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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 September 30, 1999
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 87,333,456
$.01 PER SHARE
(Class) (Shares outstanding on October 29, 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..................................
Item 3 -- Quantitative and Qualitative Disclosures about Market Risk.
PART II -- OTHER INFORMATION
Item 1 -- Legal Proceedings..........................................
Item 4 -- Submission of Matters to a Vote of Security Holders........
Item 6 -- Exhibits and Reports on Form 8-K...........................
SIGNATURE.............................................................
<PAGE>
Item 1 -- Condensed Consolidated Financial Statements
RATIONAL SOFTWARE CORPORATION
Condensed Consolidated Balance Sheets
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
September 30, March 31,
1999 1999
------------ ------------
(unaudited) (Note A)
<S> <C> <C>
ASSETS
-------------------------------------
Current assets:
Cash and cash equivalents.................... $81,175 $59,965
Short-term investments....................... 185,256 199,865
Accounts receivable, net..................... 100,706 92,367
Prepaid expenses and other assets............ 22,881 22,881
Deferred tax assets.......................... 15,824 9,176
------------ ------------
Total current assets.......................... 405,842 384,254
------------ ------------
Property and equipment, at cost:
Computer, office and manufacturing equipment. 75,358 74,867
Office furniture............................. 11,966 10,535
Leasehold improvements....................... 11,739 10,905
------------ ------------
99,063 96,307
Accumulated depreciation and amortization.... (52,920) (50,862)
------------ ------------
Property and equipment, net................... 46,143 45,445
Other assets, net............................. 22,833 24,257
------------ ------------
Total assets.................................. $474,818 $453,956
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
-------------------------------------
Current liabilities:
Accounts payable............................. $9,167 $13,848
Accrued employee benefits.................... 21,494 27,212
Income taxes payable......................... 32,821 19,652
Other accrued expenses....................... 22,759 16,334
Current portion of accrued merger and
integration expenses....................... 1,325 2,619
Deferred revenue............................. 80,566 76,223
------------ ------------
Total current liabilities..................... 168,132 155,888
Accrued rent.................................. 811 896
Long-term accrued merger and integration
expenses..................................... 1,700 2,800
------------ ------------
Total liabilities............................. 170,643 159,584
------------ ------------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.01 par value, 150,000
shares authorized........................... 959 933
Additional paid-in capital................... 599,253 562,742
Treasury stock............................... (180,851) (119,488)
Accumulated deficit.......................... (111,995) (146,013)
Cumulative translation adjustment............ (3,191) (3,802)
------------ ------------
Total stockholders' equity.................... 304,175 294,372
------------ ------------
Total liabilities and stockholders' equity.... $474,818 $453,956
============ ============
</TABLE>
Note A: The balance sheet at March 31, 1999 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 Six Months Ended
September 30, September 30,
--------- --------- --------- ---------
1999 1998 1999 1998
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Net product revenue................ $77,782 $57,708 $150,197 $107,702
Consulting and support revenue..... 50,379 36,948 95,387 69,925
--------- --------- --------- ---------
Total revenue.................. 128,161 94,656 245,584 177,627
--------- --------- --------- ---------
Cost of product revenue............ 5,709 4,635 11,719 11,081
Cost of consulting and support
revenue.......................... 13,287 10,262 24,900 19,579
--------- --------- --------- ---------
Total cost of revenue.......... 18,996 14,897 36,619 30,660
--------- --------- --------- ---------
Gross margin....................... 109,165 79,759 208,965 146,967
--------- --------- --------- ---------
Operating expenses:
Research and development......... 23,084 16,651 45,609 32,266
Sales and marketing.............. 51,165 39,913 100,526 76,378
General and administrative....... 10,520 9,001 20,611 15,808
--------- --------- --------- ---------
Total operating expenses....... 84,769 65,565 166,746 124,452
--------- --------- --------- ---------
Operating income............... 24,396 14,194 42,219 22,515
Other income, net.................. 2,445 3,234 5,029 6,349
--------- --------- --------- ---------
Income before income
taxes........................ 26,841 17,428 47,248 28,864
Provision for income taxes......... 7,516 5,228 13,230 8,659
--------- --------- --------- ---------
Net income......................... $19,325 $12,200 $34,018 $20,205
========= ========= ========= =========
Net income per common
share - basic.................... $0.22 $0.14 $0.39 $0.23
Shares used in computing per
share amounts - basic............ 86,890 85,046 86,709 86,456
Net income per common
share - diluted.................. $0.21 $0.14 $0.36 $0.22
Shares used in computing per
share amounts - diluted.......... 93,948 89,810 94,026 91,334
</TABLE>
See accompanying notes to condensed consolidated financial statements.
<PAGE>
RATIONAL SOFTWARE CORPORATION
Condensed Consolidated Statement of Cash Flows
(in thousands, unaudited)
<TABLE>
<CAPTION>
Six Months Ended
September 30
----------------------
1999 1998
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net income.......................................... $34,018 $20,205
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization..................... 11,019 10,120
Tax benefits of stock option exercises............ -- 6,000
Changes in operating assets and liabilities:
Accounts receivable............................. (8,339) 10,726
Prepaids and other, net......................... (6,648) 611
Accounts payable................................ (4,681) (1,194)
Accrued employee benefits and other accrued
expenses..................................... 622 (9,991)
Income taxes payable............................ 13,169 (385)
Accrued merger and integration expenses......... (2,394) (12,462)
Deferred revenue................................ 4,343 5,919
---------- ----------
Net cash provided by operating activities.............. 41,109 29,549
---------- ----------
Cash flows from investing activities:
Purchase of short-term investments.................. (132,899) (100,069)
Maturities and sales of short-term investments...... 147,508 138,264
Purchases of property and equipment................. (10,091) (13,959)
Net change in other assets.......................... (202) (573)
---------- ----------
Net cash provided by investing activities.............. 4,316 23,663
---------- ----------
Cash flows from financing activities:
Net proceeds from issuance of common stock.......... 36,537 7,182
Repurchases of common stock......................... (61,363) (98,385)
---------- ----------
Net cash used in financing activities.................. (24,826) (91,203)
---------- ----------
Effect of changes in foreign currency exchange
rate on cash.......................................... 611 485
---------- ----------
Net increase (decrease) in cash and cash equivalents... 21,210 (37,506)
Cash and cash equivalents at beginning of period....... 59,965 126,229
---------- ----------
Cash and cash equivalents at end of period............. $81,175 $88,723
========== ==========
</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 an audit and 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 September 30, 1999 are not necessarily indicative of the
results that may be expected for the fiscal year ending March 31,
2000.
