ITEM 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Certain information contained herein may include "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All
statements, other than statements of historical facts included herein, are
forward-looking statements. Such statements are subject to certain risks and
uncertainties, which include, but are not limited to, technological advances,
dependence upon the insurance and utilities industries, Year 2000 compliance,
attraction and retention of technical employees, and fluctuations in operating
results. Should one or more of these risks or uncertainties, among others as set
forth herein, materialize, actual results may vary materially from those
estimated, anticipated, or projected. Although the Company believes that the
expectations reflected by such forward-looking statements are reasonable based
on information currently available to the Company, no assurance can be given
that such expectations will prove to have been correct. Cautionary statements
identifying important factors that could cause actual results to differ
materially from the Company's expectations are set forth herein. All
forward-looking statements included herein and all subsequent oral
forward-looking statements attributable to the Company or persons acting on its
behalf are expressly qualified in their entirety by these cautionary statements.
Overview
DocuCorp develops, markets, and supports a portfolio of print and
Internet, enterprise-wide document automation software products that enable
users to create, publish, manage, and archive complex, high-volume,
individualized documents. In addition, the Company provides document automation
consulting, application integration, training, and document outsourcing through
a 200-person service organization. Document outsourcing is performed using the
Company's software to provide processing, print, mail, archival, and Internet
delivery of documents for customers who outsource this activity.
DocuCorp was formed in connection with the acquisition of FormMaker
Software, Inc. ("FormMaker") by Image Sciences, Inc. ("Image Sciences") (the
"Merger"). The Merger was treated as an acquisition of FormMaker by Image
Sciences, and accordingly, the Merger transaction was recorded under the
purchase method of accounting. The accompanying consolidated financial
statements include the accounts of the Company and its subsidiaries.
Consolidated results of FormMaker are included from the effective date of the
Merger, May 15, 1997. Due to the lack of comparability of the results of
operations for periods prior to and subsequent to the Merger, supplemental
analysis of unaudited pro forma combined statements of operations information of
the Company has been included in the accompanying analysis.
In March 1998, the Company acquired all of the capital stock of EZPower
Systems, Inc. ("EZPower") and Maitland Software, Inc. ("Maitland"). EZPower
develops, markets, and supports document management software products. Maitland
has developed a data acquisition and transformation program which allows users
the ability to more easily interface existing applications and databases with
document printing and publishing software. Both of these acquisitions were
recorded under the purchase method of accounting, and accordingly, the results
of operations of EZPower and Maitland for all periods subsequent to the
acquisition date are included in the accompanying consolidated financial
statements.
The Company derives its revenues from license fees, recurring maintenance
fees, and professional services fees related to its software products. License
revenues are generally derived from perpetual and term licenses of software
products. Maintenance and other recurring revenues consist primarily of
recurring license fees and annual maintenance contracts. Professional services
revenues include fees for consulting, implementation, document outsourcing, and
education services.
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Results of Operations
Historical Operating Results of the Company
The following table sets forth for the periods indicated selected
consolidated statements of operations data. The supplemental unaudited pro forma
information of the Company for the year ended July 31, 1997 was prepared
assuming the acquisition of FormMaker occurred on August 1, 1996. The
supplemental information presented below, expressed in dollars and as a
percentage of total revenues for the periods indicated, has been derived from
the consolidated financial statements of the Company and the consolidated
financial statements of FormMaker. For periods prior to May 15, 1997 the
Company, Image Sciences, and FormMaker were not under common control or
management and, as a result, the selected unaudited pro forma combined financial
information is not necessarily indicative of or comparable to the operating
results that would have occurred had the Merger occurred as of or at the
beginning of the period presented or that will occur in the future.
Year ended July 31,
---------------------------------------------
1997 1997
Dollars in thousands 1999 1998 Actual Pro Forma
-------- -------- -------- ---------
Revenues
Professional services $ 27,340 $ 25,533 $ 6,151 $ 20,828
License 11,403 8,885 4,092 8,153
Maintenance and other recurring 13,183 10,829 7,260 9,435
-------- -------- -------- --------
Total revenues $ 51,926 $ 45,247 $ 17,503 $ 38,416
======== ======== ======== ========
Percentage relationship to total revenues
Revenues
Professional services 53% 56% 35% 54%
License 22 20 23 21
Maintenance and other recurring 25 24 42 25
-------- -------- -------- --------
Total revenues 100 100 100 100
-------- -------- -------- --------
Expenses
Professional services 41 42 23 43
Product development and support 18 18 28 18
Selling and marketing 16 14 13 16
General and administrative 11 14 14 14
Merger-related charges 0 0 122 0
-------- -------- -------- --------
Total expenses 86 88 200 91
-------- -------- -------- --------
Operating income (loss) 14 12 (100) 9
Other income (expense), net 1 0 1 (2)
-------- -------- -------- --------
Income (loss) before income taxes 15 12 (99) 7
Provision (benefit) for income taxes 6 5 (7) 3
-------- -------- -------- --------
Net income (loss) 9% 7% (92)% 4%
======== ======== ======== ========
29
Fiscal Year Ended July 31, 1999 Compared to Fiscal Year Ended July 31, 1998
Revenues
Total revenues increased 15% for the year ended July 31, 1999 as compared
to the corresponding prior year period. An increase in large dollar software
licenses in the insurance market were primarily responsible for the 28% increase
in license revenues. Maintenance revenues increased 22% due to an expanding
customer base. For the year ended July 31, 1999, professional services revenues
increased 7% due to increased consulting and implementation services revenues in
the insurance and utilities markets and increased document outsourcing revenues
in the utilities market, partially offset by the approximate $4.4 million
decline in document outsourcing revenues resulting from the 1998 termination of
the Policy Management Systems Corporation ("PMSC") print outsourcing agreement.
Backlog for the Company's products and services of approximately $35.3
million as of July 31, 1999, of which approximately $19.3 million is scheduled
to be satisfied within one year, is primarily composed of recurring software
license and maintenance revenues for ongoing maintenance and support, software
implementation and consulting services, and print outsourcing services. Software
agreements for recurring license fees generally have non-cancelable terms of up
to five years. Annual maintenance contracts may generally be terminated upon 30
days' notice; however, the Company has not historically experienced material
cancellations of such contracts. Software implementation and consulting services
backlog is principally performed under time and material agreements, of which
some have cancellation provisions. Print outsourcing services agreements
generally provide that fees are charged on a per transaction basis. The
estimated future revenues with respect to software implementation and print
outsourcing services are based on management's estimate of revenues over the
remaining life of the respective contracts.
FormMaker, which was acquired by the Company in connection with the
Merger, historically distributed its line of Document Automation Platform
("DAP") software products to the insurance industry in North America through an
exclusive marketing agreement with PMSC. Revenues from PMSC under this agreement
for the year ended July 31, 1998 were approximately $5.5 million. In September
1998, both parties agreed to terminate the marketing agreement and enter into a
new non-exclusive marketing agreement. The new marketing agreement between the
Company and PMSC allows PMSC to market all of the Company's software products to
insurance and financial services companies worldwide. For the year ended July
31, 1999, the Company generated revenues of approximately $3.7 million through
the PMSC relationship.
Print outsourcing revenues declined from fiscal year 1998 levels due to
the May 1998 termination of the PMSC print outsourcing agreement. The Company
received no print outsourcing revenues from PMSC in fiscal year 1999; however,
revenues from PMSC under the print outsourcing agreement for the year ended July
31, 1998 were approximately $4.4 million.
Professional services expense
Professional services expense is composed primarily of personnel expenses
related to both consulting and document outsourcing services. Professional
services expense increased 10% due to increased personnel costs as the
professional services department expanded, offset by a decrease in postage and
supplies expense related to the decrease in print outsourcing revenues for the
year. The Company's international services expansion has also increased
professional services expense for the current fiscal year. For the fiscal years
ended July 31, 1999 and 1998, professional services expense represented 77% and
75% of professional services revenues, respectively. The Company expects
professional services expense to continue to increase in order to meet
additional resource requirements as professional services activities increase
domestically and internationally.
Product development and support expense
Product development and support expense consists primarily of research and
development efforts, amortization of capitalized software development costs,
customer support, and other product support costs. For the fiscal year ended
July 31, 1999, product development and support expense
30
increased 14% compared to the corresponding prior year period. The majority of
the increase is related to additional personnel expenses for continued
development and support efforts of the Company's products, including additional
expenses arising from the acquisitions of EZPower and Maitland in March 1998.
The Company anticipates continued increases in development efforts, including
Internet applications, integration of its existing product offerings, further
development of systems for use in industries such as utilities and financial
services, development of new software products utilizing object-oriented
technology, and continued support of its existing product lines. Expenditures in
this area are expected to increase in relation to the anticipated growth in
revenues.
