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 June 30, 1998 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to --------- -------- Commission File Number 0-16439 FAIR, ISAAC AND COMPANY, INCORPORATED (Exact name of registrant as specified in its charter) DELAWARE 94-1499887 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 120 North Redwood Drive, San Rafael, California 94903 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (415) 472-2211 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 ____. The number of shares of Common Stock, $0.01 par value per share, outstanding on August 6, 1998, was 13,963,873.
<TABLE> TABLE OF CONTENTS <CAPTION> Page PART I. FINANCIAL INFORMATION <S> <C> ITEM 1. Financial Statements.............................................................. 3 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................................................. 9 PART II. OTHER INFORMATION ITEM 6. Exhibits and Reports on Form 8-K.................................................. 15 SIGNATURES..................................................................................... 16 EXHIBIT INDEX.................................................................................. 17 </TABLE> 2
<TABLE> PART I - FINANCIAL INFORMATION ITEM 1. Financial Statements. FAIR, ISAAC AND COMPANY, INCORPORATED CONSOLIDATED BALANCE SHEETS June 30, 1998 and September 30, 1997 <CAPTION> (dollars in thousands) June 30 September 30 --------- ------------ <S> <C> <C> ASSETS Current assets: Cash and cash equivalents $ 16,757 $ 13,209 Short-term investments 13,742 6,108 Accounts receivable, net 37,831 36,147 Unbilled work in progress 20,568 18,176 Prepaid expenses and other current assets 7,737 3,673 Deferred income taxes 4,383 4,517 --------- --------- Total current assets 101,018 81,830 Long-term investments 17,482 13,261 Property and equipment, net 37,078 34,486 Intangibles, net 10,636 8,361 Deferred income taxes 3,369 3,369 Other assets 3,578 3,921 --------- --------- $ 173,161 $ 145,228 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable and other accrued liabilities $ 12,516 $ 8,228 Accrued compensation and employee benefits 19,902 19,160 Billings in excess of earned revenues 8,438 6,346 Capital lease obligations 409 369 --------- --------- Total current liabilities 41,265 34,103 Other liabilities 7,330 6,753 Capital lease obligations 895 1,183 --------- --------- Total liabilities 49,490 42,039 --------- --------- Stockholders' equity: Preferred stock --------- --------- Common stock 139 135 Paid in capital in excess of par value 31,235 26,025 Retained earnings 92,484 77,453 Less treasury stock (11,097 shares at cost at 6/30/98; 12,114 at 9/30/97) (397) (433) Cumulative translation adjustments (284) (308) Unrealized gains on investments 494 317 --------- --------- Total stockholders' equity 123,671 103,189 --------- --------- $ 173,161 $ 145,228 ========= ========= <FN> See accompanying notes to the consolidated financial statements. </FN> </TABLE> 3
<TABLE> FAIR, ISAAC AND COMPANY, INCORPORATED CONSOLIDATED STATEMENTS OF INCOME <CAPTION> For the nine month and three month periods ended June 30, 1998 and 1997 (dollars in thousands, except per share data) Nine Months Ended Three Months Ended June 30 June 30 -------------------------- -------------------------- 1998 1997 1998 1997 ---- ---- ---- ---- <S> <C> <C> <C> <C> Revenues $ 177,808 $ 142,777 $ 64,642 $ 51,074 Costs and expenses: Cost of revenues 63,746 52,912 22,114 18,715 Sales and marketing 26,612 21,265 9,283 8,061 Research and development 20,925 12,755 6,945 5,013 General and administrative 38,822 29,743 14,707 10,750 Amortization of intangibles 982 961 406 306 ----------- ----------- ----------- ----------- Total costs and expenses 151,087 117,636 53,455 42,845 ----------- ----------- ----------- ----------- Income from operations 26,721 25,141 11,187 8,229 Other income (expense), net 518 (1,218) (21) (885) ----------- ----------- ----------- ----------- Income before income taxes 27,239 23,923 11,166 7,344 Provision for income taxes 11,385 9,561 4,767 3,050 ----------- ----------- ----------- ----------- Net income $ 15,854 $ 14,362 $ 6,399 $ 4,294 =========== =========== =========== =========== Earnings per share: Diluted $ 1.11 $ 1.01 $ .45 $ .30 =========== =========== =========== =========== Basic $ 1.16 $ 1.08 $ .46 $ .32 =========== =========== =========== =========== Shares used in computing earnings per share: Diluted 14,340,000 14,282,000 14,359,000 14,325,000 =========== =========== =========== =========== Basic 13,696,000 13,349,000 13,894,000 13,395,000 =========== =========== =========== =========== <FN> See accompanying notes to the consolidated financial statements. </FN> </TABLE> 4
