Verity 10Q 2004 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended August 31, 2003

¨	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: 0-26880

VERITY, INC.

(Exact name of registrant as specified in its charter)

Delaware

77-0182779

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

894 Ross Drive

Sunnyvale, California 94089

(408) 541-1500

(Address, including zip code, and telephone number, including area code of principal executive offices)

Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

The number of shares outstanding of the Registrant’s Common Stock, $0.001 par value, was 37,552,475 as of September 30, 2003.

VERITY, INC.

FORM 10-Q

TABLE OF CONTENTS

		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets—As of August 31, 2003 and May 31, 2003	3
	Condensed Consolidated Statements of Operations—For the Three Month Periods Ended August 31, 2003 and August 31, 2002	4
	Condensed Consolidated Statements of Cash Flows—For the Three Month Periods Ended August 31, 2003 and August 31, 2002	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32
Item 4.	Controls and Procedures	33

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	34
Item 2.	Changes in Securities and Use of Proceeds	34
Item 3.	Defaults upon Senior Securities	34
Item 4.	Submission of Matters to a Vote of Security Holders	35
Item 5.	Other Information	35
Item 6.	Exhibits and Reports on Form 8-K	35
Signature		36

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

VERITY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data, unaudited)

	August 31, 2003		May 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	69,648	$	85,672
Short-term investments		75,781		52,993
Trade accounts receivable, net		19,216		22,597
Deferred tax assets		3,916		3,916
Prepaid and other		7,862		11,843

Total current assets		176,423		177,021
Property and equipment, net		4,926		5,168
Long-term investments		101,846		112,079
Deferred tax assets		18,176		18,176
Intangible assets, net		10,965		11,610
Goodwill		15,145		15,145
Other assets		449		460

Total assets	$	327,930	$	339,659

LIABILITIES
Current liabilities:
Accounts payable	$	4,382	$	5,541
Accrued compensation		8,168		8,518
Other accrued liabilities		9,510		12,074
Deferred revenue		16,916		18,874

Total current liabilities		38,976		45,007

Deferred purchase payment		—		3,021

Total liabilities		38,976		48,028

Contingencies (Note 6)
STOCKHOLDERS’ EQUITY
Common stock, $0.001 par value:
Authorized: 200,000 shares; issued and outstanding: 37,374 shares as of August 31, 2003 and 37,560 shares as of May 31, 2003		37		38
Additional paid-in capital		261,267		264,645
Other comprehensive income		2,057		3,174
Retained earnings		25,593		23,774

Total stockholders’ equity		288,954		291,631

Total liabilities and stockholders’ equity	$	327,930	$	339,659

The accompanying notes are an integral part of these condensed consolidated financial statements.

VERITY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data, unaudited)

	Three Months Ended August 31,
	2003		2002
Revenues:
Software products	$	14,177	$	12,306
Service and other		12,426		9,704

Total revenues		26,603		22,010

Costs of revenues:
Software products		339		390
Service and other		3,388		2,743

Total costs of revenues		3,727		3,133

Gross profit		22,876		18,877

Operating expenses:
Research and development		5,461		5,308
Marketing and sales		12,134		10,571
General and administrative		2,887		2,674
Amortization of purchased intangible assets		645		—

Total operating expenses		21,127		18,553

Income from operations		1,749		324

Other income, net		1,185		1,904

Income before provision for income taxes		2,934		2,228
Provision for income taxes		1,115		847

Net income	$	1,819	$	1,381

Net income per share—basic	$	0.05	$	0.04

Net income per share—diluted	$	0.05	$	0.04

Number of shares—basic		37,504		35,548

Number of shares—diluted		39,663		36,645

The accompanying notes are an integral part of these condensed consolidated financial statements.

VERITY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands, unaudited)

	Three Months Ended August 31,
	2003			2002
Cash flows from operating activities:
Net income	$	1,819		$	1,381
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,516			887
Allowance for doubtful accounts		—			139
Deferred income taxes		—			479
Amortization of premium on securities, net		267			332
Changes in operating assets and liabilities:
Trade accounts receivable		2,807			4,006
Prepaid and other assets		(986	)		819
Accounts payable		(1,088	)		(997	)
Accrued compensation and other accrued liabilities		(844	)		(979	)
Deferred revenue		(1,587	)		(2,752	)

Net cash provided by operating activities		1,904			3,315

Cash flows from investing activities:
Acquisition of property and equipment		(667	)		(361	)
Purchases of marketable securities		(114,027	)		(142,038	)
Maturity of marketable securities		39,618			61,754
Proceeds from sale of marketable securities		60,717			74,165

Net cash used in investing activities		(14,359	)		(6,480	)

Cash flows from financing activities:
Proceeds from the sale of common stock, net of issuance costs		3,621			479
Repurchases of common stock		(7,000	)		(6,566	)

Net cash used in financing activities		(3,379	)		(6,087	)

Effect of exchange rate changes on cash		(190	)		385

Net decrease in cash and cash equivalents		(16,024	)		(8,867	)
Cash and cash equivalents, beginning of period		85,672			23,251

Cash and cash equivalents, end of period	$	69,648		$	14,384

The accompanying notes are an integral part of these condensed consolidated financial statements.

VERITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Interim Financial Data (Unaudited)

The unaudited condensed consolidated financial statements for Verity, Inc. (the “Company” or “Verity”) as of August 31, 2003 and for the three month period ended August 31, 2003 and 2002 have been prepared on the same basis as the Company’s audited financial statements and, in the opinion of management, include all material adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the financial position and results of operations in accordance with generally accepted accounting principles. Although certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission, the Company believes the disclosures made are adequate to make the information presented not misleading. The accompanying financial statements should be read in conjunction with the Company’s annual financial statements contained in the Company’s Annual Report on Form 10-K for the year ended May 31, 2003.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management’s estimates, judgments and assumptions are continually evaluated based on available information and experience; however, actual amounts could differ from those estimates. Certain prior period balances have been reclassified to conform to current period presentation.

The consolidated financial statements include the accounts of Verity, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

The Company’s balance sheet as of May 31, 2003 was derived from the Company’s audited financial statements, but does not include all disclosures necessary for the presentation to be in accordance with generally accepted accounting principles.

2. Accounting for Computation of Net Income (Loss) and Net Income (Loss) Per Share and Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements under compensatory plans using the intrinsic value method, which calculates compensation expense based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the option exercise price.

VERITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Generally accepted accounting principles require companies who choose to account for stock option grants using the intrinsic value method to also determine the fair value of option grants using a stock option pricing model such as the Black-Scholes model and to disclose the impact of fair value accounting in a note to the financial statements. The impact of recognizing the fair value of option grants and stock grants under the Company’s employee stock option and stock purchase plans as an operating expense would have reduced the Company’s net income to a net loss, as follows (in thousands, except per share amounts):

	Three Months Ended August 31,
	2003			2002
Net income
Net income—as reported	$	1,819		$	1,381

Deduct: Total SFAS 123 stock-based employee compensation expense, net of related tax effects		(15,010	)		(17,685	)

Net loss—pro forma	$	(13,191	)	$	(16,304	)

Earnings per share
Net income per share—basic—as reported	$	0.05		$	0.04

Net loss per share—basic—pro forma	$	(0.35	)	$	(0.46	)

Net income per share—diluted—as reported	$	0.05		$	0.04

Net loss per share—diluted—pro forma	$	(0.35	)	$	(0.46	)

Number of shares used in basic—as reported calculation		37,504			35,548

Number of shares used in diluted—as reported calculation		39,663			36,645

Number of shares used in basic and diluted—pro forma calculation		37,504			35,548

Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed using the weighted average number of common and common equivalent shares outstanding during the period. Dilutive common equivalent shares consist of “in-the-money” stock options. “In-the-money” options are those where the exercise price is lower than the average market price being used to determine the value. The Company’s average market price for the first quarter in fiscal year 2004 was $14.2873.

The Company calculated the fair value of each option grant on the date of grant using the Black-scholes option pricing model. The following weighted average assumptions were used for each respective period:

	Three Months Ended August 31,
	2003		2002
Stock Option Plans
Expected volatility	80	%	80	%
Risk-free interest rate	1.77	%	3.01	%
Expected life	4.00 years		2.73 years
Expected dividend yield	0.00	%	0.00	%

Stock Purchase Plan
Expected volatility	80	%	100	%
Risk-free interest rate	1.52	%	2.32	%
Expected life	1.00 year		1.00 year
Expected dividend yield	0.00	%	0.00	%

VERITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

3. Investments

As of August 31, 2003 and May 31, 2003, available-for-sale securities consist of the following(in thousands):

	August 31, 2003							May 31, 2003
	Amortized Cost		Gross Unrealized Gains (Losses)			Fair Value		Amortized Cost		Gross Unrealized Gains		Fair Value
*Short-term*
Corporate	$	49,001	$	613		$	49,614	$	48,592	$	788	$	49,380
Government		1,000		7			1,007		1,000		13		1,013
Other		25,160		—			25,160		2,600		—		2,600

Total short-term	$	75,161	$	620		$	75,781	$	52,192	$	801	$	52,993

*Long-Term*
Corporate	$	10,075	$	(34	)	$	10,041	$	14,031	$	290	$	14,321
Government		89,909		(435	)		89,474		95,965		413		96,378
Other		2,375		(44	)		2,331		1,375		5		1,380

Total long-term		102,359		(513	)		101,846		111,371		708		112,079

Total investments	$	177,520	$	107		$	177,627	$	163,563	$	1,509	$	165,072

The maturity of our long-term investments ranges from one to three years.

