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 August 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the transition period from __________ to __________
Commission file number: 0-18268
------------------------------
INTEGRATED SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
California 94-2658153
(State or other jurisdiction (I.R.S. employer
of incorporation or organization) identification no.)
------------------------------
201 Moffett Park Drive
Sunnyvale, CA 94089
(408) 542-1500
(Address, including zip code, of Registrant's
principal executive offices and 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 _____
The number of shares outstanding of the Registrant's Common Stock on
September 30, 1998 was 23,049,497 shares.
<PAGE>
INTEGRATED SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED AUGUST 31, 1998
INDEX
Page
----
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements 3
Condensed Consolidated Balance Sheets as of August 31, 1998 and
February 28, 1998 4
Condensed Consolidated Statements of Income for the Three and Six
Months Ended August 31, 1998 and 1997 5
Condensed Consolidated Statements of Cash Flows for the Six Months
Ended August 31, 1998 and 1997 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 10
Item 3. Quantitative and Qualitative Disclosures about Market Risks 18
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 19
Item 4. Submission of matters to a vote of Security Holders 19
Item 6. Exhibits and Reports on Form 8-K 19
SIGNATURES 20
================================================================================
This Form 10-Q contains forward-looking statements (as defined in the
Private Securities Litigation Reform Act of 1995), including but not
limited to statements regarding the Company's expectations, hopes or
intentions regarding the future. Actual results and trends could
differ materially from those discussed in the forward-looking
statements. In addition, past trends should not be perceived as
indicators of future performance. Among the factors that could cause
actual results to differ from the forward-looking statements are those
detailed in Management's Discussion and Analysis of Financial
Condition and Results of Operations and in the Company's Annual Report
on Form 10-K for the year ended February 28, 1998, and other documents
filed by the Company with the Securities and Exchange Commission.
================================================================================
-2-
<PAGE>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
The condensed consolidated interim financial statements included herein have
been prepared by Integrated Systems, Inc. ("the Company"), without audit,
pursuant to the rules and regulations of the Securities and Exchange Commission.
Although certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted pursuant to such rules and
regulations, the Company believes that the disclosures made are adequate to make
the information presented not misleading. It is suggested that the condensed
consolidated interim financial statements be read in conjunction with the
consolidated financial statements and the notes thereto included in the
Company's Annual Report on Form 10-K for the year ended February 28, 1998. The
February 28, 1998 condensed consolidated balance sheet data was derived from the
audited financial statements, but does not include all disclosures required by
generally accepted accounting principles.
The accompanying condensed consolidated interim financial statements have been
prepared in all material respects in conformity with the standards of accounting
measurements set forth in Accounting Principles Board Opinion No. 28 and, in the
opinion of management, reflect all adjustments, consisting only of normal
recurring adjustments, necessary to summarize fairly the financial position,
results of operations, and cash flows for the periods indicated. The results of
operations for the interim periods presented are not necessarily indicative of
the results to be expected for the full year.
-3-
<PAGE>
<TABLE>
INTEGRATED SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
<CAPTION>
August 31, February 28,
1998 1998
--------- ---------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 14,812 $ 14,454
Marketable securities 2,658 6,670
Accounts receivable, net 25,449 29,455
Deferred income taxes 995 1,603
Prepaid expenses and other 5,085 4,548
--------- ---------
Total current assets 48,999 56,730
Marketable securities 58,856 46,322
Property and equipment, net 18,796 18,428
Intangible assets, net 2,515 2,867
Deferred income taxes 4,763 2,363
Other assets 1,155 1,410
--------- ---------
Total assets $ 135,084 $ 128,120
========= =========
LIABILITIES
Current liabilities:
Accounts payable $ 4,285 $ 5,073
Accrued payroll and related expenses 4,671 4,321
Other accrued liabilities 5,378 5,372
Income taxes payable 1,981 2,747
Deferred revenue 16,363 16,181
--------- ---------
Total current liabilities 32,678 33,694
SHAREHOLDERS' EQUITY
Common Stock, no par value, 50,000 shares authorized:
23,488 and 23,339 shares issued and outstanding at
August 31, 1998 and February 28, 1998, respectively 64,951 63,647
Accumulated other comprehensive income, net (1,012) (1,290)
Retained earnings 38,467 32,069
--------- ---------
Total shareholders' equity 102,406 94,426
--------- ---------
Total liabilities and shareholders' equity $ 135,084 $ 128,120
========= =========
<FN>
The accompanying notes are an integral part of these condensed consolidated financial statements.
</FN>
</TABLE>
-4-
<PAGE>
<TABLE>
INTEGRATED SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
(unaudited)
<CAPTION>
Three Months Ended Six Months Ended
August 31, August 31,
------------------------ -------------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenue:
Product $ 17,723 $ 15,502 $ 34,884 $ 29,260
Services 14,282 16,668 28,603 27,498
-------- -------- -------- --------
Total revenue 32,005 32,170 63,487 56,758
-------- -------- -------- --------
Costs and expenses:
Cost of product revenue 3,479 3,521 7,133 6,250
Cost of services revenue 6,066 9,546 11,478 15,121
Marketing and sales 11,258 10,872 23,363 20,281
Research and development 4,658 4,747 10,099 9,549
General and administrative 4,399 3,057 7,755 5,579
-------- -------- -------- --------
Total costs and expenses 29,860 31,743 59,828 56,780
-------- -------- -------- --------
Income (loss) from operations 2,145 427 3,659 (22)
Interest and other income 1,308 979 2,221 1,774
-------- -------- -------- --------
Income before income taxes 3,453 1,406 5,880 1,752
Provision (benefit) for income taxes 1,105 471 (518) 596
-------- -------- -------- --------
Net income $ 2,348 $ 935 $ 6,398 $ 1,156
======== ======== ======== ========
Earnings per share - basic $ 0.10 $ 0.04 $ 0.27 $ 0.05
======== ======== ======== ========
Earnings per share - diluted $ 0.10 $ 0.04 $ 0.26 $ 0.05
======== ======== ======== ========
Shares used in per share calculations - basic 23,501 23,182 23,464 23,151
======== ======== ======== ========
Shares used in per share calculations - diluted 24,276 23,969 24,356 23,910
======== ======== ======== ========
<FN>
The accompanying notes are an integral part of these condensed consolidated financial statements.
