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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 10-K
ANNUAL REPORT
Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the Fiscal Year Ended March 31, 1999
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 95014-0721
(Address of principal executive (Zip Code)
offices)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.01 per
share
(Title of Class)
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 periods as 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 by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
At June 11, 1999, the aggregate market value of Registrant's voting stock
held by nonaffiliates was $2,955,463,941. For the purposes of the preceding
sentence only, "affiliates" is deemed to consist of executive officers and
directors. At June 11, 1999, there were 86,943,252 shares of the Registrant's
$0.01 par value Common Stock outstanding.
Unless indicated otherwise, all Common Stock share numbers and prices have
been adjusted to reflect Rational Software Corporation's May 1995 3:1 reverse
stock split and July 1996 1:2 forward stock split, accomplished by means of a
stock dividend.
Unless indicated otherwise, all financial information has been restated to
reflect Rational Software Corporation's acquisitions of SQA, Inc., and Pure
Atria Corporation, accounted for as poolings of interests.
Certain sections of the Registrant's definitive Proxy Statement for the 1999
Annual Meeting of Stockholders to be held on August 26, 1999, are incorporated
by reference in Part III of this Form 10-K to the extent stated herein.
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An Index to Exhibits Begins on Page 53
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The statements contained in this Annual Report on Form 10-K include forward-
looking information within the meaning of Section 27A of the Securities Act of
1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended, and are subject to the safe harbor created by those sections. Such
forward-looking statements include without limitation statements regarding
product development plans and schedules, relationships with strategic partners
and other third parties, and trends in overall revenue, revenue mix, expenses,
and other financial statement items. Rational's actual future results could
differ materially from those projected in the forward-looking information.
Factors that could cause actual results to differ materially include, without
limitation, those identified in "Factors That May Affect Future Results"
below.
PART I
ITEM 1--BUSINESS
Rational Software Corporation's (Rational or the Company) mission is to
ensure the success of customers who depend on their ability to develop and
deploy software. The Company develops and markets a wide range of software
development tools, services, and software engineering best practices that
unify cross-functional software teams while also addressing the unique needs
of each member of the team. Software is developed by teams of people that
focus on different aspects of the software development life cycle, such as
analysis, design, coding, and testing. When used in combination with one
another, Rational's tools simplify the customer's software development
environment, making it easier to develop software quickly, with the expected
functionality and required levels of quality. Rational's typical customers
build software in areas such as e-business, Web, intranet, n-tier, embedded,
real-time, and software products.
Rational is an industry leader in software development. The Company was the
driving force behind, and the primary author of, the Unified Modeling Language
(UML), as well as the recently introduced Unified Process.
Industry Background
General
Software has become ubiquitous. The examples of the proliferation of
software in almost every aspect of daily life are numerous. Software
implementations include traditional business applications software to Web-
based e-commerce applications, or the software built into cellular telephones,
airplanes, telephone switches, automated teller machines, point-of-sale
devices, etc. The challenge many companies face is that the explosive growth
in the demand for software is now outpacing their ability to design and build
it. And, as the number and complexity of software applications continue to
expand, it is becoming increasingly important for businesses to migrate to
more effective approaches to software development.
The ability to quickly develop and deploy high-quality software solutions
that meet customer and user needs can be a critical competitive advantage.
Today, many organizations seek to address the software development challenge
by increasing the capabilities of their software development environment while
reducing the complexity. They also seek to employ proven techniques in each of
the crucial phases of the software development life cycle--analysis and
design, development, and test. Integrated solutions that cover the breadth of
the life cycle and that automate the chosen techniques or best practices are
highly valued.
Products and Services
Rational delivers integrated solutions that cover the crucial phases of the
software development life cycle and that automate proven software development
best practices developed from 18 years of working with customers who build
software. Rational's products primarily fall into one of two categories: those
that are designed to unify the key disciplines within the software development
life cycle, creating more effective cross-functional teams; and those that are
designed to address the unique needs of each team member, improving his or her
individual productivity.
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Team-Unifying Solutions: The major elements of Rational's team-unifying
product family include solutions for software configuration management
(Rational ClearCase), change request management (Rational ClearQuest),
requirements management (Rational RequisitePro), and software development
process (Rational Unified Process).
Role-Optimized Solutions: The major elements of Rational's role-optimized
product family include solutions designed specifically for analysts (Rational
Suite AnalystStudio, Rational RequisitePro,* and Rational Rose Modeler), for
developers (Rational Suite DevelopmentStudio, Rational Rose Enterprise,
Rational Purify, Rational Quantify, and Rational PureCoverage), and for
testers (Rational TestStudio and Rational PerformanceStudio).
Integrated Suite Solutions from Rational: Rational Suite
The Rational Suite family combines the power of Rational's team-unifying and
role-optimized tools in tightly integrated solutions that make it easy for
customers to acquire and deploy complete software development solutions. The
Company designs each suite around the needs of the various software
engineering disciplines that are part of every software development team, but
each suite also includes a core set of team-unifying tools to improve the
productivity of the entire team.
Rational Suite AnalystStudio is an answer to the problems facing today's
analysts. Analysts are responsible for collecting, managing, and communicating
project requirements to the entire team. Rational Suite AnalystStudio
optimizes the analyst's effectiveness by combining powerful tools that collect
enhancement requests, manage requirements information, and visually model use
cases for better communication.
Rational Suite DevelopmentStudio is a complete solution for software
architects and developers. Architects and developers are responsible for
designing software systems and developing code. Rational Suite
DevelopmentStudio combines the power of visual modeling for software design,
and automated testing to improve the quality of the code before it is handed
off to quality assurance professionals.
Rational Suite TestStudio is a fully integrated suite of testing tools that
automates test planning, test developments, test execution, and defect
tracking. Designed for testing and quality assurance professionals who ensure
software systems meet quality standards as well as end-user requirements, it
ensures that a common set of testing tools, methods, metrics, and data are
used by the entire project team.
Rational Suite PerformanceStudio provides an accurate prediction of an
application's performance under load by enabling organizations to test their
e-business, ERP, and client/server applications as their users will experience
it. Designed for performance engineers and performance testers, Rational Suite
PerformanceStudio integrates functional and system performance testing to
deliver the information needed to make critical development, deployment, and
resource planning decisions.
The Company also packages all of the tools found in the various editions of
Rational Suite in one simple-to-acquire package--Rational Suite Enterprise.
Configuration and Change Management Solutions: Rational ClearCase and
Rational ClearQuest
Rational's configuration and change management products unify software teams
by providing comprehensive support for development teams working in parallel
on shared project artifacts, such as source code, binary files, software
models, requirements documents, test cases, project reports, and so on.
Rational ClearCase is the Company's configuration management solution.
ClearCase accelerates development cycles, ensures the accuracy of releases,
and enables teams to reliably build and patch previously shipped products. It
provides secure and reliable access to project artifacts, allowing teams to
share their work.
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* Rational RequisitePro is both a team-unifying solution and a role-optimized
solution because every member of the cross-functional team needs to be
aware of changing requirements and be able to effect change in his or her
status. However, it is the analyst who is typically charged with soliciting
and managing requirements.
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ClearCase maintains a full audit trail of who changed what, when, where, and
why, manages multiple versions of software artifacts, and reliably performs
"builds" of software systems. Rational ClearCase MultiSite supports geographic
distribution of software development teams working on shared sets of
artifacts.
Rational ClearQuest is a flexible defect tracking/change request management
system for tracking and reporting on defects and other types of change
requests throughout the development life cycle. ClearQuest provides reliable
project metrics, and is fully customizable. ClearQuest helps project teams
ensure that change occurs in a managed fashion.
RequisitePro: Requirements Management Tool
Rational RequisitePro is the flagship member of the Rational Requisite
family. This family of tools is designed to make requirements management
intrinsic to the development process by making requirements easy to document,
organize, and track as changes are made throughout the project life cycle.
Rational RequisitePro enables team-based requirements management. RequisitePro
is supplemented with RequisiteEnterprise, which adds support for enterprise
databases, and RequisiteWeb, which provides a Web interface for viewing and
editing RequisitePro requirements.
Visual Modeling Solutions: Rational Rose
Rational Rose is a Unified Modeling Language (UML)-based software modeling
tool for designing component-based applications. The UML, pioneered by
Rational and officially adopted as a standard by the Object Management Group
(OMG), is the industry-standard language for specifying, visualizing,
constructing, and documenting the artifacts of a software system. COM,
ActiveX, and JavaBean components can be reverse engineered to derive
interfaces and determine the interrelationships of all components within a
model. Rose gives developers the ability to mix and match multiple languages,
such as C++, Visual Basic, and Java, within the same model.
Rational Rose RealTime is a visual modeling environment designed
specifically to address the needs of software teams that manage and deliver
real-time software applications. Developed jointly by Rational and ObjecTime
Limited, Rational Rose RealTime combines Rational's market-leading visual
modeling technology with ObjecTime's leading model execution and code
generation technology. Rose RealTime also supports the Unified Modeling
Language (UML).
Automated Testing Solutions: Rational Robot, Rational TestFactory, Rational
LoadTest, Rational Purify, Rational PureCoverage, Rational Quantify, and
Rational Visual Test
Rational's solutions for automated testing help testers and developers
verify the reliability and functionality of their software and improve its
performance.
Rational Robot lets you create, modify, and run automated tests on Web, ERP,
and client/server applications. This test automation solution offers
reusability and portability of test recordings across Windows platforms to
provide one recording that plays back on all Windows platforms. Rational
TestFactory automates the creation of test scripts--so testers do not have to
invest significant amounts of time developing test scripts. Robot and
TestFactory are key components of Rational Suite TestStudio. Rational LoadTest
offers load, stress, and multi-user testing of client/server applications. It
automates the use of multiple transactions from a single test script, the
creation of workloads for 10 or 10,000+ users, and the insertion of
production-level timing characteristics.
Rational Visual Test, an automated, language-independent, software-testing
tool, is designed to test proper software functionality by rapidly creating
tests for applications of virtually any size and created in any implementation
language by capturing those tests for later reuse.
Rational Purify, Rational PureCoverage, and Rational Quantify are designed
to help developers and testers verify the reliability of their software.
Purify employs patented object-code insertion (OCI) technology to executable
code and automatically detects many common runtime errors. PureCoverage also
employs OCI technology to analyze executable code and to report which parts of
the code have not been executed and tested. Quantify helps developers verify
software performance by measuring where time is spent during software
execution and by providing users with accurate data on potential performance
bottlenecks. This data tells users what portions of the application need to be
tuned or revised to improve performance.
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Rational Apex: Integrated Development Environment Tools
Rational Apex is a software-engineering environment for control of software
projects. It effectively controls large-scale development efforts, helping
customers improve time-to-market while reducing risk and cost. It also makes
large-scale software reuse possible by directly managing software
architecture, significantly improving the efficiency of the overall software-
development process. Rational Apex runs on UNIX platforms and is available in
versions that support the C/C++ and Ada programming languages for UNIX,
Windows NT, and embedded applications.
Technical Consulting and Customer-Support Services
Rational offers its customers the benefits of nearly 20 years of experience
in developing and applying tools and proven best practices for software
development. This experience is drawn from hundreds of Rational software
consultants working directly with customers, and from extensive internal use
of Rational tools. Rational's professional services facilitate customer
adoption of these tools and best practices, maximizing the probability of
project success. Customers are able to take full advantage of the Company's
experience, avoid common pitfalls, and get maximum value from their investment
in Rational's solution.
Rational and its partners offer a wide range of professional services. These
include tool and technology training delivered onsite or in public classes,
onsite implementation planning, software-engineering mentoring, and
architecture and process consulting. Rational also offers a support program
that entitles a licensee to receive all enhancements and upgrades to the
licensed product that are published in the succeeding 12-month period, as well
as certain other support services.
Business Alliances
Rational works with numerous strategic partners for e-business as well as
other application development platforms. In this context, Rational works with
vendors such as Microsoft, IBM, Sun Microsystems, Peoplesoft, Oracle, Hewlett
Packard, SGI and others. These relationships may include technology cross-
licensing arrangements, cooperative marketing relationships as well as
exchange of development plans and strategic directions. Rational's
relationship with Microsoft includes, among other things, Rational providing
certain visual modeling technology to Microsoft that is included in
Microsoft's Visual Studio Products.
See "Factors That May Affect Future Results: Dependence on Strategic
Relationships and Business Alliances."
Product Development
Rational believes that its success will depend largely on its ability to
enhance existing products and develop new products that meet the needs of a
rapidly evolving marketplace and increasingly sophisticated and demanding
customers. Rational intends to extend and strengthen its life cycle support
for team-based development by expanding its product offerings, introducing new
products, and offering higher levels of integration among its products.
Rational uses its own software processes and tools extensively in its own
software-development activities. Although Rational has primarily developed
products internally, it may, based on timing and cost considerations, acquire
technologies or products from third parties.
Rational's research and development staff, including product development,
product support, and technical writing personnel, consisted of 726 employees
as of March 31, 1999. Rational's total research and development expenses were
approximately $71.9 million, $61.6 million, and $47.2 million in fiscal years
1999, 1998, and 1997, respectively. As a result of the Company's mergers with
Pure Atria and SQA, accounted for as poolings of interests, research and
development costs are presented on a combined basis for fiscal 1998 and prior
years shown.
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Customers and Applications
More than 432,000 licenses of Rational's software products, exclusive of
Rational Visual Test, have been sold to more than 26,000 customers worldwide.
No single customer accounted for 10% or more of revenues in fiscal 1999.
Rational's comprehensive solution of software-development tools and
professional services is used by major organizations in many industry segments
to design, build, and maintain complex software systems.
Sales and Marketing
Rational markets and sells its products and services directly through its
field sales organizations, the World Wide Web, and indirectly through channels
such as value-added resellers (VARs) and distributors.
Rational's direct selling approach couples sales of its integrated software
tools with high-value technical consulting services. Rational has established
a major-account direct sales and technical consulting organization in the
United States, Canada, Europe, Latin America, and the Asia/Pacific region. In
most regions this direct sales organization includes a telesales operation to
augment its direct sales presence.
Rational's sales, marketing, and professional services organization
consisted of 1,085 employees as of March 31, 1999. This organization operated
out of corporate headquarters in Cupertino, California, and from field offices
in other locations throughout North America, the United Kingdom, France,
Germany, Sweden, Finland, The Netherlands, Belgium, Austria, Switzerland,
Italy, Israel, Australia, Hong Kong, Taiwan, India, South Korea, New Zealand,
Japan, Singapore, and Brazil. Rational's direct international operations are
staffed almost exclusively by local personnel. Rational also has distributors
and resellers in North America, Europe, and the Asia/Pacific region.
In support of its sales efforts, Rational's marketing department conducts
comprehensive programs, which include maintenance of an extensive World Wide
Web site, an electronic subscription service for news announcements about
Rational, print advertising, direct mail, public relations, trade shows, and
ongoing customer communications programs. Rational also keeps its customers
informed of advances in the field through technical papers and other mailings.
International sales accounted for approximately 40%, 34%, and 27% of the
Company's revenues in fiscal 1999, 1998, and 1997, respectively, and the
Company expects that international sales will continue to account for a
significant portion of the Company's revenues in the future. International
sales are subject to inherent risks, including unexpected changes in
regulatory requirements and tariffs, difficulties in staffing and managing
foreign operations, longer payment cycles, greater difficulty in accounts
receivable collection, potentially adverse tax consequences, price controls or
other restrictions on foreign currency, and difficulties in obtaining export
and import licenses. Any material adverse effect on the Company's
international business would be likely to materially and adversely affect the
Company's business, operating results, and financial condition as a whole. The
Company's international sales are generally transacted through its
international sales subsidiaries. The revenues generated by these
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 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. 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
macroeconomic problems in various markets or geographies in the future. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations: Overview; Revenue; International Sales."
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Product Pricing
Rational's software licenses are normally perpetual, fully paid-up floating
or node-locked licenses. Floating licenses limit the number of simultaneous
users on a network instead of being associated with a specific user or
computer. Node-locked licenses limit a software license to a single computer.
Rational also offers other kinds of licenses, such as project licenses that
provide selected Rational tools to all the developers working on a specific
project.
