INFERENCE CORP /CA/, 10-Q, 1999-06-14

INFERENCE CORP /CA/
10-Q, 1999-06-14
PREPACKAGED SOFTWARE

Previous: BUSINESS RESOURCE GROUP, SC 13G, 1999-06-14

Next: PRO TECH COMMUNICATIONS INC, 10QSB, 1999-06-14

<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
April 30, 1999 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 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 June 7, 1999, there were 6,782,922 shares of the Registrant's Class A
Common Stock, par value $0.01 per share, and 535,332 shares of the
Registrant's Class B Common Stock, par value $0.01 per share, outstanding.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -1- June 11, 1999
<PAGE>

INFERENCE CORPORATION

Index

Page
----
Part I FINANCIAL INFORMATION

ITEM 1. Condensed Consolidated Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets
at April 30, 1999 and January 31, 1999....................... 3

Condensed Consolidated Statements of Operations for the
Three Months Ended April 30, 1999 and 1998................... 4

Condensed Consolidated Statements of Cash Flows for the
Three Months Ended April 30, 1999 and 1998................... 5

Notes to Condensed Consolidated Financial Statements............ 7

ITEM 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations..........................12

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk......21

Part II OTHER INFORMATION

ITEM 1. Legal Proceedings...............................................23

ITEM 2. Changes in Securities...........................................23

ITEM 3. Defaults upon Senior Securities.................................23

ITEM 4. Submission of Matters to a Vote of Security Holders.............23

ITEM 5. Other Information...............................................23

ITEM 6. Exhibits and Reports on Form 8-K................................23

Signature.......................................................24

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -2- June 11,1999
<PAGE>

INFERENCE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

<TABLE>
<CAPTION>
April 30, January 31,
1999 1999
------------ ------------
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents................................ $ 23,531,000 $ 25,761,000
Accounts receivable, net................................. 7,208,000 7,063,000
Other current assets..................................... 977,000 884,000
------------ ------------
Total current assets.................................... 31,716,000 33,708,000
Property and equipment, net............................... 1,569,000 1,607,000
Intangible assets, net.................................... 1,067,000 --
Other assets.............................................. 57,000 60,000
------------ ------------
$ 34,409,000 $ 35,375,000
============ ============

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Accounts payable......................................... $ 578,000 $ 819,000
Accrued salaries and related items....................... 1,651,000 1,764,000
Other accrued liabilities................................ 3,733,000 3,392,000
Deferred revenue......................................... 4,393,000 4,642,000
------------ ------------
Total current liabilities............................... 10,355,000 10,617,000

Shareholders' equity:
Common stock............................................. 73,000 70,000
Additional paid-in capital............................... 47,658,000 46,328,000
Accumulated deficit...................................... (23,366,000) (21,312,000)
Accumulated other comprehensive loss..................... (311,000) (328,000)
------------ ------------
Total shareholders' equity.............................. 24,054,000 24,758,000
------------ ------------
$ 34,409,000 $ 35,375,000
============ ============
</TABLE>

See accompanying notes.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -3- June 11, 1999
<PAGE>

INFERENCE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

Three Months Ended April 30,
---------------------------

1999 1998
------------ ------------

Revenues:
Products ................................... $ 3,077,000 $ 3,075,000
Services.................................... 3,317,000 3,274,000
------------ ------------
Total revenues.......................... 6,394,000 6,349,000

Operating costs and expenses:
Cost of product revenues.................... 158,000 217,000
Cost of service revenues.................... 1,684,000 1,839,000
Product development......................... 1,447,000 1,065,000
Sales and marketing......................... 3,922,000 3,733,000
General and administrative.................. 829,000 1,201,000
Acquisition related......................... 677,000 --
Restructuring............................... -- 1,321,000
------------ ------------
Total operating costs and expenses...... 8,717,000 9,376,000
------------ ------------
Loss from operations............................ (2,323,000) (3,027,000)
Interest income................................. 279,000 326,000
Other (expense) income, net..................... (10,000) 48,000
------------ ------------

Net loss........................................ $ (2,054,000) $ (2,653,000)
============ ============

Basic and diluted net loss per share............ $ (0.29) $ (0.36)
============ ============

Shares used in computing basis and diluted
net loss per share........................... 7,053,000 7,446,000
============ ============

See accompanying notes.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -4- June 11,1999
<PAGE>

