UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 For the quarterly period ended September 30, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 For the transition period from to .
--- ---
Commission File Number: 0-26130
LEGATO SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-3077394
(State of incorporation) (I.R.S. Employer
Identification No.)
3210 PORTER DRIVE
PALO ALTO, CALIFORNIA 94304
(Address of principal executive offices)
(650) 812-6000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
The number of shares outstanding of the registrant's common stock as of
September 30, 1999 was 84,981,147.
<PAGE>
LEGATO SYSTEMS, INC.
INDEX
Page
----
PART I: CONDENSED FINANCIAL INFORMATION
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as of September 30,
1999 and December 31, 1998 3
Condensed Consolidated Statements of Income for the three
and nine month periods ended September 30, 1999 and 1998 4
Condensed Consolidated Statements of Cash Flows for the nine
month periods ended September 30, 1999 and 1998 5
Notes to the Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12
Item 3. Qualitative and Quantitative Disclosures About Market
Risks 30
PART II: OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 31
Signature 32
<PAGE>
PART I: CONDENSED FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
LEGATO SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
September 30, December 31,
1999 1998
-------- --------
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 97,319 $ 83,177
Short-term investments 37,127 33,772
Accounts receivable, net 62,087 39,982
Other current assets 17,752 6,059
Deferred tax asset 10,740 11,836
-------- --------
Total current assets 225,025 174,826
Long-term investments 10,278 9,023
Property and equipment, net 23,895 21,119
Intangible assets, net 151,620 2,243
Other assets 2,253 536
-------- --------
Total assets $413,071 $207,747
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 2,935 $ 4,577
Accrued liabilities 16,627 22,239
Deferred revenue 33,859 21,879
-------- --------
Total current liabilities 53,421 48,695
Deferred tax liability 25,518 523
Stockholders' equity:
Capital stock and other comprehensive income 274,696 115,165
Retained earnings 59,436 43,364
-------- --------
Total stockholders' equity 334,132 158,529
-------- --------
Total liabilities and stockholders' equity $413,071 $207,747
======== ========
The accompanying notes are an integral part of the Condensed Consolidated
Financial Statements.
<PAGE>
<TABLE>
<CAPTION>
LEGATO SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
----------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
Revenue:
Product license $ 47,618 $ 29,055 $ 121,991 $ 76,949
Service and support 17,656 10,312 47,741 26,451
Royalty 6,414 5,126 16,315 14,735
----------- ----------- ---------- -----------
Total revenue 71,688 44,493 186,047 118,135
Cost of revenue:
Product license 1,381 2,490 4,363 7,165
Service and support 6,643 4,077 17,980 10,869
----------- ----------- ---------- -----------
Total cost of revenue 8,024 6,567 22,343 18,034
----------- ----------- ---------- -----------
Gross profit 63,664 37,926 163,704 100,101
Operating expenses:
Research and development 10,354 6,837 27,414 18,430
Sales and marketing 23,763 17,883 66,317 51,373
General and administrative 5,052 3,717 14,637 11,220
Amortization of intangibles 7,722 279 12,162 838
Purchased in process research
and development 8,300 -- 11,470 --
Merger related expenses -- 645 4,968 645
----------- ----------- ---------- -----------
Total operating expenses 55,191 29,361 136,968 82,506
----------- ----------- ---------- -----------
Income from operations 8,473 8,565 26,736 17,595
Interest and other income, net 1,257 1,262 3,877 3,469
--------- ----------- ---------- --------
Income before provision for income taxes 9,730 9,827 30,613 21,064
Provision for income taxes 6,292 3,725 14,541 8,278
----------- ----------- ---------- -----------
Net income $ 3,438 $ 6,102 $ 16,072 $ 12,786
=========== =========== ============ ===========
Other comprehensive income (losses), net of tax
Unrealized gains (losses) on securities (14) 136 (74) 153
----------- ----------- ---------- -----------
Comprehensive income $ 3,424 $ 6,238 $ 15,998 $ 12,939
=========== =========== ========== ===========
Basic earnings per share $ 0.04 $ 0.08 $ 0.19 $ 0.17
=========== =========== ========== ===========
Diluted earnings per share $ 0.04 $ 0.07 $ 0.18 $ 0.16
=========== =========== ========== ===========
Shares used in basic earnings
per share calculation 83,766 77,275 81,353 76,319
=========== =========== ========== ===========
Shares used in diluted earnings
per share calculation 90,694 83,723 87,802 82,465
=========== =========== ========== ===========
</TABLE>
The accompanying notes are an integral part of the Condensed Consolidated
Financial Statements.
<PAGE>
<TABLE>
<CAPTION>
LEGATO SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
Nine Months Ended
September 30,
--------------------------
1999 1998
----------- -----------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 16,072 $ 12,786
Adjustments to reconcile net income to net cash provided
by operating activities:
Net deferred tax asset 4,399 (3,660)
Depreciation and amortization 20,421 5,941
Tax benefit from exercise of stock options 19,296 8,252
Purchased in-process research and development 11,470 --
Changes in operating assets and liabilities:
(in 1999, net of effects of acquisitions)
Accounts receivable (8,876) (5,971)
Other current assets (11,133) (577)
Accounts payable (2,320) 3,720
Accrued liabilities (24,369) 3,510
Deferred revenue 6,689 4,936
----------- -----------
Net cash provided by operating activities 31,649 28,937
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of available-for-sale securities (77,283) (46,393)
Proceeds from maturities and sales of available-
for-sale securities 72,598 51,695
Acquisition of property and equipment (8,539) (11,230)
Acquisition of businesses, net of cash acquired (22,908) --
Change in other assets (1,671) (100)
------------ ------------
Net cash used in investing activities (37,803) (6,028)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock 20,292 7,689
Other 4 (423)
----------- -----------
Net cash provided by financing activities 20,296 7,266
----------- -----------
Net increase in cash and cash equivalents 14,142 30,175
Cash and cash equivalents at beginning of period 83,177 38,155
----------- -----------
Cash and cash equivalents at end of period $ 97,319 $ 68,330
=========== ==========
Supplemental cash flow information:
Issuance of common stock and stock options
exchanged in purchase business combinations $ 119,733 --
Net deferred taxes recorded in a purchase business combination 22,740 --
</TABLE>
The accompanying notes are an integral part of the Condensed Consolidated
Financial Statements.
<PAGE>
LEGATO SYSTEMS, INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
NOTE 1. BASIS OF PRESENTATION
In the opinion of management, the accompanying unaudited condensed
consolidated financial statements contain all adjustments (all of which are
normal and recurring in nature) necessary to present fairly the financial
position, results of operations and cash flows of Legato Systems, Inc. and its
subsidiaries. The results of operations for the interim periods presented are
not necessarily indicative of the results that may be expected for any future
interim periods or for the full fiscal year. The Notes to the Consolidated
Financial Statements contained in the 1998 Report on Form 10-K, as amended,
should be read in conjunction with these Condensed Consolidated Financial
Statements.
NOTE 2. COMPUTATION OF EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income available to
common stockholders by the weighted average number of common shares outstanding
for the period. Diluted earnings per share is computed giving effect to all
dilutive potential common shares that were outstanding during the period.
Dilutive potential common equivalent shares consist of the incremental common
shares issuable upon exercise of stock options.
A reconciliation of the numerator and denominator of basic and diluted
earnings per share is provided as follows (in thousands, except per share
amounts):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
1999 1998 1999 1998
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Numerator - basic and diluted earnings per share
- ------------------------------------------------
Net income $ 3,438 $ 6,102 $ 16,072 $ 12,786
========= ========= ========= ========
Denominator - basic earning per share
- -------------------------------------
Weighted average common shares outstanding 83,766 77,275 81,353 76,319
--------- --------- --------- --------
Basic earnings per share $ 0.04 $ 0.08 $ 0.19 $ 0.17
========= ========= ========= ========
Denominator - diluted earnings per share
- ----------------------------------------
Weighted average common shares outstanding 83,766 77,275 81,353 76,319
Effect of dilutive securities:
Common stock options 6,928 6,448 6,449 6,146
--------- --------- --------- --------
Weighted average common and common
equivalent shares 90,694 83,723 87,802 82,465
========= ========= ========= ========
Diluted earnings per share $ 0.04 $ 0.07 $ 0.18 $ 0.16
========= ========= ========= ========
Options excluded from diluted net income
per share calculation 46 83 328 182
========= ========= ========= ========
</TABLE>
Certain shares of common stock issuable upon exercise of stock options were
excluded from the calculation of diluted net income per share because the
options' exercise price was greater than the average market price of the common
shares.
