<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-Q
(x) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended Commission File Number
OCTOBER 31, 1998 0-26334
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
INFERENCE CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-3436352
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
100 ROWLAND WAY
NOVATO, CALIFORNIA 94945
(415) 893-7200
(ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER,
INCLUDING AREA CODE, OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)
----------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for at least the past 90 days.
Yes x No
----- -----
As of December 8, 1998, there were 5,773,687 shares of the Registrant's Class A
Common Stock, par value $0.01 per share, and 1,190,332 shares of the
Registrant's Class B Common Stock, par value $0.01 per share, outstanding.
-1-
<PAGE>
INFERENCE CORPORATION
INDEX
<TABLE>
<CAPTION>
PAGE
----
<C> <S> <C>
PART I FINANCIAL INFORMATION
ITEM 1. Condensed Consolidated Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets
at October 31 and January 31, 1998............................. 3
Condensed Consolidated Statements of Operations for the Three and
Nine Months Ended October 31, 1998 and 1997.................... 4
Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended October 31, 1998 and 1997.................... 5
Notes to Condensed Consolidated Financial Statements............. 6
ITEM 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................ 9
PART II OTHER INFORMATION
ITEM 1. Legal Proceedings................................................ 19
ITEM 2. Changes in Securities............................................ 19
ITEM 3. Defaults upon Senior Securities.................................. 19
ITEM 4. Submission of Matters to a Vote of Security Holders.............. 19
ITEM 5. Other Information................................................ 19
ITEM 6. Exhibits and Reports on Form 8-K................................. 19
Signature........................................................ 20
</TABLE>
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<PAGE>
INFERENCE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
<TABLE>
<CAPTION>
OCTOBER 31, JANUARY 31,
1998 1998
----------------- -----------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents............................. $ 24,785,000 $ 28,010,000
Accounts receivable, net.............................. 5,097,000 5,770,000
Other current assets.................................. 400,000 935,000
------------ ------------
Total current assets................................. 30,282,000 34,715,000
Property and equipment, net............................ 1,806,000 2,114,000
Other assets........................................... 71,000 167,000
------------ ------------
$ 32,159,000 $ 36,996,000
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable...................................... $ 574,000 $ 623,000
Accrued salaries and related items.................... 1,486,000 1,301,000
Other accrued liabilities............................. 1,859,000 1,670,000
Deferred revenue...................................... 4,446,000 4,464,000
------------ ------------
Total current liabilities............................ 8,365,000 8,058,000
Shareholders' equity:
Common stock.......................................... 69,000 75,000
Additional paid-in capital............................ 45,960,000 48,255,000
Accumulated deficit................................... (22,235,000) (19,392,000)
------------ ------------
Total shareholders' equity........................... 23,794,000 28,938,000
------------ ------------
$ 32,159,000 $ 36,996,000
============ ============
</TABLE>
See accompanying notes.
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<PAGE>
INFERENCE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
OCTOBER 31, OCTOBER 31,
--------------------------------- ----------------------------------
1998 1997 1998 1997
--------------- ---------------- ---------------- ----------------
<S> <C> <C> <C> <C>
REVENUES:
Products........................................... $4,912,000 $ 3,236,000 $ 12,105,000 $ 9,163,000
Services........................................... 3,412,000 3,785,000 10,080,000 11,671,000
---------- ----------- ------------- -----------
Total revenues................................... 8,324,000 7,021,000 22,185,000 20,834,000
OPERATING COSTS AND EXPENSES:
Cost of product revenues........................... 233,000 243,000 611,000 732,000
Cost of service revenues........................... 1,615,000 1,886,000 5,177,000 6,190,000
Product development................................ 1,358,000 1,222,000 3,860,000 3,407,000
Sales and marketing................................ 3,807,000 4,600,000 11,278,000 12,043,000
General and administrative......................... 853,000 950,000 3,100,000 2,856,000
Restructuring...................................... 282,000 0 1,856,000 0
---------- ----------- ------------- -----------
Total operating costs and expenses............... 8,148,000 8,901,000 25,882,000 25,228,000
---------- ----------- ------------- -----------
Income (loss) from operations........................ 176,000 (1,880,000) (3,697,000) (4,394,000)
Gain from sale of investment......................... -- 3,824,000 -- 3,824,000
Interest income...................................... 324,000 351,000 980,000 1,057,000
Interest expense and other, net...................... 13,000 68,000 (27,000) 28,000
---------- ----------- ------------- -----------
Income (loss) before income taxes.................... 513,000 2,363,000 (2,744,000) 515,000
Provision for income taxes........................... 100,000 -- 100,000 --
---------- ----------- ------------- -----------
Net income (loss).................................... $ 413,000 $ 2,363,000 $ (2,844,000) $ 515,000
========== =========== ============= ===========
Net income (loss) per share:
Basic.............................................. $ 0.06 $ 0.30 $ (0.39) $ 0.06
========== =========== ============= ===========
Diluted............................................ $ 0.06 $ 0.29 $ (0.39) $ 0.06
========== =========== ============= ===========
Shares used in computing net income (loss) per share:
Basic.............................................. 6,992,000 7,838,000 7,224,000 7,953,000
========== =========== ============= ===========
Diluted............................................ 7,083,000 8,055,000 7,224,000 8,158,000
========== =========== ============= ===========
</TABLE>
See accompanying notes.
