1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q/A-1 [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998 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 NUMBER 0-26146 - -------------------------------------------------------------------------------- HNC SOFTWARE INC. (Exact name of registrant as specified in its charter) - -------------------------------------------------------------------------------- DELAWARE 33-0248788 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 5930 CORNERSTONE COURT WEST SAN DIEGO, CA 92121 (Address of principal executive offices, including zip code) (619) 546-8877 (Registrant's telephone number, including area code) 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 __ AS OF JULY 31, 1998, THERE WERE 25,673,082 SHARES OF REGISTRANT'S COMMON STOCK, $0.001 PAR VALUE, OUTSTANDING. ================================================================================ 2 EXPLANATORY NOTE In October 1998, the SEC issued a letter to the American Institute of Certified Public Accountants indicating suggested practices for determining in process research and development charges related to acquisitions to be accounted for under the purchase method of accounting. Further, the SEC has indicated that this methodology should be adopted for all transactions accounted for by the purchase method. The Company originally recorded Practical Control Systems, Inc. ("PCS"), Financial Technology, Inc. ("FTI") and Advanced Telecommunications Abuse Control System ("ATACS") product line during the first and second quarters of 1998 using then current accepted practices and has now recorded this new methodology and its related effects, retroactively to each quarter impacted. This amendment to Form 10-Q for the quarter ended June 30, 1998 is being filed to conform to these practices with respect to the acquisitions of PCS, FTI and ATACS. INDEX LISTING - -------------------------------------------------------------------------------- Page Number PART I FINANCIAL INFORMATION Item 1: FINANCIAL STATEMENTS Consolidated Balance Sheet at June 30, 1998 (unaudited) 3 and December 31, 1997 Consolidated Statement of Income and Comprehensive Income (unaudited) 4 for the three and six months ended June 30, 1998 and 1997 Consolidated Statement of Cash Flows (unaudited) for 5 the six months ended June 30, 1998 and 1997 Notes to Consolidated Financial Statements (unaudited) 6 Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 9 PART II OTHER INFORMATION Item 6: EXHIBITS AND REPORT ON FORM 8-K 20 Signatures 21 Exhibit Index 22 2 3 PART I - FINANCIAL INFORMATION - -------------------------------------------------------------------------------- Item 1: FINANCIAL STATEMENTS HNC SOFTWARE INC. CONSOLIDATED BALANCE SHEET (in thousands, except per share data) ASSETS JUNE 30, DECEMBER 31, 1998 1997 ----------- ------------ (unaudited) Current assets: Cash and cash equivalents $ 45,450 $ 18,068 Investments available for sale 50,137 24,878 Accounts receivable, net 43,712 32,980 Current portion of deferred income taxes 8,873 11,310 Other current assets 5,062 2,802 -------- -------- Total current assets 153,234 90,038 Property and equipment, net 13,183 12,102 Deferred income taxes, less current portion 16,955 15,322 Long-term investments available for sale 52,316 -- Debt issuance costs, net 2,885 -- Other assets 24,184 2,415 ======== -------- $262,757 $119,877 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 5,848 $ 5,728 Accrued liabilities 12,768 5,933 Deferred revenue 8,606 3,883 Other current liabilities 150 191 -------- -------- Total current liabilities 27,372 15,735 Convertible Subordinated Notes 100,000 -- Other non-current liabilities 94 239 Minority interest in consolidated subsidiary 103 43 Stockholders' equity: Preferred stock, $0.001 par value - 4,000 shares authorized: No shares issued or outstanding -- -- Common stock, $0.001 par value - 50,000 shares authorized: 25,515 and 24,538 shares issued and outstanding, respectively 26 25 Paid-in capital 124,362 95,919 Retained earnings 10,924 8,029 Accumulated other comprehensive income (124) (113) -------- -------- Total stockholders' equity 135,188 103,860 -------- -------- $262,757 $119,877 ======== ======== See accompanying notes to consolidated financial statements. 3 4 HNC SOFTWARE INC. CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME (in thousands, except per share data) (unaudited) THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, -------------------- -------------------- 1998 1997 1998 1997 ------- ------- ------- -------- Revenues: License and maintenance $33,796 $22,311 $60,678 $40,643 Installation and implementation 3,623 2,188 6,819 4,134 Contracts and other 3,584 1,805 6,476 4,531 Service bureau 2,138 1,289 4,249 2,357 ------- ------- ------- ------- Total revenues 43,141 27,593 78,222 51,665 ------- ------- ------- ------- Operating expenses: License and maintenance 8,175 5,036 14,147 9,030 Installation and implementation 2,729 1,251 4,592 2,052 Contracts and other 2,830 1,454 4,706 3,304 Service bureau 1,327 919 2,360 1,783 Research and development 7,605 4,930 14,466 9,361 In-process research and development 4,340 -- 6,090 -- Sales and marketing 8,807 5,233 16,448 9,786 General and administrative 3,674 2,768 7,005 5,227 Acquisition related amortization 806 -- 806 -- ------- ------- ------- ------- Total operating expenses 40,293 21,591 70,620 40,543 Operating income 2,848 6,002 7,602 11,122 Other income, net 2,037 503 2,829 957 Interest expense (1,396) (22) (1,787) (47) Minority interest in income of consolidated subsidiary (38) -- (60) -- ------- ------- ------- ------- Total other income, net 603 481 982 910 Income before income tax provision 3,451 6,483 8,584 12,032 Income tax provision 2,943 1,524 5,689 2,861 ------- ------- ------- ------- Net income $ 508 $ 4,959 $ 2,895 $ 9,171 ======= ======= ======= ======= Other comprehensive income, net of tax: Foreign currency translation adjustments (124) 107 (3) (9) Unrealized (losses) gains on securities available for sale (1) 48 (8) 81 ------- ------- ------- ------- Total other comprehensive income (125) 155 (11) 72 ------- ------- ------- ------- Comprehensive income 383 5,114 2,884 9,243 ------- ------- ------- ------- Earnings per share: Basic net income per common share $ 0.02 $ 0.20 $ 0.12 $ 0.38 ======= ======= ======= ======= Diluted net income per common share $ 0.02 $ 0.19 $ 0.11 $ 0.36 ======= ======= ======= ======= Shares used in computing basic net income per common share 25,290 24,207 24,987 24,143 ======= ======= ======= ======= Shares used in computing diluted net income per common share 26,689 25,521 26,436 25,464 ======= ======= ======= ======= See accompanying notes to consolidated financial statements. 