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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended September 30, 2008
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. 000-26937
QUEST SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
California | 33-0231678 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
5 Polaris Way Aliso Viejo, California | 92656 | |
(Address of principal executive offices) | (Zip code) |
Registrant’s telephone number, including area code: (949) 754-8000
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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x | Accelerated filer ¨ | |
Non-accelerated filer ¨ | Smaller reporting company ¨ |
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)
Yes ¨ No x
The number of shares outstanding of the Registrant’s Common Stock, no par value, as of October 31, 2008, was 105,924,577.
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QUEST SOFTWARE, INC.
FORM 10-Q
Page Number | ||||
PART I. FINANCIAL INFORMATION | ||||
Item 1. | Financial Statements (unaudited) | |||
Condensed Consolidated Balance Sheets as of September 30, 2008 and December 31, 2007 | 2 | |||
Condensed Consolidated Income Statements for the Three and Nine Months Ended September 30, 2008 and 2007 | 3 | |||
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007 | 4 | |||
Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2008 and 2007 | 5 | |||
Notes to Condensed Consolidated Financial Statements | 6 | |||
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 19 | ||
Item 3. | Quantitative and Qualitative Disclosures about Market Risk | 27 | ||
Item 4. | Controls and Procedures | 28 | ||
PART II. OTHER INFORMATION | ||||
Item 1. | Legal Proceedings | 29 | ||
Item 1A. | Risk Factors | 29 | ||
Item 6. | Exhibits | 29 | ||
SIGNATURES | 30 |
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QUEST SOFTWARE, INC.
PART I—FINANCIAL INFORMATION
Item 1. | Financial Statements |
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)
September 30, 2008 | December 31, 2007 | |||||||
ASSETS | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 280,491 | $ | 235,568 | ||||
Restricted cash | 2,370 | 48,924 | ||||||
Short-term marketable securities | 686 | 10,287 | ||||||
Accounts receivable, net of allowances of $8,886 and $8,037 at September 30, 2008 and December 31, 2007, respectively | 118,207 | 152,438 | ||||||
Prepaid expenses and other current assets | 19,764 | 19,022 | ||||||
Deferred income taxes | 12,936 | 11,014 | ||||||
Total current assets | 434,454 | 477,253 | ||||||
Property and equipment, net | 77,495 | 75,848 | ||||||
Long-term marketable securities | 91,259 | 70,936 | ||||||
Intangible assets, net | 115,250 | 76,641 | ||||||
Goodwill | 669,385 | 563,766 | ||||||
Deferred income taxes | 15,349 | 36,661 | ||||||
Other assets | 21,187 | 18,025 | ||||||
Total assets | $ | 1,424,379 | $ | 1,319,130 | ||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 3,768 | $ | 4,590 | ||||
Accrued compensation | 42,577 | 46,437 | ||||||
Other accrued expenses | 41,427 | 43,313 | ||||||
Current portion of income taxes payable | — | 1,962 | ||||||
Current portion of deferred revenue | 247,962 | 211,840 | ||||||
Total current liabilities | 335,734 | 308,142 | ||||||
Long-term liabilities: | ||||||||
Long-term portion of deferred revenue | 64,221 | 73,820 | ||||||
Long-term portion of income taxes payable | 32,673 | 37,130 | ||||||
Other long-term liabilities | 5,103 | 2,712 | ||||||
Total long-term liabilities | 101,997 | 113,662 | ||||||
Commitments and contingencies (Note 11) | ||||||||
Shareholders’ equity: | ||||||||
Preferred stock, no par value, 10,000 shares authorized; no shares issued or outstanding | — | — | ||||||
Common stock, no par value, 200,000 shares authorized; 105,541 and 101,819 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively | 885,323 | 833,050 | ||||||
Retained earnings | 103,599 | 64,728 | ||||||
Accumulated other comprehensive loss | (2,274 | ) | (452 | ) | ||||
Total shareholders’ equity | 986,648 | 897,326 | ||||||
Total liabilities and shareholders’ equity | $ | 1,424,379 | $ | 1,319,130 | ||||
See accompanying notes to condensed consolidated financial statements.
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CONDENSED CONSOLIDATED INCOME STATEMENTS
(In thousands, except per share data)
(Unaudited)
Three Months Ended September 30, | Nine Months Ended September 30, | ||||||||||||
2008 | 2007 | 2008 | 2007 | ||||||||||
Revenues: | |||||||||||||
Licenses | $ | 86,700 | $ | 69,632 | $ | 241,128 | $ | 209,704 | |||||
Services | 100,865 | 82,518 | 292,650 | 234,532 | |||||||||
Total revenues | 187,565 | 152,150 | 533,778 | 444,236 | |||||||||
Cost of revenues: | |||||||||||||
Licenses | 1,921 | 1,286 | 6,110 | 3,949 | |||||||||
Services | 15,167 | 13,566 | 46,571 | 40,082 | |||||||||
Amortization of purchased technology | 5,026 | 3,862 | 14,619 | 10,139 | |||||||||
Total cost of revenues | 22,114 | 18,714 | 67,300 | 54,170 | |||||||||
Gross profit | 165,451 | 133,436 | 466,478 | 390,066 | |||||||||
Operating expenses: | |||||||||||||
Sales and marketing | 76,957 | 65,227 | 234,604 | 194,285 | |||||||||
Research and development | 37,169 | 29,749 | 114,687 | 87,863 | |||||||||
General and administrative | 21,120 | 21,064 | 66,811 | 57,409 | |||||||||
Amortization of other purchased intangible assets | 2,418 | 1,938 | 7,730 | 5,066 | |||||||||
In-process research and development | — | — | 955 | — | |||||||||
Total operating expenses | 137,664 | 117,978 | 424,787 | 344,623 | |||||||||
Income from operations | 27,787 | 15,458 | 41,691 | 45,443 | |||||||||
Other (expense) income, net | (6,526 | ) | 7,004 | 4,385 | 18,197 | ||||||||
Income before income tax provision | 21,261 | 22,462 | 46,076 | 63,640 | |||||||||
Income tax provision | 3,944 | 7,476 | 7,204 | 25,812 | |||||||||
Net income | $ | 17,317 | $ | 14,986 | $ | 38,872 | $ | 37,828 | |||||
Net income per share: | |||||||||||||
Basic | $ | 0.16 | $ | 0.15 | $ | 0.37 | $ | 0.37 | |||||
Diluted | $ | 0.16 | $ | 0.14 | $ | 0.36 | $ | 0.36 | |||||
Weighted average shares: | |||||||||||||
Basic | 105,434 | 101,819 | 104,334 | 101,819 | |||||||||
Diluted | 107,450 | 105,198 | 106,697 | 105,121 |
See accompanying notes to condensed consolidated financial statements.
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Nine Months Ended September 30, | ||||||||
2008 | 2007 | |||||||
Cash flows from operating activities: | ||||||||
Net income | $ | 38,872 | $ | 37,828 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Depreciation and amortization | 34,859 | 26,593 | ||||||
Compensation expense associated with stock option grants | 14,306 | 13,960 | ||||||
Deferred income taxes | (421 | ) | (5,150 | ) | ||||
Excess tax benefit related to share-based compensation | (3,328 | ) | — | |||||
Provision for bad debts | 756 | 96 | ||||||
In-process research and development | 955 | — | ||||||
Changes in operating assets and liabilities, net of effects of acquisitions: | ||||||||
Accounts receivable | 37,663 | 30,882 | ||||||
Prepaid expenses and other current assets | 1,178 | 290 | ||||||
Other assets | (348 | ) | (870 | ) | ||||
Accounts payable | (1,557 | ) | (1,307 | ) | ||||
Accrued compensation | (7,840 | ) | (1,173 | ) | ||||
Other accrued expenses | (3,738 | ) | (4,783 | ) | ||||
Income taxes payable | (7,657 | ) | (4,031 | ) | ||||
Deferred revenue | 10,671 | 3,141 | ||||||
Other liabilities | 33 | 99 | ||||||
Net cash provided by operating activities | 114,404 | 95,575 | ||||||
Cash flows from investing activities: | ||||||||
Purchases of property and equipment | (8,181 | ) | (10,105 | ) | ||||
Cash paid for acquisitions, net of cash acquired | (135,226 | ) | (107,585 | ) | ||||
Change in restricted cash | 46,554 | — | ||||||
Purchases of cost-method investments | (3,160 | ) | (6,097 | ) | ||||
Purchases of marketable securities | (52,003 | ) | (30,816 | ) | ||||
Sales and maturities of marketable securities | 39,322 | 57,800 | ||||||
Net cash used in investing activities | (112,694 | ) | (96,803 | ) | ||||
Cash flows from financing activities: | ||||||||
Repayment of capital lease obligations | (205 | ) | (147 | ) | ||||
Proceeds from the exercise of stock options | 38,644 | — | ||||||
Excess tax benefit related to share-based compensation | 3,328 | — | ||||||
Proceeds received from certain executive officers as part of our restatement remedial actions | 200 | 158 | ||||||
Net cash provided by financing activities | 41,967 | 11 | ||||||
Effect of exchange rate changes on cash and cash equivalents | 1,246 | (391 | ) | |||||
Net increase (decrease) in cash and cash equivalents | 44,923 | (1,608 | ) | |||||
Cash and cash equivalents, beginning of period | 235,568 | 286,164 | ||||||
Cash and cash equivalents, end of period | $ | 280,491 | $ | 284,556 | ||||
Supplemental disclosures of consolidated cash flow information: | ||||||||
Cash paid for interest | $ | 529 | $ | 75 | ||||
Cash paid for income taxes | $ | 15,948 | $ | 34,420 | ||||
Supplemental schedule of non-cash investing and financing activities: | ||||||||
Unrealized (loss) gain on marketable securities | $ | (1,822 | ) | $ | 2 | |||
Capital lease additions | $ | 167 | $ | 275 | ||||
Unpaid purchases of property and equipment | $ | 391 | $ | 802 | ||||
See accompanying notes to condensed consolidated financial statements.
