================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
FORM 10-Q
----------------
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______________ TO ____________
COMMISSION FILE NO. 000-26937
QUEST SOFTWARE, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 33-0231678
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
8001 IRVINE CENTER DRIVE
IRVINE, CALIFORNIA 92618
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (949) 754-8000
Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
The number of shares outstanding of the Registrant's Common Stock, no par
value, as of November 2, 2001 was 89,271,842.
================================================================================
QUEST SOFTWARE, INC.
FORM 10-Q
INDEX
PAGE
NUMBER
------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of December 31, 2000 and September 30,
2001 (unaudited).............................................................. 3
Consolidated Statements of Operations for the Three and Nine Months Ended
September 30, 2000 and 2001 (unaudited)....................................... 4
Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2000 and 2001 (unaudited)....................................... 5
Consolidated Statements of Comprehensive Operations for the Three and
Nine Months Ended September 30, 2000 and 2001 (unaudited)..................... 6
Notes to Consolidated Financial Statements (unaudited)........................... 7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations.................................................................... 13
Item 3. Quantitative and Qualitative Disclosures about Market Risk....................... 27
PART II. OTHER INFORMATION
Item 4. Exhibits and Reports on Form 8-K................................................. 28
Signatures.................................................................................. 29
2
PART I
FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
QUEST SOFTWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
ASSETS
DECEMBER 31, SEPTEMBER 30,
2000 2001
------------ -------------
(UNAUDITED)
Current assets:
Cash and cash equivalents $ 25,155 $ 59,924
Short-term marketable securities available for sale 8,587 15,659
Accounts receivable, net 38,443 32,297
Prepaid expenses and other current assets 11,390 10,944
Income taxes receivable 1,558 --
Deferred income taxes 14,833 14,354
--------- ---------
Total current assets 99,966 133,178
Property and equipment, net 46,840 58,154
Long-term marketable securities available for sale 118,084 118,291
Goodwill and purchased intangible assets, net 255,858 217,394
Deferred income taxes 3,001 3,001
Other assets 10,423 9,568
--------- ---------
Total assets $ 534,172 $ 539,586
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 5,503 $ 5,274
Accrued compensation 9,350 13,028
Other accrued expenses 22,491 18,698
Income taxes payable -- 2,348
Deferred revenue 32,052 46,137
--------- ---------
Total current liabilities 69,396 85,485
Long-term liabilities and other 6,422 5,358
Shareholders' equity:
Preferred stock, no par value, 10,000 shares authorized; no shares
issued or outstanding -- --
Common stock, no par value, 150,000 shares authorized; 86,710 and
88,782 issued and outstanding at December 31, 2000 and September 30,
2001, respectively 500,324 528,961
Accumulated deficit (23,214) (61,787)
Accumulated other comprehensive income 132 1,371
Notes receivable from sale of common stock (18,888) (19,802)
--------- ---------
Total shareholders' equity 458,354 448,743
--------- ---------
Total liabilities and shareholders' equity $ 534,172 $ 539,586
========= =========
See accompanying notes to the consolidated financial statements.
3
QUEST SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- -------------------------
2000 2001 2000 2001
---------- ---------- --------- ---------
Revenues:
Licenses $ 34,036 $ 37,584 $ 84,459 $ 135,171
Services 10,086 18,755 25,043 51,142
--------- --------- --------- ---------
Total revenues 44,122 56,339 109,502 186,313
Cost of revenues:
Licenses 874 948 2,379 2,961
Services 2,911 4,616 7,034 13,105
Amortization of purchased intangible assets 1,244 1,894 3,002 5,834
--------- --------- --------- ---------
Total cost of revenues 5,029 7,458 12,415 21,900
--------- --------- --------- ---------
Gross profit 39,093 48,881 97,087 164,413
Operating expenses:
Sales and marketing 20,581 29,593 51,457 91,675
Research and development 11,118 15,262 27,820 44,649
General and administrative 5,052 5,809 11,777 18,248
Other compensation costs and intangible amortization 10,456 16,418 25,865 47,869
--------- --------- --------- ---------
Total operating expenses 47,207 67,082 116,919 202,441
--------- --------- --------- ---------
Loss from operations (8,114) (18,201) (19,832) (38,028)
Other income, net 3,680 2,654 8,317 6,143
Losses on equity investments - - - (1,465)
--------- --------- --------- ---------
Loss before income taxes (4,434) (15,547) (11,515) (33,350)
Income tax provision (benefit) 1,825 (4,706) 4,838 5,223
--------- --------- --------- ---------
Net loss $ (6,259) $ (10,841) $ (16,353) $ (38,573)
========= ========= ========= =========
Net loss per share:
Basic and Diluted $ (0.07) $ (0.12) $ (0.19) $ (0.44)
========= ========= ========= =========
Weighted average shares:
Basic and Diluted 86,536 88,299 84,420 87,613
See accompanying notes to the consolidated financial statements.
4
QUEST SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------
2000 2001
--------- ---------
Cash flows from operating activities:
Net loss $ (16,353) $ (38,573)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization 28,020 55,996
Compensation expense associated with stock option grants 2,778 4,029
Accrued interest receivable from shareholders (313) (914)
Provision for bad debts - 345
Loss on equity investments - (1,465)
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable (3,514) 6,367
Prepaid expenses and other current assets (4,293) 540
Deferred taxes 29 -
Other assets (2,516) 2,779
Accounts payable 2,673 (270)
Accrued compensation 2,740 3,691
Income taxes payable 3,032 8,811
Other accrued expenses (2,833) (4,099)
Other liabilities - 603
Deferred revenue 6,106 13,902
--------- ---------
Net cash provided by operating activities 15,556 51,742
Cash flows from investing activities:
Purchases of property and equipment (35,489) (19,435)
Purchases of software licenses (1,265) (1,150)
Cash paid for acquisitions, net of cash acquired (78,502) 114
Purchases of marketable securities (291,895) (136,807)
Sales and maturities of marketable securities 128,532 130,766
--------- ---------
Net cash used by investing activities (278,619) (26,512)
Cash flows from financing activities:
Repayment of notes payable (1,910) (1,171)
Repurchase of common stock (33) -
Repayment of capital lease obligations (390) (188)
Proceeds from exercise of stock options 3,449 5,432
Proceeds from employee stock purchase plan 3,438 5,593
Proceeds from issuance of common stock, net 253,469 -
--------- ---------
Net cash provided by financing activities 258,023 9,666
Effect of exchange rate changes on cash and cash equivalents 72 (127)
--------- ---------
Net (decrease) increase in cash and cash equivalents (4,968) 34,769
Cash and cash equivalents, beginning of period 39,643 25,155
--------- ---------
Cash and cash equivalents, end of period $ 34,675 $ 59,924
========= =========
Supplemental disclosures of consolidated cash flow information:
Cash paid for (received):
Interest $ 137 $ 81
========= =========
Income taxes, net of refunds $ 1,709 $ (4,093)
========= =========
Supplemental schedule of noncash investing and financing activities:
Unrealized (loss) gain on available-for-sale securities $ (103) $ 1,239
========= =========
Tax benefit related to stock option exercises $ 4,547 $ 4,965
========= =========
See accompanying notes to the consolidated financial statements.
5
QUEST SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS
(IN THOUSANDS)
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------- -----------------------
2000 2001 2000 2001
-------- -------- -------- --------
Net loss $ (6,259) $(10,841) $(16,353) $(38,573)
Accumulated other comprehensive income (loss):
Unrealized gain (loss) on available-
for-sale securities 412 1,280 (103) 1,239
-------- -------- -------- --------
Comprehensive loss $ (5,847) $ (9,561) $(16,456) $(37,334)
======== ======== ======== ========
See accompanying notes to the consolidated financial statements.
