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 October 31, 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 0-21342
WIND RIVER SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-2873391
(State of incorporation) (I.R.S. Employer Identification No.)
1010 ATLANTIC AVENUE, ALAMEDA, CALIFORNIA 94501
(Address of principal executive office)
(510) 748-4100
(Telephone number)
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.
26,695,418 shares of Common Stock; $.001 par value as of November 30, 1998
WIND RIVER SYSTEMS, INC.
FORM 10-Q
QUARTER ENDED OCTOBER 31, 1998
INDEX
Part I: FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated
Statements of Income for the
three and nine month periods
ended October 31, 1998 and 1997
Condensed Consolidated Balance
Sheets at October 31, 1998 and
January 31, 1998
Condensed Consolidated Statements
of Cash Flows for the nine month
periods ended October 31, 1998 and
1997
Notes to the Condensed Consolidated
Financial Statements
Item 2. Management's Discussion and
Analysis of Financial Condition and
Results of Operations
Item 3. Quantitative and Qualitative
Disclosures about Market Risk
Part II: OTHER INFORMATION
Item 1. Legal Proceedings
Item 6. Exhibits and Reports on Form 8-K
Signature
2
WIND RIVER SYSTEMS, INC.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
WIND RIVER SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(unaudited)
Three months ended Nine months ended
October 31, October 31,
1998 1997 1998 1997
-------------- ---------------- -------------- ---------------
Revenues:
Products $ 25,096 $ 16,932 $ 67,587 $ 46,115
Services 8,504 7,068 23,613 18,285
-------------- ---------------- -------------- ---------------
Total revenues 33,600 24,000 91,200 64,400
-------------- ---------------- -------------- ---------------
Cost of revenues:
Products 2,084 1,564 6,389 4,571
Services 3,328 2,664 9,380 6,964
-------------- ---------------- -------------- ---------------
Total cost of revenues 5,412 4,228 15,769 11,535
-------------- ---------------- -------------- ---------------
Gross margin 28,188 19,772 75,431 52,865
-------------- ---------------- -------------- ---------------
Operating expenses:
Selling and marketing 11,485 8,153 32,396 23,753
Product development and engineering 4,449 2,877 12,510 8,316
General and administrative 1,831 1,531 5,439 4,634
-------------- ---------------- -------------- ---------------
Total operating expenses 17,765 12,561 50,345 36,703
-------------- ---------------- -------------- ---------------
Operating income 10,423 7,211 25,086 16,162
-------------- ---------------- -------------- ---------------
Other income (expense):
Interest expense (2,227) (2,017) (6,584) (2,060)
Interest income and other, net 3,455 2,947 9,984 4,696
-------------- ---------------- -------------- ---------------
Total other income 1,228 930 3,400 2,636
-------------- ---------------- -------------- ---------------
Income before provision for income taxes 11,651 8,141 28,486 18,798
Provision for income taxes 4,486 2,931 10,955 6,768
-------------- ---------------- -------------- ---------------
Net income $ 7,165 $ 5,210 $ 17,531 $ 12,030
-------------- ---------------- -------------- ---------------
-------------- ---------------- -------------- ---------------
Net income per share:
Basic $ 0.27 $ 0.20 $ 0.67 $ 0.48
Diluted $ 0.25 $ 0.18 $ 0.62 $ 0.43
Weighted average shares:
Basic 26,843 25,480 26,250 25,222
Diluted 28,686 28,276 28,234 28,199
The accompanying notes are an integral part of these condensed
consolidated financial statements.
3
WIND RIVER SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amount)
(unaudited)
October 31, January 31,
1998 1998
--------------- ----------------
ASSETS
Current assets:
Cash and cash equivalents $ 47,569 $ 100,633
Short-term investments 11,742 61,107
Accounts receivable, net of allowances of $1,588 and $1,460 23,307 18,076
Other current assets 9,363 5,210
--------------- ----------------
Total current assets 91,981 185,026
Investments 151,384 60,329
Property and equipment, net of accumulated 28,953 24,496
depreciation of $14,332 and $10,962
Other assets 12,145 15,447
Restricted cash 28,863 2,510
--------------- ----------------
Total assets $ 313,326 $ 287,808
--------------- ----------------
--------------- ----------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,010 $ 3,806
Accrued liabilities 11,462 9,733
Accrued compensation 6,222 5,441
Income taxes payable 9,216 1,415
Deferred revenue 15,802 15,027
--------------- ----------------
Total current liabilities 45,712 35,422
Convertible subordinated notes 140,000 140,000
--------------- ----------------
Total liabilities 185,712 175,422
--------------- ----------------
Minority interest in consolidated subsidiary 492 400
--------------- ----------------
Stockholders' equity:
Common stock, par value $.001, 125,000 shares authorized,
27,376 and 26,166 shares issued; 26,689 and 25,689
shares outstanding 27 26
Additional paid in capital 109,431 101,154
Treasury stock, 687 and 477 shares, at cost (22,991) (15,485)
Cumulative translation adjustments (1,668) (1,700)
Unrealized gain (loss) on investments (1,571) 503
Retained earnings 43,894 27,488
--------------- ----------------
Total stockholders' equity 127,122 111,986
--------------- ----------------
Total liabilities and stockholders' equity $ 313,326 $ 287,808
--------------- ----------------
--------------- ----------------
The accompanying notes are an integral part of these condensed
consolidated financial statements.
4
WIND RIVER SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Nine months ended
October 31,
1998 1997
---------------- ---------------
Cash flows from operating activities:
Net income $ 17,531 $ 12,030
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 4,848 3,306
Unrealized loss on investments (2,074) -
Minority interest in consolidated subsidiary 92 (28)
Change in assets and liabilities:
Accounts receivable, net (5,108) (273)
Other assets (1,606) (4,609)
Accounts payable (949) 1,050
Accrued liabilities 1,222 2,333
Accrued compensation 681 1,143
Income taxes payable 7,798 4,359
Deferred revenue 775 6,978
---------------- ---------------
Net cash provided by operating activities 23,210 26,289
---------------- ---------------
Cash flows from investing activities:
Acquisition of property and equipment (8,453) (18,327)
Purchase of investments (188,505) (202,705)
Sales and maturities of investments 146,815 74,455
Restricted cash (26,353) -
---------------- ---------------
Net cash used in investing activities (76,496) (146,577)
---------------- ---------------
Cash flows from financing activities:
Proceeds from issuance of Common Stock, net 7,696 2,701
Purchase of treasury stock (7,506) (9,864)
Long-term debt issuance - 134,925
---------------- ---------------
Net cash provided by financing activities 190 127,762
---------------- ---------------
Effect of exchange rate changes on cash and cash equivalents 32 (1,104)
---------------- ---------------
Net increase (decrease) in cash and cash equivalents (53,064) 6,370
Cash and cash equivalents at beginning of period 100,633 9,848
---------------- ---------------
Cash and cash equivalents at end of period $ 47,569 $ 16,218
---------------- ---------------
---------------- ---------------
The accompanying notes are an integral part of these condensed
consolidated financial statements.
5
WIND RIVER SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements and related notes
are unaudited. However, in the opinion of management, all adjustments
(consisting only of normal recurring adjustments) which are necessary for a fair
presentation of the financial position, results of operations and cash flows for
the interim period have been included. These condensed consolidated financial
statements should be read in conjunction with the audited consolidated financial
statements and notes thereto for the fiscal year ended January 31, 1998 included
in the Company's Annual Report on Form 10-K. The results of operations for the
three and nine months ended October 31, 1998 are not necessarily indicative of
results to be expected for the entire fiscal year, which ends on January 31,
1999.
In accordance with the rules and regulations of the Securities and Exchange
Commission, the unaudited condensed consolidated financial statements omit or
condense certain information and footnote disclosures normally required for
complete financial statements prepared in accordance with generally accepted
accounting principles. However, the Company believes that the disclosures are
adequate to make the information presented not misleading.
