2000 non-compliance by third parties that would disrupt, reduce
or eliminate for a period of time the ability of our customers to
purchase our products, thereby reducing our revenues.
CUSTOMER FOCUS AND SPENDING ON YEAR 2000 REMEDIATION MAKE IT DIFFICULT TO
PREDICT THE BUYING PATTERNS OF OUR CUSTOMERS DURING THE THIRD AND FOURTH
QUARTERS OF 1999
The purchasing patterns of our customers and potential customers based
on Year 2000 issues make it difficult to predict future sales of our products,
especially in the third and fourth quarters of 1999. Many customers may spend
their limited financial and personnel resources remediating Year 2000 problems,
thereby delaying or foregoing purchases of other software products such as ours.
This trend could reduce our revenues in 1999 and
20
<PAGE> 22
2000. Other companies are accelerating purchases of software products prior to
2000, causing an increase in short-term demand which may in turn cause a
corresponding decrease in long-term demand for software products.
THE DEMAND FOR OUR PRODUCTS WILL DEPEND ON OUR ABILITY TO ADAPT TO RAPID
TECHNOLOGICAL CHANGE
Our future success will depend on our ability to continue to enhance our
current products and to develop and introduce new products on a timely basis
that keep pace with technological developments and satisfy increasingly
sophisticated customer requirements. Rapid technological change, frequent new
product introductions and enhancements, uncertain product life cycles, changes
in customer demands and evolving industry standards characterize the market for
our products. The introduction of products embodying new technologies and the
emergence of new industry standards can render our existing products obsolete
and unmarketable. As a result of the complexities inherent in today's computing
environments and the performance demanded by customers for embedded databases
and Web-based products, new products and product enhancements can require long
development and testing periods. As a result, significant delays in the general
availability of such new releases or significant problems in the installation or
implementation of such new releases could have a material adverse effect on our
business, operating results and financial condition. We may not be successful
in:
- developing and marketing, on a timely and cost-effective basis, new
products or new product enhancements that respond to technological
change, evolving industry standards or customer requirements;
- avoiding difficulties that could delay or prevent the successful
development, introduction or marketing of these products; or
- achieving market acceptance for our new products and product
enhancements.
WE MAY NOT BE ABLE TO ATTRACT AND RETAIN PERSONNEL
Our future success depends on the continued service of our executive
officers and other key administrative, sales and marketing and support
personnel, many of whom, including our Chief Financial Officer, have recently
joined our company. In addition, the success of our business is substantially
dependent on the services of our Chief Executive Officer and our President and
Chief Technical Officer. We intend to hire a significant number of additional
sales, support, marketing, administrative and research and development personnel
over at least the next 12 months. There has in the past been and there may in
the future be a shortage of personnel that possess the technical background
necessary to sell, support and develop our products effectively. Competition for
skilled personnel is intense, and we may not be able to attract, assimilate or
retain highly qualified personnel in the future. Our business may not be able to
grow if we cannot attract qualified personnel. Hiring qualified sales,
marketing, administrative, research and development and customer support
personnel, is very competitive in our industry, particularly in Southern
California, where Quest is headquartered.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
FOREIGN CURRENCY HEDGING INSTRUMENTS
We transact business in various foreign currencies. Accordingly, we are
subject to exposure from adverse movements in foreign currency exchange rates.
This exposure is primarily related to revenues and operating expenses in
Australia, the United Kingdom and Germany denominated in the respective local
currency. To date, we have not used hedging contracts to hedge our
foreign-currency fluctuation risks. We will assess the need to utilize financial
instruments to hedge currency exposures on an ongoing basis. We also do not use
derivative financial instruments for speculative trading purposes.
FIXED INCOME INVESTMENTS
Our general investing policy is to limit the risk of principal loss and
ensure the safety of invested funds by limiting market and credit risk. We
currently place our investments in highly liquid money market accounts and U.S.
Government obligations. All highly liquid investments with a maturity of three
months or less at the date of purchase are considered to be cash equivalents.
21
<PAGE> 23
EUROPEAN MONETARY UNION
Within Europe, the European Economic and Monetary Union introduced a new
currency, the euro, on January 1, 1999. The new currency is in response to the
European Union's policy of economic convergence to harmonize trade policy,
eliminate business costs associated with currency exchange and to promote the
free flow of capital, goods and services. On January 1, 1999, the participating
countries adopted the euro as their local currency, initially available for
currency trading on currency exchanges and non-cash transactions such as
banking. The existing local currencies, or legacy currencies, will remain legal
tender through January 1, 2002. Beginning on January 1, 2002, euro-denominated
bills and coins will be issued for cash transactions. For a period of up to six
months from this date, both legacy currencies and the euro will be legal tender.
On or before July 1, 2002, the participating countries will withdraw all legacy
currencies and exclusively use the euro. Our transactions are recorded in both
U.S. dollars and foreign currencies. Future transactions may be recorded in the
euro. We have not incurred and do not expect to incur any significant costs from
the continued implementation of the euro. However, the currency risk of the euro
could harm our business.
