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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE QUARTERLY PERIOD ENDED OCTOBER 31, 2006
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NO. 000-25285
SERENA SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE | 94-2669809 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
2755 CAMPUS DRIVE, 3rd FLOOR, SAN MATEO, CALIFORNIA 94403-2538
(Address of principal executive offices, including zip code)
650-522-6600
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨ | Accelerated Filer ¨ | Non-accelerated filer x |
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes ¨ No x
As of November 30, 2006, 99,113,930 shares of the Registrant’s common stock, $0.01 par value per share, were outstanding.
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Condensed Consolidated Balance Sheets
(In thousands, except share data)
(Unaudited)
Successor October 31, 2006 | Predecessor January 31, 2006 | |||||||
ASSETS | ||||||||
Current assets | ||||||||
Cash and cash equivalents | $ | 37,475 | $ | 148,401 | ||||
Restricted cash | — | 3,260 | ||||||
Short-term investments | 3,377 | 60,837 | ||||||
Accounts receivable, net of allowance of $1,520 and $2,224 at October 31 and January 31, 2006, respectively | 31,087 | 35,464 | ||||||
Deferred taxes, net | 8,658 | 8,658 | ||||||
Prepaid expenses and other current assets | 5,179 | 4,838 | ||||||
Total current assets | 85,776 | 261,458 | ||||||
Long-term investments | — | 13,626 | ||||||
Property and equipment, net | 6,963 | 5,927 | ||||||
Goodwill | 807,840 | 300,551 | ||||||
Other intangible assets, net | 425,925 | 87,359 | ||||||
Other assets | 11,479 | 2,689 | ||||||
TOTAL ASSETS | $ | 1,337,983 | $ | 671,610 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
Current liabilities: | ||||||||
Short-term debt and current portion of long-term debt | $ | 32,143 | $ | — | ||||
Accounts payable | 10 | 2,551 | ||||||
Income taxes payable | 5,684 | 13,961 | ||||||
Accrued expenses | 25,208 | 25,835 | ||||||
Accrued interest on term loan and subordinated notes | 4,715 | 413 | ||||||
Deferred revenue | 59,370 | 67,305 | ||||||
Total current liabilities | 127,130 | 110,065 | ||||||
Deferred revenue, net of current portion | 14,154 | 10,608 | ||||||
Long-term liabilities | 3,328 | 1,953 | ||||||
Deferred taxes | 159,267 | 27,976 | ||||||
Term loan | 342,857 | — | ||||||
Senior subordinated notes | 200,000 | — | ||||||
Convertible subordinated notes | 5 | 220,000 | ||||||
Total liabilities | 846,741 | 370,602 | ||||||
Commitments and contingencies: | ||||||||
Stockholders’ equity: | ||||||||
Preferred stock, $0.01 par value; 10,000,000 shares authorized and no shares issued and outstanding at October 31, 2006; $0.001 par value, 5,000,000 shares authorized and no shares issued and outstanding at January 31, 2006 | — | — | ||||||
Series A Preferred stock, $0.01 par value; 1 share authorized, issued and outstanding at October 31, 2006 | — | — | ||||||
Common stock, $0.01 par value; 200,000,000 shares authorized and 99,113,930 shares issued and outstanding at October 31, 2006; $0.001 par value, 90,000,000 shares authorized and 41,380,171 shares issued and outstanding at January 31, 2006 | 991 | 41 | ||||||
Additional paid-in capital | 517,959 | 153,411 | ||||||
Deferred stock-based compensation | — | (8,744 | ) | |||||
Accumulated other comprehensive loss | (31 | ) | (4,529 | ) | ||||
Retained (deficit) earnings | (27,677 | ) | 160,829 | |||||
Total stockholders’ equity | 491,242 | 301,008 | ||||||
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 1,337,983 | $ | 671,610 | ||||
See accompanying notes to condensed consolidated financial statements.
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Condensed Consolidated Statements of Operations
For the Three Months and Nine Months Ended October 31, 2006 and 2005
(In thousands)
(Unaudited)
Successor | Predecessor | Successor | Predecessor | |||||||||||||||||
Nine Months Ended October 31, 2006 | ||||||||||||||||||||
Three Months Ended October 31, | For the Period From February 1, March 9, 2006 | For the Period From March 10, October 31, 2006 | Nine Months October 31, 2005 | |||||||||||||||||
2006 | 2005 | |||||||||||||||||||
Revenue: | ||||||||||||||||||||
Software licenses | $ | 22,018 | $ | 22,511 | $ | 2,847 | $ | 53,161 | $ | 63,510 | ||||||||||
Maintenance | 34,316 | 34,156 | 13,989 | 83,557 | 101,370 | |||||||||||||||
Professional services | 8,326 | 8,254 | 2,872 | 22,331 | 20,755 | |||||||||||||||
Total revenue | 64,660 | 64,921 | 19,708 | 159,049 | 185,635 | |||||||||||||||
Cost of revenue: | ||||||||||||||||||||
Software licenses | 564 | 846 | 238 | 1,663 | 2,368 | |||||||||||||||
Maintenance | 3,572 | 3,331 | 1,375 | 8,791 | 10,028 | |||||||||||||||
Professional services | 7,878 | 7,186 | 3,035 | 20,682 | 19,156 | |||||||||||||||
Amortization of acquired technology | 8,652 | 4,222 | 1,786 | 22,123 | 12,768 | |||||||||||||||
Total cost of revenue | 20,666 | 15,585 | 6,434 | 53,259 | 44,320 | |||||||||||||||
Gross profit | 43,994 | 49,336 | 13,274 | 105,790 | 141,315 | |||||||||||||||
Operating expenses: | ||||||||||||||||||||
Sales and marketing | 19,211 | 18,754 | 6,520 | 47,703 | 53,411 | |||||||||||||||
Research and development | 9,015 | 8,726 | 3,555 | 23,151 | 26,230 | |||||||||||||||
General and administrative | 5,907 | 5,334 | 1,806 | 15,641 | 14,494 | |||||||||||||||
Amortization of intangible assets | 9,091 | 2,560 | 1,098 | 23,338 | 7,956 | |||||||||||||||
Acquired in-process research and development | — | — | — | 4,100 | — | |||||||||||||||
Restructuring, acquisition and other charges | 587 | — | 41,916 | 1,188 | — | |||||||||||||||
Total operating expenses | 43,811 | 35,374 | 54,895 | 115,121 | 102,091 | |||||||||||||||
Operating income (loss) | 183 | 13,962 | (41,621 | ) | (9,331 | ) | 39,224 | |||||||||||||
Interest income | 462 | 1,708 | 856 | 2,647 | 4,198 | |||||||||||||||
Interest expense | (12,582 | ) | (825 | ) | (355 | ) | (32,462 | ) | (2,475 | ) | ||||||||||
Change in the fair value of derivative instrument | (2,028 | ) | — | — | (2,602 | ) | — | |||||||||||||
Amortization of debt issuance costs | (450 | ) | (335 | ) | (1,931 | ) | (1,182 | ) | (1,005 | ) | ||||||||||
(Loss) income before income taxes | (14,415 | ) | 14,510 | (43,051 | ) | (42,930 | ) | 39,942 | ||||||||||||
Income tax (benefit) expense | (5,163 | ) | 3,967 | (8,335 | ) | (15,254 | ) | 12,776 | ||||||||||||
Net (loss) income | $ | (9,252 | ) | $ | 10,543 | $ | (34,716 | ) | $ | (27,676 | ) | $ | 27,166 | |||||||
See accompanying notes to condensed consolidated financial statements.
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SERENA SOFTWARE, INC.
Condensed Consolidated Statements of Cash Flows
For the Nine Months Ended October 31, 2006 and 2005
(In thousands)
(Unaudited)
Predecessor | Successor | Predecessor | ||||||||||
Nine Months Ended October 31, 2006 | ||||||||||||
For the Period March 9, 2006 | For the Period From March 10, 2006 to October 31, 2006 | Nine Months Ended October 31, 2005 | ||||||||||
Cash flows from operating activities: | ||||||||||||
Net (loss) income | $ | (34,716 | ) | $ | (27,676 | ) | $ | 27,166 | ||||
Adjustments to reconcile net income (loss) to net cash provided by operating activities: | ||||||||||||
Depreciation | 319 | 1,824 | 2,119 | |||||||||
Deferred income taxes | (1,450 | ) | (17,742 | ) | (8,005 | ) | ||||||
Tax benefit from employee stock plans | — | — | 220 | |||||||||
(Release) provision in allowance for bad debts | (17 | ) | (482 | ) | 225 | |||||||
Accrued interest income, net of cash received | — | — | (83 | ) | ||||||||
Accrued interest expense on term credit facility and subordinated notes, net of cash paid | 355 | 29,827 | 2,475 | |||||||||
Interest expense on the fair market value adjustment on the interest rate swap | — | 2,602 | — | |||||||||
Amortization of debt issuance costs | 1,931 | 1,182 | 1,005 | |||||||||
Amortization of deferred stock-based compensation | 254 | 10,793 | 1,183 | |||||||||
Amortization of acquired technology | 1,786 | 22,123 | 12,768 | |||||||||
Amortization of intangible assets | 1,098 | 23,338 | 7,956 | |||||||||
Acquired in-process research and development | — | 4,100 | — | |||||||||
Change in the value of consideration in the acquisition of Merant Plc. | — | — | 4,033 | |||||||||
Change in the value of consideration in the acquisition of TeamShare, Inc. | — | — | 763 | |||||||||
Acquisition, restructure and other charges paid related to the Silver Lake partners transaction | 40,931 | 106 | — | |||||||||
Changes in operating assets and liabilities: | ||||||||||||
Accounts receivable | 2,345 | 4,364 | 3,497 | |||||||||
Prepaid expenses and other assets | 116 | 87 | (205 | ) | ||||||||
Accounts payable | (776 | ) | (2,111 | ) | (1,103 | ) | ||||||
Income taxes payable | (6,540 | ) | (1,390 | ) | 1,879 | |||||||
Accrued expenses | (1,322 | ) | 57 | 1,927 | ||||||||
Deferred revenue | 1,736 | 7,891 | (2,388 | ) | ||||||||
Net cash provided by operating activities | 6,050 | 58,893 | 55,432 | |||||||||
Cash flows provided by (used in) investing activities: | ||||||||||||
Purchases of property and equipment | (221 | ) | (2,616 | ) | (2,268 | ) | ||||||
Cash paid in acquisition of Merant plc, net of cash received and acquisition related costs paid | (139 | ) | (860 | ) | (3,514 | ) | ||||||
Cash paid in acquisition of Apptero, Inc., net of cash received and acquisition related costs paid | (32 | ) | (855 | ) | (3,196 | ) | ||||||
Cash paid in acquisition of Data Scientific Corp., net of cash received and acquisition related costs paid | — | (3,014 | ) | — | ||||||||
Acquisition and other related costs paid in the Silver Lake Partners transaction | (30,281 | ) | (17 | ) | — | |||||||
Cash paid in the Silver Lake Partners transaction | — | (826,396 | ) | — | ||||||||
Cash paid in the acquisition of Pacific Edge Software, Inc., net of cash received and acquisition related costs paid | — | (15,832 | ) | — | ||||||||
Sales (purchases) of short-term and long-term investments | 62,647 | 8,904 | (42,041 | ) | ||||||||
Restrictions removed on restricted cash and moved to cash & cash equivalents | — | 3,260 | — | |||||||||
Net cash provided by (used in) investing activities | 31,974 | (837,426 | ) | (51,019 | ) | |||||||
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SERENA SOFTWARE, INC.
Condensed Consolidated Statements of Cash Flows (Continued)
For the Nine Months Ended October 31, 2006 and 2005
(In thousands)
(Unaudited)
Predecessor | Successor | Predecessor | |||||||||
Nine Months Ended October 31, 2006 | |||||||||||
For the Period March 9, 2006 | For the Period From March 10, 2006 to October 31, 2006 | Nine Months Ended October 31, 2005 | |||||||||
Cash flows provided by (used in) financing activities: | |||||||||||
Sale of common stock under the employee stock purchase plan | — | 1,785 | |||||||||
Exercise of stock options under the employee stock option plan | 1,067 | — | 7,856 | ||||||||
Common stock repurchased under the stock repurchase plan | — | (48,601 | ) | ||||||||
Equity contributions from Silver Lake Partners and management | — | 335,816 | — | ||||||||
Debt issuance costs paid | — | (15,617 | ) | — | |||||||
Principal borrowings under the term credit facility | — | 400,000 | — | ||||||||
Principal borrowings under the senior subordinated notes | — | 200,000 | — | ||||||||
Principal payments on the term credit facility | — | (25,000 | ) | — | |||||||
Interest payments on the term credit facility and subordinated notes | — | (25,340 | ) | — | |||||||
Payments made to the Employee Benefits Trust | — | (3,238 | ) | — | |||||||
Payment on convertible subordinated notes including the conversion premium | — | (237,899 | ) | — | |||||||
Net cash provided by (used in) financing activities | 1,067 | 628,722 | (38,960 | ) | |||||||
Effect of exchange rate changes on cash | 132 | (338 | ) | 170 | |||||||
Net increase (decrease) in cash and cash equivalents | 39,223 | (150,149 | ) | (34,377 | ) | ||||||
Cash and cash equivalents at beginning of period | 148,401 | 187,624 | 133,330 | ||||||||
Cash and cash equivalents at end of period | $ | 187,624 | $ | 37,475 | $ | 98,953 | |||||
Supplemental disclosures of cash flow information: | |||||||||||
Income taxes paid | $ | — | $ | 3,848 | $ | 9,979 | |||||
Interest expense paid | $ | — | $ | 27,755 | $ | 1,650 | |||||
Non-cash investing and financing activity: | |||||||||||
Unrealized loss on marketable securities | $ | — | $ | (464 | ) | $ | (441 | ) | |||
Unrealized loss in fair value of derivative instrument | $ | — | $ | (2,602 | ) | $ | — | ||||
Change in the value of consideration in the acquisition of Merant Plc. | $ | — | $ | — | $ | (4,033 | ) | ||||
Change in the value of consideration in the acquisition of TeamShare, Inc. | $ | — | $ | — | $ | (763 | ) | ||||
Consideration payable to Apptero shareholders in the acquisition | $ | — | $ | 527 | $ | 963 | |||||
Common stock issued in the Silver Lake Partners transaction, including estimated fair value of options assumed and fair value in excess of cash paid on the acceleration of options | $ | — | $ | 508,157 | $ | — | |||||
Consideration payable to Data Scientific Corp. shareholders in the acquisition | $ | — | $ | 525 | $ | — | |||||
Consideration payable (receivable) to Serena Software, Inc. shareholders in the acquisition | $ | — | $ | 593 | $ | — | |||||
See accompanying notes to condensed consolidated financial statements.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) Basis of Presentation and Significant Accounting Policies
Serena Software, Inc. (“Serena” or the “Company”) is the largest global independent software company in terms of revenue focused solely on managing change across information technology, or IT, environments. Its products and services are used to manage and control change in mission critical technology and business process applications. Its software configuration management, business process management, helpdesk and requirements management solutions enable its customers to improve process consistency, enhance software integrity, mitigate risks, support regulatory compliance and boost productivity. The Company’s revenue is generated by software licenses, maintenance contracts and professional services. The Company’s software products are typically embedded within its customers’ IT environment, and are generally accompanied by renewable annual maintenance contracts.
On November 11, 2005, Spyglass Merger Corp. (“Spyglass”) and Serena entered into an Agreement and Plan of Merger (the “Agreement and Plan of Merger”), pursuant to which, among other things, Spyglass merged with and into Serena (the “Merger”), and Serena was the surviving corporation. The Merger was completed on March 10, 2006. Accordingly, the condensed consolidated statements of operations and condensed consolidated statements of cash flows are presented for periods preceding the Merger and the period succeeding the Merger. During fiscal year 2006, the Predecessor period is from February 1, 2005 to October 31, 2005. During fiscal year 2007, the Predecessor period is from February 1, 2006 through March 9, 2006 and the Successor period is from March 10, 2006 through October 31, 2006.
The accompanying unaudited condensed consolidated financial statements have been prepared on substantially the same basis as the audited consolidated financial statements, and in the opinion of management include all adjustments, consisting only of normal recurring adjustments, except as otherwise noted, necessary for their fair presentation. These unaudited condensed consolidated financial statements and the notes thereto have been prepared in accordance with the Instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all disclosures required by accounting principles generally accepted in the United States of America and Regulation S-X for annual financial statements. For these additional disclosures, readers should refer to the Company’s annual financial statements for the fiscal year ended January 31, 2006, included in the registration statement on Form S-4, which was filed on July 28, 2006. The interim results presented are not necessarily indicative of results for any subsequent quarter or for the fiscal year ending January 31, 2007.
Significant Accounting Policies
The Company’s significant accounting policies are described in the Company’s consolidated financial statements for the years ended January 31, 2004, 2005 and 2006, which were included in the registration statement on Form S-4, which was filed on July 28, 2006. There have been no changes to the Company’s significant accounting policies except as described below.
Stock-Based Compensation
Effective February 1, 2006, we adopted the provisions of, and accounted for stock-based compensation in accordance with, the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards No. 123—revised 2004 (“SFAS 123R”), “Share-Based Payment” which replaced Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Under the fair value
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
recognition provisions of SFAS 123R, stock-based compensation cost is measured at the grant date based on the fair value of the award over the requisite service period, which is the vesting period. We elected the modified- prospective method of adoption, under which prior periods are not revised for comparative purposes. The Company has elected the graded-vesting attribution method for recognizing stock-based compensation expense over the requisite service period for each separately vesting tranche of awards as though the awards were, in substance, multiple awards. The valuation provisions of SFAS 123R apply to new grants and to grants that were outstanding as of the effective date and are subsequently modified. Estimated compensation for grants that were outstanding as of the effective date will be recognized over the remaining service period using the compensation cost estimated for the SFAS 123 pro forma disclosures.
The adoption of SFAS 123R had a material impact on our condensed consolidated financial statements. See Note 4 “Stock-Based Compensation” for further information regarding our stock-based compensation assumptions and expenses, including pro forma disclosures for prior periods as if we had recorded stock-based compensation expense.
Derivative Instruments
The Company accounts for derivative instruments in accordance with the provisions of Statement of Financial Accounting Standards No. 133,“Accounting for Derivative Instruments and Certain Hedging Activities”(“SFAS 133”), as amended by Statement of Financial Accounting Standards No. 138,“Accounting for Certain Derivative Instruments and Certain Hedging Activity, an Amendment of SFAS 133”(“SFAS 138”) and Statement of Financial Accounting Standards No. 149,“Amendment on Statement 133 on Derivative Instruments and Hedging Activities”(“SFAS 149”). In accordance with these standards, all derivative instruments are recorded on the balance sheet at their respective fair values. Our derivative instrument has not been designated as a hedge, and accordingly, changes in the fair value of the derivative are recognized in the statement of operations.
Reclassifications and Adjustments
Certain reclassifications have been made to the balances for the three and nine months ended October 31, 2005 in order to conform to the October 31, 2006 presentations.
In the fiscal quarter ended October 31, 2005, $0.6 million in maintenance revenue was recognized that had been fully earned and collected that related to prior periods. The maintenance revenue recognized totaling $0.6 million represented less than 2% of total maintenance revenue in the quarter and was not considered material.
