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Previous: RATIONAL SOFTWARE CORP, S-8, EX-4.3, 2000-11-13 |
Next: RATIONAL SOFTWARE CORP, 10-Q, EX-3.03, 2000-11-13 |
UNITED STATES SECURITIES AND 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, 2000 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)
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18880 Homestead Road
Cupertino, California 95014
(Address of principal executive offices including 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 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.
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RATIONAL SOFTWARE CORPORATION
TABLE OF CONTENTS
| PART I. Financial Information | Page No. |
| Item 1 -- Condensed Consolidated Financial Statements: |
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Condensed Consolidated Balance Sheets as of September 30, 2000 and March 31, 2000 |
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Condensed Consolidated Statements of Operations for the three and six months ended September 30, 2000 and 1999. |
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Condensed Consolidated Statements of Cash Flows for the six months ended September 30, 2000 and 1999. |
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| Notes to Condensed Consolidated Financial Statements |
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| Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations |
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| Item 3. Quantitative and Qualitative Disclosures about Market Risk |
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| PART II. Other Information |
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| Item 4. Submission of Matters to Vote of Security Holders |
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| Item 6. Exhibits and Reports on Form 8-K |
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| Signatures |
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PART I -- FINANCIAL INFORMATION
Item 1 -- Condensed Consolidated Financial Statements
RATIONAL SOFTWARE CORPORATION
Condensed Consolidated Balance Sheets
(in thousands, except per share amounts)
September 30, March 31,
2000 2000
------------ ------------
(unaudited) (Note A)
ASSETS
-------------------------------------
Current assets:
Cash and cash equivalents.................... $332,523 $413,230
Short-term investments....................... 687,843 493,081
Accounts receivable, net..................... 142,071 148,818
Deferred tax assets.......................... 6,824 9,384
Prepaid expenses and other assets............ 18,738 10,671
------------ ------------
Total current assets.......................... 1,187,999 1,075,184
------------ ------------
Property and equipment, at cost:
Computer, office and manufacturing equipment. 99,481 88,525
Office furniture............................. 16,952 13,957
Leasehold improvements....................... 16,570 13,850
------------ ------------
133,003 116,332
Accumulated depreciation and amortization.... (64,196) (63,892)
------------ ------------
Property and equipment, net................... 68,807 52,440
Other assets, net............................. 94,034 98,152
------------ ------------
Total assets.................................. $1,350,840 $1,225,776
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
-------------------------------------
Current liabilities:
Accounts payable............................. $11,045 $8,496
Accrued employee benefits.................... 62,717 49,290
Income taxes payable......................... 42,381 24,323
Other accrued expenses....................... 42,175 33,257
Accrued merger and integration expenses...... 3,883 5,147
Deferred revenue............................. 129,222 122,813
------------ ------------
Total current liabilities..................... 291,423 243,326
Convertible subordinated notes................ 500,000 500,000
Other long-term liabilities................ 1,060 1,668
------------ ------------
Total liabilities............................. 792,483 744,994
------------ ------------
Minority interest 17,846 24,475
Stockholders' equity:
Common stock, $0.01 par value, 500,000
shares authorized........................... 2,067 1,992
Additional paid-in capital................... 762,920 708,492
Deferred stock compensation.................. (2,383) (2,763)
Treasury stock............................... (180,851) (180,851)
Accumulated deficit.......................... (21,649) (60,699)
Accumulated other comprehensive loss......... (19,593) (9,864)
------------ ------------
Total stockholders' equity.................... 540,511 456,307
------------ ------------
Total liabilities and stockholders' equity.... $1,350,840 $1,225,776
============ ============
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Note A: The balance sheet at March 31, 2000 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.
