<PAGE>
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
DECEMBER 17, 1998
Date of Report (date of earliest event reported)
INTERNATIONAL NETWORK SERVICES
(Exact name of Registrant as specified in its charter)
<TABLE>
<S> <C> <C>
CALIFORNIA 0-21131 77-0289509
(State or other jurisdiction of (Commission File Number) (I.R.S. Employer Identification No.)
incorporation or organization)
</TABLE>
1213 INNSBRUCK DRIVE
SUNNYVALE, CALIFORNIA 94089
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
Registrant's telephone number, including area code: (408) 542-0100
N/A
(Former name or former address, if changed since last report)
================================================================================
<PAGE>
Item 5. Other Events
------------
International Network Services ("INS") is restating the following
information to give retroactive effect to its acquisition (the "Acquisition") of
VitalSigns Software, Inc. ("VitalSigns"), which was effective as of November 20,
1998 and accounted for as a pooling of interests: (i) Consolidated Financial
Statements at June 30, 1997 and 1998 and for each of the three years in the
period ended June 30, 1998, (ii) unaudited Consolidated Financial Statements at
September 30, 1998 and for the fiscal quarters ended September 30, 1998 and
1997, and (iii) Management's Discussion and Analysis of Financial Condition and
Results of Operations which relates to the foregoing financial statements. Such
information is attached hereto as Exhibit 99 and incorporated herein by this
reference.
Generally accepted accounting principles proscribe giving effect to a
consummated business combination accounted for by the pooling of interests
method in financial statements that do not include the date of consummation.
These financial statements do not extend through the date of consummation.
However, they will become the historical consolidated financial statements of
INS and its subsidiaries after financial statements covering the date of
consummation of the business combination are issued.
Item 7. Financial Statements and Exhibits
---------------------------------
(a) Financial Statements
Not Applicable
(b) Pro Forma Financial Information
Not Applicable
(c) Exhibits
23 Consent of PricewaterhouseCoopers LLP
27.1 Financial Data Schedule Period Type Three Months
27.2 Financial Data Schedule Period Type Twelve Months
99 Supplemental Financial Information:
Report of Independent Accountants
Supplemental Consolidated Balance Sheets
Supplemental Consolidated Statements of Income
Supplemental Consolidated Statements of
Shareholders' Equity
Supplemental Consolidated Statements of Cash Flows
Notes to Supplemental Consolidated Financial Statements
Management's Discussion and Analysis of Financial
Condition and Results of Operations
<PAGE>
Pursuant to the requirements of the Securities Exchange Act of 1934,
as amended, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned hereunto duly authorized.
Dated: December 17, 1998 INTERNATIONAL NETWORK SERVICES
/s/ Kevin J. Laughlin
---------------------------
Kevin J. Laughlin
Vice President, Finance and
Chief Financial Officer
<PAGE>
INTERNATIONAL NETWORK SERVICES
EXHIBIT INDEX TO FORM 8-K
Dated December 17, 1998
Exhibit
23 Consent of PricewaterhouseCoopers LLP
27.1 Financial Data Schedule Period Type Three Months
27.2 Financial Data Schedule Period Type Twelve Months
99 Supplemental Financial Information:
Report of Independent Accountants
Supplemental Consolidated Balance Sheets
Supplemental Consolidated Statements of Income
Supplemental Consolidated Statements of Shareholders' Equity
Supplemental Consolidated Statements of Cash Flows
Notes to Supplemental Consolidated Financial Statements
Management's Discussion and Analysis of Financial Condition and
Results of Operations
<PAGE>
EXHIBIT 23
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in the Registration
Statements on Form S-8 (Nos. 333-21075 and 333-68121) of International Network
Services of our report dated December 17, 1998, with respect to the supplemental
consolidated balance sheets of International Network Services and its
subsidiaries as of June 30, 1997 and 1998, and the related supplemental
consolidated statements of income, shareholders' equity and cash flows for
each of the three years in the period ended June 30, 1998, which appears in
Exhibit 99 of the Current Report on Form 8-K of International Network Services
dated December 17, 1998.
/s/ PricewaterhouseCoopers LLP
San Jose, California
December 17, 1998
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<RESTATED>
<MULTIPLIER> 1,000
<S> <C> <C>
<PERIOD-TYPE> 3-MOS 3-MOS
<FISCAL-YEAR-END> JUN-30-1998 JUN-30-1999
<PERIOD-START> JUL-01-1997 JUL-01-1998
<PERIOD-END> SEP-30-1997 SEP-30-1998
<CASH> 0 37,556
<SECURITIES> 0 15,977
<RECEIVABLES> 0 57,925
<ALLOWANCES> 0 (2,589)
<INVENTORY> 0 0
<CURRENT-ASSETS> 0 115,805
<PP&E> 0 24,405
<DEPRECIATION> 0 (11,175)
<TOTAL-ASSETS> 0 154,376
<CURRENT-LIABILITIES> 0 38,427
<BONDS> 0 0
0 0
0 0
<COMMON> 0 91,712
<OTHER-SE> 0 24,239
<TOTAL-LIABILITY-AND-EQUITY> 0 154,376
<SALES> 0 0
<TOTAL-REVENUES> 33,946 64,396
<CGS> 0 0
<TOTAL-COSTS> 29,951 55,184
<OTHER-EXPENSES> 0 0
<LOSS-PROVISION> 0 0
<INTEREST-EXPENSE> 0 0
<INCOME-PRETAX> 4,404 9,902
<INCOME-TAX> 1,762 3,961
<INCOME-CONTINUING> 2,642 5,941
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> 2,642 5,941
<EPS-PRIMARY> 0.08 0.17
<EPS-DILUTED> 0.07 0.15
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<RESTATED>
<MULTIPLIER> 1,000
<S> <C> <C>
<PERIOD-TYPE> 12-MOS 12-MOS
<FISCAL-YEAR-END> JUN-30-1997 JUN-30-1998
<PERIOD-START> JUL-01-1996 JUL-01-1997
<PERIOD-END> JUN-30-1997 JUN-30-1998
<CASH> 24,550 32,484
<SECURITIES> 12,075 25,319
<RECEIVABLES> 24,694 48,503
<ALLOWANCES> (588) (1,468)
<INVENTORY> 0 0
<CURRENT-ASSETS> 65,457 112,522
<PP&E> 15,134 21,549
<DEPRECIATION> (6,832) (10,054)
<TOTAL-ASSETS> 83,802 140,286
<CURRENT-LIABILITIES> 11,857 37,979
<BONDS> 0 0
0 0
0 0
<COMMON> 67,464 83,648
<OTHER-SE> 4,481 18,659
<TOTAL-LIABILITY-AND-EQUITY> 83,802 140,286
<SALES> 0 0
<TOTAL-REVENUES> 99,513 172,798
<CGS> 0 0
<TOTAL-COSTS> 89,126 150,926
<OTHER-EXPENSES> 0 0
<LOSS-PROVISION> 0 0
<INTEREST-EXPENSE> 0 0
<INCOME-PRETAX> 11,511 24,007
<INCOME-TAX> 4,489 9,603
<INCOME-CONTINUING> 7,022 14,404
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> 6,752 14,404
<EPS-PRIMARY> .26 .43
<EPS-DILUTED> .20 .38
</TABLE>
<PAGE>
EXHIBIT 99
INTERNATIONAL NETWORK SERVICES
INDEX
<TABLE>
<CAPTION>
Page No
-------
<S> <C>
Report of Independent Accountants 2
Supplemental Consolidated Financial Statements:
Supplemental Consolidated Balance Sheets 3
Supplemental Consolidated Statements of Income 4
Supplemental Consolidated Statements of Shareholders' Equity 5
Supplemental Consolidated Statements of Cash Flows 6
Notes to Supplemental Consolidated Financial Statements 7
Management's Discussion and Analysis of Financial Condition and Results of
Operations 18
</TABLE>
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of
International Network Services
In our opinion, the accompanying supplemental consolidated balance sheets and
the related supplemental consolidated statements of income, shareholders' equity
and cash flows present fairly, in all material respects, the financial position
of International Network Services and its subsidiaries at June 30, 1997 and
1998, and the results of their operations and their cash flows for each of the
three years in the period ended June 30, 1998, in conformity with generally
accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
San Jose, California
December 17, 1998
<PAGE>
INTERNATIONAL NETWORK SERVICES
SUPPLEMENTAL CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
June 30, September 30,
------------------------
1997 1998 1998
------------ ----------- --------------
(Unaudited)
<S> <C> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents............................... $24,550 $ 32,484 $ 37,556
Short-term investments.................................. 12,075 25,319 15,977
Accounts receivable, net................................ 24,106 47,035 55,336
Deferred income taxes................................... 1,701 3,758 3,758
Prepaid expenses and other assets....................... 3,025 3,926 3,178
---------- --------- --------
Total current assets............................... 65,457 112,522 115,805
Property and equipment, net............................... 8,302 11,495 13,230
Deferred income taxes..................................... 803 1,071 1,071
Investments............................................... 9,240 15,198 24,270
---------- -------- --------
$83,802 $140,286 $154,376
========== ======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable........................................ $ 3,370 $ 3,816 $ 5,975
Accrued compensation and employee benefits.............. 7,008 12,638 13,423
Accrued liabilities..................................... 925 4,530 1,274
Income taxes payable.................................... -- -- 2,985
Deferred revenue........................................ 554 16,995 14,770
---------- -------- --------
Total current liabilities.......................... 11,857 37,979 38,427
Commitments and contingencies (Note 10)
Shareholders' equity:
Preferred Stock, no par value,
5,000,000 shares authorized;
none issued and outstanding....................... -- -- --
Common Stock, no par value,
75,000,000 shares authorized; 35,101,676,
36,531,404 and 36,956,120 shares issued
and outstanding, respectively..................... 67,464 83,648 91,712
Notes receivable from shareholders...................... (1,937) (685) (697)
Cumulative translation adjustments...................... -- (35) (37)
Deferred compensation................................... -- (1,443) (1,792)
Retained earnings....................................... 6,418 20,822 26,763
---------- -------- --------
Total shareholders' equity......................... 71,945 102,307 115,949
---------- -------- --------
$83,802 $140,286 $154,376
========== ======== ========
</TABLE>
The accompanying notes are an integral part of these supplemental consolidated
financial statements.
