<PAGE>
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 November 30, 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 Registrant's Common Stock on December 31,
1998 was 22,647,952 shares.
<PAGE>
INTEGRATED SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED NOVEMBER 30, 1998
INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements 3
Condensed Consolidated Balance Sheets as of November 30, 1998
and February 28, 1998 4
Condensed Consolidated Statements of Income for the Three and
Nine Months Ended November 30, 1998 and 1997 5
Condensed Consolidated Statements of Cash Flows for the Nine
Months Ended November 30, 1998 and 1997 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results 10
Item 3. Quantitative and Qualitative Disclosures about Market Risks 18
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 19
Item 5. Other Information 19
Item 6. Exhibits and Reports on Form 8-K 19
SIGNATURES 20
</TABLE>
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.
<PAGE>
PART 1 - 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 comformity 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>
INTEGRATED SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
NOVEMBER 30, FEBRUARY 28,
1998 1998
------------ ------------
<S> <C> <C>
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 16,700 $ 14,454
Marketable securities 9,904 6,670
Accounts receivable, net 25,714 29,455
Deferred income taxes 840 1,603
Prepaid expenses and other 4,656 4,548
------- -------
Total current assets 57,814 56,730
Marketable securities 49,299 46,322
Property and equipment, net 18,588 18,428
Intangible assets, net 2,970 2,867
Deferred income taxes 4,763 2,363
Other assets 1,106 1,410
------- -------
Total assets $134,540 $128,120
-------- --------
-------- --------
LIABILITIES
Current liabilities:
Accounts payable $ 4,260 $ 5,073
Accrued payroll and related expenses 5,038 4,321
Other accrued liabilities 6,529 5,372
Income taxes payable 3,018 2,747
Deferred revenue 16,533 16,181
------- -------
Total current liabilities 35,398 33,694
SHAREHOLDERS' EQUITY
Common Stock, no par value, 50,000 shares
authorized: 22,623 and 23,339 shares
issued and outstanding at November 30, 1998
and February 28, 1998; respectively 58,016 63,647
Accumulated other comprehensive income (loss), net (513) (1,290)
Retained earnings 41,639 32,069
------- -------
Total shareholders' equity 99,142 94,426
------- -------
Total liabilities and shareholders' equity $134,540 $128,120
-------- --------
-------- --------
</TABLE>
The accompanying notes are an integral part of these condensed
consolidated financial statements.
4
<PAGE>
INTEGRATED SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
(unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
NOVEMBER 30, NOVEMBER 30,
-------------------- --------------------
1998 1997 1998 1997
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Revenue:
Product $ 20,604 $ 17,637 $ 55,488 $ 46,897
Services 14,358 12,265 42,961 39,763
--------- --------- --------- ---------
Total revenue 34,962 29,902 98,449 86,660
--------- --------- --------- ---------
Costs and expenses:
Cost of product revenue 5,034 3,208 12,167 9,458
Cost of services revenue 5,723 6,590 17,201 21,711
Marketing and sales 12,142 11,313 35,505 31,594
Research and development 4,399 4,672 14,498 14,221
General and administrative 4,354 2,767 12,109 8,346
--------- --------- --------- ---------
Total costs and expenses 31,652 28,550 91,480 85,330
--------- --------- --------- ---------
Income from operations 3,310 1,352 6,969 1,330
Interest and other income 1,354 1,090 3,575 2,864
--------- --------- --------- ---------
Income before income taxes 4,664 2,442 10,544 4,194
Provision for income taxes 1,492 830 974 1,426
--------- --------- --------- ---------
Net income $ 3,172 $ 1,612 $ 9,570 $ 2,768
--------- --------- --------- ---------
--------- --------- --------- ---------
Earnings per share--basic $ 0.14 $ 0.07 $ 0.41 $ 0.12
--------- --------- --------- ---------
--------- --------- --------- ---------
Earnings per share--diluted $ 0.14 $ 0.07 $ 0.40 $ 0.12
--------- --------- --------- ---------
--------- --------- --------- ---------
Shares used in per share calculations--basic 22,969 23,291 23,299 23,198
--------- --------- --------- ---------
--------- --------- --------- ---------
Shares used in per share calculations--diluted 23,241 24,349 23,984 24,057
--------- --------- --------- ---------
--------- --------- --------- ---------
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
INTEGRATED SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
NOVEMBER 30,
----------------------
1998 1997
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 9,570 $ 2,768
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 4,309 4,255
Provision for (release of) doubtful accounts receivable (25) 1,619
Deferred income taxes (1,924) (354)
Changes in assets and liabilities:
Accounts receivable 3,760 444
Prepaid expenses and other (108) (756)
Accounts payable, accrued payroll and other accrued liabilities 1,061 1,730