RATIONAL SOFTWARE CORPORATION
Condensed Consolidated Statements of Operations
(in thousands, except per share amounts, unaudited)
Three Months Ended Six Months Ended
September 30, September 30,
--------- --------- --------- ---------
2000 1999 2000 1999
--------- --------- --------- ---------
Net product revenue................ $107,966 $77,782 $207,266 $150,197
Consulting and support revenue..... 79,535 50,379 150,532 95,387
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Total revenue.................. 187,501 128,161 357,798 245,584
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Cost of product revenue............ 8,585 5,709 15,073 11,719
Cost of consulting and support
revenue.......................... 20,291 13,287 38,467 24,900
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Total cost of revenue.......... 28,876 18,996 53,540 36,619
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Gross margin....................... 158,625 109,165 304,258 208,965
--------- --------- --------- ---------
Operating expenses:
Research and development......... 45,601 23,084 84,084 45,609
Sales and marketing.............. 78,396 51,165 149,346 100,526
General and administrative....... 15,377 10,520 28,723 20,611
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Total operating expenses....... 139,374 84,769 262,153 166,746
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Operating income............... 19,251 24,396 42,105 42,219
Other income, net.................. 9,547 2,445 15,582 5,029
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Income before income
taxes........................ 28,798 26,841 57,687 47,248
Provision for income taxes......... 14,816 7,516 26,333 13,230
Minority interest.................. (5,707) -- (7,696) --
--------- --------- --------- ---------
Net income......................... $19,689 $19,325 $39,050 $34,018
========= ========= ========= =========
Net income per common
share - basic.................... $0.11 $0.11 $0.21 $0.20
Shares used in computing per
share amounts - basic............ 186,789 173,780 184,879 173,418
Net income per common
share - diluted.................. $0.10 $0.10 $0.19 $0.18
Shares used in computing per
share amounts - diluted.......... 205,858 187,896 203,594 188,052
See accompanying notes to condensed consolidated financial statements.
RATIONAL SOFTWARE CORPORATION
Condensed Consolidated Statement of Cash Flows
(in thousands, unaudited)
Six Months Ended
September 30,
----------------------
2000 1999
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Operating activities:
Net income.......................................... $39,050 $34,018
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization..................... 21,563 11,019
Compensation expense related to stock options..... 380 --
Minority interest in loss of Catapulse, Inc....... (6,629) --
Changes in operating assets and liabilities:
Accounts receivable............................. 6,747 (8,339)
Prepaid expenses and other, net................. (8,067) (6,648)
Deferred tax assets............................. 2,560 --
Accounts payable................................ 2,549 (4,681)
Accrued employee benefits and other accrued
expenses..................................... 22,345 707
Income taxes payable............................ 18,058 13,169
Accrued merger and integration expenses......... (1,264) (1,294)
Deferred revenue................................ 6,409 4,343
Other long-term liabilities (608) (1,185)
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Net cash provided by operating activities.............. 103,093 41,109
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Investing activities:
Purchase of short-term investments.................. (375,645) (132,899)
Maturities and sales of short-term investments...... 180,883 147,508
Purchases of property and equipment................. (27,712) (10,091)
Net change in other assets.......................... (4,615) (202)
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Net cash provided by (used in) investing activities.... (227,089) 4,316
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Financing activities:
Net proceeds from issuance of common stock.......... 53,018 36,537
Repurchases of common stock......................... -- (61,363)
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Net cash provided by (used in) financing activities........ 53,018 (24,826)
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Effect of changes in foreign currency exchange
rate on cash.......................................... (9,729) 611
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Net increase (decrease) in cash and cash equivalents... (80,707) 21,210
Cash and cash equivalents at beginning of period....... 413,230 59,965
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Cash and cash equivalents at end of period............. $332,523 $81,175
========== ==========
See accompanying notes to condensed consolidated financial statements.
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. Certain prior year amounts have been reclassified to conform with current year presentation. 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, 2000 are not necessarily indicative of the results that may be expected for the fiscal year ending March 31, 2001.
2. ACCOUNTS RECEIVABLE - Accounts receivable are presented net of an allowance for doubtful accounts of $3,303,000 at September 30, 2000 and $3,259,000 at March 31, 2000.
