SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report pursuant to Section 13 or 15 (d) of the Securities Exchange
Act of 1934
For the quarterly period ended September 30, 1998
or
[ ] Transition Report pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the transition period from _____ to _____
Commission File Number: 1-11859
PEGASYSTEMS INC.
(Exact name of Registrant as specified in its charter)
Massachusetts 04-2787865
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
101 Main Street
Cambridge, MA 02142-1590
(Address of principal executive offices) (zip code)
(617) 374-9600
(Registrant's telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
There were 28,683,100 shares of the Registrant's common stock, $.01 par value
per share, outstanding on December 31, 1998.
PEGASYSTEMS INC. AND SUBSIDIARIES
Index to Form 10-Q
Part I - Financial Information
Item 1. Financial Statements
Page
----
Consolidated Balance Sheets at September 30, 1998 3
and December 31, 1997
Consolidated Statements of Income for the three and nine 4
months ended September 30, 1998 and September 30, 1997
Consolidated Statements of Cash Flows for the nine 5
months ended September 30, 1998 and September 30, 1997
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial 11
Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk 20
Part II - Other Information
Item 1. Legal Proceedings 20
Item 2. Changes in Securities and Use of Proceeds 20
Item 3. Defaults upon Senior Securities 20
Item 4. Submission of Matters to a Vote of Security Holders 21
Item 5. Other Information 21
Item 6. Exhibits and Reports on Form 8-K 21
SIGNATURES 22
Page 3 of 22
PEGASYSTEMS INC.
Consolidated Balance Sheets
(in thousands, except share-related amounts)
September 30, December 31,
1998 1997
------------- ------------
Assets
Current assets:
Cash and cash equivalents $33,231 $52,005
Trade and installment accounts receivable, net of
allowance for doubtful accounts of $1,827 in 1998
and $2,200 in 1997 35,314 20,319
Prepaid expenses and other current assets 2,188 1,514
----------- ----------
Total current assets 70,733 73,838
Long-term license installments, net 58,103 36,403
Equipment and improvements, net 9,187 5,578
Purchased software, net 9,932 11,701
----------- ----------
Total assets $147,955 $127,520
=========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses $10,259 $ 5,398
Deferred revenue 18,521 1,754
Deferred income taxes 3,484 3,978
----------- ----------
Total current liabilities 32,264 11,130
----------- ----------
Deferred income taxes 3,669 3,669
----------- ----------
Stockholders' Equity:
Preferred stock, $.01 par value, 1,000,000 shares
authorized; no shares issued and outstanding -- --
Common stock, $.01 par value, 45,000,000 shares authorized;
28,648,800 shares and 28,545,100 shares issued and
outstanding in 1998 and 1997, respectively 288 285
Additional paid-in capital 87,259 86,841
Deferred compensation (41) (55)
Stock warrant 2,897 2,897
Retained earnings 22,042 23,107
Cumulative foreign currency translation adjustment (423) (354)
----------- ----------
Total stockholders' equity 112,022 112,721
----------- ----------
Total liabilities and stockholders' equity $147,955 $127,520
=========== ==========
The accompanying notes are an integral part of these
consolidated financial statements.
Page 4 of 22
PEGASYSTEMS INC.
Consolidated Statements of Income
(in thousands, except per share amounts)
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
-------------- --------------- -------------- --------------
(As Restated) (As Restated)
Revenue:
Software license $9,059 $ 5,090 $27,224 $12,601
Services 8,572 3,578 22,799 9,297
----------- ------------ ----------- -----------
Total revenue 17,631 8,668 50,023 21,898
----------- ------------ ----------- -----------
Cost of revenue:
Cost of software license 116 86 997 106
Cost of services 6,465 2,829 15,995 7,365
----------- ------------ ----------- -----------
Total cost of revenue 6,581 2,915 16,992 7,471
----------- ------------ ----------- -----------
Gross Profit 11,050 5,753 33,031 14,427
Operating expenses:
Research and development 6,335 4,261 16,856 10,100
Selling and marketing 6,268 4,782 17,380 11,878
General and administrative 1,829 721 4,315 1,967
----------- ------------ ----------- -----------
Total operating expenses 14,432 9,764 38,551 23,945
----------- ------------ ----------- -----------
Income (loss) from operations (3,382) (4,011) (5,520) (9,518)
License interest income 704 476 1,857 1,271
Other interest income 718 922 1,945 2,670
----------- ------------ ----------- -----------
Income (loss) before provision
(benefit) for income taxes (1,960) (2,613) (1,718) (5,577)
Provision (benefit) for income taxes (745) (993) (653) (2,119)
----------- ------------ ----------- -----------
Net income (loss) $(1,215) $(1,620) $(1,065) $(3,458)
=========== ============ =========== ===========
Earnings (loss) per share:
Basic $(0.04) $(0.06) $(0.04) $(0.12)
=========== ============ =========== ===========
Diluted $(0.04) $(0.06) $(0.04) $(0.12)
=========== ============ =========== ===========
Weighted average number of common and
common equivalent shares outstanding:
Basic 28,628 28,520 28,576 28,264
=========== ============ =========== ===========
Diluted 29,997 28,520 29,813 28,264
=========== ============ =========== ===========
The accompanying notes are an integral part of these
consolidated financial statements.
Page 5 of 22
PEGASYSTEMS INC.
