EXHIBIT 13.1
PORTIONS OF LHS'S 1998 ANNUAL REPORT TO STOCKHOLDERS
----------------------------------------------------
CORPORATE INFORMATION COMMON STOCK
COMMON STOCK LHS' common stock began trading on the Nasdaq National Market on
May 16, 1997 under the symbol "LHSG." The common stock began trading on the
Frankfurt Neuer Markt Exchange on May 21, 1997 under the symbol "LHI." The
following table sets forth, for the fiscal quarters indicated, the high and low
sales prices of LHS' common stock as reported by Nasdaq since the company's IPO.
As of March 15, 1999, LHS had 52,951,879 shares outstanding. There were 37
holders of record of the Company's common stock on March 15, 1999.
1998 HIGH LOW
- ---- ---- ---
First Quarter $50.38 $25.50
Second Quarter 73.75 44.50
Third Quarter 76.50 43.94
Fourth Quarter 57.38 36.75
1997
- ----
First Quarter NA NA
Second Quarter $22.25 $ 9.38
Third Quarter 30.75 21.56
Fourth Quarter 37.88 19.38
The Company has not declared or paid any cash dividends on its common stock
since 1994. The Company currently intends to retain its future earnings, if any,
to fund the development and growth of its business and therefore does not
anticipate paying any cash dividends in the foreseeable future.
On June 11, 1998, the Company issued 117,885 shares of common stock that are
unregistered. In consideration of the issuance of such shares, the Company
received all stock in InfoCellular, Inc. The unregistered LHS shares were issued
in accordance with Rule 506 of the Securities Act.
SELECTED FINANCIAL DATA
Years Ended December 31
(In thousands, except per share data) 1998 1997 1996 1995 1994
-------- -------- -------- -------- ---------
CONSOLIDATED STATEMENT OF INCOME DATA
Total revenues $163,182 $105,411 $56,864 $26,967 $20,722
Earnings before interest and taxes $ 29,823 $ 16,440 $ 5,581 $ 1,217 $ 4,182
Net earnings per share:(2)
Basic $ 0.33 $ 0.26 $ 0.11 $ 0.01 $ 0.14
Diluted $ 0.32 $ 0.23 $ 0.09 $ 0.01 $ 0.14
CONSOLIDATED BALANCE SHEET DATA
Total assets $188,545 $127,223 $43,819 $24,462 $14,006
Long-term obligations $ 239 $ 731 $ 1,360 $ 399 $ 372
Total stockholders' equity $145,858 $ 92,549 $12,325 $ 9,933 $ 3,770
(1) See Note 2 of the Notes to Consolidated Financial Statements
(2) The 1998 amount includes a one-time charge relating to the write off of
in-process research and development of $8.2 million.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Overview
In June 1998, the Company acquired the stock of Infocellular, Inc.
("InfoCellular") for $8,484, paid by the issuance of 117,885 shares of Common
Stock and $1,327 in cash. InfoCellular, which operates as a wholly-owned
subsidiary of the Company, is engaged in the business of providing point of sale
and customer acquisition software and related services to telecommunication
service providers.
This acquisition was accounted for under the purchase method of accounting and
in accordance with Accounting Principles Board Opinion No. 16, "Accounting for
Business Combinations." The Company allocated the cost of the acquisition to the
assets acquired and the liabilities assumed based on their estimated fair values
using valuation methods that were appropriate at the time. The acquired
intangible assets included in-process technology projects, among other assets,
which were related to research and development that had not reached
technological feasibility and for which there was no alternative future use. The
Company recorded a one time charge relating to the write-off of in-process
research and development of $8.2 million for the year ended December 31, 1998,
in accordance with applicable accounting pronouncements.
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
Revenues. Total revenues increased 54.8% to $163.2 million in the year ended
December 31, 1998 from $105.4 million in the year ended December 31, 1997.
License revenues increased 73.7% to $66.8 million in 1998 from $38.4 million,
while service revenues increased 43.9% to $96.4 million from $67.0 million for
the same period. Total revenues increased primarily due to the addition of new
customers and increased implementation and support revenue from existing
customers.
License revenues increased as a percentage of total revenues to 40.9% in 1998
from 36.5% in 1997, while service revenues decreased as a percentage of total
revenues to 59.1% from 63.5% for the same period. This change in the mix of
revenues was primarily due to increased license sales from our distribution
partners during 1998.
No individual customer accounted for more than 10% of total revenues in 1998.
Cost of Services. Cost of services decreased as a percentage of total
revenues to 36.7% in the year ended December 31, 1998 from 44.9% in the year
ended December 31, 1997. Costs of services increased 26.7% to $60.0 million in
1998 from $47.3 million in 1997, primarily due to compensation expense
associated with increased staffing for new projects in Europe, the Americas and
Asia and the initial costs of training newly hired employees on the
implementation of the BSCS software. This increase was partially offset by an
increase in the productivity and efficiency of the implementation and services
functions. Cost of services consists primarily of salaries and benefits of those
employees associated with the installation of the BSCS software and other
product support activities. It also includes third-party costs associated with
systems integrators and costs related to providing software maintenance and end-
user training to customers.
Sales and Marketing. Sales and marketing expenses decreased as a percentage
of total revenues to 7.2% in the year ended December 31, 1998 from 8.0% in the
year ended December 31, 1997 although sales and marketing expenses actually
increased to $11.7 million in 1998 from $8.5 million in 1997. The increase in
sales and marketing expenses was principally due to the growth in the number of
worldwide sales and marketing personnel responsible for developing business,
particularly in Europe and Asia and increased participation in trade shows and
other worldwide marketing activities. Sales and marketing expenses consist
primarily of the salaries, benefits and travel expenses of those employees
responsible for acquiring new business and maintaining existing customer
relationships, as well as marketing expenses related to trade publications,
advertisements and trade shows.
Research and Development. Research and development expenses increased as a
percentage of total revenues to 22.4% in the year ended December 31, 1998 from
18.7% in the year ended December 31, 1997. This increase in research and
development costs as a percentage of revenues was principally due to increases
in the number of personnel associated with the development of new releases of
BSCS in both the Americas and Europe. Research and development expenses are
comprised of salaries and benefits of the employees involved in product and
enhancement development. All development costs are expensed by the Company as
incurred.
General and Administrative. General and administrative expenses decreased to
10.4% of total revenues in the year ended December 31, 1998 from 12.8% in the
year ended December 31, 1997. These expenses increased 25.7% to $17.0 million
in 1998 from $13.5 million in 1997. This increase was principally due to
increases in the number of administrative personnel and increases in office rent
and other expenses incurred as a result of the general growth of the Company's
business. General and administrative expenses consist primarily of salaries and
benefits of management and administrative personnel, general office
administration expenses such as rent and occupancy, telephone expenses and other
supply costs, and fees for legal, accounting and other professional services.
Income Taxes. The provision for income taxes was 49.5% and 40.0% of earnings
before income taxes for the years ended December 31, 1998 and 1997,
respectively. The effective tax rate was higher than the statutory tax rate of
34% primarily because of the non-deductible write-off of in-process research and
development in 1998 and higher tax rates in foreign countries in 1998 and 1997.
In-Process Research and Development. During 1998, the Company completed the
acquisition of InfoCellular and, in conjunction with this acquisition, the
Company allocated a portion of the purchase price to in-process research and
development. Since the date of acquisition, the Company has used the acquired
in-process technology to develop new product offerings and enhancements, which
will become part of the Company's suite of products when completed. The Company
currently expects to complete the development of the remaining research and
development projects referred to as Brookfield and Cohasset. Upon completion,
the Company intends to offer these products to its customers.
