SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended Commission File Number
June 30, 1999 0-21131
INTERNATIONAL NETWORK SERVICES
(Exact name of registrant as specified in its charter)
Delaware 77-0289509
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1213 Innsbruck Drive, Sunnyvale, CA 94089
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (650) 318-1000
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value per share
(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. [_]
As of August 17, 1999, there were 57,355,904 shares of the Registrant's
Common Stock outstanding, and the aggregate market value of such shares held by
non-affiliates of the Registrant (based upon the closing sale price of such
shares on the Nasdaq National Market on August 17, 1999) was approximately
$2,059,690,925. Shares of Common Stock held by each executive officer and
director have been excluded in that such persons may be deemed to be affiliates.
DOCUMENTS INCORPORATED BY REFERENCE
The Registrant has not incorporated any documents by reference in this Form
10-K.
International Network Services Form 10-K
For the Fiscal Year Ended June 30, 1999
Table of Contents
Part I
Item 1. Business
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
Part II
Item 5. Market for the Company's Common Stock and Related
Stockholder Matters
Item 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Item 7A. Quantitative and Qualitative Disclosure About Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure
Part III
Item 10. Directors and Executive Officers of INS
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and
Management
Item 13. Certain Relationships and Related Transactions
Part IV
Item 14. Exhibits, Financial Statements Schedule, and Reports on Form
8-K
Exhibit Index
Signatures
Financial Statement Schedule
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PART I
ITEM 1. BUSINESS
The following discussion contains 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. Predictions of future
events are inherently uncertain. Actual events could differ materially from
those predicted in the forward-looking statements as a result of the risks set
forth in the following discussion and, in particular, the risks discussed below
under the captions "Risks Related to the Proposed Lucent Merger" and "Risk
Factors that May Affect Operating Results."
General
International Network Services ("INS" or the "Company") is a global
provider of network consulting and software solutions. The Company provides
professional services for the full life cycle of a network, including planning,
design, implementation, operations and optimization, and maintains expertise in
the most complex network technologies and multi-vendor environments. Areas of
expertise include wide area networks ("WANs"), network management, network and
host security, high-performance local area networks ("LANs"), and virtual LANs
("VLANs"). The Company believes that it is able to provide unbiased assessments
and optimal solutions for its clients. The Company offers its services on a
long or short-term basis in any or all phases of the network life cycle. The
Company's services are particularly well suited to clients who out-task a
portion of their information technology infrastructure. The Company serves its
professional services clients, many of which have multi-location networks,
through its network systems engineers in 43 offices worldwide. In addition,
through its INSoft division, the Company offers application and network
performance management software products and software services. As of June 30,
1999, the Company employed 2,169 persons, including 1,580 network systems
engineers and managers.
Recent Developments
On August 9, 1999, the Company entered into an agreement and plan of merger
with Lucent Technologies Inc. ("Lucent"), pursuant to which each outstanding
share of INS Common Stock will be exchanged for 0.8473 shares of Lucent Common
Stock, and each outstanding option or warrant to purchase INS Common Stock will
be converted into an option or warrant to purchase Lucent Common Stock (adjusted
for the exchange ratio). The proposed merger is expected to be accounted for as
a pooling of interests and is expected to close in the quarter ending December
31, 1999, subject to standard conditions, including regulatory approvals and
approval by INS stockholders.
Effective August 26, 1999, pursuant to a Preferred Shares Rights Agreement
between the Company and ChaseMellon Shareholder Services, L.L.C., as Rights
Agent, the Company's Board of Directors declared a dividend of one right (a
"Right") to purchase one one-thousandth of a share of the Company's Series A
Participating Preferred Stock, $0.001 par value ("Series A Preferred"), for each
outstanding share of Common Stock of the Company. The dividend is payable on
September 7, 1999 to stockholders of record as of the close of business on that
date. The Rights are not currently exercisable. Under certain conditions, each
Right entitles the registered holder to purchase from the Company one one-
thousandth of a share of Series A Preferred at an exercise price of Three
Hundred Dollars ($300.00) (the "Exercise Price"), subject to adjustment. If an
acquirer obtains 15% or more of the Company's Common Stock, other than any
action taken by Lucent pursuant to the agreement and plan of merger, (any such
acquirer, an "Acquiring Person"), then each Right (other than Rights owned by an
Acquiring Person or its affiliates) will entitle the holder thereof to purchase,
for the Exercise Price, a number of shares of the Company's Common Stock having
a then current market value of twice the Exercise Price. If, after an Acquiring
Person obtains 15% or more of the Company's Common Stock, (a) the Company merges
into another entity, (b) an acquiring entity merges into the Company or (c) the
Company sells more than 50% of the Company's assets or earning power, then each
Right (other than Rights owned by an Acquiring Person or its affiliates) will
entitle the holder thereof to purchase, for the Exercise Price, a number of
shares of Common Stock of the person engaging in the transaction having a then
current market value of twice the Exercise Price. Under certain conditions, the
rights may be redeemed by the Company's Board of Directors, in whole, but not in
part, at a price of $0.01 per right. The rights have no voting privileges and
will attach to and automatically trade with the Company's Common Stock. The
rights expire on the earlier of August 26, 2009, the exchange or redemption of
the rights, or the effectiveness of the Lucent merger.
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Background
Networking Industry
The network services market is growing rapidly, primarily due to the
increase in the number, size and complexity of networks, resulting from the
growth of the Internet and electronic commerce, and the convergence of voice and
data. Furthermore, the tools available to manage today's networks are very
complex. This market evolution, rapid technological change and increasing
complexity have made it difficult for enterprises and telecommunications service
providers to implement and manage their large multi-vendor network environments,
creating increased demand for third-party network services.
Growth of Networking and Convergence
The growth in data networking is a major trend, as is its anticipated
convergence with established voice networking. Convergence brings together
voice, data and video onto a single network using internet protocol (IP)
technology. Data networking services have grown from a fraction of the overall
communications market to the point where they are generally expected to equal
and then substantially exceed the voice market segment. Significant drivers of
this growth are:
- - the global expansion and use of the Internet for commercial and consumer
purposes;
- - the development of corporate intranets and the use of IP-based solutions
for internal communications within a particular business, and the
provisioning of remote access to these networks for employees;
- - the emerging areas of electronic commerce and the growth in IP-based
networks linking companies and their employees with partners, vendors,
other enterprises, and customers;
- - the emergence of bandwidth intensive applications such as multimedia
conferencing, telemedicine, distance learning; and
- - the further deployment of business applications built on the client server
and local-area computing infrastructures developed in the last decade
The amount of data generated by these applications combined with the larger
number of users connected to networks has increased traffic and placed higher
demand on networks. In this environment, companies that have the most responsive
and reliable information systems networks will have a competitive advantage.
Network Complexity
As network traffic has grown, the technology underlying networks has become
increasingly complex. Network hardware and software companies are rapidly
developing sophisticated new technologies such as routers, switches utilizing
asynchronous transfer mode ("ATM") technology and VLANs to accommodate the
increase in data traffic.
The implementation of these technologies requires significant expertise. In
addition, the complexity of networks is magnified by the need to integrate these
new technologies with legacy network systems. As a result, it is increasingly
difficult for network managers to ensure the reliability, performance and
security of these large, heterogeneous networks. Furthermore, the tools
available to manage today's networks are themselves very complex and require
investments in hardware, software, personnel and training. To ensure the
reliability and performance of these networks, and the business applications
that run on them, clients are increasingly relying on network and applications
performance management software.
Although companies have attempted to develop the necessary expertise, this
rapid technological change and increasing complexity have made it difficult for
companies to implement and manage their large multi-vendor network environments.
In addition, to remain competitive, companies are increasingly focused on their
core business competencies and often turn to third-party service providers for
non-core functions, such as those related to their computing environments. While
some companies "out-source" their entire computing environment, an increasing
number of companies are pursuing an approach to more actively manage their
computing environments by "selectively out-sourcing" or "out-tasking" only a
limited set of services. The rapid technological changes in networking and the
move to out-tasking have created increased demand for third-party network
services.
To date, it has been difficult for businesses to find adequate third-party
solutions for their complex network services needs. Although there are many
suppliers of network services, few focus on services for complex multi-vendor
networks. For example, some computer systems and network equipment vendors
provide services; however, they focus on distributing their own products and
often lack the skills to implement solutions in multi-vendor environments.
Systems integrators and value-added resellers ("VARs") have historically focused
on legacy computing environments and often do
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not have sufficient expertise in distributed client/server network environments.
Telecommunications providers are often called upon to provide complex multi-
vendor data network services as part of total communication solutions; however,
they often do not have adequate or available expertise and therefore often look
to other third-party service providers for complex network services.
INS Solution
INS is a global provider of network consulting and software solutions for
complex networks. The Company provides services for the full life cycle of a
network, including planning, design, implementation, operations and
optimization, and maintains expertise in the most complex network technologies
and multi-vendor environments. The Company believes that it is able to provide
unbiased assessments and optimal solutions for its clients. In addition, the
Company provides a focused, flexible approach to assisting clients in any or all
phases of the network life cycle. The Company's services are particularly well
suited to out-tasking. The Company has developed an on-line solutions resource,
Knowledge Network, through which the Company's network systems engineers
communicate and collaborate to provide solutions to clients' complex
communications network needs. In addition to professional services, through its
INSoft division, INS offers application and network performance management
software products and services for monitoring, managing and optimizing
application-ready networks. The Company is leveraging its expertise in complex
networks to develop software solutions that provide clients with a comprehensive
and detailed view into network and application performance. The Company serves
its clients, many of which have multi-location networks, through its network of
43 offices worldwide.
Strategy
The Company's objective is to become the premier global provider of
services and software solutions for complex networks. To achieve its objective,
the Company is pursuing the following strategies:
Build and Strengthen Client Relationships. The Company believes that
delivering dependable, high-quality network services is critical to
strengthening its relationships with existing clients, gaining repeat business
and generating new business from referrals. The Company seeks to establish long-
term relationships with its clients by becoming an integral part of their
network operations. The Company also plans to continue to build and strengthen
relationships with hardware and software vendors, system integrators and
telecommunications providers to assist them in providing total networking
solutions to their customers.
Expand Client Base in Existing and New Markets. The Company's strategy is
to expand its presence in the geographic markets it currently serves and to
enter new markets where it views the opportunity as attractive. The Company
currently offers its services and software through a network of 43 offices in
the United States, Canada, the United Kingdom, Germany and Amsterdam. The
Company believes that a broad presence will strengthen its competitive position
within the network services and software markets and enable it to better service
its clients and enter new markets worldwide.
Attract and Retain High Quality Network Systems Engineers. The Company
believes that its network systems engineers are critical to its success. The
Company's strategy is to continue to attract and retain the most qualified
network systems engineers by providing a rich environment and culture and by
offering professional development and financial opportunities. The Company
generally recruits network systems engineers that have significant technical
expertise and offers them professional training as well as the opportunity to
accelerate their career development by working on difficult problems and
collaborating with other network systems engineers to implement sophisticated
technology in complex networks. The Company promotes its corporate culture with
stated values that encourage employees to be their best, work as a team and
continually learn. The Company intends to continue to build its worldwide
recruiting organization and to invest heavily in training and development.
Expand Software Solutions. Through its INSoft Division, the Company
intends to leverage its expertise in complex networks by continuing to develop
new software products and enhance existing products to generate software license
fees and software services.
Develop and Expand Corporate Infrastructure. The Company believes that its
corporate infrastructure provides it with a competitive advantage in delivering
services and software while enabling it to expand its operations. This
infrastructure includes functions, such as recruiting, training and professional
development, collaboration tools, such as Knowledge Network, and management
information systems to give management the information necessary to make timely
and accurate decisions. The Company believes that by continuing to develop and
refine its employee recruiting and training
5
infrastructure, strengthening its operational management reporting systems and
controls, and expanding its information resources, it will be well-positioned to
deliver high quality network services and software solutions and support growth
in its operations.
Pursue Strategic Acquisitions. The Company intends to research, and if
appropriate, pursue acquisitions some of which may include expanding within
existing markets, entering new markets, increasing the range of services, adding
industry and technical expertise, and/or acquiring technology that can be used
in software solutions.
No assurance can be given that the Company will be able to implement its
strategy or achieve its objectives. See "Risk Factors That May Affect Operating
Results."
Professional Services and Software Solutions
The Company provides professional services and technology expertise for all
phases of the network life cycle and provides applications and network
performance management software solutions.
Professional Services
The Company had 1,580 network systems engineers and managers engaged in
providing services for complex networks as of June 30, 1999. The Company has
both the breadth of expertise required to support the full life cycle of a
network, which includes planning, design, implementation, operations and
optimization, and the depth of expertise required to address complex and rapidly
changing technology. The Company offers its services on a long or short-term
basis in any or all phases of the network life cycle. The Company's services
maximize flexibility in meeting customer requirements, offer added value, and
can be clearly described and presented.
In order to meet the challenge of providing consistent, quality service,
the Company staffs each project with a complement of network systems engineers
with requisite technical and management experience. The Company works with the
client to create a plan that defines what will be delivered as well as how
success or completion will be measured. To encourage quality assurance the
Company involves the service management team in all aspects of delivery and also
coordinates content and progress reviews. Further, the Company uses Knowledge
Network to bring the expertise and experience of many talented network systems
engineers to bear on an assignment.
The Company's services are provided either as discrete projects or as part
of ongoing relationships. Project content and scope range from simple task-
oriented engineering and value-added implementation efforts to large-scale
programs involving multiple resources across several client locations. The
Company generates revenue from its professional services generally on a time and
expenses basis; however, some projects are delivered on a fixed-price basis. The
success of the Company's business will depend on the Company's ability to
fulfill the increasingly sophisticated needs of its clients. The Company's
clients are generally able to reduce or cancel their use of the Company's
services without penalty and with little or no notice. See "Risk Factors That
May Affect Operating Results."
Network Life Cycle Services
The Company provides services for any or all phases of the network life
cycle, which includes planning, design, implementation, operations and
optimization.
Network Planning. The network planning phase of the network life cycle
focuses on providing clients with strategic and tactical reviews of their
current network operations and future network requirements. Network planning
services encompass a number of critical planning elements:
- - Defining client business requirements
- - Developing strategic information architectures
- - Performing network baseline audits
- - Preparing capacity plans for the physical network, logical transport and
services
- - Selecting preferred technology
- - Conducting network security audits and planning
Network Design. The network design phase includes services that assist in
the design of physical, logical and operational information infrastructures.
These services involve detailing the network specifications and implementation
tactics necessary to achieve clients' business objectives. The Company generates
a set of working papers that identify the
6
specific technologies to be used and how these technologies will be configured
and implemented. These services also take into consideration how the new
technology will integrate into the client's existing hardware and software and
how it will be managed on an ongoing basis. Examples of services provided by the
Company in the network design phase include:
- - Defining functional requirements
- - Developing multi-vendor integration plans
- - Preparing technical design documentation
- - Developing engineering specifications and documents
- - Preparing Request for Proposal specifications or other make/buy criteria
- - Providing detailed component purchasing lists
Network Implementation. The network implementation phase includes high
value-added network services, such as internet protocol (IP) addressing and
router configuration, and, to a much lesser extent, traditional system
integrator functions, such as hardware installation. The Company believes it has
expertise in integrating new systems without disrupting ongoing business
operations, thereby adding value and reducing risk to clients. The Company
customizes an implementation plan for each client, which may include the
following activities:
- - Project management
- - Integrating new hardware and software products and systems
- - Building network operations and management centers
- - Re-configuring and upgrading network devices, systems and facilities
- - Implementing installation documentation, conformance testing and compliance
certification
Network Operations. The network operations phase includes ongoing tasks
necessary to keep the client's network fully operational. The Company has
experience in delivering operations services to a range of clients, including
those with newer client/server networks running both Internet (TCP/IP) and
workgroup (Novell and Microsoft) protocols intermingled with legacy (SNA)
networks. Specific operations activities are delivered according to individual
client requirements drawing from a well-understood set of operating practices.
Examples of these practices include:
- - Network administration, including management of user accounts, service
levels, and client administrative or accounting practices
- - Network utilization analysis, involving ongoing measurement of network
activity against established network baselines
- - Ongoing management of documentation, including physical assets, logical
topologies, policies and procedures
- - Network troubleshooting, involving fault detection, isolation, repair and
restoration
- - Alarm management, including setting of alarm levels, cross-correlation,
problem diagnosis and dispatch of service resources
- - Network backup, including design and supervision of backup processes and
policies, and exercise of disaster recovery procedures
- - Routine moves, additions, and changes to network elements, infrastructure and
services
Network Optimization. The network optimization phase involves maximizing
the rate of return of communications network investments on behalf of the client
by such methods as reducing operating costs and increasing network utilization.
Although optimization may be viewed as a separate stage of the network life
cycle, optimization is closely linked with the other phases of the network life
cycle. Optimization services can be long-term in nature, address issues such as
cost containment and utilization, and are often aimed at optimizing LAN
infrastructure. These services can also be packaged as discrete projects,
designed to present alternatives for optimization of workgroup, departmental,
building, or campus network investments. Finally, the Company can assist in
optimizing "logical" networks, wherein the Company addresses a protocol, service
or application operating in the larger context of the client's network. Examples
of the Company's network optimization services include:
- - Recommendations for efficient allocation of bandwidth
- - Network traffic analysis, identification of bottlenecks and recommendations
for change
- - Network process re-engineering
- - Knowledge transfer to client operations personnel on topics, such as basic
practices, or operation of network management tools and stations
Technology Expertise
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The Company has developed expertise in a number of areas, including WANs,
network management, network and host security, high performance LANs and VLANs.
Wide Area Networks. Wide area network design and optimization has special
value in multi-protocol, multi-vendor network environments. The Company has
substantial expertise in the design and optimization of shared transport TCP/IP
and SNA networks, including emerging and legacy networking disciplines that span
more than 20 years of network technology. Subject matter expertise includes
commercial transport technologies (frame relay, ATM, T1/T3 leased lines with
HDLC, SONET, SMDS, ISDN, and X.25), interior and exterior routing protocols
(IGRP, EIGRP, CIDR, BGP-4, OSPF, RIP, and RIPv2), and commonly used network
protocols ( TCP/IP, SNA, IPX, Apple, DECnet, VINES).
Network Management. Network management practices include design and
implementation of network operations/management centers, design of distributed
network management systems, selection, installation, and integration of network
management platforms and integration with alarm managers, trouble ticket systems
and "manager of managers" tools. Subject matter expertise includes SNMP, SNMPv2,
RMON, RMON-II, HPOV, Optivity, Netview 6000, SunNet Manager, Spectrum, Seagate
NerveCenter, Remedy ARS and broad-based skills in network management concepts
and functions (fault, performance, configuration, accounting, security).
Network and Host Security. Network and host security practices include
research and documentation of security policies, selection and installation of
Internet and Intranet firewalls, secure remote access solutions, identification
and installation of various security tools, audits of server and workstation
security, and training of clients on security topics. Subject matter expertise
includes firewall design, remote access design, authentication, server, host,
and workstation industry best practices, new security protocols (S/WAN, SHTTP,
SSL), cryptography and encryption, and high performance secure platforms.
High Performance Local Area Networks and Virtual Local Area Networks.
Consulting on design and implementation of high-performance LANs and VLANs
requires maintaining state of the art expertise on a broad array of topics. The
Company has expertise in switching technology and products, performance tuning,
ATM technology and applications, ATM migration, full-duplex LANs, and other
high-speed LAN components.
Software Solutions
The VitalSuite Product Family
The Company has leveraged its expertise in complex networks to develop
applications and network performance management software solutions. The
VitalSuite product family delivers solutions that allow information technology
professionals, executives, and network managers to monitor, measure, and manage
their business-critical applications, as well as the networks that support those
applications. The product suite consists of four main components and various
extensions which, working together, deliver top-to-bottom visibility into
mission-critical network and application operations.