4. Comprehensive Income

Comprehensive income is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-operational sources, such as foreign currency translation gains and losses and unrealized gains and losses on fixed income securities that are reflected in stockholders’ equity instead of net income. The following table sets forth the calculation of comprehensive income (in thousands):

	Three Months Ended August 31,
	2003			2002
Net income	$	1,819		$	1,381
Foreign currency translations gain (loss)		(248	)		721
Unrealized gain (loss) on available-for-sale investments, net of taxes		(869	)		616

Comprehensive income	$	702		$	2,718

5. Business Segment

Substantially all of the Company’s revenues result from the sale of the Company’s software products and related services. Accordingly, the Company considers itself to be in a single reporting segment, specifically the license, implementation and support of its software. The Company’s chief operating decision-making group reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance.

VERITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The Company also has sales and marketing operations located in the Netherlands, the United Kingdom, France, Germany, South Africa, Mexico, Australia, Japan, a joint investment partnership in Brazil and a development and technical support operation in Canada. Foreign branch and subsidiary revenues consist primarily of maintenance and consulting services and are being allocated based on foreign branch and subsidiary location. Disclosed in the table below is geographic information for any individual country comprising greater than ten percent of the Company’s total revenues or greater than ten percent of the Company’s long-lived assets. Rest of world (“ROW”) includes Australia, Brazil, Canada, Japan, Mexico and South Africa.

	Three Months Ended August 31,
	2003		2002
Revenues:
USA	$	17,591	$	14,409
Europe		6,625		6,785
ROW		2,387		816

Consolidated	$	26,603	$	22,010

Long-lived assets:
USA	$	30,213	$	4,119
Europe		490		836
ROW		782		1,145

Consolidated	$	31,485	$	6,100

Transfers between geographic areas are recorded at amounts generally above cost and in accordance with the rules and regulations of the respective governing tax authorities. Long-lived assets of geographic areas are those assets used in the Company’s operations in each area.

Of the total $9.0 million and $7.6 million of revenues to Europe and other foreign countries for the three months ended August 31, 2003 and 2002, there were $4.9 million and $4.0 million of export sales and $4.1 million and $3.6 million of sales derived from those foreign operations, respectively.

No single customer accounted for more than 10% of the Company’s total revenues for the three month period ended August 31, 2003 and 2002. Revenues derived from sales to the United States government and its agencies were 11.5% and 9.1% of the Company’s total revenues for the three month period ended August 31, 2003 and 2002, respectively.

The Company does not maintain discreet information on a product line basis and therefore does not disclose such information.

6. Contingencies

On June 7, 2001, Verity filed a complaint in federal district court in the Northern District of California, San Jose Division, against BroadVision, Inc. (Case No. C01-20501-PVT-ADR). Verity sought by its complaint, among other things, an injunction to prohibit BroadVision from further distribution of software which Verity had previously licensed to BroadVision, damages, including statutory damages, according to proof based on BroadVision’s unauthorized distribution of the software and attorneys’ fees.

VERITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Verity answered BroadVision’s counterclaim on July 23, 2001 and denied the material allegations of the counterclaim and asserted various affirmative defenses to BroadVision’s claims. On August 8, 2002, Verity filed a first amended complaint against BroadVision which, among other things, added an additional claim. BroadVision answered Verity’s amended complaint on August 29, 2002 and denied the material allegations of the Complaint and asserted affirmative defenses to Verity’s claims and reasserted its counterclaim. Verity answered the counterclaim on September 23, 2002 and denied the material allegations of the counterclaim and asserted various affirmative defenses to BroadVision’s claims.

On August 7, 2003, Verity reached a confidential settlement with BroadVision relative to the outstanding litigation. The detailed terms and conditions of this settlement are confidential and cannot be disclosed without the consent of each party. The settlement involves a payment to Verity from BroadVision of past royalties, a partial payment of Verity’s legal expenses and the execution of a license agreement. The payment of past royalties was recognized as revenue in the three month period ended August 31, 2003 and was less than 10% of revenues in that period.

7. Stock Repurchase Program

On June 24, 2003, the Company announced the continuation of its stock repurchase program. The continuation calls for the additional repurchase of outstanding shares of the Company’s common stock up to an aggregate value of $50.0 million. The program will terminate at the end of the fiscal year ending May 31, 2004 unless amended by the Board of Directors. Through August 31, 2003, the Company repurchased and retired 527,150 shares of its common stock through open market transactions, valued at the fair value of approximately $7.0 million.

8. Recent Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for Asset Retirement Obligations.” This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The liability is accreted to its present value each period while the cost is depreciated over its useful life. The Company’s adoption of SFAS No. 143 did not have a significant impact on the Company’s financial position or results of operations.

In October 2001, the FASB issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 supersedes “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (SFAS No. 121), however it retains the fundamental provisions of SFAS No. 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and used and (2) the measurement of long-lived assets to be disposed of by sale. SFAS No. 144 develops a single accounting model for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired assets and consequently amends Accounting Principles Board Opinion No. 30, “Reporting Results of Operations—Reporting the Effects of Disposal of a Division of a Business.” Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for the Company’s fiscal year beginning June 1, 2002. The adoption of SFAS No. 144 did not have a significant impact on the Company’s financial position or results of operations.

VERITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Products.” EITF No. 01-09 addresses whether consideration from a vendor to a reseller of the vendor’s products is an adjustment to the selling prices of the vendor’s products and, therefore, should be deducted from revenue when recognized in the vendor’s results of operations, or a cost incurred by the vendor for assets or services received from the reseller and, therefore, should be an expense when recognized in the vendor’s results of operations. EITF No. 01-09 is effective for the Company beginning November 1, 2001. The Company’s adoption of EITF No. 01-09 did not have a significant impact on the Company’s financial position or results of operations.

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 nullifies the guidance of the EITF in EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Under EITF Issue No. 94-3, an entity recognized a liability for an exit cost on the date that the entity committed itself to an exit plan. In SFAS No. 146, the FASB acknowledges that an entity’s commitment to a plan does not, by itself, create a present obligation to other parties that meets the definition of a liability and requires that a liability for a cost that is associated with an exit or disposal activity be recognized when the liability is incurred. It also establishes that fair value is the objective for the initial measurement of the liability. SFAS No. 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. The Company’s adoption of SFAS No. 146 did not have a significant impact on the Company’s financial position or results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee. The initial recognition and measurement requirement of FIN 45 is effective for guarantees issued or modified after December 31, 2002. As of February 28, 2003, the Company’s guarantees that were issued or modified after December 31, 2002 were not material. The Company’s guarantees issued before December 31, 2002, which would have been disclosed in accordance with the disclosure requirements of FIN 45, were not material.

In November 2002, the EITF reached a consensus on Issue No. 00-21 (“Issue 00-21”), “Revenue Arrangements with Multiple Deliverables.” Issue 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of Issue 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of Issue 00-21 did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

In November 2002 the EITF reached a consensus opinion on EITF No. 02-16, “Accounting by a Customer (including a reseller) for Certain Consideration Received from a Vendor.” EITF No. 02-16 requires that cash payments, credits, or equity instruments received, as consideration by a customer from a vendor should be presumed to be a reduction of cost of sales when recognized by the customer in the income statement. In certain situations, the presumption could be overcome and the consideration recognized either as revenue or a reduction of a specific cost incurred. The consensus should be applied prospectively to new or modified arrangements entered into after December 31, 2002. At August 31, 2003, the Company was not a party to transactions contemplated by EITF 02-16.

VERITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. The Company does not currently intend to adopt the fair value based method of accounting for stock-based employee compensation and will continue to apply the intrinsic-value based method. The Company has determined the fair value of option grants using the Black-Scholes stock option pricing model and has provided this pro forma disclosure of the impact of fair value accounting in note 2 to the financial statements, “Accounting for Stock-Based Compensation.”

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. FIN 46 requires that its provisions are effective immediately for all arrangements entered into after January 31, 2003. The Company does not have any variable interest entities.

On April 30, 2003, the FASB issued Statement No. 149 (“Statement 149”), Amendment of Statement 133 on Derivative Instruments and Hedging Activities. Statement 149 is intended to result in more consistent reporting of contracts as either freestanding derivative instruments subject to Statement 133 in its entirety, or as hybrid instruments with debt host contracts and embedded derivative features. In addition, Statement 149 clarifies the definition of a derivative by providing guidance on the meaning of initial net investments related to derivatives. Statement 149 is effective for contracts entered into or modified after June 30, 2003. The Company does not believe the adoption of Statement 149 will have a material effect on its consolidated financial position, results of operations or cash flows.

