================================================================================ UNITED STATES 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 MARCH 31, 2005 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: 000-19960 DATAWATCH CORPORATION ------------------------------------------------------ (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 02-0405716 - ------------------------------- ---------------- (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 175 CABOT STREET SUITE 503 LOWELL, MASSACHUSETTS 01854 --------------------------------------- (ADDRESS OF PRINCIPAL EXECUTIVE OFFICE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (978) 441-2200 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [_] No [X] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Class Outstanding at April 29, 2005 ----- ----------------------------- Common Stock $.01 par value 5,311,846 ================================================================================ DATAWATCH CORPORATION QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2005 TABLE OF CONTENTS ----------------- PART I. FINANCIAL INFORMATION - ----------------------------- Item 1. Financial Statements Page # a) Consolidated Condensed Balance Sheets: March 31, 2005 (unaudited) and September 30, 2004 3 b) Consolidated Condensed Statements of Operations: Three and Six Months Ended March 31, 2005 and 2004 (unaudited) 4 c) Consolidated Condensed Statements of Cash Flows: Six Months Ended March 31, 2005 and 2004 (unaudited) 5 d) Notes to Consolidated Condensed Financial Statements (unaudited) 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk 28 Item 4. Internal Controls and Procedures 28 PART II. OTHER INFORMATION - -------------------------- Item 1. Legal Proceedings 30 Item 4. Submission of Matters to a Vote of Security Holders 30 Item 6. Exhibits 30 SIGNATURES 31 2 PART I. - FINANCIAL INFORMATION Item 1: Financial Statements -------------------- DATAWATCH CORPORATION CONSOLIDATED CONDENSED BALANCE SHEETS March 31, September 30, 2005 2004 ------------ ------------ (Unaudited) ASSETS CURRENT ASSETS: Cash and equivalents $ 3,540,264 $ 4,260,632 Accounts receivable, net 4,152,187 3,672,218 Inventories 81,335 67,955 Prepaid expenses 776,306 614,566 Total current assets 8,550,092 8,615,371 Property and equipment, net 460,600 433,567 Goodwill 1,630,646 1,632,646 Other intangible assets, net 1,429,554 1,650,507 Restricted cash 268,299 268,299 Other 31,427 28,404 ------------ ------------ $ 12,370,618 $ 12,628,794 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 1,075,834 $ 1,137,539 Accrued expenses 1,795,902 2,026,830 Deferred revenue 3,058,313 2,903,123 Escrow for Mergence shareholders 126,790 125,373 ------------ ------------ Total current liabilities 6,056,839 6,192,865 ------------ ------------ COMMITMENTS AND CONTINGENCIES (Note 8) SHAREHOLDERS' EQUITY: Common stock, par value $.01 - 20,000,000 shares authorized; issued, 5,323,892 shares and 5,315,108 shares, respectively; outstanding, 5,309,646 shares and 5,300,862 shares, respectively 53,239 53,151 Additional paid-in capital 21,838,857 21,828,621 Accumulated deficit (15,134,480) (14,987,462) Accumulated other comprehensive loss (303,449) (317,993) ------------ ------------ 6,454,167 6,576,317 Less treasury stock, at cost - 14,246 shares (140,388) (140,388) ------------ ------------ Total shareholders' equity 6,313,779 6,435,929 ------------ ------------ $ 12,370,618 $ 12,628,794 ============ ============ The accompanying notes are an intergral part of these consolidated condensed financial statements. 3 DATAWATCH CORPORATION CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (unaudited) Three Months Ended March 31, Six Months Ended March 31, 2005 2004 2005 2004 ---------- ---------- ---------- ---------- REVENUE: Software licenses and subscriptions $3,307,340 $3,480,205 $6,524,278 $6,430,534 Maintenance and services 1,801,407 1,714,398 3,671,797 3,171,157 ---------- ---------- ---------- ---------- Total Revenue 5,108,747 5,194,603 10,196,075 9,601,691 COSTS AND EXPENSES: Cost of software licenses and subscriptions 566,311 760,285 1,160,226 1,390,375 Cost of maintenance and services 840,503 661,193 1,756,440 1,272,873 Sales and marketing 2,183,138 1,954,977 4,361,538 3,493,928 Engineering and product development 548,143 341,481 1,098,106 621,125 General and administrative 986,836 1,066,726 2,015,910 2,102,627 ---------- ---------- ---------- ---------- Total costs and expenses 5,124,931 4,784,662 10,392,220 8,880,928 ---------- ---------- ---------- ---------- (LOSS) INCOME FROM OPERATIONS (16,184) 409,941 (196,145) 720,763 Interest expense (752) -- (1,465) -- Interest income and other income (expense), net 23,700 (14,378) 50,592 3,825 ---------- ---------- ---------- ---------- INCOME (LOSS) BEFORE INCOME TAXES 6,764 395,563 (147,018) 724,588 Provision for income taxes -- -- -- 5,500 ---------- ---------- ---------- ---------- NET INCOME (LOSS) $ 6,764 $ 395,563 $ (147,018) $ 719,088 ========== ========== ========== ========== Net income (loss) per share - Basic $ 0.00 $ 0.08 $ (0.03) $ 0.14 Net income (loss) per share - Diluted $ 0.00 $ 0.07 $ (0.03) $ 0.13 Weighted-Average Shares Outstanding - Basic 5,306,869 5,244,305 5,304,309 5,237,539 ========== ========== ========== ========== Weighted-Average Shares Outstanding - Diluted 5,847,500 5,779,465 5,304,309 5,738,526 ========== ========== ========== ========== The accompanying notes are an intergral part of these consolidated condensed financial statements. 4 DATAWATCH CORPORATION CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (unaudited) Six Months Ended March 31, 2005 2004 ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income $ (147,018) $ 719,088 Adjustments to reconcile net (loss) income to cash (used in) provided by operating activities: Depreciation and amortization 329,604 393,493 Allowances for doubtful accounts and sales returns (33,673) 119,035 Loss (gain) on disposition of equipment 20,502 (737) Changes in current assets and liabilities: Accounts receivable (405,600) (676,140) Inventories (12,848) 14,970 Prepaid expenses and other (150,124) (65,556) Accounts payable and accrued expenses (329,844) 365,357 Deferred revenue 90,646 (120,689) ----------- ----------- Cash (used in) provided by operating activities (638,355) 748,821 ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (146,110) (89,920) Proceeds from sale of equipment 2,831 737 Capitalized software development costs (9,040) (19,096) Other assets (2,179) 33,278 ----------- ----------- Cash used in investing activities (154,498) (75,001) ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from exercise of stock options 10,323 102,626 Principal payments on long-term obligations -- (3,115) Restricted cash 1,417 -- ----------- ----------- Cash provided by financing activities 11,740 99,511 ----------- ----------- EFFECT OF EXCHANGE RATE CHANGES ON CASH AND EQUIVALENTS 60,745 261,725 (DECREASE) INCREASE IN CASH AND EQUIVALENTS (720,368) 1,035,056 CASH AND EQUIVALENTS, BEGINNING OF PERIOD 4,260,632 5,070,850 ----------- ----------- CASH AND EQUIVALENTS, END OF PERIOD $ 3,540,264 $ 6,105,906 =========== =========== SUPPLEMENTAL INFORMATION: Interest paid $ 1,465 $ -- =========== =========== The accompanying notes are an integral part of these consolidated condensed financial statements. 5 DATAWATCH CORPORATION NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (unaudited) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION The accompanying consolidated condensed financial statements include the accounts of Datawatch Corporation (the "Company") and its wholly owned subsidiaries and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements and should be read in conjunction with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended September 30, 2004 filed with the Securities and Exchange Commission (the "SEC"). All significant intercompany accounts and transactions have been eliminated. In the opinion of management, the accompanying consolidated condensed financial statements have been prepared on the same basis as the audited consolidated financial statements, and include all adjustments necessary for fair presentation of the results of the interim periods presented. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year. Presentation of certain amounts for the period ended March 31, 2004 and as of September 30, 2004 have been changed to conform to the March 31, 2005 presentation. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments, which are evaluated on an on-going basis, that affect the amounts reported in the Company's consolidated condensed financial statements and accompanying notes. Management bases its estimates on historical experience and on various other assumptions that it believes are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates and judgments. In particular, significant estimates and judgments include those related to revenue recognition, allowance for doubtful accounts, sales returns reserve, useful lives of property and equipment, valuation of net deferred tax assets, business combinations, and valuation of goodwill and other intangible assets. REVENUE RECOGNITION The Company has two types of software product offerings: Enterprise Software and Desktop and Server Software. Enterprise Software products are generally sold directly to end-users. The Company sells its Desktop and Server Software products directly to end-users and through distributors and resellers. Sales to distributors and resellers accounted for approximately 31% and 27%, respectively, of total sales for the three months ended March 31, 2005 and 2004, and 31% and 28%, respectively, of total sales for the six months ended March 31, 2005 and 2004. Revenue from the sale of all software products is generally recognized at the time of shipment, provided there are no uncertainties surrounding product acceptance, the fee is fixed or determinable, collection is considered probable, persuasive evidence of the arrangement exists and there are no significant obligations remaining. Both types of the Company's software product offerings are "off-the-shelf" as such term is defined by Statement of Position No. 97-2, "SOFTWARE REVENUE RECOGNITION." The Company's software products can be installed and used by customers on their own with little or no customization required. Multi-user licenses marketed by the Company are sold as a right to use the number of licenses and license fee revenue is recognized upon delivery of all software required to satisfy the number of licenses sold. Upon delivery, the licensing fee is payable without further delivery obligations to the Company. 