Consolidated Statements of Cash Flows
(in thousands)
Nine Months Ended
September 30,
1998 1997
--------- ---------
(As Restated)
Cash Flows from Operating Activities:
Net income (loss) $(1,065) $(3,458)
Adjustments to reconcile net income (loss) to net
cash used in operating activities:
Provision for deferred income taxes (494) (2,119)
Depreciation and amortization 4,169 2,258
Provision for doubtful accounts (373) 1,315
Changes in operating assets and liabilities:
Trade and installment accounts receivable (36,322) (8,096)
Prepaid expenses and other current assets (674) (553)
Accounts payable and accrued expenses 4,862 1,214
Deferred revenue 16,767 792
--------- ---------
Net cash used in operating activities (13,130) (8,647)
--------- ---------
Cash Flows from Investing Activities:
Purchase of equipment and improvements (5,996) (3,277)
Purchased software -- (10,000)
--------- ---------
Net cash used in investing activities (5,996) (13,277)
--------- ---------
Cash Flows from Financing Activities:
Issuance of common stock, net -- 51,943
Exercise of stock options 421 623
--------- ---------
Net cash provided by financing activities 421 52,566
--------- ---------
Effect of exchange rate on cash and cash equivalents (69) (288)
--------- ---------
Net increase (decrease) in cash and cash equivalents (18,774) 30,354
Cash and cash equivalents, at beginning of period 52,005 24,201
--------- ---------
Cash and cash equivalents, at end of period $33,231 $54,555
========= =========
The accompanying notes are an integral part of these
consolidated financial statements.
Page 6 of 22
PEGASYSTEMS INC.
Notes to Consolidated Financial Statements
September 30, 1998
(Unaudited)
Note A - Basis of Presentation
The accompanying unaudited consolidated financial statements of Pegasystems Inc.
(the "Company") presented herein have been prepared in accordance with generally
accepted accounting principles and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair
presentation have been included. Operating results for the three and nine-month
periods ended September 30, 1998 are not necessarily indicative of the results
that may be expected for the full year ended December 31, 1998. The Company
suggests that these consolidated financial statements be read in conjunction
with the consolidated financial statements and notes thereto for the year ended
December 31, 1997, included in the Company's 1997 Annual Report to Stockholders
filed with the Securities and Exchange Commission.
Note B - Subsequent Event
On October 29, 1998, the Company publicly announced its preliminary, unaudited
results of operations for the three and nine-month periods ended September 30,
1998. Subsequently, based on information that had not previously come to the
attention of the Company or its independent auditors, the Company determined
that it may not have accounted properly for certain revenue transactions. As a
result, the Company, with the assistance of its independent auditors, conducted
a comprehensive review of those transactions and others relating to the three
months ended September 30, 1998 and other periods in 1998 and 1997.
Based on such review, the Company concluded that it was necessary to revise its
previously disclosed preliminary, unaudited results of operations for the three
and nine-month periods ended September 30, 1998 and to restate its consolidated
financial statements for the first and second quarters of each of 1998 and 1997.
The revision and restatements primarily reflect changes in the timing of revenue
recognition. The revenue changes are principally reversals of revenue arising
from the inability to reasonably estimate the fair market value of undelivered
elements in connection with software licenses, issues surrounding the timing of
delivery or acceptance of licensed software, certain project milestones not
being completed and billing errors or delays. The revenue changes also reflect
an increase in revenue reserves. In the opinion of management, all material
adjustments necessary to correct the consolidated financial statements have been
recorded.
A summary of the impact of such changes on the consolidated financial statements
for the unaudited three and nine-month periods ended September 30, 1998 is as
follows:
Page 7 of 22
PEGASYSTEMS INC.
Notes to Consolidated Financial Statements - Continued
September 30, 1998
Note B - Subsequent Event - Continued
Unaudited
Three Months Ended
September 30, 1998
(in thousands, except per share data) As Reported As Revised *
----------- ------------
Software license revenue $14,828 $9,059
Services revenue $11,851 $8,572
Total revenue $26,679 $17,631
Income (loss) from operations $6,676 $(3,382)
Net income (loss) $5,021 $(1,215)
Earnings (loss) per share: Basic $0.18 $(0.04)
Earnings (loss) per share: Diluted $0.17 $(0.04)
Total assets $150,596 $147,955
Unaudited
Nine Months Ended
September 30, 1998
(in thousands, except per share data) As Reported As Revised *
----------- ------------
Software license revenue $40,750 $27,224
Services revenue $27,436 $22,799
Total revenue $68,186 $50,023
Income (loss) from operations $13,806 $(5,520)
Net income (loss) $10,917 $(1,065)
Earnings (loss) per share: Basic $0.38 $(0.04)
Earnings (loss) per share: Diluted $0.37 $(0.04)
Total assets $150,596 $147,955
* Revised from the Company's preliminary financial results for the unaudited
three and nine-month periods ended September 30, 1998 announced on October 29,
1998.
Page 8 of 22
PEGASYSTEMS INC.
Notes to Consolidated Financial Statements - Continued
September 30, 1998
Note C - Earnings (Loss) Per Share
The Company follows the provisions of Statement of Financial Standards (SFAS)
No. 128, "Earnings Per Share." SFAS No. 128 establishes standards for computing
and presenting earnings per share. Calculations of basic and diluted earnings
(loss) per share and potential common shares are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands, except per share data) 1998 1997 1998 1997
- ------------------------------------ -------- -------- ------- --------
(As Restated) (As Restated)
Basic
Net income (loss) $ (1,215) $ (1,620) $(1,065) $ (3,458)
======== ======== ======= ========
Weighted average common shares outstanding 28,628 28,520 28,576 28,264
======== ======== ======= ========
Basic earnings (loss) per share $ (0.04) $ (0.06) $ (0.04) $ (0.12)
======== ======== ======= ========
Diluted
Net income (loss) $ (1,215) $ (1,620) $(1,065) $ (3,458)
======== ======== ======= ========
Weighted average common shares outstanding 28,628 28,520 28,576 28,264
Effect of:
Assumed exercise of stock options 1,369 -- 1,237 --
-------- -------- ------- --------
Weighted average common shares outstanding,
Assuming dilution 29,997 28,520 29,813 28,264
======== ======== ======= ========
Diluted earnings (loss) per share $ (0.04) $ (0.06) $ (0.04) $ (0.12)
======== ======== ======= ========
Anti-dilutive securities that were not included in
the above table are as follows:
Stock Options 97 1,345 320 1,339
Stock Warrant 285 204 285 69
-------- -------- ------- --------
382 1,549 605 1,408
======== ======== ======= ========
Note D - New Accounting Standards
The Company adopted SFAS No. 130, "Reporting Comprehensive Income," effective
January 1, 1998. SFAS 130 establishes standards for reporting and displaying
comprehensive income and its components in financial statements. The components
of the Company's comprehensive income are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands) 1998 1997 1998 1997
------------ -------- -------- ------- --------
Net income (loss) $(1,215) $(1,620) $(1,065) $(3,458)
Foreign currency translation adjustments, net
of income taxes 29 128 43 178
======== ======== ======= ========
Comprehensive income (loss) $(1,186) $(1,492) $(1,022) $(3,280)
======== ======== ======= ========
Page 9 of 22
PEGASYSTEMS INC.
