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 October 31, 2005 |
| | |
| | |
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE |
| | SECURITIES EXCHANGE ACT OF 1934. |
| | |
| | For the transition period from to . |
Commission File Number: 000-28369
VA Software Corporation
(Exact name of Registrant as specified in its charter)
Delaware | 77-0399299 |
(State or other jurisdiction of | (I.R.S. Employer |
incorporation or organization) | Identification No.) |
46939 Bayside Parkway, Fremont, California, 94538
(Address, including zip code, of principal executive offices)
(510) 687-7000
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value
(Title of Class)
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 o
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes x No o
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act ). Yes o No x
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
Title Of Class | Outstanding At December 5, 2005 |
| Common Stock, $0.001 par value | 61,732,226 |
Table of Contents |
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| PART I. | FINANCIAL INFORMATION | Page No. |
| Item 1. | Financial Statements | 3 |
| | | Condensed Consolidated Balance Sheets at October 31, 2005 (unaudited) and July 31, 2005 | 3 |
| | | Condensed Consolidated Statements of Operations for the three months ended October 31, 2005 and October 31, 2004 (unaudited) | 4 |
| | | Condensed Consolidated Statements of Cash Flows for the three months ended October 31, 2005 and October 31, 2004 (unaudited) | 5 |
| | | Notes to Unaudited Condensed Consolidated Financial Statements | 6 |
| | | | |
| Item 2 | Management’s Discussion and Analysis of Financial Condition and Results of Operations. | 17 |
| Item 3 | Quantitative and Qualitative Disclosures About Market Risk | 38 |
| Item 4 | Controls and Procedures | 39 |
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| | |
| PART II. | OTHER INFORMATION | |
| Item 1. | Legal Proceedings | 40 |
| Item 6. | Exhibits and Reports on Form 8-K | 40 |
| Signatures | 41 |
| Certifications | 44 |
PART I
VA SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
| | | | October 31, 2005 | | | July 31, 2005 | |
| | | | (unaudited) | | | | |
ASSETS | | | | | | | |
| | | | | | | | |
| Current assets: | | | | | | | |
| Cash and cash equivalents | | $ | 2,687 | | $ | 2,498 | |
| Short-term investments | | | 31,098 | | | 34,116 | |
| Accounts receivable, net of allowance of $150 and $166, respectively | | | 4,636 | | | 4,247 | |
| Related party receivables | | | 268 | | | 59 | |
| Inventories | | | 1,372 | | | 773 | |
| Prepaid expenses and other current assets | | | 1,478 | | | 1,014 | |
| Total current assets | | | 41,539 | | | 42,707 | |
| Property and equipment, net | | | 632 | | | 736 | |
| Long-term investments | | | 1,159 | | | 1,806 | |
| Restricted cash, non current | | | 1,000 | | | 1,000 | |
| Other assets | | | 1,132 | | | 1,132 | |
| Total assets | | $ | 45,462 | | $ | 47,381 | |
LIABILITIES AND STOCKHOLDERS’ EQUITY | | | | | |
| | | | | | |
| Current liabilities: | | | | | |
| Accounts payable | | $ | 1,357 | | $ | 1,574 | |
| Accrued restructuring liabilities, current portion | | | 1,592 | | | 1,748 | |
| Deferred revenue (including $51 and $47 related party deferred revenue, respectively) | | | 2,208 | | | 2,134 | |
| Accrued liabilities and other | | | 2,599 | | | 2,882 | |
| Total current liabilities | | | 7,756 | | | 8,338 | |
| Accrued restructuring liabilities, net of current portion | | | 5,709 | | | 6,107 | |
| Other long-term liabilities | | | 1,255 | | | 1,271 | |
| Total liabilities | | | 14,720 | | | 15,716 | |
| Commitments and contingencies (Notes 7 and 9) | | | | | | | |
| Stockholders’ equity: | | | | | | | |
| Common stock | | | 62 | | | 62 | |
| Treasury stock | | | (4 | ) | | (4 | ) |
| Additional paid-in capital | | | 784,166 | | | 783,895 | |
| Accumulated other comprehensive loss | | | (191 | ) | | (231 | ) |
| Accumulated deficit | | | (753,291 | ) | | (752,057 | ) |
| Total stockholders’ equity | | | 30,742 | | | 31,665 | |
| Total liabilities and stockholders’ equity | | $ | 45,462 | | $ | 47,381 | |
The accompanying notes are an integral part of these condensed consolidated financial statements.
VA SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts, unaudited)
| | | Three Months Ended | |
| | | October 31, | | October 31, | |
| | | 2005 | | 2004 | |
| | | | | | |
| Net revenues: | | | | | |
| SourceForge revenues (including $219 and $22 related party revenue, respectively) | | $ | 1,421 | | $ | 1,931 | |
| Online Media revenues | | | 2,581 | | | 1,849 | |
| E-commerce revenues | | | 3,586 | | | 2,694 | |
| Online Images revenues | | | 580 | | | 524 | |
| Net revenues | | | 8,168 | | | 6,998 | |
| Cost of revenues: | | | | | | | |
| SourceForge cost of revenues | | | 276 | | | 232 | |
| Online Media cost of revenues | | | 863 | | | 802 | |
| E-commerce cost of revenues | | | 2,842 | | | 2,355 | |
| Online Images cost of revenues | | | 111 | | | 130 | |
| Cost of revenues | | | 4,092 | | | 3,519 | |
| Gross margin | | | 4,076 | | | 3,479 | |
| Operating expenses: | | | | | | | |
| Sales and marketing | | | 2,297 | | | 2,411 | |
| Research and development | | | 1,602 | | | 1,471 | |
| General and administrative | | | 1,688 | | | 1,465 | |
| Amortization of intangible assets | | | 1 | | | 3 | |
| Total operating expenses | | | 5,588 | | | 5,350 | |
| Loss from operations | | | (1,512 | ) | | (1,871 | ) |
| Interest income, net | | | 284 | | | 190 | |
Other income, net | | | (6 | ) | | 65 | |
| Net loss | | $ | (1,234 | ) | $ | (1,616 | ) |
| Other comprehensive income (loss): | | | | | | | |
| Unrealized gain on marketable securities and investments | | | 39 | | | 36 | |
| Foreign currency translation loss | | | -- | | | (68 | ) |
| Comprehensive loss | | $ | (1,195 | ) | $ | (1,648 | ) |
| | | | | | | | |
| Net loss | | $ | (1,234 | ) | $ | (1,616 | ) |
| | | | | | | | |
| Basic and diluted net loss per share | | $ | (0.02 | ) | $ | (0.03 | ) |
| Shares used in computing basic and diluted net loss per share | | | 61,667 | | | 61,296 | |
Net income for the first quarter of fiscal 2006 included stock-based compensation expense under Statement of Financial Accounting Standards (“SFAS”) 123(R) of $0.2 million. The Consolidated Financial Statements do not reflect any stock-based compensation expense related to employee stock options and employee stock purchases under SFAS 123 in the first quarter of fiscal 2005 because the Company did not adopt the recognition provisions of SFAS 123. Net loss including pro forma stock-based compensation expense as previously disclosed in the notes to the Consolidated Financial Statements for the first quarter of fiscal 2005 was $3.1 million or $0.05 per diluted share.
The accompanying notes are an integral part of these condensed consolidated financial statements
VA SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, unaudited)
| | | Three Months Ended | |
| | | October 31, | | October 31, | |
| | | 2005 | | 2004 | |
Cash flows from operating activities: | | | | | |
| Net loss | | $ | (1,234 | ) | $ | (1,616 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in) operating activities: | | | | | | | |
| Depreciation and amortization of intangibles | | | 196 | | | 250 | |
| Stock-based compensation expense | | | 228 | | | — | |
| Provision for bad debts | | | (15 | ) | | 1 | |
| Provision for excess and obsolete inventory | | | (17 | ) | | 40 | |
| Loss on disposal of assets | | | 1 | | | -- | |
| Changes in assets and liabilities: | | | | | | | |
| Accounts receivable | | | (583 | ) | | (133 | ) |
| Inventories | | | (582 | ) | | 174 | |
| Prepaid expenses and other assets | | | (463 | ) | | (123 | ) |
| Accounts payable | | | (217 | ) | | (639 | ) |
| Accrued restructuring liabilities | | | (553 | ) | | (973 | ) |
| Deferred revenue | | | 93 | | | 681 | |
| Accrued liabilities and other | | | (272 | ) | | 318 | |
| Other long-term liabilities | | | (35 | ) | | 18 | |
| Net cash used in operating activities | | | (3,453 | ) | | (2,002 | ) |
Cash flows from investing activities: | | | | | | | |
| Purchase of property and equipment | | | (91 | ) | | (119 | ) |
| Sale of property and equipment | | | (1 | ) | | — | |
| Purchase of marketable securities | | | (5,702 | ) | | (1,162 | ) |
| Sale of marketable securities | | | 9,406 | | | 2,188 | |
| Other, net | | | (3 | ) | | -- | |
| Net cash provided by investing activities | | | 3,609 | | | 907 | |
Cash flows from financing activities: | | | | | | | |
| Payments on loans and notes payable | | | (11 | ) | | — | |
| Proceeds from issuance of common stock, net | | | 44 | | | 231 | |
| Net cash provided by financing activities | | | 33 | | | 231 | |
| | | | | | | | |
| Effect of exchange rate changes on cash and cash equivalents | | | — | | | (68 | ) |
| Net increase (decrease) in cash and cash equivalents | | | 189 | | | (932 | ) |
| Cash and cash equivalents, beginning of period | | | 2,498 | | | 10,964 | |
| Cash and cash equivalents, end of period | | $ | 2,687 | | $ | 10,032 | |
The accompanying notes are an integral part of these condensed consolidated financial statements.
VA SOFTWARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
Overview
VA Software Corporation (“VA Software,”“VA” or the “Company”) was incorporated in California in January 1995 and reincorporated in Delaware in December 1999. From the date of its incorporation through October 2001, the Company sold Linux-based hardware systems and services under the name VA Linux Systems, Inc. On June 27, 2001, the Company announced its decision to exit its Linux-based hardware business. Today, the Company does business under the name VA Software Corporation. It develops, markets and supports a software application known as SourceForge Enterprise Edition ("SourceForge") and owns and operates OSTG, Inc. ("OSTG") and its wholly-owned subsidiaries, a network of Internet Web sites offering advertising, retail and animation services and products.
The interim financial information presented in this Form 10-Q is not audited and is not necessarily indicative of the Company’s future consolidated financial position, results of operations or cash flows. The unaudited financial statements contained in this Form 10-Q have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position, results of operations and its cash flows for the stated periods, in conformity with accounting principles generally accepted in the United States of America. These financial statements and notes should be read in conjunction with the Company’s audited financial statements and notes thereto for the fiscal year ended July 31, 2005, included in the Company’s Form 10-K filed with the Securities and Exchange Commission.
2. Summary of Significant Accounting Policies
Use of Estimates in Preparation of Consolidated Financial Statements
The preparation of the Company’s consolidated financial statements and related notes requires the Company to make estimates, which include judgments and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. The Company has based its estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances and the Company evaluates its estimates on a regular basis and makes changes accordingly. Historically, the Company’s estimates relative to its critical accounting estimates have not differed materially from actual results, however actual results may differ from these estimates under different conditions.
A critical accounting estimate is based on judgments and assumptions about matters that are highly uncertain at the time the estimate is made. Different estimates that reasonably could have been used, or changes in accounting estimates could materially impact the financial statements.
There have been no significant changes to the Company’s critical accounting estimates during the three months ended October 31, 2005 as compared to what was previously disclosed in the Notes to Consolidated Financial Statements included in the Company’s Annual Report of Form 10-K for the year ended July 31, 2005.
Principles of Consolidation
The interim financial information presented in this 10-Q includes the accounts of VA and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. In September 2000, the Company acquired 68% of the outstanding shares of common stock of VA Linux Systems Japan, K.K. (“VA Linux Japan”) for a cash purchase price of approximately $6.9 million. Effective January 11, 2002, VA sold 13,500 shares of VA Linux Japan stock to a third party for approximately $5.1 million, the effect of which decreased the Company’s investment in VA Linux Japan to approximately 11%. As of October 31, 2005, VA Software’s investment in VA Linux Japan was approximately 14%. As the Company holds less than 20% of the voting stock of VA Linux Japan and does not otherwise exercise significant influence, VA Linux Japan has been accounted for under the cost method as of January 11, 2002 and thereafter. The operations of VA Linux Japan primarily relate to the Company’s former systems and services business; however, VA Linux Japan also acts as a reseller of the Company’s SourceForge application to customers in Japan and, pursuant to a license agreement with the Company, resyndicates certain OSTG Web sites for the Japanese market. There are $0.3 million of related-party receivables and $51,000 of related-party deferred revenue associated with VA Linux Japan as of October 31, 2005 that are included in trade receivables and deferred revenue in the accompanying Condensed Consolidated Balance Sheets. There were $59,000 of related-party receivables and $47,000 of related-party deferred revenue associated with VA Linux Japan as of July 31, 2005 that were included in trade receivables and deferred revenue in the accompanying Condensed Consolidated Balance Sheets. There were $0.2 million and $22,000 related-party revenues associated with VA Linux Japan for the three months ended October 31, 2005 and October 31, 2004, respectively.
Foreign Currency Translation
The functional currency of all the Company’s foreign subsidiaries is the respective country’s local currency. Operations related to all of the Company’s foreign subsidiaries were discontinued in 2001 and were included in the fiscal 2001 restructuring plan. Although several of the legal entities still exist as of October 31, 2005, no revenues were generated from these entities for the periods presented and the expenses were administrative in nature and were immaterial to the consolidated results of operations for the periods presented. Minimal cash balances have been maintained in these entities for legal purposes. Remaining balance sheet accounts are translated into U.S. dollars at exchange rates prevailing at balance sheet dates. Expenses are translated into U.S. dollars at average rates for the period. Gains and losses resulting from translation are charged or credited in other comprehensive income as a component of stockholders’ equity. As of October 31, 2005 the Company did not hold any foreign currency derivative instruments. The Company is in the process of formally liquidating all of its foreign subsidiaries.
Segment and Geographic Information
Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information for those segments to be presented in interim financial reports issued to stockholders. SFAS No. 131 also establishes standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision-maker, or decision-making group, in making decisions about how to allocate resources and assess performance. The Company’s chief decision-making group, as defined under SFAS No. 131, is the Chief Executive Officer and the executive team. The Company currently operates as four reportable business segments: SourceForge, Online Media, E-commerce and Online Images.
The Company markets its products in the United States through its direct sales force and online Web sites. Revenues for the three months ended October 31, 2005 and October 31, 2004 were generated primarily from sales to end users in the United States.
Cash, Cash Equivalents, Short-Term Investments and Long-Term Investments
The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents consist principally of cash deposited in money market and checking accounts.
The Company accounts for its investments under the provisions of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Investments in highly liquid financial instruments with remaining maturities greater than three months and maturities of less than one year are classified as short-term investments. Financial instruments with remaining maturities greater than one year are classified as long-term investments. All investments are classified as available-for-sale and are reported at fair value with net unrealized gains (losses) reported, net of tax, using the specific identification method as other comprehensive gain/(loss) in stockholders’ equity. The cost of the investments was not significantly different than the fair value for the fiscal years presented. The fair value of the Company’s available-for-sale securities are based on quoted market prices at the balance sheet dates.