6 DATAWATCH CORPORATION NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS - (CONTINUED) Desktop and Server Software products are generally not sold in multiple element arrangements. Accordingly, the price paid by the customer is considered the vendor specific objective evidence ("VSOE") of fair value for those products. Enterprise Software sales are generally multiple element arrangements which include software license deliverables, professional services and post-contract customer support. In such multiple element arrangements, the Company applies the residual method in determining revenue to be allocated to a software license. In applying the residual method, the Company deducts from the sale proceeds the VSOE of fair value of the services and post-contract customer support in determining the residual fair value of the software license. The VSOE of fair value of the services and post-contract customer support is based on the amounts charged for these elements when sold separately. Professional services include implementation, integration, training and consulting services with revenue recognized as the services are performed. These services are generally delivered on a time and materials basis, are billed on a current basis as the work is performed, and do not involve modification or customization of the software or any other unusual acceptance clauses or terms. Post-contract customer support is typically provided under a maintenance agreement which provides technical support and rights to unspecified software maintenance updates and bug fixes on a when-and-if available basis. Revenue from post-contract customer support services is deferred and recognized ratably over the contract period (generally one year). The Company also sells its Enterprise Software using a subscription model. At the time a customer enters into a binding agreement to purchase a subscription, the customer is invoiced for an initial 90 day service period and an account receivable and deferred revenue are recorded. Beginning on the date the software is installed at the customer site and available for use by the customer, and provided that all other criteria for revenue recognition are met, the deferred revenue amount is recognized ratably over the period the service is provided. The customer is then invoiced every 90 days and revenue is recognized ratably over the period the service is provided. Subscriptions can be cancelled by the customer at any time by providing 90 days written notice. The Company's software products are sold under warranty against certain defects in material and workmanship for a period of 30 to 90 days from the date of purchase. Certain software products, including desktop versions of Monarch, Monarch Data Pump and VorteXML sold directly to end-users, include a guarantee under which such customers may return products within 30 to 60 days for a full refund. Additionally, the Company provides its distributors with stock-balancing rights and applies the guidance found in Statement of Financial Accounting Standards ("SFAS") No. 48, "REVENUE RECOGNITION WHEN RIGHT OF RETURN EXISTS." Revenue from the sale of software products to distributors and resellers is recognized at the time of shipment providing all other criteria for revenue recognition as stated above are met and (i) the distributor or reseller is unconditionally obligated to pay for the products, including no contingency as to product resale, (ii) the distributor or reseller has independent economic substance apart from the Company, (iii) the Company is not obligated for future performance to bring about product resale, and (iv) the amount of future returns can be reasonably estimated. The Company's experience and history with its distributors and resellers allows for reasonable estimates of future returns. Among other things, estimates of potential future returns are made based on the inventory levels at the various distributors and resellers, which the Company monitors frequently. Once the estimates of potential future returns from all sources are made, the Company determines if it has adequate returns reserves to cover anticipated returns and the returns reserve is adjusted as required. Adjustments are recorded as increases or decreases in revenue in the period of adjustment. Actual returns have historically been within the range estimated by management. 7 DATAWATCH CORPORATION NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS - (CONTINUED) STOCK OPTIONS The Company uses the intrinsic-value method of valuing its stock options to measure compensation expense associated with grants of stock options to employees and directors. As permitted under SFAS No. 148, "ACCOUNTING FOR STOCK-BASED COMPENSATION - TRANSITION AND DISCLOSURE," that amended SFAS No. 123 ("SFAS 123"), "ACCOUNTING FOR STOCK-BASED COMPENSATION," the Company has elected to continue to follow the intrinsic-value method in accounting for its stock-based employee compensation arrangements as defined by Accounting Principles Board Opinion ("APB") No. 25, "ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES," and related interpretations including Financial Accounting Standards Board ("FASB") Interpretation No. 44, "ACCOUNTING FOR CERTAIN TRANSACTIONS INVOLVING STOCK COMPENSATION," an interpretation of APB No. 25. No stock-based employee compensation cost is reflected in net income (loss), as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of the grant. Had the Company recognized compensation for its stock options and purchase plans based on the fair value for awards under those plans, pro forma net (loss) income and pro forma net (loss) income per share would have been as follows: Three Months Ended March 31, Six Months Ended March 31, 2005 2004 2005 2004 ----------- ----------- ----------- ----------- (unaudited) (unaudited) Net income (loss), as reported $ 6,764 $ 395,563 $ (147,018) $ 719,088 Less: Total stock-based employee compensation expense determined under fair value based method for all awards (74,327) (53,445) (141,540) (107,201) ----------- ----------- ----------- ----------- Pro forma net (loss) income $ (67,563) $ 342,118 $ (288,558) $ 611,887 =========== =========== =========== =========== Net (loss) income per share: Basic - as reported $ 0.00 $ 0.08 $ (0.03) $ 0.14 Basic - pro forma $ (0.01) $ 0.07 $ (0.05) $ 0.12 Diluted - as reported $ 0.00 $ 0.07 $ (0.03) $ 0.13 Diluted - pro forma $ (0.01) $ 0.06 $ (0.05) $ 0.11 The fair values used to compute pro forma net (loss) income and pro forma net (loss) income per share were estimated on the grant date using the Black-Scholes option pricing model with the following assumptions: Three Months Ended March 31, Six Months Ended March 31, 2005 2004 2005 2004 --------- --------- --------- --------- Risk-free interest rate 4.2 % 2.8 % 3.7 % 3.0 % Expected life of option grants (years) 5.0 4.0 5.0 4.0 Expected volatility of underlying stock 103.0 % 107.2 % 107.6 % 115.0 % Expected dividend payment rate 0.0 % 0.0 % 0.0 % 0.0 % On December 16, 2004, FASB issued a revision to SFAS No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION" titled "SHARE-BASED PAYMENT." This revision requires that all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on the grant-date fair value. On April 14, 2005, the Securities and Exchange Commission adopted a rule amending SFAS 123(R) "SHARE-BASED PAYMENT" deferring the effective date of SFAS 123(R) for public companies to fiscal years beginning after June 15, 2005. The standard offers the Company 8 DATAWATCH CORPORATION NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS - (CONTINUED) alternative methods of adopting the standard. The Company has not yet determined which alternative method it will use. See Note 10 for further explanation. CONCENTRATION OF CREDIT RISKS AND MAJOR CUSTOMERS The Company sells its products and services to U.S. and non-U.S. dealers and other software distributors, as well as to end users, under customary and normal credit terms. One customer, Ingram Micro Inc., individually accounted for 20% and 21% of total revenue for the three months ended March 31, 2005 and 2004, respectively, and 21% and 19% of total revenue for the six months ended March 31, 2005 and 2004, respectively. Ingram Micro Inc. accounted for 23% and 31% of outstanding gross trade receivables as of March 31, 2005 and September 30, 2004, respectively. The Company sells to Ingram Micro Inc. under a distribution agreement, which automatically renews for successive one-year terms unless terminated. Other than this customer, no other customer constitutes a significant portion (more than 10%) of sales or accounts receivable. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are provided for anticipated doubtful accounts and sales returns. GOODWILL AND OTHER INTANGIBLE ASSETS Other intangible assets consist of capitalized software cost, acquired technology, patents, customer relationships, trademarks and trade names acquired through business combinations. The values allocated to these intangible assets are amortized using the straight-line method over the estimated useful life of the related asset and are recorded in cost of sales for software license and subscriptions. Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable and an impairment loss is recognized when it is probable that the estimated cash flows are less than the carrying amount of the asset. Goodwill and certain trademarks are not subject to amortization and are tested annually for impairment or more frequently if events and circumstances indicate that the asset might be impaired. Goodwill is tested for impairment using a two-step approach. The first step is to compare the fair value of the reporting unit to its carrying amount, including goodwill. If the fair value of the reporting unit is greater than its carrying amount, goodwill is not considered impaired, but if the fair value of the reporting unit is less than its carrying amount, the amount of the impairment loss, if any, must be measured. An impairment loss is recognized to the extent that the carrying amount exceeds the asset's fair value. NOTE 2. BUSINESS COMBINATIONS MERGENCE TECHNOLOGIES CORPORATION On August 11, 2004, the Company acquired 100% of the outstanding shares of Mergence Technologies Corporation for an acquisition cost of $2,596,691 comprised of $2,500,000 in cash and direct costs of $96,691. The Mergence purchase agreement also includes a provision for quarterly cash payments to the former Mergence shareholders equal to 10% of the revenues, as defined, of Mergence's Researcher product for a period of six years. Payment amounts will be expensed as a cost of revenue as the Researcher product is recognized as revenue. The Company expensed $10,400 during the three months ended March 31, 2005. Mergence was acquired to broaden and expand the Company's product offerings. Mergence's results are included with those of the Company from the date of acquisition. 