<PAGE> 1
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 ENDING SEPTEMBER 30, 1996
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 0-12167
RATIONAL SOFTWARE CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 54-1217099
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
2800 SAN TOMAS EXPRESSWAY, SANTA CLARA, CA 95051-0951
(Address of principal executive office) (Zip Code)
408-496-3600
(Registrant's telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
COMMON STOCK, PAR VALUE 40,159,798
$.01 PER SHARE
(Class) (Shares outstanding on October 31,
1996)
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CONTENTS PAGE
PART I -- FINANCIAL INFORMATION
Item 1 -- Consolidated Financial Statements:
Condensed Consolidated Balance Sheets......................... 3
Condensed Consolidated Statements of Income................... 5
Condensed Consolidated Statements of Cash Flows............... 6
Notes to Condensed Consolidated Financial Statements.......... 7
Item 2 -- Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................... 9
PART II -- OTHER INFORMATION
Item 1 -- Legal Proceedings............................................. 19
Item 4 -- Matters Submitted to a Vote of Security Holders............... 19
Item 6 -- Exhibits and Reports on Form 8-K.............................. 19
SIGNATURE .............................................................. 20
2
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
ASSETS
<TABLE>
<CAPTION>
September 30, March 31,
1996 1996
-------- --------
(Unaudited)
<S> <C> <C>
Cash and cash equivalents $ 48,305 $ 43,934
Short-term investments 6,763 8,711
Accounts receivable, net 25,524 23,408
Prepaid expenses and other assets 2,366 2,074
-------- --------
Total current assets 82,958 78,127
Property and equipment, at cost:
Computer, office and manufacturing equipment 25,152 22,779
Office furniture 1,891 2,109
Leasehold improvements 1,221 1,209
-------- --------
28,264 26,097
Accumulated depreciation and amortization (21,926) (20,715)
-------- --------
Property and equipment, net 6,338 5,382
Other assets, net 1,861 2,165
-------- --------
Total assets $ 91,157 $ 85,674
======== ========
</TABLE>
See accompanying notes
3
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
LIABILITIES AND STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
September 30, March 31,
1996 1996
--------- ---------
(Unaudited)
<S> <C> <C>
Accounts payable $ 2,366 $ 2,983
Accrued employee benefits 6,866 8,476
Other accrued expenses 5,415 4,285
Accrued merger and restructuring expenses, current portion 537 575
Deferred revenue 10,810 15,606
Current portion of long-term debt and lease obligations 31 654
--------- ---------
Total current liabilities 26,025 32,579
Accrued rent 594 880
Accrued merger and restructuring expenses, long-term 1,062 1,309
--------- ---------
Total liabilities 27,681 34,768
--------- ---------
Stockholders' equity:
Common stock, $.01 par value, 75,000,000
shares authorized 348 336
Additional paid-in capital 117,583 113,771
Treasury stock (1,340) (1,340)
Accumulated deficit (52,999) (61,995)
Cumulative translation adjustment (116) 134
--------- ---------
Total stockholders' equity 63,476 50,906
--------- ---------
Total liabilities and stockholders' equity $ 91,157 $ 85,674
========= =========
</TABLE>
See accompanying notes
4
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS, UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
September 30, September 30,
--------------------- ---------------------
1996 1995 1996 1995
------- ------- ------- -------
<S> <C> <C> <C> <C>
Net product revenue $17,871 $13,815 $35,171 $25,269
Consulting and support revenue 10,745 7,827 20,906 16,130
------- ------- ------- -------
Total revenue 28,616 21,642 56,077 41,399
Cost of product revenue 2,081 1,879 3,906 3,129
Cost of consulting and support revenue 5,433 4,165 10,932 8,928
------- ------- ------- -------
Total cost of revenue 7,514 6,044 14,838 12,057
------- ------- ------- -------
Gross margin 21,102 15,598 41,239 29,342
Research and development expenses 4,460 3,285 8,955 6,456
Sales and marketing expenses 9,005 8,417 17,882 16,083
General and administrative expenses 2,638 2,066 5,037 3,777
------- ------- ------- -------
Total operating expenses 16,103 13,768 31,874 26,316
------- ------- ------- -------
Operating income 4,999 1,830 9,365 3,026
Other income, net 686 446 1,219 626
------- ------- ------- -------
Income before income taxes 5,685 2,276 10,584 3,652
Provision for income taxes 853 182 1,588 292
------- ------- ------- -------
Net income $ 4,832 $ 2,094 $ 8,996 $ 3,360
======= ======= ======= =======
Net income per common share $ 0.13 $ 0.06 $ 0.24 $ 0.11
Shares used in computing per share amounts 37,182 33,206 37,056 30,872
</TABLE>
See accompanying notes
5
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS, UNAUDITED)
<TABLE>
<CAPTION>
Six Months Ended
September 30,
------------------------
1996 1995
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 8,996 $ 3,360
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 1,958 1,986
Compensation expense for stock option grants 72 0
(Increase) decrease in assets:
Accounts receivable (2,116) (3,898)
Prepaids and other, net (292) (566)
Other assets 0 (5)
Increase (decrease) in liabilities:
Accounts payable (617) (241)
Accrued employee benefits (1,610) (819)
Deferred revenue (4,796) (318)
Accrued expenses 594 (1,364)
Accrued merger and restructuring expenses (285) (399)
-------- --------
Net cash provided by (used in) operating activities 1,904 (2,264)
Cash flows from investing activities:
Purchase of investments (6,316) (2,479)
Sale of investments 8,264 3,459
Capital expenditures (2,610) (1,130)
-------- --------
Net cash used in investing activities (662) (150)
Cash flows from financing activities:
Principal payments under debt and lease obligations (623) (1,240)
Proceeds from issuance of common stock 3,752 31,392
-------- --------
Net cash provided by financing activities 3,129 30,152
-------- --------
Net increase (decrease) in cash and cash equivalents 4,371 27,738
Cash and cash equivalents at beginning of period 43,934 9,440
-------- --------
Cash and cash equivalents at end of period $ 48,305 $ 37,178
======== ========
</TABLE>
See accompanying notes.