2. ACCOUNTS RECEIVABLE - Accounts receivable are presented net of an
allowance for doubtful accounts of $3,032,000 at September 30, 1999
and $3,226,000 at March 31, 1999.
3. NET INCOME PER COMMON SHARE - The following table sets forth the
computation of basic and diluted net income per share (in
thousands, except per share amounts):
<TABLE>
<CAPTION>
(in thousands, except per share amounts)
Three Months Ended Six Months Ended
September 30, September 30,
------------------- --------- ---------
1999 1998 1999 1998
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Numerator:
Net income ....................... $19,325 $12,200 $34,018 $20,205
Denominator:
Denominator for basic net income
per share - weighted
average shares.................... 86,890 85,046 86,709 86,456
Incremental common shares
attributable to shares issuable
under employee stock plans........ 7,058 4,764 7,317 4,878
--------- --------- --------- ---------
Denominator for diluted net
income per share -
weighted average shares and
assumed conversions............... 93,948 89,810 94,026 91,334
========= ========= ========= =========
Net income per share - basic. $0.22 $0.14 $0.39 $0.23
========= ========= ========= =========
Net income per share -
diluted........................... $0.21 $0.14 $0.36 $0.22
========= ========= ========= =========
</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
included in stockholders' equity and excluded from net income, to be
included in comprehensive income.
For the three months ended September 30, 1999, total comprehensive
income amounted to approximately $21,585,000 compared to a
comprehensive income of $12,326,000 for the same period last year.
For the six months ended September 30, 1999, comprehensive income
amounted to approximately $34,628,000 compared to comprehensive
income of $20,690,000 for the same period last year.
5. RECENT PRONOUNCEMENTS - 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, 2000. Because of the Company's
limited 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 - As reported previously, in December 1996, the
Company filed suit against Silicon Graphics, Inc. ("SGI") seeking to
recover royalties due to the Company under a license agreement
between SGI and the Company's predecessor in interest, Verdix
Corporation. SGI answered the complaint, denying any liability, and
filed a cross complaint seeking unspecified damages for alleged
violations of the same license agreement. Effective August 12, 1999,
the Company and SGI entered an agreement under which this litigation
was settled in its entirety. The terms of this agreement are
confidential. The arrangement, however, will not have any material
impact on the Company's financial statements.
Beginning on October 10, 1997, a number of purported securities
class actions were filed against the Company, two of its officers,
and Cowen & Company. The cases were consolidated into one matter,
Rational Software Corporation, et al., No. C 97-03740 (N.D. Cal.),
pending in the United States District Court for the Northern
District of California. The consolidated amended complaint alleges
that defendants violated Sections 10(b) and 20A of the Securities
Exchange Act of 1934 through the selective disclosure of material
inside information regarding the Company's prospects and seeks
unspecified damages on behalf of a class of stockholders who
purchased the Company's common stock on October 8, 1997. The Court
granted with leave to amend defendants motion to dismiss the
Consolidated Amended Complaint. Plaintiffs' deadline to file an
amended complaint is December 29, 1999. The Company believes the
action is without merit and will continue to defend the case
vigorously.
7. STOCK REPURCHASE - Under a program approved in October 1998, the
Company is authorized to repurchase up to 6 million shares of its
common stock from time to time in the open market. For the six
months ended September 30, 1999 the Company repurchased 2,072,500
shares of its common stock for a total cash outlay of approximately
$61.4 million. A purpose of the stock repurchase program is to
offset the dilution resulting from shares issued under the Company's
employee stock option and stock purchase plans. The timing and size
of any future stock repurchases are subject to market conditions,
stock prices, the Company's cash position and other cash
requirements going forward.
<PAGE>
Item 2 -- Management's Discussion and Analysis of Financial Condition
and Results of Operations
Overview
The statements contained in Management's Discussion and Analysis of
Financial Condition and Results of Operations include "forward looking"
statements within the meaning of Sections 27A of the Securities Act of
1993 and 21E of the Securities and Exchange Act of 1934, as amended,
including statements about international revenue, customer acceptance,
strength of the internet market, future cash requirements, and the
Company's readiness for the Year 2000, 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 statements. 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 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 generally recognizes software license revenues when a
customer purchase order has been received and accepted, the software
product has been shipped, there are no uncertainties surrounding
product acceptance, the fees are fixed and determinable, and collection
is considered probable. 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 Six-
Months Ended September 30, 1999
Total revenue for the three- and six- month periods ended September 30,
1999 increased 35% and 38%, respectively from the comparable prior year
periods.
Net product revenue for the three- and six- month periods ended
September 30, 1999 increased 35% and 39%, respectively from the
comparable prior year periods. Consulting and support revenue for both
the three- and six- month periods ended September 30, 1999 increased
36% from the comparable prior year periods. This increase reflects
continued strong customer acceptance across the majority of the
Company's products and services to e-development customers.
International revenue from product sales and consulting and customer
support accounted for 42% of total revenue for both the three- and six-
month periods ended September 30, 1999, compared to 37% and 35%,
respectively, for the comparable prior year periods. The Company
expects international sales to continue to account for a significant
portion of total revenue in future periods, although the percentage of
international revenues could fluctuate from period to period due to
economic or other factors in international regions. The Company's
international sales are principally priced in local currencies. The
Company enters into short-term forward currency contracts to hedge
against the impact of foreign currency exchange rate fluctuations on
balance sheet exposures denominated in currencies other than the
functional currency of the Company or its subsidiaries. The total
amount of these contracts is approximately offset by the underlying
assets and liabilities denominated in non-functional currencies and
such contracts are carried at fair market value. The associated gains
and losses were not material to the Company's results of operations in
any period presented. See Risks Associated with International
Operations.