9 DATAWATCH CORPORATION NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS - (CONTINUED) The allocation of the purchase price was based on an evaluation of assets acquired and liabilities assumed. The valuation of the intangible assets is based in part on assistance from an independent valuation firm. The valuation method used to determine the intangible asset values was the income approach. The income approach presumes that the value of an asset can be estimated by the net economic benefit (i.e. cash flows) to be received over the life of the asset, discounted to present value. The discounting process uses a rate of return that accounts for both the time value of money and investment risk factors. The weighted-average discount rate (or rate of return) used to determine the value of the identifiable intangible assets was 30%. The intangible asset for existing technology is for two technologies developed and owned by Mergence. Datawatch has estimated the life of these products as three years and six years, respectively. The patents have an estimated life of twenty years, which represents the legal life. The customer list and non-compete agreements have estimated lives of four years and five years, respectively. The fair values for the existing technology, patents, customer list and non-compete agreements will be amortized over the estimated life, unless, in the future it is determined that the assets are impaired. Datawatch has determined that the trademark has an indefinite life and as such the trademark is not being amortized. The trademark and goodwill will be tested for impairment annually, or on an interim basis, if an event or circumstance indicates that it is more likely than not that an impairment loss has been incurred. No portion of the goodwill is deductible for tax purposes. NOTE 3. GOODWILL AND OTHER INTANGIBLE ASSETS, NET Other intangible assets, net were comprised of the following as of March 31, 2005 (unaudited) and September 30, 2004: March 31, 2005 September 30, 2004 --------------------------------------- --------------------------------------- Weighted Average Gross Net Gross Net Useful Life Carrying Accumulated Carrying Carrying Accumulated Carrying Identified Intangible Asset in Years Amount Amortization Amount Amount Amortization Amount - ----------------------------------------------------------------------------------- --------------------------------------- Capitalized software 3 $ 1,632,160 $(1,335,849) $ 296,311 $ 1,623,120 $(1,194,931) $ 428,189 Purchased software 5 520,000 (64,722) 455,278 520,000 (11,667) 508,333 Patents 20 140,000 (4,375) 135,625 140,000 (1,167) 138,833 Customer lists 4 130,000 (20,312) 109,688 130,000 -- 130,000 Non-compete agreements 5 100,000 (12,500) 87,500 100,000 -- 100,000 Trademarks indefinite 345,152 -- 345,152 345,152 -- 345,152 --------------------------------------- --------------------------------------- Total $ 2,867,312 $(1,437,758) $ 1,429,554 $ 2,858,272 $(1,207,765) $ 1,650,507 =========== =========== =========== =========== =========== =========== For the three months ended March 31, 2005 and 2004, amortization expense related to identified intangible assets was $114,552 and $125,858, respectively, and $229,993 and $266,201 for the six months ended March 31, 2005 and 2004, respectively. 10 DATAWATCH CORPORATION NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS - (CONTINUED) The estimated future amortization expense related to other intangible assets as of March 31, 2005 was as follows: FISCAL YEAR - ------------------------ Remainder of fiscal 2005 $ 229,106 2006 317,675 2007 163,557 2008 118,771 2009 87,833 2010 70,335 Thereafter 97,125 ----------- Total $ 1,084,402 =========== The carrying amount of goodwill and certain trademarks that have been determined to have indefinite lives as of March 31, 2005 was $1,630,646 and $345,152, respectively. NOTE 4. INVENTORIES Inventories consisted of the following at March 31, 2005 and September 30, 2004: March 31, September 30, 2005 2004 --------- ------------ (unaudited) Raw materials $ 57,427 $ 46,931 Finished goods 23,908 21,024 -------- -------- Total $ 81,335 $ 67,955 ======== ======== NOTE 5. DEFERRED REVENUE Deferred revenue consisted of the following at March 31, 2005 and September 30, 2004: March 31, September 30, 2005 2004 ----------- ----------- (unaudited) Maintenance $ 2,353,809 $ 2,440,719 Other 704,504 462,404 Total $ 3,058,313 $ 2,903,123 11 DATAWATCH CORPORATION NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS - (CONTINUED) Maintenance consists of the unearned portion of post-contract customer support services provided by the Company to customers who purchase maintenance agreements for the Company's products. Maintenance revenues are recognized on a straight-line basis over the term of the maintenance period, generally 12 months. Other consists of deferred license, subscription and professional services revenue generated from arrangements that are invoiced in accordance with the terms and conditions of the arrangement but do not meet all the criteria for revenue recognition, and are, therefore, deferred until all revenue recognition criteria are met. NOTE 6. COMPREHENSIVE (LOSS) INCOME The following table sets forth the reconciliation of net income (loss) to comprehensive (loss) income: Three Months Ended March 31, Six Months Ended March 31, 2005 2004 2005 2004 ---------- ---------- ---------- ---------- Net income (loss) $ 6,764 $ 395,563 $ (147,018) $ 719,088 Other comprehensive income: Foreign currency translation adjustments (46,230) 30,447 14,544 106,175 ---------- ---------- ---------- ---------- Comprehensive (loss) income $ (39,466) $ 426,010 $ (132,474) $ 825,263 ========== ========== ========== ========== Accumulated other comprehensive (loss) income reported in the consolidated condensed balance sheets consists only of foreign currency translation adjustments. NOTE 7. BASIC AND DILUTED NET INCOME (LOSS) PER SHARE Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share reflects the impact, when dilutive, of the exercise of options and warrants using the treasury stock method. Potential dilutive common stock options aggregating 105,870 and 128,650 shares for the three months ended March 31, 2005 and 2004, respectively, and 659,533 and 150,576 shares for the six months ended March 31, 2005 and 2004, respectively, have been excluded from the computation of diluted net income (loss) per share because their inclusion would be antidilutive. NOTE 8. COMMITMENTS AND CONTINGENCIES In May 2004, the Company was served with a charge of discrimination filed with the Massachusetts Commission Against Discrimination (MCAD) by a current employee. In addition to the Company, the employee named an executive of the Company as well as the employee's former supervisor as defendants. The employee alleged that her former supervisor engaged in sexually harassing conduct. The employee accused the executive of engaging in retaliation upon learning of the employee's complaint. The complaint was withdrawn from the MCAD in August 2004, with the stated intent of pursuing the claim in Superior Court in the state of Massachusetts. To date, the Company has not been notified of any further filing. Given the early stage and current status of the claim, the Company is unable to predict the ultimate outcome. The Company intends to vigorously defend the claims. 12 DATAWATCH CORPORATION NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS - (CONTINUED) From time to time, the Company receives other claims and may be party to other actions that arise in the normal course of business. Other than as noted above, the Company does not believe the eventual outcome of any other pending matters will have a material effect on the Company's consolidated financial condition or results of operations. NOTE 9. SEGMENT INFORMATION The Company has determined that it has only one reportable segment. The Company's chief operating decision maker, as defined, (determined to be the Chief Executive Officer) does not manage any part of the Company separately, and the allocation of resources and assessment of performance is based solely on the Company's consolidated operations and operating results. The following table presents information about the Company's revenue by product lines: Three Months Ended Six Months Ended March 31, March 31, 2005 2004 2005 2004 ------- ------- ------- ------- Desktop and Server Software (primarily Monarch) 56% 52% 56% 57% Report Management Solutions (including Datawatch|ES & iMergence) 15% 17% 15% 13% Service Management Solutions (including Visual|QSM & Visual|HD) 29% 31% 29% 30% ------- ------- ------- ------- Total 100% 100% 100% 100% ======= ======= ======= ======= The Company's operations are conducted in the U.S. and internationally (principally in the United Kingdom). The following tables present information about the Company's geographic operations: International (Principally Domestic U.K.) Eliminations Total ----------- ----------- ------------ ----------- Total Revenue - ---------------------------------- Three months ended March 31, 2005 $ 3,426,496 $ 1,964,140 $(281,889) $ 5,108,747 Three months ended March 31, 2004 $ 3,450,998 $ 2,025,553 $(281,948) $ 5,194,603 Six months ended March 31, 2005 $ 6,578,567 $ 4,158,330 $(540,822) $10,196,075 Six months ended March 31, 2004 $ 6,431,588 $ 3,698,382 $(528,279) $ 9,601,691 Total Operating Income (Loss) - ---------------------------------- Three months ended March 31, 2005 $ 201,131 $ (217,315) $ -- $ (16,184) Three months ended March 31, 2004 $ 485,613 $ (75,672) $ -- $ 409,941 Six months ended March 31, 2005 $ 141,721 $ (337,866) $ -- $ (196,145) Six months ended March 31, 2004 $ 809,396 $ (88,633) $ -- $ 720,763 Non-current Assets - ---------------------------------- At March 31, 2005 $ 3,703,671 $ 116,855 $ 3,820,526 At September 30, 2004 $ 3,896,946 $ 116,477 $ 4,013,423 13 DATAWATCH CORPORATION NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS - (CONTINUED) NOTE 10. RECENT ACCOUNTING PRONOUNCEMENTS On December 16, 2004, the FASB issued SFAS No. 123R, SHARE-BASED PAYMENT ("SFAS No. 123R"). This Statement is a revision of SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, and supersedes Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and its related implementation guidance. SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The Statement requires entities to recognize stock compensation expense for awards of equity instruments to employees based on the grant-date fair value of those awards (with limited exceptions). On April 14, 2005, the Securities and Exchange Commission adopted a rule amending SFAS 123(R) "SHARE-BASED PAYMENT" deferring the effective date of SFAS 123(R) for public companies to fiscal years beginning after June 15, 2005. We are evaluating the two methods of adoption allowed by SFAS No. 123R; the modified-prospective transition method and the modified-retrospective transition method. 14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Datawatch is engaged in the design, development, manufacture, marketing, and support of business computer software primarily for the Windows-based market. Its products address the enterprise content management and reporting, business intelligence, data replication, service management and help desk markets. Datawatch's principal products are: Monarch, a desktop report mining and business intelligence application that lets users extract and manipulate data from ASCII report files, PDF files or HTML files produced on any mainframe, midrange, client/server or PC system; Monarch Data Pump, a data replication and migration tool that offers a shortcut for populating and refreshing data marts and data warehouses, for migrating legacy data into new applications and for providing automated delivery of reports in a variety of formats via email; Monarch|RMS, a web-based report mining and analysis solution that integrates with any existing COLD/ERM, document or content management archiving solution; Datawatch|ES, a web-enabled business information portal, providing complete report management, business intelligence and content management, and the ability to analyze data within reports derived from existing reporting systems with no new programming or report writing; Datawatch|Researcher, a .NET based content and data aggregation solution that searches inter-related data, documents, and communications scattered over multiple and disparate repositories, then merges and analyzes the results into comprehensive actionable case records; Visual|QSM, a fully internet-enabled IT support solution that incorporates workflow and network management capabilities and provides web access to multiple databases via a standard browser; Visual|Help Desk or Visual|HD, a web-based help desk and call center solution operating on the IBM Lotus Domino platform; and VorteXML, a data transformation product for the emerging XML market that easily and quickly converts structured text output from any system into valid XML for web services and more using any DTD or XDR schema without programming. On August 11, 2004, Datawatch acquired 100% of the