3. STOCK SPLIT - The Company's Board of Directors authorized a two for one stock split of the Company's common stock for shareholders of record on August 17, 2000. Shares resulting from the stock split were distributed by the transfer agent on September 5, 2000. All share and per-share numbers contained herein reflect this stock split. The Company's Board also approved an increase in the Company's authorized shares of common stock to 500 million shares.
4. 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):
Three Months Ended Six Months Ended
September 30, September 30,
------------------- --------- ---------
2000 1999 2000 1999
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Numerator:
Net income ....................... $19,689 $19,325 $39,050 $34,018
Denominator:
Denominator for basic net income
per share - weighted
average shares.................... 186,789 173,780 184,879 173,418
Incremental common shares
attributable to shares issuable
under employee stock plans........ 19,069 14,116 18,715 14,634
--------- --------- --------- ---------
Denominator for diluted net
income per share -
weighted average shares and
assumed conversions............... 205,858 187,896 203,594 188,052
========= ========= ========= =========
Net income per share - basic. $0.11 $0.11 $0.21 $0.20
========= ========= ========= =========
Net income per share -
diluted........................... $0.10 $0.10 $0.19 $0.18
========= ========= ========= =========
Because the options' exercise price was greater than the average market price of common shares, the effect of options to purchase 121,572 and 718,397 shares of Common Stock was not included in the computation of the three months ended September 30, 2000 and 1999, respectively, diluted earnings per share and the effect of options to purchase 527,458 and 585,608 shares of Common Stock was not included in the computation of the six months ended September 30, 2000 and 1999, respectively, diluted earnings per share. The effect of converting 13,998,300 shares of Common Stock from outstanding Convertible Notes issued in 2000 was not included for any periods in diluted earnings per share because the assumed conversion would be antidilutive.
5. 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, 2000, total comprehensive income amounted to approximately $10,631,000 compared to a comprehensive income of $21,585,000 for the same period last year. For the six months ended September 30, 2000, comprehensive income amounted to approximately $29,321,000 compared to comprehensive income of $34,628,000 for the same period last year.
6. 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.
On March 31, 2000, the Financial Accounting Standards Board issued FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation," an interpretation of APB Opinion No. 25. The Interpretation is generally effective for new stock awards or transactions entered into on or after July 1, 2000. The Company does not anticipate that the adoption of the new Interpretation will have a significant effect on earnings or the financial position of the Company.
In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial Statements." SAB 101 summarizes certain of the SEC's views in applying generally accepted accounting principles to revenue recognition in financial statements. In June 2000, the SEC issued SAB 101B to defer the effective date of the implementation of SAB 101 until the fourth quarter of fiscal 2001. The Company does not anticipate that the adoption of SAB 101 will have a significant effect on earnings or the financial position of the Company.
7. STOCK REPURCHASE - Under a program approved in October 1998, the Company is authorized to repurchase up to 12 million shares of its common stock from time to time in the open market. For the six months ended September 30, 2000, there were no repurchases. For the six months ended September 30, 1999, the Company repurchased 4,145,000 shares of its common stock for 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.
Item 2 -- Management's Discussion and Analysis of Financial Condition and Results of Operations
The statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations include "forward looking" 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, and liquidity and capital resources, 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 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 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, 2000
Total revenue for both the three- and six- month periods ended September 30, 2000 increased 46% from the comparable prior year periods.
Net product revenue for the three- and six- month periods ended September 30, 2000 increased 39% and 38%, respectively from the comparable prior year periods. Consulting and support revenue for both the three- and six- month periods ended September 30, 2000 increased 58% from the comparable prior year periods. The overall increase reflects continued strong customer acceptance across the majority of the Company's products and services. The increase in consulting and support revenue is a result of growing demand for the Company's consulting services and continued strong sales and renewals of customer support arrangements.