<PAGE>
INTERNATIONAL NETWORK SERVICES
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
Three Months Ended
Year Ended June 30, September 30,
-----------------------------------------------------------
1996 1997 1998 1997 1998
------------ ---------- --------- -------- ---------
(Unaudited)
<S> <C> <C> <C> <C> <C>
Revenue:
Services........................................... $44,092 $99,275 $165,285 $33,518 $60,571
License............................................ -- 238 7,513 428 3,825
----------- ---------- --------- -------- ---------
Total revenue................................. 44,092 99,513 172,798 33,946 64,396
Operating expenses:
Professional personnel............................. 19,892 44,826 75,597 15,356 26,748
Other costs........................................ 5,568 13,313 24,642 4,873 8,998
Cost of license revenue............................ -- 25 402 31 70
Research and development........................... 879 2,262 4,161 756 1,281
Sales and marketing................................ 7,990 14,985 26,389 4,902 10,367
General and administrative......................... 5,049 13,715 19,735 4,033 7,720
----------- ---------- --------- -------- ---------
Total operating expenses...................... 39,378 89,126 150,926 29,951 55,184
----------- ---------- --------- -------- ---------
Income from operations............................... 4,714 10,387 21,872 3,995 9,212
Interest and other, net.............................. 3 1,124 2,135 409 690
----------- ---------- --------- -------- ---------
Income before provision for income taxes............. 4,717 11,511 24,007 4,404 9,902
Provision for income taxes........................... 1,840 4,489 9,603 1,762 3,961
----------- ---------- --------- -------- ---------
Net income........................................... 2,877 7,022 14,404 2,642 5,941
Accretion of Mandatorily Redeemable
Convertible Preferred Stock................ 1,135 270 -- -- --
----------- ---------- --------- -------- ---------
Net income attributable to Common Stock $ 1,742 $ 6,752 $ 14,404 $ 2,642 $ 5,941
=========== ========== ========= ======== =========
Net income attributable to Common Stock
per share:
Basic......................................... $ 0.21 $ 0.26 $ 0.43 $ 0.08 $ 0.17
=========== ========== ========= ======== =========
Diluted....................................... $ 0.06 $ 0.20 $ 0.38 $ 0.07 $ 0.15
=========== ========== ========= ======== =========
Shares used to compute net income
attributable to Common Stock
Per share:
Basic......................................... 8,469 26,354 33,721 32,890 35,054
=========== ========== ========= ======== =========
Diluted....................................... 28,974 34,563 38,067 37,409 40,066
=========== ========== ========= ======== =========
</TABLE>
The accompanying notes are an integral part of these supplemental consolidated
financial statements
<PAGE>
INTERNATIONAL NETWORK SERVICES
SUPPLEMENTAL CONSOLIDATED SHAREHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
Accretion of
Mandatorily
Redeemable
Notes Receivable Convertible
From Preferred
Shareholders Stock
Common Stock
----------------------
Shares Amount
---------- -------- -------------- ----------
<S> <C> <C> <C> <C>
Balance at June 30, 1995.................................................... 8,394,320 $ 435 $ (30) $ (1,319)
Accretion of Mandatorily Redeemable Convertible Preferred Stock............. -- -- -- (1,135)
Issuance of Common Stock upon exercise of stock options and warrants, net... 3,032,555 1,959 (1,850) --
Net income.................................................................. -- -- -- --
---------- -------- -------------- ----------
Balance at June 30, 1996.................................................... 11,426,875 2,394 (1,880) (2,454)
Accretion of Mandatorily Redeemable Convertible Preferred Stock............. -- -- -- (270)
Issuance of Common Stock in public offering, net of issuance costs.......... 2,875,000 41,709 -- --
Conversion of Mandatorily Redeemable Convertible Preferred Stock in
connection with IPO......................................................... 16,734,889 9,973 -- 2,724
Issuance of Common Stock upon exercise of stock options and warrants, net... 827,324 245 (57) --
Issuance of Common Stock for cash, net...................................... 3,022,231 6,566 -- --
Issuance of Common Stock under employee stock purchase plan................. 215,357 2,983 -- --
Income tax benefit related to stock option exercises........................ -- 3,594 -- --
Net income.................................................................. -- -- -- --
---------- -------- -------------- ----------
Balance at June 30, 1997.................................................... 35,101,676 67,464 (1,937) --
Issuance of Common Stock upon exercise of stock options and warrants, net... 1,008,315 1,385 (64) --
Issuance of Common Stock, net............................................... 2,046 3 -- --
Issuance of Common Stock under employee stock purchase plan, net............ 419,367 6,047 -- --
Repayment of Shareholders' Notes............................................ -- -- 1,316 --
Issuance of Warrant......................................................... -- 3,188 -- --
Translation adjustments..................................................... -- -- -- --
Deferred compensation....................................................... -- 1,513 -- --
Income tax benefit related to stock option exercises........................ -- 4,048 -- --
Net income.................................................................. -- -- -- --
---------- -------- -------------- ----------
Balance at June 30, 1998.................................................... 36,531,404 83,648 (685) --
Issuance of Common Stock upon exercise of stock options and warrants, net
(Unaudited)................................................................. 172,796 1,072 (12) --
Issuance of Common Stock, net (Unaudited)................................... 251,920 6,497 -- --
Translation adjustments (Unaudited)......................................... -- -- -- --
Deferred compensation (Unaudited).......................................... -- 495 -- --
Net income (Unaudited)...................................................... -- -- -- --
---------- -------- -------------- ----------
Balance at September 30, 1998 (Unaudited)................................... 36,956,120 $91,712 $ (697) $ --
========== ======== ============== ==========
<CAPTION>
Cumulative Retained
Translation Deferred Earnings'
Adjustment Compensation (Deficit) Total
---------- ------------ ---------- --------
<S> <C> <C> <C> <C>
Balance at June 30, 1995...................................................... $ -- $ -- $ (3,481) $ (4,395)
Accretion of Mandatorily Redeemable Convertible Preferred Stock............... -- -- -- (1,135)
Issuance of Common Stock upon exercise of stock options and warrants, net..... -- -- -- 109
Net income.................................................................... -- -- 2,877 2,877
---------- ------------ ---------- --------
Balance at June 30, 1996...................................................... -- -- (604) (2,544)
Accretion of Mandatorily Redeemable Convertible Preferred Stock............... -- -- -- (270)
Issuance of Common Stock in public offering, net of issuance costs............ -- -- -- 42,309
Conversion of Mandatorily Redeemable Convertible Preferred Stock in
connection with IPO........................................................... -- -- -- 12,693
Issuance of Common Stock upon exercise of stock options and warrants, net..... -- -- -- 188
Issuance of Common Stock for cash, net........................................ -- -- -- 6,566
Issuance of Common Stock under employee stock purchase plan................... -- -- -- 2,983
Income tax benefit related to stock option exercises.......................... -- -- -- 3,594
Net income.................................................................... -- -- 7,022 7,022
---------- ------------ ---------- --------
Balance at June 30, 1997...................................................... -- -- 6,418 71,945
Issuance of Common Stock upon exercise of stock options and warrants, net..... -- -- 1,371
Issuance of Common Stock, net................................................. -- -- -- 3
Issuance of Common Stock under employee stock purchase plan, net.............. -- -- 6,047
Repayment of Shareholders' Notes.............................................. -- -- -- 1,316
Issuance of Warrant........................................................... -- -- -- 3,188
Translation adjustments....................................................... (35) -- -- (35)
Deferred compensation......................................................... -- (1,443) -- 70
Income tax benefit related to stock option exercises.......................... -- -- -- 4,048
Net income.................................................................... -- -- 14,404 14,404
---------- ------------ ---------- --------
Balance at June 30, 1998...................................................... (35) (1,443) 20,822 102,307
Issuance of Common Stock upon exercise of stock options and warrants, net
(Unaudited)................................................................... -- -- -- 1,060
Issuance of Common Stock, net (Unaudited)..................................... -- -- -- 6,497
Translation adjustments (Unaudited)........................................... (2) -- -- (2)
Deferred compensation (Unaudited)............................................ -- (349) -- 146
Net income (Unaudited)........................................................ -- -- 5,941 5,941
---------- ------------ ---------- --------
Balance at September 30, 1998 (Unaudited)..................................... $ (37) $ (1,792) $ 26,763 $115,949
========== ============ ========== ========
</TABLE>
The accompanying notes are an integral part of these supplemental consolidated
financial statements.
<PAGE>
INTERNATIONAL NETWORK SERVICES
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
Three Months Ended
Year Ended June 30, September 30,
--------------------------------- -------------------
1996 1997 1998 1997 1998
--------- -------- -------- ------- --------
(Unaudited)
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net income.......................................................... $ 2,877 $ 7,022 $ 14,404 $ 2,642 $ 5,941
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization.................................... 1,786 3,848 5,982 1,437 1,499
Deferred income taxes............................................ (857) (1,647) (2,325) -- --
Tax benefit from employee stock plans............................ -- 3,594 4,048 -- --
Changes in assets and liabilities:
Accounts receivable............................................ (7,657) (12,285) (22,929) (7,910) (8,301)
Prepaid expenses and other assets.............................. (270) (2,639) (901) 1,616 748
Accounts payable............................................... 1,256 1,462 446 78 2,159
Accrued liabilities............................................ 2,942 3,979 9,235 888 (2,471)
Income taxes payable........................................... -- -- -- 1,305 2,985
Deferred revenue............................................... 270 (58) 16,441 204 (2,225)
------- -------- -------- ------- --------
Net cash provided by operating activities................... 347 3,276 24,401 260 335
------- -------- -------- ------- --------
Cash flows from investing activities:
Purchases of property and equipment, net............................ (4,399) (8,011) (9,105) (1,457) (3,088)
Purchases of investments............................................ -- (25,414) (38,934) (5,751) (12,669)
Sales of investments................................................ -- 4,099 19,732 -- 12,939
------- -------- -------- ------- --------
Net cash used for investing activities...................... (4,399) (29,326) (28,307) (7,208) (2,818)
------- -------- -------- ------- --------
Cash flows from financing activities:
Borrowings (payments) under line of credit.......................... 1,000 (1,000) -- -- --
Borrowings (payments) on notes payable.............................. (349) (715) -- -- --
Proceeds from issuance of Common Stock, net......................... 109 51,446 10,623 (457) 7,557
Repayments of shareholder notes receivable.......................... -- -- 1,252 1,104 --
------- -------- -------- ------- --------
Net cash provided by financing activities................... 760 49,731 11,875 647 7,557
------- -------- -------- ------- --------
Effect of exchange rate changes on cash and cash equivalents.......... -- -- (35) -- (2)
------- -------- -------- ------- --------
Increase (decrease) in cash and cash equivalents...................... (3,292) 23,681 7,934 (6,301) 5,072
Cash and cash equivalents at beginning of period...................... 4,161 869 24,550 24,550 32,484
------- -------- -------- ------- --------
Cash and cash equivalents at end of period............................ $ 869 $ 24,550 $ 32,484 $18,249 $ 37,556
======= ======== ======== ======= ========
Supplemental disclosure of cash flow information:
Cash paid for interest.............................................. $ 103 $ 99 $ 22 $ 3 $ 6
Cash paid for income taxes.......................................... $ 2,470 $ 7,599 $ 8,177 $ 32 $ 301
Non-cash transactions:
Issuance of Common Stock in exchange for notes receivable from
shareholders...................................................... $ 1,850 $ 57 $ 64 $ -- $ 12
Conversion of Mandatorily Redeemable Convertible Preferred Stock to
Common Stock...................................................... $ -- $ 9,973 $ -- $ -- $ --
Deferred compensation relating to granting of options below fair
market value...................................................... $ -- $ -- $ 1,513 $ -- $ 495
</TABLE>
The accompanying notes are an integral part of these supplemental consolidated
financial statements.
<PAGE>
INTERNATIONAL NETWORK SERVICES
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES
The Company
-----------
International Network Services (the "Company" or "INS") was incorporated in
California in August 1991. The Company is a global provider of enterprise
network professional services and software solutions. The Company provides
professional services for the full life cycle of a network, including
planning, design, implementation, operations and optimization, and maintains
expertise in the most complex network technologies and multi-vendor
environments. Through its INsoft Division, INS offers industry leading
software solutions for managing and optimizing application-ready networks.
The Company's core software solutions include EnterprisePRO, which was
introduced in June 1996, and VitalSuite, which was introduced in November
1997.
Significant accounting policies
-------------------------------
Basis of Presentation. The Company's fiscal year is composed of four 13-week
quarters, each of which ends on the last Sunday of the final fiscal month of
the quarter, with the fiscal year ending on the Sunday closest to June 30.
For financial statement presentation purposes, each fiscal year end is
titled June 30th. Certain prior year consolidated financial statement
balances have been reclassified to conform to the fiscal 1999 presentation.
Interim Results (Unaudited). The accompanying interim supplemental financial
statements as of September 30, 1998 and for the three months ended September
30, 1997 and 1998 are unaudited. In the opinion of management, the
unaudited interim supplemental financial statements have been prepared on
the same basis as the annual financial statements and reflect all
adjustments, which include only normal recurring adjustments, necessary to
present fairly the financial position of the Company as of September 30,
1998 and the results of its operations and its cash flows for the three
months ended September 30, 1997 and 1998. The financial data and other
information disclosed in the notes to the supplemental consolidated
financial statements related to these periods are unaudited. For purposes
of presentation, the Company has indicated the first three months of fiscal
1997 and 1998 as ending on September 30; whereas in fact, the Company's
fiscal quarters end on the Sunday nearest the end of the calendar quarter.
