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 SEPTEMBER 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 OCTOBER 30, 1998, THERE WERE 25,811,583 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. "FIT") 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 September 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 September 30, 1998 (unaudited) 3
and December 31, 1997
Consolidated Statement of Income (unaudited) for the three 4
and nine months ended September 30, 1998 and 1997
Consolidated Statement of Cash Flows (unaudited) for 5
the nine months ended September 30, 1998 and 1997
Consolidated Statement of Changes in Stockholders' Equity and 6
Comprehensive Income for the nine months ended
September 30, 1998
Notes to Consolidated Financial Statements (unaudited) 7
Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 12
PART II OTHER INFORMATION
Item 6: EXHIBITS AND REPORT ON FORM 8-K 27
Signatures 28
Exhibit Index 29
2
3
PART I - FINANCIAL INFORMATION
================================================================================
Item 1: FINANCIAL STATEMENTS
HNC SOFTWARE INC.
CONSOLIDATED BALANCE SHEET
(in thousands, except per share data)
ASSETS
SEPTEMBER 30, DECEMBER 31,
1998 1997
--------- ---------
(unaudited)
Current assets:
Cash and cash equivalents $ 40,746 $ 18,068
Investments available for sale 48,725 24,878
Accounts receivable, net 50,391 32,980
Current portion of deferred income taxes 8,873 11,310
Other current assets 4,711 2,802
--------- ---------
Total current assets 153,446 90,038
Property and equipment, net 14,597 12,102
Deferred income taxes, less current portion 15,531 15,322
Long-term investments available for sale 61,125 --
Other assets 26,508 2,415
--------- ---------
$ 271,207 $ 119,877
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 5,892 $ 5,728
Accrued liabilities 9,638 5,933
Deferred revenue 7,881 3,883
Other current liabilities 104 191
--------- ---------
Total current liabilities 23,515 15,735
Convertible Subordinated Notes 100,000 --
Other non-current liabilities 30 239
Minority interest in consolidated subsidiary 157 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:
25,809 and 24,538 shares issued and outstanding,
respectively 26 25
Paid-in capital 131,502 95,919
Retained earnings 16,000 8,029
Accumulated other comprehensive income (loss) (23) (113)
--------- ---------
Total stockholders' equity 147,505 103,860
--------- =========
$ 271,207 $ 119,877
========= =========
See accompanying notes to consolidated financial statements.
3
4
HNC SOFTWARE INC.
CONSOLIDATED STATEMENT OF INCOME
(in thousands, except per share data)
(unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ------------------------
1998 1997 1998 1997
--------- --------- --------- ---------
Revenues:
License and maintenance $ 36,803 $ 23,705 $ 97,480 $ 64,347
Services and other 10,947 6,284 28,492 17,307
--------- --------- --------- ---------
Total revenues 47,750 29,989 125,972 81,654
--------- --------- --------- ---------
Operating expenses:
License and maintenance 8,021 4,957 22,168 13,987
Services and other 8,521 3,813 20,179 10,952
Research and development 9,172 6,015 23,638 15,376
Sales and marketing 8,797 5,691 25,245 15,477
General and administrative 3,843 3,142 10,848 8,369
In-process research and development -- -- 6,090 --
Acquisition related amortization 1,198 -- 2,004 --
--------- --------- --------- ---------
Total operating expenses 39,552 23,618 110,172 64,161
--------- --------- --------- ---------
Operating income 8,198 6,371 15,800 17,493
Other income, net 2,084 554 4,913 1,511
Interest expense (1,418) (16) (3,205) (63)
Minority interest in income of consolidated subsidiary (54) -- (114) --
--------- --------- --------- ---------
Total other income, net 612 538 1,594 1,448
Income before income tax provision 8,810 6,909 17,394 18,941
Income tax provision 3,734 1,782 9,423 4,643
--------- --------- --------- ---------
Net income $ 5,076 $ 5,127 $ 7,971 $ 14,298
========= ========= ========= =========
Earnings per share:
Basic net income per common share $ 0.20 $ 0.21 $ 0.32 $ 0.59
========= ========= ========= =========
Diluted net income per common share $ 0.19 $ 0.20 $ 0.30 $ 0.56
========= ========= ========= =========
Shares used in computing basic net income per common share 25,694 24,359 25,217 24,213
========= ========= ========= =========
Shares used in computing diluted net income per common share 27,198 25,894 26,620 25,574
========= ========= ========= =========
See accompanying notes to consolidated financial statements.