Rational also offers a support program that entitles a licensee to receive
all enhancements and upgrades to the licensed product that are published in
the succeeding 12-month period, as well as certain other support services.
Annual fees for support generally range from 15% to 25% of the software
license fee.
Rational's packaged training courses are offered in the form of open-
enrollment public courses and in-house courses at customer facilities.
Additionally, Rational offers packaged consulting services that are generally
priced on a time-and-materials basis.
See "Factors That May Affect Future Results: Adverse Impact of Promotional
Product Versions on Actual Product Sales."
Competition
The industry 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 in 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 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
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 about the advantages of the Company's
products versus internally developed software quality systems.
Rational faces competition from, among others, Aonix, Compaq, Computer
Associates, Compuware, Continuus Software Corporation, Cyrano, GEC-Marconi,
Green Hills Software, Hewlett Packard, IBM, Merant, plc (formerly Intersolv,
Inc.), Mercury Interactive Corporation, Microsoft, Oracle, Mortice Kern
Systems (MKS), Perforce Software, Platinum Technology, Inc., Segue Software,
Inc., Select Software Tools plc, SGI, SQL Software LTD., StarBase Corporation,
Sterling Software, Inc., Sun Microsystems, Sybase Inc., Teradyne, and True
Software, as well as numerous other public and privately held software
application development and tools suppliers. 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 its combination of an
integrated family of products supporting component-based development
throughout the software development life cycle and its emphasis on controlled
iterative development, visual modeling, and an architecture-driven process,
coupled with its extensive major-account direct sales and technical consulting
organization and the supporting channels such as telesales, VARs,
distributors, and the World Wide Web helps it compete.
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Rational believes that the increased level of competition it observed in
fiscal 1999 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.
Intellectual Property
Rational regards its software as proprietary and attempts to protect it
under a combination of copyright, trademark, patent, and trade-secret laws,
employee and third-party nondisclosure agreements, and other methods of
protection. Despite these precautions, it may be possible for unauthorized
third parties to copy certain portions of Rational's products or to reverse
engineer or obtain and use information Rational regards as proprietary.
Although Rational's competitive position may be affected by its ability to
protect its proprietary information, Rational believes that trademark and
copyright protections are less significant to Rational's success than are
other factors, such as trade-secret protection, the knowledge, ability, and
experience of Rational's personnel, name recognition, and ongoing product
development and support.
Rational's software products are generally licensed 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 provisions of such licenses, including provisions
protecting against unauthorized use, copying, transfer, and disclosure of the
licensed program, may be unenforceable under the laws of certain
jurisdictions. In addition, the laws of some countries do not protect
Rational's proprietary rights to the same extent as do the laws of the United
States.
As the number of software products in the industry increases and the
functionality of these products further overlaps, Rational believes that
software programs will increasingly become subject to infringement claims.
There can be no assurance that third parties will not assert infringement
claims against Rational in the future with respect to current or future
products. Any such assertion could require Rational to enter into royalty
arrangements or result in costly litigation.
Employees
As of March 31, 1999, Rational employed 2,048 full-time personnel, including
726 in product development and support, 1,085 in sales, marketing, and
technical consulting, and 237 in finance and administration. Rational's
employees are not represented by any collective bargaining organization, and
Rational has never experienced a work stoppage. Rational believes its success
will depend in part on its continued ability to attract and retain highly
qualified personnel in a competitive market for experienced and talented
software engineers and sales and marketing personnel.
Executive Officers of the Registrant
The executive officers of the Registrant are as follows:
<TABLE>
<CAPTION>
Name Position
---- --------
<S> <C>
Paul D. Levy............ Chairman of the Board
Michael T. Devlin....... Chief Executive Officer and Director
David H. Bernstein...... Senior Vice President and General Manager, Products
Thomas F. Bogan......... Senior Vice President, Chief Operating Officer
Timothy A. Brennan...... Senior Vice President, Chief Financial Officer, and Secretary
James P. Cluchey........ Vice President, International Field Operations
Robert H. Dickerson..... Senior Vice President and General Manager, Products
</TABLE>
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<TABLE>
<S> <C>
Kevin J. Haar........... Vice President, The Americas Field Operations
John R. Lovitt.......... Senior Vice President, Worldwide Field Operations
Joseph N. Marasco....... Senior Vice President and General Manager
Eric L. Schurr.......... Vice President and General Manager, Corporate Marketing and Suite Products
</TABLE>
Paul D. Levy, age 43, cofounded Rational in 1981. He is currently Chairman
of the Board. Before April 1999, Mr. Levy served as Chief Executive Officer of
Rational. Mr. Levy is the son-in-law of James S. Campbell, a member of
Rational's Board of Directors.
Michael T. Devlin, age 44, cofounded Rational in 1981. He is currently Chief
Executive Officer and a Director. Before September 1996, Mr. Devlin served as
Chairman of the Board of Rational.
David H. Bernstein, age 47, joined Rational in 1982 as Vice President,
Product Development. In 1991, Mr. Bernstein was named Vice President and
General Manager of the Ada Business Unit. Mr. Bernstein was named Vice
President and General Manager, Object Technology Products, and Senior Vice
President and General Manager, Object Technology Products, in 1994 and 1995,
respectively. In May 1996, Mr. Bernstein was named Senior Vice President and
General Manager, Products.
Thomas F. Bogan, age 47, joined Rational as Vice President and General
Manager, Automated Test when Rational acquired SQA, Inc. In April 1999, Mr.
Bogan was named Senior Vice President, Chief Operating Officer. Prior to
joining Rational, in February 1997, Mr. Bogan served as Senior Vice President,
Finance and Administration, Chief Financial Officer, Treasurer, and Assistant
Secretary of SQA, Inc., since July 1996. Prior to joining SQA, Mr. Bogan was
President and Chief Executive Officer of Pacific Data Products, Inc., a
printer peripherals and networking vendor, from 1993 to 1996. Mr. Bogan is a
director of American Service Group, Inc, a health care provider.
Timothy A. Brennan, age 44, joined Rational as Corporate Controller in 1994.
In 1995, he was promoted to Vice President, Finance and Administration. In
January 1998, Mr. Brennan was named Senior Vice President, Chief Financial
Officer, and Secretary. From 1987 to 1994, Mr. Brennan held various financial
management and controllership positions with the ASK Group, Inc.
James P. Cluchey, age 51, joined Rational as Vice President, European
Operations when Rational acquired SQA, Inc. In 1997, Mr. Cluchey was named
Vice President, International Field Operations. Prior to joining Rational, Mr.
Cluchey served as Vice President, Managing Director of European Operations of
SQA since January 1995. From 1993 to 1995, Mr. Cluchey served as Vice
President Europe of ST Europe plc, a sales force automation software company
and a subsidiary of the Dun and Bradstreet group.
Robert H. Dickerson, age 42, joined Rational as Senior Vice President and
General Manager, Products when Rational acquired Pure Atria. From 1996 to
1997, he served as Vice President, Developer and Performix Products Groups for
Pure Atria. From 1995 to 1996, Mr. Dickerson served as Vice President of
Developer Tools for Pure Software. From 1994 to 1995 he served as Vice
President of Marketing for Pure Software. Prior to that, Mr. Dickerson was
Senior Vice President, Client/Server Division of Borland International.
Kevin J. Haar, age 42, is Vice President, The Americas Field Operations. He
joined Rational in 1986 as an account representative in the field sales force.
Since then, he has held a number of positions, most recently Vice President,
Major Accounts, North American Field Operations.
John R. Lovitt, age 54, joined Rational as a regional manager responsible
for sales and marketing in 1986. In 1990, he was promoted to Vice President,
and subsequently to Senior Vice President, North American Field Operations. In
November 1996, Mr. Lovitt was promoted to Senior Vice President, Worldwide
Field Operations, where he is responsible for worldwide field sales and
marketing and technical services.
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Joseph N. Marasco, age 53, is Senior Vice President and General Manager. He
joined Rational in 1986 as a product manager. Since then he has held a number
of positions in Rational, most recently, Senior Vice President, Operations.
Eric L. Schurr, age 41, joined Rational as Vice President, Product Marketing
Commercial IS Products when Rational acquired SQA, Inc. In 1998, Mr. Schurr
was named Vice President and General Manager, Corporate Marketing and Suite
Products. Prior to joining Rational, Mr. Schurr served as Vice President,
Product Management and Marketing of SQA since 1994. Mr. Schurr joined SQA in
1992 as the Director of Marketing. From 1983 to 1992, Mr. Schurr held various
field, technical, and marketing positions at Cognos, most recently as
Director, Marketing Support.
Factors That May Affect Future Results
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 revenues are 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 sales will also be sensitive to existing and prospective
customers' budgeting practices and global economic conditions.
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 resulted
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.
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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.
Dependence on Market Growth for Sophisticated Development Tools
Rational's future growth and financial performance will depend in part on
broad acceptance of off-the-shelf products that address critical elements of
the software development process including requirements management, modeling,
testing, configuration and change management. Sales of such 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 with the number of developers
using more traditional technology and products, or manual approaches. The
adoption of the Company's products by software developers who have
traditionally used other technology requires reorientation to significantly
different approaches to development. Customers may rely on internally
developed tools instead of off-the-shelf products, or customers may rely on
manual approaches instead of automated tools that require up-front capital
investment. The acceptance of the Company's products, therefore, may not
expand beyond sophisticated software developers who are early adopters of the
technology. Furthermore, potential customers may be unwilling to make the
investment required to retrain software developers to build software using the
Company's products rather than traditional 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.
Dependence on Acceptance of Industry Standards
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 developed the Unified Modeling
Language (UML) for visual modeling, which was adopted by the Object Management
Group (OMG), an industry consortium, for inclusion in its object analysis and
design facility specification. The official sanction in the future of a
competing standard by the OMG or the promulgation of a competing standard by
one or more major platform vendors 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 continue 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 both the Microsoft platform (including the Windows
95, Windows 98, and Windows NT operating systems) and the IBM platform. The
Company also believes its continued success will become increasingly dependent
on its ability to support Web-based development of business-critical
applications using the 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, Visual Java++, Java Beans, and other
implementation
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languages in order to be successful in its efforts to broaden its customer
base and further increase its share in its existing market segments. The
Company also believes that, over time, its products must be extended to
continually support the rapidly changing standards and technologies used in
the development of Web-based applications, as well as 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 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 in 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 on its ability to successfully compete with numerous
competitors at each point in its product line. Many of Rational's competitors
or potential competitors are much larger than the Company. As such, they may
have significantly more resources and more experience than the Company, and
could pose potential problems for Rational's competitive position. Moreover,
many of Rational's strategic partners compete with each other and this may
adversely impact Rational's relationship with an individual partner or a
number of partners. For more information on the competition Rational faces,
see "BUSINESS: Competition."
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 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
sustain and 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
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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 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.
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 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.
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
revenues. To the extent that the Company's new products or product
enhancements do not respond to technological change or evolving customer
requirements, 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 and Business Alliances
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
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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.
Rational's relationship with Microsoft includes, among other things, an
agreement for Rational to provide certain visual modeling technology to
Microsoft that is included in Microsoft's Visual Studio Products. Rational has
granted Microsoft the option to obtain a perpetual, non-exclusive right to
source code for certain aspects of the Rational Rose technology after the
expiration of the agreement.
In addition, there can be no assurance that one or more partners will not
use the information they gain from their relationship with Rational to develop
or market competing products.
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 and 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 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 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.
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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 allowances 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 40%, 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 certain 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 revenues generated by these
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 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. 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
macroeconomic problems in various markets or geographies in the future.
Risks Associated with Acquisitions
Rational acquired Pure Atria Corporation (Pure Atria) in 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. It is
possible that the continued integration of the companies' respective products
and the creation of certain integrated bundles and suites may not be
accomplished in a timely manner or may prove to be technologically infeasible.
The acquisition of Pure Atria was accounted for as a pooling of interests.
Accordingly, if such accounting treatment was to be nullified for any reason,
it would materially and adversely affect Rational's reputed earnings and,
potentially, its stock price.
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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.
Risks Associated with Asian Economic Crises
In addition to general risks associated with international operations listed
above, there are additional risks associated with the recent economic crisis
in Asia. Many of Rational's customers, who are based in either 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 and the
Americas. The Company has 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 the impact of the Asian
economic crisis both in Asia and in other geographies.
European Monetary Conversion
In January 1999, the new "Euro" currency was introduced in certain European
countries that are part of the European Monetary Union (EMU). During 2002, all
EMU countries are expected to begin operating with the Euro as their single
currency. A significant amount of uncertainty exists as to the effect the Euro
will have on the marketplace generally and, additionally, all of the final
rules and regulations have not yet been defined and finalized by the European
Commission with regard to the Euro currency. Rational is currently assessing
the effect the introduction of the Euro will have on internal accounting
systems and the sales of products. The Company is not aware of any material
operational issues or costs associated with preparing internal systems for the
Euro. However, the Company does utilize third-party vendor equipment and
software products that may or may not be EMU-compliant. Although the Company
is currently taking steps to address the impact, if any, of EMU compliance for
such third-party products, the failure of any critical components to operate
properly post-Euro may have an adverse effect on the business or results of
operations of the Company or require additional costs to remedy such problems.
Limited Protection of Intellectual Property and Proprietary Rights
Rational relies on a combination of copyright, trademark, patent, 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 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 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
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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 reductions 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 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, 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 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.
Third parties may assert infringement claims against the Company in the future
and such claims may or may 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."
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 the "more likely than not" criteria for recognition
which has not been met.
ITEM 2--PROPERTIES
Rational's headquarters are located in a leased facility, in Cupertino,
California, consisting of approximately 101,000 square feet of office space
occupied under a lease expiring in January 2007. Rational also leases
approximately 95,000 square feet of office space in Santa Clara, California,
under a lease expiring in January 2001, with a renewal option for an
additional five years, and approximately 98,000 square feet of office space in
Lexington, Massachusetts, under a lease expiring in December 2004. Rational
has additional field sales and software development offices in the Americas,
Europe, and Asia/Pacific regions.
ITEM 3--LEGAL PROCEEDINGS
The following actions have been filed against the Company, two of its
officers, and Cowen & Company: Randall v. Rational Software Corporation, et
al., No. C 97-03740 (N.D. Cal.); Sachs v. Rational Software Corporation, et
al., No. C-97-3845 (N.D. Cal.); Kalapa v. Rational Software Corporation, et
al., No. C-97-4028
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(N.D. Cal.); Weiner, et al. v. Rational Software Corporation, et al., No. C-
97-21086 (N.D. Cal.); Seiger v. Rational Software Corporation, et al., No. 97-
CV-7011 (E.D. N.Y.); Dolnick v. Rational Software Corporation, et al., No. 98-
CV-0268 (E.D. N.Y.); Lynch v. Rational Software Corporation, et al., No. CA-
97-2081-A (E.D. Va.). The actions are putative stockholder class action
lawsuits, and the complaints are virtually identical. The complaints allege
that defendants violated Sections 10(b) and 20A of the Securities Exchange Act
of 1934 through the selective disclosure of material inside information
regarding the Company's prospects and seek damages on behalf of a class of
stockholders who purchased the Company's common stock on October 8, 1997.
Defendants' motions to transfer the cases pending in New York and Virginia
have been granted, and all pending
actions will be consolidated in the Northern District of California. The Court
granted with leave to amend defendants motion to dismiss the Consolidated
Amended Complaint. Plaintiffs' obligation to file a second amended complaint
has been stayed pending resolution of a discovery dispute. The Company
believes the action is without merit and will continue to defend the case
vigorously.
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.
Any adverse outcome to these or future lawsuits against the Company may
result in a material adverse effect on the Company's financial condition.
ITEM 4--SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
PART II
ITEM 5--MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's common stock is traded on the NASDAQ national market under the
symbol RATL. As of June 11, 1999, there were approximately 1,480 stockholders
of record of the Company's common stock. The Company has not, since its
formation, declared or paid any cash dividends on its common stock. The
Company intends to employ all available funds for the development of its
business and, accordingly, does not intend to declare or pay any cash
dividends in the foreseeable future.