Major Customers
No single customer accounted for 10% or more of total revenue in either the fiscal quarter or fiscal nine months ended October 31, 2005, or 2006.
(2) Mergers and Acquisitions
Spyglass Merger Corp.
As discussed in Note 1 the Spyglass Merger was completed on March 10, 2006. Upon completion of the Merger, each share of Serena Common Stock issued and outstanding immediately prior to the effective time of
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
the Merger (other than shares held in the treasury of Serena, owned by Spyglass or any direct or indirect wholly owned subsidiary of Spyglass or Serena that was not an employee benefit trust or held by stockholders who were entitled to and who properly exercised appraisal rights under Delaware law) was converted into the right to receive $24.00 in cash, without interest. In addition, in connection with the Merger, a certain stockholder, who is one of our directors and who prior to the Merger was also an executive officer of Serena, exchanged equity interests in Serena, which were valued for purposes of such exchange at approximately $154.1 million, for equity investments in the surviving corporation. Also in connection with the Merger, certain members of Serena’s management team made equity investments in the surviving corporation through retention of their stock options and restricted stock or the acquisition of common stock in the surviving corporation. None of Serena’s existing $220 million of convertible subordinated notes (“Notes”) converted to Serena common stock prior to completion of the Merger. In accordance with the indenture provisions and upon proper notice of conversion, $154.6 million of Serena’s existing $220 million of Notes were exchanged for cash in an amount of $24.00 for each share of Serena common stock into which the Notes were convertible prior to the consummation of the Merger. Subsequent to the Merger, in May 2006, the remaining $65.4 million notes were exchanged for cash in an amount of $24.00 per share.
The Merger has been accounted for as an acquisition, using the purchase method of accounting, from the date of completion, March 10, 2006. This change has created many differences between reporting for Serena post-Merger, as Successor, and Serena pre-Merger, as Predecessor. The Predecessor financial statements for periods ending on or before March 10, 2006, generally will not be comparable to the Successor financial statements for periods after that date. Under purchase accounting, Serena’s tangible assets and liabilities and intangible assets have been recorded at fair value which has resulted in a new carrying basis for those assets and liabilities. The Merger has resulted in Serena having an entirely new capital structure, which has resulted in significant differences between the Predecessor’s and the Successor’s equity. In addition, in order to finance the acquisition, the Successor borrowed $400.0 million under a new senior secured Credit Facility, and issued $200.0 million in principal amount of 10 3/8% senior subordinated notes due 2016 and converted $220.0 million of pre-existing convertible notes.
In connection with the Merger, the Successor company recorded $798.2 million in goodwill. The goodwill is not expected to be deductible for tax purposes. The primary reason for the Merger and the factors that contributed to a purchase price that resulted in recognition of a significant amount of goodwill included the cash premium paid to public shareholders, the large installed base that generates a profitable and steady maintenance stream, allowing the company to leverage the new equity investment and it allows management to have a longer term outlook for business by taking the company’s equity private.
The total estimated purchase price was $1,009.2 million and consisted of a combination of cash and stock as follows (in thousands):
Cash paid | $ | 826,396 | |
Shares assumed | 155,510 | ||
Estimated fair value of options assumed | 16,497 | ||
Estimated direct transaction costs | 10,750 | ||
Total estimated purchase price of acquisition | $ | 1,009,153 | |
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
The total preliminary allocation of purchase price was as follows (in thousands):
Fair value of net liabilities assumed | $ | (70,851 | ) | |
Acquired technology | 165,800 | |||
Acquired in-process research and development | 4,100 | |||
Trademark / Trade name portfolio | 14,200 | |||
Customer relationships | 276,200 | |||
Deferred tax liability | (178,291 | ) | ||
Goodwill | 797,995 | |||
Total estimated purchase price of acquisition | $ | 1,009,153 | ||
Net tangible assets—The Predecessor company’s tangible assets and liabilities as of March 10, 2006 were reviewed and adjusted to their fair value as necessary. Debt issuance costs totaling $3.7 million and accrued interest expense of $0.5 million both associated with the Predecessor company’s $220 million of convertible subordinated notes that were converted in the Merger were written-off. The Predecessor company’s $220 million of convertible subordinated notes were fair value adjusted to include the conversion premium totaling $17.9 million.
Deferred revenues—The Predecessor company’s deferred revenue was derived primarily from maintenance and support contracts. We estimated our obligation related to the deferred revenue using the cost build-up approach. The cost build-up approach determines fair value by estimating the costs relating to fulfilling the obligation plus a normal profit margin. The sum of the costs and operating profit approximates the amount that we would be required to pay a third party to assume the support obligation. The estimated costs to fulfill the support obligation were based on the historical direct costs related to providing the support. As a result, we recorded an adjustment to reduce the Predecessor company’s carrying value of deferred revenue by $15.0 million to $84.5 million, which represents our estimate of the fair value of the contractual obligations assumed by the Successor company.
Other intangible assets—Approximately $165.8 million, $276.2 million and $14.2 million has been allocated to acquired technology, customer contracts and relationships, and Trademarks and Trade names, respectively.
Acquired product rights include developed and core technology and patents. Developed technology relates to the Predecessor Company’s products across all of their product lines that have reached technological feasibility. Core technology and patents represent a combination of the Predecessor Company’s processes, patents and trade secrets developed through years of experience in design and development of its products. We will amortize the fair value of the acquired product rights based on the pattern in which the economic benefits of the intangible asset will be consumed.
Customer contracts and relationships represent existing contracts and the underlying customer relationships. We will amortize the fair value of these assets based on the pattern in which the economic benefits of the intangible asset will be consumed.
Trademarks and Trade Names primarily relate to the Serena trade name and Dimensions, TeamTrack, ZMF and PVCS product names, which will be amortized on a straight-line basis.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
See Note 6 of our condensed consolidated financial statements for further information regarding other intangible assets.
Acquired in-process research and development—Approximately $4.1 million has been allocated to acquired in-process research and development. See Note 3 of our condensed consolidated financial statements for further information regarding acquired in-process research and development.
Goodwill—Approximately $798.0 million has been allocated to goodwill. Goodwill represents the excess of the purchase price over the fair value of the underlying net tangible and intangible assets. In accordance with SFAS 142, goodwill will not be amortized but instead will be tested for impairment at least annually (more frequently if certain indicators are present). See Note 6 of our condensed consolidated financial statements for further information regarding goodwill.
Taxes—As part of our accounting for the Merger, a portion of the overall purchase price was allocated to goodwill and acquired intangible assets. Amortization expense associated with acquired intangible assets is not deductible for tax purposes. Thus, approximately $178.3 million was established as a deferred tax liability for the future amortization of the intangible assets. Approximately $33.8 million of the deferred tax liabilities associated with the previous acquisitions were written off as a result. Any future adjustments to the valuation allowance, established at the time of the Merger, will be reflected in goodwill.
Any impairment charges made in the future associated with goodwill will not be tax deductible and will result in an increased effective income tax rate in the quarter the impairment is recorded.
Pro Forma Results
The unaudited financial information in the table below summarizes the results of operations of the Predecessor and Successor companies, on a pro forma basis, as though the Merger had occurred as of February 1, 2005. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the Merger had taken place on February 1, 2005 or of results that may occur in the future. The pro forma financial information for the nine months ended October 31, 2006 and 2005 includes amortization of acquired technologies, amortization of other intangible assets and amortization of stock-based compensation related to the Merger of $25.8 million, $27.2 million, and $12.2 million, respectively for the nine months ended October 31, 2006, and $22.6 million, $24.4 million, and $11.9 million, respectively for the nine months ended October 31, 2005. Restructuring costs and acquired in-process research and development costs have been excluded as they would not have been part of the results of operations for the nine months ended October 31, 2006 and 2005 that would have been achieved if the Merger had taken place on February 1, 2005.
The unaudited pro forma financial information for the nine months ended October 31, 2006 and 2005 is as follows (in thousands):
Nine Months Ended October 31, 2006 | Nine Months Ended October 31, 2005 | |||||||
Total revenue | $ | 178,757 | $ | 185,635 | ||||
Operating (loss) income | $ | (9,675 | ) | $ | 2,137 | |||
Net loss | $ | (31,172 | ) | $ | (19,016 | ) |
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
Pacific Edge Software, Inc.
On October 20, 2006, the Company acquired Pacific Edge Software, Inc. (“Pacific Edge”), a privately held company specializing in the development of project and portfolio management (“PPM”) solutions. The acquisition was accounted for using the purchase method of accounting, and accordingly, the results of operations of Pacific Edge are included in the Company’s consolidated financial statements from October 20, 2006.
With the acquisition of Pacific Edge, the Company addsMariner, a PPM product, to its existing solution set.Mariner complements Serena’s existing Change Governance strategy, which encompasses solutions for ALM, such as itsDimensionsproduct, and Operations Process Management, such as itsTeamTrack product.
The Company acquired 100% of Pacific Edge’s outstanding common stock in acquiring all of its assets and assuming all of its liabilities. The total estimated purchase price was $16.5 million and consisted of cash consideration of $16.0 million and acquisition costs of $0.5 million. The total preliminary allocation of purchase price to the fair value of tangible net assets assumed, intangible assets and goodwill was $1.1 million, $9.2 million and $9.8 million, respectively, all net of $3.6 million allocated to deferred tax liability.
(3) Acquired In-process Research and Development
As a result of the merger on March 10, 2006, the Successor company recorded acquired in-process research and development totaling $4.1 million. For this transaction, the premise of value was fair market value in continued use.
Among the assets that were valued by the Successor company were ChangeMan ZMF, ChangeMan DS/Dimensions, and RTM, new versions of which were under development at the acquisition date. These technologies then under development were valued on the premise of fair market value in continued use employing the income approach. This methodology is based on discounting to present value, at an appropriate risk-adjusted discount rate, both the expenditures to be made to complete the development efforts (excluding the efforts to be completed on the development efforts underway) and the operating cash flows which the applications are projected to generate, less a return on the assets necessary to generate the operating cash flows.
From these projected revenues, the Successor company deducted costs of sales, operating costs (excluding costs associated with the efforts to be completed on the development efforts underway), royalties and taxes to determine net cash flows. The Successor company estimated the percentage of completion of the development efforts for each application by comparing the estimated costs incurred and portions of the development accomplished through the acquisition date by the total estimated cost and total development effort of developing these same applications. This percentage was calculated for each application and was then applied to the net cash flows for which each application was projected to generate. These net cash flows were then discounted to present values using appropriate risk-adjusted discount rates in order to arrive at discounted fair values for each application.
The percentage complete and the appropriate risk-adjusted discount rate for each application were as follows:
Application Under Development | Percentage Complete | Discount Rate | ||||
ChangeMan ZMF | 95 | % | 16 | % | ||
ChangeMan DS/Dimensions | 89 | % | 16 | % | ||
RTM | 86 | % | 16 | % |
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
The rates used to discount the net cash flows to present value were initially based on the weighted average cost of capital (“WACC”). The Company used a discount rate of 16% for valuing the acquired in-process research and development. The discount rate is higher than the implied WACC due to the inherent uncertainties surrounding the successful development of the acquired in-process research and development, the useful life of such in-process research and development, the profitability levels of such in-process research and development, and the uncertainty of technological advances that were unknown at the time.
(4) Stock-Based Compensation
Effective February 1, 2006, the Company adopted the provisions of SFAS 123R. See Note 1 of our condensed consolidated financial statements for a description of Serena’s adoption of SFAS 123R.
Restricted Stock Purchase Agreements
In connection with the consummation of the Merger, the Company has entered into restricted stock agreements, dated as of March 10, 2006, with each of Mr. Woodward, the Company’s CEO, and Mr. Pender, the Company’s CFO. Pursuant to these agreements, Mr. Woodward was issued 604,800 shares of the Company’s common stock and Mr. Pender was issued 307,200 shares of the Company’s common stock. The awards are unvested and subject to the executive’s continued employment with Serena through June 16, 2010. In addition, if Serena is subject to a “change in control” (as defined in the agreements) while the executive remains an employee of Serena, the remaining unvested shares will immediately vest in full. The restricted stock agreements also provide that each of Mr. Woodward and Mr. Pender has the right to receive “gross-up payments” from Serena for excise taxes, if any, imposed under Section 4999 of the Internal Revenue Code by reason of payments or benefits made or provided to Mr. Woodward and Mr. Pender as a result of any transaction consummated on or prior to April 1, 2006 under their restricted stock agreements and under any other plans, programs and arrangements of Serena.
2006 Stock Incentive Plan
Following the completion of the Merger, Serena established a new stock incentive plan, the 2006 Stock Incentive Plan (the “2006 Plan”), which governs, among other things, the grant of options, restricted stock bonuses, and other forms of share-based payments covering shares of Serena’s common stock to our employees (including officers), directors and consultants. Serena common stock representing 12% of outstanding common stock on a fully diluted basis as of the date of the Merger is reserved for issuance under the 2006 Plan. Each award under the 2006 Plan will specify the applicable exercise or vesting period, the applicable exercise or purchase price, and such other terms and conditions as deemed appropriate. Stock options granted under the 2006 Plan are either “time options” that will vest and become exercisable over a four-year period or “time and performance options” that will vest based on the achievement of certain performance targets over a five-year period following the date of grant. All options granted under the 2006 Plan will expire not later than ten years from the date of grant, but generally will terminate earlier upon termination of employment. In the event of a sale of substantially all of the assets of Serena, or a merger or acquisition of Serena, the board of directors may provide that awards granted under the 2006 Plan will be cashed out, continued, replaced with new awards that substantially preserve the terms of the original awards, or terminated, with acceleration of vesting of the original awards determined at the discretion of the board of directors.
As of October 31, 2006, a total of 13,515,536 shares of common stock were reserved for issuance upon the exercise of stock options and for the future grant of stock options or awards under the 2006 Plan.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
The 2006 Plan does not include an evergreen provision to provide for automatic increases in the number of shares available for grant. Any increase in the number of shares available for grant under the 2006 Plan would require approval from the Company’s Board of Directors.
The Predecessor company’s Amended and Restated 1997 Stock Option and Incentive Plan (the “1997 Plan”), Amended and Restated 1999 Director Option Plan (the “1999 Director Plan”), and 1999 Employee Stock Purchase Plan (the “1999 Plan”) were all terminated concurrent with the completion of the merger. All shares that remained available for future issuance under the 1997 Plan, the 1999 Director Plan and the 1999 Plan at the time of their termination were cancelled. No further options can be granted under the 1997 Plan, the 1999 Director Plan or the 1999 Plan.
“Roll Over” Options
In connection with the merger, the management participants were permitted to elect to have the surviving company in the merger assume some or all of the Serena stock options that they held immediately prior to the merger and that had an exercise price of less than $24.00 per share. The number of shares subject to these “roll over” options was adjusted to be the number of shares equal to the product of (1) the difference between $24.00 and the exercise price of the option and (2) the quotient of the total number of shares of Serena’s common stock subject to such option, divided by $3.75. The exercise price of these “roll over” options was adjusted to $1.25 per share. The “roll over” options are subject to terms of the original option agreements with Serena, except that in the event of a “change in control” of Serena (as defined in the 2006 Plan), the treatment of the “roll over” options upon such transaction will be determined in accordance with the terms of the 2006 Plan.
Employee Stock Purchase Plan
In connection with the Merger, Serena’s 1999 Plan was terminated, and there were no offering periods under the plan on or after November 30, 2005.
Prior to February 1, 2006, Serena accounted for employee stock-based compensation using the intrinsic value method in accordance with APB 25, and related interpretations. The Company amortized deferred stock-based compensation on an accelerated basis in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” Since the exercise price of options granted under such plans was equal to the market value on the date of grant, no compensation cost had been recognized for grants under its stock option plans and stock purchase plans. In accordance with APB No. 25, the Company did not recognize compensation cost related to its employee stock purchase plan. If compensation cost for the Company’s stock-based compensation plans had been determined consistent with SFAS No. 123,“Accounting for Stock-Based Compensation”and SFAS No. 148,“Accounting for Stock-Based Compensation—Transition and Disclosure,”the Company’s net income (loss) would have been reduced to the pro forma amounts indicated in the table below.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
Prior to the adoption of SFAS 123R, the Company provided the disclosures required under SFAS 123. The Company generally did not recognize stock-based compensation expense for option grants to its employees in its consolidated statement of operations for periods prior to the adoption of SFAS 123R as most options granted had an exercise price equal to the market value of the underlying common stock on the date of the grant. Prior to February 1, 2006, unearned compensation resulted primarily from vested stock options assumed in acquisitions and restricted stock awarded to employees. The following table illustrates the effect on net income for the three and nine months ended October 31, 2005, if Serena applied the fair value recognition provisions of SFAS 123R to stock–based employee compensation (in thousands):
Predecessor | ||||||||
Three Months Ended October 31, 2005 | Nine Months Ended October 31, 2005 | |||||||
Net income as reported | $ | 10,543 | $ | 27,166 | ||||
Add: stock-based employee compensation expense included in reported net income, net of tax | 375 | 745 | ||||||
Deduct: total stock-based employee compensation expense determined under fair value based method for all awards, net of tax | (2,898 | ) | (8,770 | ) | ||||
Pro forma net income | $ | 8,020 | $ | 19,141 | ||||
Prior to the adoption of SFAS 123R, the Company presented unearned compensation as a separate component of stockholders’ equity. In accordance with the provisions of SFAS 123R, on February 1, 2006, the Predecessor company reclassified the balance in unearned compensation to additional paid-in capital on its balance sheet.
Prior to the adoption of SFAS 123R, the Company presented all tax benefits for deductions resulting from the exercise of stock options as operating cash flows on its statement of cash flows. SFAS 123R requires the cash flows resulting from the tax benefits for tax deductions in excess of the compensation expense recorded for those options (excess tax benefits) to be classified as financing cash flows. The Company did not record any excess tax benefits as financing cash inflows rather than as operating cash inflows on its statements of cash flows for either the Predecessor or Successor periods in the nine months ended October 31, 2006. Compensation costs capitalized as part of property and equipment was not material for all periods presented.
As of October 31, 2006, total unrecognized compensation costs related to unvested stock options and restricted stock awards was $28.0 million. Unvested stock options are expected to be recognized over a period of 6 to 6.5 years and restricted stock awards are expected to be recognized over a period of 4 years.
The fair value of each stock option grant under the stock option plans and the fair value of the employees’ purchase rights under the employee stock purchase plan (“ESPP”) are estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in the three and six months ended October 31, 2006 and 2005.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
Stock Option Plans | ESPP | |||||||||||||
Three Months Ended October 31, | ||||||||||||||
Successor 2006 | Predecessor 2005 | Successor 2006 | Predecessor 2005 | |||||||||||
Expected life (in years) |
| 6.0 to 6.5 | 4.5 | N/A | 0.5 | |||||||||
Risk-free interest rate |
| 4.6 | % | 4.4 | % | N/A | 4.3 | % | ||||||
Volatility |
| 55% to 63 | % | 62 | % | N/A | 32 | % | ||||||
Stock Option Plans | ESPP | |||||||||||||
Nine Months Ended October 31, | ||||||||||||||
Predecessor For the Period | Successor For the Period | Predecessor 2005 | Predecessor/ Successor 2006 | Predecessor 2005 | ||||||||||
Expected life (in years) | 3.75 | 6.0 to 6.5 | 4.5 | N/A | 0.5 | |||||||||
Risk-free interest rate | 4.8 | % | 4.6 | % | 4.4 | % | N/A | 4.3 | % | |||||
Volatility | 50 | % | 55% to 63 | % | 62 | % | N/A | 32 | % |
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We used historical volatility rates. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our options.