</FN>
</TABLE>
-5-
<PAGE>
<TABLE>
INTEGRATED SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
<CAPTION>
Six Months Ended
August 31,
---------------------------
1998 1997
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 6,398 $ 1,156
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 2,868 2,934
Provision for (release of) doubtful accounts receivable (200) 1,243
Deferred income taxes (1,989) 212
Changes in assets and liabilities:
Accounts receivable 4,146 22
Prepaid expenses and other (537) (406)
Accounts payable, accrued payroll and
other accrued liabilities (432) 3,956
Income taxes payable (766) (704)
Deferred revenue 182 880
Other assets and liabilities 213 265
-------- --------
Net cash provided by operating activities 9,883 9,558
-------- --------
Cash flows from investing activities:
Purchases of marketable securities, net (8,029) (12,345)
Additions to property and equipment (2,312) (2,815)
Capitalized software development costs (530) (250)
-------- --------
Net cash used in investing activities (10,871) (15,410)
-------- --------
Cash flows from financing activities:
Repurchase of common stock (1,059) (187)
Proceeds from exercise of common stock options and
purchases under the Employee Stock Purchase Plan 2,363 1,517
-------- --------
Net cash provided by financing activities 1,304 1,330
-------- --------
Effect of exchange rate fluctuations on cash and cash equivalents 42 (195)
Net increase (decrease) in cash and cash equivalents 358 (4,717)
Cash and cash equivalents at beginning of period 14,454 25,585
-------- --------
Cash and cash equivalents at end of period $ 14,812 $ 20,868
======== ========
Supplemental disclosure of cash flow information:
Cash paid during the period for income taxes $ 2,040 $ 986
Supplemental schedule of noncash investing and financing activities:
Unrealized gain on marketable securities $ 493 $ 198
<FN>
The accompanying notes are an integral part of these condensed consolidated financial statements.
</FN>
</TABLE>
-6-
<PAGE>
INTEGRATED SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Information for the three and six months ended
August 31, 1998 and 1997 is unaudited)
1. Summary of Significant Accounting Policies
The condensed consolidated financial statements include the accounts of
Integrated Systems, Inc. and its wholly owned subsidiaries, after elimination of
all significant intercompany accounts and transactions, and should be read in
conjunction with the Company's Annual Report on Form 10-K for the year ended
February 28, 1998. These condensed consolidated financial statements do not
include all disclosures normally required by generally accepted accounting
principles.
Certain amounts in the fiscal year 1998 condensed consolidated financial
statements have been reclassified to conform to the fiscal year 1999
presentation. These reclassifications had no effect on previously reported
results of operations or shareholder's equity.
2. Earnings Per Share
Earnings per share is computed in accordance with the provisions of Financial
Accounting Standards Board Statement of Financial Accounting Standards No. 128
("SFAS 128"), "Earnings Per Share." Basic earnings per share is computed using
the weighted average number of common shares outstanding during the period.
Diluted earnings per share is computed using the weighted average number of
common and common equivalent shares outstanding during the period. Common
equivalent shares result from the assumed exercise of outstanding stock options
that have a dilutive effect when applying the treasury stock method.
<TABLE>
The following table sets forth the calculations of earnings per share:
<CAPTION>
Three Months Ended Six Months Ended
August 31, August 31,
----------------- -----------------
(in thousands, except per share data) 1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
Basic:
Net income $ 2,348 $ 935 $ 6,398 $ 1,156
======= ======= ======= =======
Number of shares:
Weighted average number of common shares outstanding 23,501 23,182 23,464 23,151
======= ======= ======= =======
Earnings per share - basic $ 0.10 $ 0.04 $ 0.27 $ 0.05
======= ======= ======= =======
Diluted:
Net income $ 2,348 $ 935 $ 6,398 $ 1,156
======= ======= ======= =======
Number of shares:
Weighted average number of common shares outstanding 23,501 23,182 23,464 23,151
Dilutive effect of stock options, net 775 787 892 759
------- ------- ------- -------
Weighted average number of common and common equivalent shares outstanding 24,276 23,969 24,356 23,910
======= ======= ======= =======
Earnings per share - diluted $ 0.10 $ 0.04 $ 0.26 $ 0.05
======= ======= ======= =======
</TABLE>
3. Comprehensive Income
In March 1998, the Company adopted Financial Accounting Standards Board
Statement of Financial Accounting Standards No. 130 ("FAS 130"), "Reporting
Comprehensive Income." Comprehensive income is defined as the change in equity
from transactions and other events and circumstances excluding transactions
resulting from investments by owners and distributions to owners. For the
Company, the primary difference between net income and comprehensive income
results from foreign currency translation adjustments and unrealized gains and
losses on available-for-sale marketable securities.
<PAGE>
<TABLE>
Comprehensive income for the three and six months ended August 31, 1998 and 1997
is as follows:
<CAPTION>
Three Months Ended Six Months Ended
August 31, August 31,
----------------------- ------------------------
(In thousands) 1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
Net income $ 2,348 $ 935 $ 6,398 $ 1,156
Other comprehensive income, net of tax:
Foreign currency translation adjustments 79 (610) (18) (353)
Unrealized gain on marketable securities 335 180 296 119
------- ------- ------- -------
Other comprehensive income (loss) 414 (430) 278 (234)
------- ------- ------- -------
Total comprehensive income $ 2,762 $ 505 $ 6,676 $ 922
======= ======= ======= =======
</TABLE>
-7-
<PAGE>
<TABLE>
The accumulated balances of other comprehensive income as of August 31, 1998 and
1997 are as follows: (in thousands)
<CAPTION>
August 31, 1998 August 31, 1997
----------------------------------------- ----------------------------------------
Foreign Foreign
Currency Unrealized Currency Unrealized
Translation Gains/ Total Translation Gains/ Total
Adjustments Losses Other Adjustments Losses Other
----------- ---------- ------- ----------- ---------- -------
<S> <C> <C> <C> <C> <C> <C>
Beginning balance $(1,438) $ 148 $(1,290) $(1,130) $ 148 $ (982)
Current-period change (18) 296 278 (353) 119 (234)
------- ------- ------- ------- ------- -------
Ending balance $(1,456) $ 444 $(1,012) $(1,483) $ 267 $(1,216)
======= ======= ======= ======= ======= =======
</TABLE>
4. Derivative Financial Instruments
The Company enters into foreign currency forward exchange contracts to reduce
the impact of currency exchange rate fluctuations on monetary assets and
liability positions. The objective of these contracts is to minimize the impact
of exchange rate fluctuations on the Company's operating results. Gains and
losses associated with exchange rate fluctuations on foreign currency forward
exchange contracts are recorded in income as they offset corresponding gains and
losses on the foreign currency denominated assets and liabilities being hedged.
The costs of the foreign currency forward exchange contracts are also recorded
in income. All foreign currency forward exchange contracts entered into by the
Company have maturities of less than one year. At August 31, 1998, the Company
had approximately $2.5 million of foreign currency forward exchange contracts
outstanding, $2.2 million in Japanese yen and $0.3 million in Swedish Krona.
There were no foreign currency forward exchange contracts at February 28, 1998.
Unrealized gains on foreign currency forward exchange contracts at August 31,
1998 were approximately $19,000.
Other than the use of foreign currency forward exchange contracts discussed
above, the Company does not currently invest in or hold any other derivative
financial instruments.
5. Income Taxes
In May 1998, the Company made an election with the Internal Revenue Service to
treat the Company's Austrian subsidiary, Takefive Software GmbH, as a foreign
branch of the Company in the United States tax return. For financial statement
purposes, this election resulted in a one-time benefit of $2.4 million in the
first quarter of fiscal year 1999.