The condensed consolidated financial statements include the accounts of Wind
River Systems, Inc. ("Wind River" or "the Company") and its wholly-owned and
majority-owned subsidiaries. All significant inter-company accounts and
transactions have been eliminated in consolidation.
Certain amounts in the fiscal 1998 condensed consolidated financial statements
have been reclassified to conform to the fiscal 1999 presentation.
2. ZINC SOFTWARE INCORPORATED ACQUISITION
In May 1998, the Company acquired Zinc Software, Inc. ("Zinc"), a privately
held company that develops, markets and supports graphical application
software. In connection therewith, the Company issued 226,611 shares of
common stock in exchange for all of the outstanding stock of Zinc. The
acquisition was accounted for as a pooling of interests, however, as the
operations of Zinc were not material to the Company's consolidated operations
and financial position, the financial statements of Zinc have been recorded
in the Company's consolidated financial statements as of May 1, 1998.
6
3. REVENUE RECOGNITION
The Company has adopted the provisions of Statement of Position 97-2, "Software
Revenue Recognition" ("SOP 97-2"), as amended by Statement of Position 98-4,
"Deferral of the Effective Date of Certain Provisions of SOP 97-2" ("SOP 98-4"),
effective February 1, 1998. SOP 97-2 and SOP 98-4 provide guidance on
recognizing revenue on software transactions and supersede SOP 91-1. The
adoption of SOP 97-2 and SOP 98-4 did not have a material impact on the
Company's current licensing or revenue recognition practices. However, should
Wind River adopt new or change its existing licensing practices, the Company's
revenue recognition practices may be subject to change to comply with the
accounting guidance provided in SOP 97-2 and SOP 98-4.
4. CASH AND CASH EQUIVALENTS, INVESTMENTS AND RESTRICTED CASH
Cash equivalents consist of highly liquid investments with an original
maturity of three months or less. These investments consist of fixed income
securities, which are readily convertible to cash and are stated at cost,
which approximates fair value. Investments with maturities greater than three
months and less than one year are classified as short-term investments.
Investments with maturities greater than one year are classified as long-term
investments. Restricted cash consists of the investments held as collateral
under the operating lease of the Company's future headquarters and an
accreting interest rate swap agreement. The Company has classified all of its
investments as available-for-sale and carries such investments at fair value,
with unrealized gains and losses reported as a component of stockholders'
equity until disposition. Fair value is determined based upon the quoted
market prices of the securities as of the balance sheet date.
5. COMPREHENSIVE INCOME
In February 1998, the Company adopted Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" ("FAS 130"). Comprehensive
income is defined as the change in equity of a company during a period from
transactions and other events and circumstances excluding transactions resulting
from investments by owners and distributions to owners. The primary difference
between net income and comprehensive income, for the Company, results from
foreign currency translation adjustments and unrealized gains and losses on
available-for-sale securities.
Comprehensive income for the three and nine month periods ended October 31, 1998
and 1997 is as follows:
7
Three Months Ended Nine Months Ended
October 31, October 31,
(In thousands) 1998 1997 1998 1997
------------- -------------- ------------- ---------------
Net income $ 7,165 $ 5,210 $ 17,531 $ 12,030
----------- ----------- ----------- -------------
Other comprehensive income, net of tax:
Foreign currency translation adjustments (46) (510) 20 (718)
Unrealized gain (loss) on investments (404) 531 (1,348) 440
----------- ----------- ----------- -------------
Other comprehensive income (loss) (450) 21 (1,328) (278)
----------- ----------- ----------- -------------
Total comprehensive income $ 6,715 $ 5,231 $ 16,203 $ 11,752
----------- ----------- ----------- -------------
----------- ----------- ----------- -------------
6. NET INCOME PER SHARE
Net income per share is calculated in accordance with the provisions of
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("FAS
128"). FAS 128 requires the Company to report both basic net income per share,
which is based on the weighted-average number of common shares outstanding, and
diluted net income per share, which is based on the weighted-average number of
common shares outstanding and all dilutive potential common shares outstanding.
Dilutive potential common shares consist of stock options and warrants (using
the treasury stock method) and convertible subordinated notes (using the if
converted method).
In accordance with FAS 128, the calculation of basic and diluted net income per
share is presented below:
Three Months Ended Nine Months Ended
October 31, October 31,
(In thousands, except per share information) 1998 1997 1998 1997
------------ ------------- ------------ ------------
Basic computation:
Net income $ 7,165 $ 5,210 $ 17,531 $ 12,030
Weighted-average common shares 26,843 25,480 26,250 25,222
------------ ------------- ------------ ------------
Basic net income per share $ 0.27 $ 0.20 $ 0.67 $ 0.48
------------ ------------- ------------ ------------
Diluted computation:
Net income $ 7,165 $ 5,210 $ 17,531 $ 12,030
Weighted-average common shares 26,843 25,480 26,250 25,222
Assumed incremental shares from:
Stock options and warrants 1,843 2,796 1,984 2,977
Convertible subordinated notes - - - -
---------- ---------- --------- ----------
Dilutive potential common shares 1,843 2,796 1,984 2,977
---------- ---------- --------- ----------
Total dilutive weighted-average common shares 28,686 28,276 28,234 28,199
------------ ------------- ------------ ------------
Diluted net income per share $ 0.25 $ 0.18 $ 0.62 $ 0.43
------------ ------------- ------------ ------------
The effect of assumed conversion of the convertible subordinated notes is
anti-dilutive and is therefore excluded from the above computations. Options to
purchase approximately 1.2 million and 54,000 shares which were outstanding at
October 31, 1998 and 1997, respectively, were not included in the calculation
because the exercise prices were greater than the average market price of common
shares in each respective quarter and the effect would be anti-dilutive. The
exercise price ranges of these options were $39.69 to $47.88 and $41.56 to
$46.02 at October 31, 1998 and 1997, respectively.
8
7. COMMON STOCK TRANSACTIONS
The Company has repurchased approximately $2.5 million of its common stock
per quarter on the open market at prevailing market prices or in negotiated
transactions off the market. The Company repurchased and holds as treasury stock
68,500 shares, 79,300 shares and 63,000 shares of common stock in the first,
second and third quarters of fiscal year 1999, respectively, at an aggregate
cost of $7.5 million.
8. RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 131 "Disclosures about Segments of an
Enterprise and Related Information" ("FAS 131"). This statement establishes
standards for the method companies use to report information about operating
segments in annual financial statements. It also establishes standards for
related disclosures about products and services, geographic areas, and major
customers. The disclosures prescribed by FAS 131 will be effective for the
Company's consolidated financial statements for the fiscal year ending January
31, 1999. FAS 131's interim reporting disclosures are not required until the
Company's fiscal quarter ending April 30, 1999.
In April 1998, the American Institute of Certified Public Accountants issued
Statement of Position 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 provides
guidance for determining whether computer software is internal-use software
and on accounting for the proceeds of computer software originally developed
or obtained for internal use and then subsequently sold to the public. It
also provides guidance on capitalization of the costs incurred for computer
software developed or obtained for internal use. The Company believes that
the adoption of SOP 98-1 will not have a material impact on its consolidated
financial statements. SOP 98-1 will be effective for the Company's
consolidated financial statements for the fiscal year ending January 31, 2000.
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133 "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133").
FAS 133 requires companies to record derivatives on the balance sheet as assets
or liabilities, measured at fair value. Gains or losses resulting from changes
in the fair values of those derivatives would be accounted for in current
earnings unless specific hedge criteria are met. The key criterion for hedge
accounting is that the hedging relationship must be highly effective in
achieving offsetting changes in fair value or cash flows. The Company must
formally document, designate, and assess the effectiveness of transactions that
receive hedge accounting.