Under SFAS 123R, Serena’s expected volatility is based on the combination of historical volatility of the Company’s common stock and the Company’s peer group’s common stock over the period commensurate with the expected life of the options and the mean historical implied volatility from traded options. The risk-free interest rates are derived from the average U.S. Treasury constant maturity rates during the period, which approximate the rate in effect at the time of grant for the respective expected term. The expected terms are based on the observed and expected time to post-vesting exercise and/or cancellation of options. Serena does not anticipate paying any cash dividends in the foreseeable future and therefore uses an expected dividend yield of zero. Under SFAS 123R, Serena estimates forfeitures at the time of grant and revises those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses forecasted projections to estimate pre-vesting option forfeitures and records stock-based compensation expense only for those awards that are expected to vest.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
General Stock Option Information
The following table sets forth the summary of option activity under our stock option programs for the Predecessor period from February 1, 2006 through March 9, 2006 and Successor period from March 10, 2006 through October 31, 2006:
Options Available for Grant | Number of Options Outstanding | Weighted Exercise Price | |||||||
Predecessor company balances as of January 31, 2006 | 660,795 | 6,159,492 | $ | 19.16 | |||||
Activity during the Predecessor period from February 1, 2006 through March 9, 2006: | |||||||||
Granted with an exercise price equal to the fair value of common stock | — | — | |||||||
Exercised | — | (71,461 | ) | $ | 14.93 | ||||
Cancelled | — | (32,032 | ) | $ | 22.67 | ||||
Predecessor company balances as of March 9, 2006 | 660,795 | 6,055,999 | $ | 19.19 | |||||
Successor company balances as of March 9, 2006 | — | — | — | ||||||
Activity during the Successor period from March 10, 2006 through October 31, 2006: | |||||||||
Authorized, including options assumed from the Predecessor | 13,515,536 | — | — | ||||||
Options assumed in the merger | 3,940,574 | $ | 1.25 | ||||||
Options assumed in the merger | 5,955 | $ | 8.40 | ||||||
Granted | (11,105,000 | ) | 11,105,000 | $ | 5.00 | ||||
Exercised | — | — | — | ||||||
Cancelled | 71 | (71 | ) | $ | 1.25 | ||||
Cancelled | 120,000 | (120,000 | ) | $ | 5.00 | ||||
Successor company balances as of October 31, 2006 | 2,530,607 | 14,931,458 | $ | 4.01 | |||||
Information regarding the stock options outstanding at October 31, 2006 is summarized as follows:
Range of Exercise Price | Number Outstanding | Weighted Average Remaining Contractual Life | Weighted Exercise Price | Number Exercisable | Weighted Exercise Price | |||||||
$1.25 | 3,940,503 | 6.01 years | $ | 1.25 | 3,940,503 | $ | 1.25 | |||||
$5.00 | 10,985,000 | 9.41 years | $ | 5.00 | — | — | ||||||
$8.40 | 5,955 | 6.59 years | $ | 8.40 | 5,955 | $ | 8.40 | |||||
14,931,458 | 8.51 years | $ | 4.01 | 3,946,458 | $ | 1.26 | ||||||
The aggregate intrinsic value of options outstanding and options exercisable as of October 31, 2006 was $49.0 million and $14.8 million, respectively.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
General Restricted Stock Information
Non-Vested Shares | Weighted Average Grant Date Fair Value | ||||
Predecessor company balances as of January 31, 2006 | 475,000 | $ | 19.85 | ||
No activity during the Predecessor period from February 1, 2006 through March 9, 2006: | |||||
Predecessor company balances as of March 9, 2006 | 475,000 | $ | 19.85 | ||
Successor company balances as of March 9, 2006 | — | — | |||
Activity during the Successor period from March 10, 2006 through October 31, 2006: | |||||
Restricted stock assumed in the merger | 912,000 | $ | 5.00 | ||
Successor company balances as of October 31, 2006 | 912,000 | $ | 5.00 | ||
Stock-based compensation expense for the three months and nine months ended October 31, 2006 and 2005 is as follows (in thousands):
Successor | Predecessor | Successor | Predecessor | |||||||||||||
Nine Months Ended October 31, 2006 | ||||||||||||||||
Three Months Ended October 31, | For the Period From February 1, March 9, 2006 | For the Period From March 10, 2006 to October 31, 2006 | Nine Months October 31, 2005 | |||||||||||||
2006 | 2005 | |||||||||||||||
Cost of maintenance | $ | 139 | $ | 4 | $ | 1 | $ | 301 | $ | 14 | ||||||
Cost of professional services | 74 | 4 | 2 | 179 | 15 | |||||||||||
Stock-based compensation in cost of revenue | 213 | 8 | 3 | 480 | 29 | |||||||||||
Sales and marketing | 1,360 | 65 | 27 | 3,145 | 251 | |||||||||||
Research and development | 603 | 30 | 12 | 1,428 | 115 | |||||||||||
General and administrative | 2,353 | 492 | 212 | 5,740 | 788 | |||||||||||
Restructuring, acquisition and other charges | — | — | 18,457 | (1) | — | — | ||||||||||
Stock-based compensation in operating expenses | 4,316 | 587 | 18,708 | 10,313 | 1,154 | |||||||||||
Total stock-based compensation | $ | 4,529 | $ | 595 | $ | 18,711 | $ | 10,793 | $ | 1,183 | ||||||
(1) | Represents stock-based compensation expense from the acceleration of unvested stock options and unvested restricted stock resulting from the merger. |
(5) Acquisition-Related and Restructuring Charges and Accruals
The Successor company’s total acquisition-related and restructuring accrual is predominantly associated with the Merger in March 2006 and the Predecessor company’s acquisition of Merant in April 2004, and to a lesser extent, three smaller technology acquisitions in March 2005, March 2006 and October 2006.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
With respect to the Merger in March 2006, the Company recorded acquisition-related costs totaling $47.7 million, and employee severance and other restructuring costs totaling $0.6 million, accrued through purchase accounting. With the Merger, the major actions that comprised the employee severance plan included a company-wide review of the organization’s workforce and a notification to affected employees of the acquired entity. All such notifications occurred prior to the consummation of the Merger and the employee severance plan was essentially completed upon notification. All affected employees were terminated.
With respect to the Predecessor company’s smaller technology acquisition in March 2005 and the Successor company’s smaller technology acquisitions in March 2006 and October 2006, the companies recorded $0.1 million, $0.1 million and $0.5 million in legal and other acquisition-related costs, respectively.
In aggregate, the Predecessor Company and Successor Company combined accrued $42.6 million and paid $43.1 million in acquisition-related and restructuring charges in the nine months ended October 31, 2006. The nature of the acquisition-related and restructuring charges and the amounts paid and accrued as of October 31, 2005 and 2006 are summarized as follows (in thousands):
Severance, payroll taxes and other employee benefits | Facilities closures | Legal and other acquisition- | Total acquisition- related and charges and accruals | |||||||||||||
Predecessor company balances as of January 31, 2005 | $ | 5,066 | $ | 637 | $ | 940 | $ | 6,643 | ||||||||
Activity during the nine months ended October 31, 2005: | ||||||||||||||||
Accrued | — | — | 100 | 100 | ||||||||||||
Paid | (2,512 | ) | (340 | ) | (746 | ) | (3,598 | ) | ||||||||
Adjustments (1) | (1,428 | ) | (143 | ) | (665 | ) | (2,236 | ) | ||||||||
Predecessor company balances as of October 31, 2005 | $ | 1,126 | $ | 154 | $ | (371 | ) | $ | 909 | |||||||
Predecessor company balances as of January 31, 2006 | $ | 500 | $ | 155 | $ | 2,739 | $ | 3,394 | ||||||||
Activity during the Predecessor period from February 1, 2006 through March 9, 2006: | ||||||||||||||||
Accrued | 553 | — | 41,463 | 42,016 | ||||||||||||
Paid | (172 | ) | (2 | ) | (885 | ) | (1,059 | ) | ||||||||
Predecessor company balances as of March 9, 2006 | $ | 881 | $ | 153 | $ | 43,317 | $ | 44,351 | ||||||||
Successor company balances as of March 9, 2006 | $ | — | $ | — | $ | — | $ | — | ||||||||
Activity during the Successor period from March 10, 2006 through October 31, 2006: | ||||||||||||||||
Balances assumed from the Predecessor | 881 | 153 | 43,317 | 44,351 | ||||||||||||
Accrued | 10 | 201 | 366 | 577 | ||||||||||||
Paid | (545 | ) | 6 | (41,534 | ) | (42,073 | ) | |||||||||
Adjustments (2) | — | — | (200 | ) | (200 | ) | ||||||||||
Successor company balances as of October 31, 2006 | $ | 346 | $ | 360 | $ | 1,949 | $ | 2,655 | ||||||||
(1) | Purchase accounting adjustments recorded in the first fiscal quarter ended April 30, 2005 totaled $2.2 million and were the result of finalizing certain acquisition-related estimates associated with the Merant acquisition at the one year anniversary of the acquisition. There were no purchase accounting adjustments associated with acquisition-related and restructuring charges recorded in the second or third fiscal quarters ended July 31, 2005 and October 31, 2005. |
(2) | Purchase accounting adjustments recorded in the third fiscal quarter ended October 31, 2006 totaled $0.2 million and were the result of finalizing certain acquisition-related estimates associated with the Merger. |
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
Acquisition-related and restructuring accruals at October 31, 2005 and 2006 totaling $0.9 million and $2.7 million, respectively, are reflected in accrued expenses in the Company’s condensed consolidated balance sheets.
(6) Goodwill and Other Intangible Assets
(a) Goodwill:
The Company accounts for goodwill and certain intangible assets after an acquisition is completed in accordance with SFAS No. 142,“Goodwill and Other Intangible Assets”. As such, goodwill and other indefinite life intangible assets are not amortized but instead are periodically tested for impairment. The annual impairment test required by SFAS No. 142 is performed in the fourth fiscal quarter each year and has been performed in each of the fourth quarters of fiscal years 2004, 2005 and 2006. The Company has concluded that there were no indicators of impairment of goodwill as of October 31, 2006.
The change in the carrying amount of goodwill for the nine months ended October 31, 2006 is as follows (in thousands):
Predecessor company balance as of January 31, 2006 | $ | 300,551 | ||
Activity during the Predecessor period February 1, 2006 through March 9, 2006: | ||||
Purchase accounting adjustments to eliminate Predecessor goodwill | (300,551 | ) | ||
Successor company balance as of March 9, 2006 | — | |||
Goodwill recorded in the Merger | 797,995 | |||
Goodwill recorded in the Pacific Edge acquisition | 9,845 | |||
Successor company balance as of October 31, 2006 | $ | 807,840 | ||
Goodwill and other intangible assets consisted of the following (in thousands):
Successor | Predecessor | |||||
October 31, 2006 | January 31, 2006 | |||||
Goodwill | $ | 807,840 | $ | 300,551 | ||
Non-compete agreements | $ | — | $ | 10,933 | ||
Acquired technology | 178,186 | 93,755 | ||||
Customer relationships | 278,900 | 51,810 | ||||
Trademark / Trade name portfolio | 14,300 | 2,600 | ||||
471,386 | 159,098 | |||||
Less: accumulated amortization | 45,461 | 71,739 | ||||
$ | 425,925 | $ | 87,359 | |||
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(b) Other Intangible Assets:
Other intangible assets are comprised of the following (in thousands):
Predecessor As of January 31, 2006 | ||||||||||
Gross Carrying Amount | Accumulated Amortization | Net Carrying Amount | ||||||||
Amortizing intangible assets: | ||||||||||
Non-compete agreements | $ | 10,933 | $ | (4,925 | ) | $ | 6,008 | |||
Acquired technology | 93,755 | (48,636 | ) | 45,119 | ||||||
Customer relationships | 51,810 | (16,036 | ) | 35,774 | ||||||
Trademark / Trade name portfolio | 2,600 | (2,142 | ) | 458 | ||||||
Total | $ | 159,098 | $ | (71,739 | ) | $ | 87,359 | |||
Successor As of October 31, 2006 | ||||||||||
Gross Carrying Amount | Accumulated Amortization | Net Carrying Amount | ||||||||
Amortizing intangible assets: | ||||||||||
Non-compete agreements | $ | — | $ | — | $ | — | ||||
Acquired technology | 178,186 | (22,124 | ) | 156,062 | ||||||
Customer relationships | 278,900 | (22,196 | ) | 256,704 | ||||||
Trademark / Trade name portfolio | 14,300 | (1,141 | ) | 13,159 | ||||||
Total | $ | 471,386 | $ | (45,461 | ) | $ | 425,925 | |||
Aggregate amortization expense: | ||||||||||
For the remaining three months of year ending January 31, 2007 | $ | 18,307 | ||||||||
Estimated amortization expense: | ||||||||||
For year ended January 31, 2008 | 73,227 | |||||||||
For year ended January 31, 2009 | 72,915 | |||||||||
For year ended January 31, 2010 | 72,827 | |||||||||
For year ended January 31, 2011 | 71,534 | |||||||||
For year ended January 31, 2012 | 40,503 | |||||||||
Thereafter | 76,612 | |||||||||
Total | $ | 425,925 | ||||||||
As of October 31, 2006, the weighted average remaining amortization period for acquired technology is 52 months; trademark/trade name portfolio is 88 months; and customer relationships are 88 months. The total weighted average remaining amortization period for all identifiable intangible assets is 74 months. The aggregate amortization expense of acquired technology and other intangible assets was $17.7 million and $6.8 million in the three months ended October 31, 2006 and 2005, respectively, and $48.3 million and $20.7 million in the nine months ended October 31, 2006 and 2005, respectively. There were no impairment charges in the three month and nine month periods ended October 31, 2006 and 2005.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(7) Comprehensive (Loss) Income
We report components of comprehensive (loss) income in our annual consolidated statements of shareholders’ equity. Comprehensive (loss) income consists of net (loss) income, foreign currency translation adjustments, and unrealized losses on marketable equity securities. Total comprehensive (loss) income for the three and nine months ended October 31, 2006 and 2005 is as follows (in thousands):
Successor | Predecessor | Successor | Predecessor | |||||||||||||||||
Nine Months Ended October 31, 2006 | ||||||||||||||||||||
Three Months Ended October 31, | For the Period March 9, 2006 | For the Period October 31, 2006 | Nine Months October 31, | |||||||||||||||||
2006 | 2005 | |||||||||||||||||||
Comprehensive (loss) income: | ||||||||||||||||||||
Net (loss) income | $ | (9,252 | ) | $ | 10,543 | $ | (34,716 | ) | $ | (27,676 | ) | $ | 27,166 | |||||||
Other comprehensive (loss) income: | ||||||||||||||||||||
Foreign currency translation adjustments | (255 | ) | (27 | ) | 132 | (338 | ) | 170 | ||||||||||||
Unrealized gain (loss) on marketable securities, net of tax | 15 | (162 | ) | — | (464 | ) | (441 | ) | ||||||||||||
Other comprehensive (loss) income | (240 | ) | (189 | ) | 132 | (802 | ) | (271 | ) | |||||||||||
Total comprehensive (loss) income | $ | (9,492 | ) | $ | 10,354 | $ | (34,584 | ) | $ | (28,478 | ) | $ | 26,895 | |||||||
(8) Recent Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FIN 48”),“Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109,Accounting for Income Taxes.FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of this standard on our Consolidated Financial Statements.
In September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108,“Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”.SAB 108 provides interpretive guidance on how registrants should quantify financial statement misstatements. There is currently diversity in practice, with the two commonly used methods to quantify misstatements being the “rollover” method (which primarily focuses on the income statement impact of misstatements) and the “iron curtain” method (which focuses on the balance sheet impact). SAB 108 requires registrants to use a dual approach whereby both of these methods are considered in evaluating the materiality of financial statement errors. Prior materiality assessments will need to be considered using both the rollover and iron curtain methods. SAB 108 is effective for fiscal years ending on or after November 15, 2006. We do not expect this Statement to have a material impact on our Consolidated Condensed Financial Statements.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(9) Debt
Debt as of October 31, 2006 consists of the following (in thousands):
Successor | ||||
Senior Secured term loan, due March 10, 2013, three-month LIBOR plus 2.25% | $ | 375,000 | ||
Senior subordinated notes, due March 15, 2016, 10.375% | 200,000 | |||
Convertible subordinated notes due December 15, 2023, 1.5% | 5 | |||
Total long-term debt | 575,005 | |||
Less current portion | (32,143 | ) | ||
Total long-term debt, less current portion | $ | 542,862 | ||
Senior Secured Credit Agreement
In connection with the consummation of the Merger, the Successor Company entered into a senior secured credit agreement pursuant to a debt commitment we obtained from affiliates of the initial purchasers of our senior subordinated notes (“the Credit Facility”).
General. The borrower under the Credit Facility initially was Spyglass Merger Corp. and immediately following completion of the Merger became Serena. The Credit Facility provides for (1) a seven-year term loan in the amount of $400.0 million, which will amortize at a rate of 1.00% per year on a quarterly basis for the first six and three-quarters years after the closing date of the acquisition transactions, with the balance paid at maturity, and (2) a six-year revolving Credit Facility that permits loans in an aggregate amount of up to $75.0 million, which includes a letter of Credit Facility and a swing line facility. In addition, subject to certain terms and conditions, the Credit Facility provides for one or more uncommitted incremental term loan and/or revolving credit facilities in an aggregate amount not to exceed $150.0 million. Proceeds of the term loan on the initial borrowing date were used to partially finance the Merger, to refinance certain indebtedness of Serena and to pay fees and expenses incurred in connection with the Merger. Proceeds of the revolving Credit Facility and any incremental facilities will be used for working capital and general corporate purposes of the Predecessor Company and its restricted subsidiaries.
In the quarter ended July 31, 2006, the Company made a $25 million principal payment on the $400 million senior secured term loan.
Senior Subordinated Notes
We have outstanding $200.0 million principal amount of senior subordinated notes, which bear interest at a rate of 10.375%, payable semi-annually on March 15 and September 15, and which mature on March 15, 2016. Each of our domestic subsidiaries that guarantees the obligations under our senior secured credit agreement will jointly, severally and unconditionally guarantee the notes on an unsecured senior subordinated basis. We do not have any domestic subsidiaries and, accordingly, there are no guarantors. The notes are our unsecured, senior subordinated obligations, and the guarantees, if any, will be unsecured, senior subordinated obligations of the guarantors. The notes are subject to redemption at our option under terms and conditions specified in the indenture related to the notes, and may be redeemed at the option of the holders at 101% of their face amount, plus accrued and unpaid interest, upon certain change of control events.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
Subordinated Convertible Notes
On December 15, 2003, we issued an aggregate principal amount of $220.0 million of our 1.5% Convertible Subordinated Securities due 2023, or the convertible subordinated notes, in a private placement. We pay interest on June 15 and December 15 of each year. The first interest payment was made on June 15, 2004. Prior to the consummation of the Merger, the convertible subordinated notes were convertible under certain conditions into shares of Serena common stock at an initial conversion rate of 45.0577 shares per $1,000 principal (representing an initial conversion price of approximately $22.194 per share), subject to certain adjustments. Upon the consummation of the Merger, the convertible subordinated notes became convertible into $24.00 per share of Serena common stock into which such notes were convertible prior to the Merger. Approximately $4,000 of the convertible subordinated notes and an additional $1,000 in conversion premium remained outstanding on October 31, 2006. We expect to repurchase any such notes requested to be repurchased in the future.