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<PAGE>
INFERENCE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED OCTOBER 31,
----------------------------------
1998 1997
------------ ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)................................................ $(2,844,000) $ 515,000
Adjustments to reconcile net income to
net cash used in operating activities:
Gain on sale of investment..................................... -- (3,824,000)
Depreciation and amortization.................................. 762,000 673,000
Stock based compensation expense............................... 209,000 --
Changes in operating assets and liabilities:
Accounts receivable.......................................... 673,000 3,797,000
Other current assets......................................... 535,000 (241,000)
Other assets................................................. 96,000 (17,000)
Accounts payable............................................. (49,000) (179,000)
Accrued salaries and related items........................... 185,000 (117,000)
Other accrued liabilities.................................... 189,000 (188,000)
Deferred revenue............................................. (18,000) (1,258,000)
----------- -----------
Net cash used in operating activities............................ (262,000) (839,000)
CASH FLOWS FROM INVESTING ACTIVITIES:
Maturity of short-term investments............................... -- 987,000
Net proceeds from sale of investment............................ -- 3,824,000
Purchases of property and equipment.............................. (454,000) (923,000)
----------- -----------
Net cash provided by (used in) investing activities.............. (454,000) 3,888,000
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock....................... 253,000 297,000
Repurchase of common stock....................................... (2,762,000) (2,693,000)
----------- -----------
Net cash used in financing activities............................ (2,509,000) (2,396,000)
----------- -----------
Net increase (decrease) in cash and cash equivalents............... (3,225,000) 653,000
Cash and cash equivalents at beginning of period................... 28,010,000 28,620,000
----------- -----------
Cash and cash equivalents at end of period......................... $24,785,000 $29,273,000
=========== ===========
________________________
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Income taxes paid during the period.............................. $ 89,000 $ 16,000
=========== ===========
</TABLE>
See accompanying notes.
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<PAGE>
INFERENCE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal adjustments) considered necessary to present fairly the financial
information have been included. This financial information should be read in
conjunction with the consolidated financial statements and notes thereto for the
year ended January 31, 1998, included in the Annual Report on Form 10-K. The
results of operations for the three and nine months ended October 31, 1998 are
not necessarily indicative of the results to be expected for the entire fiscal
year.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make certain estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
Certain amounts have been reclassified to conform with the current quarter
presentation.
2. SOFTWARE REVENUE RECOGNITION
Effective February 1, 1998, the Company adopted the American Institute of
Certified Public Accountants ("AICPA") Statement of Position 97-2, "Software
Revenue Recognition" ("SOP 97-2"), which provides guidance on applying generally
accepted accounting principles in recognizing revenue on software transactions,
as amended by AICPA SOP 98-4. Prior years have not been restated and the
adoption of SOP 97-2 did not have a material effect on the revenues or net loss
for the three and nine months ended October 31, 1998.
3. RESTRUCTURING COSTS
In the quarter ended October 31, 1998, the Company recorded a restructuring
charge of $282,000, all of which was paid prior to the end of the quarter,
related to severance costs associated with personnel changes in the Company's
executive management team.
In July 1998, the Company downsized operations in its subsidiary in France.
This action was taken to better align operating expenses with recent revenue
trends in France and to allow for increased investment of funds in the domestic
market. As a result, the Company recorded a restructuring charge, related to
lease abandonment and severance charges, during the three months ended July 31,
1998 in the amount of $253,000, of which $167,000 remained to be paid as of
October 31, 1998.
In the quarter ended April 30, 1998, the Company announced a reduction in
the number of its employees by approximately 12 percent. This action was taken
to better align operating expenses with the recent revenue trends. In addition,
the Company appointed Charles W. Jepson to succeed Peter R. Tierney as president
and chief executive officer. Jepson's appointment closely followed the promotion
of Ralph Barletta to senior vice president of Product Development, who replaced
John Binns in that position. The Company recorded a restructuring charge,
primarily related to severance costs, during the three months ended April 30,
1998 in the amount of approximately $1.3 million, all of which had been paid as
of October 31, 1998.
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<PAGE>
INFERENCE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
4. NET INCOME (LOSS) PER SHARE
Basic earnings per share is computed using the weighted average number of
common shares outstanding. Diluted earnings per share also includes the weighted
average number of common share equivalents outstanding during the period.
Dilutive common share equivalents consist of employee stock options using the
treasury method.
The following table sets forth the computation of basic and diluted net
income per common share for the three and nine months ended October 31, 1998 and
1997 (in thousands, except per share information):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
OCTOBER 31, OCTOBER 31,
-------------------------- ---------------------------
1998 1997 1998 1997
------------ ------------ ------------- ------------
<S> <C> <C> <C> <C>
Numerator:
Net income (loss)................................... $ 413 $2,363 $(2,844) $ 515
====== ====== ======= ======
Denominator:
Denominator for basic net income per common
share -- weighted-average shares outstanding..... 6,992 7,838 7,224 7,953
Effect of dilutive securities:
Stock options and warrants....................... 91 217 -- 205
------ ------ -------- ------
Dilutive potential common shares................. 91 217 -- 205
------ ------ -------- ------
Denominator for diluted net income per
common share -- adjusted weighted-average
shares for assumed conversions.................. 7,083 8,055 7,224 8,158
====== ====== ======== ======
Net income per share:
Basic............................................. $ .06 $ .30 $ (.39) $ .06
====== ====== ======== ======
Diluted........................................... $ .06 $ .29 $ (.39) $ .06
====== ====== ======== ======
</TABLE>
Options to purchase 2,144,000 shares of common stock were outstanding
during the nine month period ended October 31, 1998, but were not included in
the computation of diluted net loss per share because the effect in periods with
a net loss would be antidilutive.