International revenue from product sales and consulting and customer support accounted for 43% and 40%, respectively of total revenue for the three- and six- month periods ended September 30, 2000, compared to 42% for both the comparable prior year periods. The Company expects international sales to continue to account for a major 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 "Factors That May Affect Future Results: Our international operations expose us to greater management, collections, currency, intellectual property, regulatory, and other risks."
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, 2000 increased 50% and 29%, respectively from the comparable prior year periods. These costs represented 8% and 7%, respectively of total product revenue for the three- and six- month periods ended September 30, 2000, as compared to 7% and 8%, respectively for the comparable prior year periods. The increase in cost of product revenue correlates to the growth of product revenue.
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, 2000 increased 53% and 54%, 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, 2000, as compared to 26% for both the comparable prior year periods. The increase in period over period costs of consulting and support is primarily a result of increased personnel costs necessary to service the growing demand for support, consulting, and education and correlates to the increase in consulting and support revenue.
Total expenditures for research and development increased 98% and 84%, respectively, for the three- and six- month periods ended September 30, 2000 from the comparable prior year periods. These costs represented 24% of total revenue for both the three- and six- month periods ended September 30, 2000 compared to 18% and 19%, respectively, for the comparable prior year periods. The increase in expenditures for research and development is due primarily to Catapulse Inc. related product development. The Catapulse research and development costs were $11.5 million and $18.1 million, respectively for the three- and six- month periods ended September 30, 2000. Catapulse is an Internet venture in which Rational invested $50.0 million in December, 1999. See "Factors That May Affect Future Results: Catapulse, an Internet company in which our founders have a management role and substantial interest, could divert the attention of our management away from our business and affairs, creating potential conflicts of interest."
Sales and marketing expenses increased 53% and 49% for the three- and six- month periods ended September 30, 2000 from the comparable prior year periods. These costs represented 42% of total revenue for both the three- and six- month periods ended September 30, 2000 compared to 40% and 41%, respectively, for the same periods last year. The increase in expenditures for sales and marketing is due to personnel costs associated with additional sales capacity, costs associated with marketing programs to raise Company visibility and sales and marketing costs incurred by Catapulse.
General and administrative expense increased 46% and 39%, respectively, for the three- and six- month periods ended September 30, 2000 from the comparable prior year periods. These costs represented 8% of total revenue for both the three- and six- month periods ended September 30, 2000 as compared to 8% for both the comparable prior year periods. The period over period increase in general and administrative expense is due primarily to additional amortization of goodwill related to the January, 2000 acquisition of ObjecTime Limited.
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 increased $7,102,000 and $10,553,000, respectively, for the three- and six- month periods ended September 30, 2000 from the comparable prior year periods. The current year increase is due primarily to increased interest earnings on higher cash balances, offset by interest expense on convertible debt.
The provision for income taxes for the three- and six- month periods ended September 30, 2000 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 2001 and 2000 differ from the federal statutory rate primarily as a result of permanently invested international income subject to a lower overall tax rate, investment in tax exempt securities, and research credits. The effective tax rate for fiscal 2001 increased from fiscal 2000 as a result of decreased investment in tax exempt securities and a greater proportion of international income subject to higher overall rates.
Minority Interest
Catapulse incurred $17.6 million and $24.2 million, respectively, of operating expenses and earned $1.0 million and $2.0 million, respectively, of interest income on cash balances for the three- and six-month periods ended September 30, 2000. Minority interest, net of tax, for the three- and six- month periods ended September 30, 2000 was approximately $5.7 million and $7.7 million.
Liquidity and Capital Resources at September 30, 2000
As of September 30, 2000, the Company had cash, cash equivalents and short-term investments of $1.02 billion and working capital of $896.6 million. Net cash provided by operating activities for the six months ended September 30, 2000 was composed primarily of net income plus noncash charges for depreciation and amortization, a decrease in accounts receivable and an increase in accrued employee benefits and other accrued expenses, taxes payable and deferred revenue, offset by an increase in prepaid expense and other assets, and the change in minority interest. Net cash used by investing activities resulted primarily from an increase in short-term investments and an increase in capital expenditures. Net cash provided in financing activities resulted primarily from the issuance of common stock under the Employee Stock Purchase Plan and the exercise of employee stock options.