Debt Covenants
The subordinated notes and the Credit Facility contain various covenants including limitations on additional indebtedness, capital expenditures, restricted payments, the incurrence of liens, transactions with affiliates and sales of assets. In addition, the Credit Facility requires the Company to comply with certain financial covenants, including leverage and interest coverage ratios and capital expenditure limitations. The Company was in compliance with all of the covenants of the Credit Facility as of October 31, 2006.
(10) Litigation Related to the Merger
On November 11, 2005, Serena entered into and Agreement and Plan of Merger with Spyglass. As a result of the announcement of the acquisition and beginning on November 11, 2005, several purported class action complaints were filed in the Delaware Chancery Court and the Superior Court of the State of California for the County of San Mateo naming Serena and the then members of our board of directors as defendants. In pursuing these actions, plaintiffs purported to represent stockholders of Serena who were similarly situated with the plaintiffs. Among other things, the complaints alleged that Serena’s then directors breached the fiduciary duties owed to the stockholders in approving the Merger with Spyglass Merger Corp. because they failed to take steps to maximize the value to Serena’s public stockholders.
On February 27, 2006, Serena and the other defendants reached an agreement in principle with the plaintiffs providing for the settlement of the actions. In connection with the settlement, Serena agreed to make available additional information to its stockholders. Some of that information was included in the Merger proxy statement. The remaining additional information was contained in a press release Serena issued on February 28, 2006. In return, the plaintiffs agreed to the dismissal of the actions and to withdraw all motions filed in connection with such actions. In addition, Serena agreed to pay the legal fees and expenses of plaintiffs’ counsel, subject to the approval by the respective courts. This payment did not affect the amount of Merger consideration that was paid to Serena’s stockholders in the Merger. Serena and the other defendants continue to deny plaintiffs’ allegations in the actions but agreed to settle the purported class actions to avoid costly litigation and the risk of delay to the closing of the Merger. On July 31, 2006, the California Superior Court conducted a hearing to consider the settlement and, on November 15, 2006, issued a final order approving the settlement, reducing the fee award to plaintiff’s counsel and dismissing the California action with prejudice. Following the judgment by the California Superior Court, the parties are required to submit the settlement to the Delaware Chancery Court for review and dismissal of the Delaware action. The settlement amount, including legal fees associated with the litigation settlement, has been accrued at January 31, 2006, and is included in acquisition-related and restructuring charges and accruals.
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SERENA SOFTWARE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(11) Derivative Instruments and Hedging Activities
The Company accounts for derivative instruments in accordance with the provisions of SFAS 133, as amended by SFAS 138 and SFAS 149. The Company utilizes certain derivative instruments to enhance its ability to manage risk relating to interest rate exposure. Derivative instruments are entered into for periods consistent with the related underlying exposures and are not entered into for speculative purposes. The Company documents all relationships between hedging instruments and hedged items, as well as its risk management objectives and strategies for undertaking various hedge transactions. In the second fiscal quarter ended July 31, 2006, the Company entered into an interest rate swap transaction to effectively convert the variable interest rate on a portion of its $400.0 million senior secured term loan to a fixed rate. The swap, which expires on April 10, 2010, is recorded on the balance sheet at fair value in accordance with SFAS 133. The swap has not been designated as a hedge and accordingly, changes in the fair value of the derivative are recognized in the statement of operations. The notional amount of the swap is $250.0 million initially and amortizes down over time to $126.0 million at the time the swap transaction expires on April 10, 2010. Under the terms of the swap, the company will pay an interest rate equal to the initial period LIBOR setting rate, set in arrears. In exchange, the Company will receive a fixed rate equal to 5.38%.
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ITEM 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are subject to safe harbors under the Securities Act of 1933 and the Securities Exchange Act of 1934. These forward-looking statements include, but are not limited to, statements about financial projections, operational plans and objectives, future economic performance and other projections and estimates contained in this report. When used in this report, the words “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions identify forward-looking statements. Because these forward-looking statements involve risks and uncertainties, they are subject to important factors that could cause actual results to differ materially from those expressed or implied by the forward-looking statements, including those factors discussed below under “Factors That May Affect Future Results” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in Item 2 of Part I of this report. We assume no obligation to update any forward-looking statements contained in this report.
Overview
We are the largest global independent software company in terms of revenue focused solely on managing change across information technology, or IT, environments. Our products and services are used to manage and control change in mission critical technology and business process applications. Our software configuration management, business process management, helpdesk and requirements management solutions enable our customers to improve process consistency, enhance software integrity, mitigate risks, support regulatory compliance and boost productivity. Our revenue is generated by software licenses, maintenance contracts and professional services. Our customers rely on our software products, which are typically embedded within their IT environment, and are generally accompanied by renewable annual maintenance contracts.
On March 10, 2006, Spyglass Merger Corp., an affiliate of Silver Lake Partners, a private equity firm, merged with and into Serena, a transaction we refer to in this report as the merger. Pursuant to the merger, Serena stockholders received $24.00 in cash in exchange for each share of stock, except that certain members of our management team retained a portion of their shares of Serena common stock and/or options to purchase Serena common stock after the merger. As a result of the merger, our common stock ceased to be traded on the NASDAQ National Market and we became a privately-held company, with approximately 56.5% of our common stock on a fully diluted basis owned by investment funds affiliated with Silver Lake Partners.
None of the $220.0 million of Serena convertible subordinated notes were converted into Serena common stock prior to the effective time of the merger, and so all the convertible subordinated notes became convertible into cash, following the merger, in an amount of $24.00 for each share of Serena common stock into which the convertible subordinated notes were convertible prior to the merger. Approximately $4,000 of the convertible subordinated notes, excluding conversion premiums totaling $1,000, remained outstanding on October 31, 2006. Holders had been able to convert such notes into cash in connection with the merger through March 25, 2006. On May 15, 2006, we extended the date on which holders could convert such notes into cash to May 30, 2006. On May 30, 2006, all but $4,000 of such notes, excluding the conversion premium of $1,000, were converted into cash.
In connection with the merger, Spyglass, the Silver Lake investors, Douglas Troxel and entities affiliated with Mr. Troxel entered into a stockholders agreement which required that, until the earlier of a control event or an initial public offering of shares of our common stock, the parties to that agreement that beneficially own shares of our common stock will vote those shares to elect a board of directors having a specified composition.
Also, in connection with the merger, we entered into a senior secured credit agreement, issued senior subordinated notes, and entered into other related transactions, which we refer to collectively as the acquisition transactions. After consummation of the acquisition transactions, we are highly leveraged. As of October 31, 2006, we had outstanding $575.0 million in aggregate indebtedness, including the conversion premium on the convertible subordinated notes, with an additional $75.0 million of borrowing capacity available under our new
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revolving credit facility. Our liquidity requirements are significant, primarily due to debt service requirements. On apro forma basis, after giving effect to the acquisition transactions, our cash interest expense for the fiscal year ended January 31, 2006 would have been $51.1 million.
We derive our revenue from software licenses, maintenance and professional services. Our distributed systems products are licensed on a per user seat basis. Customers typically purchase mainframe products under million instructions per second, or MIPS-based, perpetual licenses. Mainframe software products and applications are usually priced based on hardware computing capacity. The higher a hardware’s MIPS capacity, the more expensive a software license will be.
We also provide ongoing maintenance, which includes technical support, version upgrades and enhancements, for an annual fee of approximately 21% of the discounted list price of the licensed product for our distributed systems products and approximately 17% to 18% of the discounted list price of the licensed product for our mainframe products. We recognize maintenance revenue over the term of the maintenance contract on a straight-line basis.
Professional services revenue is derived from technical consulting and educational services. Our professional services are typically billed on a time and materials basis and revenue is recognized as the related services are performed. Maintenance revenue and professional services revenue have lower gross profit margins than software license revenue as a result of the costs inherent in operating our customer support and professional services organizations.
In the current fiscal quarter ended October 31, 2006, when compared to the same quarter a year ago, total revenues remained essentially unchanged, as total revenues for such period were $64.7 million versus $64.9 million in the same period from a year ago. The slight decrease in total revenues was primarily due to the maintenance revenue write-down to fair value in connection with the merger offset by improvements in our consulting business, fueled in part by a continued increase in the number of large engagements. In the current fiscal nine months ended October 31, 2006, when compared to the same nine months a year ago, total revenues decreased 4%, as total revenues were $178.8 million in the current fiscal nine months versus $185.6 million in the same nine months a year ago. The decrease in total revenues was primarily the result of slower seasonal software purchasing activity and distractions related to the merger, and the maintenance revenue write-down to fair value in connection with the merger; all partially offset by improvements in our consulting business, fueled in part by a continued increase in the number of large engagements.
In the current fiscal quarter and fiscal nine months ended October 31, 2006, 65% and 71%, respectively, of our total software license revenue came from our distributed systems products and 35% and 29%, respectively, came from our mainframe products.
Historically, our revenue has been generally attributable to sales in North America, Europe and to a lesser extent Asia Pacific. Revenue attributable to sales in North America accounted for approximately 67% and 66% of our total revenue for the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to 69% and 65% in the same quarter and nine months, respectively, a year ago.
Our international revenue is attributable principally to our European operations. International revenue accounted for approximately 33% and 34% of our total revenue for the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to 31% and 35% in the same quarter and nine months, respectively, a year ago.
Critical Accounting Policies and Estimates
This discussion is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported
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amounts of assets, liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by us. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation of our financial condition or results of operations could be affected.
On an ongoing basis, management evaluates its estimates and judgments, including those related to revenue recognition, trade accounts receivable and allowance for doubtful accounts, impairment or disposal of long-lived assets, and accounting for income taxes, among other things. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We refer to accounting estimates of this type as critical accounting policies, which are discussed further below.
In addition to these estimates and assumptions that we utilize in the preparation of historical financial statements, the inability to properly estimate the timing and amount of future revenue could significantly affect our future operations. We must make assumptions and estimates as to the timing and amount of future revenue. Specifically, our sales personnel monitor the status of all proposals, including the estimated closing date and potential dollar amount of such transactions. We aggregate these estimates periodically to generate a sales pipeline and then evaluate the pipeline to identify trends in our business. This pipeline analysis and related estimates of revenue may differ significantly from actual revenue in a particular reporting period as the estimates and assumptions were made using the best available data at the time, which is subject to change. Specifically, slowdowns in the global economy and information technology spending has caused and may continue to cause customer purchasing decisions to be delayed, reduced in amount or cancelled, all of which have reduced and could continue to reduce the rate of conversion of the pipeline into contracts. A variation in the pipeline or the conversion rate of the pipeline into contracts could cause us to plan or budget inaccurately and thereby could adversely affect our business, financial condition or results of operations. In addition, because a substantial portion of our software license contracts close in the latter part of a quarter, we may not be able to adjust our cost structure to respond to a variation in the conversion of the pipeline in a timely manner, and thereby the delays may adversely and materially affect our business, financial condition or results of operations.
We believe the following are critical accounting policies and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition. We recognize revenue in accordance with Statement of Position, or SOP, 97-2, Software Revenue Recognition, as amended by SOP 98-9, and recognize revenue when all of the following criteria are met as set forth in paragraph 8 of SOP 97-2: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the fee is fixed or determinable and (4) collectibility is probable.
For contracts with multiple elements (e.g., license and maintenance), revenue is allocated to each component of the contract based on vendor specific objective evidence, or VSOE, of its fair value, which is the price charged when the elements are sold separately. Since VSOE of fair value has not been established for software licenses, the residual method is used to allocate revenue to the license portion of multiple-element arrangements.
We sell our products to our end users and distributors under license agreements or purchase orders. Software license revenue from license agreements or purchase orders is recognized upon receipt and acceptance of a signed contract or purchase order and delivery of the software, provided the related fee is fixed or determinable and collection of the fee is probable. If an acceptance period is required, revenue is recognized upon the earlier of customer acceptance or the expiration of the acceptance period, as defined in the applicable software license agreement. Each new mainframe license includes maintenance, which includes the right to receive telephone
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support, “bug fixes” and unspecified upgrades and enhancements, for a specified duration of time, usually one year. The fee associated with such agreements is allocated between software license revenue and maintenance revenue based on the residual method.
We recognize maintenance revenue ratably over the life of the related maintenance contract. Maintenance contracts on perpetual licenses generally renew annually. We typically invoice and collect maintenance fees on an annual basis at the anniversary date of the license. Deferred revenue represents amounts received by us in advance of performance of the maintenance obligation. Professional services revenue includes fees derived from the delivery of training, installation, and consulting services. Revenue from training, installation, and consulting services is recognized on a time and materials basis as the related services are performed. These services do not involve significant production, modification or customization of the software and the services are not essential to the functionality of the software.
Stock-based Compensation. Effective February 1, 2006, the Company adopted the provisions of, and accounted for stock-based compensation in accordance with, the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123R (“SFAS 123R”), “Share-Based Payment”. The Company elected the modified prospective application method of adoption, under which prior periods are not revised for comparative purposes. The valuation provisions of SFAS 123R apply to new grants and to grants that were outstanding as of the effective date and are subsequently modified. Under the fair value recognition provisions of SFAS 123R stock-based compensation cost is measured at the grant date based on the fair value of the award over the requisite service period, which is the vesting period. For stock-based awards granted on or after February 1, 2006, the Company has elected the graded-vesting attribution method for recognizing stock-based compensation expense over the requisite service period for each separately vesting tranche of awards as though the awards were, in substance, multiple awards. Estimated compensation for grants that were outstanding as of the effective date will be recognized over the remaining service period using the compensation costs estimated for the SFAS No. 123 pro forma disclosures.
The Company currently uses the Black-Scholes option pricing model to determine the fair value of stock options. The determination of the fair value of stock-based awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.
The Company estimates the expected term of options granted based on observed and expected time to post-vesting exercise and/or cancellations. Expected volatility is based on the combination of historical volatility of our common stock and our peer group’s common stock over the period commensurate with the expected life of the options. The Company bases the risk-free interest rate that the Company uses in the option pricing model on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore use an expected dividend yield of zero in the option pricing model. The Company is required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses forecasted projections to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. All stock-based awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods.
If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods or if we decide to use a different valuation model, the future periods may differ significantly from what we have recorded in the current period and could materially affect our operating income, net income and net income per share.
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics not present in our option grants.
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Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our stock-based compensation. Consequently, there is a risk that our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our financial statements. There currently is no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values.
The guidance in SFAS 123R and SAB 107 is relatively new. The application of these principles may be subject to further interpretation and refinement over time. There are significant differences among valuation models, and there is a possibility that we will adopt different valuation models in the future. This may result in a lack of consistency in future periods and materially affect the fair value estimate of stock-based payments. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.
Stock-based compensation expense related to employee stock options and restricted stock awards recognized under SFAS 123R for the Predecessor period running from February 1, 2006 through March 9, 2006 was $18.7 million and for the Successor period running from March 10, 2006 through October 31, 2006 was $10.8 million.
See Note 4 of our condensed consolidated financial statements for further information regarding the SFAS 123R disclosures.
Valuation of Long-Lived Assets, Including Goodwill. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” assets such as property, plant and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Such events or changes in circumstances include, but are not limited to, a significant decrease in the fair value of the underlying business or asset, a significant decrease in the benefits realized from the acquired business or asset, difficulties or delays in integrating the business, or a significant change in the operations of the acquired business or use of an asset. Recoverability of long-lived assets other than goodwill is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Significant management judgment is required in identifying a triggering event that arises from a change in circumstances; forecasting future operating results; and estimating the proceeds from the disposition of long-lived or intangible assets. Material impairment charges could be necessary should different conditions prevail or different judgments be made. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and would be no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.
To date, there has been no significant impairment of long-lived assets.
In accordance with SFAS No. 142, goodwill is tested annually for impairment in the fourth quarter of each fiscal year, and is tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. Factors we consider important which could trigger an impairment review include, but are not limited to, significant under-performance relative to expected, historical or projected future operating results, significant changes in the manner of our use of acquired assets or the strategy for our overall business, or
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significant negative economic trends. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. First, we determine the fair value of a reporting unit and compare it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill.
We completed this test during the fourth quarters of fiscal year 2004, fiscal year 2005 and fiscal year 2006, and we have not recorded an impairment loss on goodwill.
Accounting for Income Taxes. Income taxes are recorded using the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We assess the likelihood that deferred tax assets will be recoverable from future taxable income and a valuation allowance is provided if it is determined more likely than not that some portion of the deferred tax assets will not be realized.
Recent Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FIN 48”),“Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of this standard on our Consolidated Financial Statements.
In September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108,“Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”.SAB 108 provides interpretive guidance on how registrants should quantify financial statement misstatements. There is currently diversity in practice, with the two commonly used methods to quantify misstatements being the “rollover” method (which primarily focuses on the income statement impact of misstatements) and the “iron curtain” method (which focuses on the balance sheet impact). SAB 108 requires registrants to use a dual approach whereby both of these methods are considered in evaluating the materiality of financial statement errors. Prior materiality assessments will need to be considered using both the rollover and iron curtain methods. SAB 108 is effective for fiscal years ending on or after November 15, 2006. We do not expect this Statement to have a material impact on our Consolidated Condensed Financial Statements.
Historical Results of Operations
The following table sets forth our historical results of operations expressed as a percentage of total revenue and is not necessarily indicative of the results for any future period. Historical results include the post-acquisition results of TeamShare, Inc., or TeamShare, from June 5, 2003, Merant plc, or Merant, from April 23, 2004, Integrated Chipware’sRTM product from June 21, 2004, the Apptero product from March 7, 2005, and Pacific Edge Software, Inc., or Pacific Edge, from October 20, 2006.
For purposes of the nine months ended October 31, 2006 discussed herein, we have aggregated the Predecessor period from February 1, 2006 through March 9, 2006 and the Successor period from March 10, 2006 through October 31, 2006, without further adjustment. The supplemental aggregate disclosures and discussions are not in accordance with, or an alternative for, generally accepted accounting principles, and are provided
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solely for the purpose of providing additional supplemental information when comparing the Predecessor period from February 1, 2006 through March 9, 2006 plus the Successor period from March 10, 2006 through October 31, 2006 to the Predecessor nine month period ended October 31, 2005.
The following table sets forth our results of operations expressed as a percentage of total revenue. These operating results for the periods presented are not necessarily indicative of the results for the full fiscal year or any other period.