5. GAIN ON SALE OF INVESTMENT
In August 1996, the Company agreed to sell its minority investment in
Limbex Corporation ("Limbex") to Quarterdeck Corporation ("Quarterdeck"),
pursuant to Quarterdeck's acquisition of the outstanding shares of Limbex. In
August 1997, the Company received approximately 1.4 million shares of
Quarterdeck common stock pursuant to the August 1996 agreement. These shares
were sold in the open market during the quarter ended October 31, 1997, and a
resulting gain from sale of investment was recorded in the amount of $3,824,000.
-7-
<PAGE>
INFERENCE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
6. SHARE REPURCHASE
The Board of Directors has authorized management of the company to
repurchase up to 2.1 million shares of the Company's outstanding Class A Common
Stock. The Company plans to purchase the shares on the open market from time to
time, depending on market conditions. The repurchases will be funded from the
Company's cash and cash equivalents. As of October 31, 1998, the Company had
repurchased a total of approximately 1.6 million shares of the Company's stock
at a cumulative cost of $7.5 million.
-8-
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain statements contained hereunder regarding matters that are not
historical facts are forward-looking statements (as such term is defined in the
rules promulgated pursuant to the Securities Act of 1933, as amended (the
"Securities Act")). Such forward-looking statements are subject to certain
risks, trends and uncertainties; thus, actual results may differ materially from
those expressed in or implied by such forward-looking statements. Factors that
could cause or contribute to such differences include, but are not limited to,
fluctuations in quarterly operating results, the size and timing of customer
orders for product licenses; timely delivery and acceptance of new products,
including the Company's recently announced k-Commerce suite of products; ability
to attract and retain key personnel; ability to control costs; market and
business conditions for stock repurchase; and competitive actions in the
marketplace. The Company undertakes no obligation to release publicly the result
of any revisions to these forward-looking statements to reflect events or
circumstances after the date hereof or to reflect the occurrence of
unanticipated events. Readers should also carefully review the business and risk
factors described in the documents the Company files from time to time with the
Securities and Exchange Commission, specifically the Annual Report on Form 10-K,
Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K filed by the
Company.
The following discussion should be read in conjunction with the condensed
consolidated financial statements and notes thereto.
RESULTS OF OPERATIONS
The following table sets forth the percentages that certain statement of
operations items are to total revenues for the three and nine months ended
October 31, 1998 and 1997:
<TABLE>
<CAPTION>
Three months ended Nine months ended
October 31, October 31,
----------------------- ------------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenues:
Products............................ 59% 46% 55% 44%
Services............................ 41% 54% 45% 56%
---- ---- ---- ----
Total............................. 100% 100% 100% 100%
Operating costs and expenses:
Products............................ 3% 3% 3% 3%
Services............................ 20% 27% 23% 30%
Product development................. 16% 17% 17% 16%
Selling and marketing............... 46% 66% 51% 58%
General and administrative.......... 10% 14% 14% 14%
Restructuring....................... 3% -- 8% --
---- ---- ---- ----
Total............................. 98% 127% 116% 121%
---- ---- ---- ----
Income (loss) from operations......... 2% (27)% (16)% (21)%
==== ==== ==== ====
</TABLE>
OVERVIEW
For the three months ended October 31, 1998, the Company's product revenues
increased 52% over the same quarter in the prior year. In order to sustain
growth in product license revenues, it will be necessary for the Company to
devote substantial resources to the expansion and development of its sales
organization, especially in the Americas. Competition for such personnel is
intense, and there can be no assurance that the Company will be able to hire the
resources necessary to sustain growth. While the Company's product revenues
increased, its service revenues declined 10% for the three months ended October
31, 1998 compared with the prior year's third quarter. The decline in service
revenues, specifically consulting revenues, is attributable to the Company's
strategy to focus its consulting organization on projects that help its
customers successfully implement its products and away from large custom
projects. As a result of this transition, the Company anticipates that
consulting revenue will show little if any growth over the next six months.
-9-
<PAGE>
THREE MONTHS ENDED OCTOBER 31, 1998 AND OCTOBER 31, 1997
Revenues
The Company's revenues are derived principally from two sources: (i) fees
from licenses of the Company's software products and technology and (ii) fees
from consulting services, maintenance (technical support and upgrades of
software products) and training. Product revenues result principally from non-
cancelable license agreements that provide customers the non-exclusive right to
use the products for a fixed term or on a perpetual basis. Such revenues are
recognized upon: (i) execution of a binding agreement; (ii) shipment of the
product to the customer; (iii) when the license fee is fixed or determinable;
and (iv) when collectability is reasonably assured; and (v) when fair value is
determinable on the basis of vendor specific objective evidence. Revenues from
consulting and training are recognized as the related services are performed,
and maintenance revenues are deferred and recognized over the term of the
Company's maintenance contracts, typically one year.
Total revenues increased 19% from $8,324,000 in the three months ended
October 31, 1998 from $7,021,000 in the three months ended October 31, 1997.
During the three month period ended October 31, 1998, one customer accounted for
23% of total revenues. The Company has seen an increasing pattern of large
orders, particularly in the Americas operations. To the extent that the Company
relies on these large orders to make its quarterly operating objectives, failure
to close such deals in compliance with SOP 97-2 and in a specified time period
could adversely affect the Company's operating results.