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CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)
Three Months Ended September 30, | Nine Months Ended September 30, | ||||||||||||
2008 | 2007 | 2008 | 2007 | ||||||||||
Net income | $ | 17,317 | $ | 14,986 | $ | 38,872 | $ | 37,828 | |||||
Other comprehensive income (loss): | |||||||||||||
Unrealized gain (loss) on marketable securities, net of tax | 156 | 153 | (1,822 | ) | 2 | ||||||||
Comprehensive income | $ | 17,473 | $ | 15,139 | $ | 37,050 | $ | 37,830 | |||||
See accompanying notes to condensed consolidated financial statements.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. | Organization and Basis of Presentation |
Quest Software, Inc. (“Quest,” the “Company,” “we,” “us” or “our”) was incorporated in California in 1987 and is a leading developer and vendor of application, database, Windows and virtualization management software products. We also provide consulting, training, and support services to our customers. Our accompanying unaudited condensed consolidated financial statements as of September 30, 2008 and for the three and nine months ended September 30, 2008 and 2007, reflect all adjustments (consisting of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.
The information included in this Quarterly Report on Form 10-Q should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Quantitative and Qualitative Disclosures About Market Risk,” and the Consolidated Financial Statements and Notes to the Consolidated Financial Statements included in Quest’s Annual Report on Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”). The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period.
Recently Issued Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157,Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. However, in February 2008, the FASB issued two FASB Staff Positions that remove leasing from the scope of SFAS 157 and approve a one year deferral for the implementation of SFAS 157 for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis. Nonfinancial assets and nonfinancial liabilities for which we have not applied the provisions of SFAS 157 include those measured at fair value in goodwill impairment testing and those initially measured at fair value in a business combination. In October 2008, the FASB issued an additional FASB Staff Position that clarifies the application of SFAS 157 in a market that is not active. We adopted this statement for financial assets and financial liabilities effective January 1, 2008 (see Note 9 for further details). There was no impact from adoption of this standard on our financial position or results of operations. We do not expect adoption of this standard as it pertains to non-financial assets and non-financial liabilities to have a material impact on our consolidated financial position or results of operations.
In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115 (“SFAS No. 159”), which permits entities to choose to measure many financial instruments and certain other items at fair value, on an instrument-by-instrument basis. The fair value measurement election is irrevocable and requires that unrealized gains and losses are reported in earnings. SFAS No. 159 was effective in the first quarter of fiscal 2008. We have not elected to apply the fair value option to any of our financial instruments.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), Business Combinations (“SFAS 141R”). SFAS 141R will significantly change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific items, including:
• | Acquisition costs will be generally expensed as incurred; |
• | Noncontrolling interests (formerly known as “minority interests” – see SFAS 160 discussion below) will be valued at fair value at the acquisition date; |
• | Acquired contingent liabilities will be recorded at fair value at the acquisition date and subsequently measured at either the higher of such amount or the amount determined under existing guidance for non-acquired contingencies; |
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• | In-process research and development will be recorded at fair value as an indefinite-lived intangible asset at the acquisition date; |
• | Restructuring costs associated with a business combination will be generally expensed subsequent to the acquisition date; and |
• | Changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense. |
SFAS 141R also includes a substantial number of new disclosure requirements. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. Accordingly, since we are a calendar year-end company we will continue to record and disclose business combinations following existing accounting principles generally accepted in the United States of America until January 1, 2009. We expect SFAS 141R will have an impact on accounting for business combinations once adopted but the impact will be dependent upon the nature, terms and size of acquisitions completed after the effective date.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51(“SFAS 160”). SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Like SFAS 141R discussed above, earlier adoption is prohibited. We do not expect adoption of this Statement to have a material effect on our consolidated financial position or results of operations.
In April 2008, the FASB issued FASB Staff Position (“FSP”) No. 142-3,Determination of the Useful Life of Intangible Assets. This FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142 (“SFAS 142”),Goodwill and Other Intangible Assets, and requires expanded disclosures regarding intangible assets existing as of each reporting period. The intent of this FSP is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the intangible asset under SFAS 141R and other U.S. generally accepted accounting principles. This FSP is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is prohibited. We do not expect adoption of this FSP to have a material effect on our consolidated financial position or results of operations.
In May 2008, the FASB issued SFAS No. 162,The Hierarchy of Generally Accepted Accounting Principles (“SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework, or hierarchy, for selecting the accounting principles used in preparing financial statements that are presented in conformity with U.S. generally accepted accounting principles by nongovernmental entities. This Statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board (“PCAOB”) amendments to AU Section 411,The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. We do not expect adoption of this Statement to have a material effect on our consolidated financial position or results of operations.
2. | Share-Based Payments |
Share-Based Payment Plans
In March 2008, our Board of Directors adopted the Quest Software, Inc. 2008 Stock Incentive Plan (the “2008 Plan”). The 2008 Plan, which was approved by our shareholders in May 2008, is the successor to the Quest Software, Inc. 1999 Stock Incentive Plan, as amended (the “1999 Plan”) and the Quest Software, Inc. 2001 Stock Incentive Plan (the “2001 Plan” and, together with the 1999 Plan, the “Prior Plans”). The 2008 Plan became effective and replaced the Prior Plans effective July 1, 2008. Our Board adopted the 2008 Plan to provide a means to secure and retain the services of our employees, directors, and consultants, to provide a means by which such eligible individuals may be given an opportunity to benefit from increases in the value of our Common Stock through the grant of stock awards, and thereby align the long-term compensation and interests of those individuals with our shareholders.
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We had previously authorized for issuance an aggregate 38.5 million shares of common stock available to employees, directors and consultants under the Prior Plans. Any shares remaining available for issuance pursuant to the exercise of options or settlement of stock awards under the Prior Plans are available for issuance pursuant to stock awards granted under the 2008 Plan. Any shares subject to outstanding stock awards granted under the Prior Plans that expire or terminate for any reason prior to exercise or settlement shall become available for issuance pursuant to stock awards granted under the 2008 Plan.
The 2008 Plan provides for the discretionary grant of incentive stock options, nonstatutory stock options, restricted stock awards, restricted stock unit awards, stock appreciation rights, and other forms of equity compensation (collectively, the “stock awards”). Incentive stock options granted under the 2008 Plan are intended to qualify as “incentive stock options” within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended, or the “Code.” Nonstatutory stock options granted under the 2008 Plan are not intended to qualify as incentive stock options under the Code. The 2008 Plan also provides for the automatic grant of stock options to non-employee Board members over their period of service on our Board, continuing the similar program for automatic stock option grants to non-employee directors under the 1999 Plan.
Non-qualified stock options granted under the 2008 Plan and Prior Plans generally have a 10-year life and vest ratably over a four to five year period, generally at the rate of 20% one year after the grant date and 10% semi-annually thereafter. All outstanding stock awards granted under the Prior Plans will continue to remain subject to the terms and conditions of those predecessor plans. All stock awards granted after the July 1, 2008 effective date of the 2008 Plan will be subject to the terms of the 2008 Plan. The exercise price of all options granted under the 2008 Plan is to be established by the Plan Administrator; provided, however, that the exercise price of stock options shall not be less than the market value of our Common Stock on the date of grant. The Plan Administrator for the 2008 Plan is the Compensation Committee of the Board of Directors. Except as otherwise noted, the terms of stock awards granted under the 2008 Plan are substantially similar to those granted under the Prior Plans.
The number of shares of Common Stock available for issuance under the 2008 Plan is 33,066,930 as of September 30, 2008. The number of shares of Common Stock reserved for issuance under the 2008 Plan will be reduced by 1.94 shares for each share of Common Stock issued under the 2008 Plan pursuant to a restricted stock award, restricted stock unit award, or other stock award. As of September 30, 2008, 18.1 million shares were available for grant under the 2008 Plan.
Our Board may amend or modify the 2008 Plan at any time, subject to any required shareholder approval. To the extent required by applicable law or regulation, shareholder approval will be required for any amendment that (a) materially increases the number of shares available for issuance under the 2008 Plan; (b) materially expands the class of individuals eligible to receive stock awards under the 2008 Plan; (c) materially increases the benefits accruing to the participants under the 2008 Plan or materially reduces the price at which shares of common stock may be issued or purchased under the 2008 Plan; (d) materially extends the term of the 2008 Plan; or (e) expands the types of awards available for issuance under the 2008 Plan.
Option and Award Activity for the Nine Months Ended September 30, 2008
We granted employee stock options to purchase 127,500 shares of our common stock to recently hired employees and options to purchase 35,000 shares of common stock to one non-employee director pursuant to the Company’s 1999 Stock Incentive Plan. In addition, we granted stock options to purchase 180,000 shares of common stock to our non-employee directors pursuant to the Company’s 2008 Stock Incentive Plan. We also awarded restricted stock units (RSU’s) covering 387,209 shares of common stock to our executive officers pursuant to the Company’s 1999 Stock Incentive Plan and the Company’s Executive Incentive Plan. The RSU’s were granted on May 8, 2008, when our shareholders approved the Company’s Executive Incentive Plan. RSU’s covering 167,209 shares relate to the nine-month performance period ended December 31, 2007, of which 55,737 shares have vested and will be delivered, subject to deferral elections, in January 2009 and the remaining 111,472 RSU’s remain subject to time-based vesting conditions. RSU’s covering 220,000 shares relate to the 12-month performance period ending December 31, 2008, the vesting of which remains subject to achievement of certain performance objectives relating to license bookings and operating margin criteria, as well as time-based vesting provisions.
In connection with our stock option investigation and related restatement completed in December 2007, we determined that the accounting measurement dates for most of our options granted between June 1998 and May 2002, covering options to purchase 21.8 million shares of our common stock, differed from the measurement dates previously used for such awards. As a result, there were potential adverse tax consequences that may apply to holders of affected options.
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In June 2008, pursuant to a Tender Offer, we offered to amend or replace affected options by adjusting the exercise price for each such option. The offer expired on June 27, 2008. Participants whose affected options were amended or replaced pursuant to the offer became entitled to a special cash payment with respect to those options. As a result, we will make cash payments of $1.2 million in January 2009 to reimburse affected U.S. employees, and we have made cash payments of $0.3 million in July 2008 to reimburse affected Canadian employees, for the increases in their exercise prices. A liability has been recorded for these payments and is included as accrued compensation as of September 30, 2008.
Accounting for Share-Based Payments
We account for share-based compensation awards in accordance with the provisions of SFAS No. 123 (revised 2004),Share-Based Payment(“SFAS 123R”), which requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the awards ultimately expected to vest is recognized as expense over the requisite service period. We recognized share-based compensation expense for stock options and restricted stock units (RSU’s), including the impact of related payroll taxes, of $5.2 million and $15.2 million, or $4.3 million and $12.8 million net of tax in our condensed consolidated income statements for the three and nine months ended September 30, 2008 as compared to compensation expense for stock options of $4.3 million and $14.0 million, or $2.8 million and $8.3 million net of tax, for the three and nine months ended September 30, 2007.