6
QUEST SOFTWARE, INC.
NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying unaudited interim consolidated financial statements of
Quest Software, Inc., a California corporation (the "Company" or "Quest"), as of
September 30, 2001 and for the three and nine months ended September 30, 2000
and 2001 reflect all adjustments (consisting of normal recurring accruals)
that, in the opinion of management, are necessary for a fair presentation of
the results for the interim periods presented. These financial statements have
been prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements.
These financial statements should be read in conjunction with the audited
financial statements included in the Company's Annual Report on Form 10-K for
the year ended December 31, 2000.
Operating results for the three and nine months ended September 30, 2001
are not necessarily indicative of the results that may be expected for the
quarter or full year ending December 31, 2001 or any other future period.
NEW ACCOUNTING PRONOUNCEMENTS:
In September 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 133, Accounting for Derivative
Instruments and Hedging Activities ("SFAS No. 133"). SFAS No. 133, as amended,
is effective for all fiscal years beginning after June 15, 2000, and establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts and for hedging activities.
Under SFAS No. 133, certain contracts that were not formerly considered
derivatives may now meet the definition of a derivative which would be required
to be reported as assets or liabilities and carried at fair value. The Company
adopted SFAS No. 133 effective January 1, 2001. The adoption of SFAS No. 133 did
not have a significant impact on the financial position, results of operations,
or cash flows of the Company.
In July 2001, the FASB issued Statement of Financial Accounting Standards
No. 141 ("SFAS 141"), Business Combinations. SFAS 141 requires the purchase
method of accounting for business combinations initiated after June 30, 2001 and
eliminates the pooling-of-interest method. SFAS 141 also requires
reclassification of certain other identifiable assets to a separate financial
statement line to the extent they meet certain criteria. The Company does not
believe that the adoption of SFAS 141 will have a significant impact on its
financial statements.
In July 2001, the FASB issued Statement of Financial Accounting Standard
No. 142 ("SFAS 142"), Goodwill and Other Intangible Assets, which is effective
for the Company in January of 2002. SFAS No. 142 requires that goodwill and
other intangible assets with indefinite useful lives no longer be amortized, but
instead tested for impairment at least annually. The Company will continue to
assess its recorded goodwill and other intangible assets under current generally
accepted accounting principles at each reporting period until the standard is
adopted. The adoption of SFAS No. 142 in January of 2002 will substantially
reduce charges to operations for goodwill amortization and change the method for
determining impairment. The effect on the financial statements has not been
determined. Currently, the Company's amortization of goodwill and other
intangible assets is approximately $14.0 million per quarter.
In August 2001, the FASB issued Statement of Financial Accounting Standard
No. 143 ("SFAS 143"), Accounting for Asset Retirement Obligations, which
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 is required to be adopted for fiscal years beginning after
June 15, 2002. The Company has not yet determined what effect this statement
will have on its financial statements.
Also in August 2001, the FASB issued Statement of Financial Accounting
Standard No. 144 ("SFAS 144"), Accounting for the Impairment or Disposal of
Long-Lived Assets, which supersedes FASB Statement No. 121,
7
QUEST SOFTWARE, INC.
NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of. This new statement also supersedes certain aspects of Accounting
Principles Board ("APB") 30, Reporting the Results of Operations-Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions, with regard to reporting the
effects of a disposal of a segment of a business and will require expected
future operating losses from discontinued operations to be reported in
discontinued operations in the period incurred (rather than as of the
measurement date as presently required by APB 30). In addition, more
dispositions may qualify for discontinued operations treatment. The provisions
of this statement are required to be applied for fiscal years beginning after
December 15, 2001 and interim periods within those fiscal years. The Company has
not yet determined what effect this statement will have on its financial
statements.
2. ACQUISITIONS
Actual results of operations of the companies acquired throughout fiscal
2000 and the company, RevealNet, Inc., acquired in fiscal 2001 are included in
the consolidated financial statements from the dates of acquisition. The
Company's financial results for the nine months ended September 30, 2001 include
actual results of these acquisitions for the full period. The pro forma results
of operations data for the same period of 2000 presented below assume that the
acquisitions had been made at the beginning of fiscal 2000, and include
amortization of goodwill and identified intangibles from that date. The pro
forma data is presented for informational purposes only and is not necessarily
indicative of the results of future operations nor of the actual results that
would have been achieved had the acquisitions taken place at the beginning of
fiscal 2000 (in thousands):
NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------
2000 2001
-------------- --------------
(PRO FORMA) (PRO FORMA)
Revenues $120,894 $187,751
Net loss (48,888) (38,809)
Net loss per share - basic and diluted $ (0.58) $ (0.44)
3. OTHER COMPENSATION COSTS
The Company records compensation expense for options to purchase the
Company's common stock granted with an exercise price below fair market value.
The expense equals the difference between the fair market value of the Company's
common stock on the grant date and the exercise price of the stock options and
is recognized ratably over the vesting period of the stock options, currently
four to five years. The following table shows the allocation to Cost of Services
Revenues, Sales and Marketing, Research and Development and General and
Administrative expenses of such costs based on the related headcount (in
thousands):
8
QUEST SOFTWARE, INC.
NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued)
AS REPORTED ALLOCATION PRO FORMA
----------- ---------- ---------
Three months ended September 30, 2000
Cost of services revenues $ 2,911 $ 72 $ 2,983
Sales and marketing 20,581 456 21,037
Research and development 11,118 600 11,718
General and administrative 5,052 72 5,124
Three months ended September 30, 2001
Cost of services revenues $ 4,616 $ 59 $ 4,675
Sales and marketing 29,593 439 30,032
Research and development 15,262 381 15,643
General and administrative 5,809 98 5,907
Nine months ended September 30, 2000
Cost of services revenues $ 7,034 $ 167 $ 7,201
Sales and marketing 51,457 1,000 52,457
Research and development 27,820 1,417 29,237
General and administrative 11,777 195 11,972
Nine months ended September 30, 2001
Cost of services revenues $13,105 $ 161 $13,266
Sales and marketing 91,675 1,249 92,924
Research and development 44,649 1,209 45,858
General and administrative 18,248 1,410 19,658
4. NET LOSS PER SHARE
The Company computes net loss per share in accordance with SFAS No. 128,
Earnings per Share. Basic earnings per share is computed by dividing net loss by
the weighted average number of common shares outstanding for the period. Diluted
earnings per share reflects the potential dilution of securities by including
other common stock equivalents, including stock options, in the weighted average
number of common shares outstanding for a period if the effect of such inclusion
would be dilutive.
9
QUEST SOFTWARE, INC.
NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued)
During the three and nine months ended September 30, 2000 and 2001, there
is no difference between basic and diluted earnings per share as inclusion of
common stock equivalents (stock options) would have been anti-dilutive. The
dilutive effect of stock options would have been 3,859 and 4,211 shares for the
three and nine months ended September 30, 2001, respectively, compared to 5,784
and 5,875 shares for the same periods of 2000.
5. SHAREHOLDERS' EQUITY
Under the Company's Employee Stock Purchase Plan approximately 94,000
shares of common stock were issued in January 2001 at a price of $31.82 per
share and approximately 109,000 shares of common stock were issued in July 2001
at a price of $23.86 per share.
In December 2000, the Board of Directors authorized a share repurchase
program under which the Company may repurchase up to 2.0 million shares from
time to time in open market or private transactions. As of September 30, 2001,
the Company had repurchased 1.7 million shares for approximately $57.4 million.
In October 2001, the Board of Directors increased the total number of shares
authorized for repurchase under this program to 5.0 million.