4 5 HNC SOFTWARE INC. CONSOLIDATED STATEMENT OF CASH FLOWS (in thousands, except per share data) (unaudited) SIX MONTHS ENDED JUNE 30, ------------------------- 1998 1997 -------- -------- Cash flows from operating activities: Net income $ 2,895 $ 9,171 2,895 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 4,035 2,141 Purchased research and development 6,090 -- Tax benefit from stock option transactions 2,958 2,427 Changes in assets and liabilities: Accounts receivable, net (8,573) (2,933) Other assets (991) (443) Deferred income taxes 4,229 2,410 Accounts payable (317) (303) Accrued liabilities 2,502 (802) Deferred revenue 203 1,089 Other liabilities (217) (73) -------- -------- Net cash provided by operating activities 12,814 12,684 -------- -------- Cash flows from investing activities: Purchases of investments (99,030) (21,546) Maturities of investments 17,504 6,350 Proceeds from sale of investments 4,000 5,038 Cash purchased in business acquisition 649 -- Acquisitions, net of cash acquired (6,250) Acquisitions of property and equipment (3,399) (2,786) -------- -------- Net cash used in investing activities (86,526) (12,944) -------- -------- Cash flows from financing activities: Net proceeds from issuances of common stock 4,900 1,698 Proceeds from issuances of Convertible Subordinated Notes 100,000 -- Debt issuance costs (2,933) -- Repayment of bank line of credit (770) Repayment of capital lease obligations (105) (252) Distributions to CompReview Stockholders -- (3,599) -------- -------- Net cash provided by (used in) financing activities 101,092 (2,153) -------- -------- Effect of exchange rate changes on cash 2 (9) -------- -------- Net increase (decrease) in cash and cash equivalents 27,382 (2,422) Cash and cash equivalents at the beginning of the period 18,068 8,121 -------- -------- Cash and cash equivalents at the end of the period $ 45,450 $ 5,699 ======== ======== Significant non-cash investing activities: Assets assumed in acquisitions of PCS, FTI, and ATACS $ 32,711 $ ======== ======== Liabilities assumed in acquisitions of PCS, FTI, and ATACS $ 7,297 $ ======== ======== See accompanying notes to consolidated financial statements. 5 6 HNC SOFTWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - -------------------------------------------------------------------------------- NOTE 1 GENERAL In management's opinion, the accompanying unaudited consolidated financial statements for HNC Software Inc. (the "Company") for the three months and six months ended June 30, 1998 and 1997 have been prepared in accordance with generally accepted accounting principles for interim financial statements and include all adjustments (consisting only of normal recurring accruals) that the Company considers necessary for a fair presentation of its financial position, results of operations, and cash flows for such periods. However, the accompanying financial statements do not contain all of the information and footnotes required by generally accepted accounting principles for complete financial statements. All such financial statements are unaudited except the December 31, 1997 balance sheet. This Report and the accompanying unaudited and audited financial statements should be read in conjunction with the Company's audited financial statements and notes thereto presented in its Annual Report on Form 10-K/A for the fiscal year ended December 31, 1997 (the "1997 Annual Report"). Footnotes that would substantially duplicate the disclosures in the Company's audited financial statements for the fiscal year ended December 31, 1997 contained in the 1997 Annual Report have been omitted. The interim financial information contained in this Report is not necessarily indicative of the results to be expected for any other interim period or for the full fiscal year ending December 31, 1998. NOTE 2 BASIS OF PRESENTATION The consolidated financial statements and related notes contained in this Report give retroactive effect to the Company's November 28, 1997 acquisition of CompReview, Inc., accounted for as a pooling of interests, for all periods presented. The acquisitions of Practical Control Systems Technologies, Inc. ("PCS") and Financial Technology, Inc. ("FTI") were completed on March 31, 1998 and April 7, 1998, respectively, and accounted for as purchases as of the respective acquisition dates. In addition, the acquisition of the Advanced Telecommunications Abuse Control System ("ATACS") product line of Bedford Associates, Inc., which is a wholly owned subsidiary of British Airways plc, was completed on June 11, 1998 and accounted for as a purchase as of that date. In connection with these acquisitions, acquired in-process research and development in the aggregate amount of $6.1 million was charged to operations at the respective acquisition dates. NOTE 3 ACQUISITIONS In March 1998, the Company acquired PCS, a company that develops, markets and supports fully integrated distribution center management software products that address the distribution needs of the retail, manufacturing and wholesale industries. HNC acquired PCS in exchange for 142,868 shares of HNC common stock, 14,286 of which are subject to an escrow to secure certain indemnification obligations of the former PCS stockholders plus the contingent right, subject to PCS' achievement of certain financial 6 7 objectives during calendar 1998 and 1999, to receive certain additional shares of HNC common stock. In April 1998, the Company acquired FTI, a company that develops and markets profitability measurement and decision-support software products to banks and other similar financial institutions. HNC acquired FTI in exchange for the issuance of 396,617 shares of HNC common stock, 97,390 of which are subject to an escrow to secure certain indemnification obligations of the former FTI stockholders; a cash payment of $1.5 million; and the contingent right, subject to FTI's achievement of certain financial objectives during calendar 1998, to receive additional shares of HNC common stock. In June 1998, the Company acquired the ATACS product line. ATACS is a fraud-management software solution for wireline, wireless and Internet telecommunication service providers. HNC acquired the ATACS product line for a cash payment of $4.75 million. NOTE 4 COMPREHENSIVE INCOME During the first quarter of 1998, the Company adopted Statement of Financial Accounting Standards No. 130 "Reporting Comprehensive Income" ("FAS 130"). FAS 130 requires the Company to report in the financial statements, in addition to net income, comprehensive income and its components including foreign currency items and unrealized gains and losses on certain investments in debt and equity securities. Comprehensive income is defined as "the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners." NOTE 5 RECLASSIFICATIONS Certain prior period balances have been reclassified to conform to the current period presentation. 7 8 NOTE 6 RECONCILIATION OF NET INCOME AND SHARES USED IN PER SHARE COMPUTATIONS - ------ THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------ ------------------ 1998 1997 1998 1997 ------- ------- ------- ------- NET INCOME USED: Net income used in computing basic and diluted net income per common share $ 508 $ 4,959 $ 2,895 $ 9,171 ======= ======= ======= ======= SHARES USED: Shares used in computing basic net income per common share 25,290 24,207 24,987 24,143 Weighted average options to purchase common stock as determined by application of the treasury stock method 1,304 1,297 1,354 1,304 Purchase Plan common stock equivalents 95 17 95 17 ------- ------- ------- ------- Shares used in computing diluted net income per common share 26,689 25,521 26,436 25,464 ======= ======= ======= ======= The conversion of the Company's 4.75% convertible subordinated notes for the three and six month periods ended June 30, 1998 of 2,230,000 and 1,319,000 shares, respectively, were not used to calculate diluted net income per share as their effect would be anti-dilutive. NOTE 7 NEW ACCOUNTING PRONOUNCEMENT In June 1998, the Financial Accounting Standards Board issued Statement of Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" (FAS 133") which the Company will be required to adopt for its 2000 annual financial statements. This statement establishes a new model for accounting for derivatives and hedging