Share-based compensation expense related to RSU’s is recognized on a straight-line basis over the requisite service period in accordance with SFAS 123R. The total fair value of the RSU’s was determined based upon the closing sale price of our common stock on the date of grant multiplied by the number of shares expected to be delivered. We recorded share-based compensation expense of $0.5 million and $1.7 million for the three and nine months ended September 30, 2008 for these RSU’s. As of September 30, 2008, total unrecognized share-based compensation expense related to unvested RSU’s was $3.6 million, which is expected to be recognized over a weighted-average period of 2.1 years.
In connection with the offer to amend or replace affected options we modified options granted to 309 employees resulting in additional share-based compensation expense and a corresponding reduction of capital in the amount of approximately $0.8 million in the nine months ended September 30, 2008, all of which was recorded in June 2008.
The following table presents the income statement classification of all share-based compensation expense for the three and nine months ended September 30, 2008 and 2007 (in thousands, except per share data):
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
Cost of licenses | $ | 1 | $ | 1 | $ | 3 | $ | 4 | ||||
Cost of services | 150 | 267 | 685 | 774 | ||||||||
Sales and marketing | 1,588 | 1,666 | 5,537 | 5,569 | ||||||||
Research and development | 1,283 | 1,527 | 4,505 | 5,105 | ||||||||
General and administrative | 2,212 | 790 | 4,492 | 2,571 | ||||||||
Total share-based compensation | 5,234 | 4,251 | 15,222 | 14,023 | ||||||||
Recognized income tax impact | 971 | 1,415 | 2,380 | 5,688 | ||||||||
Reduction of net income | $ | 4,263 | $ | 2,836 | $ | 12,842 | $ | 8,335 | ||||
As of September 30, 2008, total unrecognized share-based compensation cost related to unvested stock options was $14.8 million, which is expected to be recognized over a weighted-average period of 2.5 years.
3. | Acquisitions |
2008 Acquisitions
NetPro Computing, Inc. – In September 2008 we acquired NetPro Computing, Inc. (“NetPro”), a leading provider of Microsoft infrastructure optimization solutions, for purchase consideration of approximately $78.9 million, including $0.3
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million in transaction costs. The acquisition of NetPro allows Quest to further extend our product portfolio to deliver a comprehensive set of products to manage complex Microsoft infrastructures. The combined product offering is expected to provide robust solutions to better migrate, manage and secure Microsoft Active Directory, Exchange, SharePoint and SQL Server environments. The acquisition has been accounted for as a purchase and the purchase price was preliminarily allocated primarily to goodwill and other intangible assets. The allocation of purchase price is pending final fair value determinations of acquired tangible and intangible assets and liabilities which are expected to be finalized in 2008. Total goodwill of $59.2 million was preliminarily assigned $35.5 million and $23.7 million to the license and service segments of our business, respectively, and is not expected to be deductible for tax purposes. The preliminary goodwill allocation of 60% to licenses and 40% to services is based on both historical and projected relative contribution from licenses and services revenues. Actual results of operations of NetPro are included in our condensed consolidated financial statements from the date of acquisition. Our preliminary allocation of the purchase price to assets and liabilities was as follows (in thousands):
Current assets | $ | 7,368 | ||
Acquired technologies with an estimated useful life of 5.0 years | 22,500 | |||
Other identified intangibles with an estimated useful life of 5.0 years | 15,000 | |||
Goodwill | 59,232 | |||
Other non-current assets | 1,145 | |||
Other current liabilities | (3,969 | ) | ||
Deferred revenue | (7,151 | ) | ||
Non-current liabilities | (15,187 | ) | ||
Total purchase price | $ | 78,938 | ||
PassGo Technologies Limited –In January 2008 we acquired PassGo Technologies Limited (“PassGo”), a privately held, UK-based leader in access and identity management solutions, for purchase consideration of approximately $52.2 million, including $1.1 million in transaction costs. The acquisition has been accounted for as a purchase and the purchase price was allocated primarily to goodwill and other intangible assets. Total goodwill of $39.1 million was assigned $13.7 million and $25.4 million to the license and service segments of our business, respectively, and is not expected to be deductible for tax purposes. The goodwill allocation of 35% to licenses and 65% to services is based on both historical and projected relative contribution from licenses and services revenues. Actual results of operations of PassGo are included in our condensed consolidated financial statements from the date of acquisition. Our allocation of the purchase price to assets and liabilities based upon the fair value determination was finalized in the second quarter of 2008 and was as follows (in thousands):
Current assets | $ | 7,399 | ||
Acquired technologies with a weighted average useful life of 4.8 years | 9,360 | |||
Customer relationships with a weighted average useful life of 5.6 years | 9,680 | |||
Non-compete agreements with a useful life of 2.0 years | 170 | |||
Trade name with a useful life of 2.0 years | 90 | |||
Goodwill | 39,075 | |||
Other non-current assets | 4,443 | |||
Other current liabilities | (5,578 | ) | ||
Deferred revenue | (6,951 | ) | ||
Non-current liabilities | (5,448 | ) | ||
Total purchase price | $ | 52,240 | ||
Other Acquisitions – We completed two other acquisitions during the nine months ended September 30, 2008. The aggregate consideration paid for these transactions was $11.7 million paid in cash and was preliminarily allocated, pending the final fair value determination of one of the acquisition’s acquired intangible assets which is expected to be finalized in 2008, as follows: $6.2 million to goodwill, $1.0 million to in-process research and development which was written off on the date of acquisition, $5.6 million to intangible assets and $(1.1) million to assumed liabilities, net of tangible assets acquired. Actual results of operations of these acquisitions are included in our condensed consolidated financial statements from the effective dates of the acquisitions.
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The following represents the aggregate preliminary allocation of the purchase price for these two acquisitions to amortizing intangible assets (table in thousands):
Acquired technology with a weighted average useful life of 5.8 years | $ | 3,904 | |
Customer relationships with a useful life of 5.0 years | 642 | ||
Non-compete agreements with a weighted average useful life of 2.5 years | 1,006 | ||
Total intangible assets | $ | 5,552 | |
The pro forma effects of all 2008 acquisitions, individually or in the aggregate, would not have been material to our results of operations for the three and nine months ended September 30, 2008 and fiscal 2007 and, therefore, are not presented.
2007 Acquisitions
ScriptLogic Corporation –In August 2007 we acquired ScriptLogic Corporation (“ScriptLogic”), a privately held company that provides systems lifecycle management solutions for Windows-based networks, for purchase consideration of approximately $89.5 million, including $0.6 million in transaction costs. In connection with the acquisition, Quest also offered key members of the management team of ScriptLogic an opportunity to participate in a post-closing incentive bonus plan in an aggregate amount of up to $8.0 million payable over a four-year period (the “Incentive Plan”). A portion of the payments under the Incentive Plan will be based on the satisfaction of financial performance objectives and a portion of the payments will be based solely on continued employment. All bonus payments will be recorded as compensation expense in the periods such bonuses are earned. Of the cash amount paid at closing, $12.0 million was deposited in an escrow account to secure certain indemnification obligations of the selling shareholders.
The acquisition has been accounted for as a purchase and the purchase price has been allocated primarily to goodwill and other intangible assets. Total goodwill of $67.8 million was assigned $40.7 million and $27.1 million to the license and service segments of our business, respectively, and is not expected to be deductible for tax purposes. Goodwill allocation of 60% to licenses and 40% to services is based on both historical and projected relative contribution from licenses and services revenues. Actual results of operations of ScriptLogic are included in our condensed consolidated financial statements from the date of acquisition. Our allocation of the purchase price to assets and liabilities based upon the fair value determination was as follows (in thousands):
Current assets | $ | 14,190 | ||
Acquired technologies with a useful life of 5.0 years | 15,600 | |||
Customer relationships with a useful life of 5.0 years | 11,300 | |||
Trade name with an indefinite useful life | 6,200 | |||
Goodwill | 67,821 | |||
Other non-current assets | 2,154 | |||
Other current liabilities | (3,423 | ) | ||
Deferred revenue | (11,123 | ) | ||
Non-current deferred tax liability | (13,240 | ) | ||
Total purchase price | $ | 89,479 | ||
Other Acquisitions –We completed three other acquisitions during the nine months ended September 30, 2007, each of which have been fully consolidated. The aggregate consideration paid for these transactions totaled $24.6 million paid in cash, including $0.4 million of transaction costs, and was allocated as follows: $20.3 million to goodwill, $6.3 million to intangible assets and $2.0 million to assumed liabilities, net of tangible assets acquired. Actual results of operations of these acquisitions are included in our consolidated financial statements from the effective dates of the acquisitions.
The following represents the aggregate allocation of the purchase price for these three acquired companies to amortizing intangible assets (table in thousands):
Acquired technology with a weighted average useful life of 4.2 years | $ | 5,305 | |
Customer relationships with a weighted average useful life of 4.9 years | 665 | ||
Non-compete agreements with a weighted average useful life of 2.0 years | 291 | ||
Total intangible assets | $ | 6,261 | |
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The pro forma effects of all 2007 acquisitions, individually or in the aggregate, would not have been material to our results of operations for the three and nine months ended September 30, 2008 and fiscal 2007 and, therefore, are not presented.