shares of Mergence Technologies Corporation, subsequently changed to Datawatch Technologies, in exchange for $2,500,000 in cash and $96,691 in direct costs. The purchase agreement also included a provision for quarterly cash payments to the former Mergence shareholders equal to 10% of revenue, as defined, of the Datawatch|Researcher product for a period of six years. The activities of Mergence from August 11, 2004 are included in the Company's consolidated condensed financial statements. See Note 2 to the consolidated condensed financial statements which appear elsewhere herein for more detailed financial information on the acquisition of Mergence. During the first quarter of fiscal 2004, the Company introduced a subscription sales model for the sale of its enterprise products. The Company continues to offer its enterprise products through the sale of perpetual licenses and introduced the subscription pricing model to allow customers to begin using the Company's products at a lower initial cost of software acquisition. Subscriptions automatically renew unless terminated with 90 days notice. During fiscal 2004 and the six months ended March 31, 2005, revenues under the subscription model were not significant, however, customer interest in the model and sales under the model have been increasing. CRITICAL ACCOUNTING POLICIES In the preparation of financial statements and other financial data, management applies certain accounting policies to transactions that, depending on choices made by management, can result in different outcomes. In order for a reader to understand the following information regarding the financial performance and condition of the Company, an understanding of those accounting policies is important. Certain of those policies are comparatively more important to the Company's financial results and condition than others. The policies that the Company believes are most important for a reader's understanding of the financial information provided in this report are described below. Revenue Recognition, Allowance for Bad Debts and Returns Reserve The Company has two types of software product offerings: Enterprise Software and Desktop and Server Software. Enterprise Software products are generally sold directly to end-users. The Company sells its Desktop and Server Software products directly to end-users and through distributors and resellers. Sales to distributors and resellers accounted for 15 approximately 31% and 27%, respectively, of total sales for the three months ended March 31, 2005 and 2004, and 31% and 28%, respectively, of total sales for the six months ended March 31, 2005 and 2004. Revenue from the sale of all software products is generally recognized at the time of shipment, provided there are no uncertainties surrounding product acceptance, the fee is fixed or determinable, collection is considered probable, persuasive evidence of the arrangement exists and there are no significant obligations remaining. Both types of the Company's software product offerings are "off-the-shelf" as such term is defined by Statement of Position No. 97-2, "SOFTWARE REVENUE RECOGNITION." The Company's software products can be installed and used by customers on their own with little or no customization required. Multi-user licenses marketed by the Company are sold as a right to use the number of licenses and license fee revenue is recognized upon delivery of all software required to satisfy the number of licenses sold. Upon delivery, the licensing fee is payable without further delivery obligations of the Company. Desktop and Server Software products are generally not sold in multiple element arrangements. Accordingly, the price paid by the customer is considered the vendor specific objective evidence ("VSOE") of fair value for those products. Enterprise Software sales are generally multiple element arrangements which include software license deliverables, professional services and post-contract customer support. In such multiple element arrangements, the Company applies the residual method in determining revenue to be allocated to a software license. In applying the residual method, the Company deducts from the sale proceeds the VSOE of fair value of the services and post-contract customer support in determining the residual fair value of the software license. The VSOE of fair value of the services and post-contract customer support is based on the amounts charged for these elements when sold separately. Professional services include implementation, integration, training and consulting services with revenue recognized as the services are performed. These services are generally delivered on a time and materials basis, are billed on a current basis as the work is performed, and do not involve modification or customization of the software or any other unusual acceptance clauses or terms. Post-contract customer support is typically provided under a maintenance agreement which provides technical support and rights to unspecified software maintenance updates and bug fixes on a when-and-if available basis. Revenue from post-contract customer support services is deferred and recognized ratably over the contract period (generally one year). Such deferred amounts are recorded as part of deferred revenue in the Company's Consolidated Condensed Balance Sheets included elsewhere herein. The Company also sells its Enterprise Software using a subscription model. At the time a customer enters into a binding agreement to purchase a subscription, the customer is invoiced for an initial 90 day service period and an account receivable and deferred revenue are recorded. Beginning on the date the software is installed at the customer site and available for use by the customer, and provided that all other criteria for revenue recognition are met, the deferred revenue amount is recognized ratably over the period the service is provided. The customer is then invoiced every 90 days and revenue is recognized ratably over the period the service is provided. Subscriptions can be cancelled by the customer at any time by providing 90 days written notice. The Company's software products are sold under warranty against certain defects in material and workmanship for a period of 30 to 90 days from the date of purchase. Certain software products, including desktop versions of Monarch, Monarch Data Pump, and VorteXML sold directly to end-users, include a guarantee under which such customers may return products within 30 to 60 days for a full refund. Additionally, the Company provides its distributors with stock-balancing rights and applies the guidance found in SFAS No. 48, "REVENUE RECOGNITION WHEN RIGHT OF RETURN EXISTS." Revenue from the sale of software products to distributors and resellers is recognized at the time of shipment providing all other criteria for revenue recognition as stated above are met and (i) the distributor or reseller is unconditionally obligated to pay for the products, including no contingency as to product resale, (ii) the distributor or reseller has independent economic substance apart from the Company, (iii) the Company is not obligated for future performance to bring about product resale, and (iv) the amount of future returns can be reasonably estimated. The Company's experience and history with its distributors and resellers allows for reasonable estimates of future returns. Among other things, estimates of potential future returns are made based on the inventory levels at the various distributors and resellers, which the Company monitors frequently. Once the estimates of potential future returns from all sources are made, the Company determines if it has adequate returns reserves to cover anticipated returns and the returns reserve is adjusted as required. Adjustments are recorded as increases or decreases in revenue in the period of adjustment. Actual returns have historically been within the range estimated by the Company. The Company's returns reserve was $132,965 and $186,277 for the period as of March 31, 2005 and September 30, 2004, respectively. 16 The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. The Company analyzes accounts receivable and the composition of the accounts receivable aging, historical bad debts, customer creditworthiness, current economic trends, foreign currency exchange rate fluctuations and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Based upon the analysis and estimates of the uncollectibility of its accounts receivable, the Company records an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Actual results could differ from the allowances for doubtful accounts recorded, and this difference may have a material effect on the Company's financial position and results of operations. The Company's allowance for doubtful accounts was $252,007 and $230,034 for the period as of March 31, 2005 and September 30, 2004, respectively. Deferred Tax Assets The Company has deferred tax assets related to net operating loss carryforwards and tax credits that expire at different times through and until 2020. Significant judgment is required in determining the Company's provision for income taxes, the carrying value of deferred tax assets and liabilities and the valuation allowance recorded against net deferred tax assets. Factors such as future reversals of deferred tax assets and liabilities, projected future taxable income, changes in enacted tax rates and the period over which the Company's deferred tax assets will be recoverable are considered in making these determinations. The Company's domestic operations have been profitable during the past three years while international operations have continued to generate operating losses. During fiscal 2004, the Company increased sales and marketing expense by approximately 24% and introduced a subscription sales model, both of which could have an adverse effect on profitability. Accordingly, management does not believe the deferred tax assets are more likely than not to be realized and a full valuation allowance, previously provided against the deferred tax assets, continues to be provided. Management evaluates the realizability of the deferred tax assets quarterly and, if current economic conditions change or future results of operations are better than expected, future assessments may result in the Company concluding that it is more likely than not that all or a portion of the deferred tax assets are realizable. If this conclusion were reached, the valuation allowance against deferred tax assets would be reduced resulting in a tax benefit being recorded for financial reporting purposes. Total net deferred tax asset subject to a valuation allowance was approximately $5.0 million as of March 31, 2005. Capitalized Software Development Costs The Company capitalizes certain software development costs as well as purchased software upon achieving technological feasibility of the related products. Software development costs incurred and software purchased prior to achieving technological feasibility are charged to research and development expense as incurred. Commencing upon initial product release, capitalized costs are amortized to cost of software licenses using the straight-line method over the estimated life (which approximates the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product), generally 24 to 72 months. Goodwill, Other Intangible Assets and Other Long-Lived Assets The Company performs an evaluation of whether goodwill is impaired annually or when events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Fair value is determined using market comparables for similar businesses or forecasts of discounted future cash flows. The Company also reviews other intangible assets and other long-lived assets when indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Should the fair value of the Company's long-lived assets decline because of reduced operating performance, market declines, or other indicators of impairment, a charge to operations for impairment may be necessary. 