INFERENCE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

Three Months Ended April 30,
--------------------------------
1999 1998
--------------- ---------------
<S> <C> <C>
Cash flows from operating activities:
Net loss................................................ $(2,054,000) $(2,653,000)
Adjustments to reconcile net loss to
net cash used in operating activities:
Acquired in-process research and development.......... 450,000 --
Depreciation and amortization......................... 320,000 248,000
Stock based compensation expense...................... -- 80,000
Changes in operating assets and
liabilities:
Accounts receivable................................. (140,000) 332,000
Other current assets................................ (86,000) 462,000
Other assets........................................ 4,000 92,000
Accounts payable.................................... (248,000) 73,000
Accrued salaries and related items.................. (131,000) (222,000)
Other accrued liabilities........................... 1,000 556,000
Deferred revenue.................................... (249,000) (558,000)
----------- -----------
Net cash used in operating activities................... (2,133,000) (1,590,000)

Cash flows from investing activities:
Net cash paid for acquisition of Verix Software......... (84,000) --
Purchases of property and equipment..................... (257,000) (221,000)
----------- -----------
Net cash used in investing activities................... (341,000) (221,000)

Cash flows from financing activities:
Net proceeds from issuance of common stock.............. 227,000 14,000
Repurchase of common stock.............................. -- (599,000)
----------- -----------
Net cash provided by (used in) financing activities..... 227,000 (585,000)
----------- -----------

Effect of exchange rate differences on cash.............. 17,000 (85,000)
----------- -----------

Net decrease in cash and cash equivalents................ (2,230,000) (2,481,000)
Cash and cash equivalents at beginning of period......... 25,761,000 28,010,000
----------- -----------

Cash and cash equivalents at end of period............... $23,531,000 $25,529,000
=========== ===========
</TABLE>

See accompanying notes.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -5- June 11, 1999
<PAGE>

INFERENCE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS--(Continued)

(Unaudited)

<TABLE>
<CAPTION>
Three Months Ended April 30,
----------------------------
1999 1998
------------ ------------
<S> <C> <C>
Supplemental disclosure of cash flow information:
Income taxes paid during the period................... $ 6,000 $ 68,000
============ ============

Supplemental disclosure of noncash investing
Transactions:
In connection with the acquisition of Verix Software
(Note 6), the following noncash transactions occurred
Fair value of assets acquired........................ $ 1,571,000 --
Issuance of common stock............................. (1,106,000) --
Cash paid............................................ (100,000) --
Accrued acquisition costs............................ (281,000) --
------------ ------------

Liabilities assumed.................................... $ 84,000 $ --
============ ============
</TABLE>

See accompanying notes.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -6- June 11, 1999
<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 recurring accruals and 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, 1999, included in the Annual Report
on Form 10-K. The results of operations for the three months ended April 30,
1999 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

The Company recognizes revenue in accordance with the Statement of Position
97-2, Software Revenue Recognition (SOP 97-2), as amended by Statement of
Position 98-4, Deferral of the Effective Date of a Provision of SOP 97-2. The
Company derives revenue from the sale of software licenses, post-contract
support ("support") and other services. Support includes telephone technical
support, bug fixes, and rights to unspecified upgrades on a when-and-if
available basis. Services range from installation, training, and basic
consulting for software modification to meet specific customer needs. In
software arrangements that include rights to multiple software products,
specified upgrades, support and/or other services, the Company allocates the
total arrangement fee among each deliverable based on the relative fair value of
each of the deliverables determined based on vendor-specific objective evidence.

Revenue from license fees is recognized when persuasive evidence of an
agreement exists, delivery of the product has occurred, no significant Company
obligations with regard to implementation remain, the fee is fixed or
determinable and collectibility is probable. If the fee due from the customer is
not fixed or determinable, revenue is recognized as payments become due from the
customer. If collectibility is not considered probable, revenue is recognized
when the fee is collected.

Revenue allocable to support is recognized on a straight-line basis over the
period support is provided.

Arrangements that include other software services are evaluated to determine
whether those services are essential to the functionality of other elements of
the arrangement. When services are considered essential, revenue under the
arrangement is recognized using contract accounting. When services are not
considered essential, the revenue allocable to the software services is
recognized as the services are performed.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -7- June 11, 1999
<PAGE>

INFERENCE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

(Unaudited)

3. Net Loss Per Share

Statement of Financial Accounting Standards No. 128 ("SFAS 128"), "Earnings
per Share," requires companies to compute net income per share under two
different methods, basic and diluted per share data, for all periods for which
an income statement is presented. Basic earnings per share is computed by
dividing net income by the weighted average number of common shares outstanding
for all periods. Diluted earnings per share reflects the potential dilution
that could occur if the income were divided by the weighted average number of
common and common stock equivalent shares outstanding during the period.
Diluted earnings per share is computed by dividing net income by the weighted
average number of common shares and common stock equivalents from outstanding
stock options and warrants. Common stock equivalents are calculated using the
treasury stock method and represent incremental shares issuable upon exercise of
the Company's outstanding options and warrants.