4. | Goodwill and Intangible Assets, Net |
Intangible assets, net are comprised of the following (in thousands):
September 30, 2008 | December 31, 2007 | |||||||||||||||||||
Gross Carrying Amount | Accumulated Amortization | Net | Gross Carrying Amount | Accumulated Amortization | Net | |||||||||||||||
Acquired technology | $ | 157,583 | $ | (92,385 | ) | $ | 65,198 | $ | 122,883 | $ | (77,757 | ) | $ | 45,126 | ||||||
Customer relationships | 66,078 | (25,171 | ) | 40,907 | 40,809 | (19,429 | ) | 21,380 | ||||||||||||
Non-compete agreements | 11,907 | (10,794 | ) | 1,113 | 11,000 | (9,454 | ) | 1,546 | ||||||||||||
Trademarks and trade names (1) | 12,680 | (4,648 | ) | 8,032 | 12,590 | (4,001 | ) | 8,589 | ||||||||||||
$ | 248,248 | $ | (132,998 | ) | $ | 115,250 | $ | 187,282 | $ | (110,641 | ) | $ | 76,641 | |||||||
(1) | Trademarks and trade names include $6.2 million in a trade name related to our acquisition of ScriptLogic in August 2007 that has an indefinite useful life, and as such is not being amortized. |
Amortization expense for intangible assets was $7.4 million and $22.4 million for the three and nine months ended September 30, 2008, respectively. This compares to $5.8 million and $15.2 million for the three and nine months ended September 30, 2007, respectively. Estimated annual amortization expense related to intangible assets reflected on our September 30, 2008 balance sheet is as follows (in thousands):
Estimated Annual Amortization Expense | |||
2008 (remaining quarter) | $ | 8,824 | |
2009 | 30,439 | ||
2010 | 24,831 | ||
2011 | 20,998 | ||
2012 and thereafter (1) | 23,958 | ||
Total accumulated amortization | $ | 109,050 | |
(1) | All amortizing intangible assets are expected to be fully amortized by the end of 2014. |
The changes in the carrying amount of goodwill by reportable operating segment for the nine months ended September 30, 2008 are as follows (in thousands):
Licenses | Services | Total | |||||||
Balance as of December 31, 2007 | $ | 416,462 | $ | 147,304 | $ | 563,766 | |||
Acquisitions | 52,960 | 51,588 | 104,548 | ||||||
Adjustments (1) | 590 | 481 | 1,071 | ||||||
Balance as of September 30, 2008 | $ | 470,012 | $ | 199,373 | $ | 669,385 | |||
(1) | Primarily from finalization of purchase price allocations on certain 2007 acquisitions. |
5. | Cost Method Investments |
We invested $3.2 million in early stage private companies during the nine months ended September 30, 2008. We invested $6.1 million in an early stage private company during the nine months ended September 30, 2007. These investments were accounted for under the cost method, as the equity securities do not have a readily determined market value and we do not have the ability to exercise significant influence. Our cumulative investments in non-consolidated companies are included as part of other assets in our condensed consolidated balance sheet at September 30, 2008 and December 31, 2007 and were valued at $14.8 million and $11.7 million, respectively.
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6. | Other (Expense) Income, Net |
Other (expense) income, net consisted of the following (in thousands):
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Interest income | $ | 2,837 | $ | 4,504 | $ | 8,738 | $ | 14,137 | ||||||||
Interest expense | (52 | ) | (45 | ) | (161 | ) | (127 | ) | ||||||||
Foreign currency (loss) gain, net (1) | (9,499 | ) | 2,829 | (4,827 | ) | 4,289 | ||||||||||
Other income (expense), net | 188 | (284 | ) | 635 | (102 | ) | ||||||||||
Total other (expense) income, net | $ | (6,526 | ) | $ | 7,004 | $ | 4,385 | $ | 18,197 | |||||||
(1) | Our foreign currency gains or losses are predominantly attributable to translation gains or losses on the re-measurement of our net balances of monetary assets and liabilities in our foreign subsidiaries, including accounts receivable and cash, which were primarily denominated in the Euro, and to a lesser extent, the British Pound and Canadian Dollar. The foreign currency translation adjustments to these balance sheet items are calculated by comparing the currency spot rates at the end of a quarter to the spot rates at the end of the previous quarter. |
7. | Income Tax Provision |
The effective income tax rate for the three and nine months ended September 30, 2008 was approximately 18.6% and 15.6%, respectively, compared to 33.3% and 40.6% in the comparable periods of 2007. The change was primarily due to the closure of an Internal Revenue Service examination of income tax returns through December 31, 2004 which discretely impacted the nine month period ended September 30, 2008, and a combination of other factors including the mix of income between high and low jurisdictions, and the impact of net operating losses and associated valuation allowances in certain foreign jurisdictions that impacted both the three and nine months ended September 30, 2007. The provision for income taxes decreased to $3.9 million and $7.2 million, respectively, for the three and nine months ended September 30, 2008 from $7.5 million and $25.8 million in the comparable periods of 2007, representing a decrease of $3.6 million and $18.6 million.
8. | Net Income Per Share |
Basic earnings per share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities by including other common stock equivalents, including stock options and restricted stock units, in the weighted-average number of common shares outstanding for a period, if dilutive.
The table below sets forth the reconciliation of the denominator of the earnings per share calculation (in thousands):
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||
2008 | 2007 | 2008 | 2007 | |||||
Shares used in computing basic net income per share | 105,434 | 101,819 | 104,334 | 101,819 | ||||
Dilutive effect of stock options and restricted stock units (1) | 2,016 | 3,379 | 2,363 | 3,302 | ||||
Shares used in computing diluted net income per share | 107,450 | 105,198 | 106,697 | 105,121 | ||||
(1) | Options to purchase 8.2 million and 8.5 million shares of common stock during the three months ended September 30, 2008 and 2007, respectively, and 8.6 million and 9.0 million shares of common stock during the nine months ended September 30, 2008 and 2007, respectively, were outstanding but were not included in the computation of net income per share as inclusion would have been anti-dilutive. |
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9. | Fair Value Measurements |
Effective January 1, 2008, we adopted SFAS 157 for financial assets and liabilities. This standard defines fair value, provides guidance for measuring fair value and requires certain disclosures. This standard does not require any new fair value measurements, but rather applies under other accounting pronouncements that require or permit fair value measurements.
SFAS 157 discusses valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow) and the cost approach (cost to replace the service capacity of an asset or replacement cost). The statement establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:
• | Level 1: Observable inputs such as quoted prices (unadjusted) in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. |
• | Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active. |
• | Level 3: Unobservable inputs that reflect the reporting entity’s own assumptions when there is little or no market data. |
As of September 30, 2008, we held certain assets that are required to be measured at fair value on a recurring basis. These included cash equivalents and marketable securities (including auction rate securities).
Our investments associated with cash equivalents and marketable securities consist of money market funds, United States government and government agency bonds and corporate bonds for which market prices are readily available. Our investments in marketable securities also consist of municipal notes with an auction reset feature (“auction rate securities”), which are classified as non-current marketable securities and recorded at fair value.
The auction rate security instruments held by the Company at September 30, 2008 totaled $50.2 million (with a fair value of $48.4 million), of which $49.2 million par amount were in securities collateralized by student loan portfolios, which are guaranteed by the United States government. Due to our belief that the market for these student loan collateralized instruments may take in excess of 364 days to fully recover and given our intent and ability to hold these securities to maturity or until the market recovers, we have classified them as non-current and included them in Long-term marketable securities on the Condensed Consolidated Balance Sheet at September 30, 2008. As of September 30, 2008, we continue to earn interest on all of our auction rate security instruments. Any future fluctuation in fair value related to these instruments that we deem to be temporary, including any recoveries of previous write-downs, would be recorded to accumulated other comprehensive loss. If we determine that any future valuation adjustment is other than temporary, we would record an impairment charge to earnings as appropriate.
Due to recent events in credit markets, the auction events for all of the auction rate securities held by the Company have experienced failed auctions during 2008. As such, market available pricing information is not readily available at this time. Therefore, in order to determine the fair value of these securities we constructed a discounted cash flow analysis model as of September 30, 2008. This model considers, among other items, the general climate of interest rates, the collateralization underlying the security investments, the creditworthiness of the counterparty, the timing of expected future cash flows, and the expectation of the next time the security is expected to have a successful auction. From this model we determined that there was a decline in fair value of the auction rate securities. Therefore, during the three and nine months ended September 30, 2008, we recorded $0.1 million and $1.8 million, respectively, as an unrealized loss that is included in other comprehensive loss, as we believe the decline in fair value of the auction rate securities is temporary. We attribute the temporary decline to be related to the overall current liquidity issues prevalent in the auction rate securities market at this time.
During the three months ended September 30, 2008, approximately $1.1 million of principal invested in auction rate securities held by the Company received downgraded credit ratings and others were placed on credit watch.
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The following table represents our fair value hierarchy for financial assets (cash equivalents and investments) measured at fair value on a recurring basis as of September 30, 2008 (in thousands):
Fair Value Measurements at September 30, 2008 | ||||||||||||
Total | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Other Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | |||||||||
Cash Equivalents | $ | 181,837 | $ | 181,837 | $ | — | $ | — | ||||
U.S. Government Agency Securities | 37,928 | 37,928 | — | — | ||||||||
Auction Rate Securities | 48,352 | — | — | 48,352 | ||||||||
Corporate Notes/Bonds | 4,979 | 4,979 | — | — | ||||||||
Other | 686 | 686 | — | — | ||||||||
Total | $ | 273,782 | $ | 225,430 | $ | — | $ | 48,352 | ||||
Based on market conditions, we changed our valuation methodology for auction rate securities to a discounted cash flow analysis during the nine months ended September 30, 2008. Accordingly, these securities changed from Level 1 to Level 3 within SFAS 157’s hierarchy since our initial adoption of SFAS 157 at January 1, 2008.
The following table presents our assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as defined in SFAS 157 at September 30, 2008:
Auction Rate Securities | ||||
Balance at December 31, 2007 | $ | — | ||
Unrealized loss included in other comprehensive loss | (1,848 | ) | ||
Net settlements | (70 | ) | ||
Transfers to Level 3 | 50,270 | |||
Balance at September 30, 2008 | $ | 48,352 | ||
10. | Geographic and Segment Information |
Our reportable operating segments are Licenses and Services. The Licenses segment develops and markets licenses to use our software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to our software products.
We do not separately allocate operating expenses to these segments, nor do we allocate specific assets to these segments. Therefore, segment information reported includes only revenues, cost of revenues, and gross profit.
