<PAGE>
________________________________________________________________________________
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998
or
[_] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from _____ to _____
COMMISSION FILE NUMBER 0-12167
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
(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 86,721,967
$.01 PER SHARE
(Class) (Shares outstanding on July 31, 1998)
________________________________________________________________________________
<PAGE>
CONTENTS PAGE
PART I -- FINANCIAL INFORMATION
Item 1 -- Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets...................... 3
Condensed Consolidated Statements of Operations............ 4
Condensed Consolidated Statements of Cash Flows............ 5
Notes to Condensed Consolidated Financial Statements....... 6
Item 2 -- Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................. 7
PART II -- OTHER INFORMATION
Item 1 -- Legal Proceedings.......................................... 20
Item 2 -- Changes in Securities and Use of Proceeds.................. 20
Item 4 -- Submission of Matters to a Vote of Security Holders........ 20
Item 6 -- Exhibits and Reports on Form 8-K........................... 22
SIGNATURE............................................................. 23
2
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
ASSETS JUNE 30, MARCH 31,
- ------ 1998 1998
---------------------- ----------------------
<S> <C> <C>
Current assets: (unaudited) (Note A)
Cash and cash equivalents $112,935 $126,229
Short-term investments 130,168 163,241
Accounts receivable, net 58,582 71,379
Prepaid expenses and other assets 6,454 7,239
Deferred tax assets 11,846 11,846
---------------------- ----------------------
Total current assets 319,985 379,934
Property and equipment, at cost:
Computer, office and manufacturing equipment 67,671 65,339
Office furniture 8,886 9,184
Leasehold improvements 8,107 7,136
---------------------- ----------------------
84,664 81,659
Accumulated depreciation and amortization (45,226) (43,671)
---------------------- ----------------------
Property and equipment, net 39,438 37,988
Other assets, net 25,935 27,283
---------------------- ----------------------
Total assets $385,358 $445,205
====================== ======================
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
Current liabilities:
Accounts payable $ 9,505 $ 13,262
Accrued employee benefits 15,009 23,929
Income taxes payable 15,778 15,259
Other accrued expenses 14,833 18,345
Current portion of accrued merger and integration expenses 18,010 26,226
Deferred revenue 53,692 52,707
Current portion of long-term debt and lease obligations 1,777 1,809
---------------------- ----------------------
Total current liabilities 128,604 151,537
Accrued rent 748 720
Long-term accrued merger and integration expenses 5,600 5,600
Long-term debt 172 172
---------------------- ----------------------
Total liabilities 135,124 158,029
---------------------- ----------------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.01 par value, 150,000 shares authorized 868 890
Additional paid-in capital 499,600 494,718
Treasury stock (51,506) (1,340)
Accumulated deficit (197,257) (205,262)
Cumulative translation adjustment (1,471) (1,830)
---------------------- ----------------------
Total stockholders' equity 250,234 287,176
---------------------- ----------------------
Total liabilities and stockholders' equity $ 385,358 $ 445,205
====================== ======================
</TABLE>
Note A: The balance sheet at March 31, 1998 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
principal for complete financial statements.