Options to purchase approximately 2,253,000 shares and 1,652,000 shares of
common stock were outstanding at April 30, 1999 and 1998, respectively, but were
not included in the computation of diluted earnings per share as a result of
their anti-dilutive effect. Such stock options could have a dilutive effect in
future periods. In addition, the diluted net loss per share at April 30, 1998
does not include the common stock equivalent effect of 22,000 shares of common
stock which could have been issued under outstanding warrants.

The following table sets forth the computation of basic and diluted net loss
per common share for the three months ended April 30, 1999 and 1998 (in
thousands, except per share information):

<TABLE>
<CAPTION>
1999 1998
------------- -------------
<S> <C> <C>
Numerator:
Net loss........................................... $ (2,054) $ (2,653)
------------- -------------

Denominator:
Denominator for basic net loss per
common share - weighted-average shares
outstanding....................................... 7,053 7,446
------------- -------------

Effect of dilutive securities:
Stock options and warrants..................... -- --
------------- -------------
Dilutive potential common shares............... -- --
------------- -------------

Denominator for diluted net loss per
Common share - adjusted weighted-average
Shares for assumed conversions.................... 7,053 7,446
============= =============

Basic and diluted net loss per share............... $ (0.29) $ (0.36)
============= =============
</TABLE>

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -8- June 11, 1999
<PAGE>

INFERENCE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

(Unaudited)

4. New Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board issued Statement No.
133, "Accounting for Derivative Instruments and Hedging Activity," which is
required to be adopted in years beginning after June 15, 1999. The Statement
will require the Company to recognize all derivatives on the balance sheet at
fair value. The Company does not anticipate that the adoption of this Statement
will have a significant effect on its results of operations or financial
position.

SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition, With
Respect to Certain Transactions" was issued in December 1998 and addresses
software revenue recognition as it applies to certain multiple-element
arrangements. SOP 98-9 also amends SOP 98-4, "Deferral of the Effective Date of
a Provision of SOP 97-2," to extend the deferral of application of certain
passages of SOP 97-2 through fiscal years beginning on or before March 15, 1999.
All other provisions of SOP 98-9 are effective for transactions entered into in
fiscal years beginning after March 15, 1999. The Company does not anticipate
that the adoption of this SOP will have a significant effect on its results of
operations or financial position.

5. Comprehensive Income

In 1998, the Company adopted Statement of Financial Accounting Standards No.
130, "Reporting Comprehensive Income," ("SFAS 130"). This statement requires
companies to report all changes in equity during a period, except those
resulting from investment by owners and distribution to owners, in a financial
statement for the period in which they are recognized. The following table
reconciles the net loss as reported to comprehensive loss under the provisions
of SFAS 130 for the three months ended April 30, 1999 and 1998 (In thousands):

<TABLE>
<CAPTION>
Three Months Ended April 30,
---------------------------
1999 1998
------------- ------------
<S> <C> <C>
Comprehensive loss:
Net loss.......................................... $ (2,054) $ (2,653)
Other comprehensive income (loss):
Foreign currency translation adjustments......... 17 (85)
------------- ------------

Total comprehensive loss....................... $ (2,037) $ (2,738)
------------- ------------
</TABLE>

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -9- June 11, 1999
<PAGE>

INFERENCE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

(Unaudited)

6. Business Acquisition

On April 30, 1999, the Company acquired all of the outstanding capital stock
of Verix Software ("Verix"), a privately held developer of Web direct sales
applications for e-commerce companies, for approximately $1,487,000. The
results of Verix' operations have been combined with those of the Company since
the date of acquisition.

The acquisition was accounted for using the purchase method of accounting.
Consideration for this transaction consisted of the following:

Cash...........................................$ 100,000
Inference common stock......................... 1,106,000
Acquisition costs.............................. 281,000
-----------
$ 1,487,000
===========

Certain items affecting the purchase price allocation are preliminary. The
aggregate purchase price was preliminarily allocated to the fair values of the
assets and liabilities acquired as follows:

Tangible assets $ 54,000
In-process research and development............. 450,000
Developed technology............................ 400,000
Goodwill........................................ 567,000
Workforce....................................... 100,000
Liabilities assumed............................. (84,000)
----------
$1,487,000
==========

A total of $677,000 was expensed in the quarter ended April 30, 1999 relating
to acquisition items. This was comprised of in-process research and development
of $450,000 and other acquisition related expenses of $227,000.

