UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-K [x]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 30, 1997 Commission file number 0-19960 DATAWATCH CORPORATION (Exact name of registrant as specified in its charter) Delaware 02-0405716 (State of other jurisdiction of (I.R.S. Employer incorporation or organization) Identification number) 234 Ballardvale St., Wilmington, Massachusetts 01887 (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (978) 988-9700 Securities registered pursuant to Section 12 (b) of the Act: None Securities registered pursuant to Section 12 (g) of the Act: Title of Class: Common Stock $.01 par value Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes X No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Sec.229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [X] Aggregate market value of voting stock held by non-affiliates: $20,743,977 (computed by reference to the last sales price of such common stock on December 19, 1997 as reported in the National Association of Security Dealers consolidated trading index). Number of shares of common stock outstanding at December 19, 1997 : 9,111,227 Documents Incorporated By Reference Registrant intends to file a definitive Proxy Statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended September 30, 1997. Portions of such Proxy Statement are incorporated by reference in Part III of this report. PART I Item 1. BUSINESS GENERAL DATAWATCH CORPORATION (the "Company" or "Datawatch") is a provider of innovative, knowledge-based software solutions for the business enterprise. The Company was founded in 1985 to design, manufacture, test and market computer workstations and peripherals which conformed to the U.S. government's TEMPEST security standard. A precipitous decline in the market for TEMPEST products led the Company to completely transition its business based on a strategy of acquiring and growing personal computer software companies and the subsequent divestiture of its hardware operation. DATAWATCH's two principal products are: Monarch(TM), a leader in an emerging software category called Report Mining Systems and a powerful Windows-based report mining tool that lets users easily access, extract, and manipulate live data from virtually any existing computer-generated report. Q-Support(TM) (in the United States)/Quetzal (internationally), a widely-used, leading edge Help Desk product, is a comprehensive Windows-based help desk and asset management software package which features an easy-to-use graphical user interface designed specifically for the busy support center. During fiscal 1997, DATAWATCH decided that its future direction should be based on and limited to these two principal products. In order to provide the financial resources and management focus on this strategic direction, the Company divested itself of its software products for the Macintosh operating system, VIREX(R) and netOctopus(TM) which generated approximately 19% of fiscal 1997 revenues. Accordingly, the Company sold these products to Dr Solomon's Software for $16,750,000 on October 9, 1997. DATAWATCH acquired VIREX in fiscal 1993 for approximately $1,500,000 and netOctopus in fiscal 1996 for approximately $1,400,000. The Company is a Delaware corporation, with its executive offices located at 234 Ballardvale Street, Wilmington, Massachusetts 01887 and the Company's telephone number is (978) 988-9700. PRINCIPAL PRODUCTS REPORT MINING PRODUCTS - ---------------------- Monarch/ES Introduced in the summer of 1997, Monarch/ES(TM) is a scaleable report storage and delivery solution that leverages investments in existing applications and reporting systems to provide online report viewing, distributed printing, and advanced analytical processing throughout the business enterprise. At every level in the business enterprise, people rely on reports to get information. Monarch/ES lets users store, manage, and deliver those reports electronically via a network or intranet, saving paper, reducing storage costs, and empowering users with information needed to do their jobs. Monarch/ES combines state-of-the-art document management technology with powerful analytical processing technology. The result is a hybrid solution that turns report archives into a business intelligence system. Report data is accessible for online queries and analyses. Users can look things up, boil things down, and create their own custom reports with data extracted from existing reports. Client/server architecture makes Monarch/ES highly scaleable. It can be configured for a small department, or rolled out across an entire enterprise. Reports produced in any host environment can be brought into Monarch/ES which automatically identifies, indexes, compresses and stores them, in a report warehouse subsystem. Users can access the reports from any Windows 95 desktop running the Monarch/ES client. Monarch/ES works with industry-standard SQL databases which are compliant with the Open Database Connectivity (ODBC-2) standard. Database servers can be chosen based on report volume and existing network architecture. The initial release of Monarch/ES includes a Sybase SQL Anywhere database. Monarch/ES provides comprehensive, configurable security to define privileges for individual users and groups of users. A user ID and password are required to begin a Monarch/ES session. Access to reports and report segments, as well as to certain program functions, is available only with the proper authorization. Once a report has been stored in the system, it is available for online viewing. Softcopy reports (those delivered electronically) look just like hardcopy reports, but they respond to electronic commands such as zoom, scroll, page and jump. Consulting services from experienced DATAWATCH professionals complement the Monarch/ES package by providing valuable assistance for all phases of implementation. Monarch Introduced in 1991, Monarch is one of DATAWATCH's principal products and represented approximately 40% of the Company's net sales in fiscal 1997, 41% of net sales for fiscal 1996 and 46% for fiscal 1995. Monarch is a PC-compatible business intelligence software tool which allows users to access, manipulate and translate data held in report files. Monarch is a multi-function data access tool that uses computer-generated legacy reports as a source for data. Monarch accepts a report file as input, extracts the data, and delivers the data to users in a variety of formats. Monarch is marketed as "an electronic alternative to hard copy printouts." Corporate and government MIS departments have invested substantial resources in designing reports and delivering them into the hands of managers and their staffs. With Monarch, users can gain instant access to the reports used in their workplace. When the chosen report appears on screen, Monarch offers the user a variety of tools for rapid lookup and navigation. Users can view a full report, or apply filters to view only information that is relevant to their needs. With Monarch, users can create custom reports and summaries, produce local hard copy, create graphs and export data to popular PC applications such as Lotus 1-2-3 or Excel. With the September 1996 introduction of Monarch Version 3.0, users can create a Portable