Reportable segment data for the three and nine months ended September 30, 2008 and 2007, respectively, is as follows (in thousands):
Licenses | Services | Total | |||||||
Three months ended September 30, 2008 | |||||||||
Revenues | $ | 86,700 | $ | 100,865 | $ | 187,565 | |||
Cost of Revenues | 6,947 | 15,167 | 22,114 | ||||||
Gross profit | $ | 79,753 | $ | 85,698 | $ | 165,451 | |||
Three months ended September 30, 2007 | |||||||||
Revenues | $ | 69,632 | $ | 82,518 | $ | 152,150 | |||
Cost of Revenues | 5,148 | 13,566 | 18,714 | ||||||
Gross profit | $ | 64,484 | $ | 68,952 | $ | 133,436 | |||
Nine months ended September 30, 2008 | |||||||||
Revenues | $ | 241,128 | $ | 292,650 | $ | 533,778 | |||
Cost of Revenues | 20,729 | 46,571 | 67,300 | ||||||
Gross profit | $ | 220,399 | $ | 246,079 | $ | 466,478 | |||
Nine months ended September 30, 2007 | |||||||||
Revenues | $ | 209,704 | $ | 234,532 | $ | 444,236 | |||
Cost of Revenues | 14,088 | 40,082 | 54,170 | ||||||
Gross profit | $ | 195,616 | $ | 194,450 | $ | 390,066 | |||
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Revenues are attributed to geographic areas based on the location of the entity to which the products or services were invoiced. Revenues and long-lived assets concerning principal geographic areas in which we operate are as follows (in thousands):
United States | United Kingdom | Other International (2) | Total | |||||||||
Three months ended September 30, 2008: | ||||||||||||
Revenues | $ | 114,385 | $ | 20,148 | $ | 53,032 | $ | 187,565 | ||||
Long-lived assets (1) | $ | 79,486 | $ | 8,694 | $ | 10,502 | $ | 98,682 | ||||
Three months ended September 30, 2007: | ||||||||||||
Revenues | $ | 94,286 | $ | 16,627 | $ | 41,237 | $ | 152,150 | ||||
Long-lived assets (1) | $ | 76,744 | $ | 4,853 | $ | 12,944 | $ | 94,541 | ||||
Nine months ended September 30, 2008: | ||||||||||||
Revenues | $ | 310,385 | $ | 62,995 | $ | 160,398 | $ | 533,778 | ||||
Long-lived assets (1) | $ | 79,486 | $ | 8,694 | $ | 10,502 | $ | 98,682 | ||||
Nine months ended September 30, 2007: | ||||||||||||
Revenues | $ | 268,786 | $ | 53,442 | $ | 122,008 | $ | 444,236 | ||||
Long-lived assets (1) | $ | 76,744 | $ | 4,853 | $ | 12,944 | $ | 94,541 |
(1) | Includes property and equipment, net and other assets. |
(2) | No single country within Other International accounts for greater than 10% of revenues. |
11. | Commitments and Contingencies |
Securities Litigation. From June 2006 through August 2006 a number of purported Quest Software shareholders filed putative shareholder derivative actions against the Company, the members of our Board of Directors, and certain current or former officers, alleging, among other things, that the defendants improperly dated certain Quest Software employee stock option grants. These putative state and federal derivative actions are collectively referred to as the “Options Derivative Actions”. The plaintiffs in the Options Derivative Actions contend, among other things, that the defendants’ conduct violated United States and California securities laws, breached defendants’ fiduciary duties, wasted corporate assets, unjustly enriched the defendants, and caused errors in our financial statements. The plaintiffs sought, among other things, unspecified damages and disgorgement of profits from the alleged conduct, to be paid to the Company.
In November 2007, we entered into a Stipulation of Settlement with the plaintiffs in the Options Derivative Actions, pursuant to which the Options Derivative Actions were ultimately settled and dismissed with prejudice as to the Company and all of its current and former officers and directors. As part of the settlement, the Company agreed to adopt certain remedial measures and corporate governance changes, and the plaintiffs received a payment of an amount representing their attorneys’ fees, which was provided by the Company’s directors’ and officers’ liability insurance carrier. On May 19, 2008, the court preliminarily approved the Stipulation of Settlement of the Options Derivative Actions. On August 15, 2008, the U.S. District Court for the Central District of California granted Final Approval of the Settlement of the Options Derivative Actions. On September 10, 2008, the Superior Court of California, County of Orange, entered an Order dismissing the State Derivative Action with prejudice.
In October 2006, a purported shareholder class action was filed in the United States District Court for the Central District of California against Quest Software and certain of its current or former officers and directors (the “Options Class Action”). The essence of the plaintiff’s allegations in the Options Class Action is that the Company improperly backdated stock options, resulting in false or misleading disclosures concerning, among other things, Quest Software’s financial condition. Plaintiff also alleges that the individual defendants sold Quest Software stock while in possession of material nonpublic information, and that the defendants’ conduct caused damages to the putative plaintiff class. The plaintiff asserts claims under Sections 10(b), 20(a) and 20A of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. In October 2007, the Court denied the Company’s motion to dismiss the amended class action complaint. The U.S. District Court denied the Company’s subsequent motion requesting certification of the Court’s order for interlocutory
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appellate review, and the plaintiff filed a second amended class action complaint in February 2008. The Company filed a motion to dismiss the second amended class action complaint in March 2008. The court denied the Company’s motion to dismiss the second amended class action complaint on July 10, 2008. The Company filed its answer to the second amended class action complaint on July 24, 2008 and intends to defend the Options Class Action vigorously.
SEC Investigation and United States Attorney’s Office Information Request. In June 2006 the Company received an informal request for information from the staff of the Los Angeles regional office of the Securities and Exchange Commission regarding its option granting practices. In January 2007 the SEC issued a formal order of investigation and a subpoena for the production of documents. Wells notices were delivered by the SEC staff to the Company, Vincent C. Smith, Chief Executive Officer of the Company, and three other former executive officers of the Company in February 2008. The Company is cooperating with the SEC, but does not know when the inquiry and investigation will be resolved or what, if any, actions the SEC may require it to take as part of that resolution. Quest Software has also been informally contacted by the U.S. Attorney’s Office for the Central District of California (“U.S. Attorney’s Office”) and has been asked to produce on a voluntary basis documents many of which it previously provided to the SEC. The Company is fully cooperating with both the SEC and the U.S. Attorney’s Office. Any action by the SEC, the U.S. Attorney’s Office or other governmental agency could result in civil or criminal sanctions against the Company and/or certain of its current or former officers, directors and/or employees.
We have indemnification agreements with present and former directors and officers under which we are generally required to indemnify them against expenses, including attorney’s fees, judgments, fines and settlements, arising from the foregoing legal proceedings and investigations (subject to certain exceptions, including liabilities arising from willful misconduct or conduct that is knowingly fraudulent or deliberately dishonest or results in improper personal benefit). The Company is currently paying or reimbursing legal expenses being incurred in connection with these matters by a number of its current and former directors and officers. The maximum potential amount of the future payments we could be required to make under these indemnification obligations could be significant. We maintain directors’ and officers’ insurance policies that may limit our exposure and enable us to recover a portion of the amounts paid with respect to such obligations. If our coverage under these policies is reduced, denied, eliminated or otherwise not available to us, our potential financial exposure in the pending securities litigation and related government investigations would be increased.
The Company cannot predict the ultimate outcome of the foregoing legal proceedings, and it cannot estimate the likelihood or potential dollar amount of any adverse results. However, an unfavorable outcome in any of these proceedings could have a material adverse impact upon the financial position, results of operations or cash flows for the period in which the outcome occurs and in future periods.
Acquisitions. The Company has entered into escrow agreements with acquired companies to satisfy certain indemnification obligations of selling shareholders. Certain of these escrow agreements designate Quest as the holder of the escrow money. As of September 30, 2008, we hold approximately $2.4 million in cash related to these agreements, all of which is included in restricted cash.
General. The Company and its subsidiaries are also involved in other legal proceedings, claims and litigation arising in the ordinary course of business. The foregoing discussion includes material developments that occurred during the three months ended September 30, 2008 or thereafter in our material legal proceedings. In March 2008, we settled a pending patent infringement lawsuit. For additional information concerning these and other legal proceedings, see Note 11 of Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007.
In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law, and (v) letters of credit and similar obligations as a form of credit support for our international subsidiaries and certain resellers. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make there under; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been
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obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in our financial statements included in this report.
12. | Subsequent Events |
On October 8, 2008, we announced that our board of directors authorized a modified “Dutch auction” tender offer to repurchase between $135 million and $400 million of our common stock and debt financing in an aggregate principal amount of up to $300 million to provide financing for a portion of the repurchase. We further announced on October 30, 2008 our intention to initiate a modified “Dutch auction” tender offer on or before November 7, 2008 to repurchase $140 million of our common stock with a range of prices per share that is not expected to exceed $14.50. We continue to evaluate the terms of a potential debt financing in connection with the tender offer. The tender offer, when commenced, will be subject to a number of terms and conditions, including any applicable corporate and regulatory requirements, all of which will be specified in an offer to purchase to be filed with the Securities Exchange Commission on the date the offer is commenced.
On October 24, 2008, we accepted a rights offering from a broker of certain auction rate securities (“ARS”) we hold with a par value of $48.7 million, and a fair value of $47.0 million. Under the terms of the rights offering accepted by the Company, the broker may elect to purchase these ARS or cause these ARS to be sold to a third party, in each case at par value, at any time beginning in the fourth quarter of 2008 and the Company may instruct the broker to purchase these ARS at par value during the period of June 30, 2010 through July 2, 2012. The broker will also provide the Company with access to borrow up to 75% of the par value of eligible ARS until June 30, 2010.
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Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion of our financial condition and results of operations (“MD&A”) should be read in conjunction with the condensed consolidated financial statements and notes to those statements included elsewhere in this Report. Certain statements in this Report, including statements regarding our business strategies, operations, financial condition and prospects are forward-looking statements. Use of the words“believe,” “expect,” “anticipate,” “will,” “contemplate,” “would” and similar expressions that contemplate future events may identify forward-looking statements.
Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures described under Item 1A – “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2007, and in other filings with the SEC that attempt to advise interested parties of certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect management’s opinions only as of the date thereof. We do not assume any obligation to revise or update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.
Overview
Our Company and Business Model
Quest Software, Inc., together with our subsidiaries ScriptLogic and Vizioncore, delivers innovative products that help IT organizations get enhanced performance from their computing environment. Our product areas are Application Management, Database Management, Windows Management and Virtualization Management. The focus of our products is based upon generating higher levels of performance, manageability and productivity throughout our customers’ IT infrastructure and with products and services that enable them to manage the investments they have made within their IT environment.
Quarterly Update
In September 2008, we acquired NetPro Computing, Inc. (“NetPro”), a leading provider of Microsoft infrastructure optimization solutions, for purchase consideration of approximately $78.9 million, including $0.3 million in transaction costs. The acquisition of NetPro expands our product portfolio allowing us to deliver a more comprehensive set of products to manage complex Microsoft infrastructures.