<PAGE>
NOTE 3. BUSINESS COMBINATIONS
Purchase Combinations
On April 1, 1999, we completed the acquisition of Intelliguard
Software, Inc. and O.R.P., Inc., developers of standards-based storage
management solutions for storage area networks. In this document, we refer to
Intelliguard Software, Inc. and O.R.P., Inc. collectively as "Intelliguard." We
issued 1,440,000 shares of our common stock with a fair market value of $42.4
million, provided cash consideration of $9.1 million for all of the outstanding
stock of Intelliguard and incurred transaction costs consisting primarily of
professional fees of $3.9 million, resulting in a total purchase price of $55.4
million. The results of operations of Intelliguard have been included with our
results of operations since April 1, 1999, the date of acquisition.
On July 30, 1999, we completed the acquisition of Vinca Corporation
("Vinca"), a developer in high availability and data protection software. We
issued 1,530,732 shares of our common stock with a fair market value of $54.3
million, exchanged options to purchase 589,580 shares of Legato's common stock
with a fair market value of $17.6 million and provided cash consideration of
$18.8 million for all of the outstanding stock and options of Vinca. The fair
market value of the exchanged options to purchase 589,580 shares of Legato's
common stock was calculated using the Black-scholes option-pricing model with
the following assumptions: 1) expected volatility of 0.8059, 2) weighted-average
risk-free interest rate of 5.68%, 3) expected term of approximately five years
and 4) no expected dividends. In connection with the acquisition, Legato
incurred transaction costs consisting primarily of professional fees of $1.0
million, resulting in a total purchase price of $91.7 million. The results of
operations of Vinca have been included with our results of operations since July
30, 1999, the date of acquisition.
The acquisitions were accounted for as a purchase business combinations
which means that the purchase price was allocated to the assets acquired and
liabilities assumed based on the estimated fair values at the date of
acquisition.
The fair value of the assets of Intelliguard which was determined
through established valuation techniques used in the software industry, and a
summary of the consideration exchanged for these assets is follows (in
thousands):
<TABLE>
<S> <C>
Total purchase price $55,355
=======
Assets acquired:
Tangible assets, primarily cash, accounts receivable and property and equipment 1,919
Purchased software products 11,930
Purchased in-process research and development 3,170
Assembled workforce 860
Non-compete agreements 690
Goodwill 45,215
Liabilities assumed (8,429)
-------
$55,355
=======
</TABLE>
The Intelliguard projects included in in-process research and development
and the percent complete, the estimated cost to complete and the value assigned
to each project are as follows (in thousands):
Estimate Percent Estimated Cost Value
Project Completion To Complete Assigned
------- ---------- ----------- --------
A 9% $ 340 $ 780
B 50% $ 680 1,660
C 17% $ 170 730
---------
Total purchased in-process research and development $ 3,170
=========
<PAGE>
The fair value of the assets of Vinca which was determined through
established valuation techniques used in the software industry, and a summary of
the consideration exchanged for these assets is follows (in thousands):
<TABLE>
<S> <C>
Total purchase price $91,705
Deferred taxes 22,740
-------
$114,445
========
Assets acquired:
Tangible assets, primarily cash, accounts receivable and property and equipment 10,858
Patents and core technology 23,600
Distribution channel 22,500
Completed products 5,200
Purchased in-process research and development 8,300
Assembled workforce 4,500
Trademarks 7,300
Goodwill 39,621
Liabilities assumed (7,434)
--------
$114,445
========
</TABLE>
The Vinca projects included in in-process research and development and the
percent complete, the estimated cost to complete and the value assigned to each
project are as follows (in thousands):
Estimate Percent Estimated Cost Value
Project Completion To Complete Assigned
A 60% $ 800 $ 700
B 60% 180 600
C 90% 175 2,200
D 90% 150 2,200
E 90% 300 1,000
F 30% 1,035 300
G 80% 2,065 800
H 40% 5,471 200
I 20% 2,450 300
---------
Total purchased in-process research and development $ 8,300
=========
The amounts allocated to the purchased in-process technology were
determined based on an appraisal completed by an independent third party using
established valuation techniques and was expensed upon acquisition, because
technological feasibility had not been established and no future alternative
uses existed. The value of these projects was determined by estimating the costs
to develop the purchased in-process technology into commercially viable
products, estimating the resulting net cash flows from the sale of the products
resulting from the completion of the projects reduced by the portion of the
revenue attributable to core technology, and discounting the net cash flows back
to their present value. Research and development costs to bring in-process
products from Intelliguard and Vinca to technological feasibility are not
expected to have a material impact on our future results of operations or cash
flows. Amounts allocated to intangible assets and goodwill resulting from the
above acquisitions are amortized over seventeen months to five years from the
date of acquisition. At September 30, 1999, accumulated amortization related to
these items totaled $11.3 million.
Summarized below are the unaudited pro forma results of operations of
Legato as though Intelliguard and Vinca had been acquired at the beginning of
1998. Adjustments have been made for estimated increases in amortization for
purchased software products, assembled work force and non-compete agreements and
related income tax effects.
<PAGE>
Nine Months Ended
September 30,
----------------------
1999 1998
--------- ---------
(in thousands)
Revenue $ 195,246 $ 140,295
========= =========
Net income (loss) $ 8,976 $ (1,813)
========= =========
Basic earnings (loss) per share $ 0.10 $ (0.02)
========= =========
Diluted earnings (loss) per share $ 0.10 $ (0.02)
========= =========
The above amounts are based upon certain assumptions and estimates which we
believe are reasonable and do not reflect any benefit from economies of scale
which might be achieved from combined operations. The pro forma financial
information presented above is not necessarily indicative of either the results
of operations that would have occurred had the acquisitions taken place at the
beginning of fiscal 1998 or of future results of operations of the combined
companies. The charges for in-process research and development and
merger-related expenses have not been included in the unaudited pro forma
results because it is nonrecurring and directly related to the acquisition.
Pooling of Interests Combination
On April 19, 1999, we completed the merger with Qualix Group, Inc. (dba
FullTime Software, Inc.), a developer of distributed, enterprise-wide,
cross-platform, adaptive computing solutions that enable customers to
proactively manage application service level availability into a wholly-owned
subsidiary of Legato. In this document, we refer to Qualix Group, Inc. as
"FullTime". We issued 3,442,000 shares of our common stock in exchange for all
the common stock and options of FullTime. We accounted for the transaction as a
pooling-of-interests. Accordingly, we restated the accompanying financial
statements to represent the combined results of the previously separate entities
for the periods presented.
The table below presents the separate results of operations of Legato
and FullTime for the periods prior to the combination:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
1999 1998 1999 1998
--------- --------- --------- --------
<S> <C> <C> <C> <C>
Revenue:
Legato Systems, Inc. $ 71,688 $ 37,492 $ 180,957 $ 61,146
FullTime Software, Inc. -- 7,001 5,090 12,496
--------- --------- ---------- --------
Total $ 71,688 $ 44,493 $ 186,047 $ 73,642
========= ========= ========== ========
Net income (loss):
Legato Systems, Inc. - as previously reported $ 3,438 $ 7,527 $ 18,702 $ 18,127
FullTime Software, Inc. - as previously reported -- (2,120) (4,012) (7,946)
--------- ---------- ---------- ---------
Total 3,438 5,407 14,690 10,181
Adjustment to reflect elimination of
Valuation allowance -- 695 1,382 2,605
--------- --------- --------- --------
Net income - as reported $ 3,438 $ 6,102 $ 16,072 $ 12,786
========= ========= ========= ========
</TABLE>
<PAGE>
In connection with the merger with FullTime, we incurred $5.0 million
in merger related expenses, consisting primarily of charges for transaction
fees, involuntary termination benefits, non-cancelable obligations and
write-offs of leasehold improvements for sales and administrative offices that
were duplicative and vacated. In connection with the merger with FullTime, we
incurred the following expenses (in thousands):
Professional fees $ 1,782
Printing and filing fees 318
Involuntary termination costs 757
Write-off of leasehold improvements for vacated facilities 1,419
Non-cancelable obligations 692
-------
Total $ 4,968
=======
NOTE 4. COMPREHENSIVE INCOME
Our unrealized loss on investments represents the only component of
comprehensive income that is excluded from net income for the quarter and
nine-month period ended September 30, 1999. Our comprehensive income has been
presented in the consolidated financial statements.
NOTE 5. SEGMENT INFORMATION
Management uses one measurement of profitability for its business. Our
software products and related services are developed and marketed to support
heterogeneous client/server computing environments and large scale enterprises.
