CONFORMED COPY
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1999
Commission File Number 0-23611
DSET CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
New Jersey 22-3000022
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(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
1160 U. S. Highway 22, Bridgewater, New Jersey 08807
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(Address of Principal Executive Offices) (Zip Code)
(908) 526-7500
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Registrant's telephone number, including area code
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
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None
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Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value
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(Title of Class)
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(Title of Class)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes: |X| No: |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |_|
State the aggregate market value of the voting common stock held by
non-affiliates of the registrant: $ 283,974,161 at March 1, 2000 based on the
last sales price on that date.
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of March 1, 2000:
Class Number of Shares
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Common Stock, no par value 10,947,685
The following documents are incorporated by reference into the Annual
Report on Form 10-K: Portions of the registrant's definitive Proxy Statement for
its 2000 Annual Meeting of Shareholders are incorporated by reference into Part
III of this Report.
TABLE OF CONTENTS
Item Page
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PART I 1. Business.................................................... 1
2. Properties.................................................. 24
3. Legal Proceedings........................................... 24
4. Submission of Matters to a Vote of Security Holders......... 25
PART II 5. Market for the Company's Common Equity
and Related Stockholder Matters........................ 26
6. Selected Financial Data..................................... 28
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations.............................. 30
7A. Quantitative and Qualitative Disclosures About Market Risk.. 38
8. Financial Statements and Supplementary Data................. 38
9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................... 39
PART III 10. Directors and Executive Officers of the Company............. 40
11. Executive Compensation...................................... 40
12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 40
13. Certain Relationships and Related Transactions.............. 40
PART IV 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K.................................................... 41
SIGNATURES................................................................. 42
EXHIBIT INDEX.............................................................. 44
FINANCIAL DATA AND SCHEDULES............................................... F-1
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PART I
Item 1 Business.
General
DSET Corporation ("DSET" or the "Company") is a leading provider of
business-to-business e-commerce software solutions for the global
telecommunications marketplace. The Company's suite of electronic-bonding
gateways is designed to interconnect the operations support systems ("OSSs") of
competing telecommunications service providers ("Telecom Providers") and other
trading partners that must trade information and share network capabilities to
price, provision and maintain a growing range of communications services for
their customers. These solutions eliminate the need for manual data entry and
manual exchange of information with trading partners by traditional
communications channels such as telephone, facsimile, or mail. This allows
DSET's customers to increase the efficiency of their operations, reduce their
time to market, rapidly respond to changes from their customers, and effectively
manage the increasingly complex interactions with partners and customers.
DSET's primary target market are the facilities-based competitive local
exchange carriers ("CLECs") and data local exchange carriers ("DLECs") that
provide a wide range of voice, data, Internet access services and digital
subscriber line ("DSL") service to customers who traditionally received these
services from incumbent local exchange carriers ("ILECs"), such as Bell
Atlantic, Pacific Bell and GTE. CLECs and DLECs use DSET's electronic-bonding
solutions for sales force productivity, execution of orders with trading
partners, and post-order customer care applications. To date, DSET has sold its
solutions to over 27 companies including market leaders such as Allegiance
Telecom, ALLTEL, Birch Telecom, Gabriel, McLeodUSA, Net2000 Communications,
Net-tel Corporation, Network Plus, RCN, TXU Communications Services, Teligent,
and TriVergent Communications. As part of the Company's strategy to quickly
establish its products as the market leading suite of interconnection solutions,
DSET has developed alliances with other leading industry solution providers
such as Metasolv Software, Commtech, Vitria Technologies, Cygent, Clarify and
Mercator Software, as well as leading system integrators including Andersen
Consulting, ADC Telecommunications, BusinessEdge Solutions, Danet and KPMG
Consulting.
DSET is also a leader in providing local number portability solutions to
the telecommunications equipment suppliers and telecommunications providers. The
Company's local service management system ("LSMS") is currently distributed and
resold to telecommunication providers by Alcatel, Lucent Technologies and Nortel
Networks.
In addition, DSET maintains its legacy product line of application
development tools which allow network equipment vendors to build applications
which manage network devices and provision new services such as voice, data and
Internet access.
1
The Company was incorporated in New Jersey in 1989. The Company's
executive offices are located at 1160 US Highway 22, Bridgewater, New Jersey
08807, and its telephone number is (908) 626-7500.
Industry Background
Telecommunications providers face an increasingly competitive and complex
market environment due to the rapidly growing number of new entrants into the
market, technological advances and customer demand for new services. In the
U.S., the Telecommunications Act of 1996 ("Telecom Act") mandated access to the
ILECs' networks and consequently their OSSs in order to enable the flow-through
of information and services between the new competitive carriers (CLECs and
DLECs) and the incumbents to foster customer choice of carriers and facilitate
the transfer of customers to the new carriers. As a result, CLECs now have the
ability to order elements of the traditional ILEC network (e.g. local loops,
T-1's) for resale to their own customer base even though a customer may have
previously purchased these services from the ILEC. Many CLECs have made the
commitment to procure their own switch equipment and build or lease their own
networks in order to better serve their customers. However, for the most part,
they still need to establish connection with their customer through the ILEC and
purchase other enhanced services from various service bureaus or trading
partners.
To compete in this environment, CLECs must be able to rapidly and reliably
communicate with trading partners to order services and ultimately turn on phone
services for new customers. Although this can be accomplished by traditional
methods, such as manual order forms which are faxed or mailed to the trading
partner, these methods are cumbersome and lead to delays in processing new
orders, especially as the volume of orders increases. In some instances, the
trading partner will provide an Internet web interface. However, this does not
provide the automatic and rapid flow-through of orders through the CLECs' own
systems. Both of these approaches require the redundant input of data into
multiple IT systems and slow the process of activating services for new
customers.
The alternative to these approaches is to directly connect the CLEC's
order processing system with the order processing systems of its trading
partners electronically. This bonding process is made possible by software that
can translate the CLEC's order information into industry standard forms, provide
communication security, support multi-protocol communications and track data
transmission in both directions. It further eliminates redundant data entry and
ensures that the order requests are passed into the appropriate trading
partner's process. This solution can reduce service activation times for the
CLEC and result in an enhanced ability to convince the prospective customer to
leave the ILEC and sign up with the CLEC as their new service provider.
In the U.S., it is currently estimated that there are over 300
facilities-based CLECs or DLECs at various stages of developing and building
integrated communication service offerings. It is DSET's belief that a
significant majority of these companies have not yet purchased or built
interconnection solutions to connect with those companies' trading partners.
DSET estimates that the market for these solutions could amount to over $600
million over the next three years.
2
In addition to requiring ILECs to grant access to their networks and OSSs,
the Telecom Act also mandated that local telephone customers be allowed to
retain their phone numbers if they decide to change service providers. This
process, known as local number portability (LNP), required the creation of a
national number portability clearinghouse to update the addresses of telephone
numbers throughout the intelligent network (sometimes known as the SS7 network).
This allows telephone switching equipment at any carrier to quickly look-up the
location of any phone number in North America to correctly route calls over the
public switched telephone network. Number Portability Administration Centers
("NPACs") were developed and built for the U.S government by Lockheed Martin
Corporation in 1997 and 1998 utilizing DSET network applications and tools.
Telecom Providers who win new customers are required to notify the
regional NPAC when they activate service for new customers that wish to retain
their old phone numbers. This is accomplished through an electronic-bonding
gateway. If they have established their own SS7 network, they must also have a
system to track and store phone number port addresses in their own databases.
This LSMS system is a subsystem of their switching and network systems.
Products and Services
The Company has three main product areas, OSS interconnection solutions
for CLECs and DLECs, LNP solutions for Telecom Providers to provide the required
interface with one or more of the NPACs, and object-oriented application
development tools for telecommunication equipment suppliers to rapidly create
and subsequently deploy network management applications. Additionally, the
Company provides custom application development services in each of these three
main product categories.
OSS Interconnection Solutions
The Telecom Act stipulated that ILECs unbundle or decouple portions of
their networks and make them available on a lease basis, for a fee, to the
CLECs. Of the thousands of CLECs today, approximately 300 are purchasing central
office switches and building their own network facilities. These facility-based
CLECs then order from the ILEC the "local loop" or a dedicated access line (e.g.
T-1 or DS-1), also called the last mile, which connects the customer (business
or consumer) to the ILEC's central office switch. The ILEC must unbundle the
local loop or provide the dedicated access line to the CLEC. The CLEC requests
for an unbundled local loop have been predominantly handled by facsimile,
telephone or delivery service transmissions, which result in frequent
communication inefficiencies. Facsimile and overnight delivery services simply
cannot accommodate the required flow-through of information between the
competing carriers. Some ILECs offer Internet web-based access for ordering
these unbundled elements. However, this process also does not provide the
efficient flow-through of ordering information as it still requires the
redundant entry of data from multiple IT systems.
In addition to ordering services to connect customers to the existing
public switched telephone network, CLECs must also order other services to
provide enhanced communications capabilities to their customers from other
trading partners and service bureaus. These services
3
include local number portability porting updates, E911 services, calling name
and calling card services. The order processes for these services have
traditionally been handled in the same manner as orders from the ILECs.
An alternative solution for ordering services from trading partners is to
utilize a software application known as an electronic-bonding gateway. These
gateways process orders electronically between two companies, which, in the case
of a CLEC and an ILEC, is between competing telecom service providers. This
process is also known as OSS interconnection or business-to-business e-commerce
for the telecommunication industry.
The Company has developed fourteen interconnection and reporting solutions
for CLECs and DLECs. They span the areas of sales force productivity and DSL
service pre-qualification, ordering gateways, and post-ordering customer care
gateways as follows:
CLEC Solutions
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DLEC/ISP Solutions Sales Force Productivity Ordering Gateways Post-Ordering Gateways
ezDSL ezSalesQuote ezConnect ezCare
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ezDSLLeads ezCSRRetriever ezLocalLoop ezTroubleTicket
ezDSLLocalLoop ezCatalog (CLEC) ezT-1 ezLongDistance
ezDSLTroubleTicket ezCatalog (ILEC) ezNumberPort
ezUSOCTranslator ez911
ezQuoteGenerator ezCallingName
ezCallingCard
The Company's DLEC service solutions allow a DLEC to pre-qualify potential
customers prior to incurring marketing and sales expense. DSL, or digital
subscriber line service, is a form of high-speed data transmission carried over
the standard telephone lines installed by the ILECs to customer premises.
However, this service is limited to local loops that are within a restricted
distance from established central offices of the ILEC and that have good
technical line characteristics. Currently, it is estimated that only about 60%
of the local loops nationwide meet these criteria. If a DLEC were to market
indiscriminately to all telephone users, they would have a significant fall-out
of unqualified customers upon service activation and have wasted money and time
in pursuing these accounts. DSET's ezDSLLeads qualification system allows the
DLEC to pinpoint potential customers by eliminating unqualified addresses from
the DLEC's sales database, thereby lessening direct mail and telemarketing
costs. Once they have obtained a new customer, the DLEC can then use the
ezDSLLocalLoop gateway to order the service from the ILEC. After the customer is
in service, the DLEC can use the ezDSLTroubleTicket gateway when the customer's
service becomes impaired to rapidly communicate a service outage to the ILEC and
receive information on repair status.
4
The Company's sales force productivity solutions provide a CLEC's sales
force with information to compete effectively with the ILEC for new customers.
As most customers already have services with an ILEC, the ILEC has the advantage
of knowing the customer's current telecommunications service requirements. The
Telecom Act required the ILEC to allow CLECs access to this data to give them an
equal footing with the ILEC's sales representative. The ezCSRRetriever allows a
CLEC to electronically access and download the customer's service record ("CSR")
from the ILEC's database as opposed to requesting a hard copy by mail or fax.
Once the CLEC has the data in its system, it can translate the ILEC database
format into a usable format with the ezUSOCTranslator. The reformatted customer
information can then be compared to the service and price catalogs of both
carriers by the ezQuoteGenerator to prepare an easily readable comparative quote
for the customer.
Once a CLEC or DLEC secures a new customer, it must process the complex
order information and order the required service from their trading partners.
The ezLocalLoop gateway enables the CLEC to send an order from its order
management system to the ILEC's order management system to request that the
local loop be cut-over to the CLEC's new central office switch. Once the CLEC
gets confirmation that it can get the local loop from the ILEC, it must notify
the NPAC. The ezNumberPort gateway sends a message to the NPAC, alerting it to
the fact that a customer has switched service providers. This message will, in
turn, trigger messages from the NPAC that will update the appropriate SS7
networks, ensuring that the new CLEC customer can keep its local telephone
number. The Company believes these gateways are critical to reducing the time
necessary for a CLEC to turn on service for a new customer. Many CLECs are
targeting to reduce the time to turn on service from four to six weeks to only
one week.
If the customer requires additional services, the CLECs would be required
to communicate these requests over separate gateways. The ezT-1 gateway enables
the CLEC to order any required dedicated access lines from an ILEC. ez911 allows
them to order enhanced 911 services from the leading national provider of these
services, SCC Corporation. ezCallingName gives the CLEC access to a caller ID
database so that their customer may use this service. In order for the CLEC to
offer credit card services, it must have access to a valid credit card database
through ezCallingCard to ensure that its customer's credit card is recognized
throughout the public switched telephone network.
After a CLEC secures a new customer, it must be able to provide fast and
efficient customer care. If the customer has a service outage, the CLEC has to
have the ability to quickly communicate this to the ILEC if the CLEC determines
that it is not a problem within the CLEC's network. DSET's ezTroubleTicket
gateway, connected to the CLEC's customer care system, facilitates the
flow-through of trouble tickets to the ILEC's own internal trouble
administration system in order to quickly initiate the appropriate problem
investigation and necessary repair, if required. It also facilitates the
automatic feedback of status information on the problem so that the CLEC can
keep its customer informed and updated on a timely basis. If the customer
chooses to change long distance carriers, the CLEC needs a way to quickly
communicate this information to both the current and new long distance providers
in order to initiate a smooth and seamless transfer between these carriers.
DSET's ezLongDistance gateway provides the electronic link to all the
established long distance carriers using industry standard protocols.
5
Individual gateways or reporting solutions are licensed to CLECs for fees
ranging from $75,000 to $500,000, depending upon gateway type and complexity.
CLECs can order these products individually or in bundles. The price for a full
suite of gateways and solutions can range from $2.8 million to $4.0 million.
Maintenance, consulting services and customer integration to OSSs are also
available as optional services. ILEC interoperability interfaces built in
accordance with Joint Implementation Agreements between ILECs and CLECs are
available on a licensed or custom-built basis.
Local Number Portability (LNP) Solutions
As a result of the Telecom Act, the FCC has required local exchange
carriers to support the implementation of LNP, which enables customers to move
from their current telephone carrier to another carrier without a change in
telephone number. LNP applications require a significant amount of information
to be exchanged electronically between carriers and the seven independent
FCC-approved NPACs.
In addition to the ezNumberPort electronic-bonding gateway discussed
above, DSET has other applications that address LNP. DSET has built an LSMS
application that provides the required Telecommunications Management Network
("TMN") interface between the telephone companies and the NPACs. A LSMS is the
"local database manager" for all numbers ported through NPACs. A carrier's LSMS
receives information from the NPAC about subscribers who are porting telephone
numbers from one carrier to another and then downloads information about the
ported numbers to the relevant network devices. The Company primarily
distributes this product through the major network equipment suppliers Alcatel,
Lucent Technologies and Nortel Networks. The product can also be sold directly
to carriers with existing service management systems.
The Company also markets the NPAC Simulator product that helps carriers
and equipment vendors simulate the performance of the NPAC and which shortens
the interoperability testing time necessary for certifying the TMN interface.
Application Development Tools
DSET's application development tools enable its customers to rapidly
create scalable solutions for the management of network devices within wireline
or wireless telecommunications networks. However, the Company has been actively
moving away from selling its application development tools and has been
refocusing its efforts on OSS interconnection gateways and LNP solutions.
The Company offers two suites of TMN-compliant application development
tools, the TMN Agent Tool Suite and the TMN Manager++ Tool Suite.