Selling and marketing expense
Selling and marketing expense increased 42% mainly due to additional
personnel expenses incurred as the departments expanded to meet the Company's
needs, and increased incentive compensation as a result of higher revenues. In
addition, the Company concentrated on increasing market awareness through
advertising, trade shows, and market research which increased these
expenditures.
General and administrative expense
In fiscal 1999, general and administrative expense decreased 8%. This is
primarily the result of a decrease in legal fees from fiscal 1998, which
included legal defense and settlement costs related to the resolution of two
litigation matters. The decrease in legal fees was partially offset by an
increase in goodwill amortization resulting from the EZPower and Maitland
acquisitions in March 1998, and an increase in staffing levels within the
general and administrative departments.
Other income (expense), net
The significant increase in other income (expense), net was due to a
material amount of interest income generated during the fiscal year ended July
31, 1999 as compared with interest expense incurred during the prior year. As a
result of the receipt of approximately $18.5 million of Initial Public Offering
("IPO") proceeds in April 1998, interest income increased as compared to fiscal
1998 due to higher cash, cash equivalent, and short-term investment balances
maintained by the Company. The Company repaid its debt in April 1998 with
proceeds from the IPO leaving minimal interest expense, which is related to
capital lease obligations.
Provision for income taxes
The effective tax rate for the years ended July 31, 1999 and 1998, was
approximately 43% and 41%, respectively. Goodwill amortization related to the
acquisitions of EZPower and Maitland is non-deductible, which increased the
effective tax rate for the fiscal 1999 period. The majority of goodwill
amortization related to the Merger is also non-deductible. The Company used a
portion of its net operating loss carryforwards and outstanding tax credits to
offset its current tax liability for the years ended July 31, 1999 and 1998.
Net income
Net income increased 42% for fiscal 1999. The increase in net income is
due primarily to increased higher margin license fees, increased consulting
fees, elimination of the PMSC generated print outsourcing and consulting
revenues, and increased interest income, partially offset by additional expenses
required to meet the revenue levels.
Fiscal Year Ended July 31, 1998 Compared to Fiscal Year Ended July 31, 1997
(Actual)
Revenues
The inclusion of a full year of FormMaker's results for the fiscal year
ended July 31, 1998 was primarily responsible for the 159% increase in total
revenues. Professional services revenues increased significantly, and license
revenues increased 117% due to inclusion of FormMaker's results in the fiscal
year ended July 31, 1998. Maintenance and other recurring revenues
31
increased 49% as a result of inclusion of FormMaker's maintenance revenues and
an increased customer base.
Revenues from PMSC under the exclusive marketing agreement for the year
ended July 31, 1998 and 1997 (on a pro forma basis) were approximately $5.5
million and $10.3 million, respectively. In September 1998, both parties agreed
to terminate the marketing agreement and enter into a new non-exclusive
marketing agreement. The new marketing agreement between DocuCorp and PMSC
allows PMSC to market all of the Company's software products to insurance and
financial services companies worldwide.
In May 1998, the PMSC print outsourcing agreement was terminated. Revenues
from PMSC under this agreement for the year ended July 31, 1998 and 1997 (on a
pro forma basis) were approximately $4.4 million and $5.3 million, respectively.
Professional services expense
Professional services expense is composed primarily of personnel expenses
related to both consulting and print outsourcing services. The majority of the
$15.0 million increase is due to the inclusion of FormMaker personnel and
related expenses during the entire fiscal year ended July 31, 1998. Postage and
supplies expense of approximately $4.0 million for print outsourcing services,
compared with $1.0 million in the prior year, also contributed to the increase.
For the fiscal years ended July 31, 1998 and 1997, professional services expense
represented 75% and 65% of professional services revenues, respectively. The
increase in cost as a percentage of professional services revenues is mainly due
to higher profit margins earned under a short-term print outsourcing agreement
in fiscal 1997.
Product development and support expense
Product development and support expense consists primarily of research and
development efforts, amortization of capitalized software development costs,
customer support, and other product support costs. For the fiscal year ended
July 31, 1998, product development and support expense increased 68% compared to
the corresponding prior year period, largely due to development efforts related
to the Company's DAP product line, which was acquired in the Merger.
Selling and marketing expense
Selling and marketing expense increased 165% primarily as the result of
inclusion of operations acquired in the Merger and increased commissions. Sales
commissions increased due to increased revenues and a new fiscal 1998 sales
compensation plan that was expanded to provide compensation on all revenue
types. The Company also focused on advertising, marketing, and participating in
trade shows to increase market awareness, which increased these types of
expenditures.
General and administrative expense
In fiscal 1998, general and administrative expense increased 166%. The
increased expense resulted from inclusion of operations acquired in the Merger,
goodwill amortization as a result of the Merger and recent acquisitions, and
legal defense and settlement costs related to the resolution of two outstanding
litigation matters.
Other income (expense), net
The 183% decrease in other income (expense), net was due to a decrease in
interest income and a significant increase in interest expense. Interest income
decreased due to an $8.0 million distribution to stockholders and option holders
concurrent with the Merger in May 1997.
32
Interest expense was significantly higher in fiscal 1998 due to the assumption
of debt and capitalized leases in connection with the Merger and acquisitions.
As a result of the receipt of approximately $18.5 million of IPO proceeds in
April 1998, interest income increased in the fourth quarter of fiscal 1998.
Provision for income taxes
The effective tax rate for the year ended July 31, 1998 was approximately
41%. The majority of goodwill amortization related to the Merger and recent
acquisitions is non-deductible, which increased the effective tax rate for
fiscal 1998. The tax benefit related to the net loss for the fiscal year ended
July 31, 1997 was approximately 7% due to the non-deductibility, for tax
purposes, of the in-process technology charge associated with the Merger. The
Company used a portion of its net operating loss carryforwards and outstanding
tax credits to offset its current tax liability for the fiscal year ended July
31, 1998.
Net income
Net income increased significantly due to increased revenues, inclusion of
FormMaker's results for a full year, and economies of scale achieved with the
combined companies. During fiscal year 1997, the Company incurred non-recurring
Merger-related charges of $21.4 million.
Fiscal Year Ended July 31, 1998 Compared to Fiscal Year Ended July 31, 1997 (pro
forma)
Revenues
Revenues for the fiscal year ended July 31, 1998 increased 18% compared to
pro forma total revenues for the prior year period due primarily to a 23%
increase in professional services revenues. Professional services revenues
increased due to significant increases in consulting and implementation services
to the insurance and utilities industries and increases in the print outsourcing
business during fiscal 1998. License revenues increased 9% in the fiscal year
ended July 31, 1998 due primarily to increases in license revenues to the
utilities industry. Maintenance and other recurring revenues increased 15% in
the fiscal year ended July 31, 1998 due to an expanded number of customers
utilizing the combined companies' product offerings.
Professional services expense
Professional services expense increased 15% for the fiscal year ended July
31, 1998 compared to pro forma expense for the prior year period due primarily
to increased staffing and related costs as the professional services
organizations were expanded. Professional services expense represented 75% and
79% of professional services revenues for the years ended July 31, 1998 and 1997
(on a pro forma basis), respectively. The decrease in cost as a percentage of
professional services revenues is due primarily to replacement of lower margin
third-party revenues with more profitable direct business and efficiencies
achieved from the Merger.
Product development and support expense
Product development and support expense increased 22% for the fiscal year
ended July 31, 1998 as compared to pro forma expense for the prior year period
as the Company continued to develop new technologies, including integration of
the EZPower and Maitland products with its existing product offerings, as well
as enhance and update its existing product offerings. As a percentage of total
revenues, product development and support expense was 18% for both the years
ended July 31, 1998 and 1997 (on a pro forma basis).
33
Selling, general and administrative expense
Selling, general and administrative expense increased 7% for the fiscal
year ended July 31, 1998 as compared to pro forma expense for the prior year
period. As a percentage of total revenues, these expenses decreased to 28% for
the year ended July 31, 1998 from 30% for the year ended July 31, 1997 (on a pro
forma basis) as a result of increased economies of scale from higher revenues
and the impact of combined operations. The Company attributes the aggregate
increase primarily to selling costs related to the increase in revenues, as well
as legal defense and settlement costs incurred in fiscal 1998.
Other income (expense), net
Other income (expense), net decreased 74% for the fiscal year ended July
31, 1998 compared to pro forma other income (expense), net for the prior year
period due primarily to the repayment of the Company's outstanding debt in April
1998 with the receipt of IPO proceeds. Interest income increased during the
fourth quarter of fiscal 1998 as a result of the significant cash and cash
equivalent balances.
Provision for income taxes
The effective tax rates for both the years ended July 31, 1998 and 1997
(on a pro forma basis) were approximately 41%. These rates differ from the
federal statutory rate due primarily to non-deductible goodwill amortization
related to the Merger and recent acquisitions.