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.
Factors That May Affect Future Results
Significant unanticipated fluctuations in our quarterly revenues and operating results may cause us not to meet securities analysts' or investors' expectations and may result in a decline in the price of our Common Stock.
Our net revenues and operating results are difficult to predict and may fluctuate significantly from quarter to quarter. If our revenues, operating results, earnings, or future projections are below the levels expected by securities analysts, our stock price is likely to decline.
Factors that may cause quarterly fluctuations in our operating results include:
-the discretionary nature of our customers' purchase and budget cycles;
-difficulty predicting the size and timing of customer orders;
-long sales cycles;
-seasonal variations in operating results;
-introduction or enhancement of our products or our competitors' products;
-changes in our pricing policies or the pricing policies of our competitors;
-an increase in our operating costs;
-whether we are able to expand our sales and marketing programs;
-the mix of our products and services sold;
-the level of sales incentives for our direct sales force;
-the mix of sales channels through which our products and services are sold;
-the mix of our domestic and international sales;
-an increase in the level of our product returns;
-fluctuations in foreign currency exchange rates;
-costs associated with acquisitions; and
-global economic conditions.
In addition, the timing of our product revenues is difficult to predict because our sales cycles vary substantially from product to product and customer to customer. We base our operating expenses on our expectations regarding future revenue levels. As a result, if total revenues for a particular quarter are below our expectations, we could not proportionately reduce operating expenses for that quarter. Therefore, a revenue shortfall would have a disproportionate effect on our operating results for that quarter. In addition, because our service revenues are largely correlated with our license revenues, a decline in license revenues could also cause a decline in our service revenues in the same quarter or subsequent quarters.
As a result of these and other factors, our operating results are subject to significant variation from quarter to quarter, and we believe that period-to-period comparisons of our results of operations are not necessarily useful. If our operating results are below investors' or securities analysts' expectations, the price of our Common Stock could decline significantly.
If market acceptance of our sophisticated software development tools fails to grow adequately, our business may suffer.
Our future growth and financial performance will depend in part on broad market acceptance of off-the-shelf products that address critical elements of the software development process. Currently, the number of software developers using our products is relatively small compared with the number of developers using more traditional technology and products, internally developed tools, or manual approaches. Potential customers may be unwilling to make the significant capital investment needed to purchase our products and retrain their software developers to build software using our products rather than traditional techniques. Many of our customers have purchased only small quantities of our products, and these or new customers may decide not to broadly implement or purchase additional units of our products.
If industry standards relating to our business do not gain general acceptance, we may be unable to continue to develop and market our products and our business may suffer.
Our future growth and financial performance depends on the development of industry standards that facilitate the adoption of component-based development, as well as enhance our ability to play a leading role in the establishment of those standards. For example, we developed the Unified Modeling Language for visual modeling, which was adopted by the Object Management Group, or OMG, a software 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 harm our marketing and sales efforts and, in turn, our business.
If we do not develop and enhance new and existing products to keep pace with technological, market, and industry changes, our revenues may decline.
The industry for tools automating software application development and management is characterized by rapid technological advances, changes in customer requirements, and frequent new product introductions and enhancements. If we fail to anticipate or respond adequately to technology developments, industry standards, or practices and customer requirements, or if we experience any significant delays in product development, introduction, or integration, our products may become obsolete or unmarketable, our ability to compete may be impaired, and our revenues may decline. We must respond rapidly to developments related to Internet and intranet applications, hardware platforms, operating systems, and programming languages. These developments will require us to make substantial product-development investments.
In addition, rapid growth of, interest in, and use of Internet and intranet environments is a recent and emerging phenomenon. Our success may depend, in part, on the compatibility of our products with Internet and intranet applications. We may fail to effectively adapt our products for use in Internet or intranet environments, or to produce competitive Internet and intranet applications.