Income taxes payable 271 (458)
Deferred revenue 372 1,213
Other assets and liabilities 241 (3)
---------- ----------
Net cash provided by operating activities 17,527 10,458
---------- ----------
Cash flows from investing activities:
Purchases of marketable securities, net (5,493) (21,647)
Additions to property and equipment (3,104) (3,816)
Capitalized software development costs (1,405) (825)
---------- ----------
Net cash used in investing activities (10,002) (26,288)
---------- ----------
Cash flows from financing activities:
Repurchase of common stock (8,739) (187)
Proceeds from exercise of common stock options and purchases under the Employee Stock
Purchase Plan 3,108 2,679
Tax benefit from disqualifying dispositions of common stock -- 918
---------- ----------
Net cash (used in) provided by financing activities (5,631) 3,410
---------- ----------
Effect of exchange rate fluctuations on cash and cash equivalents 352 (220)
Net increase (decrease) in cash and cash equivalents 2,246 (12,640)
Cash and cash equivalents at beginning of period 14,454 25,585
---------- ----------
Cash and cash equivalents at end of period $ 16,700 $ 12,945
---------- ----------
---------- ----------
Supplemental disclosure of cash flow information:
Cash paid during the period for income taxes $ 2,340 $ 1,353
Supplemental schedule of noncash investing and financing activities:
Unrealized gain (loss) on marketable securities $ 718 $ (97)
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements
6
<PAGE>
INTEGRATED SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Information for the three and nine months ended
November 30, 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.
The following table sets forth the calculations of earnings per share:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
NOVEMBER 30, NOVEMBER 30,
------------------- -----------------
(IN THOUSANDS, EXCEPT PER SHARE DATA) 1998 1997 1998 1997
------- ------- ------- ------
<S> <C> <C> <C> <C>
Basic:
Net income $ 3,172 $ 1,612 $ 9,570 $ 2,768
------- ------- ------- -------
------- ------- ------- -------
Number of shares:
Weighted average number of common shares outstanding 22,969 23,291 23,299 23,198
------- ------- ------- -------
------- ------- ------- -------
Earnings per share - basic $ 0.14 $ 0.07 $ 0.41 $ 0.12
------- ------- ------- -------
------- ------- ------- -------
Diluted:
Net income $ 3,172 $ 1,612 $ 9,570 $ 2,768
------- ------- ------- -------
------- ------- ------- -------
Number of shares:
Weighted average number of common shares outstanding 22,969 23,291 23,399 23,198
Dilutive effect of stock options, net 272 1,058 685 859
------- ------- ------- -------
Weighted average number of common and common equivalent shares outstanding 23,241 24,349 23,964 24,957
------- ------- ------- -------
------- ------- ------- -------
Earnings per share - diluted $ 0.14 $ 0.07 $ 0.40 $ 0.12
------- ------- ------- -------
------- ------- ------- -------
</TABLE>
Certain options to purchase common stock were not included in the above
calculations as their exercise prices were greater than the average market
price of common stock in each respective period and their inclusion would be
antidilutive. The number of such options excluded was approximately 2.2
million and 0.2 million in the three months ended November 30, 1998 and 1997,
respectively, and 0.9 million and 0.4 million in the nine months ended
November 30, 1998, and 1997, respectively.
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.
7
<PAGE>
Comprehensive income for the three and nine months ended November 30, 1998
and 1997 is as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
NOVEMBER 30, NOVEMBER 30,
----------------- ------------------
(in thousands) 1998 1997 1998 1997
------ ------ ------- ------
<S> <C> <C> <C> <C>
Net income $3,172 $1,612 $ 9,570 $2,768
Other comprehensive income, net of tax:
Foreign currency translation adjustments 364 28 346 (325)
Unrealized gain (loss) on marketable securities 135 (183) 431 (64)
------ ------ ------- ------
Other comprehensive income (loss) 499 (155) 777 (389)
------ ------ ------- ------
Total comprehensive income $3,671 $1,457 $10,347 $2,379
------ ------ ------- ------
------ ------ ------- ------
</TABLE>
The accumulated balances of other comprehensive income as of November 30,
1998 and 1997 are as follows:
<TABLE>
<CAPTION>
NOVEMBER 30, 1998 NOVEMBER 30, 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 346 431 777 (325) (64) (389)
----------- ---------- -------- ----------- ---------- --------
Ending balance $(1,092) $579 $ (513) $(1,455) $ 84 $(1,371)
----------- ---------- -------- ----------- ---------- --------
----------- ---------- -------- ----------- ---------- --------
</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 November 30, 1998, the Company had approximately $2.3 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 losses on foreign currency forward exchange contracts
at November 30, 1998 were approximately $210,000.