Notes to Consolidated Financial Statements - Continued
September 30, 1998
Note E - 1997 Restatement
On April 15, 1998, the Company restated its consolidated financial statements
for the three-month periods ended March 31, 1997, June 30, 1997, and September
30, 1997. The restatements reflected revenue adjustments as a result of a change
in the timing of revenue recognition on certain contracts. Also included in the
restated consolidated financial statements were operating expenses, including a
provision for bad debts not previously recorded by the Company and the recording
of certain other expenses and reserves. In the opinion of management, all
material adjustments necessary to correct the financial statements have been
recorded.
A summary of the impact of such restatements on the financial statements for the
three and nine-month periods ended September 30, 1997 are as follows:
Three Months Ended
September 30, 1997
As Previously As
(in thousands, except per share data) Reported Restated
- ------------------------------------- ------------- -----------
Software license revenue $ 3,273 $ 5,090
Services revenue $ 3,737 $ 3,578
Total revenue $ 7,010 $ 8,668
Loss from operations $ (5,009) $ (4,011)
Net loss $ (2,239) $ (1,620)
Loss per share: Basic $ (0.08) $ (0.06)
Loss per share: Diluted $ (0.08) $ (0.06)
Total assets $121,023 $118,507
Nine Months Ended
September 30, 1997
As Previously As
(in thousands, except per share data) Reported Restated
- ------------------------------------- ------------- -----------
Software license revenue $ 13,734 $ 12,601
Services revenue $ 9,742 $ 9,297
Total revenue $ 23,476 $ 21,898
Loss from operations $ (6,102) $ (9,518)
Net loss $ (1,340) $ (3,458)
Loss per share: Basic $ (0.05) $ (0.12)
Loss per share: Diluted $ (0.05) $ (0.12)
Total assets $121,023 $118,507
Page 10 of 22
PEGASYSTEMS INC.
Management's Discussion and Analysis
of Financial Condition and Results of Operations
Results of Operations
Three and Nine Months Ended September 30, 1998 Compared to Three and Nine Months
Ended September 30, 1997
On April 15, 1998, the Company restated its consolidated financial statements
for the unaudited three-month and nine-month periods ended September 30, 1997.
The restatements reflected revenue adjustments as a result of a change in the
timing of revenue recognition on certain contracts. Also included in the
restated consolidated financial statements were operating expenses, including a
provision for bad debts not previously recorded by the Company and the recording
of certain other expenses and reserves.
On October 29, 1998, the Company publicly announced its preliminary, unaudited
results of operations for the three and nine-month periods ended September 30,
1998. Subsequently, based on information that had not previously come to the
attention of the Company or its independent auditors, the Company determined
that it may not have accounted properly for certain revenue transactions. As a
result, the Company, with the assistance of its independent auditors, conducted
a comprehensive review of those transactions and others relating to the three
months ended September 30, 1998 and other periods in 1998 and 1997.
Based on such review, the Company concluded that it was necessary to revise its
previously disclosed preliminary, unaudited results of operations for the three
and nine-month periods ended September 30, 1998 and to restate its consolidated
financial statements for the first and second quarters of each of 1998 and 1997.
The revision and restatements primarily reflect changes in the timing of revenue
recognition. The revenue changes are principally reversals of revenue arising
from the inability to reasonably estimate the fair market value of undelivered
elements in connection with software licenses, issues surrounding the timing of
delivery or acceptance of licensed software, certain project milestones not
being completed and billing errors or delays. The revenue changes also reflect
an increase in revenue reserves. In the opinion of management, all material
adjustments necessary to correct the consolidated financial statements have been
recorded.
Revenue
Total revenue for the three months ended September 30, 1998 (the "1998 Three
Month Period") increased 103.4% to $17.6 million from $8.7 million for the three
months ended September 30, 1997 (the "1997 Three Month Period"). Total revenue
for the nine months ended September 30, 1998 (the "1998 Nine Month Period")
increased 128.4% to $50.0 million from $21.9 million for the nine months ended
September 30, 1997 (the "1997 Nine Month Period"). These increases were due to
increases in both software license and services revenue.
Software license revenue for the 1998 Three Month Period increased 78.0% to $9.1
million from $5.1 million for the 1997 Three Month Period. Software license
revenue for the 1998 Nine Month Period increased 116.1% to $27.2 million from
$12.6 million for the 1997 Nine Month Period. These increases in software
license revenue
Page 11 of 22
were primarily attributable to software license acceptances by new customers,
software license agreement renewals, and extensions by existing customers.
Services revenue for the 1998 Three Month Period increased 139.6% to $8.6
million from $3.6 million for the 1997 Three Month Period. Services revenue for
the 1998 Nine Month Period increased 145.2% to $22.8 million from $9.3 million
for the 1997 Nine Month Period. These increases in services revenue were
primarily attributable to additional consulting services provided to existing
customers, increased implementation services for new customers, and to a lesser
extent, increased maintenance revenue from a larger installed product base. Due
to the Company's ability to enter into larger dollar software license
transactions, the size of services revenue transactions has increased.