6. Contingencies
In October 1997, Greenhills Software, Inc. ("Greenhills"), a supplier, filed a
demand for arbitration against the Company, alleging among other things, breach
of contract, fraud, negligent misrepresentation and misappropriation of trade
name. In December 1997, the Company responded to the arbitration demand, and
filed a counter-claim against Greenhills. The Company believes it has
meritorious defenses to all claims against the Company and intends to defend the
claims vigorously. No accrual has been made in the accompanying consolidated
financial statements related to this dispute, as the ultimate outcome is
presently not determinable. The dispute, however, is subject to inherent
uncertainties and thus, there can be no assurance that it will be resolved
favorably to the Company or that it will not have a material adverse effect on
the Company's consolidated financial position or results of operations.
The Company is subject to various legal proceedings and claims, either asserted
or unasserted, which arise in the ordinary course of business. While management
does not believe that the outcome of any of the legal matters will have a
material adverse effect on the Company's consolidated financial position, legal
matters are subject to inherent uncertainties and thus, there can be no
assurance that these matters will be resolved favorably to the Company.
7. Subsequent Events
In September 1998, the Company's Board of Directors authorized the Company to
repurchase 1,000,000 shares of common stock for cash from time-to-time at market
prices. These shares are in addition to the 1,000,000 shares previously
authorized in April 1997. As of September 30, 1998, the Company had repurchased
825,000 shares of common stock in open market transactions for $7.2 million
under this stock repurchase program.
In September 1998, the Company's Board of Directors adopted a shareholder rights
plan declaring a dividend of one preferred share purchase right for each share
of the Company's common stock outstanding on October 15, 1998 (the "Record
Date") and further directing the issuance of one such right with respect to each
share of the Company's common stock that is issued after the Record Date, except
in certain circumstances. The rights will expire on September 30, 2008.
-8-
<PAGE>
The rights are initially attached to the Company's common stock and will not
trade separately. If a person or a group acquires 20 percent or more of the
Company's common stock (an "Acquiring Person"), or announces an intention to
make a tender offer for the Company's common stock, the consummation of which
would result in a person or group acquiring 20 percent or more of the Company's
common stock, then the rights will be distributed and will thereafter trade
separately from the common stock.
In the event rights are distributed, each right may be exercised for 1/200th of
a share of a newly designated Series A Junior Participating Preferred Stock at
an exercise price of $55.00. The preferred stock has been structured so that the
value of 1/200th of a share of such preferred stock will approximate the value
of one share of common stock.
Upon a person or group becoming an Acquiring Person, holders of the rights
(other than the Acquiring Person) will have the right to acquire shares of the
Company's common stock at a substantially discounted price. Additionally, if a
person or group becomes an Acquiring Person and the Company is acquired in a
merger or other business combination, or 50 percent or more of its assets are
sold in a transaction with an Acquiring Person, the holders of rights (other
than the Acquiring Person) will have the right to receive shares of common stock
of the acquiring corporation at a substantially discounted price.
Subsequent to a person or group becoming an Acquiring Person, the Company's
Board of Directors may, at its option, require the exchange of outstanding
rights (other than those held by the Acquiring Person) for common stock at an
exchange ratio of one share of the Company's common stock per right.
The Board may redeem outstanding rights at any time prior to a person or group
becoming an Acquiring Person at a price of $0.001 per right. Prior to such time,
the terms of the rights may be amended by the Board.
8. Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosure About Segments
of an Enterprise and Related Information," which specifies disclosure
requirements for segment reporting. The statement supersedes SFAS 14 and SFAS
18, is effective for fiscal years beginning after December 15, 1997, and
requires earlier periods to be restated if practicable. The impact of the
adoption of this statement, if any, on the Financial Statements of the Company
has not yet been determined.
In April 1998, the American Institute of Certified Public Accountants issued
Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." SOP 98-1 provides guidance for
determining whether computer software is internal-use software and on accounting
for the proceeds of computer software originally developed or obtained for
internal use and then subsequently sold to the public. It also provides guidance
on capitalization of the costs incurred for computer software developed or
obtained for internal use. The Company has not yet determined the impact, if
any, of adopting this statement. The disclosure prescribed by SOP 98-1 will be
effective for the Company's fiscal year ending February 28, 2000.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative
Instruments and Hedging Activities", which supercedes and amends a number of
existing standards. The statement is effective for fiscal years beginning after
June 15, 1999, but earlier application is permitted. The impact of the adoption
of this statement, if any, on the Financial Statements of the Company has not
yet been determined.
-9-
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following information should be read in conjunction with the condensed
consolidated interim financial statements and the notes thereto included in Item
1 of this Quarterly Report and with Management's Discussion and Analysis of
Financial Condition and Results of Operations contained in the Company's Annual
Report on Form 10-K for the year ended February 28, 1998, as filed with the
Securities and Exchange Commission on May 29, 1998.
Overview
Integrated Systems, Inc. ("the Company") provides comprehensive solutions of
software products and engineering services for the development of embedded
microprocessor-based applications for the real-time embedded computer market.
Forward-Looking Information is Subject to Risk and Uncertainty
Except for the historical information contained in this Quarterly Report, the
matters herein contain "forward-looking" statements and information. All
forward-looking statements included in this document are based on information
available to the Company on the date hereof, and the Company assumes no
obligation to update any such forward-looking statements. The Company's actual
results could differ materially from those discussed herein. Factors that could
cause or contribute to such differences include, but are not limited to those
discussed below, and to other risk factors detailed in the Company's Annual
Report on Form 10-K for the year ended February 28, 1998, and other documents
filed by the Company with the Securities and Exchange Commission.