The results of operations for the three months ended September 30, 1998 are
not necessarily indicative of the results to be expected for the year ending
June 30, 1999, or any other future interim period, and the Company makes no
representations related thereto.
Principles of consolidation. The consolidated financial statements include
the accounts of the Company and its wholly-owned subsidiaries in the United
Kingdom and Canada. All intercompany accounts and transactions have been
eliminated.
Foreign currency translation. The functional currency of the Company's
wholly-owned foreign subsidiaries are the local currencies. Assets and
liabilities of these subsidiaries are translated into U.S. dollars at
exchange rates in effect at the balance sheet date. Income and expense items
are translated at average exchange rates for the period. Accumulated net
translation adjustments are recorded in shareholders' equity. Foreign
exchange transaction gains and losses were not material in all periods
presented and are included in the results of operations.
Cash equivalents and marketable securities. Cash equivalents consist of
highly liquid investments with original maturities of three months or less.
The Company's marketable securities are classified as available-for-sale
and, at the balance sheet date, are reported at fair market value which
approximates cost.
Property and equipment. Property and equipment are stated at cost.
Depreciation is computed using the straight-line method over the estimated
useful lives of the respective assets, ranging from two to five years.
<PAGE>
Revenue recognition. Services revenue consists primarily of revenues earned
from professional services. Professional services are generally performed on
a "time and expenses" basis and revenue is recognized as the services are
performed. The Company also performs a limited number of fixed-price
engagements under which revenue is recognized using the percentage-of-
completion method of accounting. Provision for estimated losses on such
engagements is made during the period in which the loss becomes probable and
can be reasonably estimated. To date, such losses have been insignificant.
The Company reports professional services revenue net of reimbursable
expenses, which are billed to and collected from clients. Services revenue
also includes software services revenue. Software services revenue
consists of all inclusive service contracts, which includes the right to
use software combined with installation, maintenance and support, as well
as services for installation, maintenance and support of software licenses
sold separately. Prior to fiscal 1998, the Company only offered its
EnterprisePRO solution as an all inclusive contract. Revenue from all
inclusive software service contracts is recognized ratably over the term
of the agreement. Services revenue related to installation is generally
recognized when the services are complete. Maintenance revenue
which consists of fees for providing updates and user documentation, and
support services, which provide access to INS' Technical Assistance Center
and field support staff, are recognized ratably over the term of the
agreement. Payments received in advance of services performed are recorded
as deferred revenue.
License revenue consists principally of revenue earned under software
license agreements and under royalty agreements with OEMs. License revenue
is generally recognized when a signed contract or other persuasive evidence
of an arrangement exists, the software has been shipped or electronically
delivered, the license fee is fixed or determinable, and collection of the
resulting receivable is probable. For contracts with multiple
elements/obligations (e.g. software products, upgrades/enhancements,
maintenance, and services), revenue is allocated to each element of the
arrangement based on the Company's objective evidence of the fair value as
determined by the amount charged when the element is sold separately.
Revenue from subscription license agreements, which include software,
rights to future products and maintenance, is recognized ratably over the
term of the subscription period. Revenue on shipments to resellers, which
is generally subject to certain rights of return and price protection, is
recognized when the products are sold by the resellers to the end-user
customer. Royalty revenues that are contingent upon sale to an end user by
OEMs are recognized upon receipt of a report by the Company from the OEM.
Effective in fiscal 1999, the Company adopted Statement of Position (SOP)
97-2, "Software Revenue Recognition." SOP 97-2 provides guidance on applying
generally accepted accounting principles in recognizing revenue on software
transactions and supercedes the previous guidance provided by SOP 91-1. The
adoption of SOP 97-2 did not have a material impact on the Company's
licensing practices or consolidated financial position or results of
operations.
Operating expenses
------------------
Professional personnel. Professional personnel expenses consist primarily of
compensation and benefits of the Company's employees engaged in the delivery
of professional services and software services.
Other costs. Other costs consist primarily of travel and entertainment,
certain recruiting and professional development expenses, field facilities,
depreciation, expensed equipment and supplies related to the delivery of
professional services and software services.
Cost of license revenue. Cost of license revenue consists primarily of the
cost of product components, product duplication, shipping and reproduction
of manuals.
Research and development. All research and development expenses, including
software development costs, are charged to expense as incurred. Statement of
Financial Accounting Standards No. 86 ("SFAS 86"), "Accounting for the Costs
of Computer Software to be Sold, Leased, or Otherwise Marketed," requires
the capitalization of certain software development costs once technological
feasibility is established, which the Company defines as the completion of a
working model. The capitalized costs are then amortized on a straight line
basis over the estimated product life, or based on the ratio of current
revenues to total projected product revenues, whichever is greater. To date,
costs incurred subsequent to achieving technological feasibility and prior
to the general commercial release of the software have not been significant.
Accordingly, the Company has not capitalized any software development costs.
<PAGE>
Income taxes
- ------------
The Company provides for income taxes using an asset and liability approach that
recognizes deferred tax assets and liabilities for expected future tax
consequences of temporary differences between the book and tax bases of assets
and liabilities.
Concentration of credit risk
- ----------------------------
The Company's financial instruments that are exposed to concentrations of credit
risk consist primarily of cash, cash equivalents, investments, and accounts
receivable. The Company's investments consist of investment grade securities
managed by qualified professional investment managers. The investment policy
limits the Company's exposure to concentration of credit risk. The Company's
accounts receivable is derived from revenue earned from customers primarily
located in the United States. The Company maintains an allowance for potential
credit losses based upon the expected collectibility of all accounts receivable;
historically, such losses have been immaterial. In fiscal 1996, one customer
accounted for 17% of revenue. In fiscal 1997 and 1998, no one customer accounted
for more than 10% of revenues.
Net income per share
- --------------------
Basic net income per share is computed by dividing net income available to
common shareholders (numerator) by the weighted average number of common shares
outstanding (denominator) during the period and excludes the dilutive effect of
stock options and Common Stock subject to repurchase. Diluted net income per
share gives effect to all dilutive potential common shares outstanding during a
period. In computing diluted net income per share, the average stock price for
the period is used in determining the number of shares to be purchased from the
exercise of stock options. All prior period net income per share data presented
has been restated in accordance with Statement of Financial Accounting Standards
No. 128 ("SFAS 128"), "Earnings per Share."
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share ("EPS") computations for all periods
presented (in thousands):
<TABLE>
<CAPTION>
Three Months Ended
Year Ended June 30, September 30,
-------------------------------- ------------------------
1996 1997 1998 1997 1998
---------- --------- --------- ---------- ------------
(Unaudited)
<S> <C> <C> <C> <C> <C>
Numerator:
Net income attributable to Common Stock.................... $ 1,742 $ 6,752 $14,404 $ 2,642 $ 5,941
========= ========= ========= ========= ==========
Denominator:
Weighted average shares.................................... 8,469 26,354 33,721 32,890 35,054
Effect of dilutive securities:
Common stock equivalents................................ 1,873 2,128 2,390 2,328 3,315
Common stock subject to repurchase...................... 1,897 2,595 1,956 2,191 1,697
Preferred Stock......................................... 16,735 3,486 - - -
--------- --------- --------- --------- ----------
Weighted average shares - assuming dilution................ 28,974 34,563 38,067 37,409 40,066
========= ========= ========= ========= ==========
Net income attributable to Common Stock per share............... $ 0.21 $ 0.26 $ 0.43 $ 0.08 $ 0.17
========= ========= ========= ========= ==========
Net income attributable to Common Stock per share -
assuming dilution............................................. $ 0.06 $ 0.20 $ 0.38 $ 0.07 $ 0.15
========= ========= ========= ========= ==========
</TABLE>
Antidilutive Options Options to purchase 30,593, 151,141 and 380,883 shares of
Common Stock were outstanding during fiscal 1996, 1997 and 1998, respectively,
but were not included in the computations of diluted EPS because the options'
exercise price was greater than the average market price of the common shares.
<PAGE>
Stock-based compensation
------------------------
The Company accounts for stock-based compensation using the intrinsic value
method prescribed by APB Opinion No. 25, "Accounting for Stock Issued to
Employees." The Company's policy is to grant options with an exercise price
equal to the quoted market price of the Company's stock on the grant date.
Accordingly, no compensation cost has been recognized in the Company's
consolidated statements of income except for a certain amount of deferred
compensation assumed by the Company through its acquisition of VitalSigns
Software, Inc. ("VitalSigns") (see Note 7). The Company has provided
additional pro forma disclosures as required under Statement of Financial
Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock-Based
Compensation" (see Note 7).
Management 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 reported amounts of assets and liabilities, the
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the
reporting period. Actual results could differ from those estimates.
Recently issued accounting pronouncements
-----------------------------------------
In June 1997, the FASB issued Statement of Financial Accounting Standards
No. 131 ("SFAS 131"), "Disclosures about Segments of an Enterprise and
Related Information," which establishes annual and interim reporting
standards for an enterprise's business segments and related disclosures
about its products, services, geographic areas and major customers. SFAS 131
will be first reflected in the Company's fiscal 1999 Annual Report and will
not impact the Company's consolidated financial position, results of
operations or cash flows.
In April 1998, the AICPA issued 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 is required to
adopt SOP 98-1 by July 1, 2000 and does not expect it to have a material
effect on the Company's consolidated financial position, results of
operations or cash flows.
2. ACQUISITION OF VITALSIGNS SOFTWARE, INC.
On November 20, 1998, the Company completed its acquisition of VitalSigns,
which has been accounted for as a pooling of interests, pursuant to the
terms of the Agreement and Plan of Reorganization, as amended and restated
as of October 30, 1998. Each issued and outstanding share of VitalSigns
Common Stock was converted into .3160826 shares of INS Common Stock; and
each outstanding option to acquire VitalSigns Common Stock was assumed by
INS and became an equivalent option with respect to INS Common Stock, on the
same terms of the original option adjusted to reflect the exchange ratio.
The Company issued approximately 3,955,000 shares of INS Common Stock in the
acquisition and assumed options that can be exercised for approximately
280,000 shares of INS Common Stock.
The supplemental consolidated financial statements give retroactive effect
to the acquisition. Generally accepted accounting principles proscribe
giving effect to a consummated business combination accounted for by the
pooling-of-interests method in financial statements that do not include the
date of consummation. These financial statements do not extend through the
date of consummation, however, they will become the historical consolidated
financial statements of the Company and its subsidiaries after financial
statements covering the date of consummation of the business combination are
issued.
<PAGE>
The results of operations previously reported by the separate companies and the
combined amounts in the accompanying supplemental consolidated financial
statements are summarized below (in thousands).
<TABLE>
<CAPTION>
Three months Ended
Year Ended June 30, September 30,
------------------------ --------------------
1997 1998 1997 1998
---------- ----------- --------- --------
(Unaudited)
<S> <C> <C> <C> <C>
Revenue:
INS........................................................... $99,275 $169,678 $33,714 $62,452
VitalSigns.................................................... 238 3,120 232 1,944
-------- --------- --------- --------
Combined...................................................... $99,513 $172,798 $33,946 $64,396
======== ========= ========= ========
Net income (loss) attributable to Common Stock:
INS........................................................... $ 7,612 $ 16,110 $ 3,056 $ 6,062
VitalSigns.................................................... (860) (1,706) (414) (121)
-------- --------- --------- --------
Combined...................................................... $ 6,752 $ 14,404 $ 2,642 $ 5,941
======== ========= ========= ========
</TABLE>
The Company estimates that it will incur approximately $6.8 million in
acquisition-related charges, principally in the three month period ending
December 31, 1998. These charges include direct transaction costs primarily
for financial advisory services, legal and consulting fees and costs
associated with combining the operations of the two companies.