Cost of Revenue
Cost of software license revenue for the 1998 Three Month Period increased 34.9%
to $0.1 million from $0.09 million for the 1997 Three Month Period and decreased
as a percentage of software license revenue to 1.3% for the 1998 Three Month
Period from 1.7% for the 1997 Three Month Period. Cost of software license
revenue for the 1998 Nine Month Period increased 840.6% to $1.0 million from
$0.1 million for the 1997 Nine Month Period and increased as a percentage of
software license revenue to 3.7% for the 1998 Nine Month Period from 0.8% for
the 1997 Nine Month Period. These increases were primarily due to licensing
third-party software and amortization costs associated with a stock purchase
warrant issued by the Company in June 1997.
Cost of services revenue for the 1998 Three Month Period increased 128.5% to
$6.5 million from $2.8 million for the 1997 Three Month Period. Cost of services
revenue for the 1998 Nine Month Period increased 117.2% to $16.0 million from
$7.4 million for the 1997 Nine Month Period. These increases were due to costs
associated with increased staffing in the Company's Client Services group. Cost
of services revenue as a percentage of services revenue decreased to 75.4% for
the 1998 Three Month Period from 79.1% for the 1997 Three Month Period. Cost of
services revenue as a percentage of services revenue decreased to 70.2% for the
1998 Nine Month Period from 79.2% for the 1997 Nine Month Period. These improved
gross margins, for both the 1998 Three and Nine Month Periods, were due to more
effective utilization of a larger Consulting Services staff.
Operating Expenses
Research and development expenses for the 1998 Three Month Period increased
48.7% to $6.3 million from $4.3 million for the 1997 Three Month Period.
Research and development expenses for the 1998 Nine Month Period increased 66.9%
to $16.9 million from $10.1 million for the 1997 Nine Month Period. These
increases were primarily due to costs associated with the addition of
approximately 50 people to the Company's research and development group. For the
1998 Nine Month Period the increase was also attributable to amortization costs
associated with the acquisition of certain third party software. As a percentage
of total revenue, research and development expenses decreased to 35.9% for the
1998 Three Month Period from 49.2% for the 1997 Three Month Period. As a
percentage of total revenue, research and development expenses decreased to
33.7% for the 1998 Nine Month Period from 46.1% for the 1997 Nine Month Period.
These decreases were due to rapid growth in the Company's total revenue.
Selling and marketing expenses for the 1998 Three Month Period increased 31.1%
to $6.3 million from $4.8 million for the 1997 Three Month Period. Selling and
marketing expenses for the 1998 Nine Month Period increased 46.3% to $17.4
million from $11.9 million for the 1997 Nine Month Period. These increases were
primarily due to costs associated with the addition of approximately 50 people
to the Company's selling and marketing group. As a percentage of total revenue,
selling and marketing expenses decreased to 35.5% for the 1998 Three Month
Period from 55.2% for the 1997 Three Month Period. As a percentage of total
revenue, selling and marketing expenses decreased to 34.7% for the 1998 Nine
Month Period from 54.2% for the 1997 Nine Month Period. These decreases were due
to rapid growth in the Company's total revenue.
Page 12 of 22
General and administrative expenses for the 1998 Three Month Period increased
153.7% to $1.8 million from $0.7 million for the 1997 Three Month Period.
General and administrative expenses for the 1998 Nine Month Period increased
119.4% to $4.3 million from $2.0 million for the 1997 Nine Month Period. General
and administrative expenses increased as a percentage of total revenue to 10.4%
for the 1998 Three Month Period from 8.3% for the 1997 Three Month Period. These
increases were due to increased staffing in the accounting, computer systems and
facilities management groups needed to support the Company's growth and to
additional professional fees. Such professional fees were incurred as a result
of additional interim audit and tax services performed and costs associated with
ongoing litigation. General and administrative expenses decreased as a
percentage of total revenue to 8.6% for the 1998 Nine Month Period from 9.0% for
the 1997 Nine Month Period due to an increase in the Company's total revenue.
License Interest Income
License interest income, which is the portion of all license fees due and
received under software license agreements that was not recognized upon product
acceptance or license renewal, increased 47.9% to $0.7 million for the 1998
Three Month Period from $0.5 million for the 1997 Three Month Period and
increased 46.1% to $1.9 million for the 1998 Nine Month Period from $1.3 million
for the 1997 Nine Month Period. These increases were due to an increase in the
dollar value of effective software license agreements.
Other Income
Other income, which consists of interest income generated on cash and cash
equivalents, and mark to market gains or losses on foreign denominated accounts
receivable, decreased 22.1% to $0.7 million for the 1998 Three Month Period from
$0.9 million for the 1997 Three Month Period and decreased 27.2% to $1.9 million
for the 1998 Nine Month Period from $2.7 million for the 1997 Nine Month Period.
These decreases were due to lower cash and cash equivalent balances being
invested, partially offset by gains recognized on the mark to market of foreign
denominated accounts receivable.
Provision for Income Taxes
The tax benefit for federal, state and foreign taxes was $0.8 million and $1.0
million for the 1998 and 1997 Three Month Periods. The tax benefit for federal,
state and foreign taxes was $0.7 million and $2.1 million for the 1998 and 1997
Nine Month Periods. The effective tax rate has remained constant at 38.0% for
the 1997 and 1998 Three and Nine Month Periods.
Liquidity and Capital Resources
From inception until the Company's initial public offering of Common Stock, the
Company funded its operations primarily through cash flows from operations and
bank borrowings. In July 1996, the Company issued and sold 2.7 million shares of
Common Stock in connection with its initial public offering. Net proceeds to the
Company from this offering were approximately $29.4 million. In January 1997,
the Company issued and sold 1.8 million shares of Common Stock in connection
with a second public offering. Net proceeds to the Company from this second
offering were approximately $51.9 million. At September 30, 1998, the Company
had cash and cash equivalents of approximately $33.2 million and working capital
of approximately $38.5 million.