17 RESULTS OF OPERATIONS Three and Six Months Ended March 31, 2005 and 2004 - -------------------------------------------------- The following table sets forth certain statements of operations data as a percentage of total revenues for the periods indicated. The data has been derived from the unaudited consolidated condensed financial statements contained in this Quarterly Report on Form 10-Q. The operating results for any period should not be considered indicative of the results expected for any future period. This information should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2004. Three Months Ended March 31, Six Months Ended March 31, 2005 2004 2005 2004 ---------- ---------- ---------- ---------- REVENUE: Software licenses and subscriptions 64.7% 67.1% 64.0% 67.0% Maintenance and services 35.3% 32.9% 36.0% 33.0% ---------- ---------- ---------- ---------- Total Revenue 100.0% 100.0% 100.0% 100.0% ---------- ---------- ---------- ---------- COSTS AND EXPENSES: Cost of software licenses and subscriptions 11.1% 14.6% 11.4% 14.5% Cost of maintenance and services 16.5% 12.7% 17.2% 13.3% Sales and marketing 42.7% 37.6% 42.8% 36.4% Engineering and product development 10.7% 6.6% 10.8% 6.5% General and administrative 19.3% 20.5% 19.8% 21.9% ---------- ---------- ---------- ---------- Total costs and expenses 100.3% 92.0% 102.0% 92.6% ---------- ---------- ---------- ---------- (LOSS) INCOME FROM OPERATIONS (0.3)% 8.0% (2.0)% 7.4% Interest expense Interest income and other income (expense), net 0.4% (0.3)% 0.5% 0.0% ---------- ---------- ---------- ---------- INCOME (LOSS) BEFORE INCOME TAXES 0.1% 7.7% (1.5)% 7.4% Provision for income taxes 0.0% 0.0% 0.0% 0.1% ---------- ---------- ---------- ---------- NET INCOME (LOSS) 0.1% 7.7% (1.5)% 7.3% ========== ========== ========== ========== 18 COMPARISON OF THE THREE MONTHS ENDED MARCH 31, 2005 AND MARCH 31, 2004 TOTAL REVENUES The following table presents total revenue, change in total revenue and total revenue growth for the three months ended March 31, 2005 and 2004: Three Months Ended Percentage March 31, Increase Increase 2005 2004 (Decrease) (Decrease) ---------- ---------- -------- -------- Software licenses and subscriptions $3,307,340 $3,483,773 (176,433) (5.1)% Maintenance and services 1,801,407 1,710,830 90,577 5.3% ---------- ---------- -------- Total revenue $5,108,747 $5,194,603 $(85,856) (1.7)% ========== ========== ======== Software licenses and subscription revenue decreased by approximately $176,000 or 5.1% as compared to the three months ended March 31, 2004. The decrease was mainly in Datawatch|ES software license revenue. During the three months ended March 31, 2004 the Company recognized approximately $348,000 of previously deferred domestic software license revenue. Deferred software license revenue is the result of contractual obligations or liabilities that delay the recognition of revenue under the Company's revenue recognition policies. Such deferred software license revenue can result in significant quarter-to-quarter fluctuations in software license revenue. Maintenance and services revenues increased approximately $91,000 or 5.3% as compared to the three months ended March 31, 2004. This increase is primarily attributable to increases in service revenues from Datawatch|ES solutions. Additionally, the Datawatch|ES revenue includes iMergence iStore maintenance and services revenue of approximately $109,000 resulting from the inclusion of Mergence products subsequent to the Mergence acquisition. The Company attributes the increases in maintenance and services revenue resulting in increased demand for professional services. COSTS AND OPERATING EXPENSES The following table presents costs and operating expenses, changes in costs and operating expenses and costs and operating expenses growth for the three months ended March 31, 2005 and 2004: Three Months Ended Percentage March 31, Increase Increase 2005 2004 (Decrease) (Decrease) ---------- ---------- ---------- ---------- Costs of software licenses and subscriptions $ 566,311 $ 760,288 (193,977) (25.5)% Costs of maintenance and services 840,503 661,190 179,313 27.1% Sales and marketing expenses 2,183,138 1,954,977 228,161 11.7% Engineering and product development expenses 548,143 341,481 206,662 60.5% General and administrative expenses 986,836 1,066,726 (79,890) (7.5)% ---------- ---------- ---------- Total costs and operating expenses $5,124,931 $4,784,662 $ 340,269 7.1% ========== ========== ========== Cost of software licenses and subscriptions for the three months ended March 31, 2005 was 17% of software license and subscription revenues, as compared to 22% of software license revenues for the three months ended March 31, 2004. The decrease in costs of software licenses and subscriptions as a percentage of software licenses and subscription revenue is due to the decreasing amortization expense of capitalized software costs and the mix of selling more software products that were internally developed and such has no royalty expenses. Cost of maintenance and services for the three months ended March 31, 2005 was 47% of maintenance and service revenues, as compared to 39% for the three months ended March 31, 2004. Cost of maintenance and services as a 19 percentage of maintenance and service revenues increased for the three months ended March 31, 2005 when compared to the three months ended March 31, 2004, primarily due to the increase in headcount associated with consulting and training staff. During fiscal year 2004, the Company implemented a sales performance strategy, under which the Company increased the consulting staff as well as the Company's sales staff. The Company has also changed its sales model to sell products via a subscription term. As the Company begins to see a shift in selling more subscription term licenses, the revenues are recognized over future periods rather than at the point of sale and the professional services expenses and systems installation costs, were incurred in the quarter for the project work associated with the implementation of the systems for these customers. Revenues from subscription sales were not significant for the three months ended March 31, 2005. Sales and marketing expenses increased approximately $228,000, or 12%. This increase is primarily attributable to increased sales staff salaries and related expenses. During fiscal year 2004, the Company implemented a sales performance strategy to increase its sales and marketing team in order to focus on driving top line revenue growth. Engineering and product development expenses increased approximately $207,000 or 61%. This increase is primarily attributable to increased costs of approximately $172,000 in product development expenses resulting from the acquisition of the Datawatch Technologies subsidiary. The Company intends to transition some existing outsourced development activities in-house, but currently continues to use third-party development activities as well as in-house development. General and administrative expenses decreased approximately $80,000 or 8%. General and administrative expenses remained relatively consistent for the three months ended March 31, 2005. The Company's current estimate is that it will not be in a significant taxable position in any jurisdiction primarily as a result of the availability of loss carryforwards for which valuation allowances had previously been provided. At March 31, 2005, the Company had federal tax loss carryforwards available to offset future taxable income of approximately $5 million; a full valuation reserve has been established against these net deferred tax assets as uncertainty continues to exist regarding the Company's ability to generate sufficient future taxable income for the utilization of these losses. (See the section titled Critical Accounting Policies included elsewhere in this Part I, Item 2 for a further discussion of the Company's income tax policy.) Net income for the three months ended March 31, 2005 was approximately $7,000, which compares to net income of approximately $396,000 for the three months ended March 31, 2004. COMPARISON OF THE SIX MONTHS ENDED MARCH 31, 2005 AND MARCH 31, 2004 TOTAL REVENUES The following table presents total revenue, change in total revenue and total revenue growth for the six months ended March 31, 2005 and 2004: Six Months Ended Percentage March 31, Increase Increase 2005 2004 (Decrease) (Decrease) ---------- ---------- -------- -------- Software licenses and subscriptions $ 6,524,278 $6,437,669 86,609 1.3% Maintenance and services 3,671,797 3,164,022 507,775 16.0% Total revenue $10,196,075 $9,601,691 $594,384 6.2% Software licenses and subscription revenue increased by approximately $87,000 or 1.3% as compared to the six months ended March 31, 2004. The increase was mainly in Datawatch|ES and Visual|QSM subscription license revenue. Subscription revenue for Datawatch|ES and Visual|QSM product was $178,000 for the six months ended March 31, 2005 as compared to $7,000 for the six month ended March 31, 2004. 20 Maintenance and services revenues increased approximately $508,000 or 16% as compared to the six months ended March 31, 2004. This increase is primarily attributable to increases in both service revenues and maintenance revenues from Datawatch|ES and Desktop solutions. Additionally, the Datawatch|ES revenue includes iMergence iStore maintenance and services revenue of approximately $220,000 resulting from the inclusion of Mergence products subsequent to the Mergence acquisition. COSTS AND OPERATING EXPENSES The following table presents costs and operating expenses, changes in costs and operating expenses and costs and operating expenses growth for the six months ended March 31, 2005 and 2004: Six Months Ended Percentage March 31, Increase Increase 2005 2004 (Decrease) (Decrease) ---------- ---------- ---------- ---------- Costs of software licenses and subscriptions $ 1,160,226 $ 1,390,381 (230,155) (16.6)% Costs of maintenance and services 1,756,440 1,272,867 483,573 38.0% Sales and marketing expenses 4,361,538 3,493,928 867,610 24.8% Engineering and product development expenses 1,098,106 621,125 476,981 76.8% General and administrative expenses 2,015,910 2,102,627 (86,717) (4.1)% ----------- ----------- ----------- Total costs and operating expenses $10,392,220 $ 8,880,928 $ 1,511,292 17.0% =========== =========== =========== Cost of software licenses and subscriptions for the six months ended March 31, 2005 was 18% of software license and subscription revenues, as compared to 22% of software license revenues for the six months ended March 31, 2004. The decrease in costs of software licenses and subscriptions as a percentage of software licenses and subscription revenue is due to the decreasing amortization expense of capitalized software costs. Cost of maintenance and services for the six months ended March 31, 2005 was 48% of maintenance and service revenues, as compared to 40% for the six months ended March 31, 2004. Cost of maintenance and services as a percentage of maintenance and service revenues increased for the six months ended March 31, 2005 when compared to the six months ended March 31, 2004, primarily due to the increase in headcount associated with consulting and training staff. During Fiscal year 2004, the Company implemented a sales performance strategy and increased the consulting staff as well as the Company's sales staff. The Company has also changed its sales model to sell products via a subscription term. The Company begins to see a shift in selling more subscription term licenses, the revenues are recognized over future periods rather than at the point of sale and the extra professional services expenses and systems installation costs, were incurred in the quarter for the project work associated with the implementation of the systems for these customers. Revenues from subscription sales were not significant for the six months ended March 31, 2005. Sales and marketing expenses increased approximately $868,000, or 25%. This increase is primarily attributable to increased sales staff salaries and related expenses. Engineering and product development expenses increased approximately $477,000 or 77%. This increase is primarily attributable to increased costs of product development expenses resulting from the acquisition of the Datawatch Technologies subsidiary. Datawatch Technologies represented approximately $332,000 of this increase. General and administrative expenses decreased approximately $87,000 or 4%. General and administrative expenses remained relatively consistent for the six months ended March 31, 2005. Net (loss) for the six months ended March 31, 2005 was approximately $(147,000), which compares to net income of approximately $719,000 for the six months ended March 31, 2004. 