6. STOCK OPTION PLANS
The following table summarizes information about stock options outstanding
as of September 30, 2001 (in thousands, except for per share data):
NUMBER OF OPTIONS
NUMBER OF WEIGHTED AVERAGE EXERCISABLE AS OF
SHARES EXERCISE PRICE SEPTEMBER 30, 2001
--------- ---------------- ------------------
Balance at December 31, 2000 10,641 $ 12.72
Granted 5,398 16.09
Exercised (1,372) 4.33
Canceled (1,817) 19.19
-------
Balance at September 30, 2001 12,850 $ 14.12 2,664
=======
7. OPERATING SEGMENT DATA
Operating segments are defined as components of an enterprise about which
separate financial information is available that is evaluated regularly by the
Company's chief operating decision maker, or decision making group, in deciding
how to allocate resources and in assessing performance. The operating segments
of the Company are managed separately because each segment represents a
strategic business unit that offers different products or services.
The Company's reportable operating segments include Licenses and Services.
The Licenses segment develops and markets the Company's software products. The
Services segment provides after-sale support for software products and fee-based
training and consulting services related to the Company's products.
The Company does not separately allocate operating expenses to these
segments, nor does it allocate specific assets to these segments. Therefore,
segment information reported includes only revenues, cost of revenues and gross
profit, as this information and the geographic information described below are
the only information provided to the chief operating decision maker on a segment
basis.
10
QUEST SOFTWARE, INC.
NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Operating segment data for the three and nine months ended September 30,
2000 and 2001 were as follows (in thousands):
LICENSES SERVICES TOTAL
-------- -------- ---------
Three months ended September 30, 2000
Revenues $ 34,036 $ 10,086 $ 44,122
Cost of Revenues 2,118 2,911 5,029
-------- -------- --------
Gross profit $ 31,918 $ 7,175 $ 39,093
======== ======== ========
Three months ended September 30, 2001
Revenues $ 37,584 $ 18,755 $ 56,339
Cost of Revenues 2,842 4,616 7,458
-------- -------- --------
Gross profit $ 34,742 $ 14,139 $ 48,881
======== ======== ========
Nine months ended September 30, 2000
Revenues $ 84,459 $ 25,043 $109,502
Cost of Revenues 5,381 7,034 12,415
-------- -------- --------
Gross profit $ 79,078 $ 18,009 $ 97,087
======== ======== ========
Nine months ended September 30, 2001
Revenues $135,171 $ 51,142 $186,313
Cost of Revenues 8,795 13,105 21,900
-------- -------- --------
Gross profit $126,376 $ 38,037 $164,413
======== ======== ========
Revenues are attributed to geographic areas based on the location of the
entity from which the products or services were sold. Revenues, gross profit,
loss from operations and long-lived assets concerning principal geographic areas
in which the Company operates for the three and nine months ended September 30,
2000 and 2001, respectively, were as follows (in thousands):
11
QUEST SOFTWARE, INC.
NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NORTH OTHER
AMERICA(1) EUROPE INTERNATIONAL TOTAL
----------- ------- ------------- ---------
Three months ended September 30, 2000
Revenues $ 37,043 $ 6,543 $ 536 $ 44,122
Gross profit 34,981 3,822 290 39,093
Loss from operations (5,983) (197) (1,934) (8,114)
Long-lived assets 300,876 1,138 3,079 305,093
Three months ended September 30, 2001
Revenues $ 44,042 $10,869 $ 1,428 $ 56,339
Gross profit 39,627 8,330 924 48,881
Loss from operations (14,949) (159) (3,093) (18,201)
Long-lived assets 270,756 2,604 2,917 276,277
Nine months ended September 30, 2000
Revenues $ 91,417 $16,222 $ 1,863 $109,502
Gross profit 87,514 8,813 760 97,087
Loss from operations (14,651) (256) (4,925) (19,832)
Long-lived assets 300,876 1,138 3,079 305,093
Nine months ended September 30, 2001
Revenues $150,395 $31,775 $ 4,143 $186,313
Gross profit 142,148 20,085 2,180 164,413
Loss from operations (24,240) (4,033) (9,755) (38,028)
Long-lived assets 270,756 2,604 2,917 276,277
(1) Principally represents operations in the United States.
8. INVESTMENTS
The Company has classified all debt securities with original maturities of
greater than three months as available-for-sale. Available-for-sale securities
are carried at fair value, with unrealized gains and losses reported as a
separate component of shareholders' equity net of applicable income taxes.
Realized gains and losses and declines in value judged to be
other-than-temporary on available-for-sale securities are included in other
income. The cost basis for realized gains and losses on available-for-sale
securities is determined on a specific identification basis. The Company has
classified available-for-sale securities as current or long-term based primarily
on the maturity date of the related securities.
The Company has certain other minority equity investments in non-publicly
traded companies. These investments are included in other assets on the
Company's consolidated balance sheet at September 30, 2001 and are carried at
cost. The Company monitors these investments for impairment and as a result
recorded a write-down of $1.5 million in June 2001. The Company does not believe
that any further impairment exists for the three months ended September 30, 2001
and has not recorded any additional impairment charges.
12
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Certain statements in this report, including statements regarding our
business strategies, operations, financial conditions and prospects, are
forward-looking statements. Use of the words "believe," "expect," "anticipate,"
"will," "contemplate," "would" and similar expressions that contemplate future
events may identify forward-looking statements. Numerous important factors,
risks and uncertainties affect our operations and could cause actual results to
differ materially from those expressed or implied by these or any other
forward-looking statements made by us or on our behalf. Readers are urged to
carefully review and consider the various disclosures made in this report,
including those described under "Risk Factors," and in our Annual Report on Form
10-K for the year ended December 31, 2000 and other filings with the SEC, that
attempt to advise interested parties of certain risks and factors that may
affect our business. Readers are cautioned not to place undue reliance on these
forward-looking statements, which are based on current expectations and reflect
management's opinions only as of the date thereof. We do not assume any
obligation to revise or update forward-looking statements.
OVERVIEW
We provide application management software solutions that enhance our
customers' return on IT investment dollars by maximizing the availability,
performance and manageability of business critical applications and their
underlying components and by improving the cost effectiveness of a customers
information technology investments, including personnel, software and hardware.
Each of our product families consists of an integrated suite of software tools
that enable personnel to manage and administer complex database systems and
business applications, both packaged and custom developed. These applications
include ERP (enterprise resource planning) systems, CRM (customer relationship
management) systems, B2B (business to business) e-commerce systems, corporate
messaging and Internet applications. We enable organizations to leverage IT
infrastructure investments by maximizing the performance and availability of
enterprise applications with solutions for High Availability, Application
Monitoring, Database Management, SQL Development, and Report Management. We also
have an integrated product suite directed at managing Microsoft 2000 and
Exchange environments.
We derive our revenues primarily from the sale of software licenses and
related annual maintenance fees. Pricing of our software licenses is generally
either server-based or, for our SQL development and report management tools,
user-based. Services consist primarily of annual maintenance contracts for
technical support and product enhancements, and consulting services.
We recognize software license revenues when a non-cancelable license
agreement has been signed with a customer, delivery of the software has
occurred, the fees are fixed and determinable, no significant post-delivery
vendor obligations remain and collection is deemed probable. Maintenance
revenues are recognized ratably over the contract term, which is typically one
year. Revenues for consulting services are recognized as such services are
performed.