Cost of product revenue consists principally of materials, packaging
and freight, amortization of developed technology and royalties. Cost
of product revenue for the three- and six- month periods ended
September 30, 1999 increased 23% and 6%, respectively from the
comparable prior year periods. These costs represented 7% and 8%,
respectively of total product revenue for the three- and six- month
periods ended September 30, 1999, as compared to 8% and 10%,
respectively for the comparable prior year periods. The decrease in
product cost as a percentage of certain product revenue was due mainly
to a higher level of materials cost associated with new product
releases in fiscal 1999.
Cost of consulting and support revenue consists principally of
personnel costs for training, consulting and customer support. Cost of
consulting and support revenue for the three- and six- month periods
ended September 30, 1999 increased 29% and 27%, respectively from the
comparable prior year periods. These costs represented 26% of total
consulting and support revenue for both the three- and six- month
periods ended September 30, 1999, as compared to 28% for both the
comparable prior year periods. The decrease in cost as a percentage of
related revenue is primarily due to the impact of a relatively fixed
support cost base servicing increased revenues.
Total expenditures for research and development increased 39% and 41%,
respectively, for the three- and six- month periods ended September 30,
1999 from the comparable prior year periods. These costs represented
18% and 19%, respectively, of total revenue for the three- and six-
month periods ended September 30, 1999 compared to 18% for both the
comparable prior year periods. The increase in year over year research
and development expense is due primarily to the cost of additional
personnel and related costs, and additional investment in department
infrastructure incurred to maintain and enhance existing products as
well as develop new products.
Sales and marketing expenses increased 28% and 32% for the three- and
six- month periods ended September 30, 1999 from the comparable prior
year periods. These costs represented 40% and 41% of total revenue for
the three- and six- month periods ended September 30, 1999 compared to
42% and 43%, respectively, for the same periods last year. The increase
in year over year sales and marketing expense reflects increases in
personnel and related costs as well as increased promotional
activities. The decrease in sales and marketing expenses as a
percentage of total revenue is a result of the increasing economies of
scale as a result of increases in total revenue.
General and administrative expense increased 17% and 30%, respectively,
for the three- and six- month periods ended September 30, 1999 from the
comparable prior year periods. These costs represented 8% of total
revenue for both the three- and six- month periods ended September 30,
1999 as compared to 10% and 9%, respectively for the comparable prior
year periods. The increase in year over year general and
administrative expense is due primarily to increased investment in the
Company's information technology infrastructure needed to support the
growing requirements of the Company. The decrease in general and
administrative expense as a percentage of total revenue is a result of
the increasing economies of scale as a result of increases in total
revenue.
Other income, net consists primarily of interest income, interest
expense and gains and losses due to fluctuations in foreign currency
exchange rates. Other income has fluctuated as a result of the amount
of cash available for investment in interest-bearing instruments and
from fluctuations in foreign currency exchange rates. Other income, net
decreased $789,000 and $1,320,000, respectively, for the three- and
six- month periods ended September 30, 1999 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
stock during the period combined with an increase in tax exempt
investments.
The provision for income taxes for the three- and six- month periods
ended September 30, 1999 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 2000
and 1999 differ from the federal statutory rate primarily as a result
of international income subject to a lower overall tax rate, investment
in tax exempt securities, and research credits. The effective tax rate
for fiscal 2000 decreased from fiscal 1999 as a result of increased
investment in tax exempt securities and increased international income
subject to lower overall rates.
Liquidity and Capital Resources at September 30, 1999
As of September 30, 1999, the Company had cash, cash equivalents and
short-term investments of $266,461,000 and working capital of
$237,710,000. Net cash provided by operating activities for the six
months ended September 30, 1999 was composed primarily of operating
income and an increase in taxes payable and deferred revenue, offset by
an increase in accounts receivable and prepaid expenses, and a decrease
in accounts payable and accrued merger costs. Net cash provided by
investing activities resulted primarily from a higher level of
maturities and sales of short-term investments, offset by an increase
in capital expenditures. Net cash used in financing activities
resulted primarily from the repurchase of common stock offset by the
issuance of common stock under the Employee Stock Purchase Plan and the
exercise of employee stock options.
Under a program approved in October 1998, the Company is authorized to
repurchase up to 6,000,000 shares of its common stock from time to time
in the open market. For the six months ended September 30, 1999 the
Company repurchased 2,072,500 shares of its common stock for a total
cash outlay of approximately $61,363,000. A purpose of the stock
repurchase program is to offset the dilution resulting from shares
issued under the Company's employee stock option and stock purchase
plans. The timing and size of any future stock repurchases are subject
to market conditions, stock prices and the Company's cash position and
other cash requirements going forward.
The Company believes that expected cash flow from operations combined
with existing cash and cash equivalents and short-term investments will
be sufficient to meet its cash requirements for the foreseeable future.
Year 2000 Readiness Disclosure
The Company is aware of the problems associated with computer
systems as the year 2000 approaches. Year 2000 problems are the result
of common computer programming techniques that result in systems that
do not function properly when manipulating dates later than December
31, 1999. The problem may affect internal information technology (IT)
systems used by the Company for product development, accounting,
distribution, and planning. The problem may also affect non-IT embedded
systems such as building security systems, machine controllers, and
other equipment.
The Company established a year 2000 project team to develop and
implement a comprehensive four-phase year 2000 readiness plan for its
worldwide operations relating to (1) the Company's software products,
(2) the Company's internal IT and non-IT systems and (3) third-party
customers, vendors, and others with whom the Company does business.
Phase One (Inventory) consisted of identifying all the Company's
systems, relationships, and products that may be impacted by year 2000.
Phase Two (Assessment) involved determining the Company's current state
of year 2000 readiness for those areas identified in the inventory
phase and prioritizing the areas that need to be fixed. Phase Three
(Remediation) consisted of developing a plan for those areas identified
as needing correction in the assessment phase. Phase Four
(Implementation) consisted of executing the action plan and completing
the steps identified to attain year 2000 readiness.