Prior to the acquisition, VitalSigns' fiscal year ended on December 31. The
supplemental consolidated financial statements for the year ended June 30, 1998
reflect the results of operations of INS for the year ended June 30, 1998
combined with the results of operations of VitalSigns for the twelve months
ended June 30, 1998. The supplemental consolidated financial statements for the
year ended June 30, 1997 reflect the results of operations of INS for the year
ended June 30, 1997 combined with the results of operations of VitalSigns for
the period from August 15, 1996 (inception) through June 30, 1997. Since
VitalSigns' inception date occurred during INS' 1997 fiscal year, the
supplemental consolidated financial statements for the year ended June 30, 1996
are the same as INS' historical financial statements for the year ended June 30,
1996.
3. BALANCE SHEET COMPONENTS (in thousands)
<TABLE>
<CAPTION>
JUNE 30, SEPTEMBER 30,
----------------------
1998
1997 1998 (Unaudited)
-------------------------------------
<S> <C> <C> <C>
Accounts receivable:
Trade...................................... $24,694 $ 48,503 $ 57,925
Less allowances............................ (588) (1,468) (2,589)
-------------------------------------
$24,106 $ 47,035 $ 55,336
=====================================
Property and equipment:
Computer equipment and software............ $12,528 $ 15,885 $ 17,564
Furniture, fixtures, and other............. 2,606 5,664 6,841
-------------------------------------
15,134 21,549 24,405
Less accumulated depreciation.............. (6,832) (10,054) (11,175)
-------------------------------------
$ 8,302 $ 11,495 $ 13,230
=====================================
</TABLE>
<PAGE>
4. INVESTMENTS
The carrying value of the Company's investment portfolio approximates fair value
for all periods presented. Cash equivalents and investments consist of the
following (in thousands):
<TABLE>
<CAPTION>
JUNE 30, SEPTEMBER 30,
1998
----------------------------------
1997 1998 (unaudited)
--------------------------------------------------
<S> <C> <C> <C>
Money market fund............................. $ 850 $ 10,334 $ 7,657
Municipal bonds............................... 33,386 56,677 53,347
--------------------------------------------------
Total available-for-sale securities........... 34,236 67,011 61,004
Less amounts classified as cash equivalents... (12,921) (26,494) (20,757)
-------------------------------------------------
Total investments............................. $ 21,315 $ 40,517 $ 40,247
==================================================
</TABLE>
The contractual maturities of marketable securities at June 30, 1998, regardless
of their balance sheet classification, was as follows (in thousands):
<TABLE>
<CAPTION>
<S> <C>
Due in 1 year or less............................................... $25,369
Due in 1-2 years.................................................... 15,148
-------
Total investments................................................... $40,517
=======
</TABLE>
Gross realized gains and losses from the sale of securities classified as
available-for-sale were not material for the years ended June 30, 1996, 1997 and
1998. For the purpose of determining gross realized gains and losses, the cost
of securities is based upon specific identification.
At June 30, 1997, marketable securities totaling $12.9 million were classified
as cash equivalents and included money market funds of $850,000 and municipal
bonds of $12.0 million. At June 30, 1998, marketable securities totaling $26.5
million were classified as cash equivalents and included money market funds of
$10.3 million and municipal bonds of $16.2 million. At September 30, 1998,
marketable securities totaling $20.8 million were classified as cash equivalents
and included money market funds of $7.7 million and municipal bonds of $13.1
million.
5. MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK
Prior to the initial public offering in September 1996, the Company had
authorized 17,000,000 shares of Mandatorily Redeemable Convertible Preferred
Stock ("Preferred Stock"), of which 2,848,000, 6,849,000 and 7,037,967 shares
were designated as Series A, B and C, respectively. The Preferred Stock was
mandatorily redeemable anytime after May 19, 1998, at a per share price equal to
the original issue price plus a 10% accretion per year, compounded annually.
Accretion of Preferred Stock was $1.1 million and $270,000 in fiscal 1996 and
1997, respectively. All issued and outstanding shares of Preferred Stock were
converted into 16,734,889 shares of Common Stock upon the closing of the public
offering.
6. COMMON STOCK
Certain Common Stock option holders (see Note 7) have the right to exercise
unvested options, subject to a repurchase right held by the Company. At June 30,
1998, 549,992 of the shares issued on the exercise of options were subject to
repurchase by the Company at the original purchase price in the event of
employee termination.
<PAGE>
In September 1996, the Company completed its initial public offering of
2,875,000 shares of Common Stock at $16 per share, which resulted in net
proceeds to the Company of approximately $41.7 million.
During 1998, in conjunction with a services agreement with a client, the
Company received aggregate proceeds of approximately $3.2 million from the
client for a warrant to purchase up to 263,000 shares of Common Stock at
$29.59 per share. The warrant, which is exercisable immediately, expires on
May 1, 2005. The warrant was issued at fair market value.
In fiscal 1997 and fiscal 1999, VitalSigns issued convertible preferred
stock for gross proceeds of approximately $6.6 million and $6.5 million,
respectively. Each share of convertible preferred stock was convertible
into Common Stock on a one-for-one basis, subject to certain adjustments.
Just prior to consummation of the acquisition, all VitalSigns' convertible
preferred stock was converted into VitalSigns Common Stock. Such amounts
have been included in the accompanying supplemental financial statements as
if 3,022,231 and 251,920 shares of INS Common Stock were issued during
fiscal 1997 and 1999, respectively.
At June 30, 1998, the Company had reserved 263,000, 565,276, and 9,895,802
shares of Common Stock for future issuance related to a warrant, its stock
purchase plan and its stock option plans, respectively.
Notes receivable from shareholders
----------------------------------
In exchange for the issuance of Common Stock upon exercise of options, the
Company has from time to time received notes receivable from shareholders
which bear interest at rates varying from 5.33% to 7.0% per annum. Principal
and interest are due and payable at different dates between 1998 and 1999.
The outstanding balance of such notes receivable has been included in
shareholders' equity.
Deferred compensation
---------------------
As of June 30, 1998, the Company has recorded approximately $1.5 million of
deferred compensation for the difference between the exercise or purchase
price and deemed fair value of certain stock options and shares of
restricted stock granted or issued to employees and consultants. This amount
is being amortized by charges to operations over the vesting period of
individual options and restricted shares, ranging from two to four years.
7. EMPLOYEE BENEFIT PLAN
Stock option plan
-----------------
On July 18, 1996, the Company's Board of Directors adopted the 1996 Stock
Option Plan (the "1996 Plan") as a successor to its 1992 Stock Option Plan
(the "1992 Plan"). In addition to the 8,000,000 shares of Common Stock
authorized for issuance under the 1992 Plan, the Board of Directors
authorized an additional 5,500,000 shares for issuance under the 1996 Plan.
As of July 18, 1996, no further option grants or stock issuances were made
under the 1992 Plan, and all option grants and stock issuances made during
the remainder of fiscal 1997 were made under the 1996 Plan. All outstanding
options under the 1992 Plan were incorporated into the 1996 Plan. The 1996
Plan provides for granting to employees (including officers and directors)
incentive stock options and for the granting to employees, directors
(including non-employee directors) and consultants nonstatutory stock
options and stock purchase rights.
On April 24, 1998, the Company's Board of Directors adopted the 1998
Nonstatutory Stock Option Plan (the "1998 Plan") and authorized 2,000,000
shares for issuance under this plan. The 1998 Plan provides for granting
nonstatutory stock options to employees and consultants, excluding officers
and directors.
The Company assumed certain options granted to former employees of
VitalSigns ("Acquired Options"). The Acquired Options have been adjusted to
effectuate the conversion under the terms of the Agreement and Plan of
Reorganization between the Company and VitalSigns. The Acquired Options
generally become exercisable over a four year period and generally expire
ten years from the date of grant. No additional options will be granted
under the VitalSigns' plan.
<PAGE>
Incentive stock options must be granted at fair market value at the date of
grant, and nonstatutory stock options and stock appreciation rights may be
granted at not less than 85% of fair market value on the date of grant. Options
generally vest 24% on the first anniversary from the date of grant, and ratably
each month over the remaining thirty-eight months. Options expire over terms not
exceeding ten years from the date of grant.
On April 25, 1997, the Board of Directors approved a plan to offer all
employees, excluding Executive Officers, the opportunity to exchange their
outstanding stock options with exercise prices greater than $23.00 per share for
new options that would be exercisable at the fair market value of the Company's
Common Stock as of the closing of the stock market on May 5, 1997 ($19.75).
These new options were otherwise identical to the old options.
A summary of the status of all of the Company's stock option plans as of and
during the years ended June 30, 1996, 1997, and 1998 follows:
<TABLE>
<CAPTION>
1996 1997 1998
------------------------- ------------------------- ---------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
OPTION EXERCISE OPTION EXERCISE OPTION EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
---------- ----------- ---------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning
of year................................... 2,676,975 $ 0.06 2,169,460 $ 1.41 3,618,221 $ 8.57
Granted............................. 3,486,350 1.64 2,998,773 16.11 5,320,618 22.09
Exercised........................... (3,016,445) 0.65 (653,744 0.41 (1,204,469) 1.71
Canceled............................ (977,420) 0.61 (896,268 22.44 (569,516) 16.42
---------- ----------- ---------- ---------- ---------- ----------
Outstanding at end of year.................. 2,169,460 $ 1.41 3,618,221 $ 8.57 7,164,854 $ 19.13
========== =========== ========== ========== ========== ==========
Options exercisable at year end............. 720,910 $ 0.04 1,122,518 $ 1.14 1,351,057 $ 6.80
========== =========== ========== ========== ========== ==========
</TABLE>
The following table summarizes information about stock options outstanding and
exercisable at June 30, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------------------------- -------------------------------------------
WEIGHTED
RANGE OF SHARES AVERAGE WEIGHTED SHARES EXERCISABLE WEIGHTED
EXERCISE PRICE OUTSTANDING AT REMAINING AVERAGE EXERCISE AT JUNE 30, 1998 AVERAGE EXERCISE
JUNE 30, 1998 CONTRACTUAL LIFE PRICE PRICE
----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$ 0.01 to $0.08 165,397 6 years $ 0.07 129,907 $ 0.07
$ 0.25 to $1.50 663,960 8 years $ 0.73 511,666 $ 0.68
$ 2.50 to $8.00 538,512 8 years $ 5.70 278,160 $ 5.30
$12.00 to $17.75 1,017,533 8 years $15.02 227,959 $13.96
$19.75 to $23.63 2,631,612 9 years $21.07 201,055 $20.44
$26.44 to $34.00 2,147,840 10 years $29.24 2,310 $27.23
----------------------------------------------------------------------------------------------------------------------------
$ 0.01 to $34.00 7,164,854 10 years $19.13 1,351,057 $ 6.80
===========================================================================================================================
</TABLE>
Employee stock purchase plan
- ----------------------------
On July 18, 1996, the Company's Board of Directors adopted an Employee Stock
Purchase Plan (the "Purchase Plan"), which was approved by shareholders in
September 1996. Under the Purchase Plan, eligible employees can have up to 15%
of their earnings withheld through payroll deductions for the purchase of shares
of Common Stock at 85% of the lower of the fair market value of the Common Stock
on the commencement date of each offering period or the specified purchase date.
Each offering period is divided into four consecutive semi-annual purchase
periods. The initial offering period commenced on the effectiveness of the
Company's initial public offering in September 1996. A total of 1,200,000 shares
of Common Stock have been reserved for issuance under the Purchase Plan. There
were 215,537 and 419,367 shares issued under the Purchase Plan in fiscal 1997
and 1998, respectively.
<PAGE>
Stock-based compensation
- ------------------------
At June 30, 1998, the Company has four stock-based compensation plans, as
described above. The Company has elected to continue to apply APB Opinion 25 and
related Interpretations in accounting for its plans (see Note 1). Accordingly,
no compensation cost has been recognized for the option plans or Purchase Plan.
Pro forma information regarding net income and earnings per share is required by
SFAS 123 for awards granted after June 30, 1994, as if the Company had accounted
for its stock-based awards to employees under the fair value method of SFAS 123.
