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UNITED STATES
SECURITIES & EXCHANGE COMMISSION
Washington, D.C. 20549
--------------------------
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
for the transition period from _______ to _______
COMMISSION FILE NUMBER 0-12167
RATIONAL SOFTWARE CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 54-1217099
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
18880 HOMESTEAD ROAD, CUPERTINO, CA 95014
(Address of principal executive office) (Zip Code)
408-863-9900
(Registrant's telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
COMMON STOCK, PAR VALUE 85,502,631
$.01 PER SHARE
(Class) (Shares outstanding on January 31, 1999)
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<PAGE>
CONTENTS
PART I -- FINANCIAL INFORMATION
Item 1 -- Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets......................
Condensed Consolidated Statements of Operations............
Condensed Consolidated Statements of Cash Flows............
Notes to Condensed Consolidated Financial Statements.......
Item 2 -- Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................
PART II -- OTHER INFORMATION
Item 1 -- Legal Proceedings..........................................
Item 6 -- Exhibits and Reports on Form 8-K...........................
SIGNATURE.............................................................
<PAGE>
RATIONAL SOFTWARE CORPORATION
Condensed Consolidated Balance Sheets
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
December 31, March 31,
1998 1998
------------ ------------
(unaudited) (Note A)
<S> <C> <C>
ASSETS
-------------------------------------
Current assets:
Cash and cash equivalents.................... $33,808 $126,229
Short-term investments....................... 187,599 163,241
Accounts receivable, net..................... 78,278 71,379
Prepaid expenses and other assets............ 8,104 7,239
Deferred tax assets.......................... 11,846 11,846
------------ ------------
Total current assets.......................... 319,635 379,934
------------ ------------
Property and equipment, at cost:
Computer, office and manufacturing equipment. 72,574 65,339
Office furniture............................. 9,998 9,184
Leasehold improvements....................... 10,542 7,136
------------ ------------
93,114 81,659
Accumulated depreciation and amortization.... (48,499) (43,671)
------------ ------------
Property and equipment, net................... 44,615 37,988
Other assets, net............................. 20,644 27,283
------------ ------------
Total assets.................................. $384,894 $445,205
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
-------------------------------------
Current liabilities:
Accounts payable............................. $11,114 $13,262
Accrued employee benefits.................... 20,659 23,929
Income taxes payable......................... 16,035 15,259
Other accrued expenses....................... 17,087 18,345
Current portion of accrued merger and
integration expenses....................... 6,156 26,226
Deferred revenue............................. 67,071 52,707
Current portion of long-term debt and
lease obligations.......................... 1,646 1,809
------------ ------------
Total current liabilities..................... 139,768 151,537
Accrued rent.................................. 586 720
Long-term accrued merger and integration
expenses..................................... 3,200 5,600
Long-term debt................................ 171 172
------------ ------------
Total liabilities............................. 143,725 158,029
------------ ------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.01 par value, 150,000
shares authorized........................... 918 890
Additional paid-in capital................... 527,885 494,718
Treasury stock............................... (119,487) (1,340)
Accumulated deficit.......................... (167,103) (205,262)
Cumulative translation adjustment............ (1,044) (1,830)
------------ ------------
Total stockholders' equity.................... 241,169 287,176
------------ ------------
Total liabilities and stockholders' equity.... $384,894 $445,205
============ ============
</TABLE>
Note A: The balance sheet at March 31, 1998 has been derived from the audited
- ------ financial statements at that date but does not include all of the
information and footnotes required by generally accepted accounting
principal for complete financial statements.
See accompanying notes to condensed consolidated financial statements.
<PAGE>
RATIONAL SOFTWARE CORPORATION
Condensed Consolidated Statements of Operations
(in thousands, except per share amounts, unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
December 31, December 31,
------------------- -------------------
1998 1997 1998 1997
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Net product revenue................ $67,382 $48,373 $175,083 $132,983
Consulting and support revenue..... 41,751 33,933 111,676 90,439
--------- --------- --------- ---------
Total revenue.................. 109,133 82,306 286,759 223,422
--------- --------- --------- ---------
Cost of product revenue............ 4,728 5,186 15,808 13,961
Cost of consulting and support
revenue.......................... 10,731 11,508 30,310 31,932
--------- --------- --------- ---------
Total cost of revenue.......... 15,459 16,694 46,118 45,893
--------- --------- --------- ---------
Gross margin....................... 93,674 65,612 240,641 177,529
--------- --------- --------- ---------
Operating expenses:
Research and development......... 18,683 14,869 50,949 45,848
Sales and marketing.............. 45,465 34,129 121,843 103,654
General and administrative....... 8,201 6,794 24,009 21,915
Merger costs..................... (1,200) -- (1,200) 63,759
--------- --------- --------- ---------
Total operating expenses....... 71,149 55,792 195,601 235,176
--------- --------- --------- ---------
Operating income (loss)........ 22,525 9,820 45,040 (57,647)
Other income, net.................. 3,124 4,004 9,473 13,305
--------- --------- --------- ---------
Income (loss) before
income taxes.................. 25,649 13,824 54,513 (44,342)
Provision for income taxes......... 7,695 3,456 16,354 4,781
--------- --------- --------- ---------
Net income (loss).................. $17,954 $10,368 $38,159 ($49,123)
========= ========= ========= =========
Net income (loss) per common
share - basic.................... $0.21 $0.12 $0.45 ($0.56)
Shares used in computing per
share amounts - basic............ 84,269 88,008 85,727 87,267
Net income (loss) per common
share - diluted.................. $0.20 $0.11 $0.42 ($0.56)
Shares used in computing per
share amounts - diluted.......... 91,254 90,632 91,308 87,267
</TABLE>
See accompanying notes to condensed consolidated financial statements.
<PAGE>
RATIONAL SOFTWARE CORPORATION
Condensed Consolidated Statement of Cash Flows
(in thousands, unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
December 31,
----------------------
1998 1997
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net income (loss)................................... $38,159 ($49,123)
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Loss on disposal of capital eqiupment............. -- 134
Depreciation and amortization..................... 14,933 14,901
Noncash expense for stock options................. -- 109
Tax benefits of stock option exercises............ 12,000 --
Changes in operating assets and liabilities:
Accounts receivable............................. (6,899) (71)
Prepaids and other, net......................... (865) (3,456)
Accounts payable................................ (2,148) 35
Accrued employee benefits and other accrued
expenses..................................... (4,662) (642)
Income taxes payable............................ 776 4,718
Accrued merger and integration expenses......... (22,470) 16,648
Deferred revenue................................ 14,364 9,424
---------- ----------
Net cash provided by (used in) operating activities. 43,188 (7,323)
---------- ----------
Cash flows from investing activities:
Purchase of short-term investments.................. (263,094) (287,453)
Maturities and sales of short-term investments...... 238,736 133,845
Purchases of property and equipment................. (17,877) (22,904)
Net cash activity for Pure Atria.................... -- (15,949)
Net change in other assets.......................... 2,956 (7,678)
Proceeds from sale of fixed assets.................. -- 4,850
---------- ----------
Net cash used in investing activities.................. (39,279) (195,289)
---------- ----------
Cash flows from financing activities:
Principal payments under long-term debt
and capital lease obligations..................... (164) (298)
Net proceeds from issuance of common stock.......... 21,195 8,294
Repurchases of common stock......................... (118,147) --
---------- ----------
Net cash provided by (used in) financing activities.... (97,116) 7,996
---------- ----------
Effect of changes in foreign currency exchange
rate on cash.......................................... 786 (651)
---------- ----------
Net increase (decrease) in cash and cash equivalents... (92,421) (195,267)
Cash and cash equivalents at beginning of period....... 126,229 244,856
---------- ----------
Cash and cash equivalents at end of period............. $33,808 $49,589
========== ==========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION -- The consolidated financial information
included herein has been prepared without audit in accordance with
the Company's accounting policies, as described in its latest annual
report filed with the Securities and Exchange Commission on Form 10-
K. In the opinion of management, all adjustments, which consist only
of normal recurring adjustments necessary for a fair presentation of
the Company's financial position, results of operations, and cash
flows for the interim periods presented have been made. As
permitted by Form 10-Q, certain information and footnote disclosures
normally included in financial statements prepared in accordance
with generally accepted accounting principles have been condensed or
omitted. Operating results for the period ended December 31, 1998
are not necessarily indicative of the results that may be expected
for the fiscal year ending March 31, 1999.