As discussed in more detail throughout our MD&A, for the three months ended September 30, 2008 compared to the three months ended September 30, 2007, we delivered the following financial performance:
• | Total revenues increased by $35.4 million, or 23.3% to $187.6 million; |
• | Total expenses increased by $23.1 million, or 16.9% to $159.8 million; |
• | Income from operations increased by $12.3 million, or 79.8% to $27.8 million; |
• | Diluted earnings per share increased by 14.3% to $0.16. |
The increase in our total revenues was primarily driven by increased sales of our Windows Management products and related services primarily in our North American regions (United States, Latin America and Canada). The increase in total expenses was primarily due to increased personnel costs, which include compensation, benefits and payroll related taxes, which are a function of our worldwide headcount. We estimate that these personnel related costs represented approximately 67% of total expenses in the three months ended September 30, 2008 and 2007. Our full-time employee headcount at the end of the third quarter of 2008 was 3,477 compared to 3,147 at the end of the third quarter of 2007. Our full-time employee headcount in locations outside of the United States was 1,672 at the end of the third quarter of 2008 compared to 1,655 at the end of the third quarter of 2007. The increase in income from operations is primarily due to higher revenues and the effect from our cost reduction initiatives that were undertaken in the second quarter of 2008. These initiatives included workforce
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reductions across all functions and geographies. The cost savings associated with this process began to be realized in the current quarter and we expect will continue throughout the fourth quarter of 2008.
Third quarter results were also impacted by the fact that the U.S. Dollar was weaker in the third quarter of 2008 versus the third quarter of 2007 for several currencies including the Euro, Canadian Dollar, Russian Ruble and Australian Dollar. Since certain of our international sales and expenses are denominated in these non-US Dollar currencies, this contributed approximately 7% of the increase in total revenues and 15% of the increase in total expenses.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses. On an on-going basis, we make and evaluate estimates and judgments, including those related to revenue recognition, asset valuations (including accounts receivable, goodwill and intangible assets), share-based compensation, income taxes and functional currencies for purpose of consolidation. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances. Our estimates form the basis for making judgments about amounts and timing of revenue and expenses, the carrying values of assets, and the recorded amounts of liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and such estimates may change if the underlying conditions or assumptions change. We have discussed the development and selection of the critical accounting policies with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed our related disclosures. The critical accounting policies related to the estimates and judgments listed above are discussed further in our Annual Report on Form 10-K for fiscal 2007 under Management’s Discussion and Analysis of Financial Condition and Results of Operations. There have been no material changes to our critical accounting policies or estimates during the nine months ended September 30, 2008.
Recently Adopted Accounting Pronouncement
See Note 1 of our Notes to Condensed Consolidated Financial Statements for information regarding recently issued accounting pronouncements.
Results of Operations
The following table sets forth selected condensed consolidated income statement data for each of the periods indicated as a percentage of total revenues:
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||
Revenues: | ||||||||||||
Licenses | 46.2 | % | 45.8 | % | 45.2 | % | 47.2 | % | ||||
Services | 53.8 | 54.2 | 54.8 | 52.8 | ||||||||
Total revenues | 100.0 | 100.0 | 100.0 | 100.0 | ||||||||
Cost of revenues: | ||||||||||||
Licenses | 1.0 | 0.8 | 1.1 | 0.9 | ||||||||
Services | 8.1 | 8.9 | 8.7 | 9.0 | ||||||||
Amortization of purchased technology | 2.7 | 2.5 | 2.7 | 2.3 | ||||||||
Total cost of revenues | 11.8 | 12.2 | 12.5 | 12.2 | ||||||||
Gross profit | 88.2 | 87.8 | 87.5 | 87.8 | ||||||||
Operating expenses: | ||||||||||||
Sales and marketing | 41.0 | 42.9 | 44.0 | 43.7 | ||||||||
Research and development | 19.8 | 19.6 | 21.5 | 19.8 | ||||||||
General and administrative | 11.3 | 13.8 | 12.5 | 12.9 | ||||||||
Amortization of other purchased intangible assets | 1.3 | 1.3 | 1.4 | 1.1 | ||||||||
In-process research and development | — | — | 0.2 | — | ||||||||
Total operating expenses | 73.4 | 77.6 | 79.6 | 77.5 | ||||||||
Income from operations | 14.8 | 10.2 | 7.9 | 10.3 | ||||||||
Other (expense) income, net | (3.5 | ) | 4.6 | 0.8 | 4.1 | |||||||
Income before income tax provision | 11.3 | 14.8 | 8.7 | 14.4 | ||||||||
Income tax provision | 2.1 | 4.9 | 1.3 | 5.8 | ||||||||
Net income | 9.2 | % | 9.9 | % | 7.4 | % | 8.6 | % | ||||
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Comparison of Three Months Ended September 30, 2008 and 2007
Revenues
Total revenues and year-over-year changes are as follows (in thousands, except for percentages):
Three Months Ended September 30, | Increase | |||||||||||
2008 | 2007 | Dollars | Percentage | |||||||||
Revenues: | ||||||||||||
Licenses | ||||||||||||
North America | $ | 54,473 | $ | 43,607 | $ | 10,866 | 24.9 | % | ||||
Rest of World | 32,227 | 26,025 | 6,202 | 23.8 | % | |||||||
Total license revenues | 86,700 | 69,632 | 17,068 | 24.5 | % | |||||||
Services | ||||||||||||
North America | 66,375 | 55,180 | 11,195 | 20.3 | % | |||||||
Rest of World | 34,490 | 27,338 | 7,152 | 26.2 | % | |||||||
Total service revenues | 100,865 | 82,518 | 18,347 | 22.2 | % | |||||||
Total revenues | $ | 187,565 | $ | 152,150 | $ | 35,415 | 23.3 | % | ||||
Licenses Revenues— Increased sales of our Windows Management products continued to be the main driver of license revenues growth over the comparable period of the prior year. Approximately 10% of the increase in sales of our Windows Management products came from the contributions of ScriptLogic. Sales of licenses for Virtualization Management products by Vizioncore also contributed to our overall growth in license revenues.
Services Revenues— Services revenues are derived from post-contract technical support services (“maintenance”) and professional consulting and training services. The largest component of our services revenues is maintenance revenue. From a product perspective, maintenance related to our Windows Management products was the primary driver of our growth in services revenues. Also contributing to the growth in services revenues were maintenance renewals on our Database and Virtualization Management products. Approximately 20% of the overall increase in services revenues during the period came from the contributions of ScriptLogic and PassGo both within our Windows product group. Revenue from professional consulting and training services represented 9.6% and 11.7% of total service revenues in the three months ended September 30, 2008 and 2007.
Services revenues continues to contribute a larger percentage of our total revenues as our installed base of customers grows, through acquisitions and their related maintenance contracts, and through multi-year pre-paid support programs. As our maintenance customer base grows, the maintenance renewal rate has a larger influence on the maintenance revenue growth rate and the amount of new software license revenues has a diminishing effect. Therefore, the growth rate of total revenues does not necessarily correlate directly to the growth rate of new software license revenues in a given period. The primary determinant of changes in our maintenance revenue profile is the rate at which our customers renew their annual maintenance and support agreements. If our maintenance renewal rates were to decline materially, our maintenance revenues, total revenues and cash flows would likely decline materially as well.
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Cost of Revenues
Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages):
Three Months Ended September 30, | Increase | |||||||||||
2008 | 2007 | Dollars | Percentage | |||||||||
Cost of revenues: | ||||||||||||
Licenses | $ | 1,921 | $ | 1,286 | $ | 635 | 49.4 | % | ||||
Services | 15,167 | 13,566 | 1,601 | 11.8 | % | |||||||
Amortization of purchased technology | 5,026 | 3,862 | 1,164 | 30.1 | % | |||||||
Total cost of revenues | $ | 22,114 | $ | 18,714 | $ | 3,400 | 18.2 | % | ||||
Cost of Licenses— Cost of licenses as a percentage of license revenues was 2.2% and 1.8% for the three months ended September 30, 2008 and 2007. The increase in cost of licenses, both in terms of absolute dollars and as a percentage of license revenues, is primarily the result of increased sales of licenses to royalty-bearing products.
Cost of Services— Personnel related costs increased by approximately $1.4 million, or 17.1%, primarily due to growth in technical support headcount. Average headcount related to our technical support group increased approximately 18%, with the impact from the acquisition of ScriptLogic contributing to the increase. Cost of services as a percentage of service revenues was 15.0% and 16.4% in the three months ended September 30, 2008 and 2007, respectively.
Amortization of Purchased Technology— The increase in amortization of purchased technology is primarily due to technology acquired in the fourth quarter of 2007 and the first three quarters of 2008. We expect amortization of purchased technology within the cost of revenues arising from acquisitions completed prior to September 30, 2008 to be approximately $5.8 million for the remaining quarter of 2008.
Operating Expenses
Total operating expenses and year-over-year changes are as follows (in thousands, except for percentages):
Three Months Ended September 30, | Increase | |||||||||||
2008 | 2007 | Dollars | Percentage | |||||||||
Operating expenses: | ||||||||||||
Sales and marketing | $ | 76,957 | $ | 65,227 | $ | 11,730 | 18.0 | % | ||||
Research and development | 37,169 | 29,749 | 7,420 | 24.9 | % | |||||||
General and administrative | 21,120 | 21,064 | 56 | 0.3 | % | |||||||
Amortization of other purchased intangible assets | 2,418 | 1,938 | 480 | 24.8 | % | |||||||
Total operating expenses | $ | 137,664 | $ | 117,978 | $ | 19,686 | 16.7 | % | ||||
Sales and Marketing— The increase in sales and marketing expense during the three months ended September 30, 2008 over the comparable period in 2007 was primarily due to higher personnel related costs, including an increase in commission expense, and increased costs associated with employee rewards programs and advertising and trade shows. Personnel related costs increased approximately $8.7 million, or 18.0%, primarily due to an 18% increase in average headcount including the effect from foreign currency within our core sales and support renewals groups. Our increase in average headcount was due to headcount hired to support the company’s growth including the impact from our acquisition of NetPro and ScriptLogic, which offset the workforce reductions that were undertaken in the second quarter of 2008. The increase in personnel related costs included a $3.4 million, or 30.4%, increase in commission expense. On a year-over-year basis, costs associated with employee rewards programs increased $1.0 million, and advertising and trade show costs increased $1.4 million, or 86.7%.