With respect to its software products, the Company has completed
the Inventory, Assessment, Remediation, and Implementation phases of
the plan in the course of developing new products and product upgrades,
all of which have been designed to be year 2000 compliant. Accordingly,
the Company does not currently sell or support any products that are
not year 2000 compliant. The Company did not separately track the
internal costs of the research and development efforts related to
making its products year 2000 compliant, and such costs were
principally composed of salaries and benefits of software engineering
personnel. The Company funded these research and development costs out
of operating cash flows.
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. No such system
implementations were undertaken or accelerated for the sole purpose of
becoming year 2000 compliant, and it is not practicable to identify any
incremental costs related to year 2000 compliance involved in these
system implementations. As an additional precautionary measure, the
Company is conducting parallel testing of the primary accounting and
sales tracking systems. Through October, 1999 these tests are nearly
complete and no material problems have been encountered. The costs
incurred for the testing have not been significant, nor are the costs
to complete the testing expected to be significant. Management expects
all testing to be completed prior to the year 2000.
With respect to noncritical IT systems, consisting primarily of
security systems, fax machines and other miscellaneous systems, and
non-IT embedded systems, the Company has completed all phases of the
plan. The Company did not incur any material costs in completing the
Remediation and Implementation phases with respect to these noncritical
IT and non-IT embedded systems. The Company funded all remediation and
implementation costs from operating cash flows and did not establish
any specific reserves for these costs. As with critical IT systems,
discussed above, many of the Company's noncritical IT systems have been
replaced or upgraded to accommodate expanded business processes due to
recent growth and merger activity. No such system implementations were
undertaken or accelerated for the sole purpose of becoming year 2000
compliant.
The Company has completed all phases of determining the year 2000
readiness of its significant suppliers, subcontractors, and customers
that do not share information systems with the Company, and has queried
such third parties about their year 2000 readiness. The Company has
no means of ensuring that these third parties will be year 2000 ready,
but believes all such companies will be able to support Rational's
business.
Based on information currently available to the Company, the
Company believes that the most reasonably likely worst case year 2000
scenarios with respect to the Company relate to the potential failure
of third-party suppliers, subcontractors, and customers to become year
2000 compliant and, to a lesser extent, the Company's potential failure
to reach year 2000 compliance with respect to noncritical IT and non-IT
embedded systems. The inability of suppliers, subcontractors, and
customers to complete their year 2000 remediation processes in a timely
fashion could result in delays in introducing new products, reduced
sales of new or existing products, and disruptions in strategic
relationships, which could in turn have a material and adverse effect
on the Company's results of operations and financial condition. The
effect of noncompliance by suppliers, subcontractors, and customers is
not reasonably quantifiable.
While the Company expects to attain year 2000 readiness with
respect to noncritical IT and non-IT embedded systems, there is no
assurance that the Company will be successful in its efforts to
identify and address all year 2000 system issues on time. Failure to
do so may adversely impact the Company's results of operations or
adversely affect the Company's relationships with customers, vendors,
or others. For example, failure to achieve year 2000 readiness could
delay the Company's ability to produce and ship products, invoice
customers, and collect payments, and could disrupt customer service,
technical support, and facilities. The Company could suffer increased
costs, lost sales, or other negative consequences resulting from
customer dissatisfaction, including litigation. Failures of security
systems relying on non-IT embedded systems could compromise the
Company's operations or ability to safeguard proprietary information.
The Company has completed year 2000 related contingency plans for
all critical business processes. The Company did not incur any
significant costs in completing the contingency plans.
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, critical, and noncritical IT systems, there could be
unanticipated year 2000 related failures in such products or systems
that could have a material and adverse effect on the Company's results
of operations and financial condition. Further, there can be no
guarantee that the systems of other companies on which the Company's
systems rely will be remediated in a timely manner, or that a failure
to remediate by another company, including without limitation any of
the Company's vendors, customers, or partners, or a remediation that is
incompatible with the Company's systems, would not have a material
adverse effect on the Company.
Factors That May Affect Future Results
Fluctuations in Operating Results
Revenue in any quarter is substantially dependent on orders
booked and shipped in that quarter. Because staffing and operating
expenses are based on anticipated revenue levels and a high percentage
of the costs are fixed, small variations in the timing of the
recognition of specific revenues could cause significant variations in
operating results from quarter to quarter. Historically, the Company
has earned a substantial portion of its revenues in the last weeks of
the quarter. To the extent these trends continue, the failure to
achieve such revenues in the last weeks of any given quarter will have
a material adverse effect on the Company's financial results for that
quarter. The Company's revenues are difficult to forecast because
Rational's sales cycles, from initial evaluation to purchase, vary
substantially from customer to customer and from product to product,
and because the markets for Rational's products are rapidly evolving.
In addition, the Company's results will be affected by the number,
timing, and significance of new product announcements by it and its
competitors, its ability to develop, introduce, and market new,
enhanced, and integrated versions of its products on a timely basis,
the level of product and price competition, changes in operating
expenses, changes in average selling prices and product mix, any
changes in its sales incentive strategy, the experience level of and
any changes in sales personnel, any changes in sales cycles, the mix of
direct and indirect sales, product returns, and general economic
factors, among others. The Company's sales will also be sensitive to
existing and prospective customers' budgeting practices and global
economic conditions.
Although Rational has experienced growth in revenues in recent
years, there can be no assurance that, in the future, Rational will
sustain revenue growth or be profitable on a quarterly or annual basis.
Further, the revenues and operating income (exclusive of nonrecurring
operating, restructuring, and merger-related expenses) experienced by
Rational in recent quarters are not necessarily indicative of future
results, and period-to-period comparisons of Rational's financial
results should not be relied on as an indication of future performance.
Fluctuations in operating results have previously resulted and may
continue to result in volatility in the price of Rational's common
stock.
Due to all of the foregoing factors, it is possible that in some
future quarter, Rational's operating results will be below the
expectations of public market analysts and investors. In such event,
the price of Rational's common stock would likely be materially
adversely affected, and significant declines in stock prices frequently
result in costly and lengthy securities litigation, with its attendant
costs, distraction, and liability exposure.