Telecommunications equipment vendors utilize the Company's TMN Agent Tool Suite
to build agent applications that are embedded in their network devices and
subsequently sold to and deployed by carriers. Such network devices include
SONET multiplexers, dense wave division multiplexers ("DWDMs"),
6
digital loop carrier systems, wireless base station controllers and ATM
switches. Carriers utilize the TMN Manager++ Tool Suite to build applications
that assist in remotely managing network devices from a specific vendor and
facilitate the flow-through of information within the carrier's network
management infrastructure.
The OSI Stack and Information Modeling Tools are distributed by the
Company pursuant to distribution arrangements with ATOS, S.A. The Company's
tools share a common software architecture enabling a wide range of platform,
operating system and communication protocol independence. The development tools
operate in UNIX and Windows NT operating systems and are supported on platforms
from Sun Microsystems, Hewlett Packard, IBM and Digital Equipment Corporation.
The Company also provides cross-platform toolkits so that the agent applications
can be ported to run under real-time operating systems. The Company's products
operate with leading real-time operating systems, including pSOS, VxWorks and
VRTX, and also support a variety of communication protocols, including OSI, RFC
1006, TCP/IP and GR-303. This cross-platform support enables DSET's customers,
when switching platform vendors, to preserve their investment in applications
built with DSET's tools.
The Company licenses its tools on both a suite and individual component
basis. Prices for development licenses of the tool suites typically range from
approximately $150,000 to $250,000, depending on the number of licensed
components and users. The Company's license agreements also typically provide
for the payment of run-time royalty fees for applications built with DSET tools
when the licensee ships such applications to carriers.
Custom Application Development Services
Although DSET's main focus is on the sale of its software products, the
Company offers a range of value-added application development and consulting
services to assist its customers in providing solutions for their own clients.
The Company offers services such as system design, information modeling,
complete "end-to-end" development, integrated testing and test plan simulations,
and design optimization services for rapid solution deployment. If the Company
provides custom application development services, it generally retains the right
to rebuild similar applications for other customers.
The Company's application development services projects are generally
individually negotiated and contracted for on a fixed price basis with
performance and payment milestones. Prices for such projects vary depending upon
the size and scope of the project and estimated time to completion. There can be
no assurance that the Company will be able to accurately estimate the resources
required for its fixed price projects or complete its contractual obligations in
a timely manner consistent with the project plans upon which such fixed price
projects are based.
Customer Satisfaction
The Company believes that its ability to provide a high level of customer
support is critical to achieving long-term customer satisfaction. Accordingly,
the Company has increased its customer support staff and expanded its service
offerings. The Company offers an optional
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annual maintenance contract to its customers that includes two segments (1)
technical support, and (2) software upgrades.
Technical Support. The Company's technical support services include
problem identification and notification, work-around solutions, temporary
software patches and bug fixes. Depending upon the complexity of the problem,
the Company provides technical support solutions via electronic mail, website
access, telephone or on-site support. Such services are offered to all licensees
of the Company's products under maintenance contracts, for which the Company
typically charges between 15% and 30% annually of the list price of the products
licensed by the customer. The Company utilizes a number of procedures to ensure
prompt service, including tracking all technical support issues in a
computerized system to ensure same-day acknowledgment of the customer report.
Technical support is provided directly by the Company's technical support
engineers. The Company's products generally are covered by a 90-day warranty
which covers defects in the media provided to the customer, as well as a
warranty for Year 2000 compliance. In certain circumstances, the Company has
provided a warranty that its products, as delivered, will meet customer
specifications.
Software Upgrades. In most cases, the Company provides its annual
maintenance customers with the option to receive product upgrades, including new
releases and product patches, for no additional fee. Software patches may be
downloaded by customers from the Company's website. Software upgrades may be
purchased for an additional fee by customers who have not contracted for annual
maintenance services.
Training. DSET provides a variety of training courses that educate users
of the software and system integrators regarding specific applications. In
addition, the Company offers customized training to meet specific customer
requests.
Technology
From its founding in 1989, the Company has focused on the creation of
applications that could be distributed among many processors in order to solve
highly complex problems in the network management arena. Additionally, the
Company has developed extensive knowledge of requirements for multi-protocol and
multi-vendor communications as well as real-time operating systems. In the early
1990's, the Company made a strategic decision to focus on creating suites of
tools that facilitate the development of solutions based upon the TMN standard.
Through these efforts, the Company's engineers broadened their expertise in
GDMO, CMIP, ASN.1 and OSI, the key technologies underlying TMN, as well as a
variety of other emerging technologies.
The Company's distributed technologies allow for concurrency, or
multi-threading, and scalability for the processing of significant amounts of
management information. The Company believes that the multi-threading and
scalability capabilities of its application development tools are competitive
advantages. Many competitive alternatives utilize sequential processing which
cannot take full advantage of the multi-processing capabilities of high
performance computing platforms. Other innovative software technologies include
sub-agent capabilities, which, in conjunction with the Company's virtual
management information tree capability, enable the
8
management of millions of objects. In addition, DSET's products can support
simultaneous synchronous/asynchronous and connection-oriented/connection-less
inter-process communications. This capability, in addition to ensuring the high
performance of applications, also facilitates integration with third-party
products. DSET has also simplified the process of using these complex
technologies by developing high level APIs and GUIs.
In the past few years, the Company has used this base technology and the
experience it has gained to develop robust carrier grade solutions for OSS
interconnection gateways and local number portability solutions. DSET's initial
gateway products were built on the Company's proprietary platform using DSET
tools and technologies. This has allowed the company to transition from a
real-time applications development environment to a commercial business process
application supplier in an accelerated timeframe. As new solutions are being
developed for the CLECs and DLECs, additional technologies such as EDI, CORBA
and XML have been, or will be used to meet new industry standards and provide
customers with leading edge solutions.
Customers
The Company's customers for OSS Interconnection Solutions (gateways) are
primarily new Telecom Providers, such as CLECs and DLECs. The following is a
partial list of customers who purchased these products or services.
Allegiance Telecom North American Telephone Co.
ALLTEL Information Services Net2000 Communications
Birch Telecom, Inc. Net-tel Corporation
BTI Telecommunication Services Network Access Solutions
Gabriel Communications Network Plus
LightNetworks RCN Communications
Local Gateway Exchange Teligent
McLeodUSA TriVergent Communications
Media Log TXU Communications Services
M-Power Communications US Xchange
Customers for the Company's LNP Solutions include Alcatel, Ariel
Communications, Lucent Technologies, Nortel Networks and Tekelec. Customers for
DSET's application development tools and related services are primarily
telecommunications network equipment vendors and carriers such as Cisco,
Jetstream, Lucent Technologies and Nortel Networks.
The Company had one significant customer for the years ended
December 31, 1998 and 1997 and no significant customer amounting to over
10% of total revenue in the year ended
9
December 31, 1999. Sales to Samsung accounted for approximately 12% of total
revenues in the year ended December 31, 1997. Sales to DSC Communications (now
known as Alcatel) accounted for approximately 17% of total revenues in the year
ended December 31, 1998. The Company anticipates that its results of operations
in any given period will continue to depend to a significant extent upon sales
to a small number of customers. Other than customer agreements that provide for
minimum royalties for run-time licenses and maintenance, none of the Company's
customers has entered into an agreement requiring minimum purchases from the
Company. The Company's software development services agreements with its
customers generally can be terminated by either party with limited or no advance
notice, and without significant penalty. Many of the Company's customers may
also be competitors of the Company.
Sales and Marketing
The Company markets its OSS interconnection products and services through
its direct sales organization in North America. As of December 31, 1999, the
Company's direct field sales force consisted of 14 sales people supported by 8
consulting engineers based in its New Jersey, California and Texas offices. The
sales cycle for CLECs and LNP solutions is approximately three to four months.
The Company has implemented marketing initiatives to support the sales and
distribution of its products and services. The objective of these efforts is to
inform customers of the capabilities and benefits of the Company's products and
services. Marketing programs include on-site customer seminars, Internet
web-based seminars, participation in industry trade shows and forums, press
relations, distribution of marketing materials and dissemination of information
concerning products and services through the Company's website.
Strategic Relationships
The Company has established several strategic relationships in order to
leverage the effectiveness of its sales force and enhance the productivity of
its installation and support organizations. These relationships include
partnerships and alliances with system integrators and complimentary technology
vendors.
System integrators (SIs) have existing and ongoing relationships with
senior management at many of the Company's potential customers in the
telecommunications market. The relationship with these SIs provides the Company
with advance insight on potential customer needs and often enables the Company
to reach key decision makers at these prospective customers more quickly, thus
reducing sales cycles. Working with SIs allows the company to additionally
leverage its installation and support resources by subcontracting or assigning
services to them to shorten installation and implementation times for customers.
The company has established relationships with several leading SIs including ADC
Telecommunications, Andersen Consulting, BusinessEdge Solutions, Danet, and KPMG
Consulting.
The Company has several strategic alliances and partnerships with leading
application software providers that either sell solutions into the target market
that DSET serves or are
10
software solutions that are directly complementary to DSET's products and
services. These relationships also help to ensure that DSET maintains
compatibility with the partners software or solutions. DSET partners with
MetaSolv Software and CommTech in telecom order management systems, with Vitria
Technology, Mercator Software and Cygent in the e-commerce and Internet arena,
and with Clarify in customer care systems.
Research and Product Development
The Company believes that its future success depends on its ability to
develop and introduce applications that embrace new technologies and evolving
industry standards to meet the rapidly changing demands of customers and the
marketplace. The Company's research and product development objectives focus on
compatibility with new technologies and enhancement of products and services in
response to customer needs and industry and market trends. While the Company
expects that new applications will continue to be developed internally, the
Company may, based on timing and cost considerations, acquire or license
technologies, products or applications from third parties.
The Company is building several new products and allocates its research
and product development resources in response both to market research and
customer demands for additional features and products. The Company's product
development strategy involves rolling out initial versions of its products and
adding features over time. The Company regularly incorporates product feedback
received from customers into its product development process. The Company's
research and product development efforts are principally focused on (i) the
enhancement of existing products to support new features; (ii) the development
of new electronic-bonding gateways and related applications; and (iii) new
development platforms/frameworks that will support emerging technology
standards.
The Company employs highly qualified engineers and utilizes its in-house
development capabilities to efficiently manage design processes and to shorten
product introduction lead times. The Company seeks to maximize the use of
existing technology to minimize time to market of its products and applications.
Most of the Company's research and development personnel hold engineering and
other advanced technical degrees. The Company's worldwide research and
development team consisted of 142 engineers and engineering services personnel
as of December 31, 1999. The Company's research and development expenditures
were approximately $3.3 million, $6.2 million and $11.0 million in 1997, 1998
and 1999, respectively.
Competition
Competition in DSET's markets is intense and involves rapidly changing
technologies, evolving industry standards, frequent new product introductions
and rapid changes in customer requirements. To maintain and improve its
competitive position, DSET must continue to develop and introduce, on a timely
and cost-effective basis, new products, features and services that keep pace
with the evolving needs of its customers. The Company believes that the
principal
11
competitive factors in the market for OSS Interconnection solutions and LNP
applications include:
Breadth of and depth of solutions offered
Product quality and performance
Strength of core technology
Facilitate the flow-through of information between trading partners
Ability to install and implement solutions
Customer support and service
Relationship with business partners and alliances
Continued building of base of satisfied and referable customers
Product price
While there can be no assurance that the Company will be able to compete
effectively based upon such competitive factors, DSET believes that the unique
capabilities of the products it has built and the wide range of product
offerings it has for telecom providers differentiates its products and services
in the marketplace. Competition in the OSS interconnection market comes from
three sources: (1) other companies that focus on interconnection products such
as Quintessent, Mantiss and Nightfire; (2) OSS solution companies that offer
broader suites of products to CLECs for order management and provisioning of
services such as Architel, Eftia, Wisor and Telcordia; and (3) system
integrators or in-house development staffs of telecom providers that build
custom solutions for a potential customer. The Company may also face additional
competition from companies that provide solutions on an outsourced basis such as
through a service bureau, as Telcordia and Quintessent presently offer, or as
part of an application service provider (ASP). The Company has recently
announced its participation in an ASP partnership to expand its market presence.
Competitors in the area of LNP products and solutions include Evolving
Systems, Inc. and in-house development teams at equipment vendors or telecom
providers. While the company believes that it offers a robust and cost effective
solution to the market for these products, it may not be able to maintain its
competitive position in this evolving market.
Intellectual Property
The Company's success and its ability to compete effectively is dependent,
in part, upon its proprietary rights. The Company relies primarily on a
combination of copyright, trademark, patent and trade secret laws, as well as
confidentiality procedures and contractual restrictions, to establish and
protect its proprietary rights. Furthermore, the Company generally enters into
non-competition, non-disclosure and invention assignment agreements with its
employees and consultants, and into non-disclosure agreements with its customers
and distributors. There can be no assurance that such measures will be adequate
to protect the Company's proprietary rights.
Additionally, the Company may be subject to further risks as it enters
into transactions in countries where intellectual property laws are not well
developed or are difficult to enforce. Legal protections of the Company's
proprietary rights may be ineffective in such countries.
12
Litigation may be necessary to defend and enforce the Company's proprietary
rights, which could result in substantial costs and diversion of management
resources and could have a material adverse effect on the Company's business,
financial condition and results of operations, regardless of the final outcome
of such litigation. Despite the Company's efforts to safeguard and maintain its
proprietary rights both in the United States and abroad, there can be no
assurance that the Company will be successful in doing so or that the steps
taken by the Company in this regard will be adequate to deter misappropriation
or independent third-party development of the Company's technology, or to
prevent an unauthorized third-party from copying or otherwise obtaining and
using the Company's products or technology. Any of these events could have a
material adverse effect on the Company's business, financial condition and
results of operations.
The Company or its employees may become subject to claims of infringement
or misappropriation of the intellectual property rights of others. In its
licenses and software development and distribution agreements, the Company
agrees to indemnify its customers and distributors for any expenses and
liabilities resulting from claimed infringements of patents, trademarks,
copyrights or other proprietary rights of third parties. The Company attempts to
limit its liability to the value of the agreement, however, the amount of the
Company's indemnity obligations may be greater than the revenues the Company may
have received under such agreements. There can be no assurance that third
parties will not assert infringement or misappropriation claims against the
Company, its customers or distributors in the future with respect to its
employees or current or future products or services. Any claims or litigation,
with or without merit, could be time-consuming, result in costly litigation,
cause product shipment delays or require the Company to enter into royalty or
licensing arrangements. Such royalty or licensing arrangements, if required, may
not be available on terms acceptable to the Company, if at all, which could have
a material adverse effect on the Company's business, financial condition and
results of operations.
A portion of the Company's revenues is generated from run-time royalty
fees which generally become due upon the deployment by equipment vendors to
telecommunications carriers of network devices which have embedded applications
built with the Company's software. Such customers are contractually required to
periodically report their sales to the Company. The Company's sales contracts
typically provide for the Company's right to audit reported sales. There can be
no assurance, however, that such customers will accurately report such sales or
that the Company will be able to effectively monitor and enforce its contractual
rights with respect to such fees.
Employees
As of December 31, 1999, the Company had a total of 220 employees. Of the
total, 142 were in engineering, product development and customer satisfaction,
38 were in sales and sales support, 18 were in administration, finance and
operations, 10 were in customer service, and 12 were in marketing. The Company's
future performance depends in significant part upon the continued service of its
management, key product and application engineers, and sales and technical sales
support personnel. Competition for such personnel is intense and there can be no
assurance that the Company will be successful in attracting or retaining such
personnel in the
13
future. None of the Company's employees are represented by a labor union or are
subject to a collective bargaining agreement. The Company has not experienced
any work stoppages and considers its relations with its employees to be good.
S. Daniel Shia, DSET's Chairman and former Chief Technology Officer
elected to take an unpaid leave of absence for one year effective January 1,
2000. Mr. Shia continues to serve as Chairman of the Board of Directors.
In connection with the acquisition of certain assets of NPL on January 25,
1999, the Company hired approximately 22 systems engineers formerly employed by
NPL. In addition, the Company acquired Konark, Inc. on September 30, 1999 and,
as part of the acquisition, hired 4 system engineers.