Results of Operations
<TABLE>
The following table sets forth for the periods presented the percentage of total
revenue represented by each line item in the Company's condensed consolidated
statements of income and the percentage change in each line item from the prior
year period:
<CAPTION>
Percentage of Period-to-Period
Total Revenue Percentage Change
------------------------ -----------------------------
Three Months Ended Three Months Ended
August 31, August 31,
1998 1997 1998 compared to 1997
---------- ---------- -----------------------------
<S> <C> <C> <C>
Revenue:
Product 55 % 48 % 14 %
Services 45 52 (14)
---------- ----------
Total revenue 100 100 (1)
---------- ----------
Costs and expenses:
Cost of product revenue 11 11 (1)
Cost of services revenue 19 30 (36)
Marketing and sales 35 34 4
Research and development 14 15 (2)
General and administrative 14 9 44
---------- ----------
Total costs and expenses 93 99 (6)
---------- ----------
Income from operations 7 1 402
Interest and other income 4 3 34
---------- ----------
Income before income taxes 11 4 146
Provision for income taxes 4 1 135
---------- ----------
Net income 7 % 3 % 151 %
========== ==========
</TABLE>
-10-
<PAGE>
<TABLE>
<CAPTION>
Percentage of Period-to-Period
Total Revenue Percentage Change
------------------------ ----------------------------
Six Months Ended Six Months Ended
August 31, August 31,
1998 1997 1998 compared to 1997
---------- ---------- ----------------------------
Revenue:
<S> <C> <C> <C>
Product 55 % 52 % 19 %
Services 45 48 4
---------- ----------
Total revenue 100 100 12
---------- ----------
Costs and expenses:
Cost of product revenue 11 11 14
Cost of services revenue 18 26 (24)
Marketing and sales 37 36 15
Research and development 16 17 6
General and administrative 12 10 39
---------- ----------
Total costs and expenses 94 100 5
---------- ----------
Income from operations 6 0 N/M
Interest and other income 3 3 25
---------- ----------
Income before income taxes 9 3 236
(Benefit)/provision for income taxes (1) 1 N/M
---------- ----------
Net income 10 % 2 % 453 %
========== ==========
<FN>
N/M = Not Meaningful
</FN>
</TABLE>
Revenue
Revenue consists of fees from the licensing and sale of software products and
providing related maintenance and support, customer training and engineering and
consulting services. Total revenue decreased by 1% from $32.2 million in the
second quarter of fiscal year 1998 to $32.0 million in the second quarter of
fiscal year 1999, and increased by 12% from $56.8 million in the first six
months of fiscal year 1998 to $63.5 million in the first six months of fiscal
year 1999. Product revenue increased 14% from $15.5 million in the second
quarter of fiscal year 1998 to $17.7 million in the second quarter of fiscal
year 1999, and by 19% from $29.3 million in the first six months of fiscal year
1998 to $34.9 million in the first six months of fiscal year 1999. The increases
in product revenue were primarily due to increases in the number of licenses of
the Company's pRISM+(TM) product, which was released in the second quarter of
fiscal year 1998, as well as from increased licensing of the Company's Diab Data
compilers and SNiFF+(TM) products.
Services revenue decreased 14% from $16.7 million in the second quarter of
fiscal year 1998 to $14.3 million in the second quarter of fiscal year 1999, and
increased by 4% from $27.5 million in the first six months of fiscal year 1998
to $28.6 million in the first six months of fiscal year 1999. The decrease
quarter over quarter is due to the impact in the second quarter of fiscal year
1998 of an engineering services contract which required the procurement of
approximately $2.6 million of materials resulting in unusually high services
revenue and cost of services revenue in the second quarter of fiscal year 1998.
The increase between the two six-month periods is due primarily to continued
growth of the installed customer base and the renewal of maintenance and support
contracts, and from growth in consulting and engineering services, offset, in
part, by the impact of the contract discussed above.
Price increases were not a material factor in the Company's revenue growth in
the periods presented.
The percentage of the Company's total revenue from customers located
internationally was 42% and 31% in the second quarters of fiscal years 1999 and
1998, respectively, and 43% and 31% in the first six months of fiscal years 1999
and 1998, respectively.
In Europe and Japan, revenues and expenses are primarily denominated in local
currencies. In the second quarter of fiscal year 1999 and for the six months
ended August 31, 1998 the U.S. dollar strengthened against many foreign
currencies as compared to the second quarter and first six months of fiscal year
1998. This resulted in relatively lower revenues and expenses when translated
into U.S. dollars for the second quarter and first six months of fiscal year
1999, compared to the comparative periods of fiscal year 1998. The Company's
operating and pricing strategies take into account changes in exchange rates
over time, however, the Company's results of operations may be significantly
affected in the short term by fluctuations in foreign currency exchange rates.
In addition, in recent months the currencies of many countries in the Asia
Pacific region have lost significant value against the dollar. As a result,
sales in this region could be adversely affected throughout fiscal year 1999.
-11-
<PAGE>
Costs and Expenses
Cost of product revenue includes third-party royalties, costs of product
packaging, documentation, amortization of capitalized software development
costs, and the costs related to equipment hardware. The Company's cost of
product revenue as a percentage of product revenue was 23% and 20% in the second
quarters of fiscal years 1998 and 1999, respectively, and 21% and 20% in the
first six months of fiscal years 1998 and 1999, respectively.
Costs of services revenue includes personnel and related direct costs associated
with providing training, maintenance, engineering and consulting services to
customers and the infrastructure to manage a services organization. Cost of
services revenue as a percentage of services revenue can fluctuate due to shifts
in the services revenue mix between higher margin maintenance and support
revenues and lower margin engineering and consulting services revenues. In
addition, the cost of services revenue as a percentage of services revenue can
fluctuate due to shifts in the proportion of fixed price versus time and
material engineering and consulting contracts. The Company's cost of services
revenue as a percentage of services revenue decreased from 57% in the second
quarter of fiscal year 1998 to 42% in the second quarter of fiscal year 1999,
and from 55% in the first six months of fiscal year 1998 to 40% in the first six
months of fiscal year 1999. These percentage decreases were due mainly to a
decrease in lower margin fixed price contracts. In particular, as discussed
above, during the second quarter of fiscal year 1998, the Company was required
to procure a significant amount of materials with no associated gross margin,
under the terms of a large engineering services contract. Excluding this
anomaly, cost of services revenue as a percentage of services revenue was 50%
for the second quarter and the first six months of fiscal year 1998.
Marketing and sales expenses were $11.3 million and $10.9 million in the second
quarters of fiscal years 1999 and 1998, respectively, representing 35% and 34%
of total revenue, respectively, and $23.4 million and $20.3 million in the first
six months of fiscal years 1999 and 1998, respectively, representing 37% and 36%
of total revenue ,respectively. The dollar increases for all periods presented
were primarily due to the Company's continued investment in its domestic and
international sales and support infrastructure.
The Company believes that significant investment for product research and
development is essential to product and technical leadership. Research and
development expenses were $4.7 million in the second quarters of fiscal years
1999 and 1998, representing 14% and 15%, respectively, of total revenue, and
$10.1 million and $9.5 million in the first six months of fiscal years 1999 and
1998, respectively, representing 16% and 17% of total revenue, respectively.
General and administrative expenses were $4.4 million and $3.1 million in the
second quarters of fiscal years 1999 and 1998, respectively, representing 14%
and 9% of total revenue, respectively, and $7.8 million and $5.6 million in the
first six months of fiscal years 1999 and 1998, respectively, representing 12%
and 10% of total revenue, respectively. The dollar increases for all periods
presented were primarily the result of CEO termination and recruitment costs,
higher legal costs and other outside service costs.
Interest and other income was $1.3 million in the second quarter of fiscal 1999
compared to $1.0 million in the second quarter of fiscal year 1998. The increase
is primarily due to higher interest earned from increased holdings of cash and
marketable securities in fiscal year 1999. Interest and other income was $2.2
million in the first six months of fiscal year 1999 compared to $1.8 million in
the first six months of fiscal year 1998.
Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosure About Segments
of an Enterprise and Related Information," which specifies disclosure
requirements for segment reporting. The statement supersedes SFAS 14 and SFAS
18, is effective for fiscal years beginning after December 15, 1997, and
requires earlier periods to be restated if practicable. The impact of the
adoption of this statement, if any, on the Financial Statements of the Company
has not yet been determined.