On May 15, 2003, the FASB issued Statement No. 150 (“Statement 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” Statement 150 establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. Statement 150 represents a significant change in practice in the accounting for a number of financial instruments, including mandatorily redeemable equity instruments and certain equity derivatives that frequently are used in connection with share repurchase programs. The Company does not use such instruments in its share repurchase program. Statement 150 is effective for all financial instruments created or modified after May 31, 2003, and to other instruments as of September 1, 2003. The adoption of Statement 150 did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

In July 2003, the EITF reached a consensus on Issue No. 03-05, “Applicability of AICPA SOP 97-2 to Non Software Deliverables in an Arrangement Containing More Than Incidental Software.” The consensus opinion in EITF No. 03-05 clarifies the guidance in EITF 00-21 and was reached on July 31, 2003. The adoption of Issue No. 03-05 did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

9. Subsequent Event

On September 10, 2003, the Company announced the elimination of approximately 40 positions within the Company, or approximately a 10 percent reduction of its employee base. The action was taken in order to reduce operating expenses and to position the Company to achieve its goal of continued profitability. The Company expects to complete the action and record a charge related to severance and other payments of approximately $1.0 million in the quarter ending November 30, 2003. The employees affected by this staffing reduction were located in the United States, Canada and Europe. The Company expects to record quarterly cost savings of approximately $1.5 million as a result of this action in the form of reduced employee compensation and benefits and other employee related expenses.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the consolidated financial statements and related notes, which appear in our Annual Report on Form 10-K for the fiscal year ended May 31, 2003. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly under the heading “Risk Factors” below.

Overview

We offer products and technology that address the business portal, e-commerce, and knowledge management markets, which we define broadly as intellectual capital management. The intellectual capital management market includes enterprise intranets and corporate portals used for sharing information within an enterprise, e-commerce sites for online selling, and extranets for business-to-business activities. Intellectual capital management solutions provide secure, personalized access to information for employees, partners, customers and suppliers, wherever that information may reside in the enterprise. We expect that for the foreseeable future we will continue to derive the largest portion of our revenues from licensing our technology for enterprise and e-commerce applications and intellectual capital management solutions.

In December 2002, we completed the acquisition of the enterprise search assets of Inktomi Corporation, further expanding our product portfolio to include solutions for smaller organizations and departments within larger enterprises. In addition to addressing these markets, the acquired enterprise search software, re-branded Verity Ultraseek, is in use at a number of larger enterprises for search-only applications as well. We are continuing development and support of the Ultraseek product line, and believe that the larger enterprises in the installed base represent an upgrade opportunity to our broader intellectual capital management solutions as their needs grow.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of assets and liabilities. On an on-going basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, bad debts, income taxes and intangible assets. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on form 10-K for the fiscal year ended May 31, 2003.

Results of Operations

The following table sets forth the percentage of total revenues represented by certain items in our Condensed Consolidated Statements of Operations for the periods indicated:

	Three Months Ended August 31,
	2003		2002
	(unaudited)
Revenues:
Software products	53.3	%	55.9	%
Service and other	46.7		44.1

Total revenues	100.0		100.0

Costs of revenues:
Software products	1.3		1.8
Service and other	12.7		12.5

Total costs of revenues	14.0		14.3

Gross profit	86.0		85.7

Operating expenses:
Research and development	20.5		24.1
Marketing and sales	45.6		48.0
General and administrative	10.9		12.1
Amortization of purchased intangible assets	2.4		0.0

Total operating expenses	79.4		84.2

Income from operations	6.6		1.5
Other income, net	4.4		8.7

Income before provision for income taxes	11.0		10.2
Provision for income taxes	4.2		3.9

Net income	6.8	%	6.3	%

Quarters Ended August 31, 2003 and 2002

Prior period financials have been reclassified to conform to presentations adopted in fiscal year 2004.

Revenues

Total revenues

August 31,

2003

August 31,

2002

Change

(dollar amounts in millions)

Three months ended:

26.6

22.0

20.9

The increase in total revenues for the three month period ended August 31, 2003, compared with the same period a year ago, was due to a $1.9 million increase in our software product revenues and to a $2.7 million increase in our service and other revenues.

The three month period ended August 31, 2003 results include the addition of our Ultraseek product, which came from the purchase of assets and assumption of obligations of Inktomi Corporation’s enterprise search software business (“Enterprise”) in December 2002. Additionally, the three month period ended August 31, 2003

includes a payment from BroadVision of past royalties in connection with the settlement of outstanding litigation, and was less than 10% of revenues in that period. Refer to Note 6 to the Notes to Condensed Consolidated Financial Statements—“Contingencies.”

Revenues derived from foreign operations accounted for 15.5% and 16.5% of total revenues for the three month period ended August 31, 2003 and 2002, respectively. Our export sales consist of products licensed for delivery outside of the United States. In the three month period ended August 31, 2003 and 2002, export sales accounted for 18.4% and 18.0% of total revenues, respectively.

No single customer accounted for 10% or more of our revenues during the three month period ended August 31, 2003 and 2002. Revenues derived from sales to the federal government and its agencies were 11.5% and 9.1% of total revenues in the three month period ended August 31, 2003 and 2002, respectively. Sales to government agencies will continue to fluctuate as a percentage of revenues in the future.

Software product revenues

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	14.2		$	12.3		15.2	%
Percentage of total revenues:		53.3	%		55.9	%

We saw an increase in demand for our software products in the three month period ended August 31, 2003, compared with the same period a year ago. This increase in software product revenues was principally the result of sales from our Ultraseek product, which we did not have prior to our acquisition of Enterprise in December 2002. Software products revenue from our non-Ultraseek products for the three month period ended August 31, 2003 included the recognition of revenue of past royalties in connection with our confidential settlement with BroadVision relative to our outstanding litigation. This revenue accounted for less than 10% of revenues in the period.

Service and other revenues

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	12.4		$	9.7		28.1	%
Percentage of total revenues:		46.7	%		44.1	%

Our service and other revenues consist primarily of fees for software maintenance, consulting and training.

The increase in service and other revenues for the three month period ended August 31, 2003, compared with the same period a year ago, was due to $0.4 million in increased sales of consulting services and to $2.3 million in increased maintenance revenues which results primarily from maintenance contracts acquired as part of the Enterprise purchase.

Costs of Revenues

Costs of software products

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	0.3		$	0.4		(13.1	)%
Percentage of software product revenues		2.4	%		3.2	%

Costs of software products consist primarily of product media, duplication, manuals, packaging materials, shipping expenses, employee compensation expenses, royalties paid to third-party vendors, and in certain instances, licensing of third-party software incorporated in our products. We believe that costs of software products will increase in absolute dollars in the quarter ending November 30, 2003, primarily as a result of increased royalties paid to third-party software vendors.

The decrease in costs of software products in absolute dollars and as a percentage of software product revenues for the three month period ended August 31, 2003, compared with the same period a year ago, was primarily attributable to a $0.1 million decrease in costs of third party software components offset, in part, by increased costs for manuals and product media associated with the recent product release of Verity K2 Enterprise 5.0. During the three month period ended August 31, 2003 and 2002, we did not capitalize any software development costs.

Costs of service and other

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	3.4		$	2.7		23.5	%
Percentage of service and other revenues		27.3	%		28.3	%

Costs of service and other consists of costs incurred in providing consulting services, customer training, telephone support and product upgrades to customers. Significant cost components include personnel-related and third-party contractor costs, facilities costs, travel expenses associated with training and consulting implementation services, depreciation expense and corporate overhead allocations. We believe that costs of service and other will remain approximately flat in absolute dollars in the quarter ending November 30, 2003.

The increase in absolute dollars for the three month period ended August 31, 2003, compared with the same period a year ago, was due primarily to a $0.6 million increase in compensation and other employee related expenses resulting from an approximately 15% higher average headcount. The higher average headcount results from the addition of personnel necessary to respond to increased demand for services and in connection with the Enterprise purchase in December 2002. The decrease as a percentage of service and other revenues, compared with the same period a year ago, results from higher utilization of personnel resulting from the increase in services rendered being greater than the increase in personnel.

Operating Expenses

Research and development

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	5.5		$	5.3		2.9	%
Percentage of total revenues		20.5	%		24.1	%

Research and development expenses consist primarily of employee compensation and benefits, payments to outside contractors, depreciation on equipment used for development and corporate overhead allocations. We believe that research and development is essential to maintaining our competitive position and we will continue to make significant investments in research and development with the goal of continuing to align research and development expenses with anticipated revenues. We believe that research and development expenses will decrease in absolute dollars in the quarter ending November 30, 2003, primarily resulting from the workforce reduction discussed in Note 9 of the Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q.

The increase in research and development expenses in absolute dollars for the three month period ended August 31, 2003, compared with the same period a year ago, was primarily due to a $0.2 million increase in compensation and other employee related expenses. The decrease in research and development expenses as a percentage of total revenues for the three month period ended August 31, 2003 was due to the increase in total revenues for the period.

Marketing and sales

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	12.1		$	10.6		14.8	%
Percentage of total revenues		45.6	%		48.0	%

Marketing and sales expenses consist primarily of employee compensation, including sales commissions and benefits, tradeshows, outbound marketing and other lead generation activities, public relations, travel expenses associated with our sales staff and corporate overhead allocations. We anticipate that we will continue to make significant investments in marketing and sales with the goal of continuing to align marketing and sales expenses with anticipated revenues. We believe that marketing and sales expenses will remain approximately flat in absolute dollars in the quarter ending November 30, 2003, resulting from the workforce reduction discussed in Note 9 of the Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q, offset by an increase in sales commissions.