Cash, cash equivalents and investments, of which $33.1 million mature within one year, consist of the following (in thousands) at market value:
| | | October 31, | | July 31, | |
| | | 2005 | | 2005 | |
| Government securities | | $ | 21,828 | | $ | 22,103 | |
| Corporate securities | | | 9,426 | | | 12,357 | |
| Asset backed securities | | | 1,809 | | | 2,021 | |
| Money market funds | | | 1,179 | | | 788 | |
| Total Investments | | $ | 34,242 | | $ | 37,269 | |
| Operating cash | | | 702 | | | 1,151 | |
| Restricted cash | | | 1,000 | | | 1,000 | |
| Total cash, cash equivalents, short-term investments & long-term investments | | $ | 35,944 | | $ | 39,420 | |
| | | | | | | | |
| Included in cash and cash equivalents | | $ | 1,985 | | $ | 1,347 | |
| Included in short-term investments | | | 31,098 | | | 34,116 | |
| Included in long-term investments | | | 1,159 | | | 1,806 | |
| Total Investments | | $ | 34,242 | | $ | 37,269 | |
Revenue Recognition
SourceForge Revenues
Software revenues are derived from fees for licenses of the Company’s SourceForge software products, maintenance, consulting and training. The Company recognizes all software revenue using the residual method in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions.” Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If evidence of the vendor specific fair value of one or more undelivered elements does not exist, revenues are deferred and recognized when delivery of those elements occurs or when fair value can be established. Company-specific objective evidence of fair value of maintenance and other services is based on the Company’s customary pricing for such maintenance and/or services when sold separately. At the outset of the arrangement with the customer, the Company defers revenue for the fair value of its undelivered elements (e.g., maintenance, consulting and training) and recognizes revenue for the remainder of the arrangement fee attributable to the elements initially delivered in the arrangement (i.e., software product) when the basic criteria in SOP 97-2 have been met. If such evidence of fair value for each undelivered element of the arrangement does not exist, the Company defers all revenue from the arrangement until such time that evidence of fair value does exist or until all elements of the arrangement are delivered.
Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, (iv)collectibility is probable and (v) the arrangement does not require services that are essential to the functionality of the software.
Persuasive evidence of an arrangement exists. The Company determines that persuasive evidence of an arrangement exists with respect to a customer when the Company has a written contract, which is signed by both the Company and the customer, or a purchase order from the customer when the customer has previously executed a standard license arrangement with the Company. The Company does not offer product return rights.
Delivery has occurred. The Company’s software may be either physically or electronically delivered to the customer. The Company determines that delivery has occurred upon shipment of the software pursuant to the billing terms of the agreement or when the software is made available to the customer through electronic delivery.
The fee is fixed or determinable. If at the outset of the customer engagement the Company determines that the fee is not fixed or determinable, the Company recognizes revenue when the fee becomes due and payable. Fees due under a contract are generally deemed not to be fixed or determinable if a significant portion of the fee is beyond the Company’s normal payment terms, which are generally no greater than 120 days from the date of invoice.
Collectibility is probable. The Company determines whether collectibility is probable on a case-by-case basis. When assessing probability of collection, the Company considers the number of years in business, history of collection, and product acceptance for each customer. The Company typically sells to customers, for whom there is a history of successful collection. New customers are subject to a credit review process, which evaluates the customer’s financial position and ultimately such customer’s ability to pay. If the Company determines from the outset that collectibility is not probable based upon its review process, revenue is recognized as payments are received.
The Company allocates revenue on software arrangements involving multiple elements to each element based on the relative fair value of each element. The Company’s determination of fair value of each element in multiple-element arrangements is based on vendor-specific objective evidence (“VSOE”). The Company aligns its assessment of VSOE for each element to the price charged when the same element is sold separately. The Company has analyzed all of the elements included in its multiple-element arrangements and determined that it has sufficient VSOE to allocate revenue to the maintenance, support and professional services components of its perpetual license arrangements. The Company sells its professional services separately, and has established VSOE for professional services on that basis. VSOE for maintenance and support is determined based upon the customer’s annual renewal rates for these elements. Accordingly, assuming all other revenue recognition criteria are met, the Company recognizes revenue from perpetual licenses upon delivery using the residual method in accordance with SOP 98-9.
Services revenues consist of professional services and maintenance fees. In general, the Company’s professional services, which are comprised of software installation and integration, business process consulting and training, are not essential to the functionality of the software. The Company’s software products are fully functional upon delivery and implementation and do not require any significant modification or alteration of products for customer use. Customers purchase these professional services to facilitate the adoption of the Company’s technology and dedicate personnel to participate in the services being performed, but they may also decide to use their own resources or appoint other professional service organizations to provide these services. Software products are billed separately from professional services, which are generally billed on a time-and-materials basis. The Company recognizes revenue from professional services as services are performed.
Maintenance agreements are typically priced based on a percentage of the product license fee and have a one-year term, renewable annually. Services provided to customers under maintenance agreements include technical product support and unspecified product upgrades. Deferred revenues from advanced payments for maintenance agreements are recognized ratably over the term of the agreement, which is typically one year.
Online Media Revenues
Online media revenues are primarily derived from cash sales of advertising space on the Company’s various Web sites, as well as sponsorship and royalty related arrangements associated with advertising on these Web sites. The Company recognizes Online Media revenues over the period in which the advertisements are displayed, provided that persuasive evidence of an arrangement exists, no significant obligations remain, the fee is fixed or determinable, and collection of the receivable is reasonably assured. The Company’s obligations typically include guarantees of a minimum number of “impressions” (times that an advertisement is viewed by users of the Company’s online services). To the extent that minimum guaranteed impressions are not met in the specified time frame, the Company does not recognize the corresponding revenues until the guaranteed impressions are achieved.
E-commerce Revenues
E-commerce revenues are derived from the online sale of consumer goods. The Company recognizes E-commerce revenues from the sale of consumer goods in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition.” Under SAB No. 104, product revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sale price is fixed or determinable, and collectibility is reasonably assured. In general, the Company recognizes E-commerce revenue upon the shipment of goods. The Company does grant customers a right to return E-commerce products. Such returns are recorded as incurred and have been immaterial for the periods presented.
The Company’s E-commerce business is highly seasonal, reflecting the general pattern associated with the retail industry of peak sales and earnings during the holiday shopping season. In the past several years, a substantial portion of the Company’s E-commerce revenues occurred in its second fiscal quarter, which in fiscal 2006, began on November 1, 2005, and will end on January 31, 2006. As is typical in the retail industry, the Company generally experiences lower E-commerce revenues during the other quarters. Therefore, the Company’s E-commerce revenues in a particular quarter are not necessarily indicative of future E-commerce revenues for a subsequent quarter or its full fiscal year.
Online Images Revenues
Online Images revenues are derived from the online sale of three-dimensional art, animations and presentations that consist of fees for software licenses and memberships for these animation software products. Software revenues related to digital animations are recognized using the residual method in accordance with SOP 97-2, as amended by SOP 98-9, as described in detail above. Revenues recognized related to animation memberships are recognized over the life of the membership, typically three months or 12 months.
Software Development Costs
In accordance with SFAS No. 86, “Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed,” development costs incurred in the research and development of new software products are expensed as incurred until technological feasibility in the form of a working model has been established at which time such costs are capitalized, subject to a net realizable value evaluation. Technological feasibility is established upon the completion of an integrated working model. To date, the Company’s software development has been completed concurrent with the establishment of technological feasibility and, accordingly, all software development costs have been charged to research and development expense in the accompanying Condensed Consolidated Statements of Operations.
In accordance with SOP 98-1, “Accounting for the Cost of Computer Software Developed or Obtained for Internal Use,” costs incurred related to internal use software are capitalized and amortized over their useful lives.
Stock Based Compensation Expense
During the quarter ended October 31, 2005, the Company adopted Financial Accounting Standards Board Statement of Financial Accounting Standards (“SFAS”) No. 123(R) -“Share-Based Payment”, a revision of SFAS 123, “Accounting for Stock-Based Compensation” and a supersession of Accounting Principles Board (“APB”) Opinion No.25, “Accounting for Stock Issued to Employees”, and its related implementation guidance. SFAS 123(R) establishes standards for the accounting for transactions where an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments. The principal focus of SFAS 123(R) however, is the accounting for transactions in which an entity obtains employee services in share-based payment transactions, and where the measurement of the cost of employee services received in exchange for an award of equity instruments is based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award-the requisite service period-and unless observable market prices for the same or similar instruments are available, will be estimated using option-pricing models adjusted for the unique characteristics of the instruments. If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. During the quarter ended October 31, 2005, the Company recognized $228,000 in compensation expense related to options granted employees.
The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of August 1, 2005, the first day of the Company’s 2006 fiscal year. The Company’s Consolidated Financial Statements as of and for the three months ended October 31, 2005 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).
The Company calculated the fair value of each option grant and stock purchase right on the date of the grant using the Black-Scholes option-pricing model as prescribed by SFAS. No. 123 (R) using the following assumptions:
| | For the Three Months Ended October 31, 2005 | | |
| Expected life (years) | 7.0 | | |
| Risk-free interest rate | 4.5% | | |
| Volatility | 91.67% | | |
| Dividend yield | None | | |
Property and Equipment
Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the lesser of the estimated useful lives or the corresponding lease term. Property and equipment consist of the following (in thousands):
| | October 31, 2005 | | July 31, 2005 | |
| Computer and office equipment (useful lives of 2 years) | | $ | 3,893 | | $ | 3,811 | |
| Furniture and fixtures (useful lives of 2 to 4 years) | | | 484 | | | 484 | |
| Leasehold improvements (useful lives of lesser of estimated life or lease term) | | | 285 | | | 285 | |
| Software (useful lives of 2 to 5 years) | | | 2,073 | | | 2,064 | |
| Total property and equipment | | | 6,735 | | | 6,644 | |
| Less: Accumulated depreciation and amortization | | | (6,103 | ) | | (5,908 | ) |
| Property and equipment, net | | $ | 632 | | $ | 736 | |
Goodwill and Intangibles
Intangible assets are amortized on a straight-line basis over three to five years. The Company continually evaluates whether events or circumstances have occurred that indicate the remaining estimated useful lives of these intangible assets may not be recoverable. When events or circumstances indicate that the intangible assets should be evaluated for possible impairment, the Company uses an estimate of the related business segment's undiscounted net income over the remaining useful life of the intangible assets in measuring whether they are recoverable. No events or circumstances occurred during the three months ended October 31, 2005 that would indicate a possible impairment in the carrying value of intangible assets at October 31, 2005.
The changes in the carrying amount of the intangible assets are as follows (in thousands):
| | | As of October 31, 2005 | | As of July 31, 2005 | |
| | Gross Carrying Amount | | Accumulated Amortization | | Gross Carrying Amount | | Accumulated Amortization | |
| Domain and trade names | | $ | 5,935 | | $ | (5,926 | ) | $ | 5,932 | | $ | (5,925 | ) |
| Purchased technology | | | 2,534 | | | (2,534 | ) | | 2,534 | | | (2,534 | ) |
| Total intangible assets | | $ | 8,469 | | $ | (8,460 | ) | $ | 8,466 | | $ | (8,459 | ) |
The aggregate amortization expense of intangible assets was $1,000 for the three-month period ending October 31, 2005 and $3,000 for the three-month period ending October 31, 2004. The estimated total amortization expense of acquired intangible assets is $4,400 for the fiscal year ending July 31, 2006, $3,000 for the fiscal year ending July 31, 2007 and $1,500 for the fiscal year ending July 31, 2008.
Inventories
Inventories related to the Company’s E-commerce and Online Images segments consist solely of finished goods that are valued at the lower of cost or market using the average cost method. Provisions, when required, are made to reduce excess and obsolete inventories to their estimated net realizable values.
Concentrations of Credit Risk and Significant Customers
The Company’s investments are held with two reputable financial institutions; both institutions are headquartered in the United States. The Company’s investment policy limits the amount of risk exposure. Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash trade receivables. The Company provides credit, in the normal course of business, to a number of companies and performs ongoing credit evaluations of its customers. The credit risk in the Company’s trade receivables is substantially mitigated by its credit evaluation process and reasonably short collection terms. The Company maintains reserves for potential credit losses and such losses have been within management’s expectations. As of October 31, 2005, no one customer accounted for a material concentration of our gross account receivables.
For the three months ended October 31, 2005 and October 31, 2004, no one customer represented more than 10% of net revenues. The Company does not anticipate that any one customer will represent more than 10% of net revenues in the near future.
Reclassifications
Certain reclassifications have been made to the prior period consolidated financial statements to conform to the current period presentation. These reclassifications have no impact on previously reported net loss or cash flows.
3. Restructuring Costs and Other Special Charges
In fiscal 2001 and 2002, the Company adopted plans to exit its hardware systems and hardware-related software engineering and professional services businesses, as well as exit a sublease agreement and reduce its general and administrative overhead costs. The Company exited these activities to pursue its SourceForge, Online Media, E-commerce and Online Images businesses and reduce its operating losses in order to improve cash flow. The Company recorded restructuring charges of $168.5 million related to exiting these activities, $160.4 million of which was included in restructuring charges and other special charges in operating expenses and $8.1 million of which was included in cost of sales. Included in the restructuring were charges related to excess facilities from non-cancelable leases. During the third quarter of fiscal 2004, in connection with its original 2002 restructuring plan which included an assumption to sublet all idle facilities, the Company relocated its Fremont, California headquarters to a smaller building in the same complex. As a result of the change in circumstances, original accruals were reevaluated and accordingly the Company recorded a restructuring adjustment of $2.9 million. Included in the $2.9 million dollar restructuring adjustment was $2.5 million of expense related to writing off leasehold improvements and fixed assets and an additional $0.4 million expense related to excess facilities from non-cancelable leases.
In addition, during the third quarter of fiscal 2004, the Company reached agreements in principal to sublet unoccupied portions of properties that it leases in Sunnyvale, California and Fremont, California. As a result of the change in circumstances due to the agreements in principal, which were thereafter formalized in executed agreements, original accruals were reevaluated and, accordingly, the Company recorded a restructuring adjustment of $0.3 million in the third quarter of fiscal 2004. The total adjustment to restructuring expenses in fiscal 2004 was therefore $3.2 million. In the second quarter of fiscal 2005, a minor credit adjustment of $0.1 million was recorded to accurately reflect the current common area maintenance fees associated with the Fremont facilities. The remaining accrual from non-cancelable lease payments is based on current circumstances. These accruals are subject to change should actual circumstances change. The Company will continue to evaluate and update, if applicable, these accruals quarterly. As of October 31, 2005, the Company had an accrual of approximately $7.3 million outstanding related to these non-cancelable leases, all of which was originally included in operating expenses.
All charges as a result of restructuring activities have been recorded in accordance with Emerging Issues Task Force (“EITF”) 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs incurred in a Restructuring).” Restructuring charges recorded in fiscal 2004 were considered adjustments to the original restructuring plans, therefore, SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” was not applicable.