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 tax 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. The arbitration hearings were completed in
early January, 1999, and a decision is pending. 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.
8
<PAGE>
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. 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
("AICPA") 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
disclosures prescribed by SOP 98-1 will be effective for the Company's fiscal
year ending February 28, 2000.
Also in April 1998, the AICPA issued Statement of Position 98-5 ("SOP 98-5"),
"Reporting on the Costs of Start-Up Activities". SOP 98-5 provides guidance
on the financial reporting of start-up costs and organization costs and
requires such costs to be expensed as incurred. This statement will be
effective for the Company's fiscal year ending February 28, 2000. The Company
has not yet determined the impact, if any, of adopting SOP 98-5.
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
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.
<TABLE>
<CAPTION>
Percentage of Period-to-Period
Total Revenue Percentage Change
------------------ ---------------------
Three Months Ended Three Months Ended
November 30, November 30,
1998 1997 1998 compared to 1997
---- ---- ---------------------
<S> <C> <C> <C>
Revenue:
Product 59% 59% 17%
Services 41 41 17
---- ----
Total revenue 100 100 17
---- ----
Costs and expenses:
Cost of product revenue 14 11 57
Cost of services revenue 17 22 (13)
Marketing and sales 35 38 7
Research and development 13 15 (6)
General and administrative 12 9 57
---- ----
Total costs and expenses 91 95 11
---- ----
Income from operations 9 5 145
Interest and other income 4 3 24
---- ----
Income before income taxes 13 8 91
Provision for income taxes 4 3 80
---- ----
Net income 9% 5% 97%
==== ====
</TABLE>
10
<PAGE>
<TABLE>
<CAPTION>
Percentage of Period-to-Period
Total Revenue Percentage Change
----------------- ---------------------
Nine Months Ended Nine Months Ended
November 30, November 30,
1998 1997 1998 compared to 1997
---- ---- ---------------------
<S> <C> <C> <C>
Revenue:
Product 56% 54% 18%
Services 44 46 8
---- ----
Total revenue 100 100 14
---- ----
Costs and expenses:
Cost of product revenue 12 11 29
Cost of services revenue 17 25 (21)
Marketing and sales 36 36 12
Research and development 15 16 2
General and administrative 13 10 45
---- ----
Total costs and expenses 93 98 7
---- ----
Income from operations 7 2 424
Interest and other income 4 3 25
---- ----
Income before income taxes 11 5 151
Provision for income taxes 1 2 (32)
---- ----
Net income 10% 3% 246%
==== ====
</TABLE>
REVENUES
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 17% from $29.9 million in
the third quarter of fiscal year 1998 to $35.0 million in the third quarter
of fiscal year 1999, and increased 14% from $86.7 million in the first nine
months of fiscal year 1998 to $98.4 million in the first nine months of
fiscal year 1999. Product revenue increased 17% from $17.6 million in the
third quarter of fiscal year 1998 to $20.6 million in the third quarter of
fiscal year 1999, and by 18% from $46.9 million in the first nine months of
fiscal year 1998 to $55.5 million in the first nine months of fiscal year
1999. The increases is product revenue were primarily due to increases in the
number of licenses of the Company's pRISM+-Trade Mark- product, and from
increased licensing of the Company's Diab Data complies and SNIFF+-Trade
Mark- products.
Services revenue increased 17% from $12.3 million in the third quarter of
fiscal year 1998 to $14.4 million in the third quarter of fiscal year 1999,
and increased by 8% from $39.8 million in the first nine months of fiscal
year 1998 to $43.0 million in the first nine months of fiscal year 1999. The
increases are due primarily to continued growth of the installed customer
base, the renewal of maintenance and support contracts, and 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 44% in both the third quarters of fiscal years 1999 and
1998, and 43% and 59% in the first nine months of fiscal years 1999 and 1998,
respectively.