At the time of the acquisition, the value of in-process research and
development was comprised of on-going projects relating to the design and
development of an Internet Relationship Commerce (IRC) software solution. The
acquired in-process research and development was valued at $450,000 by an
independent appraiser. The value of the purchased in-process technology was
determined by estimating the projected net cash flows related to such products.
These cash flows were discounted back to their net present value at appropriate
risk adjusted rates. The resulting projected net cash flows from such projects
were based on management's estimates of revenues and operating profits related
to such projects. These estimates were based on several assumptions, including
those summarized below. This valuation was predicated on the determination that
the developmental projects at the time of acquisition were not technologically
feasible and had no future alternative use. This assumption was based on the
anticipated effort required to bring the acquired technologies to technological
feasibility as illustrated by the fact that Verix had not completed coding,
alpha testing, or beta documentation for the technologies related to the
projects and that the technologies of the projects have no alternative use other
than as a part of the software application which was not yet complete. This
value is attributable solely to the development efforts completed as of the
acquisition date.

The Company anticipates that products using the acquired in-process technology
will be generally released during the third quarter of fiscal 2000. The nature
of the efforts required to develop the purchased in-process technology into
commercially viable products principally relate to the completion of all
planning, designing, prototyping, verification and testing activities that are
necessary to establish that the product can be produced to meet its design
specifications, including functions, features and technical performance
requirements. If these projects fail to develop commercial products, based on
the acquired in-process technology, and are not successfully completed, the
sales and profitability of Inference may be adversely affected in future
periods. Additionally, the value of other intangible assets may become impaired.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -10- June 11, 1999
<PAGE>

INFERENCE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

(Unaudited)

6. Business Acquisition (Continued)

The total amount allocated to developed technology and goodwill is being
amortized on a straight-line basis over a period of five years from the date of
acquisition. The amount allocated to workforce is being amortized on a
straight-line basis over a period of two years.

Unaudited proforma combined results of operations for the three months ended
April 30, 1999 and 1998 have been prepared as if the acquisition occurred at the
beginning of each period.

<TABLE>
<CAPTION>
Three Months Ended April 30,
-----------------------------
1999 1998
----------- -----------
<S> <C> <C>
Total revenue............................................$ 6,394,000 $ 6,349,000
=========== ===========
Net loss.................................................$(2,232,000) $(3,383,000)
=========== ===========
Basic and diluted net loss per share.....................$ (0.31) $ (0.44)
=========== ===========
</TABLE>

7. Restructuring Costs

During the quarter ended April 30, 1998, the Company recorded restructuring
charges, primarily related to severance costs, in the amount of $1.3 million, as
a result of a reduction in force and personnel changes in the Company's
executive management team. Employees were terminated from all areas of the
Company, inlcuding the marketing, development and administrative areas. Such
changes resulted from the Company's adoption of a new strategic direction and
included a 12% reduction in the number of Company employees. Additional
restructuring charges totaling $253,000 were recorded in July 1998 as a result
of the Company's decision to downsize operations in its subsidiary in France.
Of the total charges, $76,000 and $170,000 remained unpaid at April 30, 1999 and
1998, respectively.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -11- June 11, 1999
<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 within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of Securities Exchange Act of
1934. 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, the size and
timing of customer orders for product licenses; timely release and acceptance of
new products, including the Company's recently announced k-Commerce Support
suite of products; ability to attract, train and retain key personnel; ability
to acquire and integrate new entities; dependence on partner relationships and
products; ability to control costs; and competitive actions in the marketplace.
These business factors and others are discussed further in the section of this
Form 10-Q entitled "Year 2000 Compliance," "Additional Factors That May Affect
Future Results," and "Quantitative and Qualitative Disclosures about Market
Risk." 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, including, without limitation, the Annual
Report on Form 10-K 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.

Three months ended April 30, 1999 and April 30, 1998

The following table sets forth the percentages that certain statement of
operations items are to total revenues for the three months ended April 30, 1999
and 1998:

Three months
ended April 30,
---------------------
1999 1998
-------- --------

Revenues:
Products 48% 48%
Services 52% 52%
-------- --------
Total 100% 100%
Operating costs and expenses:
Products 2% 3%
Services 26% 29%
Product development 23% 17%
Selling and marketing 61% 59%
General and administrative 13% 19%
Acquisition related 11% --
Restructuring -- 21%
-------- --------
Total 136% 148%
-------- --------
Loss from operations (36%) (48%)
======== ========

Revenues

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -12- June 11, 1999
<PAGE>

Revenue allocable to support is recognized on a straight-line basis over the
period support is provided.

Total revenues increased to $6,394,000 in the three months ended April 30,
1999 from $6,349,000 in the three months ended April 30, 1998, representing a 1%
increase. During the three month period ended April 30, 1998, one customer
accounted for 13% of total revenues.

Total revenues from the Americas operations increased to $3,933,000 in the
three months ended April 30, 1999 from $3,708,000 in the three months ended
April 30, 1998, representing a 6% increase. Total international revenues
decreased to $2,461,000 in the three months ended April 30, 1999 from $2,641,000
in the three months ended April 30, 1998, representing a 7% decrease. Total
international revenues for the three months ended April 30, 1999 and April 30,
1998 represented 38% and 42% of total revenues, respectively. The Company
currently has subsidiaries in the United Kingdom, France and the Netherlands,
offering licenses and consulting services, and has relationships with 22
distributors worldwide, serving Europe, the Middle East and Africa, and Asia and
the Pacific Rim. International operations, however, 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 operations and, consequently, the Company's
results of operations and financial condition.