Risk Factors
The risks and uncertainties described below are not the only ones facing
the Company. Additional risks and uncertainties not presently known to the
Company or that are currently deemed immaterial may also impair DSET's business
operations and financial results.
If any of the following risks actually occur, DSET's business, financial
condition or results of operations could be materially adversely affected. In
such case, the trading price of DSET's Common Stock could decline.
This Annual Report on Form 10-K also contains forward-looking statements
that involve risks and uncertainties. DSET's actual results could differ
materially from those anticipated in the forward-looking statements as a result
of certain factors, including the risks described below and elsewhere in this
Annual Report on Form 10-K.
Substantial Variability of Quarterly Operating Results
DSET's revenue, gross profit, operating income and net income may vary
substantially from quarter to quarter due to a number of factors. Many factors,
some of which are not within the control of the Company, may contribute to
fluctuations in operating results. These factors include the following:
Timing and levels of hardware and software purchases by customers;
Timing, size and stage of application development projects;
New product and service introductions by DSET or its competitors;
Seasonal impact on projects for customers;
DSET's hiring patterns;
Costs associated with fixed-price contracts;
Market factors affecting the availability or costs of qualified
technical personnel;
14
Timing and customer acceptance of DSET's new product and service
offerings;
Length of sales cycle;
Variations in run-time royalty fees due to the size and timing of
network device deployments by equipment vendors to
telecommunications carriers;
Costs related to acquisitions of technology or businesses; and
Industry and general economic conditions.
Historically, the Company's revenue growth generally has been higher in
the fourth quarter due to capital budgeting and spending patterns by its
customers. It is anticipated that the business will continue to be subject to
such seasonal variations. In addition, a significant portion of quarterly
revenue is recognized in the last month of each quarter. As a result, the
Company may not recognize any negative fluctuations in revenue until late in a
particular quarter.
Many costs at DSET, such as personnel and facilities costs, are relatively
fixed in nature. Expense levels are based in part on expectations of future
revenue. As a result, operating results have been and in the future will
continue to be impacted by changes in technical personnel cost and utilization
rates. Technical personnel utilization rates have been and are expected to
continue to be adversely affected during periods of rapid and concentrated
hiring. In addition, during such periods, the Company is likely to incur greater
technical training costs. Due to these and other factors, if the Company is
successful in expanding its service offerings and revenue, periods of
variability in utilization are likely to occur. In addition, revenues in any
given period are likely to come from a limited number of customer contracts. Any
delay in the closing of, or the loss of any number of, such contracts would
adversely affect results of operations. Therefore, past operating results and
period-to-period comparisons should not be relied upon as an indication of
future operating performance.
Dependence on Rapidly Evolving Telecommunications Industry
DSET's success depends on the continued growth of the market for advanced
telecommunications products and services. The global telecommunications market
is evolving rapidly and it is difficult to predict its potential size or future
growth rate. The Company cannot assure investors that the global deregulation
and privatization of the worldwide telecommunication market that has resulted in
increased competition and escalating demand for new technologies and services
will continue in a manner favorable to DSET or its business strategies.
Since DSET's customers are concentrated in the telecommunications
industry, DSET's future success is dependent upon increased utilization of OSS
interconnection and LNP applications by Telecom Providers, the financial health
and buying patterns of CLECs and the continued demand for application
development tools and custom application services. The Company cannot guarantee
that current or future products or services will achieve acceptance among
telecommunications carriers, network equipment vendors and other potential
customers
15
or that these customers will not adopt alternative architectures or technologies
that are incompatible with DSET's technologies.
In addition, the telecommunications industry has experienced significant
consolidation that may continue in the future. This may cause there to be fewer
potential customers for OSS interconnection and LNP solutions, increasing the
level of competition in the industry. Also, larger consolidated Telecom
Providers will have stronger purchasing power, which could put pressure on
prices and result in lower operating margins.
Rapid Technological Change
Over the last decade, the market for telecommunications products and
related services has been characterized by rapid technological developments,
evolving industry standards, changes in end-user requirements and frequent new
product and service introductions. Continued changes such as these may render
the Company's existing product and service offerings obsolete. As a result,
DSET's position in this market could be negatively impacted due to unforeseen
changes in product features and functions of competing products. The Company's
growth and future results of operations will depend in part on its ability to
respond to these changes by enhancing existing products and services and by
developing and introducing, on a timely and cost-effective basis, new products,
features and related services to meet or exceed technological advances
introduced by competitors. However, the Company cannot guarantee that it will be
successful in identifying, developing and marketing new products, product
enhancements and related services necessary to keep pace with technological
change, which could lead to declines in sales and operating margins.
Management of Growth
Recent growth has placed, and is expected to continue to place, a
significant strain on DSET's managerial, operational and technical resources.
The Company's ability to manage growth effectively will require continued
development and improvement of operational, financial and other internal
systems, as well as business development capabilities. In addition, the Company
must continue to attract, hire, train, retain, motivate and manage its
employees. The Company must be able to allocate sufficient engineering resources
to develop new products as well as maintain and improve the quality of its
current offerings. The failure to manage the growing employee base, improve
operating systems or add resources on a cost effective and timely basis could
have a material adverse effect on the Company's business.
Intense Competition
DSET competes in rapidly changing markets that are intensely competitive
and involve changing technologies, evolving industry standards, frequent new
product introductions and rapid changes in customer requirements. The Company
competes in the OSS interconnection market with other interconnection software
providers, order management system providers, system integrators, and in-house
development staffs of Telecom Providers. Competitors in the LNP market include
other LNP software developers, system integrators and in-house development
16
staffs at network equipment vendors. Competitors in the application development
tools market include other software tool providers. Many of our current and
potential competitors have longer operating histories, greater name recognition,
larger or captive customer bases and significantly greater financial, technical,
sales, customer support, marketing and other resources.
The Company believes the principal competitive factors affecting the
market for OSS Interconnection and LNP applications are:
Breadth of and depth of solutions offered;
Product quality and performance;
Strength of core technology and product features such as
adaptability, scalability, ability to integrate with other products,
functionality and ease of use;
Ability to facilitate the flow-through of information between
trading partners;
Ability to install and implement solutions;
Customer support and service;
Relationship with business partners and alliances;
Continued building of a base of satisfied and referable customers;
and
Product price.
The principal competitive factors in the market for the Company's other
products and services include many of the same factors as the market for OSS
Interconnection and LNP applications as well compliance with industry standards
and project management capability. DSET cannot guarantee that it will be able to
compete effectively based on these competitive factors. To remain competitive,
the Company must respond promptly and effectively to the challenges of
technological change, evolving standards and competitors' innovations by
continuing to enhance its offerings and expand its sales channels.
Limited Number of Customers for a Significant Portion of Revenue
DSET currently derives, and expects to derive, a significant portion of
its revenues through large financial commitments by a limited number of
customers. For the year ended December 31, 1999, the Company's ten largest
customers accounted for approximately 42% of total revenues. The amount of
revenue derived from a specific customer for OSS Interconnection and LNP
products varies from period to period, and a major customer in one period may
not produce significant additional revenue in a subsequent period. Other than
certain agreements that provide for on-going maintenance revenues or minimum
royalties for run-time licenses, none of the Company's customers have entered
into agreements requiring on-going minimum purchases. In addition, application
development services agreements generally can be terminated with limited advance
notice and without significant penalty. To the extent that the Company is not
able to capture new major customers or to maintain relations with existing major
customers, the Company's revenues may be subject to substantial period-to-period
fluctuations and could decline significantly.
17
Limited Protection of Proprietary Rights and Enforcement of Licensing Rights
DSET's success and ability to compete effectively is dependent, in part,
upon its proprietary rights. The Company relies primarily on a combination of
copyright, trademark, patent and trade secret laws, as well as confidentiality
procedures and contractual restrictions, to establish and protect its
proprietary rights. Furthermore, the Company generally enters into
non-competition, non-disclosure and invention assignment agreements with its
employees and consultants, and into non-disclosure agreements with its customers
and distributors. The Company cannot assure investors that these measures will
be adequate to protect the Company's our proprietary rights.
The Company may also be subject to further risks as it enters into
transactions in countries where intellectual property laws are not well
developed or are difficult to enforce. Legal protections of proprietary rights
may be ineffective in other countries. Litigation may be necessary to defend and
enforce those proprietary rights, which could result in substantial costs and
diversion of management resources and could have a material adverse effect on
the Company's business, financial condition and results of operations,
regardless of the final outcome of such litigation. Despite efforts to safeguard
and maintain proprietary rights both in the United States and abroad, there is
no guarantee that the Company will be successful in doing so. Furthermore, it
cannot assure investors that the steps taken by the Company will be adequate to
deter misappropriation or independent third-party development of DSET's
technology or to prevent an unauthorized third party from copying or otherwise
obtaining and using its products or technology. Any of these events could have a
material adverse effect on the Company's business, financial condition and
results of operations.
DSET, or its employees, may become subject to claims of infringement or
misappropriation of the intellectual property rights of others. In addition, in
the Company's licenses and software development and distribution agreements,
DSET agrees to indemnify customers and distributors for any expenses and
liabilities resulting from claimed infringements of patents, trademarks,
copyrights or other proprietary rights of third parties. The amount of indemnity
obligations may be greater than the revenue that may have been received under
these development and distribution agreements. The Company cannot assure
investors that third parties will not assert infringement or misappropriation
claims against the Company, its customers or distributors in the future with
respect to its employees or current or future products or services. Any claims
or litigation, with or without merit, could be time-consuming, result in costly
litigation, cause product shipment delays or require the Company to enter into
royalty or licensing arrangements. Royalty or licensing arrangements, if
necessary, may not be available on terms acceptable to the Company, if at all,
which could have a material adverse effect on DSET's business, financial
condition and results of operations.
A portion of the Company's revenues are generated from run-time royalty
fees which generally become due upon the deployment by equipment vendors to
telecommunications carriers of network devices which have embedded applications
built with DSET's software. Many customers are contractually required to
periodically report the sales of these network devices to the Company. Although
the Company generally has the right to periodic audits in its
18
contracts which provide for run-time royalties, the Company cannot assure
investors that DSET's customers will accurately report their sales or that the
Company will be able to effectively monitor and enforce its contractual rights
with respect to run-time royalty fees.
Competitive Market for Technical Personnel
DSET's future success depends to a significant extent on its ability to
attract, hire, train, retain and motivate qualified technical and sales
personnel, with appropriate levels of managerial and technical capabilities. The
Company's complex technology generally requires a significant level of expertise
to effectively develop and market its products and services and to perform
custom application development and installation services. DSET believes that
there is a worldwide shortage of, and significant competition for, professionals
with the advanced skills required. The Company at times has experienced, and
continues to experience, difficulty in recruiting qualified personnel.
Recruiting qualified personnel is an intensely competitive and time-consuming
process. The Company competes for personnel with software companies, system
integrators and telecommunications companies, many of which have greater
resources. This makes it difficult for the Company to hire the quality and
number of technical and sales personnel required to meet current and expected
future demand. In addition, it makes it more expensive to hire those personnel
in general. Due to this competition, the Company has experienced, and expects to
continue to experience, turnover in technical and sales personnel. There is no
guarantee that the Company will be successful in attracting and retaining the
technical or sales personnel required to conduct and successfully expand
operations. The business, financial condition and results of operations of DSET
could be materially adversely affected if the Company is unable to attract,
hire, train, retain and motivate qualified technical and sales personnel.
Risks Associated with Market Acceptance of New OSS Interconnection and LNP
Product Offerings
A substantial part of the Company's recent revenues, and expected future
revenues, are derived from new OSS interconnection solutions introduced by the
Company over the last eighteen months. This limited period of sales and
deployment of these products makes prospects of wide market acceptance difficult
to predict. To date, only a small number of potential customers have licensed
the products and many of those have not commenced commercial deployment. The
deployment of these products requires the integration with a variety of software
applications and systems and the testing and integration with the customers'
trading partners. If the product fails to meet these complex and demanding
technological objectives, the Company's current customers may become
dissatisfied. Failure to establish a significant base of references could
significantly reduce the Company's ability to license products to additional
customers.
From time to time, the Company has experienced delays in the development
of new products and the enhancement of existing products, and may in the future
experience delays in the development of new applications, due to resource
constraints or technological or other reasons. The inability to develop and
introduce new applications in a timely manner could have
19
a material adverse effect on the business, financial condition and results of
operations of the Company.
Risks of Product Defects
Applications developed, licensed and sold by DSET may contain errors or
failures. The Company cannot guarantee that errors or failures will not be found
in its products or applications or, if discovered, that DSET will be able to
successfully correct any errors or failures in a timely manner or at all. The
occurrence of errors or failures in the Company's products and applications
could result in loss of or delay in market acceptance, increased service and
warranty costs or payment of compensatory or other damages. In addition, errors
or failures may result in delays in recognition of revenue and diversion of
engineering resources during the period in which the Company is required to
correct any defects. DSET does not maintain errors and omissions insurance to
cover liability associated with its software development and license agreements.
Although agreements with customers typically contain provisions intended to
limit exposure to potential claims as well as any liabilities arising from such
claims, the Company's contracts with customers may not effectively protect DSET
against the liabilities and expenses associated with software errors or
failures. Accordingly, errors or failures in the Company's products or
applications could have a material adverse effect upon its business, financial
condition and results of operations.
Dependence on Key Personnel
DSET's success to date, and its future success depends largely on the
continued service of senior management, key product and application engineers,
and sales and technical sales support personnel as well as its ability to
identify, hire and retain additional senior personnel. The Company faces intense
competition for qualified personnel, and cannot be certain that it will
successfully attract and retain additional qualified key personnel in the
future. The loss of the services of one or more of these key individuals or the
failure to attract and retain additional qualified personnel could substantially
damage the Company's business. In addition, if the Company were to lose any key
personnel, there cannot be any assurance that DSET would be able to prevent the
unauthorized disclosure or use of the Company's proprietary technical knowledge,
practices or procedures.
Length and Variability of Sales Cycle
DSET's products are often used by its customers to deploy mission-critical
solutions for their businesses. Additionally, the cost of the Company's products
and suites of products can be significant to its customers overall financial
position. As such, customers generally consider a wide range of issues before
committing to purchase the product, including product benefits, ability to
operate with existing or planned computer systems, scalability, reliability and
competitive price. Many customers, particularly for OSS interconnection and LNP
products, are still in the early stages of developing their business and need to
be educated on the use and benefits of the Company's products and services.
Additionally, the purchase of the Company's products generally involves a
significant commitment of capital and other resources by the
20
customer. This can mean additional technical reviews, assessment of competitive
products and approval at several levels within the customer's management and
executive structure.
The period of time between initial customer contact and execution of a
license agreement or contract for services with telecom providers typically
ranges from four to nine months. Telecommunications carriers and network
equipment vendors typically conduct extensive and lengthy product evaluations
before purchasing software or application development services. The sales cycle
for application development tools and custom application services can range from
two to nine months. The variability of these sales cycles could have a material
adverse effect on DSET's business, financial condition and results of
operations. Customers may also encounter delays in the sales cycles of their
products and services which depend on the implementation of applications built
using the Company's software, which may also indirectly and adversely impact
DSET's business, financial condition and results of operations.
Risks Associated with International Operations
Although recent international revenues have been minimal, the Company
intends to expand its existing international operations and sales efforts to
maintain its growth in regions outside the United States as more countries adopt
open, competitive telecommunications markets and new competitive Telecom
Providers emerge to take advantage of this change. International expansion may
be more difficult or take longer than the Company presently anticipates due to
language barriers, currency exchange risks and the fact that the
telecommunications infrastructure in foreign countries may be less advanced than
it is in the U.S. This expansion will demand significant management attention
and financial resources and will require the addition of experienced management,
sales, technical and support personnel. Furthermore, international transactions
are subject to a variety of additional risks, including longer payment cycles,
accounts receivable collection problems, unexpected regulatory requirements,
trade barriers, tariffs and duties, fluctuation of currency exchange rates,
inadequate protection of intellectual property rights and potentially adverse
tax consequences. If the Company is unable to expand its international
operations and revenues successfully, it could have a material adverse effect on
DSET's business, financial condition and results of operations
The Company's international sales currently are United States
dollar-denominated. As a result, an increase in the value of the United States
dollar relative to foreign currencies could make DSET's products and services
less competitive in international markets. Volatility and devaluation trends in
certain Asian markets have resulted in delays, cancellations and increased
pricing pressures on DSET's product sales and application development activities
in such markets. Such risks may adversely affect the Company's business,
financial condition and results of operations.