Net income
Net income increased by approximately $1.5 million for the fiscal year
ended July 31, 1998 as compared to pro forma net income for the prior year
period due primarily to an 18% increase in revenues, partially offset by a 14%
increase in operating expenses.
Year 2000
The Year 2000 computer issue is primarily the result of Information
Technology ("IT") or non-IT systems and programs with date sensitive devices,
such as embedded chips or code using a two digit date format, as opposed to four
digits, to indicate the year. Such systems and programs may be unable to
correctly interpret dates beyond the year 1999, which could cause a system
failure or other errors, with the resultant disruption in the operation of such
systems. The Company has assembled an internally staffed team to address and
manage the Year 2000 project related to the Company's products and services
offerings, as well as any IT and non-IT internal systems supporting the
Company's operations.
Status of Year 2000 Readiness
The Company's analysis of the Year 2000 project consists of the following
five phases: awareness, assessment, renovation, validation, and implementation.
The awareness phase consists of defining the scope of the Year 2000 problem and
establishing a corporate infrastructure and overall strategy to perform
compliance work. The assessment phase must identify all hardware, software,
networks, other various processing platforms, and customer and vendor
interdependencies affected by the Year 2000 problem. This assessment must go
beyond information systems and include environmental systems that are dependent
on embedded microchips, such as security systems, elevators, and vaults. The
renovation phase includes code enhancements, hardware and software upgrades,
system replacements, vendor certification, and other associated changes. The
validation process includes testing incremental changes to hardware and software
components. Finally, in the implementation phase, systems should be
34
certified as Year 2000 compliant and be accepted by the business users. For
those systems, which are not compliant, the consequences will be assessed and
any contingency plans put into effect.
Internal Infrastructure
With respect to the Company's internal IT and non-IT software systems and
hardware, the Company has identified substantially all of the major computers,
software applications, and related equipment used in connection with its
internal operations that must be modified, upgraded, or replaced to minimize the
possibility of a material disruption to its business. The Company has generally
completed the process of modifying, upgrading, and replacing major IT and non-IT
software systems and hardware which have been identified as potentially being
adversely affected. To date, the Company has incurred approximately $330,000
related to Year 2000 compliance for its internal IT and non-IT computer systems.
Additionally, the Company expects to incur an additional $225,000 related to
Year 2000 compliance for its internal IT and non-IT computer systems.
Product Line and Services Offerings
With respect to the Company's product line and services offerings, current
versions of the Company's products are designed to be Year 2000 compliant. The
Company has identified all previous versions of its products which were not Year
2000 compliant and has completed the process of testing and upgrading its
product offerings. Customers using pre-Year 2000 compliant versions of the
Company's software products are entitled to receive upgraded Year 2000 compliant
software as part of their software support agreements with the Company, as long
as the customer support agreement remains in force. The Company has completed
the process of assessing the extent to which its services implementations are
Year 2000 compliant. To the extent the Company is directly involved in resolving
any non-compliant services implementations, generally the customer will be
responsible for the fees associated with such services. Accordingly, the Company
does not currently believe that the effects of any Year 2000 non-compliance in
the Company's installed base of products or services offerings will result in a
material adverse impact on the Company's business or financial condition.
However, the Company is unable to predict the impact, if any, on the Company's
revenues as a result of its customers being distracted from their document
automation needs as their attention is re-directed, or customer resources are
diverted, to becoming Year 2000 compliant. Additionally, the Company is unable
to predict the impact, if any, on the Company's revenues as a result of
customers and prospects not purchasing additional software and services for the
remainder of this calendar year due to customers not wanting to introduce any
new products into their computing environments.
Vendors
The Company has mailed questionnaires to substantially all third-party
vendors and suppliers of the major computers, software, and other equipment
used, operated, or maintained by the Company to identify and, to the extent
possible, to resolve issues involving the Year 2000 problem. Responses to these
questionnaires are verified against information included with current releases
of vendors' products and services and on vendor web sites. Although the Company
is undertaking efforts to ensure that all its systems and programs are Year 2000
compliant, the Company has no control over services, functions, and data
provided by third-party vendors and others which may result in the inability to
provide services. The extent to which third-party customers and vendors do not
become Year 2000 compliant on a timely basis or may be indirectly impacted by
the Year 2000 issue may have a material adverse effect on the Company.
35
Systems Other than IT Systems
In addition to computers and related systems, the operation of office and
facilities equipment, such as fax machines, photocopiers, telephone switches,
security systems, elevators, air conditioning, fire systems, and other common
devices may be affected by the Year 2000 problem. The Company has completed the
remediation of these systems and believes that all major leased facilities are
Year 2000 compliant.
Contingency Plans
The Company is currently developing contingency plans to be implemented if
its efforts to identify and correct Year 2000 problems affecting its internal
systems are not effective. For mission critical projects, the Company expects to
complete its contingency plans by early November 1999. Depending on the systems
affected, these plans could include accelerated replacement of affected
equipment or software; short- to medium-term use of backup sites, equipment, and
software; increased work hours for our personnel; and use of contract personnel
to correct on an accelerated schedule any Year 2000 problems that arise or to
provide manual workarounds for IT systems.
Disclaimer
The discussion of the Company's efforts relating to Year 2000 compliance
are forward-looking statements. The ability to achieve Year 2000 compliance and
the level of incremental costs associated therewith, could be adversely affected
by, among other things, the availability and cost of programming and testing
resources, third-party suppliers' ability to modify proprietary software, and
unanticipated problems identified in the ongoing compliance review.
Acquired In-Process Research and Development and Related Costs
Based on the results of an independent third-party appraisal, the Company
recorded charges of $13.5 million in the fourth quarter of fiscal 1997 to
expense in-process research and development ("in-process R&D") costs related to
the acquisition of FormMaker. The aggregate purchase price related to the
Merger, including direct acquisition costs, was approximately $20.4 million
which was allocated to the fair value of the net identifiable assets acquired,
including in-process R&D. Acquired in-process R&D represents the present value
of the estimated future cash flows expected to be generated by FormMaker
in-process R&D. The allocation of $13.5 million to in-process R&D represented
the estimated fair value based on risk-adjusted cash flows related to the
in-process R&D projects. In the opinion of management and independent
third-party appraisers, the development of these projects had not yet reached
technological feasibility and therefore, the in-process R&D had no alternative
future uses. Accordingly, these costs were charged to operations on the closing
date of the Merger.
The value assigned to purchased in-process R&D was determined by
estimating the costs to develop the purchased in-process R&D into commercially
viable products, estimating the resulting net cash flows from the projects, and
discounting the net cash flows to their present value. The revenue projection
used to value the in-process R&D was based on estimates of relevant market sizes
and growth factors, expected trends in technology, and the nature and expected
timing of new product introductions by FormMaker and its competitors.
The estimated revenues for the in-process R&D assumed a compound annual
growth rate of approximately 30% in the four years following introduction,
assuming the successful completion and market acceptance of the major R&D
programs. For each of the acquired in-process R&D efforts, the estimated
revenues for the in-process projects were expected to peak
36
within three to four years of acquisition and then decline as other new products
and technologies are expected to enter the market.
The rates utilized to discount the net cash flows to their present value
were based on cost of capital calculations. Due to the nature of the forecast
and the risks associated with the projected growth and profitability associated
with FormMaker's in-process R&D, a discount rate of 27% was used to value
in-process R&D, and a discount rate of 20% was used for the existing products
and technology. This discount rate was commensurate with the acquired in-process
R&D projects' stages of development and the uncertainties in the economic
estimates described above. As of the date of the Merger, FormMaker had spent
approximately $1.3 million on in-process R&D projects. Subsequent to the date of
the Merger, the Company expended approximately $1.0 million for the completion
of the in-process R&D projects which approximated the expected costs to complete
such projects.
Milestones for the in-process R&D projects were also examined as of the
date of the Merger. For each in-process R&D project, Company engineers evaluated
the critical milestones. This included comprehensive analysis of each of the
acquired product lines' in-process R&D to clarify the technological hurdles that
the development team had overcome at the date of the Merger as well as the
hurdles that the engineers faced going forward to complete the remaining
development efforts. From this analysis, the overall significance of tasks
completed versus tasks remaining were assessed. For all categories, a greater
level of significance was associated with completed tasks. This implied that a
greater degree of overall value was attributable to the completed tasks relative
to those indicated by the cost metrics. Based on estimates made by FormMaker's
R&D professionals regarding technical achievements completed as of the date of
the Merger, the milestone percentage was determined to be approximately 75%.
Utilizing this milestone analysis for the in-process R&D valuation resulted in
values for incomplete R&D projects which approximated the $13.5 million
appraisal value.
At the time of the Merger, FormMaker offered a basic portfolio of document
automation processing and imaging software products. FormMaker's product lines
and related services stemmed from its DAP and Multi-user Archival & Retrieval
System ("MARS") technologies.