Report Format (PRF) which enables electronic distribution of reports via the intranet thus reducing hardcopy print and delivery costs. Redwing Introduced in December 1997, Redwing(TM) is the new Adobe(R) Acrobat(R) plug-in from DATAWATCH, which is designed to precisely extract text and tables from even the most complex, compound Portable Document Format (PDF) documents. Adobe(R) Acrobat(R) is becoming the standard for publishing, distributing and archiving electronic documents. The number of documents created in Adobe's PDF is growing exponentially. Redwing extracts data with high degrees of character and feature accuracy, which is especially important for companies where any mistake can become very costly. Tables can be edited before export with a customized table editor. Cells can be edited, merged, split and deleted. All text exported by Redwing is fully editable. Text is converted according to the user's specified rules such as line length, word spacing, case conversion, font maps, paragraph detection, etc. A user can simply use the text-optimized default settings. Redwing has the capability to automatically export data from PDF files into a format that Monarch can read - making possible sophisticated data analysis and validation over data held in PDF files. HELP DESK PRODUCTS Q-Support (U.S.)/Quetzal (Internationally) Q-Support, marketed internationally under the name Quetzal, is a Windows-based, comprehensive help desk automation and asset management software package. Q-Support/Quetzal ("Q-Support") is one of DATAWATCH's principal products and represented approximately 34% of the Company's net sales in fiscal 1997, 39% for fiscal 1996 and 33% for fiscal 1995. The program provides IS support centers with a wide-range set of PC software tools for use in a multi-user, networked environment. Featuring an easy-to-use graphical user interface, Q-Support logs, routes and tracks calls from initiation through resolution. With Q- Support, users have IS inventory control, the ability to monitor performance levels, access to third-party knowledge providers, e-mail and extensive management reporting options. Flexibility is built in - system administrators can customize the program to suit organizational needs. Q-Support automates five key functions for the corporate support center: * Asset Management - addresses the increasing needs by corporations for microcomputer asset management by providing an accurate record of every item of equipment or service, tracing of equipment movement and change, and full maintenance and warranty information. * Help Call Management - automates the receiving and resolving of problem calls from the end-user by providing a fast logging process, allocation to groups or individuals, and monitoring screens to track progress, priority and status. * User Access via the Internet - provides support staff and enduser interaction via the Internet providing remote users easier access. * Support Facilities - provides the database of resources and reference sources that are required to find the solution to end-user problems. * Management Analysis - satisfies the Information Center manager's need to provide accurate management reports on the status of either the inventory of equipment or the amount of support activity taking place. Consulting services from experienced DATAWATCH professionals complement the Q-Support package by providing valuable assistance for all phases of implementation. Q-Support offers a complete set of tools to satisfy end-users, lower support costs and optimize asset utilization. PRICING The Company's products are sold as individual units or under LAN or site licenses for multiple users. Monarch/ES typically has a minimum 10 concurrent user license for $20,000. Monarch licenses list for $499 for an individual unit with LAN licenses listing for a minimum of $1,100. Redwing licenses list for $695 for an individual unit with LAN licenses listing for a minimum of $1,995. A minimum three user license for Q-Support is $7,995. MARKETING AND DISTRIBUTION DATAWATCH markets its products through a variety of channels in order to gain broad market exposure and to satisfy the needs of its end- user customers, no matter what their buying behavior. DATAWATCH believes that some customers prefer to purchase products through service-oriented resellers, while others buy on the basis of price, purchase convenience, and/or immediate delivery. The Company is engaged in active direct sales of its products to end-user customers, including repeat and add-on sales to existing customers and sales to new customers. DATAWATCH utilizes direct mail, telemarketing and direct personal selling to generate its sales. A variety of marketing programs are used by DATAWATCH to create demand for its products. These programs include advertising, cooperative advertising with reseller partners, direct mail, exhibitor participation in industry shows, executive participation in press briefings and on-going communication with the trade press. The Company offers its resellers the ability to return obsolete versions of its products and slow-moving products for credit against purchases of other DATAWATCH products on a dollar-for-dollar basis. Defective products may also be returned for credit or exchange. Based on its historical experience, the Company believes that its exposure to such returns is minimal. DATAWATCH warrants the physical disk media and printed documentation for its products to be free of defects in material and workmanship for a period of 90 days from the date of purchase. DATAWATCH also offers a 30-60 day money-back guarantee on certain of its products sold directly to end-users. Under the guarantee, customers may return purchased products within the 60 days for a full refund if they are not completely satisfied. To date, the Company has not experienced any significant product returns under its money-back guarantee. During fiscal 1997, one distributor represented approximately 14% of DATAWATCH's net sales. No other customer accounted for more than 10% of DATAWATCH's net sales in 1997. DATAWATCH sells its products outside of the U.S. directly through WorkGroup's sales force and through international resellers. Such international sales represented approximately 47%, 47% and 45% of DATAWATCH'S net sales for fiscal 1997, 1996 and 1995, respectively. See Note 11 to Consolidated Financial Statements which appears elsewhere in this Report on Form 10- K. RESEARCH AND DEVELOPMENT The Company's product strategy necessitates the timely development of new products. DATAWATCH's product development efforts are conducted through in-house software development engineers or by external developers, who are compensated either through royalty payments based on product sales levels achieved or under contracts based on services provided. DATAWATCH's product managers work closely with developers, whether independent or in-house, to define product specifications. The initial concept for a product originates from this cooperative effort. The developer is generally responsible for coding the development project. The product managers and their staff work in parallel with the developers to produce printed documentation, on-line help files, tutorials and installation software. In some cases, DATAWATCH