Total revenues from the Americas operations increased to $4,497,000 in the
three months ended October 31, 1998 from $4,436,000 in the three months ended
October 31, 1997, representing a 1% increase. Total international revenues
increased to $3,827,000 in the three months ended October 31, 1998 from
$2,585,000 in the three months ended October 31, 1997, representing a 48%
increase. Total international revenues for the three months ended October 31,
1998 and October 31, 1997 represented 46% and 37% of total revenues,
respectively. The Company currently has agreements with over a dozen
distributors worldwide, serving Europe, the Middle East and Africa, and Asia and
the Pacific Rim. International revenues are subject to various risks, including
unexpected changes in regulatory requirements, tariffs and other trade barriers;
costs and risks of localizing products for foreign countries; longer accounts
receivable payment cycles; potentially adverse tax consequences; repatriation of
earnings; exchange rate fluctuations; and the burdens of complying with a wide
variety of foreign laws. There can be no assurance that such factors will not
have an adverse effect on the revenues from the Company's future international
sales and, consequently, the Company's results of operations.
Product revenues increased to $4,912,000 in the three months ended October
31, 1998 from $3,236,000 in the three months ended October 31, 1997,
representing a 52% increase, primarily as a result of higher unit sales volumes.
The prices of the Company's products have remained relatively constant. Product
revenues represented 59% and 46% of total revenues for the three months ended
October 31, 1998 and October 31, 1997, respectively. During the three months
ended October 31, 1998, one customer accounted for 38% of total product
revenues.
Product revenues from the Americas operations increased to $2,617,000 in
the three months ended October 31, 1998 from $2,114,000 in the three months
ended October 31, 1997, representing a 24% increase. International product
revenues increased to $2,295,000 in the three months ended October 31, 1998 from
$1,122,000 in the three months ended October 31, 1997, representing a 105%
increase.
Total service revenues decreased to $3,412,000 in the three months ended
October 31, 1998 from $3,785,000 in the three months ended October 31, 1997,
representing a 10% decrease.
Service revenues from the Americas operations decreased to $1,880,000 in
the three months ended October 31, 1998 from $2,322,000 in the three months
ended October 31, 1997, representing a 19% decrease. International service
revenues increased to $1,532,000 in the three months ended October 31, 1998 from
$1,463,000 in the three months ended October 31, 1997, representing a 5%
increase. The decline in service revenue was the result of decreased consulting
revenues. The decrease in consulting revenues is attributable to the Company's
strategy to focus its consulting organization on projects that help its
customers successfully implement its products and away from large custom
projects. As a result of this transition, the Company anticipates that
consulting revenue will show little if any growth over the next six months.
Cost of Product Revenues
Cost of product revenues, consisting primarily of the costs of product
media and duplication, manuals, packaging materials, personnel-related costs,
shipping expenses and royalties paid to third-party vendors, decreased to
$233,000 in
-10-
<PAGE>
the three months ended October 31, 1998 from $243,000 in the three months ended
October 31, 1997, representing a 4% decrease. The gross margin on product
revenues was 95% and 92% for the three months ended October 31, 1998 and October
31, 1997, respectively.
Cost of Service Revenues
Cost of service revenues, consisting principally of personnel-related costs
for consulting, training and technical support, decreased to $1,615,000 in the
three months ended October 31, 1998 from $1,886,000 in the three months ended
October 31, 1997, representing a 14% decrease. Cost of service revenues
typically varies depending on the revenue mix of training, consulting services
and technical support. The gross margin on service revenues was 53% and 50% for
the three months ended October 31, 1998 and October 31, 1997, respectively. The
gross margin on service revenues continues to be higher than in previous periods
as a result of a greater percentage of the services business coming from the
Company's maintenance support business, which earns a much higher gross margin
than the professional services business. It is expected that the gross margin
on service revenues will continue to vary, depending on the revenue mix of
professional services and maintenance support.
Product Development
Product development expense consists primarily of employee-related costs,
including salaries, benefits, equipment and recruiting fees in addition to
equipment and facility costs, incurred in the research, design, development and
enhancement of software products. Product development expenditures increased to
$1,358,000 in the three months ended October 31, 1998 from $1,222,000 in the
three months ended October 31, 1997, representing an 11% increase. Product
development expense as a percentage of total revenues was 16% and 17% for the
three months ended October 31, 1998 and October 31, 1997, respectively. The
Company believes that continued commitment to product development will be
required for its recently announced k-Commerce initiative to obtain acceptance
and competitive advantage. Accordingly, the Company intends to allocate
increasing resources to product research and development, but such expenses may
continue to vary as a percentage of total revenues.
Selling and Marketing
Selling and marketing expense consists primarily of salaries, benefits and
commissions of sales and marketing personnel, trade shows and promotional
expenses, and non-chargeable customer service and sales support. Selling and
marketing expense decreased to $3,807,000 in the three months ended October 31,
1998 from $4,600,000 in the three months ended October 31, 1997, representing a
17% decrease. This decrease is principally due to certain costs associated with
the closing of the German and Dutch sales offices which were recorded in the
third quarter of the prior year. Currently, the Company intends to aggressively
hire sales personnel to staff its direct sales force. The Company anticipates
additional costs related to the development of this expanded sales force,
particularly in the Americas operations. Additionally, the Company expects
marketing expenses to increase as a result of the launch of the recently
announced k-Commerce suite of products. Selling and marketing expense as a
percentage of total revenues was 46% and 66% for the three months ended October
31, 1998 and October 31, 1997, respectively.
General and Administration
General and administration expense consists of the personnel costs for
finance and accounting, human resources, information systems and general
management of the Company. General and administration expense decreased to
$853,000 in the three months ended October 31, 1998 from $950,000 in the three
months ended October 31, 1997, representing a 10% decrease. General and
administration expense as a percentage of total revenues were 10% and 14% for
the three months ended October 31, 1998 and October 31, 1997, respectively. The
decrease over the prior year's third quarter is due to reduced headcount in
comparison to the prior year.