3
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts, unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30,
-------------------------------------------------
1998 1997
--------------------- --------------------
<S> <C> <C>
Net product revenue $49,994 $38,355
Consulting and support revenue 32,977 27,793
---------------------- ---------------------
Total revenue 82,971 66,148
Cost of product revenue 6,446 3,873
Cost of consulting and support revenue 9,317 11,410
---------------------- ---------------------
Total cost of revenue 15,763 15,283
---------------------- ---------------------
Gross margin 67,208 50,865
Operating expenses:
Research and development expenses 15,615 13,489
Sales and marketing expenses 36,465 28,538
General and administrative expenses 6,807 6,919
---------------------- ---------------------
Total operating expenses 58,887 48,946
---------------------- ---------------------
Operating income 8,321 1,919
Other income, net 3,115 4,585
---------------------- ---------------------
Income before income taxes 11,436 6,504
Provision for income taxes 3,431 1,376
---------------------- ---------------------
Net income $ 8,005 $ 5,128
====================== =====================
Net income per common share basic $0.09 $0.06
Shares used in computing per share amounts basic 87,867 86,555
Net income per common share diluted $0.09 $0.06
Shares used in computing per share amounts - diluted 92,859 89,067
</TABLE>
4
<PAGE>
RATIONAL SOFTWARE CORPORATION
Condensed Consolidated Statement of Cash Flows
(in thousands, unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30,
--------------------------------------
1998 1997
----------------- ----------------
<S> <C> <C>
OPERATING ACTIVITIES:
Net income $ 8,005 $ 5,128
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization 5,037 2,041
Changes in operating assets and liabilities:
Accounts receivable 12,797 10,164
Prepaid expenses and other, net 785 (2,968)
Accounts payable (3,758) (6,428)
Accrued employee benefits and other accrued expenses (12,404) (1,194)
Income taxes payable 519 (1,376)
Accrued merger and integration expenses (8,216) (5,109)
Deferred revenue 985 (585)
----------------- ----------------
Net cash provided (used) by operating activities 3,750 (327)
INVESTING ACTIVITIES:
Purchase of short-term investments (88,717) (66,881)
Maturities and sales of short-term investments 121,790 5,471
Purchases of property and equipment (5,138) (9,105)
Net cash activity for Pure Atria for the quarter ended March 31, 1997 -- (463)
Net changes in other assets -- 876
----------------- ----------------
Net cash provided (used) by investing activities 27,935 (70,102)
FINANCING ACTIVITIES:
Principal payments under long-term debt and capital lease obligations (32) (389)
Net proceeds from issuances of common stock 4,891 1,811
Repurchases of common stock (50,197) --
----------------- ----------------
Net cash provided (used) by financing activities (45,338) 1,422
Effect of changes in foreign currency exchange rate on cash 359 (49)
----------------- ----------------
Net decrease in cash and cash equivalents (13,294) (69,056)
Cash and cash equivalents at beginning of period 126,229 244,856
----------------- ----------------
Cash and cash equivalents at end of period $112,935 $175,800
================= ================
</TABLE>
5
<PAGE>
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, results of
operations, 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. Operating results for the
period ended June 30, 1998 are not necessarily indicative of the results that
may be expected for the fiscal year ending March 31, 1999.
On July 30, 1997 the Company merged with Pure Atria Corporation ("Pure
Atria"). 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 Pure Atria. See Note 3 to Notes to Consolidated Financial
Statements in the Company's Annual Report to Stockholders (Form 10-K) for the
year ended March 31, 1998.
2. ACCOUNTS RECEIVABLE -- Accounts receivable are presented net of an
allowance for doubtful accounts of $3,138,000 at June 30, 1998 and $3,638,000 at
March 31, 1998.
3. NET INCOME PER COMMON SHARE -- In 1997, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standards No. 128, Earnings per
Share. Statement 128 replaced the previously reported primary and fully diluted
earnings per share with basic and diluted earnings per share. Unlike primary
earnings per share, basic earnings per share excludes any dilutive effects of
options, warrants, and convertible securities. Diluted earnings per share is
very similar to the previously reported fully diluted earnings per share. All
earnings per share amounts for all periods have been presented, and where
necessary, restated to conform to the Statement 128 requirements.
4. CONTINGENCIES -- 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 its position.
On May 28, 1998, a consolidated, amended class action Complaint was filed
against the Company and Paul D. Levy in the United States District Court for
the Northern District of California. That action, In re Rational Software
Corporation, No. 97-21001 (JF), consolidates eight prior-pending, virtually-
identical complaints. Cowen & Company and a Cowen & Company analyst, are also
named as defendants. The complaint alleges that defendants violated Sections
10(b) and 20A of the Securities Exchange Act of 1934 and California state
securities laws through the selective disclosure of material inside information
regarding the Company's prospects. The complaint seeks unspecified damages on
behalf of a class of stockholders who purchased the Company's common stock on
October 8, 1997. Defendants have filed motions to dismiss the complaint. Those
motions are scheduled to be heard on September 28, 1998. The Company believes
the lawsuit is without merit and intends to defend the case vigorously.