9
FAS 133 will be effective for the Company's consolidated financial statements
for the fiscal year ending January 31, 2001.
9. DERIVATIVE FINANCIAL INSTRUMENTS
The Company enters into foreign currency forward exchange contracts (forward
contracts) to manage exposure related to certain foreign currency transactions.
The Company does not enter into derivative financial instruments for trading
purposes. All outstanding forward contracts at the end of a reporting period are
marked-to-market, with unrealized gains and losses included in net income as a
component of other income (expense). The Company may, from time to time, adjust
its foreign currency hedging position by taking out additional contracts or by
terminating or offsetting exisiting forward contracts. These adjustments may
result from changes in the underlying foreign currency exposures or from
fundamental shifts in the economics of particular exchange rates. Gains and
losses on terminated forward contracts, or on contracts that are offset, are
recognized in income in the period of contract termination or offset. At October
31, 1998, the Company had outstanding forward contracts with notional amounts
totaling approximately $1.9 million. These contracts, which mature in less than
ninety days, are hedges of certain foreign currency transaction exposures in the
Japanese yen. The estimated fair value at October 31, 1998 was negligible.
10. LEGAL PROCEEDINGS
The Company is a party to litigation arising in the normal course of its
business. The Company believes that such litigation, even if resolved adversely
to the Company, would not have a material effect on its business, financial
condition or results of operations.
10
WIND RIVER SYSTEMS, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Except for the historical information contained herein, the following discussion
contains forward-looking statements that involve risks and uncertainties. All
forward-looking statements included in this document are based on information
available to the Company on the date hereof, and the Company assumes no
obligation to update any such forward-looking statements. The Company's actual
results could differ materially from those discussed in any forward-looking
statements. Factors that could cause or contribute to such differences include,
but are not limited to, those discussed below, in the Company's Annual Report on
Form 10-K for the fiscal year ended January 31, 1998, as well as in other of the
Company's Securities and Exchange Commission filings. The following discussions
should be read in conjunction with the unaudited consolidated financial
statements and notes included elsewhere herein.
In May 1998, the Company acquired Zinc Software, Inc. ("Zinc"), a privately held
company that develops, markets and supports graphical application software. In
connection therewith, the Company issued 226,611 shares of common stock in
exchange for all of the outstanding stock of Zinc. The acquisition was accounted
for as a pooling of interests, however, as the operations of Zinc were not
material to the Company's consolidated operations and financial position, the
financial statements of Zinc have been recorded in the Company's consolidated
financial statements as of May 1, 1998.
Wind River Systems, Inc. ("Wind River" or "the Company") develops, markets
and supports advanced software operating systems and software development
tools that allow customers to create complex, robust, real-time software
applications for embedded computers. An embedded computer is a microprocessor
that is incorporated into a larger device and is dedicated to responding to
external events by performing specific tasks quickly, predictably and
reliably. The Company's flagship product, Tornado-TM-, enables customers to
enhance product performance, standardize designs across projects, reduce
research and development costs and shorten product development cycles.
RESULTS OF OPERATIONS
REVENUES
Total revenues for the three and nine months ended October 31, 1998 were $33.6
million and $91.2 million, respectively, compared to $24 million and $64.4
million for the same periods in fiscal 1998. The increase in revenues of 40% and
42% for the three and nine month periods ended October 31, 1998, respectively,
is due to
11
increases in both the Company's product revenue and services revenues.
Revenue from the sale of products increased 48% and 47% to $25.1 million and
$67.6 million for the three and nine months ended October 31, 1998, compared to
$16.9 million and $46.1 million for the same periods in fiscal 1998. Product
revenues primarily consist of development license fees and run-time license
fees. The Company typically charges a one-time fee for a development license and
a run-time license fee for each copy of the Company's operating system embedded
in the customer's product. The increase in product revenues was due primarily to
the continued acceptance of the Company's products and increased run-time
license revenues.
Service revenues increased 20% and 29% to $8.5 million and $23.6 million for the
three and nine months ended October 31, 1998, compared to $7.1 million and $18.3
million for the same periods in the prior fiscal year. The increases were
primarily due to an increase in maintenance support agreements and training
resulting from the increase in the Company's installed base of Tornado-TM-
software development environment and software applications provided to
customers.
Total revenues from international sales for the three and nine months ended
October 31, 1998 were $10.5 million and $28.9 million, compared to $5.8 million
and $18.5 million for the same periods in the prior fiscal year. The increases
of 80% and 56% for the three and nine month periods ended October 31, 1998 were
primarily due to increased sales in Japan and Europe. International revenues
accounted for 31% and 32% of total revenues for the three and nine month periods
ended October 31, 1998, compared to 24% and 29% for the same periods in the
prior fiscal year. The Company expects international sales to continue to
represent a significant portion of net product revenues, although the percentage
may fluctuate from period to period. The Company's international sales are
denominated in the local currencies, and an increase in the relative value of
the dollar against such currencies would reduce the Company's revenues in dollar
terms or make the Company's products more expensive and, therefore, potentially
less competitive in foreign markets. The Company actively monitors its foreign
currency exchange exposure; and to date such exposures have not had a material
impact on the Company's results of operations. The Company enters into forward
contracts to hedge the short-term impact of foreign currency fluctuations. In
recent months, economic uncertainty and related weakening of foreign currencies,
particularly the Japanese yen, against the dollar, has occurred. As a result,
the Company's future sales in this region may be adversely affected which could
have a material adverse effect on the Company's business, results of operations
and financial condition. Revenues from Asia Pacific sources including Japan
represented 47% and 46% of international revenues for the three and nine months
ended October 31, 1998, compared to 41% and 39% for the same periods in the
prior fiscal year. (See "Additional Risk Factors that may affect Future Results
of Operations: Risks Associated with International Operations").
12
COSTS OF REVENUES
The overall cost of products and services as a percentage of total revenues
decreased to 16% and 17% for the three and nine month periods ended October 31,
1998, from 18% for both corresponding periods in fiscal 1998. Product-related
cost of sales as a percentage of product revenues decreased to 8% and 9% for the
three and nine month periods ended October 31, 1998, respectively, from 9% and
10% for the corresponding periods of the prior fiscal year. Product-related
costs consist primarily of product media, documentation and packaging. The
decrease in product costs as a percentage of total revenues is attributable to
the increase in run-time royalties.
Service related cost of revenues as a percentage of service revenues was 39%
and 40% for the three and nine month periods of fiscal 1999, compared to 38%
for both the same periods in fiscal 1998. Service related costs consist
primarily of personnel related costs associated with providing services to
customers and the infrastructure to manage a services organization as well as
costs to recruit, develop, and retain services professionals. The increase in
costs of service revenues is due to investment in developing new services
offerings and the addition of service professionals, and is expected to
continue. The Company expects that customer support costs will increase in
absolute dollars as the Company continues to increase customer support staff
and customer support capabilities.
OPERATING EXPENSES
Selling and marketing expenses were $11.5 million and $32.4 million for the
three and nine months ended October 31, 1998, compared to $8.2 million and $23.8
million for the same periods in the prior fiscal year. As a percentage of total
revenue, selling and marketing expenses were 34% and 36% for the three and nine
months ended October 31, 1998 compared to 34% and 37% for the corresponding
periods in the prior fiscal year. The increase in absolute dollars resulted
primarily from the growth of sales and marketing personnel and field engineers
and related costs and increases in expenses related to marketing and advertising
programs. The Company expects that sales and marketing expenses will increase in
absolute dollars as the Company continues to expand its sales and marketing
staff.