Restructuring
In the quarter ended October 31, 1998, the Company recorded a restructuring
charge of $282,000 related to severance costs associated with personnel changes
in the Company's executive management team, all of which was paid prior to the
end of the quarter.
-11-
<PAGE>
Other Income and Expense
Other income and expense, net, primarily interest income, decreased to
$337,000 in the three months ended October 31, 1998 from $419,000 in the three
months ended October 31, 1997.
NINE MONTHS ENDED OCTOBER 31, 1998 AND OCTOBER 31, 1997
Revenues
Total revenues increased 6% to $22,185,000 in the nine months ended
October 31, 1998 from $20,834,000 in the nine months ended October 31, 1997.
Total revenues from the Americas operations decreased to $12,457,000 in the
nine months ended October 31, 1998 from $12,752,000 in the nine months ended
October 31, 1997, representing a 2% decrease. Total international revenues
increased to $9,728,000 in the nine months ended October 31, 1998 from
$8,082,000 in the nine months ended October 31, 1997, representing a 20%
increase. Total international revenues for the nine months ended October 31,
1998 and October 31, 1997 represented 44% and 39% of total revenues,
respectively.
Product revenues increased to $12,105,000 in the nine months ended October
31, 1998 from $9,163,000 in the nine months ended October 31, 1997, representing
a 32% increase. The increase in revenues from products was due to higher unit
sales volumes; the prices of the Company's products have remained relatively
constant. Product revenues represented 55% and 44% of total revenues for the
nine months ended October 31, 1998 and October 31, 1997, respectively. During
the nine months ended October 31, 1998, three customers accounted in the
aggregate for 30% of total product revenues, or 16% of total revenues.
Product revenues from the Americas operations increased to $6,905,000 in
the nine months ended October 31, 1998 from $5,591,000 in the nine months ended
October 31, 1997, representing a 24% increase. International product revenues
increased to $5,200,000 in the nine months ended October 31, 1998 from
$3,572,000 in the nine months ended October 31, 1997, representing a 46%
increase.
Total service revenues decreased to $10,080,000 in the nine months ended
October 31, 1998 from $11,671,000 in the nine months ended October 31, 1997,
representing a 14% decrease. As previously discussed, the decline in service
revenues is attributable to decreased consulting revenues. The decrease in
consulting revenues is attributable to the Company's strategy to focus its
consulting organization on projects that help its customers successfully
implement its products and away from large custom projects.
Service revenues from the Americas operations decreased to $5,552,000 in
the nine months ended October 31, 1998 from $7,161,000 in the nine months ended
October 31, 1997, representing a 22% decrease. International service revenues
increased to $4,528,000 in the nine months ended October 31, 1998 from
$4,510,000 in the nine months ended October 31, 1997, representing less than a
1% increase.
Cost of Product Revenues
Cost of product revenues, consisting primarily of the costs of product
media and duplication, manuals, packaging materials, personnel-related costs,
shipping expenses and royalties paid to third-party vendors, decreased to
$611,000 in the nine months ended October 31, 1998 from $732,000 in the nine
months ended October 31, 1997, representing a 17% decrease. This decline is the
result of reduced headcount within the department responsible for the shipping
of the Company's products. The gross margin on product revenues was 95% and 92%
for the nine months ended October 31, 1998 and October 31, 1997, respectively.
Cost of Service Revenues
Cost of service revenues decreased to $5,177,000 in the nine months ended
October 31, 1998 from $6,190,000 in the nine months ended October 31, 1997,
representing a 16% decrease. The gross margin on service revenues was 49% and
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<PAGE>
47% for the nine months ended October 31, 1998 and October 31, 1997,
respectively. Cost of service revenues typically varies depending on the revenue
mix of training, consulting services and technical support.
Product Development
Product development expense increased to $3,860,000 in the nine months
ended October 31, 1998 from $3,407,000 in the nine months ended October 31,
1997, representing a 13% increase. Product development expense as a percentage
of total revenues was 17% and 16% for the nine months ended October 31, 1998 and
October 31, 1997, respectively. The Company believes that continued commitment
to product development will be required for its recently announced k-Commerce
initiative to obtain acceptance and competitive advantage. Accordingly, the
Company intends to allocate increasing resources to product research and
development, but such expenses may continue to vary as a percentage of total
revenues.
Selling and Marketing
Selling and marketing expense decreased to $11,278,000 in the nine months
ended October 31, 1998 from $12,043,000 in the nine months ended October 31,
1997, representing a 6% decrease. This decrease is the result of costs recorded
in the prior year related to the Company's downsizing of its German and Dutch
sales offices. Currently, the Company intends to aggressively hire sales
personnel to staff its direct sales force. The Company anticipates additional
costs related to the development of this expanded sales force, particularly in
the Americas operations. Additionally, the Company expects marketing expenses to
increase as a result of the launch of the recently announced k-Commerce suite of
products. Selling and marketing expense as a percentage of total revenues was
51% and 58% for the nine months ended October 31, 1998 and October 31, 1997,
respectively.
General and Administration
General and administration expense increased to $3,100,000 in the nine
months ended October 31, 1998 from $2,856,000 in the nine months ended October
31, 1997, representing a 9% increase. This increase is primarily attributable to
increased legal costs associated with the ServiceSoft litigation settled in July
1998. General and administration expense as a percentage of total revenues was
14% for the nine months ended October 31, 1998 and October 31, 1997.