13
RESULTS OF OPERATIONS
The following table sets forth certain consolidated statements of operations
data as a percentage of total revenues, except as indicated:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2000 2001 2000 2001
----- ----- ------ ------
Revenues:
Licenses 77.1% 66.7% 77.1% 72.6%
Services 22.9 33.3 22.9 27.4
----- ----- ----- -----
Total revenues 100.0 100.0 100.0 100.0
Cost of revenues:
Licenses 2.0 1.7 2.2 1.6
Services 6.6 8.2 6.4 7.0
Amortization of purchased intangible assets 2.8 3.4 2.7 3.1
----- ----- ----- -----
Total cost of revenues 11.4 13.3 11.3 11.7
----- ----- ----- -----
Gross profit 88.6 86.7 88.7 88.3
Operating expenses:
Sales and marketing 46.6 52.5 47.0 49.2
Research and development 25.2 27.1 25.4 24.0
General and administrative 11.5 10.3 10.8 9.8
Other compensation costs
and intangible amortization 23.7 29.1 23.6 25.7
----- ----- ----- -----
Total operating expenses 107.0 119.0 106.8 108.7
----- ----- ----- -----
Loss from operations (18.4) (32.3) (18.1) (20.4)
Other income, net 8.3 4.7 7.6 3.3
Losses on equity investments - - - (0.8)
----- ----- ----- -----
Loss before income taxes (10.1) (27.6) (10.5) (17.9)
Income tax provision (benefit) 4.1 (8.4) 4.4 2.8
----- ----- ----- -----
Net loss (14.2)% (19.2)% (14.9)% (20.7)%
===== ===== ===== =====
As a percentage of related revenues:
Cost of licenses 2.6% 2.5% 2.9% 2.2%
Cost of services 28.9% 24.6% 27.9% 25.5%
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 2001
REVENUES
Total revenues for the three and nine months ended September 30, 2001 were
$56.3 million and $186.3 million, respectively, an increase of 27.7% and 70.1%
from the comparable periods of 2000. Revenues outside of North America for the
three and nine months ended September 30, 2001 were $12.3 million and $35.9
million, respectively, an increase of 73.7% and 98.6% from the comparable
periods of 2000.
Licenses
License revenues for the three and nine months ended September 30, 2001 were
$37.6 million and $135.2 million, respectively, an increase of 10.4% and 60.0%
from the comparable periods of 2000. License revenues represented 66.7% and
14
2.6% of total revenues for the three and nine months ended September 30, 2001,
respectively, compared to 77.1% of total revenues for the same periods of 2000.
Licenses outside of North America accounted for 25.3% and 21.1% of total
licenses for the three and nine months ended September 30, 2001, respectively,
compared to 16.6% and 17.4% for the same periods in 2000. The increases in
licenses during the three and nine month periods ended September 30, 2001 were
due to expansion of our worldwide sales force, as well as increased market
acceptance of our software products and availability of new products relative to
the comparable periods of 2000. New products include Quest Central for DB2 and a
variety of products for the Microsoft Windows, as well as the LiveReorg and
SQLab Vision products for Oracle. Our license revenues for the three months
ended September 30, 2001 were less than originally anticipated by market
analysts, in large part due to reluctance by certain customers to complete large
license transactions in the wake of business uncertainty following the September
11, 2001 terrorist attacks. We cannot predict what continuing effects these
events, in conjunction with a weakening economic environment, may have on our
revenues in future quarters.
Services
Services for the three and nine months ended September 30, 2001 were $18.8
million and $51.1 million, respectively, an increase of 86.0% and 104.2% from
the comparable periods of 2000. Services revenues represented 33.3% and 27.4% of
total revenues for the three and nine months ended September 30, 2001,
respectively, compared to 22.9% for the same periods of 2000. Services revenues
outside of North America accounted for 14.9% and 14.5% of total services for the
three and nine months ended September 30, 2001, respectively, compared to 14.0%
and 13.7% for the same periods in 2000. The increases in services during the
three and nine month periods ended September 30, 2001 reflect an increase in the
number of software licenses sold with maintenance agreements and renewals of
maintenance agreements on an expanding installed base of products, and, to a
significantly lesser extent, the increase in consulting and training services
performed for customers.
COST OF REVENUES
Cost of Licenses
Cost of licenses includes amortization of software licenses, product media,
printing and duplication costs and product royalties. Cost of licenses was $0.9
million and $3.0 million for the three and nine months ended September 30, 2001,
respectively, versus $0.9 million and $2.4 million in the comparable periods of
2000. Cost of licenses as a percentage of license revenues were 2.5% and 2.2%
for the three and nine months ended September 30, 2001, respectively, compared
to 2.6% and 2.9% for the same periods in 2000. The dollar cost increase in cost
of licenses was principally the result of increases in royalties resulting from
the growth in sales of related products, partially offset by a decrease in
printing and duplication costs. The improvement in gross margin resulted from
increased license revenues without a corresponding increase in amortization of
acquired software licenses, which does not vary by the number of licenses sold.
Cost of Services
Cost of services includes salaries and related costs for customer support
and consulting personnel. Cost of services for the three and nine months ended
September 30, 2001 was $4.6 million and $13.1 million, respectively, versus $2.9
million and $7.0 million for the comparable periods of 2000. Cost of services as
a percentage of services revenues was 24.6% and 25.5% for the three and nine
months ended September 30, 2001, respectively, compared to 28.9% and 27.9% for
the same periods in 2000. The dollar cost increase in cost of services is
primarily due to the increase in the number of technical support personnel
required to manage and support our growing customer base as well as increased
product offerings. The improvement in gross margin resulted from a larger
installed base of customers and renewable maintenance, without an associated
increase in head count to facilitate expanded operations. Our gross margin on
services revenues could fluctuate on a quarterly basis in the future, reflecting
the timing differences between increasing our organizational investments and the
corresponding revenue growth that we expect as a result.
Amortization of Purchased Intangible Assets
Amortization of purchased intangible assets was $1.9 million and $5.8
million during the three and nine months ended September 30, 2001, respectively,
versus $1.2 million and $3.0 million in the same periods of 2000. This increase
was due entirely to amortization of technology purchased as part of the
acquisitions made during the third quarter of 2000. The useful lives of the
technology acquired range from one to three years, and we expect the
amortization to be at least $1.0 million over the next eight quarters.
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OPERATING EXPENSES
Sales and Marketing
Sales and marketing expenses consist primarily of salaries, sales
commissions benefits, recruiting costs, trade shows, travel and entertainment
and other marketing communications costs such as advertising and promotion.
Sales and marketing expenses were $29.6 million and $91.7 million for the three
and nine months ended September 30, 2001, respectively, versus $20.6 million and
$51.5 million for the comparable periods of 2000, representing increases of
43.8% and 78.2%, respectively. Sales and marketing expenses as a percentage of
total revenues were 52.5% and 49.2% for the three and nine months ended
September 30, 2001, respectively, compared to 46.6% and 47.0% in the same
periods of 2000. The increases reflect our investment in our sales and marketing
organization. In particular, sales and marketing employees increased from 509 as
of September 30, 2000 to 718 as of September 30, 2001, an increase of 41.1%. The
increase in expenses as a percentage of total revenue for the three months ended
September 30, 2001 compared to the same period in 2000 is due to sequentially
lower license revenues in the quarter.
Research and Development
Research and development expenses consist primarily of salaries and
benefits for software developers, software product managers, quality assurance
and technical documentation personnel, and of payments made to outside software
development contractors. Research and development expenses were $15.3 million
and $44.6 million for the three and nine months ended September 30, 2001,
respectively, versus $11.1 million and $27.8 million in the same periods of
2000, representing increases of 37.3% and 60.5%, respectively. These expenses as
a percentage of total revenues were 27.1% and 24.0% for the three and nine
months ended September 30, 2001, respectively, compared to 25.2% and 25.4% in
the same periods of 2000. The increase in research and development expenses was
primarily due to increases in the number of software developers, technical
documentation and quality assurance personnel. Research and development
headcount increased from 470 as of September 30, 2000 to 617 as of September 30,
2001, an increase of 31.3%. The increase in expenses as a percentage of total
revenue for the three months ended September 30, 2001 compared to the same
period in 2000 is due to sequentially decreased license revenues. We believe
significant expenditures in research and development are required to remain
competitive, and expect that research and development expenses will continue to
represent 20-25% of total revenues.