Successor | Predecessor | Successor | Predecessor | ||||||||||||
Nine Months Ended October 31, 2006 | |||||||||||||||
Three Months Ended October 31, | For the to March 9, 2006 | For the Period From October 31, 2006 | Nine Months Ended October 31, 2005 | ||||||||||||
2006 | 2005 | ||||||||||||||
Revenue: | |||||||||||||||
Software licenses | 34 | % | 35 | % | 14 | % | 33 | % | 34 | % | |||||
Maintenance | 53 | % | 52 | % | 71 | % | 53 | % | 55 | % | |||||
Professional services | 13 | % | 13 | % | 15 | % | 14 | % | 11 | % | |||||
Total revenue | 100 | % | 100 | % | 100 | % | 100 | % | 100 | % | |||||
Cost of revenue: | |||||||||||||||
Software licenses | 1 | % | 1 | % | 1 | % | 1 | % | 1 | % | |||||
Maintenance | 6 | % | 5 | % | 7 | % | 5 | % | 6 | % | |||||
Professional services | 12 | % | 11 | % | 16 | % | 13 | % | 10 | % | |||||
Amortization of acquired technology | 13 | % | 7 | % | 9 | % | 14 | % | 7 | % | |||||
Total cost of revenue | 32 | % | 24 | % | 33 | % | 33 | % | 24 | % | |||||
Gross profit | 68 | % | 76 | % | 67 | % | 67 | % | 76 | % | |||||
Operating expenses: | |||||||||||||||
Sales and marketing | 30 | % | 29 | % | 33 | % | 30 | % | 29 | % | |||||
Research and development | 14 | % | 13 | % | 18 | % | 14 | % | 14 | % | |||||
General and administrative | 9 | % | 8 | % | 9 | % | 10 | % | 8 | % | |||||
Amortization of intangible assets | 14 | % | 4 | % | 5 | % | 15 | % | 4 | % | |||||
Acquired in-process research and development | — | — | — | 3 | % | — | |||||||||
Restructuring, acquisition and other charges | 1 | % | — | 213 | % | 1 | % | — | |||||||
Total operating expenses | 68 | % | 54 | % | 278 | % | 72 | % | 55 | % | |||||
Operating income (loss) | — | 22 | % | (211 | )% | (6 | )% | 21 | % | ||||||
Interest income | 1 | % | 2 | % | 5 | % | 2 | % | 2 | % | |||||
Interest expense | (19 | )% | (1 | )% | (2 | )% | (20 | )% | (1 | )% | |||||
Change in fair value of derivative instrument | (3 | )% | — | — | (2 | )% | — | ||||||||
Amortization of debt issuance costs | (1 | )% | (1 | )% | (10 | )% | (1 | )% | — | ||||||
(Loss) income before income taxes | (22 | )% | 22 | % | (218 | )% | (27 | )% | 22 | % | |||||
Income tax (benefit) expense | (8 | )% | 6 | % | (42 | )% | (10 | )% | 7 | % | |||||
Net (loss) income | (14 | )% | 16 | % | (176 | )% | (17 | )% | 15 | % | |||||
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Revenue
We derive revenue from software licenses, maintenance, and professional services. Our total revenue decreased $0.3 million, or less than 1%, to $64.7 million in the fiscal quarter ended October 31, 2006 from $64.9 million in the same quarter a year ago. For the nine months ended October 31, 2006, total revenue decreased $6.9 million, or 4%, to $178.8 million from $185.6 million in the same nine month period a year ago.
The following table summarizes software licenses, maintenance and professional services revenues for the periods indicated (in thousands, except percentages):
Successor | Predecessor | Increase (Decrease) | Predecessor | Successor | Aggregate | Predecessor | Increase (Decrease) | |||||||||||||||||||||||||
Nine Months Ended October 31, 2006 | ||||||||||||||||||||||||||||||||
Three Months Ended October 31, | For the March 9, 2006 | For the October 31, 2006 | Nine Months Ended October 31, | Nine Months Ended October 31, | ||||||||||||||||||||||||||||
2006 | 2005 | In Dollars | In % | In Dollars | In % | |||||||||||||||||||||||||||
Revenue: | ||||||||||||||||||||||||||||||||
Software licenses | $ | 22,018 | $ | 22,511 | $ | (493 | ) | (2 | )% | $ | 2,847 | $ | 53,161 | $ | 56,008 | $ | 63,510 | $ | (7,502 | ) | (12 | )% | ||||||||||
Maintenance | 34,316 | 34,156 | 160 | — | 13,989 | 83,557 | 97,546 | 101,370 | (3,824 | ) | (4 | )% | ||||||||||||||||||||
Professional services | 8,326 | 8,254 | 72 | 1 | % | 2,872 | 22,331 | 25,203 | 20,755 | 4,448 | 21 | % | ||||||||||||||||||||
Total revenue | $ | 64,660 | $ | 64,921 | $ | (261 | ) | — | $ | 19,708 | $ | 159,049 | $ | 178,757 | $ | 185,635 | $ | (6,878 | ) | (4 | )% | |||||||||||
Software Licenses. Software licenses revenue as a percentage of total revenue was 34% and 31% in the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to 35% and 34% in the same quarter and nine months, respectively, a year ago. For the current fiscal quarter, when compared to the same quarter a year ago, the decrease in total software licenses revenue is predominantly due to decreases across the board on all products, except for and net of increases inChangeMan ZMF andTeamTracklicenses, due predominantly to slower buying patterns. For the current fiscal nine months, when compared to the same nine months a year ago, the decrease in total software licenses revenue is predominantly due to decreases across the board on all products, except for and net of increases inDimensions andTeamTracklicenses, due predominantly to slower buying patterns and distractions related to the merger. Distributed systems products accounted for $14.3 million or 65% and $38.8 million or 69% of total software licenses revenue in the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to $15.9 million or 71% and $42.9 million or 68% in the same quarter and nine months, respectively, a year ago. We expect that our Dimensions, Professional, and TeamTrack family of products will continue to account for a substantial portion of software license revenue in the future.
Maintenance. Maintenance revenue as a percentage of total revenue was 53% and 55% in the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to 52% and 55% in the same quarter and nine months, respectively, a year ago. For the current fiscal quarter ended October 31, 2006, when compared to the same quarter a year ago, the slight increase in maintenance revenue is due to the growth in installed software license base, as new licenses generally include one year of maintenance, and to a lesser extent maintenance price increases; all partially offset by the maintenance revenue write-down to fair value in connection with the merger totaling $3.0 million in the current fiscal quarter ended October 31, 2006. For the fiscal nine months ended October 31, 2006, when compared to the same nine months a year ago, the decrease in maintenance revenue is due to the maintenance revenue write-down to fair value in connection with the merger totaling $11.0 million in the current fiscal nine months ended October 31, 2006; offset by increases due to growth of our installed software license base, as new licenses generally include one year of maintenance, and to a lesser extent maintenance price increases. We expect maintenance revenue to grow in absolute dollars in the near term as maintenance contracts renew.
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Professional Services. Professional services revenue as a percentage of total revenue was 13% and 14% in the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to 13% and 11% in the same quarter and nine months, respectively, a year ago. For both the fiscal quarter and fiscal nine months, when compared to the same quarter and nine months a year ago, the increase is predominantly due to the continued improvement in our consulting business, fueled in part by continued increases in the number of large engagements. In general, professional services revenue is attributable to consulting opportunities resulting from our installed customer base and our expanded consulting service capabilities. We expect professional services revenue to grow slightly in absolute dollars in the near term.
Cost of Revenue
Cost of revenue, which consists of cost of software licenses, cost of maintenance, cost of professional services, and amortization of acquired technology, was 32% and 33% of total revenue in the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to 24% in both the same quarter and nine months, respectively, a year ago.
The following table summarizes cost of revenue for the periods indicated (in thousands, except percentages):
Successor | Predecessor | Increase (Decrease) | Predecessor | Successor | Aggregate | Predecessor | Increase (Decrease) | |||||||||||||||||||||||||||||||
Nine Months Ended October 31, 2006 | ||||||||||||||||||||||||||||||||||||||
Three Months Ended October 31, | For the Period From March 9, 2006 | For the Period From October 31, 2006 | Nine Months Ended October 31, | Nine Months Ended October 31, | ||||||||||||||||||||||||||||||||||
2006 | 2005 | In Dollars | In % | In Dollars | In % | |||||||||||||||||||||||||||||||||
Cost of revenue: | ||||||||||||||||||||||||||||||||||||||
Software licenses | $ | 564 | $ | 846 | $ | (282 | ) | (33 | )% | $ | 238 | $ | 1,663 | $ | 1,901 | $ | 2,368 | $ | (467 | ) | (20 | )% | ||||||||||||||||
Maintenance | 3,572 | 3,331 | 241 | 7 | % | 1,375 | 8,791 | 10,166 | 10,028 | 138 | 1 | % | ||||||||||||||||||||||||||
Professional services | 7,878 | 7,186 | 692 | 10 | % | 3,035 | 20,682 | 23,717 | 19,156 | 4,561 | 24 | % | ||||||||||||||||||||||||||
Amortization of acquired technology | 8,652 | 4,222 | 4,430 | 105 | % | 1,786 | 22,123 | 23,909 | 12,768 | 11,141 | 87 | % | ||||||||||||||||||||||||||
Total cost of revenue | $ | 20,666 | $ | 15,585 | $ | 5,081 | 33 | % | $ | 6,434 | $ | 53,259 | $ | 59,693 | $ | 44,320 | $ | 15,373 | 35 | % | ||||||||||||||||||
Percentage of total revenue | 32 | % | 24 | % | 33 | % | 33 | % | 33 | % | 24 | % |
Software Licenses. Cost of software licenses consists principally of fees associated with integrating third party technology into ourProfessional andDimensions distributed systems products and, to a lesser extent, salaries, bonuses, and other costs associated with our product release organization. Cost of software licenses as a percentage of total software licenses revenue was 3% in both the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to 4% in the same quarter and nine months, respectively, a year ago. The decrease in absolute dollars and as a percentage of total software licenses revenue are primarily due to decreased sales of our distributed systems licenses containing fees associated with integrating third party technology.
Maintenance. Cost of maintenance consists primarily of salaries, bonuses, and other costs associated with our customer support organization. Cost of maintenance as a percentage of total maintenance revenue was 10% in both the current fiscal quarter and fiscal nine months ended October 31, 2006, as well as in both the same quarter and same nine months a year ago. For the current fiscal quarter and fiscal nine months, when compared to the same quarter and nine months a year ago, in absolute dollar terms, the increase in cost of maintenance is primarily attributable to an increase in stock-based compensation costs as a result of adopting SFAS 123R at the
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beginning of fiscal year 2007 and increases in expenses associated with our customer support organization, as a result of the growth in both our maintenance revenue and installed customer base with our acquisition of Merant late in the first quarter of fiscal year 2005, and to a lesser extent, the increase in our installed customer base resulting from theRTM technology acquisition in the second quarter of fiscal year 2005 and the Pacific Edge acquisition in the third quarter of fiscal year 2006.
Professional Services. Cost of professional services consists of salaries, bonuses, and other costs associated with supporting and growing our professional services organization. Cost of professional services as a percentage of total professional services revenue was 95% and 94% in the current fiscal quarter and fiscal nine months ended October 31, 2006, as compared to 87% and 92% in the same quarter and nine months, a year ago. For the current fiscal quarter and nine months, when compared to the same quarter and nine months a year ago, the increase in the cost of professional services in absolute dollars is predominantly due to increases in expenses to support higher professional services revenue and an increase in stock-based compensation costs as a result of adopting SFAS 123R at the beginning of fiscal year 2007. As a percentage of total professional services revenue, the margin declines in the current fiscal quarter and fiscal nine months ended October 31, 2006, when compared to the same quarter and nine months a year ago, is predominantly the result of an increase in stock-based compensation costs as a result of adopting SFAS 123R at the beginning of fiscal year 2007.
Amortization of Acquired Technology. In connection with the Company’s merger in March 2006, and to a lesser extent, two small technology acquisitions in March 2006 and October 2006, we have recorded $178.2 million in acquired technology, offset by amortization totaling $22.1 million in the post merger Successor period ended October 31, 2006. For both the current fiscal quarter and fiscal nine months ended October 31, 2006, when compared to the same periods a year ago, the increase in amortization expense was predominantly due to the acquired technology recorded in connection with the Company’s merger. We expect to record $9.1 million in amortization expense in the remaining quarter of fiscal year 2007 and quarterly thereafter for approximately the following four fiscal years.
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Operating Expenses
The following table summarizes operating expenses for the periods indicated (in thousands, except percentages):
Successor | Predecessor | Increase (Decrease) | Predecessor | Successor | Aggregate | Predecessor | Increase (Decrease) | |||||||||||||||||||||||||||||
Nine Months Ended October 31, 2006 | ||||||||||||||||||||||||||||||||||||
Three Months Ended October 31, | For the Period From March 9, 2006 | For the Period October 31, 2006 | Nine Months Ended October 31, 2006 | Nine Months Ended October 31, 2005 | ||||||||||||||||||||||||||||||||
2006 | 2005 | In Dollars | In % | In Dollars | In % | |||||||||||||||||||||||||||||||
Operating expenses: | ||||||||||||||||||||||||||||||||||||
Sales and marketing | $ | 19,211 | $ | 18,754 | 457 | 2 | % | $ | 6,520 | $ | 47,703 | $ | 54,223 | $ | 53,411 | $ | 812 | 2 | % | |||||||||||||||||
Research and development | 9,015 | 8,726 | 289 | 3 | % | 3,555 | 23,151 | 26,706 | 26,230 | 476 | 2 | % | ||||||||||||||||||||||||
General and administrative | 5,907 | 5,334 | 573 | 11 | % | 1,806 | 15,641 | 17,447 | 14,494 | 2,953 | 20 | % | ||||||||||||||||||||||||
Amortization of intangible assets | 9,091 | 2,560 | 6,531 | 255 | % | 1,098 | 23,338 | 24,436 | 7,956 | 16,480 | 207 | % | ||||||||||||||||||||||||
Acquired in-process research and development | — | — | — | — | — | 4,100 | 4,100 | — | 4,100 | — | ||||||||||||||||||||||||||
Restructuring, acquisition and other charges | 587 | — | 587 | — | 41,916 | 1,188 | 43,104 | — | 43,104 | — | ||||||||||||||||||||||||||
Total operating expenses | $ | 43,811 | $ | 35,374 | $ | 8,437 | 24 | % | $ | 54,895 | $ | 115,121 | $ | 170,016 | $ | 102,091 | $ | 67,925 | 67 | % | ||||||||||||||||
Percentage of total revenue | 68 | % | 54 | % | 278 | % | 72 | % | 95 | % | 55 | % |
Sales and Marketing. Sales and marketing expenses consist primarily of salaries, commissions and bonuses, payroll taxes, and employee benefits as well as travel, entertainment, and marketing expenses. Sales and marketing expenses as a percentage of total revenue were 30% in both the current fiscal quarter and fiscal nine months ended October 31, 2006, as compared to 29% in both the same quarter and nine months, respectively, a year ago. For the current fiscal quarter and nine months ended October 31, 2006, when compared to the same quarter and nine months a year ago, in both absolute dollars and as a percentage of total revenue, the increases are the result of increases in stock-based compensation expenses associated with the adoption of SFAS 123R at the beginning of fiscal year 2007. In absolute dollar terms, we expect sales and marketing expenses to increase as we continue to hire additional sales and marketing personnel, market our distributed systems products, and undertake additional marketing programs.
Research and Development. Research and development expenses consist primarily of salaries, bonuses, payroll taxes, employee benefits and costs attributable to research and development activities. Research and development expenses as a percentage of total revenue were 14% and 15% in the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to 13% and 14% in the same quarter and nine months a year ago. For the current fiscal quarter and the fiscal nine months ended October 31, 2006, when compared to the same quarter and nine months a year ago, the increase in research and development expenses in absolute dollars is primarily attributable to increases in stock-based compensation expenses associated with the adoption of SFAS 123R at the beginning of fiscal year 2007. As a percentage of total revenue, research and development expenses increased in the current fiscal quarter and fiscal nine months ended October 31, 2006, when compared to the same quarter and nine months a year ago, as a result of expenses growing slightly faster
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than revenue after the deferred maintenance write-down from the merger. We expect research and development expenses to increase, both in absolute dollar terms and as a percentage of total revenue, as we localize our products and hire additional research and development personnel primarily to develop our distributed systems product suite.
General and Administrative. General and administrative expenses consist primarily of salaries, bonuses, payroll taxes, benefits, and certain non-allocable administrative costs, including legal and accounting fees and bad debt. General and administrative expenses as a percentage of total revenue were 9% and 10% in the current fiscal quarter and fiscal nine months ended October 31, 2006, as compared to 8% in both the same quarter and nine months, a year ago. For the current fiscal quarter and fiscal nine months ended October 31, 2006, when compared to the same quarter and nine months a year ago, the increases in general and administrative expenses in both absolute dollars and as a percentage of total revenue are primarily due to stock-based compensation expense associated with the adoption of SFAS 123R in the beginning of fiscal year 2007. We expect general and administrative expenses to increase in absolute dollar terms as we expand our infrastructure and our operations in the future.
Amortization of Intangible Assets. In connection with the Company’s merger in March 2006, and to a lesser extent, two small technology acquisitions in March 2006 and October 2006, we have recorded $293.2 million in identifiable intangible assets, offset by amortization totaling $23.3 million in the post merger Successor period ended October 31, 2006. For both the current fiscal quarter and fiscal nine months ended October 31, 2006, when compared to the same periods a year ago, the increase in amortization expense was predominantly due to the identifiable intangible assets recorded in connection with the Company’s merger. We expect to record $9.2 million in amortization expense in the remaining quarter of fiscal year 2007 and quarterly thereafter for approximately the following four fiscal years.
Acquired In-Process Research and Development. In connection with the Company’s merger, we recognized a charge in the three months ended April 30, 2006 of $4.1 million for acquired in-process research and development. See Note 3 to our unaudited condensed consolidated financial statements included elsewhere in this report for additional information related to the acquired in-process research and development charge.
Restructuring, acquisition and other charges. In connection with the merger we have incurred and expect to incur transaction, restructuring, acquisition and other charges related to the merger that are not part of ongoing operations. Such charges included certain employee payroll, severance and other employee related costs associated with transitional activities that are not part of ongoing operations, and travel and other direct costs associated with the merger. See Note 5 to our condensed consolidated financial statements for additional information related to the restructuring, acquisition and other charges.