The following table sets forth the range of high and low bids for the
Company's common stock as quoted on the NASDAQ national market for Rational
Common Stock for the periods indicated:
<TABLE>
<CAPTION>
High Low
------ ------
<S> <C> <C>
Fiscal year ended March 31, 1999:
Fourth Quarter.............................................. $35.63 $22.88
Third Quarter............................................... 27.36 10.88
Second Quarter.............................................. 18.94 10.50
First Quarter............................................... 18.13 12.25
Fiscal year ended March 31, 1998:
Fourth Quarter.............................................. $13.81 $10.75
Third Quarter............................................... 15.50 8.06
Second Quarter.............................................. 22.50 14.00
First Quarter............................................... 23.38 10.94
</TABLE>
The foregoing reflects interdealer prices without retail markup, markdown, or
commissions and may not necessarily reflect actual transactions.
18
<PAGE>
ITEM 6--SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
Fiscal Year Ended March 31,
------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
(in thousands, except per share data)
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENTS OF
OPERATIONS DATA:
Net product revenues........ $259,335 $184,953 $185,133 $126,876 $ 74,688
Consulting and support
revenues................... 152,481 125,717 92,735 61,261 45,419
-------- -------- -------- -------- --------
Total revenues.......... 411,816 310,670 277,868 188,137 120,107
Cost of product revenues.... 22,020 19,709 11,777 9,735 7,989
Cost of consulting and
support revenues........... 40,848 43,356 38,305 26,779 22,016
-------- -------- -------- -------- --------
Total cost of revenues.. 62,868 63,065 50,082 36,514 30,005
-------- -------- -------- -------- --------
Gross margin................ 348,948 247,605 227,786 151,623 90,102
Operating expenses:
Research and development.. 71,869 61,560 47,239 33,773 23,379
Sales and marketing....... 172,448 138,709 108,403 80,063 47,388
General and
administrative........... 33,910 29,092 27,267 19,481 12,342
Charges for acquired in-
process research and
development.............. -- -- 56,798 20,300 --
Merger and integration
costs.................... (1,200) 63,759 42,456 2,961 (1,100)
-------- -------- -------- -------- --------
Total operating
expenses............... 277,027 293,120 282,163 156,578 82,009
-------- -------- -------- -------- --------
Operating income (loss)..... 71,921 (45,515) (54,377) (4,955) 8,093
Other income, net........... 12,721 16,689 11,586 4,234 1,331
-------- -------- -------- -------- --------
Income (loss) from
continuing operations
before income taxes........ 84,642 (28,826) (42,791) (721) 9,424
Provision for income taxes.. 25,393 9,447 6,820 7,115 2,036
-------- -------- -------- -------- --------
Net income (loss)....... $ 59,249 $(38,273) $(49,611) $ (7,836) $ 7,388
======== ======== ======== ======== ========
Net income (loss) per common
share (pro forma for
fiscal 1996 and 1995):
Basic..................... $ 0.69 $ (0.44) $ (0.62) $ (0.11) $ 0.12
Diluted................... $ 0.65 $ (0.44) $ (0.62) $ (0.11) $ 0.12
Shares used in computing per
share amounts:
Basic..................... 85,697 87,575 79,631 69,778 59,718
Diluted................... 91,849 87,575 79,631 69,778 61,860
CONSOLIDATED BALANCE SHEET
DATA:
Cash, cash equivalents, and
short-term investments..... $259,830 $289,470 $327,395 $167,623 $ 55,814
Working capital............. 228,366 228,397 282,974 145,383 45,219
Total assets................ 453,956 445,205 456,740 236,213 96,738
Long-term obligations....... 3,696 6,492 3,192 2,189 3,675
Redeemable convertible
preferred stock............ -- -- -- -- 14,363
Stockholders' equity........ 294,372 287,176 330,109 162,482 39,018
</TABLE>
19
<PAGE>
ITEM 7--MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The statements contained in "Management's Discussion and Analysis of
Financial Condition and Results of Operations" include forward-looking
information within the meaning of Section 27A of the Securities Act of 1933,
as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended, and are subject to the safe harbor created by those sections. Such
forward-looking statements include without limitation statements regarding
trends in overall revenues, revenue mix, liquidity and capital resources, and
year 2000 readiness. Rational's actual future results could differ materially
from those projected in the forward-looking information. Factors that could
cause actual results to differ materially include, without limitation, those
identified in "Factors That May Affect Future Results." Rational assumes no
obligation to update the forward-looking information or such factors.
Overview
General
Rational's revenues are derived from product license fees and charges for
services, including technical consulting, training, and customer support. In
accordance with generally accepted accounting principles, Rational software
license revenues are generally recognized when a customer purchase order has
been received and accepted, the software product has been shipped, there are
no uncertainties surrounding product acceptance, the fees are fixed and
determinable, and collection is considered probable. For customer license
agreements that meet these recognition criteria, the portion of the fees
related to software licenses will generally be recognized in the current
period, while the portion of the fees related to services is recognized as the
services are performed. Revenues from consulting and training are recognized
when earned. Rational's license agreements do not provide a right of return,
and reserves are maintained for potential credit losses, of which there have
been only immaterial amounts.
International sales accounted for 40%, 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
Rational's revenues in future periods. See "Factors That May Affect Future
Results: Risks Associated with International Operations; Limited Protection of
Intellectual Property and Proprietary Rights."
In the fiscal year ended March 31, 1999, Rational's revenues from product
sales grew 40% while revenues from consulting and support grew 21%, resulting
in a net overall increase in revenues of 33%. There can be no assurance that
this revenue mix trend will continue in future periods. See "Factors That May
Affect Future Results: Fluctuations in Operating Results; Expansion of Product
Lines; Dependence on New Product Introductions; Dependence on Growth of
Emerging Industries; Development of Industry Standards."
Although Rational has experienced increasing revenues in each of the past
five fiscal years, Rational's sales compensation structure has historically
contributed to 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 Rational will continue to experience increasing revenues or
that similar fluctuations will not occur again in the future. See "Factors
That May Affect Future Results: Fluctuations in Operating Results."
As a result of the Company's acquisition of Pure Atria Corporation in July
1997, accounted for as a pooling of interests, the information herein and the
accompanying consolidated financial statements are presented on a combined
basis for fiscal 1998 and all prior periods presented, as described in more
detail below.
Acquisitions
The Company has completed several business combinations over the past three
years, accounted for as poolings of interests which include Pure Atria
Corporation (July 1997), SQA, Inc. (February 1997), and Atria Software, Inc.,
(acquired by Pure Software, Inc., August 1996). See Note 3 of Notes to
Consolidated Financial Statements for details of these combinations.
The Company has completed several business combinations over the past three
years, accounted for as purchases which include Integrity QA Software, Inc.
(acquired by Pure Atria Corporation, January 1997), Performance Awareness
Corporation (March 1997), and others. See Note 4 of the Consolidated Financial
Statements for details of these combinations. See "Factors That May Affect
Future Results: Risks Associated with Acquisitions."
20
<PAGE>
Results of Operations
The following table sets forth for the periods indicated the percentage of
total revenues represented by certain line items from Rational's consolidated
statements of operations:
<TABLE>
<CAPTION>
Fiscal Year Ended March 31,
----------------------------------
1999 1998 1997
--------- --------- ---------
<S> <C> <C> <C>
Net product revenues........................ 63% 60% 67%
Consulting and support revenues............. 37 40 33
--------- --------- ---------
Total revenues.......................... 100 100 100
Cost of product revenues.................... 5 6 4
Cost of consulting and support revenues..... 10 14 14
--------- --------- ---------
Total cost of revenues.................. 15 20 18
--------- --------- ---------
Gross margin................................ 85 80 82
Operating expenses:
Research and development.................. 18 20 17
Sales and marketing....................... 42 45 39
General and administrative................ 8 9 10
Charges for acquired in-process research
and development.......................... -- -- 21
Merger and integration costs.............. -- 20 15
--------- --------- ---------
Total operating expenses................ 68 94 102
--------- --------- ---------
Income (loss) from continuing operations.... 17 (14) (20)
Other income, net........................... 3 5 4
--------- --------- ---------
Income (loss) before provision for income
taxes...................................... 20 (9) (16)
Provision for income taxes.................. 6 3 2
--------- --------- ---------
Net income (loss)....................... 14% (12)% (18)%
========= ========= =========
</TABLE>
See "Factors That May Affect Future Results: Fluctuations in Operating
Results."
Fiscal Years Ended March 31, 1999, 1998, and 1997
Revenues
Total revenues increased 33% in fiscal 1999 compared with fiscal 1998 and
12% in fiscal 1998 compared with fiscal 1997.
Net product revenues. Net product revenues increased $74 million or 40% in
fiscal 1999 compared with fiscal 1998. This increase is a result of continued
strong customer acceptance of the Company's existing products, including
products for requirements management, modeling, testing, change and
configuration management, the introduction of the Rational Suite family of
products, and the year to year increase in sales capacity. Net product
revenues in fiscal 1998 was flat compared with fiscal 1997. The flat net
product revenues in fiscal 1998 when compared with 1997 were due to several
factors surrounding the merger and acquisition activities of the Company.
These factors include disruption in the field sales organization caused by
territory realignment and new product training, conforming business practices,
conforming product packaging, and pricing. See "Factors That May Affect Future
Results: Fluctuation in Operating Results; Risks Associated with Acquisitions;
Dependence on Growth of Emerging Industries; Development of Industry
Standards; Expansion of Product Lines; Dependence on New Product
Introductions; Competition."
Consulting and support revenues. Consulting and support revenues increased
$27 million or 21% in fiscal 1999 compared with fiscal 1998 and $33 million or
36% in fiscal 1998 compared with fiscal 1997. These increases reflected higher
demand for Rational's consulting expertise in advanced software-development
21
<PAGE>
practices and, to a lesser extent, increased training and customer-support
revenues. See "Factors That May Affect Future Results: Expansion of Product
Lines; Dependence on New Product Introductions; Dependence on Sales Force and
Other Channels of Distribution."
International sales. During fiscal 1999, 1998, and 1997, international
revenues from product sales and related consulting and customer support were
$165.2 million, $106.9 million, and $73.7 million, representing 40%, 34%, and
27% of total revenues, respectively. The growth in international sales during
1999 was due principally to increased sales and marketing activities in
international markets. 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 local, or "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 nonfunctional 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 "Factors That May Affect Future Results: Rules Associated with
International Operations; Limited Protection of Intellectual Property."
Cost of Revenues
Cost of product revenues. Cost of product revenues consists principally of
materials, packaging and freight, amortization of purchased technology, and
royalties. Cost of product revenues increased 12% in fiscal 1999 compared with
fiscal 1998 and 67% in fiscal 1998 compared with fiscal 1997. These costs
represented 8%, 11%, and 6% of net product revenues in fiscal 1999, 1998, and
1997, respectively. In fiscal 1999, the decrease in product cost as a
percentage of product revenues was due primarily to better economies of scale
on materials and packaging and freight with respect to certain products as a
result of increased volume. In fiscal 1998, the increase in product cost as a
percentage of product revenues was due primarily to amortization of developed
technology acquired in mergers. See "Factors That May Affect Future Results:
Dependence on Sales Force and Other Channels of Distribution."
Cost of consulting and support revenues. Cost of consulting and support
revenues consists principally of personnel costs for training, consulting, and
customer support. Cost of consulting and support revenues decreased 6% in
fiscal 1999 compared with fiscal 1998 and increased 13% in fiscal 1998
compared with fiscal 1997. These costs represented 27%, 34%, and 41% of
consulting and support revenues in fiscal 1999, 1998, and 1997, respectively.
In fiscal 1999, the decrease in cost and cost as a percentage of related
revenues is primarily due to changes to the Company's customer support
business model as a result of combining the Pure Atria and Rational service
organizations, combined with the impact of a relatively fixed support cost
base servicing increased revenues. In fiscal 1998, the increase in dollar
amounts was the result of additional personnel and personnel-related expenses
needed to perform professional services in object modeling, advanced software-
development practices, and business process engineering. The cost decreases as
a percentage of consulting and support revenues resulted from an overall
higher mix of customer support services, which generally have a higher gross
margin than consulting services.
Operating Expenses
Research and development. Total expenditures for research and development
increased 17% in fiscal 1999 compared with fiscal 1998 and 30% in fiscal 1998
compared with fiscal 1997. Research and development costs represented 18%,
20%, and 17% of total revenues in fiscal 1999, 1998, and 1997, respectively.
The increases in fiscal 1999 as compared with fiscal 1998, and in fiscal 1998
as compared with fiscal 1997, were due primarily to the cost of additional
personnel and related costs incurred in maintaining existing products and
developing new product releases. See "Factors That May Affect Future Results:
Rapid Technological Change."
Rational did not capitalize any software-development costs in fiscal 1999,
1998, and 1997 because eligible costs were not material. Rational expects that
the amount of software-development costs capitalized in future periods will be
immaterial to Rational's results of operations and financial position because
the time period and
22
<PAGE>
the engineering effort required between demonstration of a product's economic
and technological feasibility and the date of product release has been very
short. See "Factors That May Affect Future Results: Risk of Software Defects;
Expansion of Product Lines; Dependence on New Product Introductions."
Sales and marketing. Sales and marketing expenses increased 24% in fiscal
1999 compared with fiscal 1998 and 28% in fiscal 1998 compared with fiscal
1997. These expenses represented 42%, 45%, and 39% of total revenues in fiscal
1999, 1998, and 1997, respectively. The fiscal 1999 and 1998 increases 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. The fiscal 1998 increase over fiscal 1997 also
included expenses associated with the merger with Pure Atria. See "Factors
That May Affect Future Results: Dependence on Sales Force and Other Channels
of Distribution."
General and administrative. General and administrative expenses increased
17% in fiscal 1999 compared with fiscal 1998 and 7% in fiscal 1998 compared
with fiscal 1997. General and administrative expenses represented 8%, 9%, and
10% of total revenues in fiscal 1999, 1998, and 1997, respectively. The
increases resulted from increased employee-related expenses associated with
staffing requirements needed to support the Company's expanding business.
While general and administrative expenses have decreased as a percentage of
total revenue in each of the last two years, there can be no assurance that
this trend will continue. See "Factors That May Affect Future Results:
Management of Growth; Risks Associated with Acquisitions."
Charges for acquired in-process research and development. In-process
research and development represents the present value of the estimated cash
flow expected to be generated by acquired technology that at the acquisition
date has not yet reached the point of technological feasibility and does not
have an alternative future use. In fiscal 1997, write-offs associated with
acquired in-process research and development included $17.6 million related to
the acquisition of the Visual Test product, $5.7 million related to the
acquisition of Requisite, Inc., $6.1 million related to the acquisition of
Softlab A.B., and $27.4 million related to the acquisition of Performance
Awareness Corporation. See "Factors That May Affect Future Results: Risks
Associated with Acquisitions."
Merger and integration costs. In fiscal 1999, the Company substantially
completed certain elements of the organizational integrations following the
July 1997 Pure Atria merger. This consisted primarily of exiting certain
nonstrategic consulting activities, realignment of marketing activities and
consolidation of certain sales offices. In the December 1998 quarter, charges
related to this activity, totaling approximately $3.3 million, were primarily
for severance costs associated with employee terminations, and charges
associated with facilities closures. These charges were offset by a reduction
of previously accrued facilities expenses related to the Pure Atria merger
totaling $4.5 million. The facilities expense reduction was due to greater-
than-expected recoveries from subleasing. The net impact in fiscal 1999 was a
merger and integration cost reduction of $1.2 million. The net cost reduction
of $1.2 million is the result of ongoing assessment and estimation of costs
associated with the prior combinations of Rational and other companies. Such
assessment will continue until all related costs are incurred or determinable.
In fiscal 1998, merger-related expenses of $63.8 million were recorded related
to the merger of Rational and Pure Atria to accrue transaction costs,
severance costs associated with employee terminations, costs associated with
conforming employee benefits plans, charges associated with the closure of
duplicate facilities, and asset writedowns related to duplicate business
systems. In fiscal 1997, merger-related expenses of $35.3 million and $7.2
million were recorded related to the mergers of Pure and Atria, and Rational
and SQA, respectively. The actions related to severance and administrative
costs are substantially complete. See "Factors That May Affect Future Results:
Risks Associated with Acquisitions; Management of Growth."
