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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 JUNE 30, 1997
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)
18880 Homestead Road, Cupertino, CA 95014 95051-0951
(Address of principal executive office) (Zip Code)
408-863-9900
(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 87,098,582
$.01 PER SHARE
(Class) (Shares outstanding on July 31, 1997)
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CONTENTS PAGE
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PART I -- FINANCIAL INFORMATION
Item 1 -- Consolidated Financial Statements:
Condensed Consolidated Balance Sheets..................................3
Condensed Consolidated Statements of Operations........................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
Item 3 -- Market Risks..........................................................12
PART II -- OTHER INFORMATION
Item 6 -- Exhibits and Reports on Form 8-K.......................................22
SIGNATURE.........................................................................23
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
ASSETS
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June 30, March 31,
1997 1997
--------- ---------
(Unaudited) (Note A)
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Cash and cash equivalents ............................................. $ 155,857 $ 227,493
Short-term investments ................................................ 66,906 2,525
Accounts receivable, net .............................................. 35,279 33,565
Prepaid expenses and other assets ..................................... 4,565 3,395
--------- ---------
Total current assets ........................................ 262,607 266,978
Property and equipment, at cost:
Computer, office and manufacturing equipment ..................... 35,061 27,686
Office furniture ................................................. 2,817 3,031
Leasehold improvements ........................................... 2,385 2,342
--------- ---------
40,263 33,059
Accumulated depreciation and amortization ............................. (20,825) (19,768)
--------- ---------
Property and equipment, net ................................. 19,438 13,291
Other assets, net ..................................................... 20,897 22,521
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Total assets .......................................................... $ 302,942 $ 302,790
========= =========
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Note A: The balance sheet at March 31, 1997 has been derived from the audited
financial statements at that date but does not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements.
3
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PAR VALUE)
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
June 30, March 31,
1997 1997
--------- ---------
(Unaudited) (Note A)
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Accounts payable ........................................................................... $ 4,584 $ 9,981
Accrued employee benefits .................................................................. 8,903 12,269
Other accrued expenses ..................................................................... 10,268 8,255
Accrued merger and restructuring expenses, current portion ................................. 5,895 9,236
Deferred revenue ........................................................................... 18,978 17,936
Current portion of long-term debt and lease obligations .................................... 1,624 2,010
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Total current liabilities ........................................................ 50,252 59,687
Accrued rent ............................................................................... 434 535
Accrued merger and restructuring expenses, long-term ....................................... 808 916
Long-term debt ............................................................................. 1,738 1,741
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Total liabilities ................................................................ 53,232 62,879
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Stockholders' equity:
Common stock, $.01 par value, 75,000,000
shares authorized .................................................................. 502 477
Additional paid-in capital ............................................................ 357,706 356,270
Treasury stock ........................................................................ (1,340) (1,340)
Accumulated deficit ................................................................... (107,192) (115,006)
Cumulative translation adjustment ..................................................... 34 (490)
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Total stockholders' equity ....................................................... 249,710 239,911
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Total liabilities and stockholders' equity ................................................. $ 302,942 $ 302,790
========= =========
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Note A: The balance sheet at March 31, 1997 has been derived from the audited
financial statements at that date but does not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements.
4
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Three Months ended
June 30,
-------------------
1997 1996
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Net product revenue ...................... $27,705 $20,329
Consulting and support revenue ........... 15,223 11,673
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Total revenue .................. 42,928 32,002
Cost of product revenue .................. 3,610 1,941
Cost of consulting and support revenue ... 7,072 6,007
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Total cost of revenue .......... 10,682 7,948
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Gross margin ................... 32,246 24,054
Product research and development expenses 6,704 5,279
Sales and marketing expenses ............. 14,481 10,927
General and administrative expenses ...... 3,972 2,892
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Total operating expenses ....... 25,157 19,098
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Operating income ............... 7,089 4,956
Other income, net ........................ 3,330 947
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Income before income taxes .......... 10,419 5,903
Provision for income taxes ............... 2,605 810
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Net income ............................... $ 7,814 $ 5,093
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Net income per common share .............. $ 0.16 $ 0.11
Shares used in computing per share amounts 50,218 44,407
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RATIONAL SOFTWARE CORPROATION
CONDENSED CONSOLDIATED STATEMENTSA OF CASH FLOWS
(IN THOUSANDS, UNAUDITED)
Three Months Ended
June 30,
------------------------
1997 1996
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Cash flows from operating activities:
Net Income .......................................... $ 7,814 $ 5,093
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization .................. 2,041 1,048
Amortization of deferred compensation .......... 36 36
(Increase) decrease in assets:
Accounts receivable ....................... (1,714) 1,673
Prepaids and other, net ................... (390) (895)
Increase (decrease) in liabilities:
Accounts payable .......................... (5,397) 308
Accrued employee benefits ................. (3,366) (2,707)
Deferred revenue .......................... 1,042 (3,666)
Accrued expenses .......................... 2,436 (76)
Accrued merger and restructuring expenses . (3,449) (178)
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Net cash provided (used) by operating activities (947) 636
Cash flows used in investing activities:
Purchase of investments ............................. (66,881) (7,639)
Sale of investments ................................. 2,500 4,876
Capital expenditures ................................ (7,344) (1,743)
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Net cash used in investing activities .......... (71,725) (4,506)
Cash flows from financing activities:
Principal payments under debt and lease obligations . (389) 3,889
Proceeds from issuance of common stock .............. 1,425 2,507
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Net cash provided by financing activities ...... 1,036 6,396
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Net increase (decrease) in cash and cash equivalents ..... (71,636) 2,526
Cash and cash equivalents at beginning of period ......... 227,493 80,378
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Cash and cash equivalents at end of period ............... $ 155,857 $ 82,904
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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 June 30, 1997
are not necessarily indicative of the results that may be expected for the
year ending March 31, 1998.