In April 1998, the American Institute of Certified Public Accountants issued
Statement of Position 98-1 ("SOP 98-1") "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use". SOP 98-1 provides guidance for
determining whether computer software is internal-use software and on accounting
for the proceeds of computer software originally developed or obtained for
internal use and then subsequently sold to the public. It also provides guidance
on capitalization of the costs incurred for computer software developed or
obtained for internal use. The Company has not yet determined the impact, if
any, of adopting this statement. The disclosure prescribed by SOP 98-1 will be
effective for the Company's fiscal year ending February 28, 2000.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting Derivative
Instruments and Hedging Activities", which supercedes and amends a number of
existing standards. The statement is effective for fiscal years beginning after
June 15, 1999, but earlier application is permitted. The impact of the adoption
of this statement, if any, on the Financial Statements of the Company has not
yet been determined.
-12-
<PAGE>
"Year 2000" Issues
The Company believes that all its most current releases of its products will not
cease to perform nor generate incorrect or ambiguous data or results solely due
to a change in date to or after January 1, 2000, and will calculate any
information dependent on such dates in the same manner, and with the same
functionality, data integrity, and performance, as such products do on or before
December 31, 1999 (collectively, "Year 2000 Compliance"). However, there can be
no assurance that all of the Company's customers will implement the Year 2000
compliant release of the Company's products in a timely manner, which could lead
to failure of customer systems and product liability claims against the Company.
Even if the Company's products are Year 2000 compliant, the Company may in the
future be subject to claims based on Year 2000 issues in the products of other
companies, or issues arising from the integration of multiple products within a
system. The costs of defending and resolving Year 2000-related disputes, and any
liability of the Company for Year 2000-related damages, including consequential
damages, could have a material adverse effect on the Company's business,
financial condition and results of operations. Such failure could also affect
the perceived performance of the Company's products, which could have a negative
effect on the Company's competitive position.
The Company is reviewing its major internal corporate systems for Year 2000
Compliance and intends to take appropriate action based on the results of such
review. The Company's plan for the Year 2000 calls for compliance verification
of external vendors supplying software and information systems to the Company
and communication with significant suppliers to determine the readiness of third
parties' remediation of their own Year 2000 issues. As part of its assessment,
the Company is evaluating the level of validation it will require of third
parties to ensure their Year 2000 readiness. To date, the Company has not
encountered any material Year 2000 issues concerning its computer systems. All
costs associated with carrying out the Company's plan for the Year 2000
Compliance are being expensed as incurred. The total costs associated with
preparation for the Year 2000 has not been, and is not expected to be, material
to the Company's business, financial condition or results of operation.
Nevertheless, the Company may not timely identify and remediate all significant
Year 2000 problems and remedial efforts may involve significant time and
expense. There can be no assurance that any Year 2000 Compliance problems of the
Company or its customers or suppliers will not have a material adverse effect on
the Company's business, financial condition and results of operations.
"Euro" Issues
The Economic and Monetary Union ("EMU") and the introduction of a new currency
(the "Euro"), will begin in Europe on January 1, 1999. The new currency enables
the European Union ("EU") to blend the economies of EU's member states into one
large market with unrestricted and unencumbered trade and commerce across
borders. Eleven European countries are expected to participate in the first
membership wave of EMU, including the Netherlands, Belgium, Luxembourg, Germany,
France, Ireland, Finland, Austria, Italy, Spain and Portugal. Other member
states are expected to join in the years to come. The Company has not evaluated
the impact of the introduction of the new currency and has not determined the
impact, if any, on the Company's financial position, results of operations or
cash flows.
Liquidity and Capital Resources
The Company funds its operations principally through cash flows from operations.
As of August 31, 1998, the Company had $76.3 million of cash, cash equivalents
and marketable securities. This represents an increase of $8.9 million from
February 28, 1998. In April 1997, the Company announced that the Board of
Directors had authorized a common stock repurchase program allowing the Company
to repurchase up to 1,000,000 shares of common stock for cash, from time-to-time
at market prices. No time limit was set for the completion of the program. In
September 1998, the Board of Directors authorized a further 1,000,000 shares of
common stock to be repurchased under this program. As of September 30, 1998 the
Company had repurchased 825,000 shares of common stock for $7.2 million under
this program.
Net cash provided by operating activities during the first six months of fiscal
year 1999 totaled $9.9 million, as compared to $9.6 million in the first six
months of fiscal year 1998. Net cash provided by operating activities increased,
due to an increase in net income and changes in accounts receivable, off set by
changes in accounts payable, accrued payroll and other accrued liabilities, and
income taxes payable.
Net cash used in investing activities totaled $10.9 million in the first six
months of fiscal year 1999 compared to $15.4 million in fiscal year 1998. Net
cash used in investing activities was higher in the first six months of fiscal
year 1998 due primarily to higher purchases of marketable securities.
Net cash provided by financing activities totaled $1.3 million in the first six
months of fiscal years 1999 and 1998. Net cash provided by financing activities
is the result of proceeds from the exercise of common stock options and
purchases under the Employee Stock Purchase plan, offset by repurchases of the
Company's common stock.
The Company believes that cash flows from operations, together with existing
cash balances, will be adequate to meet the Company's cash requirements for
working capital, stock repurchase and capital expenditures for the next 12
months and the foreseeable future.
-13-
<PAGE>
Risk Factors that May Affect Future Results of Operations
Fluctuations in Quarterly Results
The Company's quarterly operating results can vary significantly depending on a
number of factors, including the volume and timing of orders received during the
quarter, the mix of and changes in customers to whom the Company's products are
sold, the timing and acceptance of new products and product enhancements by the
Company or its competitors, changes in pricing, buyouts of run-time licenses,
product life cycles, the level of the Company's sales of third party products,
purchasing patterns of customers, competitive conditions in the industry,
foreign currency exchange rate fluctuations, business cycles affecting the
markets in which the Company's products are sold, extraordinary events, such as
litigation or acquisitions, including related charges, and economic conditions
generally or in various geographic areas. All of the foregoing factors are
difficult to forecast. The future operating results of the Company may fluctuate
as a result of these and other factors, including the Company's ability to
continue to develop innovative and competitive products.
The Company historically has operated with an immaterial product backlog because
its products are generally shipped as orders are received. As a result, product
revenue in any quarter depends on the volume and timing of orders received in
that quarter. In addition, the Company generally recognizes a substantial
portion of its total revenue from sales orders received and shipped in the last
two weeks of the quarter. As such, the magnitude of quarterly fluctuations may
not become evident until very late in, or after the end of, a particular
quarter. In addition, an increasing amount of the Company's sales orders involve
products and services which yield revenue over multiple quarters or upon
completion of performance. Because the Company's staffing and operating expenses
are based on anticipated total revenue levels, and a high percentage of the
Company's costs are fixed in the short term and do not vary with revenue, small
variations between anticipated orders and actual orders, as well as
non-recurring or large orders, can cause disproportionate variations in the
Company's operating results from quarter to quarter.