may choose to subcontract a portion of this work on a project basis to third-party suppliers under contracts. DATAWATCH personnel also perform extensive quality assurance testing for all products and coordinate external beta test programs. DATAWATCH has contractual agreements with the independent developers of Monarch and Monarch/ES which require that source codes be placed into escrow. The principal developers for the products are also bound by contractual commitments which require their continuing involvement in product maintenance and enhancement. Under the agreements, the Company has been granted manufacturing, marketing and sales rights under license agreements which provide for royalty payments based on net revenues. The Company has also been granted exclusive worldwide rights to Monarch with a stated term expiring in the year 2009, and to Monarch/ES with a stated term expiring in the year 2001. The Monarch/ES license automatically renews for successive annual periods unless termination by either party prior to the regular termination date. BACKLOG The Company's software products are generally shipped within seven days of receipt of an order. Accordingly, the Company does not believe that backlog for its products is a meaningful indicator of future business. COMPETITION The software industry is highly competitive and is characterized by rapidly changing technology and evolving industry standards. DATAWATCH competes with a number of companies including IBM, McAfee Associates, Inc., Remedy, Astea, Applix and others which have substantially greater research and development, marketing and financial resources than DATAWATCH. Competition in the industry is likely to intensify as current competitors expand their product lines and as new competitors enter the market. PRODUCT PROTECTION Although DATAWATCH does not generally own patents on its software technologies, it relies on a combination of trade secret, copyright and trademark laws, nondisclosure and other contractual agreements and technical measures to protect its rights in its products. Despite these precautions, unauthorized parties may attempt to copy aspects of DATAWATCH's products or to obtain and use information that DATAWATCH regards as proprietary. Patent protection is not considered crucial to DATAWATCH's success. DATAWATCH believes that, because of the rapid pace of technological change in the software industry, the legal protections for its products are less significant than the knowledge, ability and experience of its employees and developers, the frequency of product enhancements and the timeliness and quality of its support services. DATAWATCH believes that none of its products, trademarks and other proprietary rights infringe on the proprietary rights of third parties, but there can be no assurance that third parties will not assert infringement claims against it or its developers in the future. PRODUCTION Production of DATAWATCH's products involves the duplication of master disks and the printing of user manuals, packaging and other related materials. Disk duplication is performed in-house with high- capacity disk duplication equipment, and is occasionally supplemented with duplication services performed by non-affiliated subcontractors. Printing work is also performed by non-affiliated subcontractors. To date, DATAWATCH has not experienced any material difficulties or delays in production of its software and related documentation and believes that, if necessary, alternative production sources could be secured at commercially reasonable cost. EMPLOYEES As of September 30, 1997, DATAWATCH had 261 full-time employees, including 79 engaged in marketing and sales, 48 engaged in product management, development and quality assurance, 76 engaged in providing administrative, accounting and production functions and 58 in technical support services. Subsequent to the sale of Virex and netOctopus to Dr Solomon's Software at October 9, 1997, DATAWATCH had 222 full-time employees, including 65 engaged in marketing and sales, 29 engaged in product management, development and quality assurance, 75 engaged in providing administrative, accounting and production functions and 53 in technical support services. The Company believes that its future success may depend on its ability to continue to attract and retain highly-skilled technical, marketing and management personnel, who are in great demand. The Company currently has written agreements with each of its employees prohibiting disclosure of confidential information to anyone outside of the Company, both during and subsequent to employment. These agreements also require disclosure to the Company of ideas, discoveries or inventions relating to or resulting from the employee's work for the Company, and assignment to the Company of all proprietary rights to such matters. Item 2. PROPERTIES The Company is currently headquartered in a 51,650 square foot leased facility in Wilmington, Massachusetts. The lease expires in May 1999, with an option to renew for an additional five years. The Company uses approximately 65% of this facility and the other 35% is subleased to Secure Systems Group. The Company also leases approximately 6,200 square feet in Potters Bar, Hertsfordshire, England, which expires in January 2005, approximately 3,500 square feet in Raleigh, North Carolina, which expires in January 1998, approximately 16,000 square feet in Plymouth, Devon, England, which expires in December 2017, and maintains small offices in Germany, France and Australia. The Company believes its facilities are suitable for its current needs. Item 3. LEGAL PROCEEDINGS At the current time, the Registrant does not have any material legal proceedings. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Registrant's security holders during the last quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE REGISTRANT The names, ages and titles of the executive officers of the Company are as follows: Thomas R. Foley 58 Former President, Chief Executive Officer and Director Bruce R. Gardner 54 President, Chief Executive Officer and Director Andrew W. Mathews 55 Former Vice President of Sales Marco D. Peterson 42 Senior Vice President of North American Operations Robert Hagger 49 Senior Vice President of International Operations, Managing Director of WorkGroup Systems Limited Betsy J. Hartwell 50 Vice President of Finance, Chief Financial Officer and Treasurer Scott Crenshaw 32 Vice President of Product Development John Loring 47 Vice President of Information Technology Officers are elected by, and serve at the discretion of, the Board of Directors. THOMAS R. FOLEY, Former President, Chief Executive Officer and Director. Mr. Foley resigned from the Company on October 31, 1997. Mr. Foley, a founder and director of DATAWATCH, had been its President and Chief Executive Officer since the Company was founded in 1985. BRUCE R. GARDNER, President, Chief Executive Officer and Director. Mr. Gardner, a founder and director of DATAWATCH, was the Chief Financial Officer and Treasurer since the Company was founded in 1985 until November 1, 1997. Mr. Gardner was a Senior Vice President until June 1993 when he became Executive Vice President. Mr. Gardner assumed his current position on November 1, 1997. ANDREW