EnterprisePRO. EnterprisePRO is a web-based network performance management
-------------
solution which continuously tracks the utilization rates of key elements of a
global enterprise network, from frame relay circuits to wide area networks and
associated local area networks. EnterprisePRO's high-performance multi-threaded
polling engine enables clients to quickly identify network performance trends,
troubleshoot problems, anticipate bottlenecks, and properly budget and plan for
network upgrades and expansion.
VitalAgent. VitalAgent is a powerful software agent that resides on
----------
desktops throughout the enterprise to monitor interactions between the desktop
and the server. Data is analyzed, condensed, and forwarded to centralized
server-based products, where it is aggregated with other VitalAgent data to
provide an overview of application performance.
VitalAnalysis. VitalAnalysis uses VitalAgent data to show how the desktop,
-------------
the network, servers and business applications are performing as a unit.
VitalAnalysis provides a valuable tool for monitoring and verifying corporate
service level agreements.
VitalHelp. VitalHelp is a real-time fault detection and troubleshooting
---------
tool that enables help desk personnel to identify and fix application
performance problems quickly. VitalAgent reports problems directly to VitalHelp
in real time and from anywhere in the enterprise.
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The Company believes that its professional services and software solutions
complement one another. The cumulative expertise of the Company's professional
services staff provides valuable information upon which future software
solutions may be based. Software solutions are designed to build and maintain
client relationships and may provide opportunities for additional professional
services.
Knowledge Network
Knowledge Network is the Company's on-line solutions resource. Knowledge
Network combines the Company's proprietary information stored in a document
management system, a library of industry and manufacturer product information
and specifications, periodicals, databases and CDs from vendors providing
additional technical support, and a means by which the Company's network systems
engineers can communicate and collaborate in resolving clients' complex network
issues. Network problems encountered by INS network systems engineers and the
ultimate solutions are catalogued and stored on a confidential central database
for use by INS network systems engineers and management only. INS network
systems engineers are able to query the Knowledge Network for precedents,
conversation threads and other possible solutions for difficult network issues
and can send e-mail through the Knowledge Network to other INS network systems
engineers for assistance in resolving these issues. Knowledge Network enables
the Company to leverage the collective talents and experience of network experts
in the organization to provide clients with proven and cost-effective solutions
to their network services needs. The Company believes that the Knowledge Network
provides it with a competitive advantage over other network services providers.
Clients
The Company performs professional services for a variety of clients across
a broad range of industries. The Company has derived a significant portion of
its revenue from a limited number of large clients and expects this
concentration to continue. No one client accounted for more than 10% of revenue
in fiscal 1997, 1998 or 1999. See "Risk Factors That May Affect Operating
Results."
Sales and Marketing
The Company employs account managers who identify and sell to clients and
manage client relationships. Many members of the Company's account management
team have significant experience selling complex network and computer products
and services. The Company also has a marketing group which provides sales
support materials and marketing communications. Account managers generally
identify clients through direct marketing and referrals. The Company employs a
team selling approach, whereby account managers collaborate with field and
technical managers and network systems engineers to assess potential projects
and communicate the specific expertise of the Company's consultants to potential
clients. In addition to other marketing strategies, the Company believes that
delivering dependable, high-quality services is critical to strengthening its
relationships with existing clients, gaining repeat business and generating new
business from referrals. The Company seeks to establish long-term relationships
with its clients by becoming an integral part of their network operations.
The Company markets its professional services directly to large end-user
clients who have chosen to out-task network services, and indirectly through
third parties, including large telecommunications carriers, systems integrators,
hardware and software vendors, and VARs. The Company's announcement of the
proposed merger with Lucent may be perceived as compromising the Company's
ability to provide unbiased solutions and has already had and may in the future
have an adverse effect on the Company's relationships with significant clients
and strategic partners. For example, the Company had developed a significant
relationship with Cisco Systems, Inc. ("Cisco"), a competitor of Lucent, and
had entered into direct relationships with clients as a result of referrals
from Cisco and had provided services directly to Cisco primarily as a
subcontractor. As a result of the announcement of the merger, Cisco has
terminated existing agreements with the Company and will likely cease
referring clients and subcontracting work to the Company.
The Company's VitalSuite software solutions are marketed primarily through
the Company's account managers and secondarily through OEMs and resellers.
Generally, VitalSuite resellers will identify potential clients and negotiate
the services contracts and are responsible for installation and first level
support of the client. The success of these relationships will depend in part on
the level of commitment and effort of these resellers. Software solutions may be
sold under the Company's name or under a private label of the reseller.
The Company's clients are generally able to reduce or cancel their use of
the Company's services without penalty and with little or no notice. As a
result, the Company believes that the number and size of its existing projects
are not reliable
9
indicators or measures of future revenue. The Company has in the past provided,
and is likely in the future to provide, services to clients without a written
commitment or contract. When a client defers, modifies or cancels a project, the
Company must be able to rapidly redeploy network systems engineers to other
projects in order to minimize the under-utilization of employees and the
resulting adverse impact on operating results. In addition, the Company's
operating expenses are relatively fixed and cannot be reduced on short notice to
compensate for unanticipated variations in the number or size of projects in
progress. As a result, any termination, significant reduction or modification of
its business relationships with any of its significant clients or with a number
of smaller clients could have a material adverse effect on the Company's
business, operating results and financial condition.
The Company's future success will also depend in large part on the
development of new business by the Company's account managers, who solicit new
business and manage relationships with existing clients. As a result, the
Company's success will depend on its ability to attract and retain qualified
account managers who have an understanding of the Company's business and the
industry it serves. Competition for account managers is intense and the Company
has experienced, and may in the future experience high rates of turnover among
its account managers. In addition, integration of new account managers into the
Company's business can be lengthy. Any inability of the Company to attract and
retain a sufficient number of account managers or to integrate new account
managers into the Company's operations on a timely basis, would impair the
Company's ability to obtain projects from new and existing clients which could
have a material adverse effect on the Company's business, operating results and
financial condition.
Software Product Development
The Company believes that product and technology leadership is critical to
long-term success in the software market in which it competes. Timely
development of new software products and enhancements to existing software
products are essential to maintain its competitive position in the market. The
network and applications performance management software market is characterized
by rapid technological change, evolving industry standards, changes in customer
requirements and frequent new product introductions.
The Company's research and development staff consisted of 47 employees as
of June 30, 1999. The Company's total research and development expenses were
approximately $2.3 million, $4.2 million, and $6.3 million for the years ended
June 30, 1997, 1998 and 1999, respectively.
There can be no assurance that such development efforts will result in
products, features or functionality, or that the software products, features or
functionality that are developed will be accepted by the market. If the Company
is unable to develop on a timely and cost-effective basis new software products
or enhancements to its existing products, or if such new products or
enhancements do not achieve market acceptance, the Company's business, operating
results and financial condition could suffer.
Human Resources
The Company believes that its success in recruiting and retaining
experienced, highly-qualified and highly-motivated personnel will depend in part
on its ability to provide a rich environment and culture and to offer
professional development and financial opportunities. As of June 30, 1999, the
Company employed 2,169 persons, including 1,580 network systems engineers and
managers.
Recruiting. The success of the Company is dependent in part on attracting
and retaining talented, creative and motivated personnel at all levels. The
Company dedicates significant resources to its recruiting efforts. The Company
generally seeks to meet its hiring needs through referrals from existing INS
employees, through a nationwide network of recruiters and through the new
college graduate program. The Company's network systems engineers together have
expertise in a wide array of computer and network systems of the Company's
clients and a broad understanding of the industries in which the Company's
clients are involved.
Corporate Culture. The Company believes that developing a rich environment
and culture is critical to its success in achieving its mission of becoming the
premier provider of services for complex networks. The Company actively fosters
a set of basic values, which were developed by its employees. These values
include a dedication to being the best, respecting others and working as a team,
continuous learning and development, trustworthiness and empowerment. The
Company encourages employees to use these values in daily decision making and
balance the interests of clients, stockholders and employees to maximize long-
term Company value. The Company believes that its growth and success are
attributable in large part to its high-caliber employees and the Company's
adherence to these values.
10
Professional Development. Professional development includes career
opportunities and on-the-job challenges, as well as training programs. The
Company has two career tracks for consultants, a technical track and a
management track. The Company has established a training program, which includes
national and local consultative approach workshops, collaboration workshops, new
management training and technical training. In support of its curriculum, the
Company offers advanced training through on-site simulation labs and numerous
computer-based training modules. In addition, Knowledge Network serves as an
additional training and information resource. The Company's personnel keep
apprised of technological advances and developments through a combination of on-
the-job exposure to relevant technology, special training programs, peer review
and discussions, and supervision by seasoned technical personnel.
Compensation. The Company believes that by linking employee compensation to
the success of the Company through its incentive compensation programs, the
Company encourages an owner attitude which the Company believes results in
decisions that maximize the Company's value and employee retention. The
Company's compensation package consists of a combination of salary, performance-
based incentive compensation, stock options and benefit plans.
The Company's success will depend in part on the continued services of its
key employees. The Company does not have employment or non-competition
agreements with any of its key or other employees. The loss of services of one
or more of the Company's key employees could have a material adverse effect on
the Company's business, operating results and financial condition. In addition,
if one or more key employees joins a competitor or forms a competing company,
the loss of such employees and any resulting loss of existing or potential
clients to any such competitor could have a material adverse effect on the
Company's business, operating results and financial condition. In the event of
the loss of any such employee, there can be no assurance that the Company would
be able to prevent the unauthorized disclosure or use of the Company's or its
clients' technical knowledge, practice or procedures by such personnel or that
such disclosure or use would not have a material adverse effect on the Company's
business, operating results and financial condition.
The Company's future success will depend in large part on its ability to
hire, train and retain network systems engineers who together have expertise in
a wide array of the network and computer systems and a broad understanding of
the industries the Company serves. Competition for network systems engineers is
intense, and there can be no assurance that the Company will be successful in
attracting and retaining such personnel. In particular, competition is intense
for the limited number of qualified managers and senior network systems
engineers. The Company has experienced, and may in the future experience, high
rates of turnover among its network systems engineers. As a result of the
announcement of the Company's proposed merger with Lucent, competitors have
been recruiting the Company's network system engineers and the Company's
employee turnover rate will be higher in the current quarter than in past
quarters. In addition, the recruiting cycle may take longer due to uncertainties
regarding the merger. Any inability of the Company to hire, train and retain a
sufficient number of qualified network systems engineers could impair the
Company's ability to adequately manage and complete its existing projects or to
obtain new projects, which, in turn, could have a material adverse effect on the
Company's business, operating results and financial condition. In addition, the
Company has experienced, and may in the future experience, increasing
compensation costs for its network systems engineers. Any inability of the
Company to recover increases in compensation of network systems engineers
through higher billing rates or to reduce other expenses to offset such
increases, could harm our business, operating results and financial condition.
Competition
The network services industry is comprised of a large number of
participants and is subject to rapid change and intense competition. With
respect to professional services, the Company faces competition from system
integrators, VARs, local and regional network services firms, telecommunications
providers, network equipment vendors, and computer systems vendors, many of
which have significantly greater financial, technical and marketing resources
and greater name recognition and generate greater service revenue than does the
Company. With respect to software solutions, the Company also faces competition
from companies such as Computer Associates, Concord Communications, Desktalk
Systems and Compuware, some of which have significantly greater financial,
technical and marketing resources, greater name recognition, and generate
greater revenue than the Company. The Company has faced, and expects to continue
to face, additional competition from new entrants into its markets, many of
which are well established in the software industry and have greater financial
resources. In addition, Cisco recently announced that it was making a large
investment in KPMG LLP's consulting business and Cisco has made investments in
several private companies which provide network services. Increased
competition could result in price reductions, fewer client projects, under-
utilization of employees, reduced operating margins and loss of market share,
any of which could materially adversely affect the Company's business,
operating results and financial condition. There can be no assurance that the
Company will be able to compete successfully against current or future
competitors. The failure of the Company to compete successfully would have a
material adverse effect on the Company's business, operating results and
financial condition.
11
In addition, most of the Company's clients have internal network support
services capabilities and could choose to satisfy their needs through internal
resources rather than through outside service providers. As a result, the
decision by the Company's clients or potential clients to perform network
services internally could have a material adverse effect on the Company's
business, operating results and financial condition.
The Company believes that the principal competitive factors in the markets
in which it competes include the nature of the services offered, quality of
service, client responsiveness, marketing, management, corporate culture, client
relationships, knowledge base, infrastructure, software product development and
price. The Company believes it competes favorably with respect to these factors.
The Company believes that its focus, depth and breadth of expertise and
experience, infrastructure and management distinguish it from its competitors.
Intellectual Property
The Company's success is dependent in part on its information technology,
some of which is proprietary to the Company, and other intellectual property
rights. The Company relies on a combination of nondisclosure and other
contractual arrangements, technical measures, and trade secret and trademark
laws to protect its proprietary rights. The Company also tries to protect its
software documentation and other written materials under trade secret and
copyright laws. In selling certain products, the Company relies on "end-user"
licenses that are not signed by licensees and such licenses may be unenforceable
under laws of certain jurisdictions. The laws of some foreign countries do not
protect the Company's proprietary rights to the same extent as the laws of the
United States. The steps the Company has taken to protect its proprietary rights
may not be adequate to protect its intellectual property and the Company cannot
be certain that third parties will not infringe or misappropriate its patents,
copyrights, trademarks, tradedress and similar proprietary rights.
In addition, the Company may be unable to deter misappropriation of its
proprietary information and the proprietary information of its clients.
The Company enters into confidentiality agreements with its employees and
attempts to limit access to and distribution of proprietary information. There
can be no assurance that the steps taken by the Company in this regard will be
adequate to deter misappropriation of proprietary information or that the
Company will be able to detect unauthorized use or take appropriate steps to
enforce intellectual property rights. If the Company is not successful in its
efforts to protect its proprietary information and the proprietary information
of its clients, its business, financial condition and operating results could
suffer. In addition, policing unauthorized use of its products is difficult, and
the Company cannot determine the extent to which its software has been
misappropriated.
ITEM 2. PROPERTIES
The Company's principal administrative, sales, marketing and service
development facilities are located in approximately 102,321 square feet in four
buildings in Sunnyvale, California pursuant to leases which expire in 2001
through 2005. The Company also leases a 23,305 square foot facility in Dallas,
Texas, primarily for its internal data center. In addition, the Company leases
field support offices in 43 cities. The field offices range from small executive
offices to 7,000 square foot facilities. Lease terms range from month-to-month
on certain executive offices to five years on certain direct leases. Because the
Company's professional services are generally performed at the client site,
field facilities are generally small. Field facilities are generally used for
periodic meetings, training and administration and by account managers. The
Company has field facilities in Amsterdam, The Netherlands; Atlanta, Georgia;
Austin, Texas; Baltimore, Maryland; Boston, Massachusetts; Burlington,
Massachusetts; Charlotte, North Carolina; Chicago, Illinois; Cleveland, Ohio;
Columbus, Ohio; Costa Mesa, California; Dallas, Texas; Denver, Colorado;
Detroit, Michigan; Frankfurt, Germany; Ft. Lauderdale, Florida; Hartford,
Connecticut; Houston, Texas; Iselin, New Jersey; Jacksonville, Florida; Kansas
City, Kansas; Los Angeles, California; Maidenhead, England; Minneapolis,
Minnesota; Nashville, Tennessee; New York, New York; Parsippany, New Jersey;
Philadelphia, Pennsylvania; Phoenix, Arizona; Pittsburgh, Pennsylvania; Raleigh,
North Carolina; Sacramento, California; San Antonio, Texas; San Diego,
California; San Mateo, California; San Ramon, California; Seattle, Washington;
Tampa, Florida; Toronto, Canada; Tulsa, Oklahoma; Warrington, England;
Washington, D.C., and Woodland Hills, California. The Company is continually
evaluating the adequacy of existing facilities and facilities in new cities and
believes that suitable additional space will be available in the future on
commercially reasonable terms as needed.
ITEM 3. LEGAL PROCEEDINGS
The Company is not party to any material legal proceedings.
12
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of fiscal 1999.
13
PART II
ITEM 5. MARKET FOR COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
(a) The Company's Common Stock has been traded on the Nasdaq National
Market under the trading symbol "INSS" since the Company's initial public
offering on September 18, 1996. The following table sets forth the high and low
sale prices per share of the Company's Common Stock for the periods indicated
and reflects the three-for-two stock split that was effected on April 5, 1999.
High Low
---- ---
Fiscal 1998
First Quarter $19.58 $11.83
Second Quarter $16.25 $10.17
Third Quarter $20.67 $14.00
Fourth Quarter $28.33 $18.75
Fiscal 1999
First Quarter $31.42 $21.17
Second Quarter $45.92 $16.42
Third Quarter $47.42 $30.92
Fourth Quarter $49.50 $33.63
Fiscal 2000
First Quarter (through August 17, 1999) $55.94 $38.88
As of August 17, 1999, the Company had 433 stockholders of record. The
price for the Common Stock on the close of business on August 17, 1999 was
$54.25 per share. The Company has never paid any cash dividends on its Common
Stock. The Company intends to retain any earnings for use in its business and
does not anticipate paying any cash dividends on its Common Stock in the
foreseeable future.
(b) Effective August 26, 1999, pursuant to a Preferred Shares Rights
Agreement between the Company and ChaseMellon Shareholder Services, L.L.C., as
Rights Agent, the Company's Board of Directors declared a dividend of one Right
to purchase one one-thousandth of a share of the Company's Series A Preferred,
for each outstanding share of Common Stock of the Company. The dividend is
payable on September 7, 1999 to stockholders of record as of the close of
business on that date. The Rights are not currently exercisable. Under certain
conditions, each Right entitles the registered holder to purchase from the
Company one one-thousandth of a share of Series A Preferred at the Exercise
Price of Three Hundred Dollars ($300.00), subject to adjustment. If an Acquiring
Person obtains 15% or more of the Company's Common Stock, other than any action
taken by Lucent pursuant to the agreement and plan of merger, then each Right
(other than Rights owned by an Acquiring Person or its affiliates) will entitle
the holder thereof to purchase, for the Exercise Price, a number of shares of
the Company's Common Stock having a then current market value of twice the
Exercise Price. If, after an Acquiring Person obtains 15% or more of the
Company's Common Stock, (a) the Company merges into another entity, (b) an
acquiring entity merges into the Company or (c) the Company sells more than 50%
of the Company's assets or earning power, then each Right (other than Rights
owned by an Acquiring Person or its affiliates) will entitle the holder thereof
to purchase, for the Exercise Price, a number of shares of Common Stock of the
person engaging in the transaction having a then current market value of twice
the Exercise Price. Under certain conditions, the rights may be redeemed by the
Company's Board of Directors, in whole, but not in part, at a price of $0.01 per
right. The rights have no voting privileges and will attach to and automatically
trade with the Company's Common Stock. The rights expire on the earlier of
August 26, 2009, the exchange or redemption of the rights, or the effectiveness
of the Lucent merger.