Net cash used in operating activities for the 1998 Nine Month Period was $13.1
million, primarily due to a $36.3 million increase in accounts receivable,
partially offset by increases in deferred revenue, and accounts payable and
accrued expenses. The Company's accounts receivable increased due to larger
sales volume and deterioration in the age of the accounts receivable. The amount
of cash used in operating activities for the 1998 Nine Month Period was also
attributable to the costs associated with the significant increase in new
employees during such period, some of whom, especially those in the Company's
Sales and Client Services groups, require months of training and experience
before they are able to generate revenue. Additionally, the Company's method of
licensing its software over a 60 month period with payments made in monthly
installments over the license term results in significant cash utilization
during periods of rapid growth because a substantial portion of the associated
expenses are incurred prior to the commencement of the license term. The Company
is currently taking a number of steps to reduce the amount of cash used in
operating activities, including improving billings practices in order to reduce
the time between when services are performed and when such services are billed,
intensifying collection efforts on past due accounts, exploring the possible
sale of license receivables, hiring new employees on a more selective basis and
implementing more stringent cost controls.
Page 13 of 22
Net cash used in investing activities was approximately $6.0 million during the
1998 Nine Month Period due to the purchase of property and equipment, consisting
mainly of computer hardware and software, furniture and fixtures to support the
expansion of certain facilities and the Company's growing employee base.
Net cash provided by financing activities was $0.4 million during the 1998 Nine
Month Period due to the exercise of stock options.
The Company's capital commitments consist primarily of operating leases for
office space and equipment. At September 30, 1998, the Company's commitments
under non-cancelable operating leases for office space with terms in excess of
one year totaled $1.0 million, $4.4 million and $4.2 million for 1998, 1999 and
2000, respectively. The Company's total payments under such leases was $2.4
million for the 1998 Nine Month Period.
The Company's $5.0 million revolving bank credit line matures on June 30, 1999.
The Company's credit agreement prohibits the payment of dividends and the
disposition of assets outside of the ordinary course, has profitability
requirements and requires maintenance of specified levels of tangible net worth
and certain financial ratios. At September 30, 1998 and 1997, the Company had no
borrowings under such facility. As of September 30, 1998, the Company was not in
compliance with the covenants of this credit line and accordingly there was no
borrowing availability thereunder. The Company has requested a waiver from the
bank regarding its covenant requirements under the existing line of credit, but
there can be no assurances that the bank will approve this request.
The Company recorded bad debt expense of $0.6 during the 1998 Nine Month Period
primarily to provide for the risk of non-payment of certain receivables relating
primarily to consulting and installation services rendered by the Company.
The Company believes that current cash and cash equivalents will be sufficient
to fund the Company's operations for the near term. There can be no assurance
that additional capital which may be required to support further revenue growth
will not be required or that any such required additional capital will be
available on reasonable terms, if at all, at such time as required by the
Company.
Effect of "Year 2000" Issues.
The "Year 2000" problem is pervasive and complex, as virtually every computer
operation will be affected in some way by the rollover of the two-digit year
value to "00." The issue is whether computer systems will properly recognize
date sensitive information when the year changes to 2000. Systems that do not
properly recognize such information (or other date changes) could generate
erroneous data or fail. Pegasystems' customers rely on date-sensitive operations
to calculate internal data and to service their customers. In addition, the
Company also uses other companies' products as part of market offerings and for
internal use; these programs may also be affected by the issue.
Year 2000 readiness issues may negatively affect the purchasing patterns of
existing and potential customers. Many organizations are spending significant
amounts and rededicating personnel to correct or patch their current systems to
achieve Year 2000 readiness. Thus, fewer funds may be available to purchase the
Company's products. Also, the issue may divert customers' and potential
customers' time, attention, and resources away from those projects which
typically lead to purchases of products or services. The Company does not
believe that there is any practical way to ascertain the extent of, and has no
plans to address problems associated with, any such reduction in purchasing
resources of its customers. Any such reduction could, however, result in a
material adverse effect on the Company's business, operating results and
financial condition.
Page 14 of 22
Pegasystems has designed and tested the most current versions of its products to
be Year 2000 compliant. However, some customers are using earlier product
versions. In addition the Company's products are generally integrated with the
systems and products of its customers developed by other vendors. Year 2000
problems in these systems and products might significantly limit the ability of
the Company's customers to realize the intended benefit offered by the Company's
products. The Company may in the future be subject to claims based on Year 2000
problems in others' products or issues arising from the integration of multiple
products within an overall system. Although the Company has not been involved in
any litigation or proceeding to date involving its products or services related
to Year 2000 issues, there can be no assurance that the Company will not in the
future be required to defend its products or services or to negotiate
resolutions of claims based on Year 2000 issues. The costs of defending and
resolving Year 2000-related disputes, and any liabilities of the Company for
Year 2000-related damages, including consequential damages, could have a
material adverse effect on the Company business, operating results and financial
condition.
The Company also relies on certain computer technology and software that it
licenses from third parties, including software that is integrated with the
Company's products. These programs may also present Year 2000 problems. Although
the Company has not experienced any significant product claims to date, there
can be no assurance that unanticipated errors or defects will not result in
product liability or other claims in the future. Failure of third-party software
comprising any part of the Company's systems to operate properly with regard to
Year 2000 and thereafter could require the Company to incur unanticipated
expenses to address associated problems, which could have a material adverse
effect on the Company's business, operating results and financial condition.
The Company has adopted standard industry practices to prepare for the effect of
the upcoming date change on internal data and information technology systems
(such as communications, development, accounting, billing, and other systems).
The Company's Year 2000 internal readiness program primarily covers: taking
inventory of hardware, software and embedded systems, assessing business and
customer satisfaction risks associated with such systems, creating action plans
to address known risks, executing and monitoring action plans, and contingency
planning. Pegasystems expects to substantially complete Year 2000 readiness
preparations by the end of the first quarter of 1999 with respect to core
business systems.