4
5
HNC SOFTWARE INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands, except per share data)
(unaudited)
NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------
1998 1997
------------ -------------
Cash flows from operating activities:
Net (loss) income $ 7,971 $ 14,298
Adjustments to reconcile net (loss) income to net cash provided
by operating activities:
Depreciation and amortization 6,984 3,478
Purchased research and development 6,090 --
Tax benefit from stock option transactions 6,100 4,165
Changes in assets and liabilities:
Accounts receivable, net (15,252) (8,298)
Other assets (1,648) (927)
Deferred income taxes 8,022 4,146
Accounts payable (273) 2,325
Accrued liabilities (3,769) (1,956)
Deferred revenue (522) (848)
Other liabilities (228) (110)
--------- ---------
Net cash provided by operating activities 13,475 16,273
--------- ---------
Cash flows from investing activities:
Purchases of investments (126,960) (27,712)
Maturities of investments 38,284 12,100
Proceeds from sale of investments 4,000 5,689
Cash purchased in business acquisition 649 --
Acquisitions, net of cash acquired (6,250) --
Acquisitions of property and equipment (6,472) (6,873)
--------- ---------
Net cash used in investing activities (96,749) (16,796)
--------- ---------
Cash flows from financing activities:
Net proceeds from issuances of common stock 9,671 3,447
Proceeds from issuances of Convertible Subordinated Notes 100,000 --
Debt issuance costs (2,779) --
Repayment of bank line of credit (770) --
Repayment of capital lease obligations (151) (332)
Distributions to CompReview Stockholders -- (5,798)
--------- ---------
Net cash provided by (used in) financing activities 105,971 (2,683)
--------- ---------
Effect of exchange rate changes on cash (19) (14)
--------- ---------
Net increase (decrease) in cash and cash equivalents 22,678 (3,220)
Cash and cash equivalents at the beginning of the period 18,068 8,121
--------- ---------
Cash and cash equivalents at the end of the period $ 40,746 $ 4,901
========= =========
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.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME
(in thousands)
(unaudited)
ACCUMULATED
OTHER TOTAL
COMMON STOCK PAID-IN COMPREHENSIVE RETAINED STOCKHOLDER'S COMPREHENSIVE
SHARES AMOUNT CAPITAL INCOME (LOSS) EARNINGS EQUITY INCOME
------ ------ ------- ------------- -------- ------ ------
BALANCE AT DECEMBER 31, 1997 24,538 $ 25 $ 95,919 $ (113) $ 8,029 $ 103,860 $
Common stock options exercised 663 1 7,737 7,738
Common stock issued under Employee Stock
Purchase Plan 68 1,933 1,933
Tax benefit from stock option transactions 6,100 6,100
Common stock issued for acquisition
of PCS 143 5,088 5,088
Common stock issued for acquisition of FTI 397 14,725 14,725
Unrealized gain on investments 109 109 109
Foreign currency translation adjustment (19) (19) (19)
Net income 7,971 7,971 7,971
-------- --------- --------- --------- --------- --------- ---------
BALANCE AT SEPTEMBER 30, 1998 25,809 $ 26 $ 131,502 $ (23) $ 16,000 $ 147,505 $ 8,061
======== ========= ========= ========= ========= ========= =========
See accompanying notes to consolidated financial statements
6
7
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 nine months ended September 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 objectives during
calendar 1998 and 1999, to receive certain additional shares of HNC common
stock.
7
8
In April 1998, the Company acquired FTI, a company that develops and
markets profitability measurement and decision support software products and
related support services 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 certain 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 REVENUE RECOGNITION
During the first quarter of 1998, the Company adopted Statement of
Position No. 97-2 ("SOP 97-2"), "Software Revenue Recognition," as amended by
Statement of Position No. 98-4 "Deferral of the Effective Date of a Provision of
SOP 97-2, Software Revenue Recognition". SOP 97-2 provides guidance for software
revenue recognition. The adoption of SOP 97-2 did not have a significant impact
on the Company's financial position or results of operations.
NOTE 5 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 6 RECLASSIFICATIONS
Certain prior period balances have been reclassified to conform to the
current period presentation.