5. STOCK REPURCHASE -- The Company is authorized to repurchase up to six million
shares of its common stock in the open market to be used for general
corporate purposes. Any repurchase should also help offset dilution from stock
issued under the company's stock option and stock purchase plans. Through June
30, 1998 the Company had repurchased 3,141,500 shares of its common stock for a
total cash outlay of approximately $50.2 million.
6
<PAGE>
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", at the end of this Item 2.
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.
On July 30, 1997 the Company merged with Pure Atria Corporation ("Pure Atria").
The merger was accounted for as 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 Pure Atria. See Note 3 to Notes to Consolidated Financial Statements in the
Company's Annual Report to Stockholders (Form 10-K) for the year ended March 31,
1998.
COMPARATIVE ANALYSIS OF OPERATING RESULTS FOR THE THREE MONTHS ENDED JUNE 30,
1998
Total revenue increased 25% for the three month period ended June 30, 1998 from
the comparable prior year period. Net product revenue and consulting and
support revenue increased 30% and 19%, respectively, for the three month period
ended June 30, 1998 from the comparable prior year period. This increase
reflects continued strong customer acceptance across the Company's products and
services.
International revenues from product sales and consulting and customer support
accounted for 34% of total revenues for three month period ended June 30, 1998,
and 36% for the comparable prior year period. The Company's international sales
are principally priced in local currencies. The Company enters into short-term
forward currency contracts to hedge against the impact of foreign currency
exchange rate fluctuations on balance sheet exposures denominated in currencies
other than the functional currency of the Company or its subsidiaries. The
total amount of these contracts is approximately offset by the underlying assets
and liabilities denominated in non-functional currencies and such contracts are
carried at fair market value. The associated gains and losses were not material
to the Company's results of operations in any period presented. See Risks
Associated with International Operations.
Cost of product revenue consists principally of materials, packaging and
freight, amortization of developed technology and royalties. These costs
represented 13% of total product revenue for the three month period ended June
30, 1998, as compared to 10% for the comparable prior year period. The increase
in product cost as a percentage of certain product revenue was due mainly to
costs associated with the introduction of new versions of company products
during the quarter.
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 ended June 30, 1998 from the comparable
prior year period. These costs represented 28% of total consulting and support
revenue for the three month period ended June 30, 1998 as compared to 41% for
the comparable prior year period. The decrease in cost as a percentage of
related revenue is primarily due to changes to the Company's customer support
business model as a result of combining the Pure Atria and Rational service
7
<PAGE>
organizations, combined with the impact of a relatively fixed support cost base
servicing increased revenues.
Total expenditures for research and development increased 16% for the three
month period ended June 30, 1998 from the comparable prior year period. These
costs represented 19% of total revenue for the three month period ended June 30,
1998 versus 20% for the comparable prior year period. The increase in
expenditures for research and development is due primarily to the cost of
additional personnel and related costs incurred to maintain and enhance existing
products as well as develop new products.
Sales and marketing expenses increased 28% for the three month period ended June
30, 1998 from the comparable prior year period. These costs represented 44% of
total revenue for the three month period ended June 30, 1998 compared to 43% for
the same period last year. The increase in sales and marketing expenses reflect
the additional personnel and related costs required to expand Rational's sales
channels, to penetrate new markets, and to increase its market share in core
markets.
General and administrative expense decreased 2% for the three month period ended
June 30, 1998 from the comparable prior year period. These costs represented 8%
of total revenue for the three month period ended June 30, 1998 as compared to
10% for the comparable prior year period.
Other income, net consists primarily of interest income, interest expense and
gains and losses due to fluctuations in foreign currency exchange rates. Other
income has fluctuated as a result of the amount of cash available for investment
in interest-bearing instruments and from fluctuations in foreign
currency exchange rates. Other income, net decreased $1,470,000 for the three
month period ended June 30, 1998 from the comparable prior year period. The
current year decrease is due primarily to a lower average amount of invested
cash resulting from repurchase of company stock during the quarter.