If we do not effectively compete with new and existing competitors, our revenues and operating margins will decline.
The industry for tools that automate software development and management is extremely competitive and rapidly changing. We expect competition to intensify in the future. We believe our continued success will become increasingly dependent on our ability to:
-support multiple platforms, including Microsoft Windows and Windows NT, IBM, commercial UNIX, and Linux;
-use the latest technologies to support Web-based development of business-critical applications;
-develop and market a broader line of products for programming languages such as C++, Visual Studio.NET, Java, and Java Beans; and
-continually support the rapidly changing standards and technologies used in the development of Web-based applications as well as off-the-shelf products.
We face intense competition for each of our products, generally from both Windows and UNIX vendors. Because individual product sales often lead to a broader customer relationship, each of our products must be able to successfully compete with numerous competitors' offerings. Many of our competitors or potential competitors are much larger than we are and may have significantly more resources and more experience. Moreover, many of our strategic partners compete with each other and this may adversely impact our relationship with an individual partner or a number of partners.
Catapulse, an Internet company in which our founders have a management role and substantial interest, could divert the attention of our management away from our business and affairs, creating potential conflicts of interest.
In 1999, we made a $50,000,000 investment in the Series A Preferred Stock of Catapulse, an internet company founded by Paul Levy and Mike Devlin. As of September 30, 2000, after taking into account additional investments by third parties in Catapulse, our Series A Preferred Stock represented approximately 37% of the voting power of the outstanding capital stock of this entity. Paul Levy serves as its Chief Executive Officer and Mike Devlin serves as the Vice-Chairman of the board of directors. Catapulse's board of directors is made up of five directors. Rational has the right to designate two of the members of its board of directors. As of the date hereof, four of its directors also serve on our board of directors. Paul Levy and Mike Devlin continue to serve in their roles as our Chairman of the Board and Chief Executive Officer, respectively. Catapulse is a business-to-business application service provider that will focus on developing a portal to meet the needs of the global community of software professionals. Catapulse also intends to develop an electronic marketplace for products and services relating to software development and intends to develop and deploy a hosted development service for Internet software development. During the quarter, Rational and Catapulse have entered into a strategic business relationship. Rational will be contracted to perform certain development work to optimize Rational products for the Catapulse environment. As Catapulse recognizes revenue from its customers, Rational will receive fees from Catapulse for the use of Rational technology. This strategic relationship could give rise to conflicts of interest involving the two companies and the founders in the future. In addition, Catapulse could divert the attention of Paul Levy and Mike Devlin away from the business and affairs of Rational.
If we are unable to manage our growth, our business will suffer.
We have experienced rapid growth in recent years. This growth has placed a significant strain on our financial, operational, management, marketing, and sales systems and resources. If we are unable to effectively manage growth, our business, competitive position, results of operations, and financial condition could suffer.
To achieve and manage continued growth, we must continue to expand and upgrade our information-technology infrastructure and its scalability, including improvements to various operations, financial, and management information systems, and expand, train, and manage our work force. We may not be successful in implementing these initiatives effectively and in a timely fashion.
Our international operations expose us to greater management, collections, currency, intellectual property, regulatory, and other risks.
International sales accounted for approximately 41% of our revenues in fiscal 2000, 40% in 1999, 34% in 1998 and 40% for the six months ended September 30, 2000. We expect that international sales will continue to account for a significant portion of our revenues in future periods. Our business would be harmed if our international operations experienced a material downturn. In addition, 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 some markets;
-lack of acceptance of localized products in international markets; and
-the effects of high local wage scales and other expenses.
Our international sales are generally transacted through our 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. We have engaged in limited hedging activities to protect us against losses arising from remeasuring assets and liabilities denominated in currencies other than the functional currency of the related subsidiary. We are 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 our overall expected profitability. We currently do not hedge against this exposure. Fluctuations in foreign currencies could harm our financial condition and operating results.