Volatility of Stock Price
The market price of the Company's common stock has been, and is
likely to continue to be, volatile. Factors such as new product
announcements or changes in product pricing policies by the Company or
its competitors, quarterly fluctuations in the Company's operating
results, announcements of technical innovations, announcements relating
to strategic relationships or acquisitions, changes in earnings
estimates by analysts, and general conditions in the software
development market, among other factors, may have a significant impact
on the market price of the Company's common stock. Should the Company
fail to introduce products on the schedule expected, the Company's
stock price could be adversely affected.
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, mergers, 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 lifecycle, including a
formal development process, requirements management, modeling, testing,
configuration and change management. Sales of such products may not
continue to grow, or the Company may be unable to respond effectively
to evolving customer requirements. The number of software developers
using Rational's products is relatively small compared with the number
of developers using more traditional technology and products, or manual
approaches. The adoption of the Company's products by software
developers who have traditionally used other technology requires
reorientation to significantly different approaches to development.
Customers may rely on internally developed tools instead of off-the-
shelf products, or customers may rely on manual approaches instead of
automated tools that require up-front capital investment. The
acceptance of the Company's products, therefore, may not expand beyond
sophisticated software developers. Furthermore, potential customers
may be unwilling to make the investment required to retrain software
developers to build software using the Company's products rather than
traditional techniques. Many of Rational's customers have purchased
only small quantities of the Company's products, and these or new
customers may decide not to broadly implement or purchase additional
units of such products.
Dependence on Acceptance of Industry Standards
Rational's future growth and financial performance may depend on
the development of industry standards that facilitate the adoption of
component-based development, as well as Rational's ability to play a
leading role in the establishment of those standards. The Company
developed the Unified Modeling Language (UML) for visual modeling,
which was adopted by the Object Management Group (OMG), an industry
consortium, for inclusion in its object analysis and design facility
specification. The official sanction in the future of a competing
standard by the OMG or the promulgation of a competing standard by one
or more major platform vendors could have a material adverse effect on
Rational's marketing and sales efforts and, in turn, on Rational's
business, operating results, and financial condition.
Expansion of Product Lines; Dependence on New Product Introductions
The Company believes that its continued success will depend in
part on its ability to provide a tightly integrated line of software
development tools, as well as integrated product suites and bundles,
that support software development for a number of implementation
languages. This will require the Company to continue to modify and
enhance its current products and to continue to develop, introduce, and
integrate new products. The Company believes its continued success will
become increasingly dependent on its ability to support both the
Microsoft platform (including the Windows 95, Windows 98, and Windows
NT operating systems) and the IBM platform. The Company also believes
its continued success will become increasingly dependent on its ability
to support Web-based development of business-critical applications
using the latest technologies. The Company believes that it will be
particularly important to successfully develop and market a broader
line of products for C++, Visual Basic, Java, Visual Java++, Enterprise
Java Beans, HTML, XML, and other implementation languages in order to
be successful in its efforts to broaden its customer base and further
increase its share in its existing market segments. The Company also
believes that, over time, its products must be extended to continually
support the rapidly changing standards and technologies used in the
development of Web-based applications, as well as off-the-shelf
products from companies such as SAP, Oracle, 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 alliances with Microsoft and IBM, certain of Rational's new
product releases are expected to be tightly integrated with new
releases of certain Microsoft and IBM products or development
environments. To the extent that scheduled product releases from
strategic partners are delayed, there could be a material adverse
effect on Rational's revenues from related 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 automating software application development and
management is extremely competitive and rapidly changing. Rational
expects to continue to experience significant and increasing levels of
competition in the future. Bases of competition include corporate and
product reputation, innovation with frequent product enhancement,
breadth of integrated product line, the availability of integrated
suites and bundles, product architecture, functionality and features,
product quality, performance, ease of use, support, availability of
technical consulting services, and price. Rational faces intense
competition for each product in its product lines, generally from both
Windows and UNIX vendors. Because individual product sales are often
the first step in a broader customer relationship, Rational's success
will depend in part on its ability to successfully compete with
numerous competitors at each point in its product line.
Rational faces competition from software development tools and
processes developed internally by customers, including ad hoc
integrations of numerous stand-alone development tools. Customers may
be reluctant to purchase products offered by independent vendors such
as the Company. As a result, the Company must educate prospective
customers about the advantages of the Company's products versus
internally developed software quality systems.
Rational faces competition from, among others, Aonix, Compaq,
Computer Associates, Compuware, Continuus Software Corporation, Cyrano,
GEC-Marconi, Green Hills Software, Hewlett Packard, IBM, Merant, plc
(formerly Intersolv, Inc.), Mercury Interactive Corporation, Microsoft,
Oracle, Mortice Kern Systems (MKS), Perforce Software, Platinum
Technology, Inc., Segue Software, Inc., Select Software Tools plc, SGI,
SQL Software LTD, StarBase Corporation, Sterling Software, Inc, Sun
Microsystems, Sybase Inc., Teradyne, and True Software, as well as
numerous other public and privately held software application
development and tools suppliers. The Company expects additional
competition from other established and emerging companies.
Rational believes that the major competitive factors in its
markets are corporate and product reputation, breadth of coverage by an
integrated product line, product architecture, functionality and
features, product quality, performance, ease of use, quality of
support, availability of technical consulting services, and price.
Rational believes that its combination of an integrated family of
products supporting component-based development throughout the software
development life cycle and its emphasis on controlled iterative
development, visual modeling, and an architecture-driven process,
coupled with its extensive major-account direct sales and technical
consulting organization and the supporting channels such as telesales,
VARs, distributors, and the World Wide Web helps it compete.
Rational believes that the increased level of competition it
observed in fiscal 1999 and in the current year 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 is an important selling point with respect to
its products. Although complementary to Rational's products, the
services provided by these personnel have historically yielded lower
margins for Rational than the Company's product business. If these
services constitute a higher proportion of total revenues in the
future, the Company's margins will be adversely affected. Rational
markets and sells its products and services directly through its major-
accounts field operations, its telesales organizations, and its World
Wide Web site, and indirectly through channels such as VARs and
distributors. There can be no assurance that such channels will be
successful in increasing sales of the Company's products or in reducing
its sales costs on a percentage basis.