8
9
NOTE 7 RECONCILIATION OF NET INCOME (LOSS) AND SHARES USED IN
PER SHARE COMPUTATIONS
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
1998 1997 1998 1997
------- ------- ------- -------
NET INCOME USED:
Net income used in computing
diluted net income per
common share $ 5,076 $ 5,127 $ 7,971 $14,298
======= ======= ======= =======
SHARES USED:
Shares used in computing basic net
income per common share 25,694 24,359 25,217 24,213
Weighted average options to purchase
common stock as determined by
application of the treasury stock
method 1,488 1,533 1,387 1,359
Purchase Plan common stock
equivalents 16 2 16 2
------- ------- ------- -------
Shares used in computing diluted net
income per common share 27,198 25,894 26,620 25,574
======= ======= ======= =======
The conversion of the Company's 4.75% convertible subordinated notes for the
three and nine month periods ended September 30, 1998 of 2,230,000 and 1,700,000
shares, respectively, were not used to calculate diluted net loss per share as
their effect would be anti-dilutive.
9
10
NOTE 8 NEW ACCOUNTING PRONOUCEMENTS
In June 1997, the FASB issued Statement of Financial accounting
Standards No. 131 ("FAS 131"), "Disclosures about Segments of an Enterprise and
Related Information," which HNC is required to adopt for its 1998 annual
financial statements. This statement establishes standards for reporting
information about operating segments in the annual financial statements and
requires selected information about operating segments in interim financial
reports issued to stockholders. It also establishes standards for related
disclosures about products and services, geographic areas and major customers.
Under FAS 131, operating segments are to be determined consistent with the way
that management organizes and evaluates financial information internally for
making operating decisions and assessing performance. HNC has not determined the
impact of the adoption of this new accounting standard on its consolidated
financial statement disclosures.
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
during the first quarter of 2000. 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 has not determined the impact of the adoption of this new
accounting standard on its financial position or results of operations.
NOTE 9 CONVERTIBLE SUBORDINATED NOTES
In March 1998, the Company issued $100,000,000 of 4.75% Convertible
Subordinated Notes (the "Notes") due 2003. The Notes will be convertible into
common stock at any time prior to the close of business on the maturity date,
unless previously redeemed or repurchased, at a conversion price of $44.85 per
share (equivalent to a conversion rate of approximately 22.30 shares per $1,000
principal amount of Notes), subject to adjustment.
NOTE 10 INVESTMENTS
At September 30, 1998 and December 31, 1997, the amortized cost and
estimated fair value of investments available for sale were as follows (in
thousands):
SEPTEMBER 30, 1998
-----------------------------------------------------
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
-------- -------- -------- --------
U.S. government and federal agencies $ 75,686 $ 75 $ -- $ 75,761
U.S. corporate debt 26,951 60 -- 27,010
Foreign corporate debt 7,043 36 -- 7,079
-------- -------- -------- --------
$109,680 $ 171 $ -- $109,850
======== ======== ======== ========
DECEMBER 31, 1997
-------------------------------------------------------
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
-------- -------- -------- ---------
U.S. government and federal agencies $ 20,682 $ -- $ (1) $ 20,681
U.S. corporate debt 1,894 -- (1) 1,893
Foreign corporate debt 2,304 -- -- 2,304
-------- -------- -------- --------
$ 24,880 $ -- $ (2) $ 24,878
======== ======== ======== ========
10
11
At September 30, 1998 and December 31, 1997, all foreign corporate debt
investments were denominated in U.S. dollars.
The objectives of the Company's investment policy are the safety and
preservation of invested funds and liquidity of investments that is sufficient
to meet cash flow requirements. The Company's policy is to place its cash, cash
equivalents and investments available for sale with high credit quality
financial institutions and commercial companies and government agencies in order
to limit the amount of credit exposure. It is also the Company's policy to
maintain certain concentration limits, to only invest in certain "allowable
securities" as determined by the Company's management and must be denominated in
U.S. dollars. The Company's investment portfolio shall not have an average
portfolio maturity of beyond one year and shall maintain certain liquidity
positions. Investments are prohibited in certain industries and speculative
activities.
NOTE 11 IN PROCESS RESEARCH AND DEVELOPMENT
In connection with the acquisitions of PCS, PTI and ATACS, acquired
in-process research and development in the aggregate amount 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 and 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, BNC 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.