Visual Test Acquisition. In October 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. The purchase price of the
Visual Test product consisted of a single $23 million cash payment. Rational's
operating results for the quarter ended December 31, 1996, were reduced by a
nonrecurring charge of $17.6 million associated with the acquisition of the
Visual Test
23
<PAGE>
product. The charge to operations for acquired in-process research and
development represented the present value of the estimated cash flow expected
to be generated by Visual Test related technology, which at the acquisition
date had not yet reached the point of technological feasibility and did not
have an alternative future use.
Other Income, Net
Other income, net, consists of interest income, interest expense, gains and
losses on foreign currency transactions, and miscellaneous items of income and
expense. Other income has fluctuated as a result of operating results, the
amount of cash available for investment in interest-bearing accounts, and the
extent of foreign currency transactions. Other income, net, decreased $4
million to $12.7 million in fiscal 1999 and increased $5.1 million to $16.7
million in fiscal 1998. The decrease in fiscal 1999 is due primarily to a
lower average amount of invested cash resulting from repurchase of Company
common stock and to declining interest rates. The increase in fiscal 1998 is
due primarily to interest earned on cash generated from secondary public
offerings completed by Rational, which were completed in October 1996 and June
1995, and from the initial public offering completed by SQA, Inc., in December
1995. See "Factors That May Affect Future Results: Fluctuations in Operating
Results."
Income Taxes
The income tax provisions for fiscal 1999, 1998 and 1997 differ from tax
computed at the federal statutory income tax rate due to the impact of
nondeductible charges for acquired in-process research and development and
merger-related costs, foreign losses resulting in no U.S. tax benefit, as well
as foreign and state income taxes, offset by the realized benefit of net
operating loss carryforwards and research credit carryforwards.
As of March 31, 1999, Rational had net operating loss carryforwards for
federal income tax purposes of approximately $63.5 million that expire in
years 2001 through 2013. The Company also had tax credit carryforwards for
federal and state purposes of approximately $5.6 million and $2.0 million,
respectively, that expire in years 2000 through 2012, if not utilized. As a
result of various public offerings and business combinations, the Company and
some of its acquired entities experienced an ownership change as defined in
section 382 of the Internal Revenue Code. Due to the passing of time, the
Company's net operating loss carryforwards and tax credit carryforwards are no
longer subject to limitation.
Under Statement of Financial Accounting Standards No. 109 (FAS 109),
deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. FAS 109 provides for the recognition of
deferred tax assets if realization of such assets is more likely than not.
Based on the weight of available evidence, the Company has provided a
valuation allowance against certain tax credit carryforwards and the future
amortization of certain intangible assets. The Company will continue to
evaluate the realizability of the deferred tax assets on a quarterly basis.
See Note 11 of Notes to Consolidated Financial Statements. See "Factors That
May Affect Future Results: Deferred Tax Assets."
Liquidity and Capital Resources at March 31, 1999
As of March 31, 1999, Rational had cash, cash equivalents, and short-term
investments of $260 million and working capital of $228 million. Net cash
provided by operating activities for the period ended March 31, 1999, was
composed primarily of net income plus noncash charges for depreciation and
amortization, tax benefits from employee stock plans, increases in income
taxes payable and deferred revenues, and a decrease in noncash merger and
integration liabilities. These were offset primarily by a decrease in accrued
merger and integration expenses and increases in accounts receivable, deferred
tax assets, and prepaid expenses. Total cash, cash equivalents, and short-term
investments for the period ended March 31, 1998, was $289 million, and working
capital was $228 million. Net cash provided by operating activities for the
period ended March 31, 1998, was composed primarily of noncash charges for
depreciation and amortization and an increase in accrued merger and
integration costs, deferred revenues, and income taxes payable offset by the
Company's net loss and increases in accounts receivable, prepaid expenses, and
deferred tax assets.
24
<PAGE>
Net cash used in investing activities resulted primarily from net purchases
and maturities and sales of short-term investments of $36.6 million in fiscal
1999, $80.7 million in fiscal 1998, and $19.7 million in fiscal 1997 and
expenditures for fixed assets of $21.7 million in fiscal 1999, $30 million in
fiscal 1998, and $20.6 million in fiscal 1997. Net cash used for business and
product acquisitions totaled $15.5 million in fiscal 1998 and $70 million in
1997 (See Notes 3 and 4 of Notes to Consolidated Financial Statements).
Net cash used in financing activities in fiscal 1999 resulted primarily from
$118.1 million used to repurchase common stock and $2 million used to decrease
long-term debt, offset by $36 million received from issuance of common stock
under the employee stock plans. In fiscal 1998 financing activities generated
$9.6 million, of which $11.3 million was received from the issuance of common
stock upon the exercise of common stock options and $1.8 million was used to
decrease long-term debt and capital lease obligations. In fiscal 1997
financing activities generated $206 million, of which approximately $186
million was generated by the public offering of the Company's common stock in
October 1996. Also, the Company received net proceeds of approximately $20.6
million from the issuance of common stock under the employee stock plans.
In April 1998 the Board of Directors authorized the Company to repurchase up
to 6 million shares of its common stock in the open market to be used for
general corporate purposes. The Company completed that repurchase program
during the September 1998 quarter. In October 1998, the Board of Directors
authorized the Company to repurchase an additional 6 million shares of its
common stock in the open market to be used for general corporate purposes.
Through March 31, 1999, the Company had repurchased a total of 7 million
shares of its common stock, including repurchases authorized in April 1998 and
October 1998, for a total cash outlay of approximately $118.1 million.
Repurchases helped offset dilution from stock issued under the company's stock
option and stock purchase plans.
The Company believes that expected cash flow from operations combined with
existing cash, cash equivalents, and short-term investments will be sufficient
to meet its cash requirements for the foreseeable future. See "Factors That
May Affect Future Results: Fluctuations in Operating Results; Risks Associated
with Acquisitions."
Year 2000 Readiness Disclosure
The Company 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
internal information technology (IT) systems used by the Company for product
development, accounting, distribution, and planning. The problem may also
affect non-IT embedded systems such as building security systems, machine
controllers, and other equipment.
The Company established a year 2000 project team to develop and implement a
comprehensive four-phase year 2000 readiness plan for its worldwide operations
relating to (1) the Company's software products, (2) the Company's internal IT
and non-IT systems and (3) third-party customers, vendors, and others with
whom the Company does business. Phase One (Inventory) consisted of identifying
all the Company's systems, relationships, and products that may be impacted by
year 2000. Phase Two (Assessment) involved determining the Company's current
state of year 2000 readiness for those areas identified in the inventory phase
and prioritizing the areas that need to be fixed. Phase Three (Remediation)
consisted of developing a plan for those areas identified as needing
correction in the assessment phase. Phase Four (Implementation) consists of
executing the action plan and completing the steps identified to attain year
2000 readiness.
With respect to its software products, the Company has completed the
Inventory, Assessment, Remediation, and Implementation phases of the plan in
the course of developing new products and product upgrades, all of which have
been designed to be year 2000 compliant. Accordingly, the Company does not
currently sell or support any products that are not year 2000 compliant. The
Company did not separately track the internal costs of the research and
development efforts related to making its products year 2000 compliant, and
such costs were principally composed of salaries and benefits of software
engineering personnel. The Company funded these research and development costs
out of operating cash flows.
25
<PAGE>
With respect to its most critical internal IT systems, consisting of
accounting, data processing, and other systems, the Company has completed the
Inventory, Assessment, Remediation, and Implementation phases in the course of
introducing new systems and system upgrades to support the Company's recent
rapid growth, including growth through acquisitions. No such system
implementations were undertaken or accelerated for the sole purpose of
becoming year 2000 compliant, and it is not practicable to identify any
incremental costs related to year 2000 compliance involved in these system
implementations. As an additional precautionary measure, the Company plans to
conduct parallel testing of the primary accounting and sales tracking systems
in the three months ending September 30, 1999.
With respect to noncritical IT systems, consisting primarily of security
systems, fax machines and other miscellaneous systems, and non-IT embedded
systems, the Company has completed the Inventory and Assessment phases and is
currently executing the Remediation and Implementation phases. The Company
does not anticipate any material costs for completing the Remediation and
Implementation phases with respect to these noncritical IT and non-IT embedded
systems. The Company currently expects to fund all remediation and
implementation costs from operating cash flows and has not established any
specific reserves for these costs. The Company plans to complete all material
remediation of year 2000 systems by September 1999. The Company has not yet
incurred any material costs specifically related to becoming year 2000
compliant in its noncritical IT and non-IT embedded systems. As with critical
IT systems, discussed above, many of the Company's noncritical IT systems have
been replaced or upgraded to accommodate expanded business processes due to
recent growth and merger activity. No such system implementations were
undertaken or accelerated for the sole purpose of becoming year 2000
compliant.
The Company has completed the inventory phase of determining the year 2000
readiness of its significant suppliers, subcontractors, and customers that do
not share information systems with the Company, and has queried such third
parties about their year 2000 readiness. The Company has no means of ensuring
that these third parties will be year 2000 ready.
Based on information currently available to the Company, the Company
believes that the most reasonably likely worst case year 2000 scenarios with
respect to the Company relate to the potential failure of third-party
suppliers, subcontractors, and customers to become year 2000 compliant and, to
a lesser extent, the Company's potential failure to reach year 2000 compliance
with respect to noncritical IT and non-IT embedded systems. The inability of
suppliers, subcontractors, and customers to complete their year 2000
remediation processes in a timely fashion could result in delays in
introducing new products, reduced sales of new or existing products, and
disruptions in strategic relationships, which could in turn have a material
and adverse effect on the Company's results of operations and financial
condition. The effect of noncompliance by suppliers, subcontractors, and
customers is not reasonably quantifiable.
While the Company expects to attain year 2000 readiness with respect to
noncritical IT and non-IT embedded systems, there is no assurance that the
Company will be successful in its efforts to identify and address all year
2000 system issues on time. Failure to do so may adversely impact the
Company's results of operations or adversely affect the Company's
relationships with customers, vendors, or others. For example, failure to
achieve year 2000 readiness could delay the Company's ability to produce and
ship products, invoice customers, and collect payments, and could disrupt
customer service, technical support, and facilities. The Company could suffer
increased costs, lost sales, or other negative consequences resulting from
customer dissatisfaction, including litigation. Failures of security systems
relying on non-IT embedded systems could compromise the Company's operations
or ability to safeguard proprietary information.
The Company is currently evaluating year 2000 related contingency plans. The
Company plans to complete contingency planning with respect to noncritical IT
and non-IT embedded systems by September 1999.
The above discussion regarding costs, risks, and estimated completion dates
for the year 2000 is based on the Company's best estimates given information
that is currently available, and is subject to change. There can be no
assurance that actual costs will not substantially exceed the Company's
assessment due to internal year
26
<PAGE>
2000 problems or year 2000 problems associated with the Company's IT and non-
IT systems and products. In addition, while the Company believes it has
achieved year 2000 compliance with respect to its software products and
critical IT systems, there could be unanticipated year 2000 related failures
in such products or systems that could have a material and adverse effect on
the Company's results of operations and financial condition. Further, there
can be no guarantee that the systems of other companies on which the Company's
systems rely will be remediated in a timely manner, or that a failure to
remediate by another company, including without limitation any of the
Company's vendors, customers, or partners, or a remediation that is
incompatible with the Company's systems, would not have a material adverse
effect on the Company.
ITEM 7(A)--QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk, including changes in interest rates
and currency exchange rates. To manage the volatility relating to these
exposures, the Company employs established policies and procedures to manage
its exposure to fluctuations in interest rates and changes in known or
forecasted currency exchange rates.
Foreign Currency Risk
A portion of the Company's business is conducted in currencies other than
the U.S. dollar. Changes in the value of major foreign currencies relative to
the local or "functional" currency of the Company or its subsidiaries may
adversely effect operating results. The Company enters into short-term forward
foreign exchange contracts designed to mitigate the impact of foreign currency
exchange rate fluctuations on balance sheet exposures denominated in
currencies other than the "functional" currency. The total amount of these
contracts is approximately offset by the underlying assets and liabilities
denominated in nonfunctional currencies. Forward contracts are accounted for
on a mark-to-market basis with realized and unrealized gains or losses
recognized in the period in which they are incurred. Such contracts meet the
criteria established in FASB 52 for hedge accounting treatment. As the Company
finds it impractical to hedge all foreign currency exposures, the Company will
continue to experience foreign currency gains and losses. The Company does not
use derivative financial instruments for speculative trading purposes, nor
does it hold or issue leveraged derivative financial instruments.
At March 31, 1999 and 1998, the Company had outstanding forward exchange
contracts, all having maturities of less than 90 days, to exchange various
nonfunctional currencies for U.S. dollars or Dutch guilders in the aggregate
amounts (US dollar equivalent) of $34.3 million and $25.1 million,
respectively. The net gains and losses associated with all forward exchange
contracts in fiscal 1999, 1998, and 1997 are not material to the Company's
results of operations.
Interest Rate Risk
The Company's exposure to market rate risk for changes in interest rates
relates primarily to the Company's investment portfolio. All the Company's
cash equivalents and short-term investments are classified as available-for-
sale and are recorded at amounts that approximate fair value based on quoted
market prices at March 31, 1999 and 1998. Unrecognized gains and losses and
declines in value judged to be other than temporary on available-for-sale
securities are included in other income. The cost of securities sold is based
on the specific identification method. Realized gains and losses on sales of
available-for-sale securities were immaterial for the years ended March 31,
1999 and 1998. There were no significant unrealized holding gains or losses on
such securities at March 31, 1999 and 1998.
27
<PAGE>
ITEM 8--FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Rational Software Corporation
We have audited the accompanying consolidated balance sheets of Rational
Software Corporation as of March 31, 1999 and 1998, and the related
consolidated statements of operations, stockholders' equity, comprehensive
income (loss) and cash flows for each of the three years in the period ended
March 31, 1999. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits. In July 1997, the Company merged
with Pure Atria Corporation in a transaction which was accounted for as a
pooling of interests. We did not audit the Statement of Operations, Statement
of Cash Flows, or Statement of Equity of Pure Atria Corporation for the years
prior to fiscal 1998, which statements reflect net loss of approximately
$6,657,000 of the related 1997 consolidated financial statement totals. Those
statements were audited by other auditors whose report has been furnished to
us, and our opinion, insofar as it relates to data included for Pure Atria
Corporation is based solely on the report of the other auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits and the reports of other
auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the reports of the other auditors,
the financial statements referred to above present fairly, in all material
respects, the consolidated financial position of Rational Software Corporation
at March 31, 1999 and 1998, and the consolidated results of its operations,
comprehensive income (loss) and its cash flows for each of the three years in
the period ended March 31, 1999, in conformity with generally accepted
accounting principles.
/s/ Ernst & Young LLP
Palo Alto, California
April 14, 1999
28
<PAGE>
REPORT OF KPMG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Rational Software Corporation
We have audited the consolidated statements of operations, stockholders'
equity, and cash flows of Pure Atria Corporation and subsidiaries for the year
ended December 31, 1996 (none of which are separately presented herein). These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial positions of Pure
Atria Corporation and subsidiaries and the results of their operations and
their cash flows for the year ended December 31, 1996, in conformity with
generally accepted accounting principles.