2. ACCOUNTS RECEIVABLE - Accounts receivable are presented net of an
allowance for doubtful accounts of $3,406,000 at December 31, 1998
and $3,638,000 at March 31, 1998.
3. NET INCOME PER COMMON SHARE - The following table sets forth the
computation of basic and diluted net income (loss) per share (in
thousands, except per share amounts):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
December 31, December 31,
------------------- -------------------
1998 1997 1998 1997
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Numerator:
Net income (loss)................. $17,954 $10,368 $38,159 ($49,123)
Denominator:
Denominator for basic net income
(loss) per share - weighted
average shares.................... 84,269 88,008 85,727 87,267
Incremental common shares
attributable to shares issuable
under employee stock plans........ 6,985 2,624 5,581 --
--------- --------- --------- ---------
Denominator for diluted net
income (loss) per share -
weighted average shares and
assumed conversions............... 91,254 90,632 91,308 87,267
========= ========= ========= =========
Net income (loss) per share - basic. $0.21 $0.12 $0.45 ($0.56)
========= ========= ========= =========
Net income (loss) per share -
diluted........................... $0.20 $0.11 $0.42 ($0.56)
========= ========= ========= =========
</TABLE>
4. COMPREHENSIVE INCOME - As of April 1, 1998 the Company adopted
Statement of Financial Accounting Standards No. 130 (SFAS 130),
"Reporting Comprehensive Income." SFAS 130 establishes new rules for
the reporting and display of comprehensive income and its
components; however, the adoption of this statement had no impact on
the Company's net income or stockholders' equity. SFAS 130 requires
unrealized gains or losses on the Company's available-for-sale
securities and foreign translation adjustments, which have been
consistently included in stockholders' equity and excluded from net
income, to be included in comprehensive income. Prior year
financial statements have been reclassified to conform to the
requirements of SFAS 130.
For the three months ended December 31, 1998, total comprehensive
income amounted to approximately $18,255,000 compared to a
comprehensive income of $10,188,000 for the same period last year.
For the nine months ended December 31, 1998, comprehensive income
amounted to $38,945,000 compared to a comprehensive loss of
$49,774,000 for the same period last year.
5. RECENT PRONOUNCEMENTS - In June 1997, the Financial Accounting
Standards Board issued Statement of Financial Accounting Standards
No. 131 (SFAS 131), "Disclosures about Segments of an Enterprise and
Related Information." SFAS No. 131 establishes new requirements for
the reporting of information regarding operating segments, products,
services, geographic areas and major customers. The Company will
provide the disclosures required by SFAS 131 in its Form 10-K for
the year ended March 31, 1999.
In June 1998, the Financial Accounting Standards Board issued
Statement No. 133, "Accounting for Derivative Instruments and
Hedging Activities," which is required to be adopted in years
beginning after June 15, 1999. Because of the Company's minimal use
of derivatives, management does not anticipate that the adoption of
the new statement will have a significant effect on earnings or the
financial position of the Company.
6. CONTINGENCIES - On December 16, 1996, the Company filed a lawsuit
against Silicon Graphics, Inc. ("SGI") arising from SGI's failure to
pay certain royalties due to the Company under a software license
agreement entered into between the Company's predecessor, Verdix
Corporation, and SGI. SGI has filed an answer denying the Company's
allegations, and also filed a cross-complaint against the Company
for unspecified damages for alleged wrongdoing arising out of the
license agreement with SGI. The Company denies the allegations and
intends to vigorously defend its position.
On May 28, 1998, a consolidated, amended class action Complaint was
filed against the Company and Paul D. Levy in the United States
District Court for the Northern District of California. That
action, In re Rational Software Corporation, No. 97-21001 (JF),
consolidates eight prior-pending, virtually-identical complaints.
SG Cowen & Company and an SG Cowen & Company analyst are also named
as defendants. The complaint alleges that defendants violated
Sections 10(b) and 20A of the Securities Exchange Act of 1934 and
California state securities laws through the selective disclosure of
material inside information regarding the Company's prospects. The
complaint seeks unspecified damages on behalf of a class of
stockholders who purchased the Company's common stock on October 8,
1997. Defendants' motions to dismiss the Complaint were granted,
with leave to amend. The Company anticipates that plaintiffs will
attempt to amend the Complaint. The Company further expects to file
a motion to dismiss that amended Complaint.
7. STOCK REPURCHASE - In April, 1998 the board of directors authorized
the Company to repurchase up to 6,000,000 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 6,000,000 shares of its common
stock in the open market to be used for general corporate purposes.
Through December 31, 1998 the Company had repurchased a total of
7,000,000 shares of its common stock, including repurchases
authorized in April, 1998 and October, 1998, for a total cash outlay
of approximately $118,147,000. Repurchases helped offset dilution
from stock issued under the company's stock option and stock
purchase plans.
8. RESTRUCTURING COSTS - During the three months ended December 31,
1998, the Company substantially completed certain elements of the
organizational integrations following the July 1997 acquisition of
Pure Atria Corporation (the Pure Atria merger). This consisted
primarily of exiting certain non-strategic consulting activities,
realignment of marketing activities and consolidation of certain
sales offices. The current quarter charges related to this
activity, totaling approximately $3,300,000, 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 $4,500,000. The facilities expense
reduction was due to greater-than-expected recoveries from
subleasing. The net impact on the December quarter was a merger and
integration charge reduction of $1,200,000.
<PAGE>
Item 2 -- Management's Discussion and Analysis of Financial Condition
and Results of Operations
Overview
The statements contained in Management's Discussion and Analysis of
Financial Condition and Results of Operations, including without
limitation statements in "Liquidity and Capital Resources at December
31, 1998", contain "forward looking" information within the meaning of
Sections 27A of the Securities Act of 1993 and 21E of the Securities
and Exchange Act of 1934, as amended, and are subject to the safe
harbor created by those sections. The actual future results of the
Company could differ materially from those projected in the forward
looking information. For a discussion of certain factors that could
cause actual results to differ materially from those projected by the
forward looking information see "Factors That May Affect Future
Results", at the end of this Item 2.