Although the Company does not believe that it will incur any material costs or
experience material disruptions in its business associated with preparing its
internal systems for the year 2000, there can be no assurances that the Company
will not experience serious unanticipated negative consequences and/or material
costs caused by undetected errors or defects in the technology used in its
internal system. The most reasonably likely worst case scenarios would include:
(i) corruption of data contained in internal information systems, (ii) hardware
failure, and (iii) the failure of infrastructure services provided by government
agencies and other third parties (e.g., electricity, phone service, water
transport, Internet services, etc.). The Company is in the process of completing
contingency planning for high risk areas (such as accounting, payroll, and
invoicing/billing systems) at this time and has commenced contingency planning
relating to other areas. The Company expects contingency plans to include, among
other things, manual "work-arounds" for software and hardware failures, as well
as substitution of systems, if necessary.
Inflation
Inflation has not had a significant impact on the Company's operating results to
date, and the Company does not expect it to have a significant impact in the
future. The Company's license and maintenance fees are typically subject to
annual increases based on recognized inflation indexes.
Page 15 of 22
Forward-Looking Statements
Certain statements contained in this Form 10-Q may be construed as
"forward-looking statements" as defined in the Private Securities Litigation
Reform Act of 1995. These statements involve various risks and uncertainties
which could cause the Company's actual results to differ from those expressed in
such forward-looking statements. These risks and uncertainties include the
effect of losses from prior periods, liquidity issues, pending litigation and
regulatory proceedings, recent adverse publicity, seasonal variation of the
Company's operations and fluctuations in the Company's quarterly results, rapid
technological change involving the Company's products and those of competitors,
delays in product development and implementation, the technological
compatibility of the Company's products with its customers' systems, the
Company's dependence on customers in the financial services market, intense
competition in the markets for the Company's products, risk of non-renewal by
current customers, management of the Company's growth, and other risks and
uncertainties. Further information regarding those factors which could cause the
Company's actual results to differ materially from any forward-looking
statements contained herein is provided below.
CERTAIN STATEMENTS FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The Company, desiring to avail itself of the "safe harbor" provisions of the
Private Securities Litigation Reform Act of 1995, wishes to caution readers that
the following important factors, among others, in some cases have caused and in
the future could cause the Company's actual results to differ materially from
those expressed in forward-looking statements made by or on behalf of the
Company in filings with the Securities and Exchange Commission, press releases
and oral statements.
Words such as "expects," "may," "anticipates," "intends," "would," "will,"
"plans," "believes," "estimates," "should," and similar words and expressions
are intended to identify forward-looking statements. These statements are based
on estimates, projections, beliefs, and assumptions of the Company and its
management and are not guarantees of future performance.
Losses in Prior Periods; Liquidity and Financing Risks. The Company has
experienced losses from operations during 1997 and the first three quarters of
1998. The Company intends to take measures to reduce those losses, including
implementing various cost controls. If cost containment is not achieved or
revenues are not increased, the Company may need to further reduce its cost
structure. In addition, to improve its liquidity position, the Company intends
to augment its credit/collections staff and efforts, improve its billing systems
and offer customers an alternative to the established term license model. The
Company believes that its cash balances and anticipated future cash flows will
be sufficient to fund operations for the near term. The Company can make no
assurances that measures taken to date or to be taken in the future will be
sufficient to stem losses or that future financing will be available to the
Company or, if available, on terms that will be satisfactory to the Company.
Litigation and Other Proceedings. The Company is presently a defendant in two
private securities litigation matters and is involved in an action by the Nasdaq
Stock Market that could result in a delisting of the Company's Common Stock from
the Nasdaq National Market System. Although the Company intends to defend these
actions vigorously, no assurance can be given as to the outcomes. It is possible
that in the case of the private securities litigation matters the Company may be
required to pay substantial damages or settlement costs which could have a
material adverse effect on the Company's financial position or results of
operation. In addition, regardless of the outcome of any of these actions, it is
likely that the Company will incur substantial defense costs and that such
actions will cause a diversion of management time and
Page 16 of 22
attention. The delisting of the Company's Common Stock from the Nasdaq National
Market System would have a material adverse effect on the Company and the market
price of the Company's Common Stock. See Part II - Other Information: Item 1.
Recent Events and Related Publicity. The Company's delay in filing this Form
10-Q and its announcement that it expected to make adjustments to its previously
published financial statements have resulted in negative publicity for the
Company. Such events and related publicity may adversely affect demand for the
Company's products and services, the rate of customer renewals, the Company's
ability to attract and retain qualified personnel, and its reputation generally.
Volatility in Stock Price, Fluctuations in Quarterly Results and Seasonality.
The market price of Pegasystems' Common Stock has been and may continue to be
highly volatile. Factors that are difficult to predict, such as quarterly
revenues and operating results, statements and ratings by financial analysts and
overall market performance, will have a significant affect on the price for
shares of Pegasystems' Common Stock. Revenues and operating results have varied
considerably in the past from period to period and are likely to vary
considerably in the future. Product development and other expenses are planned
anticipating future revenue. If revenue falls below expectations, financial
performance is likely to be adversely affected because only a small portion of
expenses vary with revenue. As a result, period-to-period comparisons of
operating results are not necessarily meaningful and should not be relied upon
to predict future performance. There can be no assurance that Pegasystems will
be profitable on an annual or quarterly basis or that earnings or revenues will
meet analysts' expectations.
Fluctuations may be particularly pronounced because a significant portion of
revenues in any quarter is attributable to product acceptances or license
renewals by a relatively small number of customers. Fluctuations also reflect a
policy of recognizing license fee revenue upon product acceptance or license
renewal in an amount equal to the present value of the total committed license
payment due during the term. Customers generally do not accept products until
the end of a lengthy sales cycle and an implementation period, typically ranging
from one to six months but in some cases significantly longer. Risks over which
the Company has little or no control, including customers' budgets and internal
authorization reviews, can significantly affect the sales cycle. Changes
dictated by customers may delay product implementation.