W. MATHEWS, Former Vice President of Sales. Mr. Mathews resigned his position from the Company on October 31, 1997. Mr. Mathews had been a Vice President since March 1986 serving in various capacities in the areas of marketing, sales and as a division general manager. MARCO D. PETERSON, Senior Vice President of North American Operations. Mr. Peterson was the founder of PERSONICS and has been its President since its founding in 1984. Mr. Peterson took on the additional role of Vice President of Marketing and Product Development of the Company in October 1994 until he became Senior Vice President on November 1, 1997. ROBERT HAGGER, Senior Vice President of International Operations, Managing Director of WorkGroup Systems Limited. Mr. Hagger joined DATAWATCH as Managing Director of WorkGroup Systems on March 4, 1997 and assumed the title of Senior Vice President of International Operations on November 1, 1997. Mr. Hagger, since 1993, was founder and Managing Director of Insight Strategy Management Ltd. Prior to that he was Managing Director of Byrne Fleming Ltd. BETSY J. HARTWELL, Vice President of Finance, Chief Financial Officer and Treasurer. Ms. Hartwell assumed the positions of Vice President of Finance, Chief Financial Officer and Treasurer on November 1, 1997. Prior to that and since July, 1990, Ms. Hartwell was DATAWATCH's Corporate Controller. SCOTT CRENSHAW, Vice President of Product Development. Mr. Crenshaw assumed the position of Vice President of Product Development on November 1, 1997. Prior to that and since joining DATAWATCH in 1992, Mr. Crenshaw has held various management positions, most recently as Director of Business Development and International Marketing and prior to that as Business Segment Manager and Director of Product Development. JOHN LORING, Vice President of Information Technology. Mr. Loring assumed the position of Vice President of Information Technology on November 1, 1997. Prior thereto and since November, 1993, Mr. Loring was the Company's Director of Business Development/Information Systems. Prior to that, Mr. Loring was DATAWATCH's Manager of Systems Engineering. Part II Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The Registrant's common stock is listed and traded on the Nasdaq National Market under the symbol DWCH. The range of high and low prices during each fiscal quarter for the last two fiscal years is set forth below: For the Year Ended Common Stock September 30, 1997 High Low ------------------ --------------------- 4th Quarter 2 7/8 1 7/16 3rd Quarter 4 5/16 1 5/8 2nd Quarter 6 5/8 3 5/8 1st Quarter 8 3/4 5 For the Year Ended Common Stock September 30, 1996 High Low ------------------ -------------------- 4th Quarter 11 5/8 6 3/8 3rd Quarter 11 5/8 4 3/4 2nd Quarter 5 1/4 3 3/8 1st Quarter 5 7/8 3 3/4 There are approximately 213 shareholders of record as of December 19, 1997. The Company has not paid any cash dividends and it is anticipated that none will be declared in the foreseeable future. The Company intends to retain future earnings, if any, to provide funds for the operation, development and expansion of its business. Item 6. SELECTED FINANCIAL DATA The following table sets forth selected consolidated financial data of the Company for the periods indicated. The selected consolidated financial data for and as of the end of the years in the five year period ended September 30, 1997 are derived from the Consolidated Financial Statements of the Company. The information set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and notes appearing elsewhere in this report. Statements of Operations Data Years Ended September 30, 1997 1996 1995 1994 1993 --------------------------------------------------------------- Net Sales - IBM PC-based Products $25,995,197 $24,216,794 $18,839,265 $13,027,232 $10,360,927 Net Sales - Macintosh-based Products 6,052,298 5,805,328 4,520,716 3,854,910 3,580,975 ---------------------------------------------------------------- Net Sales 32,047,495 30,022,122 23,359,981 16,882,142 13,941,902 Costs and Expenses 33,929,460 28,894,600 23,678,935 19,956,576 17,883,679 Income (Loss) from Continuing Operations (1,881,965) 1,127,522 (318,954) (3,074,434) (3,941,777) Loss from Discontinued Operation - - - - (741,145) Loss on Disposal of Discontinued Operation - - - - (1,478,082) Net Income (Loss) ($1,995,433) $1,125,360 ($331,423) ($3,042,767) ($6,125,104) Income (Loss) from Continuing Operations per Common Share ($.22) $0.13 ($0.04) ($0.41) ($0.54) Loss from Discontinued Operation per Common Share 0.00 0.00 0.00 0.00 (0.10) Loss on Disposal of Discontinued Operation per Common Share 0.00 0.00 0.00 0.00 (0.20) Net Income (Loss) per Common Share ($.22) $0.13 ($0.04) ($0.41) ($0.84) Balance Sheet Data September 30, 1997 1996 1995 1994 1993 ---------------------------------------------------------- Total Assets $16,146,645 $15,240,571 $12,358,132 $9,646,324 $12,108,270 Working Capital 4,451,821 5,210,457 2,631,759 1,547,706 3,920,512 Long-Term Obligations 1,399,089 209,824 163,868 137,324 152,484 Shareholders' Equity $6,924,849 $8,238,886 $ 6,062,170 $5,266,588 $ 8,086,154 Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is qualified by reference to, and should be read in conjunction with, the consolidated financial statements of DATAWATCH and its subsidiaries. GENERAL DATAWATCH CORPORATION (the "Company" or "DATAWATCH"), is engaged in the design, development, manufacture, marketing, consulting services and support of personal computer software. On November 7, 1996 the Company acquired all the outstanding shares of capital stock of Guildsoft Holdings Limited ("Guildsoft"), located in Plymouth, England, which provides software companies with multi-lingual telesales, support and fulfillment services throughout Europe, in exchange for 125,000 shares of DATAWATCH common stock. This acquisition was accounted for as a purchase. On October 9, 1997 (subsequent to the end of the 1997 fiscal year) the Company sold its Virex and netOctopus product lines to Dr Solomon's Software for $16,750,000 in cash. DATAWATCH's principal products are: Monarch, a report mining solution that leverages legacy reports and reporting systems to provide business intelligence on the Windows desktop; Monarch/ES, a client/server version of Monarch with an integrated report warehouse subsystem; Redwing, a plug-in for Abode(R) Acrobat(R) that accurately extracts text and tables from PDF files; Q-Support (in the United States), and Quetzal (internationally), an integrated help desk and asset management solution for multi-user, networked support centers. RESULTS OF OPERATIONS Fiscal Year Ended September 30, 1997 as Compared to Fiscal Year Ended September 30, 1996 Net sales for the fiscal year ended September 30, 1997 were $32,047,000 which represents an increase of $2,025,000 or 7% from the net sales of $30,022,000 for the fiscal year ended September 30, 1996. Sales have been segregated on the statements of operations so as to highlight the product lines which remain after the disposal of the Macintosh based products. Monarch, which amounted to approximately 40% of sales, increased by 5%; Q-Support, which amounted to approximately 34% of sales, decreased by 6%; Virex, which amounted to approximately 15% of sales and netOctopus, which