Product development and engineering expenses were $4.4 million and $12.5 million
for the three and nine months ended October 31, 1998 or 13% and 14% of total
revenues for each period, compared to $2.9 million and $8.3 million or 12% and
13% of total revenue, respectively for the same periods in the prior fiscal
year. The dollar increase in product development and engineering expense is
primarily due to the increase in staff and associated support for engineers to
expand and enhance the Company's product line. The Company believes that product
development and engineering expenses will increase in absolute dollars as it
continues to invest in developing new products, applications and product
enhancements.
13
General and administrative expenses were $1.8 million and $5.4 million or 5%
and 6% of total revenues for the three and nine month periods ended October
31, 1998, compared to $1.5 million and $4.6 million or 6% and 7% of total
revenues for the corresponding periods in the prior fiscal year. The increase
in absolute dollars was primarily due to the growth in worldwide staff and
infrastructure investments in the areas of information systems, finance and
administration. The Company believes that general and administrative expenses
will increase in absolute dollars as it continues to invest in worldwide
staff and infrastructure in the areas of information systems, finance and
administration.
OTHER INCOME AND EXPENSES
Interest expense was $2.2 million and $6.6 million for the three and nine
month period ended October 31, 1998 compared to $2.0 million for the same
periods in the prior fiscal year. The increase in interest expense for the
nine month period is primarily related to the interest paid on the 5.0%
Convertible Subordinated Notes, due in 2002 (the "Notes") and amortization of
certain issuance costs associated with the Notes. The interest on the Notes
is payable on February 1 and August 1 of each year commencing February 1,
1998. The Notes mature on August 1, 2002.
Interest income and other, net was $3.5 million and $10.0 million for the three
and nine month periods ended October 31, 1998 compared to $2.9 million and $4.7
million for the same periods in the prior fiscal year. The increase of $600,000
and $5.3 million for the three and nine months, respectively, is primarily due
to higher average cash and cash equivalent and investment balances and to the
transition of the Company's investment portfolio from tax-free investments to
taxable investments.
PROVISION FOR INCOME TAXES
The effective tax rate for the three and nine month periods ended October 31,
1998 was 38.5% compared to 36% for the same periods in the prior fiscal year.
The increase in the effective tax rate between the third quarters of fiscal 1999
and 1998 was primarily due to the transition of the Company's investment
portfolio from tax-free investments to taxable investments. The provision for
income taxes is an estimate based on the Company's anticipated effective tax
rate for the full fiscal year.
LIQUIDITY AND CAPITAL RESOURCES
At October 31, 1998, the Company had working capital of approximately $46
million and cash and investments of approximately $211 million, which include
investments with maturities of greater than one year of $151 million. The
increase in long term investments of $91 million from January 31, 1998 is
primarily due to the transfer of funds held as cash equivalents or short term
investments as of January 31, 1998 to longer term securities.
14
Net cash provided by operating activities was $23.2 million in the first nine
months of fiscal 1999. In the first nine months of fiscal 1999, net income,
depreciation and amortization, and changes in accrued liabilities and income
taxes payable were partially offset by the changes in accounts receivable,
other assets, and unrealized loss on investments and accounts payable.
Net cash used in investing activities in the first nine months of fiscal 1999
totaled $76.5 million. In the first nine months of fiscal 1999, uses of cash
relating to the acquisition of equipment, purchases of investments and
purchases of investments held as collateral for the operating lease and an
accreting interest rate swap agreements were partially offset by cash
provided from the sales of investments. As the Company transitioned its
investment portfolio from short-term to long-term investments, its long-term
investments increased by $91 million. Restricted cash increased primarily due
to the increased collateral funding for the operating lease of the Company's
future headquarters. The collateral consists of direct obligations of the
United States government, with the majority being long-term securities.
Net cash provided by financing activities in the first nine months of fiscal
year 1999 totaled $190,000. In the first nine months of fiscal 1999, cash
provided by the issuance of common stock from employee stock option exercises
was offset by cash used in the repurchase of treasury stock. During the nine
months ended October 31, 1998, the Company repurchased and holds as treasury
stock 210,800 shares of common stock at a cost of approximately $7.5 million.
In fiscal 1998, the Company entered into an operating lease agreement for its
new headquarters facility being constructed on the land the Company purchased
in Alameda, California. As of October 31, 1998, the lessor has funded a total
of $26.5 million of construction costs and has committed to fund up to a
maximum of $35 million. The operating lease payments will begin upon
completion of construction and will vary based on the total construction
costs of the property, including capitalized interest, and the London
interbank offering rate ("LIBOR").
On March 18, 1998, the Company entered into an accreting interest rate swap
agreement (the "Agreement") to reduce the impact of changes in interest rates
on its floating rate operating lease for its new corporate headquarters. This
Agreement effectively changes the Company's interest rate exposure on its
operating lease which is based on one month LIBOR to a fixed rate of 5.9%.
The notional amount of the swap under the Agreement is scheduled to increase
in relation to the funds used to construct the Company's new headquarters.
The differential to be paid or received under this Agreement will be
recognized as an adjustment to rent expense related to the operating lease.
The Agreement matures at the same time as the operating lease expires. The
amounts potentially subject to credit risk (arising from the possible
inability of counterparty to meet the term of their contracts) are generally
limited to the amounts, if any, by which the counterparty's obligations
exceed the obligations of the Company. The Company manages potential
counterparty credit risk prior to entering into transactions by requiring
that all counterparties have at least a AA Standard and Poor's, or Moody's
equivalent, long-term senior debt rating.
15
Construction of the new headquarters building is currently expected to be
completed in the first quarter of fiscal year 2000. In connection with the
lease, the Company is obligated to enter into a lease of its land in Alameda,
California to the lessor of the building at a nominal rate and for a term of
55 years. If the Company terminates or does not negotiate an extension of the
building lease, the ground lease converts to a market rental rate. The lease
provides the Company with the option at the end of the lease of either
acquiring the building at the lessor's original cost or arranging for the
building to be acquired. The Company has guaranteed the residual value
associated with the building to the lessor of approximately 82% of the
lessor's $35 million funding obligation. The Company is also required,
periodically during the construction period, to deposit fixed income
securities with a custodian as a deposit to secure the performance of its
obligations under the lease. In addition, under the terms of the lease, the
Company must maintain compliance with certain financial covenants. As of
October 31, 1998, the Company was in compliance with these covenants.
Management believes that the contingent liability relating to the residual
value guarantee will not have a material adverse effect on the Company's
financial condition or results of operations.
The Company has an investment portfolio of fixed income securities that are
classified as available-for-sale securities. These securities, like all fixed
income instruments, are subject to interest rate risk and will decline in
value if market interest rates increase. The Company attempts to limit this
exposure by investing primarily in high grade securities.
Management believes that the Company's working capital and the cash flow
generated from operations are sufficient to meet its working capital
requirements for planned expansion, product development and capital
expenditures for the next twelve months.
"YEAR 2000" ISSUES
Many currently installed computer systems and software products include coding
to accept only two digit entries in the date code field. These date code fields
will need to accept four digit entries to distinguish 21st century dates from
20th century dates. As a result, in less than thirteen months, computer systems
and/or software used by many companies will need to be upgraded to comply with
such "Year 2000" requirements. Systems that do not properly recognize such
information could generate erroneous data or cause a system to fail. Significant
uncertainty exists in the software industry concerning the potential effects
associated with such compliance.