The provision for income taxes for the three month period ended June 30, 1998 is
based on the estimated annual effective tax rate applied to the profit before
income taxes and includes federal, state and foreign income taxes. The effective
tax rates for fiscal 1999 and 1998 differ from the federal statutory rate,
primarily, as a result of the recognition of previously unrecognized deferred
tax assets, the non-deductibility of certain merger related costs, losses in
certain foreign jurisdictions for which no US benefit was derived, differing tax
rates in certain foreign jurisdictions and by state taxes.
LIQUIDITY AND CAPITAL RESOURCES AT JUNE 30, 1998
As of June 30, 1998, the Company had cash, cash equivalents and short-term
investments of $243,103,000 and working capital of $191,381,000. Net cash
provided by operating activities for the period ended June 30, 1998 was composed
primarily of operating income and a decrease in accounts receivable, offset by a
decrease in accrued employee benefits and other accrued expenses, accrued merger
costs, and accounts payable. Net cash provided by investing activities resulted
primarily from a decrease in short-term cash investments offset by an increase
in capital expenditures. Net cash used in financing activities resulted
primarily from the repurchase of common stock, offset by issuance of common
stock under the Employee Stock Purchase Plan and the exercise of employee stock
options.
The Company is authorized to repurchase up to six million shares of its common
stock in the open market to be used for general corporate purposes. Any
repurchase should also help offset dilution from stock issued under the
company's stock option and stock purchase plans. Through June 30, 1998 the
Company had repurchased 3,141,500 shares of its common stock for a total cash
outlay of approximately $50.2 million.
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.
8
<PAGE>
FACTORS THAT MAY AFFECT FUTURE RESULTS
Risks Associated with Recent and Future Acquisitions
Rational acquired Pure Atria Corporation (Pure Atria) on July 30, 1997,
with the expectation that the acquisition would result in long-term strategic
benefits. The realization of these anticipated benefits will continue to depend
in part on integration of the companies' respective product offerings and
research and development efforts. There can be no assurance that this will
occur. Successful integration of the companies' respective sales forces will
continue to require sales personnel to become familiar with the sales cycles and
sales approaches required for products recently 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 continued 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 is
compounded by the fact that each company had significant operations on both the
East Coast and the West Coast of the United States and in a number of other
countries. The acquisition of Pure Atria has been accounted for as a pooling of
interests. Accordingly, if such accounting treatment were to be nullified for
any reason, it would materially and adversely affect Rational's reported
earnings and, potentially, its stock price.
In addition to the acquisition of Pure Atria, during approximately the past
three years, Rational has made a number of strategic acquisitions, including
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 other acquisitions in earlier periods. Rational
has recently acquired 19.9% of the outstanding capital stock of ObjecTime, Ltd.
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's management has historically evaluated on an ongoing basis the
strategic opportunities available to the Company. Rational may in the near-term
or long-term future pursue acquisitions of complementary products, technologies,
or businesses.
Fluctuations in Operating Results
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 because 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,
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
9
<PAGE>
sales will also be sensitive to existing and prospective customers' budgeting
practices, global economic conditions, and potential cutbacks in U.S. defense
spending, which has historically been a significant factor for Rational.
Unanticipated expenses associated with the integration of Rational and Pure
Atria 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 transactions resulted in
an operating loss and a net loss for the Company's fiscal year ended 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 on as an indication of future
performance. Fluctuations in operating results have previously and may continue
to result in volatility in the price 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
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.
Further, the Company incurred substantial merger-related charges in the quarter
ended September 30, 1997. Although Rational entered into the merger with the
expectation that it would be accretive in the long term, the merger has been
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
resulted, 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 Rational's common stock.