Below is a summary of the restructuring charges in operating expenses (in thousands):
| | | Total Charged To Operations Fiscal 2001-2004 | | Total Charged To Operations Fiscal 2005 | | Total Cash Receipts/ (Payments) | | Restructuring Liabilities at October 31, 2005 | |
| Cash Provisions: | | | | | | | | | |
| Other special charges relating to | | | | | | | | | |
| restructuring activities | | $ | 1,349 | | $ | -- | | $ | (1,349 | ) | $ | -- | |
| Facilities charges | | | 16,889 | | | (101 | ) | | (9,487 | ) | | 7,301 | |
| Employee severance and other related charges | | | 5,532 | | | -- | | | (5,532 | ) | | -- | |
| Total cash provisions | | | 23,770 | | | (101 | ) | $ | (13,460 | ) | $ | 7,301 | |
| Non-cash: | | | | | | | | | | | | | |
| Write-off of goodwill and intangibles | | | 90,355 | | | -- | | | | | | | |
| Write-off of other special charges relating to restructuring activities | | | 11,819 | | | -- | | | | | | | |
| Write-off of accelerated options from | | | | | | | | | | | | | |
| terminated employees | | | 1,352 | | | -- | | | | | | | |
| Acceleration of deferred stock compensation | | | 36,064 | | | -- | | | | | | | |
| Total non-cash provisions | | | 139,590 | | | -- | | | | | | | |
| Total provisions | | $ | 163,360 | | $ | (101 | ) | | | | | | |
Below is a summary of the changes to the restructuring liability (in thousands):
Changes in the total accrued restructuring liability | | Balance at Beginning of Period | | Charged to Costs and Expenses | | Deductions | | Balance at End of Period | |
| From July 29, 2000 through July 31, 2004 | | $ | -- | | $ | 23,770 | | $ | (12,487 | ) | $ | 11,283 | |
| For the year ended July 31, 2005 | | $ | 11,283 | | $ | (101 | ) | $ | (3,327 | ) | $ | 7,855 | |
| For the quarter ended October 31, 2004 | | $ | 11,283 | | $ | -- | | $ | (973 | ) | $ | 10,310 | |
| For the quarter ended October 31, 2005 | | $ | 7,855 | | $ | -- | | $ | (554 | ) | $ | 7,301 | |
| | | | | | | | | | | | | | |
| Components of the total accrued restructuring liability | | | Short Term | | | Long Term | | | Total Liability | | | | |
| As of July 31, 2004 | | $ | 3,440 | | $ | 7,843 | | $ | 11,283 | | | | |
| As of July 31, 2005 | | $ | 1,748 | | $ | 6,107 | | $ | 7,855 | | | | |
| As of October 31, 2004 | | $ | 3,019 | | $ | 7,291 | | $ | 10,310 | | | | |
| As of October 31, 2005 | | $ | 1,592 | | $ | 5,709 | | $ | 7,301 | | | | |
4. Computation of Per Share Amounts
In accordance with SFAS No. 128 “Earnings Per Share,” basic net loss per common share has been calculated using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase. For the three months ended October 31, 2005 and October 31, 2004, the Company excluded all stock options and warrants from the calculation of diluted net loss per common share because all such securities are antidilutive for those periods.
The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):
| | | Three Months Ended | |
| | October 31, 2005 | | October 31, 2004 | |
| Net loss | | $ | (1,234 | ) | $ | (1,616 | ) |
| Basic and diluted: | | | | | | | |
| Weighted average shares of common stock outstanding | | | 61,667 | | | 61,296 | |
| Shares used in computing basic and diluted net loss per share | | | 61,667 | | | 61,296 | |
| Basic and diluted net loss per share | | $ | (0.02 | ) | $ | (0.03 | ) |
The following potential common shares have been excluded from the calculation of diluted net loss per share for all periods presented because they are anti-dilutive (in thousands):
| | | Three Months Ended | |
| | October 31, 2005 | | October 31, 2004 | |
| Anti-dilutive securities: | | | | | | | |
| Options to purchase common stock | | | 10,541 | | | 11,962 | |
| Warrants | | | 731 | | | 731 | |
| Total | | | 11,272 | | | 12,693 | |
5. Comprehensive Loss
Comprehensive loss is comprised of net loss and other non-owner changes in stockholders’ equity, including foreign currency translation gains or losses and unrealized gains or losses on available-for sale marketable securities.
6. Segment and Geographic Information
The Company’s operating segments are significant strategic business units that offer different products and services. The Company has four operating segments: SourceForge, Online Media, E-commerce and Online Images.
The Company’s SourceForge segment focuses on its SourceForge software products. The Company’s Online Media segment consists of a network of Internet Web sites serving the IT professional and software development communities. The Company’s E-commerce segment provides online sales of a variety of retail products of interest to the software development and IT communities. The Company’s Online Images segment provides online sales of three-dimensional art, animations and presentations. Other includes revenues and costs associated with the Company’s former hardware business as well as all corporate expenses, such as restructuring charges, legal judgments and settlements, amortization of intangible assets and amortization of deferred stock, that are not allocated to the individual operating segments and are not considered by the Company’s chief decision-making group in evaluating the performance of the operating segments.
The accounting policies of the segments are consistent with those described in the summary of significant accounting policies. All intersegment sales have been stated separately in the table below. The Company’s chief decision-making group, as defined under SFAS No. 131, consists of the Chief Executive Officer and the executive team. The Company’s chief decision-making group excludes all intersegment sales when evaluating the performance of the segments. The Company’s assets and liabilities are not discretely allocated or reviewed by operating segment. The depreciation of the Company’s property, equipment and leasehold improvements are allocated based on headcount, unless specifically identified by operating segment.
(in thousands) | | SourceForge | | Online Media | | E-commerce | | Online Images | | Other | | Eliminations | | Total Company | |
Three Months Ended October 31, 2005 | | | | | | | | | | | | | | | |
| Revenue from external customers | | $ | 1,421 | | $ | 2,581 | | $ | 3,586 | | $ | 580 | | $ | -- | | $ | -- | | $ | 8,168 | |
| Revenue from intersegments | | $ | -- | | $ | 13 | | $ | -- | | $ | -- | | $ | -- | | $ | (13 | ) | $ | -- | |
| Cost of revenues | | $ | 276 | | $ | 863 | | $ | 2,842 | | $ | 111 | | $ | -- | | $ | -- | | $ | 4,092 | |
| Gross margin | | $ | 1,145 | | $ | 1,731 | | $ | 744 | | $ | 469 | | $ | -- | | $ | (13 | ) | $ | 4,076 | |
| Operating income (loss) | | $ | (1,625 | ) | $ | (262 | ) | $ | 136 | | $ | 239 | | $ | -- | | $ | -- | | $ | (1,512 | ) |
| Depreciation expense | | $ | 127 | | $ | 52 | | $ | 9 | | $ | 6 | | $ | -- | | $ | -- | | $ | 194 | |
Three Months Ended October 31, 2004 | | | | | | | | | | | | | | | | | | | | | | |
| Revenue from external customers | | $ | 1,931 | | $ | 1,849 | | $ | 2,694 | | $ | 524 | | $ | -- | | $ | -- | | $ | 6,998 | |
| Revenue from intersegments | | $ | -- | | $ | 125 | | $ | -- | | $ | -- | | $ | -- | | $ | (125 | ) | $ | -- | |
| Cost of revenues | | $ | 232 | | $ | 802 | | $ | 2,355 | | $ | 130 | | $ | -- | | $ | -- | | $ | 3,519 | |
| Gross margin | | $ | 1,699 | | $ | 1,047 | | $ | 339 | | $ | 394 | | $ | -- | | $ | -- | | $ | 3,479 | |
| Operating income (loss) | | $ | (1,128 | ) | $ | (380 | ) | $ | (303 | ) | $ | 196 | | $ | (256 | ) | $ | -- | | $ | (1,871 | ) |
| Depreciation expense | | $ | 167 | | $ | 73 | | $ | 7 | | $ | -- | | $ | -- | | $ | ---- | | $ | 247 | |
During the time period covered by the table above, the Company marketed its products in the United States through its direct sales force and its online Web sites. Revenues for the three months ended October 31, 2005 and October 31, 2004 were primarily generated from sales to end users in the United States.
7. Litigation
The Company, two of its former officers (the "Former Officers"), and the lead underwriter in its initial public offering ("IPO") were named as defendants in a consolidated shareholder lawsuit in the United States District Court for the Southern District of New York, captioned In re VA Software Corp. Initial Public Offering Securities Litigation, 01-CV-0242. This is one of a number of actions coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, 21 MC 92 with the first action filed on January 12, 2001. Plaintiffs in the coordinated proceeding are bringing claims under the federal securities laws against numerous underwriters, companies, and individuals, alleging generally that defendant underwriters engaged in improper and undisclosed activities concerning the allocation of shares in the IPOs of more than 300 companies during late 1998 through 2000. Among other things, the plaintiffs allege that the underwriters' customers had to pay excessive brokerage commissions and purchase additional shares of stock in the aftermarket in order to receive favorable allocations of shares in an IPO. The consolidated amended complaint in the Company's case seeks unspecified damages on behalf of a purported class of purchasers of its common stock between December 9, 1999 and December 6, 2000. Pursuant to a tolling agreement, the individual defendants were dismissed without prejudice. On February 19, 2003, the court denied the Company’s motion to dismiss the claims against it. The litigation is now in discovery. In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including the Company, was submitted to the court for approval. The terms of the settlement if approved, would dismiss and release all claims against the participating defendants (including the Company). In exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On August 31, 2005, the court confirmed preliminary approval of the settlement. The proposed settlement remains subject to a number of conditions, including receipt of final approval of the court. If the settlement does not occur, and litigation against the Company continues, the Company believes it has meritorious defenses and intends to defend the case vigorously.
On Nov 9, 2001, a former employee of the Company, who had worked as a sales person in the Company's former hardware business, filed a complaint captioned Okerman v. VA Linux Systems, Inc. & Larry Augustin, Civil No. 01-01825 (Norfolk Superior Court), in the Commonwealth of Massachusetts. As amended, the complaint alleges that changes made to certain commission and bonus plans during the plaintiff's tenure at the Company entitled him to recover damages for Breach of Contract, Breach of the Implied Covenant of Good Faith and Fair Dealing, violation of the Massachusetts Wage Act Statute, Promissory Estoppel, and Quantum Meruit. On June 25, 2002, the Court dismissed the Massachusetts Wage Act claim brought against the Company's former chief executive officer. On July 26, 2002, dismissal of the Wage Act claim in favor of the Company’s former chief executive officer was upheld on interlocutory appeal. On July 9, 2003, the Court granted summary judgment in the Company's favor regarding claims for Breach of Contract, Promissory Estoppel, and Quantum Meruit, and granted judgment on the pleadings in favor of the Company regarding the Massachusetts Wage Act claim. On September 24, 2004, following a jury trial on the sole remaining claim for Breach of the Covenant of Good Faith and Fair Dealing, a jury awarded damages of $136,876 to the plaintiff, which have been included in accrued liabilities and other in the Company's Condensed Consolidated Balance Sheets as of October 31, 2005. The plaintiff has since filed a notice of appeal of his previously-dismissed claims and the judgment for Breach of Contract and Breach of the Covenant of Good Faith and Fair Dealing, and the Company has filed a notice of appeal of the judgment for Breach of the Covenant of Good Faith and Fair Dealing.
The Company is subject to various claims and legal actions arising in the ordinary course of business. The Company has accrued for estimated losses in the accompanying consolidated financial statements for those matters where it believes that the likelihood that a loss will occur is probable and the amount of loss is reasonably estimable.
8. Recent Accounting Pronouncements
In March 2004, the Financial Accounting Standards Board (“FASB”) issued EITF Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however, the disclosure requirements remain effective for annual periods ending after June 15, 2004. The Company will evaluate the impact of EITF 03-1 once the final guidance is issued.
Effective April 1, 2004, the SEC adopted Staff Accounting Bulletin (“SAB”) No. 105, “Application of Accounting Principles to Loan Commitments.” SAB 105 clarifies the requirements for the valuation of loan commitments that are accounted for as derivatives in accordance with SFAS 133. Management does not expect the implementation of this new bulletin to have any impact on the Company’s financial position, results of operations or cash flows. The Company does not have any loan commitments.
In July 2004, the EITF issued a draft abstract for EITF Issue No. 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share” (“EITF 04-08”). EITF 04-08 reflects the Task Force’s conclusion that contingently convertible debt should be included in diluted earnings per share computations regardless of whether the market price trigger has been met. EITF 04-08 is effective for reporting periods ending after December 15, 2004. Prior period earnings per share amounts presented for comparative purposes are required to be restated to conform to this consensus and the Company is required to include the shares issuable upon the conversion of the debt in the diluted earnings per share computation for all periods during which contingently convertible notes are outstanding. The Company has not yet quantified the impact of this standard on its financial statements.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning in the second quarter of fiscal 2006. The Company does not believe the adoption of SFAS No. 151 will have a material effect on its consolidated financial position, results of operations or cash flows.
In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets - an amendment of APB Opinion No. 29,” which amends Opinion 29 by eliminating the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for fiscal years beginning after June 15, 2005, and implementation is done prospectively. Management does not expect the implementation of this new standard to have a material impact on the Company’s financial position, results of operations or cash flows.
In December 2004, the FASB issued and made effective two Staff Positions (FSP) that provide accounting guidance on how companies should account for the effect of the American Jobs Creation Act of 2004 that was signed into law on October 22, 2004. In FSP FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004,” the FASB concluded that the special tax deduction for domestic manufacturing, created by the new legislation, should be accounted for as a “special deduction” instead of a tax rate reduction. As such, the special tax deduction for domestic manufacturing is recognized no earlier than the year in which the deduction is taken on the tax return. FSP FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” allows additional time to evaluate the effects of the new legislation on any plan for reinvestment or repatriation of foreign earnings for purposes of applying FASB Statement No. 109. The Company does not anticipate that this legislation will impact its results of operations or financial condition.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 replaces APB Opinion No. 20, “Accounting Changes,” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements” and changes the requirements for the accounting for and reporting of a change in accounting principle. This statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. The Company does not believe the adoption of SFAS No. 154 will have a material effect on its consolidated financial position, results of operations or cash flows.
In March 2005, the FASB issued FSP No. 46(R)-5, Implicit Variable Interests under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (FSP 46(R)-5), which provides guidance for a reporting enterprise on whether it holds an implicit variable interest in a variable interest entity (VIE) or potential VIE when specific conditions exist. FSP 46(R)-5 became applicable to the Company in the quarter ended June 30, 2005. FSP 46(R) had no impact on the Company’s consolidated results of operations and financial condition as of July 31, 2005.
In March 2005, the FASB issued FIN 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143 (FIN 47), which requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. The Company is currently evaluating the effect that the adoption of FIN 47 will have on the Company’s consolidated results of operations and financial condition, but does not expect it to have a material impact.
9. Guarantees and Indemnifications
The following is a summary of our agreements that we have determined are within the scope of Financial Accounting Standards Board (“FASB”) Interpretation 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” some of which are specifically grandfathered because the guarantees were in effect prior to December 31, 2002. Accordingly, we have no liabilities recorded for these agreements as of October 31, 2005.
As permitted under Delaware law, the Company has agreements whereby the Company’s officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at the Company’s request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has director and officer liability insurance designed to limit the Company’s exposure and to enable the Company to recover a portion of any future amounts paid. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of October 31, 2005.
The Company enters into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally, the Company’s business partners, subsidiaries and/or customers, in connection with any patent, copyright or other intellectual property infringement claim by any third party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. The Company has not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is insignificant. Accordingly, the Company has no liabilities recorded for these agreements as of October 31, 2005.
