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 May 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 June 30,
1998 was 23,512,879 shares.
Page 1 of 18 pages.
<PAGE>
INTEGRATED SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED MAY 31, 1998
INDEX
Page
----
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements 3
Condensed Consolidated Balance Sheets as
of May 31, 1998 and February 28, 1998 4
Condensed Consolidated Statements of Income
for the Three Months Ended May 31, 1998 and 1997 5
Condensed Consolidated Statements of Cash Flows
for the Three Months Ended May 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
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 17
Item 5. Other Information 17
Item 6. Exhibits and Reports on Form 8-K 17
SIGNATURES 18
================================================================================
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 elsewhere in this Report in Management's Discussion and Analysis of
Financial Condition and Results of Operations and in the Company's Securities
and Exchange Commission reports.
================================================================================
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<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.
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<PAGE>
INTEGRATED SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
May 31, February 28,
1998 1998
--------- ---------
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 24,531 $ 14,454
Marketable securities 4,989 6,670
Accounts receivable, net 25,808 29,455
Deferred income taxes 1,043 1,603
Prepaid expenses and other 5,311 4,548
--------- ---------
Total current assets 61,682 56,730
Marketable securities 43,264 46,322
Property and equipment, net 18,698 18,428
Intangible assets, net 2,493 2,867
Deferred income taxes 4,763 2,363
Other assets 1,174 1,410
--------- ---------
Total assets $ 132,074 $ 128,120
========= =========
LIABILITIES
Current liabilities:
Accounts payable $ 4,917 $ 5,073
Accrued payroll and related expenses 4,493 4,321
Other accrued liabilities 5,593 5,372
Income taxes payable 1,302 2,747
Deferred revenue 15,623 16,181
--------- ---------
Total current liabilities 31,928 33,694
--------- ---------
SHAREHOLDERS' EQUITY
Common Stock, no par value, 50,000 shares authorized:
23,495 and 23,339 shares issued and outstanding at
May 31, 1998 and February 28, 1998, respectively 65,453 63,647
Accumulated other comprehensive income, net (1,426) (1,290)
Retained earnings 36,119 32,069
--------- ---------
Total shareholders' equity 100,146 94,426
--------- ---------
Total liabilities and shareholders' equity $ 132,074 $ 128,120
========= =========
The accompanying notes are an integral part of these condensed
consolidated financial statements.
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<PAGE>
INTEGRATED SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
(unaudited)
Three Months Ended
May 31,
----------------------
1998 1997
-------- --------
Revenue:
Product $ 17,161 $ 13,758
Services 14,321 10,830
-------- --------
Total revenue 31,482 24,588
-------- --------
Costs and expenses:
Cost of product revenue 3,654 2,729
Cost of services revenue 5,412 5,575
Marketing and sales 12,105 9,409
Research and development 5,441 4,802
General and administrative 3,356 2,522
-------- --------
Total costs and expenses 29,968 25,037
-------- --------
Income (loss) from operations 1,514 (449)
Interest and other income 913 795
-------- --------
Income before income taxes 2,427 346
(Benefit)/provision for income taxes (1,623) 125
-------- --------
Net income 4,050 221
======== ========
Earnings per share - basic 0.17 0.01
======== ========
Earnings per share - diluted 0.17 0.01
======== ========
Shares used in per share calculations - basic $ 23,426 $ 23,121
======== ========
Shares used in per share calculations - diluted $ 24,436 $ 23,852
======== ========
The accompanying notes are an integral part of these condensed
consolidated financial statements
-5-
<PAGE>
<TABLE>
INTEGRATED SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
<CAPTION>
Three Months Ended
May 31,
-----------------------------
1998 1997
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 4,050 $ 221
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,414 1,469
Deferred income taxes (1,852) (35)
Provisions for doubtful accounts receivable (270) (20)
Changes in assets and liabilities:
Accounts receivable 4,414 2,396
Prepaid expenses and other (763) (2,036)
Accounts payable, accrued payroll and
other accrued liabilities 237 1,321
Income taxes payable (1,445) (424)
Deferred revenue (558) 5,328
Other assets and liabilities 215 86
-------- --------
Net cash provided by operating activities 5,442 8,306
-------- --------
Cash flows from investing activities:
Maturities (purchases) of marketable securities, net 4,712 (12,821)
Additions to property and equipment, net (1,209) (1,369)
Capitalized software development costs (80) (100)
-------- --------
Net cash provided by (used in) investing activities 3,423 (14,290)
-------- --------
Cash flows from financing activities:
Repurchase of common stock -- (187)
Proceeds from exercise of common stock options and
purchases under the Employee Stock Purchase Plan 1,806 1,059
-------- --------
Net cash provided by financing activities 1,806 872
-------- --------
Effect of exchange rate fluctuations on cash and cash equivalents (594) 33
Net increase (decrease) in cash and cash equivalents 10,077 (5,079)
Cash and cash equivalents at beginning of period 14,454 25,585
-------- --------
Cash and cash equivalents at end of period $ 24,531 $ 20,506
======== ========
Supplemental disclosure of cash flow information:
Cash paid during the period for income taxes, net $ 1,662 $ 458
Supplemental schedule of noncash investing activities:
Unrealized loss on marketable securities $ (27) $ (100)
<FN>
The accompanying notes are an integral part of these condensed consolidated financial statements.