Product Revenues

Product revenues increased to $3,077,000 in the three months ended April 30,
1999 from $3,075,000 in the three months ended April 30, 1998, representing an
increase of less than 1%. Product revenues represented 48% of total revenues
for the three months ended April 30, 1999 and April 30, 1998. During each of
the three month periods ended April 30, 1999 and 1998, one customer accounted
for 16% and 27% of total product revenues, respectively.

Product revenues from the Americas operations decreased to $1,856,000 in the
three months ended April 30, 1999 from $1,892,000 in the three months ended
April 30, 1998, representing a 2% decrease. International product revenues
increased to $1,221,000 in the three months ended April 30, 1999 from $1,183,000
in the three months ended April 30, 1998, representing a 3% increase.

Service Revenues

Total service revenues increased to $3,317,000 in the three months ended April
30, 1999 from $3,274,000 in the three months ended April 30, 1998, representing
a 1% increase.

Service revenues from the Americas operations increased to $2,077,000 in the
three months ended April 30, 1999 from $1,816,000 in the three months ended
April 30, 1998, representing a 14% increase. The increase was primarily due to
increased maintenance revenues. International service revenues decreased to
$1,240,000 in the three months ended April 30, 1999 from $1,458,000 in the three
months ended April 30, 1998, representing a 15% decrease. The decrease
primarily resulted from a decline in consulting revenues attributable to
decreased headcount in the international professional services operations.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -13- June 11, 1999
<PAGE>

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 $158,000 in the
three months ended April 30, 1999 from $217,000 in the three months ended April
30, 1998, representing a 27% decrease. The gross margin on product revenues was
95% and 93% for the three months ended April 30, 1999 and April 30, 1998,
respectively.

As part of its development of the k-Commerce product line, the Company intends
to incorporate certain third party technology into its products, allowing the
Company to focus on providing quality, performance and functionality in its
knowledge based technology. To the extent that the Company is required to pay
royalties to these third parties, the gross margin on product revenues will
decrease accordingly.

Cost of Service Revenues

Cost of service revenues, consisting principally of personnel-related costs
for consulting, training and technical support, decreased to $1,684,000 in the
three months ended April 30, 1999 from $1,839,000 in the three months ended
April 30, 1998, representing an 8% decrease. The gross margin on service
revenues was 49% and 44% for the three months ended April 30, 1999 and April 30,
1998, respectively. The gross margin on service revenues was slightly higher
than the prior year quarter as a result of a greater percentage of the services
business coming from the Company's maintenance support business, which earns a
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 facility costs, incurred in the
research, design, development and enhancement of the Company's products. Product
development expenses increased to $1,447,000 in the three months ended April 30,
1999 from $1,065,000 in the three months ended April 30, 1998, representing a
36% increase. Product development expense as a percentage of total revenues was
23% and 17% for the three months ended April 30, 1999 and April 30, 1998,
respectively. The increase was primarily due to the growth of the product
development organization to expand on the Company's k-Commerce product suite.

The Company believes that continued commitment to product development will be
required for the Company's k-Commerce products to obtain a competitive
advantage. Accordingly, the Company intends to allocate increasing resources to
product research and development. Such expenses may vary as a percentage of
total revenues.

Sales and Marketing

Sales and marketing expense consists primarily of salaries, benefits and
commissions of sales and marketing personnel, trade shows and promotional
expenses, and non-chargeable customer field service and sales support. Sales and
marketing expense increased to $3,922,000 in the three months ended April 30,
1999 from $3,733,000 in the three months ended April 30, 1998, representing a 5%
increase. Sales and marketing expense as a percentage of total revenues was 61%
and 59% for the three months ended April 30, 1999 and April 30, 1998,
respectively.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -14- June 11, 1999
<PAGE>

General and Administrative

General and administrative expense consists of the personnel costs for finance
and accounting, human resources, information systems and general management of
the Company. General and administrative expense decreased to $829,000 in the
three months ended April 30, 1999 from $1,201,000 in the three months ended
April 30, 1998, representing a 31% decrease. General and administrative expense
as a percentage of total revenues was 13% and 19% for the three months ended
April 30, 1999 and April 30, 1998, respectively. The decrease in general and
administrative expense primarily resulted from significant legal fees incurred
during the three months ended April 30, 1998 associated with the ServiceSoft
litigation, which was settled in July 1998. In addition, general and
administrative expense in the three months ended April 30, 1999 were reduced by
reimbursement of legal fees by the Company's insurance carrier.