We market our products and related services to customers in the United States,
Canada, Europe and Asia Pacific.
The table below presents revenue information by geographic area:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
1999 1998 1999 1998
--------- --------- --------- --------
(in thousands)
<S> <C> <C> <C> <C>
North America $ 55,413 $ 33,282 $ 137,441 $ 88,277
International 16,275 11,211 48,606 29,858
--------- --------- ---------- --------
Total $ 71,688 $ 44,493 $ 186,047 $118,135
========= ========= ========== ========
</TABLE>
The table below presents long-lived-asset information by geographic area:
September 30,
1999 1998
--------- ---------
(in thousands)
North America $ 170,463 $ 16,233
International 5,052 5,113
--------- ---------
Total $ 175,515 $ 21,346
========= =========
<PAGE>
NOTE 6. STOCK SPLIT
On August 13, 1999, we effected a two-for-one stock split (in the form of a
stock dividend). This stock split has been retroactively reflected in the
accompanying Condensed Consolidated Financial Statements.
NOTE 7. RECENT PRONOUNCEMENTS
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, or SFAS 133, Accounting for Derivative Instruments and Hedging
Activities. SFAS 133 establishes new standards of accounting and reporting for
derivative instruments and hedging activities. SFAS 133 requires that all
derivatives be recognized at fair value in the statement of financial position,
and that the corresponding gains or losses be reported either in the statement
of operations or as a component of comprehensive income, depending on the type
of hedging relationship that exists. We do not currently hold derivative
instruments or engage in hedging activities.
In December 1998, AcSEC released Statement of Position 98-9, or SOP 98-9,
Modification of SOP 97-2, "Software Revenue Recognition," with Respect to
Certain Transactions. SOP 98-9 amends SOP 97-2 to require that an entity
recognize revenue for multiple element arrangements by means of the "residual
method" when (1) there is vendor-specific objective evidence ("VSOE") of the
fair values of all the undelivered elements that are not accounted for by means
of long-term contract accounting, (2) VSOE of fair value does not exist for one
or more of the delivered elements, and (3) all revenue recognition criteria of
SOP 97-2 (other than the requirement for VSOE of the fair value of each
delivered element) are satisfied.
The provisions of SOP 98-9 that extend the deferral of certain paragraphs
of SOP 97-2 became effective December 15, 1998. These paragraphs of SOP 97-2 and
SOP 98-9 were effective for transactions that were entered into in fiscal years
beginning after March 15, 1999. Retroactive application is prohibited. We do not
expect the provisions of SOP 98-9 to have a significant impact on our current
revenue recognition policies.
In July 1999, the FASB issued Statement of Financial Accounting Standards
No. 137, or SFAS No. 137, Accounting for Derivative Instruments and Hedging
Activities - Deferral of the Effective Date of FASB No. 133. SFAS 137 deferred
the effective date of SFAS 133 until the first fiscal quarter beginning after
June 15, 2000.
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The discussion in this report on Form 10-Q contains forward-looking
statements that involve risks and uncertainties. The statements contained in
this Report that are not purely historical are forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, including
statements regarding our expectations, beliefs, intentions or strategies
regarding the future. All forward-looking statements included in this document
are based on information available to us on the date hereof, and we assume no
obligation to update any such forward-looking statements. Our actual results
could differ materially from those described in our forward-looking statements.
Factors that could cause or contribute to such differences include, but are not
limited to, those discussed under the heading "Risk Factors" and the risks
discussed in our other Securities and Exchange Commission filings.
RESULTS OF OPERATIONS
Overview
We develop, market and support enterprise storage management software
products for heterogeneous client/server computing environments and large scale
enterprises. Our Networker family of software products, as well as the HA+
products from our merger with FullTime, BudTool and Celestra products from our
purchase of Intelliguard and the Standby Server and Co-Standby Server products
from our purchase of Vinca support many storage management server platforms and
can accommodate a variety of servers, clients, applications, databases and
storage devices. We license our products through resellers and directly to end
users primarily located in North America, Europe and Asia Pacific. We also
license our source code to original equipment manufacturers ("OEMs") in exchange
for initial licensing fees and receive ongoing royalties from the OEMs' product
sales. Substantially all of the OEMs are large computer system and software
suppliers located in the United States, Europe and Asia Pacific.
We acquired FullTime, Intelliguard and Vinca in 1999 primarily for their
respective product offerings and research and development teams. We accounted
for the merger with FullTime as a pooling-of-interests. Accordingly, we restated
the financial statements to represent the combined financial results of the
previously separate entities for all periods presented. We accounted for the
acquisitions of Intelliguard and Vinca as purchase business combinations.
Accordingly, Intelliguard's and Vinca's results of operations are included in
our combined results for period beginning after the dates of consummation of the
acquisition on April 1, 1999 and July 30, 1999, respectively.
<PAGE>
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Revenue:
Product license 66% 65% 65% 65%
Service and support 25 23 26 22
Royalty 9 12 9 13
-------- --------- -------- ---------
Total revenue 100 100 100 100
Cost of revenue:
Product license 2 6 2 6
Service and support 9 9 10 9
-------- --------- -------- ---------
Total cost of revenue 11 15 12 15
-------- --------- -------- ---------
Gross profit 89 85 88 85
Operating expenses:
Research and development 14 16 15 16
Sales and marketing 33 40 35 44
General and administrative 7 8 8 9
Amortization of intangibles 11 1 6 1
Purchased in-process research
and development 12 -- 6 --
Merger related expenses -- 1 3 --
-------- --------- -------- ---------
Total operating expenses 77 66 73 70
-------- --------- -------- ---------
Income from operations 12 19 15 15
Interest and other income, net 2 3 2 3
-------- ------- -------- ---------
Income before provision for income taxes 14 22 17 18
Provision for income taxes 9 8 8 7
-------- --------- -------- ---------
Net income 5% 14% 9% 11%
======== ========= ======== =========
</TABLE>
Revenue
Total revenue for the third quarter ended September 30, 1999 increased 61%
percent over total revenue for the comparable period of 1998. Total revenue for
the nine months ended September 30, 1999 increased 57% percent over total
revenue for the comparable period of 1998. The increases were attributable to
the continued acceptance of our Networker family of products, as well as the HA+
products from our merger with FullTime, the BudTool and Celestra products from
our purchase of Intelliguard and Standby Server and the Co-Standby Server
products from our purchase of Vinca, increased product license sales to
large-scale enterprises and increased sales of service and support contracts.
Product License Revenue. Product license revenue was $47.6 million in the
third quarter of 1999 and $29.0 million in the third quarter of 1998,
representing an increase of 64 percent. Product license revenue was $122.0
million in the first nine months of 1999 and $76.9 million in the first nine
months of 1998, representing an increase of 59 percent. The increases were
primarily attributable to the continued acceptance of our family of products,
expansion of our product lines resulting from research and development efforts
and integration of products from acquired companies and increased product sales
to large-scale enterprises. We recognize product license revenue upon shipment
if a signed contract exists, the fee is fixed and determinable, collection of
resulting receivables is probable and product returns are reasonably estimable,
except for sales to domestic distributors, which are recognized upon sale by the
distributors to end-users. We recognize revenue from domestic distributors upon
sale by the distributor to end-users since these distributors have unlimited
rights of return and we historically have not been able to make reasonable
estimates of product returns from these distributors. Prior growth rates of our
product license revenue are not indicative of future product license revenue
growth rates and may not be sustainable in the future.
<PAGE>
Service and Support Revenue. Service and support revenue was $17.7 million
in the third quarter of 1999 and $10.3 million in the third quarter of 1998,
representing an increase of 71 percent. Service and support revenue was $47.7
million in the first nine months of 1999 and $26.5 million in the first nine
months of 1998, representing an increase of 80 percent. The increases were
primarily attributable to the growth in the number of registered customers
electing to subscribe to support contracts and to renew software support
contracts after their initial one-year term. Our increase in internal staffing
for software support and education and consulting services helped to increase
new sales and renewals of our software support contracts, as well as sales of
education and consulting services we offer. We collect fees for ongoing customer
support and product updates in advance and recognize this support revenue
ratably over the period of the contract. For education and consulting services,
we recognize revenue when such services are performed. Prior growth rates of our
software service and support revenue are not indicative of future software
service and support revenue growth rates and may not be sustainable in the
future.