The acquired in-process R&D value was comprised of several ongoing
projects intended to address the issues of technological advances in the
marketplace such as new client/server architecture, new delivery mechanisms, the
Internet, emergence of the Windows NT operating system, object integration on
the desktop, and new standards such as Microsoft's Active-X, Microsoft's ODBC,
and Sun Microsystems' Java, which were making the development and implementation
of new products increasingly complex. These advances in technology required
creating highly advanced products that could handle substantial increases in
demand, as well as end user requirements for more complex graphics-intensive
material. This led to development efforts which centered around new DAP and MARS
technologies and incorporated innovative new features and a wide array of
advanced functions. FormMaker was addressing industry and technological trends
by developing new delivery mechanisms via the Internet, object integration on
the desktop, new DAP architecture, platform independence, improved workflow
functionality, product compatibility, DAP and MARS integration, and the
development of migration and upgrade paths.
At the Merger date, there were still significant efforts needed to bring
the acquired in-process technologies and projects to fruition. These efforts
principally related to the completion of planning, designing, architecturing,
coding, prototyping, scalability, verification, and testing activities that were
necessary to establish that the proposed technologies would meet their design
specifications. These projects had not yet reached technological feasibility at
the time of the
37
Merger. Management expected to continue to support these efforts and believed
FormMaker had a reasonable chance of successfully completing the R&D programs.
However, there was risk associated with the completion of the projects and there
was no assurance that any would reach either technological or commercial
success. If these projects were not successfully developed, the sales and
profitability of the combined company could have been adversely affected in
future periods.
Subsequent to the Merger, the majority of the original R&D projects were
completed in accordance with FormMaker's plans. The fruition of these projects
resulted in advanced new product technologies represented by the launch of the
Internet Document Server ("IDS") versions 1.0 and 1.3, Bill Print version 1.0
and 1.1, and which fueled the release of two new DAP products.
The emergence of the IDS products represented the completion of a key
revolutionary technology. This new rules-based transaction processing server,
released in October 1997, allows for the dynamic generation of documents in
industry-standard Adobe PDF format for Web delivery and the ability to archive
documents in a pure "thin-client" fashion. The second phase of ongoing projects
aimed at addressing new Internet functionalities pushed forward the release of
IDS version 1.3 in December 1998, which further addressed new delivery
mechanisms and standards such as Microsoft's Active-X, Microsoft's ODBC, and Sun
Microsystem's Java and represents the completion of the in-process R&D acquired
in the Merger. The Company began recognizing revenue related to IDS products
during fiscal year 1998.
FormMaker's pre-acquisition efforts in developing new printing
technologies have resulted in the release of Bill Print versions 1.0 and 1.1 in
October 1997 and March 1998, respectively, which address the high-volume complex
bill and statement printing needs of the utilities industry.
FormMaker's investments in developing innovative features, new workflow
capabilities, object-oriented desktop integration, multiple language system
communications, improved graphics capabilities and platform and hardware
adaptability proved fruitful in yielding new DAP releases in September 1997 that
could adequately address international markets and open new industries, such as
utilities and financial services.
The release of Bill Print versions 1.0 and 1.1 and the new DAP releases
have contributed to a significant increase in revenues derived from the
utilities market. Revenues in this market increased in excess of 160% in the
fiscal year ended July 31, 1998, as compared to the previous fiscal year, and
greater than 29% for the fiscal year ended July 31, 1999, as compared to the
corresponding prior year period. In addition, these releases of in-process R&D
have resulted in recent licenses to the financial services industry.
Most of the in-process R&D projects acquired in the Merger have been
completed on schedule, but minor delays have occurred due to changes in
technological and market requirements for document automation processing and
imaging systems. Although all in-process R&D projects have been completed, no
assurance can be made that the Company's recent releases will be met with market
acceptance.
As discussed in Note 5 of the notes to consolidated financial statements,
the Company has responded to inquiries by the Securities and Exchange Commission
("SEC") regarding the value ascribed to the technology acquired as in-process
R&D in connection with the Merger. To date, the Company has not received further
inquiries from the SEC. However, depending upon the outcome of any future
discussions with the SEC, the Company's historical reported results could
potentially be subject to restatement to reflect a reduction of the in-process
R&D charge.
38
A reduction of the in-process R&D charge would result in a corresponding
increase in the amount of goodwill, which is being amortized over a ten year
period.
Liquidity and Capital Resources
At July 31, 1999, the Company's principal sources of liquidity consisted
of cash and cash equivalents of approximately $6.5 million and short-term
investments of approximately $6.9 million. The Company completed an IPO in the
form of a rights offering to Safeguard Scientifics, Inc. stockholders in April
1998. Net proceeds to the Company from this offering, after deduction of the
underwriting discount and IPO expenses, were approximately $18.5 million.
Cash and cash equivalents for the year ended July 31, 1999 decreased
approximately $8.0 million primarily as a result of investing approximately $6.9
million in short-term investments and repurchasing approximately $7.1 million of
the Company's stock on the open market. The decrease was substantially offset by
cash generated from operations. Cash flows used in investing activities of
approximately $10.4 million was primarily related to the purchase of short-term
investments, development of capitalized software, and purchase of fixed assets.
As of July 31, 1999, the Company had approximately 1,170,000 shares of treasury
stock outstanding at an average per share cost of $4.73.
Working capital was approximately $15.5 million at July 31, 1999, compared
with approximately $16.0 million at July 31, 1998.
In connection with the Merger, the Company assumed a $10.0 million
revolving credit facility from FormMaker. This credit facility was renegotiated
in September 1997. In September 1998, the Company allowed $6.5 million of the
credit facility to expire under its normal terms. The remaining $3.5 million
bears interest at the bank's prime rate less 0.25%, or 7.75% as of July 31,
1999, and was renewed and extended to March 2000. Under the credit facility, the
Company is required to maintain certain financial covenants. As of July 31, 1999
there were no borrowings under this credit facility.
The Company's liquidity needs are expected to arise primarily from funding
the continued development, enhancement, and support of its software offerings,
selling and marketing costs associated principally with continued entry into new
vertical and international markets, and repurchase of treasury stock under the
Company's stock repurchase program. Although the Company has no current
commitments or agreements with respect to any acquisition of other businesses or
technologies, a portion of the Company's cash could be used to acquire
complementary businesses or obtain the right to use complementary technologies.
The Company currently anticipates that existing cash, short-term
investment balances, its existing credit facility, and cash generated from
operations will be sufficient to satisfy its operating cash needs for the
foreseeable future.
39
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- --------------------------------------------------------------------------------
Report of Independent Accountants
To the Board of Directors and Stockholders
of DOCUCORP INTERNATIONAL, INC.
In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of cash flows and of changes in
stockholders' equity present fairly, in all material respects, the financial
position of DocuCorp International, Inc. and its subsidiaries at July 31, 1999
and 1998, and the results of their operations and their cash flows for each of
the three years in the period ended July 31, 1999 in conformity with generally
accepted accounting principles. These 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 generally accepted auditing
standards, which require that we plan and perform the audit 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.
PricewaterhouseCoopers LLP
Dallas, Texas
September 9, 1999
40
DocuCorp International, Inc.
Consolidated Balance Sheets
July 31, 1999 and 1998
(in thousands except share and per share amounts)
- --------------------------------------------------------------------------------
1999 1998
-------- --------
Assets
Current assets
Cash and cash equivalents $ 6,459 $ 14,440
Short-term investments 6,914 0
Accounts receivable, net of allowance
of $675 and $950, respectively 14,436 11,926
Current portion of deferred taxes 469 469
Income tax refund receivable 729 706
Other current assets 1,806 1,245
-------- --------
Total current assets 30,813 28,786
Fixed assets, net of accumulated depreciation
of $4,584 and $3,258, respectively 3,570 2,980
Software, net of accumulated amortization
of $9,045 and $7,047, respectively 7,728 8,136
Deferred taxes 388 671
Goodwill, net of accumulated amortization
of $2,479 and $1,127, respectively 9,693 11,022
Other assets 726 326
-------- --------
$ 52,918 $ 51,921
======== ========
Liabilities and stockholders' equity
Current liabilities
Accounts payable $ 1,692 $ 1,750
Accrued liabilities
Accrued compensation 2,893 1,207
Other 1,262 1,141
Income taxes payable 364 224
Deferred revenue 9,089 8,476
-------- --------
Total current liabilities 15,300 12,798
Other long-term liabilities 624 690
Stockholders' equity:
Common stock, 50,000,000 shares authorized, $.01 par value,
16,593,849 and 16,525,561 shares issued, respectively 166 165
Additional paid-in capital 47,976 47,562
Treasury stock, 1,170,275 shares at cost (5,539) 0
Retained deficit (5,547) (9,229)
Notes receivable from stockholders (62) (65)
-------- --------
Total stockholders' equity 36,994 38,433
-------- --------
$ 52,918 $ 51,921
======== ========
41
See accompanying notes to consolidated financial statements.