Dependence on Key Personnel
Rational believes that the hiring and retaining of qualified
individuals at all levels in the Company will be essential to the
Company's ability to sustain and manage growth successfully, and there
can be no assurance that the Company will be successful in attracting
and retaining the necessary personnel. The Company will be particularly
dependent on the efforts and abilities of its senior management
personnel. The departure of any of the senior management members or
other key personnel of the Company could have a material adverse effect
on the Company's business, financial condition, or results of
operations, depending on the timing of the departure, changes in the
Company's business prior to such time, the availability of qualified
personnel to replace them, and whether such personnel depart singly,
contemporaneously, or as a group, among other factors. Merger
activities can be accompanied or followed by the departure of key
personnel, which can compound the difficulty of integrating the
operations of the parties to the business combination.
The ability of the Company to attract and retain the highly
trained technical personnel that are integral to its direct sales and
product development teams may limit the rate at which the Company can
develop products and generate sales. Competition for qualified
personnel in the software industry is intense, and there can be no
assurance that the Company will be successful in attracting and
retaining such personnel. Merger activities may have a destabilizing
effect on employee retention at all levels within the Company.
Departures of existing personnel, particularly in key technical, sales,
marketing, or management positions, can be disruptive and can result in
departures of other existing personnel, which in turn could have a
material adverse effect on the Company's business, operating results,
and financial condition.
Rapid Technological Change
The industry for tools for automating software application
development and management is characterized by rapid technological
advances, changes in customer requirements, and frequent new product
introductions and enhancements. The introduction of products embodying
new technologies and the emergence of new industry standards and
practices can render existing products obsolete and unmarketable. The
Company must respond rapidly to developments related to Internet and
intranet applications, hardware platforms, operating systems, and
applicable programming languages. Such developments will require the
Company to make substantial product-development investments. Any
failure by the Company to anticipate or respond adequately to
technology developments and customer requirements, or any significant
delays in product development, introduction, or integration, could
result in a loss of competitiveness or revenues. To the extent that the
Company's new products or product enhancements do not respond to
technological change or evolving customer requirements, such new
products or product enhancements may fail to achieve market acceptance.
In addition, rapid growth of, interest in, and use of Internet
and intranet environments is still evolving. The Company's success may
depend, in part, on the compatibility of its products with Internet and
intranet applications. The Company may fail to continue to effectively
adapt its products for use in Internet or intranet environments, or to
produce competitive Internet and intranet applications.
Rational believes that factors affecting the ability of its
products to achieve broad consumer acceptance include product
performance, price, ease of adoption, displacement of existing
approaches, and adaptation to rapid technological change and
competitive product offerings. The Company may be unable to respond
promptly and effectively to the challenges of technological change and
its competitors' innovations, and it is possible that the Company will
be unable to achieve the necessary market acceptance or compete
effectively in new markets.
Dependence on Strategic Relationships and Business Alliances
Rational's development, marketing, and distribution strategies
rely increasingly on its ability to form long-term strategic
relationships with major software and hardware vendors, many of whom
are substantially larger than Rational. One such relationship with
Microsoft includes, among other things, Rational providing certain
visual modeling technology to Microsoft that is included in Microsoft's
Visual Studio Products. 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 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.
In addition, there can be no assurance that one or more partners
will not use the information they gain from their relationship with
Rational to develop or market competing products.
Dependence on Major Operating Systems
Many of Rational's major products have historically been licensed
for use principally on certain versions of the UNIX platform. These
products constitute a substantial portion of Rational's product and
service revenues. Any factors adversely affecting the demand for, or
use of, the UNIX operating system that would require changes to
Rational's products would have a material adverse effect on the
business, operating results, and financial condition of Rational.
Likewise, others of Rational's major products have historically been
licensed for use purely on the Windows or Windows NT operating systems.
These products also constitute a substantial portion of Rational's
product and service revenues. Any factors adversely affecting the
demand for, or use of, the Windows or Windows NT operating systems that
would require changes to Rational's products would have a material
adverse effect on the business, operating results, and financial
condition of Rational. In addition, any changes to the underlying
components of or interfaces to the UNIX, Windows or Windows NT
operating systems that would require changes to Rational's products for
those platforms would materially and adversely affect Rational if it
were not able to successfully develop or implement such changes in a
timely fashion.
Adverse Impact of Promotional Product Versions on Actual Product Sales
The Company's marketing strategy relies in part on making
elements of its technology available for no charge or at a very low
price, either directly or by incorporating such elements into products
offered by the Company's partners, such as Microsoft. This strategy is
designed to expose the Company's products to a broader customer base
than its historical customer base and to encourage potential customers
to purchase an upgrade or other higher-priced product from the Company.
There can be no assurance that the Company will be able to introduce
enhancements to its full-price products or versions of its products
with intermediate functionality at a rate necessary to adequately
differentiate them from the promotional versions, particularly in cases
where the Company's partners are distributing versions of the Company's
products with other desirable features.
Management of Growth
Rational has experienced rapid growth and the Company is
experiencing a period of aggressive product introductions that have
placed, and may continue to place, a significant strain on its
financial, operational, management, marketing, and sales systems and
resources, including its personnel. Projects such as the expansion of
or enhancements to product lines, efforts to address broader markets
and to expand distribution channels, numerous acquisitions as described
in "Risks Associated with Acquisitions," and business alliances such as
the arrangement between Rational and Microsoft or Rational and IBM,
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 allowances in its new-
product release schedule for both internal and beta site testing of
product performance. Because of the complexity of the Company's
products, however, the release of new products by the Company may be
postponed should test results indicate the need for redesign and
retesting or should the Company elect to add product enhancements in
response to beta customer feedback.
Risks Associated with International Operations
International sales accounted for approximately 40%, 34%, and 27%
of Rational's revenues in fiscal 1999, 1998, and 1997, respectively and
represented 42% for the six months ended September 30, 1999. Rational
expects that international sales will continue to account for a
significant portion of the Company's revenues in future periods.