/s/ KPMG LLP
Mountain View, California
January 21, 1997, except as to Note 2,
which is as of January 31, 1997
29
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
March 31,
--------------------
1999 1998
--------- ---------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents.............................. $ 59,965 $ 126,229
Short-term investments................................. 199,865 163,241
Accounts receivable, net of allowance for doubtful
accounts of $3,226 and $3,638 in 1999 and 1998,
respectively.......................................... 92,367 71,379
Deferred tax assets.................................... 22,881 11,846
Prepaid expenses and other assets...................... 9,176 7,239
--------- ---------
Total current assets................................. 384,254 379,934
Property and equipment, net.............................. 45,445 37,988
Other assets, net........................................ 24,257 27,283
--------- ---------
Total assets............................................. $ 453,956 $ 445,205
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable....................................... $ 13,848 $ 13,262
Accrued employee benefits.............................. 27,212 23,929
Income taxes payable................................... 19,652 15,259
Other accrued expenses................................. 16,304 18,345
Current portion of accrued merger and integration
expenses.............................................. 2,619 26,226
Deferred revenues...................................... 76,223 52,707
Current portion of long-term debt and lease
obligations........................................... 30 1,809
--------- ---------
Total current liabilities............................ 155,888 151,537
Accrued rent............................................. 896 720
Long-term accrued merger and integration expenses........ 2,800 5,600
Long-term debt........................................... -- 172
--------- ---------
Total liabilities........................................ 159,584 158,029
========= =========
COMMITMENTS AND CONTINGENCIES
Stockholders' equity:
Common stock, $0.01 par value, 150,000 shares
authorized, 93,381 and 88,975 shares issued and
outstanding in 1999 and 1998, respectively............ 933 890
Additional paid-in capital............................. 562,742 494,718
Treasury stock, 7,306 and 306 shares in 1999 and 1998,
respectively.......................................... (119,488) (1,340)
Accumulated deficit.................................... (146,013) (205,262)
Accumulated other comprehensive income (loss).......... (3,802) (1,830)
--------- ---------
Total stockholders' equity............................... 294,372 287,176
--------- ---------
Total liabilities and stockholders' equity............... $ 453,956 $ 445,205
========= =========
</TABLE>
See Notes to Consolidated Financial Statements
30
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Year Ended March 31,
----------------------------
1999 1998 1997
-------- -------- --------
<S> <C> <C> <C>
Net product revenues............................ $259,335 $184,953 $185,133
Consulting and support revenues................. 152,481 125,717 92,735
-------- -------- --------
Total revenues.............................. 411,816 310,670 277,868
Cost of product revenues........................ 22,020 19,709 11,777
Cost of consulting and support revenues......... 40,848 43,356 38,305
-------- -------- --------
Total cost of revenues...................... 62,868 63,065 50,082
-------- -------- --------
Gross margin.................................... 348,948 247,605 227,786
Operating expenses:
Research and development expenses............. 71,869 61,560 47,239
Sales and marketing expenses.................. 172,448 138,709 108,403
General and administrative expenses........... 33,910 29,092 27,267
Charges for acquired in-process research and
development.................................. -- -- 56,798
Merger and integration costs.................. (1,200) 63,759 42,456
-------- -------- --------
Total operating expenses...................... 277,027 293,120 282,163
-------- -------- --------
Operating income (loss)....................... 71,921 (45,515) (54,377)
Other income, net............................... 12,721 16,689 11,586
-------- -------- --------
Income (loss) before income taxes............. 84,642 (28,826) (42,791)
Provision for income taxes...................... 25,393 9,447 6,820
-------- -------- --------
Net income (loss)............................... $ 59,249 $(38,273) $(49,611)
======== ======== ========
Net income (loss) per share--basic.............. $ 0.69 $ (0.44) $ (0.62)
-------- -------- --------
Shares used in computing net income (loss) per
share--basic................................... 85,697 87,575 79,631
-------- -------- --------
Net income (loss) per share--diluted............ $ 0.65 $ (0.44) $ (0.62)
-------- -------- --------
Shares used in computing net income (loss) per
share--diluted................................. 91,849 87,575 79,631
======== ======== ========
</TABLE>
See Notes to Consolidated Financial Statements
31
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands)
<TABLE>
<CAPTION>
Stockholders' Equity
-------------------------------------------------------------------------
Common Stock Additional Cumulative Total
------------- Paid-In Treasury Accumulated Translation Stockholders'
Shares Amount Capital Stock Deficit Adjustment Equity
------ ------ ---------- --------- ----------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at March 31,
1996................... 75,390 $754 $233,150 $ (1,340) $ (70,070) $ (12) $162,482
Issuance of common
stock, net of
expenses of $675..... 5,446 55 190,673 -- -- -- 190,728
Exercise of common
stock options........ 2,697 27 10,465 -- -- -- 10,492
Issuance of common
stock under Employee
Stock Purchase Plan.. 945 9 5,726 -- -- -- 5,735
Tax benefit from
employee stock
plans................ -- -- 9,830 -- -- -- 9,830
Compensation expense
for stock option
grants............... -- -- 5,758 -- -- -- 5,758
Cumulative translation
adjustment........... -- -- -- -- -- (1,309) (1,309)
Net loss.............. -- -- -- -- (49,611) -- (49,611)
Net transactions of
SQA from January 1,
1997, to March 31,
1997................. 24 -- 151 -- (4,147) -- (3,996)
------ ---- -------- --------- --------- ------- --------
Balance at March 31,
1997................... 84,502 $845 $455,753 $ (1,340) $(123,828) $(1,321) $330,109
Exercise of common
stock options........ 2,057 22 5,141 -- -- -- 5,163
Issuance of common
stock under Employee
Stock Purchase Plan.. 698 6 6,178 -- -- -- 6,184
Cumulative translation
adjustment........... -- -- -- -- -- (53) (53)
Net loss.............. -- -- -- -- (38,273) -- (38,273)
Net transactions of
Pure Atria from
January 1, 1997, to
March 31, 1997....... 1,718 17 27,646 -- (43,161) (456) (15,954)
------ ---- -------- --------- --------- ------- --------
Balance at March 31,
1998................... 88,975 $890 $494,718 $ (1,340) $(205,262) $(1,830) $287,176
Exercise of common
stock options........ 3,553 34 27,745 -- -- -- 27,779
Issuance of common
stock under Employee
Stock Purchase
Plans................ 853 9 8,258 -- -- -- 8,267
Tax benefit from
employee stock
plans................ -- -- 32,021 -- -- -- 32,021
Treasury stock
repurchases.......... -- -- -- (118,148) -- -- (118,148)
Cumulative translation
adjustment........... -- -- -- -- -- (1,972) (1,972)
Net income............ -- -- -- -- 59,249 -- 59,249
------ ---- -------- --------- --------- ------- --------
Balance at March 31,
1999................... 93,381 $933 $562,742 $(119,488) $(146,013) $(3,802) $294,372
====== ==== ======== ========= ========= ======= ========
</TABLE>
See Notes to Consolidated Financial Statements
32
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
<TABLE>
<CAPTION>
Year Ended March 31,
---------------------------
1999 1998 1997
------- -------- --------
<S> <C> <C> <C>
Net income (loss).................................. $59,249 $(38,273) $(49,611)
Other comprehensive income:
Foreign currency translation adjustments, net of
tax of ($592), ($153), and ($393)................ (1,380) (356) (916)
------- -------- --------
Comprehensive income (loss)........................ $57,869 $(38,629) $(50,527)
======= ======== ========
</TABLE>
See Notes to Consolidated Financial Statements
33
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Year Ended March 31,
-------------------------------
1999 1998 1997
--------- --------- ---------
<S> <C> <C> <C>
Operating activities:
Net income (loss)............................ $ 59,249 $ (38,273) $ (49,611)
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Charges for acquired in-process research
and development........................... -- -- 56,798
Depreciation............................... 14,285 13,387 9,381
Amortization............................... 4,480 7,496 1,985
Compensation expense related to stock
options................................... -- -- 145
Tax benefits from employee stock plans..... 32,021 -- 9,830
Noncash merger and integration costs....... 5,699 7,625 7,109
Changes in operating assets and
liabilities:
Accounts receivable...................... (20,988) (8,336) (22,782)
Prepaid expenses and other, net.......... (1,937) (318) (904)
Deferred tax assets...................... (11,035) (4,851) (6,765)
Accounts payable......................... 586 (521) 7,112
Accrued employee benefits and other
accrued expenses........................ 1,418 5,671 3,250
Income taxes payable..................... 4,393 11,225 (2,052)
Accrued merger and integration expenses.. (32,106) (1,322) 21,288
Deferred revenues........................ 23,516 10,490 10,324
--------- --------- ---------
Net cash provided by operating
activities............................ 79,581 2,273 45,108
Investing activities:
Purchase of short-term investments........... (327,012) (486,710) (185,015)
Maturities and sales of short-term
investments................................. 290,388 406,008 165,314
Purchases of property and equipment.......... (21,742) (29,961) (20,648)
Proceeds from sale of fixed assets........... -- 4,850 --
Net changes in other assets.................. (1,454) (8,657) 74
Business combinations, net of cash acquired.. -- (15,498) (69,992)
--------- --------- ---------
Net cash used in investing activities........ (59,820) (129,968) (110,267)
Financing activities:
Principal payments under long-term debt and
capital lease obligations................... (1,951) (1,770) (965)
Net proceeds from issuances of common stock.. 36,046 11,347 206,810
Purchase of treasury stock................... (118,148) -- --
--------- --------- ---------
Net cash (used in) provided by financing
activities.................................. (84,053) 9,577 205,845
Effect of changes in foreign currency
exchange rate on cash....................... (1,972) (509) (502)
--------- --------- ---------
Net (decrease) increase in cash and cash
equivalents................................. (66,264) (118,627) 140,184
Cash and cash equivalents at beginning of
year........................................ 126,229 244,856 104,672
--------- --------- ---------
Cash and cash equivalents at end of year..... $ 59,965 $ 126,229 $ 244,856
========= ========= =========
Supplemental disclosure of cash flow
information:
Cash paid for income taxes................... $ 4,100 $ 2,577 $ 4,235
</TABLE>
See Notes to Consolidated Financial Statements
34
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 1999
1. Organization and Significant Accounting Policies
Organization and basis of presentation. Rational Software Corporation (the
Company) was incorporated under the laws of Delaware on July 28, 1982. The
Company develops, markets, and supports a comprehensive solution for companies
that depend on their ability to develop and deploy software. The Company
provides an integrated suite of software products and services designed to
improve the software development process.
The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries, including Pure Atria
Corporation and SQA, Inc., which merged with the Company effective July 30,
1997, and February 26, 1997, respectively. The historical consolidated
financial statements of the Company for all periods prior to such merger dates
have been restated to reflect the mergers, which have been accounted for as
poolings of interests. The consolidated financial statements at March 31,
1997, and for the year ended March 31, 1997, have been restated to include the
financial results of Pure Atria at December 31, 1996, and the year ended
December 31, 1996. All intercompany transactions and balances have been
eliminated upon consolidation.
Use of estimates. The preparation of the financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
Revenue recognition. The Company generally recognizes software license
revenues when a customer purchase order has been received and accepted, the
software product has been shipped, there are no uncertainties surrounding
product acceptance, the fees are fixed and determinable, and collection is
considered probable. For customer license agreements, which meet these
recognition criteria, the portion of the fees related to software licenses
will generally be recognized in the current period, while the portion of the
fees related to services is recognized as the services are performed. Revenues
from software royalties, whether they are advance payments that are
nonrefundable or minimum royalty guarantee payable over a fixed period, are
recorded when the earnings process is complete and collection is considered
probable. Revenues from consulting services are recognized when earned.
Customer-support revenues are deferred and recognized on a straight-line basis
over the period covered by the customer-support agreements. Contract revenues,
which generally represent special or custom engineering development with
milestone payments, are recognized under the percentage of completion method
in conformity with Accounting Research Bulletin No. 45, "Long-Term
Construction-Type Contracts," using the relevant guidance in Statement of
Position 81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts."
The Company adopted Statement of Position 97-2 "Software Revenue
Recognition" in fiscal 1999. This Statement supersedes Statement of Position
91-1 on software revenue recognition. This Statement establishes revenue
recognition criteria for arrangements to deliver software that do not require
significant production, modifications or customization of the software. This
Statement also establishes guidelines for recognizing revenues when multiple
elements exist in a software arrangement. The Company believes that the
adoption of this Statement did not have a material effect on its financial
statements for fiscal 1999.
Translation of local currencies. The Company's international subsidiaries
operate primarily using local functional currencies. Accordingly, all assets
and liabilities of these subsidiaries are translated using exchange rates in
effect at the end of the period, and revenues and costs are translated using
average exchange rates for the period. The resulting cumulative translation
adjustments are presented as a separate component of stockholders' equity.
Realized and unrealized exchange gains or losses from transaction adjustments
are reflected in operations and have not been material.
35
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
Other income. During the year ended March 31, 1999, other income consisted
primarily of interest earned on the Company's excess cash, cash equivalents,
and short-term investments and interest expense. It also included gains and
losses on foreign currency transactions.
Earnings (loss) per share. Calculation of earnings (loss) per share is as
follows (in thousands, except per share amounts):
<TABLE>
<CAPTION>
Year Ended March 31,
--------------------------
1999 1998 1997
------- -------- --------
<S> <C> <C> <C>
Numerator:
----------
Net income (loss)............................ $59,249 $(38,273) $(49,611)
Denominator:
------------
Denominator for basic net income (loss) per
share--weighted average shares.............. 85,697 87,575 79,631
Incremental common shares attributable to
shares issuable under employee stock plans
(Treasury Stock Method)..................... 6,152 -- --
------- -------- --------
Denominator for diluted net income (loss) per
share--weighted average shares and assumed
conversions................................. 91,849 87,575 79,631
------- -------- --------
Net income (loss) per share--basic........... $ 0.69 $ (0.44) $ (0.62)
------- -------- --------
Net income (loss) per share--diluted......... $ 0.65 $ (0.44) $ (0.62)
------- -------- --------
</TABLE>
The effect of options to purchase 185,112 shares of common stock were not
included in the computation of the 1999 diluted earnings per share because the
options' exercise price was greater than the average market price of common
shares.
Cash, cash equivalents, and short-term investments. Cash equivalents are
highly liquid investments with original maturity dates of three months or less
at the date of acquisition. Investments with maturity dates of greater than
three months are considered to be short-term investments.
All the Company's cash equivalents and short-term investments are classified
as available-for-sale and are recorded at amounts that approximate fair value
based on quoted market prices at March 31, 1999 and 1998. Unrecognized gains
and losses and declines in value judged to be other than temporary on
available-for-sale securities are included in interest income. The cost of
securities sold is based on the specific identification method.
Property and equipment. The Company's property and equipment are recorded at
cost and are generally depreciated over three- to five-year periods using the
straight-line method. The cost of furniture and equipment under capital leases
is recorded at the lower of the present value of the minimum lease payments or
the fair value of the asset and is amortized over the shorter of the term of
the related lease or the estimated useful life of the asset. Leasehold
improvements are depreciated over the remaining life of the lease.
In accordance with Statement of Financial Accounting Standards No. 121 (FAS
121), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed of," the Company is required to review for impairment
long-lived assets, certain identifiable intangibles, and goodwill related to
those assets whenever events or changes in circumstances indicate that the
carrying amount of an asset might not be recoverable. In certain situations,
an impairment loss has been recognized.
36
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
Stock-based compensation. The Company has elected to follow Accounting
Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to
Employees," and related interpretations in accounting for its employee stock
options, because the alternative fair value accounting provided for under FASB
Statement No. 123 (FAS 123), "Accounting for Stock-Based Compensation,"
requires use of option valuation models that were not developed for use in
valuing employee stock options. The Company generally grants stock options for
a fixed number of shares to employees with an exercise price equal to the fair
value of the shares at the date of grant, and accordingly, no compensation
expense is recorded. The Company recognizes compensation expense for those
options granted with an exercise price less than the fair value of the
underlying common stock at the date of grant.
Fair value of financial instruments. The carrying values reported in the
balance sheet for cash and cash equivalents, short-term investments, and long-
term debt approximate fair value. The fair value of short-term investments is
based on quoted market prices.
Advertising costs. The Company expenses advertising costs as incurred.
Advertising costs totaled $6.6 million, $6.5 million, and $4.1 million for the
years ended March 31, 1999, 1998, and 1997, respectively.
Reclassifications. Certain prior-year amounts have been reclassified to
conform with current-year presentation.
Recent pronouncements. In June 1998, the Financial Accounting Standards
Board (FASB) issued Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities" (FAS 133). FAS
133 is effective for all fiscal quarters of all fiscal years beginning after
June 15, 2000 . FAS 133 requires that all derivative instruments be recorded
on the balance sheet at their fair value. Changes in the fair value of
derivatives are recorded each period in either current earnings or other
comprehensive income, depending on whether a derivative is designated as part
of a hedge transaction and, if it is, the type of hedge transaction. For fair
value hedge transactions in which the Company is hedging changes in fair value
of an asset, liability or firm commitment, changes in the fair value of the
derivative instrument will generally be offset in the income statement by
changes in the fair value of the hedged item. For cash flow hedge
transactions, in which the Company is hedging the variability of cash flows
related to a variable-rate asset, liability, or a forecasted transaction,
changes in the fair value of the derivative instrument will be reported in
other comprehensive income. The gains and losses on the derivative instrument
that are reported in other comprehensive income will be reclassified as
earnings in the periods in which earnings are impacted by the variability of
the cash flows of the hedged item. The ineffective portion of all hedges will
be recognized in current earnings. The Company will adopt FAS 133 in fiscal
2002. Adoption of FAS 133 is not expected to have a material impact on the
Company's consolidated financial statements.