activities. Under FAS 133, all derivatives must be recognized as assets and liabilities and measured at fair value. The Company had not determined the impact of the adoption of this new accounting standard on its consolidated financial position or results of operations. NOTE 8 IN PROCESS RESEARCH AND DEVELOPMENT In connection with the acquisitions of PCS, FTI and ATACS, acquired in-process research and development in the aggregate total of $6.1 million was charged to operations at the respective acquisition dates. Practical Control Solutions, Inc. PCS is a worldwide supplier of fully integrated distribution center management software products that address the distribution needs of the retail, wholesale and manufacturing industries. PCS' products may be classified into two categories: Nautilus, an off-the-shelf warehouse management software system designed with all the tools needed to control the course of warehouse operations and Nautilus CBT, an operational tutorial database which guides the user through Nautilus operations. Certain products were complete in certain areas and under development in others. The classification of the technology as complete or under development was made in accordance with the guidelines of Statement of Financial Accounting Standards No. 86 ("SFAS 86"), Statement of Financial Accounting Standards No. 2 ("SFAS 2") and Financial Accounting Standards Board Interpretation No. 4 ("FIN4"). At the time of acquisition, PCS had a number of new software products under development including Nautilus Versions 6.0 and 7.0 and Nautilus CBT. Nautilus Version 6.0 and Nautilus CBT were both nearly complete but had not reached technological feasibility as of the acquisition date. Financial Technology, Inc. FTI has been a leading provider of management accounting software for financial institutions since 1982. Since 1994, FTI has focused on profitability measurement and other decision support systems. FTI's products are generally classified into six categories: ProfitVision, MarketVision, RiskVision, DataVision, Decision Support Products and Financial Platform Products. FTI had various new products under development in each of these categories, none of which had reached technological feasibility as of the acquisition date. The classification of each new technology as complete or under development was made in accordance with the guidelines of SFAS 86, SFAS 2 and FIN4. ATACS. ATACS is a fraud management software solution for the wireline, wireless and Internet telecommunication service provider industries. The system detects fraudulent traffic thereby avoiding significant financial losses to traditional telecommunication carriers and Internet Service Providers. ATACS' Version 4.2 includes significant enhanced features from its prior version, including new enhancements to Velocity, Message Handlers and a subsystem to support fraud detection of on-line transactions. ATACS Version 4.1 was completed and producing revenues prior to the acquisition date while Version 4.2, which includes new technology that allows the system to function on three interface platforms, was under development and had not yet reached technological feasibility as of the acquisition date. Although Version 4.2 has as its foundation technology from the completed as well as in-process technology, HNC believes that it will have changed significantly so as to be considered new research and development efforts. The classification of each research and development project as complete or under development was made in accordance with the guidelines of SFAS 86, SFAS 2 and FIN4. 8 9 HNC SOFTWARE INC. - -------------------------------------------------------------------------------- Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD LOOKING STATEMENTS: NO ASSURANCES INTENDED This Report (including without limitation the following section regarding Management's Discussion and Analysis of Financial Condition and Results of Operations) contains certain forward-looking statements (within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934) regarding the Company and its business, financial condition, results of operations and prospects. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks" and "estimates," and similar expressions or variations of such words, are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Report. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements. Although forward-looking statements in this Report reflect the good faith judgment of the Company's management, such statements can only be based on facts and factors currently known by the Company. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include without limitation those discussed in "Potential Fluctuations in Operating Results" as well as those discussed elsewhere in this Report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this Report. The Company undertakes no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Report. Readers are urged to carefully review and consider the various disclosures made by the Company in this Report, which attempt to advise interested parties of the risks and factors that may affect the Company's business, financial condition, results of operations and prospects. POTENTIAL FLUCTUATIONS IN OPERATING RESULTS The Company's revenues and operating results have varied significantly in the past and may do so in the future. Factors affecting the Company's revenues and operating results include, but are not limited to: the degree of acceptance of the Company's products; by the markets and industries served by the Company; the historical tendency of the Company to receive, during a given fiscal period, a small number of relatively large customer orders, such that failure to recognize revenue from any such order in that fiscal period may disproportionately and adversely affect the Company's revenues and operating results for that fiscal period; customer cancellation of long-term contracts that yield recurring revenues or customers' ceasing their use of Company products for which the Company receives recurring, usage-based fees and disputes with customers regarding fees payable to the Company; the lengthy sales cycle of most of the Company's products; the Company's ability to successfully and timely develop, introduce and market new products and product enhancements; the timing of new product announcements and 9 10 introductions by the Company and its competitors; changes in the mix of distribution channels; changes in the level of operating expenses; the Company's ability to timely achieve progress and fulfill its obligations under contracts on which revenue is recognized in the percentage-of-completion basis; the Company's success in completing certain pilot installations within contracted fee budgets; competitive conditions in the enterprise software industry; domestic and international economic conditions; and market conditions in the Company's targeted markets. In addition, as a result of recently issued guidance on software revenue recognition, license agreements entered into during a quarter may not meet the Company's revenue recognition criteria, with the result that, even if the Company meets or exceeds its forecast of aggregate licensing and other contracting activity for a given fiscal period, it is possible that the Company's revenues for that fiscal period would not meet expectations. Furthermore, the Company's operating results may be affected by factors unique to certain of its product lines. For example, although in the past a large portion of