The business has experienced and may continue to experience significant
seasonality. In recent years, the Company has recognized a greater percentage of
its revenue in the third and fourth quarters than in the first and second
quarters because of the effect of the sales commission structure on the timing
of product acceptances and license renewals by customers. Some maintenance
contracts entitle customers to a fixed number of hours of service per calendar
year. Once the annual allotment of hours is exhausted, customers pay for
additional services on an hourly basis, typically resulting in higher service
revenue in the second, third and fourth quarters.
Need to Develop New Products and Adapt to Technological Change. Technological
developments, customer requirements, programming languages and industry
standards change frequently in the Company's markets. As a result, success in
current markets and new markets will depend upon the Company's ability to
enhance current products, to develop and introduce new products that meet
customer needs, keep pace with technological changes, respond to competitive
products, and achieve market acceptance. Product development requires
substantial investments for research, refinement and testing. There can be no
assurance that the Company will have sufficient resources to make necessary
product development investments. Pegasystems may experience difficulties that
will delay or prevent the successful development, introduction or implementation
of new or enhanced products. Inability to introduce or implement new or enhanced
products in a timely manner would adversely affect future financial performance.
Page 17 of 22
The Company's products are complex and may contain errors which can delay
shipping while errors are corrected. Errors in products have also required the
Company to ship corrected products to our customers. Errors in products in the
future could cause the loss of or delay in market acceptance or sales and
revenue, the diversion of development resources, injury to the Company's
reputation, or increased service and warranty costs would have an adverse effect
on our financial performance.
Dependence on the Financial Services Market; Industry Consolidation. The Company
derived a significant portion of its revenue from customers in the financial
services market, and our future growth depends, in part, upon increased sales to
this market. Competitive pressures, decreasing operating margins within this
industry, currency fluctuations, geographic expansion and deregulation affect
the financial condition of our customers and their willingness to pay. Customers
purchasing patterns are somewhat discretionary. As a result, some or all of the
factors listed above may adversely affect the demand by customers.
The financial services market is undergoing intense domestic and international
consolidation. In recent years, several customers have been merged or
consolidated. Future mergers or consolidations may cause a decline in revenues
and adversely affect future financial performance.
Uncertainty of Growth into Other Markets. A critical part of the Company's
growth strategy is to continue selling products to markets other than financial
services, such as insurance, telecommunications, health care, public utilities
and retail. The Company will most likely need to hire additional personnel with
expertise in these other markets. Deterioration in economic or market conditions
generally may also adversely affect the demand by customers in these other
markets. There can be no assurance that the Company will continue to be
successful in selling products to these other markets or in continuing to
attract and retain personnel with the necessary industry expertise.
Inability to succeed in penetrating these other markets could have an adverse
effect on future financial performance.
Risks of Customer License Non-Renewal. A significant portion of total revenue
has been attributable to license renewals. While historically a substantial
number have been renewed, there can be no assurance that a substantial majority
of customers will continue to renew expiring licenses. Any non-renewals would
require the Company to obtain revenue from other sources to achieve revenue
targets. A decrease in license renewal rate without offsetting revenue from
other sources would have an adverse effect on future financial performance.
Dependence on Key Personnel; Ability to Attract and Retain Qualified Personnel.
The business is dependent on a number of key, highly skilled technical,
managerial, consulting, sales and marketing personnel including the President
and Chief Executive Officer. The loss of key personnel could adversely affect
financial performance. No employees have entered into an employment contract
with Pegasystems, although each is subject to a non-disclosure and
non-competition agreement. The Company does not have any significant amount of
key-man life insurance on any employees and does not plan to put any in place.
The Company's success will depend in large part on the ability to hire and
retain qualified personnel. The number of potential employees who have the
extensive knowledge of computer hardware and operating systems needed to
develop, sell and maintain our products is limited. Competition for qualified
personnel is intense.
Intense Competition. The market for customer relationship management software
and related consulting and training services is relatively new, intensely
competitive and highly fragmented. The Company currently encounters significant
competition from internal information systems departments of potential or
existing customers that develop custom software. It also competes with companies
that target the customer interaction and workflow markets and professional
services organizations that develop custom software in conjunction with
rendering consulting services. Competition for market share and pressure to
reduce prices and make sales concessions are likely to increase.
Page 18 of 22
Many competitors have far greater resources and may be able to respond more
quickly and efficiently to new or emerging technologies, programming languages
or standards or to changes in customer requirements or preferences. Competitors
may also be able to devote greater managerial and financial resources to
develop, promote and distribute products and provide related consulting and
training services. There can be no assurance that the Company will be able to
compete successfully against current or future competitors.
Management of Growth. The business has grown in size, geographic scope and
complexity and product offerings and the customer base have expanded. This
growth and expansion have placed, and are expected to continue to place, a
significant strain on management, operations and capital needs. Continued growth
will require the Company to hire, train and retrain many employees in the United
States and abroad, particularly additional sales and financial personnel. The
Company will also need to enhance its financial and managerial controls and
reporting systems. There can be no assurance that the Company will attract and
retain the personnel necessary to meet our business challenges.
Failure to manage growth effectively may adversely affect future financial
performance.
Effect of "Year 2000" Issues. The "Year 2000" problem is pervasive and complex
and is discussed in Management's Discussion and Analysis of Financial Condition
and Results of Operations. Year 2000 issues could have an adverse effect on
Pegasystems in a number of ways. Pegasystems' customers rely on date-sensitive
operations to calculate internal data and to service their customers. There can
be no assurance that the Company's products will not contain errors or defects
affecting Year 2000 problems or that litigation involving Pegasystems will not
arise out of such problems. In addition, the Company also uses other companies'
products as part of market offerings and for internal use; these programs may
also be affected by the issue. As a result of efforts to correct or patch their
current systems, customers may have fewer funds available to purchase the
Company's products. Also, the issue may divert current and potential customers'
time, attention and resources away from those projects which typically lead to
purchases of products or services.