Royalty Revenue. Royalty revenue was $6.4 million in the third quarter of
1999 and $5.1 million in the third quarter of 1998, representing an increase of
25 percent. Royalty revenue was $16.3 million in the first nine months of 1999
and $14.7 million in the first nine months of 1998, representing an increase of
11 percent. The increase in royalty revenue was primarily attributable to
increased product sales by our OEMs. Royalty revenue is recognized upon receipt
of quarterly royalty reports from OEMs related to their product sales for the
previous quarter. Prior growth rates of our royalty revenue are not indicative
of future royalty revenue growth rates and may not be sustainable in the future.
International product license revenue was $16.3 million in the third
quarter of 1999 and $11.2 million in the third quarter of 1998. International
product license revenue increased 45 percent from the third quarter of 1998 to
the third quarter of 1999. International product license revenue accounted for
34 percent of total product license revenue in the third quarter of 1999 and 39
percent in the third quarter of 1998. International product license revenue was
$48.6 million in the first nine months of 1999 and $29.9 million in the first
nine months of 1998. International product license revenue increased 63 percent
from the first nine months of 1998 to the first nine months of 1999.
International product license revenue accounted for 40 percent of total product
license revenue in the first nine months of 1999 and 39 percent in the first
nine months of 1998. International license revenue increased in absolute dollars
primarily as a result of the continued market acceptance of our products
overseas. An increase in the number of international sales offices, personnel
and international distributors and resellers marketing our products helped
increase the market acceptance of our products overseas. Sales in Europe
accounted for the majority of our international revenue during these periods. We
intend to continue to expand our international operations, which requires
significant management attention and financial resources. Such diversion of
resources could materially adversely affect our operating results. To the extent
that we are unable to effect these additions in a timely manner, our growth, if
any, in international revenue will be limited, and our business, operating
results and financial condition could be seriously harmed. In addition, we
cannot guarantee that we will be able to maintain or increase international
market demand for our products.
Gross Profit
Gross profit was $63.7 million in the third quarter of 1999 and $37.9
million in the third quarter of 1998, representing 89 percent of total revenue
in the third quarter of 1999 and 85 percent of total revenue in the third
quarter of 1998. Gross profit was $163.7 million in the first nine months of
1999 and $100.1 million in first nine months of 1998, representing 88 percent in
the first nine months of 1999 and 85 percent in the first nine months of 1998.
Gross profit consists of product license and service and support revenue less
related costs.
Gross profit from product license revenue was $46.2 million in the third
quarter of 1999 and $26.6 million in the third quarter of 1998, representing 97
percent of product license revenue in the third quarter of 1999 and 91 percent
in the third quarter of 1998. Gross profit from product license revenue
increased 74 percent from the third quarter of 1998 to the third quarter of
1999. Gross profit from product license revenue was $117.6 million in the first
nine months of 1999 and $69.8 million in the first nine months of 1998,
representing 96 percent of product license revenue in the first nine months of
1999 and 91 percent in the first nine months of 1998. Gross profit from product
license revenue increased 69 percent from the first nine months of 1998 to the
first nine months of 1999. The increases in gross profit from product license
revenue as a percentage of product license revenue were primarily attributable
to our merger with FullTime in April 1999. Prior to the merger, FullTime's gross
<PAGE>
profit from product license revenue as a percentage of product license revenue
was lower than ours. Once the combination was completed, FullTime's
manufacturing facility was closed. Therefore, the costs of product license
revenue declined. Gross profit from product license revenue consists of product
license revenue less the related costs. Related costs of revenue consist
primarily of product media, documentation and packaging. The rate of increase in
gross profit from product license revenue was greater than the rate of increase
in the related costs of product license revenue.
Gross profit from service and support revenue was $11.0 million in the
third quarter of 1999 and $6.2 million in 1998, representing 62 percent of the
service and support revenue in the third quarter of 1999 and 61 percent in the
third quarter of 1998. Gross profit from service and support revenue increased
77 percent from the third quarter of 1998 to the same period of 1999. Gross
profit from service and support revenue was $29.8 million in the first nine
months of 1999 and $15.6 million in the first nine months of 1998, representing
62 percent of the service and support revenue in the first nine months of 1999
and 59 percent in 1998. Gross profit from service and support revenue increased
91 percent from the first nine months of 1998 to the same period of 1999. Gross
profit from service and support revenue as a percentage of service and support
revenue increased primarily as a result of leveraging the costs of service and
support revenue over a larger revenue base. The rate of increase in service and
support revenue was greater than the rate of increase in the related costs of
service and support revenue. The increase in our costs of service and support
revenue in absolute dollars is attributable to our continued investment in
developing new services and support offerings. The continued investment consists
of costs associated with supporting a larger installed base of products, as well
as costs to provide higher support levels to customers. Costs of service and
support revenue consist primarily of personnel-related costs incurred in
providing telephone support, consulting services, and training to customers as
well as costs of providing software updates and costs of education and
consulting materials.
Operating Expenses
Research and Development. Research and development expenses consist
primarily of personnel-related costs. Research and development expenses were
$10.4 million in the third quarter of 1999 and $6.8 million in the third quarter
of 1998, representing 14 percent of total revenue in the third quarter of 1999
and 16 percent of total revenue in the third quarter of 1998. Research and
development expenses increased 51 percent from the third quarter of 1998 to the
third quarter of 1999. Research and development expenses were $27.4 million in
the first nine months of 1999 and $18.4 million in the first nine months of
1998, representing 15 percent of total revenue in the first nine months of 1999
and 16 percent in first nine months of 1998. Research and development expenses
increased 49 percent from the first nine months of 1998 to the first nine months
of 1999. The increases in research and development expenses in absolute dollars
primarily reflect increased staffing and associated support for engineers
necessary to continue to expand and enhance our product line. Research and
development expenses as a percentage of total revenue decreased primarily as a
result of research and development expenses increasing at a slower rate than the
rate of increase in total revenue. We believe that research and development
expenses will continue to increase in absolute dollars as we continue to invest
in developing new products, applications, and product enhancements.
Sales and Marketing. Sales and marketing expenses consist primarily of
salaries and commissions for sales and marketing personnel and promotional
expenses. Sales and marketing expenses were $23.8 million in the third quarter
of 1999 and $17.9 million in the third quarter of 1998, representing 33 percent
of total revenue in the third quarter of 1999 and 40 percent in the third
quarter of 1998. Sales and marketing expenses increased 20 percent from the
third quarter of 1998 to the third quarter of 1999. Sales and marketing expenses
were $66.3 million in the first nine months of 1999 and $51.4 million in the
first nine months of 1998, representing 35 percent of total revenue in the nine
months of 1999 and 44 percent in the first nine months of 1998. Sales and
marketing expenses increased 27 percent from the first nine months of 1998 to
the first nine months of 1999. The increases in sales and marketing expenses in
absolute dollars was primarily attributable to the continued growth of our sales
force and associated support personnel. Sales and marketing expenses also
increased as a result of additional marketing and promotional activities to
increase awareness of our products. The decreases in sales and marketing
expenses as a percentage of total revenue were primarily attributable to our
merger with FullTime in April 1999, accounted for as a pooling-of-interests.
Prior to the merger, FullTime's sales and marketing expenses as a percentage of
total revenue were higher than ours. We believe that sales and marketing
expenses will continue to increase in absolute dollars as we continue to expand
our sales and marketing staff.
<PAGE>
General and Administrative. General and administrative expenses include
personnel and other costs of our finance, human resources, facilities,
information systems and other administrative departments. General and
administrative expenses were $5.1 million in the third quarter of 1999 and $3.7
million in the third quarter of 1998, representing 7 percent of total revenue in
the third quarter of 1999 and 8 percent of total revenue in the third quarter of
1998. General and administrative expenses increased 36 percent from the third
quarter of 1998 to the third quarter of 1999. General and administrative
expenses were $14.6 million in the first nine months of 1999 and $11.2 million
in the first nine months of 1998, representing 8 percent of total revenue in the
first nine months of 1999 and 9 percent of total revenue in the first nine
months of 1998. General and administrative expenses increased 28 percent from
the first nine months of 1998 to the first nine months of 1999. The increase in
absolute dollars of general and administrative expenses from the third quarter
of 1998 to the third quarter of 1999 was primarily attributable to increased
staffing and related costs required to manage and support our expansion. The
decreases in general and administrative expenses as a percentage of total
revenue were attributable to leveraging general and administrative expenses over
a larger revenue base and our merger with FullTime in April 1999, accounted for
as a pooling-of-interests. Prior to the merger, FullTime's general and
administrative expenses as a percentage of total revenue were higher than ours.
We expect that general and administrative expenses will increase in dollar
amount as we continue to expand our operations.