The Company warrants that its software products will perform in all material respects in accordance with the Company’s standard published specifications in effect at the time of delivery of the licensed products to the customer for a specified period, which generally does not exceed ninety days. Additionally, the Company warrants that its maintenance services will be performed consistent with generally accepted industry standards through the completion of the agreed upon services. If necessary, the Company would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history, however, the Company has not incurred significant expense under its product or services warranties. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of October 31, 2005.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Special Note Regarding Forward-Looking Statements
This Form 10-Q contains forward-looking statements that involve risks and uncertainties. Words such as “intend,”“expect,”“believe,”“in our view,” and variations of such words and similar expressions, are intended to identify such forward-looking statements, which include, but are not limited to, statements regarding our expectations and beliefs regarding future revenue growth; gross margins; financial performance and results of operations; technological trends in, and emergence of the market for collaborative software development applications; the future functionality, business potential, demand for, efficiencies created by and adoption of SourceForge; demand for online advertising; management's strategy, plans and objectives for future operations; the impact of our restructuring and the amount of cash utilized by operations; our intent to continue to invest significant resources in development; competition, competitors and our ability to compete; liquidity and capital resources; the outcome of any litigation to which we are a party; our accounting policies; and sufficiency of our cash resources, cash generated from operations and investments to meet our operating and working capital requirements. Actual results may differ materially from those expressed or implied in such forward-looking statements due to various factors, including those set forth in the Risk Factors contained in the section of this Form 10-Q entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations." We undertake no obligation to update the forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-Q.
Critical Accounting Estimates
There have been no significant changes in our critical accounting estimates during the three months ended October 31, 2005 as compared to what was previously disclosed in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended July 31, 2005.
Overview
We were incorporated in California in January 1995 and reincorporated in Delaware in December 1999. From the date of our incorporation through October 2001, we sold Linux-based hardware systems and services under the name VA Linux Systems, Inc. On June 27, 2001, we announced our decision to exit our Linux-based hardware business. Today, we do business under the name VA Software Corporation and we develop, market and support a software application known as SourceForge Enterprise Edition ("SourceForge") and also own and operate OSTG, Inc. ("OSTG") and its wholly-owned subsidiaries, a network of Internet Web sites offering advertising, retail and animation services and products.
We currently view our business in four operating segments: SourceForge, Online Media, E-commerce and Online Images. Our SourceForge segment focuses on our SourceForge software products and services. Our Online Media segment represents a network of Internet Web sites serving the IT professional and software development communities. Our E-commerce segment provides online sales of a variety of retail products of interest to the software development and IT communities through ThinkGeek, Inc. (“ThinkGeek”) a wholly-owned subsidiary of OSTG. Our Online Images segment provides online sales of digital animation sold in the form of CD’s or as a subscription offered through Animation Factory, Inc., a wholly-owned subsidiary of OSTG.
Within the SourceForge segment, we continued to increase the number of customers to whom we have sold our SourceForge products, totaling 136 at October 31, 2005. Within the Online Media segment, during the first quarter of fiscal 2006 we reached record levels of page views, unique visitors and advertisers. As of October 31, 2005, OSTG reached nearly 19 million unique visitors and served more than 290 million page views per month. Within the E-commerce segment, we continued to increase our customer base, increasing the number of orders by 32% from the prior year. Within the Online Images segment, we grew our revenue for the first quarter by 11%.
Net revenues during the three months ended October 31, 2005 increased as compared to the three months ended October 31, 2004 primarily due to increased sales in our Online Media, E-commerce and Online Images businesses, offset by a decrease in our SourceForge business. Online Media sales increased due to an increase in average CPM rate. E-commerce sales increased due to an increase in our customer base and an increase in the average order size. Online Images sales increased due to an increase in our customer base related to this segment. SourceForge revenue decreased due to a decrease in the average order size.
Our sales continue to be primarily attributable to customers located in the United States of America.
For total operations, the net loss was $1.2 million and $1.6 million during the three months ended October 31, 2005 and October 31, 2004, respectively, or $0.02 and $0.03, respectively, in basic and diluted net loss per share.
Results of Operations
The application of accounting standards is central to a company's reported financial position, results of operations and cash flows. We review our annual and quarterly results, along with key accounting policies, with our audit committee prior to the release of financial results. We do not use off-balance-sheet arrangements with unconsolidated related parties, nor do we use other forms of off-balance-sheet arrangements such as research and development arrangements.
We have completed sixteen quarters of operations focused on building our application software business. While we believe that we are making good progress in our application software business, a substantial majority of our revenues continue to be derived from our other businesses and we face numerous risks and uncertainties that commonly confront businesses in emerging markets, some of which we have identified in the "Risk Factors" section below.
The following table sets forth our operating results for the periods indicated as a percentage of net revenues, represented by selected items from the unaudited condensed consolidated statements of operations. This table should be read in conjunction with the consolidated financial statements and the accompanying notes included in this Form 10-Q.
| | | Three Months Ended | |
| | | October 31, | | October 31, | |
| | | 2005 | | 2004 | |
Consolidated Statements of Operations Data: | | | | | |
| Software revenues | | | 17.4 | % | | 27.6 | % |
| Online Media revenues | | | 31.6 | | | 26.4 | |
| E-commerce revenues | | | 43.9 | | | 38.5 | |
| Online Images revenues | | | 7.1 | | | 7.5 | |
| Net revenues | | | 100.0 | % | | 100.0 | % |
| Software cost of revenues | | | 3.4 | | | 3.2 | |
| Online Media cost of revenues | | | 10.5 | | | 11.5 | |
| E-commerce cost of revenues | | | 34.8 | | | 33.7 | |
| Online Images cost of revenues | | | 1.4 | | | 1.9 | |
| Cost of revenues | | | 50.1 | | | 50.3 | |
| Gross margin | | | 49.9 | | | 49.7 | |
| Operating expenses: | | | | | | | |
| Sales and marketing | | | 28.1 | | | 34.5 | |
| Research and development | | | 19.6 | | | 21.0 | |
| General and administrative | | | 20.7 | | | 20.8 | |
| Amortization of goodwill and intangible assets | | | 0.0 | | | 0.1 | |
| Total operating expenses | | | 68.4 | | | 76.4 | |
| Loss from operations | | | (18.5 | ) | | (26.7 | ) |
| Interest Income, net | | | 3.5 | | | 2.7 | |
| Interest and other income, net | | | (0.1 | ) | | 0.9 | |
| Net loss | | | (15.1 | )% | | (23.1 | )% |
Net Revenues
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| SourceForge revenues | | $ | 1,421 | | $ | 1,931 | | $ | (510 | ) | | (26 | %) |
| Online Media revenues | | | 2,581 | | | 1,849 | | | 732 | | | 40 | % |
| E-commerce revenues | | | 3,586 | | | 2,694 | | | 892 | | | 33 | % |
| Online Images revenues | | | 580 | | | 524 | | | 56 | | | 11 | % |
| Net revenues | | $ | 8,168 | | $ | 6,998 | | $ | 1,170 | | | 17 | % |
Net revenues increased during the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 due primarily to an increase in our Online Media, E-commerce and Online Images businesses, offset by a decrease in our SourceForge business.
Sales for the three months ended October 31, 2005 and October 31, 2004 were primarily to customers located in the United States of America.
For the three months ended October 31, 2005 and October 31, 2004 no one customer represented 10% or greater of net revenues. We do not anticipate that any one customer will represent more than 10% of net revenues in the near future.
Net Revenues by Segment
SourceForge Revenues
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| SourceForge revenues | | $ | 1,421 | | $ | 1,931 | | $ | (510 | ) | | (26 | %) |
| Percentage of total net revenues | | | 17 | % | | 28 | % | | | | | | |
| Aggregate # of customers sold to | | | 136 | | | 108 | | | 28 | | | 26 | % |
| Avg. contract value | | $ | 68 | | $ | 146 | | $ | (78 | ) | | (53 | %) |
SourceForge revenues consist principally of fees for licenses of our SourceForge software products, maintenance, consulting and training.
The decrease during the three months ended October 31, 2005 was primarily related to the SourceForge licensing component of SourceForge revenue. We have increased the number of customers to whom we have licensed SourceForge to 136 but the average value of the contracts we sold during the quarter ended October 31, 2005 decreased to $68,000. This is compared to 108 customers to whom we had licensed Sorceforge to with an average contract value sold during the quarter ended October 31, 2004 of $146,000. The decrease in the average contract value was due to one large (greater than $100K) contract being sold during the quarter ended October 31, 2005, compared to the first quarter ended October 31, 2004, when a seven-figure contract was sold to a new customer and several six-figure add-on sales were made.
We expect SourceForge revenues to increase as our new and returning customer base grows, our average contract value increases and the length of the sales cycle decreases.
Online Media Revenues
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| Online Media revenues | | $ | 2,581 | | $ | 1,849 | | $ | 732 | | | 40 | % |
| Percentage of total net revenues | | | 32 | % | | 26 | % | | | | | | |
During the three months ended October 31, 2005, Online Media revenues were primarily derived from cash sales of advertising space on our various Web sites, as well as sponsorship and royalty related arrangements associated with advertising on these Web sites.
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| Cash advertising | | $ | 1,937 | | $ | 1,421 | | $ | 516 | | | 36 | % |
| Sponsorships | | | -- | | | 88 | | | (88 | ) | | (100 | %) |
| Donations | | | 7 | | | 6 | | | 1 | | | 17 | % |
| Other revenue | | | 637 | | | 334 | | | 303 | | | 91 | % |
| Online Media revenues | | $ | 2,581 | | $ | 1,849 | | $ | 732 | | | 40 | % |
Cash advertising revenue is derived from the number of impressions delivered and the average CPM rate (i.e., the average rate at which we receive revenue per 1,000 banner advertisements (impressions) we display to users of our online services) charged for the impressions delivered.
Sponsorship revenue is derived from non-CPM rate Web marketing programs that are used to increase brand awareness. Revenue related to sponsorships is recognized ratably over the term of the marketing program. Sponsorship revenue in the three months ended October 31, 2004 related to certain contracts with one customer, IBM. The decrease in sponsorship revenue in the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was due to the expiration of one of those certain IBM contracts in the fourth quarter of fiscal 2004.
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| Cash advertising | | $ | 1,937 | | $ | 1,421 | | $ | 516 | | | 36 | % |
| Impressions delivered | | | 93,870 | | | 126,022 | | | (32,152 | ) | | (26 | %) |
| Average CPM rate | | $ | 20.63 | | $ | 11.28 | | $ | 9.36 | | | 83 | % |
The increase in cash advertising revenue during the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was due to the substantial increase in the average contract CPM rate, offset by a significant decrease in the number of impressions delivered. The increase in average CPM rates was the result of our focus on selling higher CPM contracts. The decrease in the number of impressions delivered was primarily due to not accepting low CPM contracts. We believe that our prominent position in serving the growing Open Source software and Linux markets, along with our favorable online visitor demographics, make us an attractive advertising vehicle for advertising customers.
E-commerce Revenues
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| E-commerce revenues | | $ | 3,586 | | $ | 2,694 | | $ | 892 | | | 33 | % |
| Percentage of total net revenues | | | 44 | % | | 39 | % | | | | | | |
| # of Orders (per quarter) | | | 54,957 | | | 41,657 | | | 13,300 | | | 32 | % |
| Avg. order size (in whole dollars) | | $ | 65.25 | | $ | 64.67 | | $ | 0.58 | | | 1 | % |
E-commerce revenues are derived from the online sale of consumer goods, including shipping, net of any returns and allowances. The growth in the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was primarily due to increased consumer awareness of our site as a result of expanded advertising, a broader product offering which attracted a larger customer base, as well as Web site enhancements and affiliate programs that drove more traffic to our site. As a result of our efforts we experienced a 16% increase in the number of orders placed year over year. We expect E-commerce revenues to continue to grow as our E-commerce customer base grows.
Online Images Revenues
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| Online Images revenues | | $ | 580 | | $ | 524 | | $ | 56 | | | 11 | % |
| Percentage of total net revenues | | | 7 | % | | 8 | % | | | | | | |
Online Images revenues are derived from the online sale of three-dimensional art, animations and presentations.
The growth in the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was primarily due to increased consumer awareness of our site as a result of a broader product offering which attracted a larger customer base, as well as Web site enhancements and affiliate programs that drove more traffic to our site. We expect Online Images revenues to continue to grow as our customer base grows.
Cost of Revenues/Gross Margin
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| Cost of revenues | | $ | 4,092 | | $ | 3,519 | | $ | 573 | | | 16 | % |
| Gross margin | | $ | 4,076 | | $ | 3,479 | | $ | 597 | | | 17 | % |
| Gross margin % | | | 50 | % | | 50 | % | | | | | | |
Cost of revenues consist of personnel costs and related overhead associated with providing software professional services, personnel costs and related overhead associated with providing and running advertising campaigns and product costs associated with our E-commerce business.
The increase in gross margins was primarily the result of improvements in the Online Media, E-commerce and Online Images businesses, offset by a decline in the SourceForge business, resulting from a decrease in the average value of contracts sold during the quarter ended October 31, 2005..
Cost of Revenues/Gross Margin by Segment
SourceForge Cost of Revenues/Gross Margin
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| SourceForge cost of revenues | | $ | 276 | | $ | 232 | | $ | 44 | | | 19 | % |
| SourceForge gross margin | | $ | 1,145 | | $ | 1,699 | | $ | (554 | ) | | (33 | %) |
| SourceForge gross margin % | | | 81 | % | | 88 | % | | | | | | |
SourceForge cost of revenues consist of personnel and outside service provider costs associated with providing software customer and professional services. The decrease in our SourceForge gross margin percentages for the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was primarily the result of lower revenue.
Online Media Cost of Revenues/Gross Margin
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| Online Media cost of revenues | | $ | 863 | | $ | 802 | | $ | 61 | | | 8 | % |
| Online Media gross margin | | $ | 1,718 | | $ | 1,047 | | $ | 671 | | | 64 | % |
| Online Media gross margin % | | | 67 | % | | 57 | % | | | | | | |
Online Media cost of revenues consist of personnel costs and related overhead associated with developing the editorial content of the sites and providing and running advertising campaigns. The increase in Online Media gross margin percentages for the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was primarily driven by the increase in Online Media revenues partially offset by slightly higher cost of revenues. The increase in cost of revenues was primarily due to the cost of outsourcing our ad serving system to Falk North America LLC.
E-commerce Cost of Revenues/Gross Margin
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| E-commerce cost of revenues | | $ | 2,842 | | $ | 2,355 | | $ | 487 | | | 21 | % |
| E-commerce gross margin | | $ | 744 | | $ | 339 | | $ | 405 | | | 119 | % |
| E-commerce gross margin % | | | 21 | % | | 13 | % | | | | | | |
E-commerce cost of revenues consist of product costs, shipping and fulfillment costs and personnel costs associated with the operations and merchandising functions. The increase in E-commerce cost of revenues in absolute dollars was primarily due to increased product costs, shipping costs and fulfillment costs. The increase in product, shipping and fulfillment costs were the result of increased E-commerce revenue levels. E-commerce gross margin percentages increased for the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 due to higher gross margins on shipping, lower costs associated with our GeekPoints loyalty program and lower charges for excess and obsolete inventory. We expect E-commerce cost of revenues in absolute dollars to grow proportionately with E-commerce revenues in the future. In addition, we expect E-commerce overall gross margins to improve slightly as volume grows.