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Other Income (Expense)
The following table summarizes other income (expense) for the periods indicated (in thousands, except percentages):
Predecessor | Successor | |||||||||||||||||||||||||||||||||||||
Successor | Predecessor | Nine Months Ended October 31, 2006 | Aggregate | Predecessor | ||||||||||||||||||||||||||||||||||
Three Months Ended October 31, | Increase (Decrease) | For the Period March 9, 2006 | For the Period October 31, 2006 | Nine Months Ended October 31, 2006 | Nine Months Ended October 31, 2005 | Increase (Decrease) | ||||||||||||||||||||||||||||||||
2006 | 2005 | In Dollars | In % | In Dollars | In % | |||||||||||||||||||||||||||||||||
Other income (expense): | ||||||||||||||||||||||||||||||||||||||
Interest income | $ | 462 | $ | 1,708 | $ | (1,246 | ) | (73 | )% | $ | 856 | $ | 2,647 | $ | 3,503 | $ | 4,198 | $ | (695 | ) | (17 | )% | ||||||||||||||||
Interest expense | (12,582 | ) | (825 | ) | (11,757 | ) | ( | *) | (355 | ) | (32,462 | ) | (32,817 | ) | (2,475 | ) | (30,342 | ) | ( | *) | ||||||||||||||||||
Change in fair value of derivative instrument | (2,028 | ) | — | (2,028 | ) | — | — | (2,602 | ) | (2,602 | ) | — | (2,602 | ) | — | |||||||||||||||||||||||
Amortization of debt issuance costs | (450 | ) | (335 | ) | (115 | ) | 34 | % | (1,931 | ) | (1,182 | ) | (3,113 | ) | (1,005 | ) | (2,108 | ) | 210 | % | ||||||||||||||||||
Total other income (expense) | $ | (14,598 | ) | $ | 548 | $ | (15,146 | ) | ( | *) | $ | (1,430 | ) | $ | (33,599 | ) | $ | (35,029 | ) | $ | 718 | $ | (34,747 | ) | ( | *) | ||||||||||||
Percentage of total revenue | (23 | %) | 1 | % | (7 | %) | (21 | %) | (20 | %) | — |
(*) | Percentage is not meaningful. |
Interest Income. For the current fiscal quarter ended October 31, 2006, when compared to the same quarter a year ago, and to a lesser extent, for the current fiscal nine months ended October 31, 2006, when compared to the same nine months a year ago, the dollar decrease in interest income is predominantly due to decreases in balances on interest-bearing accounts, such as cash and cash equivalents, and both short and long-term investments, resulting from the merger in which the Company paid approximately $826 million in cash in the first fiscal quarter ended April 30, 2006; all partially offset by increases in cash balances resulting from the accumulation of earnings and higher yields.
Interest Expense. For both the current fiscal quarter and fiscal nine months ended October 31, 2006, when compared to the same quarter and nine months a year ago, the dollar increase in interest expense is predominantly due to the debt associated with the merger which accrued interest beginning on March 10, 2006. In addition, on December 15, 2003, we issued convertible subordinated notes and we recorded interest expense in connection with such notes totaling $825,000 per fiscal quarter. Upon consummation of the merger in March 2006, no interest expense associated with our convertible subordinated notes was recorded in the fiscal quarter or fiscal nine months ended October 31, 2006, since such notes have been or will be converted to equity as part of the merger and therefore all interest would have been forfeited. See Notes 2 and 9 to our condensed consolidated financial statements for additional information related to the merger with Spyglass Merger Corp. and related debt.
Change in fair value of derivative instrument. We use an interest rate swap as part of our interest rate risk management strategy. In the second fiscal quarter ended July 31, 2006, we entered into an interest rate swap transaction to effectively convert the variable interest rate on a portion of the $400.0 million senior secured term loan to a fixed rate. The swap, which expires on April 10, 2010, is recorded on the balance sheet at fair value in accordance with SFAS 133. The swap has not been designated as a hedge, and accordingly, changes in the fair value of the derivative are recognized in the statement of operations. The notional amount of the swap is $250.0 million initially and amortizes down over time to $126.0 million at the time the swap transaction expires on April 10, 2010. Under the terms of the swap, we will pay an interest rate equal to the initial period LIBOR
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setting rate, set in arrears. In exchange, we will receive a fixed rate equal to 5.38%. In the current fiscal quarter and fiscal nine months ended October 31, 2006, we recorded $2.0 million and $2.6 million, respectively, related to the changes in the fair value of the derivative.
Amortization of Debt Issuance Costs. In connection with the merger, we recorded $16.1 million in debt issuance costs, offset by amortization totaling $3.1 million for the nine months ended October 31, 2006. We expect to record $0.4 million per quarter in amortization expense over the fourth quarter of fiscal year 2007 and quarterly thereafter for approximately the following seven fiscal years.
Income Taxes
Income Taxes. Income tax benefit was $5.2 million and $23.6 million in the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to income tax expense of $4.0 million and $12.8 million in the same quarter and nine months, respectively, a year ago. Our projected effective income tax rate benefit for fiscal year 2007 is 28%, and excluding the impact of the one-time in-process research and development charge of $4.1 million and related acquisition expenses taken in the nine months ended October 31, 2006, would have been an income tax rate benefit of 40%. Our effective income tax rate for fiscal year 2006 was 53%, and excluding the impact of the one-time in-process research and development charge of $10.4 million taken in the three months ended July 31, 2005, would have been 35%. Our effective income tax rate has historically benefited from the U.S. research and experimentation tax credit and tax benefits generated from export sales made from the United States.
Liquidity and Capital Resources
Cash, cash equivalents and investments. Since our inception, we have financed our operations and met our capital expenditure requirements through cash flows from operations. As of October 31, 2006, we had $37.5 million in cash and cash equivalents, and an additional $3.4 million in short-term investments.
Net cash provided by operating activities. Cash flows provided by operating activities were $64.9 million and $55.4 million in the nine months ended October 31, 2006 and the same period a year ago, respectively. In the nine months ended October 31, 2006, our cash flows provided by operating activities exceeded net loss principally due to the inclusion of acquisition related charges and non-cash expenses in net loss, a decrease in accounts receivable, and cash collections in advance of revenue recognition for maintenance contracts; all partially offset by decreases in income taxes payable, accounts payable and accrued expenses. In the same nine months a year ago, our cash flows provided by operating activities exceeded net income principally due to the inclusion of non-cash expenses in net income, a decrease in accounts receivable, and increases in accrued expenses and income taxes payable; all partially offset by cash collections in advance of revenue recognition on maintenance contracts and a decrease in accounts payable.
Net cash used in investing activities. Net cash used in investing activities was $805.5 million and $51.0 million in the nine months ended October 31, 2006 and the same period a year ago, respectively. In the nine months ended October 31, 2006, net cash used in investing activities related to cash paid in the merger including acquisition related costs totaling $856.7 million, acquisition related costs paid in connection with the acquisitions of Pacific Edge Software, Inc., Data Scientific Corp., Merant plc., and Apptero Inc., totaling $15.8 million, $3.0 million, $1.0 million and $0.9 million, respectively, and the purchase of computer equipment and office furniture and equipment totaling $2.8 million; all partially offset by net sales of short and long-term investments totaling $71.6 million and the removal of restrictions on restricted cash totaling $3.3 million. In the same nine months a year ago, net cash used in investing activities related to net purchases of short and long-term investments totaling $42.0 million, acquisition related costs paid in connection with the acquisitions of Merant plc. and Apptero Inc., totaling $3.5 million and $3.2 million, respectively, and the purchase of computer equipment and office furniture and equipment totaling $2.3 million.
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Net cash provided by (used in) financing activities. Net cash provided by financing activities was $629.8 million in the nine months ended October 31, 2006 and net cash used in financing activities was $39.0 million in the same nine months a year ago. In the nine months ended October 31, 2006, net cash provided by financing activities related to our incurring debt in the context of the merger to finance the merger in the form of a senior secured term loan and senior subordinated notes totaling $400.0 million and $200.0 million, respectively, equity contributions from Silver Lake investors and management totaling $335.8 million, and to a lesser extent, the exercise of stock options under our employee stock option plan totaling $1.1 million; all partially offset by the payment of convertible subordinated notes including the conversion premium totaling $237.9 million, the payment of principal and interest on the senior secured term loan and senior subordinated notes totaling $50.3 million, debt issuance costs paid totaling $15.6 million, and payments made to the Employee Benefits Trust totaling $3.2 million. In the same nine months a year ago, net cash used in financing activities related to common stock repurchased under the stock repurchase plan totaling $48.6 million; partially offset by the exercise of stock options under our employee stock option plan totaling $7.9 million, and the sale of common stock under the employee stock purchase plan totaling $1.8 million.
Contractual Obligations and Commitments
After consummation of the acquisition transactions, we are highly leveraged. As of October 31, 2006, we had outstanding $575.0 million in aggregate indebtedness, with an additional $75.0 million of borrowing capacity available under our new revolving credit facility. Our liquidity requirements are significant, primarily due to debt service requirements. On a pro forma basis, after giving effect to the acquisition transactions, our cash interest expense for the nine months ended October 31, 2006 and fiscal year ended January 31, 2006 would have been $38.0 million and $51.1 million, respectively. Our cash interest expense determined pursuant to accounting principles generally accepted in the United States of America for these same periods was $32.8 million and 3.3 million, respectively. The assumptions and methodology used to calculate pro forma interest expense are described underUnaudited Pro Forma Condensed Consolidated Financial Informationin our registration statement on Form S-4, filed with the Securities and Exchange Commission on July 28, 2006.
We believe that current cash and short-term investments, and cash flows from operations will satisfy our working capital and capital expenditure requirements through fiscal year 2007. At some point in the future we may require additional funds for either operating or strategic purposes and may seek to raise the additional funds through public or private debt or equity financing. If we ever need to seek additional financing, there is no assurance that this additional financing will be available, or if available, will be on reasonable terms and not legally or structurally senior to or on parity with the notes.
The following is a summary of our various contractual commitments, including non-cancelable operating lease agreements for office space that expire between calendar years 2006 and 2013. All periods start from November 1, 2006.
Successor | |||||||||||||||
Payments Due by Period | |||||||||||||||
Total | Less than 1 year | 1-3 years | 3-5 years | Thereafter | |||||||||||
(in thousands) | |||||||||||||||
Operating lease obligations | $ | 14,014 | $ | 4,252 | $ | 5,863 | $ | 3,779 | $ | 120 | |||||
Restructuring-related operating lease obligations | 2,156 | 1,466 | 329 | 211 | 150 | ||||||||||
Senior secured term loan | 375,000 | — | — | — | 375,000 | ||||||||||
Senior subordinated notes | 200,000 | — | — | — | 200,000 | ||||||||||
Convertible subordinated notes | 5 | 5 | — | — | — | ||||||||||
$ | 591,175 | $ | 5,723 | $ | 6,192 | $ | 3,990 | $ | 575,270 | ||||||
Accounts Receivable and Deferred Revenue. At October 31, 2006, we had accounts receivable, net of allowances, of $24.4 million and total deferred revenue was $73.8 million.
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Acquisitions. The aggregate amount of cash paid relating to acquisitions during the nine months ended October 31, 2006 was approximately $877.4 million and consisted of $856.7 million related to the merger in March 2006, including acquisition related costs paid, $15.8 million related to our acquisition of Pacific Edge Software, Inc. in October 2006, net of cash received and acquisition related costs paid, $3.0 million related to our acquisition of Data Scientific Corp. in March 2006, net of cash received and acquisition related costs paid, $1.0 million related to our acquisition of Merant plc. in April 2005, net of cash received and acquisition related costs paid, and $0.9 million related to our acquisition of Apptero, Inc. in 2005, net of cash received and acquisition related costs paid. See Notes 2, 5 and 10 to our condensed consolidated financial statements for additional information related to acquisition related activities, which have affected our liquidity.
Off-Balance Sheet Arrangements. As part of our ongoing operations, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, or SPEs, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of October 31, 2006, we are not involved in any unconsolidated SPE transactions.
Senior Secured Credit Agreement
In connection with the consummation of the merger, we entered into a senior secured credit agreement pursuant to a debt commitment we obtained from affiliates of the initial purchasers of our senior subordinated notes.
General. The borrower under the senior secured credit agreement initially was Spyglass Merger Corp. and immediately following completion of the merger became Serena. The senior secured credit agreement provides for (1) a seven-year term loan in the amount of $400.0 million, which will amortize at a rate of 1.00% per year on a quarterly basis for the first six and three-quarter years after the closing date of the acquisition transactions, with the balance paid at maturity, and (2) a six-year revolving credit facility that permits loans in an aggregate amount of up to $75.0 million, which includes a letter of credit facility and a swing line facility. In addition, subject to certain terms and conditions, the senior secured credit agreement provides for one or more uncommitted incremental term loan and/or revolving credit facilities in an aggregate amount not to exceed $150.0 million. Proceeds of the term loan on the initial borrowing date were used to partially finance the merger, to refinance certain indebtedness of Serena and to pay fees and expenses incurred in connection with the merger. Proceeds of the revolving credit facility and any incremental facilities will be used for working capital and general corporate purposes of the borrower and its restricted subsidiaries.
Interest Rates and Fees. The $400.0 million term loan, of which $375.0 million is currently outstanding as of October 31, 2006, bears interest at a rate equal to three-month LIBOR plus 2.25%. That rate was 7.62% as of October 10, 2006. More generally, the loans under the senior secured credit agreement bear interest, at the option of the borrower, at the following:
• | a rate equal to the London Interbank Offered Rate, or LIBOR, plus an applicable margin of (1) 2.25% with respect to the term loan and (2) 2.50% with respect to the revolving credit facility or |
• | the alternate base rate, which is the higher of (1) the corporate base rate of interest announced by the administrative agent and (2) the Federal Funds rate plus 0.50%, plus, in each case, an applicable margin of (a) 1.25% with respect to the term loan and (b) 1.50% with respect to the revolving credit facility. |
The revolving credit facility currently bears an annual commitment fee of 0.50% on the undrawn portion of that facility commencing on the date of execution and delivery of the senior secured credit agreement.
We use an interest rate swap as part of our interest rate risk management strategy. In the second fiscal quarter ended July 31, 2006, we entered into an interest rate swap transaction to effectively convert the variable interest rate on a portion of the $400.0 million senior secured term loan to a fixed rate. The swap, which expires
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on April 10, 2010, is recorded on the balance sheet at fair value in accordance with SFAS 133. The swap has not been designated as a hedge and accordingly, changes in the fair value of the derivative are recognized in the statement of operations. The notional amount of the swap is $250.0 million initially and amortizes down over time to $126.0 million at the time the swap transaction expires on April 10, 2010. Under the terms of the swap, we will pay an interest rate equal to the initial period LIBOR setting rate, set in arrears. In exchange, we will receive a fixed rate equal to 5.38%.
After the Company’s delivery of financial statements and a computation of the maximum ratio of total debt (defined in the senior secured credit agreement) to trailing four quarters of EBITDA (defined in the senior secured credit agreement), or “total leverage ratio,” for the first full quarter ending after the closing date of the merger, the applicable margins and the commitment fee will be subject to a grid based on the most recent total leverage ratio and to be agreed upon by the issuer and the lenders.
Prepayments. At the option of the Company (1) amounts outstanding under the term loan may be voluntarily prepaid and (2) the unutilized portion of the commitments under the revolving credit facility may be permanently reduced and the loans under such facility may be voluntarily repaid, in each case subject to requirements as to minimum amounts and multiples, at any time in whole or in part without premium or penalty, except that any prepayment of LIBOR rate advances other than at the end of the applicable interest periods will be made with reimbursement for any funding losses or redeployment costs of the lenders resulting from the prepayment. Loans under the term loan and under any incremental term loan facility are subject to mandatory prepayment with (a) 50% of annual excess cash flow with certain step downs to be based on the most recent total leverage ratio and agreed upon by the issuer and the lenders, (b) 100% of net cash proceeds of asset sales and other asset dispositions by the borrower or any of its restricted subsidiaries, subject to various reinvestment rights of the Company and other exceptions, and (c) 100% of the net cash proceeds of the issuance or incurrence of debt by the Company or any of its restricted subsidiaries, subject to various baskets and exceptions.
In the second fiscal quarter ended July 31, 2006, the Company made a $25 million principal payment on the $400 million senior secured term loan.
Guarantors. All obligations under the senior secured credit agreement are to be guaranteed by each future direct and indirect restricted subsidiary of the Company, other than foreign subsidiaries. We do not have any domestic subsidiaries and, accordingly, there are no guarantors.
Security. All obligations of the Company and each guarantor (if any) under the senior secured credit agreement are secured by the following:
• | a perfected lien on and pledge of (1) the capital stock and intercompany notes of each existing and future direct and indirect domestic subsidiary of the Company, (2) all the intercompany notes of the Company and (3) 65% of the capital stock of each existing and future direct and indirect first-tier foreign subsidiary of the Company, and |
• | a perfected first priority lien, subject to agreed upon exceptions, on, and security interest in, substantially all of the tangible and intangible properties and assets of the Company and each guarantor. |
Covenants, Representations and Warranties. The senior secured credit agreement contains customary representations and warranties and customary affirmative and negative covenants, including, among other things, restrictions on indebtedness, investments, capital expenditures, sales of assets, mergers and acquisitions, liens and dividends and other distributions. There are no financial covenants included in the senior secured credit agreement, other than a minimum interest coverage ratio and a maximum total leverage ratio.
Events of Default. Events of default under the senior secured credit agreement include, among others, nonpayment of principal or interest, covenant defaults, a material inaccuracy of representations or warranties, bankruptcy and insolvency events, cross defaults and a change of control.
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Senior Subordinated Notes
We have outstanding $200.0 million principal amount of senior subordinated notes, which bear interest at a rate of 10.375%, payable semi-annually on March 15 and September 15, and which mature on March 15, 2016. Each of our domestic subsidiaries that guarantees the obligations under our senior secured credit agreement will jointly, severally and unconditionally guarantee the notes on an unsecured senior subordinated bases. As of the date of this report, we do not have any domestic subsidiaries and, accordingly, there are no guarantors on such date. The notes are our unsecured, senior subordinated obligations, and the guarantees, if any, will be unsecured, senior subordinated obligations of the guarantors. The notes are subject to redemption at our option under terms and conditions specified in the indenture related to the notes, and may be redeemed at the option of the holders at 101% of their face amount, plus accrued and unpaid interest, upon certain change of control events. See “Description of Notes.”
Covenant Compliance
Our senior secured credit agreement and the indenture governing the senior subordinated notes contain various covenants that limit our ability to engage in specified types of transactions. These covenants limit our and our restricted subsidiaries’ ability to, among other things:
• | incur additional indebtedness or issue certain preferred shares; |
• | pay dividends on, redeem or repurchase our capital stock or make other restricted payments; |
• | make investments; |
• | make capital expenditures; |
• | create certain liens; |
• | sell certain assets; |
• | enter into agreements that restrict the ability of our subsidiaries to make dividend or other payments to us; |
• | guarantee indebtedness; |
• | engage in transactions with affiliates; |
• | prepay, repurchase or redeem the notes; |
• | create or designate unrestricted subsidiaries; and |
• | consolidate, merge or transfer all or substantially all of our assets and the assets of our subsidiaries on a consolidated basis. |
In addition, under our senior secured credit agreement, we are required to satisfy and maintain specified financial ratios and other financial condition tests, including minimum interest coverage ratio and a maximum total leverage ratio. We were in compliance with all of the covenants under the secured credit agreement and indenture as of October 31, 2006. Our ability to meet those financial ratios and tests can be affected by events beyond our control, and we cannot assure you that we will meet those ratios and tests in the future. A breach of any of these covenants would result in a default (which, if not cured, could mature into an event of default) and in certain cases an immediate event of default under our senior secured credit agreement. Upon the occurrence of an event of default under our senior secured credit agreement, all amounts outstanding under our senior secured credit agreement could be declared to be (or could automatically become) immediately due and payable and all commitments to extend further credit could be terminated.