The procurement process of the Company's customers typically ranges from a few
weeks to several months or longer from initial inquiry to order, making the
timing of sales and license fees difficult to predict. Moreover, as licensing of
the Company's products increasingly becomes a more strategic decision made at
higher management levels, there can be no assurance that sales cycles for the
Company's products will not lengthen. In addition, a portion of the Company's
revenues from services are earned pursuant to fixed price contracts. Variances
in costs associated with those contracts could have a material adverse effect on
the Company's business and results of operations. The Company's results of
operations may also be affected by seasonal trends. While the Company's revenues
are not generally seasonal in nature, the Company's total revenue and net income
during the first fiscal quarter have historically been lower than the previous
fourth fiscal quarter for a variety of reasons, including customer purchase
cycles related to expiration of budgetary authorizations. Due to all of the
foregoing factors, the Company believes that period-to-period comparisons of its
results of operations are not necessarily meaningful and should not be relied
upon as an indication of future performance. During previous fiscal years, the
Company has experienced actual performance that did not meet financial market
expectations. It is likely that, in some future quarters, the Company's
operating results will again be below the expectations of stock market analysts
and investors.
Rapid Technological Change; Dependence on New Products
The market for embedded applications is fragmented and is characterized by
ongoing technological developments, evolving industry standards and rapid
changes in customer requirements. The Company's success depends upon its ability
to continue to develop and introduce in a timely manner new products that take
advantage of technological advances, to continue to enhance its existing product
lines, to offer its products across a spectrum of microprocessor families used
in the embedded systems market and to respond promptly to customers'
requirements and preferences. The Company must continuously update its existing
products to keep them current with changing technology and must develop new
products to take advantage of new technologies that could render the Company's
existing products obsolete. The Company has experienced delays in the
development of new products and the enhancement of existing products. Such
delays are commonplace in the software industry and are likely to be experienced
by the Company in the future. The Company's future prospects depend upon the
Company's ability to increase the functionality of existing products in a timely
manner and to develop new products that address new technologies and achieve
market acceptance. New products and enhancements must keep pace with competitive
offerings, adapt to evolving industry standards and provide additional
functionality. The inability of the Company, due to resource constraints or
technological or other reasons, to develop and introduce new products or product
enhancements in a timely manner or the failure of such new products or product
enhancements to achieve market acceptance could have a material adverse effect
on the Company's business, financial condition or results of operations. From
time to time, the Company or its competitors may announce new products,
capabilities or technologies that have the potential to replace or shorten the
life cycles of the Company's existing products. There can be no assurance that
announcements of currently planned or other new products will not cause
customers to defer purchasing existing Company products. Any failure by the
Company to anticipate or respond adequately to changing market conditions, or
any significant delays in product development or introduction, would have a
material adverse effect on the Company's business, financial condition and
results of operations.
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<PAGE>
Risks Associated with New or Emerging Markets
From time to time, the Company embarks on product development for new or
emerging markets. Currently, the Company is continuing to expend substantial
time and financial resources to develop product lines for applications that use
Internet technology with embedded microprocessors. The Company has introduced
both embedded operating software and development tools for Internet
applications. The commercial Internet market has only recently begun to develop,
is rapidly changing and is characterized by an increasing number of new entrants
with competitive products. It is difficult to predict with any assurance whether
the Internet will prove to be a viable commercial marketplace, or whether demand
for Internet related products and services will increase in the future. If the
Internet market, or any other new market targeted by the Company in the future,
fails to develop or develops more slowly than anticipated or becomes saturated
with competitors, or if the Company's products and services do not achieve or
sustain market acceptance, the Company's business, financial condition and
results of operations would be materially adversely affected.
Competition.
The market for commercially available software tools and embedded operating
systems is fragmented, highly competitive and is characterized by pressures to
incorporate new features and accelerate the release of new product versions. The
Company's products compete with software developed internally by embedded
systems manufacturers and software offered by other third parties. Many
organizations that internally develop and maintain real-time operating systems
have substantial programming resources and can develop specific products for
their needs. Many of these companies have significant investments in their
existing software and there can be no assurance that the Company will be able to
persuade existing and potential customers to replace or augment their internally
developed real-time operating systems with the Company's products. The Company's
principal competitors for third-party embedded software and related tools are
Wind River Systems, Inc., Microsoft Corporation and Sun Microsystems, Inc. The
MATRIXx product family competes with products offered by Mathworks Incorporated
and a number of other companies that provide design and analysis, modeling and
simulation, and code generation products. The Company also competes with a
number of other vendors that address one or more segments of the system design
process, including vendors that have modified general purpose software
engineering products for real-time and control design applications.
As the industry continues to develop, the Company expects competition to
increase in the future from existing competitors and from other companies that
may enter the Company's existing or future markets with similar or substitute
solutions that may be less costly or provide better performance or functionality
than the Company's products. Some of the Company's existing and many of its
potential competitors have substantially greater financial, technical, marketing
and sales resources than the Company and there can be no assurance that the
Company will be able to compete successfully against these companies. In the
event that price competition increases significantly, competitive pressures
could cause the Company to reduce the prices of its products, which would result
in reduced profit margins. Prolonged price competition would have a material
adverse effect on the Company's business, financial condition and results of
operations. Also, run-time licenses, which provide for per-unit royalty payments
for each embedded system that incorporates the Company's real-time operating
systems, may be subject to significant pricing pressures. A variety of other
potential actions by the Company's competitors, including increased promotion
and accelerated introduction of new or enhanced products, could have a material
adverse effect on the Company's business, financial condition and results of
operations.
Acquisition-Related Risks
The Company completed a number of acquisitions in fiscal year 1996 and one in
fiscal year 1997 and may complete additional acquisitions in the future. The
process of integrating an acquired company's business into the Company's
operations may result in unforeseen operating difficulties and expenditures and
may absorb significant management attention that would otherwise be available
for the ongoing development of the Company's business. Moreover, there can be no
assurance that the anticipated benefits of an acquisition will be realized.
Future acquisitions by the Company could result in potentially dilutive
issuances of equity securities, the incurrence of debt and contingent
liabilities and amortization expenses related to goodwill and other intangible
assets, which could have a material adverse effect on the Company's business,
financial condition and results of operations. In addition, acquisitions involve
numerous risks, including difficulties in the assimilation of the operations,
technologies and products of the acquired companies, difficulties in managing
diverse geographic sales and research and development operations, the diversion
of management attention from other business concerns, risks of entering markets
in which the Company has no or limited direct prior experience and the potential
loss of key employees of the acquired company. From time to time, the Company
evaluates potential acquisitions of businesses, products or technologies. The
Company has no present understandings, commitments or agreements with respect to
any material acquisition of other businesses, products or technologies, and no
material acquisition is currently being pursued actively. In the event that such
an acquisition were to occur, however, there can be no assurance that the
Company's business, operating results and financial condition would not be
materially adversely affected.