DocuCorp International, Inc.
Consolidated Statements of Operations
For the Years Ended July 31, 1999, 1998, and 1997
(in thousands except per share amounts)
- --------------------------------------------------------------------------------
1999 1998 1997
-------- -------- --------
Revenues
Professional services $ 27,340 $ 25,533 $ 6,151
License 11,403 8,885 4,092
Maintenance and other recurring 13,183 10,829 7,260
-------- -------- --------
Total revenues 51,926 45,247 17,503
-------- -------- --------
Expenses
Professional services 20,958 19,032 4,000
Product development and support 9,492 8,318 4,956
Selling and marketing 8,437 5,955 2,246
General and administrative 5,808 6,341 2,383
Merger-related charges 0 0 21,378
-------- -------- --------
Total expenses 44,695 39,646 34,963
-------- -------- --------
Operating income (loss) 7,231 5,601 (17,460)
Other income (expense), net 622 (177) 214
-------- -------- --------
Income (loss) before income taxes 7,853 5,424 (17,246)
Provision (benefit) for income taxes 3,340 2,240 (1,144)
-------- -------- --------
Net income (loss) $ 4,513 $ 3,184 $(16,102)
======== ======== ========
Net income (loss) per share:
Basic $ .28 $ .25 $ (2.18)
======== ======== ========
Diluted $ .26 $ .21 $ (2.18)
======== ======== ========
Weighted average shares outstanding used in
the net income (loss) per share calculation:
Basic 16,001 12,587 7,377
======== ======== ========
Diluted 17,570 14,865 7,377
======== ======== ========
42
See accompanying notes to consolidated financial statements.
DocuCorp International, Inc.
Consolidated Statements of Cash Flows
For the Years Ended July 31, 1999, 1998, and 1997
(in thousands)
- --------------------------------------------------------------------------------
1999 1998 1997
-------- -------- --------
Cash flows from operating activities
Net income (loss) $ 4,513 $ 3,184 $(16,102)
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Charge for acquired in-process technology 0 0 13,500
Stock option compensation expense 12 20 7,698
Depreciation 1,326 1,274 574
Amortization of capitalized software 1,998 1,787 931
Amortization of goodwill 1,352 966 160
Tax benefit from utilization of net operating loss 0 350 0
Increase (decrease) in allowance for doubtful
accounts (275) 404 (63)
Changes in assets and liabilities, net of effects
from acquisitions:
Increase in accounts receivable (2,235) (3,234) (76)
Increase in income tax refund receivable (23) (202) (504)
(Increase) decrease in deferred tax assets 283 2 (1,011)
Increase in other assets (961) (45) (23)
Increase (decrease) in accounts payable (81) 508 (175)
Increase (decrease) in accrued liabilities 1,803 (615) 432
Increase (decrease) in income taxes payable 140 (188) (243)
Increase in deferred revenue 613 1,667 1,326
Decrease in deferred tax liabilities 0 0 (383)
-------- -------- --------
Total adjustments 3,952 2,694 22,143
-------- -------- --------
Net cash provided by operating activities 8,465 5,878 6,041
-------- -------- --------
Cash flows from investing activities
(Purchase) sale of short-term investments, net (6,914) 0 5,309
Purchase of fixed assets (1,916) (995) (547)
Capitalized software development costs (1,590) (1,515) (997)
Net cash acquired in business combinations 0 31 1,714
-------- -------- --------
Net cash provided by (used in)
investing activities (10,420) (2,479) 5,479
-------- -------- --------
Cash flows from financing activities
Repayment of debt 0 (11,877) (2,448)
Principal payments under capital lease obligations (62) (401) (148)
Purchase of treasury stock (7,076) 0 0
Purchase of tendered stock and options 0 0 (5,192)
Preferred stock dividend 0 0 (2,808)
Proceeds from exercise of warrants and options 569 1,056 16
Proceeds from sale of warrants 0 0 6
Tax benefit related to stock option exercises 192 531 14
Net proceeds from issuance of stock 0 18,589 0
Proceeds from repayment of note receivable from stockholder 3 6 0
Proceeds from stock issued to employees under Employee
Stock Purchase Plan 348 268 0
-------- -------- --------
Net cash provided by (used in)
financing activities (6,026) 8,172 (10,560)
-------- -------- --------
Net increase (decrease) in cash and cash equivalents (7,981) 11,571 960
Cash and cash equivalents at beginning of year 14,440 2,869 1,909
======== ======== ========
Cash and cash equivalents at end of year $ 6,459 $ 14,440 $ 2,869
======== ======== ========
See non-cash activities disclosed in Notes 4 and 10.
43
See accompanying notes to consolidated financial statements.
DocuCorp International, Inc.
Consolidated Statements of Changes in Stockholders' Equity
For the Years Ended July 31, 1999, 1998 and 1997
(in thousands except share amounts)
- --------------------------------------------------------------------------------
Additional Retained
Preferred Common Paid-in Treasury Earnings Notes
Stock Stock Capital Stock (Deficit) Receivable Total
--------- -------- --------- --------- -------- ---------- -------
Balance at July 31, 1996 $ 202 $ 40 $ 1,298 $ 0 $ 6,497 $ 0 $ 8,037
Exercise of stock options to purchase
34,339 and 520 shares of Common
Stock and Class B common stock,
respectively 1 14 15
Payment of preferred stock dividend (2,808) (2,808)
Purchase of 865,513 shares of tendered
Common Stock (9) (2,488) (2,497)
Conversion of Image Sciences common
stock and preferred stock to 5,622,709
shares of Class B common stock (202) (32) (18,883) (19,117)
Conversion of FormMaker common stock to
5,114,789 shares of Common Stock 51 19,949 20,000
Assumption of notes receivable from
stockholders (71) (71)
Sale of warrants to purchase Common Stock 6 6
Compensation expense related to
non-qualified stock options 5,002 5,002
Tax benefit from stock option exercises 15 15
Net loss (16,102) (16,102)
--------- -------- --------- --------- -------- -------- -------
Balance at July 31, 1997 0 51 4,913 0 (12,413) (71) (7,520)
Exercise of stock options to purchase
885,993 shares of Common Stock 9 1,047 1,056
Conversion of 5,623,229 shares of Class B
common stock to Common Stock 56 19,063 19,119
Issuance of 4,000,000 shares of Common
Stock in initial public offering 40 18,549 18,589
Repayment of note receivable from
stockholder 6 6
Stock issued for acquisitions 8 3,172 3,180
Issuance of 62,982 shares of Common
Stock to employees under ESPP 1 267 268
Compensation expense related to
non-qualified stock options 20 20
Tax benefit from stock option exercises 531 531
Net income 3,184 3,184
--------- -------- --------- --------- -------- -------- -------
Balance at July 31, 1998 0 165 47,562 0 (9,229) (65) 38,433
Exercise of stock options to purchase
338,571 shares of Common Stock 1 210 1,132 (774) 569
Purchase of 1,522,526 shares of Treasury
Stock (7,076) (7,076)
Repayment of note receivable from
stockholder 3 3
Issuance of 81,968 shares of Common
Stock to employees under ESPP 405 (57) 348
Compensation expense related to
non-qualified stock options 12 12
Tax benefit from stock option exercises 192 192
Net income 4,513 4,513
--------- -------- --------- --------- -------- -------- -------
Balance at July 31, 1999 $ 0 $ 166 $ 47,976 $ (5,539) $ (5,547) $ (62) $36,994
========= ======== ========= ========= ======== ======== =======
44
See accompanying notes to consolidated financial statements.
Note 1 - Organization and Summary of Significant Accounting Policies
DocuCorp International, Inc. ("DocuCorp" or the "Company"), a Delaware
corporation, was organized on January 13, 1997 in connection with the
acquisition of FormMaker Software, Inc. ("FormMaker") by Image Sciences, Inc.
("Image Sciences") (the "Merger"). The accompanying consolidated financial
statements include the accounts of the Company and its wholly owned
subsidiaries, Image Sciences, FormMaker, EZPower Systems, Inc. ("EZPower"), and
Maitland Software, Inc. ("Maitland"). Results of FormMaker are included from the
effective date of the Merger, May 15, 1997. Results of EZPower and Maitland are
included from the effective date of the acquisitions, March 31, 1998. All
significant intercompany accounts and transactions have been eliminated in
consolidation.
The Company's business includes developing, marketing, and supporting computer
software designed to automate the process of storing, managing, and distributing
business documents. The Company also provides professional services and
outsourcing of document processing, printing, and Internet document services.
The majority of the Company's business is currently derived from companies in
the insurance industry.