The increase in marketing and sales expenses in absolute dollars for the three month period ended August 31, 2003, compared with the same period a year ago, was due to a $0.9 million increase in sales commissions resulting from the combination of higher revenue and an increased payout rate and a $0.5 million increase in overall marketing program spending, primarily attributable to the addition of the Enterprise product. Additionally, there was a $0.4 million increase in other miscellaneous expenses, offset by a $0.4 million decrease in employee related expenses associated with transferring our CEO to the general and administrative organization from marketing and sales. The decrease in marketing and sales expenses as a percentage of total revenues for the three month period ended August 31, 2003 was due to the increase in total revenues for the period.

General and administrative

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	2.9		$	2.7		8.0	%
Percentage of total revenues		10.9	%		12.1	%

General and administrative expenses consist primarily of personnel costs for finance, legal, human resources and general management, provisions for doubtful accounts, insurance, fees for external professional advisors and corporate overhead allocations. We believe that general and administrative expenses will increase modestly in the quarter ending November 30, 2003.

The increase in general and administrative expenses in absolute dollars for the three month period ended August 31, 2003, compared with the same period a year ago, was primarily related to a $0.4 million increase in employee related expenses associated with transferring our CEO to the general and administrative organization from marketing and sales, offset in part by a $0.2 million decrease in bad debt expense. The decrease in general and administrative expenses as a percentage of total revenues for the three month period ended August 31, 2003 was due to the increase in total revenues for the period.

Amortization of purchased intangible assets

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	0.6		$	0.0		—
Percentage of total revenues		2.4	%		0.0	%

During the three month period ended August 31, 2003, we amortized $0.6 million of the purchased intangible assets in connection with acquired technology, patents and maintenance agreements from our Enterprise purchase. We will record quarterly amortization expenses of $0.6 million associated with the purchased intangible assets of Enterprise over the estimated useful life of 5 years from the quarter ended February 28, 2003.

Other income, net

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	1.2		$	1.9		(37.8	)%
Percentage of total revenues		4.4	%		8.7	%

Other income, net consists primarily of interest income, net and realized gains (losses) from our investments in marketable securities and gains (losses) on our foreign currency forward contracts.

The decrease in other income in absolute dollars for the three month period ended August 31, 2003, compared with the same period a year ago, was primarily due to decreasing overall yields on our portfolio of marketable securities caused by the decreasing interest rate environment, partially offset by a slightly higher balance of marketable securities. The decrease in other income, net as a percentage of total revenues for the three month period ended August 31, 2003 was due to the decrease in absolute dollars combined with the increase in total revenues.

Income tax provision

	August 31, 2003			August 31, 2002			Change
	(dollar amounts in millions)
Three months ended:	$	1.1		$	0.8		31.6	%
Percentage of total revenues		4.2	%		3.9	%

Income tax provision includes U.S. and foreign income taxes, as well as the provision for U.S. taxes on undistributed earnings of international subsidiaries. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of this difference is reported as deferred income taxes.

We expect the tax savings for fiscal 2004 due to research and development tax credits to result in a marginally lower effective tax rate and accordingly applied an effective tax rate of 38.0% to the results of our quarter ended August 31, 2003. We will continue to reassess the impact of our research and development expenses on our effective tax rate in future periods.

Liquidity and Capital Resources

Three month period ended	August 31, 2003			August 31, 2002
	(dollar amounts in millions)
Net cash provided by operating activities	$	1.9		$	3.3
Net cash used in investing activities	($	14.4	)	($	6.5	)
Net cash used in financing activities	($	3.4	)	($	6.1	)

As of August 31, 2003, we had $247.3 million in cash and cash equivalents and available-for-sale securities compared to $250.7 million at May 31, 2003. At August 31, 2003, our principal sources of liquidity were our cash and cash equivalents and short-term investments of $145.4 million. As of August 31, 2003, we had no outstanding long-term debt obligations.

Cash provided by operating activities for the three month period ended August 31, 2003 was primarily due to our net income of $1.8 million, which reflected among other non-cash charges a charge for depreciation and amortization of $1.5 million, which we add back to reconcile net income to net cash provided by operating activities. Cash provided by operating activities also includes a $2.8 million decrease in accounts receivable, partially offset by a $1.6 million decrease in deferred revenue, a $1.1 million decrease in accounts payable, a $1.0 million increase in prepaid and other current assets and a $0.8 million decrease in accrued compensation and other accrued liabilities. Cash provided by operating activities for the three month period ended August 31, 2002 was primarily due to our net income of $1.4 million, which reflected among other non-cash charges a charge for depreciation and amortization of $0.9 million, which we add back to reconcile net income to net cash provided by operating activities. Cash provided by operating activities also includes a $4.0 million decrease in accounts receivable, and a $0.8 million decrease in prepaid and other current assets, partially offset by a $2.8 million decrease in deferred revenue, a $1.0 million decrease in accrued compensation and other accrued liabilities and a $1.0 million decrease in accounts payable.

Cash used in investing activities for the three month period ended August 31, 2003 and 2002 was the result of capital expenditures of $0.7 million and $0.4 million in the respective periods and net purchases of marketable securities. For the three month period ended August 31, 2003 and 2002, the capital expenditures consisted primarily of purchases of computer hardware and software.

Cash used in financing activities for the three month period ended August 31, 2003 was primarily due to $7.0 million in repurchases of our common stock through our stock repurchase program, partially offset by $3.6 million in proceeds from the sale of common stock as a result of stock option exercises. Cash used in financing activities for the three month period ended August 31, 2002 consisted of $6.6 million in repurchases of our common stock through our stock repurchase program, partially offset by $0.5 million in proceeds from the sale of common stock as a result of stock option exercises.

Our principal commitments as of August 31, 2003 consist of obligations under operating leases, totaling $9.9 million over the life of these leases.

Under our operating leases, we have minimum rental payments as follows:

Fiscal Year Ending May 31,	Rental Payments
2004	$	2,438
2005		2,714
2006		1,463
2007		1,434
2008 and thereafter		1,861

	$	9,910

On June 24, 2003, we announced the continuation of our stock repurchase program. The continuation calls for the additional repurchase of outstanding shares of our common stock up to an aggregate value of $50.0 million. The program will terminate at the end of the fiscal year ending May 31, 2004 unless amended by the Board of Directors. Through August 31, 2003, we repurchased and retired 527,150 shares of our common stock through open market transactions, valued at the fair value of approximately $7.0 million

We believe that our current cash and cash equivalents, interest income and cash generated from operations, if any, will provide adequate liquidity to meet our working capital and operating resource expenditure requirements through at least fiscal 2004. If the global economy weakens further, our cash, cash equivalents and investments balances may decline. As a result, or if our spending plans materially change, we may find it necessary to seek to obtain additional sources of financing to support our capital needs, but we cannot assure you that a financing will be available on commercially reasonable terms, or at all.

Recent Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for Asset Retirement Obligations.” This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The liability is accreted to its present value each period while the cost is depreciated over its useful life. The adoption of SFAS No. 143 did not have a significant impact on our financial position or results of operations.

In October 2001, the FASB issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 supersedes “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (SFAS No. 121), however it retains the fundamental provisions of SFAS No. 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and used and (2) the measurement of long-lived assets to be disposed of by sale. SFAS No. 144 develops a single accounting model for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired assets and consequently amends Accounting Principles Board Opinion No. 30, “Reporting Results of Operations—Reporting the Effects of Disposal of a Division of a Business.” Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for our fiscal year beginning June 1, 2002. The adoption of SFAS No. 144 did not have a significant impact on our financial position or results of operations.

In November 2001, the Emerging Issues Task Force (“EITF”) of the FASB reached a consensus on Issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products.” EITF No. 01-09 addresses whether consideration from a vendor to a reseller of the vendor’s products is an adjustment to the selling prices of the vendor’s products and, therefore, should be deducted from revenue when recognized in the vendor’s results of operations, or a cost incurred by the vendor for assets or services received from the reseller and, therefore, should be an expense when recognized in the vendor’s results of operations. EITF No. 01-09 is effective for us beginning November 1, 2001. The adoption of EITF No. 01-09 did not have a significant impact on our financial position or results of operations.

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 nullifies the guidance of the EITF in EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Under EITF Issue No. 94-3, an entity recognized a liability for an exit cost on the date that the entity committed itself to an exit plan. In SFAS 146, the FASB acknowledges that an entity’s commitment to a plan does not, by itself, create a present obligation to other parties that meets the definition of a liability and requires that a liability for a cost that is associated with an exit or disposal activity be recognized when the liability is incurred. It also establishes that fair value is the objective for the initial measurement of the liability. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a significant impact on our financial position or results of operations.

In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of certain guarantees or indemnifications. In addition, FIN 45 requires disclosures about the guarantees or indemnifications that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees or indemnifications issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements are effective for financial statements for interim or annual periods issued after December 15, 2002. We have adopted the disclosure provisions of FIN 45 and evaluated the impact of the measurement provisions on the our financial position and results of operations. As of May 31, 2003, our guarantees that were issued or modified after December 31, 2002 were not material. Our guarantees issued before December 31, 2002, which would have been disclosed in accordance with the disclosure requirements of FIN 45, were not material.