The nature of the efforts required to develop and integrate the acquired
in-process technology into commercially viable products or features and
functions within the LHS suite of existing products principally relate to the
completion of all planning, designing and testing activities that are necessary
to establish that the products can be produced to meet design requirements,
including functions, features and technical performance requirements. The
Company currently expects that products utilizing the acquired in-process
technology will be successfully developed, but there can be no assurance that
commercial viability of any of these products will be achieved. Furthermore,
future developments in the software industry, changes in technology, changes in
other products and offerings or other developments may cause the Company to
alter or abandon product plans.
Failure to complete the development of these projects in their entirety, or
in a timely manner, could have a material, adverse impact on the Company's
financial condition and results of operations. No assurance can be given that
actual revenues and operating profit attributable to acquired in-process
research and development will not deviate from the projections used to value
such technology. Ongoing operations and financial results for the acquired
technology, and the Company as a whole, are subject to a variety of factors
which may not have been known or estimable at the date of such transaction, and
the estimates discussed below should not be considered the Company's current
projections for operating results for the acquired assets or licensed technology
or the Company as a whole.
The fair value of the in-process technology was based on analyses of the
markets, projected cash flows and risks associated with achieving such projected
cash flows. In developing these cash flow projections, revenues were estimated
based on relevant factors, including aggregate revenue growth rates for the
business as a whole, individual service offering revenues, characteristics of
the potential market for the service offerings and the anticipated life of the
underlying technology. Operating expenses and
resulting profit margins were estimated based on the characteristics and cash
flow generating potential of the acquired in-process research and development.
The Company assumed material net cash inflows would commence in 1999.
Appropriate adjustments were made to operating income to derive net cash flow,
and the estimated net cash flows of the in-process technologies were then
discounted to present value using a rate of return that the Company believes
reflects the specific risk/return characteristics of the research and
development projects. The selection of discount rates for application was based
on the consideration of: (i) the weighted average cost of capital, which
measures a company's cost of debt and equity financing weighted by the
percentage of debt and percentage of equity in its target capital structure;
(ii) the corresponding weighted average return on assets which measures the
after-tax return required on the assets employed in the business weighted by
each asset group's percentage of the total asset portfolio; and (iii) venture
capital required rates of return which typically relate to equity financing for
relatively high-risk business projects. The risk adjusted discount rate utilized
in the valuation analysis of the acquired in-process technology was 20%.
Revenues attributable to the acquired in-process technology were assumed to
increase between the first three years of the six-year projection period at
annual rates of 46% to 569% before decreasing over the remaining years at rates
of 3% to 40% as other products are released into the marketplace. Projected
annual revenue attributable to the product ranged from $1.6 million to $15.7
million over the term of the projection. This projection was based on the
aggregate revenue growth rate for the business as a whole, individual product
revenues, anticipated growth rates for the billing software market, anticipated
product development and product introduction cycles, and the estimated life of
the underlying technology. Projected revenues from the in-process research and
development were assumed to peak during 2000, and decline from 2001 to 2003 as
other new products are expected to enter the market.
Gross profit was assumed to increase in the first three years of the
projection period at annual rates of 46% to 569% before decreasing over the
remaining years at rates of 3% to 40%, resulting in annual gross profits that
ranged from $1.0 million to $10.2 million over the term of the projection.
Operating profit was assumed to increase in the first three years of the
projection from $0.01 million to $5.6 million before decreasing over the
remaining years at rates of 3% to 40%, resulting in annual operating profits
that ranged from $0.01 million to $5.6 million over the term of the projection.
The in-process research and development acquired from InfoCellular
consisted of the Brookfield and Cohasset technology. These new releases of the
Converge software product include new features that will provide for the ability
to recognize/accommodate multi-language and multi-currency operations and
functionality that extends beyond the basic level of POS functionality. The
Company estimated that this project was approximately 80% complete at the date
of acquisition. At the date of valuation, the expected cost to complete these
projects was approximately $1.1 million. As of December 31, 1998, approximately
$0.9 million had been incurred since the date of acquisition. The Company
estimates that projects will be completed by the end of the third quarter of
1999. The remaining efforts to complete the project are primarily the
construction and testing of the software. The research and development risks
associated with these projects primarily relate to delays due to unanticipated
architectural constraints and unplanned resource assignment changes to
accommodate customer requests.
There can be no assurance that the Company will not incur additional
charges in subsequent periods to reflect costs associated with these
transactions or that the Company will be successful in its efforts to integrate
and further develop these technologies.
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
Revenues. Total revenues increased 85.4% to $105.4 million in the year ended
December 31, 1997 from $56.9 million in the year ended December 31, 1996.
License revenues increased 62.2% to $38.4 million in 1997 from $23.7 million in
1996, while service revenues increased 101.9% to $67.0 million from $33.2
million. The increase in total revenues was primarily due to increased market
penetration of the Company's products and services and the successful releases
of BSCS in Europe, Asia and the Americas.
License revenues decreased as a percentage of total revenues to 36.5% in 1997
from 41.7% in 1996, while service revenues increased as a percentage of total
revenues to 63.5% from 58.3%. This change in the mix of revenues was primarily
due to an increase in the implementation effort and production support required
by customers following implementation combined with increased software
maintenance and end-user training provided to customers.
During 1997, o-tel-o, an LHS customer in Europe, accounted for 12% of total
revenues while Aerial Communications, an LHS customer in the Americas, and Swiss
Telecom, an LHS customer in Europe, accounted for 12% and 10% of total revenues
in 1996, respectively.
Cost of Services. Cost of services increased as a percentage of total
revenues to 44.9% in the year ended December 31, 1997 from 33.6% in the year
ended December 31, 1996. Costs of services increased 147.7% to $47.3 million in
1997 from $19.1 million in 1996, primarily due to compensation expense
associated with increased staffing for new projects in Europe, the Americas and
Asia, an increase in the use of outside consultants and systems integrators and
the up front costs of training newly hired LHS employees on implementation of
the BSCS software product.
Sales and Marketing. Sales and marketing expenses decreased as a percentage
of total revenues to 8.0% in the year ended December 31, 1997 from 13.5% in the
year ended December 31, 1996 although sales and marketing expenses actually
increased to $8.5 million in 1997 from $7.7 million in 1996. The increase in
sales and marketing expenses was principally due to growth in the number of
worldwide sales and marketing personnel responsible for developing business,
particularly in Europe and Asia and, to a lesser extent, increased participation
in trade shows and other marketing activities.
Research and Development. Research and development expenses decreased as a
percentage of total revenues to 18.7% in the year ended December 31, 1997 from
28.6% in the year ended December 31, 1996. These expenses increased 21.2% to
$19.7 million in 1997 from $16.2 million in 1996. This increase was principally
due to increases in the number of personnel associated with the development of a
new release of BSCS in both the Americas and Europe and the initial design and
development of another release of BSCS in the Americas in the latter half of
1997.
General and Administrative. General and administrative expenses decreased to
12.8% of total revenues in the year ended December 31, 1997 from 14.6% in the
year ended December 31, 1996. These expenses increased 63.0% to $13.5 million
in 1997 from $8.3 million in 1996. This increase was principally due to
increases in the number of administrative personnel and increases in office rent
and other expenses incurred as a result of the general growth of the Company's
business.