The fair value of the Company's stock-based awards to employees was estimated
using a Black-Scholes option pricing model. The Black-Scholes option valuation
model was developed for use in estimating the fair value of traded options that
have no vesting restrictions and are fully transferable. The Black-Scholes model
requires the input of highly subjective assumptions including the expected stock
price volatility. Because the Company's stock-based awards to employees have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its stock-
based awards to employees. The fair value of the Company's stock-based awards to
employees was estimated assuming no expected dividends and the following
weighted-average assumptions:
<TABLE>
<CAPTION>
OPTIONS PURCHASE PLAN
------- --------------
1996 1997 1998 1997 1998
--------------------------------------------------
<S> <C> <C> <C> <C> <C>
Expected life (years).................. 4.50 4.50 4.50 0.50 0.50
Expected volatility.................... 55% 55% 55% 75% 70%
Risk-free interest rate................ 5.92% 6.32% 5.47% 5.82% 5.23%
Dividend yield......................... -- -- -- -- --
</TABLE>
The weighted average estimated fair value of options granted under all option
plans during 1996, 1997 and 1998 was $0.81, $6.90, and $11.19 respectively. The
weighted average estimated fair value of purchase rights granted under the
Purchase Plan during 1997 and 1998 was $7.65 and $7.94, respectively. For pro
forma purposes, the estimated fair value of the Company's stock-based awards to
employees is generally amortized over the options' vesting period (for options)
and the six-month purchase period (for stock purchases under the Purchase Plan).
The Company's pro forma information follows (in thousands, except per share
data):
<TABLE>
<CAPTION>
YEAR ENDED JUNE 30,
------------------------------
1996 1997 1998
------------------------------
<S> <C> <C> <C> <C>
Net income (loss) attributable to Common Stock............... As reported $1,742 $ 6,752 $14,404
Pro forma $1,580 $(1,799) $ 702
Basic income (loss) per share................................ As reported $ 0.21 $ 0.26 $ 0.43
Pro Forma $ 0.19 $ (0.07) $ 0.02
Diluted income (loss) per share.............................. As reported $ 0.06 $ 0.20 $ 0.38
Pro forma $ 0.05 $ (0.07) $ 0.02
</TABLE>
The above pro forma disclosures are not likely to be representative of
pro forma disclosures of future years.
8. COMPREHENSIVE INCOME
In 1997, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income,"
which was adopted by the Company in the first quarter of 1999. SFAS No. 130
requires companies to report a new, additional measure of income on the income
statement or to create a new financial statement that has the new measure of
income on it. "Comprehensive income" includes foreign currency translation gains
and losses and other unrealized gains and losses that have been previously
excluded from net income and reflected instead in equity. The components of
comprehensive income, which are excluded from net income, are not significant
individually or in the aggregate, and therefore, no separate statement of
comprehensive income has been presented.
<PAGE>
9. INCOME TAXES
The provision for income taxes for the years ended June 30, 1996, 1997 and
1998 consists of the following (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED JUNE 30,
-----------------------------------------------------
1996 1997 1998
-----------------------------------------------------
<S> <C> <C> <C>
Current:
Federal.......................................... $1,940 $ 4,705 $ 9,442
State............................................ 757 1,266 2,249
Foreign.......................................... -- 165 231
-----------------------------------------------------
2,697 6,136 11,922
-----------------------------------------------------
Deferred:
Federal........................................... (757) (1,443) (2,027)
State............................................. (100) (204) (292)
-----------------------------------------------------
(857) (1,647) (2,319)
-----------------------------------------------------
$1,840 $ 4,489 $ 9,603
=====================================================
</TABLE>
The provision for income taxes differs from the amount determined by applying
the U.S. statutory income tax rate to income before income taxes as summarized
below (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED JUNE 30,
---------------------------------------------------
1996 1997 1998
---------------------------------------------------
<S> <C> <C> <C>
Tax provision at statutory rate.......................... $1,604 $4,029 $8,402
State income taxes, net of federal benefit............... 370 690 1,462
Change in valuation allowance............................ (309) -- --
Tax exempt interest...................................... -- (271) (528)
Nondeductible expenses................................... 98 83 235
Other.................................................... 77 (42) 32
--------------------------------------------------
$1,840 $4,489 $9,603
==================================================
</TABLE>
Deferred income taxes reflect the tax effects of temporary differences between
carrying amounts of assets and liabilities for financial reporting and income
tax purposes. The Company provides a valuation allowance for deferred tax assets
when it is more likely than not, based on available evidence, that some portion
or all of the deferred tax assets will not be realized. Based on a reevaluation
of the realizability of future tax benefits based on income earned in fiscal
1996, creating available tax carrybacks, the Company reversed the previously
established valuation allowance during fiscal 1996. Significant components of
the Company's deferred tax assets are as follows (in thousands):
<TABLE>
<CAPTION>
JUNE 30,
-------------------------
1997 1998
-------------------------
<S> <C> <C>
Depreciation...................................... $ 964 $1,071
Net operating loss................................ 551 --
State income taxes................................ 201 325
Allowance for doubtful accounts................... 225 594
Reserves and other accruals....................... 563 1,225
Deferred revenue.................................. -- 1,612
----------------------
$2,504 $4,829
======================
</TABLE>
<PAGE>
10. COMMITMENTS AND CONTINGENCIES
The Company leases office space for its corporate headquarters and various field
offices and certain computer equipment. Future annual minimum lease payments
under all noncancellable operating leases as of June 30, 1998 are as follows (in
thousands):
<TABLE>
<CAPTION>
FISCAL YEAR
<S> <C>
1999 $ 5,239
2000 4,203
2001 2,863
2002 1,683
2003 867
Thereafter 1,379
----------
$ 16,234
==========
</TABLE>
Total rent expense for the years ended June 30, 1996, 1997 and 1998 was
approximately $545,000, $1.4 million, and $3.2 million respectively.
During 1998, the Company entered into an agreement with a client under which the
Company is required to pay royalties to the client, if and when revenue from
specified services exceeds a predetermined base of revenue for those services.
No royalties have been recorded under this agreement in fiscal 1998.
11. LINES OF CREDIT
The Company had a $10 million line of credit with a bank which expired in August
1998. Borrowings under the line of credit bore interest at the bank's prime rate
(8.5% at June 30, 1998). There were no borrowings under the line of credit at
June 30, 1998. The line of credit was secured by substantially all of the
Company's assets and required the Company to comply with certain financial
covenants. At June 30, 1998, the Company was in compliance with these financial
covenants.
In August 1998, the Company entered into an unsecured revolving line of credit
agreement with another bank which provides for borrowings up to $10 million.
Borrowings under the revolving line of credit bear interest at the bank's prime
rate less 1/2%, or the Company has the option to borrow at a fixed rate at 1
1/2% above the bank's LIBOR for a fixed term of up to three months. Balances
outstanding at February 14, 2000 that have been used to fund capital equipment
may be converted to a 3-year term loan which provides for the same interest rate
options. The line of credit expires in February 2000 and requires the Company to
comply with certain financial covenants.
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
International Network Services ("INS" or "the Company") is a global
provider of enterprise network professional services and software solutions. The
Company provides professional services for the full life cycle of a network,
including planning, design, implementation, operations and optimization, and
maintains expertise in the most complex network technologies and multi-vendor
environments. Through its INsoft division, INS offers industry leading software
products and software services for managing and optimizing application-ready
networks. The Company's core software solutions include EnterprisePRO, which was
introduced in June 1996, and VitalSuite, which was introduced in November 1997.
Services revenue consists primarily of revenues earned from professional
services. Professional services are generally performed on a "time and expenses"
basis and revenue is recognized as the services are performed. The Company also
performs a limited number of fixed-price engagements under which revenue is
recognized using the percentage-of-completion method of accounting. Provision
for estimated losses on such engagements is made during the period in which the
loss becomes probable and can be reasonably estimated. To date, such losses have
been insignificant. The Company reports professional services revenue net of
reimbursable expenses, which are billed to and collected from clients. Services
revenue also includes software services revenue. Software services revenue
consists of all inclusive service contracts, which include the right to use
software combined with installation, maintenance and support, as well as
services for installation, maintenance and support of software licenses sold
separately. Prior to fiscal 1998, the Company only offered its EnterprisePRO
solution as an all inclusive contract. Revenue from all inclusive software
service contracts is recognized ratably over the term of the agreement.
Service revenue related to installation is generally recognized when the
services are complete. Maintenance revenue, which consists of fees for providing
updates and user documentation, and support services, which provide access to
INS' Technical Assistance Center and field support staff, are recognized ratably
over the term of the agreement. Payments received in advance of services
performed are recorded as deferred revenue.
License revenue consists principally of revenue earned under software license
agreements and under royalty agreements with OEMs. License revenue is generally
recognized when a signed contract or other persuasive evidence of an arrangement
exists, the software has been shipped or electronically delivered, the license
fee is fixed or determinable, and collection of the resulting receivable is
probable. For contracts with multiple elements/obligations (e.g. software
products, upgrades/enhancements, maintenance, and services), revenue is
allocated to each element of the arrangement based on the Company's objective
evidence of the fair value as determined by the amount charged when the
element is sold separately. Revenue from subscription license agreements,
which include software, rights to future products and maintenance, is
recognized ratably over the term of the subscription period. Revenue on
shipments to distributors and retailers, which is generally subject to certain
rights of return and price protection, is recognized when the products are
sold by the distributor or retailer to the end-user customer. Royalty revenues
that are contingent upon sale to an end user by OEMs are recognized upon
receipt of a report by the Company from the OEM.
On November 20, 1998, the Company completed its acquisition of VitalSigns
Software, Inc. ("VitalSigns"), which has been accounted for as a pooling of
interests, pursuant to the terms of the Agreement and Plan of Reorganization, as
amended and restated as of October 30, 1998. The supplemental consolidated
financial statements give retroactive effect to the VitalSigns acquisition.
Prior to the acquisition, VitalSigns' fiscal year ended on December 31. The
supplemental consolidated financial statements for the year ended June 30, 1998
reflect the results of operations of INS for the year ended June 30, 1998
combined with the results of operations of VitalSigns for the twelve months
ended June 30, 1998. The supplemental consolidated financial statements for the
year ended June 30, 1997 reflect the results of operations of INS for the year
ended June 30, 1997 combined with the results of operations of VitalSigns for
the period from August 15, 1996 (inception) through June 30, 1997. Since
VitalSigns' inception date occurred during INS' 1997 fiscal year, the
supplemental consolidated financial statements for the year ended June 30, 1996
are the same as INS' historical financial statements for the year ended June 30,
1996.
The following discussion contains forward looking statements within the
meaning of Section 27A of
<PAGE>
the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Predictions of future events are inherently
uncertain. Actual events could differ materially from those predicted in the
forward looking statements as a result of the risks set forth in the following
discussion, and in particular, the risks discussed below under the caption "Risk
Factors that May Affect Operating Results."