In the development of new products and enhancements of existing products,
the technological feasibility of the software is not established until
substantially all product development is complete. Historically, our software
development costs eligible for capitalization have been insignificant, and all
costs related to internal research and development have been expensed as
incurred.
General and Administrative
General and administrative expenses consist primarily of salaries, benefits
and related costs for our executive, finance, administrative and information
services personnel. General and administrative expenses were $5.8 million and
$18.2 million for the three and nine months ended September 30, 2001,
respectively, versus $5.1 million and $11.8 million in the same periods of 2000,
representing increases of 15.0% and 54.9%, respectively. These expenses as a
percentage of total revenues were 10.3% and 9.8% for the three and nine months
ended September 30, 2001, respectively, compared to 11.5% and 10.8% in the same
periods of 2000. The increase in general and administrative expenses was
primarily due to the increase in headcount to support our growing infrastructure
and expanding operations. General and administrative expenses are decreasing as
a percentage of revenues, primarily because associated headcount is growing
more slowly than revenues.
Other Compensation Costs and Intangible Amortization
Other compensation costs and intangible amortization include compensation
expense associated with the issuance (primarily in 1999) of stock options below
fair market value and the amortization of goodwill and other intangible assets
associated with acquisitions. These costs totaled $16.4 million and $47.9
million for the three and nine months ended September 30, 2001, respectively,
compared to $10.5 million and $25.9 million in the same
16
periods of 2000. These expenses as a percentage of total revenues were 29.1% and
25.7% for the three and nine months ended September 30, 2001, respectively,
compared to 23.7% and 23.6% in the same periods of 2000. The increase in these
costs was due to the acquisitions made during the third quarter of 2000 and
2001. The adoption of SFAS No. 142 in January of 2002 will substantially reduce
charges to operations for goodwill amortization and change the method for
determining impairment. The effect on the financial statements has not been
determined. Currently, the Company's amortization of goodwill and other
intangible assets is approximately $14.0 million per quarter. The Company will
continue to monitor goodwill for impairment through the end of the fiscal year.
OTHER INCOME, NET
Other income, net was $2.7 million and $6.1 million for the three and nine
months ended September 30, 2001, respectively, compared to $3.7 million and $8.3
million for the same periods of 2000, representing a decrease of 27.9% and
26.1%, respectively. The decrease is due primarily to less interest income
earned in the three months ended September 30, 2001 versus the same period in
2000. The decrease in interest earned is a result of declining interest rates
and reductions in cash balances by cash used in acquisitions and the stock
repurchases made in December 2000. The average interest rates of our investments
are summarized under "Item 3: Quantitative and Qualitative Disclosures About
Market Risks -- Interest Rate Risk" below. We expect these average interest
rates to come down significantly given the current historically low interest
rate environment. Other income, net in the September quarter included a foreign
currency benefit of $0.5 million.
LOSSES ON EQUITY INVESTMENTS
During the second quarter of 2001 we wrote down the carrying value of
certain equity investments by $1.5 million to reflect their estimated fair
value. Based on the Company's most recent analysis, no additional impairment
exists as of September 30, 2001.
INCOME TAXES
Income tax provision (benefit) for the three and nine months ended
September 30, 2001 was $(4.7) million and $5.2 million, respectively, compared
with $1.8 million and $4.8 million for the same periods of 2000, representing
effective rates of 30.3% and (15.7)%, for the three and nine months ended
September 30, 2001, respectively, compared to (41.1)% and (42.0)% in the same
periods of 2000. The estimated annual effective rate for 2001 decreased from
55.8% in the second quarter to 15.7% in the third quarter resulting in a tax
(benefit) in the third quarter. The decrease in the estimated annual effective
rate is due primarily to lower operating income.
INFLATION
Inflation has not had a significant effect on our results of operations or
financial position for the three and nine months ended September 30, 2001 or the
comparable periods of 2000.
LIQUIDITY AND CAPITAL RESOURCES
We have funded our business, to date, primarily from cash generated by our
operations, net proceeds of $64.9 million from our initial public offering in
August 1999, and net proceeds of $253.5 million from our secondary offering in
March 2000. Our sources of liquidity as of September 30, 2001 consisted
principally of cash and cash equivalents of $59.9 million and $134.0 million in
short- and long-term high grade corporate and government marketable securities.
Net cash provided by operating activities was $15.6 million and $51.7
million for the nine months ended September 30, 2000 and 2001, respectively. The
increase in 2001 is primarily due to higher net income and higher non-cash
depreciation and amortization expenses as a result of increased amortization of
goodwill and other intangible assets, which increased by $28.0 million, or
97.5%, over the comparable period of 2000. A tax refund of $4.6 million,
increases in deferred revenue, accounts receivable and income taxes payable,
offset by net losses also contributed to the increase in 2001.
Investing activities used $278.6 million and $26.5 million during the nine
months ended September 30, 2000 and 2001, respectively. The decrease in 2001 is
due to purchases of marketable securities made in March of 2000 as a result of
our secondary public offering as well as acquisitions made during the first and
second quarter of 2000 with dissimilar activity in 2001.
17
Financing activities provided $258.0 million and $9.7 million for the nine
months ended September 30, 2000 and 2001, respectively. The decrease is
primarily due to proceeds of $253.5 million received from the secondary public
offering in March 2000. Offsetting this decrease were increases in proceeds from
the exercise of stock options and our employee stock purchase plan during 2001.
We believe that our existing cash, cash equivalents and investment balances
and cash flows from operations will be sufficient to finance our working capital
and capital expenditure requirements through at least the next 12 months. We may
require additional funds to support our working capital requirements or for
other purposes, and may seek to raise additional funds through public or private
equity or debt financing, or from other sources. If additional financing is
needed, we cannot assure you that such financing will be available to us at
commercially reasonable terms or at all.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In September 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 133, Accounting for Derivative
Instruments and Hedging Activities ("SFAS No. 133"). SFAS No. 133, as amended,
is effective for all fiscal years beginning after June 15, 2000, and establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts and for hedging activities.
Under SFAS 133, certain contracts that were not formerly considered derivatives
may now meet the definition of a derivative which would be required to be
reported as assets or liabilities and carried at fair value. The Company adopted
SFAS 133 effective January 1, 2001. The adoption of SFAS No. 133 did not have a
significant impact on the financial position, results of operations, or cash
flows of the Company.
In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business
Combinations." SFAS 141 requires the purchase method of accounting for business
combinations initiated after June 30, 2001 and eliminates the pooling-of-
interests method. SFAS 141 also requires reclassification of certain other
identifiable assets to a separate financial statement line to the extent they
meet certain criteria. The Company does not believe that the adoption of SFAS
141 will have a significant impact on its financial statements.
In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 142 ("SFAS 142"), "Goodwill and
Other Intangible Assets", which is effective for the Company in January of 2002.
SFAS No. 142 requires that goodwill and other intangible assets with indefinite
useful lives no longer be amortized, but instead tested for impairment at least
annually. The Company will continue to assess its recorded goodwill and other
intangible assets under current generally accepted accounting principles at each
reporting period until the standard is adopted. The adoption of SFAS No. 142 in
January of 2002 will substantially reduce charges to operations for goodwill
amortization and change the method for determining impairment. The effect on the
financial statements has not been determined. Currently, the Company's
amortization of goodwill and other intangible assets is approximately $14.0
million per quarter.