Income Taxes. The provision for income taxes increased to 40.0% of earnings
before income taxes in the year ended December 31, 1997 from 37.9% of earnings
before income taxes in the year ended December 31, 1996. The higher effective
tax rate in 1997 is principally the result of greater income from certain
European countries with higher statutory tax rates.
Liquidity and Capital Resources
Net cash provided by operating activities totaled $22.0 million in 1998 and
$12.5 million in 1997 while net cash used by operating activities aggregated
$4.8 million in 1996. The net cash used by operating activities in 1996 was
primarily the result of the increased use of working capital required to fund
the new business opportunities in the Americas and Asia. The increase in cash
provided by operations in 1997 and 1998 was primarily the result of increased
earnings and decreased use of net working capital.
The Company invested $9.5 million, $5.1 million and $4.2 million in furniture,
fixtures and equipment during 1998, 1997 and 1996, respectively. These
investments were primarily for computer hardware and software and improvements
to new leased office space required to accommodate the growth in the number of
employees.
In May 1997, the Company sold 4,865,000 shares of its Common Stock in an Initial
Public Offering ("IPO") in which it received approximately $70.6 million, net of
$7.2 million in costs of the offering. During 1997 and 1998, the Company also
received proceeds from the exercise of employee stock options.
In June 1996, the Company repurchased shares of common stock from one of its
stockholders for $10.0 million, of which $4.0 million was paid to the
stockholder in 1997, and simultaneously sold an equal number of shares of common
stock to other stockholders of the Company for $10.0 million.
The Company has a short-term overdraft facility with a bank which provides for
borrowings of up to $2.4 million and bears interest at 7.5% per annum. At
December 31, 1998, no borrowings were outstanding under this facility.
At December 31, 1998, the Company did not have any material commitments for
capital expenditures. The Company believes that its existing cash balances,
available credit facilities, and funds generated by operations, will be
sufficient to meet its anticipated working capital and capital expenditure
requirements for the foreseeable future.
Year 2000 Issues
Introduction
The term "Year 2000 issue" is a general term used to describe the various
problems that may result from the improper processing of dates and date-
sensitive calculations by computers and other machinery as the year 2000 is
approached and reached. These problems generally arise from the fact that most
of the world's legacy computer hardware and software have historically used only
two digits to identify the year in a date, often meaning that the computer will
fail to distinguish dates in the "2000's" from dates in the "1900's". These
problems may also arise from other sources, such as the use of special codes and
conventions in software that make use of the date field. This could result in a
system failure or miscalculations causing disruptions of operations, including,
among other things, a temporary inability to process transactions, send
invoices, or engage in similar normal business activities. The Company may be
affected by the Year 2000 issue in two ways: through its software products and
its operations.
Given the fact that Company is engaged in the business of software development
and because the Company was founded in the early 1990's, after the Year 2000
issue had begun to surface within the computer industry, the Company believes
that any Year 2000 issues that arise with its software products are not
material. However, the Company believes that the Year 2000 issue could
negatively impact the Company's operations as a result of Year 2000 disruptions
suffered by the Company's significant suppliers, domestic and international
government agencies, and other third parties.
State of Readiness
Based on its ongoing internal assessment of Year 2000 issues, the Company
believes that its internal IT systems, non-IT systems, and software currently
offered to its customers are Year 2000 compliant. Nevertheless, the Year 2000
issue could negatively affect the demand for the Company's products and the
spending habits of our customers. The Company cannot be certain that software
licensed by its customers in the past is fully Year 2000 compliant, but the
Company is not aware of any material Year 2000 problems with any software
licensed to and currently in use by its customers. The Company is addressing
such issues with existing customers on a case-by-case basis to ensure that there
are no significant Year 2000 issues with earlier versions of the Company's
software products. The Company also is upgrading its software products so that
current, Year 2000 compliant versions of embedded third party software will be
available to its customers. The Company is not aware of any Year 2000 issues
with its customers that cannot be remedied or that could have a material adverse
impact on the Company's financial condition or results, or overall trends in
results, of operations.
Many hardware, operating system and application products developed by third
parties interact or operate with the Company's software products. In addition,
customers or others may modify our software products after they have been
installed. The Company cannot assess the Year 2000 readiness of these hardware
and software products, operating systems or modified hardware and software
products and operating systems. If these products are not Year 2000 compliant,
it could adversely affect the performance and functionality of the Company's
applications that work with these products. While the Company would not be
responsible for these Year 2000 problems, the Company is unable to assess the
effect they may have on the Company's business, financial condition and results
of operations.
The Company principally relies on software products to support our internal
accounting, payables and invoicing operations. While these software products
have been or are in the process of being tested for Year 2000 compliance, the
Company also relies on third party systems developed by others for many of the
Company's critical internal operations. In addition, the Company's internal
operations may also be affected by Year 2000 issues affecting third parties with
whom we have relationships, including vendors such as utilities, distributors,
banks. A Year 2000 problem affecting our systems or those of third parties that
the Company relies upon may have a material adverse effect on the Company's
business, financial condition and results of operations.
The Company has assembled a Year 2000 taskforce consisting of representatives
from our development, information systems, facilities and finance departments to
assess the Year 2000 readiness of the Company's internal operations and the
readiness of third parties on which the Company relies. The taskforce has
identified and assessed the Year 2000 readiness of most of the material
information technology and non-information technology systems used internally as
part of the Company's operations, but such work is ongoing. The taskforce has
tested or will test these systems where feasible and practicable. We expect
testing to be complete by mid-1999. The Company believes the taskforce to have
appropriate plans in place to achieve timely Year 2000 readiness for the
Company's internal systems. However, the Company's ongoing assessment program
may in the future reveal Year 2000 issues that are not currently identified or
fully understood.
Costs
The Company has not incurred any material costs solely in connection with
remedying Year 2000 issues arising in connection with either internal systems or
its own software products and does not anticipate incurring any material costs
in connection with remedying such Year 2000 issues in the future. Although the
Company has not incurred expenses for the purpose of addressing Year 2000 issues
in connection with its own software products, the Company has, as part of its
ongoing R & D efforts, incurred immaterial costs to ensure that its software
products are Year 2000 compliant.
Risks
Although the Company's internal systems and software products are Year 2000
compliant, the Company is vulnerable to the risk that government agencies,
significant suppliers and other third parties will not be able to remedy their
own year 2000 issues. The Company relies, both domestically and
internationally, upon government agencies, utility companies, telecommunication
service companies and other service providers outside of the Company's control.
There is no assurance that such suppliers, governmental agencies, or other third
parties will not suffer a year 2000 business disruption. Such failures could
have a material adverse affect on the Company's operations.
The Company currently believes that its most reasonably likely worst case Year
2000 scenario would involve the temporary interruption of electric power,
telephone or other utility supplies to our offices or our support operations
facilities due to a failure of a utility supplier to be Year 2000 compliant. In
addition, despite assurances and testing, it is also possible that our internal
systems or those of our customers and suppliers may not be Year 2000 ready.
In addition, "business interruption" litigation may arise out of the Year 2000
issue. The Company is not currently aware of any possible claim against it
arising from instances of business interruption. The Company currently believes
that its hardware and software products are Year 2000 compliant, but cannot
ensure such compliance for software products that were designed exactly to
customer specifications to interface with their other internal systems.
Consequently, the Company cannot assure that all of these customers are aware of
the Year 2000 issue or that they have adopted appropriate corrective solutions,
and will therefore not bring Year 2000-related claims against the Company which,
with or without merit, could be time consuming and expensive for the Company to
defend or resolve.