We are subject to risks associated with the European monetary conversion.
In January 1999, the new ''Euro'' currency was introduced in certain European countries that are part of the European Monetary Union, or 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. We are currently assessing the effect the introduction of the Euro will have on internal accounting systems and the sales of products. We are not aware of any material operational issues or costs associated with preparing internal systems for the Euro. However, we do utilize third-party vendor equipment and software products that may or may not be EMU-compliant. The failure of any critical components to operate properly after introduction of the Euro may harm our business or results of operations or require additional costs to remedy these problems.
If we lose key personnel or cannot hire enough qualified personnel, our ability to manage our business, develop new products, and increase our revenues will suffer.
We believe that the hiring and retaining of qualified individuals at all levels in our organization will be essential to our ability to sustain and manage growth successfully. Competition for highly qualified technical personnel is intense and we may not be successful in attracting and retaining the necessary personnel, which may limit the rate at which we can develop products and generate sales. We will be particularly dependent on the efforts and abilities of our senior management personnel. The departure of any of our senior management members or other key personnel could harm our business. 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.
If we fail to maintain and expand our distribution channels, our business will suffer.
We currently distribute our products primarily through field sales personnel teamed with highly trained technical support personnel as well as through our telesales organizations, our Web site, and indirectly through channels such as value-added resellers and distributors. Our ability to achieve revenue growth in the future will depend in large part on our success in expanding our direct sales force and in maintaining a high level of technical consulting, training, and customer support.
We depend on strategic relationships and business alliances for continued growth of our business.
Our development, marketing, and distribution strategies rely increasingly on our 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 us. Merger activity, such as the acquisition of ObjecTime Ltd., may disrupt these relationships or activities, and some companies may reassess the value of their relationship with us as a result of this merger activity. Divergence in strategy or change in focus by or competitive product offerings by any of these companies may interfere with our ability to develop, market, sell, or support our products, which in turn could harm our business. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products.
Our products could contain software defects that could reduce our revenues and make it more difficult for us to achieve market acceptance of our products.
Software products as complex as those sold by us often contain undetected errors, or ''bugs,'' or performance problems. These 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, our 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 our products could result in loss of revenues or delays in market acceptance, which could harm our business. Further, because we rely on our own products in connection with the development of our software, these errors may make it more difficult to sell our products in the future.
If we fail to adequately protect our intellectual property rights, competitors may use our technology and trademarks, which could weaken our competitive position, reduce our revenues, and increase our costs.
We rely on a combination of copyright, trademark, patent, and trade-secret laws, employee and third-party nondisclosure agreements, and other arrangements to protect our proprietary rights. Despite these precautions, it may be possible for unauthorized third parties to copy our products or obtain and use information that we regard as proprietary to create products that compete against ours. In addition, some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our licensed programs 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. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our 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 our products.
We rely on software licensed from third parties that is used in our products.
We also rely on some software that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. These third-party software licenses may not be available to us on commercially reasonable terms or at all. Further, the software may not be appropriately supported, maintained, or enhanced by the licensors. The loss of licenses to or the inability to support, maintain, and enhance any of this software could result in increased costs or in delays or reductions in our product shipments until equivalent software could be developed, identified, licensed, and integrated.
Third parties could assert that our software products and services infringe on their intellectual property rights, which could expose us to increased costs and litigation.
We expect that we 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 us in the future and their claims may or may not be successful. We could incur substantial costs in defending ourselves and our customers against their claims. Parties making their claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the United States and abroad and could result in an award of substantial damages against us. In the event of a claim of infringement, we may be required to obtain one or more licenses from third parties. We cannot be sure that we can obtain necessary licenses from third parties at a reasonable cost or at all. Defense of any lawsuit or failure to obtain any required license could delay shipment of our products and increase our costs.
Promotional product versions may adversely impact our actual product sales.