Dependence on the TMN Industry Standard
Until 1999, substantially all of the Company's revenue had come from
application development tools and application development services based on the
TMN standard. A portion of ongoing revenue will still come from these
applications. Telecom Providers have only
21
recently widely embraced TMN solutions as an industry standard. In order to
remain an industry standard, TMN must continue to be adapted to accommodate
emerging technologies, such as CORBA and Java. The Company believes that the
continued use of TMN solutions will also depend, in part, upon the continued
demand from Telecom Providers and equipment vendors to quickly and
cost-effectively implement TMN solutions. It is uncertain whether TMN will
remain a standard for the management of complex telecommunications networks. The
introduction of new or more favorable industry standards may affect the
Company's business, financial condition and results of operations.
Risks Associated with Year 2000 Problem
Although the Company has passed the rollover from December 31, 1999 to
January 1, 2000 without disruption or customer claims, it still faces risks to
the extent that suppliers of products, services, and systems purchased by the
Company or the suppliers of others whom it transacts business cannot timely
provide products, components, services, or systems that meet Year 2000
requirements. The Company believes that it is not possible to determine with
complete certainty that all Year 2000 problems affecting the Company have been
identified or corrected.
Additionally, the Company cannot guarantee that its products will not be
used by other companies, or its customers, to build applications which might not
be Year 2000 compliant, or that the Company's products or applications built
with the Company's products will not be integrated by the Company or its
customers or interact with non-compliant software or other products which may
expose the Company to claims from its customers for Year 2000 related
liabilities.
In November 1998, we determined that certain custom applications developed
and delivered to approximately ten customers were not Year 2000 compliant. All
of these customers were notified of such Year 2000 compliance status in November
1998. We have also analyzed the extent to which any of the affected custom
applications were integrated by customers into other products which may expose
us to claims from our customers. We have agreed to assist each of these
customers with any and all remediation solutions required to achieve Year 2000
compliance with our products. To date, we have not been notified of any Year
2000 problems that have occurred in these custom applications. However, a
failure to properly implement any correction, or problems with any correction,
could cause errors in customers' products which may materially impact the
functionality of those products.
Other than time spent by the Company's personnel, the costs associated
with remediating non-compliant custom applications and assessing Year 2000
compliance issues have not been significant to date. The Company believes that
the continued analysis of compliance of new releases of products and evaluation
of potential Year 2000 problems will result in aggregate expenditures of less
than $100,000 in 2000.
22
Government Regulation and Legal Uncertainties
While DSET's operations are not directly regulated, existing and potential
customers are subject to a variety of U.S. and foreign governmental regulations.
These regulations and future changes to them may negatively impact the
telecommunications industry, limit the number of potential customers for the
Company's products and services or otherwise have a material adverse effect on
DSET's business, financial condition and results of operations. Recently enacted
legislation, including the Telecom Act, deregulating the telecommunications
industry has caused and may continue to cause changes in the telecommunications
industry, including the entrance of new competitors and possible industry
consolidation. These events could reduce the Company's potential customer base,
increase pricing pressures, decrease demand for the Company's products, increase
the cost of doing business or otherwise have a material adverse effect on DSET's
business, financial condition and results of operations. Currently the Federal
Communications Commission ("FCC") and state authorities are implementing the
provisions of the Telecom Act and several of the decisions by the FCC and state
authorities are being challenged in court. The Company cannot predict the extent
to which such legislation and related litigation will affect its current and
potential customers or ultimately affect its business, results of operations and
financial condition.
Risks Relating to Potential Acquisitions
As part of DSET's growth strategy, the Company intends to continue to
pursue acquisitions of businesses or technologies to broaden its product and
service offerings, add technical or sales personnel, increase its presence in
existing markets, expand into new geographic markets, establish strategic
relationships and obtain desirable customer relationships. If the Company buys
another company or selected assets or technologies, it could have difficulty
assimilating acquired personnel, operations, customers or vendors. In addition,
one or more of such personnel, customers or vendors may decide not to work for
or continue to do business with the Company. These difficulties could disrupt
the ongoing business of DSET, distract management and employees and increase
expenses. Although the Company conducts due diligence reviews with respect to
all acquisition candidates, all material liabilities or risks related to
potential acquisitions may not be successfully identified. Furthermore, the
Company may have to incur debt or issue equity securities to pay for any future
acquisitions, the issuance of which could be dilutive to existing shareholders.
Possibility of Volatility of Stock Prices
The market prices for securities of technology companies have been highly
volatile and the market has experienced significant price and volume
fluctuations that are unrelated to the operating performance of particular
companies. Announcements of technological innovations or new products or service
offerings by the Company or its competitors, developments concerning proprietary
rights, including patents and litigation matters, domestic or international
regulatory developments affecting the telecommunications industry, general
market conditions, any shortfall in revenues or earnings from expected levels or
other failures by the Company to meet
23
expectations of securities analysts and other factors, may have a significant
impact on the market price of the Company's Common Stock.
Anti-Takeover Effect of Certain Charter and By-Law and Other Provisions and New
Jersey Law
Anti-takeover provisions of New Jersey law, DSET's Certificate of
Incorporation and By-Laws could make it more difficult for a third party to
acquire control of the Company, even if such change would be beneficial to
shareholders. DSET's Certificate of Incorporation provides that the board of
directors may issue preferred stock with superior rights and preferences without
common shareholder approval. The issuance of preferred stock could have the
effect of delaying, deterring or preventing a change in control.
Item 2. Properties.
The Company's principal sales, marketing, research and product
development, and administrative offices are currently located in Bridgewater,
New Jersey where the Company occupies approximately 46,679 square feet. The
annual base rent for this facility is approximately $770,000 per year for the
first three years. Thereafter, certain rent escalation clauses become effective.
This lease commenced in May 1999 and will expire in August 2009.
The Company also leases 20,446 square feet of office space for additional
research and development, professional services and sales offices in Plano,
Texas. The annual base rent for the first year in this facility is approximately
$218,000 and increases to $418,000 per year, subject to normal escalation
clauses, for the remaining six years. This lease commenced in July 1999 and will
expire in July 2005.
As of December 31, 1999 the Company also leased facilities for research
and development and sales in Campbell, California, Freemont, California and San
Ramon, California occupying 2,797, 3,275, and 910 square feet, respectively. In
February 2000, the Company consolidated its West Coast operations in a new
leased facility of 5,500 square feet in San Ramon, California. The Campbell and
original San Ramon leases will be terminated as of March 2000. The Fremont
office has been sub-let until the end of its lease period in December 2002.
The Company's subsidiary, Chengdu DSET Science and Technology Co., Ltd.,
leases approximately 2,100 square feet of office space in Chengdu, China. See
note 11 of Notes to the Financial Statements for information regarding the
Company's obligations under such leases. The Company believes that suitable
additional or alternative space will be available as needed on commercially
reasonable terms.
Item 3. Legal Proceedings.
The Company is not a party to any material legal proceedings.
24
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
25
PART II
Item 5. Market for the Company's Common Equity and Related Stockholder Matters.
Prior to March 1998, there was no established market for shares of the
Company's Common Stock. Since March 13, 1998, the Common Stock has traded on the
Nasdaq National Market ("NNM") under the symbol "DSET." The initial public
offering price per share in the Company's initial public offering was $16.00 per
share.
The following table sets forth the high and low bid information for
the Common Stock for each of the quarters in the period beginning March 13, 1998
as reported on the NNM. Such quotations reflect inter-dealer prices, without
retail mark-up, mark-down or commission and may not represent actual
transactions.
Quarter Ended High Low
- --------------------------------------------------------------------------------
March 31, 1998.................... $20.313 $17.000
June 30, 1998..................... $21.563 $13.375
September 30, 1998................ $19.625 $ 7.125
December 31, 1998................. $15.500 $ 6.125
March 31, 1999.................... $18.750 $ 9.500
June 30, 1999..................... $14.813 $ 9.875
September 30, 1999................ $15.000 $ 8.750
December 31, 1999................. $40.313 $12.875
As of March 1, 2000, the approximate number of holders of record of the
Common Stock was 135 and the approximate number of beneficial holders of the
Common Stock was 2200.
The Company has never declared or paid any cash dividends on its capital
stock. The Company intends to retain any earnings to fund future growth and the
operation of its business and, therefore, does not anticipate paying any cash
dividends in the foreseeable future.
Changes in Securities
The following information relates to all securities of the Company sold by
the Company within the past quarter which were not registered under the
securities laws at the time of grant, issuance and/or sale:
26
Option Grants
1. During the fourth quarter of 1999, the Company granted stock options
pursuant to its 1998 Stock Plan which were not registered under the
Securities Act of 1933, as amended (the "Securities Act"). All of
such option grants were granted at the then current fair market
value of the Common Stock. The following table sets forth certain
information regarding such grants during the quarter:
Weighted
Average
Number Exercise
of shares Price
--------- -----
333,752 $17.35
Common Stock Issuances
2. During the fourth quarter of 1999, the Company issued shares of
Common Stock pursuant to exercises of stock options granted under
its 1993 Stock Option Plan and 1998 Stock Plan which were not
registered under the Securities Act. The following table sets forth
certain information regarding such issuances during the quarter:
Weighted
Average
Number Exercise
of shares Price
--------- -----
144,786 $4.22
The Company did not employ an underwriter in connection with the issuance
of the securities described above. The Company believes that the issuance of the
foregoing securities was exempt from registration under either (i) Section 4(2)
of the Securities Act as transactions not involving any public offering and such
securities having been acquired for investment and not with a view to
distribution, or (ii) Rule 701 under the Securities Act as transactions made
pursuant to a written compensatory benefit plan or pursuant to a written
contract relating to compensation. All recipients had adequate access to
information about the Company.
Use of Proceeds from Initial Public Offering
On March 12, 1998, the Securites and Exchange Commission declared
effective the Company's Registration Statement (Registration Statement No.
333-43827) as filed with the Commission in connection with the Company's
initial public offering of Common Stock, which was managed by BT Alex. Brown
Incorporated, BancAmerica Robertson Stephens and SoundView Financial Group,
Inc.
27
Pursuant to such Registration Statement, the Company registered and sold an
aggregate of 2,500,000 shares of its Common Stock, for a gross aggregate
offering price of $40.0 million. The Company incurred underwriting discounts and
commissions of approximately $2.8 million. In connection with such offering, the
Company incurred total expenses of approximately $1.1 million.
On January 25, 1999, DSET Acquisition Corp., a wholly-owned subsidiary of
the Company, consummated the acquisition of certain assets of Network Programs
LLC, a Delaware limited liability company ("NPL"). The purchase price consisted
of $2,500,000 payable in cash to NPL plus professional fees. NPL provided
specialized software to CLECs.
On September 30, 1999, the Company completed the purchase of Konark Inc.
and related technologies for approximately $3.3 million in cash at closing and
certain deferred payments, plus professional fees and the related deferred
taxes.
As of December 31, 1999, all of the remaining net proceeds received by the
Company in its initial public offering, pending specific application, were
invested in short-term securities of grade A2 or better with maturities of two
years or less.
Item 6. Selected Financial Data.
The selected financial data set forth below with respect to the Company's
statement of income and comprehensive income data for each of the years in the
three-year period ended December 31, 1999, and with respect to the balance
sheet data at December 31, 1999 and 1998 are derived from and are qualified by
reference to the consolidated financial statements and the related notes
thereto of the Company found at "Item 14. Exhibits, Financial Statement
Schedules, and Reports on Form 8-K." The statement of income and comprehensive
income data for the years ended December 31, 1995 and December 31, 1996 and the
balance sheet data as of December 31, 1995, 1996 and 1997 are derived from
consolidated financial statements not included in this Annual Report on Form
10-K. The selected financial data set forth below should be read in
conjunction with and is qualified in its entirety by, the Company's
consolidated financial statements and related notes thereto found at
"Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K"
and "Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations" which are included elsewhere in this Annual Report on
Form 10-K.
28
Years ended December 31,
----------------------------------------------------------
1995 1996 1997 1998 1999
------- ------- ------- ------- -------
(in thousands, except per share data)
Statement of Income and Comprehensive Income Data:
Revenues:
License revenues ......................................... $ 5,734 $ 7,005 $10,850 $16,338 $24,084
Service revenues ......................................... 2,179 6,111 8,515 12,952 20,545
------- ------- ------- ------- -------
Total revenues ......................................... 7,913 13,116 19,365 29,290 44,629
------- ------- ------- ------- -------
Cost of revenues:
License revenues ......................................... 74 133 1,274 1,775 1,823
Service revenues ......................................... 436 2,149 3,405 3,692 7,063
------- ------- ------- ------- -------
Total cost of revenues ................................. 510 2,282 4,679 5,467 8,886
------- ------- ------- ------- -------
Gross profit ............................................... 7,403 10,834 14,686 23,823 35,743
------- ------- ------- ------- -------
Operating expenses:
Sales and marketing ...................................... 2,588 4,255 4,986 9,193 12,537
Research and product development ......................... 865 1,328 3,299 6,237 11,046
General and administrative ............................... 1,297 2,381 2,881 2,708 4,221
------- ------- ------- ------- -------
Total operating expenses ............................... 4,750 7,964 11,166 18,138 27,804
------- ------- ------- ------- -------
Operating income ........................................... 2,653 2,870 3,520 5,685 7,939
------- ------- ------- ------- -------
Net income ................................................... $ 1,705 $ 2,013 $ 2,469 $ 4,794 $ 6,517
======= ======= ======= ======= =======
Net income per common share .................................. $ 0.28 $ 0.37 $ 0.45 $ 0.53 $ 0.63
Weighted average number of common shares outstanding ......... 6,003 3,309 3,567 9,012 10,425
Net income per common share assuming dilution ................ $ 0.26 $ 0.27 $ 0.30 $ 0.43 $ 0.59
Weighted average number of common shares and common equivalent
shares outstanding ......................................... 6,490 7,393 8,346 11,043 11,067
December 31,
----------------------------------------------------------
1995 1996 1997 1998 1999
------- ------- ------- ------- -------
(in thousands)
Balance Sheet Data:
Cash, cash equivalents and marketable securities............ $ 7,004 $ 1,778 $ 3,206 $45,023 $40,696
Working capital ............................................ 2,541 4,284 6,276 49,037 53,626
Total assets ............................................... 10,424 7,445 13,315 56,854 73,495
Long-term debt, including capital leases.................... -- -- 332 112 3,003
Series A preferred stock ................................... 9,943 10,744 11,604 -- --
Retained earnings .......................................... 2,117 3,328 4,937 9,731 16,248
Total shareholders' equity (deficit) ....................... (6,669) (5,410) (3,401) 51,189 61,523
29
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Forward-Looking Statements
Statements contained or incorporated by reference in this Annual Report
on Form 10-K that are not based on historical fact are "forward-looking
statements" within the meaning of Section 21E of the Securities Exchange Act of
1934, as amended (the "Exchange Act"), including statements related to markets
for the Company's products and trends in its business that involve risks and
uncertainties. Forward-looking statements may be identified by the use of
forward-looking terminology such as "may," "will," "should," "expect,"
"estimate," "anticipate," "continue," or similar terms, variations of such terms
or the negative of those terms. Factors that might cause such a difference
include, but are not limited to, those discussed in "Risk Factors" as well as
discussed elsewhere in this Form 10-K. As a result of such factors and others
expressed from time to time in the Company's filings with the Securities and
Exchange Commission, the Company's actual results may differ materially from the
results discussed in or implied by the forward-looking statements contained
hererin.
Overview
General
DSET is a leading provider of business-to-business e-commerce software
solutions created specifically for the global telecommunications marketplace.