21 OFF BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS The Company leases various facilities, equipment and automobiles in the U.S. and overseas under noncancelable operating leases that expire through 2009. The lease agreements generally provide for the payment of minimum annual rentals, pro rata share of taxes, and maintenance expenses. Rental expense for all operating leases was approximately $168,000 and $152,000 for the three months ended March 31, 2005 and 2004, respectively, and $330,000 and $301,000 for the six months ended March 31, 2005 and 2004, respectively. As of March 31, 2005, minimum rental commitments under noncancelable operating leases are as follows: Fiscal Year ----------- Remainder of 2005 $ 317,006 2006 196,884 2007 26,221 2008 13,909 2009 3,837 --------- Total minimum lease payments $ 557,857 ========= The Company is also committed to pay royalties ranging from 7% to 50% on revenue generated by the sale of certain licensed software products. Royalty expense included in cost of software licenses was approximately $375,000 and $495,000, respectively, for the three months ended March 31, 2005 and 2004, and $747,000 and $888,000 for the six months ended March 31, 2005 and 2004, respectively. The Company is not obligated to pay any minimum amounts for royalties. On August 11, 2004, the Company acquired 100% of the shares of Mergence Technologies Corporation. The purchase agreement includes a provision for quarterly cash payments to the former Mergence shareholders equal to 10% of revenue, as defined, of the Datawatch|Researcher product until September 30, 2010. The Company expensed approximately $10,400 for the three months ended March 31, 2005. See Note 2 to the Consolidated Condensed Financial Statements which appear elsewhere herein for more detailed financial information on the acquisition of Mergence. The Company's software products are sold under warranty against certain defects in material and workmanship for a period of 30 to 90 days from the date of purchase. If necessary, the Company would provide for the estimated cost of warranties based on specific warranty claims and claim history. However, the Company has never incurred significant expense under its product or service warranties. As a result, the Company believes the estimated fair value of these warranty agreements is minimal. Accordingly, there are no liabilities recorded for warranty claims as of March 31, 2005. The Company is required by the lease related to its Lowell, Massachusetts facility to provide a letter of credit in the amount of approximately $143,000 as a security deposit to provide credit support payment to the landlord of amounts due under the lease. Cash on deposit providing security in the amount of this letter of credit is classified as part of restricted cash in the Company's consolidated condensed balance sheets as of March 31, 2005 and September 30, 2004. In the August 2004 Stock Purchase Agreement for the acquisition of Mergence, the Company made certain warranties regarding, among other things, its legal authority to enter into the agreement consummating the acquisition and its ability to continue in its business. The Company further agreed to indemnify the sellers of Mergence and hold them harmless for any damages incurred or suffered arising out of any misrepresentation or breach of such warranties made by the Company in the agreement. The Company believes that no such misrepresentations or breaches of warranty exist, or are likely to exist in the future, and, accordingly, has recorded no liabilities related to such indemnification. The Company enters into indemnification agreements in the ordinary course of business. Pursuant to these agreements, the Company agrees to indemnify, hold harmless, and reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its customers, in connection with any patent, copyright or other intellectual property infringement claim by any third party with respect to the Company's products. The term of these indemnification 22 agreements is generally perpetual. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of March 31, 2005. Certain of the Company's agreements also provide for the performance of services at customer sites. These agreements may contain indemnification clauses, whereby the Company will indemnify the customer from any and all damages, losses, judgments, costs and expenses for acts of its employees or subcontractors resulting in bodily injury or property damage. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has general and umbrella insurance policies that would enable us to recover a portion of any amounts paid. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of March 31, 2005. As permitted under Delaware law, the Company has agreements with its directors whereby the Company will indemnify them for certain events or occurrences while the director is, or was, serving at the Company's request in such capacity. The term of the director indemnification period is for the later of ten years after the date that the director ceases to serve in such capacity or the final termination of proceedings against the director as outlined in the indemnification agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company's director and officer insurance policy limits the Company's exposure and enables it to recover a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. The Company has no liabilities recorded for these agreements as of March 31, 2005. LIQUIDITY AND CAPITAL RESOURCES The Company had net loss of approximately $(147,000) for the six months ended March 31, 2005 as compared to net income of approximately $719,000 for the six months ended March 31, 2004. During the six months ended March 31, 2005, approximately $(638,000) of cash was used by the Company's operations as compared to approximately $749,000 of cash provided by operations during the six months ended March 31, 2004. The main use of cash from operations for the six months ended March 31, 2005 was a result of the payment of Fiscal 2004 year end accrued expenses and accounts payables related to accounting fees, legal fees and year-end bonus amounts, as well as an increase in the accounts receivable balances due to the timing of invoicing and cash collections. Net cash used in investing activities for the six months ended March 31, 2005 of $(154,000) is primarily the result of the purchase of fixed assets. Net cash provided by financing activities for the six months ended March 31, 2005 of $12,000 is primarily the result of the cash received from the exercise of employee stock options. During fiscal 2004, the Company introduced a subscription sales model for the sale of its enterprise products. This new pricing model allows customers to begin using the Company's products at a lower initial cost of software acquisition when compared to the more traditional perpetual license sale. While this initiative is designed to increase the number of enterprise solutions sold and also reduce dependency on short-term sales by building a recurring revenue stream, it introduces increased risks for the Company primarily associated with the timing of revenue recognition and reduced cash flows. The subscription model delays revenue recognition when compared to the typical perpetual license sale and also, as the Company allows termination of certain subscriptions with 90 days notice, could result in decreased revenue for solutions sold under the model if the Company experiences a high percentage of subscription cancellations during the first two years of the subscription. Further, as amounts due from customers are invoiced over the life of the subscription, there are delayed cash flows from subscription sales when compared to perpetual license sales. The Mergence purchase agreement includes a provision for quarterly cash payments to the former Mergence shareholders equal to 10% of revenue, as defined, of the Datawatch|Researcher product for a period of six years. As the 23 cash payments are based on recognized revenue and no minimum payments are required, they are not expected to have a significant impact on the Company's liquidity or cash flows. See the section titled OFF BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS included elsewhere herein for a more complete disclosure of the Company's commitments and contingent liabilities. An existing agreement between Datawatch and Math Strategies grants the Company exclusive worldwide rights to use and distribute certain intellectual property owned by Math Strategies and incorporated by the Company in its Monarch, Monarch Data Pump, VorteXML and certain other products. In April 2004, the Company entered into an Option Purchase Agreement with Math Strategies giving the Company the option to purchase these intellectual property rights for $8,000,000. This option, if exercised, would provide the Company with increased flexibility to utilize the purchased technology in the future. The option can be exercised by Datawatch at any time during the two years following the effective date of the Option Purchase Agreement. Management believes that its current cash balances and cash generated from operations will be sufficient to meet the Company's cash needs for working capital and anticipated capital expenditures for at least the next twelve months. The Company does not currently anticipate any cash requirements, during that time, to fund significant growth, capital expenditures or the acquisition of complementary technology or businesses. However, if in the future, such expenditures are anticipated or required, the Company may need to seek additional financing by issuing equity or obtaining credit facilities to fund such requirements. Management believes that the Company's current operations have not been materially impacted by the effects of inflation. RECENT ACCOUNTING PRONOUNCEMENTS On December 16, 2004, the FASB issued SFAS No. 123R, SHARE-BASED PAYMENT ("SFAS No. 123R"). This Statement is a revision of SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, and supersedes Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and its related implementation guidance. SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The Statement requires entities to recognize stock compensation expense for awards of equity instruments to employees based on the grant-date fair value of those awards (with limited exceptions). On April 14, 2005, the Securities and Exchange Commission adopted a rule amending SFAS 123(R) "SHARE-BASED PAYMENT" deferring the effective date of SFAS 123(R) for public companies to fiscal years beginning after June 15, 2005. We are evaluating the two methods of adoption allowed by SFAS No. 123R; the modified-prospective transition method and the modified-retrospective transition method. 