6
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RATIONAL SOFTWARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION -- The consolidated financial information
included herein has been prepared without audit in accordance with the
Company's accounting policies, as described in its latest annual report
filed with the Securities and Exchange Commission on Form 10-K. In the
opinion of management, all adjustments, which consist only of normal
recurring adjustments necessary for a fair presentation of the
Company's financial position, statements of income, and cash flows for
the interim periods presented have been made. As permitted by Form
10-Q, certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted where such
disclosure would substantially duplicate previous disclosures.
Operating results for the period ended September 30, 1996 are not
necessarily indicative of the results that may be expected for the year
ending March 31, 1997.
2. ACCOUNTS RECEIVABLE -- Accounts receivable were reduced by an allowance
for doubtful accounts of $1,046,000 at September 30, 1996 and
$1,042,000 at March 31, 1996, respectively.
3. NET INCOME PER COMMON SHARE -- Net income per share has been computed
by dividing the net income by the weighted average numbers of common
and dilutive common equivalent shares outstanding during the period.
Common stock equivalents consist of stock options using the treasury
stock method.
4. CONTINGENCY -- On December 1, 1995, Interactive Development
Environments ("IDE") filed an action against the Company in the San
Francisco County Superior Court seeking monetary damages in excess of
$3 million and other relief for the Company's alleged breach of an
alleged contract, misrepresentation and related claims based on the
Company's preliminary, non-binding merger discussions in 1995 with IDE.
In March 1996, the court sustained the Company's demurrer to IDE's
claim for specific performance of the alleged contract between the
parties. In October 1996, IDE amended its complaint to add a claim for
"Fraud--Non-Disclosure," in which it alleges that the Company was
obligated to tell IDE of the Company's acquisition discussions
regarding Objectory AB, and to lower the amount of damages claimed to
$2 million. Trial on IDE's remaining claims is set for January 1997,
although the parties have signed a stipulation extending the trial date
to March 1997 and the Company anticipates the Court will so order. The
Company believes IDE's complaints are without merit and intends to
defend the case vigorously, although the Company makes no assurance
that the Company will be successful in defending the action. There are
no other material pending legal proceedings to which the Company is a
party or to which any of the Company's property is subject.
5. STOCKHOLDERS' EQUITY -- On July 23, 1996, the Company's Board of
Directors approved a two-for-one stock split payable in the form of a
stock dividend to stockholders of record as of August 27, 1996. All
shares and per share information have been adjusted to reflect this
change. On August 27, 1996 the stockholders approved an increase in the
authorized number of shares of
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5. STOCKHOLDERS' EQUITY -- (continued) common stock from 25,000,000 to
75,000,000. On September 10, 1996, the stock dividend was distributed
to stockholders.
6. SUBSEQUENT EVENTS -- On October 2, 1996, the Company purchased the
Visual Test product from Microsoft Corporation. The purchase price
consisted of a single $23,000,000 cash payment, which will be allocated
to the fair value of the assets acquired, including in-process research
and development. The Company's earnings for the quarter ended December
31, 1996 will be reduced by an expected charge to operations for
acquired in-process research and development expense of approximately
$15,000,000 to $19,000,000.
During October 1996, the Company sold 5,188,094 shares of common stock
in a public offering. Net proceeds from the sales were approximately
$186,000,000 after deducting underwriting discounts, commissions and
other related expenses. The Company is contractually obligated to
reimburse certain of its stockholders for the underwriting discount
applicable to the shares of common stock sold by them, as well as
certain fees and expenses of such stockholders' legal counsel incurred
in connection with the public offering. This reimbursement will result
in a reduction in earnings by a charge of approximately $1,300,000.
On November 12, 1996, the Company and SQA, Inc. jointly
announced a definitive merger agreement to create a worldwide company
providing a comprehensive solution for component-based software
development. Under the terms of the merger agreement, all outstanding
shares of SQA common stock will be exchanged for shares of the Company
on the basis of 0.86 shares of the Company for each share of SQA. The
transaction is expected to be accounted for as a pooling of interests
and to qualify as a tax-free reorganization. The Company expects to
recognize a one-time charge related to certain merger costs and
related expenses in the fourth quarter of its fiscal 1997. Completion
of the transaction is subject to customary conditions, including
approval by the stockholders of the Company and SQA and HSR review.
The merger is expected to close in the fourth quarter of fiscal 1997.
8
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ITEM 2 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The statements contained in Management's Discussion and Analysis of Financial
Condition and Results of Operations include "forward looking" information within
the meaning of Sections 27A of the Securities Act of 1993 and 21E of the
Securities and Exchange Act of 1934, as amended, and are subject to the safe
harbor created by those sections. The actual future results of the Company could
differ materially from those projected in the forward looking information. For a
discussion of certain factors that could cause actual results to differ
materially from those projected by the forward looking information see "Factors
That May Affect Future Results".