Amortization of Intangibles. Amortization of intangibles was $7.7 million
in the third quarter of 1999 and $279,000 in the third quarter of 1998.
Amortization of intangibles was $12.2 million in the first nine months of 1999
and $838,000 in the first nine months of 1998. During the first nine months of
1999, we recorded additional intangibles related to the acquisitions of
Intelliguard totaling $58.7 million and Vinca totaling $102.7 million (See Note
3 in the Notes to the Condensed Consolidated Financial Statements). We amortize
these intangibles on a straight-line basis from seventeen months to five years
from the dates of acquisition which resulted in additional amortization of $11.3
million in the first nine months of 1999.
In-process Research and Development. During the first nine months of 1999,
we incurred in-process research and development costs of $11.5 million in
connection with our acquisitions of Intelliguard and Vinca. We did not incur
in-process research and development costs during periods presented for 1998.
The fair value of Intelliguard's and Vinca's core technologies, existing
products, as well as the technology currently under development were determined
by an independent appraisers using the income approach, which discounts expected
future cash flows to present value. The discount rates used in the present value
calculations were derived from a weighted average cost of capital analysis,
adjusted upward by a premium of 5% for the in-process projects from the
Intelliguard acquisition and 8.5% to 26% for the in-process projects from Vinca
acquisition to reflect additional risks inherent in the development life cycle.
We expect that the pricing models related to these acquisitions will be
considered standard within the high-technology industry. However, we do not
expect to achieve a material amount of expense reductions or synergies as a
result of integrating the acquired in-process technology. Therefore, the
valuation assumptions do not include anticipated cost savings.
The Intelliguard projects included in in-process research and development
and the percent complete, the estimated cost to complete and the value assigned
to each project follows (in thousands):
Estimate Percent Estimated Cost Value
Project Completion To Complete Assigned
A 9% $ 340 $ 780
B 50% $ 680 1,660
C 17% $ 170 730
---------
Total purchased in-process research and development $ 3,170
=========
<PAGE>
The Vinca projects included in in-process research and development and the
percent complete, the estimated cost to complete and the value assigned to each
project as follows (in thousands):
Estimate Percent Estimated Cost Value
Project Completion To Complete Assigned
A 60% $ 800 $ 700
B 60% 180 600
C 90% 175 2,200
D 90% 150 2,200
E 90% 300 1,000
F 30% 1,035 300
G 80% 2,065 800
H 40% 5,471 200
I 20% 2,450 300
---------
Total purchased in-process research and development $ 8,300
=========
We expect that products incorporating the acquired technology will be
completed and begin to generate cash flows within the next six months. However,
development of these technologies remains a significant risk to Legato due to
the remaining effort to achieve technical viability, rapidly changing customer
markets, uncertain standards for new products and significant competitive
threats from numerous companies. The nature of efforts to develop the acquired
technology into commercially viable products consists principally of planning,
designing, coding and testing activities necessary to determine that the product
can meet market expectations, including functionality and technical
requirements. Failure to achieve the expected levels of revenue and net income
from these products will negatively impact the return on investment expected at
the time of the acquisition and potentially result in impairment of any other
assets related to the development activities.
Recent actions and comments from the Securities and Exchange Commission
have indicated that the Commission is reviewing the current valuation
methodology of purchased in-process research and development relating to
acquisitions. The Commission is concerned that some companies are writing off
more of the value of an acquisition than is appropriate. We believe that we are
in compliance with all the rules and related guidance as they currently exist.
However, there can be no assurance that the Commission will not seek to reduce
the amount of purchased in-process research and development previously expensed
by Legato. This would result in the restatement of previously filed financial
statements of Legato and could have a material negative impact on the financial
results for the period subsequent to the acquisition.
Merger-Related Expenses. In connection with the merger with FullTime, we
incurred $5.0 million in merger related expenses, consisting primarily of
charges for transaction fees, involuntary termination benefits, non-cancelable
lease obligations and write-offs of leasehold improvements for sales and
administrative offices that were duplicative and vacated. Since the merger with
FullTime was accounted for as a pooling-of-interests, qualified merger related
expenses are included in the statement of operations. Our acquisitions of
Intelliguard and Vinca were accounted for as purchase business combinations.
Therefore, acquisition-related costs were included as part of the purchase
prices and allocated to goodwill and intangible assets.
Interest and Other Income, Net. Interest and other income, net, was $1.3
million in the third quarter of 1999 and 1998. Interest and other income, net,
was $3.8 million in the first nine months of 1999 and $3.5 million in the first
nine months of 1998. Interest and other income primarily represent interest
income from funds available for investment.
Provision for Income Taxes. The provision for income taxes for the third
quarter of 1999 was $6.3 million, compared to $3.7 million for the third quarter
of 1998. The provision for income taxes for the first nine months of 1999 was
$14.5 million, compared to $8.3 million for the first nine months of 1998. The
effective tax rate was 65 percent for the third quarter of 1999 and 38 percent
for the third quarter of 1998. The effective tax rate was 47 percent for the
first nine months of 1999 and 39 percent for the first nine months of 1998. The
increase in the effective rate from the third quarter of 1998 to the third
quarter of 1999 is primarily attributable to merger related expenses and
amortization of goodwill and intangible assets which are not deductible for tax
purposes.
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
Our cash, cash equivalents and investments totaled $144.7 million at
September 30, 1999, and represented 35 percent of total assets. Cash and cash
equivalents are highly liquid investments with original maturities of ninety
days or less. Investments consist mainly of short-term and long-term municipal
securities. At September 30, 1999, we had no long-term debt and stockholders'
equity was $334.1 million.
We have financed our operations to date primarily by cash from operations
and sales of common stock. Net cash provided by operating activities was $31.6
million in the first nine months of 1999. Net cash provided by operations in the
first nine months of 1999 consisted primarily of net income of $16.1 million
plus depreciation and amortization of $20.4 million, tax benefit from exercise
of stock options of $19.3 million and the write-off of $11.5 million of
purchased in-process research and development for the acquisitions of
Intelliguard and Vinca and the net change in deferred tax assets of $4.4 million
offset by the net change in operating assets and liabilities of $40.0 million.
Net cash used in investing activities was $37.8 million in the first nine
months of 1999. Net cash used in investing activities primarily reflected
purchases of marketable securities of $77.3 million, purchases of property and
equipment of $8.5 million and the purchases of Intelliguard and Vinca, net of
cash acquired, of $22.9 million. The cash used in investing activities was
offset primarily by proceeds from the maturity and sale of marketable securities
of $72.6 million. The increase in cash used for investing activities from 1998
is primarily attributable to acquisition activities during 1999 and purchases of
available for sale securities resulting from our higher cash and investment
balances.
Net cash provided by financing activities was $20.3 million in the first
nine months of 1999. Net cash provided by financing activities consisted
primarily of proceeds received from the issuance of our common stock. The
increase in cash provided by financing activities is primarily attributable to
the exercise of stock options by employees as the price of our common stock has
increased from 1998.
Non-cash transactions consisted primarily of the issuance of 1,440,000
shares of common stock in connection with the acquisition of Intelliguard and
1,530,732 shares of common stock in connection with the acquisition of Vinca
during 1999.
We believe our current cash balances and cash flow from operations, if any,
will be sufficient to meet our working capital and capital expenditure
requirements for at least the next twelve months.
YEAR 2000 COMPLIANCE
Many currently installed computer systems and software products include
coding to accept only two digit entries in the date code field. These date code
fields will need to accept four digit entries to distinguish 21st century dates
from 20th century dates. Systems that do not properly recognize such information
could generate erroneous data or cause a system to fail. Significant uncertainty
exists in the software industry concerning the potential effects associated with
such problems.
We have conducted Year 2000 compliance reviews for current versions of our
products. The reviews include:
- Assessment;
- Implementation;
- Validation testing; and
- Contingency planning.
<PAGE>
We respond to customer concerns about our products on a case-by-case basis.
Although we have performed validation testing to ensure our products are Year
2000 compliant and believe our software products are Year 2000 compliant, our
software products may not contain all the necessary software routines and
programs for the accurate calculation, display, storage and manipulation of data
involving dates. Failures of our software products to contain all the necessary
software routines and programs for the accurate calculation, display, storage
and manipulation of data involving dates would seriously harm our business,
operating results and financial condition.
We have tested software obtained from third parties that is incorporated
into our products and believe that such licensed software is Year 2000
compliant. Despite such testing and assurances, products incorporated into our
products may contain undetected errors or defects associated with Year 2000 date
functions. Known or unknown errors or defects in our products may result in:
- Delay or loss of revenue;
- Diversion of development resources;
- Damage to our reputation; or
- Increased service and warranty costs.