the Company's revenues were derived from contracts providing for periodic, recurring fees, the Company now derives a substantial and increasing portion of its revenues from products (particularly products for the retail industry) priced as "perpetual" license transactions in which the Company receives a one-time license fee that is recognized upon delivery of the software and acceptance by the customer. Thus, failure to complete a perpetual license transaction during a fiscal quarter would have a disproportionate adverse impact on the Company's operating results for that quarter. The Company expects that fluctuations in its operating results will continue for the foreseeable future. Consequently, the Company believes that period-to-period comparisons of its financial results should not be relied upon as an indication of future performance. Because the Company's expense levels are based in part on its expectations regarding future revenues and are fixed to a large extent in the short term, in the event of an unexpected revenue shortfall during a fiscal period, the Company may be unable to adjust spending in time to maintain anticipated operating results for that fiscal period. Accordingly, the Company may not be able to maintain profitability on a quarterly or annual basis in the future. Due to some or all of the foregoing factors, or other factors, it is possible that in some future quarter the Company's operating results will be below the expectations of public market analysts and investors. In that event, the market price of the Company's common stock and, in turn, the market price of the Company's 4.75% convertible subordinated notes due 2003 (the "Notes"), would likely be materially adversely affected. YEAR 2000 COMPLIANCE It is generally anticipated that many organizations will experience operational difficulties at the beginning of the Year 2000 as a result of the fact that many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. Significant uncertainty exists in the software and other industries concerning the scope and magnitude of problems associated with the century change. Based on the Company's assessment to date, the Company believes that the current version of each of its material products is Year 2000 compliant. However, there can be no assurance that all of the Company's customers will install the Year 2000 compliant version of the Company's products in a timely manner, which could lead to failure of customer systems and product liability claims against the Company. The Company is assessing the products it has acquired in its recent acquisitions for Year 2000 compliance. The inability of the Company to complete its assessment and any necessary modifications to these recently acquired products could have a material adverse effect on the Company's business, financial condition and results of operations. Even if the Company's products are Year 2000 compliant, the Company may in the future be subject to claims based on Year 2000 issues in the products of other companies, or issues arising from the integration of multiple products within a system. The costs of defending and resolving Year 2000-related disputes, and any liability of the Company for Year 2000-related damages, including consequential damages, could have a material adverse effect on the Company's business, financial condition and results of operations. Further, the Company's products are generally used with enterprise systems involving complicated software products developed by other vendors, which may not be Year 2000 compliant. In particular, many of the Company's customers are financial institutions, insurance companies and other companies with insurance and financial services businesses, all of which use legacy computer systems that are expected to be particularly susceptible to Year 2000 compliance issues. If the Company's customers are unable to use their information systems because of the failure of such noncompliant systems or software or for any other reason, there would be a decrease in the volume of transactions that the Company's customers process using the Company's products. As a result, the Company's recurring revenue in the form of transactional fees from customers in the insurance and financial services markets would decline, which would have a material adverse effect on the 10 11 Company's business, financial condition and results of operations. Such failure could also affect the perceived performance of the Company's products, which could have a negative effect on the Company's competitive position. In addition, the Company believes that the purchasing patterns of customers and potential customers may be affected by Year 2000 issues as companies expend significant resources to correct or patch their current software systems for Year 2000 compliance. These expenditures may result in reduced funds available to purchase software products such as those offered by the Company, which could result in a material adverse effect on the Company's business, financial condition and results of operations. The Company is reviewing its major internal corporate systems for Year 2000 compliance and intends to take appropriate action based on the results of such review. The Company's plan for the Year 2000 calls for compliance verification of external vendors supplying software and information systems to the Company and communication with significant suppliers to determine the readiness of third parties' remediation of their own Year 2000 issues. As part of its assessment, the Company is evaluating the level of validation it will require of third parties to ensure their Year 2000 readiness. To date, the Company has not encountered any material Year 2000 issues concerning its computer systems. The Company plans to complete its Year 2000 research and testing by the end of the first quarter of 1999. All costs associated with carrying out the Company' plan for the Year 2000 compliance are being expensed as incurred. The total cost associated with preparation for the Year 2000 has not been, and is not expected to be, material to the Company's business, financial condition or results of operations. Nevertheless, the Company may not timely identify and remediate all significant Year 2000 problems and remedial efforts may involve significant time and expense. There can be no assurance that any Year 2000 compliance problems of the Company or its customers or suppliers will not have a material adverse effect on the Company's business, financial condition and results of operations. RESULTS OF OPERATIONS HNC develops, markets and supports predictive software solutions for several leading service industries. These predictive software solutions may employ proprietary neural-network predictive decision engines, profiles, traditional statistical modeling, business models, expert 11 12 rules and context vectors to convert existing data and business experiences into meaningful recommendations and actions. HNC has developed a growing family of predictive software products that provide specific solutions for each of the healthcare/insurance, financial services and retail markets. The Company's healthcare/insurance products, which are developed and marketed by its Insurance Solutions subsidiary, emphasize the workmen's compensation field and provide a variety of solutions to insurers, parties who administer insurance claims and health care administrators. HNC's products for the financial services market include products targeted at bank and private label payment card issuers and payment