The Company's revenue is derived from product license fees and charges for
services, including technical consulting, training, and customer support. In
accordance with generally accepted accounting principles, the Company recognizes
software license revenue upon shipment and recognizes customer-support revenue
over the term of the maintenance agreement. Revenue from consulting and training
is recognized when earned. The Company's license agreements generally do not
provide a right of return, and reserves are maintained for potential credit
losses, of which there have been only immaterial amounts incurred to date.
COMPARATIVE ANALYSIS OF OPERATING RESULTS FOR THE THREE AND SIX MONTHS
ENDED SEPTEMBER 30, 1996
Total revenue increased 32% and 35%, respectively, for the three- and six-month
periods ended September 30, 1996 from the comparable prior year periods. The
Company's revenue is derived from product license fees and charges for services
including training, consulting, and customer support.
Net product revenue increased by 29% and by 39% for the three- and six-month
periods ended September 30, 1996, respectively, from the comparable prior year
periods. The increase in net product revenue for the three-month period was due
to continued strong customer acceptance of the Company's object modeling tools
(the Rational Rose family), while year-to-date product revenue was also
positively impacted by the introduction of new versions of the Company's
Rational Apex product for C/C++ application construction.
Consulting and support revenue increased 37% and 30% , respectively, in the
fiscal 1997 three- and six-month periods versus the same fiscal 1996 periods.
These increases reflected higher demand for the Company's consulting expertise
in object
9
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modeling and advanced software development practices, and, to a lesser extent,
increased training and customer support revenues.
Cost of product revenue consists principally of materials, packaging and
freight, and royalties. Cost of product revenue increased 11% and 25% for the
three- and six-month periods of fiscal 1997 compared to the corresponding
periods of fiscal 1996. These costs represented 12% and 11% of total product
revenue for the three- and six-month periods of fiscal 1997 compared to 14% and
12% for the corresponding periods of fiscal 1996. The decrease in product cost
as a percentage of product revenue was due mainly to lower royalty expense
resulting from a decrease in third party product sales.
Cost of consulting and support revenue consists principally of personnel costs
for training, consulting and customer support. Cost of consulting and support
increased 30% and 22% for the three- and six-month periods of fiscal 1997
compared to the corresponding periods of fiscal 1996. These costs represented
51% and 52% of total consulting and support revenue for the three- and six-month
periods of fiscal 1997 compared to 53% and 55% for the corresponding periods of
fiscal 1996. The decrease in cost as a percentage is primarily due to more
efficient management of the Company's consulting resources, combined with the
impact of an underlying relatively fixed support cost base being spread over
increased revenues.
Total expenditures for research and development increased 36% and 39% for the
three- and six-month periods of fiscal 1997 compared to the corresponding
periods of fiscal 1996. Research and development costs represented 16% of total
revenue for the three- and six-month periods of fiscal 1997 compared to 15% and
16% for the corresponding periods of fiscal 1996. This increase is attributable
to the cost of additional personnel and related costs incurred in maintaining
existing products and developing new product releases.
Sales and marketing expenses increased 7% and 11% for the three- and six-month
periods of fiscal 1997 compared to the corresponding periods of fiscal 1996.
These expenses represented 31% and 32% of total revenue for the three- and
six-month periods of fiscal 1997 compared to 39% for the corresponding periods
of fiscal 1996. The fiscal 1997 increase in sales and marketing expenses reflect
the additional personnel, commissions and related costs required in sales and
marketing to expand the Company's sales channels, penetrate new markets and
increase its market share in core markets.
General and administrative expense consists of personnel costs for
administration, finance, information systems, human resources and general
management, as well as legal and accounting expenses. General and administrative
expense increased 28% and 33% for the three- and six-month periods of fiscal
1997 compared to the corresponding periods of fiscal 1996. General and
administrative expenses represented 9% of total revenue for the three- and
six-month periods of fiscal 1997
10
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compared to 10% and 9% for the corresponding periods of fiscal 1996. The
increased expense for the fiscal 1997 period resulted from increased
employee-related expenses associated with staffing requirements needed to
support the Company's expanding business and increased amortization of goodwill
arising from the Objectory purchase.
Other income, net consists of interest income, interest expense, gains and
losses on foreign currency transactions and miscellaneous items of income and
expense. Other income has fluctuated as a result of operating results, the
amount of cash available for investment in interest-bearing accounts and the
extent of foreign currency transactions. Other income, net increased $240,000
and $593,000 and for the three- and six-month periods of fiscal 1997 compared to
the corresponding periods of fiscal 1996. The increases are the result of
earnings on the additional cash generated by operating activities as compared to
the prior period as well as a full six months of interest income earned on cash
generated from the Company's secondary public offering which was completed in
June 1995, versus four months of interest income for the fiscal 1996 six-month
period.
The provision for income taxes for the first three and six months of fiscal 1997
and 1996 is based on the estimated annual effective tax rate and includes
current federal, state and foreign income taxes. The effective tax rates for
fiscal 1997 and 1996 differ from the federal statutory rate, primarily as a
result of the utilization of net operating loss carryforwards, offset by certain
foreign and state taxes. The higher tax rate in fiscal 1997 is primarily
attributable to higher state taxes due to utilization of remaining state net
operating losses in 1996, as well as federal minimum tax.