Online Images Cost of Revenues/Gross Margin
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| Online Images cost of revenues | | $ | 111 | | $ | 130 | | $ | (19 | ) | | (15 | %) |
| Online Images gross margin | | $ | 469 | | $ | 394 | | $ | 75 | | | 19 | % |
| Online Images gross margin % | | | 81 | % | | 75 | % | | | | | | |
Online Images cost of revenues consists of direct material and production costs for animation CDs. The increase in our Online Images gross margin percentages for the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was due to decreased material costs and increased revenues.
Operating Expenses
Sales and Marketing Expenses
Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in sales, marketing and sales support functions, as well as costs associated with trade shows, advertising and promotional activities.
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| Sales & Marketing | | $ | 2,297 | | $ | 2,411 | | $ | (114 | ) | | (5 | %) |
| Percentage of total net revenues | | | 28 | % | | 35 | % | | | | | | |
| Headcount | | | 27 | | | 30 | | | | | | | |
The slight decrease in absolute dollars in the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was primarily decreased commission expenses of $0.1 million. The $0.1 million in commission expense was a direct result of decreased revenue related to our SourceForge segment. The majority of the decrease as a percentage of net revenues was due to increased revenue levels. We believe our sales and marketing expenses in absolute dollars will increase in the future as we intend to grow our sales force. However, in the future, we expect sales and marketing expenses to decrease slightly as a percentage of revenue.
Research and Development Expenses
Research and development expenses consist primarily of salaries and related expenses for software engineers. We expense all of our research and development costs as they are incurred.
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| SourceForge Research & Development | | $ | 834 | | $ | 905 | | $ | (71 | ) | | (8 | %) |
| Online Media Research & Development | | | 608 | | | 408 | | | 200 | | | 49 | % |
| E-commerce Research & Development | | | 72 | | | 59 | | | 13 | | | 22 | % |
| Online Images Research & Development | | | 88 | | | 99 | | | (11 | ) | | (11 | %) |
| Total Research & Development | | $ | 1,602 | | $ | 1,471 | | $ | 131 | | | 9 | % |
| Percentage of total net revenues | | | 20 | % | | 21 | % | | | | | | |
| Headcount | | | 38 | | | 36 | | | | | | | |
The increase in research and development expenses in absolute dollars in the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was primarily due to our investment in SourceForge.net. We increased employee-related expenses by $0.1 million. The increase in employee-related expenses was primarily due to an increase in salary expense as headcount increased to 38 from 36. The decrease as a percentage of net revenues was primarily due to increased revenue levels. We expect research and development expenses to increase slightly in absolute dollars and decrease as a percentage of revenue in the future.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed,” development costs incurred in the research and development of new software products are expensed as incurred until technological feasibility in the form of a working model has been established at which time such costs are capitalized, subject to a net realizable value evaluation. Technological feasibility is established upon the completion of an integrated working model. To date, our software development has been completed concurrent with the establishment of technological feasibility and, accordingly, all software development costs have been charged to research and development expense in the accompanying consolidated statements of operations. Going forward, should technological feasibility occur prior to the completion of our software development, all costs incurred between technological feasibility and software development completion will be capitalized.
General and Administrative Expenses
General and administrative expenses consist of salaries and related expenses for finance and administrative personnel, bad debts and professional fees for accounting and legal services.
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| General & Administrative | | $ | 1,688 | | $ | 1,465 | | $ | 223 | | | 15 | % |
| Percentage of total net revenues | | | 21 | % | | 21 | % | | | | | | |
| Headcount | | | 21 | | | 19 | | | | | | | |
The increase in general and administrative expenses in absolute dollars in the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was primarily related to stock-based compensation expense of $0.2 million, increased accounting fees of $0.1 million, partially offset by decreased legal fees of $0.1 million. The increase in accounting fees of $0.1 million was associated with complying with the Sarbanes-Oxley Act of 2002. The decrease in legal fees was associated with the $0.1 million accrual for damages awarded as part of an ex-employee’s legal proceedings that was incurred in the three months ended October 31, 2004. No comparable fees were incurred in the three months ended October 31, 2005. There was no change in general and adminstrative expense as a percentage of net revenues due to the 15% increase in expense closely mirroring the 17% increase in revenue. We expect general and administrative expenses to remain fairly constant in absolute dollars, due to a decrease in Sarbanes-Oxley compliance costs, offset by expected increases associated with accounting staffing levels, and decrease as a percentage of revenue in the future.
Restructuring Costs and Other Special Charges
In fiscal 2001 and 2002, we adopted plans to exit our hardware systems and hardware-related software engineering and professional services businesses, as well as exit a sublease agreement and reduce our general and administrative overhead costs. We exited these activities to pursue our current SourceForge, Online Media, E-commerce and Online Images businesses and reduce our operating losses to improve cash flow. We recorded restructuring charges of $168.5 million related to exiting these activities, $160.4 million of which was included in restructuring charges and other special charges in operating expenses and $8.1 million of which was included in cost of sales. Included in the restructuring were charges related to excess facilities from non-cancelable leases. During the third quarter of fiscal 2004, in connection with our original 2002 restructuring plan which included an assumption to sublet all idle facilities, we relocated our Fremont, California headquarters to a smaller building in the same complex. As a result of the change in circumstances, original accruals were reevaluated and we accordingly recorded a restructuring adjustment of $2.9 million. Included in the $2.9 million dollar restructuring adjustment was $2.5 million of expense related to writing off leasehold improvements and fixed assets and an additional $0.4 million expense related to excess facilities from non-cancelable leases. In addition, during the third quarter of fiscal 2004, we reached agreements in principal to sublet unoccupied portions of properties that we lease in Sunnyvale, California and Fremont, California, which was finalized in the fourth quarter of fiscal 2004. As a result of the change in circumstances due to the agreements in principal, which were thereafter formalized in executed agreements, original accruals were reevaluated and we accordingly recorded a restructuring adjustment of $0.3 million in the third quarter of fiscal 2004. The $3.2 million total adjustment to restructuring expenses in fiscal 2004 has been recorded in the consolidated statement of operations for that period. The remaining accrual from non-cancelable lease payments is based on current circumstances. These accruals are subject to change should actual circumstances change. We will continue to evaluate and update, if applicable, these accruals quarterly. As of October 31, 2005, we had an accrual of approximately $7.3 million outstanding related to these non-cancelable leases, all of which was originally included in operating expenses.
All charges as a result of restructuring activities have been recorded in accordance with Emerging Issues Task Force (“EITF”) 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs incurred in a Restructuring)”. Restructuring charges recorded in fiscal 2004 were considered adjustments to the original restructuring plans, therefore, SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” was not applicable.
Below is a summary of the restructuring charges in operating expenses (in thousands):
| | | Total Charged To Operations Fiscal 2001-2004 | | Total Charged To Operations Fiscal 2005 | | Total Cash Receipts/ (Payments) | | Restructuring Liabilities at October 31, 2005 | |
| Cash Provisions: | | | | | | | | | |
| Other special charges relating to | | | | | | | | | |
| restructuring activities | | $ | 1,349 | | $ | -- | | $ | (1,349 | ) | $ | -- | |
| Facilities charges | | | 16,889 | | | (101 | ) | | (9,487 | ) | | 7,301 | |
| Employee severance and other related charges | | | 5,532 | | | -- | | | (5,532 | ) | | -- | |
| Total cash provisions | | | 23,770 | | | (101 | ) | $ | (13,460 | ) | $ | 7,301 | |
| Non-cash: | | | | | | | | | | | | | |
| Write-off of goodwill and intangibles | | | 90,355 | | | -- | | | | | | | |
| Write-off of other special charges relating to restructuring activities | | | 11,819 | | | -- | | | | | | | |
| Write-off of accelerated options from | | | | | | | | | | | | | |
| terminated employees | | | 1,352 | | | -- | | | | | | | |
| Acceleration of deferred stock compensation | | | 36,064 | | | -- | | | | | | | |
| Total non-cash provisions | | | 139,590 | | | -- | | | | | | | |
| Total provisions | | $ | 163,360 | | $ | (101 | ) | | | | | | |
Below is a summary of the changes to the restructuring liability (in thousands):
Changes in the total accrued restructuring liability | | Balance at Beginning of Period | | Charged to Costs and Expenses | | Deductions | | Balance at End of Period | |
| From July 29, 2000 through July 31, 2004 | | $ | -- | | $ | 23,770 | | $ | (12,487 | ) | $ | 11,283 | |
| For the year ended July 31, 2005 | | $ | 11,283 | | $ | (101 | ) | $ | (3,327 | ) | $ | 7,855 | |
| For the quarter ended October 31, 2004 | | $ | 11,283 | | $ | -- | | $ | (973 | ) | $ | 10,310 | |
| For the quarter ended October 31, 2005 | | $ | 7,855 | | $ | -- | | $ | (554 | ) | $ | 7,301 | |
| | | | | | | | | | | | | | |
| Components of the total accrued restructuring liability | | | Short Term | | | Long Term | | | Total Liability | | | | |
| As of July 31, 2004 | | $ | 3,440 | | $ | 7,843 | | $ | 11,283 | | | | |
| As of July 31, 2005 | | $ | 1,748 | | $ | 6,107 | | $ | 7,855 | | | | |
| As of October 31, 2004 | | $ | 3,019 | | $ | 7,291 | | $ | 10,310 | | | | |
| As of October 31, 2005 | | $ | 1,592 | | $ | 5,709 | | $ | 7,301 | | | | |
Amortization of Intangible Assets
In connection with the acquisition of OSTG (formerly known as OSDN), we amortized $1,100 of intangibles for the three months ended October 31, 2005 and $3,000 for the three months ended October 31, 2004. The estimated total amortization expense of acquired intangible assets is $4,400 for the fiscal year ending July 31, 2006, $3,000 for the fiscal year ending July 31, 2007 and $1,500 for the fiscal year ending July 31, 2008.
We periodically evaluate the carrying amount of our long-lived assets and apply the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 requires that long-lived assets and certain identifiable intangibles to be held and used or disposed of by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. No changes occurred during the three months ended October 31, 2005 that would indicate a possible impairment in the carrying value of intangible assets at October 31, 2005. The carrying value of intangible assets as of October 31, 2005 is $8,500 and is included in Other assets in the Condensed Consolidated Balance Sheets.
Interest and Other Income, Net
| | | Three Months Ended | | | | | |
| ($ in thousands) | | October 31, 2005 | | October 31, 2004 | | Change | | % Change | |
| Interest Income | | $ | 287 | | $ | 193 | | $ | 94 | | | 49 | % |
| Interest Expense | | | (3 | ) | | (3 | ) | | -- | | | -- | |
| Other Income (Expense) | | | (6 | ) | | 65 | | | (71 | ) | | N.M. | |
The increase in interest income in the three months ended October 31, 2005 as compared to the three months ended October 31, 2004 was due to increased returns on our cash as a result of increasing interest rates from the same period for the prior year.
Other expense during the three months ended October 31, 2005 as compared to other income during the three months ended October 31, 2004 was primarily due to the gain in 2004 on the closedown of one of our European subsidiaries during the three months ended October 31, 2004.
Income Taxes
As of October 31, 2005, we had federal and state net operating loss carry-forwards for tax reporting purposes available to offset future taxable income. A valuation allowance has been recorded for the total deferred tax assets as a result of uncertainties regarding realization of the assets based on the lack of consistent profitability to date and the uncertainty of future profitability. The federal and state net operating loss carry-forwards expire at various dates through fiscal year 2024 and fiscal year 2014, respectively, to the extent that they are not utilized. We have not recognized any benefit from these net operating loss carry-forwards because of uncertainty surrounding their realization. The amount of net operating losses that we can utilize is limited under tax regulations because we have experienced a cumulative stock ownership change of more than 50% over the last three years.
Liquidity and Capital Resources
| | | Three Months Ended | |
| (in thousands) | | October 31, 2005 | | October 31, 2004 | |
| Net cash provided by (used in): | | | | | |
| Operating activities | | $ | (3,453 | ) | $ | (2,002 | ) |
| Investing activities | | | 3,609 | | | 907 | |
| Financing activities | | | 33 | | | 231 | |
| Effect of exchange rate changes on cash and cash equivalents | | | -- | | | (68 | ) |
| Net change in cash and cash equivalents | | $ | 189 | | $ | (932 | ) |
Our principal sources of cash as of October 31, 2005 are our existing cash, cash equivalents, short-term and long-term investments of $34.9 million, which excludes restricted cash of $1.0 million. Cash and cash equivalents decreased by $7.3 million, and short-term and long-term investments increased by $.2 million at October 31, 2005 when compared to October 31, 2004. This decrease is primarily due to cash used in operations and payments and to a minor extent, for capital expenditures.
The cash flow discussion below describes the cash used or provided in one period as compared to the cash used or provided in the same period for the previous year. As such, the year to year fluctuations discussed can be calculated from the Consolidated Statements of Cash Flows.
Operating Activities
The increase in cash usage related to operating activities in the first quarter of fiscal 2006, as compared to the first quarter of fiscal 2005, was primarily the result of an increase in accounts receivable of $0.4 million, an increase in inventories of $0.8 million, an increase in prepaids and other assets of $0.3 million and a decrease in accrued liabilities and other of $0.6 million, offset partly by an increase of $0.4 million in accounts payable and a decrease in net loss (excluding all non-cash items) of $0.4 million. The decreased cash inflow related to accounts receivable was primarily the result of increased sales in the first quarter of fiscal 2006 compared to the first fiscal quarter of 2005. The decreased cash inflow related to inventories was primarily the result of increased purchasing levels in the first quarter of fiscal 2006, compared to the first quarter of fiscal 2005. The decreased cash inflow related to prepaid expenses and other assets was primarily the result of inventory prepayments in the first quarter of fiscal 2005. The decrease in cash inflow was offset by an decrease in net loss (excluding all non-cash items) of $0.4 million, a decrease in accrued restructuring liabilities of $0.4 million as the lease on one restructured property expired and a decrease in accounts payable of $0.4 million as a result of the timing of payments.
Investing Activities
Our investing activities primarily include purchases and sales of marketable securities, and purchases of property and equipment.
The increase in cash provided related to investing activities in the first quarter of fiscal 2006, as compared to the first quarter of fiscal 2005, was primarily the result of an increase in net sales of marketable securities of $2.7 million. During the first quarter of fiscal 2006, we sold (net) $3.7 million in short and long-term marketable securities compared to a net sale of $1.0 million in the first quarter of fiscal 2005.
Financing Activities
The decrease in cash provided related to financing activities in the first quarter of fiscal 2006, as compared to the first quarter of fiscal 2005, was the result of a decline in the issuance of common stock to our employees. We are uncertain of the level of cash that will be generated in the future from the issuance of common stock to our employees as the exercising of options is dependant upon several factors such as the price of our common stock and the number of employees participating in our stock option plans.
For the first quarter of fiscal 2006 and 2005, exchange rate changes had a negligible effect on cash and cash equivalents. We expect that exchange rate changes will have an immaterial effect on cash and cash equivalents in the near future due to our focus on U.S.-based business.
As of October 31, 2005 and July 31, 2005, we had outstanding letters of credit issued under a line of credit of approximately $1.0 million, respectively, related to the corporate facility lease. The amount related to this letter of credit is recorded in the “Restricted cash” section of the condensed consolidated balance sheet. The $1.0 million will decline as the Company meets certain financial covenants.