Acquisition Related

Restructuring

Other Income, Net

Other income and expense, net, primarily interest income, decreased to
$269,000 in the three months ended April 30, 1999 from $374,000 in the three
months ended April 30, 1998, representing a 28% decrease. The decrease was
primarily due to a decrease in interest income resulting from a reduction in
cash and cash equivalents.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -15- June 11, 1999
<PAGE>

Liquidity and Capital Resources

Cash and cash equivalents at April 30, 1999 were $23,531,000, a decrease of
$2,230,000 since January 31, 1999. Working capital at April 30, 1999 was
$21,361,000.

Net cash used in operating activities amounted to $2,133,000 during the three
months ended April 30, 1999, as compared to net cash used in operating
activities of $1,590,000 during the three months ended April 30, 1998.

Investing activities for the three months ended April 30, 1999 included
$257,000 for purchases of property and equipment and $84,000 related to the
acquisition of Verix Software. The Company had no significant capital
commitments as of April 30, 1999.

Cash provided by financing activities for the three months ended April 30,
1999 included $227,000 for the issuance of 80,000 shares of the Company's common
stock.

The Company's international operations are principally transacted in British
pounds. 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 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 and the U.S.
dollar could have an adverse effect on the Company's financial position.

The Company believes that existing cash balances, taking into consideration
the anticipated effect of cash flows 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 April 30, 1999.
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. The Company is currently in the
process of testing and evaluating all internal hardware systems and software
applications, both domestically and internationally, to determine that they are
compliant with the Year 2000. 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

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -16- June 11, 1999
<PAGE>

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.

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 is in the process of developing a
contingency plan to address situations that may result if unanticipated problems
caused by undetected errors or defects in either internal systems or the
Company's products arise. The Company's contingency plan is expected to be
complete in the second quarter of fiscal year 2000. 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

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 and operating
results for the Company's fourth quarter are improved from 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. 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. Product revenue is also difficult to forecast because the
market for client/server and web-based software products is rapidly evolving,
and the Company's sales cycle, from initial trial to multiple copy purchases and
the provision of support services, varies substantially from customer to
customer. 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.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -17- June 11, 1999
<PAGE>

Product Transitions. The Company recently launched 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 purposes of extending the offerings and
capabilities of the Company's products. There can be no assurance that these
relationships will translate into increased revenues or 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. To the extent one or more of the Company's competitors introduce
products that more fully address customer requirements, the Company's business,
operating results and financial condition could be adversely affected. 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.

Continued Volatility of Stock Price. In the past, the price of the Company's
common stock has been volatile. Future announcements concerning the Company or
its competitors, quarterly variations in operating results, announcements of
technological innovations, the introduction of new products or changes in
products pricing policies by the Company or its competitors, proprietary rights
or other litigation, changes in earnings estimates or purchase recommendations
by analysts or other factors could cause the market price of the Company's Class
A Common Stock to fluctuate substantially, particularly on a quarterly basis.
In addition, stock prices for many technology companies fluctuate widely for
reasons which may be unrelated to operating results of such companies. These
fluctuations, as well as general economic, market and political conditions, such
as international currency and stock market volatility, recessions or military
conflicts, may materially and adversely affect the market price of the Company's
Class A Common Stock.

Risks Associated with Selling to Large Enterprise Customers. The Company
occasionally will sell its products to large enterprise customers. Large
enterprise customers are expected to deploy the Company's products in business
critical operations which involve significant capital and management commitments
by such customers. Potential large enterprise customers generally commit
significant resources to an evaluation of available software and require the
Company to expend substantial time, effort and money educating them about the
value of the Company's solutions. Sales of the Company's products to such
customers require an extensive sales effort throughout a customer's organization
because decisions to purchase such products generally involve the evaluation of
the software by a significant number of customer personnel in various functional
and geographic areas, each often having specific and conflicting requirements.
A variety of factors, including factors over which the Company has little or not
control, may cause potential large enterprise customers to favor a particular
supplier or to delay or forego a purchase. As a result of these or other
factors, the sales cycle for the Company's products is long, typically ranging
between three and nine months. As a result of the length of the sales cycle and
the significant selling expenses resulting from selling into the large
enterprise, the Company's ability to forecast the timing and amount of specific
sales is limited. The delay or failure to complete, in compliance with SOP
97-2, one or more large transactions to which the Company has devoted
significant resources could have a

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -18- June 11, 1999
<PAGE>

material adverse effect on the Company's business, operating results or
financial condition and could cause significant variations in the Company's
operating results from quarter to quarter.

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 Clarify, Inc. and Verity, Inc. and 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.