Restructuring
In the quarter ended October 31, 1998, the Company recorded a restructuring
charge of $282,000, all of which was paid prior to the end of the quarter,
related to severance costs associated with personnel changes in the Company's
executive management team.
In July 1998, the Company downsized operations in its subsidiary in France.
This action was taken to better align operating expenses with recent revenue
trends in France and to allow for increased investment of funds in the domestic
market. As a result, the Company recorded a restructuring charge, related to
lease abandonment and severance charges, during the three months ended July 31,
1998 in the amount of $253,000, of which $167,000 remained to be paid as of
October 31, 1998.
In the quarter ended April 30, 1998, the Company announced a reduction in
the number of its employees by approximately 12 percent. This action was taken
to better align operating expenses with the recent revenue trends. In addition,
the Company appointed Charles W. Jepson to succeed Peter R. Tierney as president
and chief executive officer. Jepson's appointment closely followed the promotion
of Ralph Barletta to senior vice president of Product Development, who replaced
John Binns in that position. The Company recorded a restructuring charge,
primarily related to severance costs, during the three months ended April 30,
1998 in the amount of approximately $1.3 million, all of which was paid prior to
October 31, 1998.
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<PAGE>
Other Income and Expense
Other income and expense primarily interest income, decreased to $953,000
in the nine months ended October 31, 1998 from $1,085,000 in the nine months
ended October 31, 1997.
LIQUIDITY AND CAPITAL RESOURCES
Cash, cash equivalents and short-term investments at October 31, 1998 were
$24,785,000, a decrease of $3,225,000 since January 31, 1998. Working capital at
October 31, 1998 was $21,917,000.
Net cash used in operating activities amounted to $262,000 during the nine
months ended October 31, 1998, as compared to net cash used in operating
activities of $839,000 during the nine months ended October 31, 1997.
Investing activities for the nine months ended October 31, 1998 included
$454,000 for purchases of property and equipment. The Company had no significant
capital commitments as of October 31, 1998.
Cash used in financing activities for the nine months ended October 31,
1998 included $2,762,000 for the repurchase of approximately 674,000 shares of
the Company's common stock.
The Company's international operations are principally transacted in
British pound sterling. Translation into the Company's reporting currency, the
U.S. dollar, has not historically had a material impact on the Company's
financial position. Additionally, the Company's net assets denominated in
currencies other than the functional currency has not exposed the Company to
material risk associated with fluctuations in currency rates. Given this and the
relatively stable nature of the exchange rates, historically, between the
British pound sterling and the U.S. dollar, the Company has not considered it
necessary to use foreign currency contracts or other derivative instruments to
manage changes in currency rates. However, future changes in the exchange rates
between the foreign currencies, primarily the British pound sterling, and the
U.S. dollar could have an adverse effect on the Company's financial position.
The Company believes that existing cash balances, together with anticipated
cash flow from operations, will be sufficient to meet its working capital and
capital expenditure requirements for at least the next twelve months.
YEAR 2000 COMPLIANCE
Many computer systems were not designed to handle any dates beyond the year
1999, and therefore computer hardware and software will need to be modified
prior to the year 2000 in order to remain functional. Inference has completed a
Year 2000 compliance review for all products released through October 31, 1998.
The Company does not anticipate that addressing the Year 2000 problem for its
products will have a material impact on operations or financial results. To
date, costs incurred in remediating identified Year 2000 issues have not been
material.
Inference Corporation is firmly committed to ensure its commercially
available software products are "Year 2000 Ready." All Company products are
capable of correctly identifying, manipulating, and performing calculations on
dates later than December 31, 1999, where operations based on dates held in 2
digit format are affected due to re-sequencing from 99 to 00. The Company
institutes, within its product design specifications, the requirement that
internal date representations are held in full format and manipulations are not
performed on short formats. This assumes the software is used in accordance with
its associated documentation and provided that when the software is linked up to
other components, such components factor in the calendar date on the same
conditions as the Company's products. However, despite design review and ongoing
testing, the Company's products may contain undetected errors or defects
associated with Year 2000 date handling. Known or unknown errors or defects in
its products could result in (i) delay or loss of revenue; (ii) diversion of
development resources; (iii) damage to reputation; and (iv) increased service
and warranty costs.
Year 2000 issues may also affect the computer systems used internally by
the Company to manage and operate its business. To date the Company has not
incurred and does not believe that it will incur significant operating expenses
or be required to invest heavily in computer systems improvements to be Year
2000 compliant. However, the Company may experience significant unanticipated
problems and costs caused by undetected errors or defects in internal systems.
The worst-case scenario if such problems occur would be the inability to ship
products and record revenue.
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<PAGE>
The Company does not currently have any information concerning the Year
2000 compliance status of its customers or prospective customers. If current or
future customers fail to achieve Year 2000 compliance or if they divert
technology expenditures (especially technology expenditures reserved for
software and services) to address Year 2000 compliance issues, the Company's
business, results of operations or financial condition would be materially
adversely affected.
The Company has funded its Year 2000 activities from available cash and has
not separately accounted for these costs in the past. To date, these costs have
not been material. The Company may incur additional costs for administrative,
customer support, internal IT and product engineering activities to address
ongoing Year 2000 issues. The Company has not yet fully developed a contingency
plan to address situations that may result if it is unable to achieve Year 2000
readiness of critical operations. The cost of developing and implementing such a
plan may itself be material. Finally, the Company is also subject to external
forces that might generally affect industry and commerce, such as utility or
transportation company Year 2000 compliance failures and related service
interruptions.
ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS
Product Transitions. The Company recently announced the launch of its
k-Commerce suite of products. Broad market acceptance of k-Commerce products is
critical to the Company's future success. As a result, a decline in demand for
or failure to achieve broad market acceptance of k-Commerce products as a result
of competition, technological change or otherwise would have a material adverse
effect on the business, operating results and financial condition of the
Company. As part of the k-Commerce initiative, the Company has entered into
several partnering agreements for the purpose of extending the offerings and
capabilities of the Company's products. There can be no assurance that these
relationships will translate into additional demand for the Company's products.
The market for the Company's products is characterized by rapid
technological developments, evolving industry standards, swift changes in
customer requirements and frequent new product introductions and enhancements.
As a result, the Company's success depends upon its ability to continue to
enhance its existing products, respond to customer requirements, and to develop
and introduce, in a timely manner, new products incorporating technological
advances. There can be no assurance that the Company will be successful in
developing and marketing new products or enhancements to its existing products
on a timely basis or that any new or enhanced products will adequately address
the changing needs of the marketplace.
If the Company is unable to develop and introduce new products or
enhancements to existing products in a timely manner in response to changing
market conditions or customer requirements, the Company's business, operating
results and financial condition will be materially and adversely affected. From
time to time, the Company or its competitors may announce new products,
capabilities or technologies that have the potential to replace or shorten the
life cycles of the Company's existing products. There can be no assurance that
announcements of currently planned or other new products will not cause
customers to delay their purchasing decisions in anticipation of such products,
which could have a material adverse effect on the Company's business, operating
results and financial condition.
-15-
<PAGE>
Fluctuations in Quarterly Operating Results. The Company has experienced
significant quarterly fluctuations in operating results and anticipates such
fluctuations will continue in the future. Typically, revenues, operating income
and net income for the Company's fourth quarter are higher than those for the
first quarter of the following year. In addition, the Company has historically
recognized a substantial portion of its license revenues in the last month of
the quarter, typically in the last week. The Company generally ships orders as
they are received and as a result has little or no backlog. Quarterly revenues
and operating results therefore depend on the volume and timing of orders
received during the quarter, which are difficult to forecast. In addition,
consulting service revenues tend to fluctuate as projects, which may continue
over several quarters, are undertaken or completed. Operating results may also
fluctuate due to factors such as the demand for the Company's products; the size
and timing of customer orders; the introduction of new products and product
enhancements by the Company or its competitors; the budgeting cycles of
customers; changes in the proportion of revenues attributable to licenses and
service fees; changes in the level of operating expenses; and competitive
conditions in the industry. The value of individual licenses as a percentage of
quarterly revenues can be substantial, and particular licenses may generate a
substantial portion of the operating profits for the quarter in which they are
signed. The sales cycle typically ranges from three to nine months, and license
signing may be delayed for a number of reasons outside of the control of the
Company. Because the Company's staffing and other operating expenses are based
on anticipated revenues, a substantial portion of which is not typically
generated until the end of each quarter, delays in the receipt of orders can
cause significant variations in operating results from quarter to quarter. The
Company also may choose to reduce prices or to increase spending in response to
competition or to pursue new market opportunities, which may adversely affect
the Company's operating results. Accordingly, the Company believes that period-
to-period comparisons of its results of operations may not be meaningful and
should not be relied upon as an indication of future performance.
Due to all of the foregoing factors, it is likely that in some future
quarters the Company's operating results will be below the expectations of
investors. Regardless of the general outlook for the Company's business, the
announcement of quarterly operating results below investor expectations is
likely to result in a decline in the trading price of the Company's Class A
Common Stock.
Competition. The market for customer support software is highly
competitive, and there are certain competitors with substantially greater sales,
marketing, development and financial resources than the Company. Among the
Company's major competitors in the problem identification and resolution segment
of the market are Primus Knowledge Solutions, Inc., ServiceSoft Corporation, and
ServiceWare Inc., as well as other smaller privately held companies.
Furthermore, many potential customers implement low-end text retrieval solutions
or develop internal applications that eliminate the need to acquire software and
services from third-party vendors such as the Company.
The Company believes that the competitive factors affecting the market for
the Company's products and services include vendor and product reputation;
product quality, performance and price; product functionality and features;
product scaleability; product integration with other enterprise applications;
the availability of products on multiple platforms; product ease-of-use; and the
quality of customer support services, documentation and training. The relative
importance of each of these factors depends upon the specific customer involved.
There can be no assurance that the Company will be able to compete effectively
with respect to any of these factors.
The Company's present or future competitors may be able to develop products
comparable or superior to those offered by the Company or adapt more quickly
than the Company to new technologies or evolving customer requirements. In order
to be successful in the future, the Company must respond to technological
change, customer requirements and competitors' current products and innovations.
In particular, while the Company is currently developing additional product
enhancements that the Company believes address customer requirements, there can
be no assurance that the Company will successfully complete the development or
introduction of these additional product enhancements on a timely basis or that
these product enhancements will achieve market acceptance. Accordingly, there
can be no assurance that the Company will be able to continue to compete
effectively in its market, that competition will not intensify or that future
competition will not have a material adverse effect on the Company's business,
operating results and financial condition.
-16-
<PAGE>
Pricing. The Company believes that its products are competitively priced
with other products in the customer support market. However, the market for the
Company's products is highly competitive, and the Company expects that it will
face increased pricing pressures from its current competitors and new market
entrants. Any material reduction in the price of the Company's products would
negatively affect gross margins and could materially adversely affect the
Company's business, operating results and financial condition if the Company
were unable to increase unit sales. In addition, the Company expects increased
competition and intends to invest significantly in its business.