amounted to approximately 4% of sales, did not change as a percentage of sales from fiscal year ended September 30, 1996. Guildsoft, acquired in November 1997, had net sales for fiscal 1997 which amounted to $1,876,000 or 6% of total net sales. For the fiscal year ended September 30, 1997, the Company's products for the IBM compatible PC accounted for approximately 81% of sales while the Company's products for the Macintosh PC accounted for approximately 19%. The Company's cost of sales for the fiscal year ended September 30, 1997 were $5,900,000 or approximately 18% of net sales. Cost of sales for the fiscal year ended September 30, 1996 were $4,516,000 or approximately 15% of net sales. The increase in cost of sales, as a percentage of net sales, results from the inclusion of Guildsoft's product sales which bear lower gross margins than the Company's other products. Cost of sales, as a percentage of net sales for the fiscal year ended September 30, 1997, excluding Guildsoft, would have been 16%, which is relatively consistent with the prior period. Engineering and product development expenses were $2,804,000 for the fiscal year ended September 30, 1997, an increase of $465,000 or approximately 20% from $2,339,000 for the fiscal year ended September 30, 1996. This increase (net of approximately $80,000 of expenses associated with organizational changes) is primarily attributable to the increase in personnel costs and expenses necessary for continued development of the Q-Support product and quality assurance for the Monarch product. Product development costs related to the Virex and netOctopus products were approximately $1,296,000 in 1997 and $1,104,000 in 1996. Selling, general and administrative expenses were $25,225,000 for fiscal year ended September 30, 1997, an increase of $3,186,000 or approximately 14% from $22,039,000 for the fiscal year ended September 30, 1996. Included in the expenses were $608,000 of one-time expenses principally associated with organizational changes within WorkGroup during the third fiscal quarter. Included in the expenses for the fiscal year ended September 30, 1996 were $450,000 of expenses associated with the acquisition of WorkGroup in March 1996. Excluding these expenses, selling, general and administrative expenses were $24,617,000 for the 1997 fiscal year and were $21,589,000 for the 1996 fiscal year resulting in an increase of $3,028,000 or approximately 14%. This increase is primarily attributable to increases in personnel within the sales and marketing organizations, principally for Q-Support and Monarch, and the inclusion of Guildsoft operating expenses amounting to approximately $912,000 for the period or approximately 30% of the increase. As a result of the foregoing, the net loss from operations for the fiscal year ended September 30, 1997 was $1,995,000, which compares to the net income of $1,125,000 for the fiscal year ended September 30, 1996. The Company recorded only de minimis tax provisions, both domestically and internationally, during the periods because of its ability to utilize net operating loss ("NOL") carryforwards during fiscal 1996 and because of its ability to utilize domestic NOL carryforwards and foreign losses during fiscal 1997. Fiscal Year Ended September 30, 1996 as Compared to Fiscal Year Ended September 30, 1995 Net sales for the fiscal year ended September 30, 1996 were $30,022,000 which represents an increase of $6,662,000 or 29% from the net sales of $23,360,000 for the fiscal year ended September 30, 1995. Sales have been segregated on the statements of operations so as to highlight the product lines which remain after the disposal of the Macintosh based products. This increase results from growth in sales of all of DATAWATCH's products. Monarch, which amounted to approximately 41% of sales, increased by 14%; Q-Support, which amounted to approximately 39% of sales, increased by 51%; Virex, which amounted to approximately 15% of sales, increased by 14%; and netOctopus, which amounted to approximately 4% of sales, increased by 143%. For the fiscal year ended September 30, 1996, the Company's products for the IBM compatible PC accounted for approximately 80% of sales while the Company's products for the Macintosh PC accounted for approximately 20%. Revenues were reduced by approximately $400,000 for the fourth quarter, and consequently for the year, as a result of consultancy revenue deferrals. See Note 1 (Revenue Recognition - Services and Other) to Notes to Consolidated Financial Statements which appear elsewhere in this Report on Form 10-K. The Company's cost of sales for the fiscal year ended September 30, 1996 were $4,516,000 or approximately 15% of net sales. Cost of sales for the fiscal year ended September 30, 1995 were $3,809,000 or approximately 16% of net sales. These costs remained reasonably constant as a percentage of net sales for the two periods. Engineering and product development expenses were $2,339,000 for the fiscal year ended September 30, 1996, an increase of $119,000 or approximately 5% from $2,220,000 for the fiscal year ended September 30, 1995. This increase is primarily attributable to the increase in personnel costs associated with the development and quality assurance for its products. Product development costs related to the Virex and netOctopus products were approximately $1,104,000 in 1996 and $1,072,000 in 1995. Selling, general and administrative expenses were $22,039,000 for fiscal year ended September 30, 1996. Included in these expenses were non-recurring expenses associated with the acquisition of WorkGroup amounting to $450,000. Excluding these non-recurring expenses, selling, general and administrative expenses were $21,589,000 for the 1996 fiscal year resulting in an increase of $3,939,000 or approximately 22% from $17,650,000 for the fiscal year ended September 30, 1996. This increase is primarily attributable to increases in personnel within the sales and marketing organizations and in promotional expenses principally for Q-Support and Monarch. As a result of the foregoing, the net income for the fiscal year ended September 30, 1996 was $1,125,000, an increase of $1,457,000 when compared to the net loss of $331,000 for the fiscal year ended September 30, 1995. The Company recorded only de minimis tax provisions, both domestically and internationally, during the fiscal year ended September 30, 1996 because of its ability to utilize NOL loss carryforwards. LIQUIDITY AND CAPITAL RESOURCES In October 1997, the Company received $16,750,000 from Dr Solomon's Software for its Virex and netOctopus product lines. The Company's management believes that its currently anticipated capital needs for future operations of the Company will be satisfied through at least September 30, 1998 by funds currently available from the above mentioned sale. The Company also has its unused $3,000,000 bank lines of credit. Working capital decreased by approximately $759,000 during fiscal 1997 primarily as a result of unprofitable operations of and cash flow required by the Company's international subsidiaries. Management believes that the Company's current operations are not materially impacted by the effects of inflation. CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS The Company