In November 2002, the EITF reached a consensus on Issue No. 00-21 (“Issue 00-21”), “Revenue Arrangements with Multiple Deliverables.” Issue 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of Issue 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of Issue 00-21 did not have a material effect on our consolidated financial position, results of operations or cash flows.

In November 2002 the EITF reached a consensus opinion on EITF No. 02-16, “Accounting by a Customer (including a reseller) for Certain Consideration Received from a Vendor.” EITF No. 02-16 requires that cash payments, credits, or equity instruments received, as consideration by a customer from a vendor should be presumed to be a reduction of cost of sales when recognized by the customer in the income statement. In certain situations, the presumption could be overcome and the consideration recognized either as revenue or a reduction of a specific cost incurred. The consensus should be applied prospectively to new or modified arrangements entered into after December 31, 2002. At August 31, 2003, we were not a party to any transactions contemplated by EITF 02-16.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” SFAS No. 148 amends certain provisions of SFAS No. 123 and is effective for financial statements for fiscal years ending after December 15, 2002. It provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires the disclosure of the pro forma effects on an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. We do not currently intend to adopt the fair value based method of accounting for stock-based employee compensation and will continue to apply the intrinsic-value based method. We have determined the fair value of option grants using the Black-Scholes stock option pricing model and have provided this pro forma disclosure of the impact of fair value accounting in note 2 to the financial statements, “Accounting for Stock-Based Compensation.”

derivatives. Statement 149 is effective for contracts entered into or modified after June 30, 2003. We do not believe the adoption of Statement 149 will have a material effect on our consolidated financial position, results of operations or cash flows.

On May 15, 2003, the FASB issued Statement No. 150 (“Statement 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” Statement 150 establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. Statement 150 represents a significant change in practice in the accounting for a number of financial instruments, including mandatorily redeemable equity instruments and certain equity derivatives that frequently are used in connection with share repurchase programs. We do not use such instruments in our share repurchase program. Statement 150 is effective for all financial instruments created or modified after May 31, 2003, and to other instruments as of September 1, 2003. The adoption of Statement 150 did not have a material effect on our consolidated financial position, results of operations or cash flows.

In July 2003, the EITF reached a consensus on Issue No. 03-05, “Applicability of AICPA SOP 97-2 to Non Software Deliverables in an Arrangement Containing More Than Incidental Software.” The consensus opinion in EITF No. 03-05 clarifies the guidance in EITF 00-21 and was reached on July 31, 2003. The adoption of Issue No. 03-05 did not have a material effect on our consolidated financial position, results of operations or cash flows.

RISK FACTORS

The risks and uncertainties described below are not the only risks and uncertainties we face. Additional risks and uncertainties not currently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks actually occur, our business, results of operations and financial condition would suffer. In that event, the trading price of our common stock could decline, and our stockholders may lose all or part of their investment in our common stock. The discussion below and elsewhere in this report also includes forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements as a result of the risks discussed below.

Risks Related to Our Business

We have sustained quarterly and annual losses in the past and may not be able to maintain profitability

We have incurred net losses in the past and, although we reported net income in fiscal years 2002 and 2003 and the first quarter of fiscal year 2004, we may not be able to maintain profitability. In the future, our revenues may decline, remain flat, or grow at a rate slower than was experienced in fiscal year 2003, especially in light of the current economic environment. To achieve revenue growth and maintain fiscal year profitability, we must:

•

increase market acceptance of our products;

•

respond effectively to competitive developments;

•

execute sales despite the recent economic slowdown and resulting decrease in our customers’ capital spending;

•

attract, retain and motivate qualified personnel; and

•

upgrade our technologies and commercialize our products and services incorporating these technologies.

We cannot assure you that we will be successful in achieving any of these goals or that we will experience increased revenues, positive cash flows, or achieve long-term profitability.

Our revenues and operating results may fluctuate in future periods, which could adversely affect our stock price

The results of operations for any quarter are not necessarily indicative of results to be expected in future periods. We expect our stock price to vary with our operating results and, consequently, any adverse fluctuations in our operating results could have an adverse effect on our stock price. Our operating results have in the past been, and will continue to be, subject to quarterly fluctuations as a result of a number of factors. These factors include:

•

the downturn in capital spending by customers;

•

the size and timing of orders;

•

changes in the budget or purchasing patterns of customers or potential customers, changes in foreign country exchange rates, or pricing pressures from competitors;

•

increased competition in the software and Internet industries;

•

the introduction and market acceptance of new technologies and standards in search and retrieval, Internet, document management, database, networking, and communications technology;

•

variations in sales channels, product costs, the mix of products sold, or the success of quality control measures;

•

the integration of people, operations, and products from acquired businesses and technologies;

•

changes in operating expenses and personnel;

•

changes in accounting principals, such as a requirement that stock options be included in compensation, which is widely expected to occur and may become effective as early as 2004 and, which if adopted, would increase our compensation expenses and have a negative effect on our earnings;

•

the overall trend toward industry consolidation; and

•

changes in general economic and geo-political conditions and specific economic conditions in the computer and software industries.

Any of the factors, some of which are discussed in more detail below, could materially and adversely impact our operations and financial results, and consequently cause our stock price to fall.

Our expenditures are tied to anticipated revenues, and therefore imprecise revenue forecasts may result in poor operating results

Revenues are difficult to forecast because the market for search and retrieval software is uncertain and evolving. Because we generally ship software products within a short period after receipt of an order, we typically do not have a material backlog of unfilled orders, and revenues in any quarter are substantially dependent on orders booked in that quarter. In addition, a portion of our revenues is derived from royalties based upon sales by third-party vendors of products incorporating our technology. These revenues may be subject to extreme fluctuation and are difficult for us to predict. Our expense levels are based, in part, on our expectations as to future revenues and are, to a large extent, fixed in the short term. Therefore, we may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Any significant shortfall of demand in relation to our expectations or any material delay of customer orders would have an almost immediate adverse affect on our operating results and on our ability to achieve profitability.

Demand for our products may be adversely affected if unfavorable economic and market conditions do not improve or continue to decline

Adverse economic conditions worldwide have contributed to slowdowns in the software information technology spending environment and may continue to impact our business, resulting in reduced demand for our products as a result of a decrease in capital spending by our customers, increased price competition for our products and higher overhead costs as a percentage of revenues. Decreased demand for our products would result in decreased revenues, which could harm our operating results and cause the price of our common stock to fall.

Changes in effective tax rates could affect our results

Our future effective tax rates could be adversely affected by earnings being lower than anticipated in foreign countries where we have lower statutory rates, changes in the valuation of our deferred tax assets and liabilities, or changes in U.S. or foreign tax laws or interpretations thereof.

The size and timing of large orders may materially affect our quarterly operating results

The size and timing of individual orders may cause our operating results to fluctuate significantly. Our operating results for a quarter could be materially and adversely affected if one or more large orders are either not received or are delayed or deferred by customers. A significant portion of our revenues in recent quarters has been derived from these relatively large sales to a limited number of customers, and we currently anticipate that future quarters will continue to reflect this trend. Sales cycles for these customers can be up to nine months or longer. In addition, customer order deferrals in anticipation of new products may cause our operating results to fluctuate. Like many software companies, we have generally recognized a substantial portion of our revenues in

the last month of each quarter, with these revenues concentrated in the last weeks of the quarter. Accordingly, the cancellation or deferral of even a small number of purchases of our products could harm our business in any particular quarter. In addition, to the extent that the significant sales occur earlier than expected, operating results for subsequent quarters may fail to keep pace or even decline.

Our sales cycle is lengthy and unpredictable

Any delay in sales of our products and services could cause our quarterly revenue and operating results to fluctuate. The typical sales cycle of our products is lengthy, generally between six to eighteen months, unpredictable, and involves significant investment decisions by prospective customers, as well as our education of potential customers regarding the use and benefits of our products. Our customers spend a substantial amount of time before purchasing our products in performing internal reviews and obtaining capital expenditure approvals. We believe our sales cycle lengthened in 2002 and 2003 as a result of macro-economic factors and we cannot be certain that this cycle will not continue to lengthen in the future.

Our business may suffer due to risks associated with international sales

Historically, our foreign operations and export sales account for a significant portion of our annual revenues. Our international business activities are subject to a number of risks, each of which could impose unexpected costs on us that would have an adverse effect on our operating results. These risks include:

•

difficulties in complying with regulatory requirements and standards;

•

tariffs and other trade barriers;

•

costs and risks of localizing products for foreign countries;

•

reliance on third parties to distribute our products;

•

longer accounts receivable payment cycles;

•

potentially adverse tax consequences;

•

adverse fluctuations in monetary exchange rates;

•

limits on repatriation of earnings; and

•

burdens of complying with a wide variety of foreign laws.

We currently engage in only limited hedging activities to protect against the risk of currency fluctuations. Fluctuations in currency exchange rates could cause sales denominated in U.S. dollars to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. Also, these fluctuations could cause sales denominated in foreign currencies to affect a reduction in the current U.S. dollar revenues derived from sales in a particular country. Furthermore, future international activity may result in increased foreign currency denominated sales and, in this event, gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute significantly to fluctuations in our results of operations. The financial stability of foreign markets could also affect our international sales. In addition, income earned in various countries where we do business may be subject to taxation by more than one jurisdiction, thereby adversely affecting our consolidated after-tax earnings. We cannot assure you that any of these factors will not have an adverse effect on the revenues from our future international sales and, consequently, our results of operations.