24 RISK FACTORS The Company does not provide forecasts of its future financial performance. However, from time to time, information provided by the Company or statements made by its employees may contain "forward looking" information that involves risks and uncertainties. In particular, statements contained in this Quarterly Report on Form 10-Q that are not historical facts (including, but not limited to statements contained in "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations" of Part I of this Quarterly Report on Form 10-Q relating to liquidity and capital resources) may constitute forward looking statements and are made under the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. The Company cautions readers not to place undue reliance on any such forward looking-statements, which speak only as of the date they are made. The Company disclaims any obligation, except as specifically required by law and the rules of the Securities and Exchange Commission, to publicly update or revise any such statements to reflect any change in the Company's expectations or in events, conditions or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forward-looking statements. The Company's actual results of operations and financial condition have varied and may in the future vary significantly from those stated in any forward looking statements. Factors that may cause such differences include, without limitation, the risks, uncertainties and other information discussed below and within this Quarterly Report on Form 10-Q, as well as the accuracy of the Company's internal estimates of revenue and operating expense levels. The following discussion of the Company's risk factors should be read in conjunction with the financial statements contained herein and related notes thereto. Such factors, among others, may have a material adverse effect upon the Company's business, results of operations and financial condition. Subscription Sales Model Risk During fiscal 2004, the Company introduced a subscription sales model for the sale of its enterprise products. This new pricing model allows customers to begin using the Company's products at a lower initial cost of software acquisition when compared to the more traditional perpetual license sale. While this initiative is designed to increase the number of enterprise solutions sold and also reduce dependency on short-term sales by building a recurring revenue stream, it introduces increased risks for the Company primarily associated with the timing of revenue recognition and reduced cash flows. The subscription model delays revenue recognition when compared to the typical perpetual license sale and also, as the Company allows termination of certain subscriptions with 90 days notice, could result in decreased revenue for solutions sold under the model if the Company experiences a high percentage of subscription cancellations during the first two years of the subscription. Further, as amounts due from customers are invoiced over the life of the subscription, there are delayed cash flows from subscription sales when compared to perpetual license sales. Fluctuations in Quarterly Operating Results The Company's future operating results could vary substantially from quarter-to-quarter because of uncertainties and/or risks associated with such things as technological change, competition, and delays in the introduction of products or product enhancements and general market trends. Historically, the Company has operated with little backlog of orders because its software products are generally shipped as orders are received. As a result, net sales in any quarter are substantially dependent on orders booked and shipped in that quarter. Further, the Company's introduction of the subscription sales model could result in decreased revenues over the short term. Because the Company's staffing and operating expenses are based on anticipated revenue levels and a high percentage of the Company's costs are fixed in the short-term, small variations in the timing of revenues can cause significant variations in operating results from quarter-to-quarter. Because of these 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 indications of future performance. There can be no assurance that the Company will not experience such variations in operating results in the future or that such variations will not have a material adverse effect on the Company's business, financial condition or results of operation. Weakening of World Wide Economic Conditions and the Computer Software Market May Result in Lower Revenue Growth Rates or Decreased Revenues The revenue growth and profitability of the Company's business depends on the overall demand for computer software and services, particularly in the markets in which it competes. Because the Company's sales are primarily to major 25 corporate customers, its business also depends on general economic and business conditions. A softening of demand for computer software and services caused by a weakening of the economy in the United States or abroad, may result in lower revenue growth rates, decreased revenues and reduced profitability. In addition, terrorist attacks against the United States, and the United States military response to these attacks have added to economic and political uncertainty which may adversely affect worldwide demand for computer software and services and result in significant fluctuations in the value of foreign currencies. In a weakened economy, the Company cannot be assured that it will be able to effectively promote future growth in its software and services revenues or maintain profitability. Dependence on Principal Products In the six months ended March 31, 2005, Monarch, Visual|QSM and Visual|HD, and Datawatch|ES accounted for approximately 56%, 29% and 15%, respectively, of the Company's total revenue. The Company is wholly dependent on the Monarch, Visual|QSM, Visual|HD, Datawatch|ES and the recently acquired Datawatch|Researcher products. As a result, any factor adversely affecting sales of any of these products could have a material adverse effect on the Company. The Company's future financial performance will depend in part on the successful introduction of its new and enhanced versions of these products and development of new versions of these and other products and subsequent acceptance of such new and enhanced products. In addition, competitive pressures or other factors may result in significant price erosion that could have a material adverse effect on the Company's business, financial condition, results of operations, or cash flows. International Sales In the six months ended March 31, 2005, and fiscal years 2004 and 2003, international sales, including export sales from domestic operations, accounted for approximately 42%, 41% and 39%, respectively, of the Company's total revenue. The Company anticipates that international sales will continue to account for a significant percentage of its total revenue. A significant portion of the Company's total revenue will therefore be subject to risks associated with international sales, including unexpected changes in legal and regulatory requirements, changes in tariffs, exchange rates and other barriers, political and economic instability, possible effects of war and acts of terrorism, difficulties in account receivable collection, difficulties in managing distributors or representatives, difficulties in staffing and managing international operations, difficulties in protecting the Company's intellectual property overseas, seasonality of sales and potentially adverse tax consequences. Acquisition Strategy As evidenced by its August 2004 acquisition of Mergence Technologies Corporation and its October 2002 acquisition of Auxilor Inc., the Company continues to address the need to develop new products, in part, through the acquisition of other companies. Acquisitions involve numerous risks including difficulties in the assimilation of the operations, technologies and products of the acquired companies, the diversion of management's attention from other business concerns, risks of entering markets in which the Company has no or limited direct prior experience and where competitors in such markets have stronger market positions, and the potential loss of key employees of the acquired company. Achieving and maintaining the anticipated benefits of an acquisition will depend in part upon whether the integration of the companies' business is accomplished in an efficient and effective manner, and there can be no assurance that this will occur. The successful combination of companies in the high technology industry may be more difficult to accomplish than in other industries. Dependence on New Introductions; New Product Delays Growth in the Company's business depends in substantial part on the continuing introduction of new products. The length of product life cycles depends in part on end-user demand for new or additional functionality in the Company's products. If the Company fails to accurately anticipate the demand for, or encounters any significant delays in developing or introducing, new products or additional functionality on its products, there could be a material adverse effect on the Company's business. Product life cycles can also be affected by the introduction by suppliers of operating systems of comparable functionality within their products. The failure of the Company to anticipate the introduction of additional functionality in products developed by such suppliers could have a material adverse effect on the Company's business. In addition, the Company's competitors may introduce products with more features and lower prices than the Company's 26 products. Such increase in competition could adversely affect the life cycles of the Company's products, which in turn could have a material adverse effect on the Company's business. Software products may contain undetected errors or failures when first introduced or as new versions are released. There can be no assurance that, despite testing by the Company and by current and potential end-users, errors will not be found in new products after commencement of commercial shipments, resulting in loss of or delay in market acceptance. Any failure by the Company to anticipate or respond adequately to changes in technology and customer preferences, or any significant delays in product development or introduction, could have a material adverse effect on the Company's business. Rapid Technological Change The markets in which the Company competes have undergone, and can be expected to continue to undergo, rapid and significant technological change. The ability of the Company to grow will depend on its ability to