14
ITEM 6. SELECTED FINANCIAL DATA
STATEMENT OF OPERATIONS DATA
(In thousands, except per share amounts)
Year Ended June 30,
-----------------------------------------------------------------
1999 1998 1997 1996 1995
-----------------------------------------------------------------
Revenue:
Professional services............................... $276,488 $158,001 $95,542 $43,262 $15,419
Software licenses................................... 29,681 7,513 238 - -
Software support and maintenance.................... 8,920 7,284 3,733 830 130
-------- -------- ------- ------- -------
Total revenue.................................... 315,089 172,798 99,513 44,092 15,549
-------- -------- ------- ------- -------
Operating expenses:
Professional services personnel..................... 125,756 73,911 44,268 19,692 6,541
Other costs of professional services................ 39,306 23,155 12,216 5,110 2,116
Cost of software licenses........................... 847 402 25 - -
Cost of software support and maintenance............ 4,952 3,173 1,655 658 266
Research and development............................ 6,263 4,161 2,262 879 77
Sales and marketing................................. 48,826 26,389 14,985 7,990 3,843
General and administrative.......................... 38,575 19,735 13,715 5,049 1,890
Acquisition related charges......................... 7,176 - - - -
-------- -------- ------- ------- -------
Total operating expenses.......................... 271,701 150,926 89,126 39,378 14,733
-------- -------- ------- ------- -------
Income from operations................................... 43,388 21,872 10,387 4,714 816
Interest and other, net.................................. 3,102 2,135 854 3 17
-------- -------- ------- ------- -------
Income before provision for income taxes................. 46,490 24,007 11,241 4,717 833
Provision for income taxes............................... 21,037 9,603 4,489 1,840 58
-------- -------- ------- ------- -------
Net income............................................... 25,453 14,404 6,752 2,877 775
Accretion of Mandatorily Redeemable Convertible
Preferred Stock......................................... - - - 1,135 883
-------- -------- ------- ------- -------
Net income (loss) attributable to Common Stock........... $ 25,453 $ 14,404 $ 6,752 $ 1,742 $ (108)
======== ======== ======= ======= =======
Net income (loss) attributable to Common Stock:
Basic............................................... $0.47 $0.28 $0.17 $0.14 $(0.01)
Diluted............................................. $0.41 $0.25 $0.13 $0.04 $(0.01)
Shares used to compute net income attributable to Common
Stock per share(1):
Basic............................................... 54,444 50,582 39,531 12,704 10,580
Diluted............................................. 62,210 57,101 51,845 43,461 10,580
(1) See Note 1 of Notes to Consolidated Financial Statements for an explanation
of shares used to compute net income (loss) per share.
15
Selected Financial Data
(continued)
The following table sets forth, for the periods indicated, certain financial
information as a percent of revenue:
Year Ended June 30,
---------------------------------------------------
1999 1998 1997 1996 1995
---------------------------------------------------
Revenue:
Professional services.......................................... 88% 92% 96% 98% 99%
Software licenses.............................................. 9 4 - - -
Software support and maintenance............................... 3 4 4 2 1
--- --- --- --- ---
Total revenue............................................... 100 100 100 100 100
--- --- --- --- ---
Operating expenses:
Professional services personnel................................. 40 43 44 45 42
Other costs of professional services............................ 13 14 12 12 14
Cost of software licenses....................................... - - - - -
Cost of software support and maintenance....................... 2 2 2 1 2
Research and development........................................ 2 2 2 2 0
Sales and marketing............................................. 15 15 15 18 25
General and administrative...................................... 12 11 14 11 12
Acquisition related charges..................................... 2 - - - -
--- --- --- --- ---
Total operating expenses.................................... 86 87 89 89 95
--- --- --- --- ---
Income from operations.............................................. 14 13 11 11 5
Interest and other, net............................................. 1 1 1 - -
--- --- --- --- ---
Income before provision for income taxes............................ 15 14 12 11 5
Provision for income taxes.......................................... 7 6 5 4 -
--- --- --- --- ---
Net income.......................................................... 8 8 7 7 5
Accretion of Mandatorily Redeemable Convertible
Preferred Stock.................................................... - - - 3 6
--- --- --- --- ---
Net income (loss) attributable to Common Stock...................... 8% 8% 7% 4% (1)%
=== === === === ===
BALANCE SHEET DATA
(in thousands)
Year Ended June 30,
----------------------------------------------------------------
1999 1998 1997 1996 1995
----------------------------------------------------------------
Cash, cash equivalents and investments.............................. $109,382 $ 73,001 $45,865 $ 869 $4,161
Working capital..................................................... 84,882 74,543 53,600 6,060 6,103
Total assets........................................................ 223,236 140,286 83,802 18,072 9,967
Notes payable, less current portion................................. - - - 316 732
Stockholders' equity (2)............................................ 163,353 102,307 71,945 9,883 6,897
(2) Includes Mandatorily Redeemable Convertible Preferred Stock which converted
to Common Stock upon the consummation of the Company's initial public
offering on September 18, 1996.
16
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion contains forward-looking statements that involve
risks and uncertainties. The Company's actual results could differ materially
from those anticipated in these forward-looking statements as a result of
certain factors, including those set forth below in "Risks Related to the
Proposed Lucent Merger" and "Risk Factors That May Affect Operating Results".
Revenue
Total Revenue
- -------------
The Company's total revenue was $315.1 million, $172.8 million and $99.5
million in fiscal 1999, 1998 and 1997, representing increases over the prior
fiscal year of 82%, 74% and 126%, respectively. The Company does not believe
that this rate of growth is sustainable over the long term.
Professional Services
- ---------------------
The majority of the Company's revenue is derived from fees for professional
services. Professional services revenue was $276.5 million, $158.0 million and
$95.5 million in fiscal 1999, 1998 and 1997, representing increases over the
prior fiscal year of 75%, 65% and 121%, respectively. Professional services
revenue accounted for 88%, 92% and 96% of total revenue in fiscal 1999, 1998 and
1997, respectively. Professional services revenue increased primarily due to an
increase in the number and size of professional service projects and secondarily
due to an increase in average billing rates.
Software Licenses
- -----------------
Software licenses revenue consists principally of revenue earned under
software license agreements and under royalty agreements with OEMs. Software
licenses revenue was $29.7 million, $7.5 million and $238,000 in fiscal 1999,
1998 and 1997, respectively. Software licenses revenue was 9%, 4% and less than
1% of total revenue in fiscal 1999, 1998 and 1997, respectively. The increase
in software licenses revenue resulted from increased sales to new customers and
sales to existing customers for new products. Also, prior to fiscal 1998, the
Company offered its software solutions to clients only as a service, which
resulted in revenue recognition over the contract term. The Company currently
allows clients to separately purchase a software license, software subscription
and support services as an alternative to the service contract.
Software Support and Maintenance
- --------------------------------
The Company also derives revenue from software services. Software services
revenue consists of all inclusive service contracts, which include the right to
use software combined with installation, maintenance and support, as well as
services for installation, maintenance and support of software licenses sold
separately. Software support and maintenance revenue was $8.9 million, $7.3
million and $3.7 million in fiscal 1999, 1998 and 1997, respectively. Software
support and maintenance revenue was 3% of total revenue in fiscal 1999 and 4% of
total revenue in fiscal 1998 and 1997. The increase in software services
revenue resulted from increased sales to new customers and sales to existing
customers for new products.
No one client accounted for more than 10% of total revenue in fiscal 1999, 1998
or 1997.
Operating Expenses
Professional Services Personnel
- -------------------------------
Professional services personnel expenses consist primarily of compensation
and benefits of the Company's employees engaged in the delivery of professional
services. Professional personnel expenses were $125.8 million, $73.9 million and
$44.3 million in fiscal 1999, 1998 and 1997, respectively, representing
increases over the prior fiscal year of 70%, 67% and 125%, respectively. These
increases were due primarily to an increase in the number of network systems
engineers. The number of employees included in professional personnel was 1,580,
1,053 and 651 at the end of fiscal 1999, 1998 and 1997, respectively.
Professional personnel expenses were 40%, 43% and 44% of total revenue in fiscal
1999, 1998 and 1997, respectively. Professional personnel expenses were lower as
a percent of total revenue in fiscal 1999 than fiscal 1998 and 1997, due
primarily to an increase in billing rates for professional services, and to a
lesser extent, an increase in license revenue as a percent of sales.
Professional personnel expenses were 45%, 47% and 46% of total professional
services revenue in fiscal 1999, 1998 and 1997, respectively. Professional
personnel expenses were lower as a
17
percent of professional services revenue in fiscal 1999 than fiscal 1998 and
1997, due primarily to primarily to an increase in billing rates for
professional services.
Other Costs of Professional Services
- ------------------------------------
Other costs of professional services consist primarily of travel and
entertainment, certain recruiting and professional development expenses, field
facilities, depreciation, expensed equipment and supplies related to the
delivery of professional services. Other costs were $39.3 million, $23.2
million and $12.2 million in fiscal 1999, 1998 and 1997, respectively,
representing increases over the prior fiscal year of 70%, 90% and 139%,
respectively. The increases were primarily due to an increase in the number of
employees and, to a lesser extent, to the costs of field offices. Other costs
were 13%, 14%, and 12% of total revenue in fiscal 1999, 1998 and 1997,
respectively. Other costs were lower as a percent of total revenue in fiscal
1999 than fiscal 1998, due primarily to an increase in billing rates for
professional services, and an increase in software revenue. Other costs, as a
percent of total revenue, increased in fiscal 1998 from fiscal 1997 primarily
due to increases in recruiting, professional development and travel and
entertainment expenses.
Cost of Software Licenses
- -------------------------
Cost of software licenses consists primarily of the cost of product
components, product duplication, shipping and reproduction of manuals. Cost of
software license was $847,000, $402,000 and $25,000 in fiscal 1999, 1998 and
1997, respectively. Cost of software licenses was 3%, 5% and 11% of software
license revenue in fiscal 1999, 1998 and 1997, respectively. The decrease in
cost of software licenses as a percent of software licenses revenue was due
primarily to an increase in sales compared to increases in fixed costs.
Cost of Software Support and Maintenance
- ----------------------------------------
Cost of software support and maintenance expenses consist primarily of
compensation and benefits of the Company's employees engaged in the delivery of
software support and maintenance services as well as the related costs of travel
and entertainment, certain recruiting and professional development expenses,
field facilities, depreciation, expensed equipment and supplies. Cost of
software support and maintenance was $5.0 million, $3.2 million and $1.7 million
in fiscal 1999, 1998 and 1997, respectively. The increase in cost of software
support and maintenance was due to an increase in sales and was 2% of total
revenue in fiscal 1999, 1998 and 1997.
Research and Development
- ------------------------
All research and development expenses, including software development costs,
are charged to expense as incurred. Statement of Financial Accounting Standards
("SFAS") No. 86, "Accounting for the Costs of Computer Software to be Sold,
Leased, or Otherwise Marketed," requires the capitalization of certain software
development costs once technological feasibility is established, which the
Company defines as the completion of a working model. The capitalized costs are
then amortized on a straight line basis over the estimated product life, or
based on the ratio of current revenues to total projected product revenues,
whichever is greater. To date, costs incurred subsequent to achieving
technological feasibility and prior to the general commercial release of the
software have not been significant. Accordingly, the Company has not capitalized
any software development costs. Research and development expenses were $6.3
million, $4.2 million, and $2.3 million in fiscal 1999, 1998 and 1997,
respectively. Research and development expenses were 2% of total revenue in
fiscal 1999, 1998 and 1997. The absolute dollar increase reflects an increase in
the number of employees to support the development of, and enhancements to,
software products.
Sales and Marketing
- -------------------
Sales and marketing expenses consist primarily of compensation, including
commissions and benefits of sales and marketing personnel as well as outside
marketing expenses. Sales and marketing expenses were $48.8 million, $26.4
million and $15.0 million in fiscal 1999, 1998 and 1997, respectively,
representing increases over the prior fiscal year of 85%, 76% and 88%,
respectively. The increase in each year was due primarily to the growth in the
number of sales and marketing employees and to commissions resulting from
increased revenue. Sales and marketing expenses were 15% of total revenue in
fiscal 1999, 1998 and 1997.
General and Administrative
- --------------------------
General and administrative expenses consist of expenses associated with
executive staff, finance, corporate facilities, information services and human
resources. General and administrative expenses were $38.6 million, $19.7 million
and $13.7 million in fiscal 1999, 1998 and 1997, respectively, representing
increases over the prior fiscal year of
18
96%, 44% and 172%, respectively. The dollar increase reflects an increase in
the number of employees and the implementation of new human resource and
financial systems necessary to support the Company's growth in operations.
General and administrative expenses were 12%, 11% and 14% of total revenue in
fiscal 1999, 1998 and 1997, respectively. The increase from fiscal 1998 to
fiscal 1999 on a percentage basis was the result of increases in infrastructure
across finance, human resources and information services to support the
Company's growth. The decrease from fiscal 1997 to fiscal 1998 on a percentage
basis was due primarily to an increase in revenue.
Interest and Other, Net
Interest and other, net consists primarily of interest income. Interest and
other, net were $3.1 million, $2.1 million, and $854,000 in fiscal 1999, 1998
and 1997, respectively. Interest income consists primarily of interest on cash,
cash equivalents, investments and notes receivable from stockholders. Interest
expense consists of interest associated with bank borrowings. The increase in
net interest income was due primarily to an increase in funds available for
investment.
Provision for Income Taxes
The Company provides for income taxes using an asset and liability approach
that recognizes deferred tax assets and liabilities for expected future tax
consequences of temporary differences between the book and tax bases of assets
and liabilities. The effective tax rates were 45.2%, 40% and 39% for fiscal
1999, 1998 and 1997, respectively. The increase in the effective tax rate for
fiscal 1999 was due to the acquisition related charges. In fiscal 1998 and
1997, the Company's effective tax rates approximated the combined federal and
state statutory rates, net of federal benefits.
Liquidity and Capital Resources
At June 30, 1999, the Company had $109.4 million in cash, cash equivalents
and investments, representing an increase of $36.4 million from June 30, 1998.
Working capital at June 30, 1999 was $84.9 million.
Net cash provided by operating activities was $27.7 million, $24.4 million and
$3.0 million in fiscal 1999, 1998 and 1997, respectively. The increase in cash
provided by operations each year primarily reflects the Company's increased
profitability offset by increases in accounts receivable. Although the Company
believes its collections experience is within industry standards, the Company's
inability to collect its receivables on a timely basis in the future could have
a material adverse effect on the Company's business, operating results and
financial condition. In fiscal 1998, cash provided by operating activities also
resulted from prepayments for services and software resulting in an increase in
deferred revenue of $16.4 million. Net cash used in investing activities was
$61.8 million, $28.3 million and $29.3 million in fiscal 1999, 1998 and 1997,
respectively. Cash used in investing activities in fiscal 1999 primarily
reflected net investment activity and capital expenditures related to the
installation of new internal software as well as capital expenditures related to
new office facilities. Cash used in investing activities in fiscal 1998 and 1997
primarily reflected net investment activity in marketable securities and, to a
lesser extent, purchases of computer equipment and software. Net cash provided
by financing activities in fiscal 1999 of $26.5 million resulted primarily from
the proceeds from issuance of Common Stock related to the exercise of stock
options and employee stock purchases under the Company's Employee Stock Purchase
Plan. Net cash provided by financing activities in fiscal 1998 and 1997 of $11.9
million and $50.0 million, respectively, primarily resulted from the issuance of
Common Stock and a warrant to purchase Common Stock.
The Company has a $10 million line of credit with a bank, which expires in
February 2000. Borrowings under the line of credit bear interest at the bank's
prime rate less one half of one percent, or the Company has the option to borrow
at a fixed rate at one and one half percent above the bank's LIBOR for a fixed
term of up to three months. Balances outstanding at February 2000 that have
been used to fund capital equipment may be converted to a three-year term loan,
which provides for the same interest rate option. There were no borrowings
under the line of credit at June 30, 1999. The line of credit requires the
Company to comply with certain financial covenants. At June 30, 1999, the
Company was in compliance with these financial covenants.
The Company believes that its current cash and investment balances and cash
flow from operations will be sufficient to meet its working capital and capital
expenditure requirements for at least the next twelve months. The Company may
also utilize cash to acquire or invest in complementary businesses or to obtain
the right to use complementary technologies.
19
Year 2000
The year 2000 issue is the result of computer programs having been written
using two digits, rather than four, to define the applicable year. Any of the
Company's computers, computer programs, and administration equipment or products
that have date-sensitive software may recognize a date using "00" as the year
1900 rather than the year 2000. If any of the Company's systems that have date-
sensitive software use only two digits, system failures or miscalculations may
result causing disruptions of operations, including, among other things, a
temporary inability to process transactions or send and receive electronic data
with third parties or engage in similar normal business activities.
The Company believes its current software products are year 2000 compliant.
However, there can be no assurances that the Company's current products do not
contain undetected errors or defects associated with year 2000 date functions
that may result in material cost to the Company.
With respect to its internal information technology systems (including
information technology-based office facilities such as data and voice
communications, building management and security systems), the Company has
formed an ongoing internal review team to address the year 2000 issue. A team
of professionals has been engaged in a process to identify and resolve
significant year 2000 issues in a timely manner. The process includes an
assessment of issues, testing of systems and development of remediation plans,
where necessary, as they relate to internally used software, computer hardware
and use of computer applications in the Company's products. This internal review
team has substantially completed their assessment and while the Company has not
identified any significant issues, it is currently finalizing a contingency plan
to support critical business operations should it become necessary. The Company
anticipates that it will complete the assessment and contingency plans by the
end of October 1999. Executive management regularly monitors the status of the
Company's year 2000 remediation plans.
The Company has been contacting its key suppliers and other key third
parties to certify their year 2000 readiness and conducting ongoing risk
analysis and anticipates completing this process by the end of October 1999. To
the extent such third parties are materially adversely affected by the year 2000
issue, this could disrupt the Company's operations. There can be no assurance
that the Company's key contractors will have successful conversion programs, and
that any such year 2000 compliance failures will not have a material adverse
effect on the Company's business, results of operation or financial condition.
Based on information available to date, the Company has substantially
completed its year 2000 assessment. To date, the Company has not incurred any
material costs related to the assessment of, and efforts in connection with, its
year 2000 issues. The Company further believes that any further review and
modification, if any, will not require a material charge to operating expenses
over the next several years. Management believes that the Company is devoting
the necessary resources to identify and resolve significant year 2000 issues in
a timely manner.
Recently issued accounting pronouncements
In April 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use." SOP 98-1 provides
guidance for determining whether computer software is internal-use software and
on accounting for the proceeds of computer software originally developed or
obtained for internal use and then subsequently sold to the public. It also
provides guidance on capitalization of the costs incurred for computer software
developed or obtained for internal use. The Company is required to adopt SOP
98-1 by July 1, 1999 and does not expect it to have a material effect on the
Company's consolidated financial position, results of operations or cash flows.
RISKS RELATED TO THE PROPOSED LUCENT MERGER
We face risks relating to the proposed Lucent merger.
On August 9, 1999, we executed a merger agreement to be acquired by Lucent.
Under the terms of the agreement, each outstanding share of INS Common Stock
will be exchanged for 0.8473 shares of Lucent Common Stock. The announcement of
the proposed merger may have a negative impact on our ability to sell our
services and products, attract and retain employees and clients, and maintain
strategic relationships. The announcement has already had and may in the future
have an adverse effect on our relationships with significant clients and
strategic partners. The merger is subject to approval by the Company's
stockholders and various regulatory agencies, and there can be no assurance that
the merger will be successfully completed. In the event that the merger is not
successfully completed, the Company's results of operations and Common Stock
price could be materially adversely affected.
If the merger is successfully completed, holders of INS Common Stock will
become holders of Lucent Common Stock. Lucent's business differs from our
business, and Lucent's results of operations, as well as the price of Lucent
Common Stock, may be affected by factors different than those affecting our
results of operations and the price of our
20
Common Stock. For a discussion of Lucent's business and certain factors to
consider in connection with such business, see Lucent's Annual Report on
Form 10-K for the fiscal year ended September 30, 1998, as amended by Lucent's
Form 8-K filed on August 2, 1999, and Lucent's Quarterly Report on Form 10-Q for
the quarter ended June 30, 1999.
If the Lucent merger is completed, our stockholders will receive a fixed number
of shares of Lucent Common Stock despite changes in the market value of our
Common Stock or Lucent Common Stock.