10
<PAGE>
Dependence on Market Growth and Development of Industry Standards
Rational's future growth and financial performance will depend in part on
broad acceptance of modeling for developing mission-critical applications, and
continued growth in the need for and sales of tools for automating software
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 reorientation
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 on 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, which has been adopted by the Object
Management Group (OMG), an industry consortium, for inclusion in their object
analysis and design facility specification. The official sanction in the future
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 on New Product Introductions
The Company believes that its continued success will depend in part on 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 believes its continued
success will become increasingly dependent on its ability to support the
Microsoft platform, including the Windows 95, Windows 98, and Windows NT
operating systems. The Company also believes its continued success will become
increasingly dependent on its ability to support Web-based development of
business-critical applications using latest technologies. 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 in its existing market segments. The Company
also believes that, over time, its products must be extended to fully support
off-the-shelf products from companies such as SAP, The Baan Company, and
PeopleSoft. 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
11
<PAGE>
and retesting or should the Company elect to add product enhancements in
response to beta customer feedback.
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, Windows NT, and UNIX vendors. Because individual product sales are
often the first step in a broader customer relationship, Rational's success will
depend in part on its ability to successfully compete with numerous competitors
at each point in its product line.
Rational faces competition from software-development tools and processes
developed internally by customers, including ad hoc integrations of numerous
standalone 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 about 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 Corporation
(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--Purify, Quantify,
PureCoverage, 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 that compete with Rational Apex.
Rational's ClearCase, ClearDDTS, and ClearQuest product line faces competition
from various suppliers offering products with configuration and change
management functions, including Continuus Software Corporation, StarBase
Corporation, Hewlett Packard, True Software, SQL Software, LTD., Intersolv,
Inc., Sun Microsystems, and IBM. The Rational Apex Ada product line faces
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 standalone 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 others of the Company's products and
would compete directly with such products if offered on a standalone basis. The
Company's recently announced ClearQuest defect-tracking product is expected to
compete with products from LBMS, Inc., which was recently acquired by Platinum
Technology, Inc. There can be no assurance that Sun, which has a license to some
of the Company's patents, will not introduce standalone products that compete
with the Company's products. Companies offering products competitive with
12
<PAGE>
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 Continuus
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.
Rational believes that the major competitive factors in its markets are
corporate and product reputation, breadth of coverage by an integrated product
line, product architecture, functionality and features, product quality,
performance, ease of use, quality of support, availability of technical
consulting services, and price.
Rational believes that the increased level of competition it observed in
fiscal 1998 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 on 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 on 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.
Although 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 its major-
accounts field operations, its telesales organizations, and its World Wide Web
site, 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.
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 on 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 on 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
13
<PAGE>
followed by the departure of key personnel, which can compound the difficulty of
integrating the operations of the parties to the business combination.
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 on 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. On November 4, 1997, the Company's board of directors
approved a program enabling the Company to reprice stock options for most
employees. The repriced options are subject to additional lock-up and repurchase
restrictions. Members of the Company's senior management team at that time were
not eligible to participate in that repricing program. In April 1998, the
compensation committee of the board, after consulting with all of the outside
directors, approved repricing agreements with the members of the senior
management team who were not eligible to participate in the November 1997
repricing program. The senior officer repricing was completed on substantially
the same terms, including the disposition limitations and repurchase provisions,
offered to the rest of the employees in November 1997, although at the higher
fair market price existing at the time of the April 1998 repricing. There can be
no assurance that such repricing will be sufficient to retain employees or
senior management or that at some future date the outstanding stock options will
not again be underwater. To the extent that options held by employees, including
members of senior management, again become underwater, those options may not
serve as an incentive to retain these individuals. The departure of one or more
members of the senior management team could have a material adverse effect on
the Company's business, results of operations, and financial condition.
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
14
<PAGE>
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 on
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."
Business Alliance with Microsoft
On October 2, 1996, Rational and Microsoft announced the formation of a
business alliance that consisted of Rational's acquisition of Microsoft's Visual
Test product, technology cross-licensing, joint development projects, and joint
marketing programs. Although 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 the Visual Test product 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 nonexclusive, 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++.