In August 2001, the FASB issued Statement of Financial Accounting Standard
No. 143 ("SFAS 143"), Accounting for Asset Retirement Obligations, which
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 is required to be adopted for fiscal years beginning after
June 15, 2002. The Company has not yet determined what effect this statement
will have on its financial statements.
Also in August 2001, the FASB issued Statement of Financial Accounting
Standard No. 144 ("SFAS 144"), Accounting for the Impairment or Disposal of
Long-Lived Assets, which supersedes FASB Statement No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of.
This new statement also supersedes certain aspects of Accounting Principles
Board ("APB") 30, Reporting the Results of Operations-Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions, with regard to reporting the effects of a
disposal of a segment of a business and will require expected future operating
losses from discontinued operations to be reported in discontinued operations in
the period incurred (rather than as of the measurement date as presently
required by APB 30). In addition, more dispositions may qualify for discontinued
operations treatment. The provisions of this
18
statement are required to be applied for fiscal years beginning after December
15, 2001 and interim periods within those fiscal years. The Company has not yet
determined what effect his statement will have on its financial statements.
19
RISK FACTORS
An investment in our shares involves risks and uncertainties. You should
carefully consider the factors described below before making an investment
decision in our securities. The risks described below are the risks that we
currently believe are material risks of business and the industry in which we
compete.
Our business, financial condition and results of operations could be
adversely affected by any of the following risks. If we are adversely affected
by such risks, then the trading price of our common stock could decline, and you
could lose all or part of your investment.
RISKS RELATED TO OUR BUSINESS
OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE IN FUTURE PERIODS AND, AS A
RESULT, WE MAY FAIL TO MEET EXPECTATIONS OF INVESTORS AND ANALYSTS, CAUSING OUR
STOCK PRICE TO FLUCTUATE OR DECLINE
Our revenues and operating results may vary significantly from quarter to
quarter due to a number of factors. These factors include the following:
- the size and timing of customer orders. See "-- The size and timing of
our customer orders may vary significantly from quarter to quarter
which could cause fluctuations in our revenues."
- the unpredictability of the timing and level of sales through our
indirect sales channel;
- the timing of revenue recognition for sales of software products and
services;
- the extent to which our customers renew their maintenance contracts
with us;
- exposure to general economic conditions and reductions in corporate IT
spending;
- changes in our level of operating expenses and our ability to control
costs;
- our ability to attain market acceptance of new products and services
and enhancements to our existing products;
- changes in our pricing policies or the pricing policies of our
competitors;
- the relative growth rates of competing operating system, database and
application platforms;
- costs related to acquisitions of technologies or businesses, including
amortization of goodwill and other intangible assets; and
- the timing of releases of new versions of third-party software
products that our products support.
20
Fluctuations in our results of operations are likely to affect the market
price of our common stock that may not be related to our long-term performance.
THE SIZE AND TIMING OF OUR CUSTOMER ORDERS MAY VARY SIGNIFICANTLY FROM QUARTER
TO QUARTER WHICH COULD CAUSE FLUCTUATIONS IN OUR REVENUES AND OPERATING RESULTS
Our license revenues in any quarter are substantially dependent on orders
booked and shipped in that quarter. Our revenues in a given quarter could be
adversely affected if we are unable to complete one or more large license
agreements, or if the contract terms were to prevent us from recognizing revenue
during that quarter. The sales cycles for certain of our software products, such
as Vista Plus and SharePlex, can last from three to nine months and often
require pre-purchase evaluation periods and customer education. Also, we have
often booked a large amount of our sales in the last month or weeks of each
quarter and delays in the closing of sales near the end of a quarter could cause
quarterly revenue to fall short of anticipated levels. Finally, while a portion
of our revenues each quarter is recognized from previously deferred revenue, our
quarterly performance will depend primarily upon entering into new contracts to
generate revenues for that quarter. These factors may cause significant periodic
variation in our license revenues. In addition, we incur or commit to operating
expenses based on anticipated revenue levels, and generally do not know whether
revenues in any quarter will meet expectations until the end of that quarter.
Accordingly, if our revenue growth rates slow or our revenues decline, our
operating results could be seriously impaired because many of our expenses are
relatively fixed in nature and cannot be easily or quickly changed.
GENERAL ECONOMIC CONDITIONS AND REDUCTIONS IN CORPORATE IT SPENDING MAY CONTINUE
TO AFFECT REVENUE GROWTH RATES AND IMPACT OUR BUSINESS
Our business and operating results are subject to the effects of changes in
general economic conditions. Recent unfavorable economic conditions have
resulted in reduced corporate IT spending in the industries that we serve and a
softening of demand for computer software, not only in the database and
application market segments we support but also in the product segment in which
we compete. In addition, recent terrorist attacks upon the United States have
added or exacerbated economic, political and other uncertainties. If these
economic conditions do not improve, or we experience continued deterioration in
general economic conditions or reduced corporate IT spending, our business and
operating results could be adversely impacted.
MANY OF OUR PRODUCTS ARE DEPENDENT ON ORACLE'S TECHNOLOGIES; IF ORACLE'S
TECHNOLOGIES LOSE MARKET SHARE OR BECOME INCOMPATIBLE WITH OUR PRODUCTS, THE
DEMAND FOR OUR PRODUCTS COULD SUFFER
We believe that our success has depended in part, and will continue to
depend in part for the foreseeable future, upon our relationship with Oracle and
our status as a complementary software provider for Oracle's database and
application products. Many versions of our products, including SharePlex, SQLab
Vision, and SQL Navigator, are specifically designed to be used with Oracle
databases. Although a number of our products work with other environments, our
competitive advantage consists in substantial part on the integration between
our products and Oracle's products, and our extensive knowledge of Oracle's
technology. Currently, a significant portion of our total revenues are derived
from products that specifically support Oracle-based products. If Oracle for any
reason decides to promote technologies and standards that are not compatible
with our technology, or if Oracle loses market share for its database products,
our business, operating results and financial condition would be materially
adversely affected.
MANY OF OUR PRODUCTS ARE VULNERABLE TO DIRECT COMPETITION FROM ORACLE
We currently compete with Oracle in the market for database management
solutions. We expect that Oracle's commitment to and presence in the database
management product market will increase in the future and therefore
substantially increase competitive pressures. We believe that Oracle will
continue to incorporate database management technology into its server software
offerings, possibly at no additional cost to its users. We believe that Oracle
will also continue to enhance its database management technology. Furthermore,
Oracle could attempt to increase its presence in this market by acquiring or
forming strategic alliances with our competitors, and Oracle may be in better
position to withstand and respond to the current factors impacting this
industry. Oracle has a longer operating history, a larger installed base of
customers and substantially greater financial, distribution, marketing and
21
technical resources than we do. In addition, Oracle has well-established
relationships with many of our present and potential customers. As a result, we
may not be able to compete effectively with Oracle in the future, which could
materially adversely affect our business, operating results and financial
condition.
OUR SUCCESS DEPENDS ON OUR ABILITY TO DEVELOP NEW AND ENHANCED PRODUCTS THAT
ACHIEVE WIDESPREAD MARKET ACCEPTANCE
Our future success depends on our ability to address the rapidly changing
needs of our customers by developing and introducing new products, product
updates and services on a timely basis, by extending the operation of our
products on new platforms and by keeping pace with technological developments
and emerging industry standards. In order to grow our business, we are
committing substantial resources to developing software products and services
for the applications management market. If this market does not continue to
develop as anticipated, or demand for our products in this market does not
materialize or occurs more slowly than we expect, or if our development efforts
are delayed or unsuccessful, we will have expended substantial resources and
capital without realizing sufficient revenues, and our business and operating
results could be adversely affected.