Our liquidity and capital requirements depend on numerous factors, including market acceptance of our products, the resources we devote to developing, marketing, selling and supporting our products, the timing and expense associated with expanding our distribution channels, potential acquisitions and other factors. We expect to devote capital resources to continue our research and development efforts, to invest in our sales, support, marketing and product development organizations, to enhance and introduce marketing programs, and for other general corporate activities. We believe that our existing cash balances will be sufficient to fund our operations through fiscal 2006 under our current business strategy, however, if we fail to adequately monitor and minimize our use of existing cash, we may need additional capital to fund continued operations beyond fiscal year 2006. Unless we monitor and minimize the level of use of our existing cash, cash equivalents and marketable securities, we may require additional capital to fund continued operations beyond our fiscal year 2006. See “Risks Related to our Financial Results” in the Risk Factors section of this Form 10-Q.
Contractual Obligations
The contractual obligations presented in the table below represent our estimates of future payments under fixed contractual obligations and commitments. Changes in our business needs, cancellation provisions and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of payments. The following table summarizes our fixed contractual obligations and commitments as of October 31, 2005 (in thousands):
Contractual Obligations | | Total | | Less than 1 year | | 1-3 years | | 3-5 years | |
| Gross Operating Lease Obligations | | $ | 16,696 | | $ | 2,632 | | $ | 7,158 | | $ | 6,906 | |
| Sublease Income | | | 4,874 | | | 743 | | | 2,097 | | | 2,034 | |
| Net Operating Lease Obligations | | | 11,822 | | | 1,889 | | | 5,061 | | | 4,872 | |
| | | | | | | | | | | | | | |
| Capital Lease Obligations | | | -- | | | -- | | | -- | | | -- | |
| Purchase Obligations | | | 2,887 | | | 2,887 | | | -- | | | -- | |
| Total Obligations | | $ | 14,709 | | $ | 4,776 | | $ | 5,061 | | $ | 4,872 | |
Financial Risk Management
As a primarily U.S.-centric company, we face limited exposure to adverse movements in foreign currency exchange rates and we do not engage in hedging activity. We do not anticipate significant currency gains or losses in the near term. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results.
We maintain investment portfolio holdings of various issuers, types and maturities. These securities are classified as available-for-sale, and consequently are recorded on the consolidated balance sheet at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss). These securities are not leveraged and are held for purposes other than trading.
Recent Accounting Pronouncements
In March 2004, the Financial Accounting Standards Board (“FASB”) issued EITF Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however, the disclosure requirements remain effective for annual periods ending after June 15, 2004. The Company will evaluate the impact of EITF 03-1 once the final guidance is issued.
Effective April 1, 2004, the SEC adopted Staff Accounting Bulletin No. 105, “Application of Accounting Principles to Loan Commitments” (“SAB 105”). SAB 105 clarifies the requirements for the valuation of loan commitments that are accounted for as derivatives in accordance with SFAS 133. Management does not expect the implementation of this new bulletin to have any impact on the Company’s financial position, results of operations or cash flows. The Company does not have any loan commitments.
In July 2004, the EITF issued a draft abstract for EITF Issue No. 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share” (“EITF 04-08”). EITF 04-08 reflects the Task Force’s conclusion that contingently convertible debt should be included in diluted earnings per share computations regardless of whether the market price trigger has been met. EITF 04-08 is effective for reporting periods ending after December 15, 2004. Prior period earnings per share amounts presented for comparative purposes are required to be restated to conform to this consensus and the Company is required to include the shares issuable upon the conversion of the debt in the diluted earnings per share computation for all periods during which contingently convertible notes are outstanding. The Company has not yet quantified the impact of this standard on its financial statements.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning in the second quarter of fiscal 2006. The Company does not believe the adoption of SFAS No. 151 will have a material effect on its consolidated financial position, results of operations or cash flows.
In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets - an amendment of APB Opinion No. 29,” which amends Opinion 29 by eliminating the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for fiscal years beginning after June 15, 2005, and implementation is done prospectively. Management does not expect the implementation of this new standard to have a material impact on the Company’s financial position, results of operations or cash flows.
In December 2004, the FASB issued and made effective two Staff Positions (FSP) that provide accounting guidance on how companies should account for the effect of the American Jobs Creation Act of 2004 that was signed into law on October 22, 2004. In FSP FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004,” the FASB concluded that the special tax deduction for domestic manufacturing, created by the new legislation, should be accounted for as a “special deduction” instead of a tax rate reduction. As such, the special tax deduction for domestic manufacturing is recognized no earlier than the year in which the deduction is taken on the tax return. FSP FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” allows additional time to evaluate the effects of the new legislation on any plan for reinvestment or repatriation of foreign earnings for purposes of applying FASB Statement No. 109. The Company does not anticipate that this legislation will impact its results of operations or financial condition.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 replaces APB Opinion No. 20, “Accounting Changes,” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements” and changes the requirements for the accounting for and reporting of a change in accounting principle. This statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. The Company does not believe the adoption of SFAS No. 154 will have a material effect on its consolidated financial position, results of operations or cash flows.
In March 2005, the FASB issued FSP No. 46(R)-5, Implicit Variable Interests under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (FSP 46(R)-5), which provides guidance for a reporting enterprise on whether it holds an implicit variable interest in a variable interest entity (VIE) or potential VIE when specific conditions exist. FSP 46(R)-5 became applicable to the Company in the quarter ended June 30, 2005. FSP 46(R) had no impact on the Company’s consolidated results of operations and financial condition as of July 31, 2005.
In March 2005, the FASB issued FIN 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143 (FIN 47), which requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. The Company is currently evaluating the effect that the adoption of FIN 47 will have on the Company’s consolidated results of operations and financial condition, but does not expect it to have a material impact.
Risk Factors
CURRENT AND PROSPECTIVE INVESTORS IN VA SOFTWARE SECURITIES SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW BEFORE MAKING AN INVESTMENT DECISION. IN ADDITION, THESE RISKS ARE NOT THE ONLY ONES FACING OUR COMPANY. ADDITIONAL RISKS OF WHICH WE ARE NOT PRESENTLY AWARE OR THAT WE CURRENTLY BELIEVE ARE IMMATERIAL MAY ALSO IMPAIR OUR BUSINESS OPERATIONS. OUR BUSINESS COULD BE HARMED BY ANY OF THESE RISKS. THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE DUE TO ANY OF THESE RISKS, AND INVESTORS MAY LOSE ALL OR PART OF THEIR INVESTMENT.
Risks Related To Our SourceForge Business
Because the market for our SourceForge application software is still emerging, we do not know whether existing and potential customers will license SourceForge in sufficient quantities for us to achieve profitability.
Our future growth and financial performance will depend on market acceptance of SourceForge and our ability to license our software in sufficient quantities and under acceptable terms. The number of customers using SourceForge is still relatively small. We expect that we will continue to need intensive marketing and sales efforts to educate prospective clients about the uses and benefits of SourceForge. Various factors could inhibit the growth of the market for and market acceptance of SourceForge. In particular, potential customers may be unwilling to make the significant capital investment needed to license SourceForge. Many of our customers have licensed only limited quantities of SourceForge, and these or new customers may decide not to deploy our software more broadly. We cannot be certain that a viable market for SourceForge will emerge or, if it does emerge, that it will be sustainable. If a sustainable viable market for SourceForge fails to emerge, this would have a significant, adverse effect upon our software business and operating results.
We are devoting the majority of our research and development spending to our SourceForge application, so if this software does not achieve market acceptance we are likely to experience continued operating losses.
Although in the first quarter of our fiscal year 2006, which ended on October 31, 2005, approximately 17% of our revenue was derived from our SourceForge business, we devoted 52%, or $0.8 million, of our research and development spending to research and development associated with our SourceForge software application. We expect to continue to allocate the majority of our research and development resources to SourceForge for the foreseeable future. There can be no assurance, however, that we will be sufficiently successful in marketing, licensing, upgrading and supporting SourceForge to offset our substantial software research and development expenditures. A failure to grow SourceForge revenue sufficiently to offset SourceForge’s significant research and development costs will materially and adversely affect our business and operating results.
If we fail to attract and retain larger corporate and enterprise-level customers, our revenues will not grow and may decline.
We have focused our sales and marketing efforts upon larger corporate and enterprise-level customers. This strategy may fail to generate sufficient revenue to offset the substantial demands that this strategy will place on our business, in particular the longer sales cycles, higher levels of service and support and volume pricing and terms that larger corporate and enterprise accounts often demand. In addition, these larger customers generally have significant financial and personnel resources. As a result, rather than license SourceForge, our target customers may develop collaborative software development applications internally, including ad hoc development of applications based on open source code. A failure to successfully obtain revenues from larger corporate or enterprise-level customers will materially and adversely affect our operating results.
If we fail to anticipate or respond adequately to technology developments, industry standards or practices, and customer requirements, or if we experience any significant delays in product development, introduction, or integration, SourceForge may become obsolete or unmarketable, our ability to compete may be impaired, and our SourceForge revenues may not grow or may decline.
Rapid technological advances, changes in customer requirements, and frequent new product introductions and enhancements characterize the software industry generally. We must respond rapidly to developments related to hardware platforms, operating systems, and software development tools. These developments will require us to make substantial product development investments. We believe the success of our SourceForge business will become increasingly dependent on our ability to:
| · | support multiple platforms, including Linux, commercial UNIX and Microsoft Windows; |
| · | use the latest technologies to continue to support web-based collaborative software development; and |
| · | continually support the rapidly changing standards, tools and technologies used in software development. |
Our SourceForge application software has a long and unpredictable sales cycle, which makes it difficult to forecast our future results and may cause our operating results to vary significantly.
The period between initial contact with a prospective customer and the licensing of SourceForge varies and has often exceeded three and occasionally exceeded twelve months. Additionally, our sales cycle is complex because customers consider a number of factors before committing to license SourceForge. Factors that our customers and potential customers have informed us that they considered when evaluating SourceForge include product benefits, cost and time of implementation, and the ability to operate with existing and future computer systems and applications. We have found that customer evaluation, purchasing and budgeting processes vary significantly from company to company. We spend significant time and resources informing prospective customers about our SourceForge products, which may not result in completed transactions and associated revenue. Even if SourceForge has been chosen by a customer, completion of the transaction is subject to a number of contingencies, which make our quarterly revenues difficult to forecast. These contingencies include but are not limited to the following:
| · | Our ability to sell SourceForge licenses may be impacted by changes in the strategic importance of software projects due to our customers' budgetary constraints or changes in customer personnel; |
| · | A customer's internal approval and expenditure authorization process can be difficult and time consuming. Delays in approvals, even after we are selected as a vendor, could impact the timing and amount of revenues recognized in a quarterly period; and |
| · | The number, timing and significance of enhancements to our SourceForge products and future introductions of new software by our competitors and us may affect customer-purchasing decisions. |
If we do not continue to receive repeat business from existing SourceForge customers, our revenue will not grow and may decline.
We generate a significant amount of our SourceForge license revenues from existing customers. Generally, our customers initially purchase a limited number of licenses as they evaluate, implement and adopt SourceForge. Even if customers successfully use SourceForge, such customers may not purchase additional licenses to expand the use of our product. Purchases of additional licenses by these customers will depend on their success in deploying SourceForge, their satisfaction with our product and support services and their use of competitive alternatives. A customer's decision to widely deploy SourceForge and purchase additional licenses may also be affected by factors that are outside of our control or which are not related to our product or services. In addition, as we deploy new versions of SourceForge, or introduce new products, our current customers may not require the functionality of our new versions or products and may decide not to license these products.
Increased utilization and costs of our technical support services may adversely affect our financial results.
Over the short term, we may be unable to respond to fluctuations in customer demand for support services. We may also be unable to modify the format of our support services to compete with changes in support services provided by competitors. Further, customer demand for these services could cause increases in the costs of providing such services and adversely affect our operating results.
Contractual issues may arise during the negotiation process that may delay the anticipated closure of a transaction and our ability to recognize revenue as anticipated. The occurrence of such issues might cause our SourceForge revenue and operating results to fall below our publicly-stated expectations, the expectations of securities analysts or the expectations of investors. Failure to meet public expectations is likely to materially and adversely affect the trading price of our common stock.
Because we focus on selling enterprise solutions, the process of contractual negotiation is critical and may be lengthy. Additionally, several factors may require us to defer recognition of license revenue for a significant period of time after entering into a license agreement, including instances where we are required to deliver either unspecified additional products or specified upgrades for which we do not have vendor-specific objective evidence of fair value. While we have a standard software license agreement that provides for revenue recognition provided that delivery has taken place, collectibility from the customer is reasonably assured and assuming no significant future obligations or customer acceptance rights exist, customer negotiations and revisions to these terms could impact our ability to recognize revenues at the time of delivery.
Many enterprise customers negotiate software licenses near the end of each quarter. In part, this is because enterprise customers are able, or believe that they are able, to negotiate lower prices and more favorable terms at that time. Our reliance on a large portion of SourceForge revenue occurring at the end of the quarter and the increase in the dollar value of transactions that occur at the end of a quarter can result in increased uncertainty relating to quarterly revenues. Due to end-of-period variances, forecasts may not be achieved, either because expected sales do not occur or because they occur at lower prices or on terms that are less favorable to us.
In addition, slowdowns in our quarterly license contracting activities may impact our service offerings and may result in lower revenues from our customer training, professional services and customer support organizations. Our ability to maintain or increase service revenues is highly dependent on our ability to increase the number of license agreements we enter into with customers.
Risks Related To Our Online Media Business
If our online business fails to continue to deliver original and compelling content and services, we will be unable to attract and retain users, which will adversely affect our financial results.
The successful development and production of content and services is subject to numerous uncertainties, including our ability to:
| · | anticipate and successfully respond to rapidly changing consumer tastes and preferences; |
| · | fund new program development; and |
| · | attract and retain qualified editors, writers and technical personnel. |
We cannot assure you that our online content and services will be attractive to a sufficient number of users to generate revenues consistent with our estimates or sufficient to sustain operations. In addition, we cannot assure you that any new content or services will be developed in a timely or cost-effective manner. If we are unable to develop content and services that allow us to attract, retain and expand a loyal user base that is attractive to advertisers, we will be unable to generate sufficient revenue to grow our online business.
If our online business fails to deliver innovative marketing programs, we will be unable to attract and retain advertisers, which will adversely affect our financial results.
The successful development and production of marketing programs is subject to numerous uncertainties, including our ability to:
| · | enable advertisers to showcase products, services and/or brands to their intended audience; |
| · | anticipate and successfully respond to emerging trends in online advertising; and |
| · | attract and retain qualified marketing and technical personnel. |
We cannot assure you that our online marketing programs will enable us to attract and retain advertisers and generate revenues consistent with our estimates or sufficient to sustain operations. In addition, we cannot assure you that any new marketing programs will be developed in a timely or cost-effective manner. If we are unable to deliver innovative marketing programs that allow us to expand our advertiser base, we will be unable to generate sufficient revenue to grow our online business.
Decreases or delays in advertising spending due to general economic conditions could harm our ability to generate advertising revenue, which would adversely affect our financial results.