International sales are subject to inherent risks, including unexpected
changes in regulatory requirements and tariffs, unexpected changes in
global economic conditions, difficulties in staffing and managing
foreign operations, longer payment cycles, greater difficulty in
accounts receivable collection, potentially adverse tax consequences,
price controls or other restrictions on foreign currency, difficulties
in obtaining export and import licenses, costs of localizing products
for certain markets, lack of acceptance of localized products in
international markets, and the effects of high local wage scales and
other expenses. Any material adverse effect on the Company's
international business would be likely to materially and adversely
affect the Company's business, operating results, and financial
condition as a whole.
Rational's international sales are generally transacted through
its international sales subsidiaries. The revenues generated by these
subsidiaries, as well as their local expenses, are generally
denominated in local currencies. Accordingly, the functional currency
of each international sales subsidiary is the local currency. Rational
has engaged in limited hedging activities to protect it against losses
arising from remeasuring assets and liabilities denominated in
currencies other than the functional currency of the related
subsidiary. The Company is also exposed to foreign exchange rate
fluctuations as the financial results of international subsidiaries are
translated into U.S. dollars in consolidation. As exchange rates vary,
these results, when translated, may vary from expectations and
adversely impact overall expected profitability. The Company currently
does not hedge against this exposure. There can be no assurance that
the Company will not experience a material adverse impact on its
financial condition and results of operations from fluctuations in
foreign currencies or from macroeconomic problems in various markets or
geographies in the future.
Risks Associated with Acquisitions
Rational acquired Pure Atria Corporation (Pure Atria) in 1997,
with the expectation that the acquisition would result in long-term
strategic benefits. The realization of these anticipated benefits will
continue to depend in part on integration of the companies' respective
product offerings and research and development efforts. There can be no
assurance that this will occur. It is possible that the continued
integration of the companies' respective products and the creation of
certain integrated bundles and suites may not be accomplished in a
timely manner or may prove to be technologically infeasible. The
acquisition of Pure Atria was accounted for as a pooling of interests.
Accordingly, if such accounting treatment was to be nullified for any
reason, it would materially and adversely affect Rational's reported
earnings and, potentially, its stock price.
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.
European Monetary Conversion
In January 1999, the new "Euro" currency was introduced in
certain European countries that are part of the European Monetary Union
(EMU). During 2002, all EMU countries are expected to begin operating
with the Euro as their single currency. A significant amount of
uncertainty exists as to the effect the Euro will have on the
marketplace generally and, additionally, all of the final rules and
regulations have not yet been defined and finalized by the European
Commission with regard to the Euro currency. Rational is currently
assessing the effect the introduction of the Euro will have on internal
accounting systems and the sales of products. The Company is not aware
of any material operational issues or costs associated with preparing
internal systems for the Euro. However, the Company does utilize third-
party vendor equipment and software products that may or may not be
EMU-compliant. Although the Company is currently taking steps to
address the impact, if any, of EMU compliance for such third-party
products, the failure of any critical components to operate properly
post-Euro may have an adverse effect on the business or results of
operations of the Company or require additional costs to remedy such
problems.
Limited Protection of Intellectual Property and Proprietary Rights
Rational relies on a combination of copyright, trademark, patent,
and trade-secret laws, employee and third-party nondisclosure
agreements, and other methods to protect its proprietary rights.
Despite these precautions, it may be possible for unauthorized third
parties to copy certain portions of the Company's products or reverse
engineer or obtain and use information that Rational regards as
proprietary. Rational generally licenses its software products to end
users on a right-to-use basis pursuant to a perpetual license. Rational
licenses its products primarily under "shrink-wrap" licenses (that is,
licenses included as part of the product packaging). Shrink-wrap
licenses are not negotiated with or signed by individual licensees and
purport to take effect upon the opening of the product package. Certain
license provisions protecting against unauthorized use, copying,
transfer, and disclosure of the licensed program may be unenforceable
under the laws of certain jurisdictions and foreign countries. In
addition, the laws of some countries do not protect proprietary rights
to the same extent as do the laws of the United States. There can be no
assurance that these protections will be adequate. To the extent that
the Company increases its international activities, its exposure to
unauthorized copying and use of its products and proprietary
information will increase.
The scope of United States patent protection in the software
industry is not well-defined and will evolve as the United States
Patent and Trademark Office grants additional patents. Because patent
applications in the United States are not publicly disclosed until the
patent is issued, applications may have been filed that would relate to
Rational's products.
Rational also relies on certain software that it licenses from
third parties, including software that is integrated with internally
developed software and used in its products to perform key functions.
There can be no assurance that these third-party software licenses will
continue to be available to the Company on commercially reasonable
terms or that the software will be appropriately supported, maintained,
or enhanced by the licensors. The loss of licenses to or inability to
support, maintain, and enhance any of such software could result in
increased costs or in delays or reductions in product shipments until
equivalent software could be developed, identified, licensed, and
integrated, which would materially adversely affect the Company's
business, operating results, and financial condition. In addition,
Rational licenses certain of its technology to its development
partners. There can be no assurance that such partners' use of the
technology will be complementary to Rational's strategies or that such
partners will not use such technology to develop and market competing
products in the future.
Risks of Litigation
Competitors and potential competitors may resort to litigation as
a means of competition. Such litigation or other legal disputes may be
costly and may expose the Company to claims that it may not have
anticipated. In the past, Rational has instituted litigation against
several companies. Although patent and intellectual property disputes
in the software area have often been settled through licensing, cross-
licensing, or similar arrangements, costs associated with such
arrangements may be substantial. The Company has recently been a party
to securities litigation. The matter was dismissed, but there is a
possibility that the plaintiffs in that matter may file an amended
complaint. 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. Third parties may assert infringement
claims against the Company in the future and such claims may or may not
be successful. The Company could incur substantial costs in defending
itself and its customers against any such claims. Parties making such
claims may be able to obtain injunctive or other equitable relief that
could effectively block the Company's ability to sell its products in
the United States and abroad and could result in an award of
substantial damages. In the event of a claim of infringement, the
Company and its customers may be required to obtain one or more
licenses from third parties. There can be no assurance that the Company
or its customers could obtain necessary licenses from third parties at
a reasonable cost or at all. Defense of any lawsuit or failure to
obtain any such required license would have a material adverse effect
on the Company's business, results of operations, and financial
condition. See also "Item 1-Legal Proceedings."