In June 1997, the Financial Accounting Standards Board issued Statement No.
130 (FAS 130), "Reporting Comprehensive Income." This statement requires that
all items required to be recognized under accounting standards as components
of comprehensive income be reported in a financial statement that is displayed
with the same prominence as other financial statements. The Company has
adopted this statement for the year ended March 31, 1999. Accumulated other
comprehensive income presented in the accompanying consolidated balance sheets
consists of the accumulated net unrealized gains and losses on foreign
currency translation adjustments, net of related tax effect, for all periods
presented.
In June 1997, FASB issued Statement No. 131 (FAS 131), "Disclosures about
Segments of an Enterprise and Related Information." This statement replaces
Statement No. 14 and changes the way public companies report segment
information. This Statement establishes standards for reporting information
about operating segments in annual financial statements. Operating segments
are defined as components of an enterprise
37
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
evaluated regularly by the Company's senior management in deciding how to
allocate resources and in assessing performance. The Company adopted FAS 131
for the fiscal year ended March 31, 1999, and has provided the required
disclosures in Note 12.
2. Risks Due to Concentrations
Concentrations of credit risk. Financial instruments that potentially
subject the Company to concentrations of credit risk consist primarily of cash
equivalents, short-term investments, and accounts receivable. The Company's
investment policy limits its exposure to concentrations of credit risk for
cash equivalents and short-term investments. The Company sells its products
primarily to major corporations that develop software and systems integrators
that serve a wide variety of international markets. Collateral or deposits
generally are not required from customers who demonstrate a positive credit
record and sound financial condition. The Company maintains reserves for
potential credit losses, and such losses have been within management's
expectations. No single customer accounted for 10% or more of total revenues
for all periods presented.
International sales. International sales currently account for approximately
40% of the Company's revenues, and the Company expects that international
sales will continue to account for a significant portion of the Company's
revenues in future periods. Any material adverse effect on the Company's
international business would have a material adverse effect on the Company's
financial statements. Also, the Company's international sales are generally
denominated in foreign currencies. Losses on the conversion of foreign-
denominated receivables into U.S. dollars may have a material adverse effect
on the Company's financial statements.
A portion of the Company's business is conducted in currencies other than
the U.S. dollar. Changes in the value of major foreign currencies relative to
the local or "functional," currency of the Company or its subsidiaries may
adversely effect operating results. The Company enters into short-term forward
foreign exchange contracts designed to mitigate the impact of foreign currency
exchange rate fluctuations on balance sheet exposures denominated in
currencies other than the "functional" currency. The total amount of these
contracts is approximately offset by the underlying assets and liabilities
denominated in nonfunctional currencies. Forward contracts are accounted for
on a mark-to-market basis with realized and unrealized gains or losses
recognized in the period in which they are incurred. Such contracts meet the
criteria established in FAS 52 for hedge accounting treatment. As the Company
finds it impractical to hedge all foreign currency exposures, the Company will
continue to experience foreign currency gains and losses. The Company does not
use derivative financial instruments for speculative trading purposes, nor
does it hold or issue leveraged derivative financial instruments.
At March 31, 1999 and 1998, the Company had outstanding forward exchange
contracts, all having maturities of less than 90 days, to exchange various
nonfunctional currencies for U.S. dollars or Dutch guilders in the aggregate
amounts (U.S. dollar equivalent) of $34.3 million and $25.1 million,
respectively. Two major U.S. multinational banks are counterparty to all these
contracts. The gains and losses associated with all forward exchange contracts
when combined with the gains and losses on the underlying exposures hedged in
fiscal 1999, 1998, and 1997 were not material to the Company's results of
operations.
3. Business Combinations: Poolings of Interests
Merger with Pure Atria Corporation. On July 30, 1997, the Company acquired
Pure Atria Corporation (Pure Atria) pursuant to which the Company issued
approximately 39.082 million shares of common stock. In addition, each
outstanding option or right to purchase Pure Atria common stock under various
stock option and purchase plans was assumed by the Company and became an
option or right to purchase the Company's common
38
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
stock. The number of shares of Pure Atria common stock subject to such assumed
options and rights was multiplied by the 0.9 exchange ratio in the acquisition
and the exercise price therefor was divided by the same exchange ratio. Pure
Atria was primarily involved in developing, marketing, and supporting a
comprehensive, integrated suite of software products that enabled the
production of reliable, high-quality software and improved the development
process. For income tax purposes, Pure Atria was acquired in a tax-deferred
reorganization. In addition, on August 26, 1996, Pure Software, Inc. acquired
Atria Software, Inc.(Atria), pursuant to which the Company issued
approximately 20.015 million shares of common stock. In addition, each
outstanding option or right to purchase Atria common stock under Atria's
various stock option and purchase plans was assumed by the Company. Each share
of Atria common stock subject to such assumed options or rights was multiplied
by the 1.3902 exchange ratio in the acquisition and the exercise price
therefor was divided by the same exchange ratio. Atria was primarily involved
in developing, marketing, and supporting software that facilitated the
management of complex software development, enhancement, and maintenance. For
income tax purposes, Atria was acquired in a tax-deferred reorganization. The
revenues and net income (loss) associated with Atria are presented in
connection with Pure Atria below.
Merger with SQA, Inc. On February 26, 1997, the Company acquired SQA, Inc.
(SQA), pursuant to which the Company issued approximately 6.997 million shares
of common stock. In addition, each outstanding option or right to purchase SQA
common stock under various stock option and purchase plans was assumed by the
Company and became an option or right to purchase the Company's common stock.
The number of shares of SQA common stock subject to such assumed options or
rights was multiplied by the 0.86 exchange ratio in the acquisition and the
exercise price therefor was divided by the same exchange ratio. SQA was
primarily involved in developing and marketing integrated software products
for the automated testing and quality management of Windows-based
client/server applications. For income tax purposes, SQA was acquired in a
tax-deferred reorganization.
These acquisitions were accounted for as poolings of interests, and
accordingly, the Company's consolidated financial statements and notes thereto
have been restated to include the financial position and results of these
mergers for all periods presented.
The following information shows revenues and net income (loss) of the
separate companies for the periods preceding the combination (in thousands):
<TABLE>
<CAPTION>
Three Months Year Ended
Ended June 30, March 31,
1997 1997
-------------- ----------
(unaudited)
<S> <C> <C>
Revenues:
Rational......................................... $42,928 $121,264
Pure Atria....................................... 23,220 132,495
SQA.............................................. -- 24,109
------- --------
Combined....................................... $66,148 $277,868
======= ========
Net income (loss):
Rational......................................... $ 7,814 $(40,518)
Pure Atria....................................... (2,686) 28,598
SQA.............................................. -- 4,765
Merger charges................................... -- (42,456)
------- --------
Combined....................................... $ 5,128 $(49,611)
======= ========
</TABLE>
39
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
Revenues and net loss of Pure Atria for the three months ended March 31,
1997, were $30 million and $43.2 million, respectively. These results include
the acquisition of Integrity QA in January 1997. (See Note 4.) Revenues and
net loss of SQA for the three months ended March 31, 1997, were $2.4 million
and $4.1 million, respectively. The net transactions of Pure Atria and SQA for
the three months ended March 31, 1997, have been included in the consolidated
statement of stockholders' equity as single line items and excluded from the
consolidated statements of operations and cash flows as a result of the
different fiscal year ends of these merged entities.
4. Business Combinations: Purchases
Purchase of Integrity QA Software, Inc. During January 1997, the Company
acquired all the outstanding shares of capital stock of Integrity QA Software,
Inc. (Integrity), and all outstanding warrants to purchase Integrity preferred
stock in exchange for 1,113,505 shares of common stock. The Company also
assumed all outstanding options to purchase Integrity common stock in exchange
for options to purchase 100,263 shares of the Company's stock. Integrity
developed, marketed, and supported quality assurance software products. As a
result of the acquisition, the Company recorded one-time pretax charges to
operations of $43.6 million for acquired in-process research and development
and $1.1 million for certain merger and integration expenses during the
quarter ended March 31, 1997. As a result of the different year ends of
Rational and Pure Atria, net transactions of Pure Atria for the quarter ended
March 31, 1997, which include the charge for acquired in-process research and
development, are reflected in the consolidated statements of redeemable
convertible preferred stock and stockholders' equity. The operating results of
Integrity are included in the consolidated results of the Company from the
date of acquisition. For income tax purposes, Integrity was acquired in a tax-
deferred reorganization.
Purchase of Performance Awareness Corporation. During March 1997, the
Company acquired all the outstanding shares of capital stock of Performance
Awareness Corporation for cash and assumed the outstanding Performance
Awareness employee stock options in exchange for options to purchase 250,000
shares of the Company's common stock. Performance Awareness developed,
marketed, and supported automated software quality products and related
services that provided solutions for the software testing market. The
aggregate purchase price (including direct acquisition costs) was $32.9
million in cash and fair value of options that were assumed by the Company.
The operating results of Performance Awareness are included in the
consolidated results of the Company from the date of acquisition.
Other business combinations: purchases. In fiscal 1997, the Company made
four separate purchase transactions relating to different software companies
and products. The aggregate purchase price (including direct acquisition
costs) was $38.9 million plus notes payable of approximately $2.8 million for
those acquisitions. Also, the Company assumed the outstanding employee stock
options from one acquisition in exchange for stock options to purchase 6,450
shares of common stock of the Company.
The Company has accounted for the acquisitions of Integrity QA, Performance
Awareness Corporation, and the other business combinations using the purchase
method, and accordingly, the operating results of the
40
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
respective companies are included in the consolidated results of the Company
from the dates of acquisition. The consolidated balance sheets include the
assets and liabilities of these businesses at March 31, 1998. The total
purchase price paid for each acquisition was allocated based on discounted
cash flow valuation techniques and is summarized as follows (in thousands):
<TABLE>
<CAPTION>
March 31,
-----------------------------------
1998 1997
--------- ------------------------
Performance Other
Integrity Awareness Business
QA Corporation Combinations
--------- ----------- ------------
<S> <C> <C> <C>
Property and equipment.................. $ 184 $ 894 $ 656
Intangible assets....................... -- 10,094 11,933
Severance and facility accruals......... (1,100) (3,573) (163)
Net assets (liabilities) acquired....... 102 (1,848) (128)
In-process research and development..... 44,700 27,362 29,436
-------- ------- -------
$ 43,886 $32,929 $41,734
======== ======= =======
</TABLE>
Intangible assets include developed technology, assembled work force,
customer base, trade name, and covenant not to compete. The estimated average
useful life of these assets is four years. Accumulated amortization of
intangible assets totaled $19.7 million and $11.4 million at March 31, 1999
and 1998, respectively. In-process research and development represents the
present value of the estimated cash flows expected to be generated by the
related technology from each acquisition, which at the date of purchase had
not yet reached the point of technological feasibility and did not have an
alternative future use. Therefore, in accordance with generally accepted
accounting principles, the in-process research and development was written off
and charged to operations during the quarter in which the purchase took place.
The unaudited combined pro forma results of operations of the Company for
fiscal 1997, assuming the business combinations had occurred at the beginning
of fiscal 1997, would have resulted in net revenues of $291.1 million, net
loss of $56.7 million, and net loss per share of $0.71, including nonrecurring
charges for acquired in-process research and development of $56.8 million. The
unaudited pro forma information is presented for illustrative purposes only
and is not necessarily indicative of the operating results that would have
occurred had the transactions been completed at the beginning of fiscal 1997,
nor is it necessarily indicative of future operating results.
41
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
5. Cash Equivalents and Short-Term Investments
The Company's short-term investments are as follows (in thousands):
<TABLE>
<CAPTION>
March 31,
-----------------
1999 1998
-------- --------
<S> <C> <C>
Bank certificates of deposit.............................. $ -- $ 10,529
U.S. treasury and agency obligations...................... 5,060 18,007
Municipal obligations..................................... 48,149 65,077
Corporate securities...................................... 146,656 69,628
-------- --------
Total................................................... $199,865 $163,241
======== ========
</TABLE>
Realized gains and losses on sales of available-for-sale securities were
immaterial for the years ended March 31, 1999 and 1998. There were no
significant unrealized holding gains or losses on such securities at March 31,
1999 and 1998.
Debt securities at March 31, 1999 and 1998, by contractual maturity, are
shown below (in thousands). Expected maturities may differ from contractual
maturities because issuers of the securities may have the right to prepay
obligations.
<TABLE>
<CAPTION>
March 31,
-----------------
1999 1998
-------- --------
<S> <C> <C>
Short-term investments:
Due in one year or less.................................. $140,031 $134,241
Due after one year....................................... 59,834 29,000
-------- --------
Total.................................................. $199,865 $163,241
======== ========
</TABLE>
6. Property and Equipment
Property and equipment is as follows (in thousands):
<TABLE>
<CAPTION>
March 31,
----------------
1999 1998
------- -------
<S> <C> <C>
Computer, office, and manufacturing equipment.............. $71,754 $62,063
Office furniture........................................... 10,535 9,184
Leasehold improvements..................................... 10,905 7,136
Construction in progress................................... 3,113 3,276
------- -------
96,307 81,659
Accumulated depreciation and amortization.................. (50,862) (43,671)
------- -------
Net property and equipment................................. $45,445 $37,988
======= =======
</TABLE>
42
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
7. Accrued Merger and Integration Expenses
Merger expenses consist principally of transaction fees for investment
bankers, attorneys, accountants, financial printing, and other related
charges. Integration costs include severance and other employee-related
charges, elimination of redundant facilities, write-off of excess property and
equipment and certain intangible assets, and other professional fees. Details
of the merger and integration provisions recorded at the time of the Pure
Atria, SQA, and Atria poolings of interests are as follows (in thousands):
<TABLE>
<CAPTION>
Severance
and Other Asset
Employee- Write-Offs
Transaction Related and Lease
Costs Charges Cancellations Other Total
----------- --------- ------------- ------ -------
<S> <C> <C> <C> <C> <C>
Provision recorded at
acquisition of Atria.... $ 8,319 $16,538 $5,998 $4,400 $35,255
Provision recorded at
acquisition of SQA...... 3,100 1,767 584 1,750 7,201
Change in estimate....... -- 960 (560) (400) --
Noncash write-offs....... -- (4,018) (2,451) (640) (7,109)
Cash payments............ (10,285) (3,469) (550) (2,313) (16,617)
------- ------- ------ ------ -------
Accrued as of March 31,
1997.................... 1,134 11,778 3,021 2,797 18,730
Provision recorded at
acquisition of Pure
Atria................... 15,629 18,339 19,352 10,439 63,759
Change in estimate....... -- -- -- -- --
Noncash write-offs....... -- -- (6,469) (1,156) (7,625)
Cash payments............ (15,556) (21,773) (2,006) (7,635) (46,970)
------- ------- ------ ------ -------
Accrued as of March 31,
1998.................... 1,207 8,344 13,898 4,445 27,894
Change in estimate....... (1,078) (668) (4,585) 5,131 (1,200)
Noncash write-offs....... -- -- (2,927) (2,772) (5,699)
Cash payments............ (129) (7,043) (1,600) (6,804) (15,576)
------- ------- ------ ------ -------
Accrued as of March 31,
1999.................... $ -- $ 633 $4,786 $ -- $ 5,419
======= ======= ====== ====== =======
</TABLE>
Severance and other employee-related charges. As a result of the mergers,
certain technical support, customer service, distribution, sales, marketing,
and administrative functions were combined and reduced. Approximately 26, 37,
and 20 employees were terminated in fiscal 1999, 1998, and 1997, respectively,
as a result of this activity. The Company also committed to pay noncontingent
retention bonuses and commissions to other employees, and these costs have
been included in the accrual. In addition, in fiscal 1997, certain employees
received accelerated vesting on their options in conjunction with their
termination subsequent to the merger, for which a compensation charge of $4
million was recorded.