The Company's revenue is derived from product license fees and charges
for services, including technical consulting, training, and customer
support. In accordance with generally accepted accounting principles,
the Company recognizes software license revenue upon shipment and
recognizes customer-support revenue over the term of the maintenance
agreement. Revenue from consulting and training is recognized when
earned. The Company's license agreements generally do not provide a
right of return, and reserves are maintained for potential credit
losses, of which historically there have been only immaterial amounts.
Comparative Analysis of Operating Results for the Three- and Nine-
Months Ended December 31, 1998
Total revenue for the three- and nine- month periods ended December 31,
1998 increased 33% and 28%, respectively, from the comparable prior
year periods.
Net product revenue for the three- and nine- month periods ended
December 31, 1998 increased 39% and 32%, respectively, from the
comparable prior year periods. Consulting and support revenue for both
the three- and nine- month periods ended December 31, 1998 increased
23% from the comparable prior year periods. These increases reflect
continued strong customer acceptance across the Company's products and
services.
International revenues from product sales and consulting and customer
support accounted for 41% and 37%, respectively, of total revenues for
the three- and nine- month periods ended December 31, 1998, compared to
34% for both the comparable prior year periods. 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 non-functional currencies and
such contracts are carried at fair market value. The associated gains
and losses were not material to the Company's results of operations in
any period presented. See Risks Associated with International
Operations.
Cost of product revenue consists principally of materials, packaging
and freight, amortization of developed technology and royalties. Cost
of product revenue for the three- and nine- month periods ended
December 31, 1998 decreased 9% and increased 13%, respectively, from
the comparable prior year periods. These costs represented 7% and 9%,
respectively, of total product revenue for the three- and nine- month
periods ended December 31, 1998, as compared to 11% and 10%,
respectively, for the comparable prior year periods. The decrease in
product cost as a percentage of product revenue 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.
Cost of consulting and support revenue consists principally of
personnel costs for training, consulting and customer support. Cost of
consulting and support for the three- and nine- month periods ended
December 31, 1998 decreased 7% and 5%, respectively, from the
comparable prior year periods. These costs represented 26% and 27%,
respectively, of total consulting and support revenue for the three-
and nine- month periods ended December 31, 1998 compared to 34% and
35%, respectively, for the comparable prior year periods. The decrease
in cost as a percentage of related revenue is primarily due to changes
to the Company's customer support business model as a result of
combining the Pure Atria and Rational service organizations, combined
with the impact of a relatively fixed support cost base servicing
increased revenues.
Total expenditures for research and development for the three- and
nine- month periods ended December 31, 1998 increased 26% and 11%,
respectively, from the comparable prior year periods. These costs
represented 17% and 18%, respectively, of total revenue for the three-
and nine- month periods ended December 31, 1998 compared to 18% and
21%, respectively, for the comparable prior year periods. The increase
in year to year research and development expenses is due primarily to
additional personnel and related costs to maintain and enhance existing
products as well as develop new products.
Sales and marketing expenses for the three- and nine- month periods
ended December 31, 1998 increased 33% and 18%, respectively, from the
comparable prior year periods. These costs represented 42% of total
revenue for both the three- and nine- month periods ended December 31,
1998 compared to 41% and 46%, respectively, for the comparable prior
year periods. The increase in year to year sales and marketing expenses
reflects additional personnel and related costs to expand Rational's
sales channels, to penetrate new markets, and to increase its market
share in core markets.
General and administrative expenses for the three- and nine- month
periods ended December 31, 1998 increased 21% and 10%, respectively,
from the comparable prior year periods. These costs represented 8% of
total revenue for both the three- and nine- month periods ended
December 31, 1998 compared to 8% and 10%, respectively, for the
comparable prior year periods. The increase in year to year general and
administrative expenses is due primarily to employee related expenses
associated with the staffing requirements needed to support the
Company's expanding business.
In the nine-month period ended December 31, 1997 the Company recorded a
charge of $63,759,000 related to the Pure Atria merger. During the
three months ended December 31, 1998, the Company substantially
completed certain elements of the organizational integrations following
the July 1997 Pure Atria merger. This consisted primarily of exiting
certain non-strategic consulting activities, realignment of marketing
activities and consolidation of certain sales offices. The current
quarter charges related to this activity, totaling approximately
$3,300,000, 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 $4,500,000. The
facilities expense reduction was due to greater-than-expected
recoveries from subleasing. The net impact on the December quarter was
a merger and integration cost reduction of $1,200,000. The net cost
reduction of $1,200,000 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.
Other income, net, consists primarily of interest income, interest
expense and gains and losses due to fluctuations in foreign currency
exchange rates. Other income has fluctuated as a result of the amount
of cash available for investment in interest-bearing instruments and
from fluctuations in foreign currency exchange rates. Other income,
net, for the three- and nine- month periods ended December 31, 1998
decreased $880,000 and $3,832,000, respectively, from the comparable
prior year periods. The current year decrease is due primarily to a
lower average amount of invested cash resulting from repurchase of
Company common stock in the current periods and to declining interest
rates.
The provision for income taxes for the three- and nine- month periods
ended December 31, 1998 is based on the estimated annual effective tax
rate applied to the profit before income taxes and includes federal,
state and foreign income taxes. The effective tax rates for fiscal 1999
and 1998 differ from the federal statutory rate, primarily as a result
of the recognition of previously unrecognized deferred tax assets, the
non-deductibility of certain merger related costs, losses in certain
foreign jurisdictions for which no U.S. benefit was derived, differing
tax rates in certain foreign jurisdictions and by state taxes.
Liquidity and Capital Resources at September 30, 1998
As of December 31, 1998, the Company had cash, cash equivalents and
short-term investments of $221,407,000 and working capital of
$179,867,000. Net cash provided by operating activities for the period
ended December 31, 1998 was composed primarily of net income plus non-
cash charges for depreciation and amortization, tax benefits from stock
option exercises and an increase in deferred revenue, offset by an
increase in accounts receivable, a decrease in accrued employee
benefits and other accrued expenses, accrued merger costs, and accounts
payable. Net cash used in investing activities resulted primarily from
an increase in short-term cash investments and capital expenditures.
Net cash used in financing activities resulted primarily from the
repurchase of common stock, offset by issuance of common stock under
the Employee Stock Purchase Plan and the exercise of employee stock
options.
In April, 1998 the board of directors authorized the Company to
repurchase up to 6,000,000 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 6,000,000 shares of its common stock in the open market to
be used for general corporate purposes. Through December 31, 1998 the
Company had repurchased a total of 7,000,000 shares of its common
stock, including repurchases authorized in April, 1998 and October,
1998, for a total cash outlay of approximately $118,147,000.
Repurchases helped offset dilution from stock issued under the
company's stock option and stock purchase plans.
The Company believes that expected cash flows from operations combined
with existing cash and cash equivalents and short-term investments will
be sufficient to meet its cash requirements for the foreseeable future.
See also Note 7 to Notes to Condensed Consolidated Financial
Statements.
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 has 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) will consist of identifying all the
Company's systems, relationships and products that may be impacted by
year 2000. Phase Two (Assessment) will involve 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) will consist of developing a
plan for those areas identified as needing correction in the assessment
phase. Phase Four (Implementation) will consist 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 which 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 comprised
of salaries and benefits of software engineering personnel. The
Company funded these research and development costs out of operating
cash flows.
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 nor
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.