The occurrence of any of the foregoing could seriously harm our business,
operating results, or financial condition.
We do not currently have any information concerning the Year 2000
compliance status of our customers. If our current or future customers fail to
achieve Year 2000 compliance or if they divert technology expenditures to
address Year 2000 compliance problems, our business, results of operations, or
financial condition could be seriously harmed.
We believe the software and hardware we use internally comply with Year
2000 requirements. During 1998, we replaced or upgraded much of our internal use
hardware and software. In addition, we are not aware of any material operational
issues or costs associated with preparing our internal use software and hardware
for the Year 2000. However, serious, unanticipated negative consequences,
including material costs caused by undetected errors or defects in the
technology used in our internal systems may occur. The occurrence of any of the
foregoing could seriously harm our business, operating results or financial
condition.
We have funded our Year 2000 compliance review from operating cash flows
and have not separately accounted for these costs in the past. We will incur
additional amounts related to the Year 2000 compliance review including:
- Administrative personnel to manage the review; and
- Outside contractors to provide technical advice and technical support
for our products, product engineering, and customer satisfaction.
We have developed contingency plans to be implemented as part of our
efforts to identify and correct Year 2000 problems. Depending on the systems
affected, these plans include:
- Accelerated replacement of affected equipment or software;
- Short to medium-term use of backup equipment and software;
- Increased work hours for our personnel or use of contract personnel to
correct (on an accelerated schedule) any Year 2000 problems that arise
or to provide manual workarounds for information systems; and
- Other similar approaches
If we are required to implement any of these contingency plans, it could
seriously harm our business, financial condition and operating results. Our
ability to achieve Year 2000 compliance and the level of incremental costs
associated therewith, could be seriously impacted by, among other things:
- The availability and cost of programming and testing resources;
<PAGE>
- Vendors' ability to modify proprietary software; and
- Unanticipated problems identified in the ongoing compliance review.
RISK FACTORS
In addition to the other information in this Report, the following risk
factors should be considered carefully in evaluating our business and us:
Our Quarterly Operating Results Are Volatile.
Our quarterly operating results have varied in the past and may vary in the
future. Our quarterly operating results may vary depending on a number of
factors, many of which are outside of our control, including:
- The size and timing of orders;
- Increased competition;
- Market acceptance of our new products, applications and product
enhancements or those of our competitors;
- Changes in pricing policies of our competitors or by us;
- Our ability to timely develop, introduce and market new products,
applications and product enhancements;
- Our ability to integrate acquired businesses;
- Our ability to control costs;
- Quality control of products sold;
- Lengthy sales cycles, particularly with enterprise license
transactions;
- Our success in expanding sales and marketing programs;
- Technological changes in our markets;
- The mix of sales among our channels;
- Deferrals of customer orders in anticipation of new products,
applications or product enhancements;
- Market readiness to deploy our products for distributed computing
environments;
- Changes in our strategy or that of our competitors;
- Customer budget cycles and changes in these budget cycles;
- Foreign currency and exchange rates;
- Acquisition costs or other non-recurring charges in connection with
the acquisition of companies, products or technologies;
- Personnel changes; and
- General economic factors.
Our Future Operating Results Are Uncertain.
We cannot predict our future revenue with any significant degree of
certainty for several reasons including the following:
- Product revenue in any quarter is substantially dependent on orders
booked and shipped in that quarter, since we operate with virtually no
order backlog;
- We do not recognize revenue on sales to domestic distributors until
the products are sold through to end-users;
- The storage management market is rapidly evolving;
- Our sales cycles vary substantially from customer to customer, in
large part because we are becoming increasingly dependent upon larger
company-wide enterprise license transactions to corporate customers.
<PAGE>
Such transactions include product license, service and support
components and take a long time to complete;
- The timing of large orders can significantly affect revenue within a
quarter; and
- License and royalty revenue is difficult to forecast. Our royalty
revenue is dependent upon product license sales by OEMs of their
products that incorporate our software. Accordingly, royalty revenue
is subject to OEMs' product cycles, which are also difficult to
predict. Fluctuations in licensing activity from quarter to quarter
further impact royalty revenue, because initial license fees generally
are non-recurring and recognized upon the signing of a license
agreement.
Our expense levels are relatively fixed and are based, in part, on our
expectations of our future revenue. Consequently, if revenue levels fall below
our expectations, our net income will decrease because only a small portion of
our expenses varies with our revenue.
We believe that period-to-period comparisons of our results of operations
are not meaningful and should not be relied upon as indications of future
performance. Our operating results will be below the expectations of public
market analysts and investors in some future quarter or quarters. Our failure to
meet such expectations would likely seriously harm the market price of our
common stock.
Our Market is Highly Competitive.
We operate in the enterprise storage management market, which is intensely
competitive, highly fragmented and characterized by rapidly changing technology
and evolving standards. Competitors vary in size and in the scope and breadth of
the products and services offered. Our major competitors according to hardware
platforms include:
Novell NetWare and Windows NT platforms:
----------------------------------------
Computer Associates (Cheyenne Software); and
Veritas (Palindrome and Arcada).
Sun Solaris/SunOS platform:
---------------------------
Computer Associates (Legent/Lachman);
EMC2 (Epoch);
Spectra Logic; and
Veritas.
AIX platform and the HP-UX platform:
------------------------------------
IBM; and
Hewlett Packard.
We expect to encounter new competitors as we enter new markets. In
addition, many of our existing competitors are broadening their platform
coverage. We also expect increased competition from systems and network
management companies, especially those that have historically focused on the
mainframe market and are broadening their focus to include the client/server
market. In addition, since there are relatively low barriers to entry in the
software market, we expect additional competition from other established and
emerging companies. We also expect that competition will increase as a result of
future software industry consolidations. Increased competition could harm us by
causing, among other things:
- Price reductions;
- Reduced gross margins; and
- Loss of market share.
Many of our current and potential competitors have longer operating
histories and have substantially greater financial, technical, sales, marketing
and other resources, as well as greater name recognition and a larger customer
base, than we have. As a result, certain current and potential competitors can
respond more quickly to new or emerging technologies and changes in customer
requirements. They can also devote greater resources to the development,
<PAGE>
promotion, sale and support of their products. In addition, current and
potential competitors may establish cooperative relationships among themselves
or with third parties. If so, new competitors or alliances among competitors may
emerge and rapidly acquire significant market share. In addition, network
operating system vendors could introduce new or upgrade existing operating
systems or environments that include functionality offered by our products. If
so, our products could be rendered obsolete and unmarketable. For all these
reasons, we may not be able to compete successfully, which would seriously harm
our business, operating results and financial condition.
We Must Manage Our Growth and Expansion.
We have recently experienced a period of significant expansion of our
operations that has placed a significant strain upon our management systems and
resources. In addition, we have recently hired a significant number of
employees, and plan to further increase our total headcount. We also plan to
expand the geographic scope of our customer base. This expansion has resulted
and will continue to result in substantial demands on our management resources.
From time to time, we receive customer complaints about the timeliness and
accuracy of customer support. We plan to add customer support personnel in order
to address current customer support needs. If we are not successful hiring such
personnel, our business, operating results and financial condition could be
seriously harmed. Our ability to compete effectively and to manage future
expansion of our operations, if any, will require us to (a) continue to improve
our financial and management controls, reporting systems and procedures on a
timely basis, and (b) expand, train and manage our employee work force. Our
failure to do so could seriously harm our business, operating results and
financial condition.
We Must Integrate Recent Mergers and Acquisitions.
On April 1, 1999, we completed the acquisition of Intelliguard, a developer
of standards-based storage management solutions for storage area networks. On
April 19, 1999, we completed the merger with FullTime, a developer of
distributed, enterprise-wide, cross-platform, adaptive computing solutions that
enable customers to proactively manage application service level availability
into a wholly-owned subsidiary of Legato. On July 30, 1999, we completed the
acquisition of Vinca Corporation, a Utah-based provider of high availability and
data protection software. We may make additional acquisitions in the future.
Acquisitions of companies, products or technologies entail numerous risks,
including:
- An inability to successfully assimilate acquired operations and products;
- Diversion of management's attention;
- Loss of key employees of acquired companies;
- Substantial transaction costs; and
- Substantial additional costs charged to operations as a result of the
failure to consummate acquisitions.