Asset write-offs and lease cancellations. The Company has consolidated
duplicate offices in Europe and has relocated the North American headquarters
to a larger facility. The accrual includes lease payments resulting from the
planned closure of these facilities, which are expected to continue through
the lease term or penalties associated with early termination of the leases.
Certain intangibles that will have no benefit to the combined operations were
written off. Redundant property and equipment were either disposed of or
written down to their estimated net realizable value.
Other. Other consists of incurred costs associated with communication of the
merger to employees and costs associated with existing offices in Europe,
discontinuance of the Pure Vision product line, and termination of European
and Asian distributors. Payments associated with these activities were
primarily expended through the first quarter of 1997.
43
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
8. Notes Payable and Capital Lease Obligations
The Company leases certain equipment and furniture under capitalized lease
obligations. The related obligations under capitalized leases represent the
present value of future minimum lease payments. Assets capitalized under
leases were fully depreciated at March 31, 1999 and 1998. Notes payable to
former Softlab A.B. stockholders and capitalized lease obligations consist of
the following (in thousands):
<TABLE>
<CAPTION>
March 31,
------------
1999 1998
---- ------
<S> <C> <C>
Notes payable to former Softlab A.B. stockholders............ $-- $1,490
Present value of capital lease obligations................... 30 197
Other........................................................ -- 294
---- ------
30 1,981
Less current portion of notes payable and capital lease
obligations................................................. (30) (1,809)
---- ------
Due after one year........................................... $-- $ 172
==== ======
</TABLE>
9. Commitments and Contingencies
The Company leases its primary office space under operating leases. Rental
expense for facilities was approximately $12.3 million, $13.4 million, and
$7.2 million for the fiscal years ended March 31, 1999, 1998, and 1997,
respectively. Estimated future rents from sublease agreements are $3.1
million, $1.3 million, and $106,000 in fiscal 2000, 2001, and 2002,
respectively. Future minimum rental payments, net of sublease income, are as
follows for the fiscal years indicated as of March 31 (in thousands):
<TABLE>
<S> <C>
2000................................................................. $14,051
2001................................................................. 12,172
2002................................................................. 9,451
2003................................................................. 7,489
2004................................................................. 6,185
Thereafter........................................................... 10,184
-------
$59,532
=======
</TABLE>
As of March 31, 1999, the Company had two letters of credit outstanding in
the amount of $62,500 and $3 million guaranteeing certain rental payments at
its office locations in Lexington, Massachusetts, and Cupertino, California,
respectively.
Legal matters. The following actions have been filed against the Company,
two of its officers, and Cowen & Company: Randall v. Rational Software
Corporation, et al., No. C 97-03740 (N.D. Cal.); Sachs v. Rational Software
Corporation, et al., No. C-97-3845 (N.D. Cal.); Kalapa v. Rational Software
Corporation, et al., No. C-97-4028 (N.D. Cal.); Weiner, et al. v. Rational
Software Corporation, et al., No. C-97-21086 (N.D. Cal.); Seiger v. Rational
Software Corporation, et al., No. 97-CV-7011 (E.D. N.Y.); Dolnick v. Rational
Software Corporation, et al., No. 98-CV-0268 (E.D. N.Y.); Lynch v. Rational
Software Corporation, et al., No. CA-97-2081-A (E.D. Va.). The actions are
putative stockholder class action lawsuits, and the complaints are virtually
identical. The complaints allege that defendants violated Sections 10(b) and
20A of the Securities Exchange Act of 1934 through the selective disclosure of
material inside information regarding the Company's prospects and seek damages
on behalf of a class of stockholders who purchased the Company's common stock
on October 8, 1997. Defendants' motions to transfer the cases pending in New
York and Virginia have been granted, and all
44
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
pending actions will be consolidated in the Northern District of California.
The Court granted with leave to amend defendants motion to dismiss the
Consolidated Amended Complaint. Plaintiffs' obligation to file a second
amended complaint has been stayed pending resolution of a discovery dispute.
The Company believes the action is without merit and will continue to defend
the case vigorously.
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 itself.
From time to time, the Company is subject to legal claims. Historically, the
cost of resolution of the claims has not been significant. However, any
adverse outcome to these or future lawsuits against the Company may result in
a material adverse effect on the Company's financial condition.
10. Stockholders' Equity
Common stock. In July 1996, the Company's Board of Directors and
stockholders approved a two-for-one stock split payable in the form of a stock
dividend to stockholders. All share and per share information has been
adjusted to reflect this change.
During October 1996, the Company sold 5.188 million shares of common stock
in a public offering. Net proceeds from the sale were $186.4 million after
deducting underwriting discounts, commissions, and other related expenses.
Stock repurchase program. In April 1998, the Company's Board of Directors
authorized the purchase of up to 6 million shares of the Company's common
stock from time to time in the open market. The Company completed the
repurchase of these 6 million shares by August 1998 for an aggregate cost of
$98.4 million. In October 1998, the Company's Board of Directors authorized
the purchase of an additional 6 million shares. As of March 31, 1999, the
Company had repurchased approximately 1 million shares of its common stock
under this program for an aggregate cost of $19.8 million.
The stock repurchase program is intended to help offset the dilution
resulting from shares issued under the Company's employee stock plans. The
timing and size of any future stock repurchases are subject to market
conditions, stock prices, and Company's cash position and other cash
requirements going forward.
Stock options. The Company provides equity incentives to employees and
directors by means of incentive stock options and nonstatutory options which
historically have been provided under various stock option plans. The Company
now issues options from the Stock Option Plan for Directors, the 1997 Stock
Option Plan, and the 1997 Supplemental Plan. Stock options generally vest over
a period of four years. Under these plans, the Company may grant either
nonstatutory or incentive stock options, and the option price per share cannot
be less than 85% of fair value in the case of nonstatutory options, or 100% of
fair value in the case of incentive stock options, determined on the date that
the option is granted. Under these plans, the Company has reserved 17,857,700
shares for issuance at March 31, 1999. Options generally expire 10 years from
the date of grant.
45
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
Activity under the plans including options assumed by the Company in mergers
(adjusted for exchange ratios) is summarized as follows:
<TABLE>
<CAPTION>
Options Outstanding
---------------------
Weighted-
Shares Average
Available Exercise
for Grant Options Price
---------- ---------- ---------
<S> <C> <C> <C>
Balance at March 31, 1996.................... 2,528,664 10,273,708 $ 4.98
Additional shares authorized............... 6,256,659 -- --
Expiration of SQA option plans............. (123,036) -- --
Granted.................................... (9,041,372) 9,041,372 26.82
Exercised.................................. -- (2,697,828) 3.79
Canceled................................... 1,279,053 (1,279,053) 19.74
Expired or retired......................... (235,009) -- --
Net transactions of SQA during the period
from January 1, 1997,
to March 31, 1997......................... (94,385) 90,070 32.98
---------- ---------- ------
Balance at March 31, 1997.................... 570,574 15,428,269 $17.08
Net transactions of Pure Atria during the
period from January 1, 1997, to March 31,
1997...................................... 1,611,351 (416,912) 25.65
Additional shares authorized............... 4,350,000 -- --
Granted.................................... (6,523,621) 6,523,621 13.71
Exercised.................................. -- (2,056,891) 10.52
Canceled................................... 1,910,661 (1,910,661) 20.41
Expired or retired......................... (1,204,801) -- --
---------- ---------- ------
Balance at March 31, 1998.................... 714,164 17,567,426 $12.57
Additional shares authorized............... 4,450,000 -- --
Granted.................................... (6,138,937) 6,138,937 15.32
Exercised.................................. -- (3,552,847) 7.95
Canceled................................... 3,983,241 (3,983,241) 20.39
Expired or retired......................... (1,321,043) -- --
---------- ---------- ------
Balance at March 31, 1999.................... 1,687,425 16,170,275 $12.63
========== ========== ======
</TABLE>
In November 1997, the Company entered into agreements with most of its
employees to reprice (at the closing price for the Company's common stock on
November 14, 1997, of $10.00) employees' stock options for an aggregate of
approximately 6.9 million shares of common stock. In April 1998, the Company
entered into agreements with certain executive officers to reprice (at the
closing price for the Company's common stock on April 2, 1998, of $13.38)
employee stock options for an aggregate of approximately 1.7 million shares of
common stock. All employees participating in the repricing agreed to certain
limitations on the disposition of repriced options. The foregoing table has
not been adjusted for such repriced options.
46
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
At March 31, 1999, options to purchase 4,872,497 shares of common stock were
exercisable and unrestricted at a weighted-average exercise price of $12.21.
At March 31, 1999, the range of options outstanding and exercisable is as
follows:
<TABLE>
<CAPTION>
Options Exercisable
Options Outstanding and Unrestricted
--------------------------------- ---------------------
Weighted-
Average
Remaining Weighted- Weighted-
Range of Contractual Average Average
Exercise Shares Life Exercise Number Exercise
Prices Outstanding (years) Price Exercisable Price
-------- ----------- ----------- --------- ----------- ---------
<S> <C> <C> <C> <C> <C>
$0.09-$9.89 1,416,294 5.83 $ 4.40 1,116,191 $ 3.83
$10.00 5,003,686 7.50 10.00 999,962 10.00
$10.06-$10.38 1,143,530 8.55 10.36 238,196 10.35
$10.48-$11.13 1,887,299 9.27 11.10 328,454 11.00
$11.18-$12.31 1,078,659 8.63 11.57 247,249 11.51
$13.37-$13.38 2,222,900 8.18 13.37 977,886 13.38
$13.56-$21.69 2,071,510 9.15 17.43 307,842 16.16
$21.69-$41.94 1,346,397 8.54 27.31 656,717 27.58
---------- ---- ------ --------- ------
16,170,275 8.10 $12.63 4,872,497 $11.65
========== ==== ====== ========= ======
</TABLE>
Employee Stock Purchase Plans. During fiscal 1999, all remaining shares
previously approved by the stockholders for the "1994 Employee Stock Purchase
Plan" were issued. In July 1998, the "1998 Employee Stock Purchase Plan" was
approved by the shareholders with an initial 2 million shares reserved. Under
both plans, substantially all employees may purchase common stock through
payroll deductions at a price equal to 85% of the lower of fair values as of
the date of the employee's entrance into the plan or the end of each six month
purchase period. Employees may elect to have up to 10% of their compensation
withheld to purchase company stock, with a value not to exceed $25,000 in any
calendar year. During fiscal 1999, approximately 853,000 shares were issued
under the plans.
Stock-based compensation. Pro forma information regarding net income (loss)
and earnings (loss) per share is required by FAS 123 for awards granted or
modified after December 31, 1994, as if the Company had accounted for its
stock-based awards to employees under the fair value method of FAS 123. The
fair value of the Company's stock-based awards to employees was estimated
using a Black-Scholes option pricing model. The Black-Scholes model requires
the input of highly subjective assumptions, including the expected stock price
volatility. Because the Company's stock-based awards to employees have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its stock-
based awards to employees. The fair value of the Company's stock-based awards
to employees was estimated assuming no expected dividends and the following
weighted-average assumptions:
<TABLE>
<CAPTION>
Year ended March 31,
-----------------------------
Stock Options ESPP
-------------- --------------
1999 1998 1997 1999 1998 1997
---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C>
Expected life (in years)....................... 3.35 3.02 4.26 0.60 0.50 0.50
Expected volatility............................ 0.72 0.60 0.55 0.67 0.60 1.02
Risk-free interest rate........................ 5.21 5.80 6.36 5.15 5.54 5.38
</TABLE>
47
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
For pro forma purposes, the estimated fair value of the Company's stock-
based awards to employees is amortized over the options' vesting period (for
options) and the six-month purchase period (for stock purchases under the
ESPP). The Company's pro forma information is as follows (in thousands, except
for per share amounts):
<TABLE>
<CAPTION>
Year Ended March 31,
--------------------------
1999 1998 1997
------- -------- --------
<S> <C> <C> <C>
Net income (loss):
As reported................................... $59,249 $(38,273) $(49,611)
Pro forma..................................... 13,635 (90,277) (67,636)
Basic net income (loss) per share:
As reported................................... $ 0.69 $ (0.44) $ (0.62)
Pro forma..................................... 0.16 (1.03) (0.85)
Diluted net income (loss) per share:
As reported................................... $ 0.65 $ (0.44) $ (0.62)
Pro forma..................................... 0.15 (1.03) (0.85)
</TABLE>
The effects of applying FAS 123 in this pro forma disclosure are not
indicative of future amounts. FAS 123 does not apply to awards made prior to
1995. Additional awards in future years are anticipated.
The weighted-average fair value of options granted at market value during
fiscal 1999, 1998, and 1997 was $7.76, $5.63, and $12.55 per share,
respectively. The weighted-average fair value of employee stock purchase
rights during fiscal 1999, 1998, and 1997 was $4.82, $4.17, and $4.65 per
share, respectively.
48
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
11. Income Taxes
Income (loss) before income taxes and the provision for income taxes consist
of the following (in thousands):
<TABLE>
<CAPTION>
March 31,
----------------------------
1999 1998 1997
-------- -------- --------
<S> <C> <C> <C>
Income (loss) before income taxes:
United States.................................. $ 51,372 $ 424 $(17,743)
Foreign........................................ 33,270 (29,250) (25,048)
-------- -------- --------
Total........................................ $ 84,642 $(28,826) $(42,791)
======== ======== ========
Provision for income taxes:
Current:
Federal........................................ $ 1,469 $ 9,908 $ 607
State.......................................... 3,120 2,220 896
Foreign........................................ 3,904 2,170 1,877
-------- -------- --------
Total........................................ $ 8,493 $ 14,298 $ 3,380
-------- -------- --------
Deferred:
Federal........................................ $(13,858) $ (5,988) $ (6,358)
State.......................................... (1,263) (375) (32)
-------- -------- --------
Total........................................ $(15,121) $ (6,363) $ (6,390)
-------- -------- --------
Charge in lieu of taxes attributable to employee
stock plans..................................... $ 32,021 -- $ 9,830
Charge in lieu of taxes resulting from initial
recognition of acquired tax benefits that were
allocated to reduce intangible assets related to
the acquired entity............................. -- 1,512 --
-------- -------- --------
$ 25,393 $ 9,447 $ 6,820
======== ======== ========
</TABLE>
The provision for income taxes differs from the amount of income tax
determined by applying the applicable U.S. statutory federal income tax rate as
a result of the following differences (in thousands):
<TABLE>
<CAPTION>
Year Ended March 31,
---------------------------
1999 1998 1997
------- -------- --------
<S> <C> <C> <C>
Income tax provision (benefit) at the federal
statutory rate............................... $29,625 $(10,089) $(14,977)
Tax benefit of net operating loss
carryforwards................................ (7,027) (19,260) (6,361)
Tax benefit of research credit carryforwards.. (3,000) -- --
Nondeductible charges for acquired in-process
research and development..................... -- -- 19,879
State income taxes (net of federal benefit)... 5,502 1,845 750
Foreign taxes in excess of U.S. statutory
rates........................................ 1,333 651 1,700
Nondeductible merger-related costs............ -- 6,075 5,781
Foreign losses not resulting in a U.S. tax
benefit...................................... -- 21,297 --
Change in valuation allowance................. (1,474) 7,562 315
Other......................................... 434 1,366 (267)
------- -------- --------
Total......................................... $25,393 $ 9,447 $ 6,820
======= ======== ========
</TABLE>
49
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
Significant components of the Company's deferred tax assets are as follows
(in thousands):
<TABLE>
<CAPTION>
March 31,
------------------
1999 1998
-------- --------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards........................... $ 22,218 $ 9,734
Tax credit carryforwards................................... 6,865 5,850
Allowances, reserves, and accrued expenses................. 9,240 21,706
Property, equipment, and intangibles....................... 6,058 6,326
Other...................................................... 1,928 2,158
-------- --------
Gross deferred tax assets................................. 46,309 45,774
Less valuation allowance.................................. (11,100) (31,023)
-------- --------
Total deferred tax assets................................. 35,209 14,751
Deferred tax liabilities:
Unremitted earnings of foreign subsidiaries................ (5,337) --
-------- --------
Net deferred tax assets..................................... $ 29,872 $ 14,751
======== ========
</TABLE>
The valuation allowance decreased by $19.9 million and $7.4 million in 1999
and 1998, respectively. In 1999, approximately $18.4 million of such decrease
was attributable to the tax benefit associated with employee stock plans and
was credited to additional paid-in capital.