With respect to non-critical IT systems, consisting primarily of
security systems, fax machines and other miscellaneous systems, and
non-IT embedded systems, the Company is presently in the Inventory and
early Assessment phases. The Company is not yet able to provide
reasonably accurate estimates of the costs of completing the
Remediation and Implementation phases with respect to these non-
critical IT and non-IT embedded systems, but the Company presently
expects to fund all remediation and implementation costs from operating
cash flows and has not established any specific reserves for these
costs. The Company has not yet determined a completion date for
remediation of all year 2000 systems, but it intends to complete such
implementation well in advance of January 1, 2000. The Company has not
yet incurred any material costs specifically related to becoming year
2000 compliant in its non-critical IT and non-IT embedded systems. As
with critical IT systems, discussed above, many of the Company's non-
critical 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 nor accelerated for the
sole purpose of becoming year 2000 compliant.
The Company is currently early in 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 is preparing to query 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 non-critical 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 non-compliance by suppliers, subcontractors and customers is
not reasonably quantifiable.
While the Company expects to the attain year 2000 readiness with
respect to non-critical 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 does not currently have any year 2000 related
contingency plans. The Company may institute contingency planning at
the completion of the Assessment phase of its year 2000 readiness plan
with respect to non-critical IT and non-IT embedded systems.
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 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
averse 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.
Factors That May Affect Future Results
Risks Associated with Recent and Future Acquisitions
Rational acquired Pure Atria Corporation (Pure Atria) on July 30,
1997, with the expectation that the acquisition would result in long-
term strategic benefits. The realization of these anticipated benefits
will continue to depend in part on integration of the companies'
respective product offerings and research and development efforts.
There can be no assurance that this will occur. Successful integration
of the companies' respective sales forces will continue to require
sales personnel to become familiar with the sales cycles and sales
approaches required for products recently added to their portfolios,
and any failure to do so may result in sales delays and decreased
revenues for the Company. It is possible that the continued integration
of the companies' respective products and the creation of integrated
bundles and suites may not be accomplished in a timely manner or may
prove to be technologically infeasible. The difficulties of integrating
the two companies' respective operations is compounded by the fact that
each company had significant operations on both the East Coast and the
West Coast of the United States and in a number of other countries. The
acquisition of Pure Atria has been accounted for as a pooling of
interests. Accordingly, if such accounting treatment were to be
nullified for any reason, it would materially and adversely affect
Rational's reported earnings and, potentially, its stock price.
In addition to the acquisition of Pure Atria, during approximately the
past four years, Rational has made a number of strategic acquisitions,
including SQA, Inc., Performance Awareness Corporation, Requisite,
Inc., Softlab AB, and Software 9000 in the quarter ended March 31,
1997, the Visual Test product from Microsoft in October 1996, and other
acquisitions in earlier periods. Rational has recently acquired 19.9%
of the outstanding capital stock of ObjecTime, Ltd. Acquisitions result
in the diversion of management's attention from day-to-day operations
and include numerous other risks, including difficulties in the
integration of operations, products, and personnel. To the extent that
acquisitions have in the past resulted, or may in the future result, in
a diversion of resources or that efforts to integrate recent and future
acquisitions fail, there could be a material adverse effect on
Rational's business, results of operations, and financial condition.
Acquisitions have the potential to result in dilutive issuances of
equity securities, the incurrence of debt, and amortization expenses
related to goodwill and other intangible assets. Rational's management
has historically evaluated on an ongoing basis the strategic
opportunities available to the Company. Rational may in the near-term
or long-term future pursue acquisitions of complementary products,
technologies, or businesses.
Fluctuations in Operating Results
Revenue in any quarter is substantially dependent on orders
booked and shipped in that quarter. Because staffing and operating
expenses are based on anticipated revenue levels and a high percentage
of the costs are fixed, small variations in the timing of the
recognition of specific revenues could cause significant variations in
operating results from quarter to quarter. Historically, the Company
has earned a substantial portion of its revenues in the last weeks of
the quarter. To the extent these trends continue, the failure to
achieve such revenues in the last weeks of any given quarter will have
a material adverse effect on the Company's financial results for that
quarter. The Company's revenue is difficult to forecast because
Rational's sales cycles, from initial evaluation to purchase, vary
substantially from customer to customer and from product to product and
because the markets for Rational's products are rapidly evolving. In
addition, the Company's results will be affected by the number, timing,
and significance of new product announcements by it and its
competitors, its ability to develop, introduce, and market new,
enhanced, and integrated versions of its products on a timely basis,
the level of product and price competition, changes in operating
expenses, changes in average selling prices and product mix, any
changes in its sales incentive strategy, the experience level of and
any changes in sales personnel, any changes in sales cycles, the mix of
direct and indirect sales, product returns, and general economic
factors, among others. The Company's sales will also be sensitive to
existing and prospective customers' budgeting practices and global
economic conditions.
Unanticipated expenses associated with the integration of
Rational and Pure Atria may arise, or the Company may incur additional
material charges in subsequent quarters to reflect additional costs
associated with the integration of the two companies. Total costs
associated with such transactions resulted in an operating loss and a
net loss for the Company's fiscal year ended March 31, 1998, and could
negatively impact financial results in future periods for the reasons
discussed above.
Although Rational has experienced growth in revenues in recent
years, there can be no assurance that, in the future, Rational will
sustain revenue growth or be profitable on a quarterly or annual basis.
Further, the revenues and operating income (exclusive of nonrecurring
operating, restructuring, and merger-related expenses) experienced by
Rational in recent quarters are not necessarily indicative of future
results, and period-to-period comparisons of Rational's financial
results should not be relied on as an indication of future performance.
Fluctuations in operating results have previously and may continue to
result in volatility in the price of Rational's common stock.
Due to all of the foregoing factors, it is possible that in some future
quarter, Rational's operating results will be below the expectations of
public market analysts and investors. In such event, the price of
Rational's common stock would likely be materially adversely affected,
and significant declines in stock prices frequently result in costly
and lengthy securities litigation, with its attendant costs,
distraction, and liability exposure.
Volatility of Stock Price
The market price of the Company's common stock has been, and is
likely to continue to be, volatile. Factors such as new product
announcements or changes in product pricing policies by the Company or
its competitors, quarterly fluctuations in the Company's operating
results, announcements of technical innovations, announcements relating
to strategic relationships or acquisitions, changes in earnings
estimates by analysts, and general conditions in the software-
development market, among other factors, may have a significant impact
on the market price of the Company's common stock. Should the Company
fail to introduce products on the schedule expected, the Company's
stock price could be adversely affected.
Any shortfall in anticipated operating results could have an
immediate and significant adverse effect on the market price of the
Company's common stock. Further, the Company incurred substantial
merger-related charges in the quarter ended September 30, 1997.
Although Rational entered into the merger with the expectation that it
would be accretive in the long term, the merger has been dilutive in
the initial periods following its effective time, and there can be no
assurance as to when the merger will become accretive, if ever. Any
failure of the Pure Atria merger to meet expectations as to potential
business synergies or any failure of the Pure Atria merger to be
accretive in any quarter could have an immediate and significant
adverse effect on the market price of the Company's common stock.