Based on currently available information, management does not believe that the
Year 2000 matters discussed above relating to internal systems and software
products sold to customers will have a material adverse impact on the Company's
financial condition or overall trends in results of operations; however, it is
uncertain to what extent the Company may be affected by such matters. In
addition, there can be no assurance that the failure to ensure Year 2000
capability by a supplier, government agency or another third party would not
have a material adverse impact on the Company.
Contingency Plans
-2-
Through the first half of 1999, the Company intends to develop a contingency
plan based on the results of its analysis of the most reasonably likely worst
case Year 2000 scenarios. Because the Company believes that its internal systems
are Year 2000 compliant, the Company's contingency plan will primarily focus on
addressing the possible issues that might arise as a result of Year 2000
business disruptions suffered by third parties. However, due to the general
uncertainty inherent in the Year 2000 problem, in the Company's case resulting
primarily from the uncertainty of the Year 2000 readiness of third parties, the
Company is unable to determine at this time whether the consequences of Year
2000 failures will have a material impact on the company's operations.
Forward-Looking Statements
The foregoing discussion contains forward-looking statements subject to the safe
harbor created by the Private Securities Litigation Reform Act of 1995. The
words "may", "would", "could", "will", "expect", "estimate", "anticipate",
"believe", "intends", "plans" and similar expressions and variations thereof are
intended to identify forward-looking statements. Management cautions that these
statements represent projections and estimates of future performance and involve
certain 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, without limitation, rapid and significant
technological developments that could delay the introduction of improvements in
existing products or of new products; any dependencies on any proprietary
technologies (which may be independently developed by competitors); dependence
on a small number of large customers; potential fluctuation in financial results
as a result of an inability to make sales to large customers; competition from
existing companies as well as new market entrants; and dependence on key
personnel.
CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Auditors
The Board of Directors
LHS Group Inc.
We have audited the accompanying consolidated balance sheets of LHS Group Inc.
and Subsidiaries (the "Company") as of December 31, 1998 and 1997, and the
related consolidated statements of income, stockholders' equity and cash flows
for each of the three years in the period ended December 31, 1998. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of LHS Group Inc. and
Subsidiaries at December 31, 1998 and 1997 and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 1998, in conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
February 12, 1999
Atlanta, Georgia
F-1
LHS Group Inc.
Consolidated Balance Sheets
December 31
1998 1997
----------------------------------
(In thousands of U.S. Dollars,
except share data)
Assets
Current assets:
Cash and cash equivalents.......................................... $ 42,084 $ 27,867
Short-term marketable debt securities.............................. 62,218 45,907
Trade accounts receivable, net of allowance for
doubtful accounts of $3,316 and $1,236........................... 60,860 37,045
Prepaid expenses and other current assets.......................... 3,976 2,330
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Total current assets................................................ 169,138 113,149
Furniture, fixtures and equipment:
Computer equipment................................................. 10,039 6,720
Purchased computer software........................................ 7,267 1,904
Furniture and fixtures............................................. 6,861 4,726
Other.............................................................. 2,601 1,924
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26,768 15,274
Allowance for depreciation and amortization......................... (11,179) (6,404)
----------------------------------
15,589 8,870
Deferred income taxes............................................... 914 1,083
Long-term marketable debt securities................................ - 3,653
Intangible assets net of accumulated amortization of $396........... 2,066 -
Other............................................................... 838 468
----------------------------------
Total assets........................................................ $188,545 $127,223
==================================
Liabilities and stockholders' equity
Current liabilities:
Accounts payable................................................... $ 7,523 $ 6,747
Accrued expenses and other liabilities............................. 15,796 14,192
Deferred revenues.................................................. 6,095 4,553
Income taxes payable............................................... 8,907 5,396
Deferred income taxes.............................................. 4,127 3,055
----------------------------------
Total current liabilities........................................... 42,448 33,943
Other long-term obligations......................................... 239 731
Stockholders' equity:
Common stock ($.01 par value) 200,000,000 shares authorized;
52,625,677 and 50,530,710 shares issued and outstanding........... 526 505
Additional paid-in-capital......................................... 110,583 79,445
Retained earnings.................................................. 34,858 17,509
Accumulated other comprehensive income............................. (109) (4,910)
----------------------------------
Total stockholders' equity.......................................... 145,858 92,549
----------------------------------
Total liabilities and stockholders' equity.......................... $188,545 $127,223
==================================
See accompanying notes.
F-2
LHS Group Inc.
Consolidated Statements of Income
Year ended December 31
1998 1997 1996
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(In thousands of U.S. Dollars, except per share data)
Revenues:
License.................................................... $ 66,780 $ 38,439 $23,701
Service.................................................... 96,402 66,972 33,163
-----------------------------------------------------------
Total....................................................... 163,182 105,411 56,864
Cost of services............................................ 59,953 47,325 19,107
-----------------------------------------------------------
Gross margin................................................ 103,229 58,086 37,757
Operating expenses:
Sales and marketing........................................ 11,700 8,454 7,653
Research and development................................... 36,530 19,682 16,236
General and administrative................................. 16,976 13,510 8,287
Cost of purchased in-process research and development
related to computer software technology................... 8,200 - -
-----------------------------------------------------------
73,406 41,646 32,176
-----------------------------------------------------------
Earnings before interest and taxes.......................... 29,823 16,440 5,581
Interest (income) expense, net.............................. (4,557) (2,238) 77
-----------------------------------------------------------
Earnings before income taxes................................ 34,380 18,678 5,504
Income taxes................................................ 17,031 7,470 2,084
-----------------------------------------------------------
Net earnings................................................ $ 17,349 $ 11,208 $ 3,420
===========================================================
Net earnings per share:
Basic...................................................... $ 0.33 $ 0.26 $ 0.11
Diluted.................................................... $ 0.32 $ 0.23 $ 0.09
===========================================================
Shares used in per share calculation (Note 2)
Basic...................................................... 51,799 42,906 31,000
===========================================================
Diluted.................................................... 54,495 49,164 40,000
===========================================================
See accompanying notes.
F-3
LHS Group Inc.
Consolidated Statements of Stockholders' Equity
Series A
Convertible Accumulated
Preferred Stock Common Stock Additional Other
---------------------------------- Paid-in Retained Treasury Comprehensive Total
Shares Amount Shares Amount Capital Earnings Stock Income Equity
-----------------------------------------------------------------------------------------
(In thousands of U.S. Dollars, except share data)
Balance December 31, 1995................ 225,000 $ 2 31,000,000 $310 $ 5,955 $ 2,881 $ - $ 785 $ 9,933
Comprehensive income:
Net earnings........................... - - - - - 3,420 - - 3,420
Translation adjustment................. - - - - - - - (1,293) (1,293)
------------
2,127
Repurchase of shares of common stock.... - - (3,723,120) - (9,963) - (37) - (10,000)
Issuance of common stock................ - - 3,723,120 - 9,963 - 37 - 10,000
Exercise of stock options............... - - 100,000 1 264 - - - 265
----------------------------------------------------------------------------------------
Balance December 31, 1996................ 225,000 2 31,100,000 311 6,219 6,301 - (508) 12,325
Comprehensive income:
Net earnings........................... - - - - - 11,208 - - 11,208
Translation adjustment................. - - - - - - - (4,402) (4,402)
------------
6,806
Issuance of common stock, net of costs
of issuance............................ - - 9,730,000 97 70,533 - - - 70,630
Conversion of preferred stock into
common................................. (225,000) (2) 9,000,000 90 (88) - - - -
Exercise of stock options............... - - 700,710 7 1,850 - - - 1,857
Tax benefit relating to stock options... - - - - 931 - - - 931
----------------------------------------------------------------------------------------
Balance December 31, 1997................ - - 50,530,710 505 79,445 17,509 - (4,910) 92,549
Comprehensive income:
Net earnings........................... - - - - - 17,349 - - 17,349
Translation adjustment................. - - - - - - - 4,801 4,801
------------
22,150
Issuance of common stock in connection
with business acquisition.............. - - 117,885 1 7,022 - - - 7,023
Exercise of stock options............... - - 1,977,082 20 13,955 - - - 13,975
Tax benefit relating to stock options... - - - - 10,161 - - - 10,161
----------------------------------------------------------------------------------------
Balance December 31, 1998................ - $ - 52,625,677 $526 $110,583 $34,858 $ - $ (109) $145,858
========================================================================================
See accompanying notes.