</FN>
</TABLE>
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<PAGE>
INTEGRATED SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Information for the three months ended May 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 shareholders' equity.
2. Revenue Recognition
The Company has adopted the provisions of Statement of Position 97-2 ("SOP
97-2"), "Software Revenue Recognition" as amended by SOP 98-4 ("SOP 98-4"),
"Deferral of the Effective Date of Certain Provisions of SOP 97-2" effective
March 1, 1998. SOP 97-2 and SOP 98-4 provide guidance on recognition of revenue
on software transactions and supersede Statement of Position 91-1 ("SOP 91-1").
The adoption of SOP 97-2 and SOP 98-4 did not have a material effect on the
Company's current licensing or revenue recognition practices.
3. 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 numbers 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.
The following table sets forth the calculations of earnings per share:
Three Months Ended
May 31,
---------------------
(in thousands, except per share data) 1998 1997
------- -------
(unaudited)
Basic:
Net income $ 4,050 $ 121
======= =======
Weighted average number of common shares
outstanding 23,426 23,121
======= =======
Earnings per share - basic $ 0.17 $ 0.01
======= =======
Diluted:
Net income $ 4,050 $ 221
======= =======
Weighted average number of common shares
outstanding 23,426 23,121
Dilutive effect of stock options, net 1,010 731
------- -------
Weighted average number of common and
common equivalent shares outstanding 24,436 23,852
======= =======
Earnings per share - diluted $ 0.17 $ 0.01
======= =======
-7-
<PAGE>
4. 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.
Comprehensive income for the three months ended May 31, 1998 and 1997 is as
follows:
Three Months Ended
May 31,
----------------------
(In thousands) 1998 1997
------- -------
Net income $ 4,050 $ 221
Other comprehensive income, net of tax:
Foreign currency translation adjustments (97) 257
Unrealized loss on investments (39) (61)
------- -------
Other comprehensive income (136) 196
======= =======
Total comprehensive income $ 3,914 $ 417
======= =======
<TABLE>
The accumulated balances of other comprehensive income as of May 31, 1998 and
1997 are as follows:
<CAPTION>
May 31, 1998 May 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 (97) (39) (136) 257 (61) 196
------- ------- ------- ------- ------- -------
Ending balance $(1,535) $ 109 $(1,426) $ (873) $ 87 $ (786)
======= ======= ======= ======= ======= =======
</TABLE>
5. 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 May 31, 1998, the Company had
approximately $5.2 million of foreign currency forward exchange contracts
outstanding, all in Japanese yen. There were no foreign currency forward
exchange contracts at February 28, 1998. Unrealized gains on foreign currency
forward exchange contracts at May 31, 1998 totaled $366,000.
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.
6. Income Taxes
In May 1998, the Company made an election with the Internal Revenue Service to
treat the Company's Austrian Subsidiary, TakeFive 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 tax benefit of $2.4 million in the first
quarter of fiscal year 1999.
-8-
<PAGE>
7. 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.
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.