On February 26, 1997 the Company merged with SQA, Inc. ("SQA"). The
merger was accounted for as a pooling-of-interests and the historical
consolidated financial statements of the Company for prior periods have
been restated to include the financial position, results of operations
and cash flows of SQA. See Note 3 in the Notes to Consolidated Financial
Statements in the Company's Annual Report to Stockholders (Form 10-K) for
the year ended March 31, 1997.
2. ACCOUNTS RECEIVABLE -- Accounts receivable is net of an allowance
for doubtful accounts of $1,948,000 at June 30, 1997 and $1,960,000 at
March 31, 1997, 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. In February 1997, the Financial Accounting Standards Board issued
Statement No. 128, Earnings Per Share, which is required to be adopted on
March 31, 1998. At that time the Company will be required to change the
method currently used to compute earnings per share and restate all prior
periods. Under the new requirements for calculating primary earnings per
share, the dilutive effects of stock options will be excluded. The impact
is not expected to result in a change in primary earnings per share for
the first quarter ended June 30, 1997 and will increase primary
earnings per share for the quarter ended June 30, 1996 by $0.02. The
impact of Statement 128 on the calculation of fully diluted earnings per
share for these quarters is not expected to be material.
4. CONTINGENCY -- On December 16, 1996, the Company filed a lawsuit against
Silicon Graphics, Inc. ("SGI") arising from SGI's failure to pay certain
royalties due to the Company under a software license agreement entered
into between the Company's predecessor, Verdix Corporation, and SGI. SGI
has filed an answer denying the Company's allegations, and also filed a
cross-complaint against the Company for unspecified damages for alleged
wrongdoing arising out of the license agreement with SGI. The Company
denies the allegations and intends to vigorously defend SGI's claims.
From time to time the Company is subject to legal claims. Historically,
the cost of resolution of the claims has not been significant, and the
Company is not aware of any asserted or unasserted claims pending against
it, including the suit mentioned above, the resolution of which would have
a material adverse impact on the operations or financial position of the
Company.
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5. MAJOR CUSTOMERS -- No single customer accounted for 10% or more of revenues
for the three months ended June 30, 1997. Sales to United Defense accounted
for 12% of revenue for the three months ended June 30, 1996.
6. SUBSEQUENT EVENTS
ACQUISITION OF PURE ATRIA - On July 30, 1997, the Company completed the
acquisition of Pure Atria Corporation ("Pure Atria"). Under the terms of
the acquisition, which was accounted for as a pooling of interests, the
Company exchanged approximately thirty nine million (39,000,000) shares
of common stock for all of Pure Atria's outstanding shares and assumed
approximately eight million (8,000,000) options to purchase its common
stock, at a common exchange ratio of 0.9 of a share of the Company's
common stock for each share of Pure Atria's common stock. Pure Atria,
based in Cupertino, California, is a leading provider of software
products that enable the production of reliable, high-quality software
and improves the development process.
Presented below is unaudited selected pro forma financial information,
reflecting the combination, for the year ended March 31, 1997 and the
three month periods ended June 30, 1996 and 1997 (in thousands), except
per share data:
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For the three months
Year ended ended June 30,
March 31, 1997 1996 1997
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Total revenues $283,546 $60,632 $66,148
Net Income (loss) $(56,528) $ 8,944 $ 5,128
Net income (loss) per share $ (0.70) $ 0.11 $ 0.06
Shares used in per share computation 80,643 83,466 86,619
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The unaudited pro forma results for the three months ended June 30, 1997
do not include non-recurring charges of approximately $55 to $75 million
arising from the acquisition of Pure Atria which will be recorded in the
quarter ending September 30, 1997.
The unaudited pro forma information is not necessarily indicative of the
actual results of operations had the acquisition occurred at the
beginning of the periods indicated, nor should it be used to project the
Company's results of operations for any future date or period.
INCREASE IN AUTHORIZED SHARES - On July 30, 1997, the stockholders
approved an amendment to increase the number of authorized shares from
75,000,000 to 150,000,000 which among other things provided the
Company with a sufficient number of authorized shares of common stock to
consummate the above acquisition.
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 historically there have been only immaterial amounts.
COMPARATIVE ANALYSIS OF OPERATING RESULTS FOR THE THREE MONTHS ENDED
JUNE 30, 1997
Total revenue increased 34% for the three month period ended June 30, 1997 from
the comparable prior year period.
Net product revenue increased by 36% for the three month period ended June 30,
1997 from the comparable prior year period. The increase in net product revenue
for the three month period was due to continued strong customer acceptance of
the Company's visual modeling tools (the Rational Rose family), and growth in
the Company's automated software testing and quality product line.
Consulting and support revenue increased 30% for the three month period ended
June 30, 1997 from the comparable prior year period. This increase reflects
higher demand for the Company's consulting expertise in object modeling and
advanced software development practices, and, to a lesser extent, increased
training and customer support revenues.