F-4
LHS Group Inc.
Consolidated Statements of Cash Flows
Year ended December 31
1998 1997 1996
-----------------------------------------------------------
(In thousands of U.S. Dollars)
Operating activities
Net earnings................................................ $ 17,349 $ 11,208 $ 3,420
Adjustments to reconcile net earnings to net cash
provided by (used in) operating activities:
Depreciation and amortization............................. 4,265 2,072 1,474
Provision for deferred income taxes....................... 1,229 3,754 (492)
Write-off of in-process research and development related 8,200 - -
to computer software technology..........................
Changes in operating assets and liabilities:
Trade accounts receivable................................ (20,647) (12,196) (21,604)
Amounts due from stockholders............................ - - 297
Prepaid expenses and other current assets................ (135) (245) (2,141)
Accounts payable......................................... 189 4,405 37
Accrued expenses and other liabilities................... (1,317) 5,860 6,196
Deferred revenues........................................ 1,323 (4,068) 5,358
Income taxes payable..................................... 11,548 1,666 2,632
-----------------------------------------------------------
Net cash provided by (used in) operating activities......... 22,004 12,456 (4,823)
Investing activities
Additions of furniture, fixtures and equipment.............. (9,452) (5,064) (4,221)
Purchase of investments..................................... (13,879) (49,560) -
Acquisition of business, net of cash acquired............... (2,955) - -
Other....................................................... (444) (240) 264
-----------------------------------------------------------
Net cash used in investing activities....................... (26,730) (54,864) (3,957)
Financing activities
Proceeds from issuance of common stock...................... 13,975 72,487 10,265
Purchase of treasury stock.................................. - - (6,000)
Proceeds from bank borrowings............................... - - 450
Repayment of bank borrowings................................ - (1,661) (1,833)
Repayment to former shareholder............................. (4,000) -
Other....................................................... (612) (629) 64
-----------------------------------------------------------
Net cash provided by financing activities................... 13,363 66,197 2,946
Effect of exchange rate differences on cash................. 5,580 (211) (77)
-----------------------------------------------------------
Increase (decrease) in cash and cash equivalents............ 14,217 23,578 (5,911)
Cash and cash equivalents at beginning of period............ 27,867 4,289 10,200
-----------------------------------------------------------
Cash and cash equivalents at end of period.................. $ 42,084 $ 27,867 $ 4,289
===========================================================
Additional cash flow information
Cash paid for interest...................................... $ 112 $ 148 $ 167
===========================================================
Cash paid for income taxes.................................. $ 698 $ 1,386 $ 260
===========================================================
See accompanying notes.
F-5
LHS Group Inc.
Notes to Consolidated Financial Statements
December 31, 1998
1. Significant Accounting Policies
Basis of Presentation
The consolidated financial statements include the accounts of LHS Group Inc. and
its wholly-owned subsidiaries ("LHS Group" or the "Company"). Significant
intercompany accounts and transactions have been eliminated in preparing the
accompanying financial statements.
Business Activity and Basis of Revenue Recognition
The Company provides scaleable client/server-based billing and customer care
solutions to carriers in the telecommunications industry. Solutions based on the
Company's software products enable carriers to offer flexible, customer-
tailored, cost-effective billing and customer care services in the wireless and
wireline telecommunications markets. LHS configures its proprietary software
tools to give each carrier a flexible and cost-effective billing solution
tailored to specific network technology and marketing needs.
The Company derives revenues from license fees and fees for its services.
License revenues consist of license fees for the Company's client/server-based
software and service revenues consist of fees for implementation and production
support services. The typical BSCS license is perpetual and non-refundable by
the Company.
The Company's customers often require significant customization of the software
products and, therefore, the license and service fees are recognized as long
term contracts in conformity with Accounting Research Bulletin ("ARB") No. 45
"Long Term Construction Type Contracts", Statement of Position ("SOP") 81-1
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts" and SOP 97-2 "Software Revenue Recognition" For long term contracts,
revenue is recognized using the percentage of completion method of accounting
based on hours worked on the project compared to the total hours expected to be
worked through completion. Revenue related to ongoing production support
services following the completion of the initial production launch of the
software is recognized as the work is performed. Revenue from maintenance
services are recognized ratably over the term of the maintenance contract.
Deferred revenue represents cash collections from customers in advance of the
performance of the work.
License revenues for one-time licenses without significant customization are
recognized upon delivery of the software to the customer unless the Company has
significant related obligations remaining or the collectibility of the
receivable is doubtful. When significant obligations remain after the software
product has been delivered or the collectibility of the receivable is doubtful,
revenue is not recognized until such obligations have been completed and the
collectibility of the software is no longer doubtful.
Additional license revenues are recognized and realized only when the Company is
notified that the number of customer subscribers supported by the software
exceeds the number of subscribers for which the customer is currently licensed.
Losses on long-term contracts are recognized in the period that the anticipated
loss is identified.
F-6
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
1. Significant Accounting Policies (continued)
Business Activity and Basis of Revenue Recognition (continued)
In accordance with the provisions of ARB No. 45, SOP 81 and SOP 97-2 trade
accounts receivable includes amounts earned by the Company but not yet billed to
the customer as stipulated based on milestones defined in certain contracts. At
December 31, 1998 and 1997, trade accounts receivable includes $10,823 and
$8,062 of unbilled receivables.
Cash Equivalents
The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.
Marketable Debt Securities
Management determines the appropriate classification of debt securities at the
time of purchase and reevaluates such designation as of each balance sheet date.
Debt securities are classified as held-to-maturity when the Company has the
positive intent and ability to hold the securities to maturity. Held-to-
maturity securities are stated at amortized cost.
The amortized cost of debt securities classified as held-to maturity is adjusted
for amortization of premiums and accretion of discounts to maturity. Such
amortization is included in interest income from investments. Interest and
dividends are included in interest income from investments. Realized gains and
losses, and declines in value judged to be other-than-temporary are included in
net securities gains (losses). The cost of securities sold is based on the
specific identification method.
Furniture, Fixtures, And Equipment
Furniture, fixtures and equipment are stated at cost. Depreciation and
amortization is provided over the estimated useful lives of the assets or the
term of the lease on a straight-line basis.
Depreciation and amortization expense for the years ended December 31, 1998,
1997, and 1996 was $4,265, $2,072, and $1,474 respectively.
Software Development Costs
Software development costs incurred to develop new versions of the software or
to enhance the core software are expensed as incurred.