The DSET suite of electronic-bonding gateways interconnects OSSs of competing
telecommunications providers that must trade information and share network
capabilities to serve customers. In addition, DSET's LNP solutions play a
key role in enabling customers to change Telecom Providers without changing
their local phone numbers. The Telecom Act encourages competition among
providers of local phone services by requiring ILECs to allow new CLECs to
lease portions of the incumbents' networks and access their OSSs. Hundreds of
CLECs are vying to win customers from the incumbents by offering better
pricing and service. With DSET solutions, CLECs can complete key tasks that
assist "provisioning" or "service-fulfillment" of phone service for new
customers in days rather than weeks. In addition, DSET solutions help CLECs
maintain a higher level quality of service for their customers.
Historically, the Company has focused on the creation of applications that
could be distributed among many processors in order to solve highly complex
problems in the network management arena. These applications are predominately
sold to network equipment vendors, both domestically and internationally. Until
1999, substantially all the Company's revenues had been derived from application
development tools and applications or services based on TMN standards. However,
the Company is actively moving away from selling these application development
tools.
30
The Company's continued success will depend on continued growth in the
market for advanced telecommunications products, OSS interconnection products
and services and LNP solutions.
The Company's revenues are generated from two sources: license and service
revenues from CLECs and license and service revenues from network equipment
vendors.
For the years ended December 31, 1999 and 1998, the Company derived
approximately 54.0% and 55.8%, respectively, of its total revenues from license
revenues and approximately 46.0% and 44.2%, respectively, of its total revenues
from service revenues. During 1999, revenues generated from CLECs were
approximately $19.7 million. Revenues generated from network equipment vendors
for LNP solutions, application development tools and related services were
approximately $24.9 million in 1999. Revenues generated from CLECs were
$3.1 million in 1998, and revenues generated from network equipment vendors
was $26.2 million.
DSET's license revenues from CLECs are derived from the sale of
electronic-bonding gateways to carriers under contracts that provide for license
fees. Prices for licenses of the CLECs products and other applications range
from $75,000 to $500,000, depending on the number of licensed components.
License revenues from CLEC products are recognized at the time product is
shipped to the customer only to the extent that it can be billed. Any contract
holdbacks or contingent charges are recognized as revenue when they become
billable.
License revenues derived from the sale of its LNP solutions and
application development tools to customers under contracts generally provide for
license fees and run-time royalty fees. Prices for development licenses of the
Company's LNP solutions tool suites can range from approximately $150,000 to
$400,000 and prices for tool suites typically range from approximately $150,000
to $250,000 depending on the number of licensed components and development
users. The Company's license agreements for development tools also typically
provide for run-time royalty fees that are earned at the time of deployment by
equipment vendors to telecommunications carriers of network devices which have
embedded applications built with the Company's software. A run-time license
permits an equipment vendor to incorporate applications developed with the
Company's software tools in such vendor's telecommunications network devices.
License revenues from development licenses are recognized at the time the
product is shipped to the customer. Run-time royalty fees are recognized as the
Company is notified of such deployment. Notification is typically received from
customers pursuant to quarterly reports or via purchase orders for individual
licenses.
The Company's service revenues are comprised of fees derived from custom
application development products and services, maintenance fees, installation
and training fees and other revenues generated from customer support services.
The Company's application development services are generally individually
negotiated and contracted for on a fixed price basis. Prices for such projects
vary depending upon the size and scope of the project and estimated time and
effort to completion. Revenues from application development services are
generally recognized on a percentage of completion basis calculated as direct
labor costs are incurred in relation to estimated total costs at completion for
each project. The impact of revisions in percentage of completion
estimates is reflected in the period in which the revisions are made.
31
Maintenance services, for which the Company typically charges between 15% and
30% annually of the list price of the products licensed by the customer, may be
purchased at the customer's option. Maintenance fees are recognized as service
revenue over the term of the maintenance period, which is typically a 12-month
term.
The Company had no customer accounting for more than 10% of revenues for
the year ending December 31, 1999. Sales to DSC Communications (now known as
Alcatel) accounted for approximately 17% of total revenues in the year ended
December 31, 1998. Sales to Samsung accounted for approximately 12% of total
revenues in the year ended December 31, 1997. The Company anticipates that its
results of operations in any given period will continue to depend to a
significant extent upon sales to a small number of customers. As a result of
this customer concentration, the Company's revenues from quarter to quarter and
business, financial condition and results of operations may be subject to
substantial period-to-period fluctuations.
The Company's costs of license revenues consist primarily of royalties
paid to third party software companies. The Company generally is not
contractually obligated to make minimum royalty payments. Costs of service
revenues include primarily payroll, related benefit costs, personnel and other
operating expenses. Sales and marketing expenses consist of salaries,
commissions and bonuses paid to sales and marketing personnel, as well as travel
and promotional expenses. Research and product development expenses encompass
primarily software engineering personnel costs, costs of third-party equipment,
costs associated with customer satisfaction and quality and software utilized
for development purposes. Research and product development expenses are
generally charged to operations as such costs are incurred. The Company's
research and development projects are evaluated for technological feasibility in
order to determine whether they meet capitalization requirements. General and
administrative expenses are comprised of personnel costs and occupancy costs for
administrative, executive and finance personnel.
During the year ended December 31, 1997, deferred stock compensation of
$876,000 was recorded for options granted during the year. This amount has
been amortized to compensation expense over the vesting period of the options
(two to four years). At December 31, 1999, the remaining unamortized deferred
stock compensation balance was $197,000.
The Company primarily markets and sells its products and services through
a direct sales force in North America.
The Company derives a portion of its revenues from international sales
which constituted approximately 7%, 15% and 27% of the Company's total revenues
in 1999, 1998 and 1997, respectively. International sales are derived from
Europe (primarily Italy and Germany) and Asia (primarily Korea and China). The
Company's international sales currently are United States dollar-denominated. As
a result, an increase in the value of the United States dollar relative to
foreign currencies could make the Company's products and services less
competitive in international markets.
32
On January 25, 1999, DSET Acquisition Corp., a wholly-owned subsidiary of
the Company, consummated the acquisition of certain assets of Network Programs
LLC, a Delaware limited liability company ("NPL"). The purchase price consisted
of $2.5 million payable in cash to NPL plus professional fees. NPL provided
specialized software to CLECs.
On September 30, 1999, the Company completed the purchase of the capital
stock of Konark Inc. and related technologies for approximately $3.3 million
in cash at closing and certain deferred payments, plus professional fees and
related deferred taxes. Konark provided two post ordering electronic-bonding
gateway products.
Results of Operations
Years Ended December 31, 1999 and December 31, 1998
Revenues. Total revenues increased 52.4% to $44.6 million in 1999 from
$29.3 million in 1998. License revenues increased by 47.4% to $24.1 million in
1999 from $16.3 million in 1998. This increase was primarily attributable to an
increase in the sale of carrier-to-carrier products. Service revenues increased
58.6% to $20.5 million in 1999 from $13.0 million in 1998. This increase was
attributable primarily to custom application development projects for OSS
interconnection and LNP solutions, fees from consulting services and training
courses. Revenues recorded using the percentage of completion method of contract
accounting amounted to $14.3 million or 32.1% of total revenue, in 1999 versus
$7.9 million, or 27.1% of total revenue, in 1998.
Gross profit. The Company's gross profit increased 50.0% to $35.7 million
in 1999 from $23.8 million in 1998. Gross profit percentage decreased to 80.1%
of total revenues in 1999 from 81.3% in 1998. Gross profit percentage for
license revenues increased to 92.4% in 1999 from 89.1% in 1998 due to a
reduction of third party software and sales of more internally developed
products. Gross profit percentage for service revenues decreased to 65.6% in
1999 from 71.5% in 1998. This decrease was primarily attributable to increased
use of consultants to complete custom development projects and the amortization
of the acquisition of certain products.
Sales and marketing expenses. Sales and marketing expenses increased 36.4%
to $12.5 million in 1999 from $9.2 million in 1998, but decreased to 28.1% from
31.4% of total revenues. The increase in sales and marketing expenses in
absolute dollars was primarily attributable to increased personnel and related
costs resulting from the increase in the Company's sales force, provision for
bad debt expense and commissions related to higher sales.
Research and product development expenses. Research and product
development expenses increased 77.1% to $11.0 million in 1999 from $6.2 million
in 1998, and increased from 21.3% to 24.8% of total revenues. The increase in
research and product development expenses both in absolute dollars and as a
percentage of total revenues was due primarily to an increase in staffing,
including increases due to the NPL and Konark acquisitions, and an expansion in
the number of new products under development.
33
General and administrative expenses. General and administrative expenses
increased 55.9% to $4.2 million in 1999 from $2.7 million in 1998, and increased
from 9.2% to 9.5% of total revenues. The increase in general and administrative
expenses in absolute dollars and as a percentage of total revenues was due
primarily to relocation costs, recruiting and additional staffing.
Amortization of goodwill. Amortization expense increased to approximately
$199,000 as compared to $38,000 in 1998. This increase was due primarily to
amortization of goodwill from the Konark and NPL acquisitions.
Interest expense and other income and expenses, net. Net interest expense
and other income and expense increased to approximately $179,000 for 1999 from
approximately $120,000 for 1998, reflecting higher interest cost incurred with
the capital lease agreement and other miscellaneous cost increases.
Interest income. Interest income increased to $2.2 million in 1999 as
compared to $1.8 million for 1998. This increase was due primarily to interest
earned on higher cash and short-term investment balances available as a result
of the Company's initial public offering of its Common Stock in March 1998.
Income taxes. The Company's effective tax rate was 33.3% and 34.8% for
1999 and 1998, respectively. In 1999, the effective tax rate was lower than the
statutory tax rates due to the utilization of research and development tax
credits. The decrease from 1998 to 1999 was due to increased research and
development tax credits.
Years Ended December 31, 1998 and December 31, 1997
Revenues. Total revenues increased 51.3% to $29.3 million in 1998 from
$19.4 million in 1997. License revenues increased by 50.6% to $16.3 million in
1998 from $10.9 million in 1997. This increase was primarily attributable to an
increase in market acceptance of the Company's TMN-based agent tools,
recognition of run-time royalties, and licenses associated with OSS gateway
products. Service revenues increased 52.1% to $13.0 million in 1998 from $8.5
million in 1997. This increase was attributable primarily to custom application
development projects, fees from consulting services and training courses and new
customers purchasing the Company's GR-303 solutions, which include custom
application development work. Revenues recorded using the percentage of
completion method of contract accounting amounted to $7.9 million, or 27.1% of
total revenue, in December 1998 versus $5.8 million, or 30.0% of total revenues
in 1997.
Gross profit. The Company's gross profit increased 62.2% to $23.8 million
in 1998 from $14.7 million in 1997. Gross profit percentage increased to 81.3%
of total revenues in 1998 from 75.8% in 1997. Gross profit percentage for
license revenues increased to 89.1% in 1998 from 88.3% in 1997 due to less third
party software as a component of sales. Gross profit percentage for service
revenues increased to 71.5% in 1998 from 60.0% in 1997. This increase was
attributable to higher margins associated with consulting services, training
revenues, an increase in the average billing rate and new GR-303 solutions
purchased by network equipment vendors.
34
Sales and marketing expenses. Sales and marketing expenses increased 84.4%
to $9.2 million in 1998 from $5.0 million in 1997 and increased to 31.4% from
25.7% of total revenues. The increase in sales and marketing expenses in
absolute dollars and as a percentage of total revenues was primarily
attributable to increased personnel and related costs resulting from the
increase in the Company's sales force and an expanded marketing department as
well as higher variable expenses such as travel and living costs and commissions
related to higher sales.
Research and product development expenses. Research and product
development expenses increased 89.1% to $6.2 million in 1998 from $3.3 million
in 1997, and increased from 17.0% to 21.3% of total revenues. The increase in
research and product development expenses both in absolute dollars and as a
percentage of total revenues was due primarily to an increase in staffing and an
expansion in the number of new products under development.
General and administrative expenses. General and administrative expenses
decreased 6.0% to $2.7 million in 1998 from $2.9 million in 1997, and decreased
from 14.9% to 9.2% of total revenues. The decrease in general and administrative
expenses in absolute dollars and as a percentage of total revenues was due
primarily to the transition of the Company's Chief Technical Officer from
administrative functions to technical research and development functions, and
significantly lower recruiting costs.
Amortization of goodwill. Amortization of goodwill increased to $38,000
in 1998 from $22,000 in 1997 due to a full year of amortization expense in
1998 as compared to a partial year of expense in 1997.
Interest income. Interest income increased to $1.8 million in 1998
compared to $161,000 for 1997. This increase was primarily due to significantly
higher balances in cash and short-term investments as a result of the Company's
initial public offering of its Common Stock in March 1998.
Income taxes. The Company's effective tax rate was 34.8% and 32.3% for
each of 1998 and 1997, respectively. The effective rate was higher than the
statutory tax rates in 1998 due to the non-deductibility of deferred stock
compensation associated with the issuance of stock options, offset by the
utilization of research and development tax credits. In 1997, the effective tax
rate was lower than the statutory tax rates due to the utilization of research
and development tax credits.
Liquidity and Capital Resources
Since its inception in 1989, the Company has financed its operations
primarily through cash generated by operations and cash raised through its March
1998 initial public offering. At December 31, 1999, the Company's cash, cash
equivalents and marketable securities aggregated approximately $40.7 million, of
which cash and cash equivalents aggregated approximately $3.7 million and
marketable securities aggregated approximately $37.0 million. Marketable
securities at December 31, 1999 were comprised of fixed income government
securities and corporate bonds. The Company's working capital was $53.6 million
and $49.0 million at December 31, 1999 and 1998, respectively.
Accounts receivable, net increased to $20.1 million at December 31, 1999
from $9.1 million at December 31, 1998 primarily as a result of delays in
collection of certain accounts receivable
35
and increased unbilled project revenue. Included in accounts receivable in 1999
was $16.8 million for trade receivables and $4.8 million for unbilled
project revenue as compared to $8.1 million for trade receivables and $1.5
million for unbilled project revenue in 1998. Unbilled project revenue is the
excess amount of revenue recognized through percentage of completion that has
not been billed to the customer. Payment terms to customers are net zero to net
ninety days.
The Company bills its foreign customers, which are generally based in
China, Korea and Japan, in U.S. dollars at agreed-upon contractual terms. The
Company has not experienced any significant negative effects on its liquidity as
a result of the volatility and devaluation trends that have been experienced in
certain Asian markets, although no assurance can be made that the Company will
not experience difficulty collecting accounts receivable from such customers in
the future. Accounts receivable at December 31, 1999 includes approximately
$744,000 from customers in this region.
The Company's capital expenditures, including software development costs,
were approximately $3.0 million and $593,000 for the years ending December 31,
1999 and 1998, respectively. The increase in equipment and facilities-related
expenditures are primarily the result of the move to an expanded corporate
headquarters facility in Bridgewater, New Jersey, the move of the Texas office
to accommodate current and future growth and software development costs which
were capitalized.
In June 1999, the Company entered into a five year capital lease agreement
at an annual interest rate of 8.21% for equipment, furniture and fixtures at its
new office facilities. Assets recorded under this lease are included in fixed
assets. Annual lease payments approximate $180,000.
In August 1997, the Company obtained an unsecured revolving credit
facility with a bank pursuant to which the Company may borrow up to a maximum of
$3.0 million. Borrowings under this line of credit bear interest at the bank's
prime rate less 0.25% on aggregate principal amounts outstanding of less than
$1.0 million and at the bank's prime rate for aggregate principal amounts
exceeding $1.0 million. No borrowings under this line were outstanding as of
December 31, 1999. This credit facility contains, among other provisions,
covenants which (i) mandate the amount of working capital the Company must
maintain at the end of each calendar quarter and (ii) restrict the Company's
ability to pay cash dividends. The unsecured revolving credit facility expires
on August 5, 2000.
On March 18, 1998, the Company consummated an initial public offering of
3,500,000 shares of its Common Stock at a price of $16.00 per share of which
2,500,000 shares were issued and sold by the Company and 1,000,000 shares were
sold by certain selling shareholders. The net proceeds to the Company from the
offering were approximately $36.1 million. On April 7, 1998, certain selling
shareholders sold an additional 525,000 shares of Common Stock at a price of
$16.00 per share. The Company did not receive any of the proceeds from the sale
of shares by the selling shareholders.