11
12
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 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," "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. Accordingly,
actual results and outcomes may differ materially from the results and outcomes
discussed in 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" or
"Year 2000 Compliance" 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: the degree of acceptance of the
Company's products; 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; 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 introductions by the
12
13
Company and its competitors; changes in the mix of distribution channels;
changes in the level of operating expenses; the Company's ability to achieve
progress and fulfill its obligations under percentage-of-completion contracts;
the Company's success in completing certain pilot installations within
contracted fee budgets; competitive conditions in the industry; domestic and
international economic conditions; and market conditions in the Company's
targeted markets. In addition, 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, the Company may be unable to adjust spending in
time to compensate for any revenue shortfall. 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 price
of the Company's common stock and, in turn, the price of the Company's 4.75%
convertible subordinated notes due 2003 (the "Notes"), would likely be
materially adversely affected.
YEAR 2000 COMPLIANCE
GENERAL
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. As early as 1997, the
Company had begun the process of planning and updating, in some cases, its
earlier versions of existing software products. More recent versions of these
same products as well as new products were developed with Year 2000 date
processing in mind. To track performance of completing any remaining compliance
work as well as to assess the Year 2000 issue more broadly, the Company
developed a Year 2000 project plan.
PROJECT
The Company initiated a company-wide Year 2000 Project (Y2k Project)
during 1998 to more formally monitor compliance of its year 2000 exposure for
each major business unit and has divided the project into three major sections
that address its critical date sensitive
13
14
components: software products, information technology ("IT") infrastructure, and
non-IT systems. The Y2k Project consists of (1) assessing the current state of
readiness for all critical components, (2) developing project plans that track
the status of work performed toward completing planned solutions and (3)
developing contingency plans.
In August 1998, IT directors of all significant business units were
asked to inventory all major components and provide the current state of
readiness as well as an indication as to when readiness would otherwise be
expected. In addition, each major business unit was asked to provide project
plan status reports that indicate how compliance would be achieved, as well as
to quantify the extent and timing of the effort and to identify when testing of
the solution would be completed. Finally, each major business unit was asked to
consider various scenarios that might impact successful implementation of their
Year 2000 solutions and to develop alternative or back-up plans to mitigate the
risk of not being ready on time.
CURRENT STATUS
The Company has completed the initial stage of its Y2k Project by taking
inventory of its more major software products, identifying the state of
readiness for each and developing project plans for completing and implementing
designed solutions. Based on the Company's assessment of its major software
products to date, the Company believes that the current version of each 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 also expected to complete its review of the remaining
major components of its IT infrastructure, such as its applications developed
in-house or purchased from a supplier, by the end of 1998.
The Company is reviewing its major non-IT system components for Year
2000 compliance and intends to take appropriate action based on the results of
such review. Non-IT systems include hardware and other electronic systems,
excluding application systems, used in operations of the Company's business. The
assessment and project plans of non-IT Year 2000 solutions are currently
expected to be available by the end of 1998.
The Company's plan for the Year 2000 calls for compliance verification
of third parties supplying software and information systems to the Company for
both IT and non-IT systems 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.
Potential worst case Year 2000 scenarios currently being considered by
HNC address issues arising from non-compliance by its customers, suppliers or
internal operating systems. Although the Company's Y2k Project will strive to
uncover significant non-compliance issues, in the worst case not all Y2k
problems may be uncovered by the year 2000, which could have a material adverse
effect on the Company's business. However, the Company believes that its most
probable worst case scenario is more likely to arise from its customers' and
vendors' inability to become Year 2000 compliant than from the Company's failure
to bring its own products into
14
15
compliance. As a result, the Company's supply chain and revenues could be
adversely impacted. As discussed below, the Company generates a significant
portion of its revenues from usage-based license fees which would be at risk if
its customers are unable to operate their computer systems due to Year 2000
problems caused by software developed internally by the customer or purchased
from a third party vendor. Some considerations include quantifying the impact
that usage-based fees may have on the Company's business and understanding the
compliance programs and contingency plans, if any, the Company's vendors and
customers have developed.
COSTS
All costs associated with carrying out the Company's 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. Failure to identify such problems could, for example, impair the
Company's internal product development efforts and internal management systems.
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.
RISKS
The inability of the Company to complete its assessment and any
necessary modifications to 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 complex
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 non-compliant 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 usage-based transactional fees from customers in the
insurance and financial solutions markets would decline, which would have a
material adverse effect on the 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.