-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
May 31, May 31,
1998 1997 1998 compared to 1997
---- ---- ---------------------
<S> <C> <C> <C>
Revenue:
Product 55% 56% 25%
Services 45 44 32
----- -----
Total revenue 100 100 28
----- -----
Costs and expenses:
Cost of product revenue 12 11 34
Cost of services revenue 17 23 (3)
Marketing and sales 38 38 29
Research and development 17 20 13
General and administrative 11 10 33
----- -----
Total costs and expenses 95 102 20
----- -----
Income (loss) from operations 5 (2) NM
Interest and other income 3 3 15
----- -----
Income before income taxes 8 1 NM
(Benefit)/provision for income taxes (5) -- NM
----- -----
Net income 13% 1% NM
===== =====
<FN>
NM= Not Meaningful
</FN>
</TABLE>
-10-
<PAGE>
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 increased by 28% from $24.6 million in the
first quarter of fiscal year 1998 to $31.5 million in the first quarter of
fiscal year 1999. Product revenue increased 25% from $13.8 million in the first
quarter of fiscal year 1998 to $17.2 million in fiscal year 1999. The increase
in product revenue was primarily due to an increase 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
SNiFF+(TM) and MATRIXxR products.
Services revenue increased 32% from $10.8 million in the first quarter of fiscal
year 1998 to $14.3 million in the first quarter of fiscal year 1999. The
increase 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.
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 33% and 45% in the first quarters of fiscal years 1998 and
1999, respectively. The increase in international revenue as a percentage of
total revenue in the first quarter of fiscal year 1999, as compared to the first
quarter of fiscal year 1998, was due primarily to revenue in Europe growing
faster than revenue in the United States.
In Europe and Japan, revenues and expenses are primarily denominated in local
currencies. In the first quarter of fiscal year 1999 the U.S. dollar
strengthened against many foreign currencies, particularly the Japanese yen,
which resulted in relatively lower revenues and expenses when translated into
U.S. dollars. In the first quarter of fiscal year 1998, revenue was less
influenced by fluctuations in foreign exchange rates. 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. More generally,
recent instability in the Asian currency and stock markets could adversely
affect the economic health of the entire region and adversely affect revenue
throughout fiscal year 1999.
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. Cost of product revenue as a
percentage of product revenue was 20% and 21% in the first quarters of fiscal
year 1998 and fiscal year 1999, respectively.
Cost 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. The
Company's cost of services revenue as a percentage of services revenue was 51%
and 38% in the first quarters of fiscal years 1998 and 1999, respectively. 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. Fixed price engineering and
consulting contracts generally have lower gross margins than time and material
contracts. Cost of services revenue as a percentage of services revenue
decreased in the first quarter of fiscal year 1999 compared to the first quarter
of fiscal year 1998 due to a higher percentage of total services revenues being
derived from maintenance and support. In addition, in the first quarter of
fiscal year 1998 there was a higher proportion of fixed price engineering and
consulting services contracts than in the first quarter of fiscal year 1999.
Marketing and sales expenses increased by 29% from $9.4 million in the first
quarter of fiscal year 1998 to $12.1 million in the first quarter of fiscal year
1999 and represented 38% of total revenue in both periods. The dollar increase
in marketing and sales expenses in the first quarter of fiscal year 1999 was due
to continued growth of the 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 increased 13% from $4.8 million in the first quarter of
fiscal year 1998 to $5.4 million in the first quarter of fiscal year 1999, but
decreased as a percentage of total revenue from 20% to 17%, respectively. The
dollar increase in research and development expenses was due primarily to an
increase in personnel and consulting costs associated with the Company's
continued emphasis on developing new products and enhancing existing products.
The decrease in research and development expense as a percentage of total
revenue was due to having significant costs in the first quarter of fiscal year
1998 related to the development effort associated with the Company's pRISM+
product. The Company anticipates that it will continue to devote substantial
resources to product research and development throughout fiscal year 1999.
-11-
<PAGE>
General and administrative expenses were $2.5 million or 10% of total revenue in
the first quarter of fiscal year 1998 compared to $3.4 million or 11% of total
revenue in the first quarter of fiscal year 1999. The increase in general and
administrative expenses was due primarily to an increase in personnel and
personnel related expenses and due to the Company incurring higher legal costs
and other outside service costs.
Interest and other income increased from $0.8 million in the first quarter of
fiscal year 1998 to $0.9 million in the first quarter of fiscal year 1999 due
primarily to an increase in the amount of interest-bearing cash equivalents and
marketable securities.
Net income in the first quarter of fiscal year 1999 was positively impacted by a
$2.4 million one-time federal tax benefit related to a tax election made during
the quarter. Excluding this tax benefit, the effective tax rate for the first
quarter of fiscal year 1999 was 32%.