In Europe and Japan, revenues and expenses are primarily denominated in local
currencies. In the third quarter of fiscal year 1999 the U.S. dollar was
weaker against many foreign currencies as compared to the third quarter of
fiscal year 1998. This resulted in relatively higher revenues and expenses
when translated into U.S. dollars for the third quarter of fiscal year 1999,
compared to the comparative period of fiscal year 1998. However, the U.S.
dollar was stronger against many foreign currencies the first nine months of
fiscal year 1999 compared to the first nine months of fiscal year 1998,
resulting in relatively lower revenues and expenses in the first nine months
of fiscal year 1999 versus in the same period fiscal year 1998. The Company's
operating and pricing strategic 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.
11
<PAGE>
COSTS AND EXPENSES
Cost of product revenue includes third-party royalties, cost of product
packaging and 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 24% and 18% in the
third quarters of fiscal years 1999 and 1998, respectively, and 22% and 20%
in the first nine months of fiscal years 1999 and 1998, respectively. These
percentage increases are due primarily to the inclusion of low margin product
revenue from product sales of the Integrated Systems Design Center.
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, and 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 was 40% and 54% in the
third quarters of fiscal years 1999 and 1998, respectively, and 40% and 55%
in the first nine months of fiscal years 1999 and 1998, respectively. These
percentage decreases were due mainly to an increase to higher margin
maintenance revenue, combined with a decrease in lower margin fixed price
contracts.
Marketing and sales expenses were $12.1 million and $11.3 million in the third
quarters of fiscal years 1999 and 1998, respectively, representing 35% and
38% of total revenue, respectively, and $35.5 million and $31.6 million in
the first nine months of fiscal years 1999 and 1998, respectively,
representing 36% of total revenue in both periods. 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 $4.4 million and $4.7 million in the third quarters
of fiscal years 1999 and 1998, respectively, representing 13% and 15%,
respectively, of total revenue, and $14.5 million and $14.2 million in the
first nine months of fiscal years 1999 and 1998, respectively, representing
15% and 16% of total revenue, respectively. This dollar decrease in the third
quarter of fiscal year 1999 was primarily due to an increase in capitalized
software development costs associated with certain product development.
General and administrative expenses were $4.4 million and $2.8 million in the
third quarters of fiscal years 1999 and 1998, respectively, representing 12%
and 9% of total revenue, respectively, and $12.1 million and $8.3 million in
the first nine months of fiscal years 1999 and 1998, respectively,
representing 13% and 10% of total revenue, respectively. The dollar increase
in the third quarter of fiscal year 1999 was primarily the result of legal
costs incurred in association with an arbitration. The dollar increase in the
first nine months of fiscal year 1999 was primarily due to CEO termination and
recruitment costs, higher legal costs and other outside service costs.
Interest and other income was $1.4 million in the third quarter of fiscal
1999 compared to $1.1 million in the third quarter of fiscal year 1998.
Interest and other income was $3.6 million in the first nine months of fiscal
year 1999 compared to $2.9 million in the first nine months of fiscal year
1998. These increases are primarily due to higher interest income from
increased holdings of cash and marketable securities in fiscal year 1999.
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 resinfed 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,
("AICPA") 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
disclosures prescribed by SOP 98-1 will be effective for the Company's fiscal
year ending February 28, 2000.
Also in April 1998, the AICPA issued Statement of Position 98-5 ("SOP 98-5"),
"Reporting on the Costs of Start-Up Activities." SOP 98-5 provides guidance
on the financial reporting of start-up costs and organization costs and
requires such costs to be expensed as incurred. This statement will be
effective for the Company's fiscal year ending February 28, 2000. The Company
has not yet determined the impact, if any, of adopting SOP 98-5.
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.
12
<PAGE>
"YEAR 2000" ISSUES
The Company believes that all of its most current product releases will not
cease to perform nor generate incorrect on 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 operations for Year 2000 Compliance and has
identified three categories of risks; internal business software, internal
non-financial software and embedded chip technology, and external
noncompliance by customers and suppliers. With respect to internal business
software, the Company expects to be in full compliance before the year 2000.
Accordingly, the Company has not developed formal contingency plans. The
Company feels there is minimal risk that the systems will not be compliant
before Year 2000. All costs associated with carrying out the Company's plan
for the Year 2000 Compliance are being expensed as incurred.