ACQUISITIONS OF COMPANIES OR TECHNOLOGIES MAY RESULT IN DISRUPTIONS TO OUR
BUSINESS AND DIVERSION OF MANAGEMENT ATTENTION
We have in the past made and we expect to continue to make acquisitions of
complementary companies, products or technologies. If we make any additional
acquisitions, we will be required to assimilate the operations, products and
personnel of the acquired businesses and train, retain and motivate key
personnel from the acquired businesses. We may be unable to maintain uniform
standards, controls, procedures and policies if we fail in these efforts.
Similarly, acquisitions may subject us to liabilities and risks that are not
known or identifiable at the time of the acquisition or may cause disruptions in
our operations and divert management's attention from day-to-day operations,
which could impair our relationships with our current employees, customers and
strategic partners. We may have to incur debt or issue equity securities to pay
for any future acquisitions. The issuance of equity securities for any
acquisition could be substantially dilutive to our shareholders. In addition,
our profitability may suffer because of acquisition-related costs or
amortization costs for acquired goodwill and other intangible assets. In
consummating acquisitions, we are also subject to risks of entering geographic
and business markets in which we have no or limited prior experience. If we are
unable to fully integrate acquired businesses, products or technologies with our
existing operations, we may not receive the intended benefits of acquisition.
OUR ABILITY TO INCREASE OUR REVENUES DEPENDS ON OUR ABILITY TO EXPAND OUR
INDIRECT SALES CHANNELS
We intend to aggressively pursue expansion of our indirect sales channels
through arrangements with resellers, systems integrators and distributors. In
certain domestic and international markets we may miss sales opportunities if we
are unable to enter into successful relationships with locally based resellers.
We may become more dependent on these type of relationships. There can be no
assurance that we will successfully develop these relationships or that the
expansion of indirect sales distribution methods will increase revenues.
OUR PAST AND FUTURE GROWTH MAY STRAIN OUR MANAGEMENT, ADMINISTRATIVE,
OPERATIONAL AND FINANCIAL INFRASTRUCTURE
We have recently experienced a period of rapid growth in our operations
that has placed and will continue to place a strain on our management,
administrative, operational and financial infrastructure. During this period, we
have experienced an increase in the number of our employees, increasing demands
on our operating and financial systems and personnel, and an expansion in the
geographic coverage of our operations. Our ability to manage our operations and
growth requires us to continue to improve our operational, financial and
management controls, and reporting systems and procedures. We may need to expand
our facilities or relocate some or all of our employees or operations from time
to time to support growth. These relocations could result in temporary
disruptions of our operations or a diversion of management's attention and
resources. In addition, we will be required to hire additional management,
financial and sales and marketing personnel to manage our expanding operations.
If we are unable to manage this growth effectively, our business, operating
results and financial condition may be materially adversely affected.
22
WE MAY NOT GENERATE INCREASED BUSINESS FROM OUR CURRENT CUSTOMERS, WHICH COULD
SLOW OUR REVENUE GROWTH IN THE FUTURE
Most of our customers initially make a purchase of our products for a
single department or location. Many of these customers may choose not to expand
their use of our products. If we fail to generate expanded business from our
current customers, our business, operating results and financial condition could
be materially adversely affected. In addition, as we deploy new modules and
features for our existing products or introduce new products, our current
customers may choose not to purchase this new functionality or these new
products. Moreover, if customers elect not to renew their maintenance
agreements, our service revenues would be materially adversely affected.
OUR INTERNATIONAL OPERATIONS AND OUR PLANNED EXPANSION OF OUR INTERNATIONAL
OPERATIONS EXPOSES US TO CERTAIN RISKS
We intend to expand our international sales activities as part of our
business strategy. As a result, we face increasing risks from doing business on
an international basis, including, among others:
- difficulties in staffing and managing foreign operations;
- longer payment cycles;
- seasonal reductions in business activity in Europe;
- increased financial accounting and reporting burdens and complexities;
- potentially adverse tax consequences;
- potential loss of proprietary information due to piracy,
misappropriation or weaker laws regarding intellectual property
protection;
- delays in localizing our products;
- compliance with a wide variety of complex foreign laws and treaties;
and
- licenses, tariffs and other trade barriers.
In addition, because our international subsidiaries generally conduct
business in the currency of the country in which they operate, our exposure to
exchange rate fluctuations, which are outside of our control, will increase as
our international operations expand. We have not yet entered into any hedging
transactions to mitigate exposure to foreign currency fluctuations.
Operating in international markets also requires significant management
attention and financial resources and will place additional burdens on our
management, administrative, operational and financial infrastructure. We cannot
be certain that our investments in establishing facilities in other countries
will produce desired levels of revenue or profitability. In addition, we have
sold our products internationally for only a few years and we have limited
experience in developing localized versions of our products and marketing and
distributing them internationally.
23
INVESTING IN DEVELOPMENT-STAGE COMPANIES INVOLVES A NUMBER OF RISKS AND
UNCERTAINTIES
We have and may continue to make investments in development-stage companies
that we believe provide strategic opportunities for Quest. Each of these
investments involves a number of risks and uncertainties, including diversion of
management attention, inability to identify strategic opportunities, inability
to value investments appropriately, inability to manage investments effectively
and loss of cash invested. We intend that these investments will complement our
own research and development efforts, provide access to new technologies and
emerging markets, and create opportunities for additional sales of our products
and services. However, we cannot assure you that this initiative will have the
above mentioned desired results, or even that we will not lose all or any part
of these investments.
FAILURE TO DEVELOP STRATEGIC RELATIONSHIPS COULD HARM OUR BUSINESS BY DENYING US
SELLING OPPORTUNITIES AND OTHER BENEFITS
Our current collaborative relationships may not prove to be beneficial to
us, and they may not be sustained. We also may not be able to enter into
successful new strategic relationships in the future, which could have a
material adverse effect on our business, operating results and financial
condition. From time to time, we have collaborated with other companies,
including Hewlett-Packard and Oracle and certain of the national accounting
firms that provide system integration services, in areas such as product
development, marketing, distribution and implementation. We could lose sales
opportunities if we fail to work effectively with these parties. Moreover, we
expect that maintaining and enhancing these and other relationships will become
a more meaningful part of our business strategy in the future. However, many of
our current partners are either actual or potential competitors with us. In
addition, many of these third parties also work with competing software
companies and we may not be able to maintain these existing relationships, due
to the fact that these relationships are informal or, if written, are terminable
with little or no notice.
OUR PROPRIETARY RIGHTS MAY BE INADEQUATELY PROTECTED, AND THERE IS RISK OF
INFRINGEMENT CLAIMS OR INDEPENDENT DEVELOPMENT OF COMPETING TECHNOLOGY THAT
COULD HARM OUR COMPETITIVE POSITION
Our success and ability to compete are dependent on our ability to develop
and maintain the proprietary aspects of our technology. We rely on a combination
of trademark, trade secret, copyright law and contractual restrictions to
protect the proprietary aspects of our technology.
Despite our efforts to protect our proprietary rights, unauthorized parties
may attempt to copy aspects of our products or to obtain and use information
that we regard as proprietary. Litigation may be necessary in the future to
enforce our intellectual property rights, to protect our trade secrets, and to
determine the validity and scope of the proprietary rights of others. Any such
resulting litigation could result in substantial costs and diversion of
resources.
Our means of protecting our proprietary rights may prove to be inadequate
and competitors may independently develop similar or superior technology.
Policing unauthorized use of our products is difficult, and we cannot be certain
that the steps we have taken will prevent misappropriation of our technology,
particularly in foreign countries where the laws may not protect our proprietary
rights as fully as in the United States. We also believe that, because of the
rapid rate of technological change in the software industry, trade secret and
copyright protection are less significant than factors such as the knowledge,
ability and experience of our employees, frequent product enhancements and the
timeliness and quality of customer support services.