22
<PAGE> 24
PART II
OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
On May 25, 1999, Mobius Management Systems, Inc. filed a complaint in
the United States District Court for the District of New Jersey (Mobius
Management Systems, Inc. v. Quest Software, Inc., Case No. 99-2337). The
complaint alleges that we published three advertisements that were false and
misleading and therefore in violation of the Lanham Act and common law, and that
we misappropriated unspecified trade secrets belonging to Mobius. The
advertisements that Mobius alleges in its complaint are false and misleading are
two e-mails intended for internal use, a comparison chart believed to have been
prepared by a former Quest employee in 1997 for internal purposes, and a
statement made regarding our Vista Plus Java client which had been posted on the
Internet. The complaint seeks injunctive relief and unspecified damages. No
factual basis was set forth in the complaint in support of Mobius'
misappropriation of trade secrets claim. In response to Mobius' complaint, we
have filed a motion to transfer venue to California which was set for hearing
later this year, as this case has no bearing in the state of New Jersey. We
intend to defend this action vigorously, and, based on the complaint and the
facts underlying the complaint of which we are currently aware, we do not
believe that this lawsuit will have a material adverse effect on our business,
results of operations or financial condition; however, it is too early to
determine the ultimate outcome of the lawsuit.
The Company is a party to various other litigation and administrative
proceedings related to claims arising from its operations in the normal course
of business. Management believes that the resolution of these matters will not
have a material adverse effect on the Company's business, results of operation,
financial condition or cash flows.
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
(c) SALES OF UNREGISTERED SECURITIES. During the three months ended
September 30, 1999, following the exercise of options to purchase shares of
Common Stock that had been granted under the Company's 1998 Stock Option/Stock
Issuance Plan by seven employees, the Company issued an aggregate of 26,373
shares of Common Stock for an aggregate purchase price of $26,373. All sales of
Common Stock made by the Company pursuant to the exercise of stock options were
made pursuant to the exemption from the registration requirements of the
Securities Act afforded by Rule 701 promulgated under the Securities Act.
(d) USE OF PROCEEDS FROM SALES OF REGISTERED SECURITIES. On August
18, 1999, the Company completed an initial public offering of its Common Stock,
no par value. The managing underwriters in the offering were BancBoston
Robertson Stephens, Donaldson, Lufkin & Jenrette, CIBC World Markets and
FAC/Equities (the "Underwriters"). The shares of Common Stock sold in the
Offering were registered under the Securities Act of 1933, as amended, on a
Registration Statement on Form S-1 (the "Registration Statement") (Reg. No.
333-80543) that was declared effective by the SEC on August 12, 1999. The
offering commenced on August 13, 1999 after all 4,400,000 shares of Common Stock
registered under the Registration Statement were sold at a price of $14.00 per
share. The Underwriters also exercised an overallotment option of 660,000 shares
on August 26, 1999. All 660,000 overallotment shares were sold at a price of
$14.00 per share. The aggregate price of the Offering amount registered was
$70,840,000. In connection with the offering, the Company paid an aggregate of
$4,958,000 in underwriting discounts and commissions to the Underwriters. In
addition, the following table sets forth the expenses incurred in connection
with the offering, other than underwriting discounts and commissions.
23
<PAGE> 25
<TABLE>
<S> <C>
SEC registration fee $ 26,000
NASD filing fee 11,000
Nasdaq National Market listing fee 96,000
Printing and engraving expenses 276,000
Legal fees and expenses 361,000
Accounting fees and expenses 188,000
Transfer Agent fees 3,000
Miscellaneous 63,000
----------
Total $1,024,000
</TABLE>
After deducting the underwriting discounts and commissions and the
estimated Offering expenses described above, the Company received net proceeds
from the offering of approximately $64,858,000. As of September 30, 1999, the
Company has used the net proceeds from its initial public offering of Common
Stock to redeem all outstanding shares of Series B Preferred Stock for
$10,000,000, repay outstanding term debt and all accrued and unpaid interest
thereon in the amount of $10,037,778, and invest in interest bearing investment
grade instruments. The Company has used its existing cash balances to fund the
general operations of the Company. The remaining proceeds will be used for
general corporate purposes, including working capital, expansion of its sales
and marketing capabilities, and acquisitions of, or investments in, businesses,
products and technologies that are complementary to the Company's business. None
of the Company's net proceeds of the Offering were paid directly or indirectly
to any director, officer, general partner of the Company or their associates,
persons owning 10% or more of any class of equity securities of the Company, or
an affiliate of the Company.
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
EXHIBIT
NUMBER DESCRIPTION
27.1 Financial Data Schedule
B. REPORTS ON FORM 8-K
None.
24
<PAGE> 26
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report on Form 10-Q to be signed on
its behalf by the undersigned thereunto duly authorized.
QUEST SOFTWARE, INC.
November 12, 1999 /s/ JOHN J. LASKEY
-----------------------------------------
John J. Laskey
Chief Financial Officer and Vice
President, Finance (Principal Financial
and Accounting Officer)
25
<PAGE> 27
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<S> <C>
27.1 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 43,358
<SECURITIES> 9,250
<RECEIVABLES> 15,499
<ALLOWANCES> 2,140
<INVENTORY> 0
<CURRENT-ASSETS> 67,616
<PP&E> 6,587
<DEPRECIATION> 2,723
<TOTAL-ASSETS> 75,634
<CURRENT-LIABILITIES> 24,090
<BONDS> 0
0
0
<COMMON> 84,374
<OTHER-SE> (32,830)
<TOTAL-LIABILITY-AND-EQUITY> 75,634
<SALES> 35,360
<TOTAL-REVENUES> 46,597
<CGS> 2,138
<TOTAL-COSTS> 5,030
<OTHER-EXPENSES> 38,752
<LOSS-PROVISION> 21
<INTEREST-EXPENSE> 256
<INCOME-PRETAX> 3,175
<INCOME-TAX> 1,339
<INCOME-CONTINUING> 1,836
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,246
<EPS-BASIC> 0.03
<EPS-DILUTED> 0.03
</TABLE>