Service and other revenues derived from foreign operations accounted for 15.5%, 15.0%, 13.9% and 6.3% of total revenues for the three month period ended August 31, 2003 and fiscal years 2003, 2002 and 2001, respectively. Our export sales consist primarily of products licensed for delivery outside of the United States. For the three month period ended August 31, 2003 and fiscal years 2003, 2002 and 2001, export sales accounted for

18.4%, 22.4%, 21.8% and 26.0% of total revenues, respectively. We expect that revenues derived from foreign operations and export sales will continue to account for a significant percentage of our revenues for the foreseeable future. These revenues may fluctuate significantly as a percentage of revenues from period to period. In addition, a portion of these revenues was derived from sales to foreign government agencies, which may be subject to risks similar to those described immediately below.

A portion of our revenues is derived from sales to the federal and state governments, which are subject to budget cuts and, consequently, the potential loss of revenues upon which we have historically relied

Revenues derived from sales to the federal and state governments and their agencies were 11.5%, 9.8%, 6.1% and 7.4% of total revenues for the three month period ended August 31, 2003 and fiscal years 2003, 2002 and 2001, respectively. Future reductions in government spending on information technologies could harm our operating results. In recent years, budgets of many governments and/or their agencies have been reduced, causing certain customers and potential customers of our products to re-evaluate their needs. These budget reductions are expected to continue over at least the next several years.

Almost all of our government contracts contain termination clauses, which permit contract termination upon our default or at the option of the other contracting party. We cannot assure you a cancellation will not occur in the future, and any termination would adversely affect our operating results.

We must successfully introduce new products or our customers will purchase our competitors products

During the past few years, management and other personnel have focused on modifying and enhancing our core technology to support a broader set of search and retrieval solutions for use on enterprise-wide systems, over online services, over the Internet and on CD-ROM. In order for our strategy to succeed and to remain competitive, we must continue to leverage our core technology to develop new product offerings by us and by our OEM customers that address the needs of these new markets or we must acquire new technology. The development of new products, whether by leveraging our core technology or by acquiring new technology, is expensive. If these new products do not generate substantial revenues, our business and results of operations will be adversely affected. We cannot assure you that any of these new products will be successfully developed and completed on a timely basis or at all, will achieve market acceptance or will generate significant revenues.

Our future operating results will depend upon our ability to increase the installed base of our information retrieval technology and to generate significant product revenues from our core products. Our future operating results will also depend upon our ability to successfully market our technology to online and Internet publishers who use this technology to index their published information in our format. To the extent that customers do not adopt our technology for indexing their published information, it will limit the demand for our products.

If we are unable to enhance our existing products to conform to evolving industry standards in our rapidly changing markets, our products may become obsolete

The computer software industry is subject to rapid technological change, changing customer requirements, frequent new product introductions, and evolving industry standards that may render existing products and services obsolete. As a result, our position in our existing markets or other markets that we may enter could be eroded rapidly by any of these factors, including product advancements by competitors. If we are unable to develop and introduce products in a timely manner in response to changing market conditions or customer requirements, our financial condition and results of operations would be materially and adversely affected.

The life cycles of our products are difficult to estimate. Our future success will depend upon our ability to keep pace with technological developments, conform to evolving industry standards, particularly client/server and Internet communication and security protocols, as well as publishing formats such as HTML and XML, and address increasingly sophisticated customer needs. We cannot assure you that we will not experience difficulties

that could delay or prevent the successful development, introduction and marketing of new products, or that new products and product enhancements will meet the requirements of the marketplace and achieve market acceptance.

We strive to achieve compatibility between our products and the text publication formats we believe are or will become popular and widely adopted. We invest substantial resources in development efforts aimed at achieving compatibility. Any failure by us to anticipate or respond adequately to technology or market developments could result in a loss of competitiveness or revenue. For instance, to date we have focused our efforts on integration with the Adobe PDF and Lotus Notes environments and, more recently, the Microsoft Exchange environment. Should any of these products or technologies lose or fail to achieve acceptance in the marketplace or be replaced by other products or technologies, our business could be materially and adversely affected.

We embed our basic search engine in key OEM application products and, therefore, our sales of information retrieval products depend on our ability to maintain compatibility with these OEM applications. We cannot assure you that we will be able to maintain compatibility with these vendors’ products or continue to be the search technology of choice for OEMs. The failure to maintain compatibility with or be selected by OEMs would materially and adversely affect our sales. Further, the failure of the products of our key OEM partners to achieve market acceptance could harm our results of operations.

Our software products are complex and may contain errors that could damage our reputation and decrease sales

Our complex software products may contain errors that may be detected at any point in the products’ life cycles. We have in the past discovered software errors in some of our products and have experienced delays in shipment of products during the periods required to correct these errors. We cannot assure you that, despite our testing and quality assurance efforts and similar efforts by current and potential customers, errors will not be found. The discovery of an error may result in loss of or delay in market acceptance and sales, diversion of development resources, injury to our reputation, or increased service and warranty costs, any of which could harm our business. Although we generally attempt by contract to limit our exposure to incidental and consequential damages, and to cap our liabilities to our proceeds under the contract, if a court fails to enforce the liability limiting provisions of our contracts for any reason, or if liabilities arise which are not effectively limited, our operating results could be harmed.

We are dependent on proprietary technologies licensed from third parties, the loss of which could delay shipments of products incorporating these technologies and could be costly

Some of the technology used by our products is licensed from third parties, generally on a nonexclusive basis. We believe that there are alternative sources for each of the material components of technology we license from third parties. However, the termination of any of these licenses, or the failure of the third-party licensors to adequately maintain or update their products, could result in delay in our ability to ship these products while we seek to implement technology offered by alternative sources. Any required replacement licenses could prove costly. Also, any delay, to the extent it becomes extended or occurs at or near the end of a fiscal quarter, could harm our quarterly results of operations. While it may be necessary or desirable in the future to obtain other licenses relating to one or more of our products or relating to current or future technologies, we cannot assure you that we will be able to do so on commercially reasonable terms or at all.

Our ability to compete successfully will depend, in part, on our ability to protect our intellectual property rights, which we may not be able to protect

We rely on a combination of patent, trade secrets, copyright and trademark laws, nondisclosure agreements and other contractual provisions and technical measures to protect our intellectual property rights. The source

code for our proprietary software is protected both as a trade secret and as a copyrighted work. Policing unauthorized use of our products, however, is difficult. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Litigation could result in substantial costs and diversion of resources and could harm our business regardless of the outcome of the litigation.

Effective copyright and trade secret protection may be unavailable or limited in some foreign countries. To license our products, we frequently rely on “shrink wrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of several jurisdictions. In addition, employees, consultants and others who participate in the development of our products may breach their agreements with us regarding our intellectual property, and we may not have adequate remedies for any such breach. We also realize that our trade secrets may become known through other means not currently foreseen by us. Notwithstanding our efforts to protect our intellectual property, our competitors may be able to develop products that are equal to or superior to our products without infringing on any of our intellectual property rights.

Our products employ technology that may infringe on the proprietary rights of third parties, which may expose us to litigation

Third parties may assert that our products infringe their proprietary rights, or may assert claims for indemnification resulting from infringement claims against us. Any such claims may cause us to delay or cancel shipment of our products, which could harm our business. In addition, irrespective of the validity or the successful assertion of claims, we could incur significant costs in defending against claims. To date, no third party has asserted such claims.

We have been sued in the past and are at risk of future securities class action litigation, due to our past and expected stock price volatility

In the past, securities class action litigation has often been brought against companies following a decline in the market price of their securities. For example, in December 1999 our stock price dramatically declined and a number of lawsuits were filed against us. Because we expect our stock price to continue to fluctuate significantly, we may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and resources, and could seriously harm our business.

If we lose key personnel, or are unable to attract additional qualified personnel, our ability to conduct and grow our business will be impaired

We believe that hiring and retaining qualified individuals at all levels is essential to our success, and we cannot assure you that we will be successful in attracting and retaining the necessary personnel. In addition, we are highly dependent on our direct sales force for sales of our products as we have limited distribution channels. Continuity of technical personnel is an important factor in the successful completion of development projects, and any turnover of our research and development personnel could harm our development and marketing efforts.

Our future success also depends on our continuing ability to identify, hire, train and retain other highly qualified sales, technical and managerial personnel. Competition for this type of personnel is intense, and we cannot assure you that we will be able to attract, assimilate or retain other highly qualified technical and managerial personnel in the future. The inability to attract, hire or retain the necessary sales, technical and managerial personnel could harm our business.

We face intense competition from companies with significantly greater financial, technical, and marketing resources, which could adversely affect our ability to maintain or increase sales of our products

The information retrieval, classification and recommendation software markets are intensely competitive and we cannot assure you that we will maintain our current position or market share. A number of companies

offer competitive products addressing these markets. In the enterprise market, we compete with Autonomy, Convera, Endeca, FAST, Google, Hummingbird, iPhrase, Mercado, Microsoft, Open Text and Thunderstone, among others. Plumtree is on occasion a competitor, but is viewed primarily as our partner and customer. In the Internet/publishing market, we compete with Autonomy, Convera, Dataware, FAST, iPhrase, Lotus and Microsoft, among others. We also compete indirectly with database vendors, such as Oracle, that offer information search and retrieval capabilities with their core database products, as well as with ERP (Enterprise Resource Planning) vendors, such as SAP, that offer these capabilities as part of their overall solution.