36
The net proceeds received by the Company upon the consummation of such
offering, pending specific application, are invested in short-term,
investment-grade, interest-bearing instruments.
The Company believes that its existing available cash, credit facility and
the cash flow expected to be generated from operations, together with the
proceeds from its initial public offering, will be adequate to satisfy its
current and planned operations for at least the next 12 months. There can be no
assurance, however, that the Company will not require additional financing prior
to such time to fund its operations or possible acquisitions.
Acquisitions
On January 25, 1999, DSET Acquisition Corp., a wholly owned subsidiary of
the Company, acquired certain assets of NPL for $2.5 million. NPL was a New
Jersey-based company which specialized in software aimed at reducing the time
necessary for a CLEC to provide prospective customers with sales proposals that
clearly define the CLEC's current service offering compared to the incumbent
local exchange carrier's current service offering.
On September 30, 1999, DSET Corporation purchased the capital stock of
Konark and related technologies owned by an affiliate of Konark for an aggregate
of approximately $3.3 million in cash paid at closing and certain deferred
payments. The purchase provided DSET with all rights to: (i) two
electronic-bonding gateways that the Company previously had been reselling; and
(ii) a new Electronic Access Ordering product. Electronic Access Ordering
facilitates the ordering of high-speed access circuits by a CLEC from an
incumbent local exchange carrier enabling the CLEC to rapidly activate new
service for its customers.
Impact of the Year 2000
Although the rollover has passed from December 31, 1999 to January 1,
2000, the Company still faces risks to the extent that suppliers of products,
services, and systems purchased by the Company or the suppliers with whom the
Company transacts business cannot timely provide the Company with the products,
components, services, or systems that meet Year 2000 requirements. The Company
believes that it is not possible to determine with complete certainty that all
Year 2000 problems affecting the Company have been identified or corrected.
Additionally, the Company cannot guarantee that its products will not be
used by other companies or its customers to build applications which might not
be Year 2000 compliant, or that the Company's products or applications built
with the Company's products will not be integrated by the Company or its
customers or interact with non-compliant software or other products which may
expose the Company to claims from its customers.
In November 1998, the Company determined that certain custom applications
developed and delivered to approximately ten customers were not Year 2000
compliant. All of these customers were notified of such Year 2000 compliance
status in November 1998. The Company has also analyzed the extent to which any
of the affected custom applications were integrated by customers into
37
other products which may expose the Company to claims from its customers. The
Company has agreed to assist each of these customers with any and all
remediation solutions required to achieve Year 2000 compliance with the
Company's products. To date, the Company has not been notified of any Year 2000
problems that have occurred in these custom applications. However, a failure
to properly implement any correction, or problems with any correction, could
cause errors in customers' products which may materially impact the
functionality of those products.
Other than time spent by the Company's personnel, the costs associated
with remediating non-compliant custom applications and assessing Year 2000
compliance issues have not been significant to date. The Company believes that
the continued analysis of compliance of new releases of products and evaluation
of potential Year 2000 problems will result in aggregate expenditures of less
than $100,000.
European Monetary Union
On January 1, 1999, eleven of the fifteen member countries of the European
Union set fixed conversion rates between their existing currencies and the euro.
At such time, these participating countries adopted the euro as their common
legal currency. The eleven participating countries now issue sovereign debt
exclusively in euros and will redenominate outstanding sovereign debt. The
legacy currencies will continue to be used as legal tender through January 1,
2002, at which point the legacy currencies will be canceled and euro bills and
coins will be used for cash transactions in the participating countries.
The Company does not denominate its international revenues in foreign
currencies. The Company currently does not believe that the euro conversion will
have a material impact on the Company's results of operations or financial
condition.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The Company believes that it is not subject to a material impact to its
financial position or results of operations relating to market risk associated
with derivative securities. See Note 3 of Notes to the Consolidated Financial
Statements.
Item 8. Financial Statements and Supplementary Data.
The financial statements required to be filed pursuant to this Item 8 are
appended to this Annual Report on Form 10-K. A list of the financial statements
filed herewith is found at "Item 14. Exhibits, Financial Statement Schedules,
and Reports on Form 8-K." Quarterly financial data is found at Note 15 of Notes
to the consolidated Financial Statements.
38
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
Not applicable.
39
PART III
Item 10. Directors and Executive Officers of the Company.
The information relating to the Company's directors, nominees for election
as directors and executive officers under the headings "Election of Directors"
and "Executive Officers" in the Company's definitive proxy statement for the
2000 Annual Meeting of Shareholders is incorporated herein by reference to such
proxy statement.
Item 11. Executive Compensation.
The discussion under the heading "Executive Compensation" in the Company's
definitive proxy statement for the 2000 Annual Meeting of Shareholders is
incorporated herein by reference to such proxy statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The discussion under the heading "Security Ownership of Certain Beneficial
Owners and Management" in the Company's definitive proxy statement for the 2000
Annual Meeting of Shareholders is incorporated herein by reference to such proxy
statement.
Item 13. Certain Relationships and Related Transactions.
The discussion under the heading "Certain Relationships and Related
Transactions" in the Company's definitive proxy statement for the 2000 Annual
Meeting of Shareholders is incorporated herein by reference to such proxy
statement.
40
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) (1) Financial Statements.
Reference is made to the Index to Financial Statements and Schedules
on Page F-1.
(2) Financial Statement Schedules:
Report of Independent Accountants
Schedule:
II -- Valuation and Qualifying Accounts
(3) Exhibits.
Reference is made to the Index to Exhibits on Page 44.
(b) Reports on Form 8-K.
No Reports on Form 8-K were filed during the quarter ended December
31, 1999.
41
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized this 30th day of March,
2000.
DSET CORPORATION
By: /s/ William P. McHale, Jr.
------------------------------------
William P. McHale, Jr., President
and Chief Executive Officer
42
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
- -------------------------- ---------------------------------- ---------------
/s/ William P. McHale, Jr. President, Chief Executive Officer March 30, 2000
- -------------------------- and Director (Principal Executive
William P. McHale, Jr. Officer)
/s/ Bruce M. Crowell Chief Financial Officer (Principal March 30, 2000
- -------------------------- Financial and Accounting Officer)
Bruce M. Crowell
/s/ S. Daniel Shia Chairman of the Board and Director March 30, 2000
- --------------------------
S. Daniel Shia
/s/ Andrew D. Lipman Director March 30, 2000
- --------------------------
Andrew D. Lipman
/s/ Bruce R. Evans Director March 30, 2000
- --------------------------
Bruce R. Evans
/s/ C. Daniel Yost Director March 30, 2000
- --------------------------
C. Daniel Yost
/s/ Jacob J. Goldberg Director March 30, 2000
- --------------------------
Jacob J. Goldberg
43
EXHIBIT INDEX
Exhibit No. Description of Exhibit
- ----------- ----------------------
3.1(a) Amended and Restated Certificate of Incorporation.
3.2(a) Amended and Restated Bylaws.
4.1(a) 1993 Stock Option Plan of the Company, as amended.
4.2(a) 1998 Stock Plan of the Company.
4.3(a) Form of Warrant Agreement, dated as of September 13, 1996
between the Company and Summit Ventures IV, L.P. and Summit
Investors II, L.P.
4.4(a) Registration Rights Provisions granted to Summit Ventures IV,
L.P. and Summit Investors II, L.P.
10.1(a) Corporate Revolving and Term Loan Agreement between
Manufacturers and Traders Trust Company and the Company dated
August 5, 1997.
10.2(a) Joint Venture Agreement dated as of May 21, 1997 between ATOS,
S.A. (formerly Sligos/Marben S.A.) and the Company.
10.3(a)(c) Form of Indemnification Agreement executed by each of the
Company's directors and executive officers.
10.4(a)(c) Employment Agreement dated October 1, 1996 between the Company
and S. Daniel Shia.
10.5(a)(c) Employment Agreement dated January 1, 1998 between the Company
and William P. McHale, Jr.
10.6(a) DSET Corporation 401(k) Plan.
10.7(b) Lease Agreement dated December 31, 1998 between Advance/GLBI
L.L.C. and the Company.
14A2.1 Report of Independent Accountants
14A2.2 Schedule II
21 List of Subsidiaries.
23.1 Consent of PricewaterhouseCoopers LLP.
27 Financial Data Schedule.
- ----------
(a) Incorporated by reference to the Company's Registration Statement on Form
S-1 (File Number 333-43827) which became effective on March 12, 1998.
(b) Incorporated by reference to the Company's Quarterly Report on Form 10-Q
for the quarterly period ended March 31,1999.
(c) A management contract or compensatory plan or arrangement required to be
filed as an exhibit pursuant to Item 14(c) of Form 10-K.
44
DSET CORPORATION AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
Page
----
Report of Independent Accountants........................................... F-2
Consolidated Balance Sheets as of December 31, 1999 and 1998................ F-3
Consolidated Statements of Income and Comprehensive Income for the Years
Ended December 31, 1999, 1998 and 1997.................................... F-4
Consolidated Statements of Changes in Cumulative Redeemable Convertible
Preferred Stock and Shareholders' Equity for the Years Ended December 31,
1999, 1998 and 1997....................................................... F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1999, 1998 and 1997.......................................... F-6
Notes to Consolidated Financial Statements.................................. F-7
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of
DSET Corporation
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income and comprehensive income, of changes in
cumulative redeemable convertible preferred stock and shareholders' equity
and of cash flows present fairly, in all material respects, the financial
position of DSET Corporation and its subsidiaries at December 31, 1999 and
1998, and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 1999, in conformity with
accounting principles generally accepted in the United States. These
consolidated financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States which
require that we plan and perform the audits to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
Florham Park, New Jersey
March 29, 2000
F-2
DSET Corporation and Subsidiaries
December 31, 1999
Consolidated Balance Sheets
- --------------------------------------------------------------------------------
December 31,
1999 1998
Assets
Current assets:
Cash and cash equivalents $ 3,721,333 $ 9,198,270
Marketable securities 36,973,702 35,824,780
Accounts receivable, net of allowance for doubtful accounts
of $600,000 and $175,979 20,132,404 9,108,059
Deferred income taxes 735,774 258,144
Prepaid expenses and other current assets 1,452,265 193,418
------------ ------------
Total current assets 63,015,478 54,582,671
Acquired technology, net 4,343,313 --
Software development costs, net 564,854 --
Fixed assets, net 3,428,268 1,592,114
Goodwill, net 1,258,175 129,864
Other assets 885,290 548,963
------------ ------------
Total assets $ 73,495,378 $ 56,853,612
============ ============
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable and accrued expenses $ 6,144,874 $ 3,560,994
Income taxes payable 394,206 145,673
Deferred revenues 1,719,975 1,726,906
Notes payable 1,000,000 111,657
Current portion of capital lease obligation 130,415 --
------------ ------------
Total current liabilities 9,389,470 5,545,230
Deferred income taxes 710,765 119,127
Long-term notes payable 1,310,560 --
Capital lease obligation 561,670 --
------------ ------------
Total liabilities 11,972,465 5,664,357
------------ ------------
Commitments (Notes 5 and 12)
Shareholders' equity:
Preferred stock, no par value; 5,000,000 shares authorized, no shares issued
or outstanding at December 31, 1999 and 1998 -- --
Common stock, no par value; 40,000,000 shares authorized, 10,860,070
and 9,817,559 shares issued and outstanding at December 31, 1999
and 1998, respectively 45,635,959 41,912,361
Deferred stock compensation (196,737) (494,306)
Retained earnings 16,247,807 9,731,077
Accumulated other comprehensive income (164,116) 40,123
------------ ------------
Total shareholders' equity 61,522,913 51,189,255
------------ ------------
Total liabilities and shareholders' equity $ 73,495,378 $ 56,853,612
============ ============
The accompanying notes are an integral part of these financial statements.
F-3
DSET Corporation and Subsidiaries
December 31, 1999
Consolidated Statements of Income and Comprehensive Income
- --------------------------------------------------------------------------------
Years ended December 31,
1999 1998 1997
Revenues:
License revenues $ 24,083,661 $ 16,337,615 $ 10,850,275
Service revenues 20,545,290 12,952,549 8,514,512
------------ ------------ ------------
Total revenues 44,628,951 29,290,164 19,364,787
------------ ------------ ------------
Cost of revenues:
License revenues 1,823,375 1,775,144 1,274,355
Service revenues 7,062,653 3,692,092 3,404,484
------------ ------------ ------------
Total cost of revenues 8,886,028 5,467,236 4,678,839
------------ ------------ ------------
Gross profit 35,742,923 23,822,928 14,685,948
------------ ------------ ------------
Operating expenses:
Sales and marketing 12,536,633 9,192,593 4,986,286
Research and product development 11,046,334 6,237,484 3,299,337
General and administrative 4,220,600 2,707,856 2,880,804
Amortization of goodwill 199,629 38,009 22,172
------------ ------------ ------------
Total operating expenses 28,003,196 18,175,942 11,188,599
------------ ------------ ------------
Operating income 7,739,727 5,646,986 3,497,349
Interest expense and other income (expense) (179,096) (120,160) (12,194)
Interest income 2,206,006 1,827,830 160,847
------------ ------------ ------------
Income before income taxes 9,766,637 7,354,656 3,646,002
Provision for income taxes 3,249,907 2,560,473 1,177,396
------------ ------------ ------------
Net income 6,516,730 4,794,183 2,468,606
Less: preferred stock dividends -- -- 859,555
------------ ------------ ------------
Net income 6,516,730 4,794,183 1,609,051
Other comprehensive income, net of tax
Unrealized (depreciation)/appreciation
on investments (204,569) 40,123 --
------------ ------------ ------------
Comprehensive income $ 6,312,161 $ 4,834,306 $ 1,609,051
============ ============ ============
Net income applicable to common shares $ 6,516,730 $ 4,794,183 $ 1,609,051
============ ============ ============
Net income per common share $ 0.63 $ 0.53 $ 0.45
============ ============ ============
Weighted average number of common shares
outstanding 10,425,250 9,012,019 3,566,764
------------ ------------ ------------
Net income per common share assuming dilution $ 0.59 $ 0.43 $ 0.30
------------ ------------ ------------
Weighted average number of common shares and
common equivalent shares outstanding 11,066,728 11,043,422 8,346,365
============ ============ ============
The accompanying notes are an integral part of these financial statements.