International revenues from product sales and related consulting and customer
support accounted for 36% of total revenues for the three month period ended
June 30, 1997, as compared to 24% for the three month period ended June 30,
1996. The Company's international sales are principally priced in foreign
currencies and are generally exported out of the U.S. From time to time the
Company enters into short-term forward exchange contracts to hedge against the
impact of foreign currency fluctuations on the accounts receivable denominated
in foreign currencies. The total amount of these contracts is offset by the
underlying foreign currency denominated accounts receivable. The gains or
losses on the contracts are included in income as the contracts expire and are
offset by gains and losses on the underlying receivables being hedged. At June
30, 1997, the Company had outstanding forward exchange contracts, all having
maturities of approximately 35 days, to exchange various European currencies
for US dollars in the amounts of $2,779,000. Neither the carrying amount nor
the fair value of these foreign currency forward exchange contracts was
material at June 30, 1997. One major U.S. multinational bank is counterparty
to all these contracts. The associated gains and losses are not material to
the Company's results of operations. There were no forward exchange contracts
outstanding at June 30, 1996.
9
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Cost of product revenue consists principally of materials, packaging and
freight, amortization of developed technology from recent mergers and
acquisitions, and royalties. Cost of product revenue increased 86% for the first
quarter of fiscal 1998 compared to the corresponding period of fiscal 1997.
These costs represented 13% of total product revenue for the three month period
of fiscal 1998 compared to 10% for the corresponding periods of fiscal 1997. The
increase in product cost as a percentage of product revenue was due mainly to
amortization of developed technology associated with recent mergers and
acquisitions.
Cost of consulting and support revenue consists principally of personnel costs
for training, consulting and customer support. Cost of consulting and support
increased 18% for the three month period of fiscal 1998 compared to the
corresponding period of fiscal 1997. These costs represented 46% of total
consulting and support revenue for the three month period of fiscal 1998
compared to 51% for the corresponding period of fiscal 1997. 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 27% for the
three-month period of fiscal 1998 compared to the corresponding period of fiscal
1997. Research and development costs represented 16% of total revenue for both
the three month periods of fiscal 1998 compared to the corresponding periods of
fiscal 1997. The increase in expenditures for research and development is due
primarily to the cost of additional personnel and related costs incurred in
maintaining existing products and developing new product releases.
Sales and marketing expenses increased 33% for the three-month period of fiscal
1998 compared to the corresponding period of fiscal 1997. These expenses
represented 34% of total revenue for both the three month period of fiscal 1998
and the corresponding period of fiscal 1997. The comparative increase in sales
and marketing expenses reflect the additional personnel, commissions and related
costs required in sales and marketing departments to expand Rational's sales
channels, to penetrate new markets, and to 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 37% for the three month period of fiscal 1998 compared to the
corresponding period of fiscal 1997. General and administrative expenses
represented 9% of total revenue for both the three month periods of fiscal 1998
and fiscal 1997. The increased expense for the fiscal 1998 period resulted from
employee related expenses associated with the staffing requirements needed to
support the Company's expanding business, and from an increase in amortization
of purchased intangibles related to the Company's recent mergers and
acquisitions.
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 the amount of cash available
for investment in interest-bearing accounts and from foreign currency
transactions. Other income, net increased $2,383,000 for the three month period
of fiscal 1998 compared to the corresponding period of fiscal 1997. The
increases are primarily the result of investment earnings on the additional cash
generated by the Company's public offering in October 1996.
The provision for income taxes for the three month period ending June 30, 1997
is based on the estimated annual effective tax rate applied to the profit before
income taxes (excluding one-time charges for acquired in-process research and
development) and includes current federal, state and foreign income taxes. The
provision for income taxes for the three month period ending June 30, 1997
consists primarily of foreign income taxes as well as federal and state minimum
taxes. The effective tax rates for fiscal 1998 and 1997 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.
10
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On June 11, 1997, the Company and Osaka Gas Information System Research
Institute Company, Ltd., (OGIS) announced that they agreed to form a joint
venture in Japan that will operate as a subsidiary of the Company and provide
local marketing, sales, and support of the Company's products in Japan.
LIQUIDITY AND CAPITAL RESOURCES AT JUNE 30, 1997
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 are being used for working capital
and general corporate purposes.
As of June 30, 1997, the Company had cash, cash equivalents and short-term
investments of $222,763,000 and working capital of $212,355,000. Net cash used
in operating activities for the period ending June 30, 1997 was composed
primarily of a decrease in accounts payable and accrued employee benefits.
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.
11
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FACTORS THAT MAY AFFECT FUTURE RESULTS
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.
Item III. Market Risks.
Risks related to the Recent Acquisition of Pure Atria Corporation.
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Rational acquired Pure Atria Corporation ("Pure Atria") with the
expectation that the acquisition would result in long-term strategic benefits.