successfully update and improve its existing products and market and license new products to meet the changing demands of the marketplace and that can compete successfully with the existing and new products of the Company's competitors. There can be no assurance that the Company will be able to successfully anticipate and satisfy the changing demands of the personal computer software marketplace, that the Company will be able to continue to enhance its product offerings, or that technological changes in hardware platforms or software operating systems, or the introduction of a new product by a competitor, will not render the Company's products obsolete. Competition in the PC Software Industry The software market for personal computers is highly competitive and characterized by continual change and improvement in technology. Several of the Company's existing and potential competitors, including BMC Software, Actuate Corporation, Mobius Management Systems, Inc., and others, have substantially greater financial, marketing and technological resources than the Company. No assurance can be given that the Company will have the resources required to compete successfully in the future. Dependence on Proprietary Software Technology The Company's success is dependent upon proprietary software technology. Although the Company does not own all patents on any such technology, it does hold exclusive licenses to such technology and relies principally on a combination of trade secret, copyright and trademark laws, nondisclosure and other contractual agreements and technical measures to protect its rights to such proprietary technology. Despite such precautions, there can be no assurance that such steps will be adequate to deter misappropriation of such technology. Reliance on Software License Agreements Substantially all of the Company's products incorporate third-party proprietary technology which is generally licensed to the Company on an exclusive, worldwide basis. Failure by such third-parties to continue to develop technology for the Company and license such technology to the Company could have a material adverse effect on the Company's business and results of operations. Dependence on the Ability to Hire and Retain Skilled Personnel Qualified personnel are in great demand throughout the software industry. The Company's success depends, in large part, upon its ability to attract, train, motivate and retain highly skilled employees, particularly, technical personnel and product development and professional services personnel, sales and marketing personnel and other senior personnel. The Company's failure to attract and retain the highly trained technical personnel that are integral to the Company's product development, professional services and direct sales teams may limit the rate at which the Company can generate sales and develop new products or product enhancements. A change in key management could result in transition and attrition in the affected department. This could have a material adverse effect on the Company's business, operating results and financial condition. 27 Indirect Distribution Channels The Company sells a significant portion of its products through resellers, none of which are under the direct control of the Company. The loss of major resellers of the Company's products, or a significant decline in their sales, could have a material adverse effect on the Company's operating results. There can be no assurance that the Company will be able to attract or retain additional qualified resellers or that any such resellers will be able to effectively sell the Company's products. The Company seeks to select and retain resellers on the basis of their business credentials and their ability to add value through expertise in specific vertical markets or application programming expertise. In addition, the Company relies on resellers to provide post-sales service and support, and any deficiencies in such service and support could adversely affect the Company's business. Volatility of Stock Price As is frequently the case with the stocks of high technology companies, the market price of the Company's common stock has been, and may continue to be, volatile. Factors such as quarterly fluctuations in results of operations, increased competition, the introduction of new products by the Company or its competitors, expenses or other difficulties associated with assimilating companies acquired by the Company, changes in the mix of sales channels, the timing of significant customer orders, and macroeconomic conditions generally, may have a significant impact on the market price of the stock of the Company. Any shortfall in revenue or earnings from the levels anticipated by securities analysts could have an immediate and significant adverse effect on the market price of the Company's common stock in any given period. In addition, the stock market has from time to time experienced extreme price and volume fluctuations, which have particularly affected the market price for many high technology companies and which, on occasion, have appeared to be unrelated to the operating performance of such companies. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ---------------------------------------------------------- Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments At March 31, 2005, the Company did not participate in any derivative financial instruments, or other financial and commodity instruments. The Company holds no investment securities that possess significant market risk. Primary Market Risk Exposures The Company's primary market risk exposure is in the area of foreign currency exchange rate risk. The Company's exposure to currency exchange rate fluctuations has been and is expected to continue to be modest due to the fact that the operations of its international subsidiaries are almost exclusively conducted in their respective local currencies, and dollar advances to the Company's international subsidiaries, if any, are usually considered to be of a long-term investment nature. Therefore, the majority of currency movements are reflected in the Company's other comprehensive loss. There are, however, certain situations where the Company will invoice customers in currencies other than its own. Such gains or losses, whether realized or unrealized, are reflected in income. These have not been material in the past nor does management believe that they will be material in the future. Currently the Company does not engage in foreign currency hedging activities. ITEM 4. INTERNAL CONTROLS AND PROCEDURES -------------------------------- The principal executive officer and principal financial officer, with the participation of the Company's management, evaluated the effectiveness of the Company's "disclosure controls and procedures" (as defined in Exchange Act Rule 13(a)-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, they have concluded that, as of the end of the period covered by this Quarterly Report on Form 10-Q, the Company's disclosure controls and procedures are operating in an effective manner and are designed to ensure that information required to be disclosed in the Company's filings and submissions under the Securities and Exchange Act of 1934 is accumulated and communicated to management, including the Company's principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure, and is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. It should be noted that any system of controls is designed to 28 provide reasonable, but not absolute, assurances that the system will achieve its stated goals under all reasonably foreseeable circumstances. The Company's principal executive officer and principal financial officer have concluded that the Company's disclosure controls and procedures are effective at a level that provides such reasonable assurances. There were no changes in the Company's internal controls over financial reporting, or in other factors that could significantly affect these controls, during the fiscal quarter to which this report relates that materially affected, or are reasonably likely to materially affect, the Company's internal controls over financial reporting. 29 PART II. OTHER INFORMATION Item 1. Legal Proceedings ----------------- In May 2004, the Company was served with a charge of discrimination filed with the Massachusetts Commission Against Discrimination (MCAD) by a current employee. In addition to the Company, the employee named an executive of the Company as well as the employee's former supervisor as defendants. The employee alleged that her former supervisor engaged in sexually harassing conduct. The employee accused the executive of engaging in retaliation upon learning of the employee's complaint. The complaint was withdrawn from the MCAD in August 2004, with the stated intent of pursuing the claim in Superior Court in the state of Massachusetts. To date, the Company has not been notified of any further filing. Given the early stage and current status of the claim, the Company is unable to predict the ultimate outcome. The Company intends to vigorously defend the claims. From time to time, the Company receives other claims and may be party to other actions that arise in the normal course of business. Other than as noted above, the Company does not believe the eventual outcome of any other pending matters will have a material effect on the Company's consolidated condensed financial condition or results of operations. Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- A. The Annual Meeting of Stockholders of Datawatch Corporation was held on March 11, 2005. B. The directors elected at the meeting are Robert W. Hagger, Thomas H. Kelly, Richard de J. Osborne, Terry W. Potter, David T. Riddiford and James Wood, which constitute all of the directors of the Company. C. A vote was proposed to elect the following nominees to the Board of Directors to serve for the ensuing year or until their respective successor are duly elected and qualified: ------------------------- ------------------- ------------------------ ------------------------ Nominee Total Vote For: Total Votes Against: Total Vote Abstaining: ------------------------- ------------------- ------------------------ ------------------------ Robert W. Hagger 5,082,193 0 111,412 ------------------------- ------------------- ------------------------ ------------------------ Thomas H. Kelly 5,082,193 0 111,412 ------------------------- ------------------- ------------------------ ------------------------ Richard de J. Osborne 5,081,451 0 112,154 ------------------------- ------------------- ------------------------ ------------------------ Terry W. Potter 5,081,451 0 112,154 ------------------------- ------------------- ------------------------ ------------------------ David T. Riddiford 5,077,195 0 116,410 ------------------------- ------------------- ------------------------ ------------------------ James Wood 5,081,251 0 112,354 ------------------------- ------------------- ------------------------ ------------------------ D. No information provided due to inapplicability of item. Item 6. Exhibits -------- 31.1 Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 30 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 on May 10, 2005. DATAWATCH CORPORATION /s/ Robert W. Hagger --------------------------- Robert W. Hagger. President, Chief Executive Officer, and Director (Principal Executive Officer) /s/ John J. Hulburt --------------------------- John J. Hulburt Vice President of Finance and Chief Financial Officer (Principal Financial Officer) 31