The Company has conducted Year 2000 compliance reviews for current versions of
the Company's products. The review includes assessment, implementation,
validation testing and contingency planning. The Company continues to respond to
customer concerns about prior versions of the Company's products on a
case-by-case basis. For certain older versions of the Company's products which
may not be Year 2000 compliant, the Company is providing a patch to bring the
product into
16
compliance. With respect to certain third party products in the Company's
product offerings that may not be Year 2000 compliant, the Company is
working with software vendors to bring the products into compliance. Although
the Company believes its most current releases of its products will neither
cease to perform nor generate incorrect or ambiguous data or results solely
due to a change in date to or after January 1, 2000 and will calculate any
information dependent on such dates in the same manner, and with the same
functionality, data integrity and performance as such products on or before
December 31, 1999 (collectively "Year 2000 Compliance"), the Company provides
no assurance that its software products contain all the necessary software
routines and programs for the accurate calculation, display, storage and
manipulation of data involving dates. Failure of the Company's software
products to contain all the necessary software routines and programs for the
accurate calculation, display, storage and manipulation of data involving
dates would have a material adverse effect on the Company's business,
financial condition and results of operation. The majority of the Company's
products are combined by its customers with other software programs or
hardware devices not provided by the Company. Such combination with other
products that are not Year 2000 Compliant or modifications of the Company's
products by its customers may introduce Year 2000 Compliance issues for its
customers. The Company's customers' inability to remedy their own Year 2000
Compliance issues could affect their demand for the Company's products, which
may have a material adverse effect on the Company's business, financial
condition and results of operations.
To address Year 2000 issues, the Company has initiated a program designed to
address the most critical Year 2000 items that would affect the Company's
products, its worldwide business systems, and the operations of the following
functions: research and development, finance, sales and marketing,
manufacturing, and human resources. Assessment and remediation efforts regarding
these critical items are proceeding in parallel.
The Company has tested software obtained from third parties that is
incorporated into the Company's products, and seeks assurances from vendors
that licensed software is Year 2000 Compliant. Despite testing by the
Company, current customers and potential customers, and assurances from
developers of products incorporated into the Company's products, such
products may contain undetected errors or defects associated with Year 2000
date functions. Known or unknown errors or defects in the Company's products
or third party products may result in delay or loss of revenue, diversion of
development resources, damage to the Company's reputation, or increased
service and warranty costs. The occurrence of any of the foregoing could
materially adversely affect the Company's business, financial condition and
results of operations.
The Company is also creating a plan to work with critical suppliers to determine
that such suppliers' operations and the products and services they provide the
Company are Year 2000 capable or to monitor their progress towards Year 2000
capability. The Company does not currently have information concerning the
Year 2000
17
Compliance status of its outside vendors or customers. Project plans
are being developed and will include the process of identifying and prioritizing
critical suppliers and customers at the direct interface level and communicating
with them about their plans and progress in addressing Year 2000 issues. The
Company expects to complete the process in the second quarter of calendar 1999.
As is the case with other software companies, if its current or future outside
customers or suppliers fail to achieve Year 2000 Compliance or if they divert
technology expenditures to address their own Year 2000 Compliance problems, the
Company's business, financial condition or results of operations, could be
materially adversely affected.
The Company has initiated an assessment of material internal systems. In 1997,
the Company commenced a worldwide financial business systems replacement project
that uses software primarily from Oracle. The new systems are targeted at
bringing the Company's business computer systems into Year 2000 Compliance. The
Company anticipates its financial system will be operational in the third
quarter of 1999. In January 1998 the Company initiated an analysis of the
condition of Year 2000 readiness for the programs it uses for internal
development. The Company will modify or replace programs that were
determined not to be Year 2000 compliant. The Company believes the software and
hardware it uses internally or will have installed for internal use will comply
with Year 2000 requirements and is not aware of any material operational issues
or costs associated with preparing its internally used software and hardware for
the Year 2000. However, the Company provides no assurances that it will not
experience serious, unanticipated negative consequences, including material
costs caused by undetected errors or defects in the technology used in its
internal systems. The occurrence of any of the foregoing could have a material
adverse effect on the Company's business, operating results or financial
condition.
The Company has funded its Year 2000 compliance review from operating cash
flows and, except for its new financial reporting system, has not separately
accounted for these costs in the past. The Company will incur additional
amounts related to the Year 2000 Compliance review including administrative
personnel to manage the review, outside contractors to provide technical
advice and technical support for its products, product engineering and
customer satisfaction. The Company will incur costs of approximately $3.5
million to implement its financial reporting system. The Company's Year 2000
budget will be modified as necessary to address correction of any additional
systems identified to be non-compliant. However, management does not
anticipate that the Company will incur other significant operating expenses
or be required to invest heavily in computer systems improvements to be Year
2000 compliant.
The Company is currently developing contingency plans to be implemented as part
of its efforts to identify and correct Year 2000 problems affecting its internal
systems. The Company expects to complete its contingency plans by the first
quarter of 1999. Depending on the systems affected, these plans could include
accelerated
18
replacement of affected equipment or software, short to medium-term
use of backup equipment and software, increased work hours for Company personnel
or use of contract personnel to correct (on an accelerated schedule) any Year
2000 problems that arise or to provide manual workarounds for information
systems, and similar approaches. If the Company is required to implement any of
these contingency plans, it could have a material adverse effect on the
Company's financial condition and results of operations.
The Company's ability to achieve Year 2000 Compliance and the level of
incremental costs associated therewith, could be adversely impacted by, among
other things, the availability and cost of programming and testing resources,
vendors' ability to modify propriety software, and unanticipated problems
identified in the ongoing compliance review. Such failures could have a material
adverse affect on the Company's business, financial condition and results of
operations.
EURO CURRENCY
On January 1, 1999, several member countries of the European Union will
establish fixed conversion rates between their existing sovereign currencies and
adopt the Euro as their new common legal currency. As of that date, the Euro
will trade on currency exchanges and the legacy currencies will remain legal
tender in the participating countries for a transition period between January
1999 and January 1, 2002. During the transition period, noncash payments can be
made in the Euro, and parties can elect to pay for goods and services and
transact business using either the Euro or a legacy currency. Between January 1,
2002 and July 1, 2002 the participating countries will introduce Euro notes and
coins and withdraw all legacy currencies so that they will no longer be
available. The Euro conversion may affect cross-border competition by creating
cross-border price transparency. The Company is assessing its pricing/marketing
strategy in order to insure that it remains competitive in a broader European
market and reviewing whether certain existing contracts will need to be
modified. The Company has assessed the ability of information technology systems
to allow for transactions to take place in both the legacy currencies and the
Euro and the eventual elimination of the legacy currencies and believes that its
information technology systems will not be affected by the transition to the
Euro. The Company does not presently expect that introduction and use of the
Euro will materially affect the Company's foreign exchange or will result in any
material increase in costs to the Company. The Company's currency risk and risk
management for operations in participating countries may be reduced as the
legacy currencies are converted to the Euro. Final accounting, tax and
governmental legal and regulatory guidance is not available. The Company will
continue to evaluate issues involving introduction of the Euro. Based on current
information and the Company's current assessment, it does not expect that the
Euro conversion will have a material adverse effect on its business or financial
condition.
19
ADDITIONAL RISK FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
FLUCTUATIONS IN OPERATING RESULTS
The Company has experienced from time to time significant period-to-period
fluctuations in revenues and operating results and anticipates that such
fluctuations will occur in the future. These fluctuations may be attributable to
a number of factors, including the volume and timing of orders received during
the quarter, the timing and acceptance of new products and product enhancements
by the Company or its competitors, unanticipated sales and buyouts of run-time
licenses, stages of product life cycles, purchasing patterns of customers and
distributors, market acceptance of products sold by the Company's customers,
competitive conditions in the industry, business cycles affecting the markets in
which the Company's products are sold, extraordinary events, such as
acquisitions, including related charges, and economic conditions generally or in
specific geographic areas. The future operating results of the Company may
fluctuate as a result of these and other factors, including the Company's
ability to continue to develop innovative and competitive products. In addition,
the Company generally does not enter into long-term agreements with its
customers, and the timing of license fees is difficult to predict. The
procurement process of the Company's customers is often several months or longer
from initial inquiry to order and may involve competing considerations. Further,
as licensing of the Company's products increasingly becomes a more strategic
decision made at higher management levels, there can be no assurance that sales
cycles for the Company's product will not lengthen. Product revenue in any
quarter depends primarily on the volume and timing of orders received in that
quarter. The Company has at times recognized a substantial portion of its total
revenue from sales booked and shipped in the latter part of the quarter; thus,
the magnitude of quarterly fluctuations may not become evident until late in a
particular quarter. Because the Company's staffing and operating expenses are
based on anticipated total revenue levels, and a high percentage of the
Company's costs are fixed in the short term, small variations between
anticipated orders and actual orders, as well as non-recurring or large orders,
could cause disproportionate variations in the Company's operating results from
quarter to quarter. Revenues also are typically higher in the fourth
quarter,which ends on January 31, than in other quarters of the fiscal
yearprimarily as a result of purchases by customers prior to the calendar year
end, as well as by customers who purchase at the commencement of a new calendar
year. These trends are expected to continue.