Our marketing strategy relies in part on making elements of our technology available for no charge or at a very low price, either directly or by incorporating these elements into products offered by third parties, such as Microsoft, with whom we have strategic alliances. This strategy is designed to expose our products to a broader customer base than to our historical customer base and to encourage potential customers to purchase an upgrade or other higher-priced product from us. We may not be able to introduce enhancements to our full-price products or versions of our products with intermediate functionality at a rate necessary to adequately differentiate them from the promotional versions, particularly in cases where our partners are distributing versions of our products with other desirable features, which could reduce sales of our products.
If we cannot successfully integrate our past and future acquisitions and achieve intended financial or strategic benefits, our revenues may decline and our expenses increase.
We have acquired a number of businesses, technologies, and products, most recently in January 2000. If we fail to achieve the intended financial or strategic benefits of past and future acquisitions, our operating results will suffer. Acquisitions entail numerous risks, including:
-difficulty with the assimilation of acquired operations and products;
-failure to achieve targeted synergies;
-inability to retain key employees of the acquired companies;
-loss of key business relationships of the acquired company; and
-diversion of the attention of our management team.
In addition, if we undertake future acquisitions, we may issue dilutive securities, assume or incur additional debt obligations, incur large, one-time expenses, or acquire intangible assets that would result in significant future amortization expense. Any of these events could harm our business.
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. As of September 30, 2000 no significant changes concerning market risk have occurred since our Annual Report on Form 10-K for the year ended March 31, 2000.
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.
PART II -- OTHER INFORMATION
ITEM 4 - Submission of matters to a Vote of Security Holders
On August 17, 2000 the Company held its annual meeting of stockholders. The following items were submitted to a vote of the stockholders (the following votes do not reflect the effect of the two for one stock split effective for shareholders of record on August 17, 2000):
|
Election of Directors |
Votes For |
Votes Withheld |
|
Paul D. Levy |
84,494,325 |
173,279 |
|
John E. Montague |
84,490,770 |
176,834 |
As a result, Messrs. Levy and Montague were elected directors of the Company. Additionally, Messrs. Michael T. Devlin, Leslie G. Denend and Allison R. Schleicher continue as members of the Board of Directors.
|
Votes |
|
|
For |
73,999,071 |
|
Against |
10,611,372 |
|
Abstain |
57,161 |
|
Broker Non-Vote |
0 |
This proposal was approved.
|
Votes |
|
|
For |
37,489,201 |
|
Against |
32,795,810 |
|
Abstain |
130,252 |
|
Broker Non-Vote |
14,252,341 |
This proposal was approved.
|
Votes |
|
|
For |
46,060,775 |
|
Against |
25,207,237 |
|
Abstain |
147,252 |
|
Broker Non-Vote |
13,252,340 |
This proposal was approved.
|
Votes |
|
|
For |
84,598,353 |
|
Against |
39,990 |
|
Abstain |
29,261 |
|
Broker Non-Vote |
0 |
This proposal was approved.
ITEM 6 - Exhibits and Reports on Form 8-K
Exhibit 10.01: 2000 Director Option Plan is incorporated herein by reference to exhibit 4.3 filed with Registrant's Form S-8 dated November 13, 2000.
Exhibit 10.02: 1997 Stock Option Plan is incorporated herein by reference to exhibit 4.1 filed with Registrant's Form S-8 dated October 15, 1999.
Exhibit 10.03: 1998 Employee Stock Purchase Plan is incorporated herein by reference to exhibit 4.1 filed with Registrant's Form S-8 dated January 22, 1999.
Exhibit 27.01: Financial Data Schedule.
RATIONAL SOFTWARE CORPORATION
SIGNATURES
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.
Date: November 13, 2000
| RATIONAL SOFTWARE CORPORATION |
| (Registrant) |
| By: | /s/ Timothy A. Brennan |
|
| |
| Timothy A. Brennan | |
| Senior Vice President Chief Financial Officer and Secretary | |
| (Principal Financial Officer) |
|
|