Some of the products we acquired may require significant additional
development before they can be marketed and may not generate revenue at levels
we anticipate. Moreover, our future acquisitions may result in dilutive
issuances of our equity securities, the incurrence of debt, large one-time
write-offs and the creation of goodwill or other intangible assets that could
result in amortization expense. We cannot guarantee that our efforts to
consummate acquisitions or integrate acquisitions will be successful. If our
efforts are not successful, our business, financial condition and results of
operations could be seriously harmed.
We Depend on Our NetWorker Product Line.
We currently derive, and expect to continue to derive, a substantial
majority of our revenue from our NetWorker software products and related
services. A decline in the price of or demand for NetWorker, or failure to
achieve broad market acceptance of NetWorker, would seriously harm our business,
operating results and financial condition. We cannot reasonably predict
NetWorker's remaining life for several reasons, including:
- The recent emergence of our market;
<PAGE>
- The effect of new products, applications or product enhancements;
- Technological changes in the network storage management environment
in which NetWorker operates; and
- Future competition.
We Must Respond to Rapid Technological Changes with New Product Offerings.
The markets for our products are characterized by:
- Rapid technological changes;
- Changing customer needs;
- Frequent new software product introductions; and
- Evolving industry standards.
The introduction of products embodying new technologies and the emergence
of new industry standards could render our existing products obsolete and
unmarketable.
To be successful, we need to develop and introduce new software products
(including new releases, applications and enhancements) on a timely basis that:
- Keep pace with technological developments and emerging industry
standards; and
- Address the increasingly sophisticated needs of our customers.
We may:
- Fail to develop and market new products that respond to technological
changes or evolving industry standards;
- Experience difficulties that could delay or prevent the successful
development, introduction and marketing of these new products; or
- Fail to develop new products that adequately meet the requirements of
the marketplace or achieve market acceptance
If so, our business, operating results and financial condition would be
seriously harmed.
We currently have plans to introduce and market several potential new
products in the next twelve months. Some of our competitors currently offer
certain of these potential new products. Such potential new products are subject
to significant technical risks. We may fail to introduce such potential new
products on a timely basis or at all. In the past, we have experienced delays in
the commencement of commercial shipments of our new products. Such delays caused
customer frustrations and delay or loss of product revenue. If potential new
products are delayed or do not achieve market acceptance, our business,
operating results and financial condition would be seriously harmed. In the
past, we have also experienced delays in purchases of our products by customers
anticipating our launch of new products. Our business, operating results and
financial condition would be seriously harmed if customers defer material orders
in anticipation of new product introductions.
Software products as complex as those we offer may contain undetected
errors or failures when first introduced or as new versions are released. We
have in the past discovered software errors in certain of our new products after
their introduction. We experienced delays or lost revenue during the period
required to correct these shipments, despite testing by us and by our current
and potential customers. This may result in loss of or delay in market
acceptance of our products, which could seriously harm our business, operating
results and financial condition.
<PAGE>
We Rely on Enterprise-Level License Transactions.
In the past, we marketed our products at the department level of corporate
customers. Within the last two years, we began to pursue larger enterprise
license transactions with corporate customers. We may fail to successfully
market our products in larger enterprise license transactions. Such failure
would seriously harm our business, operating results and financial condition.
Our operating results are sensitive to the timing of such orders. Such orders
are difficult to manage and predict, because:
- The sales cycle is typically lengthy, generally lasting three to nine
months, and varies substantially from transaction to transaction;
- They often include product license, service and support components;
- They typically involve significant technical evaluation and commitment
of capital and other resources; and
- Customers' internal procedures frequently cause delays in orders. Such
internal procedures include approval large capital expenditures,
implementation of new technologies within their networks, and testing
new technologies that affect key operations.
Due to the large size of enterprise transactions, if orders forecasted for a
specific transaction for a particular quarter are not realized in that quarter,
our operating results for that quarter may be seriously harmed.
Historically, we have not had a separate large enterprise or national
accounts sales force and only within the last two years have we begun to develop
direct sales groups focused on these larger accounts. To succeed in the national
accounts market, we will be required to continue to transition our existing
sales forces into enterprise-level sales groups and attract and retain qualified
personnel. New personnel will require training to obtain knowledge of product
attributes for our products. We may not be successful in creating the necessary
sales organization or in attracting, retaining or training these individuals. To
succeed in the enterprise and national accounts market will require, among other
things, establishing and continuing to develop relationships and contacts with
senior technology officers at these accounts. Our business, financial condition
and results of operations would be seriously harmed if our sales force is not
successful in these efforts.
We Rely on Indirect Sales Channels.
We rely significantly on our distributors, systems integrators and value
added resellers (collectively, "resellers") for the marketing and distribution
of our products. Our agreements with resellers are generally not exclusive and
in many cases may be terminated by either party without cause. Many of our
resellers carry product lines that are competitive with ours. These resellers
may not give a high priority to the marketing of our products. Rather, they may
give a higher priority to other products, including the products of competitors,
or may not continue to carry our products. Events or occurrences of this nature
could seriously harm our business, operating results and financial condition. In
addition, we may not be able to retain any of our current resellers or
successfully recruit new resellers. Any such changes in our distribution
channels would seriously harm our business, operating results and financial
condition.
Our strategy is also to increase the proportion of our customers licensed
through OEMs. We may fail to achieve this strategy. We are currently investing,
and intend to continue to invest resources to develop this channel. Such
investments could seriously harm our operating margins. We depend on our OEMs'
ability to develop new products, applications and product enhancements on a
timely and cost-effective basis that will meet changing customer needs and
respond to emerging industry standards and other technological changes. Our OEMs
may not effectively meet these technological challenges.
These OEMs:
- Are not within our control;
- May incorporate the technologies of other companies in addition to, or to
the exclusion of, our technologies; and
- Are not obligated to purchase our products. In addition, our OEMs
generally have exclusive rights to our technology on their platforms,
subject to certain minimum royalty obligations.
<PAGE>
Our OEMs may not continue to carry our products. The inability to recruit,
or the loss of, important OEMs could serious harm our business, operating
results and financial condition.
We Depend on International Revenue.
Our continued growth and profitability will require further expansion of
our international operations. To successfully expand international operations,
we must:
- Establish additional foreign operations;
- Hire additional personnel; and
- Recruit additional international resellers.
This will require significant management attention and financial resources
and could seriously harm our operating margins. If we fail to further expand our
international operations in a timely manner, our business, operating results and
financial condition could be seriously harmed. In addition, we may fail to
maintain or increase international market demand for our products. Our
international sales are currently denominated in U.S. dollars. An increase in
the value of the U.S. dollar relative to foreign currencies could make our
products more expensive and, therefore, potentially less competitive in those
markets. In some markets, localization of our products is essential to achieve
market penetration. We may incur substantial costs and experience delays in
localizing our products. We may fail to generate significant revenue from
localized products.
Additional risks inherent in our international business activities
generally include:
- Significant reliance on our distributors and other resellers who do not
offer our products exclusively;
- Unexpected changes in regulatory requirements;
- Tariffs and other trade barriers;
- Lack of acceptance of localized products, if any, in foreign countries;
- Longer accounts receivable payment cycles;
- Difficulties in managing international operations;
- Potentially adverse tax consequences, including restrictions on the
repatriation of earnings;
- The burdens of complying with a wide variety of foreign laws; and
- The risks related to the recent global economic turbulence and adverse
economic circumstances in Asia.
The occurrence of such factors could seriously harm our international sales and,
consequently, our business, operating results and financial condition.
We Rely on Our Key Personnel.
Our future performance depends on the continued service of our key
technical and senior management personnel. None of the our key technical or
senior management personnel is bound by an employment agreement. The loss of the
services of one or more of our officers or other key employees could seriously
harm our business, operating results and financial condition.
Our future success also depends on our continuing ability to attract and
retain highly qualified technical and managerial personnel. Competition for such
personnel is intense, and we may fail to retain our key technical and managerial
employees or attract, assimilate or retain other highly qualified technical and
managerial personnel in the future.
We Depend on Growth in the Enterprise Storage Management Market.
All of our business is in the enterprise storage management market. The
storage management market is still an emerging market. Our future financial
performance will depend in large part on continued growth in the number of
organizations adopting company-wide storage and management solutions for their
client/server computing environments. The market for enterprise storage
management may not continue to grow. If the enterprise storage management market
<PAGE>
fails to grow or grows more slowly than we currently anticipate, our business,
operating results and financial condition would be seriously harmed.
We Are Affected by General Economic and Market Conditions.
During recent years, segments of the computer industry have experienced
significant economic downturns characterized by:
- Decreased product demand;
- Product overcapacity;
- Price erosion;
- Work slowdowns; and
- Layoffs.