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.
"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 the Company
does not currently have complete information concerning Year 2000 Compliance for
all of its suppliers and customers. In addition, the Company is currently in the
process of evaluating its internal information technology infrastructure for
Year 2000 Compliance. In the event that the Company's significant suppliers or
customers do not successfully and timely achieve Year 2000 Compliance, the
Company's business, financial condition and results of operations could be
adversely affected.
"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 had funded its operations to date principally through cash flows
from operations. As of May 31, 1998, the Company had $72.8 million of cash, cash
equivalents and marketable securities. This represents an increase of $5.3
million from February 28, 1998. During the first quarter of fiscal year 1998,
the Company announced that the Board of Directors had authorized the Company to
repurchase up to 1,000,000 shares of common stock for cash, from time-to-time at
market prices, pursuant to a repurchase program. To date, the Company
repurchased 135,000 shares of common stock for $1.7 million under this program.
Net cash provided by operating activities was $5.4 million during the first
quarter of fiscal year 1999. This represents a decrease of $2.9 million from the
amount generated in the first quarter of fiscal year 1998. Net cash from
operating activities decreased in the first quarter of fiscal year 1999, despite
higher net income than in the first quarter of fiscal year 1998 due primarily to
larger payments of income taxes and an increase in deferred tax assets. In
addition, in the first quarter of fiscal year 1998 deferred revenue increased
$5.3 million compared to a decrease of $0.6 million in the first quarter of
fiscal year 1999. The increase in deferred revenue in the first quarter of
fiscal year 1998 was due to advanced customer payments on engineering services
contracts.
-12-
<PAGE>
Net cash provided by investing activities was $3.4 million in the first quarter
of fiscal year 1999. This compares to net cash used in investing activities of
$14.3 million in the first quarter of fiscal year 1998. The difference between
the two comparative quarters is due primarily to the timing of purchases and
maturities of marketable securities.
Net cash provided by financing activities totaled $1.8 million in the first
quarter of fiscal year 1999 compared to $0.9 million in the first quarter of
fiscal year 1998. The increase in net cash provided by financing activities was
due to primarily to an increase in the proceeds from the exercise of options to
purchase common stock and purchases under the employee Stock Purchase Plan.
The Company believes that the cash flows from operations, together with existing
cash and investment balances, will be adequate to meet the Company's cash
requirements for working capital, capital expenditures and stock repurchases for
the next 12 months and the foreseeable future.
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 insignificant 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
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<PAGE>
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
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.
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, through its introduction of
Windows CE and Sun Microsystems, Inc., with its acquisition of Chorus. 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
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<PAGE>
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.
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 first quarter of fiscal year 1999 the Company generated 45% 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 quarter of fiscal
year 1999 were adversely affected by the weakness of the yen against the dollar.
Continued weakness of the yen could 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. More generally, recent instability in
Asian currency and stock markets could adversely affect the economic health of
the entire region and could have an adverse effect on the Company's results of
operations. 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
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<PAGE>
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.
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. 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
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<PAGE>
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.
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.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Information with respect to this item is incorporated by reference to Note 7 of
Notes to Condensed Consolidated Financial Statements included herein on page 9
of this Form 10-Q
Item 5. Other Information
The following statement is provided pursuant to Rule 14a-5 promulgated by the
Securities and Exchange Commission under Securities Exchange Act of 1934, as
amended: Proxies solicited by the Company for the Company's 1999 Annual Meeting
of Shareholders will be voted in the discretion of the persons voting such
proxies with respect to all proposals presented by shareholders for
consideration at such meeting after April 30, 1999.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
The following exhibit is filed herewith:
Exhibit Page
Number Title Number
------ ----- ------
27.01 Financial Data Schedule 19
(b) Reports on Form 8-K. No reports on Form 8-K were filed by Registrant
during the three months ended May 31, 1998.
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<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: July 14, 1998 INTEGRATED SYSTEMS, INC.
(Registrant)
/s/ DAVID P. ST. CHARLES
-------------------------------------
DAVID P. ST. CHARLES
President and Chief Executive Officer
/s/ WILLIAM C. SMITH
-------------------------------------
WILLIAM C. SMITH
Vice President, Finance and
Chief Financial Officer
-18-
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THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM Q1 FY99
FORM 10-Q FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
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