15
16
HNC is also reviewing its major internal corporate systems for Year 2000
compliance and intends to take appropriate action based on the results of such
review. HNC's plan for the Year 2000 calls for compliance verification of
external vendors supplying software and information systems to HNC and
communication with significant suppliers to determine the readiness of third
parties' remediation of their own Year 2000 issues. As part of its assessment,
HNC is evaluating the level of validation it will require of third parties to
ensure their Year 2000 readiness. To date, HNC has not encountered any material
Year 2000 issues concerning its computer systems. HNC plans to complete its Year
2000 research and testing and create any necessary contingency plans by the end
of the first quarter of 1999. All costs associated with carrying out HNC's plan
for Year 2000 compliance are being expenses as incurred. The total cost
associated with preparation for the Year 2000 has not been, and is not expected
to be, material to HNC's business, financial condition or results of operations.
Nevertheless, HNC may not timely identify and remediate all significant Year
2000 problems and remedial efforts may involve significant time and expense.
Failure to identify such problems could, for example, impair HNC's internal
product development efforts and internal management systems. There can be no
assurance that any Year 2000 compliance problems of HNC or its customers or
suppliers will not have a material adverse effect on HNC's business, financial
condition and results of operations.
RESULTS OF OPERATIONS
HNC develops, markets and supports predictive software solutions for
leading service industries. These predictive software solutions employ,
variously, proprietary neural-network predictive decision engines, profiles,
traditional statistical modeling, business models, expert 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 solutions and retail markets. The Company's
healthcare/insurance products, which are developed and marketed by its HNC
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
solutions 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.
For the nine months ended September 30, 1998, approximately 7% of the
Company's sales were denominated in currencies other than the Company's
functional currency, which is the US dollar. These foreign currencies are
primarily those of Western Europe, Canada and Australia.
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
September 30, 1998 were $47.8 million, an increase of 59% over revenues of $30.0
million for the same period in the prior year. The Company's revenues for the
nine months ended September 30, 1998 were $126.0 million, an increase of 54%
over revenues of $81.7 million for the same period in the prior year.
16
17
During the first quarter of 1998, the Company adopted Statement of
Position No. 97-2 ("SOP 97-2"), "Software Revenue Recognition" and as amended by
Statement of Position No. 98-4 "Deferral of the Effective Date of a Provision of
SOP 97-2, Software Revenue Recognition". SOP 97-2 provides guidance for software
revenue recognition. The adoption of SOP 97-2 did not have a significant impact
on the Company's financial position or results of operations.
REVENUES
LICENSE AND MAINTENANCE REVENUES. The Company's license and maintenance
revenues are derived from annual license fees, monthly license fees, perpetual
license fees and annual maintenance fees. License and maintenance revenues were
$36.8 million for the quarter ended September 30, 1998, an increase of 55% from
$23.7 million for the comparable quarter in 1997. The increase in license and
maintenance revenues was due primarily to the growth of license fee revenues
from the financial solutions segment of approximately $5.3 million and the
retail solutions segment of approximately $3.4 million. The increase in the
financial solutions industry revenue during the quarter ended September 30, 1998
compared to the quarter ended September 30, 1997, is attributable to an increase
in sales of the Falcon and AREAS product lines and sales generated by the
recently acquired company, FTI. On September 30, 1998, the Company entered into
a two year service agreement and a three year sale/license agreement for its
AREAS, Data Mining Workstation, DeployNet/API and SIMD Numerical Array Processor
products with Transamerica Intellitech. The increase in license and maintenance
revenues in the retail solutions segment in the quarter ended September 30, 1998
compared to the quarter ended September 30, 1997, was primarily attributable to
an increase in sales of the Retek suite of products. Products of the recently
acquired company, PCS, were added to the Retek suite of products during the
first quarter of 1998. Contributing to the increase in license and maintenance
revenues in the quarter ended September 30, 1998 compared to the quarter ended
September 30, 1997, were increases in the insurance solutions segment of
approximately $2.7 million due primarily to an increase in the customer base and
in the telecommunications solutions segment of approximately $1.6 million due to
the recently acquired ATACS product line.
License and maintenance revenues were $97.5 million for the nine months
ended September 30, 1998, an increase of 51% from $64.3 million for the
comparable period in 1997. The increase in license and maintenance revenues was
due primarily to the growth of license fee revenues from the financial solutions
segment of approximately $14.3 million and the retail solutions segment of
approximately $11.9 million. The increase in the financial solutions industry
revenue during the nine months ended September 30, 1998 compared to the nine
months ended September 30, 1997, is attributable primarily to an increase in
sales of the Falcon, FTI (the recently acquired company), AREAS and ProfitMax.