<TABLE> FAIR, ISAAC AND COMPANY, INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS <CAPTION> For the nine months ended June 30, 1998 and 1997 (dollars in thousands) Nine Months Ended June 30 ------------------ 1998 1997 ---- ---- <S> <C> <C> Cash flows from operating activities: Net income $ 15,854 $ 14,362 Adjustments to reconcile net income to cash provided by operating activities: Depreciation and amortization 11,125 8,793 Deferred compensation 408 -- Gain on sale of investment (165) -- Equity loss in investment 8 1,618 Deferred income taxes 311 (16) Change to reflect change in Risk Management Technologies fiscal year -- (214) Changes in operating assets and liabilities: Increase in accounts receivable (1,660) (3,340) Increase in unbilled work in progress (2,392) (5,266) Increase in prepaid expenses and other assets (4,064) (2,245) Decrease (increase) in other assets 343 (551) Increase in accounts payable and other accrued liabilities 4,835 596 Increase (decrease) in accrued compensation and employee benefits 2,149 (801) Increase in billings in excess of earned revenues 2,092 1,823 Increase (decrease) in other liabilities (47) 2,312 -------- -------- Net cash provided by operating activities 28,797 17,071 -------- -------- Cash flows from investing activities: Purchases of property and equipment (11,447) (16,410) Proceeds from sale of property and equipment -- 340 Payments for acquisitions of subsidiaries (3,146) (78) Purchases of investments (16,708) (8,615) Proceeds from maturities of investments 5,010 7,493 -------- -------- Net cash used by investing activities (26,291) (17,270) -------- -------- Cash flows from financing activities: Principal payments of capital lease obligations (288) (263) Issuance of common stock 2,181 779 Dividends paid (823) (759) Repurchase of company stock (28) (232) -------- -------- Net cash provided (used) by financing activities 1,042 (475) -------- -------- Increase (decrease) in cash and cash equivalents 3,548 (674) Cash and cash equivalents, beginning of period 13,209 _11,487 -------- -------- Cash and cash equivalents, end of period $ 16,757 $ 10,813 ======== ======== <FN> See accompanying notes to the consolidated financial statements. </FN> </TABLE> 5
<TABLE> FAIR, ISAAC AND COMPANY, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS <CAPTION> Note 1 Earnings Per Share The following reconciles the numerators and denominators of diluted and basic earnings per share (EPS): Nine months ended June 30, Three months ended June 30, (dollars in thousands, except per share data) 1998 1997 1998 1997 - ----------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Numerator - Net income $ 15,854 $ 14,362 $ 6,399 $ 4,294 ======== ======== ======== ======== Denominator - Shares: Diluted weighted-average shares and assumed conversions 14,340 14,282 14,359 14,325 of stock options Effect of dilutive securities - employee stock options (644) (933) (465) (930) -------- -------- -------- -------- Basic weighted-average shares 13,696 13,349 13,894 13,395 ======== ======== ======== ======== Earnings per share: Diluted $ 1.11 $ 1.01 $ .45 $ .30 ======== ======== ======== ======== Basic $ 1.16 $ 1.08 $ .46 $ .32 ======== ======== ======== ======== </TABLE> Total options outstanding included 959,000 and 361,000 options to purchase shares of common stock at prices ranging from $36.50 to $45.63 and $38.25 to $41.88 at June 30, 1998 and 1997, respectively. These options were not included in the computation of diluted EPS because the exercise price for such options was greater than the average market price of the common shares for the nine and three months ended June 30, 1998 and 1997. Note 2 Cash Flow Statement Supplemental disclosure of cash flow information: Nine months ended June 30, (dollars in thousands) 1998 1997 - -------------------------------------------------------------------------------- Income tax payments $12,489 $13,121 Interest paid $ 89 $ 246 Non-cash investing and financing activities: Issuance of common stock to ESOP $ 1,323 $ 969 Tax benefit of stock options $ 1,171 $ --- Purchase of CRMA with common stock $ 111 $ --- Vesting of restricted stock $ 84 $ --- Capital lease obligations $ 40 $ --- Contributions of treasury stock to ESOP $ --- $ 499 6
Note 3 Merger In July 1997, the Company issued 1,252,665 shares of its common stock (including 544,218 shares underlying options assumed by the Company) in connection with the merger with Risk Management Technologies (RMT). The acquisition has been accounted for under the pooling-of-interests method. Accordingly, the financial statements have been restated for all prior periods to include RMT. Further, all common share and per share data have been restated for prior periods. RMT previously used the fiscal year ended December 31 for its financial reporting. RMT's operating results for the year ended December 31, 1996 are included in the accompanying balance sheet at September 30, 1997 in the line item retained earnings. The statement of income's comparative 1997 results reflect the operations of the Company and RMT for the nine-month period ended June 30, 1997. Accordingly, the duplication of RMT's net income for the three months ended December 31, 1996, has been adjusted by a $214,000 charge to retained earnings in fiscal 1997. Note 4 Accounting Pronouncements In June 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 130, "Reporting Comprehensive Income." SFAS No. 130 established standards for reporting comprehensive income and its components in financial statements. This statement requires that all items which are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income is equal to net income plus the change in "other comprehensive income." SFAS No. 130 requires that an entity: (a) classify items of other comprehensive income by their nature in a financial statement, and (b) report the accumulated balance of other comprehensive income separately from common stock and retained earnings in the equity section of the statement of financial position. This statement is effective for financial statements issued for fiscal years beginning after December 15, 1997. Beginning with fiscal year 1999, management intends to conform its consolidated financial statements to this pronouncement. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement establishes standards for publicly held entities to follow in reporting information about operating segments in annual financial statements and requires that those entities report selected information about operating segments in interim financial statements. This statement also establishes standards for related disclosures about products and services, geographic areas and major customers. This statement is effective for financial statements issued for fiscal years beginning after December 15, 1997. Beginning with fiscal year 1999, management intends to conform its consolidated financial statements to this pronouncement. In October 1997, the American Institute of Certified Public Accountants issued Statement of Position (SOP) No. 97-2, "Software Revenue Recognition," which supersedes SOP 91-1. The Company will be required to adopt SOP 97-2 for software transactions entered into beginning October 1, 1998, and retroactive application to years prior to adoption is prohibited. SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements (i.e., software products, upgrades/enhancements, postcontract customer support, installation, training, etc.) to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on evidence which is specific to the vendor. The revenue allocated to software products (including specified upgrades/enhancements) generally is recognized upon delivery of the products. The revenue allocated to postcontract customer support generally is recognized ratably over the term of the support and revenue allocated to service elements (such as training and installation) generally is recognized as the services are performed. If a vendor does not have evidence of the fair value for all elements in a multiple-element arrangement, all revenue from the arrangement is deferred until such evidence exists or until all elements are delivered. The Company's management anticipates that the adoption of SOP 97-2 will not have a material impact on the Company's results of operations. Beginning with fiscal year 1999, management intends to conform its consolidated financial statement to this pronouncement. In February, 1998, the FASB issued SFAS No. 132, "Employers' Disclosure about Pensions and Other Postretirement Benefits." The statement standardizes the disclosure requirements for pension and other postretirement benefits. This statement is effective for financial statements issued for fiscal years beginning after December 15, 1997. The Company is currently evaluating the impact of the disclosure. 7
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the statement of financial position and measure them at fair value. This statement is effective for all quarters of fiscal years beginning after June 15, 1999. As of June 30, 1998, the Company did not have any derivative instruments or engage in hedging activities. Note 5 Leases In May, 1998, the Company entered into a synthetic lease agreement to lease undeveloped land in San Rafael, California and improvements comprising the first phase of an office complex facility to be constructed on the land. A synthetic lease is asset-based financing structured to be treated as a lease for accounting purposes but as a loan for tax purposes. The office complex facility is intended to accommodate the future growth of the Company. The Company had exercised an option (the "Option") to purchase the undeveloped land in December, 1997, at an approximate cost of $9.35 million plus certain other costs incurred by the seller as defined in the Option agreement. The Option was assigned to the lessor under the synthetic lease. The lessor under the synthetic lease has committed to spend up to $55 million for the purchase of the land and construction of this first phase of the facility, and the Company will act as construction agent for the lessor. The lease term began as of May, 1998 and continue thereafter for five years. Rent payments will commence on the completion of construction which is expected to occur in January, 2001. With the approval of the lessor, the Company may extend the lease term for up to three one-year periods or one three-year period. The Company has the option either to purchase the entire facility at a purchase price approximating lessor's then accumulated total costs or only certain portions of the facility at a pre-set price, at any time during the term or, at the expiration of the lease term, to cause the facility to be sold to a third party. 8
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations General Fair, Isaac and Company, Incorporated, provides products and services designed to help a variety of businesses use data to make better decisions on their customers, prospective customers and existing portfolios. The Company's products include statistically derived, rule-based analytical tools, software designed to implement those analytical tools and consulting services to help clients use and track the performance of those tools. The Company also provides a range of credit scoring and credit account management services in conjunction with credit bureaus and credit card processing agencies. Its DynaMark subsidiary provides data processing and database management services to businesses engaged in direct marketing activities, many of which are in the credit and insurance industries. On July 21, l997, the Company acquired Risk Management Technologies (RMT), a