In the future, we may encounter competition from a number of companies. Many of our existing competitors, as well as a number of other potential new competitors, have significantly greater financial, technical and marketing resources than we do. Because the success of our strategy is dependent in part on the success of our strategic customers, competition between our strategic customers and the strategic customers of our competitors, or failure of our strategic customers to achieve or maintain market acceptance could harm our competitive position. Although we believe that our products and technologies compete favorably with competitive products, we cannot assure you that we will be able to compete successfully against our current or future competitors or that competition will not harm our business.

Our recent acquisition of the Inktomi enterprise search software assets and other potential acquisitions may have unexpected consequences or impose additional costs on us

Our business is highly competitive and our growth is dependent upon market growth and our ability to enhance our existing products and introduce new products on a timely basis. One of the ways we may address the need to develop new products is through acquisitions of complementary businesses and technologies, such as our acquisition of Inktomi’s enterprise search software assets. From time to time, we consider and evaluate potential business combinations both involving our acquisition of another company and transactions involving the sale of Verity through, among other things, a possible merger or consolidation of our business into that of another entity. Acquisitions involve numerous risks, including the following:

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difficulties in integration of the operations, technologies, products and personnel of the acquired companies;

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the risk of diverting management’s attention from normal daily operations of the business;

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accounting consequences, including changes in purchased research and development expenses, resulting in variability in our quarterly earnings;

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potential difficulties in completing projects associated with purchased in-process research and development;

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risks of entering markets in which we have no or limited direct prior experience and where competitors in these markets have stronger market positions;

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the potential loss of key employees of the acquired company;

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the assumption of known and potentially unknown liabilities of the acquired company;

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we may find that the acquired company or assets do not further our business strategy or that we paid more than what the company or assets are worth;

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we may have product liability associated with the sale of the acquired company’s products;

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we may have difficulty maintaining uniform standards, controls, procedures and policies;

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our relationship with current and new employees and clients could be impaired;

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the acquisition may result in litigation from terminated employees or third parties who believe a claim against us would be valuable to pursue;

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our due diligence process may fail to identify significant issues with product quality, product architecture and legal contingencies, among other matters; and

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insufficient revenues to offset increased expenses associated with acquisitions.

Acquisitions may also cause us to:

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issue common stock that would dilute our current stockholders’ percentage ownership;

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record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges;

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incur amortization expenses related to certain intangible assets; or

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incur large and immediate write-offs.

We cannot assure you that our acquisition of Inktomi’s enterprise search software assets and future acquisitions will be successful and will not adversely affect our business. We must also maintain our ability to manage any growth effectively. Failure to manage growth effectively and successfully integrate acquisitions we make could harm our business.

If we account for employee stock option and employee stock purchase plans using the fair value method, it could significantly reduce our net income and earnings per share

There has been ongoing public debate whether employee stock option and employee stock purchase plans shares should be treated as a compensation expense and, if so, how to properly value such charges. If we elected or were required to record an expense for our stock-based compensation plans using the fair value method, we could have significant accounting charges. For example, in the first quarter of fiscal year 2004, had we accounted for stock-based compensation plans using the fair-value method prescribed in FASB Statement No. 123 as amended by Statement 148, earnings per share would have been reduced by $0.40 per share. Although we are not currently required to record any compensation expense using the fair value method in connection with option grants to employees that have an exercise price at or above fair market value at the grant date and for shares issued under our employee stock purchase plan, it is possible that future laws or regulations will require us to treat all stock-based compensation as an expense using the fair value method. See Note 2 to Consolidated Financial Statements for a more detailed presentation of accounting for stock-based compensation plans.

Risks Related to Our Industry

We depend on increasing use of the Internet, intranets, extranets and portals and on the growth of electronic commerce. If the use of the Internet, intranets, extranets and portals and electronic commerce do not grow as anticipated, our business will be seriously harmed

The products of most of our customers depend on the increased acceptance and use of the Internet as a medium of commerce and on the development of corporate intranets, extranets and portals. As a result, acceptance and use may not continue to develop at historical rates and a sufficiently broad base of business customers may not adopt or continue to use the Internet as a medium of commerce. The lack of such development would impair demand for our products and would adversely affect our ability to sell our products. Demand and market acceptance for recently introduced services and products over the Internet and the development of corporate intranets, extranets and portals are subject to a high level of uncertainty, and there exist few proven services and products.

The business of many of our customers, and consequently our ability to sell our products, would be seriously harmed if:

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use of the Internet, the Web and other online services does not continue to increase or increases more slowly than expected;

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the infrastructure for the Internet, the Web and other online services does not effectively support expansion that may occur; or

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the Internet, the Web and other online services do not create a viable commercial marketplace, inhibiting the development of electronic commerce and reducing the need for our products and services.

Capacity constraints may restrict the use of the Internet as a commercial marketplace, which would restrict our growth

The Internet may not be accepted as a viable long-term commercial marketplace for a number of reasons. These include:

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potentially inadequate development of the necessary communication and network infrastructure, particularly if rapid growth of the Internet continues;

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delayed development of enabling technologies and performance improvements;

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delayed development or adoption of new standards and protocols; and

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increased governmental regulation.

Our ability to grow our business is dependent on the growth of the Internet and, consequently, any adverse events would impair our ability to grow our business.

Security risks and concerns may deter the use of the Internet for conducting electronic commerce, which would adversely affect the demand for our products

A significant barrier to electronic commerce and communications is the secure transmission of confidential information over public networks. Advances in computer capabilities, new discoveries in the field of cryptography or other events or developments could result in compromises or breaches of our security systems or those of other web sites to protect proprietary information. If any well-publicized compromises of security were to occur, it could have the effect of substantially reducing the use of the Internet for commerce and communications, resulting in reduced demand for our products, thus adversely affecting our revenues.

Security risks expose us to additional costs and to litigation

Anyone who circumvents our security measures could misappropriate proprietary information or cause interruptions in our services or operations. The Internet is a public network, and data is sent over this network from many sources. In the past, computer viruses, software programs that disable or impair computers, have been distributed and have rapidly spread over the Internet. We may be required to expend significant capital and other resources to protect against the threat of security breaches or to alleviate problems caused by breaches. To the extent that our activities may involve the storage and transmission of proprietary information, such as credit card numbers, security breaches could expose us to a risk of loss or litigation and possible liability. Our security measures may be inadequate to prevent security breaches, and our business would be harmed if we do not prevent them.

Risks Related to Ownership of Our Common Stock

The market price of our common stock will fluctuate and you may lose all or part of your investment

Our common stock is quoted for trading on the Nasdaq National Market. The market price for our common stock has been, and may continue to be, highly volatile for a number of reasons including:

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future announcements concerning us or our competitors;

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quarterly variations in operating results;

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announcements of technological innovations;

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the introduction of new products or changes in product pricing policies by us or our competitors;

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announcements of acquisitions by us or competitors;

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litigation involving proprietary rights or other matters; and

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changes in earnings estimates by analysts or other factors.

In addition, stock prices for many technology companies fluctuate widely for reasons, which may be unrelated to operating results. These fluctuations, as well as general economic, market and political conditions such as recessions, terrorist attacks or military conflicts, may materially and adversely affect the market price of our common stock.

We have implemented certain anti-takeover provisions that may prevent or delay an acquisition of Verity that might be beneficial to our stockholders

Provisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could make it more difficult for a third-party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:

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establishment of a classified board of directors such that not all members of the board may be elected at one time;

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the ability of the board of directors to issue, without stockholder approval, up to 1,999,995 shares of preferred stock to increase the number of outstanding shares and thwart a takeover attempt;

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no provision for cumulative voting in the election of directors, which would otherwise allow less than a majority of stockholders to elect director candidates;

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limitations on who may call special meetings of stockholders;

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prohibiting stockholder action by written consent, thereby requiring all stockholder actions to be taken at a meeting of our stockholders; and

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advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.

We also have in place a Share Purchase Rights Plan, commonly referred to as a “poison pill.” In addition, the anti-takeover provisions of Section 203 of the Delaware General Corporations Law and the terms of our stock option plan may discourage, delay or prevent a change in control of Verity.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk. The primary objective of our investment activities is to preserve the principal while at the same time maximize yields without significantly increasing our risk. To achieve this objective, we maintain our portfolio of cash equivalents and investments in a variety of securities, including both government and corporate obligations and money market funds. As of August 31, 2003, approximately 59% of our portfolio matures in one year or less, with the remainder maturing in less than three years. We do not use derivative financial instruments in our investment portfolio. We place our investments with high credit quality issuers and, by policy, limit the amount of credit exposure to any one issuer.