The increase in license and maintenance revenues in the retail solutions segment
in the nine months ended September 30, 1998 compared to the nine months ended
September 30, 1997, was primarily due to an increase in sales of the Retek suite
of products. Contributing to the increase in license and maintenance revenues
were increases in the insurance solutions segment of approximately $4.2 million
and license and maintenance revenues in the telecommunications solutions segment
from the recently acquired ATACS product line of approximately $2.2 million.
17
18
SERVICES AND OTHER REVENUES. Services and other revenues are comprised
of installation and implementation revenues, service bureau operations revenues
and revenues which are derived from consulting contracts, new product
development contracts with commercial customers and, to a lesser extent,
research and development contracts with the United States Government. Revenues
from installation and implementation services and 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. Service bureau revenues are derived from the Company's
service bureau operations, which provide CRLink's functionality to customers
that do not wish to obtain a license, that use this service until they can
implement their own internal CRLink operation or that use this service when
their volumes peak to high levels. Service bureau customers typically subscribe
for services under month-to-month agreements and service bureau fees are
recognized as revenue when the processing services are performed.
Services and other revenues for the quarter ended September 30, 1998
were $10.9 million, an increase of 74% from $6.3 million for the quarter ended
September 30, 1997. Additionally, services and other revenues for the nine
months ended September 30, 1998 were $28.5 million, an increase of 65% from
$17.3 million for the nine months ended September 30, 1997. The retail solutions
segment accounted for approximately $3.0 million and $8.0 million of the
increase during the quarter and nine months ended September 30, 1998,
respectively. These increases were attributable to increases in consulting
contracts with commercial customers in the retail industry. The insurance
solutions segment accounted for approximately $600,000 and $2.5 million of the
increase during the quarter and nine months ended September 30, 1998 compared to
the quarter and nine months ended September 30, 1997, respectively. These
increases were attributable to an increase in the number of customers utilizing
the Company's service bureau operations. The financial solutions segment
accounted for approximately $600,000 and $1.2 million of the increase during the
quarter and nine months ended September 30, 1998, respectively. This increase
was primarily due to new installations of the Capstone product line during the
third quarter of 1998, and the Capstone, Falcon and ProfitMax product lines for
the nine months ended September 30, 1998.
EXPENSES
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 third quarter
of 1998 were $8.0 million and constituted 22% of license and maintenance
revenues for the quarter, whereas such expenses were $5.0 million and
represented 21% of license and maintenance revenues in the third quarter of
1997. Additionally, license and maintenance expenses for the nine months ended
September 30, 1998 were $22.2 million and represented 23% of license and
maintenance revenues for that nine-month period, whereas such expenses were
$14.0 million and represented 22% of license and maintenance revenues for the
nine months ended September 30, 1997.
The financial solutions segment accounted for approximately $1.0 million
and $3.6 million of the increase during the quarter and nine months ended
September 30, 1998 compared to the quarter and nine months ended September 30,
1997, respectively. The insurance solutions
18
19
segment accounted for approximately $1.2 million and $2.4 million of the
increase during the quarter and nine months ended September 30, 1998,
respectively. The retail solutions segment accounted for approximately $700,000
and $2.0 million of the increase during the quarter and nine months ended
September 30, 1998, respectively. The primary reason for the increase in these
expenses across all industry segments in the three and nine month periods ended
September 30, 1998 over the comparable periods in 1997 (both 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.
SERVICES AND OTHER EXPENSES. Services and other expenses consist of
personnel and other expenses associated with providing installation and
implementation services, the Company's performance of development, consulting,
and research and development contracts and the costs associated with the service
bureau operations. Service and other expenses for the third quarter of 1998 were
$8.5 million and 78% of services and other revenues, whereas such expenses were
$3.8 million and 61% of service and other revenues during the third quarter of
1997. Services and other expenses for the first nine months of 1998 were $20.2
million and 71% of service and other revenues, whereas such expenses were $11.0
million and 63% of services and other revenues during the first nine months of
1997.