Under the merger agreement, each share of INS Common Stock will be
converted into the right to receive 0.8473 shares of Lucent Common Stock. This
exchange ratio is a fixed number and will not be adjusted in the event of any
increase or decrease in the price of Lucent Common Stock or INS Common Stock.
The prices of Lucent Common Stock and INS Common Stock at the closing of the
proposed merger may vary from their respective prices on the date the merger
agreement was signed. These prices may vary because of changes in the business,
operations or prospects of Lucent or INS, market assessments of the likelihood
that the merger will be completed, the timing of the completion of the merger,
the prospects of post-merger operations, regulatory considerations, general
market and economic conditions and other factors.
The anticipated benefits of the proposed merger may not be realized.
The success of our business has historically depended on our current and
potential clients perceiving us as a vendor independent provider of professional
services. Following the proposed merger, our existing and potential clients may
perceive our relationship with Lucent, a leading vendor of networking systems,
as compromising our ability to provide unbiased solutions. Such a perception
could have a material adverse effect on our business and operating results,
which would result in Lucent and us not achieving the anticipated potential
benefits of the proposed merger.
Our failure to complete the proposed merger with Lucent could adversely affect
our business.
If the merger is not completed, we may be subject to a number of material risks,
including the following:
. the public announcement of the proposed merger has adversely affected our
relationships with some of our clients and strategic partners, including
Cisco;
. the public announcement of the proposed merger has had an adverse effect
on our ability to attract and retain employees;
. we may be required to pay Lucent a termination fee of $110 million;
. the option we granted to Lucent to acquire 19.9% of the outstanding shares
of our Common Stock with an exercise price of $53.91 per share may become
exercisable and if Lucent exercises the option, we may not be able to
account for future transactions as a "pooling of interests";
. the price of our Common Stock may decline to the extent that the current
market price for our Common Stock reflects a market assumption that the
proposed merger will be completed; and
. costs related to the proposed merger, such as legal, accounting, and
financial advisor fees, must be paid even if the merger is not completed.
RISK FACTORS THAT MAY AFFECT OPERATING RESULTS
The following risk factors could materially and adversely affect our future
operating results and could cause actual events to differ materially from those
predicted in our forward-looking statements related to our business.
Our quarterly operating results are uncertain and are likely to fluctuate
significantly.
The underutilization of our network systems engineers may cause our operating
results to fluctuate. We derive the majority of our revenue from professional
services, which are generally provided on a "time and expenses" basis. We
recognize professional services revenue only when network systems engineers are
engaged on client projects. In addition, a majority of our operating expenses,
particularly personnel and related costs, depreciation and rent, are relatively
fixed in advance of any particular quarter. As a result, any underutilization of
network systems engineers may cause significant variations in our operating
results in any particular quarter and could result in losses for such quarter.
Factors which could cause such underutilization, include:
21
. the reduction in size, delay in commencement, interruption or termination
of one or more significant projects
. the completion during a quarter of one or more significant projects;
. the inability to obtain new projects;
. the overestimation of resources required to complete new or ongoing
projects; and
. the timing and extent of training, weather related shut-downs, vacation
days and holidays.
A shortfall in software revenue could cause our operating results to decline.
We also derive a significant portion of our revenue from the license of our
software solutions. Our revenue from software solutions is hard to predict
because our license fee revenue is substantially dependent on orders booked and
shipped in that quarter and because we generally recognize a substantial portion
of our revenue from software solutions in the last month of the quarter. An
unanticipated shortfall of sales of our software solutions could harm our
operating results, particularly because profit margins are higher on software
solutions than on professional services.
Other factors may cause our operating results to fluctuate. Our revenue and
earnings may also fluctuate from quarter to quarter based on a variety of
factors, including:
. an inability to hire and retain sufficient numbers of employees, including
network systems engineers, account managers and software engineers;
. changes in billing rates or product pricing;
. market acceptance of current and future products;
. write-offs of billings or services performed at no charge as a result of
our failure to meet client expectations, product returns and undetected
product errors or failures;
. claims by our clients arising from actions of our employees which result
in damages to our clients' business or otherwise;
. competition;
. the development and introduction of new services and products by us and
our competitors;
. the loss of key employees;
. corporate acquisitions;
. decrease or slowdown in the growth of the networking industry as a whole;
. any slowdown in systems and software spending or in general business
expansion in connection with year 2000 issues; and
. general economic conditions.
In addition, we plan to continue to expand our operations based on sales
forecasts by hiring additional network systems engineers, account managers and
other employees, investing in new product development and adding new offices,
systems and other infrastructure. The resulting increase in operating expenses
would harm our operating results if revenue does not increase as much as
forecasted.
We believe that quarterly revenue and operating results are likely to vary
significantly in the future and that period-to-period comparisons of our
operating results are not necessarily meaningful. You should not rely on period-
to-period comparisons as indications of future performance. In some future
quarter, our revenue or operating results may be below the expectations of
public market analysts or investors. In that event, the price of our Common
Stock would probably decline.
Our pending merger with Lucent may create uncertainties which may cause our
existing and potential clients to delay purchasing our services and software,
which would impair our revenues and operating results. In addition, our
employee turnover has increased since the announcement of the proposed merger.
As a result of the foregoing factors, our revenue or operating results could be
below the expectations of public market analysts and investors in the current
and future quarters.
The announcement of our proposed merger with Lucent has had an impact on our
business.
The announcement of our proposed merger with Lucent may be perceived as
compromising our ability to provide unbiased solutions and has already had and
may in the future have an adverse effect on our relationships with significant
clients and strategic partners. For example, we had developed a significant
relationship with Cisco, a competitor of Lucent, and had entered into direct
relationships with clients as a result of referrals from Cisco and had provided
services directly to Cisco primarily as a subcontractor. As a result of the
announcement of the merger, Cisco has terminated existing agreements with us and
will likely cease referring clients and subcontracting work to us.
22
In addition, our pending merger with Lucent may create uncertainties which may
cause our existing and potential clients to delay purchasing our services, which
would impair our revenues and operating results. In addition, competitors have
been recruiting our employees and our employee turnover rate will be higher in
the current quarter than in past quarters. As a result of the foregoing factors,
our revenue or operating results could be below the expectations of public
market analysts and investors in the current and future quarters.
Our success depends on our ability to attract and retain qualified network
systems engineers.
Our future success will depend in large part on our ability to hire, train and
retain network systems engineers who together have expertise in a wide array of
network and computer systems and a broad understanding of the industries we
serve. Competition for network systems engineers is intense, and we cannot be
certain that we will be successful in attracting and retaining such personnel.
In particular, competition is intense for the limited number of qualified
managers and senior network systems engineers. We have experienced, and may in
the future experience, high rates of turnover among our network systems
engineers. As a result of the announcement of our proposed merger with Lucent,
competitors have been recruiting our network systems engineers and our employee
turnover rate will be higher in the current quarter than in past quarters. In
addition, the recruiting cycle may take longer due to uncertainties regarding
the merger. Our inability to hire, train and retain a sufficient number of
qualified network systems engineers could impair our ability to adequately
manage and complete our existing projects or to obtain new projects, which, in
turn, could harm our business, operating results and financial condition. In
addition, we have experienced, and may in the future experience, increasing
compensation costs for our network systems engineers. Our inability to recover
increases in compensation of network systems engineers through higher billing
rates or to reduce other expenses to offset such increases, could harm our
business, operating results and financial condition.
We depend on a small number of customers for most of our revenues.
We have historically derived a significant portion of our revenue from a
limited number of clients and expect this concentration to continue. For the
fiscal year ended June 30, 1999, no one client accounted for more than 10% of
revenue and ten clients accounted for approximately 42% of revenue. We have
regularly experienced declines in revenue from clients that have accounted for
significant revenue, and we expect to continue to experience these declines in
the future. When revenue for one or more significant clients declines in a
quarter, we must rapidly redeploy network systems engineers to other projects in
order to minimize the underutilization of employees. If we are unable to do so,
our business, operating results and financial condition could suffer.
Our customers are generally able to reduce or cancel their contracts.
Our clients are generally able to reduce or cancel their use of our
professional services without penalty and with little or no notice. As a result,
we believe that the number and size of our existing projects are not reliable
indicators or measures of future revenue. When a client defers, modifies or
cancels a project, if we are not able to rapidly redeploy network systems
engineers to other projects in order to minimize the underutilization of
employees, our business, operating results and financial condition could suffer.
We face risks associated with our software solutions.
Development and introduction risks. The market for our software solutions is
characterized by rapid technological change, evolving industry standards,
changes in customer requirements and frequent new product introductions and
enhancements. The introduction of software products embodying new technologies
and the emergence of new industry standards can render existing software
products obsolete and unmarketable. The life cycles of our software solutions
are difficult to estimate. As a result, our future success will depend, in part,
upon our ability to continue to enhance our existing software solutions and
develop and introduce in a timely manner new software solutions that keep pace
with technological developments, satisfy customer requirements and achieve
market acceptance. We cannot be certain that we will successfully identify new
software product opportunities and develop and bring new software products to
market in a timely and cost-effective manner, or that software products,
capabilities or technologies developed by others will not render our software
products or technologies obsolete or noncompetitive or shorten the life cycles
of our software products. If we are unable to develop on a timely and cost-
effective basis new software products or enhancements to our existing products,
or if such new products or enhancements do not achieve market acceptance, our
business, operating results and financial condition will suffer.
Risk of product "bugs." Software products as complex as ours frequently
contain undetected errors or "bugs" when first introduced or when new versions
are released that, despite testing by use, are discovered only after a product
has been
23
installed and used by customers. There can be no assurance that errors
will not be found in our software solutions or that such errors will not result
in delay or loss of revenue, diversion of development resources, damage to our
reputation or impaired market acceptance of these products, which could harm our
business, operating results and financial condition.
Our success depends on our development of new business and our ability to
attract and retain qualified account managers.
Our future success will also depend in large part on the development of new
business by our account managers, who solicit new business and manage
relationships with existing clients. As a result, our success will depend on our
ability to attract and retain qualified account managers who have an
understanding of our business and the industry it serves. Competition for
account managers is intense and we have experienced, and may in the future
experience, high rates of turnover among our account managers. In addition,
integration of new account managers into our business can be lengthy. Our
inability to attract and retain a sufficient number of account managers or to
integrate new account managers into our operations on a timely basis could harm
our business, operating results and financial condition.
We must effectively manage the growth of our operations.
We have experienced a period of rapid revenue and client growth and an
increase in the number of employees and offices and in the scope of our
supporting infrastructure. We do not believe this rate of growth is sustainable.
This growth has resulted in new and increased responsibilities for management
personnel and has placed and continues to place a significant strain on our
management and operating and financial systems. We will have to continue to hire
management personnel and improve our systems on a timely basis and in the manner
necessary to accommodate any increase in the number of our transactions and
clients, any increase in the size of our operations and any introduction of new
products and services. Our management or systems may not be adequate to support
our existing or future operations, particularly as we expand internationally.
Any failure to implement and improve our systems or to hire and retain
appropriate personnel to manage our operations would harm our business,
operating results and financial condition.
We face intense competition.
Our industry is comprised of a large number of participants and is subject to
rapid change and intense competition. With respect to professional services, we
face competition from system integrators, value-added resellers, local and
regional network services firms, telecommunications providers, network equipment
vendors, and computer systems vendors, many of which have significantly greater
financial, technical and marketing resources and greater name recognition, and
generate greater service revenue than we do. With respect to software solutions,
we face competition from companies such as Concord Communications, Desktalk
Systems and Compuware, some of which have significantly greater financial,
technical and marketing resources and greater name recognition, and generate
greater revenue than we do. We have faced, and expect to continue to face,
additional competition from new entrants into our markets, many of which are
well established in the software industry and have greater financial resources.
In addition, Cisco recently announced that it was making a large investment in
KPMG LLP's consulting business and Cisco has made investments in several private
companies which provide network services. Increased competition could result in
price reductions, fewer client projects, underutilization of employees, reduced
operating margins and loss of market share, any of which could harm our
business, operating results and financial condition. We cannot be sure that we
will be able to compete successfully against current or future competitors. Our
failure to compete successfully would harm our business, operating results and
financial condition.
We face risks from expansion of our international operations.
A component of our long-term strategy is to expand into international markets.
We have offices in the United Kingdom, the Netherlands, Germany and Canada. We
expect to generate an increasing proportion of our revenue from international
operations. The revenue generated from international operations may not be
adequate to offset the expense of establishing and maintaining these foreign
operations, and if revenue does not materialize as anticipated, our business,
operating results and financial condition could suffer. We cannot be certain
that we will be able to successfully market, sell and deliver our services in
international markets.
In addition to the uncertainty as to our ability to expand into international
markets, there are certain risks inherent in conducting business on an
international level, any one of which could adversely impact the success of our
international operations. These risks include:
. unexpected changes in regulatory requirements, export restrictions,
tariffs and other trade barriers;
. difficulties in staffing and managing foreign operations;
24
. employment laws and practices in foreign countries;
. longer payment cycles and problems in collecting accounts receivable;
. political instability;
. fluctuations in currency exchange rates;
. imposition of currency exchange controls;
. seasonal reductions in business activity during the summer months in
Europe and certain other parts of the world; and
. potentially adverse tax consequences.
One or more of these factors could harm our future international operations
and our business, operating results and financial condition. In addition, we may
not be able to compete effectively in these markets.
We face liability risks from the actions of our employees and the license of our
software products.
We are subject to claims by our clients for the actions of our employees
arising from damages to our clients' business or otherwise. In selling certain
products, we rely on "end user" licenses that are not signed by licensees and it
is possible that such licenses may be unenforceable under the laws of certain
jurisdictions. For these and other reasons, the limitation of liability
provisions contained in our license agreements may not be effective. A
successful liability claim brought against us as a result of the actions of our
employees or the license of our software products could harm our operating
results.
We may be unable to adequately protect our intellectual property.
Our success depends in part on our information technology, only some of which
is proprietary to us, and other intellectual property rights. We rely on a
combination of nondisclosure and other contractual arrangements, technical
measures, copyrights, patents and trade secret and trademark laws to protect our
proprietary rights. We also try to protect our software, documentation and other
written materials under trade secret and copyright laws. In selling certain
products, we rely on "end user" licenses that are not signed by licensees and
such licenses may be unenforceable under the laws of certain jurisdictions. The
laws of some foreign countries do not protect our proprietary rights to the same
extent as the laws of the United States. The steps we have taken to protect our
proprietary rights may not be adequate to protect our intellectual property and
we cannot be certain that third parties will not infringe or misappropriate our
patents, copyrights, trademarks, tradedress and similar proprietary rights.
We may be unable to deter misappropriation of our proprietary information and
the proprietary information of our clients.
We enter into confidentiality arrangements with our employees and attempt to
limit access to and distribution of our proprietary information and the
proprietary information of our clients. The steps we have taken in this regard
may not be adequate to deter misappropriation of proprietary information and we
may not be able to detect unauthorized use or take appropriate steps to enforce
intellectual property rights. If we are not successful in our efforts to protect
our proprietary information and the proprietary information of our clients, our
business, financial condition and operating results could suffer. In addition,
policing unauthorized use of our products is difficult, and we cannot determine
the extent to which piracy of our software exists.
We may infringe the intellectual property rights of others.
We may receive communication in the future from third parties or clients
asserting that we have infringed or misappropriated the proprietary rights of
such parties. We expect that software developers will increasingly be subject to
infringement claims as the number of products and the number of competitors in
our industry segment grows and the functionality of products in other industry
segments overlaps that of our products. Any such claims, with or without merit,
could be time consuming, result in costly litigation and divert technical and
management personnel, result in delays of product shipments, require us to
develop non-infringing technology or require us to enter into royalty or
licensing agreements. Such royalty or licensing agreements, if required, may not
be available on terms acceptable to us or at all. If a claim of infringement or
misappropriation against us is successful and we fail to or cannot develop non-
infringing technology or license the infringed, misappropriated, or similar
technology, our business, operating results and financial condition could
suffer.
We face risks associated with acquisitions.
25
We have recently acquired VitalSigns Software, and we may make additional
acquisitions of, or significant investments in, complementary companies,
products or technologies. Any such acquisitions will be accompanied by the risks
commonly encountered in making acquisitions of companies, products and
technologies. Such risks include, among others:
. the difficulty associated with assimilating the personnel and operations
of acquired companies;
. the potential disruption of our ongoing business;
. the distraction of management and other resources;
. the inability of management to maximize our financial and strategic
position through the successful integration of acquired personnel,
technology and rights;
. the maintenance of uniform standards, controls, procedures and policies;
and
. the impairment of relationships with employees, partners and clients as a
result of the acquisition.
We cannot be certain that we will be successful in overcoming these risks or
any other problems encountered in connection with any acquisitions. Any such
problems encountered in the transition and integration process could harm our
business, operating results and financial condition.
We face risks associated with the year 2000.
As a result of the year 2000 issue, we face risks including:
. Demand for our services and products may decrease as current and potential
clients reduce their spending on software and systems during the second
half of 1999 and into the year 2000 due to concerns or issues they
anticipate or experience in connection with the year 2000;
. Our internal systems may experience year 2000-related problems which may
significantly disrupt our operations, including a temporary inability to
process transactions or engage in normal business activities; and
. Our clients who experience year 2000 problems with their systems may claim
that our software products which they use are not Year 2000 compliant or
that our employees who performed services for them are responsible for the
year 2000 problems and, as a result, we could be required to provide
extensive technical support or services or we could become involved in
costly and/or protracted litigation.
The occurrence of any of the above events as well as other year 2000-related
problems could cause significant diversion of our management and financial
resources and could harm our business, financial condition and results of
operations.
We recently adopted a Preferred Shares Rights Plan which has anti-takeover
effects.
We recently entered into a Preferred Shares Rights Plan. See Item 5(b) of
this Form 10-K. The Plan has the anti-takeover effect of causing substantial
dilution to a person or group (other than Lucent) that attempts to acquire us on
terms not approved by our board of directors. These anti-takeover provisions
could limit the price that certain investors might be willing to pay in the
future for shares of our Common Stock.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company invests in marketable securities in accordance with its investment
policy. The primary objectives of the Company's investment policy are to
preserve principal, maintain proper liquidity to meet operating needs and
maximize yields. The Company's investment policy specifies credit quality
standards for the Company's investments and limits the amount of credit exposure
to any single issue, issuer or type of investment. The maximum allowable
maturity of a single issue is three years and the maximum allowable average
maturity of the portfolio is fifteen months.
At the end of fiscal 1999, the Company had an investment portfolio of fixed
income securities totaling $84.6 million, excluding those classified as cash and
cash equivalents. The Company's investments consist primarily of money market
funds and various municipal obligations. These securities are classified as
available-for-sale and are recorded on the balance sheet at fair market value
with unrealized gains or losses reported as a component of other comprehensive
income/loss. Unrealized losses are charged against income when a decline in fair
market value is determined to be other than temporary. The specific
identification method is used to determine the cost of securities sold. Gains
and losses on marketable securities are included in interest and other income
when realized.
26
The investment portfolio is subject to interest rate risk and will fall in
value in the event market interest rates increase. If market interest rates
were to increase immediately and uniformly by 50 basis points (approximately 14%
of current rates in the portfolio) from levels as of June 30, 1999, the fair
market value of the portfolio would decline by approximately $678,000. However,
the Company has the ability to hold its fixed income securities to maturity and
may avoid recognizing a decline in income or cash flows.
To date, revenue from foreign sources and operations in foreign locations
have not been material. In addition, substantially all of the revenue has been
received in the U.S. dollars. As such, the current foreign exchange rate risk is
considered minimal, and the Company believes that sudden significant changes in
foreign currency exchange rates would not have a material impact on its
operating results or financial position. However, a component of the Company's
long-term strategy is to further expand into international markets. As a result,
fluctuations in currency exchange rates in the future could have a material
adverse effect on the Company's business, operating results and financial
condition. Commencing in fiscal 2000, the Company has entered into foreign
currency forward exchange contracts to manage exposure related to certain
foreign currency transactions. The Company does not enter into derivative
financial instruments for trading purposes. There were no outstanding forward
exchange contracts at June 30, 1999.