Revenue recognition
Revenue from licensing of standard software is recognized upon shipment of the
software. Revenue from software licenses which include a cancellation clause is
recognized upon expiration of the cancellation period. Revenue derived from the
development and installation of software packages under long-term contracts is
recognized on a percentage-of-completion basis measured by the relationship of
hours worked to total estimated contract hours. Revenue related to products
still in the testing phase is deferred until formal acceptance of the product by
the purchaser. Anticipated losses, if any, on uncompleted contracts are
recognized in the period in which such losses are determined.
Revenue from maintenance contracts, and maintenance revenue that is packaged
with license fees, is recognized ratably over the term of the agreements. The
Company records deferred revenue for maintenance amounts invoiced prior to
revenue recognition. Revenue related to outsourcing and professional services,
such as training and consulting, is recognized as the services are performed.
Cash equivalents
The Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents. Cash equivalents are
stated at cost, which approximates fair market value.
Short-term investments
The Company has the intent and ability to hold short-term investments to
maturity; consequently, such investments are carried at cost, which approximates
fair market value. At July 31, 1999, the Company held short-term investments
which totaled approximately $6.9 million. Interest income from such investments
was approximately $244,000, $0, and $173,000 in 1999, 1998, and 1997,
respectively.
Accounts receivable
Included in accounts receivable at July 31, 1999 and 1998 are unbilled amounts
of approximately $2.5 million and $1.4 million, respectively. Such amounts have
been recognized as revenue under the percentage-of-completion method or upon
execution of the contract and shipment of the software, but prior to contractual
payment terms.
45
Fixed assets, depreciation, and amortization
Property and equipment are carried at cost, less accumulated depreciation and
amortization. Depreciation and amortization are computed over the estimated
service lives using the straight-line method.
Amortization of assets recorded under capital leases is included in depreciation
expense. Estimated service lives are as follows:
Computer equipment 4-5 years
Furniture and fixtures 5 years
Leasehold improvements life of lease
Leased equipment under capital leases 3-5 years
Repairs and maintenance are expensed as incurred. Major renewals and betterments
are capitalized and depreciated over the assets' remaining estimated service
life. Upon retirement or sale of an asset, the cost and accumulated depreciation
are removed from the accounts with any resulting gain or loss included in
income.
Software
Costs of internally developed software are capitalized after the technological
feasibility of the software has been established. Research and development costs
incurred prior to the establishment of the technological feasibility of a
product are expensed as incurred. The cost of capitalized software is amortized
on a straight-line basis over its estimated useful life, generally four to six
years, or the ratio of current revenues to current and anticipated revenues from
the software, whichever provides the greater amortization. During 1999, 1998,
and 1997, the Company charged to expense approximately $5.9 million, $5.2
million, and $2.2 million, respectively, for research and development costs
incurred prior to the establishment of the technological feasibility of
products. Such expense is included in product development and support on the
Consolidated Statements of Operations.
Goodwill
Goodwill is amortized on a straight-line basis over eight to ten years. The
carrying value of goodwill is evaluated periodically in relation to the
operating performance and anticipated future undiscounted net cash flows of the
related business. In the event that assets are found to be carried at amounts
which are in excess of estimated gross future cash flows, the intangible assets
are adjusted for impairment to a level commensurate with a discounted cash flow
analysis of the underlying assets.
Impairment of long-lived assets
The Company has adopted Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-lived Assets and Assets to be Disposed
of." Under the provisions of this statement, the Company has evaluated its
long-lived assets for financial impairment, and will continue to do so as events
or changes in circumstances indicate that the carrying value of such assets may
not be fully recoverable.
Income taxes
Income taxes are presented pursuant to Statement of Financial Accounting
Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 uses an
asset and liability approach to account for income taxes. In the event
differences between the financial reporting basis and the tax basis of the
Company's assets and liabilities result in deferred tax assets, an evaluation of
the probability of being able to realize the future benefits indicated by such
assets is required. A valuation allowance is provided for the deferred tax
assets when there is sufficient uncertainty regarding the Company's ability to
recognize the benefits of these assets in future years.
46
Net income (loss) per share
The Company's basic and diluted net income (loss) per share are computed in
accordance with Statement of Financial Accounting Standards No. 128, "Earnings
Per Share" ("SFAS 128"). Concurrent with the completion of the Company's Initial
Public Offering ("IPO"), all outstanding shares of Class B common stock were
converted into shares of Common Stock on a one-for-one basis. Both basic and
diluted net income (loss) per share have been computed assuming the conversion
of Class B common stock occurred as of the date of original issuance. Basic net
income (loss) per share is computed using the weighted average number of common
shares outstanding. Diluted net income (loss) per share is computed using the
weighted average number of common shares outstanding and the assumed exercise of
stock options and warrants (using the treasury stock method). Following is a
reconciliation of the shares used in computing basic and diluted net income
(loss) per share for the fiscal years indicated (in thousands):
1999 1998 1997
------ ------ ------
Shares used in computing basic net
income (loss) per share 16,001 12,587 7,377
Dilutive effect of stock options and warrants 1,569 2,278 0
------ ------ ------
Shares used in computing diluted net income
(loss) per share 17,570 14,865 7,377
====== ====== ======
At July 31, 1999, outstanding options to purchase approximately 246,000 shares
of Common Stock at an average price of $5.44 per share were anti-dilutive and
are not included in the computation of diluted net income per share, because the
options' exercise price was greater than the average market price of the Common
Stock for the period.
Stock-based compensation
During fiscal 1997, the Company adopted the disclosure provisions of Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"). In accordance with the provisions of SFAS 123, the
Company applies Accounting Principles Board Opinion No. 25 and related
interpretations in accounting for its employee stock option plans. Note 9
contains a summary of the pro forma effects on reported net income (loss) and
net income (loss) per share for fiscal 1999, 1998, and 1997 based on the fair
value of options and shares as prescribed by SFAS 123.
Management estimates
The preparation of the Company's financial statements, in accordance 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 July 31, 1999 and 1998, and
the reported amounts of revenues and expenses for the periods then ended. Actual
results could differ from those estimates.
Advertising costs
The Company's policy for advertising costs is to expense such costs as incurred.
Advertising expenses for 1999, 1998, and 1997 were approximately $995,000,
$324,000, and $59,000, respectively.
Recently issued accounting pronouncements
In June 1997, Statement of Financial Accounting Standards No. 130, "Reporting
Comprehensive Income" ("SFAS 130") and No. 131, "Disclosures about Segments of
an Enterprise and Related Information" ("SFAS 131"), were issued. SFAS 130
establishes standards for reporting comprehensive income and its components with
the same prominence as other financial statements. The Company adopted SFAS 130
on August 1, 1998; however, the Company does not have any material items of
other comprehensive income in the periods presented. SFAS 131
47
establishes standards for reporting information about operating segments in
annual and interim financial statements, although this statement need not be
applied to interim financial statements in the initial year of its application.
The Company adopted the disclosure requirements of SFAS 131 for the fiscal year
ended July 31, 1999 and has determined it has a single reportable segment.
Effective August 1, 1998, the Company adopted Statement of Position No. 97-2,
"Software Revenue Recognition" ("SOP 97-2") issued by the Accounting Standards
Executive Committee of the American Institute of Certified Public Accountants,
which supersedes Statement of Position No. 91-1 "Software Revenue Recognition."
The adoption of SOP 97-2 did not have a material effect on the Company's
financial position or results of operations during the year ended July 31, 1999.
Also, effective December 15, 1998, the Accounting Standards Executive Committee
issued Statement of Position No. 98-9, "Modification of SOP 97-2, Software
Revenue Recognition, With Respect to Certain Transactions" ("SOP 98-9") which
amends Statement of Position 98-4, "Deferral of the Effective Date of A
Provision of SOP 97-2." Provisions of SOP 98-9 are effective for transactions
entered into during fiscal years beginning after March 15, 1999. Accordingly,
the Company will adopt SOP 98-9 for the year ending July 31, 2000 and the
Company does not believe the adoption of SOP 98-9 will have a material effect on
the Company's financial position or results of operations.
In March 1998, the Accounting Standards Executive Committee issued Statement of
Position No. 98-1, "Accounting for Costs of Computer Software Developed or
Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 provides guidance on
accounting for the costs of computer software developed or obtained for internal
use. This pronouncement identifies the characteristics of internal use software
and provides guidance on new cost recognition principles. SOP 98-1 is effective
for financial statements for fiscal years beginning after December 15, 1998.
Accordingly, the Company will adopt SOP 98-1 for the year ending July 31, 2000.
The Company does not believe the adoption of SOP 98-1 will have a material
effect on the Company's financial position or results of operations.
Note 2 - Fixed assets
Fixed asset balances at July 31, 1999 and 1998 are as follows (in thousands):
1999 1998
------- -------
Computer equipment $ 6,409 $ 4,767
Furniture and fixtures 1,439 1,258
Leasehold improvements 306 213
------- -------
8,154 6,238
Less accumulated depreciation (4,584) (3,258)
------- -------
$ 3,570 $ 2,980
======= =======
Note 3 - Initial Public Offering
The Company completed an IPO in the form of a rights offering to Safeguard
Scientifics, Inc. ("Safeguard") stockholders in April 1998. The Company's
Registration Statement on Form S-1 (File No. 333-44427) with respect to the IPO
was declared effective on February 24, 1998. The Company's Common Stock began
trading on the Nasdaq National Market under the symbol DOCC on April 6, 1998.