The following table presents the amounts of our cash equivalents and investments that are subject to interest rate risk by year of expected maturity and average interest rates as of August 31, 2003:

	FY2004			FY2005			FY2006		FY2007		Total			Fair Value
	(Dollars in thousands)
Cash equivalents	$	69,648			—		—		—		$	69,648		$	69,648
Average interest rate		1.2	%		—		—		—			1.2	%		1.2	%
Fixed-rate securities	$	46,421		$	35,796		46,530		23,720		$	152,467		$	152,467
Average interest rate		4.4	%		2.4	%	2.4	%	2.2	%		3.0	%		3.0	%
Variable-rate securities	$	25,160			—		—		—		$	25,160		$	25,160
Average interest rates		1.1	%		—		—		—			1.1	%		1.1	%

Foreign Currency Risk. We transact business in various foreign currencies, including the Euro, the British pound, the Canadian dollar, the Australian dollar, the Swedish krona, the South African rand, the Mexican peso, the Brazilian real, the Japanese yen and the Singaporean dollar. We have established a foreign currency hedging program utilizing foreign currency forward exchange contracts to offset the risk associated with the effects of certain foreign currency transaction exposures. Under this program, increases or decreases in our foreign currency transactions are in part offset by gains and losses on the forward contracts, so as to mitigate the possibility of foreign currency transaction gains and losses. These foreign currency transactions typically arise from intercompany transactions.

Our forward contracts generally have terms of 90 days or less. We do not use forward contracts for trading purposes. All foreign currency transactions and all outstanding forward contracts (non equity hedges) are marked to market at the end of the period with any changes in market value included in Other income (expense). Our ultimate realized gain or loss with respect to currency fluctuations will depend on the currency exchange rates and other factors in effect as the contracts mature. Net foreign exchange transaction gains (losses) included in Other income, net in the accompanying consolidated of operations were ($222,000) and ($127,000) in the three month period ended August 31, 2003 and 2002, respectively. The fair value of the foreign currency exchange contracts was not material to our consolidated financial statements.

Item 4. Controls and Procedures

Limitations on the Effectiveness of Controls. Our management, including the Chief Executive Officer and Chief Financial Officer, believes that our disclosure controls and procedures and our internal control over financial reporting will provide reasonable assurance that all errors will be detected, but does not expect that our disclosure controls and procedures or our internal control over financial reporting will provide absolute assurance that all errors will be detected. 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. 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 Verity 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, controls 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.

Evaluation of Disclosure Controls and Procedures. An evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of August 31, 2003. Based on that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of August 31, 2003, to provide reasonable assurance that the information required to be disclosed by us in this Quarterly Report on Form 10-Q was recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and Form 10-Q.

Changes in Internal Control over Financial Reporting. During the three month period ended August 31, 2003, there were no changes in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On June 7, 2001, Verity filed a complaint in federal district court in the Northern District of California, San Jose Division, against BroadVision, Inc. (Case No. C01-20501-PVT-ADR), as described in Item 3 of Verity’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on August 7, 2003. BroadVision is a software company that Verity in the past has licensed to distribute Verity’s copyrighted software known as the Verity Developer Kit (“VDK”). Verity alleged in its complaint that under the terms of the parties’ licenses, BroadVision was authorized to distribute certain limited portions of VDK as an embedded component of specified software applications of BroadVision. Verity further alleged that BroadVision had distributed portions of VDK that it was not authorized to distribute, failed to prevent end users from accessing unlicensed functions and encouraged end users to make use of unlicensed functions of VDK. Verity further alleged that it terminated its license with BroadVision on April 24, 2001 and that BroadVision no longer had any right to distribute any portion of VDK.

Verity sought by its complaint, among other things, an injunction to prohibit BroadVision from further distribution of VDK, damages, including statutory damages, according to proof based on BroadVision’s unauthorized distribution of VDK and attorneys’ fees.

BroadVision answered Verity’s complaint on June 28, 2001 and denied the material allegations of the Complaint and asserted affirmative defenses to Verity’s claims. BroadVision also asserted a counterclaim alleging that Verity had breached the parties’ license and the implied covenant of good faith and fair dealing contained therein (1) by failing to pay BroadVision referral fees that it claims Verity owes to BroadVision for BroadVision’s efforts in securing the sale of Verity Advanced K-2 Search Modules; and (2) by failing to provide support to BroadVision for VDK after Verity terminated the parties’ license. BroadVision sought by its counterclaim, among other things, damages according to proof, a declaration that BroadVision has not breached the parties’ license and attorneys’ fees.

Verity answered BroadVision’s counterclaim on July 23, 2001 and denied the material allegations of the counterclaim and asserted various affirmative defenses to BroadVision’s claims. On August 8, 2002, Verity filed a first amended complaint against BroadVision which, among other things, added a claim for contributory copyright infringement against BroadVision based on allegations that BroadVision knowingly facilitated the use by end users of unlicensed functionality of VDK. BroadVision answered Verity’s amended complaint on August 29, 2002 and denied the material allegations of the Complaint and asserted affirmative defenses to Verity’s claims. BroadVision reasserted its counterclaim described above. Verity answered the counterclaim on September 23, 2002 and denied the material allegations of the counterclaim and asserted various affirmative defenses to BroadVision’s claims.

Item 2. Changes in Securities and Use of Proceeds

Not Applicable.

Item 3. Defaults upon Senior Securities

Not Applicable.

Item 4. Submission of Matters to a Vote of Security Holders

Not Applicable.

Item 5. Other Information

Reclassification of First Quarter Fiscal 2003 Expenses. In connection with the preparation of our first quarter fiscal 2004 financial results, as previously announced in our Annual Report on Form 10-K filed with the SEC on August 7, 2003, we began allocating total Management Information Systems (“MIS”) expenses throughout the organization in order to more closely match the practices of other software companies. Previously our MIS operations expense was fully allocated to the research and development function. Accordingly, we have reclassified our previously reported first quarter fiscal 2003 operating expenses to conform to the presentation adopted in fiscal 2004. This reclassification of our previously reported first quarter fiscal 2003 operating expenses, however, was not reflected in our September 10, 2003 earnings announcement. Our worldwide MIS expenses consist primarily of employee compensation and benefits, capital equipment related (expensed or depreciated, including associated maintenance contracts and rentals) and corporate overhead allocations. In fiscal year 2003, these expenses were approximately $1.0 million per quarter.

Item 6. Exhibits and Reports on Form 8-K

Exhibits—See Exhibit Index following the signature page to this report, which is incorporated by reference here.

Reports on Form 8-K

We filed one report on Form 8-K during the quarter covered by this report.

Date		Item Reported On
June 24, 2003		We reported on Item 9 that we were furnishing under Item 12 a press release we issued on June 24, 2003, announcing financial results for fiscal year ended May 31, 2003.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

VERITY, INC.
(Registrant)

By:		/s/ STEVEN R. SPRINGSTEEL
		Steven R. Springsteel
		*Senior Vice President of Finance and Administration and* *Chief Financial Officer*

Dated: October 9, 2003

INDEX TO EXHIBITS

Exhibit Number		Description of Document

2.1		Asset Purchase Agreement among Inktomi Corporation, Quiver, Inc., Ultraseek Corporation, Quiver Ltd. and the Company, dated November 13, 2002. (1)

2.2		Amendment No. 1 to Asset Purchase Agreement among Inktomi Corporation, Inktomi Quiver Corporation, Ultraseek Corporation, Quiver Ltd. and the Company, dated December 17, 2002, amending Asset Purchase Agreement dated November 13, 2002. (1)

3.1		Restated Certificate of Incorporation of the Company. (2)

3.2		By-Laws. (2)

4.1		Amended and Restated Rights Agreement dated August 1, 1995, as amended. (3)

4.2		Form of Rights Agreement between Verity, Inc. and First National Bank of Boston dated September 18, 1996. (4)

4.3		First Amendment to Rights Agreement dated as of July 23, 1999 among Verity, Inc. and BankBoston, N.A. (5)

10.42		Key Employment Agreement, between Anthony J. Bettencourt and Verity, Inc. effective as of March 4, 2003.(6)

31.1		Certification of Anthony J. Bettencourt.

31.2		Certification of Steven R. Springsteel.

32		Certification of Chief Executive Officer and Chief Financial Officer.

(1)	Incorporated by reference from the exhibits with corresponding numbers from the Company’s Form 8-K filed with the Securities and Exchange Commission on December 20, 2002 (Commission No. 000-26880).

(2)	Incorporated by reference from the exhibits with corresponding numbers from the Company’s Form 10-Q for the quarter ended November 30, 2000 with the Securities and Exchange Commission on January 10, 2001. (Commission No. 000-26880).

(3)	Incorporated by reference from the exhibits with corresponding numbers from the Company’s Registration Statement (No. 33-96228), declared effective on October 5, 1995.

(4)	Incorporated by reference from Exhibit No. 1 to the Company’s Form 8-K as filed with the Securities and Exchange Commission on October 10, 1996 (Commission No. 000-26880).

(5)	Incorporated by reference to Exhibit 99.2 from the Company’s Report on Form 8-K filed with the Securities and Exchange Commission on July 29, 1999 (Commission No. 000-26880).

(6)	Incorporated by reference from the exhibit with corresponding number from the Company’s Form 10-K/A filed with the Securities and Exchange Commission on August 27, 2003 (Commission No. 000-26880).

Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	8th grade Good

Verity (VRTY) Inactive 10-Q2004 Q1 Quarterly report

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