27
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INTERNATIONAL NETWORK SERVICES
Consolidated Balance Sheets
(in thousands, except par value)
June 30,
1999 1998
--------- ---------
ASSETS
Current Assets:
Cash and cash equivalents....................................................................... $ 24,818 $ 32,484
Short-term investments.......................................................................... 28,297 25,319
Accounts receivable, net........................................................................ 77,962 47,035
Deferred income taxes........................................................................... 6,880 3,758
Prepaid expenses and other assets............................................................... 6,808 3,926
--------- ---------
Total current assets....................................................................... 144,765 112,522
Property and equipment, net....................................................................... 21,489 11,495
Deferred income taxes............................................................................. 715 1,071
Investments....................................................................................... 56,267 15,198
--------- ---------
$ 223,236 $ 140,286
--------- ---------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable................................................................................ $ 10,723 $ 3,816
Accrued compensation and employee benefits...................................................... 24,653 12,638
Accrued liabilities............................................................................. 2,411 4,530
Income taxes payable............................................................................ 3,213 --
Deferred revenue................................................................................ 18,883 16,995
--------- ---------
Total current liabilities.................................................................. 59,883 37,979
--------- ---------
Commitments and contingencies (Note 7)
Stockholders' equity:
Preferred Stock, $0.001 par value (no par value -- June 30, 1998),
5,000 shares authorized; none issued and outstanding..................................... -- --
Common Stock and additional paid-in capital, $0.001 par value (no par value -- June 30, 1998),
150,000 and 75,000 shares authorized; 57,174 and 54,797 shares issued
and outstanding.......................................................................... 120,280 83,648
Notes receivable from stockholders.............................................................. (919) (685)
Deferred compensation........................................................................... (1,792) (1,443)
Accumulated other comprehensive loss............................................................ (491) (35)
Retained earnings............................................................................... 46,275 20,822
--------- ---------
Total stockholders' equity................................................................. 163,353 102,307
--------- ---------
$ 223,236 $ 140,286
========= =========
The accompanying notes are an integral part of these consolidated financial
statements.
28
INTERNATIONAL NETWORK SERVICES
Consolidated Statements of Income
(in thousands, except per share amount)
Year Ended June 30,
--------------------------------
1999 1998 1997
--------- --------- --------
Revenue:
Professional services.......................................... $ 276,488 $ 158,001 $ 95,542
Software licenses.............................................. 29,681 7,513 238
Software support and maintenance............................... 8,920 7,284 3,733
--------- --------- --------
Total revenue.............................................. 315,089 172,798 99,513
--------- --------- --------
Operating Expenses:
Professional services personnel................................ 125,756 73,911 44,268
Other costs of professional services........................... 39,306 23,155 12,216
Cost of software licenses...................................... 847 402 25
Cost of software support and maintenance....................... 4,952 3,173 1,655
Research and development.......................................... 6,263 4,161 2,262
Sales and marketing............................................... 48,826 26,389 14,985
General and administrative........................................ 38,575 19,735 13,715
Acquisition related charges....................................... 7,176 -- --
--------- --------- --------
Total operating expenses................................... 271,701 150,926 89,126
--------- --------- --------
Income from operations............................................ 43,388 21,872 10,387
Interest and other, net........................................... 3,102 2,135 854
--------- --------- --------
Income before provision for income taxes.......................... 46,490 24,007 11,241
Provision for income taxes........................................ 21,037 9,603 4,489
--------- --------- --------
Net income........................................................ $ 25,453 $ 14,404 $ 6,752
========= ========= ========
Net income per share:
Basic...................................................... $ 0.47 0.28 $ 0.17
========= ========= ========
Diluted.................................................... $ 0.41 0.25 $ 0.13
========= ========= ========
Shares used to compute net income per share:
Basic...................................................... 54,444 50,582 39,531
========= ========= ========
Diluted.................................................... 62,210 57,101 51,845
========= ========= ========
The accompanying notes are an integral part of these consolidated financial
statements
29
INTERNATIONAL NETWORK SERVICES
Consolidated Statement of Stockholders' Equity (Deficit)
(in thousands)
Accretion of
Common Stock Notes Mandatorily
and Additional Paid-in Capital Receivable Redeemable
------------------------------ From Convertible
Shares Amount Stockholders Preferred Stock
------------- ------------- -------------- -------------------
Balance at June 30, 1996................................... 17,140 $ 2,394 $ (1,880) $ (2,454)
Net income................................................. -- -- -- --
Issuance of Common Stock in public
offering, net of issuance costs........................... 4,313 41,709 -- --
Conversion of Mandatorily Redeemable
Convertible Preferred Stock in
connection with IPO....................................... 25,102 9,973 -- 2,454
Issuance of Common Stock upon exercise of
stock options and warrants, net........................... 1,241 245 (57) --
Issuance of Common Stock for cash, net..................... 4,533 6,566 -- --
Issuance of Common Stock under employee
stock purchase plan....................................... 323 2,983 -- --
-------- --------- -------- --------
Income tax benefit related to stock
option exercises.......................................... -- 3,594 -- --
Balance at June 30, 1997................................... 52,652 67,464 (1,937) --
Net income................................................. -- -- -- --
Translation adjustments.................................... -- -- -- --
Comprehensive income....................................... -- -- -- --
Issuance of Common Stock upon exercise of
stock options and warrants, net........................... 1,516 1,388 (64) --
Issuance of Common Stock under employee
stock purchase plan....................................... 629 6,047 -- --
Repayment of stockholders' notes........................... -- -- 1,316 --
Issuance of warrant........................................ -- 3,188 -- --
Deferred compensation , net................................ -- 1,513 -- --
Income tax benefit related to stock
option exercises.......................................... -- 4,048 -- --
-------- --------- -------- --------
Balance at June 30, 1998................................... 54,797 83,648 (685) --
Net income................................................. -- -- -- --
Translation adjustments.................................... -- -- -- --
Unrealized loss on investments, net........................ -- -- -- --
Comprehensive income
Issuance of Common Stock upon exercise of
stock options............................................. 1,290 8,818 (350) --
Issuance of Common Stock, net.............................. 328 6,570 -- --
Issuance of Common Stock under employee
stock purchase plan....................................... 759 11,345 -- --
Repayment of stockholders' notes........................... -- -- 116 --
Deferred compensation, net................................. -- 1,125 -- --
Income tax benefit related to stock
option exercises.......................................... -- 8,774 -- --
-------- --------- -------- --------
Balance at June 30, 1999................................... 57,174 $ 120,280 $ (919) $ --
======== ========= ======== ========
Accumulated
Other Retained
Deferred Comprehensive Earnings/
Compensation Income/(loss) (Deficit) Total
------------- --------------- ----------- ----------
Balance at June 30, 1996................................... $ -- $ -- $ (334) $ (2,274)
Net income................................................. -- -- 6,752 6,752
Issuance of Common Stock in public
offering, net of issuance costs........................... -- -- -- 41,709
Conversion of Mandatorily Redeemable
Convertible Preferred Stock in
connection with IPO....................................... -- -- -- 12,427
Issuance of Common Stock upon exercise of
stock options and warrants, net........................... -- -- -- 188
Issuance of Common Stock for cash, net..................... -- -- -- 6,566
Issuance of Common Stock under employee
stock purchase plan....................................... -- -- -- 2,983
Income tax benefit related to stock
option exercises.......................................... -- -- -- 3,594
-------- ------ -------- ---------
Balance at June 30, 1997................................... -- -- 6,418 71,945
Net income................................................. -- -- 14,404 14,404
Translation adjustments.................................... -- (35) -- (35)
Comprehensive income....................................... 14,369
Issuance of Common Stock upon exercise of
stock options and warrants, net........................... -- -- -- 1,324
Issuance of Common Stock under employee
stock purchase plan....................................... -- -- -- 6,047
Repayment of stockholders' notes........................... -- -- -- 1,316
Issuance of warrant........................................ -- -- -- 3,188
Deferred compensation , net................................ (1,443) -- -- 70
-------- ------ -------- ---------
Income tax benefit related to stock
option exercises.......................................... -- -- -- 4,048
Balance at June 30, 1998................................... (1,443) (35) 20,822 102,307
Net income................................................. -- -- 25,453 25,453
Translation adjustments.................................... -- (113) -- (113)
Unrealized loss on investments, net........................ -- (343) -- (343)
Comprehensive income....................................... 24,997
Issuance of Common Stock upon exercise of
stock options............................................. 8,468
Issuance of Common Stock, net.............................. -- -- -- 6,570
Issuance of Common Stock under employee
stock purchase plan....................................... -- -- -- 11,345
Repayment of stockholders' notes........................... -- -- -- 116
Deferred compensation, net................................. (349) -- -- 776
Income tax benefit related to stock
option exercises.......................................... -- -- -- 8,774
-------- ------ -------- ---------
Balance at June 30, 1999................................... $ (1,792) $ (491) $ 46,275 $ 163,353
======== ====== ======== =========
The accompanying notes are an integral part of these consolidated financial
statements.
30
INTERNATIONAL NETWORK SERVICES
Consolidated Statements of Cash Flows
(in thousands)
Year Ended June 30,
------------------------------------------------------
1999 1998 1997
-------- -------- --------
Cash flows from operating activities:
Net income...................................................... $ 25,453 $ 14,404 $ 6,752
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization................................ 8,144 5,982 3,848
Deferred income taxes........................................ (2,766) (2,325) (1,647)
Tax benefit from employee stock plans........................ 8,774 4,048 3,594
Changes in assets and liabilities:
Accounts receivable.......................................... (30,927) (22,929) (12,285)
Prepaid expenses and other assets............................ (2,882) (901) (2,639)
Accounts payable............................................. 6,907 446 1,462
Accrued liabilities.......................................... 9,896 9,235 3,979
Income taxes payable......................................... 3,213 -- --
Deferred revenue............................................. 1,888 16,441 (58)
-------- -------- --------
Net cash provided by operating activities.................. 27,700 24,401 3,006
Cash flows from investing activities:............................. -------- -------- --------
Purchases of property and equipment............................ (17,362) (9,105) (8,011)
Purchases of investments....................................... (82,770) (38,934) (25,414)
Sales of investments........................................... 38,380 19,732 4,099
-------- -------- --------
Net cash used for investing activities..................... (61,752) (28,307) (29,326)
-------- -------- --------
Cash flows from financing activities:
Payments under line of credit.................................. -- -- (1,000)
Payments on notes payable...................................... -- -- (715)
Proceeds from issuance of Common Stock, net.................... 26,383 10,623 51,716
Repayments of stockholder notes receivable..................... 116 1,252 --
-------- -------- --------
Net cash provided by financing activities.................. 26,499 11,875 50,001
-------- -------- --------
Effect of exchange rate changes on cash and cash equivalents...... (113) (35) --
-------- -------- --------
(Decrease) increase in cash and cash equivalents................. (7,666) 7,934 23,681
Cash and cash equivalents at beginning of period.................. 32,484 24,550 869
-------- -------- --------
Cash and cash equivalents at end of period........................ $ 24,818 $ 32,484 $ 24,550
-------- -------- --------
Supplemental disclosure of cash flow information:
Cash paid for income taxes..................................... $ 10,938 $ 8,177 $ 7,599
Non-cash transactions:
Issuance of Common Stock in exchange for notes receivable
from stockholders............................................ $ 350 $ 64 $ 57
Conversion of Mandatorily Redeemable Convertible Preferred
Stock to Common Stock........................................ $ -- $ -- $ 9,973
Deferred compensation relating to granting of options below
fair market value................................................ $ 1,125 $ 1,513 $ --
The accompanying notes are an integral part of these consolidated financial
statements.
31
INTERNATIONAL NETWORK SERVICES
Notes to Consolidated Financial Statements
June 30, 1999
1. THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES
The Company
- -----------
International Network Services (the "Company") was incorporated in California in
August 1991. Effective December 28, 1998 (the first day of the Company's third
fiscal quarter), the Company changed its state of incorporation from California
to Delaware. The Company is a global provider of enterprise network
professional services and software solutions. The Company provides professional
services for the full life cycle of a network, including planning, design,
implementation, operations and optimization, and maintains expertise in the most
complex network technologies and multi-vendor environments. To date, the
Company has provided limited professional services to certain of its United
States based clients in foreign locations. Through its INSoft Division, the
Company offers industry leading software solutions for managing and optimizing
application-ready networks. The Company's core software solutions include
EnterprisePRO, which was introduced in June 1996, and VitalSuite, which was
introduced in November 1997.
Significant accounting policies
- -------------------------------
Basis of Presentation The Company's fiscal year is composed of four 13-week
quarters, each of which ends on the last Sunday of the final fiscal month of the
quarter, with the fiscal year ending on the Sunday closest to June 30. For
financial statement presentation purposes, each fiscal year end is titled June
30th. Certain prior year consolidated financial statement balances have been
reclassified to conform to the fiscal 1999 presentation.
Principles of consolidation The consolidated financial statements include
the accounts of the Company and its wholly-owned subsidiaries in the United
Kingdom, Germany, the Netherlands and Canada. All intercompany accounts and
transactions have been eliminated.
Stock Split In April 1999, the Company's Board of Directors effected a three-
for-two stock split payable in the form of a dividend of one additional share of
Common Stock for every two shares owned by stockholders. The stock split
resulted in the issuance of approximately 18.8 million additional shares of
Common Stock from authorized but unissued shares. Accordingly, all share and per
share data have been adjusted to retroactively reflect the stock split.
Management estimates and assumptions 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, the disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenue and expenses during
the reporting period. Actual results could differ from those estimates.
Foreign currency translation The functional currency of the Company's
wholly-owned foreign subsidiaries are the local currencies. Assets and
liabilities of these subsidiaries are translated into U.S. dollars at exchange
rates in effect at the balance sheet date. Income and expense items are
translated at average exchange rates for the period. Accumulated translation
adjustments are recorded in stockholders' equity. Foreign exchange transaction
gains and losses were not material in all periods presented.
Derivative Financial Instruments Commencing in fiscal 2000, the Company has
entered into foreign currency forward exchange contracts ("forward contracts")
to manage exposure related to certain foreign currency transactions. The
Company does not enter into derivative financial instruments for trading
purposes. There were no outstanding forward contracts at June 30, 1999.
Revenue recognition Professional services revenue consists primarily of
revenues earned from professional services generally performed on a "time and
expenses" basis and related revenue is recognized as the services are performed.
The Company also performs a limited number of fixed-price engagements under
which revenue is recognized using the percentage-of-completion method of
accounting. Provision for estimated losses on such engagements is made during
the period in which the loss becomes probable and can be reasonably estimated.
To date, such losses have been insignificant. The Company reports professional
services revenue net of reimbursable expenses, which are billed to and collected
from clients. Payments received in advance of services performed are recorded
as deferred revenue.
32
License revenue consists principally of revenue earned under software license
agreements and under royalty agreements with OEMs. License revenue is generally
recognized when a signed contract or other persuasive evidence of an arrangement
exists, the software has been shipped or electronically delivered, the license
fee is fixed or determinable, and collection of the resulting receivable is
probable. For contracts with multiple elements/obligations (e.g. software
products, upgrades/enhancements, maintenance, and services), revenue is
allocated to each element of the arrangement based on the Company's objective
evidence of the fair value as determined by the amount charged when the element
is sold separately. Revenue from subscription license agreements, which include
software, rights to future products and maintenance, is recognized ratably over
the term of the subscription period. Revenue on shipments to resellers, which
is generally subject to certain rights of return and price protection, is
recognized when the products are sold by the resellers to the end-user customer.
Royalty revenues that are contingent upon sale to an end user by OEMs are
generally recognized upon receipt of a report by the Company from the OEM.
Software support and maintenance consists of all inclusive service contracts,
which includes the right to use software combined with installation, maintenance
and support, as well as services for installation, maintenance and support of
software licenses sold separately and included in license fees. Prior to fiscal
1998, the Company only offered its EnterprisePRO solution as an all inclusive
contract. Revenue from all inclusive software service contracts is recognized
ratably over the term of the agreement. Services revenue related to
installation is generally recognized when the services are complete.
Maintenance revenue, which consists of fees for providing updates and user
documentation, and support services, which provide access to the Company's
Technical Assistance Center and field support, are recognized ratably over the
term of the agreement. Support services, which consists of technical support
and configuration, is recognized ratably over the term of the agreement.
Effective in fiscal 1999, the Company adopted Statement of Position ("SOP") 97-
2, "Software Revenue Recognition" and its related amendments. SOP 97-2 provides
guidance on applying generally accepted accounting principles in recognizing
revenue on software transactions and supercedes the previous guidance provided
by SOP 91-1. The adoption of SOP 97-2 did not have a material impact on the
Company's licensing practices or consolidated financial position or results of
operations.
Comprehensive income Effective in fiscal 1999, the Company adopted SFAS No.
130, "Reporting Comprehensive Income." SFAS No.130 establishes new rules for
the reporting and display of comprehensive income and its components. The
adoption of SFAS No. 130 had no impact on the Company's results of operations or
stockholders' equity. SFAS No. 130 requires companies to report a new,
additional measure of income on the income statement or to create a new
financial statement that has the new measure of income on it. "Comprehensive
income" includes foreign currency translation gains and losses and other
unrealized gains and losses that have been previously excluded from net income
and reflected instead in equity. The Company has reported the components of
comprehensive income on its Consolidated Statement of Stockholders' Equity
(Deficit).
Net income per share Basic net income per share is computed by dividing net
income (numerator) by the weighted average number of common shares outstanding
(denominator) during the period and excludes the dilutive effect of stock
options, warrants and Common Stock subject to repurchase. Diluted net income per
share gives effect to all dilutive potential Common Shares outstanding during a
period. In computing diluted net income per share, the average stock price for
the period is used in determining the number of shares to be purchased from the
exercise of stock options.
Operating expenses:
Professional services personnel Professional personnel expenses consist
primarily of compensation and benefits of the Company's employees engaged in
the delivery of professional services.
33
Other costs of professional services Other costs consist primarily of travel
and entertainment, certain recruiting and professional development expenses,
field facilities, depreciation, expensed equipment and supplies related to the
delivery of professional services.
Cost of software licenses Cost of software licenses consists primarily of the
cost of product components, product duplication, shipping and reproduction of
manuals.
Cost of software support and maintenance Cost of software support and
maintenance expenses consist primarily of compensation and benefits of the
Company's employees engaged in the delivery of software support and maintenance
services as well as the related costs of travel and entertainment, certain
recruiting and professional development expenses, field facilities,
depreciation, expensed equipment and supplies.
Research and development All research and development expenses, including
software development costs, are charged to expense as incurred. SFAS 86,
"Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise
Marketed," requires the capitalization of certain software development costs
once technological feasibility is established, which the Company defines as the
completion of a working model. The capitalized costs are then amortized on a
straight line basis over the estimated product life, or based on the ratio of
current revenues to total projected product revenues, whichever is greater. To
date, costs incurred subsequent to achieving technological feasibility and prior
to the general commercial release of the software have not been significant.
Accordingly, the Company has not capitalized any software development costs.
Income taxes The Company provides for income taxes using an asset and liability
approach that recognizes deferred tax assets and liabilities for expected future
tax consequences of temporary differences between the book and tax bases of
assets and liabilities.
Cash equivalents and investments Cash equivalents consist of highly liquid
investments with original maturities of three months or less. Investments
consist of high quality debt securities with original maturity dates greater
than 90 days. In accordance with SFAS No. 115, "Accounting for Certain
Investments in Debt and Equity Securities," the Company's investments are
classified as available-for-sale and, at the balance sheet date, are reported at
fair value, with the unrealized gains and losses, net of related taxes, reported
as a component of stockholders' equity.