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
financial data as a percent of revenue:
<TABLE>
<CAPTION>
Three Months Ended
Year Ended June 30, September 30,
---------------------------- ----------------------------
1996 1997 1998 1997 1998
------- ------ ------ --------- ----------
Revenue: (Unaudited)
<S> <C> <C> <C> <C> <C>
Services.......................................... 100.0% 99.8% 95.7% 98.7% 94.1%
License........................................... 0.0 0.2 4.3 1.3 5.9
----- ----- ----- ----- -----
Total revenue................................. 100.0 100.0 100.0 100.0 100.0
----- ----- ----- ----- -----
Operating expenses:
Professional personnel............................ 45.1 45.0 43.7 45.2 41.5
Other costs....................................... 12.6 13.4 14.3 14.4 14.0
Cost of license revenue........................... 0.0 0.0 0.2 0.1 0.1
Research and development.......................... 2.0 2.3 2.4 2.2 2.0
Sales and marketing............................... 18.1 15.1 15.3 14.4 16.1
General and administrative........................ 11.5 13.8 11.4 11.9 12.0
----- ----- ----- ----- -----
Total operating expenses...................... 89.3 89.6 87.3 88.2 85.7
----- ----- ----- ----- -----
Income from operations............................... 10.7 10.4 12.7 11.8 14.3
Interest and other, net.............................. 0.0 1.1 1.2 1.2 1.1
----- ----- ----- ----- -----
Income before provision for income taxes............. 10.7 11.6 13.9 13.0 15.4
Provision for income taxes........................... 4.2 4.5 5.6 5.2 6.2
----- ----- ----- ----- -----
Net income........................................... 6.5% 7.1% 8.3% 7.8% 9.2%
===== ===== ===== ===== =====
</TABLE>
COMPARISON OF FISCAL 1996, 1997, AND 1998
REVENUE
Total Revenue. The Company's total revenue was $44.1 million, $99.5 million
-------------
and $172.8 million in fiscal 1996, 1997 and 1998 representing increases over the
prior fiscal year of 183.6%, 125.7% and 73.6%, respectively. The Company does
not believe that this rate of growth is sustainable over the long term.
Services. The substantial majority of the Company's services revenue is
--------
derived from fees for professional services. The Company also derives revenue
from software services. Software services revenue consists of all inclusive
service contracts, which include the right to use software combined with
installation, maintenance and support, as well as services for installation,
maintenance and support of software licenses sold separately. Services revenue
was $44.1 million, $99.3 million, $165.3 million in fiscal 1996, 1997, and
1998, representing increases over the prior fiscal year of 183.6%, 125.2%,
66.5%, respectively. Services revenue accounted for 100.0%, 99.8% and 95.7% of
total revenue in fiscal 1996, 1997 and 1998, respectively. Services revenue
increased primarily due to an increase in the number and size of professional
service projects and secondarily due to an increase in average billing rates,
and increases in software services.
License. License revenue consists principally of revenue earned under
-------
software license agreements and under royalty agreements with OEMs. License
revenue was $238,000 and $7.5 million in fiscal 1997 and 1998, respectively.
License revenue was 0.2% and 4.3% of total revenue in fiscal 1997 and 1998,
respectively. The increase in license revenues resulted from increased sales to
new customers and sales to existing customers for new products.
One client accounted for approximately 17.0% of total revenue in fiscal
1996. No one client accounted for more than 10% of total revenue in fiscal 1997
or 1998.
<PAGE>
OPERATING EXPENSES
Professional Personnel. Professional personnel expenses consist primarily
----------------------
of compensation and benefits of the Company's employees engaged in the delivery
of professional services and software services. Professional personnel expenses
were $19.9 million, $44.8 million and $75.6 million in fiscal 1996, 1997 and
1998, respectively, representing increases over the prior fiscal year of 198.9%,
125.3% and 68.6%, respectively. These increases were due primarily to an
increase in the number of employees. The number of employees included in
professional personnel was 344, 651 and 1,053 at the end of fiscal 1996, 1997
and 1998, respectively. Professional personnel expenses were 45.1%, 45.0% and
43.7% of total revenue in fiscal 1996, 1997 and 1998, respectively. Professional
personnel expenses were lower as a percent of total revenue in fiscal 1998 than
fiscal 1996 and 1997 due primarily to an increase in billing rates for
professional services, and to a lesser extent, an increase in license revenue as
a percent of sales.
Other Costs. Other costs consist primarily of travel and entertainment,
-----------
certain recruiting and professional development expenses, field facilities,
depreciation, expensed equipment and supplies related to the delivery of
professional services and software services. Other costs were $5.6 million,
$13.3 million and $24.6 million in fiscal 1996, 1997 and 1998, respectively,
representing increases over the prior fiscal year of 150.6%, 139.1% and 85.1%,
respectively. The increases were primarily due to an increase in the number of
employees and, to a lesser extent, to the costs of field offices. Other costs
were 12.6%, 13.4%, and 14.3% of total revenue in fiscal 1996, 1997 and 1998,
respectively. Other costs, as a percent of total revenue, increased primarily
due to increases in recruiting, professional development and travel and
entertainment expenses.
Cost of License Revenue. Cost of license revenue consists primarily of the
-----------------------
cost of product components, product duplication, shipping and reproduction of
manuals. Cost of license revenue was $25,000 and $402,000 in fiscal 1997 and
1998, respectively. Cost of license revenues was less than 0.01% of total
revenue in fiscal 1997 and 0.2% of total revenue in 1998. The increase was due
primarily to an increase in the number of software licenses shipped. Cost of
license revenue was 10.5% and 5.4% of license fee revenue in fiscal 1997 and
1998, respectively. The decrease in cost of license revenue as a percent of
license revenue was due primarily to an increase in sales compared to
increases in fixed costs.
Research and Development. All research and development expenses, including
------------------------
software development costs, are charged to expense as incurred. Statement of
Financial Accounting Standards No. 86 ("SFAS 86"), "Accounting for the Costs of
Computer Software to be Sold, Leased, or Otherwise Marketed," requires the
capitalization of certain software development costs once technological
feasibility is established, which the Company defines as the completion of a
working model. The capitalized costs are then amortized on a straight line basis
over the estimated product life, or based on the ratio of current revenues to
total projected product revenues, whichever is greater. To date, costs incurred
subsequent to achieving technological feasibility and prior to the general
commercial release of the software have not been significant. Accordingly, the
Company has not capitalized any software development costs. Research and
development expenses were $879,000, $2.3 million, and $4.2 million in fiscal
1996, 1997 and 1998, respectively. Research and development expenses were 2.0%,
2.3%, and 2.4% of total revenue in fiscal 1996, 1997 and 1998, respectively.
These increases were primarily a result of increased headcount to support the
development of, and enhancements to, software solutions.
Sales and Marketing. Sales and marketing expenses consist primarily of
-------------------
compensation, including commissions and benefits of sales and marketing
personnel as well as outside marketing expenses. Sales and marketing expenses
were $8.0 million, $15.0 million and $26.4 million in fiscal 1996, 1997 and
1998, respectively, representing increases over the prior fiscal year of 107.9%,
87.5% and 76.1%, respectively. The increase in each year was due primarily to
the growth in the number of sales and marketing employees and to commissions
resulting from increased revenue. Sales and marketing expenses were 18.1%, 15.1%
and 15.3% of total revenue in fiscal 1996, 1997 and 1998, respectively. The
decrease from fiscal 1996 to fiscal 1997 on a percentage basis was due primarily
to leverage of the field management organization and changes in compensation
plans.
General and Administrative. General and administrative expenses consist of
--------------------------
expenses associated with executive staff, finance, corporate facilities,
information services and human resources. General and administrative expenses
were $5.1 million, $13.7 million and $19.7 million in fiscal 1996, 1997 and
1998, respectively, representing increases over the prior fiscal year of 167.1%,
171.6% and 43.9%, respectively. The dollar increase reflects an increase in the
number of employees necessary to support the Company's growth in operations.
General and administrative expenses were 11.5%, 13.8% and 11.4% of total revenue
in fiscal 1996, 1997 and 1998, respectively. The increase from fiscal 1996 to
fiscal 1997 on a percentage basis was due
<PAGE>
primarily to increased headcount and facilities to support the growth in
operations. The decrease from fiscal 1997 to fiscal 1998 on a percentage basis
was due primarily to an increase in revenue.
INTEREST AND OTHER, NET
Interest and other, net consists of interest income and expense. Interest
and other, net were $3,000, $1.1 million, and $2.1 million in fiscal 1996, 1997
and 1998, respectively. Interest income consists primarily of interest on cash,
cash equivalents, investments and notes receivable from shareholders. Interest
expense consists of interest associated with bank borrowings. Interest expense
was $108,000, $87,000 and $22,000, in fiscal 1996, 1997 and 1998, respectively.
The increase in fiscal 1997 to $1.1 million or 1.1% of total revenue compared to
$3,000 or less than 0.1% of revenue in fiscal 1996 was due primarily to
increases in funds available for investment and the repayment of debt as a
result of the Company completing its initial public offering in September 1996.
The increase in fiscal 1998 to $2.1 million was due primarily to an increase in
funds available for investment.
PROVISION FOR INCOME TAXES
The Company provides for income taxes using an asset and liability approach
that recognizes deferred tax assets and liabilities for expected future tax
consequences of temporary differences between the book and tax bases of assets
and liabilities. The effective tax rates for fiscal 1996, 1997 and 1998 were
39%, 39% and 40%, respectively. The Company's effective tax rates approximated
the combined federal and state statutory rates, net of federal benefits.
COMPARISON OF THREE MONTHS ENDED SEPTEMBER 30, 1997 AND 1998 (UNAUDITED)
REVENUE
Total Revenue. The Company's total revenue was $33.9 million and $64.4
-------------
million for the three-month periods ended September 30, 1997 and 1998,
respectively, representing an increase of 89.7%. The Company does not believe
that this rate of growth is sustainable over the long term.
Services. The substantial majority of the Company's services revenue is
--------
derived from fees for professional services. The Company also derives revenue
from software services. Software services revenue consists of all inclusive
service contracts, which include the right to use software combined with
installation, maintenance and support, as well as services for installation,
maintenance and support of software licenses sold separately and included in
license fees. Services revenue was $33.5 million and $60.6 million for the
three-month periods ended September 30, 1997 and 1998, respectively,
representing an increase of 80.7%. Services revenue increased primarily due to
an increase in the number and size of professional service projects and, to a
lesser extent, an increase in average billing rates and increases in software
services.
License. License revenue consists principally of revenue earned under
-------
software license agreements and under royalty agreements with OEMs. License
revenue was $428,000 and $3.8 million for the three-month periods ended
September 30, 1997 and 1998, respectively, representing an increase of 793.7%.
The increase in license revenue resulted from increased sales to new customers
and additional sales to existing customers for new products and upgrades of
existing licenses.
No one client accounted for more than 10% of the Company's revenue for the
three-month period ended September 30, 1997. One client accounted for 12% of the
Company's revenue for the three-month period ended September 30, 1998.
OPERATING EXPENSES
Professional Personnel. Professional personnel expenses consist primarily
----------------------
of compensation and benefits of the Company's employees engaged in the delivery
of professional services and software services. Professional personnel expenses
were $15.4 million and $26.8 million for the three-month periods ended
<PAGE>
September 30, 1997 and 1998, respectively. The increase was due primarily to an
increase in the number of employees. Professional personnel expenses were 45.2%
and 41.5% of total revenue for the three-month periods ended September 30, 1997
and 1998, respectively. Professional personnel expenses were lower as a percent
of revenue due primarily to an increase in billing rates for professional
services and, to a lesser extent, an increase in license revenue as a percent of
total revenue.
Other Costs. Other costs consist primarily of travel and entertainment,
-----------
certain recruiting and professional development expenses, field facilities,
depreciation, expensed equipment and supplies related to the delivery of
professional services and software services. Other costs were $4.9 million and
$9.0 million for the three-month periods ended September 30, 1997 and 1998,
respectively. The increase was due to the increase in the number of professional
personnel employed and to a lesser extent, the costs of field offices
established. Other costs were 14.4% and 14.0% of total revenue for the three-
month periods ended September 30, 1997 and 1998, respectively.
Cost of License Revenue. Cost of license revenue consists primarily of
-----------------------
the cost of product components, product duplication, shipping and reproduction
of manuals. Cost of license revenue was $31,000 and $70,000 for the three-month
periods ended September 30, 1997 and 1998, respectively. The increase was due
primarily to an increase in the number of software licenses shipped. Cost of
license revenue was 7.2% and 1.8% of license revenue for the three month periods
ended September 30, 1997 and 1998, respectively. The decrease in cost of license
revenue as a percent of license revenue was due primarily to an increase in
sales compared to increases in fixed costs.