At March 31, 1996, the Company had net operating loss carryforwards for federal
income tax purposes of approximately $47,400,000 that expire in 1997 through
2011, and other tax carryforwards of approximately $3,100,000 which expire in
years 1996 through 2010. As a result of the sale of common stock in June 1995,
the Company incurred a change in stock ownership as defined under Section 382 of
the Internal Revenue Code of 1986. Accordingly, approximately $34,000,000 of the
Company's net operating loss carryforwards and all of the tax credit
carryforwards will be subject to an annual limitation of approximately
$8,700,000 regarding their utilization against taxable income in future periods.
In addition, as a result of the fiscal 1994 merger with old Rational and
provisions in the Internal Revenue Code, utilization of approximately $4,600,000
of net operating loss carryforwards are further limited to the future income of
the Company.
LIQUIDITY AND CAPITAL RESOURCES AT SEPTEMBER 30, 1996
As of September 30, 1996, the Company had cash, cash equivalents and short-term
investments of $55,068,000 and working capital of $56,933,000. Net cash provided
by operating activities for the period ending September 30, 1996 was composed
primarily of net income offset by an increase in accounts receivable and
decreases in accrued employee benefits and deferred revenue.
11
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On October 2, 1996, the Company purchased the Visual Test product from
Microsoft Corporation. The purchase price consisted of a single $23,000,000 cash
payment, which will be allocated to the fair value of the assets acquired,
including in-process research and development estimated at $15,000,000 to
$19,000,000.
During October 1996, the Company sold 5,188,094 shares of common stock in a
public offering. Net proceeds from the sales were approximately $186,000,000
after deducting underwriting discounts, commissions and other related expenses.
The proceeds to the Company from the offering will be used for working capital
and general corporate purposes.
The Company believes that expected cash flow from operations combined with
existing cash and cash equivalents and short-term investments will be sufficient
to meet its cash requirements for the foreseeable future.
FACTORS THAT MAY AFFECT FUTURE RESULTS
Dependence Upon Market Growth and Development of Industry Standards. The
Company's product lines are designed for use in visual modeling of business
processes, in the development of software systems and in the day-to-day
development of software by teams of developers. The Company's future growth and
financial performance will depend in part upon continued growth in the market
for tools supporting component-based development. There can be no assurance that
the market will continue to grow or that the Company will be able to respond
effectively to the evolving requirements of the market. In addition, the
Company's future growth and financial performance may depend upon the
development of industry standards that facilitate the adoption of
component-based development, as well as the Company's ability to play a leading
role in the establishment of those standards. The Company believes that the
Unified Modeling Language developed at Rational has become the de facto standard
language for visual modeling and intends to submit an application to the Object
Management Group ("OMG"), an industry consortium, for inclusion of the UML in
their Object Analysis and Design Facility specification. Competing standards,
including some that support the UML as well as other notations, also are
expected to be submitted to the OMG. The official sanction of a competing
standard by the OMG could have a material adverse effect on Rational's marketing
and sales efforts and, in turn, on revenues and operating results.
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The number of software developers using component-based development
technology is relatively small compared to the number of developers using more
traditional software development technology. The adoption of component-based
development technology by software programmers who have traditionally used other
technology requires re-orientation to significantly different programming
methods, and there can be no assurance that the acceptance of component-based
development technology will expand beyond sophisticated programmers who are
early adopters of the technology. Furthermore, there can be no assurance that
potential customers will be willing to make the investment required to retrain
programmers to build software using component-based development technology
rather than traditional programming techniques. Many of the Company's customers
have purchased only small quantities of the Company's tools, and there can be no
assurance that these or new customers will broadly implement component-based
development technology or purchase additional tools.
Expansion of Product Lines. The Company believes that its continued
success will depend in part upon its ability to provide a tightly integrated
line of software application development tools that support software development
for a number of implementation languages. This will require the Company to
enhance its current products and to continue to develop and introduce new
products. The Company also believes its continued success will become
increasingly dependent on its ability to support the Microsoft platform,
including Windows 95 and Windows NT. The Company believes that it will be
particularly important to successfully develop and market a broader line of
products for C++, Visual Basic, Java and other implementation languages in order
to be successful in its efforts to reach broader markets and to further increase
its market share within its existing market segments. There can be no assurance
that the Company will be able to successfully develop and market such a broad
line of products or that the Company will not encounter unexpected difficulties
and delays in integrating new products with existing product lines.
Fluctuations in Operating Results. The Company's revenue is difficult to
forecast due to the fact that the Company's sales cycle, from initial evaluation
to purchase, varies substantially from customer to customer. The Company
typically has operated with little backlog because software products are
generally shipped as orders are received. As a result, revenue in any quarter is
substantially dependent
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on orders booked and shipped in that quarter. Because the Company's staffing and
operating expenses are based on anticipated revenue levels, and a high
percentage of the Company's costs are fixed, small variations in the timing of
the recognition of specific revenues could cause significant variations in
operating results from quarter to quarter. Historically, the Company has earned
a substantial portion of its revenues in the last weeks of the quarter. To the
extent this trend continues, the failure to achieve such revenues in the last
weeks of any given quarter will have a material adverse effect on the Company's
financial results for that quarter. Although the Company has experienced
increasing revenues in each of the past nine quarters, the Company's sales
compensation structure has historically resulted in revenues for the first
quarter of a fiscal year being lower than revenues for the fourth quarter of the
prior fiscal year. There can be no assurance that similar fluctuations will not
occur again in the future.