Property and equipment Property and equipment are stated at cost.
Depreciation is computed using the straight-line method over the estimated
useful lives of the respective assets, ranging from two to five years.
Leasehold improvements are depreciated over the shorter of the lease term or the
estimated useful life.
Concentration of credit risk The Company's financial instruments that are
exposed to concentrations of credit risk consist primarily of cash, cash
equivalents, investments, and accounts receivable. The Company's investments
consist of investment grade securities managed by qualified professional
investment managers. The investment policy limits the Company's exposure to
concentration of credit risk. The Company's accounts receivable is derived from
revenue earned from customers primarily located in the United States. The
Company maintains an allowance for potential credit losses based upon the
expected collectibility of all accounts receivable; historically, such losses
have been immaterial. In fiscal 1999, 1998 and 1997, no one customer accounted
for more than 10% of revenues.
Stock-based compensation The Company accounts for stock-based compensation
using the intrinsic value method prescribed by APB Opinion No. 25, "Accounting
for Stock Issued to Employees." The Company's policy is to grant options with
an exercise price equal to the quoted market price of the Company's stock on the
grant date. Accordingly, no compensation cost has been recognized in the
Company's consolidated statements of income except for a certain amount of
deferred compensation assumed by the Company through its acquisition of
VitalSigns Software, Inc. ("VitalSigns") (see Note 2). The Company has provided
additional pro forma disclosures as required under SFAS No. 123, "Accounting
for Stock-Based Compensation" (see Note 5).
Recently issued accounting pronouncements In April 1998, the American
Institute of Certified Public Accountants ("AICPA") issued SOP 98-1, "Accounting
for the Costs of Computer Software Developed or Obtained for Internal Use." SOP
98-1 provides guidance for determining whether computer software is internal-use
software and on accounting for the proceeds of computer software originally
developed or obtained for internal use and then subsequently sold to the public.
It also provides guidance on capitalization of the costs incurred for computer
software developed or obtained for internal use. The Company is required to
adopt SOP 98-1 by July 1, 1999 and does not expect it to have a material effect
on the Company's consolidated financial position, results of operations or cash
flows.
34
2. ACQUISITION OF VITALSIGNS SOFTWARE, INC.
On November 20, 1998, the Company completed its acquisition of VitalSigns, which
has been accounted for as a pooling of interests, pursuant to the terms of the
Agreement and Plan of Reorganization, as amended and restated as of October 30,
1998. Each issued and outstanding share of VitalSigns Common Stock was
converted into .474124 shares of INS Common Stock; and each outstanding option
to acquire VitalSigns Common Stock was assumed by INS and became an equivalent
option with respect to the Company's Common Stock, on the same terms of the
original option adjusted to reflect the exchange ratio. The Company issued
approximately 5,933,000 shares of INS Common Stock in the acquisition and
assumed options that can be exercised for approximately 420,000 shares of INS
Common Stock.
Prior to the acquisition, VitalSigns' fiscal year ended on December 31. The
consolidated financial statements for the year ended June 30, 1998 reflect the
results of operations of the Company for the year ended June 30, 1998 combined
with the results of operations of VitalSigns for the twelve months ended June
30, 1998. The consolidated financial statements for the year ended June 30,
1997 reflect the results of operations of INS for the year ended June 30, 1997
combined with the results of operations of VitalSigns for the period from August
15, 1996 (inception) through June 30, 1997.
The results of operations previously reported by the separate companies and the
combined amounts in the accompanying consolidated statements of operations are
summarized below (in thousands):
Year Ended June 30,
------------------------
1998 1997
--------- --------
Revenue:
INS........................................ $ 169,678 $ 99,275
VitalSigns................................. 3,120 238
--------- --------
Combined................................ $ 172,798 $ 99,513
========= ========
Net income (loss):
INS........................................ $ 16,110 $ 7,612
VitalSigns................................. (1,706) (860)
--------- --------
Combined................................ $ 14,404 $ 6,752
========= ========
The Company incurred approximately $7.2 million in acquisition-related charges,
principally in the quarter ended December 31, 1998. These charges include
direct transaction costs primarily for financial advisory services, legal and
consulting fees and costs associated with combining the operations of the two
companies.
3. BALANCE SHEET COMPONENTS (in thousands)
June 30,
---------------------------
1999 1998
--------- ---------
Accounts receivable:
Trade............................................................. 82,607 $ 48,503
Less: allowances.................................................. (4,645) (1,468)
--------- ---------
$ 77,962 $ 47,035
Property and equipment:............................................. --------- ---------
Computer equipment and software................................... $ 25,935 $ 15,885
Leasehold improvements............................................ 4,810 2,300
Furniture, fixtures, and other.................................... 7,790 3,364
--------- ---------
38,535 21,549
Less: accumulated depreciation.................................... (17,046) (10,054)
--------- ---------
$ 21,489 $ 11,495
========= =========
35
4. INVESTMENTS
The carrying value of the Company's investment portfolio approximates fair value
for all periods presented. Cash equivalents and investments consist of the
following (in thousands):
June 30,
------------------------
1999 1998
--------- ---------
Money market fund............................................... $ 12,147 $ 10,334
Corporate debt securities....................................... 7,035 --
Government notes................................................ 2,967 --
State and local municipalities notes............................ 79,613 56,677
--------- ---------
Total available-for-sale securities.......................... 101,762 67,011
Less: amounts classified as cash equivalents................... (17,198) (26,494)
--------- ---------
Total investments............................................ $ 84,564 $ 40,517
========= =========
The contractual maturities of marketable securities at June 30, 1999, regardless
of their balance sheet classification, was as follows (in thousands):
Due in 1 year or less $ 28,297
Due in 1-2 years 25,204
Due in 2-3 years 31,063
--------
Total investments $ 84,564
========
At June 30, 1999, marketable securities totaling $17.2 million were classified
as cash equivalents and included money market funds of $12.1 and state and local
municipalities notes of $5.1 million.
5. STOCKHOLDERS' EQUITY
Common Stock
- ------------
In September 1996, the Company completed its initial public offering of
approximately 4,313,000 shares of Common Stock at $10.67 per share, which
resulted in net proceeds to the Company of approximately $41.7 million.
During 1998, in conjunction with a services agreement with a client, the Company
received aggregate proceeds of approximately $3.2 million from the client for a
warrant to purchase up to 395,000 shares of Common Stock at $19.73 per share.
The warrant, which is exercisable immediately, expires on May 1, 2005. The
warrant was issued at fair market value.
In both fiscal 1999 and fiscal 1997, VitalSigns issued convertible preferred
stock for gross proceeds of approximately $6.6 million. Just prior to
consummation of the acquisition, all VitalSigns convertible preferred stock was
converted into VitalSigns Common Stock. Such amounts have been included in the
accompanying consolidated financial statements as if approximately 378,000 and
4,533,000 shares of the Company's Common Stock were issued during fiscal 1999
and 1997, respectively.
During 1999, the Company changed its state of incorporation from California to
Delaware. As a result of the change, the par value of the Company's stock was
changed from no par value to $0.001 per share. There was no impact on the
Company's financial condition or results of operations as a result of the
reincorporation. The reincorporation proposal was approved by the Company's
stockholders at the Company's annual meeting of stockholders. In addition, the
stockholders approved an increase in the number of authorized shares of the
Company's Common Stock from 75,000,000 to 150,000,000.
Certain Common Stock option holders (see "Stock Option Plans") have the right to
exercise unvested options, subject to a repurchase right held by the Company. At
June 30, 1999 and 1998, approximately 781,000 and 2,663,000 shares outstanding,
respectively, were subject to repurchase by the Company at the original purchase
price in the event of employee termination.
36
At June 30, 1999, the Company had reserved 395,000, 1,077,000, and 19,290,000
shares of Common Stock for future issuance related to a warrant, its stock
purchase plan and its stock option plans, respectively.
Net Income Per Share
- --------------------
The following is a reconciliation between basic and diluted net income per share
computations for all periods presented (in thousands, except per share data):
Year Ended June 30,
-----------------------------------
1999 1998 1997
-------- --------- --------
Net income............................................................ $ 25,453 $ 14,404 $ 6,752
-------- -------- --------
Weighted average common shares used to
compute basic net income per share............................... 54,444 50,582 39,531
Effect of dilutive securities:
Option and warrants.............................................. 6,152 3,585 3,191
Common Stock subject to repurchase............................... 1,614 2,934 3,893
Preferred Stock.................................................. -- -- 5,230
-------- -------- --------
Weighted average common shares used to
compute diluted net income per share............................. 62,210 57,101 51,845
======== ======== ========
Net income per share:
Basic............................................................ $ 0.47 $ 0.28 $ 0.17
======== ======== ========
Diluted.......................................................... $ 0.41 $ 0.25 $ 0.13
========= ========= =========
Options to purchase approximately 148,000, 571,000 and 227,000 shares of Common
Stock were outstanding during fiscal 1999, 1998 and 1997, respectively, but were
not included in the computations of diluted EPS because the options' exercise
price was greater than the average market price of the common shares, and
therefore were anti-dilutive.
Notes receivable from stockholders
- ----------------------------------
In exchange for the issuance of Common Stock upon exercise of options, the
Company has from time to time received notes receivable from stockholders which
bear interest at rates varying from 5.32% to 6.0% per annum. Principal and
interest are due and payable at different dates between 1998 and 1999. The
outstanding balance of such notes receivable has been included in stockholders'
equity.
Deferred compensation
- ---------------------
As of June 30, 1999, the Company has recorded approximately $2.6 million of
deferred compensation for the difference between the exercise or purchase price
and deemed fair value of certain stock options and shares of restricted stock
granted or issued to VitalSigns employees and consultants prior to the
acquisition. This amount is being amortized by charges to operations over the
vesting period of individual options and restricted shares, ranging from two to
four years.
Stock option plans
- ------------------
On July 18, 1996, the Company's Board of Directors adopted the 1996 Stock Option
Plan (the "1996 Plan") as a successor to its 1992 Stock Option Plan (the "1992
Plan"). A total of 20,250,000 shares of Common Stock plus annual increases equal
to the lesser of (i) 3,750,000 shares, (ii) 2.5 percent of the number of shares
of Common Stock outstanding on the last day of the preceding fiscal year, or
(iii) a lesser amount determined by the Company's Board of Directors are
currently reserved for issuance pursuant to both the 1996 Plan and the 1992
Plan. As of July 18, 1996, no further option grants or stock issuances were
made under the 1992 Plan, and all option grants and stock issuances made during
the remainder of fiscal 1997 were made under the 1996 Plan. All
37
outstanding options under the 1992 Plan were incorporated into the 1996 Plan.
The 1996 Plan provides for granting to employees (including officers and
directors) incentive stock options and for the granting to employees, directors
(including non-employee directors) and consultants nonstatutory stock options
and stock purchase rights.
On April 24, 1998, the Company's Board of Directors adopted the 1998
Nonstatutory Stock Option Plan (the "1998 Plan.") and authorized 7,750,000
shares for issuance under this plan. The 1998 Plan provides for granting
nonstatutory stock options to employees and consultants, excluding officers and
directors.
In August 1998, the Company's Board of Directors adopted the 1998 Director
Option Plan (the "Director Plan") and reserved 450,000 shares of Common Stock
for issuance thereunder. The Director Plan provides for granting options to
non-employee directors. There were no options granted under the Director Plan
in fiscal 1999.
The Company assumed certain options granted to former employees of VitalSigns
("Acquired Options"). The Acquired Options have been adjusted to effectuate the
conversion under the terms of the Agreement and Plan of Reorganization between
the Company and VitalSigns. The Acquired Options generally become exercisable
over a four-year period and generally expire ten years from the date of grant.
No additional options will be granted under VitalSigns' plan.
Incentive stock options must be granted at fair market value at the date of
grant, and non-statutory stock options and stock appreciation rights may be
granted at not less than 85% of fair market value on the date of grant. Options
generally vest 24% on the first anniversary from the date of grant, and ratably
each month over the remaining thirty-eight months. Options expire over terms not
exceeding ten years from the date of grant.
On April 25, 1997, the Board of Directors approved a plan to offer all
employees, excluding executive officers, the opportunity to exchange their
outstanding stock options with exercise prices greater than $15.33 per share for
new options that would be exercisable at the fair market value of the Company's
Common Stock as of the closing of the stock market on May 5, 1997 or $13.17 per
share. These new options were otherwise identical to the old options.
A summary of the status of all of the Company's stock option plans as of and
during the years ended June 30, 1999, 1998, and 1997 follows (in thousands,
except exercise price):
1999 1998 1997
---------------------------------- --------------------------------- ----------------------------------
Weighted Weighted Weighted
Average Average Average
Option Exercise Option Exercise Option Exercise
Shares Price Shares Price Shares Price
--------- ---------- --------- ---------- --------- ----------
Outstanding at
beginning of
year............ 10,747 $ 12.75 5,427 $ 5.71 3,254 $ 0.94
Granted..... 9,930 28.05 7,981 14.73 4,498 10.74
Exercised... (1,290) 6.84 (1,807) 1.14 (981) 0.27
Canceled.... (745) 18.42 (854) 10.95 (1,344) 14.96
-------- ------- --------- ------- -------- -------
Outstanding at
end of year 18,642 $ 21.11 10,747 $ 12.75 5,427 $ 5.71
======== ======= ========= ======= ======== =======
Options vested
and exercisable
at year end..... 4,715 $ 13.54 2,027 $ 4.53 1,684 $ 0.76
======== ======= ========= ======= ======== =======
The following table summarizes information about stock options outstanding and
exercisable at June 30, 1999 (in thousands, except exercise price):
Options Outstanding Options Vested and Exercisable
-------------------------------------------------------------- ------------------------------------------
Weighted
Range of Average Weighted Shares Weighted
Exercise Price Shares Outstanding Remaining Average Exercisable Average Exercise
at June 30, 1999 Contractual Life Exercise Price at June 30, 1999 Price
- ---------------- ------------------- ------------------- ---------------- ------------------ ------------------
$0.01 to $0.05 130 5 Years $ 0.05 129 $ 0.05
$0.17 to $1.06 622 7 Years $ 0.54 554 $ 0.53
$1.67 to $8.00 1,031 7 Years $ 5.71 602 $ 5.26
$11.08 to $13.33 2,954 8 Years $12.75 1,240 $12.82
$15.00 to $17.63 3,459 9 Years $16.78 941 $16.39
$18.17 to $24.75 4,978 9 Years $22.99 1,200 $23.09
$25.17 to $35.50 5,468 10 Years $32.38 49 $28.12
- ---------------------------------------------------------------------------------------------------------------------------
$0.01 to $35.50 18,642 9 Years $21.11 4,715 $13.54
============================================================================================================================
38
Employee stock purchase plan
- ----------------------------
On July 18, 1996, the Company's Board of Directors adopted the 1996 Employee
Stock Purchase Plan (the "Purchase Plan"). Under the Purchase Plan, eligible
employees can have up to 15% of their earnings withheld through payroll
deductions for the purchase of shares of Common Stock at 85% of the lower of the
fair market value of the Common Stock on the commencement date of each offering
period or the specified purchase date. Each offering period is divided into four
consecutive semi-annual purchase periods. The initial offering period commenced
on the effectiveness of the Company's initial public offering in September 1996.
A total of 2,788,000 shares of Common Stock have been authorized for issuance
under the Purchase Plan.
Pro Forma Information
- ---------------------
Pro forma information regarding net income (loss) per share is required by SFAS
No. 123 to illustrate the financial results of operations as if the Company had
accounted for its stock-based awards to employees under the fair value method of
SFAS No. 123. The fair value of the Company's stock-based awards to employees
was estimated using a Black-Scholes option pricing model. The Black-Scholes
option valuation model was developed for use in estimating the fair value of
traded options that have no vesting restrictions and are fully transferable. The
Black-Scholes model requires the input of highly subjective assumptions
including the expected stock price volatility. Because the Company's stock-based
awards to employees have characteristics significantly different from those of
traded options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in management's opinion, the existing
models do not necessarily provide a reliable single measure of the fair value of
its stock-based awards to employees. The fair value of the Company's stock-based
awards to employees was estimated assuming no expected dividends and the
following weighted-average assumptions:
Option Plans Purchase Plan
------------------------------- -------------------------------
1999 1998 1997 1999 1998 1997
---------- --------- --------- ---------- --------- ---------
Expected life (in years)....................... 4.5 4.5 4.5 0.5 0.5 0.5
Expected volatility............................ 55% 55% 55% 70% 70% 75%
Risk free interest rate........................ 5.5% 5.5% 5.5% 5.2% 5.2% 5.8%
The weighted average estimated fair value of options granted under all option
plans during 1999, 1998 and 1997 was $14.19, $7.46 and $4.60, respectively. The
weighted average estimated fair value of purchase rights granted under the
Purchase Plan during 1999, 1998 and 1997 was $7.99, $5.29 and $5.10,
respectively. For pro forma purposes, the estimated fair value of the Company's
stock-based awards to employees is generally amortized over the options' vesting
period or the six-month purchase period, as applicable. The Company's pro forma
information follows (in thousands, except per share data):
Year Ended June 30,
-------------------------------------
1999 1998 1997
--------- -------- --------
Net income (loss)........................ As reported $ 25,453 $ 14,404 $ 6,752
Pro forma (10,173) 702 (1,799)
Basic net income (loss) per share........ As reported 0.47 0.28 0.17
Pro Forma (0.19) 0.01 (0.05)
Diluted net income (loss) per share..... As reported 0.41 0.25 0.13
Pro forma (0.19) 0.01 (0.05)
The above pro forma disclosures are not likely to be representative of pro
forma disclosures of future years.
39
6. INCOME TAXES
The provision for income taxes for the years ended June 30, 1999, 1998 and 1997
consists of the following (in thousands):
Year Ended June 30,
-------------------------------------------------------------
1999 1998 1997
----------- ----------- ------------
Current:
Federal................................................... $19,423 $ 9,442 $ 4,705
State..................................................... 3,854 2,249 1,266
Foreign................................................... 525 231 165
------- ------- -------
23,802 11,922 6,136
------- ------- -------
Deferred:
Federal................................................... (2,429) (2,027) (1,443)
State..................................................... (336) (292) (204)
------- ------- -------
(2,765) (2,319) (1,647)
------- ------- -------
$21,037 $ 9,603 $ 4,489
======= ======= =======
The provision for income taxes differs from the amount determined by applying
the U.S. statutory income tax rate to income before income taxes as summarized
below (in thousands):
Year Ended June 30,
-------------------------------------------------------------
1999 1998 1997
----------- ------------ ------------
Tax provision at statutory rate............................. $16,272 $8,402 $4,029
State income taxes, net of federal benefit.................. 2,286 1,462 690
Tax exempt interest......................................... (757) (528) (271)
Nondeductible expenses...................................... 2,648 235 83
Other....................................................... 588 32 (42)
------- ------- -------
$21,037 $9,603 $4,489
------- ------- -------
Deferred income taxes reflect the tax effects of temporary differences between
carrying amounts of assets and liabilities for financial reporting and income
tax purposes. The Company provides a valuation allowance for deferred tax
assets when it is more likely than not, based on available evidence, that some
portion or all of the deferred tax assets will not be realized. Significant
components of the Company's deferred tax assets are as follows (in thousands):
June 30,
-------------------------------------
1999 1998
---------------- ---------------
Depreciation................................................................. $ 715 $1,071
State income taxes........................................................... 581 325
Allowance for doubtful accounts.............................................. 1,868 594
Reserves and accruals........................................................ 1,536 1,225
Deferred revenue............................................................. 2,895 1,614
------ ------
$7,595 $4,829
====== ======
40
7. COMMITMENTS AND CONTINGENCIES
The Company leases office space for its corporate headquarters and various field
offices and certain computer equipment. Future annual minimum lease payments
under all noncancellable operating leases as of June 30, 1999 are as follows (in
thousands):
Year Ending
June 30,
----------------
2000............................................................................... $ 9,415
2001............................................................................... 7,005
2002............................................................................... 4,723
2003............................................................................... 3,279
2004............................................................................... 1,892
Thereafter.............................................................................. 604
-------
$26,918
=======
Total rent expense for the years ended June 30, 1999, 1998 and 1997 was
approximately $4.8 million, $3.2 million, and $1.4 million, respectively.