The retail solutions segment accounted for approximately $3.0 million
and $6.1 million of the increase during the quarter and nine months ended
September 30, 1998 compared to the quarter and nine months ended September 30,
1997, respectively. These increases are attributable to an increase in
consulting contracts with commercial customers in the retail industry. Due to
the increase in demand for retail consulting services, the retail solutions
segment utilized a significant amount of contract labor, which in turn caused a
decrease in gross margins. The financial solutions segment accounted for
approximately $900,000 and $1.9 million of the increase during the quarter and
nine months ended September 30, 1998, respectively. This increase (and the
associated decrease in gross margins) was a result of a shift in the mix of
implementations within the financial solutions segment due primarily to an
increase in Capstone implementations, which have substantially lower margins
than implementations of the Falcon line of products. The insurance solutions
segment accounted for approximately $500,000 and $1.2 million of the increase
during the quarter and nine months ended September 30, 1998, respectively. The
associated increases in gross margins were the result of increased volume of
service bureau customers combined with relatively fixed costs.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses
consist primarily of salaries and other personnel-related expenses and
subcontracted development services. Research and development expenses in the
third quarter of 1998 were $9.2 million or 19% of total revenues compared to
$6.0 million or 20% of total revenues in the third quarter of the prior year.
Research and development expenses for the first nine months of 1998 were $23.6
million or 19% of total revenues compared to $15.4 million or 19% of total
revenues for the first nine months of the prior year.
The insurance solutions segment accounted for approximately $2.0 million
and $4.4 million of the increase during the quarter and nine months ended
September 30, 1998 compared to the quarter and nine months ended September 30,
1997, respectively. The retail solutions segment accounted for approximately
$400,000 and $2.6 million of the increase during the quarter and nine months
ended September 30, 1998, respectively. The financial solutions
19
20
segment accounted for approximately $600,000 and $1.6 million of the increase
during the quarter and nine months ended September 30, 1998, respectively. 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 insurance solutions and retail
solutions products and, to a lesser extent, the financial solutions products.
Research and development expenses also increased in absolute dollars due to
increased efforts required to support the research and development functions of
businesses acquired by the Company in late fiscal 1997 and in fiscal 1998.
SALES AND MARKETING EXPENSES. Sales and marketing expenses consist
primarily of salaries and benefits, commissions, travel, entertainment and
promotional expenses. Sales and marketing expenses were $8.8 million or 18% of
total revenues in the third quarter of 1998 compared to $5.7 million or 19% of
total revenues in the third quarter of 1997. Sales and marketing expenses were
$25.2 million or 20% of total revenues in the first nine months of 1998 compared
to $15.5 million or 19% of total revenues in the first nine months of 1997.
The retail solutions segment accounted for approximately $1.0 million
and $4.8 million of the increase during the quarter and nine months ended
September 30, 1998 compared to the quarter and nine months ended September 30,
1997, respectively. The financial solutions segment accounted for approximately
$1.4 million and $3.6 million of the increase during the quarter and nine months
ended September 30, 1998, respectively. The insurance solutions segment
accounted for approximately $200,000 and $800,000 of the increase during the
quarter and nine months ended September 30, 1998, respectively. 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.
Contributing to the increases were increased expenses for trade shows,
advertising, corporate marketing programs and other expenses to support the
recently acquired businesses.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
were $3.8 million or 8% of total revenues in the third quarter of 1998, compared
to $3.0 million or 10% of total revenues in the third quarter of the prior year.
General and administrative expenses were $10.8 million or 9% of total revenues
in the first nine months of 1998, compared to $8.4 million or 10% of total
revenues in the first nine months of the prior year. Included in general and
administrative expenses were acquisition related costs of $123,000 for the three
month period ended September 30, 1997. These costs were related to the
acquisition of CompReview in November 1997. Acquisition related costs of
$673,000 and $123,000 were included in general and administrative expenses in
the first nine months of 1998 and in the first nine months of 1997,
respectively. These costs related to the acquisition of CompReview in November
1997 and the acquisition of PCS in first quarter of 1998 and the acquisitions of
FTI and ATACS in the second quarter of 1998.
Excluding acquisition costs, the retail solutions segment accounted for
approximately $60,000 and $900,000 of the increase during the quarter and nine
months ended September 30, 1998 compared to the quarter and nine months ended
September 30, 1997, respectively. Excluding acquisition costs, the financial
solutions segment accounted for approximately $300,000 and $600,000 of the
increase during the quarter and nine months ended September 30, 1998,
respectively. The increase in absolute dollars was due primarily to increased
staffing and
20
21
related expenses, including recruiting costs, to support higher levels of sales
and development activity across the Company resulting in part from the Company's
recent acquisitions. The decrease of general and administrative expenses as a
percentage of total revenues was the result of general and administrative
expenses increasing at a lower rate than revenues in the same fiscal periods.