Statements or changes in opinions, ratings, or earnings estimates
made by brokerage firms or industry analysts relating to the market for
software and high-technology company stocks or relating to Rational
specifically have resulted, and could in the future result, in an
immediate and adverse effect on the market price of Rational's common
stock. Statements by financial or industry analysts regarding the
extent of the dilution in Rational's net income per share resulting
from operating results, the Pure Atria merger, or other developments
and the extent to which such analysts expect potential business
synergies to offset such dilution can be expected to contribute to
volatility in the market price of Rational's common stock. In addition,
in recent years the stock market in general, and the shares of
technology companies in particular, have experienced extreme price
fluctuations. This volatility has had a substantial effect on the
market prices of securities issued by many companies, including
Rational, in certain cases for reasons unrelated to the operating
performance of the specific companies. These broad market fluctuations
may adversely affect the market price of Rational's common stock.
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, and 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 to 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 has
developed the Unified Modeling Language (UML) for visual modeling,
which has been adopted by the Object Management Group (OMG), an
industry consortium, for inclusion in their object analysis and design
facility specification. The official sanction in the future of a
competing standard by the OMG 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 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 latest technologies. The Company believes that it will be
particularly important to successfully develop and market a broader
line of products for C++, Visual Basic, Java, and other implementation
languages in order to be successful in its efforts to broaden its
customer base and to further increase its share in its existing market
segments. The Company also believes that, over time, its products must
be extended to 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. Rational believes that
the major competitive factors in its markets include corporate and
product reputation, innovation with frequent product enhancement,
breadth of integrated product line, the availability of integrated
suites and bundles, product architecture, functionality and features,
product quality, performance, ease of use, support, availability of
technical consulting services, and price. Rational faces intense
competition for each product within its product lines, generally from
both Windows, Windows NT, and UNIX vendors. Because individual product
sales are often the first step in a broader customer relationship,
Rational's success will depend in part on its ability to successfully
compete with numerous competitors at each point in its product line.
Rational faces competition from software-development tools and
processes developed internally by customers, including ad hoc
integrations of numerous standalone development tools. Customers may be
reluctant to purchase products offered by independent vendors such as
the Company. As a result, the Company must educate prospective
customers about the advantages of the Company's products versus
internally developed software-quality systems.
Rational faces competition from, among others, Micro Focus Group,
plc, Platinum Technology, Inc., Select Software Tools plc, Cayenne,
Oracle, IBM Corporation (IBM), Sun Microsystems, and Sybase Inc., as
well as numerous privately held tool suppliers offering traditional
CASE tools that compete with the Rational Rose approach to visual
modeling and component-based development. Rational's RequisitePro
requirements-management product faces competition from companies such
as GEC-Marconi. Rational's software-testing tools-Purify, Quantify,
PureCoverage, SQA Suite, Rational Visual Test, Performance Studio,
Rational DevelopmentDesktop and preVue--face competition from
Compuware, Mercury Interactive Corporation, Segue Software, Inc., Micro
Focus Group, plc, Inc., Computer Associates, Platinum Technologies,
Terodyne, Cyrano, SQL Bench International, Inc., and several private
companies offering testing-automation tools. Microsoft, Compuware,
Oracle, Sybase, and several of the major UNIX platform vendors,
including Sun Microsystems, Hewlett Packard, Digital Equipment
Corporation (recently acquired by Compaq Computer Corporation), Silicon
Graphics, Inc., and IBM, also compete with Rational with respect to
software-quality products and testing tools, with testing products
customized to certain of their other software products. Rational Apex
for C/C++ faces competition from, among others, major UNIX platform
vendors such as Sun Microsystems, Hewlett-Packard, and Digital
Equipment Corporation, which have C/C++ compilers and debuggers and, in
some cases, programming environments for their platforms. In addition,
numerous privately held companies offer compilers, debuggers, and
programming environments that compete with Rational Apex. Rational's
ClearCase, ClearDDTS, and ClearQuest product line faces competition
from various suppliers offering products with configuration and change
management functions, including Continuus Software Corporation,
StarBase Corporation, Hewlett Packard, True Software, SQL Software,
ltd., Micro Focus Group, plc, Sun Microsystems, Platinum Technologies,
Mortice Kern Systems (MKS) Inc., and IBM. The Rational Apex Ada product
line faces competition from Aonix, Green Hills Software, Inc., and a
large number of other suppliers offering Ada products for native and
embedded systems.
The Company also experiences competition with respect to a number
of its products, both from utilities commonly bundled with versions of
operating systems and from standalone product offerings. For example,
versions of UNIX are commonly bundled with utilities (such as SCCS and
RCS) that provide version control, which is part of the functionality
provided by ClearCase. Some system vendors, such as Sun, already have
products, such as Workshop, that provide features similar to those in
Purify or others of the Company's products and would compete directly
with such products if offered on a standalone basis. The Company's
ClearQuest defect-tracking product competes with products from LBMS,
Inc., which was acquired by Platinum Technology, Inc. There can be no
assurance that Sun, which has a license to some of the Company's
patents, will not introduce standalone products that compete with the
Company's products. Companies offering products competitive with
Rational Summit and ClearCase in the UNIX marketplace include Sun,
which offers TeamWare, IBM, which offers Configuration
Management/Version Control (CMVC), Computer Associates (CA), which
offers the Endeavor WSX product, and Platinum through its acquisition
of Softool Corp., which markets CCC Harvest. In addition, there are
several smaller, privately held companies that market competitive
products, including Continuus Software Corporation, which markets
Continuus/CM. Other companies have offered version control or
configuration management products outside the UNIX market. Companies in
this category include CA, Micro Focus Group, plc, and Microsoft. CA has
a large installed base of its configuration management product on IBM
mainframes. Micro Focus has a large installed base of DOS and Windows
software developers. In 1994, Microsoft acquired OneTree Software,
which offers a version control product. The Company expects additional
competition from other established and emerging companies.
Rational believes that the increased level of competition it
observed in fiscal 1998 and the first three quarters of 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.
Dependence on Sales Force and Other Channels of Distribution
Rational currently distributes its products primarily through field
sales personnel teamed with highly trained technical-support personnel.
Rational believes that a high level of technical consulting, training,
and customer support is essential to maintaining its competitive
position and has found that the ability to deliver a high level of
technical consulting, training, and customer support is an important
selling point with respect to its products. Although complementary to
Rational's products, the services provided by these personnel have
historically yielded lower margins for Rational than the Company's
product business. If these services constitute a higher proportion of
total revenues in the future, the Company's margins will be adversely
affected. Rational markets and sells its products and services directly
through its major-accounts field operations, its telesales
organizations, and its World Wide Web site, and indirectly through
channels such as VARs and distributors. There can be no assurance that
such channels will be successful in increasing sales of the Company's
products or in reducing its sales costs on a percentage basis.
Dependence on Key Personnel
Rational believes that the hiring and retaining of qualified
individuals at all levels in the Company will be essential to the
Company's ability to manage growth successfully, and there can be no
assurance that the Company will be successful in attracting and
retaining the necessary personnel. The Company will be particularly
dependent on the efforts and abilities of its senior management
personnel. The departure of any of the senior management members or
other key personnel of the Company could have a material adverse effect
on the Company's business, financial condition, or results of
operations, depending on the timing of the departure, changes in the
Company's business prior to such time, the availability of qualified
personnel to replace them, and whether such personnel depart singly,
contemporaneously, or as a group, among other factors. Merger
activities, such as the acquisition of Pure Atria, can be accompanied
or followed by the departure of key personnel, which can compound the
difficulty of integrating the operations of the parties to the business
combination.