Research and Development. All research and development expenses, including
------------------------
software development costs, are charged to expense as incurred. Statement of
Financial Accounting Standards No. 86 ("SFAS 86"), "Accounting for the Costs of
Computer Software to be Sold, Leased, or Otherwise Marketed," requires the
capitalization of certain software development costs once technological
feasibility is established, which the Company defines as the completion of a
working model. The capitalized costs are then amortized on a straight line basis
over the estimated product life, or based on the ratio of current revenues to
total projected product revenues, whichever is greater. To date, costs incurred
subsequent to achieving technological feasibility and prior to the general
commercial release of the software have not been significant. Accordingly, the
Company has not capitalized any software development costs. Research and
development expenses were $756,000 and $1.3 million for the three-month periods
ended September 30, 1997 and 1998, respectively. The increase was a result of
increased headcount to support the development of, and enhancements to, software
products. Research and development expenses were 2.2% and 2.0% of total revenue
for the three-month periods ended September 30, 1997 and 1998, respectively.
Sales and Marketing. Sales and marketing expenses consist primarily of
-------------------
compensation, including commissions and benefits of sales and marketing
personnel as well as outside marketing expenses. Sales and marketing expenses
were $4.9 million and $10.4 million for the three-month periods ended September
30, 1997 and 1998, respectively. These increases were due primarily to the
growth in the number of sales and marketing employees and a significant increase
in marketing spending, primarily for advertising. Sales and marketing expenses
were 14.4% and 16.1% of total revenue for the three-month periods ended
September 30, 1997 and 1998, respectively. The increase as a percent of revenue
was primarily due to increased marketing programs.
General and Administrative. General and administrative expenses consist of
--------------------------
expenses associated with executive staff, finance, corporate facilities,
information services and human resources. General and administrative expenses
were $4.0 million and $7.7 million for the three-month periods ended September
30, 1997 and 1998, respectively. General and administrative expenses have
increased as the Company has continued to add personnel to support the Company's
growth in operations. General and administrative expenses were 11.9% and 12.0%
of total revenue for the three-month periods ended September 30, 1997 and 1998,
respectively.
INTEREST AND OTHER, NET
Net interest income was $409,000 and $690,000 for the three-month periods
ended September 30, 1997 and 1998, respectively. The increase in net interest
income reflects higher average investment balances.
PROVISION FOR INCOME TAXES
<PAGE>
Income tax expense represents combined federal and state taxes at an
effective rate of 40% for the three months ended September 30, 1997 and 1998.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, the Company has financed its operations primarily through
a combination of cash generated from operations, the sale of equity and debt
securities and bank borrowings. In September 1996, the Company completed its
initial public offering of 2,875,000 shares of Common Stock at $16 per share,
which resulted in net proceeds to the Company of approximately $41.7 million.
During fiscal 1997 and 1999, VitalSigns issued convertible preferred stock for
gross proceeds of approximately $6.6 million and $6.5 million, respectively.
Such amounts have been included in the accompanying supplemental financial
statements as if 3,022,231 and 251,920 shares of INS Common Stock were issued
during fiscal 1997 and 1999, respectively. At September 30, 1998, the Company
had $77.8 million in cash, cash equivalents and investments, representing an
increase of $4.8 million from June 30, 1998.
Net cash provided by operating activities was $347,000, $3.3 million and
$24.4 million in fiscal 1996, 1997 and 1998, respectively. The increase in
cash provided by operations each year primarily reflects the Company's
increased profitability offset by increases in accounts receivable. Although
the Company believes its collections experience is within industry standards,
the Company's inability to collect for its services on a timely basis in the
future could have a material adverse effect on the Company's business,
operating results and financial condition. In fiscal 1998, cash provided by
operating activities also resulted from prepayments for services and software
resulting in an increase in deferred revenue of $16.4 million. Net cash used
in investing activities was $4.4 million, $29.3 million and $28.3 million in
fiscal 1996, 1997 and 1998, respectively. Cash used in investing activities in
fiscal 1996 reflected purchases of equipment and software. Cash used in
investing activities in fiscal 1997 and 1998 primarily reflected net
investment activity and, to a lesser extent, purchases of computer equipment
and software. Net cash provided by financing activities in fiscal 1996 of
$760,000 primarily reflected borrowings under the Company's credit facility,
which were principally offset by repayments on long-term debt. Net cash
provided by financing activities in fiscal 1997 and 1998 of $49.7 million and
$11.9 million, respectively, primarily resulted from the issuance of Common
Stock and a warrant to purchase Common Stock.
Net cash provided by operating activities was $260,000 and $335,000 for
the three month periods ended September 30, 1997 and 1998, respectively. The
increase in cash provided by operating activities primarily reflects the
Company's increased profitability offset by increases in accounts receivables
and timing of payments. Net cash used in investing activities was $7.2 million
and $2.8 million for the three month periods ended September 30, 1997 and
1998, respectively. Net cash used in investing activities primarily reflects
changes in net investment activity which were offset by increases in purchases
of computer equipment and software. Net cash provided by financing activities
was $647,000 and $7.6 million for the three month periods ended September 30,
1997 and 1998, respectively, and primarily resulted from the issuance of
Common Stock.
The Company has a $10 million line of credit with a bank, which expires in
February 2000. Borrowings under the line of credit bear interest at the bank's
prime rate less one half of one percent, or the Company has the option to borrow
at a fixed rate at one and one half percent above the bank's LIBOR for a fixed
term of up to three months. Balances outstanding at February 2000 that have been
used to fund capital equipment may be converted to a three-year term loan, which
provides for the same interest rate option. There were no borrowings under the
line of credit at September 30, 1998. The line of credit requires the Company to
comply with certain financial covenants. At September 30, 1998, the Company was
in compliance with these financial covenants.
The Company believes that its current cash and investment balances and cash
flow from operations will be sufficient to meet its working capital and capital
expenditure requirements for at least the next twelve months. The Company may
also utilize cash to acquire or invest in complementary businesses or to obtain
the right to use complementary technologies.
RISK FACTORS THAT MAY AFFECT OPERATING RESULTS
<PAGE>
This Management's Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that involve risks and
uncertainties. The following risk factors could materially and adversely affect
our future operating results and could cause actual events to differ materially
from those predicted in our forward-looking statements related to our business.
In evaluating our business, prospective investors should consider carefully the
following risk factors in addition to the other information set forth herein.
Variability of Quarterly Operating Results. We derive substantially all of
our revenue from professional services, which are generally provided on a "time
and expenses" basis. We recognize professional services revenue only when
network systems engineers are engaged on client projects. In addition, a
majority of our operating expenses, particularly personnel and related costs,
depreciation and rent, are relatively fixed in advance of any particular
quarter. As a result, any underutilization of network systems engineers may
cause significant variations in our operating results in any particular quarter
and could result in losses for such quarter. Factors, which could cause such
underutilization, include:
* the reduction in size, delay in commencement, interruption or
termination of one or more significant projects;
* the completion during a quarter of one or more significant projects;
* the inability to obtain new projects;
* the overestimation of resources required to complete new or ongoing
projects; and
* the timing and extent of training, weather related shut-downs,
vacation days and holidays.
Our revenue and earnings may also fluctuate from quarter to quarter based
on a variety of factors including:
* the loss of key employees;
* an inability to hire and retain sufficient numbers of employees,
including network systems engineers, account managers and software
engineers;
* reductions in billing rates or product pricing;
* write-offs of billings or services performed at no charge as a result
of our failure to meet client expectations;
* product returns and undetected product errors or failures;
* the timing of new product announcements and changes in pricing
policies by INS and our competitors;
* claims by our clients for the actions of our employees arising from
damages to our clients' business or otherwise;
* competition;
* the development and introduction of new services and products;
* corporate acquisitions;
* decrease or slowdown in the growth of the networking industry as a
whole;
* general economic conditions;
* ongoing market acceptance; and
* the timing and size of orders for software solutions.
We recently acquired VitalSigns, a company that manufactures and develops
software products that monitor and measure network and application performance.
As a result, our revenues will include a greater percentage of sales from
software solutions.
In addition, we plan to continue to expand our operations based on sales
forecasts by hiring additional network systems engineers, account managers and
other employees, investing in new product development and adding new offices,
systems and other infrastructure. The resulting increase in operating expenses
would materially adversely affect our operating results if revenue does not
increase as much as forecasted.
<PAGE>
We believe that quarterly revenue and operating results are likely to vary
significantly in the future and that period-to-period comparisons of our
operating results are not necessarily meaningful. You should not rely on period-
to-period comparisons as indications of future performance. In some future
quarter, our revenue or operating results will likely be below the expectations
of public market analysts or investors. In such event, the price of INS Common
Stock would likely be materially adversely affected.
Risks Associated with Client Concentration; Absence of Long-Term
Agreements. We have historically derived a significant portion of our revenue
from a limited number of clients and expect this concentration to continue. In
the quarter ended September 30, 1998, one client accounted for approximately 12%
of revenue and ten clients accounted for approximately 44% of revenue. No one
client accounted for more than 10% of revenue for the fiscal year ended June 30,
1998. There can be no assurance that revenue from clients that have accounted
for significant revenue in past periods, individually or as a group, will
continue, or if continued will reach or exceed historical levels in any future
period. We have, in the past, experienced declines in revenue from clients that
have accounted for significant revenue.
In addition, we generally do not have a long-term services contract with
any of our clients. Our clients are generally able to reduce or cancel their use
of our professional services without penalty and with little or no notice. As a
result, we believe that the number and size of our existing projects are not
reliable indicators or measures of future revenue. When a client defers,
modifies or cancels a project, we must be able to rapidly redeploy network
systems engineers to other projects in order to minimize the underutilization of
employees and the resulting adverse impact on our operating results. In
addition, our operating expenses are relatively fixed and cannot be reduced on
short notice to compensate for unanticipated variations in the number or size of
projects in progress. As a result, the following could have a material adverse
effect on our business, operating results and financial conditions:
* any significant reduction in the scope of the work performed for any
significant client or a number of smaller clients; or
* the failure of anticipated projects to materialize.
Need to Attract and Retain Qualified Network Systems Engineers. Our future
success will depend in large part on our ability to hire, train and retain
network systems engineers who together have expertise in a wide array of network
and computer systems and a broad understanding of the industries we serve.
Competition for network systems engineers is intense, and there can be no
assurance that we will be successful in attracting and retaining such personnel.
In particular, competition is intense for the limited number of qualified
managers and senior network systems engineers. We have experienced, and may in
the future experience, high rates of turnover among our network systems
engineers. Our inability to hire, train and retain a sufficient number of
qualified network systems engineers could impair our ability to adequately
manage and complete our existing projects or to obtain new projects, which, in
turn, could have a material adverse effect on our business, operating results
and financial condition.
We have experienced, and may in the future experience, increasing
compensation costs for our network systems engineers. Our inability to recover
increases in compensation of network systems engineers through higher billing
rates or to reduce other expenses to offset such increases, could have a
material adverse effect on our business, operating results and financial
condition. In addition, our inability to attract and retain a sufficient number
of qualified network systems engineers in the future could impair our planned
expansion of our business.Dependence on New Business Development. Our future
success will also depend in large part on the development of new business by our
account managers, who solicit new business and manage relationships with
existing clients. As a result, our success will depend on our ability to attract
and retain qualified account managers who have an understanding of our business
and the industry it serves. Competition for account managers is intense and we
have experienced, and may in the future experience, high rates of turnover among
our account managers. In addition, integration of new account managers into our
business can be lengthy. Our inability to attract and retain a sufficient number
of account managers or to integrate new account managers into our operations on
a timely basis could have a material adverse effect on our business, operating
results and financial condition.
Risks Associated with Software Solutions. Our long-term strategy is to
derive a significant portion of our revenue from the sale of software solutions.
We have devoted, and expect to continue to devote, substantial
<PAGE>
amounts of money and employees in the development and marketing of our software
solutions. The introduction of software solutions is subject to risks generally
associated with new product and service introductions, including delays in
development, testing or introduction, or the failure to satisfy clients'
requirements.