The Company's earnings for the quarter ending December 31, 1996 will be
reduced by charges and operating expenses associated with the acquisition of the
Visual Test product, including an expected acquired in-process research and
development charge to operations of between $15 million and $19 million, as well
as increased marketing expenditures related to the promotion of the Visual Test
product. The Company expects to incur an additional expense of approximately
$1,300,000 in the quarter ending December 31, 1996 in connection with its
contractual commitment to reimburse the Selling Stockholders for the
underwriting discount applicable to the 684,631 shares of Common Stock being
sold by them, as well as certain fees and expenses of the Selling Stockholders'
legal counsel incurred in connection with the offering made by this Prospectus.
As a result of these factors, the Company will incur a significant net loss for
the quarter ending December 31, 1996, and may incur a net loss for fiscal 1997.
The growth in revenues and operating income (exclusive of nonrecurring
operating, restructuring and merger-related expenses) experienced by the Company
in recent quarters is not necessarily indicative of future results and
period-to-period comparisons of its financial results should not be relied upon
as an indication of future performance. Fluctuations in operating results may
also result in volatility in the price of the Company's Common Stock. See
"-- Possible Volatility of Stock Price."
Dependence Upon Revenues From New Products. The Company plans to introduce
new products during fiscal 1997. Delay in the start of shipment of the Company's
new products would have an adverse effect on the Company's revenues, gross
profit and operating income. As a result of the Company's business alliance with
Microsoft, certain of the Company's new product releases are expected to be
tightly integrated with new releases of certain Microsoft products. To the
extent that scheduled Microsoft product releases are delayed, there could be a
material adverse effect on the Company's revenues from new products. The Company
attempts to make adequate allowances in its new product release schedules for
both internal and beta-site testing of product performance. Because of the
complexity of the Company's products, however, the release of new products may
be postponed should test results indicate the need for redesign and retesting,
or should the Company elect to add product enhancements in response to beta
customer feedback. The Company's sales remain sensitive to its existing and
prospective customers' budgeting practices and to potential cutbacks in defense
spending.
Business Alliance with Microsoft. On October 2, 1996, Rational and
Microsoft announced the formation of a business alliance which will consist of
Rational's acquisition of Microsoft's Visual Test product, technology
cross-licensing, joint development projects and joint marketing programs. While
the Company believes that Microsoft's current strategy in relation to the
enterprise information systems market is based on component-based development,
there can be no assurance that this strategy will continue or that, if it does
continue, Microsoft's emphasis or priorities will not change in the future,
resulting in less attention and fewer resources being devoted to Microsoft's
relationship with Rational. Although certain aspects of the business alliance
are contractual in nature, many important aspects of the relationship depend on
the continued cooperation of the two companies, and there can be no assurance
that the Company and Microsoft will be able to work together successfully over
an extended period of time. In addition, there can be no assurance that
Microsoft will not use the
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<PAGE> 15
information it gains in its relationship with Rational to develop or market
competing products. See "Business -- Business Alliance with Microsoft."
Acquisition of the Visual Test Product. The Company acquired the Visual
Test product from Microsoft on October 2, 1996. There can be no assurance that
Rational will be able to successfully incorporate Visual Test into its
integrated family of products, or that it will be able to achieve significant
sales of the Visual Test product. Many potential customers for Visual Test
differ from the Company's historical customer base in terms of component-based
software development expertise, purchasing processes, financial resources and
expectations regarding software-engineering tools. There can be no assurance
that the Company will not encounter unanticipated concerns of Visual Test
customers that are different from the concerns of the Company's traditional
customers, or that the Company will have the infrastructure and experience
necessary to adequately respond to the volume and type of such concerns.
Rational has granted Microsoft a non-exclusive, perpetual license to the
Visual Test product source code for the purpose of creating derivative works and
for the purpose of distributing portions of the Visual Test product and
derivative works as part of Microsoft products that do not directly compete with
the Visual Test product in the market for software testing tools. There can be
no assurance that Microsoft will not use such rights to create and distribute
products that compete with Rational in other segments of the component-based
development tools market. Rational has also granted Microsoft a five-year option
to obtain a license to incorporate certain elements of Visual Test technology
into Microsoft development tool products, including Visual Basic, Visual C++ and
Visual J++. Should Microsoft exercise such right, sales of the Visual Test
product by Rational could be materially and adversely impacted.
See "-- Fluctuations in Operating Results," "Business -- Products and
Services -- Visual Test: Software Testing Automation Tools" and "-- Business
Alliance with Microsoft."
Licensing of Rose Technology to Microsoft. Microsoft and Rational have
entered into a two-year agreement providing for the inclusion of a subset of the
Rational Rose visual modeling technology in future versions of Microsoft's
enterprise-oriented visual tools. The Company's objective in entering into this
arrangement is to expose the Company's technology to a broader market than
Rational's historical customer base, and is not to generate direct product
revenue from Microsoft. The Company expects that changes in the Company's
pricing models and combinations of features within product lines will be
required to appeal to this market, and there can be no assurance that such
changes will achieve market acceptance. Rational does not expect the licensing
of its Rose technology to Microsoft to directly result in a material increase in
product revenue. In addition, there can be no assurance that developers
introduced to the Rose technology incorporated into Microsoft products will
become purchasers of Rational products in the future. Rational has granted
Microsoft the option to obtain a perpetual, non-exclusive right to source code
for certain aspects of Rational's Rose technology after the expiration of the
agreement. While Rational believes that Microsoft's and Rational's strategies
currently are complementary, there can be no assurance that Microsoft will not
use this right to develop and market competing products in the future. See
"Business -- Business Alliance with Microsoft."