Because the software industry is intensely competitive, software vendors have
from time to time experienced price erosion of their products. As is typical in
the software industry, the Company's fixed costs as a percentage of revenues are
high, and significant price erosion could have a material adverse effect on the
Company's revenues and operating results. A number of additional factors may in
the future cause the Company's revenues and operating results to vary
significantly from period to period. These factors include: software "bugs" or
other product quality
20
problems including Year 2000 Compliance issues, changes in operating
expenses; changes in Company strategy; personnel changes; foreign currency
exchange rates; and mix of products sold. Although the Company has been
profitable for the last several years on an annual basis, there can be no
assurance that the Company will be able to continue its growth in revenue or
sustain its profitability on a quarterly or annual basis. Due to all of the
foregoing factors, the Company believes that period-to-period comparisons of
its results of operations are not necessarily meaningful and should not be
relied upon as an indication of future performance. It is possible that, in
some future quarters, the Company's operating results will be below the
expectations of stock market analysts and investors. In such event, the price
of the Common Stock could be materially and adversely affected.
RELIANCE ON CORE FAMILY OF PRODUCTS
Revenue from sales of the Tornado-TM- and VxWorks-Registered Trademark-
family of products and services accounted for a significant majority of the
Company's revenues in each of the fiscal years ended January 31, 1998, 1997
and 1996 and the nine months ended October 31, 1998. The Company's future
results depend heavily on continued market acceptance of these products in
the Company's current markets and successful application in new markets. Any
factor adversely affecting the market for the Tornado and VxWorks family of
products and services could have a material adverse affect on the Company's
business, financial condition and results of operations. The Company
typically charges a one-time fee for a development license and a run-time
license fee for each copy of the Company's operating system embedded in the
customer's products. A key component of the Company's strategy is to increase
revenue through run-time license fees. Any increase in the percentage of
revenues attributable to run-time licenses will depend on the Company's
successful negotiation of run-time license agreements and on the successful
commercialization by the Company's customers of the underlying products. To
the extent that such customers are not successful, the Company may not be
able to meet its objectives, and its business, financial condition and
results of operations could be materially and adversely affected.
COMPETITION
The embedded real-time software industry is highly competitive and is
characterized by rapidly advancing technology. Therefore, the Company's ability
to obtain such business is dependent upon its ability to offer better strategic
concepts and technical solutions, competitive prices, a quicker response or a
combination of these factors. There can be no assurance that the Company will be
able to effectively compete in each of these areas, and any failure to compete
in the embedded real-time software market would have a material adverse effect
on the Company's business, financial condition and results of operations. In
order to maintain or improve its position in the industry, the Company must
continue to enhance its current products and rapidly develop new products and
product extensions. The Company believes that its principal competition comes
from companies that develop real-time embedded software development systems
in-house rather than purchasing such systems from
21
independent software vendors such as the Company, and the Company is thus
subject to the customers' "develop versus buy" decisions in addition to the
factors set forth above. Many of these organizations have substantial
internal programming resources with the capability to develop specific
products for their needs. The Company also competes with other independent
software vendors, including Integrated Systems, Inc., Mentor Graphics, Inc.
(through its acquisition of Microtec/Ready Systems), Microware Systems
Corporation, and Microsoft Corporation. In addition, hardware or other
software vendors could seek to expand their product offerings by designing
and selling products that directly compete with or adversely affect sales of
the Company's products. Many of the Company's existing and potential
competitors have substantially greater financial, technical, marketing and
sales resources than the Company. As a result, they may be able to respond
more quickly to new or emerging technologies and changes in customer
requirements, or to devote greater resources to the development, promotion,
sale and support of their products than the Company. Furthermore, current and
potential competitors have established or may establish cooperative
relationships among themselves or with third parties. Accordingly, it is
possible that new competitors or alliances among competitors may emerge and
rapidly acquire significant market share. In addition, the Company is aware
of ongoing efforts by competitors to emulate the performance and features of
the Company's products, and there can be no assurance that competitors will
not develop equivalent or superior technology to that of the Company. Because
a substantial percentage of the Company's revenues has been derived from
sales of the Tornado and VxWorks family of products and services, the effects
of competition could be more adverse than would be the case if the Company
had a broader product offering. In addition, competitive pressures could
cause the Company to reduce the prices of its products and services, which
would result in reduced profit margins. There can be no assurance that the
Company will be able to compete effectively against its current and future
competitors. If the Company is unable to compete successfully, its business,
financial condition and results of operations would be materially and
adversely affected.
RISKS ASSOCIATED WITH NEW AND CHANGING MARKETS
The Company is continuously engaged in product development for new or changing
markets. In particular, the Company has invested significant time and effort,
together with a consortium of industry participants, in the development of I2O,
a new specification that is intended to create an open standard set of interface
specifications for high performance I/O systems. The specification is intended
to be used by system, network and peripheral interface card and operating
systems vendors to simplify the task of building and maintaining
high-performance I/O subsystems. The Company also has developed IxWorks, a
real-time operating system for use in conjunction with the I2O specification.
The success of the I2O specification and the IxWorks product line depends
heavily on its adoption by a broad segment of the industry. The Company also has
expended, and continues to expend, substantial time and financial resources to
develop embedded operating software and development tools for Internet
applications. The commercial Internet market has
22
only recently begun to develop, is rapidly changing and is characterized by
an increasing number of new entrants with competitive products. Moreover,
there is an increasing number of new Internet protocols to which the
Company's products must be ported. It is unclear which of these competing
protocols ultimately will achieve market acceptance. If the protocols upon
which the Company's Internet products are based ultimately fail to be widely
adopted, the Company's business, financial condition and results of
operations may be materially and adversely affected. It is difficult to
predict with any assurance whether demand for any of these products will
develop or increase in the future. If these markets, or any other new market
targeted by the Company in the future, fail to develop, develop more slowly
than anticipated or become saturated with competitors, if the Company's
products are not developed in a timely manner, or if the Company's products
and services do not achieve or sustain market acceptance, the Company's
business, financial condition and results of operations would be materially
and adversely affected.
RAPID TECHNOLOGICAL CHANGE; DEPENDENCE ON NEW PRODUCTS
The embedded real-time software industry faces a fragmented market characterized
by ongoing technological developments, evolving industry standards and rapid
changes in customer requirements. The introduction of products embodying new
technologies and the emergence of new industry standards could render the
Company's existing products obsolete and unmarketable. The Company's success
depends and will continue to depend upon its ability to continue to develop and
introduce in a timely manner new products, including new releases, applications
and enhancements, that take advantage of technological advances, to identify and
adhere to emerging standards, to continue to improve the functionality of its
Tornado development environment and the scalability and functionality of the
VxWorks operating system, to offer its products across a spectrum of
microprocessor families used in the embedded systems market and to respond
promptly to customers' requirements. The Company has from time to time
experienced delays in the development of new products and the enhancement of
existing products. Such delays are commonplace in the software industry. There
can be no assurance that the Company will be successful in developing and
marketing, on a timely basis or at all, competitive products, product
enhancements and new products that respond to technological change, changes in
customer requirements and emerging industry standards, or that the Company's
enhanced or new products will adequately address the changing needs of the
marketplace. The inability of the Company, due to resource constraints or
technological or other reasons, to develop and introduce new products or product
enhancements in a timely manner could have a material adverse effect on the
Company's business, financial condition or results of operations.