F-4
DSET Corporation and Subsidiaries
December 31, 1999
Consolidated Statements of Changes in Cumulative Redeemable
Convertible Preferred Stock and Shareholders' Equity
- --------------------------------------------------------------------------------
Series A Convertible
Preferred Stock Common Stock Deferred
Number Number Stock
of Shares Amount of Shares Amount Compensation
Balance at January 1, 1997 676,361 $ 10,744,441 6,390,360 $ 1,261,817 --
Exercise of stock options -- -- 384,732 275,813 --
Tax benefit from exercise of stock options -- -- -- 124,341 --
Dividends on redeemable
convertible preferred stock -- 859,555 -- -- --
Deferred stock compensation -- -- -- 875,835 $(875,835)
Net income -- -- -- -- --
-------- ----------- ---------- ----------- ---------
Balance at December 31, 1997 676,361 11,603,996 6,775,092 2,537,806 (875,835)
Exercise of stock options -- -- 542,467 1,307,790 --
Tax benefit from exercise of stock options -- -- -- 501,217 --
Amortization of deferred stock compensation -- -- -- (6,808) 298,620
Forfeitures of 55,571 shares of stock options -- -- -- (82,909) 82,909
Sale - Issuance of common stock -- -- 2,500,000 37,200,000 --
Costs related to issuance of common stock -- -- -- (1,148,734) --
Conversion of series A cumulative
redeemable convertible preferred stock (676,361) (11,603,996) 3,043,625 11,603,996 --
Retirement of treasury stock -- -- (3,043,625) (9,999,997) --
Unrealized appreciation on investments -- -- -- -- --
Net income -- -- -- -- --
-------- ----------- ---------- ----------- ---------
Balance at December 31, 1998 -- -- 9,817,559 41,912,361 (494,306)
-------- ----------- ---------- ----------- ---------
Exercise of stock options -- -- 920,231 2,135,508 --
Conversion of warrants, net -- -- 122,280 -- --
Tax benefit from exercise of stock options -- -- -- 1,642,532 --
Amortization of deferred stock compensation -- -- -- -- 243,196
Forfeitures of 90,653 shares of stock options -- -- -- (54,373) 54,373
Unrealized depreciation on investments,
net of tax -- -- -- -- --
Cumulative translation adjustment -- -- -- (69) --
Net income -- -- -- -- --
-------- ----------- ---------- ----------- ---------
Balance at December 31, 1999 -- $ -- 10,860,070 $45,635,959 $(196,737)
======== =========== ========== =========== =========
Other
Retained Treasury Comprehensive
Earnings Stock Income Total
Balance at January 1, 1997 $ 3,327,843 $(9,999,997) -- $(5,410,337)
Exercise of stock options -- -- -- 275,813
Tax benefit from exercise of stock options -- -- -- 124,341
Dividends on redeemable
convertible preferred stock (859,555) -- -- (859,555)
Deferred stock compensation -- -- --
Net income 2,468,606 -- -- 2,468,606
----------- ----------- --------- -----------
Balance at December 31, 1997 4,936,894 (9,999,997) -- (3,401,132)
Exercise of stock options -- -- -- 1,307,790
Tax benefit from exercise of stock options -- -- -- 501,217
Amortization of deferred stock compensation -- -- -- 291,812
Forfeitures of 55,571 shares of stock options -- -- -- --
Sale - Issuance of common stock -- -- -- 37,200,000
Costs related to issuance of common stock -- -- -- (1,148,734)
Conversion of series A cumulative
redeemable convertible preferred stock -- -- -- 11,603,996
Retirement of treasury stock -- 9,999,997 -- --
Unrealized appreciation on investments -- -- $40,123 40,123
Net income 4,794,183 -- -- 4,794,183
----------- ----------- --------- -----------
Balance at December 31, 1998 9,731,077 -- 40,123 51,189,255
----------- ----------- --------- -----------
Exercise of stock options -- -- -- 2,135,508
Conversion of Warrants, net -- -- -- --
Tax benefit from exercise of stock options -- -- -- 1,642,532
Amortization of deferred stock compensation -- -- -- 243,196
Forfeitures of 90,653 shares of stock options -- -- -- 0
Unrealized depreciation on investments,
net of tax -- -- (204,239) (204,239)
Cumulative translation adjustment, -- -- -- (69)
Net income 6,516,730 -- -- 6,516,730
----------- ----------- --------- -----------
Balance at December 31, 1999 $16,247,807 $ -- $(164,116) $61,522,913
=========== =========== ========= ===========
The accompanying notes are an integral part of these financial statements.
F-5
DSET Corporation and Subsidiaries
December 31, 1999
Consolidated Statements of Cash Flows
- --------------------------------------------------------------------------------
Years ended December 31,
1999 1998 1997
Cash flows from operating activities:
Net income $ 6,516,730 $ 4,794,183 $ 2,468,606
Adjustments to reconcile net income to net cash
provided by operating activities:
Deferred income taxes (308,254) (84,050) (123,482)
Accrued interest expense 28,531 -- --
Tax benefit from exercise of stock options 1,642,532 501,217 124,341
Amortization of deferred stock compensation 243,196 291,812 --
Depreciation 815,372 559,954 399,035
Loss (gain) on disposal of assets 41,391 (1,172) --
Amortization 562,683 38,009 121,776
Bad debt expense 665,116 50,475 --
Loss (earnings) from joint venture 36,238 79,914 (26,131)
Changes in assets and liabilities:
Accounts receivable (11,689,461) (1,594,092) (3,014,841)
Prepaid assets and other current assets (1,158,847) -- --
Other assets 288,167 (264,652) (94,759)
Accounts payable and accrued expenses 2,583,881 781,040 1,631,892
Income taxes payable 248,533 145,673 (108,468)
Deferred revenues (6,931) (170,133) 887,386
------------- ------------- -----------
Net cash provided by operating activities 508,877 5,128,178 2,265,355
------------- ------------- -----------
Cash flows from investing activities:
Purchases of marketable securities (20,697,479) (52,474,277) (950,893)
Redemption of marketable securities 19,241,579 16,789,620 1,150,000
Acquisitions of businesses (3,778,416) -- --
Purchase of acquired technology (39,660) -- --
Software development costs (634,788) -- --
Acquisition of fixed assets (2,352,287) (593,007) (807,640)
Proceeds on disposition of fixed assets -- 3,059 --
Investment in joint venture -- -- (245,000)
------------- ------------- -----------
Net cash used in investing activities (8,261,051) (36,274,605) (853,533)
------------- ------------- -----------
Cash flows from financing activities:
Proceed from capital sale/leaseback 402,761 -- --
(Loans to) repayment from officers and shareholders, net (100,000) 100,000 (150,000)
Repayment of notes payable (111,657) (220,000) (110,000)
Repayments capital lease obligation (51,375) -- --
Proceeds from issuance of common stock, net -- 36,051,266 --
Purchases of treasury stock -- -- --
Proceeds from the exercise of stock options 2,135,508 1,307,790 275,813
------------- ------------- -----------
Net cash provided by financing activities 2,275,237 37,239,056 15,813
------------- ------------- -----------
Net (decrease) increase in cash and cash equivalents (5,476,937) 6,092,629 1,427,635
Cash and cash equivalents, beginning of period 9,198,270 3,105,641 1,678,006
------------- ------------- -----------
Cash and cash equivalents, end of period $ 3,721,333 $ 9,198,270 $ 3,105,641
============= ============= ===========
Supplemental disclosure of cash flow information:
Cash paid during the period for income taxes $ 1,657,601 $ 1,142,000 $ 1,157,868
Cash paid during the period for interest 127,426 12,458 12,194
Non-cash activities:
Conversion of Series A preferred stock to common stock $ -- $ 11,603,996 $ --
Retirement of treasury stock -- 9,999,997 --
Accrued dividends on Series A preferred stock -- -- 859,555
Note issued for net assets of Marben Products Inc. -- -- 441,657
Lease of fixed assets 340,702 -- --
Notes payable issued for acquisitions 2,282,029 -- --
Deferred taxes on purchased intangibles 525,000 -- --
Forfeiture of stock options with deferred stock compensation 54,373 82,909 --
The accompanying notes are an integral part of these financial statements.
F-6
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
1. Nature of Business
DSET Corporation and its subsidiaries (the "Company") is a leading
provider of business-to-business e-commerce software solutions for the
global telecommunications marketplace. The DSET suite of electronic-
bonding gateways is designed to interconnect the operations support
systems (OSSs) of service providers that must exchange information and
share network capabilities as trading partners to provide and maintain a
growing range of services for customers in the competitive
telecommunications market. The Company's local number portability
solutions play a key role in enabling business and residential customers
to change service providers without changing their local phone numbers. In
addition, the Company provides its customers with consulting, training and
technical services. Headquartered in Bridgewater, New Jersey, the Company
serves customers worldwide.
2. Summary of Significant Accounting Policies
Consolidation
The consolidated financial statements include all wholly owned
subsidiaries from the respective dates of their acquisition.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents.
Marketable Securities
The marketable securities portfolio held by the Company are considered to
be available-for-sale securities and are reported at fair value.
Unrealized depreciation was $164,116 (net of deferred tax of $102,738) at
December 31, 1999. Cost is determined on specific identification basis. At
December 31, 1998 unrealized appreciation was $40,123.
Fixed Assets
Equipment, furniture and purchased software are stated at cost less
accumulated depreciation. Depreciation is calculated using a straight-line
method over estimated useful lives ranging from three to seven years.
Leasehold improvements are amortized over the lesser of the estimated
useful life or the lease term.
Goodwill
The Company amortizes goodwill using a straight-line method over its
estimated useful life of five years. The Company periodically assesses the
realizability of the asset based on estimated future cash flows.
Accumulated amortization was $168,525 and $60,181 as of December 31, 1999
and 1998 respectively.
Software Development Costs
Capitalization of software development costs begins on establishment of
technological feasibility. Costs incurred prior to establishment of
technological feasibility are charged to research and product development
expense. The ongoing assessment of recoverability of capitlized costs
require considerable judgement by management with respect to certain
factors including the anticipated future gross revenue, estimated economic
life and changes in technology. These factors are considered on a
product-by-product basis. Amortization of software development costs is
the greater amount computed using (a) the ratio that current gross
revenues for a product bear to the total of current and anticipated future
gross revenues for that product or (b) the straight-line method over the
remaining estimated economic life ranging from three to five years of the
product including the period being reported on. Accumulated amortization
was $69,934 as of December 31, 1999.
F-7
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Acquired Technology
Acquired technology represents the costs of feasible technology acquired
from external sources. At December 31, 1999, acquired technology reflects
the purchase of certain assets of Network Programs LLC ("NPL") and Konark
Inc., as well as related costs to acquire such assets. Accumulated
amortization was $350,270 as of December 31, 1999.
Amortization of acquired technology is the greater of the amount computed
using (a) the ratio that current gross revenues for a product bear to the
total of current and anticipated future gross revenues for that product or
(b) the straight-line method over the remaining estimated economic life
ranging from three to five year of the product including the period being
reported on.
Research and Product Development
Research and development costs are charged to expense as incurred.
However, the costs incurrred for the development of computer software that
will be sold, leased, or otherwise marketed are capitalized when
technological feasibility has been established.
Long-Lived Assets
The Company reviews its long-lived assets for impairment whenever events
or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable.
Revenue Recognition
License revenues are recorded when the software has been shipped to the
Company's licensees and all significant obligations have been satisfied.
Any contract holdbacks or contingent charges are recognized as revenue
when they are satisfied. Revenues from run-time licenses are recognized
as equipment using the Company's software is deployed by the Company's
customers. Notification is typically received from customers pursuant to
quarterly reports or via purchase orders for individual licenses. Custom
application development service revenues are recognized over the period
in which the service is performed based on the percentage of direct
labor costs incurred to the total estimated direct labor costs.
When the engineering of a product is not yet completed, revenue is
recognized on orders for that product using the percentage of completion
method as defined above. Any revenue recognized in excess of amounts
invoiced to the customer for progress billings are recorded as unbilled
accounts receivable.
Service revenue from maintenance contracts is deferred and recognized over
the term of the respective contracts (typically twelve months).
F-8
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Revenues under software arrangements involving multiple elements of the
sale are allocated to each element based on vendor specific objective
evidence of the elements.
Income Taxes
The Company utilizes an asset and liability approach to financial
reporting for income taxes. Deferred income tax assets and liabilities are
computed annually for differences between the financial statement and tax
bases of assets and liabilities that will result in taxable or deductible
amounts in the future, based on enacted tax laws and rates applicable to
the period in which the differences are expected to affect taxable income.
Valuation allowances are established, when necessary, to reduce the
deferred tax assets to the amount expected to be realized.
For certain stock options, the Company receives a tax deduction for the
difference between the fair value at the date of exercise of the stock
option and the exercise price. To the extent the amount deducted for
income taxes exceeds the amount charged to operations for financial
statement purposes, the related tax benefits are credited to shareholders'
equity.
Fair Value of Financial Instruments
The carrying amounts in the financial statements for cash and cash
equivalents, accounts receivable, and accounts payable and accrued
expenses approximate their market value because of the short maturity of
those instruments.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates. Estimates are used when accounting for certain items such as
the allowance for doubtful accounts, depreciation and amortization, and
income taxes. Additionally, the Company evaluates the useful lives of its
acquired technology and software development costs based upon changes in
technology and industry conditions.
Recently Issued Accounting Standards
On June 15, 1998, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 133 "Accounting for
Derivatives and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 is
effective for all fiscal quarters of all fiscal years beginning after June
15, 1999 (January 1, 2000 for the Company). SFAS No. 133 requires that all
derivative instruments be recorded on the balance sheet at their fair
value. Changes in the fair value of derivatives are recorded each period
in current earnings or other comprehensive income, depending on whether a
derivative is designated as part of a hedge transaction and, if it is, the
type of hedge transaction. Management of the Company anticipates that, due
to its limited use of derivative instruments, the adoption of SFAS No. 133
will not have a significant effect on the Company's results of operations
or its financial position.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial
Statements," which must be adopted by June 30, 2000. The Company is
currently evaluating the impact of SAB 101 on its results of operations.
Reclassifications
Certain amounts in 1998 and 1997 have been reclassified to conform to the
1999 presentation.
F-9
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
3. Marketable Securities
Marketable securities at December 31, 1999 and 1998 were comprised as
follows:
December 31,
1999 1998
Government fixed income securities $32,970,905 $26,174,048
Corporate bonds 4,002,797 9,650,732
----------- -----------
Total $36,973,702 $35,824,780
=========== ===========
The Company's credit policy provides for all short-term securities of
grade A2 or better with maturities of two years or less. Interest income
earned related to marketable securities was $2,206,006 and $1,827,830 for
the years ended December 31, 1999 and 1998, respectively.
4. Fixed Assets
Fixed assets consist of the following:
December 31,
1999 1998
Computer equipment $ 2,339,570 $ 1,688,910
Purchased software 1,416,716 839,668
Furniture, fixtures and office equipment 1,387,397 451,452
Leasehold improvements 389,398 68,080
Transportation equipment 32,692 32,692
----------- -----------
5,565,773 3,080,802
Less: accumulated depreciation and amortization (2,137,505) (1,488,688)
----------- -----------
$ 3,428,268 $ 1,592,114
=========== ===========
5. Debt Obligations
a) Capital Lease Obligation
In June 1999, the Company entered into a five-year capital lease agreement
mainly for office furniture and fixtures in the new facilities in
Bridgewater, New Jersey and Plano, Texas at annual rate of 8.21%. Annual
lease payments approximate $180,000. Assets recorded under this lease are
included in fixed assets as follows:
December 31, 1999
-----------------
Furniture and fixtures $ 743,462
Accumulated amortization (51,550)
---------
$ 691,912
=========
F-10
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
b) Lines of Credit
In August 1997, the Company obtained an unsecured revolving credit
facility with a bank totaling $3 million. Borrowings under this line of
credit bear interest at the bank's prime rate (8.50% at December 31, 1999)
less 0.25% on amounts outstanding of less than $1 million and at the
bank's prime rate for aggregate principal amounts exceeding $1 million. No
borrowings under this line were outstanding at December 31, 1998 or 1999.
This credit facility contains, among other provisions, a covenant which
restricts the Company's ability to pay cash dividends.
c) Notes Payable
As part of the acquisition of Konark Inc., the Company paid $1.0 million
in cash and issued a $2.5 million non-interest bearing note payable which
has been discounted at 8.25%. Interest expense is accreted monthly and
totalled $28,531 in 1999. The note is payable in five installments, and
matures on March 1, 2002.
As of December 31, 1999, future payments under the notes are as follows:
Principal
Year Ending December 31, Payments
----------------------- --------
2000 $1,000,000
2001 1,000,000
2002 500,000
----------
2,500,000
Less: Unamortized interest (189,440)
----------
Present value of notes payable 2,310,560
Less: Current portion 1,000,000
----------
Long-term portion $1,310,560
==========
6. Cumulative Redeemable Convertible Preferred Stock
During 1995, the Company issued 676,361 shares of cumulative, convertible
Series A Preferred Stock in exchange for $10,000,000. As an integral part
of the Agreement, the Company was required to use the proceeds received
upon the sale of the preferred stock to repurchase, on or before January
31, 1996, an aggregate of 3,043,625 shares of common stock, which the
Company has completed.
Shareholders of Series A Preferred Stock were entitled to votes equal to
the number of common shares into which the shares of preferred stock were
convertible. The Series A Preferred shareholders were also entitled to
receive cumulative annual dividends equal to the "Applicable Percentage
Rate" of 8%, as defined in the Agreement, of the original purchase price
paid per share. In the event of conversion of the preferred stock to
Common Stock, however, all accumulated and unpaid dividends on the
preferred stock were to be forgiven. The holders of the Series A Preferred
stock also had certain redemption and liquidation rights.