If we introduce products embodying new technologies or if new industry
standards emerge, our existing software products could become obsolete and
unmarketable. The life cycles of our software products are difficult to
estimate. Our future success depends upon our ability to enhance our current
products and to develop and introduce new products 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 not be successful
in developing and marketing product enhancements or new products that respond to
technological change or evolving industry standards. We could experience
difficulties that could delay or prevent the successful development,
introduction and marketing of these products. Our new products and product
enhancements may not adequately meet the requirements of our current or
potential customers or achieve market acceptance. If we cannot, for
technological or other reasons, develop and introduce new products or
enhancements of existing products in a timely manner in response to changing
market conditions or customer requirements, our business, operating results and
financial condition could be materially adversely affected. If these products
are not accepted in the marketplace, our operating results and financial
condition will be adversely affected.
Dependence on Growth in an Emerging Market. We currently expect our
VitalAnalysis and VitalHelp application performance management software products
to account for a significant part of our future software product revenue.
Although demand for VitalHelp and VitalAnalysis has grown recently, the
application performance management market is still an emerging market. Our
future software product financial performance will largely depend on continued
growth in the number of organizations adopting application performance
management environments from the end user's perspective. If the application
performance management market fails to grow or grows more slowly than we
currently anticipate, our operating results could be adversely affected.
Dependence on Proprietary Technology; Risks of Infringement. Our success
depends in part on our information technology, only some of which is proprietary
to us, and other intellectual property rights. We rely on a combination of
nondisclosure and other contractual arrangements, technical measures, copyrights
and trade secret and trademark laws to protect our proprietary rights. We also
try to protect our software, documentation and other written materials under
trade secret and copyright laws. In addition, we presently have eight patent
applications pending, seven applications for federal trademark rights pending
and one federal trademark issued. There can be no assurance that such patent and
trademarks applications will be granted. We have in the past entered into
services contracts with clients that assign rights to certain of the work
performed under such contracts to such clients. We do not believe that these
contracts will limit our ability to render services to other clients, although
we can not assure you that this will be the case. In selling certain products,
we rely on "end user" licenses that are not signed by licensees and, therefore,
such licenses may be unenforceable under the laws of certain jurisdictions. The
laws of some foreign countries do not protect our proprietary rights to the same
extent as the laws of the United States. There can be no assurance that the
steps we have taken to protect our proprietary rights will be adequate or that
third parties will not infringe or misappropriate our patents, copyrights,
trademarks, trade dress and similar proprietary rights.
We enter into confidentiality arrangements with our employees and attempt
to limit access to and distribution of proprietary information. There can be no
assurance that the steps we have taken in this regard will be adequate to deter
misappropriation of proprietary information and that we will be able to detect
unauthorized use or take appropriate steps to enforce intellectual property
rights.
We expect software piracy to be a persistent problem. Policing unauthorized
use of our products is difficult, and we cannot determine the extent to which
piracy of our software exists.
We may receive communication in the future from third parties or clients
asserting that we have infringed or misappropriated the proprietary rights of
such parties. We expect that software developers will increasingly be subject to
infringement claims as the number of products and the number of competitors in
our industry segment grows and the functionality of products in other industry
segments overlap. Any such claims, with or without merit, could be time
consuming, result in costly litigation and divert technical and management
personnel, result in delays of product shipments, require us to develop non-
infringing technology or require us to enter into royalty or licensing
agreements. Such royalty or licensing agreements, if required, may not be
<PAGE>
available on terms acceptable to us or at all. If a claim of infringement or
misappropriation against us is successful and we fails to or cannot develop non-
infringing technology or license the infringed, misappropriated, or similar
technology, our business, operating results and financial condition could be
materially adversely affected.
Management of Growth. We have experienced a period of rapid revenue and
client growth and an increase in the number of employees and offices and in the
scope of our supporting infrastructure. We do not believe this rate of growth is
sustainable over the long term. This growth has resulted in new and increased
responsibilities for management personnel and has placed and continues to place
a significant strain on our management and operating and financial systems. We
will be required to continue to hire management personnel and improve our
systems on a timely basis and in such a manner as is necessary to accommodate
any increase in the number of transactions and clients, any increase in the size
of our operations and any introduction of new products and services. There can
be no assurance that our management or systems will be adequate to support our
existing or future operations. Any failure to implement and improve our systems
or to hire and retain appropriate personnel to manage our operations would have
a material adverse effect on our business, operating results and financial
condition.
Intense Competition. The network industry is comprised of a large number of
participants and is subject to rapid change and intense competition. With
respect to professional services, we face competition from system integrators,
VARs, local and regional network services firms, telecommunications providers,
network equipment vendors, and computer systems vendors, many of which have
significantly greater financial, technical and marketing resources and greater
name recognition, and generate greater service revenue than we do. With respect
to software solutions, we face competition from companies such as Hewlett
Packard, Tivoli, Computer Associates, Network Associates Concord
Communications, Desktalk Systems and Compuware, some of which have significantly
greater financial, technical and marketing resources and greater name
recognition, and generate greater service revenue than we do. We have faced, and
expect to continue to face, additional competition from new entrants into our
markets.
Increased competition could result in price reductions, fewer client
projects, underutilization of employees, reduced operating margins and loss of
market share, any of which could have a material adverse effect on our business,
operating results and financial condition. There can be no assurance that we
will be able to compete successfully against current or future competitors. Our
failure to compete successfully would have a material adverse effect on our
business, operating results and financial condition.
Risks Associated with Acquisitions. We may make acquisitions of, or
significant investments in, complementary companies, products or technologies.
We recently completed the acquisition of VitalSigns. This acquisition, as well
as any future acquisitions, will be accompanied by the risks commonly
encountered in making acquisitions of companies, products and technologies. Such
risks include, among others:
* the difficulty associated with assimilating the personnel and
operations of acquired companies,
* the potential disruption of our ongoing business,
* the distraction of management and other resources,
* the inability of management to maximize our financial and strategic
position through the successful integration of acquired personnel,
technology and rights,
* the maintenance of uniform standards, controls, procedures and
policies, and
* the impairment of relationships with employees, partners and clients
as a result of the acquisition.
There can be no assurance that we will be successful in overcoming these
risks or any other problems encountered in connection with the acquisition of
VitalSigns or any future acquisitions. Any such problems encountered in the
transition and integration process could have a material adverse effect on our
business, operating results and financial condition.
Risks Associated With International Expansion. A component of our long-term
strategy is to expand into international markets. We provide professional
services to certain of our United States clients in foreign locations, and have
opened offices in the United Kingdom, the Netherlands, Germany and Canada. To
date, revenue generated from international operations has not been significant.
There is no assurance that the revenue generated from international operations
will be adequate to offset the expense of establishing and maintaining these
foreign operations, and if revenue does not materialize as anticipated, our
business, operating results and financial condition could be materially
adversely affected. There can be no assurance that we will be able to
successfully market, sell and deliver our services in international markets.
<PAGE>
In addition to the uncertainty as to our ability to expand into
international markets, there are certain risks inherent in conducting business
on an international level, any one of which could adversely impact the success
of our international operations. These risks include:
* unexpected changes in regulatory requirements, export restrictions,
tariffs and other trade barriers;
* difficulties in staffing and managing foreign operations;
* employment laws and practices in foreign countries;
* longer payment cycles and problems in collecting accounts receivable;
* political instability;
* fluctuations in currency exchange rates;
* imposition of currency exchange controls;
* seasonal reductions in business activity during the summer months in
Europe and certain other parts of the world; and
* potentially adverse tax consequences.
There can be no assurance that one or more of these factors will not have a
material adverse effect on our future international operations and,
consequently, on our business, operating results and financial condition. There
can be no assurance that we will be able to compete effectively in these
markets.
Relationship with Cisco Systems. Although we are a vendor independent
provider of network services, we have a significant relationship with Cisco and
believe that maintaining and enhancing this relationship is important to our
business due to Cisco's leading position in the large scale enterprise
internetworking market. Cisco develops, manufactures, markets and supports high-
performance, multiprotocol internetworking systems that link geographically
dispersed LANs and WANs. We have entered into direct relationships with clients
as a result of referrals from Cisco and provide services directly to Cisco,
primarily as a subcontractor.
Cisco is a shareholder of ours, and an officer of Cisco is a member of our
Board of Directors. Although we believe that our relationship with Cisco is
good, there can be no assurance that we will be able to maintain or enhance our
relationship with Cisco. Any deterioration in our relationship with Cisco could
have a material adverse effect on our business, operating results and financial
condition. In addition, should our relationship with Cisco be perceived as
compromising our ability to provide unbiased solutions, our relationship with
existing or potential clients could be materially adversely affected.
Risk of Product "Bugs." Software products as complex as ours may contain
undetected errors or failures when first introduced or when new versions are
released. Although we have not experienced material adverse effects resulting
from any such errors to date, errors could be found in new products or releases
after they have been sold, despite testing by us and by current and potential
customers, which would result in loss of or delay in market acceptance.
Product Liability. Our software product license agreements with customers
typically contain provisions designed to limit our exposure to potential product
liability claims. In selling certain products, we rely on "end user" licenses
that are not signed by licensees and, therefore, it is possible that such
licenses may be unenforceable under the laws of certain jurisdictions. For these
and other reasons, the limitation of liability provisions contained in our
license agreements may not be effective. Although we have not had any product
liability claims to date, the sale and support of products may result in such
claims in the future. A successful product liability claim brought against us
could have an adverse effect upon our operating results.
Year 2000. The year 2000 issue is the result of computer programs having
been written using two digits, rather than four, to define the applicable year.
Any of our computers, computer programs, and administration equipment or
products that have date-sensitive software may recognize a date using "00" as
the year 1900 rather than the year 2000. If any of our systems that have date-
sensitive software use only two digits, system failures or miscalculations may
result causing disruptions of operations, including, among other things, a
temporary inability to process transactions or send and receive electronic data
with third parties or engage in similar normal business activities.
<PAGE>
We believe that our current software products are year 2000 compliant.
However, there can be no assurance that our current products do not contain
undetected errors or defects associated with year 2000 date functions that may
result in material cost to us.
With respect to our internal information technology systems (including
information technology-based office facilities such as data and voice
communications, building management and security systems), we have formed an
ongoing internal review team to address the Year 2000. A team of professionals
has been engaged in a process to identify and resolve significant Year 2000
issues in a timely manner. The process includes an assessment of issues, testing
of systems and development of remediation plans, where necessary, as they relate
to internally used software, computer hardware and use of computer applications
in our products. Further, based on the exposures found as a result of this
review, the team will assess the need to develop a contingency planning effort
necessary to support critical business operations. Executive management
regularly monitors the status of our Year 2000 remediation plans.
We are in the process of contacting our key suppliers and other key third
parties to certify their year 2000 readiness and conducting ongoing risk
analysis. To the extent such third parties are materially adversely affected by
the Year 2000 issue, this could disrupt our operations. There can be no
assurance that our key contractors will have successful conversion programs, and
that any such Year 2000 compliance failures will not have a material adverse
effect on our business, results of operation or financial condition.Based on
information available to date, we plan to substantially complete our Year 2000
assessment and remediation in the summer of 1999. To date, we have not incurred
any material costs related to the assessment of, and preliminary efforts in
connection with, our Year 2000 issues. We further believe that such review and
modification, if any, will not require material charge to operating expenses
over the next several years. The costs of the project and the date on which we
plan to complete our Year 2000 assessment and remediation are based on our
estimates, which were derived utilizing numerous assumptions of future events
including the continued availability of certain resources, third party
modification plans and other factors. However, there can be no guarantee that
these estimates will be achieved and actual results could differ significantly
from those plans. Specific factors that might cause differences from our
estimates include, but are not limited to, the availability and cost of
personnel trained in this area, and similar uncertainties. We believe that we
are devoting the necessary resources to identify and resolve significant Year
2000 issues in a timely manner.