Our success and ability to compete are also dependent on our ability to
operate without infringing upon the proprietary rights of others. Third parties
may claim infringement by us of their intellectual property rights. In the event
of a successful claim of product infringement against us and our failure or
inability to either license the infringed or similar technology or develop
alternative technology on a timely basis, we may incur substantial licensing
fees, be liable for infringement damage, or be unable to market our products.
OUR BUSINESS WILL SUFFER IF OUR SOFTWARE CONTAINS ERRORS
The software products we offer are inherently complex. Despite testing and
quality control, we cannot be certain that errors will not be found in current
versions, new versions or enhancements of our products after commencement of
commercial shipments. Significant technical challenges also arise with our
products because our customers purchase and deploy our products across a variety
of computer platforms and integrate it with a number of third-
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party software applications and databases. If new or existing customers have
difficulty deploying our products or require significant amounts of customer
support, our operating margins could be harmed. Moreover, we could face possible
claims and higher development costs if our software contains undetected errors
or if we fail to meet our customers' expectations. As a result of the foregoing,
we could experience:
- loss of or delay in revenues and loss of market share;
- loss of customers;
- damage to our reputation;
- failure to achieve market acceptance;
- diversion of development resources;
- increased service and warranty costs;
- legal actions by customers against us which could, whether or not
successful, increase costs and distract our management; and
- increased insurance costs.
In addition, a product liability claim, whether or not successful, could
harm our business by increasing our costs and distracting our management.
WE INCORPORATE SOFTWARE LICENSED FROM THIRD PARTIES INTO SOME OF OUR PRODUCTS
AND ANY SIGNIFICANT INTERRUPTION IN THE AVAILABILITY OF THESE THIRD-PARTY
SOFTWARE PRODUCTS OR DEFECTS IN THESE PRODUCTS COULD REDUCE THE DEMAND FOR, OR
PREVENT THE SHIPPING OF, OUR PRODUCTS
Certain of our software products contain components developed and
maintained by third-party software vendors. We expect that we may have to
incorporate software from third-party vendors in our future products. We may not
be able to replace the functionality provided by the third-party software
currently offered with our products if that software becomes obsolete, defective
or incompatible with future versions of our products or is not adequately
maintained or updated. Any significant interruption in the availability of these
third-party software products or defects in these products could harm our sales
unless and until we can secure an alternative source. Although we believe there
are adequate alternate sources for the technology licensed to us, such alternate
sources may not provide us with the same functionality as that currently
provided to us.
NATURAL DISASTERS OR POWER OUTAGES COULD DISRUPT OUR BUSINESS
A substantial portion of our operations are located in California, and we
are subject to risks of damage and business disruptions resulting from
earthquakes, floods and similar events, as well as from power outages. We have
recently experienced limited and temporary power losses in our California
facilities due to power shortages, and we expect in the future to experience
additional power losses. While the impact to our business and operating results
has not been material, we cannot assure you that power losses will not adversely
affect our business in the future, or that the cost of acquiring sufficient
power to run our business will not increase significantly. Since we do not have
sufficient redundancy in our networking infrastructure, a natural disaster or
other unanticipated problem could have an adverse effect on our business,
including both our internal operations and our ability to communicate with our
customers or sell and deliver our products.
RISKS RELATED TO OUR INDUSTRY
THE DEMAND FOR OUR PRODUCTS WILL DEPEND ON OUR ABILITY TO ADAPT TO RAPID
TECHNOLOGICAL CHANGE
Our future success will depend on our ability to continue to enhance our
current products and to develop and introduce new products on a timely basis
that keep pace with technological developments and satisfy increasingly
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sophisticated customer requirements. Rapid technological change, frequent new
product introductions and enhancements, uncertain product life cycles, changes
in customer demands and evolving industry standards characterize the market for
our products. The introduction of products embodying new technologies and the
emergence of new industry standards can render our existing products obsolete
and unmarketable. As a result of the complexities inherent in today's computing
environments and the performance demanded by customers for embedded databases
and Web-based products, new products and product enhancements can require long
development and testing periods. As a result, significant delays in the general
availability of such new releases or significant problems in the installation or
implementation of such new releases could have a material adverse effect on our
business, operating results and financial condition. We may not be successful
in:
- developing and marketing, on a timely and cost-effective basis, new
products or new product enhancements that respond to technological
change, evolving industry standards or customer requirements;
- avoiding difficulties that could delay or prevent the successful
development, introduction or marketing of these products; or
- achieving market acceptance for our new products and product
enhancements.
WE MAY NOT BE ABLE TO ATTRACT AND RETAIN PERSONNEL
Our future success depends on the continued service of our executive
officers and other key administrative, sales and marketing and support
personnel, many of whom have recently joined our company. In addition, the
success of our business is substantially dependent on the services of our Chief
Executive Officer and other executive officers. There has in the past been and
there may in the future be a shortage of personnel that possess the technical
background necessary to sell, support and develop our products effectively.
Competition for skilled personnel is intense, and we may not be able to attract,
assimilate or retain highly qualified personnel in the future. Our business may
not be able to grow if we cannot attract qualified personnel. Hiring qualified
sales, marketing, administrative, research and development and customer support
personnel is very competitive in our industry, particularly in Southern
California where Quest is headquartered.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
FOREIGN CURRENCY HEDGING INSTRUMENTS
We transact business in various foreign currencies. Accordingly, we are
subject to exposure from adverse movements in foreign currency exchange rates.
This exposure is primarily related to revenues and operating expenses in Canada,
the United Kingdom, Germany, and Australia denominated in the respective local
currency.
To date, we have not used hedging contracts to hedge our foreign-currency
fluctuation risks. We will assess the need to utilize financial instruments to
hedge currency exposures on an ongoing basis. We also do not use derivative
financial instruments for speculative trading purposes.
INTEREST RATE RISK
Our exposure to market rate risk for changes in interest rates relates
primarily to our investment portfolio. We have not used derivative financial
instruments in our investment portfolio. We place our investments with
high-quality issuers and, by policy, limit the amount of credit exposure to any
one issuer other than the United States government and its agencies. Our
investments in marketable securities consist primarily of high-grade government
securities with maturities of less than three years. Investments purchased with
an original maturity of three months or less are considered to be cash
equivalents. We classify all of our investments as available-for-sale.
Available-for-sale securities are carried at fair value, with unrealized gains
and losses, net of tax, reported in a separate component of shareholders'
equity. At September 30, 2001, the net gain on available-for-sale securities of
$1.4 million comprised 30 positions, of which all 30 carry unrealized gains.
The following table provides information about our investment portfolio at
September 30, 2001 (dollars in thousands):
BALANCE AVERAGE RATE
------- ------------
Cash and cash equivalents 35,726 4.32%
Short-term marketable securities, available for sale 15,659 6.69%
Long-term marketable securities, available for sale 118,291 5.15%
Total portfolio 169,676 5.12%
We consider the carrying value of our investment securities to approximate
their fair value due to the relatively short period of time between origination
of the investments and their expected realization. We also maintain a level of
cash and cash equivalents such that we have generally been able to hold our
investments to maturity. Accordingly, changes in the market interest rate would
not have a material effect on the fair value of such investments.
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PART II
OTHER INFORMATION
ITEM 4: EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
None
(b) REPORTS ON FORM 8-K
None.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
QUEST SOFTWARE, INC.
November 14, 2001 /s/ M. BRINKLEY MORSE
--------------------------------------
M. Brinkley Morse
Vice President, Finance and Operations
/s/ KEVIN E. BROOKS
--------------------------------------
Kevin E. Brooks
Principal Accounting Officer
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