IN-PROCESS RESEARCH AND DEVELOPMENT EXPENSES. In-process research and
development expenses were $6.1 million for the nine month period ended September
30, 1998. These one-time write-offs were related to the acquisitions of PCS,
$1.8 million, and FTI, $3.0 million, and the asset purchase of ATACS, $1.3
million, during the first nine 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 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 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 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
21
22
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.
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
22
23
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 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:
23
24
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 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.
ACQUISITION RELATED AMORTIZATION EXPENSES. Acquisition related
amortization expenses were $1.2 million or 3% of total revenues in the third
quarter of 1998 and $2.0 million or 2% of total revenues in the first nine
months of 1998. 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 nine months of 1998.
TOTAL OTHER INCOME, NET. Other income for the third quarter of 1998 was
$612,000 compared to $538,000 in the third quarter of the prior year. Other
income for the first nine months of 1998 was $1.6 million compared to $1.4
million in the first nine 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 in the quarter ended September 30, 1998 compared to the quarter
ended September
24
25
30, 1997, 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 $3.7 million and $1.8
million in the third quarters of 1998 and 1997, respectively, and the income tax
provisions of $9.4 million and $4.6 million during the first nine months of 1998
and 1997, respectively, are based on 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
$1.8 million in the third quarter of 1997 and $4.6 million during the first nine
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 rather than by CompReview. 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 nine months
of 1998 was $13.5 million, which primarily represented net income before
non-cash charges for purchased research and development and depreciation and
amortization of approximately $21.0 million, offset in part by an increase in
accounts receivable. Net cash used in investing activities was $96.7 million
during the first nine months of 1998, primarily due to net purchases of
investments of $127.0 million. Net cash provided by financing activities of
$106.0 million during the first nine months of 1998 was primarily related to
proceeds from the issuance of the Company's 4.75% Convertible Subordinated Notes
(the "Notes") due 2003 of $100.0 million issued in conjunction with the
Company's debt offering in March 1998 and net proceeds of $9.7 million from the
issuance of common stock. This was partially offset by costs of approximately
$2.8 million related to the issuance of the above-mentioned Notes.
At September 30, 1998, the Company had $150.6 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. The Company expects to
invest approximately $2.0 million in capital assets, including computer
equipment and building improvements throughout the remainder of 1998. 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. The proceeds from the Notes will be used for general
corporate purposes, including working capital or to acquire complementary
businesses, products or technologies. From time to time, in the ordinary course
of business, the Company evaluates potential acquisitions of such businesses,
products, technologies or data.
25
26
The objectives of the Company's investment policy are the safety and
preservation of invested funds and liquidity of investments that is sufficient
to meet cash flow requirements. The Company's policy is to place its cash, cash
equivalents and investments available for sale with high credit quality
financial institutions and commercial companies and government agencies in order
to limit the amount of credit exposure. It is also the Company's policy to
maintain certain concentration limits, to only invest in certain "allowable
securities" as determined by the Company's management and must be denominated in
U.S. dollars. The Company's investment portfolio shall not have an average
portfolio maturity of beyond one year and shall maintain certain liquidity
positions. Investments are prohibited in certain industries and speculative
activities.
26
27
Item 6: EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
2.01 Agreement and Plan of Reorganization dated as of
September 16, 1998 among the Registrant, Open
Solutions, Inc. and Oahu Transaction Corp., a
wholly-owned subsidiary of the Registrant
(incorporated by reference to Appendix A to the Proxy
Statement/Prospectus included in the Company's
Registration Statement on Form S-4 Registration No.
333-64527.).
27.01 Financial Data Schedule.
27.02 Restated Financial Data Schedule.*
(b) Reports on Form 8-K
None
- ----------------
*Filed herewith.
27
28
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)
28
29
EXHIBIT INDEX
Exhibits
--------
2.02 Agreement and Plan of Reorganization dated as of September
16, 1998 among the Registrant, Open Solutions, Inc. and
Oahu Transaction Corp., a wholly-owned subsidiary of the
Registrant (incorporated by reference to Appendix A to the
Proxy Statement/Prospectus included in the Company's
Registration Statement on Form S-4 Registration No.
333-64527.).
27.01 Financial Data Schedule.
27.02 Restated Financial Data Schedule.*
- ----------------
*Filed herewith.
29