15
<PAGE>
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 Rational 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 not to generate direct
product revenue from Microsoft. The Company expects that continued 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 Rational 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 Rational 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, nonexclusive
right to source code for certain aspects of the Rational 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.
Dependence on 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 on the business, operating results, and financial condition of Rational.
Likewise, others of Rational's major products have historically been licensed
for use purely on the Windows or Windows NT operating systems. 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
or Windows NT operating systems that would require changes to Rational's
products would have a material adverse effect on the business, operating
results, and financial condition of Rational. In addition, any changes to the
underlying components of or interfaces to the UNIX, Windows or Windows NT
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.
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
16
<PAGE>
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
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.
To achieve and manage continued growth, the Company must continue to expand
and upgrade its information-technology infrastructure and its scalability,
including improvements to various operations, financial, and management
information systems. In addition, the Company believes that to remain
competitive it must significantly expand its capabilities for electronic
commerce. Improving management systems and infrastructure and building
electronic commerce capabilities will require that the Company recruit and
retain highly qualified technical personnel, and such personnel resources are
extremely scarce in the areas where the Company operates. Failure to improve
management infrastructure and build electronic commerce capabilities for future
growth would materially and adversely affect the Company's business, competitive
position, results of operations, and financial condition. See "Dependence on Key
Personnel."
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 34%, 34%, and 27% of
Rational's revenues in fiscal 1999, 1998, and 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, unexpected changes in global economic conditions,
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
international markets, and the effects 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 transacted through its
international sales subsidiaries. The revenue generated by these foreign
subsidiaries, as well as their local expenses, are generally denominated in
local currencies. Accordingly, the functional currency of each international
sales subsidiary is the local currency. Rational has engaged in limited hedging
activities to protect it against losses arising from remeasuring assets and
liabilities denominated in currencies other than the functional currency of the
17
<PAGE>
related subsidiary. The Company is also exposed to foreign exchange rate
fluctuations as the financial results of international subsidiaries are
translated into U.S. Dollars in consolidation. As exchange rates vary, these
results, when translated, may vary from expectations and adversely impact
overall expected profitability. The Company currently does not hedge against
this exposure. The Company has currently experienced no significant adverse
impact on revenues or operating results as a result of changes in exchange rates
or current economic conditions in many Asian countries. 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 or from further economic problems in Asia in the future.
Risks Associated with Asian Economic Crises
In addition to general risks associated with international operations
listed above, there are additional risks associated with the continuing
economic crisis in Asia. Many of Rational's customers, who are either based
in Europe or the Americas, do a substantial amount of business in Asia. As
economic conditions have affected buying behavior in Asia, Rational's
customers may also be affected, resulting in changes to their own buying
behavior in Europe or the Americas. There can be no assurance that the
Company will not experience a material adverse impact on its financial
condition and results of operations from the impact of the Asian economic
crisis both in Asia and in other geographies.
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 (that is, 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 countries do not protect proprietary rights to the
same extent as 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 that 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. In addition, Rational licenses
certain of its technology to its development partners. There can be no assurance
that such partners' use of the technology will be complementary to Rational's
strategies or that such partners will not use such technology to develop and
market competing products in the future.
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 may
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. The Company is also currently a party
to securities litigation. 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, instituted either by or against the Company, will not
be
18
<PAGE>
necessary to resolve issues that may arise from time to time in the future. Any
such litigation could have a material adverse effect on 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. See also "Item 3--Legal Proceedings" of Part I in the
Company's latest annual report filed with the Securities and Exchange Commission
on Form 10-K.
Year 2000 Compliance
Rational is aware of the problems associated with computer systems as the
year 2000 approaches. Year 2000 problems are the result of common computer
programming techniques that result in systems that do not function properly when
manipulating dates later than December 31, 1999. The problem may affect
transaction processing computer applications used by the Company for accounting,
distribution, and planning. The problem may also affect embedded systems such as
building security systems, machine controllers, and other equipment.