Dependence on Key Personnel. The Company's future performance depends in
significant part upon the continued service of its key technical, sales and
senior management personnel. The loss of the services of one or more of these
key employees could have a material adverse effect on the Company's business,
operating results and financial condition. The Company's future success also
depends on its ability to attract and retain highly qualified technical, sales
and managerial personnel. Competition for such personnel is intense, and there
can be no assurance that the Company can retain its key employees or that it can
attract or retain other highly qualified personnel in the future. In addition,
the Company has recently hired, and plans to continue to hire, a significant
number of development engineers to design and implement improvements to the
Company's technologies.
Possible Volatility of Stock Price. The trading price of the Company's
Class A Common Stock has been and is subject to wide fluctuations in response to
quarterly variations in operating results, announcements of technological
innovations or new products by the Company or its competitors, changes in
financial estimates or recommendations by securities analysts and other events
or factors. In addition, the stock market has experienced volatility that has
particularly affected the market prices of equity securities of many technology
companies and that often has been unrelated to the operating performance of such
companies. These broad market fluctuations may adversely affect the trading
price of the Company's Class A Common Stock.
Uncertainty of Proprietary Rights. The Company's success depends in part
upon its proprietary technology. Although case-based reasoning ("CBR")
technology is available in the public domain, the Company believes its
implementation of the CBR technology is proprietary. The Company relies on a
combination of copyright, trademark and trade secret laws, confidentiality
procedures and licensing arrangements to establish and protect its proprietary
rights. The Company has been awarded three patents for its CBR technology which
is embedded in its CBR family of products. Despite the precautions the Company
has taken, it may be possible for an unauthorized third party to copy or
otherwise obtain and use the Company's products, technology or other information
that the Company regards as proprietary or to develop similar products or
technology independently. In addition, effective trademark, copyright and trade
secret protection may be unavailable or limited in certain foreign countries
where the Company operates.
The Company occasionally publishes articles regarding its technical
developments in industry publications that may prevent the Company from
obtaining patent protection for ideas contained in such publications, thus
increasing the availability to third parties of fundamental aspects of the
Company's technology.
The Company is not aware that any of its products infringe upon the
proprietary rights of third parties. There can be no assurance, however, that
third parties will not claim such infringement by the Company with respect to
current or future products. The Company expects that it will increasingly be
subject to such claims as the number of products and competitors in the customer
support software market grows and the functionality of such products overlaps
with other industry segments. Any such claims, whether or not they are
meritorious, could result in costly litigation or require the Company to enter
into royalty or licensing agreements. Such royalty or license agreements, if
required, may not be available on terms acceptable to the Company or at all. If
the Company was found to have infringed upon the proprietary rights of third
parties, it could be required to pay damages, cease sales of the infringing
products and redesign or discontinue such products, any of which could have a
material adverse effect on the Company's business, operating results and
financial condition.
-17-
<PAGE>
Risks Associated with Potential Acquisitions. As part of its business
strategy, the Company may in the future review acquisition prospects that would
complement its existing product offerings, augment its market coverage or
enhance its technological capabilities, or that may otherwise offer growth
opportunities. Such acquisitions by the Company could result in potentially
dilutive issuances of equity securities, the incurrence of debt and contingent
liabilities or amortization expenses related to goodwill and other intangible
assets, any of which could materially adversely affect the Company's operating
results. Acquisitions entail numerous risks, including difficulties in the
assimilation of acquired operations, technologies and products, diversion of
management's attention to other business concerns, risks of entering markets
which the Company has no or limited prior experience and potential loss of key
employees of acquired organizations. No assurance can be given as to the ability
of the Company to successfully integrate any businesses, products, technologies
or personnel that might be acquired in the future, and the failure of the
Company to do so could have a material adverse effect on the business, operating
results and financial condition of the Company.
Litigation. The Company is subject to legal proceedings and claims that
arise in the ordinary course of business. Management currently believes that the
ultimate amount of liability, if any, with respect to any pending actions,
either individually or in the aggregate, will not materially affect the
financial position, results of operations or liquidity of the Company. However,
the ultimate outcome of any litigation is uncertain. If an unfavorable outcome
were to occur, the impact could be material. Furthermore, any litigation,
regardless of the outcome, can have an adverse impact on the Company's results
of operations as a result of defense costs, diversion of management resources,
and other factors.
-18-
<PAGE>
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 2. CHANGES IN SECURITIES
In November 1998, J.P. Morgan, holder of the Company's Class B Common
Stock, notified the Company of its intention to convert such shares to Class A
Common Stock, subject to certain conversion restrictions. Pursuant to the
Company's certificate of incorporation, holders may convert shares of Class B
Common Stock into Class A Common Stock, except that no holder of shares of Class
B Common Stock may convert any such shares to the extent that, as a result, the
holder and its affiliates, directly or indirectly, would own, control or have
the power to vote more than 5% of the outstanding shares of the Class A Common
Stock. As currently provided, each conversion will be on a one-for-one basis.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits required by Item 601 of Regulation S-K
Exhibit
Number Exhibit
------ -------
27 Financial Data Schedule
(b) Reports on Form 8-K
None.
-19-
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Act OF 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
INFERENCE CORPORATION
/s/ MARK A. WOLF
----------------------------------------
MARK A. WOLF
VICE PRESIDENT,
ACTING CHIEF FINANCIAL OFFICER
(Duly Authorized and Principal Financial
and Accounting Officer)
Dated: December 15, 1998
-20-
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