Expenditures by advertisers tend to be cyclical, reflecting overall economic conditions as well as budgeting and buying patterns. The overall market for advertising, including Internet advertising, has been generally characterized in recent quarters by modest growth of marketing and advertising budgets. Because we derive a large part of our revenues from advertising fees, decreases in or delays of advertising spending could reduce our revenues or negatively impact our ability to grow our revenues. Even if economic conditions continue to improve, marketing budgets and advertising spending may not increase from current levels.
If we fail to maintain our strategic relationship with IDG, our advertising revenue will not grow as anticipated and may decline, and our financial performance will suffer.
During the first quarter of fiscal year 2005, we entered into a marketing and sales agreement with International Data Group (“IDG”). Under the agreement with IDG, IDG's Global Solution’s sales force will sell international advertising on OSTG's network of Web sites, but it is not committed to providing any guaranteed amount of sales of referrals. If we are unable to expand this strategic relationship with IDG, our ability to increase our international online advertising sales may be harmed. In addition, IDG can terminate this relationship with us, pursue other relationships, or attempt to develop or acquire Web sites that compete with our Web sites for online advertising revenue. Even if we succeed in maintaining or expanding our relationship with IDG, the relationship may not result in additional online advertising customers or revenues.
Risks Related To Our E-Commerce Business
We cannot predict our E-commerce customers’ preferences with certainty and such preferences may change rapidly. If we fail to accurately assess and predict our E-commerce customers’ preferences, it will adversely impact our financial results.
Our E-commerce offerings on our ThinkGeek.com web site are designed to appeal to IT professionals, software developers and others in technical fields. Misjudging either the market for our products or our customers' purchasing habits will cause our sales to decline, our inventories to increase and/or require us to sell our products at lower prices, all of which would have a negative effect on our business.
We are exposed to significant inventory risks as a result of seasonality, new product launches, rapid changes in product cycles and changes in consumer tastes with respect to our products offered at our ThinkGeek E-commerce web site. Failure to properly assess our inventory needs will adversely affect our financial results.
In order to be successful, we must accurately predict our customers’ tastes and avoid overstocking or under-stocking products. Demand for products can change significantly between the time inventory is ordered and the date of sale. In addition, when we begin selling a new product, it is particularly difficult to forecast product demand accurately. The acquisition of certain types of inventory, or inventory from certain sources, may require significant lead-time and prepayment, and such inventory may not be returnable. We carry a broad selection and significant inventory levels of certain products and we may be unable to sell products in sufficient quantities or during the relevant selling seasons.
If we do not maintain sufficient E-commerce inventory levels, or if we are unable to deliver our E-commerce products to our customers in sufficient quantities, our E-commerce business operating results will be adversely affected.
We must be able to deliver our merchandise in sufficient quantities to meet the demands of our customers and deliver this merchandise to customers in a timely manner. We must be able to maintain sufficient inventory levels, particularly during the peak holiday selling seasons. If we fail to achieve these goals, we may be unable to meet customer demand, and our financial results will be adversely affected.
Our ThinkGeek E-commerce web site is dependent upon a single third party fulfillment and warehouse provider. The satisfaction of our E-commerce customers is highly dependent upon fulfillment of orders in a professional and timely manner, so any decrease in the quality of service offered by our fulfillment and warehouse provider will adversely affect our reputation and the growth of our E-commerce business.
Our ThinkGeek E-commerce web site’s ability to receive inbound inventory and ship completed orders efficiently to our customers is substantially dependent on a third-party contract fulfillment and warehouse provider. We currently utilize the services of Dotcom Distribution, Inc. (“Dotcom Distribution”), located in Edison, New Jersey. If Dotcom Distribution fails to meet our future distribution and fulfillment needs, our relationship with and reputation among our E-commerce customers will suffer and this will adversely affect our E-commerce growth. Additionally, if Dotcom Distribution cannot meet our distribution and fulfillment needs, particularly during the peak holiday selling seasons, or our contract with Dotcom Distribution terminates, we may fail to secure a suitable replacement or second-source distribution and fulfillment provider on comparable terms, which would adversely affect our E-commerce financial results.
Risks Related To Our Online Images Business
We cannot predict our Online Images customers’ preferences with certainty and such preferences may change rapidly. If we fail to accurately assess and predict our Online Images customers’ preferences, it will adversely impact our financial results.
Our Online images offerings on our AnimationFactory.com web site are designed to appeal to small businesses, educational and religious groups and hobbyists and individuals. Misjudging either the market for our products or our customers’ purchasing habits will cause our sales to decline.
Risks Related To Our Financial Results
If we fail to adequately monitor and minimize our use of existing cash, we may need additional capital to fund continued operations beyond fiscal year 2006.
Since becoming a public company, we have experienced negative cash flow from operations. Our average net monthly cash flow shortfall during our first quarter of fiscal 2006, which ended October 31, 2005 was approximately $1.1 million. Although this average net monthly cash flow shortfall approximation should not be relied upon as an indicator of our average net monthly cash flow shortfall in the future, it further illustrates that unless we monitor and minimize the level of use of our existing cash, cash equivalents and marketable securities, we may require additional capital to fund continued operations beyond our fiscal year 2006. While we believe we will not require additional capital to fund continued operations through fiscal year 2006, we may require additional funding within this time frame, and this additional funding, if needed, may not be available on terms acceptable to us, or at all. A slowdown in technology or advertising spending, as well as other factors that may arise, could affect our future capital requirements and the adequacy of our available funds. As a result, we may be required to raise additional funds through private or public financing facilities, strategic relationships or other arrangements. Any additional equity financing would likely be dilutive to our stockholders. Debt financing, if available, may involve restrictive covenants on our operations and financial condition. Our inability to raise capital when needed could seriously harm our business.
Certain factors specific to our businesses over which we have limited or no control may nonetheless adversely impact our quarterly total revenues and financial results.
The primary factors over which we have limited or no control that may adversely impact our quarterly total revenues and financial results include the following:
| · | specific economic conditions relating to IT spending; |
| · | the discretionary nature of our software and online media customers' purchase and budget cycles; |
| · | the size and timing of software and online media customer orders; |
| · | long software and online media sales cycles; |
| · | our ability to retain skilled engineering and sales personnel; |
| · | economic conditions relating to online advertising and sponsorship, and E-commerce; |
| · | our ability to demonstrate and maintain attractive online user demographics; |
| · | the addition or loss of specific online advertisers or sponsors, and the size and timing of advertising or sponsorship purchases by individual customers; and |
| · | our ability to keep our web sites operational at a reasonable cost. |
If our revenues and operating results fall below our expectations, the expectations of securities analysts or the expectations of investors, the trading price of our common stock will likely be materially and adversely affected. You should not rely on the results of our business in any past periods as an indication of our future financial performance.
Future guidelines and interpretations regarding software revenue recognition could cause delays in our ability to recognize revenue, which will adversely impact our quarterly financial results.
From time to time, the American Institute of Certified Public Accountants (“AICPA”) and the SEC may issue guidelines and interpretations regarding the recognition of revenue from software and other activities. These new guidelines and interpretations could result in a delay in our ability to recognize revenue. If the Company has to delay the recognition of a significant amount of revenue in the future, this will have a material impact on the Company's reported financial results.
We have a history of losses and expect to continue to incur net losses for the foreseeable future. Failure to become and remain profitable may materially and adversely affect the market price of our common stock and our ability to raise capital and continue operations.
We incurred a loss of $1.2 million for our first fiscal quarter ended October 31, 2005, and we had an accumulated deficit of $753.3 million as of October 31, 2005. We may continue to incur net losses in the future. If we do achieve profitability, we may not be able to sustain it. Failure to become and remain profitable may materially and adversely affect the market price of our common stock and our ability to raise capital and continue operations beyond our fiscal year 2006.
Despite reductions in the size of our workforce, our business may fail to grow rapidly enough to offset our ongoing operating expenses.
During fiscal years 2001, 2002 and 2003, we substantially reduced the size of our workforce. As of October 31, 2005, we had 121 employees. Despite these reductions in our workforce, our business may fail to grow rapidly enough to offset our ongoing operating expenses. As a result, our quarterly operating results could fluctuate, and such fluctuation could adversely affect the market price of our common stock.
Risks Related To Competition
If we do not effectively compete with new and existing competitors, our revenues will not grow and may decline, which will adversely impact our financial results.
We believe that the emerging collaborative software development market continues to be fragmented, subject to rapid change and highly sensitive to new product introductions and marketing efforts by industry participants. Competition in related markets is intense. If our products gain market acceptance, we expect the competition to rapidly intensify as new competitors enter the marketplace. Our potential competitors include companies entrenched in closely related markets who may choose to enter and focus on collaborative software development. We expect competition to intensify in the future if the market for collaborative software development applications continues to expand. Our potential competitors include providers of software and related services as well as providers of hosted application services. Many of our potential competitors have significantly more resources, more experience, longer operating histories and greater financial, technical, sales and marketing resources than we do. In addition, open source code can be obtained through commercial vendors or downloaded and used on an ad hoc basis to address some collaborative software development challenges. We cannot guarantee that we will be able to compete successfully against current and future competitors or that competitive pressure and/or the availability of open source code will not result in price reductions, reduced operating margins and loss of market share, any one of which could seriously harm our business. Because individual product sales often lead to a broader customer relationship, our products must be able to successfully compete with and complement numerous competitors' current and potential offerings. Moreover, we may be forced to compete with our strategic partners, and potential strategic partners, and this may adversely impact our relationship with an individual partner or a number of partners. Consolidation is underway among companies in the software industry as firms seek to offer more extensive suites of software products and broader arrays of software solutions. Changes resulting from this consolidation may negatively impact our competitive position and operating results.
Online competition is intense. Our failure to compete successfully could adversely affect our revenue and financial results.
The market for Internet content and services is intensely competitive and rapidly evolving. It is not difficult to enter this market and current and new competitors can launch new Internet sites at relatively low cost. We derive revenue from online advertising and sponsorships, for which we compete with various media including newspapers, radio, magazines and various Internet sites. We also derive revenue from E-commerce, for which we compete with other E-commerce companies as well as traditional, "brick and mortar" retailers. We may fail to compete successfully with current or future competitors. Moreover, increased competition could result in price reductions, reduced margins or loss of market share, any of which could have a material adverse effect on our future revenue and financial results. If we do not compete successfully for new users and advertisers, our financial results may be materially and adversely affected.
Risks Related To Intellectual Property
We are vulnerable to claims that our products infringe third-party intellectual property rights. Any resulting claims against us could be costly to defend or subject us to significant damages.
We expect that our software products will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. In addition, we may receive patent infringement claims as companies increasingly seek to patent their software. Our developers may fail to perform patent searches and may therefore unwittingly infringe on third-party patent rights. We cannot prevent current or future patent holders or other owners of intellectual property from suing us and others seeking monetary damages or an injunction against shipment of our software offerings. A patent holder may deny us a license or force us to pay royalties. In either event, our operating results could be seriously harmed. In addition, employees hired from competitors might utilize proprietary and trade secret information from their former employers without our knowledge, even though our employment agreements and policies clearly prohibit such practices.
Any litigation regarding our intellectual property, with or without merit, could be costly and time consuming to defend, divert the attention of our management and key personnel from our business operations and cause product shipment delays. Claims of intellectual property infringement may require us to enter into royalty and licensing agreements that may not be available on terms acceptable to us, or at all. In addition, parties making claims against us may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the United States and abroad and could result in an award of substantial damages against us. Defense of any lawsuit or failure to obtain any required license could delay shipment of our products and increase our costs. If a successful claim is made against us and we fail to develop or license a substitute technology, our business, results of operations, financial condition or cash flows could be immediately and materially adversely affected.
If we fail to adequately protect our intellectual property rights, competitors may use our technology and trademarks, which could weaken our competitive position, reduce our revenues, and increase our costs.
We rely on a combination of copyright, trademark and trade-secret laws, employee and third-party nondisclosure agreements, and other arrangements to protect our proprietary rights. Despite these precautions, it may be possible for unauthorized third parties to copy our products or obtain and use information that we regard as proprietary to create products that compete against ours. Some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries.
In addition, the laws of some countries do not protect proprietary rights to the same extent as do the laws of the United States. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase.
Our collection of trademarks is important to our business. The protective steps we take or have taken may be inadequate to deter misappropriation of our trademark rights. We have filed applications for registration of and registered some of our trademarks in the United States and internationally. Effective trademark protection may not be available in every country in which we offer or intend to offer our products and services. Failure to protect our trademark rights adequately could damage our brand identity and impair our ability to compete effectively. Furthermore, defending or enforcing our trademark rights could result in the expenditure of significant financial and managerial resources.
The scope of United States patent protection in the software industry is not well defined and will evolve as the United States Patent and Trademark Office grants additional patents. Because patent applications in the United States are not publicly disclosed until the patent is issued, applications may have been filed that would relate to our products.
Our software business success depends significantly upon our proprietary technology. Despite our efforts to protect our proprietary technology, it may be possible for unauthorized third parties to copy certain portions of our products or to reverse engineer or otherwise obtain and use our proprietary information. We do not have any software patents, and existing copyright laws afford only limited protection. In addition, we cannot be certain that others will not develop substantially equivalent or superseding proprietary technology, or that equivalent products will not be marketed in competition with our products, thereby substantially reducing the value of our proprietary rights. We cannot assure you that we will develop proprietary products or technologies that are patentable, that any patent, if issued, would provide us with any competitive advantages or would not be challenged by third parties, or that the patents of others will not adversely affect our ability to do business. Litigation may be necessary to protect our proprietary technology. This litigation may be time-consuming and expensive.
Other Risks Related To Our Overall Business
Failure to remediate the material weaknesses in our internal control over financial reporting in a timely manner, or at all, could harm our operating results or cause us to fail to meet our regulatory or reporting obligations.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 ("Section 404"), we evaluated the effectiveness of our internal control over financial reporting as of July 31, 2005 as well as our disclosure controls and procedures. Based on this evaluation, management concluded that as of July 31, 2005, neither our internal control over financial reporting nor our disclosure controls and procedures were effective because of certain material weaknesses detailed in Item 9A, Part II (Controls and Procedures) of our Annual Report on Form 10-K for the year ended July 31, 2005 and in Item 4 of Part I (Controls and Procedures) of this Quarterly Report on Form 10-Q for the quarter ended October 31, 2005. In particular, the material weaknesses that we identified included the lack of sufficient personnel and technical accounting and financial reporting expertise, inadequate controls over period-end financial reporting, inadequate controls in the areas of revenue and accounts receivable, inadequate controls in the area of purchases, inadequate controls in the area of information technology, and lack of internal control reports (under SAS70) from critical external service providers. While we believe that these material weaknesses did not have a material effect on our reported results, they nevertheless constituted deficiencies in our internal controls over financial reporting. In addition, to remediate the material weaknesses summarized above, we may need to increase staffing levels, hire personnel and/or consultants with more specialized technical accounting expertise and/or upgrade our financial systems to a higher degree of automation. If, despite our remediation efforts, we fail to ameliorate our material weaknesses, we could be subject to regulatory scrutiny and a loss of public confidence in our internal controls over financial reporting. These remediation efforts will likely increase our general and administrative expenses and could, therefore, have an adverse effect on our reported net income.
Even if we are to successfully remediate such material weaknesses, because of its inherent limitations, our internal control over financial reporting may not prevent or detect misstatements or material omissions. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
We may be subject to claims as a result of information published on, posted on or accessible from our Internet sites, which could be costly to defend and subject us to significant damage claims.