The realization of these anticipated benefits will depend in part on whether
the companies' operations can be integrated in an efficient and effective
manner. There can be no assurance that this will occur. The successful
integration of Pure Atria's operations into Rational will require, among other
things, integration of the companies' respective product offerings and
coordination of the companies' sales and marketing efforts and research and
development efforts. Successful integration of the companies' respective sales
forces will require sales personnel to quickly become familiar with the sales
cycles and sales approaches required for products newly added to their
portfolios, and any failure to do so may result in sales delays and decreased
revenues for the Company. It is possible that the intended integration of the
companies' respective products, and the creation of integrated bundles and
suites, may not be accomplished in a timely manner or may prove to be
technologically infeasible. The difficulties of integrating the two companies'
respective operations will be compounded by the fact that each company has
significant operations on both the East Coast and the West Coast of the United
States and in a number of foreign countries. The acquisition of Pure Atria may
cause resellers and present and potential customers of either company to delay
or cancel orders as a result of concerns and uncertainty over evolution,
integration and support of products. If affiliates of Rational or Pure Atria
sell their Rational Common Stock despite their contractual obligations not to
do so until Rational publicly announces financial results covering at least 30
days of combined operations, the acquisition of Pure Atria may not qualify for
accounting as a pooling of interests, which in turn would materially and
adversely affect Rational's reported earnings and, potentially, its stock
price. For a more detailed discussion of the risks relating to the acquisition
of Pure Atria, see the "Risk Factors" section of the Company's
Prospectus/Joint Proxy Statement dated June 24, 1997.
12
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Fluctuations In Operating Results.
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Revenue in any quarter is substantially dependent on orders booked and
shipped in that quarter. Because staffing and operating expenses are based on
anticipated revenue levels, and a high percentage of the 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 these trends continue, 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. The
Company's revenue is difficult to forecast due to the fact that Rational's
sales cycles, from initial evaluation to purchase, vary substantially
from customer to customer and from product to product, and because the markets
for Rational's products are rapidly evolving. In addition, the Company's results
will be affected by the number, timing and significance of new product
announcements by it and its competitors, its ability to develop, introduce and
market new and enhanced and integrated versions of its products on a timely
basis, the level of product and price competition, changes in operating
expenses, changes in average selling prices and product mix, any changes in its
sales incentive strategy, the experience level of and any changes in sales
personnel, any changes in sales cycles, the mix of direct and indirect sales,
product returns and general economic factors, among others. The Company's sales
will also be sensitive to existing and prospective customers' budgeting
practices and to potential cutbacks in defense spending, which has historically
been a significant factor for Rational.
Although Rational has experienced increasing revenues in each of the past
thirteen quarters, its 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 estimates that direct transaction costs associated with the
acquisition of Pure Atria Corporation ("Pure Atria") will total
approximately $15 million, which will result in a non-recurring charge to
operations upon consummation of such transaction. The Company expects to incur
a non-recurring charge to operations of between $40 million and $60 million,
primarily in the quarter ending September 30, 1997, the quarter in which such
transaction is expected to be consummated, to reflect costs associated with
integrating the two companies. Actual costs may substantially exceed such
estimates, unanticipated expenses associated with the integration of the two
companies may arise, or the Company may incur additional material charges in
subsequent quarters to reflect additional costs associated with the integration
of the two companies. Total costs associated with such transaction are
anticipated to result in an operating loss and a net loss for the Company's
quarter ending September 30, 1997, and for the fiscal year ending March 31,
1998, and could negatively impact financial results in future periods for
the reasons discussed above.
Although Rational has experienced growth in revenues in recent years, there
can be no assurance that, in the future, Rational will sustain revenue growth or
be profitable on a quarterly or annual basis. Further, the revenues and
operating income (exclusive of nonrecurring operating, restructuring and
merger-related expenses) experienced by Rational in recent quarters are not
necessarily indicative of future results, and period-to-period comparisons of
Rational's financial results should not be relied upon as an indication of
future performance. Fluctuations in operating results may also result in
volatility in the prices of Rational's Common Stock.
Due to all of the foregoing factors, it is possible that in some future
quarter Rational's operating results will be below the expectations of public
market analysts and investors. In such event, the price of Rational's Common
Stock would likely be materially adversely affected, and significant declines in
stock prices frequently result in costly and lengthy securities litigation, with
its attendant costs, distraction and liability exposure.
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.
Any shortfall in anticipated operating results could have an immediate
and significant adverse effect on the market price of the Company's Common
Stock. Potential business synergies, if achieved, of Rational and Pure Atria
may not offset any such dilution. Further, the Company will incur substantial
merger-related charges primarily in the quarter ending September 30, 1997.
Rational expects the merger to be accretive in the long-term. However, this
forward-looking statement may not prove to be an accurate prediction due to
unforseen changes, inaccurate or incomplete assumptions regarding the current
business or future prospects of either or both of the companies, or other
reasons. Rational expects that the Pure Atria merger will be dilutive in the
initial periods following its effective time, and there can be no assurance as
to when the merger will become accretive, if ever. Any failure of the Pure
Atria merger to meet expectations as to potential business synergies or any
failure of the Pure Atria merger to be accretive in any quarter could have an
immediate and significant adverse effect on the market price of the Company's
Common Stock.
Statements or changes in opinions, ratings, or earnings estimates made by
brokerage firms or industry analysts relating to the market for software and
high technology company stocks or relating to Rational specifically have
restulted, and could in the future result, in an immediate and adverse effect
on the market price of Rational's Common Stock. Statements by financial or
industry analysts regarding the extent of the dilution in Rational's net
income per share resulting from operating results, the Pure Atria
merger or other developments and the extent to which such analysts expect
potential business synergies to offset such dilution can be expected to
contribute to volatility in the market price of Rational's Common Stock. 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, including Rational, in certain
cases for reasons unrelated to the operating performance of the specific
companies. These broad market fluctuations may adversely affect the market
price of the Rational Common Stock.
13
<PAGE>
Risks Associated With Recent And Future Acquisitions.