processors and products that allow lenders to automate the loan approval decision process. For the retail industry, HNC has developed a group of products that address inventory control, merchandise management and financial control management. The Company's revenues are comprised of license and maintenance revenues, installation and implementation revenues, contracts and other revenues and service bureau revenues. The Company's revenues for the three months ended June 30, 1998 were $43.1 million, an increase of 56% over revenues of $27.6 million for the same period in the prior year. The Company's revenues for the six months ended June 30, 1998 were $78.2 million, an increase of 51% over revenues of $51.7 million for the same period in the prior year. LICENSE AND MAINTENANCE REVENUES. License and maintenance revenues were $33.8 million for the quarter ended June 30, 1998, an increase of 51% from $22.3 million for the comparable quarter in 1997. License and maintenance revenues were $60.7 million for the six months ended June 30, 1998, an increase of 49% from $40.6 million for the comparable period in 1997. The Company's license and maintenance revenues are derived from periodic recurring license and maintenance fees and perpetual license fees. These increases in license and maintenance revenues were due primarily to the growth of license fee revenues from the retail and financial services industry segments. The increase in license and maintenance revenues in the retail industry was primarily due to an increase in sales of the Retek suite of products and sales related to the recently acquired company, PCS. The increase in the financial services industry is attributable to an increase in sales of the Falcon and Capstone product lines and sales of the ProfitMax product. Sales generated by the recently acquired company, FTI, also contributed to this increase. INSTALLATION AND IMPLEMENTATION REVENUES. Installation and implementation revenues for the quarter ended June 30, 1998 were $3.6 million, an increase of 66% from $2.2 million for the quarter ended June 30, 1997. Additionally, installation and implementation revenues for the six months ended June 30, 1998 were $6.8 million, an increase of 65% from $4.1 million for the six months ended June 30, 1997. These increases were primarily due to new installations within the financial services industry, primarily related to the ProfitMax and Capstone product lines. Revenues from installation and implementation services are generally recognized as the services are performed using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. CONTRACTS AND OTHER REVENUES. Contracts and other revenues for the three months ended June 30, 1998 were $3.6 million, an increase of 99% from $1.8 million for the same period in the prior year. Likewise, contracts and other revenues for the six months ended June 30, 1998 were $6.5 million, an increase of 43% from $4.5 million for the same period in the prior year. Contracts and other revenues are derived primarily from development and consulting contracts 12 13 with commercial customers and, to a lesser extent, research and development contracts with the United States Government. Revenues for new product pilots (i.e., the first production installation of a new product) are also reported as contract and other revenues. Revenues from contract services are generally recognized as the services are performed using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. These increases were attributable to increases in consulting contracts with commercial customers primarily in the retail industry segment. SERVICE BUREAU REVENUES. Service bureau revenues for the three months ended June 30, 1998 were $2.1 million, an increase of 66% from $1.3 million for the same period in the prior year. Service bureau revenues for the six months ended June 30, 1998 were $4.2 million, an increase of 80% from $2.4 million for the same period in the prior year. This increase was attributable to an increase in the number of customers utilizing the Company's CRLink service bureau operations. LICENSE AND MAINTENANCE EXPENSES. License and maintenance expenses primarily consist of the Company's expenses for personnel engaged in customer support activities, costs of travel to customer sites and the costs of documentation materials. License and maintenance expenses for the second quarter of 1998 were $8.2 million and constituted 24% of license and maintenance revenues for the quarter, whereas such expenses were $5.0 million and represented 23% of license and maintenance revenues in the second quarter of 1997. Additionally, license and maintenance expenses for the six months ended June 30, 1998 were $14.1 million and represented 23% of license and maintenance revenues for that six-month period, whereas such expenses were $9.0 million and represented 22% of license and maintenance revenues for the six months ended June 30, 1997. The primary reason for the increase in these expenses, in absolute dollars and as a percent of revenues, was increased staffing and associated costs in client services to support an increased volume of business. INSTALLATION AND IMPLEMENTATION EXPENSES. Installation and implementation expenses for the second quarter of 1998 were $2.7 million and 75% of installation and implementation revenues, whereas such expenses were $1.3 million and 57% of installation and implementation revenues during the second quarter of 1997. Installation and implementation expenses for the first six months of 1998 were $4.6 million and 67% of installation and implementation revenues, whereas such expenses were $2.1 million and 50% of installation and implementation revenues during the first six months of 1997. The primary reason for the increase in these expenses in absolute dollars was increased staffing and associated costs to support an increased volume of business. Installation and implementation expenses as a percent of installation and implementation revenues increased during the quarter and six months ended June 30, 1998, respectively, as compared to the respective periods in 1997. The associated decrease in gross margins was a result of a shift in the mix of implementations within the financial services segment due primarily to an increase in Capstone implementations, which have substantially lower margins than implementations of the Falcon products. CONTRACTS AND OTHER EXPENSES. Contracts and other expenses consist primarily of personnel-related expenses associated with the Company's performance of such development, consulting, and research and development contracts. Contracts and other expenses in the second quarter of 1998 were $2.8 million or 79% of contracts and other revenues as compared to $1.5 million or 81% of such revenues in the second quarter of 1997. Contracts and other expenses for 13 14 technology the first six months of 1998 were $4.7 million or 73% of contracts and other revenues as compared to $3.3 million or 73% of such revenues for the first six months of 1997. The decreases in the second quarter expenses as a percentage of contracts and other revenues were due to the increase in revenue from commercial consulting contracts in the retail industry out pacing the increase in costs to support the increased volume in business. The remaining development contracts were primarily retail consulting contracts, government contacts and on-going model development projects, which typically yield lower margins than commercial new product pilot contracts. SERVICE BUREAU EXPENSES. Service bureau expenses during the second quarter of 1998 were $1.3 million or 62% of service bureau revenues as compared to $919,000 or 71% of such revenues during the second quarter of 1997. Service bureau expenses during the first six months of 1998 were $2.4 million or 56% of service bureau revenues as compared to $1.8 million or 76% of such revenues during the first six months of 1997. The associated increases in gross margins were the result of increases in the number of "complex" bills processed, which typically yield higher margins than normal bills. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses in the second quarter of 1998 were $7.6 million or 18% of total revenues compared to $4.9 million or 18% of total revenues in the second quarter of the prior year. Research and development expenses for the first six months of 1998 were $14.5 million or 18% of total revenues compared to $9.4 million or 18% of total revenues for the first six months of the prior year. The increase in these expenses in absolute dollars was due primarily to increases in staffing and related costs to support increased product development activities, primarily related to enhancements to the healthcare/insurance and retail segment products and, to a lesser extent, the financial services segment products. IN-PROCESS RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses were $4.3 million and $6.1 million for the three and six month periods ended June 30, 1998, respectively. These one-time write-offs were related to the acquisitions of PCS and FTI and the asset purchase of ATACS during the first six months of 1998. Practical Control Solutions, Inc. PCS is a worldwide supplier of fully integrated distribution center management software products that address the distribution needs of the retail, wholesale and manufacturing industries. PCS' products may be classified into two categories: Nautilus, an off-the-shelf warehouse management software system designed with all the tools needed to control the course of warehouse operations and Nautilus CBT, an operational tutorial database which guides the user through Nautilus operations. Certain products were complete in certain areas and under development in others. The classification of the technology as complete or under development was made in accordance with the guidelines of Statement of Financial Accounting Standards No. 86 ("SFAS 96"), Statement of Financial Accounting Standards No. 2 ("SFAS 2") and Financial Accounting Standards Board Interpretation No. 4 ("FIN4"). At the time of acquisition, PCS had a number of new software products under development, including Nautilus Versions 6.0 and 7.0 and Nautilus CBT. Nautilus Version 6.0 and Nautilus CBT were both nearly complete but had not reached technological feasibility as of the acquisition date and approximately $280,000 of development costs were assumed to be incurred through to their scheduled completion in mid-1998. Nautilus 7.0 was in an early stage of development as of the 14 15 acquisition date. HNC assumed that it would incur approximately $974,000 of additional development costs through to technological feasibility, which was assumed to be in early 1999. All in-process research and development (R&D) projects continue to progress, in all material respects, consistently with the assumptions that HNC provided to the independent appraiser for use in the valuation of the in-process R&D. The inability of HNC to complete this technology within the expected timeframes could materially impact future revenues and earnings, which could have a material adverse effect on HNC's business, financial condition and results of operations. Financial Technology, Inc. FTI has been a leading provider of management accounting software for financial institutions since 1982. Since 1994, FTI has focused on profitability measurement and other decision support systems. FTI's products are generally classified into six categories: ProfitVision, MarketVision, RiskVision, DataVision, Decision Support Products and Financial Platform Products. FTI had various new products under development in each of these categories, none of which had reached technological feasibility as of the acquisition date. The classification of each new technology as complete or under development was made in accordance with the guidelines of SFAS 86, SFAS 2 and FIN4. Each new product under development has varying release dates for completion ranging from July 1998 through December 1999. The valuation was based on the assumption that the estimated cost to complete all products under development, measured as of the acquisition date, is approximately $2.1 million, of which $1.2 million would be incurred through December 1998 and an additional $900,000 would be incurred during 1999. The valuation approach also assumed that these products would generate revenues through the year 2002. These statements regarding revenues and expenses are forward-looking statements, which are subject to risks and uncertainties. Actual results may differ materially from those anticipated. The important factors that could cause actual results to differ include those discussed in "Potential Fluctuations in Operating Results" and elsewhere in this Report. The inability of HNC to complete this technology within the expected timeframes could materially impact future revenues and earnings, which could have a material adverse effect on HNC's business, financial condition and results of operations. In-process research and development projects continue to progress, in all material respects, consistently with management's original assumptions that were provided to the independent appraiser and used to value the in-process R&D. ATACS. ATACS is a fraud management software solution for the wireline, wireless and Internet telecommunication service provider industries. The system detects fraudulent traffic thereby avoiding significant financial losses to traditional telecommunication carriers and Internet Service Providers. ATACS' Version 4.2 includes significant enhanced features from its prior version, including new enhancements to Velocity, Message Handlers and a subsystem to support fraud detection of on-line transactions. ATACS Version 4.1 was completed and producing revenues prior to the acquisition date while Version 4.2, which includes new technology that allows the system to function on three interface platforms, was under development and had not yet reached technological feasibility as of the acquisition date. Although Version 4.2 has as its foundation technology from the completed as well as in-process technology, HNC believes that it will have changed significantly so as to be considered new research and development efforts. The classification of each research and development project as complete or under development was made in accordance with the guidelines of SFAS 86, SFAS 2 and FIN4. The valuation approach assumed that the cost to reach technological feasibility would be approximately $250,000 and the release would be completed by July 1998. 