Adverse Impact of Promotional Product Versions on Actual Product
Sales. The Company's marketing strategy relies in part on making elements of
its technology available for no charge or at a very low price, either directly
or by incorporating such elements into products offered by the Company's
partners, such as Microsoft. This strategy is designed to expose the Company's
products to a broader market than its historical customer base, and to encourage
potential customers in that market to purchase an upgrade or other higher-priced
product from the Company. There can be no assurance that the Company will be
able to introduce enhancements to its full-price products or versions of its
products with intermediate functionality at a rate necessary to adequately
differentiate them from the promotional versions, particularly in cases where
the Company's partners are distributing versions of the Company's products with
other desirable features.
15
<PAGE> 16
Management of Growth. The Company is experiencing a period of rapid growth
and aggressive product introductions that have placed, and may continue to
place, a significant strain on its resources, including its personnel. Projects
such as the expansion of the Company's product lines, efforts to address broader
markets and to expand distribution channels, acquisitions of companies or
technologies such as the recent acquisitions of Objectory AB and the Visual Test
product, and business alliances such as the recent arrangement with Microsoft,
when added to the day-to-day activities of the Company, will place a further
strain on the Company's resources and personnel. The Company believes that the
hiring and retaining of qualified individuals at all levels in the Company is
essential to the Company's ability to manage growth successfully, and there can
be no assurance that the Company will be successful in attracting and retaining
the necessary personnel. If Company management is unable to effectively manage
growth, the Company's business, competitive position, results of operations and
financial condition will be materially and adversely affected.
Risks Associated With Recent and Future Acquisitions. During the past
three years the Company has made a number of strategic acquisitions.
Acquisitions by the Company may result in the diversion of management's
attention from the day-to-day operations of the Company's business and may
include numerous other risks, including difficulties in the integration of
operations, products and personnel. To the extent that efforts to integrate
recent and future acquisitions fail, there could be a material adverse effect on
results of operations. Acquisitions by the Company have the potential to result
in dilutive issuances of equity securities, the incurrence of additional debt,
and amortization expenses related to goodwill and other intangible assets. While
there are currently no commitments with respect to any particular future
acquisitions, Company management frequently evaluates the strategic
opportunities available to it and may in the near-term or long-term future
pursue acquisitions of complementary products, technologies or businesses.
Dependence on Strategic Relationships. The Company's development,
marketing and distribution strategies rely increasingly on the Company's ability
to form long-term strategic relationships with major software and hardware
vendors, many of whom are substantially larger than the Company. Divergence in
strategy between the Company and any given partner, or a change in focus by a
given partner, may interfere with the Company's ability to develop, market, sell
or support its products. See "-- Business Alliance with Microsoft."
Rapid Technological Change. The market for software development tools is
characterized by rapid technological advances, changes in customer requirements
and frequent new product introductions and enhancements. The Company must
respond rapidly to developments related to hardware platforms, operating systems
and applicable programming languages. Such developments will require the Company
to make substantial product development investments. Any failure by the Company
to anticipate or respond adequately to technology developments and customer
requirements, or any significant delays in product development or introduction,
could result in a loss of competitiveness or revenue. In addition, there can be
no assurance that new products or product enhancements intended to respond to
technological change or evolving customer requirements will achieve market
acceptance.
Risk of Software Defects. Software products like those sold by the Company
often contain undetected errors, or "bugs," or performance problems. Such
defects are most frequently found during the period immediately following
introduction of new products or enhancements to existing products. Despite
extensive product testing prior to introduction, the Company's products have in
the past contained software errors that were discovered after commercial
introduction. There can be no assurance that errors or performance problems will
not be discovered in the future. Any future software defects discovered after
shipment of the Company's products could result in loss of revenues or delays in
market acceptance, which could have a material adverse effect on the Company's
business, operating results or financial condition.
Competition. The software engineering tools market is extremely
competitive and rapidly changing. The Company believes that the increased level
of competition it observed in fiscal 1996 and
16
<PAGE> 17
the first half of fiscal 1997 will continue to increase. The Company competes
primarily on the bases of corporate and product reputation, breadth of its
integrated product line, product architecture, functionality and features,
product quality, performance, ease-of-use, quality of support, availability of
technical consulting services and price. The Company faces intense competition
for each product within its product line. Because individual product sales are
often the first step in a broader customer relationship, the Company's success
depends in part upon its ability to successfully compete with numerous
competitors at each point within its product line. Certain of the Company's
competitors are more experienced than the Company in the development of
software-engineering tools, databases or software-development products. Some of
the Company's competitors have, and new competitors may have larger technical
staffs, more established distribution channels and greater financial resources
than the Company. The Company also encounters substantial competition from
in-house developers of solutions for large organizations. There can be no
assurance that either existing or new competitors will not develop products that
are superior to the Company's products or that achieve greater market
acceptance. The Company's future success will depend in large part upon its
ability to increase its share of its target markets and to license additional
products and product enhancements to existing customers. There can be no
assurance that future competition will not have a material adverse effect on the
Company's results of operations. See "Business -- Competition."