Risks Associated with the Acquisition of Verix. The managements of the
Company and Verix have entered into an acquisition agreement with the
expectation that the acquisition will result in beneficial synergies for the
Company and Verix. Achieving the anticipated benefits of the acquisition will
depend in part upon whether the integration of the two companies' businesses is
accomplished in an efficient and effective manner, and there can be no assurance
that this will occur. There are numerous risks associated with the acquisition,
which include, but are not limited to, (i) potential difficulties in integration
of the two companies' operations; (ii) the risk of diverting management's
attention from normal daily operations of the business; (iii) potential
difficulties in completing projects associated with in-process research and
development; (iv) risks of entering a market where the Company has no direct
prior experience and where competitors in such markets have stronger market
positions; and (v) the potential loss of key employees of the acquired company.
Acquisitions of high-technology companies are inherently risky and no assurance
can be given that the integration of the two companies' businesses will be
successful. Failure to successfully accomplish the integration of the two
companies' businesses could have a material adverse effect on the combined
company's business, financial condition or results of operations.

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 write-off of software development
costs or other assets, the incurrence of severance liabilities, the amortization
of expenses related to goodwill and other intangible assets and/or the
incurrence of debt, any of which could materially adversely affect the Company's
business, financial conditions, cash flows and results of operations.
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. In addition, potential acquisition candidates
targeted by the Company may not have audited financial statements, detailed

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -19- June 11, 1999
<PAGE>

financial information or any degree of internal controls. There can be no
assurance that an audit subsequent to any successful completion of an
acquisition will not reveal matters of significance, including with respect to
revenues, expenses, liabilities, contingent or otherwise, and intellectual
property. There can be no assurance that the Company would be successful in
overcoming these or any other significant risks encountered and failure to do so
could have a material adverse effect upon the Company's business, operating
results and financial condition.

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.

Dependence on the Continued Growth and Commercial Acceptance of the Web. The
Company's future success depends in part upon the widespread adoption of the Web
as a primary medium for business applications and communications. If the Web
does not continue to increase in importance as a commercial medium, the
Company's business, operating results and financial condition could be
materially affected. Critical issues concerning the commercial use of the Web,
such as security, reliability, cost, accessibility and quality of service,
remain unresolved and may negatively affect the growth of Web use or the
attractiveness of business communications over the Web.

Ability to Hire and Retain Skilled Personnel in a Tight Labor Market.
Qualified personnel are in great demand throughout the software industry. The
demand for qualified personnel is particularly acute in the San Francisco Bay
Area, due to the large number of software companies and the low unemployment in
the region. The Company's success depends in large part upon its ability to
attract, train, motivate and retain highly skilled employees, particularly sales
and marketing personnel, development personnel and other senior level employees.
The Company's failure to attract and retain the highly-trained technical
personnel that are integral to our direct sales, product development, and
professional services teams may limit the rate at which we can generate sales
and develop new products or product enhancements. This could have a material
effect on the Company's business, operating results and financial condition.

Dependence on Service Revenues. Service revenues represented 52% of total
revenues for the quarters ended April 30, 1999 and 1998. We anticipate that
service revenues will continue to represent a significant percentage of total
revenues. Because service revenues have lower gross margins than license
revenues, a continued increase in the percentage of total revenues represented
by service revenues or an unexpected decrease in license revenues could have a
detrimental impact on overall gross margins and operating results.
Additionally, service revenues depend in part on ongoing renewals of support
contracts by the Company's customers, some of which may not renew their support
contracts. If service revenues are lower than anticipated, the Company's
business, financial condition and operating results could be materially
adversely affected.

Uncertainty of Proprietary Rights. The Company's success depends in part upon
its proprietary technology. Although case-based reasoning 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 was
awarded two patents for its Case-Based Reasoning technology in December 1996,
and a third patent was awarded in January 1998. The Company's CBR technology is
embedded in its k-Commerce and 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 generally provides its products to end-users under signed license
agreements. These agreements are negotiated with and signed by the licensee. The
Company occasionally publishes articles regarding its technical developments in
industry publications that may prevent the Company from obtaining patent

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -20- June 11, 1999
<PAGE>

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.

Product Liability. The Company's license agreements with its customers
typically contain provisions designed to limit the Company's exposure to
potential product liability claims. However, it is possible that the limitation
of liability provisions contained in the Company's license agreements may not be
effective under the laws of certain jurisdictions. Although the Company has not
experienced any product liability claims to date, the sale and support of
products by the Company may entail the risk of such claims, and there can be no
assurance that the Company will not be subject to such claims in the future. A
successful product liability claim brought against the Company could have a
material adverse effect upon the Company's business, operating results and
financial condition.

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.

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.