15 16 In-process research and development projects continue to progress, in all material respects, consistently with HNC's original assumptions that were provided to the independent appraiser and used to value the in-process R&D. Valuation Approach. HNC used an independent appraisal firm to assist it with its valuation of the fair market value of the purchased assets of PCS, FTI and ATACS. Fair market value is defined as the estimated amount at which an asset might be expected to be exchanged between a willing buyer and willing seller assuming the buyer continues to use the assets in their current operations. HNC provided assumptions by product line of revenue, cost of goods sold and operating expense to the appraiser to assist in the valuation. The appraisal considered three traditional approaches to valuation: the cost approach, the market approach and the income approach. Practical Control Solutions, Inc. With respect to the forecasted earnings provided to the appraiser, PCS is forecasting slightly higher revenue growth rates as long as it can continue to meet market demands with new releases each year. These higher growth rates reflect PCS' expectation of greater market acceptance with the release of its ORACLE-based platform, as well as new improvements, that will be found in Nautilus versions 6 and 7. PCS' gross margins are forecasted to remain consistent relative to prior years. PCS is also expecting its current operating expense levels to only moderately increase in absolute dollars and, as a result, earnings before interest and taxes is expected to increase in later years. Management believes these growth expectations are reasonable if the new product versions are offered according to the schedules reflected in the financial statements. The statements regarding expectations for PCS are forward-looking statements, which are subject to risks and uncertainties. Actual results may differ materially from those anticipated. The important factors that could cause actual results to differ include those discussed in "Potential Fluctuations in Operating Results" and elsewhere in this Report. Financial Technology Inc. Prior to 1997, FTI primarily sold financial reporting general ledger software to mid-sized banks. During 1997, FTI began to derive a significant amount of its revenue from ProfitVision, a customer profitability system for the same financial institutions. With respect to the forecasted earnings provided to the appraiser, FTI is forecasting significant revenue growth from a full line of new software measurement tools. The financial forecasts reflected in the appraiser's report reflect management's expectation of significant revenue growth from a number of new product offerings. Operating margins (before interest and taxes) are currently expected to increase from historical trends. Management currently believes that these projected increases are reasonable in light of the number of new product offerings and increased gross profit obtained from these new software measurement tools which is in contrast to those obtained from its financial reporting packages historically sold by FTI. The statements regarding expectations for FTI are forward-looking statements, which are subject to risks and uncertainties. Actual results may differ materially from those anticipated. The important factors that could cause actual results to differ include those discussed in "Potential Fluctuations in Operating Results" and elsewhere in this Report. ATACS. ATACS represented a product line within Bedford Associates, Inc. since 1995. Management was provided with limited historical information but, in conjunction with the acquisitions, reviewed contracts that supported revenue and identified and ultimately hired the development and support team that represents the underling costs of revenue as well as 16 17 development costs. Under Bedford, ATACS was not an aggressively marketed product and, as a result, sales growth slowed and margins slightly dropped. The product becomes more widely marketable with the offering of Version 4.2, which expands the functionality to three new operating environments. With respect to the forecasted earnings provided to the appraiser, the forecasts reflected higher growth rates than prior years' ranges, reflecting the new product offering and several years of prior marketing of the product now generating sales opportunities. Gross margins are also forecasted to increase rather significantly reflecting higher revenue levels and economies of scale in the production and support cost areas. The statements regarding expectations for ATACS are forward-looking statements, which are subject to risks and uncertainties. Actual results may differ materially from those anticipated. The important factors that could cause actual results to differ include those discussed in "Potential Fluctuations in Operating Results" and elsewhere in this Report. With respect to the discount rates used in the valuation approach, the incomplete technology represents a mix of near and mid-term prospects for the business and imparts a level of uncertainty to its prospects. It is the nature of the business to be constantly developing new software for future product releases. A reasonable expectation of return on the incomplete technology would be higher than that of completed technology due to these inherent risks. As a result, the earnings associated with incomplete technology were discounted at a rate of 40.0%, 27.0% and 22.5% for PCS, FTI and ATACS, respectively, based upon the following methodologies: Practical Control Solutions, Inc. Because PCS did not have short-term or long term debt as of the date of acquisition, the Moody's seasoned Baa rate for March 31, 1998 was utilized as the cost of debt. The Capital Asset Pricing Model was used to determine the cost of equity. It combines a risk free rate of return with an equity risk premium multiplied by a factor, referred to as Beta, which is based on the performance of common stock prices of similar publicly traded companies. Employing these data, the discount rate attributable to the business was 30%, which was used for valuing completed technology. Since incomplete technology represents a mix of near- and mid-term prospects for the business and imparts a certain level of uncertainty and would require a higher return than completed technology, the valuation report prepared by the Company's appraiser suggests that a rate of 40% be ascribed to the excess earnings of incomplete technology. Financial Technology Inc. The cash flows attributable to FTI's technology were discounted based on a weighted average cost of capital ("WACC") analysis attributable to the business. In determining an appropriate discount rate utilizing the WACC analysis, an analysis was made of short-term interest rates, the yields of long-term corporate and government bonds, and other alternative investment instruments, as well as the typical capital structure of companies in the industry. Employing this formula, the discount rate attributed to the business was 17% , which was used to discount the completed technology. Incomplete technology represents a mix of near- and mid-term prospects for the business and imparts a certain level of uncertainty. The valuation report prepared by the Company's appraiser suggests that a rate of 27% be ascribed to the excess earnings of incomplete technology. ATACS. Because ATACS did not have short-term or long term debt as of the date of acquisition, the Moody's seasoned Baa rate for May 19, 1998 was utilized as the cost of debt. The Capital Asset Pricing Model was used to determine the cost of equity. It combines a risk 17 18 free rate of return with an equity risk premium multiplied by a factor, referred to as Beta, which is based on the performance of common stock prices of similar publicly traded companies. Employing these data, the discount rate attributable to the business was 17.5%, which was used for valuing completed technology. Since incomplete technology represents a mix of near- and mid-term prospects for the business and imparts a certain level of uncertainty and would require a higher return than completed technology, the valuation report prepared by the Company's appraiser suggests that a rate of 22.5% be ascribed to the excess earnings of incomplete technology. SALES AND MARKETING EXPENSES. Sales and marketing expenses were $8.8 million or 20% of total revenues in the second quarter of 1998 compared to $5.2 million or 19% of total revenues in the second quarter of 1997. Sales and marketing expenses were $16.4 million or 21% of total revenues in the first six months of 1998 compared to $9.8 million or 19% of total revenues in the first six months of 1997. The increases in sales and marketing expenses were due primarily to increases in staffing related to the Company's expansion of its direct sales and marketing staff, including opening sales offices in Canada, Germany, South Africa, France and Japan. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses were $3.7 million or 9% of total revenues in the second quarter of 1998, compared to $2.8 million or 10% of total revenues in the second quarter of the prior year. General and administrative expenses were $7.0 million or 9% of total revenues in the first six months of 1998, compared to $5.2 million or 10% of total revenues in the first six months of the prior year. General and administrative expenses, excluding acquisition related costs of $429,000, were $3.2 million or 8% of total revenues in the second quarter of 1998, compared to $2.8 million or 10% of total revenues in the second quarter of the prior year. General and administrative expenses, excluding acquisition related costs of $673,000, were $6.3 million or 8% of total revenues in the first six months of 1998, compared to $5.2 million or 10% of total revenues in the first six months of the prior year. The increase in absolute dollars was due primarily to increased staffing and related expenses, including recruiting costs, to support higher levels of sales and development activity of the Company resulting in part from the Company's recent acquisitions. ACQUISITION RELATED AMORTIZATION EXPENSES. Acquisition related amortization expenses were $806,000 or 2% and 1% of total revenues during the three and six month periods ended June 30, 1998, respectively. These expenses represent the amortization of intangible assets purchased in conjunction with the Company's acquisitions of PCS and FTI and the asset purchase of ATACS during the first six months of 1998. TOTAL OTHER INCOME, NET. Other income for the second quarter of 1998 was $603,000 compared to $481,000 in the second quarter of the prior year. Other income for the first six months of 1998 was $982,000 compared to $910,000 in the first six months of the prior year. Other income is comprised primarily of interest income earned on cash and investment balances, net of interest expense related to the 4.75% convertible subordinated notes due 2003. The increase is the result of increased interest income related to the increase in investments, partially offset by the interest expense related to the notes. INCOME TAX PROVISION. The income tax provisions of $2.9 million and $1.5 million in the second quarters of 1998 and 1997, respectively, and the income tax provisions of $5.7 million and $2.9 million during the first six months of 1998 and 1997, respectively, are based on 18 19 management's estimates of the effective tax rates to be incurred by the Company during those respective full fiscal years. The 1998 income tax provisions include the tax effects of non-deductible, one-time write-offs of in-process research and development and/or amortization expense related to the purchases of PCS and FTI. The income tax provision of $1.5 million in the second quarter of 1997 and $2.9 million during the first six months of 1997 was lower than 1997 taxes at statutory rates primarily as a result of CompReview's subchapter S corporation status prior to the acquisition, which resulted in CompReview's tax liability being borne by its former stockholders. As of the date of the acquisition, CompReview's tax status was changed to C corporation. In the future, the Company expects that the effective tax rate will be reflective of the tax rate of other California-based companies. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities during the first six months of 1998 was $12.8 million, which primarily represented net income before non-cash charges for purchased research and development and depreciation and amortization of approximately $13.0 million, offset in part by an increase in accounts receivable. Net cash used in investing activities was $86.5 million during the first six months of 1998, primarily due to net purchases of investments of $81.5 million. Net cash provided by financing activities of $101.1 million during the first six months of 1998 was primarily related to proceeds from the issuance of the Company's 4.75% convertible subordinated notes due 2003 of $100.0 million issued in conjunction with the Company's debt offering in March 1998 and net proceeds of $4.9 million from the issuance of common stock. This was partially offset by costs of approximately $2.9 million related to the issuance of the above-mentioned convertible subordinated notes. At June 30, 1998, the Company had $147.9 million in cash, cash equivalents and investments available for sale. The Company believes that its current cash, cash equivalents and investments available for sale balances, borrowings under its credit facility and net cash provided by operating activities, will be sufficient to meet its working capital and capital expenditure requirements for at least the next 12 months. Management intends to invest the Company's cash in excess of current operating requirements in short-term, interest-bearing, investment-grade securities. A portion of the Company's cash could also be used to acquire or invest in complementary businesses or products or otherwise to obtain the right to use complementary technologies or data. From time to time, in the ordinary course of business, the Company evaluates potential acquisitions of such businesses, products, technologies or data. 19 20 PART II - OTHER INFORMATION Item 6: EXHIBITS AND REPORTS ON FORM 8-K (a)Exhibits 3(i).01 Registrant's Bylaws, as amended. 10.01 Registrant's 1995 Equity Incentive Plan and related documents, as amended. 10.02 Registrant's 1998 Stock Option Plan, as amended. 27.01 Financial Data Schedule. 27.02 Restated Financial Data Schedule.* (b)Reports on Form 8-K On April 21, 1998, the Company filed a Report on Form 8-K filed with respect to an event dated April 7, 1998 (the acquisition of Financial Technology, Inc. described in Item 2). No other reports on Form 8-K were filed during the quarter ended June 30, 1998. - ---------------- *Filed herewith. 20 21 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this amendment to report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized. HNC SOFTWARE INC. Date: February 5, 1999 By: /s/ Raymond V. Thomas ---------------------------------------- Raymond V. Thomas Vice President, Finance & Administration and Chief Financial Officer (for Registrant as duly authorized officer and as Principal Financial Officer) 21 22 EXHIBIT INDEX Exhibits 3(i).01 Registrant's Bylaws, as amended. 10.01 Registrant's 1995 Equity Incentive Plan and related documents, as amended. 10.02 Registrant's 1998 Stock Option Plan, as amended. 27.01 Financial Data Schedule. 27.02 Restated Financial Data Schedule* - ---------------- *Filed herewith.