During 1998, the Company entered into an agreement with a client under which the
Company is required to pay royalties to the client, if and when revenue from
specified services exceeds a predetermined base of revenue for those services.
Royalty amounts recorded in fiscal 1999 and 1998 were not significant.
8. LINE OF CREDIT
The Company has a $10 million line of credit with a bank which expires in
February 2000. Borrowings under the line of credit bear interest at the bank's
prime rate (7.75% at June 30, 1999) less one half of one percent, or the Company
has the option to borrow at a fixed rate at one and one half percent above the
bank's LIBOR for a fixed term of up to three months. Balances outstanding at
February 2000 that have been used to fund capital equipment may be converted to
a three-year term loan, which provides for the same interest rate option. There
were no borrowings under the line of credit at June 30, 1999. The line of credit
requires the Company to comply with certain financial covenants. At June 30,
1999, the Company was in compliance with these financial covenants.
9. SEGMENT INFORMATION
In fiscal 1999, the Company adopted SFAS 131, "Disclosures about Segments of an
Enterprise and Related Information."
The Company currently operates in two operating segments: professional services
and software solutions. Operating segments are defined as components of an
enterprise about which financial information is available and is evaluated by
the chief decision maker when deciding how to allocate resources and when
assessing performance. The Company's chief operating decision making group
consist of the Chief Executive Officer, the Chief Operating Officer and Chief
Financial Officer.
The professional services segment principally involves consulting services for
complex enterprise networks. The software solutions segment provides solutions
for managing and optimizing application-ready networks. The Company evaluates
the performance of its segments and allocates resources to them based on
contribution margin. There are no differences between the accounting policies
used to measure profit and loss for segments and those used on a consolidated
basis.
41
The information in the following table is derived from the Company's internal
financial reporting used for corporate management purposes (in thousands).
For the Year Ended June 30, 1999
--------------------------------------------------------------------
Professional Software
Services Solutions Other Total
--------------- -------------- ------------ ------------
Revenue.................................... $ 276,488 $ 38,601 $ -- $ 315,089
Expenses:
Professional services personnel........... (125,756) -- -- (125,756)
Other costs of professional services...... (39,306) -- -- (39,306)
Cost of software licenses................. -- (847) -- (847)
Cost of software support and maintenance.. -- (4,952) -- (4,952)
Research and development.................. -- (6,263) -- (6,263)
--------- --------- --------- ---------
Contribution margin........................ 111,426 26,539 -- 137,965
Sales and marketing........................ -- -- (48,826) (48,826)
General and administrative................. -- -- (38,575) (38,575)
Acquisition related charges................ -- -- (7,176) (7,176)
Interest and other, net.................... -- -- 3,102 3,102
Income before provision for --------- --------- --------- ---------
income taxes........................... $ 111,426 $ 26,539 $ (91,475) $ 46,490
========= ========= ========= =========
Depreciation and amortization.............. $ 1,515 $ 947 $ 4,906 $ 7,368
========= ========= ========= =========
For the Year Ended June 30, 1998
------------------------------------------------------------------
Professional Software
Services Solutions Other Total
------------- ------------ ------------- -----------
Revenue.................................... $158,001 $14,797 $ -- $172,798
Expenses:
Professional services personnel........... (73,911) -- -- (73,911)
Other costs of professional services...... (23,155) -- -- (23,155)
Cost of software licenses................. -- (402) -- (402)
Cost of software support and maintenance.. -- (3,173) -- (3,173)
Research and development.................. -- (4,161) -- (4,161)
-------- -------- -------- --------
Contribution margin........................ 60,935 7,061 -- 67,996
Sales and marketing........................ -- -- (26,389) (26,389)
General and administrative................. -- -- (19,735) (19,735)
Interest and other, net.................... -- -- 2,135 2,135
Income before provision for -------- -------- -------- --------
income taxes........................... $ 60,935 $ 7,061 $(43,989) $ 24,007
======== ======= ======== ========
Depreciation and amortization.............. $ 2,516 $ 713 $ 2,683 $ 5,912
======== ======= ======== ========
42
For the Year Ended June 30, 1997
--------------------------------------------------------------
Professional Software
Services Solutions Other Total
------------- ----------- -------------- --------------
Revenue........................................ $ 95,542 $ 3,971 $ -- $ 99,513
Expenses:
Professional services personnel............... (44,268) -- -- (44,268)
Other costs of professional services.......... (12,216) -- -- (12,216)
Cost of software licenses..................... -- (25) -- (25)
Cost of software support and maintenance...... -- (1,655) -- (1,655)
Research and development...................... -- (2,262) -- (2,262)
-------- -------- -------- --------
Contribution margin............................ 39,058 29 -- 39,087
Sales and marketing............................ -- -- (14,985) (14,985)
General and administrative..................... -- -- (13,715) (13,715)
Interest and other, net........................ -- -- 854 854
Income before provision for -------- -------- -------- --------
income taxes............................... $ 39,058 $ 29 $(27,846) $ 11,241
======== ======== ======== ========
Depreciation and amortization.................. $ 1,820 $ 459 $ 1,569 $ 3,848
======== ======== ======== ========
Revenue from no single foreign country was material to the consolidated revenues
of the Company. The Company does not segregate assets by segment nor are there
any significant assets located in any foreign country.
10. SUBSEQUENT EVENT
On August 9, 1999, the Company and Lucent Technologies Inc. ("Lucent") signed a
definitive merger agreement. Under the terms of the agreement, each share of
the Company's Common Stock will be converted into 0.8473 shares of Lucent's
Common Stock. Subject to Stockholder and other regulatory approvals, the
proposed merger is expected to be completed during the quarter ending December
31, 1999 and is expected to be accounted for as a pooling of interests.
43
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
International Network Services
In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) on page 55 present fairly, in all material
respects, the financial position of International Network Services and its
subsidiaries as of June 30, 1999 and 1998, and the results of their operations
and their cash flows for each of the three years in the period ended June 30,
1999, in conformity with generally accepted accounting principles. In addition,
in our opinion, the financial statement schedule listed in the index appearing
under Item 14(a)(2) on page 55 presents fairly, in all material respects, the
information set forth therein when read in conjunction with the related
consolidated financial statements. These financial statements and financial
statement schedule are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements and
financial statement schedule 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.
/s/ PricewaterhouseCoopers LLP
San Jose, California
July 23, 1999 (except for Note 10 which is dated as of August 9, 1999)
44
Quarterly Results of Operations
(unaudited)
(In thousands, except per share data)
Three Months Ended Fiscal 1999
----------------------------------------------------------------
June 30, Mar. 31, Dec. 31, Sept. 30,
1999 1999 1998 1998
----------------------------------------------------------------
Revenue:
Professional services......................................... $81,736 $72,071 $64,864 $57,817
Software licenses............................................. 10,024 8,583 7,249 3,825
Software support and maintenance.............................. 2,383 2,050 1,733 2,754
------- ------- ------- -------
Total revenue............................................ 94,143 82,704 73,846 64,396
------- ------- ------- -------
Operating expenses:
Professional services personnel............................... 36,827 33,297 29,541 26,091
Other costs of professional services.......................... 11,463 9,881 9,517 8,445
Cost of software licenses..................................... 294 278 205 70
Cost of software support and maintenance...................... 1,425 1,111 1,206 1,210
Research and development...................................... 1,825 1,676 1,481 1,281
Sales and marketing........................................... 15,052 12,209 11,198 10,367
General and administrative.................................... 11,512 10,596 8,747 7,720
Acquisition related charges................................... - - 7,176 -
------- ------- ------- -------
Total operating expenses................................. 78,398 69,048 69,071 55,184
------- ------- ------- -------
Income from operations........................................... 15,745 13,656 4,775 9,212
Interest and other, net.......................................... 915 733 764 690
------- ------- ------- -------
Income before provision for income taxes......................... 16,660 14,389 5,539 9,902
Provision for income taxes....................................... 6,668 5,720 4,688 3,961
------- ------- ------- -------
Net income....................................................... $ 9,992 $ 8,669 $ 851 $ 5,941
======= ======= ======= =======
Net income per share:
Basic......................................................... $0.18 $0.16 $0.02 $0.11
Diluted....................................................... $0.16 $0.14 $0.01 $0.10
Shares used to compute net income per share:
Basic......................................................... 56,065 55,188 53,943 52,581
Diluted....................................................... 63,725 63,451 61,565 60,099
Three Months Ended Fiscal 1998
-----------------------------------------------------------------
June 30, Mar. 31, Dec. 31, Sept. 30,
1998 1998 1997 1997
-----------------------------------------------------------------
Revenue:
Professional services......................................... $48,597 $42,039 $35,564 $31,801
Software licenses............................................. 3,143 2,048 1,894 428
Software support and maintenance.............................. 2,227 1,960 1,380 1,717
------- ------- ------- -------
Total revenue............................................ 53,967 46,047 38,838 33,946
------- ------- ------- -------
Operating expenses:
Professional services personnel............................... 22,357 19,524 17,027 15,002
Other costs of professional services.......................... 7,222 6,427 4,958 4,548
Cost of software licenses..................................... 168 162 42 31
Cost of software support and maintenance...................... 1,038 744 712 679
Research and development...................................... 1,245 997 1,163 756
Sales and marketing........................................... 8,364 6,962 6,161 4,902
General and administrative.................................... 6,011 5,278 4,413 4,033
Acquisition related charges................................... - - - -
------- ------- ------- -------
Total operating expenses................................. 46,405 40,094 34,476 29,951
------- ------- ------- -------
Income from operations........................................... 7,562 5,953 4,362 3,995
Interest and other, net 556 577 593 409
------- ------- ------- -------
Income before provision for income taxes......................... 8,118 6,530 4,955 4,404
Provision for income taxes....................................... 3,247 2,612 1,982 1,762
------- ------- ------- -------
Net income....................................................... $ 4,871 $ 3,918 $ 2,973 $ 2,642
======= ======= ======= =======
Net income per share:
Basic......................................................... $0.09 $0.08 $0.06 $0.05
Diluted....................................................... $0.08 $0.07 $0.05 $0.05
Shares used to compute net income per share:
Basic......................................................... 51,800 51,013 50,179 49,335
Diluted....................................................... 58,750 57,409 56,129 56,114
45
Quarterly Results of Operations
(unaudited)
(as a percentage of revenue)
Three Months Ended Fiscal 1999
-----------------------------------------------------------------------
June 30, Mar. 31, Dec. 31, Sept. 30,
1999 1999 1998 1998
-----------------------------------------------------------------------
Revenue:
Professional services.......................... 87% 87% 88% 90%
Software licenses.............................. 10 10 10 6
Software support and maintenance............... 3 3 2 4
------- ------- ------- -------
Total revenue................................ 100 100 100 100
------- ------- ------- -------
Operating expenses:
Professional services personnel................ 39 40 40 41
Other costs of professional services........... 12 12 13 13
Cost of software licenses...................... 0 0 0 0
Cost of software support and maintenance....... 2 1 2 2
Research and development....................... 2 2 2 2
Sales and marketing............................ 16 15 15 16
General and administrative..................... 12 13 12 12
Acquisition related charges.................... 0 - 10 -
------- ------- ------- -------
Total operating expenses..................... 83 83 94 86
------- ------- ------- -------
Income from operations........................... 17 17 6 14
Interest and other, net.......................... 1 1 1 1
------- ------- ------- -------
Income before provision for income taxes......... 18 18 7 15
Provision for income taxes....................... 7 7 6 6
------- ------- ------- -------
Net income....................................... 11% 11% 1% 9%
======= ======= ======= =======
Three Months Ended Fiscal 1998
---------------------------------------------------------------------
June 30, Mar. 31, Dec. 31, Sept. 30,
1998 1998 1997 1997
---------------------------------------------------------------------
Revenue:
Professional services............................. 90% 91% 91% 94
Software licenses................................. 6 5 5 1
Software support and maintenance.................. 4 4 4 5
------ ------ ------ ------
Total revenue................................... 100 100 100 100
------ ------ ------ ------
Operating expenses:
Professional services personnel................... 42 42 44 44
Other costs of professional services.............. 13 14 13 13
Cost of software licenses......................... 0 0 0 0
Cost of software support and maintenance.......... 2 2 2 2
Research and development.......................... 2 2 3 2
Sales and marketing............................... 16 15 16 15
General and administrative........................ 11 11 11 12
Acquisition related charges....................... - - - -
------ ------ ------ ------
Total operating expenses........................ 86 86 89 88
------ ------ ------ ------
Income from operations.............................. 14 14 11 12
Interest and other, net............................. 1 1 2 1
------ ------ ------ ------
Income before provision for income taxes............ 15 15 13 13
Provision for income taxes.......................... 6 6 5 5
------ ------ ------ ------
Net income.......................................... 9% 9% 8% 8%
====== ====== ====== ======
46
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
The following table sets forth certain information regarding the directors
and executive officers of the Company as of August 17, 1999.
Name Age Position With the Company
- ---------------------- ------- -----------------------------------------------------------------------
Donald K. McKinney................ 50 Chairman of the Board
John L. Drew...................... 43 President, Chief Executive Officer and Director
Kevin J. Laughlin................. 38 Vice President of Finance and Chief Financial Officer
David M. Butze.................... 42 Vice President of Worldwide Operations and Chief Operating Officer
Vernon R. Anderson................ 68 Director
David Carlick..................... 49 Director
Lawrence G. Finch`................ 65 Director
- ------------------
Donald K. McKinney. Mr. McKinney, the founder of the Company, served as
President and Director from the Company's inception in August 1991 until January
1996 and Chief Executive Officer from August 1991 until July 1998. Mr. McKinney
has served as Chairman of the Board since January 1996. Mr. McKinney formed
Watershed Capital Partners in October 1998 and has been a Partner since the
formation. Mr. McKinney served as the Vice President of Sales and Marketing of
Electronics for Imaging, Inc., a provider of hardware and software products for
the digital color imaging market, from May 1989 to February 1991. Mr. McKinney
has also served in various sales, management and consulting positions at Sequoia
Capital, Silicon Graphics, Inc., Chromatics and IBM. Mr. McKinney is also on the
Board of Directors of C-Cube Microsystems and several privately held companies.
John L. Drew. Mr. Drew served as Vice President of Operations from June
1994 to January 1996 and as President and Chief Operating Officer from February
1996 to July 1998. Mr. Drew has served as President and Chief Executive Officer
since July 1998. Mr. Drew is also a Director of the Company. Prior to joining
the Company, Mr. Drew was Vice President and General Manager for the Network
Enable Division of Unisys Corporation from April 1991 to June 1994. Mr. Drew
also served in other finance, marketing and management positions for Unisys
Corporation from July 1984 to March 1991.
Kevin J. Laughlin. Mr. Laughlin joined the Company in August 1993 as
Director of Finance and Secretary, became Vice President of Finance in August
1994, and became Chief Financial Officer in July 1996. Mr. Laughlin was
Controller of Electronics for Imaging, Inc., a provider of hardware and software
products for the digital color imaging market, from November 1989 to July 1993.
Mr. Laughlin also served as an Accounting Manager of Oracle Corporation and in
various positions at Ernst & Young.
David M. Butze. Mr. Butze joined the Company in April 1995 as Vice
President of Western Operations, served as Vice President of North American
Field Operations from September 1997 to June 1999 and became Vice President of
Worldwide Operations and Chief Operating Officer in July 1999. Mr. Butze was
Vice President of Sales and Marketing of Valence Technology, Inc., a battery
technology company, from May 1992 to March 1995. Mr. Butze was Vice President
of JWP Information Services, a systems integrator, from March 1989 to May 1992.
47
Vernon R. Anderson. Mr. Anderson has served as a member of the Company's
Board of Directors since April 1992 and served as Chairman of the Board from
April 1992 to January 1996. Mr. Anderson has been a private investor and
management advisor since January 1994. Mr. Anderson was the President, Chief
Executive Officer and Vice Chairman of Axel Johnson, Inc., a diversified
industrial company, from March 1988 to October 1989, and Vice Chairman from
October 1989 to December 1993. Mr. Anderson was a founder, President and Chief
Executive Officer of Silicon Graphics, Inc., Collagen Corporation and Vidar
Corporation.
David Carlick. Mr. Carlick has served as a member of the Board of Directors
since April 1992. Mr. Carlick was the founder of Carlick Advertising in 1981,
which merged with Poppe Tyson in 1993, and was an Executive Vice President and
Director of Poppe Tyson from 1993 to March 1997. From April 1997 to September
1997, Mr. Carlick was President, Media Services, of PowerAgent. Since September
1997, Mr. Carlick has served as Senior Advisor to VantagePoint Venture Partners
and in June 1999 became a Venture Partner. Mr. Carlick is on the Board of
Directors of several privately held companies.
Lawrence G. Finch. Mr. Finch has served as a member of the Board of
Directors since June 1993. Mr. Finch has been a partner of Sigma Partners since
1989. Mr. Finch is on the Board of Directors of Splash Technology Inc., Genesis
Microchip Incorporated and several privately held companies.
Mr. Giancarlo resigned as a member of the Board of Directors in August 1999.
Mr. Giancarlo serves as the Senior Vice President of Small-to-Medium Business at
Cisco Systems, Inc.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Exchange Act of 1934 ("Section 16(a)") requires the
Company's executive officers, directors and persons who own more than ten
percent of the Company's Common Stock to file initial reports of ownership on
Form 3 and changes in ownership on Form 4 or Form 5 with the SEC and the
National Association of Securities Dealers, Inc. Such executive officers,
directors and ten-percent stockholders are also required by SEC rules to furnish
the Company with copies of all such forms that they file.
Based solely on its review of the copies of such forms received by the
Company and written representations from certain reporting persons that all
required Forms 5 have been filed, the Company believes that during fiscal 1999
all Section 16(a) filing requirements applicable to its executive officers,
directors and ten-percent stockholders were complied with except that Form 4s
were filed late for Vernon Anderson in April 1999, John Drew in August 1998 and
Donald McKinney in July 1999. Additionally, Form 5s were filed late for Vernon
Anderson, David Butze, David Carlick, John Drew, Lawrence Finch and Kevin
Laughlin for fiscal 1999.
48
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following table shows, as to the Chief Executive Officer and the
Company's other executive officers whose salary plus bonus exceeded $100,000
during the last fiscal year (the "Named Officers"), information concerning
compensation earned for services to the Company in all capacities during the
last three fiscal years.
Long-Term
Compensation
Awards
Annual Compensation --------------
---------------------
Securities
Fiscal Underlying
Name and Principal Position(1) Year Salary($) Bonus($) Options (#)
- -------------------------------------------------- -------- ---------- ---------- --------------
Donald K. McKinney............................... 1999 $236,115 $ - 225,000
Chairman of the Board 1998 260,000 130,000 750,000
1997 245,000 105,000 0
John L. Drew..................................... 1999 346,538 - 2,475,000
President, Chief Executive Officer and Director 1998 260,000 130,000 749,999
1997 245,000 105,000 0
Kevin J. Laughlin................................ 1999 185,618 86,996 24,000
Vice President, Finance, Chief Financial 1998 148,560 62,616 187,500
Officer and Secretary 1997 148,000 37,500 0
David M. Butze................................... 1999 213,577 132,007 325,000
Vice President of Worldwide Operations and 1998 173,462 167,927 345,000
Chief Operating Officer 1997 123,077 179,754 149,999
- ----------------
(1) Mr. McKinney was Chief Executive Officer until July 1998 at which time Mr.