The ability of the Company to attract and retain the highly
trained technical personnel that are integral to its direct sales and
product development teams may limit the rate at which the Company can
develop products and generate sales. Competition for qualified
personnel in the software industry is intense, and there can be no
assurance that the Company will be successful in attracting and
retaining such personnel. Merger activities, such as the acquisition of
Pure Atria, may have a destabilizing effect on employee retention at
all levels within the Company. Departures of existing personnel,
particularly in key technical, sales, marketing, or management
positions, can be disruptive and can result in departures of other
existing personnel, which in turn could have a material adverse effect
on the Company's business, operating results, and financial condition.
A traditional means of retaining employees following declines in
a corporation's stock price, such as those experienced recently by
Rational, is to reprice "underwater" stock options, both to offer an
equity incentive to existing employees and to avoid inequities relative
to new employees offered lower-priced options. On November 4, 1997, the
Company's board of directors approved a program enabling the Company to
reprice stock options for most employees. The repriced options are
subject to additional lock-up and repurchase restrictions. Members of
the Company's senior management team at that time were not eligible to
participate in that repricing program. In April 1998, the compensation
committee of the board, after consulting with all of the outside
directors, approved repricing agreements with the members of the senior
management team who were not eligible to participate in the November
1997 repricing program. The senior officer repricing was completed on
substantially the same terms, including the disposition limitations and
repurchase provisions, offered to the rest of the employees in November
1997, although at the higher market price existing at the time of the
April 1998 repricing. There can be no assurance that such repricing
will be sufficient to retain employees or senior management or that at
some future date the outstanding stock options will not again be
underwater. To the extent that options held by employees, including
members of senior management, again become underwater, those options
may not serve as an incentive to retain these individuals. The
departure of one or more members of the senior management team could
have a material adverse effect on the Company's business, results of
operations, and financial condition.
Rapid Technological Change
The industry for tools for automating software application
development and management is characterized by rapid technological
advances, changes in customer requirements, and frequent new product
introductions and enhancements. The introduction of products embodying
new technologies and the emergence of new industry standards and
practices can render existing products obsolete and unmarketable. The
Company must respond rapidly to developments related to Internet and
intranet applications, hardware platforms, operating systems, and
applicable programming languages. Such developments will require the
Company to make substantial product-development investments. Any
failure by the Company to anticipate or respond adequately to
technology developments and customer requirements, or any significant
delays in product development, introduction, or integration, could
result in a loss of competitiveness or revenue. To the extent the
Company does not respond to technological change or evolving customer
requirements with new products or product enhancements, such new
products or product enhancements may fail to achieve market acceptance.
In addition, rapid growth of, interest in, and use of Internet
and intranet environments is a recent and emerging phenomenon. The
Company's success may depend, in part, on the compatibility of its
products with Internet and intranet applications. The Company may fail
to effectively adapt its products for use in Internet or intranet
environments or to produce competitive Internet and intranet
applications.
Rational believes that factors affecting the ability of its
products to achieve broad consumer acceptance include product
performance, price, ease of adoption, displacement of existing
approaches, and adaptation to rapid technological change and
competitive product offerings. The Company may be unable to respond
promptly and effectively to the challenges of technological change and
its competitors' innovations, and it is possible that the Company will
be unable to achieve the necessary market acceptance or compete
effectively in new markets.
Dependence on Strategic Relationships
Rational's development, marketing, and distribution strategies
rely increasingly on its ability to form long-term strategic
relationships with major software and hardware vendors, many of whom
are substantially larger than Rational. These business relationships
often consist of cooperative marketing programs, joint customer
seminars, lead referrals, or joint development projects. Although
certain aspects of some of these relationships are contractual in
nature, many important aspects of these relationships depend on the
continued cooperation of each party with Rational. Merger activity,
such as the acquisition of Pure Atria, may disrupt these relationships
or activities, and certain partners may reassess the value of their
relationship with Rational as a result of such merger activity.
Divergence in strategy between Rational and any given partner, a change
in focus by any given partner, or competitive product offerings
introduced by any given partner may interfere with Rational's ability
to develop, market, sell, or support its products, which in turn would
have a material adverse effect on Rational's business, results of
operations, and financial condition. See "Business Alliance with
Microsoft."
Business Alliance with Microsoft
On October 2, 1996, Rational and Microsoft announced the formation of a
business alliance that consisted of Rational's acquisition of
Microsoft's Visual Test product, technology cross-licensing, joint
development projects, and joint marketing programs. Although Rational
believes that Microsoft's current strategy in relation to the
enterprise information systems market is based on component-based
development, there can be no assurance that this strategy will continue
or that, if it does continue, Microsoft's emphasis or priorities will
not change in the future, resulting in less attention and fewer
resources being devoted to Microsoft's relationship with Rational.
Although certain aspects of the business alliance are contractual in
nature, many important aspects of the relationship depend on the
continued cooperation of the two companies, and there can be no
assurance that Rational and Microsoft will be able to work together
successfully over an extended period of time. In addition, there can be
no assurance that Microsoft will not use the information it gains in
its relationship with Rational to develop or market competing products.
Acquisition of the Visual Test Product
The Company acquired the Visual Test product from Microsoft on
October 2, 1996. There can be no assurance that Rational will be able
to successfully incorporate the Visual Test product into its integrated
family of products or that it will be able to achieve significant sales
of the Visual Test product. Many potential customers for Visual Test
differ from the Company's historical customer base in terms of
component-based software-development expertise, purchasing processes,
financial resources, and expectations regarding software-engineering
tools. There can be no assurance that the Company will not encounter
unanticipated concerns of Visual Test customers that are different from
the concerns of the Company's traditional customers or that the Company
will have the infrastructure and experience necessary to adequately
respond to the volume and type of such concerns.
Rational has granted Microsoft a nonexclusive, perpetual license
to the Visual Test product source code for the purpose of creating
derivative works and for the purpose of distributing portions of the
Visual Test product and derivative works as part of Microsoft products
that do not directly compete with the Visual Test product in the
software-testing tools area. There can be no assurance that Microsoft
will not use such rights to create and distribute products that compete
with other Rational products. Rational has also granted Microsoft a
five-year option to obtain a license to incorporate certain elements of
Visual Test technology into Microsoft development tool products,
including Visual Basic, Visual C++, and Visual J++. Should Microsoft
exercise such right, sales of the Visual Test product by Rational could
be materially and adversely impacted. See "Fluctuations in Operating
Results."
Licensing of Rational Rose Technology to Microsoft
In October 1996, Microsoft and Rational entered into an agreement
providing for the inclusion of a subset of the Rational Rose visual
modeling technology in future versions of Microsoft's enterprise-
oriented visual tools. The Company's objective in entering into this
arrangement is to expose the Company's technology to a broader customer
base and not to generate direct product revenue from Microsoft. The
Company expects that continued changes in the Company's pricing models
and combinations of features within product lines will be required to
appeal to this customer base, and there can be no assurance that such
changes will achieve customer acceptance. The licensing of Rational's
Rose technology to Microsoft has not resulted and the Company does not
expect it to result in a material increase in product revenue. In
addition, there can be no assurance that developers introduced to the
Rational Rose technology incorporated into Microsoft products will
become purchasers of Rational products in the future. Rational has
granted Microsoft the option to obtain a perpetual, nonexclusive right
to source code for certain aspects of the Rational Rose technology
after the termination of the agreement. While Rational believes that
Microsoft's and Rational's strategies currently are complementary,
there can be no assurance that Microsoft will not use this right to
develop and market competing products in the future.