Dependence on Sales Force and Other Channels of Distribution. The Company
currently distributes its products primarily through field sales personnel
teamed with highly trained technical support personnel. The Company believes
that a high level of technical consulting, training and customer support is
essential to maintaining its competitive position, and has found that the
ability to deliver a high level of technical consulting, training and customer
support is an important selling point with respect to its products. While
complementary to the Company's products, the services provided by these
personnel have historically yielded lower margins for the Company than its
product business. To the extent that these services constitute a higher
proportion of total revenues in the future, the Company's margins will be
adversely affected. The Company has also developed other direct and indirect
sales channels, including telesales, the World Wide Web, and partnering with
external service providers and VARs. There can be no assurance that such
channels will be successful in increasing sales of the Company's products or in
reducing the Company's sales costs on a percentage basis.
Dependence on Key Personnel. The Company is dependent upon the efforts and
abilities of a number of key management, sales, product development, support and
technical personnel. The success of the Company depends to a large extent upon
its ability to retain and continue to attract key employees. The rate at which
the Company can attract and retain the highly trained technical personnel that
are integral to its direct sales teams may limit the rate at which the Company
can increase sales. Competition for qualified personnel in the software industry
is intense, and there can be no assurance that the Company will be successful in
attracting and retaining such personnel. See "Business -- Employees" and
"Management -- Directors and Executive Officers."
Risks Associated with International Operations. International sales
accounted for approximately 31%, 34% and 36% of the Company's revenues in fiscal
1994, 1995 and 1996, respectively, and the Company expects that international
sales will continue to account for a significant portion of the Company's
revenues in future periods. In addition, the Company expects that the majority
of Visual Test product sales will come from outside the United States.
International sales are subject to inherent risks, including unexpected changes
in regulatory requirements and tariffs, difficulties in staffing and managing
foreign operations, longer payment cycles, greater difficulty in accounts
receivable collection, potentially adverse tax consequences, price controls or
other restrictions on foreign currency and difficulties in obtaining export and
import licenses. Any material adverse effect on the Company's international
business would be likely to materially and adversely affect the Company's
business, operating results and financial condition as a whole. The Company's
international sales are generally denominated in foreign currencies. Gains and
losses on the conversion of foreign payments into U.S. dollars may contribute to
fluctuations in the Company's results of operations. Although the Company has
not experienced any material adverse impact to date from fluctuations in foreign
currencies, there
17
<PAGE> 18
can be no assurance that the Company will not experience a material adverse
impact on its financial condition and results of operations from fluctuations in
foreign currencies in the future. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
Limited Protection of Intellectual Property and Proprietary Rights. The
Company regards its software as proprietary and attempts to protect it with a
combination of copyright, trademark and trade secret laws, employee and
third-party nondisclosure agreements and other methods of protection. Despite
these precautions, it may be possible for unauthorized third parties to copy
certain portions of the Company's products or reverse engineer or obtain and use
information the Company regards as proprietary. The Company's software products
are generally licensed to end-users on a "right to use" basis pursuant to a
perpetual license. The Company licenses its products primarily under
"shrink-wrap" licenses (i.e., licenses included as part of the product
packaging). Shrink-wrap licenses are not negotiated with or signed by individual
licensees, and purport to take effect upon the opening of the product package.
Certain license provisions protecting against unauthorized use, copying,
transfer and disclosure of the licensed program may be unenforceable under the
laws of certain jurisdictions and foreign countries. In addition, the laws of
some foreign countries do not protect proprietary rights to the same extent as
do the laws of the United States. There can be no assurance that these
protections will be adequate. To the extent that the Company increases its
international activities, it expects that its exposure to unauthorized copying
and use of its products and proprietary information will increase.
The status of United States patent protection in the software industry is
not well defined and will evolve as the United States Patent and Trademark
Office grants additional patents. Because patent applications in the United
States are not publicly disclosed until the patent is issued, applications may
have been filed which would relate to the Company's products. There can be no
assurance that third parties will not assert infringement claims against the
Company in the future or that such claims will not be successful. The Company
could incur substantial costs in defending itself and its customers against any
such claims. Parties making such claims may be able to obtain injunctive or
other equitable relief that could effectively block the Company's ability to
sell its products in the United States and abroad, and could result in an award
of substantial damages. In the event of a claim of infringement, the Company and
its customers may be required to obtain one or more licenses from third parties.
There can be no assurance that the Company or its customers could obtain
necessary licenses from third parties at a reasonable cost or at all. Defense of
any lawsuit or failure to obtain any such required license would have a material
adverse effect on the Company's results of operations. See
"Business -- Intellectual Property."
Possible Volatility of Stock Price. The market price of the Company's
Common Stock has been, and is likely to continue to be, volatile. Factors such
as new product announcements or changes in product pricing policies by the
Company or its competitors, quarterly fluctuations in the Company's operating
results, announcements of technical innovations, announcements relating to
strategic relationships or acquisitions, changes in earnings estimates by
analysts and general conditions in the component-based software development
market, among other factors, may have a significant impact on the market price
of the Company's Common Stock. Should the Company fail to introduce products on
the schedule expected, the Company's stock price could be adversely affected. In
addition, in recent years the stock market in general, and the shares of
technology companies in particular, have experienced extreme price fluctuations.