Drew was appointed Chief Executive Officer.
The following table sets forth for each of the Named Officers certain
information concerning stock options granted during fiscal 1999.
Options Grants in Fiscal Year 1999
Individual Grants
- --------------------------------------------------------------------------------------------------------------------------------
Percentage of Potential Realizable Value at Assumed
Number Total Options Annual Rates of Stock Price
Securities Granted to Appreciation for Option Term (4)
Underlying Employees in Exercise or -------------------------------------
Options Fiscal 1999 Base Price Expiration
Name Granted (1) (2) ($/Share) Date (3) 5% ($) 10% ($)
- ------------------------ -------------- ------------- ----------- ----------- -------------- -----------------
Donald K. McKinney (5) 150,000 1.5% $ 24.75 09/23/02 $ 837,621 $ 1,811,686
Donald K. McKinney (5) 75,000 0.8 24.75 07/23/08 1,167,386 2,958,384
John L. Drew (5) 150,000 1.5 24.75 09/23/02 837,621 1,811,686
John L. Drew (5) 2,325,000 23.4 24.75 07/23/08 36,188,955 91,709,918
Kevin J. Laughlin (5) 24,000 0.2 34.50 06/15/09 520,725 1,319,619
David M. Butze 225,000 2.3 17.50 10/06/08 2,476,273 6,275,361
David M. Butze 100,000 1.0 34.50 06/15/09 2,169,686 5,498,411
49
- -------------------
(1) Options granted pursuant to the Company's 1996 Stock Plan typically vest as
follows: a total of 24% of the options vest upon completion of 12 months of
service with the Company, and the remaining shares vest at the rate of two
percent per month over the next 38 months of service.
(2) The Company granted options for 9,915,318 shares of Common Stock to
employees in fiscal 1999.
(3) Options may terminate before their expiration dates if the optionee's
status as an employee or consultant is terminated or upon the optionee's
death or disability.
(4) The 5% and 10% assumed annual rates of compounded stock price appreciation
are mandated by rules of the Securities and Exchange Commission and do not
represent the Company's estimate or projection of the Company's future
Common Stock prices.
(5) A portion of these options will accelerate upon a change of control. See
"Employee Contracts and Change In Control".
The following table sets forth for each of the Named Officers certain
information concerning options exercised during fiscal 1999 and the number of
shares subject to both exercisable and unexercisable stock options as of fiscal
year-end. The table also sets forth information with respect to the value of
Stock Options held by such individuals as of June 27, 1999 (the Company's fiscal
year-end).
AGGREGATED OPTIONS EXERCISES IN FISCAL 1999 AND YEAR-END OPTION VALUES
NUMBER OF SECURITIES VALUE OF UNEXERCISED
NUMBER OF UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS AT
SHARES VALUE OPTIONS AT FISCAL YEAR-END FISCAL YEAR-END ($) (1)
ACQUIRED ON REALIZED ------------------------------ --------------------------------
NAME EXERCISE ($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- -------------------- ------------- ---------- ----------- ------------- ----------- -------------
Donald McKinney - $0 362,999 612,001 $ 6,022,421 $10,904,329
John L. Drew - 0 932,999 2,292,000 $14,851,528 $32,023,974
Kevin Laughlin - 0 77,999 133,501 $ 1,586,466 $ 2,163,962
David M. Butze - 0 216,148 566,352 $ 5,339,754 $10,276,010
(1) These values have been calculated based on the closing price of the
Company's Common Stock on The Nasdaq National Market on June 25, 1999 of
$36.63 per share minus the exercise price.
EMPLOYEE CONTRACTS AND CHANGE IN CONTROL
The Company currently has no employment contracts with any of the Company's
Named Officers. The Company, however, adopted an executive management group
change-of-control plan in July 1998, and has entered into "change-of-control"
agreements with Messrs. McKinney, Drew and Laughlin. Pursuant to these
agreements, in the event of a change-of-control of the Company, the vesting
schedule of any options or restricted stock (the "Unvested Awards") that each
such officer holds shall accelerate such that a portion of such Unvested Awards
shall vest in full. In addition, each such officer is eligible to receive, in
the event that his employment is terminated within one year following a change-
of-control of the Company, other than for cause (as defined), death, disability
(as defined), or resignation other than for good reason (as defined), an amount
equal to 100% of his annual compensation, continuation of health benefits for
twelve months thereafter, and the remaining portion of Unvested Awards held by
such officer shall vest in full. For purposes of the agreement, "annual
compensation" means annual salary and incentive compensation. A "change-of-
control" is defined to include the following events (i) any person (as defined
in the Securities Exchange Act of 1934) becomes the beneficial owner, directly
or indirectly, of 50% or more of the outstanding voting securities of the
Company, (ii) a merger or acquisition of the Company resulting in a 50% or
greater change in the total voting power of the Company immediately following
such transaction, (iii) certain changes in the majority composition of the Board
of Directors during a twenty-four
50
month period not initiated by the Board of Directors or (iv) the sale or
disposition of at least 75% of the Company's assets.
DIRECTOR COMPENSATION
Members of the Company's Board of Directors do not receive compensation for
their services as directors. Directors are eligible to receive stock option
grants to purchase Common Stock under the Company's 1996 Stock Plan and non-
employee directors are also eligible to receive option grants pursuant to the
Company's 1998 Director Option Plan. In August 1998, Messrs. Anderson and
Carlick each received an option to purchase 7,500 shares of Common Stock. The
options vest monthly over a 50 month period.
In addition, all directors are reimbursed for expenses incurred in attending
Board meetings.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Company's Compensation Committee is currently composed of Messrs.
Anderson and Carlick. No interlocking relationship exists between any member of
the Company's Board of Directors or Compensation Committee and any member of the
Board of Directors or compensation committee of any other company, nor has any
such interlocking relationship existed in the past. No member of the
Compensation Committee is or was formerly an officer or an employee of the
Company.
51
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth the beneficial ownership of Common Stock of
the Company as of August 17, 1999 for the following: (i) each person or entity
who is known by the Company to own beneficially 5% or more of the outstanding
shares of the Company's Common Stock; (ii) each of the Company's directors;
(iii) each of the executive officers named in the Summary Compensation Table;
and (iii) all directors and executive officers of the Company as a group.
Number of
Shares
Beneficially Percentage of
Name and Address of Beneficial Owner Owned Total (1)
- ---------------------------------------------------------------------------- --------------- ----------------
Donald K. McKinney(2)....................................................... 15,808,464 27.4%
c/o International Network Services
1213 Innsbruck Drive
Sunnyvale, CA 94089
Lucent Technologies Inc.(3)................................................. 15,808,464 27.4%
600 Mountain Avenue
Murray Hill, NJ 07974
Cisco Systems, Inc.......................................................... 3,872,418 6.8%
170 West Tasman Drive
San Jose, CA 95134
Pilgrim Baxter & Associates, Ltd. (4)....................................... 3,230,550 5.6%
825 Duportail Road
Wayne, PA 19087
John L. Drew(5)............................................................. 1,868,405 3.2%
Vernon R. Anderson(6)....................................................... 620,613 1.1%
Kevin J. Laughlin(7)........................................................ 385,914 *
Lawrence G. Finch(8)........................................................ 235,504 *
David Carlick(9)............................................................ 104,550 *
David M. Butze(10).......................................................... 365,801 *
-----------------------------------------------
All executive officers and directors as a group (7 persons)(11)............. 19,389,251 32.7%
-----------------------------------------------
- ---------------
* Represents beneficial ownership of less than 1% of the outstanding shares of
the Company's Common Stock.
1. Based on 57,355,904 shares outstanding as of August 17, 1999. Beneficial
ownership is determined in accordance with the rules of the Securities and
Exchange Commission. In computing the number of shares beneficially owned by
a person and the percentage ownership of that person, shares of Common Stock
subject to options held by that person that are currently exercisable or
exercisable within 60 days of August 17, 1999 are deemed outstanding. Such
shares, however, are not deemed outstanding for the purpose of computing the
percentage ownership of each other person. Except as indicated in the
footnotes to this table and pursuant to applicable community property laws,
each stockholder named in the table has sole voting and investment power
with respect to the shares set forth opposite such stockholder's name.
2. Includes 14,473,465 shares held by the McKinney Family Trust, of which Mr.
McKinney is a trustee. Also includes 434,999 shares subject to options held
by Mr. McKinney that are exercisable within 60 days of August 17, 1999. All
of the shares beneficially owned by Mr. McKinney and the McKinney Family
Trust are subject to a Stockholder Agreement with Lucent under which Mr.
McKinney has agreed to vote the shares in favor of the proposed merger with
Lucent.
52
3. Pursuant to a Stockholder Agreement between Lucent, Mr. McKinney and Mr.
McKinney as trustee of the McKinney Family Trust, Mr. McKinney has agreed to
vote the shares held in his name and in the McKinney Family Trust in favor
of the proposed Lucent merger. Lucent may be deemed to have acquired shared
voting power with respect to such shares.
4. As indicated in the Schedule 13G filed on February 9, 1999 by Pilgrim Baxter
& Associates, Ltd. pursuant to the Exchange Act.
5. Includes 95,583 shares held by John Drew and Ellen Drew Community Property
and 9,240 shares held by minor children. Also includes 37,500 shares subject
to a repurchase option in favor of the Company as of August 17, 1999. Also
includes 1,136,999 shares subject to options held by Mr. Drew that are
exercisable within 60 days of August 17, 1999.
6. Includes 600,663 shares held by the Vernon R. & Lysbeth W. Anderson Family
Trust of which Mr. Anderson is a trustee. Also includes 19,950 shares
subject to options held by Mr. Anderson that are exercisable within 60 days
of August 17, 1999.
7. Includes 7,500 shares subject to a repurchase option in favor of the Company
as of August 17, 1999. Also includes 92,666 shares subject to options held
by Mr. Laughlin that are exercisable within 60 days of August 17, 1999.
8. Also includes 23,400 shares subject to options held by Mr. Finch that are
exercisable within 60 days of August 17, 1999.
9. Includes 1,200 shares subject to a repurchase option in favor of the Company
as of August 17, 1999. Also includes 14,550 shares subject to options held
by Mr. Carlick that are exercisable within 60 days of August 17, 1999.
10. Includes 304,348 shares subject to options held by Mr. Butze that are
exercisable within 60 days of August 17, 1999.
11. Includes 46,200 shares subject to a repurchase option in favor of the
Company as of August 17, 1999. Also includes 2,026,912 shares subject to
options that are exercisable within 60 days of August 17, 1999.
As part of the executive management group change-of-control plan adopted in
July 1998, the Company entered into individual change-of-control agreements with
each of Messrs. McKinney, Drew and Laughlin. See "Employee Contracts and Change-
In-Control Arrangements."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In fiscal 1999, the Company recognized revenue of $16,437,761 from services
provided to or on behalf of Cisco, which beneficially owns more than 5% of the
Company's outstanding Common Stock.
The Company has loans outstanding from certain of its executive officers
related to the exercise of stock options. The notes are collateralized by the
underlying stock and the stock is subject to a right of repurchase by the
Company in the event of termination. As of June 27, 1999, the amounts
outstanding for principal and interest on these loans were $183,316 and $63,960
for Messrs. McKinney and Carlick, respectively. On August 12, 1999, Mr. Carlick
repaid his loan in full.
The Company believes that all of the transactions set forth above were made
on terms no less favorable to the Company than could have been obtained from
unaffiliated third parties. All future transactions, including loans, between
the Company and its officers, directors and principal stockholders
53
and their affiliates will be approved by a majority of the Board of Directors,
including a majority of the disinterested directors of the Board of Directors,
and will be on terms no less favorable to the Company than could be obtained
from unaffiliated third parties.
54
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Form 10-K:
1. Financial Statements. The following financial statements of the
Company and the Report of Independent Accountants are included in this
Form 10-K:
Page #
------
Consolidated Balance Sheets at June 30, 1998 and 1999 28
Consolidated Statements of Income for each of the three years in the
period ended June 30, 1999 29
Consolidated Statements of Stockholders' Equity for each of the three
years in the period ended June 30, 1999 30
Consolidated Statements of Cash Flows for each of the three years in the
period ended June 30, 1999 31
Notes to Consolidated Financial Statements 32
Report of Independent Accountants 44
2. Financial Statement Schedule. The following financial statement
schedule of the Company for each of the three years in the period
ended June 30, 1999 is filed as part of this Form 10-K and should
be read in conjunction with the Company's Consolidated Financial
Statements and related notes thereto:
----------------------------------------------------------------------
Page #
----------------------------------------------------------------------
Schedule II Valuation and Qualifying Accounts and Reserves S-1
----------------------------------------------------------------------
Schedules not listed above have been omitted since they are
either not required, not applicable, or the information is
otherwise included herein.
3. Exhibits: See Item 14(c) below.
(b) Reports on Form 8-K. The Registrant filed the following
Reports on Form 8-K during the fourth quarter ended June 30, 1999:
On April 27, 1999, the Registrant filed a Report on Form 8-K dated
April 26, 1999 in connection with an anticipated follow-on offering of
Common Stock.
On May 13, 1999, the Registrant filed a Report on Form 8-K in
connection with its decision not to pursue a proposed follow-on offering of
Common Stock due to reduced interest by selling stockholders to participate
in the offering.
(c) Exhibits. The exhibits listed on the accompanying index to exhibits
immediately following the financial statement schedule are filed as part
of, or incorporated by reference into, this Form 10-K.
(d) Financial Statement Schedules. See Item 14(a)2 above.
55
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Form 10-K to be signed
on its behalf by the undersigned, thereunto duly authorized, on this 26th day
of August, 1999.
International Network Services
By: /s/ Kevin J. Laughlin
----------------------------
Kevin J. Laughlin
Vice President, Finance,
Chief Financial Officer, Secretary
POWER OF ATTORNEY
KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose
signature appears below constitutes and appoints John L. Drew and Kevin J.
Laughlin and each of them, jointly and severally, his attorneys-in-fact, each
with full power of substitution, for him in any and all capacities, to sign any
and all amendments to this Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each said
attorneys-in-fact or his substitute or substitutes, may do or cause to be done
by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Form 10-K 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/ John L. Drew President, Chief Executive Officer and Director August 26, 1999
- ---------------------------- (Principal Executive Officer) ---------------
John L. Drew
/s/ Kevin J. Laughlin Vice President, Finance, Chief Financial Officer and August 26, 1999
- ---------------------------- Secretary (Principal Financial and Accounting Officer) ---------------
Kevin J. Laughlin
/s/ Donald K. McKinney Chairman of the Board August 26, 1999
- ---------------------------- ---------------
Donald K. McKinney
/s/ Vernon R. Anderson Director August 26, 1999
- ---------------------------- ---------------
Vernon R. Anderson
/s/ David Carlick Director August 26, 1999
- ---------------------------- ---------------
David Carlick
/s/ Lawrence G. Finch Director August 26, 1999
- ---------------------------- ---------------
Lawrence G. Finch
56
EXHIBIT INDEX
- -----------------------------------------------------------------------------------------------------------------
Exhibit Exhibits
No.
- -----------------------------------------------------------------------------------------------------------------
2.1 Agreement and Plan of Merger dated as of August 9, 1999 among Lucent Technologies Inc., Intrepid
Merger Inc. and the Registrant.
- -----------------------------------------------------------------------------------------------------------------
3.1 Certificate of Incorporation. (3)
- -----------------------------------------------------------------------------------------------------------------
3.2 Certificate of Designations of Rights, Preferences and Privileges of Series A Participating Preferred
Stock of Registrant
- -----------------------------------------------------------------------------------------------------------------
3.3 Bylaws, as amended.
- -----------------------------------------------------------------------------------------------------------------
4.1 Reference is made to Exhibits 3.1 and 3.2.
- -----------------------------------------------------------------------------------------------------------------
4.2 Specimen Common Stock Certificate.
- -----------------------------------------------------------------------------------------------------------------
4.3 Investors' Rights Agreement between the Registrant and the parties named therein dated June 11, 1993,
as amended. (1)
- -----------------------------------------------------------------------------------------------------------------
4.4 Stock Option Agreement dated as of August 9, 1999, among Lucent Technologies Inc., Intrepid Merger
Inc. and the Registrant.
- -----------------------------------------------------------------------------------------------------------------
4.5 Stockholder Agreement dated as of August 9, 1999 between Lucent Technologies Inc. and a significant
stockholder of the Registrant.
- -----------------------------------------------------------------------------------------------------------------
4.6 Preferred Shares Rights Agreement Dated August 26, 1999
- -----------------------------------------------------------------------------------------------------------------
10.1* Form of Indemnification Agreement entered into between the Registrant and each of the executive
officers and directors and certain key employees. (5)
- -----------------------------------------------------------------------------------------------------------------
10.2* Amended and Restated 1992 Flexible Stock Incentive Plan, as amended, and forms of agreements thereto.
(1)
- -----------------------------------------------------------------------------------------------------------------
10.3* 1996 Stock Plan and form of agreement thereto. (3)
- -----------------------------------------------------------------------------------------------------------------
10.4* 1996 Employee Stock Purchase Plan. (3)
- -----------------------------------------------------------------------------------------------------------------
10.5 Lease Agreement between the Registrant and Aetna Life Insurance Company dated May 8, 1996. (1)
- -----------------------------------------------------------------------------------------------------------------
10.6 Lease Agreement between the Registrant and John Hancock Mutual Life Insurance Company dated December
8, 1997. (2)
- -----------------------------------------------------------------------------------------------------------------
10.7 Credit Agreement between the Registrant and Wells Fargo Bank dated August 14, 1998. (2)
- -----------------------------------------------------------------------------------------------------------------
10.8 1998 Non Statutory Stock Option Plan.
- -----------------------------------------------------------------------------------------------------------------
10.9* Form of Change of Control Agreement entered into between the Registrant and each of the executive
officers. (2)
- -----------------------------------------------------------------------------------------------------------------
10.10* 1998 Director Option Plan. (2)
- -----------------------------------------------------------------------------------------------------------------
10.11 VitalSigns Software, Inc. 1996 Stock Option Plan. (4)
- -----------------------------------------------------------------------------------------------------------------
10.12 VitalSigns Software, Inc. Pre-Plan Options. (4)
- -----------------------------------------------------------------------------------------------------------------
23.1 Consent of PricewaterhouseCoopers LLP, Independent Accountants.
- -----------------------------------------------------------------------------------------------------------------
24.1 Power of Attorney (see page 56).
- -----------------------------------------------------------------------------------------------------------------
27.1 Financial Data Schedule.
- -----------------------------------------------------------------------------------------------------------------
* Indicates management compensatory plan, contract or arrangement.
(1) Incorporated by reference to the Registrant's Registration Statement on
Form S-1 (File No. 333-9287) declared effective on September 18, 1996.
(2) Incorporated by reference to the Registrant's Annual Report on Form 10-K
for the fiscal year ended June 30, 1998.
(3) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q
for the quarter ended September 30, 1998.
(4) Incorporated by reference to the Registrant's Registration Statement on
Form S-8 (File No. 333-68121) as filed on December 1, 1998.
(5) Incorporated by reference to the Registrant's Current Report on Form 8-K
dated December 28, 1998.
57
INTERNATIONAL NETWORK SERVICES
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
(IN THOUSANDS)
Additions
Balance at Charged to
Beginning of Costs and Balance at
Description Year Expenses Deductions: End of Year
Allowance for returns and doubtful
accounts:
Year Ended June 30, 1997 $ 554 $ 561 $ (527) $ 588
Year Ended June 30, 1998 $ 588 $2,690 $(1,810) $1,468
Year Ended June 30, 1999 $1,468 $4,722 $(1,545) $4,645
S-1