Earnings before interest, taxes, depreciation and amortization, or EBITDA, is a non-GAAP measure used to determine our compliance with certain covenants contained in the indenture governing the senior subordinated notes and in our senior secured credit agreement. Adjusted EBITDA is defined as EBITDA further adjusted to
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exclude unusual items and other adjustments permitted in calculating covenant compliance under the indenture governing the senior subordinated notes and our senior secured credit agreement. We believe that the inclusion of supplementary adjustments to EBITDA applied in presenting Adjusted EBITDA is appropriate to provide additional information to investors to demonstrate compliance with our financing covenants.
The breach of financial covenants in our senior secured credit agreement (i.e., those that require the maintenance of ratios based on Adjusted EBITDA) would result in an event of default under that agreement, in which case the lenders could elect to declare all amounts borrowed due and payable. Any such acceleration would also result in a default under the indenture governing the senior subordinated notes. Additionally, under our debt agreements, our ability to engage in activities such as incurring additional indebtedness, making investments and paying dividends is also tied to ratios based on Adjusted EBITDA.
Adjusted EBITDA does not represent net income (loss) or cash flow from operations as those terms are defined by GAAP and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. While Adjusted EBITDA and similar measures are frequently used as measures of operations and the ability to meet debt service requirements, these terms are not necessarily comparable to other similarly titled captions of other companies due to the potential inconsistencies in the method of calculation. Adjusted EBITDA does not reflect the impact of earnings or charges resulting from matters that we may consider not to be indicative of our ongoing operations. In particular, the definition of Adjusted EBITDA in the indentures allows us to add back certain non-cash, extraordinary, unusual or non-recurring charges that are deducted in calculating net income (loss). However, these are expenses that may recur, vary greatly and are difficult to predict. Further, our debt agreements require that Adjusted EBITDA be calculated for the most recent four fiscal quarters. As a result, the measure can be disproportionately affected by a particularly strong or weak quarter. Further, it may not be comparable to the measure for any subsequent four-quarter period or any complete fiscal year.
The following is a reconciliation of net (loss) income, which is a GAAP measure of our operating results, to Adjusted EBITDA as defined in our debt agreements (in thousands).
Successor | Predecessor | Successor | Predecessor | |||||||||||||||||
Nine Months Ended October 31, 2006 | ||||||||||||||||||||
Three Months October 31, | For the Period From February 1, March 9, 2006 | For the Period From March 10, 2006 to October 31, | Nine Months Ended October 31, 2005 | |||||||||||||||||
2006 | 2005 | |||||||||||||||||||
Net (loss) income(1) | $ | (9,252 | ) | $ | 10,543 | $ | (34,716 | ) | $ | (27,676 | ) | $ | 27,166 | |||||||
Interest expense (income), net(3) | 14,598 | (548 | ) | 1,430 | 33,599 | (718 | ) | |||||||||||||
Income tax (benefit) expense | (5,163 | ) | 3,967 | (8,335 | ) | (15,254 | ) | 12,776 | ||||||||||||
Depreciation and amortization expense(2) | 22,917 | 8,082 | 3,457 | 58,078 | 24,026 | |||||||||||||||
Acquired in-process research and development | — | — | — | 4,100 | — | |||||||||||||||
EBITDA | 23,100 | 22,044 | (38,164 | ) | 52,847 | 63,250 | ||||||||||||||
Deferred maintenance writedown(1) | 2,955 | 285 | 77 | 10,941 | 2,201 | |||||||||||||||
Restructuring, acquisition and other charges | 587 | — | 41,916 | 1,188 | — | |||||||||||||||
Adjusted EBITDA(1) | $ | 26,642 | $ | 22,329 | $ | 3,829 | $ | 64,976 | $ | 65,451 | ||||||||||
(1) | Net (loss) income for the periods presented includes the deferred maintenance write down associated with both Serena’s acquisition of Merant in the first quarter of fiscal year 2005, the merger in the first quarter of fiscal year 2007, and the Pacific Edge acquisition in the third quarter of fiscal year 2007. This maintenance revenue is added back in calculating Adjusted EBITDA for purposes of the indenture governing the senior subordinated notes and the senior secured credit agreement. |
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(2) | Depreciation and amortization expense includes depreciation of fixed assets, amortization of leasehold improvements, amortization of acquired technologies and other intangible assets, and amortization of stock-based compensation. |
(3) | Interest expense (income), net includes interest income, interest expense, the change in the fair value of derivative instruments and amortization of debt issuance costs. |
Factors That May Affect Future Results
Risks Related to Our Indebtedness
Our substantial leverage could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our variable rate debt and prevent us from meeting our obligations under the senior subordinated notes.
As of October 31, 2006, our total indebtedness was $575.0 million, excluding our convertible subordinated notes that have substantially since been converted. We also had an additional $75.0 million available at that date for borrowing under the revolving credit facility of our senior secured credit agreement.
Our high degree of leverage could have important consequences for you, including:
• | making it more difficult for us to make payments on the senior subordinated notes; |
• | increasing our vulnerability to general economic and industry conditions; |
• | requiring a substantial portion of cash flows from operating activities to be dedicated to the payment of principal and interest on our indebtedness, therefore reducing our ability to use our cash flow to fund our operations, capital expenditures and future business opportunities; |
• | exposing us to the risk of increased interest rates as certain of our borrowings, including borrowings under our senior secured credit agreement, are at variable rates of interest; |
• | restricting us from making strategic acquisitions or causing us to make non-strategic divestitures; |
• | limiting our ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes; and |
• | limiting our ability to adjust to changing market conditions and placing us at a competitive disadvantage compared to our competitors who are less highly leveraged. |
We and our subsidiaries may be able to incur substantial additional indebtedness in the future, subject to the restrictions contained in our senior secured credit agreement and the indenture governing the senior subordinated notes. If new indebtedness is added to our current debt levels, the related risks that we now face could intensify.
Our pro forma cash interest expense for the fiscal year ended January 31, 2006 and the nine months ended October 31, 2006 would have been $51.1 million and $38.0 million, respectively. Our cash interest expense determined pursuant to accounting principles generally accepted in the United States of America for these same periods was $3.3 million and 32.8 million, respectively. The assumptions and methodology used to calculate pro forma interest expense are described underUnaudited Pro Forma Condensed Consolidated Financial Informationin our registration statement on Form S-4, filed with the Securities and Exchange Commission on July 28, 2006. At October 31, 2006, we had $375.0 million of debt under our senior secured credit agreement, which is based on a floating rate index that is assumed to be equal to 7.5%. A 0.5% increase in this floating rate would increase interest expense on a pro forma basis for the fiscal year ended January 31, 2006 and the nine months ended October 31, 2006 by $2.0 million and $1.5 million, respectively.
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We may not be able to generate sufficient cash to service all of our indebtedness, including the senior subordinated notes, and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.
Our ability to make scheduled payments on or to refinance our debt obligations depends on our financial condition and operating performance, which are subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We cannot assure you that we will maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness, including the notes.
If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure or refinance our indebtedness, including our senior subordinated notes. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. Our senior secured credit agreement and the indenture governing the notes restrict our ability to dispose of assets and use the proceeds from the disposition. We may not be able to consummate those dispositions or to obtain the proceeds that we could realize from them and these proceeds may not be adequate to meet any debt service obligations then due.
Our debt agreements contain restrictions that limit our flexibility in operating our business.
Our senior secured credit agreement and the indenture governing the senior subordinated notes contain various covenants that limit our ability to engage in specified types of transactions. These covenants limit our and our restricted subsidiaries’ ability to, among other things:
• | incur additional indebtedness or issue certain preferred shares; |
• | pay dividends on, redeem or repurchase our capital stock or make other restricted payments; |
• | make investments; |
• | make capital expenditures; |
• | create certain liens; |
• | sell certain assets; |
• | enter into agreements that restrict the ability of our subsidiaries to make dividend or other payments to us; |
• | guarantee indebtedness; |
• | engage in transactions with affiliates; |
• | prepay, repurchase or redeem the senior subordinated notes; |
• | create or designate unrestricted subsidiaries; and |
• | consolidate, merge or transfer all or substantially all of our assets and the assets of our subsidiaries on a consolidated basis. |
In addition, under our senior secured credit agreement, we are required to satisfy and maintain specified financial ratios and other financial condition tests. Our ability to meet those financial ratios and tests can be affected by events beyond our control, and we cannot assure you that we will meet those ratios and tests. A breach of any of these covenants would result in a default under our senior secured credit agreement. Upon the occurrence of an event of default under our senior secured credit agreement, all amounts outstanding under our senior secured credit agreement could be declared to be (or could automatically become) immediately due and payable and all commitments to extend further credit could be terminated. If we were unable to repay those
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amounts, the lenders under our senior secured credit agreement could proceed against the collateral granted to them to secure that indebtedness. We have pledged a significant portion of our assets as collateral under our senior secured credit agreement. If the repayment of borrowings under our senior secured credit agreement is accelerated, we cannot assure you that we will have sufficient assets to repay our indebtedness under our senior secured credit agreement, as well as our unsecured indebtedness, including the senior subordinated notes.
Risks Related to Our Business
Economic conditions worldwide could adversely affect our revenue growth and ability to plan effectively.
The revenue growth and profitability of our business depends on the overall demand for application software and services. Because our sales are primarily to major corporate customers, our business also depends on general economic and business conditions. In the past, the general weakening of the worldwide economy has caused us to experience a decrease in revenue and revenue growth rates of our software licenses. A softening of demand for computer software caused by a weakening of the economy, domestically or internationally, may result in a decrease in our revenue and revenue growth rates. Our license revenue has fluctuated in recent years and we may not experience any license revenue growth in the future and our license revenue could in fact decline.
Management personnel identify, track and forecast future revenue and trends in our business. Our sales personnel monitor the status of all proposals, such as the estimated date when a transaction will close and the potential dollar amount of such sale. We aggregate these estimates periodically in order to generate a sales pipeline and then evaluate the pipeline at various times to look for trends in our business. While this pipeline analysis provides visibility to our potential customers and the associated revenue for budgeting and planning purposes, these pipeline estimates may not correlate to revenue in a particular quarter or ever. A slowdown in the economy, domestically and internationally, has caused in the past and may cause in the future customer purchasing decisions to be delayed, reduced in amount or cancelled, all of which have reduced and could reduce the rate of conversion of the pipeline into contracts. A variation in the pipeline or in the conversion of the pipeline into contracts could cause us to plan or budget improperly and thereby could adversely affect our business, operating results and financial condition. In addition, primarily due to a substantial portion of our software licenses revenue contracts closing in the latter part of a quarter, management may not be able to adjust our cost structure in response to a variation in the conversion of the pipeline into contracts in a timely manner, and thereby adversely affect our business, operating results and financial condition.
If our target markets do not evolve as we anticipate, our business will be adversely affected.
If we fail to properly assess and address our target markets or if our products and services fail to achieve market acceptance for any reason, our business, operating results and financial condition would be materially adversely affected. Our target markets are in an early stage of development. IT organizations have traditionally addressed software configuration management, or SCM, needs internally and have only recently become aware of the benefits of third-party SCM solutions as their SCM requirements have become more complex. Since the market for our products is still evolving, it is difficult to assess the competitive environment or the size of the market that may develop. Our future financial performance will depend in large part on the continued growth in the number of businesses adopting third-party SCM products and the expansion of their use on a company-wide basis. The SCM market for third-party products may grow more slowly than we anticipate. In addition, technologies, customer requirements and industry standards may change rapidly. If we cannot improve or augment our products as rapidly as existing technologies, customer requirements and industry standards evolve, our products or services could become obsolete. The introduction of new or technologically superior products by competitors could also make our products less competitive or obsolete. As a result of any of these factors, our position in existing markets or potential markets could be eroded.
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Our future revenue is substantially dependent upon our installed customers renewing maintenance agreements for our products and licensing or upgrading additional Serena products; our future professional service and maintenance revenue is dependent on future sales of our software products.
We depend on our installed customer base for future revenue from maintenance renewal fees and licenses or upgrades of additional products. If our customers do not purchase additional products, do not upgrade existing products or cancel or fail to renew their maintenance agreements, this could materially adversely affect our business, operating results and financial condition. The terms of our standard license arrangements provide for a one-time license fee and a prepayment of one year of software maintenance and support fees. The maintenance agreements are renewable annually at the option of the customer and there are no minimum payment obligations or obligations to license additional software. Therefore, our current customers may not necessarily generate significant maintenance revenue in future periods. In addition, our customers may not necessarily purchase additional products, upgrades or professional services. Our professional service and maintenance revenue are also dependent upon the continued use of these services by our installed customer base. Any downturn in our software license sales would have a negative impact on the growth of our professional service revenue and maintenance revenue in future periods.
If the market for IBM and IBM-compatible mainframes decreases, it could adversely affect our business.
Our mainframe revenue is dependent upon the continued use and acceptance of IBM Corporation, or IBM, and IBM-compatible mainframes and the growth of this market. If the role of the mainframe does not increase as we anticipate, or if it in any way decreases, this may materially adversely affect our business, operating results and financial condition. Additionally, if there is a wide acceptance of other platforms or if new platforms emerge that provide enhanced enterprise server capabilities, our business, operating results and financial condition may be materially adversely affected. We expect that, for the foreseeable future, a significant portion of our software license revenue will continue to come from the sales of our mainframe products. As a result, future sales of our existing products and associated maintenance revenue and professional service revenue will depend on continued use of mainframes.
Any delays in our normally lengthy sales cycles could result in significant fluctuations in our operating results.
Our sales cycle typically takes three to eighteen months to complete and varies from product to product. Any delay in the sales cycle of a large license or a number of smaller licenses could result in significant fluctuations in our operating results. The length of the sales cycle may vary depending on a number of factors over which we may have little or no control, including the size and complexity of a potential transaction and the level of competition that we encounter in our selling activities. We have experienced an overall lengthening of sales cycles as customers have more rigorously scrutinized potential IT purchases. Additionally, the emerging market for our products and services contributes to the lengthy sales process in that during the sales cycle we often have to educate potential customers on the use and the benefits of our products. In certain circumstances, we license our software to customers on a trial basis to assist customers in their evaluation of our products. Our sales cycle can also be further extended for product sales made through third party distributors.
Our license revenue from products for distributed systems may fluctuate.
We introduced ourChangeMan DS product in fiscal year 2000 and ourChangeMan ZDD product in the first quarter of fiscal year 2003. We acquired theTeamTrack product in fiscal year 2004, and the Merant product line and theRTM product in fiscal year 2005. In the third quarter of fiscal year 2006 we acquired project and portfolio management technology in an acquisition. While license revenue from these and our other distributed systems products was 69% and 67% of total license revenue in the nine months ended October 31, 2006 and the fiscal year ended January 31, 2006, respectively, license revenue from our distributed products may fluctuate materially and could in fact decline. We are currently developing new products and enhancing our product suite to support additional distributed systems products. If we do not successfully develop, market, sell and support
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our distributed systems products, this would materially adversely affect our business, operating results and financial condition. Prior to our acquisition of Merant in the first quarter of fiscal year 2005, the majority of our products had been designed for the mainframe platform, and the majority of our software license, maintenance and professional services revenue had been attributable to licenses for these mainframe products. Additionally, our distributed system products may be adversely impacted by pricing pressures resulting from increased competition. Our competitors may have substantially greater experience providing distributed systems compatible software products than we do, and many also may have significantly greater financial and organizational resources.
Seasonal trends in sales of our software products may affect our operating results.
We have experienced and expect to continue to experience seasonality in sales of our software products. These seasonal trends materially affect our operating results. Revenue and operating results in our quarter ending January 31 are typically higher relative to other quarters, because many customers make purchase decisions based on their calendar year-end budgeting requirements. In addition, our January quarter tends to reflect the effect of the incentive compensation structure for our sales organization, which is based on satisfaction of fiscal year-end quotas. As a result, we have historically experienced a substantial decline in revenue in the first quarter of each fiscal year relative to the preceding quarter.
We expect that our operating expenses will increase in the future and these increased expenses may adversely affect our future operating results and financial condition.
Although we have been profitable in recent years, we may not remain profitable in the future. We anticipate that our expenses will increase in the foreseeable future as we:
• | incur restructuring and other expenses in connection with the merger; |
• | increase our sales and marketing activities, including expanding our United States and international direct sales forces and extending our telesales efforts; |
• | develop our technology, including our distributed systems products; |
• | invest in penetrating the federal government marketplace; |
• | expand our distribution channels, including in the Asia Pacific region; |
• | expand our professional services organization; and |
• | pursue strategic relationships and acquisitions. |
With these additional expenses, in order to maintain our current levels of profitability, we will be required to increase our revenue correspondingly. Our efforts to expand our software product suites, sales and marketing activities, direct and indirect distribution channels and professional service offerings and to pursue strategic relationships or acquisitions may not succeed or may prove more expensive than we currently anticipate. Any failure to increase our revenue as we implement our product, service and distribution strategies would materially adversely affect our business, operating results and financial condition.
Our industry changes rapidly due to evolving technology standards and our future success will depend on our ability to continue to meet the sophisticated needs of our customers.
Our future success will depend on our ability to address the increasingly sophisticated needs of our customers by supporting existing and emerging hardware, software, database and networking platforms particularly for our distributed systems products. We must develop and introduce enhancements to our existing products and new products on a timely basis to keep pace with technological developments, evolving industry standards and changing customer requirements. We expect that we will have to respond quickly to rapid technological change, changing customer needs, frequent new product introductions and evolving industry
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standards that may render existing products and services obsolete. As a result, our position in existing markets or potential markets could be eroded rapidly by product advances. Our growth and future financial performance will depend in part upon our ability to enhance existing applications, develop and introduce new applications that keep pace with technological advances, meet changing customer requirements and respond to competitive products. We expect that our product development efforts will continue to require substantial investments. We may not have sufficient resources to make the necessary investments. Any of these events could have a material adverse effect on our business, operating results and financial condition.
We are subject to intense competition in our target markets and we expect to face increased competition in the future, including competition in the distributed systems market.
We may not be able to compete successfully against current or future competitors and such inability would materially adversely affect our business, operating results and financial condition. The market for our products is highly competitive and diverse. Moreover, the technology for products in our target markets may change rapidly. New products are frequently introduced, and existing products are continually enhanced. Competition may also result in changes in pricing policies by us or our competitors, which could materially adversely affect our business, operating results and financial condition. Competitors vary in size and in the scope and breadth of the products and services that they offer. Many of our current and potential competitors have greater financial, technical, marketing and other resources than we do. As a result, they may be able to respond more quickly to new or emerging technologies and changes in customer requirements. They may also be able to devote greater resources to the development, promotion and sale of their products than we can.
Mainframe Competition. We currently face competition from a number of sources, including:
• | customers’ internal IT departments; |
• | providers of products that compete directly withChangeMan ZMF andComparex, such as Computer Associates, IBM and smaller private companies; and |
• | providers of application development programmer productivity and system management products, such as Compuware, IBM and smaller private companies. |
Competition in the Distributed Systems Market. We also face significant competition as we develop, market and sell our distributed systems products, includingChangeMan DS,TeamTrack,Dimensions andVersion Manager products. If we are unable to successfully penetrate the distributed systems market, our business, operating results and financial condition will be materially adversely affected. Penetrating the existing distributed systems market will be difficult. Competitors in the distributed systems market include IBM, Computer Associates, Microsoft, Telelogic and other smaller private companies.