We may be subject to claims of defamation, negligence, copyright or trademark infringement (including contributory infringement) or other claims relating to the information contained on our Internet sites, whether written by third parties or us. These types of claims have been brought against online services in the past and can be costly to defend regardless of the merit of the lawsuit. Although federal legislation protects online services from some claims when third parties write the material, this protection is limited. Furthermore, the law in this area remains in flux and varies from state to state. We receive notification from time to time of potential claims, but have not been named as a party to litigation involving such claims. While no formal complaints have been filed against us to date, our business could be seriously harmed if one were asserted.
We may be subject to product liability claims if people or property are harmed by the products we sell on our E-commerce web sites, which could be costly to defend and subject us to significant damage claims.
Some of the products we offer for sale on our E-commerce web sites, such as consumer electronics, toys, computers and peripherals, toiletries, beverages and clothing, may expose us to product liability claims relating to personal injury, death or property damage caused by such products, and may require us to take actions such as product recalls. Although we maintain liability insurance, we cannot be certain that our coverage will be adequate for liabilities actually incurred or that insurance will continue to be available to us on economically reasonable terms, or at all. In addition, some of our vendor agreements with our suppliers do not indemnify us from product liability.
If we are unable to implement appropriate systems, procedures and controls, we may not be able to successfully offer our services and grow our business.
Our ability to successfully offer our services and grow our business requires an effective planning and management process. We updated our operations and financial systems, procedures and controls following our strategic decision to exit the hardware business. Our systems will continue to require additional modifications and improvements to respond to current and future changes in our business. If we cannot grow our businesses, and manage that growth effectively, or if we fail to implement in a timely manner appropriate internal systems, procedures, controls and necessary modifications and improvements to these systems, our businesses will suffer.
If we lose key personnel or fail to integrate replacement personnel successfully, our ability to manage our business could be impaired.
Our future success depends upon the continued service of our key management, technical, sales, and other critical personnel. Our officers and other key personnel are employees-at-will, and we cannot assure you that we will be able to retain them. Key personnel have left our company in the past and there likely will be additional departures of key personnel from time to time in the future. The loss of any key employee could result in significant disruptions to our operations, including adversely affecting the timeliness of product releases, the successful implementation and completion of company initiatives, and the results of our operations. Competition for these individuals is intense, and we may not be able to attract, assimilate or retain highly qualified personnel. Competition for qualified personnel in our industry and the San Francisco Bay Area, as well as other geographic markets in which we recruit, is intense and characterized by increasing salaries, which may increase our operating expenses or hinder our ability to recruit qualified candidates. In addition, the integration of replacement personnel could be time consuming, may cause additional disruptions to our operations, and may be unsuccessful.
Our stock price has been volatile historically and may continue to be volatile.
The trading price of our common stock has been and may continue to be subject to wide fluctuations. During the first quarter of fiscal year 2006, the closing sale prices of our common stock on the Nasdaq ranged from $1.32 to $1.80 per share and the closing sale price on October 31, 2005 was $1.34 per share. Our stock price may fluctuate in response to a number of events and factors, such as quarterly variations in operating results, announcements of technological innovations or new products and media properties by us or our competitors, changes in financial estimates and recommendations by securities analysts, the operating and stock price performance of other companies that investors may deem comparable to us, and news reports relating to trends in our markets or general economic conditions.
In addition, the stock market in general, and the market prices for Internet-related companies in particular, have experienced volatility that often has been unrelated to the operating performance of such companies. These broad market and industry fluctuations may adversely affect the price of our stock, regardless of our operating performance. Additionally, volatility or a lack of positive performance in our stock price may adversely affect our ability to retain key employees, all of whom have been granted stock options.
Sales of our common stock by significant stockholders may cause the price of our common stock to decrease.
Several of our stockholders own significant portions of our common stock. If these stockholders were to sell significant amounts of their holdings of our common stock, then the market price of our common stock could be negatively impacted. The effect of such sales, or of significant portions of our stock being offered or made available for sale, could result in strong downward pressure on our stock price. Investors should be aware that they could experience significant short-term volatility in our stock if such stockholders decide to sell a substantial amount of their holdings of our common stock at once or within a short period of time.
Our networks may be vulnerable to unauthorized persons accessing our systems, which could disrupt our operations and result in the theft of our proprietary information.
A party who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions or malfunctions in our Internet operations. We may be required to expend significant capital and resources to protect against the threat of security breaches or to alleviate problems caused by breaches in security.
Increasing regulation of the Internet or imposition of sales and other taxes on products sold or distributed over the Internet could harm our business.
The electronic commerce market on the Internet is relatively new and rapidly evolving. While this is an evolving area of the law in the United States and overseas, currently there are relatively few laws or regulations that directly apply to commerce on the Internet. Changes in laws or regulations governing the Internet and electronic commerce, including, without limitation, those governing an individual's privacy rights, pricing, content, encryption, security, acceptable payment methods and quality of products or services could have a material adverse effect on our business, operating results and financial condition. Taxation of Internet commerce, or other charges imposed by government agencies or by private organizations, may also be imposed. Any of these regulations could have an adverse effect on our future sales and revenue growth.
Business disruptions could affect our future operating results.
Our operating results and financial condition could be materially and adversely affected in the event of a major earthquake, fire or other catastrophic event. Our corporate headquarters, the majority of our research and development activities and certain other critical business operations are located in California, near major earthquake faults. A catastrophic event that results in the destruction of any of our critical business or information technology systems could severely affect our ability to conduct normal business operations and as a result our future operating results could be adversely affected.
System disruptions could adversely affect our future operating results.
Our ability to attract and maintain relationships with users, advertisers, merchants and strategic partners will depend on the satisfactory performance, reliability and availability of our Internet channels and network infrastructure. Our Internet advertising revenues relate directly to the number of advertisements delivered to our users. System interruptions or delays that result in the unavailability of Internet channels or slower response times for users would reduce the number of advertisements and sales leads delivered to such users and reduce the attractiveness of our Internet channels to users, strategic partners and advertisers or reduce the number of impressions delivered and thereby reduce revenue. In the past twelve months, some of our sites have experienced a small number of brief service interruptions. We will continue to suffer future interruptions from time to time whether due to natural disasters, telecommunications failures, other system failures, rolling blackouts, viruses, hacking or other events. System interruptions or slower response times could have a material adverse effect on our revenues and financial condition.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk, we maintain a portfolio of cash equivalents, short-term investments and long-term investments in a variety of securities, including commercial paper, money market funds and government and non-government debt securities. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate.
The following table presents the amounts of our cash equivalents, short-term investments and long-term investments (in thousands) that are subject to market risk and weighted-average interest rates, categorized by expected maturity dates, as of October 31, 2005. This table does not include money market funds because those funds are not subject to market risk.
(in thousands) | | Maturing within three months | | Maturing within three months to one year | | Maturing Greater than one year | |
| As of October 31, 2005 | | | | | | | |
| Cash equivalents | | $ | 1,500 | | | | | | | |
| Weighted-average interest rate | | | 4.01 | % | | | | | | |
| Short-term investments | | | | | $ | 30,403 | | | | |
| Weighted-average interest rate | | | | | | 3.73 | % | | | |
| Long-term investments | | | | | | | | $ | 1,159 | |
| Weighted-average interest rate | | | | | | | | | 4.20 | % |
We have operated primarily in the United States, and virtually all sales have been made in U.S. dollars. Accordingly, we have not had any material exposure to foreign currency rate fluctuations.
The estimated fair value of our cash, cash equivalents and investments approximate carrying value. We do not currently hold any derivative instruments and do not engage in hedging activities.
Item 4. Controls and Procedures
| a) | Evaluation of disclosure controls and procedures. |
The Company’s management evaluated, with the participation of its Chief Executive Officer (CEO) and its Chief Financial Officer (CFO), the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 (the “’34 Act”)) as of the end of the period covered by this report.
Disclosure controls and procedures are designed with the objective of ensuring that (i) information required to be disclosed in the Company’s reports filed under the ’34 Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) information is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal control procedures, which are designed with the objective of providing reasonable assurance that the Company’s transactions are properly authorized, its assets are safeguarded against unauthorized or improper use and its transactions are properly recorded and reported, all to permit the preparation of the Company’s financial statements in conformity with generally accepted accounting principles. To the extent that elements of our internal control over financial reporting are included within our disclosure controls and procedures, they are included in the scope of our quarterly controls evaluation.
Based on that evaluation, the CEO and CFO concluded that as of the end of the period covered by this report, the disclosure controls and procedures were not effective because of the material weaknesses described below and that the remediation efforts of the Company have not been in effect for a sufficient amount of time to allow for testing and validation.
| b) | Changes in internal controls over financial reporting. |
There were no changes in the Company’s internal controls over financial reporting (as defined in Rule 13a-15(f) of the ’34) during the quarter ended October 31, 2005 that has materially affected, or is reasonably likely to materially affect, its internal controls over financial reporting.
| c) | Limitations on the Effectiveness of Controls. |
The Company’s management, including its CEO and our CFO, does not expect that its disclosure controls or its internal controls will prevent all error or fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected on a timely basis.
| d) | Internal Control over Financial Reporting. |
Section 404 of the Sarbanes-Oxley Act of 2002 (the “Act”) required the Company to include an internal control report in its Annual Report on Form 10-K for the year ended July 31, 2005 and in subsequent Annual Reports thereafter.
As previously reported in our Annual Report on Form 10-K for the year ended July 31, 2005, we concluded that, as of July 31, 2005, our internal controls over financial reporting were not effective due to:
| · | Lack of sufficient personnel and technical accounting and financial reporting expertise within the Company's accounting and finance function; |
| · | Inadequate controls over period-end financial reporting, where our Chief Financail Officer was responsible for preparing or compiling certain critical portions of the quarerly and annual internal financial information and was also responsible for performing a review of this information to monitor the results of operations; |
| · | Inadequate controls in the areas of revenue and accounts receivable, where there were certain instances in which fully executed contracts were not obtained in a timely manner in connection with providing online advertising services, were, in a limited number of situations, revenue was not adjusted to properly reflect below-estimated “click-throughs” on certain advertising sponsorship buttons and links, and where the same individual had authority for activities which should be segregated; |
| · | Inadequate controls in the area of purchases, where the purchasing manager did not obtain appropriate approvals for purchasing and the facilities manager did not always sign off on the packing slips to provide evidence of the actual quantity received and we did not maintain adequate segregation of duties among members of our purchasing and receiving departments; |
| · | Inadequate controls in the area of information technology where we did not maintain effective controls over access to the accounting system and in some cases did not maintain complete documentation regarding these access rights and we did not maintain adequate controls in the areas of system development life cycle and change management; and |
| · | Lack of internal control reports (under SAS 70) from critical external service providers. |
PART II
Item 1. Legal Proceedings
The Company, two of its former officers (the "Former Officers"), and the lead underwriter in its initial public offering ("IPO") were named as defendants in a consolidated shareholder lawsuit in the United States District Court for the Southern District of New York, captioned In re VA Software Corp. Initial Public Offering Securities Litigation, 01-CV-0242. This is one of a number of actions coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, 21 MC 92, with the first action filed on January 12, 2001. Plaintiffs in the coordinated proceeding are bringing claims under the federal securities laws against numerous underwriters, companies, and individuals, alleging generally that defendant underwriters engaged in improper and undisclosed activities concerning the allocation of shares in the IPOs of more than 300 companies during late 1998 through 2000. Among other things, the plaintiffs allege that the underwriters' customers had to pay excessive brokerage commissions and purchase additional shares of stock in the aftermarket in order to receive favorable allocations of shares in an IPO. The consolidated amended complaint in the Company's case seeks unspecified damages on behalf of a purported class of purchasers of its common stock between December 9, 1999 and December 6, 2000. Pursuant to a tolling agreement, the individual defendants were dismissed without prejudice. On February 19, 2003, the court denied the Company’s motion to dismiss the claims against it. The litigation is now in discovery. In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including the Company, was submitted to the court for approval. The terms of the settlement if approved, would dismiss and release all claims against the participating defendants (including the Company). In exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On August 31, 2005, the court confirmed preliminary approval of the settlement. The proposed settlement remains subject to a number of conditions, including receipt of final approval of the court. If the settlement does not occur, and litigation against the Company continues, the Company believes it has meritorious defenses and intends to defend the case vigorously.
On Nov 9, 2001, a former employee of the Company, who had worked as a sales person in the Company's former hardware business, filed a complaint captioned Okerman v. VA Linux Systems, Inc. & Larry Augustin, Civil No. 01-01825 (Norfolk Superior Court), in the Commonwealth of Massachusetts. As amended, the complaint alleges that changes made to certain commission and bonus plans during the plaintiff's tenure at the Company entitled him to recover damages for Breach of Contract, Breach of the Implied Covenant of Good Faith and Fair Dealing, violation of the Massachusetts Wage Act Statute, Promissory Estoppel, and Quantum Meruit. On June 25, 2002, the Court dismissed the Massachusetts Wage Act claim brought against the Company's former chief executive officer. On July 26, 2002, dismissal of the Wage Act claim in favor of the Company’s former chief executive officer was upheld on interlocutory appeal. On July 9, 2003, the Court granted summary judgment in the Company's favor regarding claims for Breach of Contract, Promissory Estoppel, and Quantum Meruit, and granted judgment on the pleadings in favor of the Company regarding the Massachusetts Wage Act claim. On September 24, 2004, following a jury trial on the sole remaining claim for Breach of the Covenant of Good Faith and Fair Dealing, a jury awarded damages of $136,876 to the plaintiff, which have been included in accrued liabilities and other in the Company's Condensed Consolidated Balance Sheets as of October 31, 2005. The plaintiff has since filed a notice of appeal of his previously-dismissed claims and the judgment for Breach of Contract and Breach of the Covenant of Good Faith and Fair Dealing, and the Company has filed a notice of appeal of the judgment for Breach of the Covenant of Good Faith and Fair Dealing.
The Company is subject to various claims and legal actions arising in the ordinary course of business. The Company has accrued for estimated losses in the accompanying consolidated financial statements for those matters where it believes that the likelihood that a loss will occur is probable and the amount of loss is reasonably estimable.
Item 6. Exhibits and Reports On Form 8-K
(a) Exhibits
| Exhibit No. | Description |
| | |
31.1 | Rule 13a-14(a) Certification of Chief Executive Officer. |
31.2 | Rule 13a-14(a) Certification of Chief Financial Officer. |
32.1 | Certification Of Chief Executive Officer and Chief Financial Officer Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 Of The Sarbanes-Oxley Act Of 2002. |
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | |
| | VA SOFTWARE CORPORATION |
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| | By: | /s/ ALI JENAB |
| |
Ali Jenab |
| | President and Chief Executive Officer |
| | | |
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| | By: | /s/ KATHLEEN R. MCELWEE |
| |
Kathleen R. McElwee |
| | Senior Vice President and Chief Financial Officer |
| | |
| Date: December 12, 2005 | |
EXHIBIT INDEX
Exhibit Number | | |
31.1 | — | Rule 13a-14(a) Certification of Chief Executive Officer. |
31.2 | — | Rule 13a-14(a) Certification of Chief Financial Officer. |
32.1 | — | Certification Of Chief Executive Officer and Chief Financial Officer Pursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 Of The Sarbanes-Oxley Act Of 2002 |