- ----------------------------------------------------
During approximately the past three years, and the past year in
particular, Rational has made a number of strategic acquisitions. Rational
acquired Pure Atria Corporation, on July 30, 1997, SQA, Inc., Performance
Awareness Corporation, Requisite, Inc., Softlab AB, and Software 9000 in the
quarter ended March 31, 1997; the Visual Test product from Microsoft in
October 1996; and made other acquisitions in earlier periods. Acquisitions
result in the diversion of management's attention from day-to-day operations
and include numerous other risks, including difficulties in the integration of
operations, products and personnel. To the extent that acquisitions have in
the past resulted,or may in the future result, in a diversion of resources or
that efforts to integrate recent and future acquisitions fail, there could be
a material adverse effect on Rational's business, results of operations and
financial condition. Acquisitions have the potential to result in dilutive
issuances of equity securities, the incurrence of debt, and amortization
expenses related to goodwill and other intangible assets. Rational management
has historically evaluated on an ongoing basis the strategic opportunities
available to the Company. Rational may in the near-or long-term future pursue
acquisitions of complementary products, technologies or businesses.
Dependence Upon Market Growth And Development Of Industry Standards.
- -------------------------------------------------------------------
Rational's future growth and financial performance will depend in part upon
continued growth in the need for and sales of tools for automating software
application development and management. Sales of these products may not continue
to grow or the Company may be unable to respond effectively to evolving customer
requirements. The number of software developers using Rational's products is
relatively small compared to the number of developers using more traditional
technology and products. The adoption of the Company's products by software
programmers who have traditionally used other technology requires re-orientation
to significantly different programming methods. The acceptance of the Company's
products, therefore, may not expand beyond sophisticated programmers who are
early adopters of the technology. Furthermore, potential customers may be
unwilling to make the investment required to retrain programmers to build
software using the Company's products rather than traditional programming
techniques. Many of Rational's customers have purchased only small quantities of
the Company's products, and these or new customers may decide not to broadly
implement or purchase additional units of such products.
Rational'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 Rational's ability to play a leading
role in the establishment of those standards. The Company has developed the
Unified Modeling Language ("UML") for visual modeling and has submitted 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 Rational's business,
operating results and financial condition.
Expansion Of Product Lines; Dependence Upon New Product Introductions.
- ----------------------------------------------------------------------
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, as well as integrated product suites and bundles, that
support software development for a number of implementation languages. This will
require the Company to modify and enhance its current products and to continue
to develop, introduce and integrate 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 operating systems.
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
broaden its customer base and to further increase its share within its existing
market segments. The Company may be unable to successfully develop and market
such a broad line of products, or may encounter unexpected difficulties and
delays in integrating new products with existing product lines.
Rational has plans to introduce new products and enhanced versions of
current products during the next few fiscal quarters. Delay in the start of
shipment of new, enhanced or integrated products, suites and bundles would
have an adverse effect on the Company's revenues, gross profit and operating
income. As a result of Rational's business alliance with Microsoft, certain of
Rational'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
Rational's revenues from new products.
Rational attempts to make adequate allowances in its 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.
14
<PAGE>
COMPETITION
The industry for tools for automating software application development
and management is extremely competitive and rapidly changing. Rational expects
to continue to experience significant and increasing levels of competition in
the future. Bases of competition include corporate and product reputation,
innovation with frequent product enhancement, breadth of integrated product
line, the availability of integrated suites and bundles, product architecture,
functionality and features, product quality, performance, ease-of-use, support,
availability of technical consulting services and price. Rational faces
intense competition for each product within its product lines, generally from
both Windows and UNIX vendors. Because individual product sales are often the
first step in a broader customer relationship, Rational's success will depend
in part upon its ability to successfully compete with numerous competitors at
each point within its product line.
Rational faces competition from software development tools and
processes developed internally by customers, including ad hoc integrations of
numerous stand-alone development tools. Customers may be reluctant to purchase
products offered by independent vendors such as the Company. As a result, the
Company must educate prospective customers as to the advantages of the
Company's products versus internally developed software quality systems.
Rational faces competition from, among others, Intersolv, Inc.,
Platinum Technology, Inc., Select Software Tools plc, Cayenne, Oracle, IBM,
Sun Microsystems, and Sybase Inc. as well as numerous privately held tool
suppliers offering traditional CASE tools that compete with the Rational Rose
approach to visual modeling and component-based development. Rational's
RequisitePro requirements management product faces competition from companies
such as GEC-Marconi. Rational's software testing tools--SQA Suite, Rational
Visual Test and preVue--face competition from Compuware, Mercury Interactive
Corporation, Segue Software, Inc., Intersolv, Inc., Computer Associates,
Platinum Technologies, Terodyne, Cyrano, SQL Bench International, Inc., and
several private companies offering testing automation tools. Microsoft,
Compuware, Oracle, Sybase and several of the major UNIX platform vendors,
including Sun Microsystems, Hewlett Packard, Digital Equipment Corporation,
Silicon Graphics Inc., and IBM, also compete with Rational with respect to
software quality products and testing tools, with testing products customized
to certain of their other software products. Rational Apex for C/C++ faces
competition from, among others, major UNIX platform vendors such as Sun
Microsystems, Hewlett-Packard and Digital Equipment Corporation, which have
C/C++ compilers and debuggers and in some cases programming environments for
their platforms. In addition, numerous privately held companies offer
compilers, debuggers and programming environments which compete with Rational
Apex. Rational's Apex Ada and VADs product lines face competition from Aonix,
Green Hills Software, Inc. and a large number of other suppliers offering Ada
products for native and embedded systems.