Deferred Tax Assets
Based on the weight of available evidence, which includes the
Company's historical operating performance and the reported cumulative
net loss for the prior three years, the Company has provided a
valuation against certain deferred tax assets for the "more likely than
not" criteria for recognition which has not been met.
ITEM 3-Quantitative and Qualitative Disclosures about Market Risk
The Company is exposed to market risk, including changes in
currency exchange rates and interest rates. To manage the volatility
relating to these exposures, the Company employs established policies
and procedures to manage its exposure to changes in known or forecasted
currency exchange rates and to fluctuations in interest rates.
Foreign Currency Risk
A portion of the Company's business is conducted in currencies
other than the U.S. dollar. Changes in the value of major foreign
currencies relative to the local or "functional" currency of the
Company or its subsidiaries may adversely effect operating results.
The Company enters into short-term forward foreign exchange contracts
designed to mitigate the impact of foreign currency exchange rate
fluctuations on balance sheet exposures denominated in currencies other
than the "functional" currency. The total amount of these contracts is
approximately offset by the underlying assets and liabilities
denominated in nonfunctional currencies. Forward contracts are
accounted for on a mark-to-market basis with realized and unrealized
gains or losses recognized in the period in which they are incurred.
Such contracts meet the criteria established in FAS 52 for hedge
accounting treatment. As the Company finds it impractical to hedge all
foreign currency exposures, the Company will continue to experience
foreign currency gains and losses. The Company does not use derivative
financial instruments for speculative trading purposes, nor does it
hold or issue leveraged derivative financial instruments.
Interest Rate Risk
The Company's exposure to market rate risk for changes in
interest rates relates primarily to the Company's investment portfolio.
All the Company's cash equivalents and short-term investments are
classified as available-for-sale and are recorded at amounts that
approximate fair value. Unrecognized gains and losses and declines in
value judged to be other than temporary on available-for-sale
securities are included in other income. The cost of securities sold is
based on the specific identification method.
<PAGE>
PART II -- OTHER INFORMATION
ITEM 1 - Legal Proceedings
In December 1996, the Company filed suit against Silicon Graphics, Inc.
("SGI") seeking to recover royalties due to the Company under a license
agreement between SGI and the Company's predecessor in interest, Verdix
Corporation. SGI answered the complaint, denying any liability, and
filed a cross complaint seeking unspecified damages for alleged
violations of the same license agreement. Effective August 12, 1999,
the Company and SGI entered an agreement under which this litigation
was settled in its entirety. The terms of this agreement are
confidential. The arrangement, however, will not have any material
impact on the Company's financial statements.
Beginning on October 10, 1997, a number of purported securities class
actions were filed against the Company, two of its officers, and Cowen
& Company. The cases were consolidated into one matter, Rational
Software Corporation, et al., No. C 97-03740 (N.D. Cal.), pending in
the United States District Court for the Northern District of
California. The consolidated amended complaint alleges that defendants
violated Sections 10(b) and 20A of the Securities Exchange Act of 1934
through the selective disclosure of material inside information
regarding the Company's prospects and seeks unspecified damages on
behalf of a class of stockholders who purchased the Company's common
stock on October 8, 1997. The Court granted with leave to amend
defendants motion to dismiss the Consolidated Amended Complaint.
Plaintiffs' deadline to file an amended complaint is December 29, 1999.
The Company believes the action is without merit and will continue to
defend the case vigorously.
ITEM 4 - Submission of matters to a Vote of Security Holders
On August 26, 1999 the Company held its annual meeting of stockholders.
The following items were submitted to a vote of the stockholders:
1. To elect two Class I members of the Board of Directors.
Election of Directors Votes For Votes Withheld
Michael T. Devlin 77,228,233 358,807
Leslie G. Denend 77,207,528 379,512
As a result, Messrs. Devlin and Denend were elected directors of the
Company. Additionally, Messrs. Levy, Campbell, Schleicher, Case
and Montague continue as members of the Board of Directors.
2. To approve amendment to the 1997 Stock Option Plan reserving an
additional 6,000,000 shares of the Company's Common Stock for
issuance thereunder.
Votes
For 32,198,201
Against 30,446,104
Abstain 282,130
Broker Non-vote 24,103,437
This proposal was approved.
3. To approve an amendment to the 1997 Stock Option Plan providing for
reservation for issuance of up to 12,000,000 shares of common stock
repurchased under the company's stock repurchase program for
issuance under the 1997 stock option plan.
Votes
For 35,000,581
Against 27,650,992
Abstain 274,863
Broker Non-vote 24,103,436
This proposal was approved.
4. To ratify the appointment of Ernst & Young LLP as the Company's
independent auditors to examine the financial statements of the
Company for the fiscal year ending March 31, 2000.
Votes
For 77,318,398
Against 62,255
Abstain 217,523
Broker Non-vote 9,431,696
This proposal was approved.
ITEM 6 - Exhibits and Reports on Form 8-K
(a) 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
November 12, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CONDENSED
CONSOLIDATED BALANCE SHEETS, CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> MAR-31-2000
<PERIOD-START> APR-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 81,175
<SECURITIES> 185,256
<RECEIVABLES> 103,738
<ALLOWANCES> 3,032
<INVENTORY> 0
<CURRENT-ASSETS> 405,842
<PP&E> 99,063
<DEPRECIATION> 52,920
<TOTAL-ASSETS> 474,818
<CURRENT-LIABILITIES> 168,132
<BONDS> 0
0
0
<COMMON> 959
<OTHER-SE> 303,216
<TOTAL-LIABILITY-AND-EQUITY> 474,818
<SALES> 77,782
<TOTAL-REVENUES> 128,161
<CGS> 5,709
<TOTAL-COSTS> 18,996
<OTHER-EXPENSES> 84,769
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (2,445)
<INCOME-PRETAX> 26,841
<INCOME-TAX> 7,516
<INCOME-CONTINUING> 19,325
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 19,325
<EPS-BASIC> $0.22
<EPS-DILUTED> $0.21
</TABLE>