Reliance on Certain Relationships. The Company has a number of relationships
with third parties that are significant to sales, marketing and support
activities and product development efforts. The Company relies on relational
database management system applications and development tool vendors, software
and hardware vendors, and consultants to provide marketing and sales
opportunities for the direct sales force and to strengthen the Company's
products through the use of industry-standard tools and utilities. The Company
has also recently begun establishing relationships with third parties that will
distribute its products. In particular, its relationship with First Data
Corporation is central to the distribution of products to several markets. There
can be no assurance that these companies, most of which have significantly
greater financial and marketing resources, will not develop or market products
that compete with those of the Company in the future or will not otherwise end
their relationships with or support of Pegasystems.
Product Liability; Warranty Claims. The Company's license agreements typically
contain provisions intended to limit the nature and extent of the Company's
liability for product liability and warranty claims. There is a risk that a
court might interpret these terms in a limited way or could hold part or all of
these terms to be unenforceable. Also, there is a risk that these contract terms
might not bind a party other than the direct customer. Furthermore, some of the
Company's licenses with its customers are governed by non-U.S. law, and there is
a risk that foreign law might give the Company less or different protection.
Although the Company has not experienced any material product liability claims
to date, the license and support of products by the Company and the
incorporation of third party products and components may cause such claims. A
product liability suit or action claiming a breach of warranty, whether or not
meritorious, could result in substantial costs and a diversion of management's
attention and the Company's resources. Additionally, litigation may establish
adverse precedents harmful for future or another actions.
Page 19 of 22
Adoption of the EURO. A new currency, "EURO", was introduced in certain Economic
and Monetary Union ("EMU") countries. It is expected that by 2002 (at the
latest) all participating EMU countries will use the EURO as their single
currency. As a result, software used by many companies headquartered or
maintaining a subsidiary in a participating EMU country is expected to be
EURO-enabled. In less than four years, all companies headquartered or
maintaining a subsidiary in an EMU country will need to be EURO-enabled. These
changes will change budgetary, accounting and fiscal systems in companies and
public administration, and require the simultaneous handling of parallel
currencies and conversion of legacy data. These requirements (and the fact that
the final rules and regulations are not yet available) may curb market demand
for the Company's products because the budgets and priorities of our customers
and prospective customers may change. The Company is monitoring the rules and
regulations as they become known in order to make any changes to its software
products that the Company deems necessary to comply with such rules and
regulations. Although the Company believes that its most recent products address
these requirements, there can be no assurance that, once the final rules and
regulations are completed, the Company's software will contain all of the
necessary changes or meet all of the EURO requirements. Any inability to comply
with the EURO requirements could have an adverse effect on the Company's
business, operating results and financial condition.
Page 20 of 22
PEGASYSTEMS INC.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Not applicable.
Part II - Other Information:
Item 1. Legal Proceedings
Chelverus Case:
In April 1998, a complaint purporting to be a class action was filed with the
United States District Court for the District of Massachusetts (the "Court")
alleging that the Company and several of its officers violated section 10(b) of
the Securities Exchange Act of 1934, as amended (the "Exchange Act"), Rule 10b-5
promulgated by the Commission thereunder, and section 20(a) of the Exchange Act.
In December 1998, the plaintiffs filed their First Amended Consolidated
Complaint which names the Company, the Company's President (Alan Trefler) and a
former officer and director (Ira Vishner) as defendants. The Amended Complaint
alleges that the defendants issued false and misleading financial statements and
press releases concerning the Company's publicly reported earnings. The Amended
Complaint seeks certification of a class of persons who purchased the Company's
Common Stock between July 2, 1997 and October 29, 1997, and does not specify the
amount of damages sought. The defendants have not yet filed an answer or any
responsive pleadings in this litigation. The Company intends to defend this
matter vigorously.
Gelfer Case:
In December 1998, a complaint also purporting to be a class action was filed
with the Court alleging that the Company and Alan Trefler violated section 10(b)
of the Exchange Act, Rule 10b-5 promulgated by the Commission thereunder, and
that defendant Trefler also violated section 20(a) of the Exchange Act. The
litigation arises from the delay in filing this Quarterly Report on Form 10-Q
and the Company's announcement on November 24, 1998 that it might be recording
revenue adjustments, and seeks certification of a class of persons who purchased
the Company's Common Stock between October 29, 1998 through November 24, 1998.
The Complaint does not specify the amount of damages sought. The Company is
currently reviewing the allegations in the Complaint and will respond to the
allegations in a timely manner when a response becomes due. The Company intends
to defend this matter vigorously. No discovery has thus far occurred. The
Company is thus unable to ascertain a probable outcome.
Pending Nasdaq Proceeding:
As a result of the delay in filing this Report on Form 10-Q, the Nasdaq Stock
Market scheduled a hearing to be held on February 4, 1999 to consider the
continued listing of the Company's Common Stock on the Nasdaq National Market
System. The Company believes that by filing this Quarterly Report on Form 10-Q,
it is in compliance with all applicable Nasdaq maintenance requirements. The
Company is cooperating with Nasdaq on this matter and intends to vigorously
pursue the continued listing of its Common Stock on the Nasdaq National Market
System.
Item 2. Changes in Securities and Use of Proceeds
None; not applicable
Item 3. Defaults upon Senior Securities
None
Page 21 of 22
PEGASYSTEMS INC.
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
27.1 Financial Data Schedule.
(b) Reports on Form 8-K:
None
Page 22 of 22
PEGASYSTEMS INC.
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Pegasystems Inc.
Date: January 20, 1999 /s/ Richard B. Goldman
---------------------------------------
Richard B. Goldman
Vice President, Chief Financial Officer
(principal financial officer and
chief accounting officer)