The holders of the Series A Preferred Stock had the option to convert, at
any time, their shares into fully-paid and nonassessable shares of Common
Stock at the "Applicable Conversion Rate," which was four and one-half
shares of Common Stock for each share of Series A Preferred Stock
converted. The Series A Preferred Stock was to be automatically converted
into Common Stock upon the closing of an initial public offering in which
net proceeds to the Company equaled or exceeded $15,000,000 and the price
paid by the public for such shares was at least three times the then
conversion value per share as defined by the Agreement. The shares of the
Series A Preferred Stock were automatically converted upon the
consummation of the Company's initial public offering.
In the event of the issuance of stock options to two specified executives
(one of which is no longer with the Company), the Series A Preferred
Shareholders were entitled to receive warrants to purchase a proportionate
number of shares with an identical exercise price per share. In September
1996, warrants to purchase 185,331 shares with an exercise price of $2.18
per share were issued for no additional consideration. Such warrants are
or will be exercisable to the extent of 25% on each of September 13, 1997,
1998, 1999 and 2000. During 1999, 138,998 warrants were exercised, of
which 16,718 underlying common shares were purchased by the Company for
their fair value approximately aggregating $303,000 which were used
to fund the exercise price of these warrants. At December 31, 1999,
warrants to purchase 46,333 shares were outstanding.
F-11
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
7. Common Stock
On December 29, 1997, the Company amended its Certificate of Incorporation
to increase the number of authorized shares of Common Stock to 40,000,000
shares. On December 31, 1997, the Company's Board of Directors authorized
the officers of the Company to amend and restate the Company's Certificate
of Incorporation to reflect, among other things, the authorization of
5,000,000 shares of a new class of undesignated preferred stock. Such
amendment and restatement to the Certificate of Incorporation became
effective upon the effectiveness of the Company's registration statement
filed in connection with the Company's initial public offering of its
Common Stock.
On March 18, 1998, the Company consummated an initial public offering of
3,500,000 shares of its Common Stock at a price of $16.00 per share, of
which 2,500,000 shares were issued and sold by the Company and 1,000,000
shares were sold by certain shareholders of the Company (the "Selling
Shareholders"). The net proceeds to the Company from the offering were
approximately $36.1 million. On April 7, 1998, certain Selling
Shareholders sold an additional 525,000 shares of the Company's Common
Stock at a price of $16.00 per share upon the consummation of the exercise
of the underwriters' over-allotment option. The Company did not receive
any of the proceeds from the sale of shares by the Selling Shareholders.
8. Stock Options
The Company maintains a stock option plan (the "1993 Plan") covering
officers, employees, directors and consultants, pursuant to which options
were granted to purchase shares of the Company's Common Stock. Options
granted under this 1993 Plan were either incentive stock options or
nonqualified stock options, as designated at the time of grant and vest
over a period not to exceed four years. The 1993 Plan provides that the
option price shall not be less than the fair market value of the shares at
date of grant (as determined by the 1993 Plan's administrators), except
for a more than 10% voting shareholder, in which case it will not be less
than 110% of the fair market value at date of grant. Incentive stock
options are exercisable for ten years from the date of grant ("10 Year
Options"), except for a more than 10% voting shareholder, in which case
the option is exercisable for five years ("5 Year Options"). Nonqualified
stock options are exercisable for five years from the date of grant. Upon
consummation of the Company's initial public offering (March 18, 1998) no
further grants were issued under the 1993 Plan.
The 1998 Stock Plan was adopted by the Board of Directors on December 31,
1997. The 1998 Stock Plan became effective on the date of the consummation
of the Company's initial public offering (March 18, 1998) and terminates
ten years from such date. Upon effectiveness of the 1998 Stock Plan, a
total of 1,800,000 shares were reserved for issuance upon the exercise of
option and/or stock purchase rights granted thereunder. Those eligible to
receive stock option grants or stock purchase rights under the 1998 Stock
Plan include employees, non-employee directors and
F-12
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
consultants. The 1998 Stock Plan is administered by the Compensation
Committee of the Board of Directors of the Company.
During the year ended December 31, 1997, deferred stock compensation of
$875,835 was recorded for options granted during the year. This amount
will be amortized to compensation expense over the vesting period of the
options (two to four years). At December 31, 1999, the remaining
unamortized deferred stock compensation balance was $196,737.
At December 31, 1999 and 1998, options to purchase 806,623 and 1,208,344
shares of Common Stock were exercisable under the Company's stock option
plans at a weighted average exercise price per share of $3.52 and $1.59,
respectively.
A summary of option transactions during 1997, 1998 and 1999 are as
follows:
Number of Weighted
Shares Average
------------------------------------------- Exercise
10 Year 5 Year Price Per
Options Options Total Share
Outstanding January 1, 1997 977,250 1,261,614 2,238,864 $ 1.23
Granted 827,400 392,359 1,219,759 $ 3.67
Forfeited (141,000) (84,398) (225,398) $ 2.67
Exercised (157,500) (227,232) (384,732) $ 0.72
--------- --------- ---------
Outstanding December 31, 1997 1,506,150 1,342,343 2,848,493 $ 2.23
Granted 602,500 229,500 832,000 $11.99
Forfeited (111,074) (126,724) (237,798) $ 6.38
Exercised (205,322) (337,145) (542,467) $ 1.56
--------- --------- ---------
Outstanding December 31, 1998 1,792,254 1,107,974 2,900,228 $ 4.79
Granted 534,081 510,332 1,044,413 $13.98
Forfeited (367,518) (122,437) (489,955) $11.17
Exercised (640,701) (310,142) (950,843) $12.61
--------- --------- ---------
Outstanding December 31, 1999 1,318,116 1,185,727 2,503,843 $ 8.79
========= ========= =========
In October, 1995, the Financial Accounting Standards Board issued SFAS No.
123, "Accounting for Stock-Based Compensation," which establishes
financial accounting and reporting standards for stock-based employee
compensation plans. However, SFAS No. 123 also permits the measurement of
compensation costs using the intrinsic value based method of accounting
prescribed by Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees." The Company has elected to
account for its employee stock compensation plans under the guidance
prescribed by APB Opinion No. 25 and has made the required pro forma
disclosures of net income and net income per share as if the fair value
based method of accounting defined in SFAS No. 123 had been applied as
indicated below:
F-13
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Years ended December 31,
1999 1998 1997
Net income applicable to common shares:
As reported $6,516,730 $4,794,183 $1,609,051
Pro forma 4,593,009 3,639,098 950,593
Net income per common share:
As reported $ 0.63 $ 0.53 $ 0.45
Pro forma $ 0.44 $ 0.40 $ 0.27
Net income per common share assuming dilution:
As reported $ 0.59 $ 0.43 $ 0.30
Pro forma $ 0.42 $ 0.33 $ 0.22
The fair value for options issued prior to the Company's initial public
offering were estimated at the date of grant using the minimum value
method with the following weighted average assumptions for the year ended
December 31, 1997: risk-free interest rates of 4.65% to 7.28%; expected
life of five to ten years, volatility 0% and dividend yields of 0%. The
fair value of option grants subsequent to the initial public offering were
calculated using the absolute method. The assumptions for the year
ended December 31, 1998 were: risk-free interest rates of 4.65% to 5.49%;
expected life of 4 years, volatility of 80% and dividend yields of 0%. The
assumptions for the year ended December 31, 1999 were: risk-free interest
rates of 4.53% to 6.10%; expected life of 4 years, volatility of 80% and
dividend yield of 0%. These methods require the input of highly subjective
assumptions. Changes in the assumptions can materially affect the fair
value estimates. In management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its
employee stock options.
9. Income Taxes
The provision (benefit) for federal and state and foreign taxes consists
of the following:
Years Ended December 31,
1999 1998 1997
Current:
Federal $ 3,065,129 $ 2,262,893 $ 1,079,038
State 465,217 259,780 149,584
Foreign 27,815 121,850 72,256
----------- ----------- -----------
3,558,161 2,644,523 1,300,878
----------- ----------- -----------
Deferred:
Federal (269,652) (76,649) (111,830)
State (38,602) (7,401) (11,652)
----------- ----------- -----------
(308,254) (84,050) (123,482)
----------- ----------- -----------
Provision for income taxes $ 3,249,907 $ 2,560,473 $ 1,177,396
----------- ----------- -----------
F-14
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
The following reconciles the tax provision to the amount computed by
multiplying income before income taxes by the United States federal
statutory rate of 34% as follows:
Years Ended December 31,
1999 1998 1997
Provision at statutory rate 34.0% 34.0% 34.0%
State taxes, net of federal benefit 3.1 2.2 2.5
Research and development tax credits (4.6) (3.3) (4.2)
Deferred stock compensation 0.6 1.3 --
Other 0.2 0.6 --
---- ---- ----
33.3% 34.8% 32.3%
==== ==== ====
Deferred tax assets (liabilities) are comprised of the following:
December 31,
1999 1998
Current:
Accrued vacation $ 133,178 $ 127,656
Bad debt reserve 233,100 65,939
Deferred maintenance revenue 42,122 36,446
Accrued bonus -- 28,103
Depreciation on investments 102,738 --
Warranty reserve 224,636 --
--------- ---------
Total $ 735,774 $ 258,144
========= =========
Non-current:
Fixed assets (126,487) (119,127)
Deferred rent 99,163 --
Amortization 56,343 --
Capitalized software costs (214,784) --
Acquired technology (525,000) --
--------- ---------
Total $(710,765) $(119,127)
========= =========
F-15
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
10. Revenue and Receivable Concentration
The Company had no customers which accounted for more than 10% of revenues
for the year ended 1999. The Company had one significant customer for each
of the years ended 1998 and 1997, which accounted for approximately 17%
and 12% of total revenues, respectively. No other customer accounted for
more than 10% of total revenues in any of the three years ended December
31, 1999. Revenues from customers in the following geographic regions as a
percentage of total revenues are as follows:
Years Ended December 31,
1999 1998 1997
North America 93% 85% 73%
Asia/Pacific Rim 3 9 22
Europe 4 6 5
--- --- ---
100% 100% 100%
=== === ===
At December 31, 1998 and 1999, one customer accounted for approximately
25% and 14%, respectively, of accounts receivable. Unbilled accounts
receivable were $4.8 million and $1.5 million as of December 31, 1999 and
1998, respectively.
11. Employee Benefit Plan
The Company maintains a savings plan pursuant to Section 401(k) of the
Internal Revenue Code (the "Code") covering all employees meeting
eligibility requirements. Subject to certain limits set forth in the Code,
employees are permitted to make contributions to the plan on a pre-tax
salary reduction basis, and the Company may make voluntary contributions
of up to 60% of employee contributions. The Company made contributions
approximating $164,000, $251,000, and $296,000 for the years ended
December 31, 1997, 1998 and 1999, respectively.
12. Commitments
Leases
The Company has operating leases for its offices and certain equipment.
Generally, the leases carry renewal provisions and require the payment of
maintenance costs. Rental expense charged to operations for the years
ended December 31, 1997, 1998 and 1999 was approximately $402,000,
$786,000 and $2,050,000 respectively.
F-16
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
The future minimum rental payments under noncancellable operating leases
are as follows:
Years Ending December 31,
2000 $ 2,133,704
2001 2,165,541
2002 2,005,195
2003 1,705,643
2004 1,663,158
For the years 2005 and beyond 6,176,734
-----------
Total $15,849,975
===========
13. Acquisitions
In March 1997, the Company acquired the net assets of Marben Products,
Inc., ("MPI") a software distribution company located in California. The
purchase price was $190,045. Included in the net assets acquired was a
note payable of $441,657 to MPI's parent company. The note bears interest
at 5% per annum and requires quarterly payment of interest and $55,000 of
principal. The Company has accounted for the acquisition using the
purchase method, and the results of operations of the acquired business
are included in the Company's operations since acquisition.
The following is a summary of the purchase price allocation:
Current assets and other tangible assets $ 426,615
Goodwill 190,045
Current liabilities assumed (175,003)
Note issued in acquisition (441,657)
On January 25, 1999, DSET Acquisition Corp., a wholly-owned subsidiary of
the Company consummated the acquisition of certain assets of NPL. The
purchase price consisted of $2,500,000 payable to NPL and professional
fees of $158,416.
In addition, the costs to acquire NPL are recorded as acquired technology
and goodwill. In addition, research and development costs associated with
bringing the acquired assets to market have been recorded as capitalized
software development costs. Amortization of these costs commenced with the
shipment of the product in the second quarter of 1999: amortization
expense related to this expense was $240,495 through December 31, 1999.
All future development costs associated with the product will be expensed.
The following is a summary of the purchase price allocation:
Acquired technology $2,458,416
Goodwill 200,000
----------
Total $2,658,416
==========
F-17
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
On September 30, 1999, the Company purchased Konark Inc. and related
technologies for approximately $3.3 million in cash and certain
deferred payments plus professional fees and the related deferred tax
liabilities. The acquisition price, along with certain other acquisition
costs and associated deferred tax liabilities have been recorded as
acquired technology and goodwill that will be amortized over five years.
The following is a summary of the purchase price allocation and
consideration:
Purchase Price Allocation
-------------------------
Acquired technology $ 2,195,507
Other assets 695,507
Goodwill 1,036,015
-----------
$ 3,927,029
===========
Consideration
-------------
Cash $(1,120,000)
Notes payable-current (971,470)
Long-term notes payable (1,310,559)
Deferred income taxes (525,000)
-----------
$ 3,927,029
===========
14. Earnings Per Share
The Company calculates, presents and discloses EPS in accordance with SFAS
No. 128, "Earnings per Share" (EPS). The statement defines two earnings
per share calculations, basic and assuming dilution. The objective of
basic EPS is to measure the performance of an entity over the reporting
period by dividing net income available to common stock by the weighted
average shares outstanding. The objective of diluted EPS is consistent
with that of basic EPS, that is to measure the performance of an entity
over the reporting period, while giving effect to all dilutive potential
common shares that were outstanding during the period. The calculation of
diluted EPS is similar to basic EPS except both the numerator and
denominator are increased for the conversion of potential common shares.
The following table is a reconciliation of the numerator and denominator
under each method:
For the Year Ended December 31, 1997
Per Share
Income Shares Amount
Basic EPS:
Net income applicable to common shares $1,609,051 3,566,764 $0.45
Assuming dilution:
Net income applicable to common shares
Convertible preferred stock 859,555 3,043,625
Warrants -- 98,216
Stock options -- 1,637,760
---------- ---------
$2,468,606 8,346,365 $0.30
========== =========
F-18
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
For the Year Ended December 31, 1998
Per Share
Income Shares Amount
Basic EPS:
Net income applicable to common shares $ 4,794,183 9,012,019 $0.53
Assuming dilution:
Net income applicable to common shares
Stock options -- 1,875,759
Warrants -- 155,644
----------- ----------
$ 4,794,183 11,043,422 $0.43
=========== ==========
For the Year Ended December 31, 1999
Per Share
Income Shares Amount
Basic EPS:
Net income applicable to common shares $ 6,516,730 10,425,250 $0.63
Assuming dilution:
Net income applicable to common shares
Stock options -- 502,513
Warrants -- 138,965
----------- ----------
$ 6,516,730 11,066,728 $0.59
=========== ==========
F-19
DSET Corporation and Subsidiaries
December 31, 1999
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
15. Selected Quarterly Results of Operations (unaudited)
The following table presents certain condensed unaudited quarterly financial
information for each of the eight most recent quarters in the period ended
December 31, 1999. This information is derived fron unaudited financial
statements of the Company that include, in the opinion of the Company, all
adjustments (consisting only of normal recurring adjustments) necessary for a
fair presentation of results of operation of such periods.
(In $000 Except Per Share Amounts)
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
Ended Ended Ended Ended Ended Ended Ended Ended
3/31/99 6/30/99 9/30/99 12/31/99 3/31/98 6/30/98 9/30/98 12/31/98
Revenue $7,476 $9,118 $12,909 $15,126 $5,322 $6,940 $7,822 $9,206
Gross Profit 5,926 7,202 10,208 12,406 4,379 5,494 6,209 7,740
Net Income 572 653 2,135 3,156 291 1,052 1,544 1,908
Earnings Per Share
of Common Stock:
Basic 0.06 0.06 0.21 0.29 0.04 0.11 0.16 0.20
Diluted 0.05 0.06 0.19 0.27 0.03 0.09 0.13 0.17
F-20