The Company sold 4,000,000 shares of Common Stock at a per share price of $5.00.
Net proceeds to the Company, after deduction of the underwriting discount and
IPO expenses, were approximately $18.5 million. Selling stockholders sold
3,460,000 shares at a per share price of $5.00. The Company did not receive any
proceeds from the sale of shares by the selling stockholders. Concurrent with
the completion of the IPO, the Company used approximately $6.4 million of the
net proceeds to repay (i) approximately $3.0 million due under the Company's
line of credit with NationsBank, N.A., (ii) approximately $3.1 million due
pursuant to three subordinated notes to Safeguard, Technology Leaders II, and TL
Ventures Third Corp. which were due in full at the earlier of the closing of a
public offering yielding net proceeds to the
48
Company in excess of $13.0 million or May 15, 2000, and (iii) approximately
$336,000 due to Safeguard pursuant to two notes assumed by the Company in
connection with the Merger.
Note 4 - Acquisitions
On March 31, 1998, the Company completed the acquisitions of EZPower and
Maitland. EZPower develops, markets, and supports flexible Internet and
client/server solutions for document management, workflow, and web content
management. The Company acquired all of the outstanding capital stock of EZPower
in exchange for 650,000 shares of the Company's Common Stock, repayment of
approximately $2.5 million of EZPower's indebtedness, and potential payment of
certain contingent cash consideration based on future performance. Maitland has
developed a data acquisition and transformation program which allows users the
ability to more easily interface existing applications and databases with
document printing and publishing software. The Company issued 170,000 shares of
its Common Stock as consideration for the Maitland acquisition. The Company has
the right to repurchase up to 100,000 of those shares based upon cumulative
licensing and maintenance of the Maitland software product through the period
ending July 31, 2001. In August 1999, the Company waived its repurchase rights.
Accordingly, additional goodwill was recorded and is being amortized over the
remaining amortization period. Both acquisitions were recorded under the
purchase method of accounting, and accordingly, the results of operations of
EZPower and Maitland for all periods subsequent to the acquisition date are
included in the consolidated financial statements. The aggregate purchase
prices, including direct acquisition costs, were approximately $5.9 million and
$605,000 which have been allocated to the fair value of net identifiable assets
in the acquisitions of EZPower and Maitland, respectively. The excess of the
purchase price over the fair value of the net identifiable assets acquired of
approximately $4.8 million and $583,000 related to the acquisitions of EZPower
and Maitland, respectively, has been recorded as goodwill and is being amortized
on a straight-line basis over eight years.
Note 5 - Acquired In-Process Research and Development
In connection with a review conducted by the Securities and Exchange Commission
("SEC") related to the Company's filing of its Annual Report on Form 10-K for
the year ended July 31, 1998, the Company has responded to the SEC regarding
inquiries related to the value ascribed to the technology acquired as in-process
research and development ("in-process R&D") in the May 1997 Merger. In
connection with the Merger, the Company recorded in-process R&D charges in the
amount of $13.5 million in the fourth quarter of fiscal 1997. The Company
understands that the SEC is engaged in similar discussions with other companies,
and is examining the basis for valuing in-process R&D charges versus the SEC's
recent guidance on the preferred calculation of these charges. The Company has
consulted with its independent accountants and independent appraisers and
believes that the purchase price allocations and related amortization charges
stemming from the acquisition were determined in accordance with generally
accepted accounting principles.
Depending upon the outcome of any future discussions with the SEC, the Company's
historical reported results could potentially be subject to restatement to
reflect a reduction of the in-process R&D charge. A reduction of the in-process
R&D charge would result in a corresponding increase in the amount of goodwill,
which is being amortized over a ten year period.
Note 6 - Lease Commitments
The Company leases computer and office equipment under noncancelable leases
which are classified as capital leases and included in fixed assets at July 31,
1999 and 1998 as follows (in thousands):
49
1999 1998
----- -----
Computer equipment $ 498 $ 498
Office equipment 326 326
----- -----
824 824
Less accumulated depreciation (426) (323)
----- -----
$ 398 $ 501
===== =====
Certain other equipment leases and the Company's obligation under leases for
office space are treated as operating leases and the rentals are expensed as
incurred. Rent expense on these operating leases for the years ended July 31,
1999, 1998, and 1997 totaled approximately $2.9 million, $2.6 million, and
$926,000, respectively. Generally, the Company's leases provide for renewals for
various periods at stipulated rates.
Future minimum lease obligations on leases in effect at July 31, 1999 are as
follows (in thousands):
Capital Operating
Leases Leases
------ ------
2000 $ 26 $2,403
2001 0 2,396
2002 0 2,327
2003 0 1,220
2004 0 488
Thereafter 0 366
------ ------
Minimum lease payments 26 $9,200
======
Less amount representing interest (1)
------
Present value of minimum lease payments 25
Less current portion (25)
------
Obligations under capital leases $ 0
======
The future minimum lease obligations for operating leases assumes that the
Company does not exercise its option to terminate its office lease for its
corporate headquarters in 2000. If the office lease is terminated in 2000, a
penalty is due at that time and no further obligations would exist after the
year ended July 31, 2000 under this office lease.
Note 7 - Long-Term Debt
At July 31, 1999 and 1998, the Company did not have any long-term debt
outstanding. All long-term debt of the Company was repaid in full with proceeds
from the IPO.
In connection with the Merger, the Company assumed a $10.0 million revolving
credit facility from FormMaker. This credit facility was renegotiated in
September 1997. In September 1998, the Company allowed $6.5 million of the
credit facility to expire under its normal terms. The remaining $3.5 million
bears interest at the bank's prime rate less 0.25%, or 7.75% as of July 31,
1999, and was renewed and extended to March 2000. Under the credit facility, the
Company is required to maintain certain financial covenants. As of July 31, 1999
there were no borrowings under this credit facility.
Note 8 - Redeemable Class B Common Stock
If the Company did not consummate by January 31, 1998 an underwritten public
offering of securities in which the managing underwriter valued the equity of
the Company at $62.1 million or
50
more, holders of Class B common stock of the Company had the option to redeem
such shares. This redemption option was exercisable from February 1, 1998
through February 1, 1999 at $3.40 per share; however, no shares of Class B
common stock were presented for redemption. Upon consummation of the IPO in
April 1998, each issued and outstanding share of the Company's Class B common
stock automatically converted into Company Common Stock on a one-for-one basis.
Note 9 - Stockholders' Equity
Preferred stock
During fiscal year 1997, the Company authorized 1,000,000 shares of preferred
stock which the board of directors of the Company may issue with such
preferences and rights as it may designate. As of July 31, 1999 and 1998, there
were no issued or outstanding shares of preferred stock.
Employee Stock Purchase Plan
During the year ended July 31, 1998, the Company adopted an employee stock
purchase plan which allows eligible employees to purchase Company Common Stock
at a 15% discount of market value. An aggregate of 600,000 shares of Common
Stock have been reserved for issuance upon purchases pursuant to the stock
purchase plan. At July 31, 1999 and 1998, the Company has issued approximately
145,000 and 63,000 shares under the plan, respectively.
Stock options
The Company provides equity incentives to employees and directors by means of
incentive stock options and non-qualified stock options which historically have
been provided under various stock option plans. The Company now issues options
from the 1997 Equity Compensation Plan. Stock options generally vest over a
period of three to five years. The Company may grant non-qualified stock options
at an option price per share determined by the board of directors. Under this
plan, the Company has reserved 980,000 shares for issuance as of July 31, 1999.
Options generally expire ten years from the date of grant. Activity under all
plans is summarized as follows (in thousands except per share amounts):
Shares Under
Outstanding Options
---------------------------------
Weighted
Outstanding Average
Options Exercise Price
--------- --------------
Balances at July 31, 1997 2,970 $ 1.40
Granted 767 3.72
Exercised (886) 1.19
Expired (287) 3.34
------ ------
Balances at July 31, 1998 2,564 $ 1.91
Granted 557 4.60
Exercised (340) 1.67
Expired (69) 3.38
------ ------
Balances at July 31, 1999 2,712 $ 1.96
====== ======
Of the outstanding options at July 31, 1999, the weighted average remaining
contractual life is 6.66 years. Options to purchase approximately 1,821,000
shares of Common Stock at a weighted average exercise price of $1.74 are vested
at July 31, 1999.