With respect to internal non-financial software and embedded chip technology,
the Company is currently gathering data to assess the impact of the Year 2000
on its non-financial systems such as security equipment, telephones, etc.,
with Year 2000 Compliance scheduled for mid-1999. The Company does not, at
this time, have sufficient data to estimate the cost of achieving Year 2000
Compliance for its non-financial systems. If the Company is unable to achieve
Year 2000 Compliance for its major non-financial systems, the Year 2000 could
have a material impact on the operations of the Company. Since the Company is
in the information-gathering phase, the Company does not currently have a
contingency plan in place for its internal non-financial software and
embedded chip technology.
With respect to external noncompliance by customers and suppliers, the
Company is in the process of identifying and contacting its critical
suppliers, service providers and contractors to determine the extent to which
the Company's interface systems are vulnerable to those third parties'
failure to remedy their own Year 2000 issuers. It is expected that full
identification will be completed by mid-1999. To the extent that responses to
Year 2000 readiness are unsatisfactory, the Company intends to change
suppliers, service providers or contractors to those who have demonstrated
Year 2000 readiness but cannot be assured that it will be successful in
finding such alternative suppliers, service providers and contractors. The
Company does not currently have formal information concerning the Year 2000
Compliance status of all its customers and suppliers. In the event that any
of the Company's significant customers and suppliers do not successfully and
timely achieve Year 2000 Compliance, and the Company is unable to replace
them with new customers or alternate suppliers, the Company's business or
operations could be adversely affected.
The total costs associated with preparation for the Year 2000 are currently
being assessed but have not been, and are not expected to be material to the
Company's business, financial condition or results of operations.
LIQUIDITY AND CAPITAL RESOURCES
The Company funds its operations principally through cash flows from
operations. As of November 30, 1998, the Company had $75.9 million of cash,
cash equivalents and marketable securities. This represents an increase of
$8.5 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 an additional 1,000,000 shares of common stock to be repurchased
under this program. As of November 30, 1998 the Company had repurchased
1,206,000 shares of common stock for $10.4 million under this program.
Net cash provided by operating activities during the first nine months of
fiscal year 1999 totaled $17.5 million, as compared to $10.5 million in the
first nine months of fiscal year 1998. Net cash provided by operating
activities increased, due primarily to an increase in net income.
Net cash used in investing activities totaled $10.0 million in the first nine
months of fiscal year 1999 compared to $26.3 million in fiscal year 1998. Net
cash used in investing activities was higher in the first nine months of
fiscal year 1998 due primarily to higher purchases of marketable securities.
Net cash used in financing activities totaled $5.6 million in the first nine
months of fiscal years 1999 compared to net cash provided of $3.4 million in
the first nine months of fiscal year 1998. This change was primarily the
result of the Company's repurchases of common stock under the stock
repurchase program discussed above.
13
<PAGE>
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.
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 no 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 and ease-of-use 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.
14
<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 application. 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. 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 Sum 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 unforseen 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.
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 third quarter and first nine months of fiscal year 1999 the
Company generated 44% 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.
15
<PAGE>
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 no
increase in the relative value of the dollar against such currencies, 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 nine months of fiscal year 1999 was adversely
affected by the weakness of the yen against the dollar. 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
years, 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 are Year 2000 compliant. 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.
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.
16
<PAGE>
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 counties. 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.
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.
17
<PAGE>
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 November 30, 1998, the Company had approximately $2.3 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 losses on foreign currency forward exchange contracts at November
30, 1998 were approximately $210,000.
18
<PAGE>
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Information with respect to this item is incorporated by reference to Note 6
of Notes in Condensed Consolidated Financial Statements included on Page 8 of
this Form 10-Q.
ITEM 5. OTHER INFORMATION
Effective December 14, 1998, Charles M. Boesenberg joined the Company as
President and Chief Executive Officer.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(A) EXHIBITS.
The following exhibit is filed as part of the Report:
Exhibit
Number Title
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 November 30, 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: January 14, 1999 INTEGRATED SYSTEMS, INC.
(Registrant)
/S/ CHARLES M. BOESENBERG
-------------------------------------
CHARLES M. BOESENBERG
President and Chief Executive Officer
/S/ WILLIAM C. SMITH
-------------------------------------
WILLIAM C. SMITH
Vice President, Finance and
Chief Financial Officer
20
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM Q3 FY99 FORM
10-Q FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
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<PERIOD-START> MAR-01-1998
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<CGS> 12,167
<TOTAL-COSTS> 29,368
<OTHER-EXPENSES> 62,112
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 10,544
<INCOME-TAX> 974
<INCOME-CONTINUING> 9,570
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 9,570
<EPS-PRIMARY> 0.41
<EPS-DILUTED> 0.40
</TABLE>