-15-
<PAGE>
Risks Associated with International Operations
In fiscal years 1996, 1997 and 1998, the Company derived approximately 34%, 38%,
and 41%, respectively, of its total revenue from sales outside of North America.
In the second quarter and first six months of fiscal year 1999 the Company
generated 42% and 43%, respectively, of its total revenue from sales outside of
North America. The Company expects that international sales will continue to
generate a significant percentage of its total revenue in the foreseeable
future. International operations are subject to a number of special risks,
including foreign government regulation, reduced protection of intellectual
property rights, longer receivable collection periods and greater difficulty in
accounts receivable collection, unexpected changes in, or imposition of,
regulatory requirements, tariffs, import and export restrictions and other
barriers and restrictions, potentially adverse tax consequences, the burdens of
complying with a variety of foreign laws, staffing and managing foreign
operations, general geopolitical risks, such as political and economic
instability, hostilities with neighboring countries and changes in diplomatic
and trade relationships, possible recessionary environments in economies outside
the United States and other factors beyond the control of the Company. The
Company generally denominates sales to and by foreign subsidiaries in local
currency, and an increase in the relative value of the dollar against such
currencies, as has recently occurred, would reduce the Company's revenue in
dollar terms or make the Company's products more expensive and, therefore,
potentially less competitive in foreign markets. In particular, revenue from
sales in Japan during fiscal years 1997, 1998 and in the first six months of
fiscal year 1999 was adversely affected by the weakness of the yen against the
dollar. Continued weakness of the yen may affect revenue from Japan during
fiscal year 1999. The Company has little experience in hedging its foreign
currency sales, but has done so on a limited basis. There can be no assurance
that the Company's future results of operations will not be adversely affected
by currency fluctuations. In recent months, the currencies of many countries in
the Asia Pacific region have lost significant value against the dollar, notably
the currencies of Korea and Taiwan. As a result, the Company's sales in these
countries could be adversely affected. The Company relies on distributors and
representatives for sales of its products in certain foreign countries and,
accordingly, is dependent on their ability to promote and support the Company's
products and, in some cases, to translate them into foreign languages. The
Company's international distributors and representatives generally offer
products of several different companies, including in some cases products that
are competitive with the Company's products, and such distributors and
representatives are not subject to any minimum purchase or resale requirements.
There can be no assurance that the Company's international distributors and
representatives will continue to purchase the Company's products or provide them
with adequate levels of support.
Risks of Product Defects; Product and Other Liability; Year 2000 Compliance
As a result of their complexity, software products may contain undetected errors
or compatibility issues, particularly when first introduced or as new versions
are released. There can be no assurance that, despite testing by the Company and
testing and use by current and potential customers, errors will not be found in
new products after commencement of commercial shipments. The occurrence of such
errors could result in loss of or delay in market acceptance of the Company's
products, which could have a material adverse effect on the Company's business,
financial condition and results of operations. The increasing use of the
Company's products for applications in systems that interact directly with the
general public, particularly applications in transportation, medical systems and
other markets where the failure of the embedded system could cause substantial
property damage or personal injury, could expose the Company to significant
product liability claims. In addition, the Company's products are used for
applications in mission-critical business systems where the failure of the
embedded system could be linked to substantial economic loss. The Company
believes that all of its most current releases of its products will not cease to
perform nor generate incorrect or ambiguous data or results solely due to a
change in date to or after January 1, 2000, and will calculate any information
dependent on such dates in the same manner, and with the same functionality,
data integrity, and performance, as such products do on or before December 31,
1999 (collectively, "Year 2000 Compliance"). Year 2000 Compliance issues may
arise with respect to any modifications made to the Company's products by a
party other than the Company or from the combination or use of the Company's
products with any other software programs or hardware devices not provided by
the Company, and therefore may result in unforeseen Year 2000 Compliance
problems for some of the Company's customers, which may have a material adverse
effect on the Company's business, financial condition and results of operations.
The Company's license and other agreements with its customers typically contain
provisions designed to limit the Company's exposure to potential product
liability and other claims. It is likely, however, that the limitation of
liability provisions contained in the Company's agreements are not effective in
all circumstances and in all jurisdictions. The Company currently does not have
insurance against product liability risks or errors or omissions coverage and
there can be no assurance that such insurance will be available to the Company
on commercially reasonable terms or at all. A product liability claim or claim
for economic loss brought against the Company, or a product recall involving the
Company's software, could have a material adverse effect on the Company's
business, financial condition and results of operations. Additionally, as with
any company with a computing infrastructure and utilizing business-application
software programs written over many years, the Company's internal operations may
be subject to Year 2000 Compliance issues. The Company's operations are
dependent on its ability to protect its computer equipment and the information
stored in its databases against damage by fire, natural disaster, power loss
telecommunications failure, unauthorized intrusion, and other catastrophic
events. The Company believes it has taken prudent measure to reduce the risk of
interruption in its operations. However, there can be no assurance that these
measures are sufficient. Any damage or failure that causes interruption in the
Company's operations could have a material adverse effect on its business,
financial condition, and results of operations.
-16-
<PAGE>
Dependence on Key Personnel; Need for Additional Personnel
The Company's future performance depends to a significant degree upon the
continued contributions of its key management, product development, sales,
marketing and operations personnel. The Company does not have employment
agreements with any of its key personnel and does not maintain any key person
life insurance policies. In addition, the Company believes its future success
will also depend in large part upon its ability to attract and retain highly
skilled managerial, engineering, sales, marketing and operations personnel, many
of whom are in great demand. Competition for such personnel is intense in Santa
Clara County, California, where the Company is headquartered, and there can be
no assurance that the Company will be successful in attracting and retaining
such personnel. In particular, the Company is currently searching for a new
President and Chief Executive Officer, and has appointed an interim CEO from
within the Company during this transition. The failure of the Company to
attract, assimilate and retain the necessary personnel could have a material
adverse effect on the Company's business, financial condition and results of
operations.
Limited Protection of Proprietary Technology
The Company's success is heavily dependent upon its proprietary technology. To
protect its proprietary rights, the Company relies on a combination of
copyright, trade secret, patent and trademark laws, nondisclosure and other
contractual restrictions on copying and distribution and technical measures.
Despite the Company's efforts to protect its proprietary rights, it may be
possible for unauthorized third parties to copy the Company's products or to
reverse engineer or obtain and use information that the Company regards as
proprietary. Policing unauthorized use of the Company's products is difficult,
and while the Company is unable to determine the extent to which software piracy
of its products exists, software piracy can be expected to be a persistent
problem. In addition, effective protection of intellectual property rights may
be unavailable or limited in certain countries. The status 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.
Patents have been granted on fundamental technologies in software, and patents
may issue that relate to fundamental technologies incorporated into the
Company's products.