The Company also experiences competition with respect to a number of
its products, both from utilities commonly bundled with versions of operating
systems and from stand-alone product offerings. For example, versions of UNIX
are commonly bundled with utilities (such as SCCS and RCS) that provide
version control, which is part of the functionality provided by ClearCase.
Some system vendors, such as Sun, already have products, such as Workshop,
that provide features similar to those in Purify or other of the Company's
products and would compete directly with such products if offered on a stand-
alone basis. There can be no assurance that Sun, which has a license to some
of the Company's patents, will not introduce stand-alone products that compete
with the Company's products. Companies offering products competitive with
Rational Summit and ClearCase in the UNIX marketplace include Sun, which
offers TeamWare, IBM, which offers Configuration Management/Version Control
("CMVC"), Computer Associates ("CA") through its acquisition of LEGENT
Corporation, which offers the Endeavor WSX product, and Platinum through its
acquisition of Softool Corp., which markets CCC Harvest. In addition, there
are several smaller, privately-held companies that market competitive
products, including Continuous Software Corporation, which markets
Continuus/CM. Other companies have offered version control or configuration
management products outside the UNIX market. Companies in this category
include CA, Intersolv and Microsoft. CA has a large installed base of its
configuration management product on IBM mainframes. Intersolv has a large
installed base of DOS and Windows software developers. In 1994, Microsoft
acquired OneTree Software, which offers a version control product. The Company
expects additional competition from other established and emerging companies.
Digital Equipment Corporation has spun-off an independently operated
subsidiary, TracePoint Technology, Inc., which has stated that it intends to
produce development and testing tools and compete against the Company.
Rational believes that the increased level of competition it observed
in fiscal 1997 will continue to increase. Certain of Rational's competitors
are more experienced than Rational in the development of software-engineering
tools, databases or software-development products. Some of Rational's
competitors have, and new competitors may have, larger technical staffs, more
established distribution channels and greater financial resources than
Rational. There can be no assurance that either existing or new competitors
will not develop products that are superior to Rational's products or that
achieve greater market acceptance. Rational'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.
Future competition may result in price reductions, reduced margins or loss of
sales which in turn would have a material adverse effect on the Company's
business, results of operations and financial condition.
Dependence Upon Sales Force And Other Channels Of Distribution.
- ------------------------------------------------------------
Rational currently distributes its products primarily through field sales
personnel teamed with highly trained technical support personnel. Rational
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 Rational's products, the services provided by these
personnel have historically yielded lower margins for Rational than the
Company's product business. If these services constitute a higher proportion
of total revenues in the future, the Company's margins will be adversely
affected. Rational markets and sells its products and services directly
through telesales organizations, field operations, sales organizations and
indirectly through channels such as VARs and distributors. There can be no
assurance that such channels will be successful in increasing sales of the
Company's products or in reducing its sales costs on a percentage basis.
15
<PAGE>
Dependence on Key Personnel.
- ---------------------------
Rational believes that the hiring and retaining of qualified individuals at
all levels in the Company will be 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. The Company will
be particularly dependent upon the efforts and abilities of its senior
management personnel. The departure of any of the senior management members or
other key personnel of the Company could have a material adverse effect on the
Company's business, financial condition, or results of operations depending upon
the timing of the departure, changes in the Company's business prior to such
time, the availability of qualified personnel to replace them, and whether such
personnel depart singly contemporaneously, or as a group, among other factors.
Merger activities, such as the acquisition of Pure Atria, can be accompanied
or followed by the departure of key personnel, which can compound the
difficulty of integrating the operations of the parties to the business
combination. None of the Rational executive officers is subject to any
agreement not to compete or severance agreement with Rational.
The ability of the Company to attract and retain the highly trained
technical personnel that are integral to its direct sales and product
development teams may limit the rate at which the Company can develop products
and generate 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. Merger activities, such
as the acquisition of Pure Atria, may have a destabilizing effect on employee
retention at all levels within the Company. Departures of existing personnel,
particularly in key technical, sales, marketing or management positions, can
be disruptive and can result in departures of other existing personnel, which
in turn could have a material adverse effect upon the Company's business,
operating results and financial condition.
A traditional means of retaining employees following declines in a
corporation's stock price, such as those experienced recently by Rational, is
to reprice "underwater" stock options, both to offer an equity incentive to
existing employees and to avoid inequities relative to new employees offered
lower-priced options. However, attempts to address potential employee
attrition by repricing employee stock options could be negatively interpreted
by analysts and investors and possibly negatively affect the pooling-of-
interests accounting treatment for the Pure Atria Merger. As long as
substantial numbers of options remain underwater, Rational may suffer employee
attrition in excess of historical rates, which could have a material adverse
effect on the Company's business, results of operations and financial
condition.
16
<PAGE>
Rapid Technological Change.
- --------------------------
The industry for tools for automating software application development and
management is characterized by rapid technological advances, changes in customer
requirements and frequent new product introductions and enhancements. The
introduction of products embodying new technologies and the emergence of new
industry standards and practices can render existing products obsolete and
unmarketable. The Company must respond rapidly to developments related to
Internet and intranet applications, 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, introduction or
integration could result in a loss of competitiveness or revenue. To the extent
the Company does not respond to technological change or evolving customer
requirements with new products or product enhancements, such new products or
product enhancements may fail to achieve market acceptance.