Dependence on Major Operating Systems
Many of Rational's major products have historically been licensed
for use principally on certain versions of the UNIX platform. These
products constitute a substantial portion of Rational's product and
service revenues. Any factors adversely affecting the demand for, or
use of, the UNIX operating system that would require changes to
Rational's products would have a material adverse effect on the
business, operating results, and financial condition of Rational.
Likewise, others of Rational's major products have historically been
licensed for use purely on the Windows or Windows NT operating systems.
These products also constitute a substantial portion of Rational's
product and service revenues. Any factors adversely affecting the
demand for, or use of, the Windows or Windows NT operating systems that
would require changes to Rational's products would have a material
adverse effect on the business, operating results, and financial
condition of Rational. In addition, any changes to the underlying
components of or interfaces to the UNIX, Windows or Windows NT
operating systems that would require changes to Rational's products for
those platforms would materially 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, particularly as a result
of its acquisitions, and the Company is experiencing a period of
aggressive product introductions that have placed, and may continue to
place, a significant strain on its financial, operational, management,
marketing, and sales systems and resources, including its personnel.
Projects such as the expansion of or enhancements to product lines,
efforts to address broader markets and to expand distribution channels,
numerous acquisitions as described in "Risks Associated with Recent and
Future Acquisitions" and business alliances such as the arrangement
between Rational and Microsoft, when added to the day-to-day activities
of Rational, have placed and will continue to place further strain on
management resources and personnel. If Rational's management is unable
to effectively manage growth, its business, competitive position,
results of operations, and financial condition will be materially and
adversely affected.
To achieve and manage continued growth, the Company must continue
to expand and upgrade its information-technology infrastructure and its
scalability, including improvements to various operations, financial,
and management information systems. In addition, the Company believes
that to remain competitive it must significantly expand its
capabilities for electronic commerce. Improving management systems and
infrastructure and building electronic commerce capabilities will
require that the Company recruit and retain highly qualified technical
personnel, and such personnel resources are extremely scarce in the
areas where the Company operates. Failure to improve management
infrastructure and build electronic commerce capabilities for future
growth would materially and adversely affect the Company's business,
competitive position, results of operations, and financial condition.
See "Dependence on Key Personnel."
Risk of Software Defects
Software products as complex as those sold by the Company often
contain undetected errors, or "bugs," or performance problems. Such
defects are most frequently found during the period immediately
following the introduction of new products or enhancements to existing
products. Despite extensive product testing prior to introduction, the
Company's products have in the past contained software errors that were
discovered after commercial introduction. Errors or performance
problems may also be discovered in the future. Any future software
defects discovered after shipment of the Company's products could
result in loss of revenues or delays in market acceptance, which could
have a material adverse effect on the Company's business, operating
results, or financial condition. Further, because the Company relies on
its own products in connection with the development of its software,
any such errors could make it more difficult to sell such products in
the future. Rational attempts to make adequate allowance in its new-
product release schedule for both internal and beta-site testing of
product performance. Because of the complexity of the Company's
products, however, the release of new products by the Company may be
postponed should test results indicate the need for redesign and
retesting or should the Company elect to add product enhancements in
response to beta customer feedback.
Risks Associated with International Operations
International sales accounted for approximately 34%, 27% and 27%
of Rational's revenues in fiscal 1998, 1997, and 1996, respectively and
represented 37% for the nine months ended December 31, 1998. Rational
expects that international sales will continue to account for a
significant portion of the Company's revenues in future periods.
International sales are subject to inherent risks, including unexpected
changes in regulatory requirements and tariffs, unexpected changes in
global economic conditions, difficulties in staffing and managing
foreign operations, longer payment cycles, greater difficulty in
accounts receivable collection, potentially adverse tax consequences,
price controls or other restrictions on foreign currency, difficulties
in obtaining export and import licenses, costs of localizing products
for foreign markets, lack of acceptance of localized products in
international markets, and the effects of high local wage scales and
other expenses. Any material adverse effect on the Company's
international business would be likely to materially and adversely
affect the Company's business, operating results, and financial
condition as a whole.
Rational's international sales are generally transacted through
its international sales subsidiaries. The revenue generated by these
foreign subsidiaries, as well as their local expenses, are generally
denominated in local currencies. Accordingly, the functional currency
of each international sales subsidiary is the local currency. Rational
has engaged in limited hedging activities to protect it against losses
arising from remeasuring assets and liabilities denominated in
currencies other than the functional currency of the 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 further economic problems in Asia in the
future.
Risks Associated with Asian Economic Crises
In addition to general risks associated with international
operations listed above, there are additional risks associated with the
continuing economic crisis in Asia. Many of Rational's customers, who
are 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 be 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. We are currently
assessing the effect the introduction of the Euro will have on our
internal accounting systems and the sales of our products. We are not
aware of any material operational issues or costs associated with
preparing our internal systems for the Euro. However, we do utilize
third party vendor equipment and software products that may or may not
be EMU compliant. Although we are 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 our
Company or require us to incur expenses to remedy such problems.
Limited Protection of Intellectual Property and Proprietary Rights
Rational relies on a combination of copyright, trademark, and
trade-secret laws, employee and third-party nondisclosure agreements,
and other methods to protect its proprietary rights. Despite these
precautions, it may be possible for unauthorized third parties to copy
certain portions of the Company's products or reverse engineer or
obtain and use information that Rational regards as proprietary.
Rational generally licenses its software products to end-users on a
right-to-use basis pursuant to a perpetual license. Rational licenses
its products primarily under "shrink-wrap" licenses (that is, licenses
included as part of the product packaging). Shrink-wrap licenses are
not negotiated with or signed by individual licensees and purport to
take effect upon the opening of the product package. Certain license
provisions protecting against unauthorized use, copying, transfer, and
disclosure of the licensed program may be unenforceable under the laws
of certain jurisdictions and foreign countries. In addition, the laws
of some countries do not protect proprietary rights to the same extent
as the laws of the United States. There can be no assurance that these
protections will be adequate. To the extent that the Company increases
its international activities, its exposure to unauthorized copying and
use of its products and proprietary information will increase.
The scope of United States patent protection in the software
industry is not well defined and will evolve as the United States
Patent and Trademark Office grants additional patents. Because patent
applications in the United States are not publicly disclosed until the
patent is issued, applications may have been filed that would relate to
Rational's products.
Rational also relies on certain software that it licenses from
third parties, including software that is integrated with internally
developed software and used in its products to perform key functions.
There can be no assurance that these third-party software licenses will
continue to be available to the Company on commercially reasonable
terms or that the software will be appropriately supported, maintained,
or enhanced by the licensors. The loss of licenses to or inability to
support, maintain, and enhance any of such software could result in
increased costs or in delays or deductions in product shipments until
equivalent software could be developed, identified, licensed, and
integrated, which would materially adversely affect the Company's
business, operating results, and financial condition. In addition,
Rational licenses certain of its technology to its development
partners. There can be no assurance that such partners' use of the
technology will be complementary to Rational's strategies or that such
partners will not use such technology to develop and market competing
products in the future.