Our operations may experience substantial fluctuations from
period-to-period as a consequence of such industry patterns, general economic
conditions affecting the timing of orders from major customers, and other
factors affecting capital spending. The occurrence of such factors could
seriously harm our business, operating results or financial condition.
Protection of Our Intellectual Property is Limited.
Our success depends significantly upon proprietary technology. To protect
our proprietary rights, we rely on a combination of:
- Patents;
- Copyright and trademark laws;
- Trade secrets;
- Confidentiality procedures; and
- Contractual provisions.
We seek to protect our software, documentation and other written materials
under patent, trade secret and copyright laws, which afford only limited
protection. However,
- We may not develop proprietary products or technologies that are
patentable;
- Any issued patent may not provide us with any competitive advantages or
may be challenged by third parties; or
- The patents of others may seriously impede our ability to do business.
Despite our efforts to protect our proprietary rights, unauthorized parties
may attempt to copy aspects of our products or to obtain and use information
that we regard as proprietary. Policing unauthorized use of our products is
difficult, and software piracy can be expected to be a persistent problem. In
licensing our products, other than in enterprise license transactions, we rely
on "shrink wrap" licenses that are not signed by licensees. Such licenses may be
unenforceable under the laws of certain jurisdictions. In addition, the laws of
some foreign countries do not protect our proprietary rights to as great an
extent as do the laws of the United States. Our means of protecting our
proprietary rights may not be adequate. Our competitors may independently
develop similar technology, duplicate our products or design around patents
issued to us or other intellectual property rights of ours.
From time to time, we have received claims that we are infringing third
parties' intellectual property rights. In the future, we may be subject to
claims of infringement by third parties with respect to current or future
products, trademarks or other proprietary rights. We expect that software
product developers will increasingly be subject to infringement claims as the
number of products and competitors in our industry segment grows and the
functionality of products in different industry segments overlaps. Any such
<PAGE>
claims, with or without merit, could be time-consuming, result in costly
litigation, cause product shipment delays or require us to enter into royalty or
licensing agreements with third parties. If such royalty or licensing
agreements, if required, are not available on terms acceptable to us, our
business, operating results and financial condition could be seriously harmed.
Defects in Our Products Would Harm Our Business.
Our products can be used to manage data critical to organizations. As a
result, the risk of product liability claims is inherent in the sale and support
of the products we offer. A successful product liability claim brought against
us could seriously harm our business, operating results and financial condition.
Year 2000 Issues Could Affect Our Business.
Many currently installed computer systems and software products include
coding to accept only two digit entries in the date code field. These date code
fields will need to accept four digit entries to distinguish 21st century dates
from 20th century dates. Systems that do not properly recognize such information
could generate erroneous data or cause a system to fail. Significant uncertainty
exists in the software industry concerning the potential effects associated with
such problems.
We have conducted Year 2000 compliance reviews for current versions of our
products. The reviews include:
- Assessment;
- Implementation;
- Validation testing; and
- Contingency planning.
We respond to customer concerns about our products on a case-by-case basis.
Although we have performed validation testing to ensure our products are Year
2000 compliant and believe our software products are Year 2000 compliant, our
software products may not contain all the necessary software routines and
programs for the accurate calculation, display, storage and manipulation of data
involving dates. Failures of our software products to contain all the necessary
software routines and programs for the accurate calculation, display, storage
and manipulation of data involving dates would seriously harm our business,
operating results and financial condition.
We have tested software obtained from third parties that is incorporated
into our products and believe that such licensed software is Year 2000
compliant. Despite such testing and assurances, products incorporated into our
products may contain undetected errors or defects associated with Year 2000 date
functions. Known or unknown errors or defects in our products may result in:
- Delay or loss of revenue;
- Diversion of development resources;
- Damage to our reputation; or
- Increased service and warranty costs.
The occurrence of any of the foregoing could seriously harm our business,
operating results, or financial condition.
We do not currently have any information concerning the Year 2000
compliance status of our customers. If our current or future customers fail to
achieve Year 2000 compliance or if they divert technology expenditures to
address Year 2000 compliance problems, our business, results of operations, or
financial condition could be seriously harmed.
We believe the software and hardware we use internally comply with Year
2000 requirements. During 1998, we replaced or upgraded much of our internal use
hardware and software. In addition, we are not aware of any material operational
issues or costs associated with preparing our internal use software and hardware
for the Year 2000. However, serious, unanticipated negative consequences,
<PAGE>
including material costs caused by undetected errors or defects in the
technology used in our internal systems may occur. The occurrence of any of the
foregoing could seriously harm our business, operating results or financial
condition.
We have funded our Year 2000 compliance review from operating cash flows
and have not separately accounted for these costs in the past. We will incur
additional amounts related to the Year 2000 compliance review including:
- Administrative personnel to manage the review; and
- Outside contractors to provide technical advice and technical support
for our products, product engineering, and customer satisfaction.
We have developed contingency plans to be implemented as part of our
efforts to identify and correct Year 2000 problems. Depending on the systems
affected, these plans include:
- Accelerated replacement of affected equipment or software;
- Short to medium-term use of backup equipment and software;
- Increased work hours for our personnel or use of contract personnel to
correct (on an accelerated schedule) any Year 2000 problems that arise
or to provide manual workarounds for information systems; and
- Other similar approaches
If we are required to implement any of these contingency plans, it could
seriously harm our business, financial condition and operating results. Our
ability to achieve Year 2000 compliance and the level of incremental costs
associated therewith, could be seriously impacted by, among other things:
- The availability and cost of programming and testing resources;
- Vendors' ability to modify proprietary software; and
- Unanticipated problems identified in the ongoing compliance review.
Our Trading Price is Volatile.
The market price of our common stock may decrease significantly. A number
of factors could significantly affect the market price of our common stock
including:
- Quarterly fluctuations in financial results or results of other software
companies;
- Changes in our revenue growth rates or our competitors' growth rates;
- Announcements that our revenue or income are below analysts'
expectations;
- Changes in analysts' estimates of our performance or industry
performance;
- Announcements of new products by our competitors or by us;
- Developments with respect to our patents, copyrights, or proprietary
rights or those of our competitors;
- Sales of large blocks of our common stock;
- Conditions in the financial markets in general;
- General business conditions and trends in the distributed computing
environment and software industry;
- Deferred purchases of our products as a result of customers needs to
expend available resources to become Year 2000 compliant;
- Costs and resources required to address potential Year 2000 problems
relating to our products or our internal use software and hardware; and
- Changes in prices of our products.
<PAGE>
In addition, the stock market may experience extreme price and volume
fluctuations, which may affect the market price for the securities of technology
companies without regard to their operating performance or any of the factors
listed above. These broad market fluctuations may seriously harm the market
price of our common stock. In the past, securities class action litigation has
often been brought against a company following periods of volatility in the
market price of such company's securities. Such litigation may occur in the
future with respect to us and could result in substantial costs and diversion of
management's attention and resources, which could seriously harm our business,
financial condition and results of operations.
<PAGE>
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
As a global concern, we face exposure to adverse movements in foreign
currency exchange rates. These exposures may change over time as business
practices evolve and could seriously harm our financial results. All of our
international sales are currently denominated in U.S. dollars. An increase in
the value of the U.S. dollar relative to foreign currencies could make our
products more expensive and therefore, reduce the demand for our products.
Reduced demand for our products could seriously harm our financial results.
Currently, we do not hedge against any foreign currencies and as a result, could
incur unanticipated gains or losses.
We maintain an investment portfolio of various issuers, types and
maturities. Our investment portfolio consists of both fixed and variable rate
financial instruments. These securities are classified as available-for-sale,
and consequently, are recorded on the balance sheet at fair value with
unrealized gains or losses reported as a separate component of stockholders'
equity, net of taxes. At any time, a sharp rise in interest rates could
seriously harm the fair value of our investment portfolio. Conversely, declines
in interest rates could seriously harm interest earnings of our investment
portfolio. Currently, we do not hedge these interest rate exposures.
<PAGE>
PART II: OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
27.1 Financial Data Schedule
(b) Reports on Form 8-K
(i) The Company filed a report on Form 8-K, dated July 30, 1999, in
connection with our acquisition of Vinca Corporation.
(i) The Company filed a report on Form 8-K, as amended, dated October 12,
1999, in connection with our acquisition of Vinca Corporation.
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
LEGATO SYSTEMS, INC.
Date: November 10, 1999 /S/ Stephen C. Wise
---------------------------------------
Stephen C. Wise
Senior V.P. of Finance and
Chief Financial Officer
(Duly authorized officer and principal
financial and accounting officer)
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