does not provide forecasts of its future financial performance. However, time to time, information provided by the Company or statements made by its employees may contain "forward looking" information that involves risks and uncertainties. In particular, statements contained in this Form 10-K that are not historical facts (including, but not limited to statements contained in "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations" relating to liquidity and capital resources) may constitute forward looking statements and are made under the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. The Company's actual results of operations and financial condition have varied and may in the future vary significantly from those stated in any forward looking statements. Factors that may cause such differences include, without limitation, the risks, uncertainties and other information discussed below and within this Form 10-K, as well as the accuracy of the Company's internal estimates of revenue and operating expense levels. The following discussion of the Company's risk factors should be read in conjunction with the financial statements and related notes thereto. Such factors, among others, may have a material adverse effect upon the Company's business, results of operations and financial condition. FLUCTUATIONS IN QUARTERLY OPERATING RESULTS The Company's future operating results could vary substantially from quarter to quarter because of uncertainties and/or risks associated with such things as technological change, competition, delays in the introduction of products or product enhancements and general market trends. Historically, the Company has operated with little backlog of orders because its software products are generally shipped as orders are received. As a result, net sales in any quarter are substantially dependent on orders booked and shipped in that quarter. Because the Company's staffing and operating expenses are based on anticipated revenue levels and a high percentage of the Company's costs are fixed in the short-term, small variations in the timing of revenues can cause significant variations in operating results from quarter to quarter. Because of these factors, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. There can be no assurance that the Company will not experience such variations in operating results in the future or that such variations will not have a material adverse effect on the Company's business, financial condition or results of operation. DEPENDENCE ON PRINCIPAL PRODUCTS In fiscal 1997, Monarch and Q-Support accounted for approximately 40% and 34%, respectively, of the Company's net sales. Subsequent to year end with the disposal of the Virex and netOctopus products, the Company is wholly dependent on such principal products. As a result, any factor adversely affecting sales of either of these products could have a material adverse effect on the Company. The Company's future financial performance will depend in part on the successful introduction of its new and enhanced versions of these products and development of new versions of these and other products and subsequent acceptance of such new and enhanced products. In addition, competitive pressures or other factors may result in significant price erosion that could have a material adverse effect on the Company's business, financial condition or results of operations. INTERNATIONAL SALES In 1997, 1996 and 1995, international sales accounted for approximately 47%, 47% and 45%, respectively, of the Company's net sales. The Company anticipates that international sales will continue to account for a significant percentage of its revenues. A significant portion of the Company's net sales will therefore be subject to risks associated with international sales, including unexpected changes in legal and regulatory requirements, changes in tariffs, exchange rates and other barriers, political and economic instability, difficulties in account receivable collection, difficulties in managing distributors or representatives, difficulties in staffing and managing international operations, difficulties in protecting the Company's intellectual property overseas, seasonality of sales and potentially adverse tax consequences. ACQUISITION STRATEGY The Company has addressed and may continue to address the need to develop new products, in part, through the acquisition of other companies. Acquisitions involve numerous risks including difficulties in the assimilation of the operations, technologies and products of the acquired companies, the diversion of management's attention from other business concerns, risks of entering markets in which the Company has no or limited direct prior experience and where competitors in such markets have stronger market positions, and the potential loss of key employees of the acquired company. Achieving and maintaining the anticipated benefits of an acquisition will depend in part upon whether the integration of the companies' business is accomplished in an efficient and effective manner, and there can be no assurance that this will occur. The successful combination of companies in the high technology industry may be more difficult to accomplish than in other industries. DEPENDENCE ON NEW INTRODUCTIONS; NEW PRODUCT DELAYS Growth in the Company's business depends in substantial part on the continuing introduction of new products. The length of product life cycles depends in part on end-user demand for new or additional functionality in the Company's products. If the Company fails to accurately anticipate the demand for, or encounters any significant delays in developing or introducing, new products or additional functionality on its products, there could be a material adverse effect on the Company's business. Product life cycles can also be affected by the introduction by suppliers of operating systems of comparable functionality within their products. The failure of the Company to anticipate the introduction of additional functionality in products developed by such suppliers could have a material adverse effect on the Company's business. In addition, the Company's competitors may introduce products with more features and lower prices than the Company's products. Such increase in competition could adversely affect the life cycles of the Company's products, which in turn could have a material adverse effect on the Company's business. Software products may contain undetected errors or failures when first introduced or as new versions are released. There can be no assurance that, despite testing by the Company and by current and potential end-users, errors will not be found in new products after commencement of commercial shipments, resulting in loss of or delay in market acceptance. Any failure by the Company to anticipate or respond adequately to changes in technology and customer preferences, or any significant delays in product development or introduction, could have a material adverse effect on the Company's business. RAPID TECHNOLOGICAL CHANGE The markets in which the Company competes have undergone, and can be expected to continue to undergo, rapid and significant technological change. The ability of the Company to grow will depend on its ability to successfully update