Rational is in the process of assessing and upgrading systems which fail to
be year 2000 compliant and will continue to review internal system requirements
and correct further issues as they are identified. Based on recent assessment,
the Company does not anticipate incurring material costs to be year 2000
compliant. However, there can be no assurance that actual costs will not
substantially exceed the Company's assessment due to internal year 2000 problems
or year 2000 problems associated with the Company's products. Further, there
can be no guarantee that the systems of other companies on which the Company's
systems rely will be converted on a timely manner, or that a failure to convert
by another company, including without limitation any of the Company's vendors,
customers, or partners, or a conversion that is incompatible with the Company's
systems would not have a material adverse effect on the Company.
Deferred Tax Assets
Based on the weight of available evidence, which includes the Company's
historical operating performance and the reported cumulative net loss for the
prior three years, the Company has provided a valuation against certain deferred
tax assets for which the "more likely than not" criteria for recognition has not
been met.
19
<PAGE>
PART II -- OTHER INFORMATION
ITEM 1 -- Legal Proceedings
On May 28, 1998, a consolidated, amended class action Complaint was filed
against the Company and Paul D. Levy in the United States District Court for the
Northern District of California. That action, In re Rational Software
Corporation, No. 97-21001 (JF), consolidates eight prior-pending, virtually-
identical complaints. Cowen & Company and a Cowen & Company analyst, are also
named as defendants. The complaint alleges that defendants violated Sections
10(b) and 20A of the Securities Exchange Act of 1934 and California state
securities laws through the selective disclosure of material inside information
regarding the Company's prospects. The complaint seeks unspecified damages on
behalf of a class of stockholders who purchased the Company's common stock on
October 8, 1997. Defendants have filed motions to dismiss the complaint. Those
motions are scheduled to be heard on September 28, 1998. The Company believes
the lawsuit is without merit and intends to defend the case vigorously.
ITEM 2 -- Changes in Securities and Use of Proceeds
(a) Effective April 2, 1998, the Compensation Committee of the Board of
Directors, after consulting with all of the outside directors, approved
agreements with Messrs. Levy, Devlin, Bernstein, Dickerson, Lovitt and Bond (the
"Repricing Agreements") to reprice (at the closing price for the Company's
Common Stock on April 2, 1998) such employees' stock options with exercise
prices higher than the closing price for the Company's Common Stock on April 2,
1998. The closing price for the Company's Common Stock on April 2, 1998 was
$13.38. Options to purchase a total of 1,700,000 shares were repriced pursuant
to the Repricing Agreements. Pursuant to the Repricing Agreements, each employee
participating in the repricing agreed to certain limitations on the disposition
of, and granted the Company certain rights of repurchase with respect to, shares
subject to repriced options. The foregoing discussion is qualified in its
entirety by reference to the form of Repricing Agreement filed with Form 10K for
the fiscal year ended March 31, 1998 as Exhibit 10.05, which is incorporated
herein by reference.
(b) The 1998 Employee Stock Purchase Plan as approved by the stockholders is
incorporated herein by reference to Registrant's Form S-8 Registration Statement
on August 4, 1998 (Registration No. 333-60579).
ITEM 4 -- Submission of matters to a Vote of Security Holders
On July 16, 1998 the Company held its annual meeting of stockholders. The
following items were submitted to a vote of the stockholders:
1. To elect two Class III members of the Board of Directors.
Election of Directors Votes For Votes Withheld
--------------------------------- ---------------- ------------------
James S. Campbell 77,902,726 817,876
Allison R. Schleicher 78,297,239 423,363
As a result, Messrs. Campbell and Schleicher were elected directors of the
Company.
2. To approve amendment to the Certificate of Incorporation authorizing the
issuance of 5,000,000 shares of "Blank Check" Preferred Stock.
Votes
-----
For 23,572,117
Against 28,774,160
Abstain 327,124
Broker Non-Vote 26,047,198
This proposal was not approved.
20
<PAGE>
3. To approve an amendment to the 1997 Stock Option Plan reserving an
additional 4,000,000 shares of the Company's Common Stock for issuance
thereunder.