Stock-based compensation
51
Pursuant to SFAS 123, the Company is required to report pro forma information
regarding net income (loss) and net income (loss) per share for awards granted
or modified in fiscal years 1996 and thereafter as if the Company had accounted
for its stock-based awards to employees under the fair value method of SFAS 123.
The weighted average fair value of options granted during fiscal 1999, 1998, and
1997 was $1.84, $0.59, and $3.40 per option, respectively. The fair value of the
Company's stock-based awards to employees was estimated using the Black-Scholes
option pricing model with the following weighted average assumptions used for
grants in 1999, 1998 and 1997, respectively: risk-free interest rates of 4.96%,
5.76%, and 5.75%; no expected dividend yields; and expected lives of 3.50, 3.00,
and 1.75 years. The weighted average volatility used for fiscal year 1999 grants
was 46.11%.
For pro forma purposes, the estimated fair value of the Company's stock-based
awards to employees is amortized over the options' vesting period. The Company's
pro forma information for the years ended July 31 is as follows (in thousands
except per share amounts):
1999 1998 1997
---------- ---------- ----------
Net income (loss):
As reported $ 4,513 $ 3,184 $ (16,102)
Pro forma $ 3,972 $ 2,872 $ (16,119)
Net income (loss) per share:
As reported
Basic $ 0.28 $ 0.25 $ (2.18)
Diluted $ 0.26 0.21 $ (2.18)
Pro forma
Basic $ 0.25 $ 0.23 $ (2.19)
Diluted $ 0.23 $ 0.19 $ (2.19)
Warrants
In connection with the Merger, the Company assumed warrants with a seven-year
term held by stockholders and a director of FormMaker to purchase Common Stock.
Additional warrants with a three-year term were issued by FormMaker to
stockholders immediately prior to the Merger in connection with $3.0 million of
subordinated notes. All of the above warrants were converted into warrants to
purchase approximately 627,000 shares of Common Stock based on the Merger
exchange ratios.
Warrants to purchase 732,000 shares of Common Stock at an exercise price of
$4.17 per share were sold to stockholders for $6,100 in connection with certain
stockholders' obligations under a liquidity agreement. These warrants are
currently exercisable and expire May 15, 2000.
The following warrants are outstanding as of July 31, 1999 (in thousands except
per share amounts):
52
Exercise
Price
Warrants Per Share
-------- ---------
Warrants to Safeguard,
Technology Leaders II, L.P., And Technology
Leaders II Offshore C.V 258 $0.03
Warrants to a director of the Company 123 $3.40
Warrants to Safeguard, Technology
Leaders II, L.P., and TL Venture Third Corp. 246 $4.25
Warrants to Safeguard, Technology
Leaders II, L.P., and Technology Leaders II
Offshore C.V 732 $4.17
-----
Total 1,359
=====
Note 10 - Income Taxes
The provision (benefit) for income taxes charged to operations was as follows
(in thousands):
1999 1998 1997
------- ------- -------
Current tax expense:
U.S. federal $ 2,726 $ 1,004 $ 185
State, local, and foreign 330 264 65
------- ------- -------
Total current 3,056 1,268 250
------- ------- -------
Deferred tax expense:
U.S. federal 266 1,056 (1,394)
State, local, and foreign 18 (84) 0
------- ------- -------
Total deferred 284 972 (1,394)
------- ------- -------
Total provision (benefit) $ 3,340 $ 2,240 $(1,144)
======= ======= =======
The provision (benefit) for income taxes differs from the amount of income taxes
determined by applying the applicable U.S. statutory federal income tax rate to
pre-tax income as a result of the following differences (in thousands):
1999 1998 1997
------- ------- -------
Statutory U.S. tax rates $ 2,670 $ 1,899 $(5,864)
Increase (decrease) in rates resulting from:
Nondeductible items:
In-process technology 0 0 4,590
Goodwill 335 204 23
Other 51 70 19
State, local, and foreign taxes (net) 230 58 43
Other 54 9 45
------- ------- -------
Effective tax rates $ 3,340 $ 2,240 (1,144)
======= ======= =======
53
Deferred tax assets (liabilities) are composed of the following at July 31 (in
thousands):
1999 1998 1997
------- ------- -------
Gross deferred tax assets:
Deferred revenue $ 84 $ 7 $ 128
Loss carryforwards 3,833 4,209 2,491
Tax credit carryforwards 235 331 426
Accounts receivable allowance 246 347 178
Deferred lease costs 217 232 205
Compensation expense related to stock
options 994 1,155 1,752
Other 682 303 291
------- ------- -------
6,291 6,584 5,471
------- ------- -------
Gross deferred tax liabilities:
Capitalized software (2,852) (2,965) (2,519)
Other (315) (130) (149)
------- ------- -------
(3,167) (3,095) (2,668)
------- ------- -------
Net 3,124 3,489 2,803
------- ------- -------
Less valuation allowance (2,267) (2,349) (1,393)
------- ------- -------
Net deferred tax asset $ 857 $ 1,140 $ 1,410
======= ======= =======
At July 31, 1999, the Company had net operating loss carryforwards for federal
income tax purposes of approximately $10.5 million that generally expire in the
years ending 2005 through 2017.
During fiscal 1998, the Company released the valuation allowance in the amount
of approximately $893,000 based on management's assessment of the likelihood of
realizability of the Company's loss carryforwards. The reduction of the
valuation allowance was recorded as a decrease in goodwill related to the
Merger.
The Company has approximately $235,000 of general business credit carryforwards.
The tax credit carryforwards generally expire in the years ending 2007 through
2011.
Due to ownership changes, a portion of the Company's net operating loss and tax
credit carryforwards are subject to an annual cumulative limitation with respect
to the amounts which may be utilized in any one year. The Company believes
realization of the net deferred tax asset, net of valuation allowance, to be
more likely than not.
The Company made estimated and regular income tax payments of approximately $2.6
million, $525,000, and $640,000 during the years ended July 31, 1999, 1998, and
1997, respectively.
Note 11 - Retirement Plan
The Company maintains a discretionary defined contribution plan (401(k) plan),
as defined by the United States Internal Revenue Code, which allows participants
to contribute a percentage of their compensation. The plan also allows for a
discretionary matching contribution by the Company as determined by the
Company's board of directors.
54
Note 12 - Major Customers and Related-Party Transactions
At July 31, 1999 and 1998, Safeguard owns approximately 20% and 10%,
respectively, of the Company's fully diluted outstanding Common Stock.
Technology Leaders II, L.P., Technology Leaders II Offshore C.V., and TL
Ventures Third Corp. own approximately 5% and 6% of the Company's fully diluted
outstanding Common Stock at July 31, 1999 and 1998, respectively.
FormMaker historically distributed its line of Document Automation Platform
("DAP") software products to the insurance industry in North America through an
exclusive marketing agreement with PMSC. Revenues from PMSC under this agreement
for the year ended July 31, 1998 were approximately $5.5 million. In September
1998, both parties agreed to terminate the marketing agreement and enter into a
new non-exclusive marketing agreement. The new marketing agreement between the
Company and PMSC allows PMSC to market all of the Company's software products to
insurance and financial services companies worldwide. For the year ended July
31, 1999, the Company generated revenues of approximately $3.7 million through
the PMSC relationship.
In May 1998, the PMSC print outsourcing agreement was terminated. The Company
received no print outsourcing revenues from PMSC in fiscal year 1999; however,
revenues from PMSC under the print outsourcing agreement for the year ended July
31, 1998 were approximately $4.4 million.
For the year ended July 31, 1999 and 1998, one customer accounted for
approximately 10% and 13%, respectively, of the Company's total revenues.
Note 13 - Quarterly Financial Information (Unaudited)
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
(in thousands except per share amounts)
1999:
Total revenues $12,210 $13,012 $13,225 $13,479
Total expenses 10,602 11,174 11,324 11,595
Operating income 1,608 1,838 1,901 1,884
Net income 1,019 1,122 1,170 1,202
Net income per share:
Basic $ 0.06 $ 0.07 $ 0.07 $ 0.08
Diluted $ 0.06 $ 0.06 $ 0.07 $ 0.07
1998:
Total revenues $10,846 $11,204 $11,305 $11,892
Total expenses 9,487 9,820 9,873 10,466
Operating income 1,359 1,384 1,432 1,426
Net income 719 768 811 886
Net income per share:
Basic $ 0.07 $ 0.07 $ 0.07 $ 0.05
Diluted $ 0.06 $ 0.06 $ 0.05 $ 0.05
Net income per share calculations for each period are based on the weighted
average number of shares outstanding in each period; therefore, the sum of the
net income per share amounts for the quarters does not necessarily equal the
year-to-date net income per share amounts.
55
Due to the adoption of SFAS 128 and the conversion feature of Class B common
stock into Common Stock, which conversion occurred on April 9, 1998, the
historical basic and diluted calculations include the effect of conversion of
Class B common stock as of the date of original issuance, which were previously
reported in pro forma computations prior to conversion.
56