and improve its existing products and market and license new products to meet the changing demands of the marketplace and that can compete successfully with the existing and new products of the Company's competitors. There can be no assurance that the Company will be able to successfully anticipate and satisfy the changing demands of the personal computer software marketplace, that the Company will be able to continue to enhance its product offerings, or that technological changes in hardware platforms or software operating systems, or the introduction of a new product by a competitor, will not render the Company's products obsolete. COMPETITION IN THE PC SOFTWARE INDUSTRY The software market for personal computers is highly competitive and characterized by continual change and improvement in technology. Several of the Company's existing and potential competitors (including IBM, McAfee Associates, Inc., Remedy, Astea and Applix) have substantially greater financial, marketing and technological resources than the Company. No assurance can be given that the Company will have the resources required to compete successfully in the future. YEAR 2000 ISSUE Although the Company does not expect that Year 2000 issues will have a material effect on the Company's results of operations or financial condition, the Company is exposed to Year 2000 issues with respect to internal software and external product offerings. Should this issue not be addressed properly, there may be an event that would cause reported financial information not to be necessarily indicative of future operating results. The Company continues to undertake an evaluation of these issues. DEPENDENCE ON PROPRIETARY SOFTWARE TECHNOLOGY The Company's success is dependent upon proprietary software technology. Although the Company does not own any patents on any such technology, it does hold exclusive licenses to such technology and relies principally on a combination of trade secret, copyright and trademark laws, nondisclosure and other contractual agreements and technical measures to protect its rights to such proprietary technology. Despite such precautions, there can be no assurance that such steps will be adequate to deter misappropriation of such technology. RELIANCE ON SOFTWARE LICENSE AGREEMENTS Substantially all of the Company's products incorporate third party proprietary technology which is generally licensed to the Company on an exclusive, worldwide basis. Failure by such third parties to continue to develop technology for the Company and license such technology to the Company could have a material adverse effect on the Company's business and results of operations. INDIRECT DISTRIBUTION CHANNELS During 1997, 1996 and 1995, the Company derived approximately 20%, 17% and 19%, respectively, of its net sales through resellers, none of which are under the direct control of the Company. The loss of major resellers of the Company's products, or a significant decline in their sales, could have a material adverse effect on the Company's operating results. Other than Ingram Micro Inc., which accounted for approximately 14%, 13%, and 10% of the Company's 1997, 1996 and 1995 net sales, respectively, no reseller or other customer accounted for more than 10% of the Company's revenues in 1997, 1996 or 1995. There can be no assurance that the Company will be able to attract or retain additional qualified resellers or that any such resellers will be able to effectively sell the Company's products. The Company seeks to select and retain resellers on the basis of their business credentials and their ability to add value through expertise in specific vertical markets or application programming expertise. In addition, the Company relies on resellers to provide post-sales service and support, and any deficiencies in such service and support could adversely affect the Company's business. VOLATILITY OF STOCK PRICE As is frequently the case with the stocks of high technology companies, the market price of the Company's common stock has been, and may continue to be, volatile. Factors such as quarterly fluctuations in results of operations, increased competition, the introduction of new products by the Company or its competitors, expenses or other difficulties associated with assimilating companies acquired by the Company, changes in the mix of sales channels, the timing of significant customer orders, and macroeconomics conditions generally, may have a significant impact on the market price of the stock of the Company. Any shortfall in revenue or earnings from the levels anticipated by securities analysts could have an immediate and significant adverse effect on the market price of the Company's common stock in any given period. In addition, the stock market has from time to time experienced extreme price and volume fluctuations, which have particularly affected the market price for many high technology companies and which, on occasion, have appeared to be unrelated to the operating performance of such companies. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is set forth in Item 14(a) under the captions "Consolidated Financial Statements" and "Consolidated Financial Statement Schedule" as a part of this report. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to Directors may be found under the caption "Election of Directors" appearing in the Company's definitive Proxy Statement for the Annual Meeting of Shareholders for the fiscal year ended September 30, 1997. Such information is incorporated herein by reference. Information with respect to the Company's executive officers may be found under the caption "Executive Officers of the Registrant" appearing in Part I of this Annual Report on Form 10-K. Item 11. EXECUTIVE COMPENSATION The information set forth under the caption "Compensation and Other Information Concerning Directors and Officers" appearing in the Company's definitive Proxy Statement for the Annual Meeting of Shareholders for the fiscal year ended September 30, 1997 is incorporated herein by reference. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the caption "Principal Holders of Voting Securities" appearing in the Company's definitive Proxy Statement for the Annual Meeting of Shareholders for the fiscal year ended September 30, 1997 is incorporated herein by reference. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information set forth under the caption "Certain Transactions" appearing in the Company's definitive Proxy Statement for the Annual Meeting of Shareholders for the fiscal year ended September 30, 1997 is incorporated herein by reference. PART IV Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8- K The following documents are filed as part of this report: (a) 1. Consolidated Financial Statements Independent Auditors' Report Consolidated Balance Sheets as of September 30, 1997 and 1996 Consolidated Statements of Operations for the Years Ended September 30, 1997, 1996 and 1995. Consolidated Statements of Changes in Shareholders' Equity for the Years Ended September 30, 1997, 1996 and 1995. Consolidated Statements of Cash Flows for the Years Ended September 30, 1997, 1996 and 1995. Notes to Consolidated Financial Statements 2. Consolidated Financial Statement Schedule Schedule VIII Valuation and Qualifying Accounts All other schedules are omitted as the required information is not applicable or is included in the financial statements or related notes. The Independent Auditors' Report included with the Consolidated Financial Statements under Item 14(a)1 above contains the Independent Auditors' Report on the Consolidated Financial Statement Schedule. 