FASB Statement No. 109 provides for the recognition of deferred tax assets
if realization of such assets is more likely than not. Based on the weight of
available evidence, the Company has provided a valuation allowance against
certain tax credit carryforwards and the future amortization of certain
intangible assets. The Company will continue to evaluate the realizability of
the deferred tax asset on a quarterly basis.
At March 31, 1999, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $63.5 million that expire in 2001
through 2013. The Company also had tax credit carryforwards for federal and
state purposes of approximately $5.6 million and $2 million, respectively,
that expire in 2000 through 2012, if not utilized. As a result of various
public offerings and business combinations, the Company and some of its
acquired entities experienced an ownership change as defined in section 382 of
the Internal Revenue Code. Due to the passing of time, the Company's net
operating loss carryforwards and tax credit carryforwards are no longer
subject to limitation.
50
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
March 31, 1999
12. Segment Information
The Company has adopted FAS 131 for the fiscal year ended March 31, 1999.
The Company's software products and related services are developed and
marketed to support heterogeneous environments in a broad customer base.
Management uses one measurement of profitability for its business within a
single operating segment. The Company markets its software products and
related services in the United States, Europe, and other parts of the world.
Revenues and long-lived asset information are as follows (in thousands):
<TABLE>
<CAPTION>
Year Ended March 31,
--------------------------
1999 1998 1997
-------- -------- --------
<S> <C> <C> <C>
Revenues:
United States................................... $246,650 $203,810 $204,136
Europe.......................................... 121,848 82,202 56,398
Other........................................... 43,318 24,658 17,334
-------- -------- --------
Consolidated.................................... $411,816 $310,670 $277,868
======== ======== ========
Long-lived assets:
United States................................... $ 60,178 $391,951 $424,520
Europe.......................................... 6,117 38,011 28,363
Other........................................... 3,407 15,243 3,857
-------- -------- --------
Consolidated.................................... $ 69,702 $445,205 $456,740
======== ======== ========
</TABLE>
"Other" represents Canada, Latin America, and the Asia/Pacific region.
Export sales out of the U.S. have been made primarily to customers in Europe,
Australia, and Canada and represent less than 10% of U.S. revenues in all
periods.
13. Quarterly Information (Unaudited)
The following table presents unaudited quarterly operating results for each
of the Company's eight quarters in the two-year period ended March 31, 1999.
The quarters prior to the Company's merger with Pure Atria Corporation have
been restated and presented on a combined basis as follows (in thousands,
except per share amounts).
<TABLE>
<CAPTION>
Quarter Ended
-----------------------------------------
June 30 September 30 December 31 March 31
------- ------------ ----------- --------
<S> <C> <C> <C> <C>
Fiscal 1999:
Total revenues...................... $82,971 $94,656 $109,133 $125,056
Gross margin........................ 67,208 79,759 93,674 108,307
Operating income.................... 8,321 14,194 22,525 26,881
Net income.......................... 8,005 12,200 17,954 21,090
Net income per share--basic......... 0.09 0.14 0.21 0.25
Net income per share--diluted....... 0.09 0.14 0.20 0.23
Fiscal 1998:
Total revenues...................... $66,148 $74,968 $ 82,306 $ 87,248
Gross margin........................ 50,865 61,052 65,612 70,076
Operating income (loss)............. 1,919 (69,386) 9,820 12,132
Net income (loss)................... 5,128 (64,619) 10,368 10,850
Net income (loss) per share--basic.. .06 (0.74) 0.12 0.12
Net income (loss) per share--
diluted............................ .06 (0.74) 0.11 0.12
</TABLE>
51
<PAGE>
ITEM 9--CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10--DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Reference is made to "election of directors" in the Company's proxy
statement for the 1999 annual meeting of stockholders, incorporated by
reference herein.
ITEM 11--EXECUTIVE COMPENSATION
Reference is made to "executive compensation" and "performance graph" in the
Company's proxy statement for the 1999 annual meeting of stockholders,
incorporated by reference herein.
ITEM 12--SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Reference is made to "beneficial ownership of common stock" in the Company's
proxy statement for the 1999 annual meeting of stockholders, incorporated by
reference herein.
ITEM 13--CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Reference is made to "certain transactions" in the Company's proxy statement
for the 1999 annual meeting of stockholders, incorporated by reference herein.
PART IV
ITEM 14--EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. FINANCIAL STATEMENTS
See Item 8 of this Form 10-K.
2. FINANCIAL STATEMENT SCHEDULES
The following financial statement schedule of the Company for each of the
years ended March 31, 1999, 1998, and 1997, is filed as part of this Form 10-K
and should be read in conjunction with the consolidated financial statements
and related notes thereto of the Company.
<TABLE>
<CAPTION>
Page Number
-----------
<S> <C>
Schedule II--Valuation and Qualifying Accounts................... S-1
</TABLE>
Schedules other than those listed above have been omitted because they are
either not required or not applicable or because the information is otherwise
included.
52
<PAGE>
3. EXHIBITS
<TABLE>
<CAPTION>
Exhibit
-------
<C> <S>
3.01 Certificate of Incorporation as amended through July 30, 1997, is
incorporated herein by reference to Exhibit 3.1 filed with the
Registrant's Form 10-Q dated November 14, 1997.
3.02 Bylaws as amended through April 1998 is incorporated by reference to
Exhibit 3.02 filed with the Registrant's Form 10-K dated June 1,
1998.
4.01 Reference is made to Exhibits 3.01 and 3.02.
4.02 Specimen of Common Stock Certificate is incorporated by reference to
Exhibit 4.06 filed with the Registrant's Amendment No. 1 to Form S-3
Registration Statement on May 31, 1995 (File No. 33-91740).
10.01 Relocation Agreement with David Bernstein is incorporated herein by
reference to Exhibit 10 filed with the Registrant's Form 10Q dated
November 14, 1997.
10.02* Form of Employment Agreement is incorporated herein by reference to
Exhibit 10.03 filed with the Registrant's Form 10-K dated June 1,
1998.
10.03* Form of Employment Agreement is incorporated herein by reference to
Exhibit 10.04 filed with the Registrant's Form 10-K dated June 1,
1998.
10.04 Form of Stock Option Repricing Agreement is incorporated herein by
reference to Exhibit 10.05 filed with the Registrant's Form 10-K
dated June 1, 1998.
10.05 Form of Director and Officer Indemnification Agreement incorporated
herein by reference to Exhibit 10.1 filed with the Registrant's
Registration Statement on Form S-4, dated January 17, 1997, as
amended on January 17, 1997.
10.6* Rational Software Corporation Stock Option Plan for Directors is
incorporated herein by reference to Exhibit 1 filed with the
Registrant's Form 8-K Current Report dated October 2, 1996.
10.7* Form of Stock Option Agreements for the Rational Software
Corporation Stock Option Plan for Directors is incorporated herein
by reference to Exhibit 4.6 filed with the Registrant's Form S-8
Registration Statement on September 18, 1995 (Registration No. 33-
97042).
21.01 Subsidiaries of the Registrant.
23.01 Consent of Ernst & Young LLP, independent auditors.
23.02 Consent of KPMG LLP.
24.01 Power of attorney is contained on the signature pages of this
registration statement.
27.1 Annual financial data schedule.
</TABLE>
--------
* Indicates those exhibits that are management contracts or compensatory
plans or arrangements required to be filed as an exhibit to this form.
(b) REPORTS ON FORM 8-K
None.
53
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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
Date: June 28, 1999
/s/ Timothy A. Brennan
_____________________________________
Timothy A. Brennan
Senior Vice President,
Chief Financial Officer, and
Secretary
POWER OF ATTORNEY
KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Paul D. Levy and Timothy A. Brennan,
jointly and severally, as such person's true and lawful attorneys-in-fact and
agents, each with full power of substitution, for such person, in any and all
capacities, to sign any and all amendments (including post-effective
amendments) to this report on Form 10-K, and to file with same, with all
exhibits thereto and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents full power and authority to do and perform each and every act and thing
requisite and necessary to be done in connection therewith, as full to all
intents and purposes as such person might or could do in person, hereby
ratifying and confirming all that said attorney-in-fact and agent, or his
substitutes, may do or be done by virtue hereof. Pursuant to the requirements
of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has
been signed below by the following persons on behalf of the Registrant and in
the capacities and on the dates indicated:
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ Paul D. Levy Chairman of the Board June 28, 1999
____________________________________
Paul D. Levy
/s/ Michael T. Devlin Chief Executive Officer and June 28, 1999
____________________________________ Director
Michael T. Devlin
/s/ Timothy A. Brennan Senior Vice President, Chief June 28, 1999
____________________________________ Financial Officer, and
Timothy A. Brennan Secretary (principal
financial officer and
principal accounting
officer)
/s/ James S. Campbell Director June 28, 1999
____________________________________
James S. Campbell
/s/ Daniel H. Case III Director June 28, 1999
____________________________________
Daniel H. Case III
/s/ Leslie G. Denend Director June 28, 1999
____________________________________
Leslie G. Denend
/s/ John E. Montague Director June 28, 1999
____________________________________
John E. Montague
/s/ Allison R. Schleicher Director June 28, 1999
____________________________________
Allison R. Schleicher
</TABLE>
54
<PAGE>
RATIONAL SOFTWARE CORPORATION
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
Years Ended March 31, 1999, 1998, and 1997
(in thousands)
<TABLE>
<CAPTION>
Balance at Balance at
Beginning Ending of
of Period Additions Deductions Period
---------- --------- ---------- ----------
<S> <C> <C> <C> <C>
March 31, 1999
Allowance for doubtful accounts.... $3,638 $ -- $ (412) $3,226
March 31, 1998
Allowance for doubtful accounts.... $4,001 $ 664 $(1,027) $3,638
March 31, 1997
Allowance for doubtful accounts.... $2,124 $3,310 $(1,433) $4,001
</TABLE>
INDEX OF ATTACHED EXHIBITS
<TABLE>
<C> <S>
21.01 Subsidiaries of Registrant.
23.01 Consent of Ernst & Young LLP, Independent Auditors.
23.02 Consent of KPMG LLP, Independent Auditors.
27.1 Annual financial data schedule.
</TABLE>
For documents incorporated by reference, see Item 14(a)(3) above.
55
<PAGE>
EXHIBIT 21.01
LIST OF WHOLLY OWNED SUBSIDIARIES
RATIONAL SOFTWARE CORPORATION
<TABLE>
<CAPTION>
JURISDICTION OF
NAME INCORPORATION
- ---- ---------------
<S> <C>
Rational Software Holdings Corp. Delaware
Rational Software Technology Corp. Delaware
Rational Software SPC Corp. Delaware
Rational International California
Rational Software Canada Co. Canada
Rational Software Corporation Ltd. United Kingdom
Rational Software SARL France
Rational Software GmbH Germany
Rational Software Holdings B.V. Netherlands
Rational Software Benelux B.V. Netherlands
Rational Software International B.V. Netherlands
Rational Software Nordic A.B. Sweden
Rational Software Schweiz GmbH Switzerland
Rational Software s.r.l. Italy
Rational Software GmbH Austria
Rational Software Israel Ltd. Israel
Rational Software Pty Ltd. Australia
Rational Software Pte Ltd. Singapore
Rational Software Korea Ltd. Korea
Rational Software Corp. Pvt. Ltd. India
Rational Software New Zealand Limited New Zealand
Rational Software Greater China Ltd. Hong Kong
Nihon Rational K.K. Japan
Rational Software Do Brasil Ltda. Brazil
Rational Software S.A. de C.V. Mexico
</TABLE>
<PAGE>
EXHIBIT 23.01
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We have audited the consolidated financial statements of Rational Software
Corporation as of March 31, 1999 and 1998, and for each of the three years in
the period ended March 31, 1999, and have issued our report thereon dated
April 14, 1999 (included elsewhere in this Annual Report on Form 10-K). Our
audits also included the financial statement schedule of Rational Software
Corporation listed in Item 14(a). This schedule is the responsibility of the
Company's management. Our responsibility is to express an opinion based on our
audits.
In our opinion, the financial statement schedule referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.
We also consent to the incorporation by reference in the Registration
Statements (Form S-8 No. 33-77382, No. 33-85906, No. 33-97044, No. 333-15015,
No. 333-15007, No. 333-21563, No. 333-22687, No. 333-25815, No. 333-31505, No.
333-32991, No. 333-39455, No. 333-39569, No. 333-45393, No. 333-52017, 333-
60579 and 333-70989) pertaining to the Rational 1983 Incentive Stock Option
Plan, Verdix Corporation 1983 Incentive Stock Option Plan, Verdix Corporation
1986 Stock Option Plan, Rational 1993 Stock Option Plan, Rational Software
Corporation 1994 Stock Option Plan, Rational Software 1994 Employee Stock
Purchase Plan, Requisite, Inc., 1994 Stock Option Plan, SQA 1995 Stock Plan,
SQA 1995 Employee Stock Purchase Plan, SQA 1995 NonEmployee Director Stock
Option Plan, SQA 1990 Incentive and Nonqualified Stock Option Plan, Rational
Software Corporation 1997 Stock Plan, Performance Awareness Corporation 1997
Stock Plan, Rational Software Corporation 1997 Supplemental Stock Plan, Pure
Atria 1995 Stock Plan, Pure Software, Inc. 1992 Stock Opton/Stock Issuance
Plan, Atria Software, Inc. 1994 Stock Plan, Atria Software, Inc. 1994 Non-
Employee Director Stock Option Plan, Atria Software, Inc. 1990 Stock Option
Plan, Integrity QA Software, Inc. 1995 Stock Option Plan, Performix, Inc. 1991
Stock Option Plan, Qualtrak 1994 Stock Option Plan, Vigor Technology, Inc.
1996 Stock Option Plan, 1998 Indian Stock Option Plan, Rational Software
Corporation 1997 Stock Option Plan, 1998 Employee Stock Purchase Plan and
Directors Stock Option Plan of our report dated April 14, 1999, with respect
to the consolidated financial statements included herein and our report
included in the preceding paragraph with respect to the financial statement
schedule included in this annual report (Form 10-K) of Rational Software
Corporation.
/s/ Ernst & Young LLP
Palo Alto, California
June 23, 1999
<PAGE>
EXHIBIT 23.02
CONSENT OF KPMG LLP, INDEPENDENT AUDITORS
The Board of Directors
Rational Software Corporation
We consent to incorporation by reference in the registrations statements
(Nos.33-77382, 33-85906, 33-97044, 333-15007, 333-15015, 333-21563, 333-22687,
333-25815, 333-31505, 333-32991, 333-39455, 333-39569, 333-45393, 333-52017,
333-60579 and 333-70989) on form S-8 of Rational Software Corporation of our
report dated January 21, 1997, except as to Note 2, which is as of January 31,
1997, relating to the consolidated statements of operations, stockholders'
equity, and cash flows of Pure Atria Corporation and subsidiaries for the year
ended December 31, 1996 which, report appears in the March 31, 1996, annual
report on Form 10-K of Rational Software Corporation.
/s/ KPMG LLP
Mountain View, California
June 24, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> MAR-31-1999
<PERIOD-START> APR-01-1998
<PERIOD-END> MAR-31-1999
<CASH> 59,965
<SECURITIES> 199,865
<RECEIVABLES> 95,593
<ALLOWANCES> 3,226
<INVENTORY> 0
<CURRENT-ASSETS> 384,254
<PP&E> 96,307
<DEPRECIATION> 50,862
<TOTAL-ASSETS> 453,956
<CURRENT-LIABILITIES> 155,888
<BONDS> 0
0
0
<COMMON> 933
<OTHER-SE> 293,439
<TOTAL-LIABILITY-AND-EQUITY> 453,956
<SALES> 259,335
<TOTAL-REVENUES> 411,816
<CGS> 22,020
<TOTAL-COSTS> 62,868
<OTHER-EXPENSES> 277,027
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (12,721)
<INCOME-PRETAX> 84,642
<INCOME-TAX> 25,393
<INCOME-CONTINUING> 59,249
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 59,249
<EPS-BASIC> 0.69
<EPS-DILUTED> 0.65
</TABLE>