In addition, rapid growth of interest in and use of Internet and intranet
environments is a recent and emerging phenomenon. The Company's success may
depend, in part, on the compatibility of its products with Internet and intranet
applications. The Company may fail to effectively adapt its products for use in
Internet or intranet environments or to produce competitive Internet and
intranet applications.
Rational believes that factors affecting the ability of its products to
achieve broad consumer acceptance include product performance, price, ease of
adoption, displacement of existing approaches and adaptation to rapid
technological change and competitive product offerings. The Company may be
unable to respond promptly and effectively to the challenges of technological
change and its competitors' innovations, and it is possible that the Company
will be unable to achieve the necessary market acceptance, or compete
effectively, in new markets.
Dependence On Strategic Relationships.
- -------------------------------------
Rational's development, marketing and distribution strategies rely
increasingly on its ability to form long-term strategic relationships with major
software and hardware vendors, many of whom are substantially larger than
Rational. These business relationships often consist of cooperative marketing
programs, joint customer seminars, lead referrals or joint development projects.
Although certain aspects of some of these relationships are contractual in
nature, many important aspects of these relationships depend upon the
continued cooperation of each party with Rational. Merger activity, such as
the acquisition of Pure Atria, may disrupt these relationships or activities,
and certain partners may reassess the value of their relationship with
Rational as a result of such merger activity. Divergence in strategy between
Rational and any given partner, a change in focus by any given partner, or
competitive product offerings introduced by any given partner, may interfere
with Rational's ability to develop, market, sell or support its products,
which in turn would have a material adverse effect on Rational's business,
results of operations and financial condition. See "- Business Alliance with
Microsoft."
17
<PAGE>
Business Alliance With Microsoft.
- --------------------------------
On October 2, 1996, Rational and Microsoft announced the formation of a
business alliance which consists of Rational's acquisition of Microsoft's Visual
Test product, technology cross-licensing, joint development projects and joint
marketing programs. While Rational 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 Rational 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 information it gains in its
relationship with Rational to develop or market competing products.
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 software testing tools area. There can be
no assurance that Microsoft will not use such rights to create and distribute
products that compete with other Rational products. 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."
Licensing Of Rose Technology To Microsoft.
- -----------------------------------------
In October 1996, Microsoft and Rational 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 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 customer base, and there can be no
assurance that such changes will achieve customer 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.
18
<PAGE>
Dependence Upon Major Operating Systems.
- ---------------------------------------
Many of Rational's major products have historically been licensed for use
principally on certain versions of the UNIX platform. These products constitute
a substantial portion of Rational's product and service revenues. Any factors
adversely affecting the demand for, or use of, the UNIX operating system that
would require changes to Rational's products would have a material adverse
effect upon the business, operating results and financial condition of Rational.
Likewise, other of Rational's major products have historically been licensed for
use purely on the Windows operating system. These products also constitute a
substantial portion of Rational's product and service revenues. Any factors
adversely affecting the demand for, or use of, the Windows operating system that
would require changes to Rational's products would have a material adverse
effect upon the business, operating results and financial condition of Rational.
In addition, any changes to the underlying components of or interfaces to the
UNIX or Windows operating systems that would require changes to Rational's
products for those platforms would materially adversely affect Rational if it
were not able to successfully develop or implement such changes in a timely
fashion.
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 customer base than its historical customer base, and to encourage
potential customers 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.
19
<PAGE>
Management Of Growth.
- --------------------
Rational has experienced rapid growth, particularly as a result of its
acquisitions, and the Company is experiencing a period of aggressive product
introductions that have placed, and may continue to place, a significant strain
on its financial, operational, management, marketing and sales systems and
resources, including its personnel. Projects such as the expansion of or
enhancements to product lines, efforts to address broader markets and to expand
distribution channels, numerous acquisitions as described in "Risks Associated
with Recent and Future Acquisitions'' and business alliances such as the recent
arrangement between Rational and Microsoft, when added to the day-to-day
activities of Rational, have placed and will continue to place further strain on
management resources and personnel. If Rational's management is unable to
effectively manage growth, its business, competitive position, results of
operations and financial condition will be materially and adversely affected.
Risk Of Software Defects.
- ------------------------
Software products as complex as 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 the 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.
Errors or performance problems may also 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. Further, because the Company relies on its own products
in connection with the development of its software, any such errors could make
it more difficult to sell such products in the future. Rational attempts to
make adequate allowance in its new product release schedule 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 by the Company 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.
Risks Associated with International Operations.
- ----------------------------------------------
International sales accounted for approximately 33%, 35%, and 32% of
Rational's revenues in fiscal 1995, 1996 and 1997, respectively and
represented 19%, 28%, 30% and 31% of Pure Atria's revenues in fiscal 1994,
1995, and 1996, and the three months ended March 31, 1997, respectively.
Rational expects that international sales will continue to account for a
significant portion of the Company's revenues in future periods. 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, difficulties in obtaining export and
import licenses, costs of localizing products for foreign markets, lack of
acceptance of localized products in foreign markets, and the efforts of high
local wage scales and other expenses. 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. Rational's international sales are generally denominated in foreign
currencies. Rational has engaged in only limited hedging activities. 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 a material adverse impact to date from fluctuations in
foreign currencies, there 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.