Votes
-----
For 36,127,157
Against 16,676,976
Abstain 311,588
Broker Non-Vote 25,604,878
This proposal was approved.
4. To approve an amendment to the 1997 Stock Option Plan (i) increasing the
maximum number of shares subject to options and stock purchase rights that
may be granted in any fiscal year to a single employee under the Plan from
500,000 to 1,000,000 and (ii) eliminating provision for grants of up to an
additional 500,000 shares for new employees.
Votes
-----
For 35,439,190
Against 17,187,617
Abstain 420,114
Broker Non-Vote 25,673,678
This proposal was approved.
5. To approve the adoption of the Company's 1998 Employee Stock Purchase Plan
and the reservation of 2,000,000 shares of the Company's Common Stock for
issuance thereunder, with a semi-annual increase in the number of shares
available for issuance under the plan on the first business day on or after
May 1 and November 1 of each year.
Votes
-----
For 41,422,507
Against 11,202,862
Abstain 421,552
Broker Non-Vote 25,673,678
This proposal was approved.
6. To approve an amendment to the Directors' Stock Option Plan reserving an
additional 350,000 shares of the Company's Common Stock for issuance
thereunder.
Votes
-----
For 38,778,046
Against 13,971,557
Abstain 366,118
Broker Non-Vote 25,604,878
This proposal was approved.
7. To ratify the appointment of Ernst & Young LLP as the Company's independent
auditors to examine the financial statements of the Company for the fiscal
year ending March 31, 1999.
Votes
-----
For 78,402,891
Against 125,009
Abstain 123,900
Broker Non-Vote 68,799
This proposal was approved.
21
<PAGE>
ITEM 6 -- Exhibits and Reports on Form 8-K
(a) Exhibit 4.1: 1998 Employee Stock Purchase Plan and form of Agreement
thereunder are incorporated herein by reference to Exhibit 4.2
of Registrant's Form S-8 Registration Statement on August 4,
1998 (Registration No. 333-60579).
Exhibit 11.1: Statement of Computation of Net Income per Common Share
Exhibit 27: Financial Data Schedule
(b) Reports on Form 8-K:
On April 22, 1998 the Company filed Form 8-K regarding the authorization to
institute a stock repurchase program whereby up to six million shares of its
common stock may be repurchased in the open market from time to time.
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/ Timothy A. Brennan
--------------------------------
Timothy A. Brennan
Senior Vice President
Chief Financial Officer and Secretary
August 14, 1998
23
<PAGE>
Exhibit 11.1
Statement of Computation of Net Income Per Common Share
(In thousands, except per share Three Months Ended
amounts) June 30,
1998 1997
------------------------------------
Basic:
Weighted average
shares outstanding 87,867 86,555
------------------------------------
Diluted:
Weighted average
shares outstanding 87,867 86,555
Dilutive stock options 4,992 2,512
------------------------------------
Total 90,632 81,751
====================================
Net income $ 8,005 $ 5,128
Income per common share
Basic: $ 0.09 $ 0.06
Diluted: $ 0.09 $ 0.06
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> MAR-31-1999
<PERIOD-START> APR-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 112,935
<SECURITIES> 130,168
<RECEIVABLES> 61,720
<ALLOWANCES> 3,138
<INVENTORY> 0
<CURRENT-ASSETS> 319,985
<PP&E> 84,664
<DEPRECIATION> 45,226
<TOTAL-ASSETS> 385,358
<CURRENT-LIABILITIES> 128,604
<BONDS> 1,777
0
0
<COMMON> 868
<OTHER-SE> 249,366
<TOTAL-LIABILITY-AND-EQUITY> 385,358
<SALES> 49,994
<TOTAL-REVENUES> 82,971
<CGS> 6,446
<TOTAL-COSTS> 15,763
<OTHER-EXPENSES> 58,887
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (3,115)
<INCOME-PRETAX> 11,436
<INCOME-TAX> 3,431
<INCOME-CONTINUING> 8,005
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 8,005
<EPS-PRIMARY> 0.09
<EPS-DILUTED> 0.09
</TABLE>