This volatility has had a substantial effect on the market prices of securities
issued by many companies for reasons unrelated to the operating performance of
the specific companies. These broad market fluctuations may adversely affect the
market price of the Company's Common Stock. See "-- Fluctuations in Operating
Results" and "-- Dependence Upon Revenues From New Products."
Shares Eligible for Future Sale. Other than approximately 1,000,000 shares
subject to a lock-up expiring 90 days after effectiveness of the offering made
hereby and certain shares of affiliates subject to volume limitations on resale,
substantially all of the shares of the Company's Common Stock outstanding
following this offering will be freely tradeable. Sales of substantial amounts
of Common Stock in the public market after this offering could adversely
affect the prevailing market price of the Common Stock.
18
<PAGE> 19
PART II -- OTHER INFORMATION
ITEM 1 -- LEGAL PROCEEDINGS
On December 1, 1995, Interactive Development Environments ("IDE") filed an
action against the Company in the San Francisco County Superior Court seeking
monetary damages in excess of $3 million and other relief for the Company's
alleged breach of an alleged contract, misrepresentation and related claims
based on the Company's preliminary, non-binding merger discussions in 1995 with
IDE. In March 1996, the court sustained the Company's demurrer to IDE's claim
for specific performance of the alleged contract between the parties. In October
1996, IDE amended its complaint to add a claim for "Fraud -- Non-Disclosure," in
which it alleges that the Company was obligated to tell IDE of the Company's
acquisition discussions regarding Objectory AB, and to lower the amount of
damages claimed to $2 million. Trial on IDE's remaining claims is set for
January 1997, although the parties have signed a stipulation extending the trial
date to March 1997 and the Company anticipates the Court will so order. The
Company believes IDE's complaints are without merit and intends to defend the
case vigorously, although the Company makes no assurance that the Company will
be successful in defending the action. There are no other material pending legal
proceedings to which the Company is a party or to which any of the Company's
property is subject.
ITEM 4 -- MATTERS SUBMITTED TO A VOTE OF SECURITY HOLDERS
Matters submitted to a vote of security holders are incorporated herein by
reference to the Company's Form 8-K filed on October 2, 1996.
ITEM 6 -- EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 11.1: Statement of Computation of Net Income per Common Share
(b) Exhibit 27: Financial Data Schedule
(c) Reports on Form 8-K:
On October 2, 1996, the Company filed Form 8-K regarding the outcome of the
Company's annual meeting of stockholders held on August 27, 1996.
On October 2, 1996, the Company filed Form 8-K regarding two agreements entered
into between the Company and Microsoft Corporation, an Agreement for Purchase
and Sale of Assets and a Development and License Agreement.
On October 16, 1996, the Company filed Form 8-K/A, which was amendment number 1
to the Company's Form 8-K Current Report filed October 2, 1996 regarding two
agreements entered into between the Company and Microsoft Corporation.
19
<PAGE> 20
SIGNATURE
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.
RATIONAL SOFTWARE CORPORATION
by: /s/ Robert T. Bond
------------------------------------
Robert T. Bond
Senior Vice President
Chief Operating Officer,
Chief Financial Officer and Secretary
November 14, 1996
20
<PAGE> 21
EXHIBIT INDEX
Exhibit Description
- ------- -----------
11.1 Statement of Computation of Net Income Per Common Share
27 Financial Data Schedule
<PAGE> 1
Exhibit 11.1
Statement of Computation of Net Income Per Common Share
<TABLE>
<CAPTION>
(In thousands, except per share Three Months Ended Six Months Ended
amounts) September 30, September 30,
--------------------- ---------------------
1996 1995 1996 1995
------- ------- ------- -------
<S> <C> <C> <C> <C>
Primary:
Weighted average
shares outstanding 34,358 30,838 34,086 28,720
Dilutive stock options 2,824 2,368 2,970 2,152
------- ------- ------- -------
Total 37,182 33,206 37,056 30,872
======= ======= ======= =======
Fully diluted:
Weighted average
shares outstanding 34,358 30,838 34,086 28,720
Dilutive stock options 2,947 2,368 3,032 2,280
------- ------- ------- -------
Total 37,305 33,206 37,118 31,000
======= ======= ======= =======
Net income $ 4,832 $ 2,094 $ 8,996 $ 3,360
Income per common share
Primary: $ .13 $ .06 $ .24 $ .11
Fully diluted: $ .13 $ .06 $ .24 $ .11
</TABLE>
<TABLE> <S> <C>
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<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> MAR-31-1997
<PERIOD-START> APR-01-1996
<PERIOD-END> SEP-30-1996
<CASH> 48305
<SECURITIES> 6763
<RECEIVABLES> 26570
<ALLOWANCES> 1046
<INVENTORY> 0
<CURRENT-ASSETS> 82958
<PP&E> 28264
<DEPRECIATION> 21926
<TOTAL-ASSETS> 91157
<CURRENT-LIABILITIES> 26025
<BONDS> 31
0
0
<COMMON> 116591
<OTHER-SE> (53115)
<TOTAL-LIABILITY-AND-EQUITY> 91157
<SALES> 35171
<TOTAL-REVENUES> 56077
<CGS> 3906
<TOTAL-COSTS> 14838
<OTHER-EXPENSES> 31874
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (1299)
<INCOME-PRETAX> 10584
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<CHANGES> 0
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<EPS-PRIMARY> .24
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