20
<PAGE>
Limited Protection of Intellectual Property and Proprietary Rights.
- ------------------------------------------------------------------
Rational relies on a combination of copyright, trademark and trade secret
laws, employee and third-party nondisclosure agreements and other methods to
protect its proprietary rights. 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 that Rational
regards as proprietary. Rational generally licenses its software products to
end-users on a "right to use" basis pursuant to a perpetual license. Rational
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, its
exposure to unauthorized copying and use of its products and proprietary
information will increase.
The scope 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 Rational's products.
Rational also relies on certain software that it licenses from third
parties, including software that is integrated with internally developed
software and used in its products to perform key functions. There can be no
assurance that these third-party software licenses will continue to be available
to the Company on commercially reasonable terms, or that the software will be
appropriately supported, maintained or enhanced by the licensors. The loss of
licenses to, or inability to support, maintain and enhance any of such software
could result in increased costs, or in delays or deductions in product shipments
until equivalent software could be developed, identified, licensed and
integrated, which would materially adversely affect the Company's business,
operating results and financial condition.
Risks of Litigation.
- -------------------
Competitors and potential competitors may resort to litigation as a means
of competition. Such litigation or other legal disputes may be costly and expose
the Company to new claims that it may not have anticipated. In the past,
Rational has instituted litigation against several companies. Although patent
and intellectual property disputes in the software area have often been settled
through licensing, cross-licensing or similar arrangements, costs associated
with such arrangements may be substantial. Any litigation involving the Company,
whether as plaintiff or defendant, regardless of the outcome, may result in
substantial costs and expenses to the Company and significant diversion of
effort by the Company's technical and management personnel. In addition, there
can be no assurance that litigation, either instituted by or against the
Company, will not be necessary to resolve issues that may arise from time to
time in the future. Any such litigation could have a material adverse effect
upon the Company's business, operating results and financial condition.
Rational expects that software product developers will be increasingly
subject to infringement claims as the number of products and competitors grows
and the functionality of products in different industry segments overlaps. 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 business, results of operations and
financial condition.
21
<PAGE>
ITEM 6 -- EXHIBITS AND REPORTS ON FORM 8-K
- --------------------------------------------------------------------------------
(a) Exhibit 4.1: Rational Software Corporation's 1997 Supplemental Stock
Plan and form of Stock Option Agreement therunder, incorporated by
reference to Rational's S-8 Registration Statement, registration number
333-31505, as filed with the Securities and Exchange Commission on July
17, 1997.
(b) Exhibit 11.1: Statement of Computation of Net Income per Common Share
(c) Exhibit 27: Financial Data Schedule
(d) Reports on Form 8-K:
On April 9, 1997 the Company filed Form 8-K regarding the Stock Purchase
agreement dated march 31, 1997 by and among the Company, Performance Awareness
Corporation, a North Carolina corporation, and all of the stockholders of
Performance Awareness Corporation.
On April 14, 1997 the Company filed Form 8-K regarding the Plan and
Reorganization dated April 7, 1997 by and among the Company, Wings Merger
Corporation, a wholly-owned subsidiary of the Company, and Pure Atria
Corporation, a Delaware corporation.
On May 12, 1997, the Company filed Form 8-K/A, which was amendment number 1 to
the Company's Form 8-K Current Report filed February 27, 1997 regarding pro
forma financial information related to the Company's acquisition of SQA, Inc.
On June 16, 1997, the Company filed Form 8-K/A, which was amendment number 1 to
the Company's Form 8-K Current Report filed April 9, 1997 regarding financial
statements of business acquired, and related pro forma financial information
related to the Company's acquisition of Performance Awareness Corporation.
22
<PAGE>
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
August 11, 1997
23
<PAGE>
Exhibit 11.1
Statement of Computation of Net Income Per Common Share
(In thousands, except per share amounts)
Three Months Ended
June 30,
-----------------
1997 1996
------ ------
Primary:
Weighted average
shares outstanding 47,706 40,576
Dilutive stock options 2,512 3,831
------ ------
Total 50,218 44,407
====== ======
Fully diluted:
Weighted average
shares outstanding 47,706 40,576
Dilutive stock options 2,586 3,833
------ ------
Total 50,292 44,409
====== ======
Net income $7,814 $5,093
Income per common share
Primary: .16 .11
Fully diluted: .16 .11
24
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> MAR-31-1998
<PERIOD-START> APR-01-1997
<PERIOD-END> JUN-30-1997
<CASH> 155,857
<SECURITIES> 66,906
<RECEIVABLES> 37,227
<ALLOWANCES> 1,948
<INVENTORY> 0
<CURRENT-ASSETS> 262,607
<PP&E> 40,263
<DEPRECIATION> 20,825
<TOTAL-ASSETS> 302,942
<CURRENT-LIABILITIES> 50,252
<BONDS> 3,362
0
0
<COMMON> 356,868
<OTHER-SE> (107,158)
<TOTAL-LIABILITY-AND-EQUITY> 302,942
<SALES> 27,705
<TOTAL-REVENUES> 42,928
<CGS> 3,610
<TOTAL-COSTS> 10,682
<OTHER-EXPENSES> 25,157
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 3,330
<INCOME-PRETAX> 10,419
<INCOME-TAX> 2,605
<INCOME-CONTINUING> 7,814
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 7,814
<EPS-PRIMARY> .16
<EPS-DILUTED> .16
</TABLE>