Translation of Foreign Currencies
All assets and liabilities are translated into U.S. Dollars using the exchange
rate in effect at the balance sheet date. All revenue, costs and expenses are
translated using an average exchange rate. The gains and losses of foreign
subsidiaries resulting from the change in exchange rates from year to year have
been reported separately as a component of stockholders' equity. The effect on
the statements of income of transaction gains and losses is insignificant for
all years presented.
F-7
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
1. Significant Accounting Policies (continued)
Income Taxes
The Company accounts for income taxes under the liability method. Under the
liability method, deferred income taxes are recorded to reflect the net tax
effects of temporary differences between the carrying amounts of assets and
liabilities for financial reporting and the amounts used for income tax
purposes.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrated
credit risks consists primarily of cash and trade receivables. The Company
maintains cash and cash equivalents with various financial institutions. The
Company policy is designed to limit exposure to any one institution. Due to the
size and terms of certain customer contracts and the industry in which the
Company competes, trade accounts receivable include amounts due from certain
customers that are considered significant in relation to total trade accounts
receivable.
Fair Value of Financial Instruments
The carrying value of financial instruments such as cash, accounts receivable
and accounts payable approximate their fair value based on the short-term
maturities of these instruments. The carrying value of bank debt approximates
fair value based on quoted market prices for the same or similar issues as well
as the current rates offered to the Company. (See Note 3 for fair value
disclosures regarding marketable debt securities)
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.
Reclassifications
Certain prior year balances were reclassified to conform to the current year
presentation.
2. Capitalization
Initial Public Offering
In May, 1997, the Company sold 9,730,000 shares of its Common Stock in an
Initial Public Offering ("IPO") in which it received approximately $70,630 in
net proceeds. At the completion of the offering, 225,000 shares of the
Company's Series A Convertible Preferred Stock were converted into 9,000,000
shares of Common Stock.
Common Stock
Effective May of 1998, the Company amended its certificate of incorporation to
increase the authorized Common Stock to 200,000,000 shares, and effected a 2-
for-1 Common Stock split. All common share and per common share amounts have
been adjusted for all periods to reflect the stock split.
F-8
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
2. Capitalization (continued)
Preferred Stock
The board of directors of the Company is authorized to issue up to 225,000
shares of preferred stock, par value $.01 per share, in one or more series and
to fix the powers, voting rights, designations and preferences of each series.
During 1995, the board of directors authorized for issuance 225,000 shares of
Preferred Stock ranking senior to common stock. The Preferred Stock ranks senior
to common stock and is entitled to dividends, if declared by the board of
directors, in an amount equal to the pro rata share that would have been
received had the Preferred Stock been converted to common stock. Upon
liquidation, holders of Preferred Stock, on an equal basis, are entitled to
receive the preference value of $88.89, plus accumulated and unpaid dividends,
if any, before any distribution or payment is made to the holders of common
stock. No dividends have been declared or paid on Preferred Stock.
The holders of Preferred Stock have the right to vote at special or annual
meetings of stockholders on all matters entitled to be voted on by holders of
common stock voting together as a single class with other shares entitled to
vote thereon. With respect to such vote, each share of Preferred Stock shall
entitle the holder to cast that number of votes per share as would be cast had
the Preferred Stock been converted to common stock at the Conversion Ratio.
At the time of the initial public offering, the holders of Preferred Stock
converted each share of Preferred Stock into 40 shares of common stock.
Per Share Data
Earnings per share was computed by dividing net earnings by the weighted average
number of shares of Common Stock outstanding. In 1997, the Financial Accounting
Standards Board issued Statement of Financial Accounting Standards No. 128,
"Earnings per Share" ("SFAS 128"). SFAS 128 replaced the calculation of primary
and fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to the previously reported fully diluted
earnings per share. All earnings per share amounts for all periods have been
presented, and where appropriate, restated to conform to the SFAS 128
requirements. Retroactive effect has been given to share and per share amounts
for the stock split as noted above.
In addition, in February 1998, the Securities and Exchange Commission issued
Staff Accounting Bulletin No. 98 ("SAB 98"), which revised the guidance for
earnings per share calculations in an IPO. As a result of SAB 98, the Company
restated its 1997 and 1996 earnings per share calculation by excluding the
effect of cheap stock, which was included in the calculation of weighted shares
outstanding for the period prior to the public offering.
Diluted EPS for the years ended December 31, 1998 and 1997 includes the effect
of options to purchase 2,639,029 and 2,864,404 shares of common stock and 56,235
and 65,626 shares of restricted common stock respectively. Diluted EPS in 1997
and 1996 also includes the weighted average effect of the conversion of
Preferred Stock into Common Stock prior to the IPO. The effect was to increase
diluted weighted average shares outstanding by 3,328,768 in 1997 and 9,000,000
in 1996. Options to purchase 627,000 shares of common stock at prices ranging
from $51.00 to $66.12 were outstanding during 1998 and options to purchase
1,824,000 shares of common stock at prices ranging from $20 to $30 per share
were outstanding during 1997 and options to purchase 5,809,000 shares were
outstanding during 1996 at prices ranging from $2.65 to $8.37 per share, but
were not included in the computations of diluted earnings per share because the
options' exercise price was greater than the average market price of the common
shares and, therefore, the effect would be antidilutive.
F-9
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
3. Marketable Debt Securities
The following is a summary of investments in marketable debt securities that the
Company has classified as held-to-maturity securities:
Gross
Amortized Unrealized Gross Unrealized Estimated
Cost Gains Losses Fair Value
-----------------------------------------------------------------------------
December 31, 1998
Obligations of U.S. Government agencies.. $20,739 $28 $ (2) $20,765
U.S. Corporate Securities................ 41,479 26 (26) 41,479
-----------------------------------------------------------------------------
$62,218 $54 $(28) $62,244
=============================================================================
December 31, 1997
Obligations of U.S. Government agencies.. $ 6,720 $ 7 $ - $ 6,727
U.S. Corporate Securities................ 42,840 79 (28) 42,891
-----------------------------------------------------------------------------
$49,560 $86 $(28) $49,618
=============================================================================
The amortized cost and estimated fair value of debt securities held-to-maturity
at December 31, 1997, by contractual maturity are shown below. All debt
securities held-to-maturity at December 31, 1998 are due in one year or less.
Expected maturities will differ from contractual maturities because the issues
of the securities may have the right to prepay obligations without prepayment
penalties.
Amortized Estimated
Cost Fair Value
--------------------------------------
December 31, 1997
Due in one year or less.................. $45,907 $45,965
Due after one year through five years.... 3,653 3,653
--------------------------------------
$49,560 $49,618
======================================
4. Acquisition
In June 1998, the Company acquired the stock of Infocellular, Inc.
("Infocellular") for $8,484, paid by the issuance of 117,885 shares of Common
Stock and $1,327 in cash. Infocellular, which operates as a wholly-owned
subsidiary of the Company, is engaged in the business of providing point of sale
and customer acquisition software and related services to telecommunication
service providers. The purchase price was allocated as follows:
Purchased in-process research and development related to $ 8,200
computer software technology.............................
Fully developed computer software technology.............. 500
Current assets............................................ 1,327
Furniture and fixtures.................................... 716
Other assets.............................................. 127
Other intangible assets................................... 500
Current liabilities....................................... (4,348)
Goodwill.................................................. 1,462
-------------------
Total purchase price...................................... $ 8,484
===================
F-10
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
4. Acquisition (continued)
The acquisition was accounted for as a purchase and the results of
Infocellular's operations have been included in the consolidated financial
statements of LHS Group Inc. effective June 11, 1998. Goodwill recorded in
connection with this acquisition is being amortized over five years.