From time to time, the Company or its competitors may announce new products,
capabilities or technologies that have the potential to replace or shorten the
life cycles of the Company's existing products. There can be no assurance that
announcements of currently planned or other new products by the Company or
others will not cause customers to defer purchasing existing Company products.
Any failure by the
23
Company to anticipate or respond adequately to changing market conditions, or
any significant delays in product development or introduction, would have a
material adverse effect on the Company's business, financial condition and
results of operations.
DEPENDENCE ON VME MARKET
A significant amount of the Company's revenues historically has been derived
from sales of systems built to the VME (versabus module eurocard) standard.
These systems typically are used in high cost, low volume applications,
including military, telecommunications, space and research applications.
Although the Company believes that revenues from sales of products designed for
embedded systems applications will account for an increasing percentage of the
Company's revenues in the future, the Company expects revenues from the VME
market to continue to be significant for the foreseeable future. Academic
institutions and defense industry participants, which generate a significant
portion of the Company's VME revenues, are dependent on government funding, the
continued availability of which is uncertain. Although the Company's VME
customers typically have received government funding prior to placing its
product orders with Wind River, any unanticipated future termination of
government funding of VME customers could have a material adverse effect on the
Company's business, financial condition and results of operations.
MANAGEMENT OF GROWTH; DEPENDENCE ON KEY PERSONNEL; NEED FOR ADDITIONAL PERSONNEL
The Company has experienced, and expects to continue to experience, significant
growth in the number of employees, the scope and complexity of its operations
and financial systems and the geographic area of its operations. The Company's
continued success will depend significantly on its ability to integrate new
operations and new personnel. The Company's ability to manage future expansion
of its operations, if any, will require the Company to continue to improve its
financial and management controls, reporting systems and procedures on a timely
basis and expand, train and manage its employee work force efficiently. There
can be no assurance that the Company will be able to do so successfully. The
Company's failure to do so could have a material adverse effect on the Company's
business, operating results and financial condition. In addition, the Company
anticipates the need to relocate its management, product development, marketing,
sales, customer support and operations functions to a new facility within the
next year. During fiscal 1998, the Company purchased real property in the City
of Alameda, California for $11.4 million. In fiscal 1998, the Company entered
into an operating lease agreement for its new headquarters facility being
constructed on such property. As of October 31, 1998, the lessor has funded a
total of $26.5 million of construction costs and has committed to fund up to a
maximum of $35 million. The operating lease payments will begin upon completion
of construction. The property is being developed to construct the Company's new
headquarters facility. There can be no assurance that any such relocation will
be accomplished efficiently, or that the Company's
24
operations will not be materially and adversely affected by such relocation.
The Company's future performance depends to a significant degree upon the
continued contributions of its key management, product development,
marketing, sales, customer support and operations personnel, several of whom
have joined the Company only recently. In addition, the Company believes its
future success will depend in large part upon its ability to attract and
retain highly-skilled managerial, product development, marketing, sales,
customer support and operations personnel, many of whom are in great demand.
Competition for such personnel is particularly intense in the San Francisco
Bay Area, where the Company is headquartered, and there can be no assurance
that the Company will be successful in attracting and retaining such
personnel. The failure of the Company to attract, integrate and retain the
necessary personnel could have a material adverse effect on the Company's
business, financial condition and results of operations.
RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS
During the nine month period ended October 31, 1998 and the fiscal year ended
January 31, 1998, the Company derived approximately 32% and 29%, respectively,
of its total revenue from sales outside of North America. The Company expects
that international sales will continue to generate a significant percentage of
its total revenue in the foreseeable future. The Company also expects to make
substantial investments to expand further its international operations and to
increase its direct sales force in Europe and Asia. There can be no assurance
that these investments will result in commensurate increases in the Company's
international sales. International operations are subject to certain risks,
including foreign government regulation; more prevalent software piracy; longer
payment cycles; unexpected changes in, or imposition of, regulatory
requirements, tariffs, import and export restrictions and other barriers and
restrictions; greater difficulty in accounts receivable collection; potentially
adverse tax consequences including restrictions on repatriation of earnings; the
burdens of complying with a variety of foreign laws; staffing and managing
foreign operations; political and economic instability; changes in diplomatic
and trade relationships; possible recessionary environments in economies outside
the United States; and other factors beyond the control of the Company. There
can be no assurance that such factors will not have a material adverse effect on
the Company's international sales and consequently, the Company's business,
operating results and financial condition. Sales by the Company's foreign
subsidiaries are denominated in the local currency, and an increase in the
relative value of the dollar against such currencies would reduce the Company's
revenues in dollar terms or make the Company's products more expensive and,
therefore, potentially less competitive in foreign markets. Although the Company
attempts to reduce the impact of foreign currency fluctuations, there can be no
assurance that the Company's future results of operations will not be adversely
affected by currency fluctuations. The Company enters into forward contracts to
hedge the short-term impact of foreign currency fluctuations. A portion of the
Company's international revenues are derived from the Asia Pacific region
including Japan. In recent months, economic uncertainty and related weakening of
foreign currencies, particularly the
25
Japanese yen, against the dollar, has occurred. As a result, the Company's
future sales in this region may be adversely affected, which could have a
material adverse effect on the Company's business, results of operations and
financial condition. The Company relies on distributors for sales of its
products in certain foreign countries and, accordingly, is dependent on their
ability to promote and support the Company's products and, in some cases, to
translate them into foreign languages. The Company's international
distributors generally offer products of several different companies,
including in some cases products that are competitive with the Company's
products, and such distributors are not subject to any minimum purchase or
resale requirements. There can be no assurance that the Company's
international distributors will continue to purchase the Company's products
or provide them with adequate levels of support. Any changes in the
relationships the Company has with its international distributors may have a
material adverse effect on the Company's business, operating results and
financial condition.
RISKS ASSOCIATED WITH ACQUISITIONS
As part of its business strategy, the Company has recently completed the
acquisitions of Objective Software Technology, Ltd. and Zinc Software
Incorporated, has acquired equity interests in Emultek, Ltd., 3Soft GmbH, and
XACT, Inc. and has also licensed certain technologies from Network Computer,
Inc. The Company expects to make additional acquisitions of, or significant
investments in, businesses that offer complementary products, services and
technologies. Any acquisitions or investments will be accompanied by the risks
commonly encountered in acquisitions of businesses and technologies including,
among other things, the difficulty of assimilating the operations and personnel
of the acquired businesses, the potential disruption of the Company's ongoing
business, the inability to integrate acquired technologies into new and existing
products, the inability of management to maximize the financial and strategic
position of the Company, the maintenance of uniform standards, controls,
procedures and policies and the impairment of relationships with employees and
customers as a result of any integration of new management personnel. These
factors could have a material adverse effect on the Company's business, results
of operations or financial condition. Consideration paid for future
acquisitions, if any, could be in the form of cash, stock, debt, rights to
purchase stock or a combination thereof. Dilution to existing stockholders and
to earnings per share may result to the extent that shares of stock or other
rights to purchase stock are issued in connection with any such future
acquisitions.