Future Competition. We may face competition in the future from established companies who have not previously entered the mainframe or distributed systems market, or from emerging software companies. Increased competition may materially adversely affect our business, operating results and financial condition due to price reductions, reduced gross margins and reduction in market share. Established companies may not only develop their own mainframe or distributed systems solutions, but they may also acquire or establish cooperative relationships with our current competitors, including cooperative relationships between large, established companies and smaller private companies. Because larger companies have significant financial and organizational resources available, they may be able to quickly penetrate the mainframe or distributed systems market through acquisitions or strategic relationships and may be able to leverage the technology and expertise of smaller companies and develop successful SCM products for the mainframe. We expect that the software industry, in general, and providers of SCM solutions, in particular, will continue to consolidate. It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share.
Bundling or Compatibility Risks. Our ability to sell our products also depends, in part, on the compatibility of our products with other third party products, particularly those provided by IBM. Developers of these third
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party products may change their products so that they will no longer be compatible with our products. These third party developers may also decide to bundle their products with other SCM products for promotional purposes. If that were to happen, our business, operating results and financial condition may be materially adversely affected as we may be priced out of the market or no longer be able to offer commercially viable products.
We may experience delays in developing our products which could adversely affect our business.
If we are unable, for technological or other reasons, to develop and introduce new and improved products in a timely manner, this could materially adversely affect our business, operating results and financial condition. We have experienced product development delays in new version and update releases in the past and may experience similar or more significant product delays in the future. To date, none of these delays has materially affected our business. Difficulties in product development could delay or prevent the successful introduction or marketing of new or improved products or the delivery of new versions of our products to our customers. Any delay in releasing our new distributed systems products, for whatever reason, could have a material adverse effect on our business, operating results and financial condition.
Acquisitions may be difficult to integrate, disrupt our business or divert the attention of our management.
Historically, we have expanded our product offerings by acquiring other companies and by acquiring specific products from third parties. We may acquire or make investments in other companies and technologies. In the event of any acquisitions or investments, we could:
• | incur debt; |
• | assume liabilities; |
• | incur charges for the impairment of the value of investments or acquired assets; or |
• | incur amortization expense related to intangible assets. |
If we fail to achieve the financial and strategic benefits of past and future acquisitions or investments, our operating results will suffer. Acquisitions and investments involve numerous other risks, including:
• | difficulties integrating the acquired operations, technologies or products with ours; |
• | failure to achieve targeted synergies; |
• | unanticipated costs and liabilities; |
• | diversion of management’s attention from our core business; |
• | adverse effects on our existing business relationships with suppliers and customers or those of the acquired organization; |
• | difficulties entering markets in which we have no or limited prior experience; and |
• | potential loss of key employees, particularly those of the acquired organizations. |
We intend to expand our international operations and may encounter a number of problems in doing so; there are also a number of factors associated with international operations that could adversely affect our business.
Expansion of International Operations. We have sales subsidiaries in the United Kingdom, Germany, Sweden, France, Belgium, Spain, the Netherlands, Australia and Singapore. If we are unable to expand our international operations successfully and in a timely manner, or if these operations experience declining revenue growth, this could materially adversely affect our business, operating results and financial condition. We have limited experience in marketing, selling and supporting our products internationally. Additionally, we do not have significant experience in developing foreign language versions of our products. Such development may be
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more difficult or take longer than we anticipate. We may not be able to successfully market, sell, deliver and support our products internationally.
Risks of International Operations. International sales were 33% and 34% of our total revenue in the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively, as compared to 31% and 35% in the same quarter and nine months, respectively, a year ago. Our international revenue is attributable principally to our European operations; however, we plan to increase our investment in sales and marketing in the Asia Pacific region. Our international operations are, and any expanded international operations will be, subject to a variety of risks associated with conducting business internationally that could materially adversely affect our business, operating results and financial condition, including the following:
• | difficulties in staffing and managing international operations; |
• | problems in collecting accounts receivable; |
• | longer payment cycles; |
• | fluctuations in currency exchange rates; |
• | inability to control or predict the levels of revenue produced by our international distributors; |
• | seasonal reductions in business activity during the summer months in Europe and certain other parts of the world; |
• | limitations on repatriation of earnings; |
• | reduced protection of intellectual property rights and less favorable contract interpretation rules in some countries; |
• | political and economic instability; |
• | recessionary environments in foreign economies; or |
• | increases in tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries. |
Fluctuations in the value of foreign currencies could result in currency transaction losses.
A majority of our international business is conducted in foreign currencies, principally the British pound and the euro. Fluctuations in the value of foreign currencies relative to the U.S. dollar will continue to cause currency transaction gains and losses. We cannot predict the effect of exchange rate fluctuations upon future operating results. We may experience currency losses in the future. To date, we have not adopted a hedging program to protect us from risks associated with foreign currency fluctuations.
If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings.
Under generally accepted accounting principles, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least annually. Factors that may be considered a change in circumstances indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable include a decline in future cash flows and slower growth rates in our industry. We may be required to record a significant charge to earnings in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, resulting in an impact on our results of operations.
Third parties in the future could assert that our products infringe their intellectual property rights, which could adversely affect our business.
Third parties may claim that our current or future products infringe their proprietary rights. Any claims of this type could affect our relationships with existing customers and may prevent future customers from licensing our products. Because we are dependent upon a limited number of products, any such claims, with or without
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merit, could be time consuming to defend, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Royalty or license agreements may not be available on acceptable terms or at all. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in the software industry segment grows and the functionality of products in different industry segments overlaps. As a result of these factors, infringement claims could materially adversely affect our business.
Errors in our products or the failure of our products to conform to specifications could result in our customers demanding refunds from us or asserting claims for damages against us.
Because our software products are complex, they often contain errors or “bugs” that can be detected at any point in a product’s life cycle. While we continually test our products for errors and work with customers through our customer support services to identify and correct bugs in our software, we expect that errors in our products will continue to be found in the future. Although many of these errors may prove to be immaterial, certain of these errors could be significant. Detection of any significant errors may result in, among other things, loss of, or delay in, market acceptance and sales of our products, diversion of development resources, injury to our reputation, or increased service and warranty costs. These problems could materially adversely affect our business, operating results and financial condition. In the past we have discovered errors in certain of our products and have experienced delays in the shipment of our products during the period required to correct these errors. These delays have principally related to new version and product update releases. To date, none of these delays have materially affected our business. However, product errors or delays in the future, including any product errors or delays associated with the introduction of our distributed systems products, could be material. In addition, in certain cases we have warranted that our products will operate in accordance with specified customer requirements. If our products fail to conform to such specifications, customers could demand a refund for the software license fee paid to us or assert claims for damages.
Product liability claims asserted against us in the future could adversely affect our business.
We may be subject to claims for damages related to product errors in the future. A material product liability claim could materially adversely affect our business. Our license agreements with our customers typically contain provisions designed to limit exposure to potential product liability claims. Our standard software licenses provide that if our products fail to perform, we will correct or replace such products. If these corrective measures fail, we may be required to refund the license fee for such non-performing product. Our standard license agreement limits our liability for non-performing products to the amount of license fee paid, if the license has been in effect for less than one year, or to the amount of the licensee’s current annual maintenance fee, if the license is more than one year old. Our standard license also provides that we shall not be liable for indirect or consequential damages caused by the failure of our products. Such limitation of liability provisions may, however, not be effective under the laws of certain jurisdictions to the extent local laws treat certain warranty exclusions as unenforceable. Although we have not experienced any product liability claims to date, the sale and support of our products entail the risk of such claims.
Changes in accounting regulations and related interpretations and policies regarding revenue recognition could cause us to defer recognition of revenue or recognize lower revenue and profits.
Although we use standardized license agreements designed to meet current revenue recognition criteria under generally accepted accounting principles, we must often negotiate and revise terms and conditions of these standardized agreements, particularly in multi-product or multi-year transactions. As our transactions increase in complexity with the sale of larger, multi-product, multi-year licenses, negotiation of mutually acceptable terms and conditions can extend the sales cycle and, in certain situations, may require us to defer recognition of revenue on such licenses. We believe that we are in compliance with Statement of Position 97-2, “Software Revenue Recognition” as amended; however these future, more complex, multi-product, multi-year license transactions may require additional accounting analysis to account for them accurately, could lead to unanticipated changes in our current revenue accounting practices and may contain terms affecting the timing of revenue recognition.
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If we do not adequately manage and evolve our financial reporting and managerial systems and processes, our ability to manage and grow our business may be harmed.
Our ability to successfully implement our business plan and comply with regulations, including the Sarbanes-Oxley Act, requires an effective planning and management process. We expect that we will need to continue to improve existing, and implement new, operational and financial systems, procedures and controls to manage our business effectively in the future. Any delay in the implementation of, or disruption in the transition to, new or enhanced systems, procedures and controls, could harm our ability to accurately forecast sales demand, manage our supply chain and record and report financial and management information on a timely and accurate basis.
Our executive officers and certain key personnel are critical to our business and such officers and key personnel may not remain with us in the future.
Our success will depend to a significant extent on the continued service of our senior executives and certain other key employees, including certain sales, consulting, technical and marketing personnel. If we lost the services of one or more of our executives or key employees, including if one or more of our executives or key employees decided to join a competitor or otherwise compete directly or indirectly with us, this could materially adversely affect our business. In particular, we have historically relied on the experience and dedication of our product authors. Other than Mark Woodward, our Chief Executive Officer, and Robert Pender, our Chief Financial Officer, none of our senior and key employees, including key product authors, is party to an employment agreement with us. In addition, we do not maintain key man life insurance on our employees and have no plans to do so.
The interests of our controlling stockholder may differ from the interests of the holders of the senior subordinated notes.
Silver Lake and its affiliates own, in the aggregate, approximately 56.5% of our common stock, on a fully diluted basis, and beneficially own the only authorized share of our series A preferred stock. In addition, Silver Lake and its affiliates, by virtue of their ownership of our common stock and their voting rights under a stockholders agreement, control the vote, in connection with substantially all matters subject to stockholder approval, of approximately 97.9% of our outstanding common stock. As a result of this ownership and the terms of a stockholders agreement, Silver Lake is entitled to elect directors with majority voting power in our Board of Directors, to appoint new management and to approve actions requiring the approval of the holders of our outstanding voting shares as a single class, including adopting most amendments to our certificate of incorporation and approving mergers or sales of all or substantially all of our assets. Silver Lake, through its control of us, will also control all of our subsidiary guarantors, if any.
The interests of Silver Lake and its affiliates may differ from yours in material respects. For example, if we encounter financial difficulties or are unable to pay our debts as they mature, the interests of Silver Lake and its affiliates, as equity holders, might conflict with the interests of our note holders. Silver Lake and its affiliates may also have an interest in pursuing acquisitions, divestitures, financings or other transactions that, in its judgment, could enhance its equity investments, even though such transactions might involve risks to you as a note holder, including the incurrence of additional indebtedness. Additionally, the indenture governing our senior subordinated notes permits us to pay advisory fees, dividends or make other restricted payments under certain circumstances, and Silver Lake may have an interest in our doing so. We are party to a management advisory agreement with Silver Lake that provides for us to pay advisory and other fees to Silver Lake.
Silver Lake and its affiliates are in the business of making investments in companies and may, from time to time in the future, acquire interests in businesses that directly or indirectly compete with certain portions of our business or are suppliers or customers of ours. You should consider that the interests of Silver Lake and its affiliates may differ from yours in material respects.
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ITEM 3. | Quantitative and Qualitative Disclosures About Market Risk |
We do not use derivative financial instruments in our investment portfolio and have no foreign exchange contracts. Our financial instruments consist of cash and cash equivalents, short-term investments, trade accounts receivable and accounts payable. We consider investments in highly liquid instruments purchased with a remaining maturity of 90 days or less to be cash equivalents. All of our cash equivalents and short-term investments principally consist of commercial paper and debt securities, and are classified as available-for-sale as of October 31, 2006. Our exposure to market risk for changes in interest rates relates primarily to our short-term investments and short-term obligations; thus, a hypothetical 10% fluctuation in interest rates would not have a material impact on the fair value of these securities.
Sales to foreign countries accounted for approximately 33% and 34% of total sales in the current fiscal quarter and fiscal nine months ended October 31, 2006, respectively. Because we invoice certain foreign sales in currencies other than the United States dollar, predominantly the British pound sterling and euro, and do not hedge these transactions, fluctuations in exchange rates could adversely affect the translated results of operations of our foreign subsidiaries. Therefore, foreign exchange fluctuations could create a risk of significant balance sheet gains or losses on our consolidated financial statements. However, given our foreign subsidiaries’ net book values as of October 31, 2006 and net cash flows for the most recent fiscal nine months ended October 31, 2006, we do not believe that a hypothetical 10% fluctuation in foreign currency exchange rates would have a material impact on our financial position or results of operations.
We account for derivative instruments in accordance with the provisions of SFAS 133, as amended by SFAS 138 and SFAS 149. We utilize certain derivative instruments to enhance our ability to manage risk relating to interest rate exposure. Derivative instruments are entered into for periods consistent with the related underlying exposures and are not entered into for speculative purposes. We document all relationships between hedging instruments and hedged items, as well as its risk management objectives and strategies for undertaking various hedge transactions.
Interest Rate Risk. We use an interest rate swap as part of our interest rate risk management strategy. In the second fiscal quarter ended July 31, 2006, we entered into an interest rate swap transaction to effectively convert the variable interest rate on a portion of our $400.0 million senior secured term loan to a fixed rate. The swap, which expires on April 10, 2010, is accounted for as a fair value hedge under SFAS 133, and accordingly, the change in the fair market value of the derivative is recognized in the statement of operations. The notional amount of the swap is $250.0 million initially and amortizes down over time to $126.0 million at the time the swap transaction expires on April 10, 2010. Under the terms of the swap, we will pay an interest rate equal to the initial period LIBOR setting rate, set in arrears. In exchange, we will receive a fixed rate equal to 5.38%.
ITEM 4. | Controls and Procedures |
Attached as exhibits to this quarterly report on Form 10-Q are the certifications of our Chief Executive Officer and Chief Financial Officer, which are required in accordance with Rule 15d-14 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). This Item 4 includes information concerning the controls and controls evaluation referred to in the certifications, and it should be read in conjunction with the certifications for a more complete understanding of the topics presented.
Evaluation of disclosure controls and procedures. Our disclosure controls and procedures are designed to ensure that the information required to be disclosed in our reports filed under the Exchange Act, such as this quarterly report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures are also designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
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Our Chief Executive Officer and Chief Financial Officer, with the assistance of senior management personnel, have conducted an evaluation of the effectiveness of our disclosure controls and procedures as of October 31, 2006. We perform this evaluation on a quarterly basis so that the conclusions concerning the effectiveness of our disclosure controls and procedures can be reported in our annual and quarterly reports filed under the Exchange Act. Based on this evaluation, and subject to the limitations described below, our Chief Executive Officer and our Chief Financial Officer have concluded that, as of October 31, 2006, our disclosure controls and procedures were effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
Our management, including our Chief Executive Officer and the Chief Financial Officer, does not expect that our disclosure controls and procedures or internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can only provide reasonable, not absolute, assurances that the objectives of the control system are met. The design of a control system reflects resource constraints, and the benefits of controls must be considered relative to their costs. Because there are inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of error or fraud, if any, have been or will be detected.
Changes in internal control over financial reporting. There was no change in our internal control over financial reporting that occurred during the period covered by this quarterly report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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ITEM 1. | Legal Proceedings |
Information with respect to this Item may be found in Note 10 of Notes to Condensed Consolidated Financial Statements in Item I of Part I of this report, which information is incorporated into this Item 1 by reference.
ITEM 1A. | Risk Factors |
A description of the risk factors associated with our business is set forth in “Factors that Could Affect Future Results” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contained in Item 2 of Part I of this report. Our merger with Spyglass Merger Corp. on March 10, 2006 resulted in the termination of the registration of our then-existing equity and debt securities pursuant to Rule 12g-4(a)(1)(i) and Rule 12h-3(b)(1)(i) of the Securities Exchange Act of 1934. As a result, we were not required to file an annual report on Form 10-K for the fiscal year ended January 31, 2006 and, accordingly, are unable to identify changes to risk factors set forth in an annual report for such fiscal year.
ITEM 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
Not Applicable
ITEM 3. | Defaults Upon Senior Securities |
Not Applicable
ITEM 4. | Submission of Matters to a Vote of Security Holders |
Pursuant to a written consent effective as of August 16, 2006, our stockholders approved an amended and restated certificate of incorporation and elected Elizabeth Hackenson as a director to our board of directors. These matters are described in our Current Report on Form 8-K (File No. 000-25285) filed with the Securities and Exchange Commission on August 21, 2006 (Items 5.02 and 5.03 of which are incorporated herein by reference). The written consent was executed by stockholders representing 97,925,780 shares, or 98.8%, of our outstanding common stock.
ITEM 5. | Other Information |
Not Applicable
ITEM 6. | Exhibits |
(a) Exhibits
Exhibit No. | Exhibit Description | |
3.01 | Restated Certificate of Incorporation of Serena Software, Inc. (incorporated by reference to Exhibit 3.01 to the registrant’s current report on Form 8-K (File No. 000-25285), filed with the SEC on August 21, 2006) | |
3.02 | Bylaws of Serena Software, Inc. (incorporated by reference to Exhibit 3.02 to the registrant’s current report on Form 8-K (File No. 000-25285), filed with the SEC on August 21, 2006) | |
10.01* | FY 2007 Executive Annual Incentive Plan (incorporated by reference to Exhibit 10.01 to the registrant’s current report on Form 8-K (File no. 000-25285), filed with the SEC on August 21, 2006) |
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31.01† | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
31.02† | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
32.01‡ | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |
32.02‡ | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
* | Indicates a management contract or compensatory plan or arrangement. |
† | Exhibit is filed herewith. |
‡ | Exhibit is furnished rather than filed, and shall not be deemed incorporated by reference into any filing, in accordance with Item 601 of Regulation S-K. |
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
SERENA SOFTWARE, INC. | ||
By: | /S/ ROBERT I. PENDER, JR. | |
Robert I. Pender, Jr. Senior Vice President, Finance And Administration, Chief Financial Officer (Principal Financial And Accounting Officer) |
Date: December 15, 2006
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EXHIBIT INDEX
Exhibit No. | Exhibit Description | |
3.01 | Restated Certificate of Incorporation of Serena Software, Inc. (incorporated by reference to Exhibit 3.01 to the registrant’s current report on Form 8-K (File No. 000-25285), filed with the SEC on August 21, 2006) | |
3.02 | Bylaws of Serena Software, Inc. (incorporated by reference to Exhibit 3.02 to the registrant’s current report on Form 8-K (File No. 000-25285), filed with the SEC on August 21, 2006) | |
10.01* | FY 2007 Executive Annual Incentive Plan (incorporated by reference to Exhibit 10.01 to the registrant’s current report on Form 8-K (File no. 000-25285), filed with the SEC on August 21, 2006) | |
31.01† | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
31.02† | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
32.01‡ | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |
32.02‡ | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
* | Indicates a management contract or compensatory plan or arrangement. |
† | Exhibit is filed herewith. |
‡ | Exhibit is furnished rather than filed, and shall not be deemed incorporated by reference into any filing, in accordance with Item 601 of Regulation S-K. |
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