Item 3. Quantitative and Qualitative Disclosure about Market Risk

Euro Currency. The participating member countries of the European Union agreed
to adopt the European Currency Unit (the "Euro") as the common legal currency
beginning January 1, 1999. On that same date they established fixed conversion
rates between their existing sovereign currencies and the Euro. The Euro will
then trade on currency exchanges and be available for non-cash transactions. A
three year transition period is expected during which transactions can be made
in the old currencies.

The Company is taking steps to evaluate internal system capabilities, review
the ability of financial institution vendors to support Euro transactions and
examine current marketing and pricing policies and strategies in light of the
Euro conversion. The cost of this effort is not expected to have a material
adverse effect on the Company's results of operations of financial condition.
There can be no assurance, however, that all issues related to the Euro
conversion have been identified and that any additional issues would not have a
material effect on the Company's results of operations or financial condition.
The conversion to the Euro may have competitive implications on the Company's
pricing and marketing strategies, the impact of which are not

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -21- June 11, 1999
<PAGE>

known at this time. Additionally, the Company is at risk to the extent its
principal European suppliers and customers are unable to deal effectively with
the impact of the Euro conversion. The Company has not yet completed its
evaluation of the impact of the Euro conversion on its functional currency
designations.

Interest Rate Risk. The Company's exposure to market rate risk for changes in
interest rates relates primarily to the Company's investment portfolio. The
Company has not used derivative financial instruments. The Company invests, by
policy, its excess cash balances in money market accounts, debt instruments of
the U.S. Government and its agencies, and in high-quality corporate issuers and
limits the amount of credit exposure to any one issuer. At April 30, 1999, the
Company's investments consisted primarily of funds contained in money market
accounts.

Investments in both fixed rate and floating rate interest earning instruments
carry a degree of interest rate risk. Fixed rate securities may have their fair
market value adversely impacted due to a rise in interest rates, while floating
rate securities may produce less income than expected if interest rates fall.
Due in part to these factors, the Company's future investment income may fall
short of expectations due to changes in interest rates.

Foreign Currency Risk. International sales are made mostly from the Company's
foreign sales subsidiaries in their respective countries and are typically
denominated in the local currency of each country. These subsidiaries also
incur most of their expenses in the local currency. Accordingly, all foreign
subsidiaries use the local currency as their functional currency.

The Company's international business is subject to risks typical of an
international business, including, but not limited to differing economic
conditions, changes in political climate, differing tax structures, other
regulations and restrictions, and foreign exchange rate volatility. Accordingly
the Company's future results could be materially adversely impacted by changes
in these or other factors.

The Company's exposure to foreign exchange rate fluctuations arises in part
from intercompany accounts in which costs incurred in the United States are
charged to the Company's foreign sales subsidiaries. These intercompany
accounts are typically denominated in the functional currency of the foreign
subsidiary in order to centralize foreign exchange risk with the parent company
in the United States. The Company is also exposed to foreign exchange rate
fluctuations as the financial results of foreign subsidiaries are translated
into U.S. dollars in consolidation. As exchange rates vary, these results, when
translated, may vary from expectations and adversely impact overall expected
results. The effect of foreign exchange rate fluctuations on the Company in the
quarter ended April 30, 1999 was not material.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -22- June 11, 1999
<PAGE>

PART II

OTHER INFORMATION

ITEM 1. Legal Proceedings

None.

ITEM 2. Changes in Securities

None.

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

On May 17, 1999, the Company filed a Form 8-K with the Securities and
Exchange Commission reporting that on April 30, 1999 the Company acquired all
of the outstanding capital stock of Verix Software.

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -23- June 11, 1999
<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,
Chief Financial Officer
(Duly Authorized Officer and Principal
Financial and Accounting Officer)

Dated: June 11, 1998

- --------------------------------------------------------------------------------
Inference Corporation (Form 10-Q) -24- June 11, 1999

<PAGE>
<ARTICLE> 5

<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> JAN-31-2000
<PERIOD-START> FEB-01-1999
<PERIOD-END> APR-30-1999
<CASH> 23,531,000
<SECURITIES> 0
<RECEIVABLES> 7,208,000
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 31,716,000
<PP&E> 5,896,000
<DEPRECIATION> 4,327,000
<TOTAL-ASSETS> 34,409,000
<CURRENT-LIABILITIES> 10,355,000
<BONDS> 0
0
0
<COMMON> 73,000
<OTHER-SE> 23,981,000
<TOTAL-LIABILITY-AND-EQUITY> 34,409,000
<SALES> 6,394,000
<TOTAL-REVENUES> 6,394,000
<CGS> 158,000
<TOTAL-COSTS> 1,842,000
<OTHER-EXPENSES> 2,124,000
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (2,054,000)
<INCOME-TAX> 0
<INCOME-CONTINUING> (2,054,000)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (2,054,000)
<EPS-BASIC> (.29)
<EPS-DILUTED> (.29)

</TABLE>