Research and Development— The increase in research and development expense during the third quarter of 2008 as compared to the third quarter of 2007 was primarily due to higher personnel related costs, which increased $4.1 million, or 17.3%, as a result of a 5% increase in average headcount including the effect from foreign currency. The increase in average headcount was due to headcount hired to support the company’s growth including the reassignment of certain product management professionals from marketing to research and development and the impact from our acquisition of NetPro and ScriptLogic, all of which offset the workforce reductions that were undertaken in the second quarter of 2008. An additional $1.4 million of the increase is attributable to certain post-acquisition contingent payment obligations tied to technology development milestones.
General and Administrative— General and administrative expense was $21.1 million during both the third quarter of 2008 and 2007. There was a $2.8 million, or 25.3%, increase in personnel related costs on a 12% increase in average headcount hired to support the company’s growth including the headcount added from our acquisition of ScriptLogic. The
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increase in personnel related costs included a $1.4 million increase in share-based compensation related to our July 2008 non-employee director grant and was offset by a reduction of $2.6 million, or 69.7%, in professional accounting, consulting and legal fees.
Amortization of Other Purchased Intangible Assets— The increase in amortization expense from the quarter ended September 30, 2008 over the comparable period in 2007 was primarily due to other purchased intangible assets from acquisitions in the fourth quarter of 2007 and the first three quarters of 2008. We expect amortization of other purchased intangible assets within operating expenses arising from acquisitions completed prior to September 30, 2008 to be approximately $3.0 million for the remaining quarter of 2008.
Other (Expense) Income, Net
Other (expense) income, net decreased to a $6.5 million expense in the third quarter of 2008 from $7.0 million in income in the third quarter of 2007. The largest impact to other (expense) income this quarter was attributed to a foreign currency loss of $9.5 million compared to a gain of $2.8 million in the third quarter of 2008 and 2007, respectively. Our foreign currency gains or losses are predominantly attributable to translation gains or losses relative to the U.S. Dollar on the re-measurement of net monetary assets, including accounts receivable and cash, which were primarily denominated in the Euro, and to a lesser extent, the British Pound and Canadian Dollar. Interest income was $2.8 million and $4.5 million in the three months ended September 30, 2008 and 2007, respectively. The decrease in interest income was due primarily to lower average investment yields.
Income Tax Provision
During the three months ended September 30, 2008, the effective income tax rate was 18.6% versus 33.3% in the comparable period of 2007. The reduction was primarily due to a combination of factors including the mix of income between high and low jurisdictions and the impact of net operating losses and associated valuation allowances in certain foreign jurisdictions. The provision for income taxes decreased to $3.9 million for the three months ended September 30, 2008 from $7.5 million in the comparable period of 2007, representing a decrease of $3.6 million.
Comparison of Nine Months Ended September 30, 2008 and 2007
Revenues
Total revenues and year-over-year changes are as follows (in thousands, except for percentages):
Nine Months Ended September 30, | Increase | |||||||||||
2008 | 2007 | Dollars | Percentage | |||||||||
Licenses | ||||||||||||
North America | $ | 139,088 | $ | 127,344 | $ | 11,744 | 9.2 | % | ||||
Rest of World | 102,040 | 82,360 | 19,680 | 23.9 | % | |||||||
Total license revenues | 241,128 | 209,704 | 31,424 | 15.0 | % | |||||||
Services | ||||||||||||
North America | 190,664 | 157,428 | 33,236 | 21.1 | % | |||||||
Rest of World | 101,986 | 77,104 | 24,882 | 32.3 | % | |||||||
Total service revenues | 292,650 | 234,532 | 58,118 | 24.8 | % | |||||||
Total revenues | $ | 533,778 | $ | 444,236 | $ | 89,542 | 20.2 | % | ||||
Licenses Revenues— Increased sales of our Windows and Virtualization Management products were the main drivers of license revenues growth over the comparable period in the prior year. Approximately 42% of the increase in sales of our Windows Management products came from the contributions of ScriptLogic. Growth in our Windows and Virtualization Management product areas was offset slightly by a decrease in license revenues from our Database Management products. Total license revenues in the first nine months of 2007 benefited by a change in our revenue recognition practices for large reseller transactions. The modified practice was applied to transactions consummated on or after January 1, 2007 due to change in circumstances involving improved cash collection histories with these resellers. If this change had been implemented prior to January 1, 2007 we would have reported $196.7 million in license revenues in the first nine months of 2007, which would imply a 23% growth rate in total license revenues in the current period.
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Services Revenues— The primary driver of our growth in services revenue was the maintenance renewals generated by a larger customer installed base created by license revenue growth from previous periods. Maintenance revenues from our Windows, Database and Virtualization Management products were the main drivers of services revenues growth during the period. Approximately 30% of the overall increase in services revenues during the period came from the contributions of ScriptLogic and PassGo. Revenue from professional consulting and training services as a percentage of total service revenues represented 10.3% and 11.6% in the nine months ended September 30, 2008 and 2007, respectively.
Cost of Revenues
Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages):
Nine Months Ended September 30, | Increase | |||||||||||
2008 | 2007 | Dollars | Percentage | |||||||||
Cost of revenues: | ||||||||||||
Licenses | $ | 6,110 | $ | 3,949 | $ | 2,161 | 54.7 | % | ||||
Services | 46,571 | 40,082 | 6,489 | 16.2 | % | |||||||
Amortization of purchased technology | 14,619 | 10,139 | 4,480 | 44.2 | % | |||||||
Total cost of revenues | $ | 67,300 | $ | 54,170 | $ | 13,130 | 24.2 | % | ||||
Cost of Licenses— Cost of licenses as a percentage of license revenues was 2.5% and 1.9% for the nine months ended September 30, 2008 and 2007, respectively. The increase in cost of licenses, both in terms of absolute dollars and as a percentage of license revenues, is primarily the result of a $1.4 million, or 93.2%, increase in royalty expense related to sales of licenses to royalty-bearing products and a $0.7 million, or 99.3%, increase in hardware purchases that are sold with certain of our software products.
Cost of Services— Personnel related costs increased by approximately $5.6 million, or 24.1%, primarily due to growth in technical support headcount. Average headcount related to our technical support group increased approximately 23%, with the impact from our acquisition of ScriptLogic contributing to the increase. Cost of services as a percentage of service revenues was 15.9% and 17.1% in the nine months ended September 30, 2008 and 2007, respectively.
Amortization of Purchased Technology— The increase in amortization of purchased technology is primarily due to technology acquired in the fourth quarter of 2007 and the first three quarters of 2008.
Operating Expenses
Total operating expenses and year-over-year changes are as follows (in thousands, except for percentages):
Nine Months Ended September 30, | Increase | |||||||||||
2008 | 2007 | Dollars | Percentage | |||||||||
Operating expenses: | ||||||||||||
Sales and marketing | $ | 234,604 | $ | 194,285 | $ | 40,319 | 20.8 | % | ||||
Research and development | 114,687 | 87,863 | 26,824 | 30.5 | % | |||||||
General and administrative | 66,811 | 57,409 | 9,402 | 16.4 | % | |||||||
Amortization of other purchased intangible assets | 7,730 | 5,066 | 2,664 | 52.6 | % | |||||||
In-process research and development | 955 | — | 955 | 100.0 | % | |||||||
Total operating expenses | $ | 424,787 | $ | 344,623 | $ | 80,164 | 23.3 | % | ||||
Sales and Marketing— The increase in sales and marketing expense during the nine months ended September 30, 2008 over the comparable period in 2007 was primarily due to higher personnel costs, including increased commission expense as well as severance payments and related costs associated with our lay-offs in the second quarter of 2008, and increased costs associated with employee rewards programs and advertising and trade shows. Personnel related costs increased approximately $28.7 million, or 20.6%, primarily due to a 19% increase in average headcount within our core sales and presales groups, including the headcount added with our acquisition of ScriptLogic, severance payments and related costs of $3.0 million, an increase of $7.4 million, or 23.4%, in commission expense and the effect from foreign exchange. On a
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year-over-year basis, costs associated with employee rewards programs increased $0.8 million, or 49.3%, and advertising and trade show costs increased $4.6 million, or 89.5%.
Research and Development— The increase in research and development expense during the nine months ended September 30, 2008 as compared to the same period in 2007 was primarily due to higher personnel related costs, which increased $18.2 million, or 26.0%, as a result of a 9% increase in average headcount (some of which was due to reassignment of certain product management from marketing to research and development), the impact from our acquisition of ScriptLogic and the devaluation of the U.S. Dollar relative to non-dollar denominated compensation and other expenses. An additional $2.6 million of the increase is attributable to certain post-acquisition contingent payment obligations tied to technology development milestones.
General and Administrative— The increase in general and administrative expense during the nine months ended September 30, 2008 over the comparable period in 2007 was primarily due to higher personnel related costs, which increased $9.0 million, or 27.8%, on a 19% increase in average headcount hired to support the company’s growth including the headcount added from our acquisition of ScriptLogic. The increase in personnel related costs included a $1.4 million increase in share-based compensation related to our July 2008 non-employee director grant.
Amortization of Other Purchased Intangible Assets— The increase in amortization of other purchased intangible assets is primarily due to other purchased intangible assets from acquisitions in the fourth quarter of 2007 and the first three quarters of 2008.
In-Process Research and Development— In-process research and development expenses relate to in-process technology acquired in May 2008. These costs were charged to operations as the technologies had not reached technological feasibility and did not have alternative future uses at the date of acquisition.
Other Income, Net
Other income, net was $4.4 million in the nine months ended September 30, 2008 compared to $18.2 million in the same period of 2007. Interest income was $8.7 million and $14.1 million in the nine months ended September 30, 2008 and 2007, respectively. The decrease in interest income was due primarily to lower average investment yields as well as lower average investment balances primarily as a result of funding the PassGo acquisition. We had a foreign currency loss of $4.8 million and a gain of $4.3 million in the 2008 and 2007 periods, respectively. Our foreign currency gains or losses are predominantly attributable to translation gains or losses relative to the U.S. Dollar on the re-measurement of net monetary assets, including accounts receivable and cash, which were primarily denominated in the Euro, and to a lesser extent, the British Pound and Canadian Dollar.