The valuations of core and developed technologies and in-process research and
development were based on the present value of estimated future cash flows over
the lesser of: (i) five years or (ii) the period in which the product is
expected to be integrated into an existing LHS product. The resulting values
were reviewed for reasonableness based on the time and cost spent on the effort,
the complexity of the development effort and, in the case of in-process
development projects, the stage to which it had progressed. For in-process
research and development, the valuation was reduced for the core technology
component of such product and the percentage of product development remaining at
the acquisition date. The resulting in-process research and development amount
of $8,200 is reflected as a charge in the 1998 statement of operations. No
income tax benefit was recognized on the write-off of the purchased in-process
research and development related to computer software technology because the
merger was structured as tax free to the selling shareholders and the write-off
of this asset and the amortization of the other intangibles will not be
deductible for federal income tax purposes.
The following table summarizes pro forma unaudited results of operations as if
the acquisition was concluded on January 1, 1997. The adjustments to the
historical data reflects the amortization of goodwill and intangibles. This
unaudited pro forma financial information is not necessarily indicative of what
the combined operations would have been if LHS had control of Infocellular for
the periods presented.
1998 1997
--------------------------------------
Revenues.......................................... $164,896 $110,361
Earnings before interest and taxes................ 36,296 5,500
Net earnings...................................... 24,227 1,016
Earnings Per share:
Basic........................................... $ 0.47 $ 0.02
Diluted......................................... $ 0.44 $ 0.02
5. Debt
The Company had a short-term credit facility with a bank which expired on
December 31, 1998 under which it could borrow up to $3,000 at 7.5% per annum. At
December 31, 1998, the Company had $2,300 of outstanding letters of credit.
Outstanding letters of credit incur a fee of 1.5% of the amount outstanding. No
other borrowings were outstanding under the facility at December 31, 1998 or
1997.
F-11
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
6. Leases
LHS Group leases certain of its office buildings from a Company related through
common ownership under an operating lease agreement which expires in 2003. The
lease agreement requires monthly rental payments of $32 adjusted annually for
inflation. Rental expenses under all operating leases totaled $5,720, $3,903,
and $1,982 for the years ended December 31, 1998, 1997 and 1996, respectively.
Telecommunications equipment in the amount of $598 was acquired under capital
lease arrangements. Future minimum lease payments are as follows:
Capital Operating
Leases Total
----------------------------------------------------------
1999...................................... $142 $ 6,774 $ 6,916
2000...................................... 142 5,561 5,703
2001...................................... 135 4,721 4,856
2002...................................... - 1,285 1,285
2003...................................... - 216 216
----------------------------------------------------------
Total future minimum lease payments....... 419 $18,557 $18,976
====================================
Less amounts representing interest........ (79)
-------------------
Present value of net minimum lease
payments................................. $340
===================
7. Income Taxes
The Company and each of its consolidated subsidiaries file separate tax returns.
For financial reporting, the Company and consolidated subsidiaries calculate
their respective tax liabilities on a separate return basis which are combined
in the accompanying consolidated financial statements.
The provision for income taxes consists of the following:
Year ended December 31
1998 1997 1996
-----------------------------------------------------------
Currently payable income taxes:
U.S. federal............................. $ 3,061 $ 931 $1,143
Foreign.................................. 12,729 3,620 1,433
Deferred income taxes (credit):
U.S. federal............................. (360) (390) (230)
Foreign.................................. 1,601 3,309 (262)
-----------------------------------------------------------
$17,031 $7,470 $2,084
===========================================================
F-12
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
7. Income Taxes (continued)
The net deferred income tax asset (liability) consists of the following:
December 31
1998 1997
---------------------------------------
Deferred tax assets:
Deferred revenue.................................. $ - $ 524
Research and development tax credit............... 914 381
Net operating loss carryforward................... - 165
Accrued vacation and bonuses...................... 916 1,303
Tax on foreign differences........................ 86 357
Warranty expense.................................. 322 -
Allowance for doubtful accounts................... 419 -
Other............................................. 564 -
Valuation allowance............................... - -
---------------------------------------
3,221 2,730
Deferred tax liabilities:
Unbilled receivables.............................. (1,075) (1,598)
Warranty expenses................................. - (205)
Depreciation expense.............................. - (54)
Tax on foreign differences........................ (5,359) (2,845)
---------------------------------------
(6,434) (4,702)
---------------------------------------
$(3,213) $(1,972)
=======================================
The reconciliation of income tax expense computed using the statutory tax rates
in the United States to the income tax expense recognized in the financial
statements is as follows:
Year ended December 31
1998 1997 1996
---------------------------------------------------------
Tax at statutory rates............................. $11,689 $6,351 $1,871
Differences resulting from higher tax rates in
foreign countries................................. 2,564 1,119 213
Non-deductible write off of in-process research
and development................................... 2,778 - -
---------------------------------------------------------
$17,031 $7,470 $2,084
=========================================================
During 1998 and 1997, the Company received $66,500 and $10,387 million in tax
deductions from the exercise of nonqualified employee stock options of which
$10,161 and $931 was realized and recognized as a reduction to taxes currently
payable and an increase to equity. At December 31, 1998 and 1997, the Company
had tax net operating loss carryovers of $58,908 and $6,486 which is primarily
the result of the tax deductions from the exercises of the nonqualified stock
options. The benefit of the tax net operating loss carryovers will be credited
to additional paid-in-capital when realized.
F-13
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
8. Related Party Transactions
The Company leases office space and housing space for certain of its employees
from partnerships consisting in part of one of the Company's directors. During
the years ended December, 31, 1998, 1997, and 1996, the Company made lease
payments totaling $382, $387, and $437, respectively, to the partnerships. The
Company periodically charters the use of an aircraft owned by a director of the
Company. During the years ended December 31, 1998 and 1997, the Company paid
approximately $103 and $114 for its use of the aircraft.
9. Major Customers
No customer accounted for more than 10% of revenues in 1998 while in 1997, one
customer accounted for 12% of revenues and in 1996 two customers accounted for
12% and 10% of revenues.
10. Retirement Plans
The Company maintains the LHS Communications Systems, Inc. 401(k) Plan.
Employees age 21 or older are eligible to participate in the quarter following
their date of hire and to elect to defer a percentage of his/her salary. The
Company has the discretion to make contributions to the 401(k) plans. During
1998 and 1997, the Company made matching contributions to the Plan of $520 and
$248, respectively.
11. Stock Option Plan
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-
Based Compensation," ("SFAS 123") requires use of option valuation models
that were not developed for use in valuing employee stock options. Under APB 25,
because the exercise price of the Company's employee stock options equals the
market price of the underlying stock on the date of grant, no compensation
expense is recognized.
The Company has a nonqualified Stock Incentive Plan (the "Plan") under which
stock options, restricted stock and other stock-based awards may be granted to
certain officers, directors, key employees and non-employee directors. Awards
may be granted under the Plan for up to 16,000,000 shares of common stock. All
options are exercisable over a five year period with 25% vesting on the first
anniversary of the grant date and the remaining 75% vesting ratable over 48
months. The terms of the options are 10 years from the date of the grant at
which time all unexercised options expire and are again available for future
grant.