RISKS OF PRODUCT DEFECTS; PRODUCT AND OTHER LIABILITY
As a result of their complexity, software products may contain undetected errors
or compatibility issues, particularly when first introduced or as new versions
are released. There can be no assurance that, despite testing by the Company and
testing and use by current and potential customers, errors will not be found in
new products after commencement of commercial shipments. The occurrence of such
errors could result in loss of or delay in market acceptance of the Company's
products, which could have a material adverse effect on the Company's business,
financial condition
26
and results of operations. The increasing use of the Company's products for
applications in systems that interact directly with the general public,
particularly applications in transportation, medical systems and other
markets where the failure of the embedded system could cause substantial
property damage or personal injury, could expose the Company to significant
product liability claims. In addition, the Company's products may be used for
applications in mission-critical business systems where the failure of the
embedded system could be linked to substantial economic loss. Although the
Company has not experienced material adverse effects resulting from any such
errors to date, there can be no assurance that, despite testing by the
Company and testing and use by current and potential customers, errors will
not be found in new products after commencement of commercial shipments,
resulting in loss of or delay in market acceptance, which could have a
material adverse effect upon the Company's business, operating results and
financial condition. Although the Company's license and other agreements with
its customers typically contain provisions designed to limit the Company's
exposure to potential product liability and other claims, these provisions
may not be effective in all circumstances and in all jurisdictions. Although
the Company has not experienced any product liability or economic loss claims
to date, the sale and support of the Company's products entails the risk of
such claims. The Company carries insurance against product liability risks
and errors or omissions coverage, although there can be no assurance that
such insurance will continue to be available to the Company on commercially
reasonable terms or at all. A product liability claim or claim for economic
loss brought against the Company in excess of or outside the limits of its
insurance coverage, or a product recall involving the Company's software,
could have a material adverse effect on the Company's business, financial
condition and results of operations.
IMPACT OF THE YEAR 2000
As discussed above, many older computer software programs use two digits in
their date fields, identifying years by the last two digits only. Such programs
may interpret the year 2000 as 1900 instead, causing such systems to fail after
1999. Although the Company believes its products will not have such date-related
failures, it has not yet performed the testing and analysis necessary to permit
identification and correction of Year 2000 issues in its internal computer and
information systems and office equipment. There can be no assurance that the
Company will be able to identify and correct any such problems successfully and
in the requisite time frame. Year 2000 issues also could affect the Company's
suppliers and customers. Unresolved Year 2000 issues within the Company, its
significant suppliers or customers could have a material adverse effect on the
Company's business, results of operations and financial condition.
LIMITED PROTECTION OF PROPRIETARY TECHNOLOGY; RISKS OF INFRINGEMENT
The Company's success is heavily dependent upon its proprietary technology. To
protect its proprietary rights, the Company relies on a combination of
copyright, trade secret, patent and trademark laws, nondisclosure and other
contractual
27
restrictions on copying, distribution and technical measures. The Company
seeks to protect its software, documentation and other written materials
through trade secret and copyright laws, which provide only limited
protection. In addition, the Company has two United States patent
applications pending. There can be no assurance that patents will issue from
the Company's pending applications or that any claims allowed will be of
sufficient scope or strength (or be issued in all countries where the
Company's products can be sold) to provide meaningful protection or any
commercial advantage to the Company. As a part of its confidentiality
procedures, the Company generally enters into nondisclosure agreements with
its employees, consultants, distributors and corporate partners and limits
access to and distribution of its software, documentation and other
proprietary information. End user licenses of the Company's software are
frequently in the form of shrink wrap license agreements, which are not
signed by licensees, and therefore may be unenforceable under the laws of
many jurisdictions. Despite the Company's efforts to protect its proprietary
rights, it may be possible for unauthorized third parties to copy the
Company's products or to reverse engineer or obtain and use information that
the Company regards as proprietary. There can be no assurance that the
Company's competitors will not independently develop technologies that are
substantially equivalent or superior to the Company's technologies. Policing
unauthorized use of the Company's products is difficult, and while the
Company is unable to determine the extent to which software piracy of its
products exists, software piracy can be expected to be a persistent problem.
In addition, effective protection of intellectual property rights may be
unavailable or limited in certain countries. The status of U.S. patent
protection in the software industry is not well defined and is likely to
evolve as the U.S. Patent and Trademark Office grants additional patents.
Patents have been granted on fundamental technologies in software, and
patents may issue in the future that relate to fundamental technologies
incorporated into the Company's products.
As the number of patents, copyrights, trademarks, trade secrets and other
intellectual property rights in the Company's industry increases, products based
on the Company's technology may increasingly become the subject of infringement
claims. The Company has received in the past and may receive in the future
letters from third parties asserting infringement claims against the Company.
There can be no assurance that third parties will not assert infringement claims
against the Company in the future. Any such claims, whether with or without
merit, could be time consuming, result in costly litigation, cause product
shipment delays or require the Company to enter into royalty or licensing
agreements. Such royalty or licensing agreements, if required, may not be
available on terms acceptable to the Company, or at all, which could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, the Company may initiate claims or
litigation against third parties for infringement of the Company's proprietary
rights or to establish the validity of the Company's proprietary rights.
Litigation to determine the validity of any claims, whether or not such
litigation is determined in favor of the Company, could result in significant
expense to the
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Company and divert the efforts of the Company's technical and management
personnel from productive tasks. In the event of an adverse ruling in any
such litigation, the Company might be required to pay substantial damages,
discontinue the use and sale of infringing products, expend significant
resources to develop non-infringing technology or obtain licenses to
infringing technology.
LEVERAGE
In connection with the sale of Convertible Subordinated Notes in fiscal 1998,
the Company incurred $140 million in debt which resulted in an increase in its
ratio of long-term debt to total capitalization. As a result of this additional
indebtedness, the Company's principal and interest obligations have increased
substantially. The degree to which the Company will be leveraged could
materially and adversely affect the Company's ability to obtain financing for
working capital, acquisitions or other purposes and could make it more
vulnerable to industry downturns and competitive pressures. The Company's
ability to meet its debt service obligations will be dependent upon the
Company's future performance, which will be subject to financial, business and
other factors affecting operations of the Company, many of which are beyond its
control.
VOLATILITY OF STOCK PRICE
The market price of the Company's Common Stock has fluctuated in the past, and
is likely to fluctuate in the future. The Company believes that various factors,
including quarterly fluctuations in results of operations, announcements of new
products by the Company or by its competitors, and changes in the software
industry in general may significantly affect the market price of the Common
Stock. In addition, in recent years the stock market in general, and the shares
of technology companies in particular, have experienced extreme price
fluctuations. This volatility has had a substantial effect on the market prices
of securities issued by the Company and other high technology companies, often
for reasons unrelated to the operating performance of the specific companies.
The market prices of many high technology companies' stocks are at or near their
historical highs and reflect price/earning ratios substantially above historical
norms. There can be no assurance that the market price of the Common Stock will
remain at or near its current level. In the past, following periods of
volatility in the market price of a company's securities, securities class
action litigation has often been instituted against that company. Such
litigation, if instituted against the Company, could result in substantial costs
and a diversion of management attention and resources, which would have a
material adverse effect on the Company's business, financial condition and
results of operation, even if the Company is successful in such suits. These
market fluctuations, as well as general economic, political and market
conditions such as recessions, may adversely affect the market price of the
Common Stock.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Not Applicable
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is a party to litigation arising in the normal
course of its business. The Company believes that such
litigation, even if resolved adversely to the Company, would
not have a material effect on its business, financial
condition or results of operations.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
3.1 Certificate of Incorporation, as amended to date
27.1 Financial Data Schedule
(B) REPORTS ON FORM 8-K
None.
No other items.
SIGNATURE
Pursuant to the Securities Exchange Act of 1934, the Registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto authorized.
WIND RIVER SYSTEMS, INC.
Date: December 15, 1998 \S\ RICHARD W. KRABER
-----------------------------
Richard W. Kraber
Vice President and Chief Financial Officer
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