Income Tax Provision
During the nine months ended September 30, 2008, the effective income tax rate was 15.6% versus 40.6% in the comparable period of 2007. The reduction was primarily due to the closure of an Internal Revenue Service examination of income tax returns through December 31, 2004 which discretely impacted the nine months ended September 30, 2008, and a combination of other factors including the mix of income between high and low jurisdictions, and the impact of net operating losses and associated valuation allowances in certain foreign jurisdictions that impacted the nine months ended September 30, 2007. The provision for income taxes decreased to $7.2 million from $25.8 million in 2007, representing a decrease of $18.6 million.
Liquidity and Capital Resources
Cash and cash equivalents and short-term and long-term marketable securities were approximately $372.4 million and $316.8 million as of September 30, 2008 and December 31, 2007, respectively.
At September 30, 2008, we held within long-term marketable securities $50.2 million (with a fair value of $48.4 million) of investment grade municipal notes with an auction reset feature (“auction rate securities”). For more information concerning our auction rate securities see Note 9 of our Notes to Condensed Consolidated Financial Statements.
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Summarized cash flow information is as follows (in thousands):
Nine Months Ended September 30, | ||||||||
2008 | 2007 | |||||||
Cash provided by operating activities | $ | 114,404 | $ | 95,575 | ||||
Cash used in investing activities | (112,694 | ) | (96,803 | ) | ||||
Cash provided by financing activities | 41,967 | 11 | ||||||
Effect of exchange rate changes | 1,246 | (391 | ) | |||||
Net increase (decrease) in cash and cash equivalents | $ | 44,923 | $ | (1,608 | ) | |||
Operating Activities
Cash provided by operating activities is primarily comprised of net income, adjusted for non-cash activities such as depreciation and amortization. These non-cash adjustments represent charges reflected in net income, therefore, to the extent that non-cash items increase or decrease our future operating results, there will be no corresponding impact on our cash flows. After excluding the effects of these non-cash charges, the primary changes in cash flows relating to operating activities resulted from changes in operating assets and liabilities. The analyses of the changes in our operating assets and liabilities are as follows:
• | Accounts receivable decreased to $118.2 million due to a decrease in day’s sales outstanding (“DSO”), which resulted in a decrease in operating assets, reflecting a cash inflow of $37.7 million for the nine months ended September 30, 2008. The remaining difference in the change in accounts receivable of $(3.5) million, relating to the impact of non-cash foreign currency translation adjustments, is included as part of the “effect of exchange rate changes” section of our condensed consolidated statements of cash flows. DSO was 58 days and 75 days at September 30, 2008 and December 31, 2007, respectively. Collection of accounts receivable and related DSO could fluctuate in future periods due to the timing and amount of our revenues and their linearity and the effectiveness of our collection efforts. |
• | The primary cash outflow within operating assets and liabilities during the nine months ended September 30, 2008 was $15.9 million paid for taxes, a decrease of $18.5 million over the comparable 2007 period. |
Investing Activities
Cash used in investing activities in the nine months ended September 30, 2008 included $135.2 million paid for acquisitions (of which $48.9 million was held as restricted cash on our December 31, 2007 balance sheet) and $3.2 million for minority cost method investments. We spent $8.2 million in capital expenditures, $52.0 million for purchases of marketable securities, offset by $39.3 million in sales and maturities of marketable securities.
Cash used in investing activities in the nine months ended September 30, 2007, included $107.6 million paid for acquisitions. We also paid $6.1 million in July of 2007 for a minority cost method investment in an early stage private company.
We will continue to purchase property and equipment needed in the normal course of our business. We also plan to use cash generated from operations and/or proceeds from investments in marketable securities to fund other strategic investment and acquisition opportunities that we continue to evaluate and to fund the share repurchase program. We plan to use excess cash generated from operations to invest in short and long-term marketable securities consistent with past investment practices.
Financing Activities
In the nine months ended September 30, 2008 we received net proceeds of $38.8 million from the issuance of our common stock due to exercises of stock options.
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In October 2008, our board of directors authorized a modified “Dutch auction” tender offer to repurchase between $135 million and $400 million of our common stock and debt financing in an aggregate principal amount of up to $300 million to provide financing for a portion of the repurchase. We subsequently announced our intent to initiate a modified “Dutch auction” tender offer on or before November 7, 2008 to repurchase $140 million of our common stock with a range of prices per share that is not expected to exceed $14.50. We continue to evaluate the terms of a potential debt financing in connection with the tender offer. The tender offer, when commenced, will be subject to a number of terms and conditions, including any applicable corporate and regulatory requirements, all of which will be specified in an offer to purchase to be filed with the Securities Exchange Commission on the date the offer is commenced.
Based on our current operating plan, we believe that our existing cash, cash equivalents, investment balances and cash flows from operations will be sufficient to finance our operational cash needs through at least the next 12 to 24 months. Our ability to generate cash from operations is subject to substantial risks as described in Item 1A –“Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2007. One of these risks is that our future business does not stay at a level that is similar to, or better than, our recent past. Should a general economic downturn or similar event occur, or should the company’s products become uncompetitive or less attractive to end customers, we may be unable to generate or sustain positive cash flow from operating activities. We would then be required to use existing cash, cash equivalents and investment balances to support our working capital and other cash requirements. Also, acquisitions are an important part of our business model. As such, significant amounts of cash could and will likely be used in the future for additional acquisitions or strategic investments. If additional funds are required to support our working capital requirements, acquisitions or other purposes, we may seek to raise funds through public or private equity or debt financing or from other sources. We can provide no assurance that additional financing will be available at all or, if available, that we would be able to obtain additional financing on terms favorable to us.
Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
Foreign Exchange Risk
We are a U.S. Dollar functional company and transact business in a number of different foreign countries around the world. In most instances, revenues are collected and operating expenses are paid in the local currency of the country in which we are transacting. Accordingly, we are exposed to both transaction and translation risk relating to changes in foreign exchange rates.
Our exposure to foreign exchange risk is composed of the combination of our foreign net profits and losses denominated in currencies other than the U.S. Dollar, as well as our net balances of monetary assets and liabilities in our foreign subsidiaries. These exposures have the potential to produce either gains or losses depending on the directional movement of the foreign currencies versus the U.S. Dollar and our operational profile in foreign subsidiaries. Our cumulative currency gains or losses in any given period may be lessened by the economic benefits of diversification and low correlation between different currencies, but there can be no assurance that this pattern will continue to be true in future periods. During the three and nine months ended September 30, 2008, we had a $9.5 million and $4.8 million foreign currency loss, respectively, compared to a $2.8 million and $4.3 million gain in the comparable periods in 2007.
The foreign currencies to which we currently have the most significant exposure are the Euro, the Canadian Dollar, the British Pound, the Russian Ruble and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for speculative trading purposes. We regularly monitor the potential cost and benefits of hedging foreign exchange exposures with derivatives and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.
Interest Rate Risk
Our exposure to market interest-rate risk relates primarily to our investment portfolio. We have not used derivative financial instruments to hedge the market risks of our investments. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer other than the United States government and its agencies. Our investments in marketable securities consist of United States government and government agency bonds, auction rate municipal securities and corporate bonds. Investments purchased with an original maturity of three months or less are
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considered to be cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders’ equity.
We presently do not intend to liquidate our short and long-term investments prior to their scheduled maturity dates or, with respect to our auction rate securities, the reset dates. However, in the event that we did liquidate these investments prior to their scheduled maturities and there were no changes in market interest rates, we could be required to recognize a realized loss on those investments when we liquidate. At September 30, 2008, we have an unrealized loss of $2.3 million on our investments in debt securities compared to $0.8 million at September 30, 2007. Our remaining investment positions and duration of the portfolio would not be materially affected by a 100 basis point shift in interest rates.
Information about our investment portfolio is presented in the table below, which states the amortized book value and related weighted-average interest rates by year of maturity (in thousands):
Amortized Book Value | Weighted Average Rate | |||||
Investments maturing by September 30, | ||||||
2009 (1) | $ | 187,509 | 2.33 | % | ||
2010 | — | — | % | |||
2011 | 20,000 | 3.25 | % | |||
2012 | 18,290 | 4.30 | % | |||
Thereafter | 50,201 | 8.13 | % | |||
Total portfolio | $ | 276,000 | 3.58 | % | ||
(1) | Includes $181.8 million in cash equivalents. |
Item 4. | Controls and Procedures |
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of the chief executive officer and chief financial officer, has performed an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934). Based on such evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2008, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
No changes in our internal control over financial reporting during the quarter ended September 30, 2008 have come to our management’s attention that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II—OTHER INFORMATION
Item 1. | Legal Proceedings |
The information set forth under Note 11 of our Notes to Condensed Consolidated Financial Statements, included in Part I of this Report, is incorporated herein by reference. For an additional discussion of certain risks associated with legal proceedings, see the section entitled “Risk Factors” in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2007.
Item 1A. | Risk Factors |
You should carefully consider the risks described in Item 1A – “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2007, as our business, financial condition and results of operations could be adversely affected by any of the risks and uncertainties described therein.
Item 6. | Exhibits |
Exhibit | Exhibit Title | |
2.1 | Agreement and Plan of Merger dated as of September 11, 2008, by and among Quest Software, Inc.; Nimble Acquisition Corp.; NetPro Computing, Inc.; and JMI Equity Fund IV, L.P. as the Stockholders’ Representative. | |
3.1 | Second Amended and Restated Articles of Incorporation.(1) | |
3.2 | Certificate of Amendment of Articles of Incorporation of Quest Software, Inc.(2) | |
3.3 | Bylaws of Quest Software, Inc.(3) | |
4.1 | Form of Registrant’s Specimen Common Stock Certificate.(4) | |
31.1 | Certification of the Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. | |
31.2 | Certification of the Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. | |
32.1 | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
32.2 | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
(1) | Incorporated herein by reference to Amendment No. 1 to our Registration Statement on Form S-1 (File No. 333-80543) filed June 30, 1999. |
(2) | Incorporated herein by reference to our Quarterly Report on Form 10-Q for the period ended September 30, 2005 filed November 9, 2005. |
(3) | Incorporated herein by reference to our Current Report on Form 8-K filed November 7, 2007. |
(4) | Incorporated herein by reference to Amendment No. 2 to our Registration Statement on Form S-1 (File No. 333-80543) filed July 22, 1999. |
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Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
QUEST SOFTWARE, INC. | ||||
Date: November 6, 2008 | /s/ Scott J. Davidson | |||
Scott J. Davidson Senior Vice President, Chief Financial Officer |
/s/ Scott H. Reasoner | ||||
Scott H. Reasoner Vice President, Corporate Controller |
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