Pro forma information regarding net earnings and earnings per share is required
by SFAS 123, which also requires that the information be determined as if the
Company has accounted for its employee stock options granted subsequent to
December 31, 1994 under the fair value method of that Statement. The fair value
for options granted in 1996 was estimated at the date of grant using a minimum
value option pricing model with the following assumptions: risk-free interest
rates of 6.3%; no anticipated dividends; and a weighted-average expected life of
the option of seven years. In 1997, the fair value for options granted was
estimated at the date of grant using the Black Scholes option pricing models
with the following assumptions: volatility of .904; average risk-free interest
rate of 6.2%; no anticipated dividends; and a weighted-average expected life of
the option of five years. In 1998, the fair value for options granted was
estimated at the date of grant using the Black Scholes option pricing models
with the following assumptions: volatility of .800; average risk-free interest
rate of 5.44%; no anticipated dividends; and a weighted-average expected life of
the option of five years.
F-14
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
11. Stock Option Plan (continued)
Option valuation models require the input of highly subjective assumptions.
Because the Company's employee stock options 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 employee stock options. The weighted average
grant date fair value of options granted during the year 1996 using the minimum
value option pricing model was $1.79. The weighted average grant date fair value
of options granted during 1997 and 1998 using the Black-Scholes option pricing
model was $30.76 and $28.29, respectively.
For purposes of SFAS 123 pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period as follows:
1998 1997 1996
---------------------------------------------------------
Pro forma net earnings........... $6,961 $8,966 $3,078
Basic earnings per share......... $ 0.13 $ 0.21 $ 0.10
Diluted earnings per share....... $ 0.13 $ 0.18 $ 0.08
A summary of the Company's stock option activity, and related follows:
Weighted
Number of Average Price
Shares Issued per Share
-----------------------------------------
Outstanding as of January 1, 1996.................. - $ -
Granted........................................... 5,909,000 2.70
Exercised......................................... (100,000) 2.65
---------------------------------------
Outstanding as of December 31, 1996................ 5,809,000 2.70
Granted........................................... 2,173,000 21.19
Exercised......................................... (700,710) 2.65
Cancelled......................................... (636,626) 3.13
---------------------------------------
Outstanding as of December 31, 1997................ 6,644,664 8.70
Granted........................................... 2,346,500 41.74
Exercised......................................... (1,977,082) 7.07
Cancelled......................................... (611,695) 8.86
---------------------------------------
Outstanding as of December 31, 1998................ 6,402,387 $21.19
=======================================
Exercisable as of December 31, 1998................ 759,388 $ 5.76
=======================================
Exercisable as of December 31, 1997................ 899,332 $ 2.72
=======================================
F-15
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
11. Stock Option Plan (continued)
Information regarding stock options outstanding as of December 31, 1998 is as
follows:
Options Outstanding Options Exercisable
- -------------------------------------------------------------------------- --------------------------------------
Weighted Average
Range of Number Remaining Weighted-Average Number Weighted-Average
Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
- -------------------------------------------------------------------------- --------------------------------------
$ 2.65 2,553,250 7.8 $ 2.65 634,981 $ 2.65
$8.00 - 8.38 144,775 8.2 8.17 12,699 8.18
$12.50 15.00 71,094 8.5 14.26 7,343 15.00
$21.91 30.19 1,514,789 8.8 24.12 103,628 23.65
$34.88 51.31 1,701,479 9.2 39.11 737 35.03
$54.12 66.12 417,000 9.5 58.99
- -------------------------------------------------------------------------- --------------------------------------
$2.65 - 66.12 6,402,387 8.5 $21.19 759,388 $ 5.76
========================================================================== ======================================
12. Segment Information
In accordance with the requirements of SFAS 131, the following disclosure
represents the information used by management when evaluating the operating
performance of its operating segments. The information reviewed by management
includes the operating revenue from external customers and identifiable assets
for the Company's three geographic areas, the Americas, Europe and Asia-Pacific:
1998 1997 1996
---------------------------------------------------------
Revenues:
Americas................................. $ 66,742 $ 44,569 $18,115
Europe................................... 78,516 48,612 32,495
Asia-Pacific............................. 17,924 12,230 6,254
---------------------------------------------------------
Total in financial statements............. $163,182 $105,411 $56,864
=========================================================
December 31,
1998 1997
---- ----
Long-lived assets:
Americas $11,223 $ 3,496
Europe 6,589 5,212
Asia 681 630
------- -------
7,270 5,842
------- -------
Total $18,493 $ 9,330
======= =======
F-17
LHS Group Inc.
Notes to Consolidated Financial Statements (continued)
13. Impact of Recently Issued Accounting Standards
On January 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). The Company
reported comprehensive income in its statement of stockholders' equity. The
adoption of SFAS 130 resulted in revised and additional disclosures but had no
effect on the financial position, results of operations, or liquidity of the
Company.
In June 1997, the FASB issued Statement of Financial Accounting Standards No.
131, "Disclosures about Segments of an Enterprise and Related Information"
("SFAS 131"), which establishes standards for the way public business
enterprises report information about operating segments in annual financial
statements and requires that those enterprises report selected information about
operating segments in interim financial reports issued to shareholders.
Operating segments are components of an enterprise about which separate
financial information is available which is evaluated regularly by the chief
operating decision maker in deciding how to allocate resources and in assessing
performance. SFAS 131 also establishes standards for related disclosures about
products and services, geographic areas, and major customers. The Company
adopted SFAS 131 in 1998, and the effect of the adoption was not material to the
consolidated financial statements. (see Note 12).
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities", which
requires the recognition of all derivatives as either assets or liabilities in
the balance sheet and the measurement of those instruments at fair value. The
accounting for changes in the fair value of a derivative depends on the planned
use of the derivative and the resulting designation. The Company is required to
implement the statement in the first quarter of the year 2000. The Company has
not used derivative instruments and believes the impact of adoption of this
statement will not have significant effect on the financial statements.
The American Institute of Certified Public Accountants issued SOP 97-2, SOP 98-4
and SOP 98-9 to clarify guidance on applying generally accepted accounting
principles to software transactions and to provide guidance on when revenue
should be recognized and in what amounts for licensing, selling, leasing, or
otherwise marketing computer software. The Company adopted this guidance during
1997. Such adoption had no effect on the Company's methods of recognizing
revenue.
14. Unaudited Quarterly Information
Quarter ended
-----------------------------------------------------------------------------
March 31, 1998 June 30, 1998 Sept. 30, 1998 Dec. 31, 1998
-----------------------------------------------------------------------------
Revenues................................. $33,165 $37,779 $43,904 $48,334
Gross margin............................. 20,279 23,358 27,949 31,643
Net earnings (loss)...................... 4,463 (2,105) 7,034 7,957
Net earnings (loss) per share
Basic................................. $ 0.09 $ (0.04) $ 0.13 $ 0.15
Diluted............................... $ 0.08 $ (0.04) $ 0.13 $ 0.15
-----------------------------------------------------------------------------
Quarter ended
-----------------------------------------------------------------------------
March 31, 1997 June 30, 1997 Sept. 30, 1997 Dec. 31, 1997
-----------------------------------------------------------------------------
Revenues................................. $20,886 $23,312 $28,886 $32,327
Gross margin............................. 11,342 13,294 15,907 17,543
Net earnings............................. 1,152 2,041 3,734 4,281
Net earnings per share
Basic................................. $ 0.03 $ 0.05 $ 0.08 $ 0.09
Diluted............................... $ 0.03 $ 0.04 $ 0.07 $ 0.08
F-17