As the number of patents, copyrights, trademarks and other intellectual property
rights in the Company's industry increases, products based on its technology may
increasingly become the subject of infringement claims. There can be no
assurance that third parties will not assert infringement claims against the
Company in the future. Any such claims with or without merit could be time
consuming, result in costly litigation, cause product shipment delays or require
the Company to enter into royalty or licensing agreements. Such royalty or
licensing agreements, if required, might not be available on terms acceptable to
the Company, or at all, which could have a material adverse affect on the
Company's business, financial condition and results of operations. In addition,
the Company may initiate claims or litigation against third parties for
infringement of the Company's proprietary rights or to establish the validity of
the Company's proprietary rights. Litigation to determine the validity of any
claims, whether or not such litigation is determined in favor of the Company,
could result in significant expense to the Company and divert the efforts of the
Company's technical and management personnel from productive tasks. In the event
of an adverse ruling in any such litigation, the Company may be required to pay
substantial damages, discontinue the use and sale of infringing products, expend
significant resources to develop non-infringing technology or obtain licenses to
infringing technology. The failure of the Company to develop or license a
substitute technology could have a material adverse affect on the Company's
business, financial condition and results of operations.
Dependence on Licenses from Third Parties
The Company licenses certain software development tool products from other
companies to distribute with its own products. The inability of such third
parties to provide competitive products with adequate features and high quality
on a timely basis or to provide sales and marketing cooperation could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, the Company's products compete with products
produced by certain of the Company's licensors. There can be no assurance that,
upon the termination or expiration of these licenses, such licenses will be
available on reasonable terms or at all, or that similar products could be
obtained to substitute into the tool suites. The inability to license such
products could have a material adverse effect on the Company's business,
financial condition and results of operations.
Volatility of Stock Price
The prices for the Company's common stock have fluctuated widely in the past.
The management of the Company believes that such fluctuations may have been
caused by actual or anticipated variations in the Company's operating results,
announcements of technical innovations or new products or services by the
Company or its competitors, changes in earnings estimates by securities analysts
and other factors, including changes in conditions of the software and other
technology industries in general. Stock markets have experienced extreme price
volatility in recent years. This volatility has had a substantial effect on the
market prices of securities issued by the Company and other high technology
companies, often for reasons unrelated to the operating performance of the
specific companies. In the past, following periods of volatility in the market
price of a company's securities, securities class action litigation has often
been instituted against such a company. Such litigation, if instituted, could
result in substantial costs and a diversion of management attention and
resources, which would have a material adverse effect on the Company's business,
financial condition and results of operations even if the Company is successful
in such suits. These market fluctuations, as well as general economic, political
and market conditions such as recessions, may adversely affect the market price
of the common stock.
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<PAGE>
Financial Statements are Based on Estimates and Assumptions
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the recorded amounts of assets and liabilities at the date of the
financial statements and the recorded amounts of revenues and expenses during
the reporting period. A change in the facts and circumstances surrounding these
estimates could result in a change to the estimates and impact future operating
results.
Item 3. Quantitative and Qualitative Disclosures about Market Risks
Foreign Currency Risk.
The Company enters into foreign currency forward exchange contracts to reduce
the impact of currency exchange rate fluctuations on monetary assets and
liability positions. The objective of these contracts is to minimize the impact
of exchange rate fluctuations on the Company's operating results. Gains and
losses associated with exchange rate fluctuations on foreign currency forward
exchange contracts are recorded in income as they offset corresponding gains and
losses on the foreign currency denominated assets and liabilities being hedged.
The costs of the foreign currency forward exchange contracts are also recorded
in income. All foreign currency forward exchange contracts entered into by the
Company have maturities of less than one year. At August 31, 1998, the Company
had approximately $2.5 million of foreign currency forward exchange contracts
outstanding, $2.2 million in Japanese yen and $0.3 million in Swedish Krona.
There were no foreign currency forward exchange contracts at February 28, 1998.
Unrealized gains on foreign currency forward exchange contracts at August 31,
1998 were approximately $19,000.
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<PAGE>
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Information with respect to this item is incorporated by reference to Note
6 of Notes to Condensed Consolidated Financial Statements included herein
on Page 8 of this Form 10-Q.
Item 4. Submission of Matters to a Vote of Security Holders
At the Annual Meeting of Shareholders held July 15, 1998, the following
matters were submitted to a vote of the security holders:
(1) To elect the following to serve as directors of the Company:
Name For Withheld
John C. Bolger 19,960,987 27,577
Michael A. Brochu 19,961,489 27,075
Narendra K. Gupta 19,951,172 37,392
Vinita Gupta 19,715,498 273,066
Thomas Kailath 19,724,489 264,075
Richard C. Murphy 19,725,262 263,302
David P. St. Charles 19,581,017 407,547
(2) To approve the adoption of the Company's 1998 Equity Incentive
Plan:
Votes for 9,674,261
Votes against 4,867,189
Votes abstaining 93,864
(3) To approve an amendment to the 1994 Directors Stock Option Plan
to eliminate the provision which limits the maximum number of
shares that may be issued to any one director to 40,000 shares:
Votes for 13,315,176
Votes against 1,225,171
Votes abstaining 94,967
(4) To ratify the selection of PricewaterhouseCoopers L.L.P. as
independent accountants for the Company for the fiscal year
ending February 28, 1999:
Votes for 19,959,564
Votes against 13,400
Votes abstaining 15,510
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
The following exhibits are filed as part of the Report:
Exhibit
Number Title
10.14 Registrant's 1998 Equity Incentive Plan
(Incorporated by reference to Exhibit 4.04 of the
Company's Registration Statement on Form S-8, File
No. 333-64673)
27.01 Financial Data Schedule
(b) Reports on Form 8-K. No reports on Form 8-K were filed by
Registrant during the three months ended August 31, 1998.
-19-
<PAGE>
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.
Dated: October 9, 1998 INTEGRATED SYSTEMS, INC.
(Registrant)
/S/ JOSEPH ADDIEGO
------------------------------------
JOSEPH ADDIEGO
Interim Chief Executive Officer
/S/WILLIAM C. SMITH
------------------------------------
WILLIAM C. SMITH
Vice President, Finance and
Chief Financial Officer
-20-
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<ARTICLE> 5
<LEGEND>
THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM Q2 FY99
FORM 10-Q 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> FEB-28-1999
<PERIOD-START> MAR-01-1998
<PERIOD-END> AUG-31-1998
<CASH> 14,812
<SECURITIES> 2,658
<RECEIVABLES> 25,449
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 48,999
<PP&E> 18,796
<DEPRECIATION> 0
<TOTAL-ASSETS> 135,084
<CURRENT-LIABILITIES> 32,678
<BONDS> 0
0
0
<COMMON> 64,951
<OTHER-SE> 37,455
<TOTAL-LIABILITY-AND-EQUITY> 135,084
<SALES> 34,884
<TOTAL-REVENUES> 63,487
<CGS> 7,133
<TOTAL-COSTS> 18,611
<OTHER-EXPENSES> 41,217
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 5,880
<INCOME-TAX> (518)
<INCOME-CONTINUING> 6,398
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 6,398
<EPS-PRIMARY> 0.27
<EPS-DILUTED> 0.26
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