Risks of Litigation
Competitors and potential competitors may resort to litigation as
a means of competition. Such litigation or other legal disputes may be
costly and may expose the Company to new claims that it may not have
anticipated. In the past, Rational has instituted litigation against
several companies. Although patent and intellectual property disputes
in the software area have often been settled through licensing, cross-
licensing, or similar arrangements, costs associated with such
arrangements may be substantial. The Company is also currently a party
to securities litigation. Any litigation involving the Company, whether
as plaintiff or defendant, regardless of the outcome, may result in
substantial costs and expenses to the Company and significant diversion
of effort by the Company's technical and management personnel. In
addition, there can be no assurance that litigation, instituted either
by or against the Company, will not be necessary to resolve issues that
may arise from time to time in the future. Any such litigation could
have a material adverse effect on the Company's business, operating
results, and financial condition.
Rational expects that software product developers will be
increasingly subject to infringement claims as the number of products
and competitors grows and the functionality of products in different
industry segments overlaps. There can be no assurance that third
parties will not assert infringement claims against the Company in the
future or that such claims will not be successful. The Company could
incur substantial costs in defending itself and its customers against
any such claims. Parties making such claims may be able to obtain
injunctive or other equitable relief that could effectively block the
Company's ability to sell its products in the United States and abroad
and could result in an award of substantial damages. In the event of a
claim of infringement, the Company and its customers may be required to
obtain one or more licenses from third parties. There can be no
assurance that the Company or its customers could obtain necessary
licenses from third parties at a reasonable cost or at all. Defense of
any lawsuit or failure to obtain any such required license would have a
material adverse effect on the Company's business, results of
operations, and financial condition. See also "Item 3-Legal
Proceedings" of Part I in the Company's latest annual report filed with
the Securities and Exchange Commission on Form 10-K.
Deferred Tax Assets
In fiscal 1998, the Company recognized approximately $15 million
out of $45 million previously unrecognized deferred tax assets. The
"more likely than not" criteria for recognition had been met as a
result of current and anticipated operating results. Should the
Company's operating results not achieve anticipated levels, these
deferred tax assets may not be realized thereby adversely impacting the
Company's reported tax expense. The Company has provided a valuation
allowance on the remaining deferred tax assets as the "more likely than
not" criteria has not been met.
PART II -- OTHER INFORMATION
ITEM 1 - Legal Proceedings
On May 28, 1998, a consolidated, amended class action Complaint was
filed against the Company and Paul D. Levy in the United States
District Court for the Northern District of California. That action,
In re Rational Software Corporation, No. 97-21001 (JF), consolidates
eight prior-pending, virtually-identical complaints. SG Cowen &
Company and an SG Cowen & Company analyst are also named as defendants.
The complaint alleges that defendants violated Sections 10(b) and 20A
of the Securities Exchange Act of 1934 and California state securities
laws through the selective disclosure of material inside information
regarding the Company's prospects. The complaint seeks unspecified
damages on behalf of a class of stockholders who purchased the
Company's common stock on October 8, 1997. Defendants' motions to
dismiss the Complaint were granted, with leave to amend. The Company
anticipates that plaintiffs will attempt to amend the Complaint. The
Company further expects to file a motion to dismiss that amended
Complaint.
ITEM 6 - Exhibits and Reports on Form 8-K
(a) Exhibit 10.1: Amendment to Development and License
Agreement with Microsoft Corporation, dated October 28,
1998.
Exhibit 27: Financial Data Schedule
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
RATIONAL SOFTWARE CORPORATION
by: /s/ Timothy A. Brennan
--------------------------------
Timothy A. Brennan
Senior Vice President
Chief Financial Officer and Secretary
February 16, 1999
Exhibit 10.1
AMENDMENT TO DEVELOPMENT AND LICENSE AGREEMENT
THIS AMENDMENT TO DEVELOPMENT AND LICENSE AGREEMENT ("Amendment")
is made and entered into this 28th day of October, 1998 (the "Amendment
Effective Date"), by and between Microsoft Corporation, a Washington
corporation with its principal office located at One Microsoft Way,
Redmond, Washington 98052-6399, ("Microsoft") and Rational Software
Corporation, a Delaware corporation with its principal offices located
at 18880 Homestead Road, Cupertino, California 65014 (the "Company").
RECITALS
A. Microsoft and Company are parties (the "Parties") to that
certain Development and License Agreement dated as of September 24,
1996 (the "Agreement") pursuant to which Company developed and licensed
certain technology for and to Microsoft as more fully described in the
Agreement.
B. The parties temporarily extended the Term of the Agreement
for thirty (30) days to October 24, 1998, by a Letter Agreement (the
"Letter") dated September 15, 1998.
C. The parties wish to permanently extend the Term of
Agreement as set forth below.
NOW THEREFORE, in consideration of the mutual promises herein and
for good and valuable consideration, the receipt and sufficiency of
which is hereby acknowledged, the parties agree as follows:
AGREEMENT
1. Defined terms not otherwise defined herein, shall be defined
according to the Agreement.
2. Section 9.1 of the Agreement is hereby deleted in its entirety
and restated as follows:
"9.1 Term. The term of this Agreement shall be for two (2)
consecutive years commencing on the effective Date of the
Agreement (the "Initial Term") and shall continue from year to
year thereafter (the "Annual Renewal Term") unless terminated
earlier as provided in this Section 9. At any time after the
Initial Term of the Agreement, either party may elect to
terminate or allow the Agreement to be terminated for any reason,
upon ninety (90) days written notice to the other party."
3. This Amendment may be executed in any number of counterparts and
by different parties hereto in separate counterparts, each of which
when so executed shall be deemed to be an original, and all of which
taken together shall constitute one and the same Amendment. Delivery
of an executed counterpart of a signature page to this Amendment by
facsimile transmission shall be effective as delivery of an originally
executed counterpart of this Amendment.
4. The Agreement as amended by the Amendment, is and shall continue to
be in full force and effect and is hereby ratified and confirmed in all
respects. Except to the extent specifically set forth herein, nothing
contained in this Amendment shall constitute a waiver of any conditions
or any other terms, provisions or requirements of the Agreement or any
other agreements between the parties.
IN WITNESS WHEREOF, the parties hereto execute this Amendment to
be effective as of the Effective Date set forth above.
MICROSOFT CORPORATION RATIONAL SOFTWARE CORPORATION
"Microsoft" "Company"
By: /s/ Paul H. Gross By: /s/ Robert H. Dickerson
Paul H. Gross Robert H. Dickerson
Vice President, Developer Tools Senior Vice President,
Products
October 28, 1998 October 23, 1998
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ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
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<FISCAL-YEAR-END> MAR-31-1999
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<PERIOD-END> DEC-31-1998
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<SECURITIES> 187,599
<RECEIVABLES> 81,684
<ALLOWANCES> 3,406
<INVENTORY> 0
<CURRENT-ASSETS> 319,635
<PP&E> 93,114
<DEPRECIATION> 48,499
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0
0
<COMMON> 918
<OTHER-SE> 240,251
<TOTAL-LIABILITY-AND-EQUITY> 384,894
<SALES> 175,083
<TOTAL-REVENUES> 286,759
<CGS> 15,808
<TOTAL-COSTS> 46,118
<OTHER-EXPENSES> 195,601
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 54,513
<INCOME-TAX> 16,354
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