3. Exhibits The exhibits listed in the Exhibit Index immediately preceding the Exhibits are filed as a part of this Annual Report on Form 10- K. (b) Reports on Form 8-K No current report on Form 8-K was filed during the quarterly period ended September 30, 1997. (c) EXHIBIT INDEX (6) 2.1 Asset Purchase Agreement, dated October 9, 1997, among DATAWATCH CORPORATION, Pole Position Software GmbH and Dr Solomon's Software, Inc. (Exhibit 2.1) (6) 2.2 Escrow Agreement, dated October 9, 1997, among DATAWATCH CORPORATION, Dr Solomon's Software, Inc. and State Street Bank and Trust Company. (Exhibit 2.2) (1) 3.1 Restated Certificate of Incorporation of the Registrant (Exhibit 3.2) (1) 3.2 By-Laws, as amended, of the Registrant (Exhibit 3.3) (1) 4.1 Specimen certificate representing the Common Stock (Exhibit 4.4) (1)10.1 Lease by and between the Registrant and CBOB Fund Corp., as Trustee of Ballardvale Building D Nominee Trust, dated February 17, 1992 (Exhibit 10.2) (1)10.2 1987 Stock Plan (Exhibit 10.7) (1)10.3 Form of Incentive Stock Option Agreement of the Registrant (Exhibit 10.8) (1)10.4 Form of Nonqualified Stock Option Agreement of the Registrant (Exhibit 10.9) (1)10.5 Software Development and Marketing Agreement by and between PERSONICS CORPORATION and Raymond Huger, dated January 19, 1989 (Exhibit 10.12) (2)10.6 Asset Purchase Agreement by and between the Registrant and Secure Systems Group, dated as of May 14, 1993 (Exhibit 2.1) (2)10.7 Promissory Note of Secure Systems Group to the Registrant in the original principal amount of $968,782, dated May 14, 1993 (Exhibit 10.1) (2)10.8 Promissory Note of Secure Systems Group to the Registrant in the original principal amount of $1,821,018, dated May 14, 1993 (Exhibit 10.2) (2)10.9 Security Agreement dated as of May 14, 1993 between Secure Systems Group as debtor and the Registrant as secured party (Exhibit 10.3) (2)10.10 Sublease dated as of May 14, 1993 between the Registrant as sublandlord and Secure Systems Group as subtenant (Exhibit 10.4) (3)10.11 Marketing Agreement dated May 1, 1994 between WorkGroup Systems Ltd. and DATAWATCH CORPORATION (Exhibit 10.1) (4)10.12 Commercial Security Agreement between DATAWATCH CORPORATION and Silicon Valley Bank doing business as Silicon Valley East dated November 1, 1994 (Exhibit 10.23) (4)10.13 Commercial Security Agreement between PERSONICS CORPORATION and Silicon Valley Bank doing business as Silicon Valley East dated November 1, 1994 (Exhibit 10.24) (5)10.14 Executive Agreement between the Company and Andrew W. Mathews dated April 11, 1996 (Exhibit 10.1) (5)10.15 Executive Agreement between the Company and Marco D. Peterson dated April 11, 1996 (Exhibit 10.2) (5)10.16 Executive Agreement between the Company and Bruce R. Gardner dated April 11, 1996 (Exhibit 10.3) (5)10.17 Executive Agreement between the Company and Thomas R. Foley dated April 11, 1996 (Exhibit 10.4) (7)10.18 Loan Modification Agreement dated October 31, 1996 between DATAWATCH CORPORATION, Personics Corporation and Silicon Valley Bank (Exhibit 10.29) (7)10.19 1996 Non-Employee Director Stock Option Plan, as amended on December 10, 1996 (Exhibit 10.30) (7)10.20 1996 International Employee Non-Qualified Stock Option Plan (Exhibit 10.31) (8)10.21 Amended and Restated Letter Agreement, dated February 12, 1997, by and between DATAWATCH CORPORATION, Personics Corporation and Silicon Valley Bank (Exhibit 10.1) (8)10.22 Promissory Note, dated February 12, 1997, by and between DATAWATCH CORPORATION, Personics Corporation and Silicon Valley Bank (Exhibit 10.21). (8)10.23 Loan Modification Agreement, dated October 30, 1997, by and between DATAWATCH CORPORATION, Personics Corporation and Silicon Valley Bank (filed herewith) (9)10.24 1996 Stock Plan (Appendix A) 11.1 Statement re: computation of per share earnings (filed herewith) 21.1 Subsidiaries of the Registrant (filed herewith) 23.1 Consent of Independent Auditors (filed herewith) 27 Financial Data Schedule (filed herewith) - ------------------------------ (1) Previously filed as exhibits to Registration Statement 33-46290 on Form S-1 and incorporated herein by reference (the number given in parenthesis indicates the corresponding exhibit in such Form S-1). (2) Previously filed as exhibits to Registrant's Current Report on Form 8-K dated May 14, 1993, filed May 28, 1993 and incorporated herein by reference (the number given in parenthesis indicates the corresponding exhibit in such Form 8-K). (3) Previously filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1994 and incorporated herein by reference (the number given in parenthesis indicates the corresponding exhibit in such Form 10-Q). (4) Previously filed as an exhibit to Registrant's Annual Report on Form 10-K for the Fiscal Year ended September 30, 1994 and incorporated herein by reference (the number given in parenthesis indicates the corresponding exhibit in such Form 10-K). (5) Previously filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996 and incorporated herein by reference (the number given in parenthesis indicates the corresponding exhibit in such Form 10-Q). (6) Previously filed as exhibits to Registrant's Current Report on Form 8-K dated October 9, 1997 and incorporated herein by reference (the number given in parenthesis indicates the corresponding exhibit in such Form 8-K). (7) Previously filed as an exhibit to Registrant's Annual Report on Form 10-K for the Fiscal Year ended September 30, 1996 and incorporated herein by reference (the number given in parenthesis indicates the corresponding exhibit in such for 10-K). (8) Previously filed as exhibits to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997 and incorporated herein by reference (the number in parenthesis indicates the corresponding exhibit in such Form 10-Q). (9) Previously filed as appendix A to the Company's definitive Proxy Statement for the Annual Meeting of Shareholders held on March 19, 1997 and incorporated herein by reference (the number given in parenthesis indicates the corresponding appendix in such definitive Proxy Statement). (d) Financial Statement Schedules The Company hereby files as financial statement schedules to this Form 10-K the Consolidated Financial Statement Schedules listed in Item 14(a)2 above which are attached hereto. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DATAWATCH CORPORATION Date: December 29, 1997 By: /s/ Bruce R. Gardner Bruce R. Gardner President, Chief Executive Officer and Director (Principal Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Bruce R. Gardner President, Chief Executive December 29, 1997 Bruce R. Gardner Officer and Director /s/ Betsy J. Hartwell Vice President Finance, December 29, 1997 Betsy J. Hartwell Chief Financial Officer (Principal Financial and Treasurer and Accounting Officer) /s/ Jerome Jacobson Director December 29, 1997 Jerome Jacobson /s/ David Riddiford Director December 29, 1997 David Riddiford