privately held company which provides enterprise-wide risk management and performance measurement solutions to major financial institutions. The Company's historical financial statements for prior periods have been restated to account for the Company's merger with RMT on a pooling-of-interests basis. The Company is organized into business units that correspond to its principal markets: consumer credit, insurance, direct marketing (DynaMark), enterprise-wide financial risk management (RMT) and a new unit, healthcare information. Sales to the consumer credit industry have traditionally accounted for the bulk of the Company's revenues. Products developed specifically for a single user in this market are generally sold on a fixed-price basis. Such products include application and behavior scoring algorithms (also known as "analytic products" or "scorecards"), credit application processing systems (ASAP(TM) and CreditDesk(R)) and custom credit account management systems, including those marketed under the name TRIAD(TM). Software systems usually also have a component of ongoing maintenance revenue, and CreditDesk systems have also been sold under time- or volume-based price arrangements. Credit scoring and credit account management services sold through credit bureaus and third-party credit card processors are generally priced based on usage. Products sold to the insurance industry are generally priced based on the number of policies in force, subject to contract minimums. DynaMark and RMT employ a combination of fixed-fee and usage-based pricing, and the Healthcare Information unit intends to employ a combination of fixed-fee and usage-based pricing for its products. This discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and Notes. In addition to historical information, this report includes certain forward-looking statements regarding events and trends that may affect the Company's future results. Such statements are subject to risks and uncertainties that could cause the Company's actual results to differ materially. Such factors include, but are not limited to, those described in this discussion and analysis. 9
Results of Operations Revenues <TABLE> The following table sets forth for the fiscal periods indicated (a) the percentage of revenues represented by fixed-price and usage-priced revenues from the Credit business unit, and the percentage of revenues contributed by the DynaMark, RMT, Insurance and Healthcare Information business units; and (b) the percentage change in revenues within each category from the corresponding period in the prior fiscal year. Fixed-price revenues from the Credit business unit include all revenues from custom scorecard, software and consulting projects. Most credit usage revenues are generated through third-party alliances such as those with credit bureaus and third-party credit card processors. In addition, some credit scorecards and software products are licensed under volume-based fee arrangements and these are included in usage-priced revenues. <CAPTION> Percentage of Percentage of Revenue Revenue Three Months Ended Percentage Nine Months Ended Percentage June 30, Change June 30, Change ------------------ ---------- ----------------- ---------- 1998 1997 1998 1997 ---- ---- ---- ---- <S> <C> <C> <C> <C> <C> <C> Credit Fixed-price 25% 28% 12% 25% 29% 8% Usage-priced 48% 47% 29% 48% 49% 24% DynaMark 21% 17% 55% 20% 15% 63% RMT 2% 4% (29)% 3% 4% (13%) Insurance 4% 3% 70% 4% 3% 52% Healthcare Information <1% 1% (57)% <1% <1% 17% ---- ---- ---- ---- Total revenues 100% 100% 27% 100% 100% 25% ==== ==== ==== ==== </TABLE> The increase in fixed-price credit revenues in the quarter ended June 30, 1998 and in the nine months ended June 30, 1998 was due primarily to increased revenues from Credit and Risk Management Associates, Inc. (CRMA), a subsidiary acquired in September 1996; sales of credit application scorecards and credit application processing software; and its end-user credit account management systems ("TRIAD") and behavior scoring projects. CRMA's revenues were up 47 percent in the quarter and 85 percent in the nine months ended June 30, 1998, compared with the same periods of the prior fiscal year. Compared with the same periods of fiscal 1997, revenues from sales of credit application scorecards and credit application processing software increased by approximately 17 percent in the quarter and by 12 percent in the nine months ended June 30, 1998. Revenues from end-user credit account management systems ("TRIAD") and behavior scoring projects in the three- and nine-month periods ended June 30, 1998, were up 42 percent and 28 percent, respectively, from the same periods of fiscal 1997 due primarily to the release of the new version of TRIAD software. The increase in usage revenues from the Credit business unit in the quarter and nine-months ended June 30, 1998, compared with the same periods the prior year, was due to continuing growth in (a) usage of the Company's scoring services distributed through the three major credit bureaus in the United States and (b) the number of bankcard accounts being managed by the Company's account management services delivered through third-party processors. Revenues from the credit bureau scoring services in the nine-months ended June 30, 1998, were approximately 24 percent higher than in the first nine months of fiscal 1997; approximately one-twelfth of this increase was due to the recognition of usage revenue pertaining to prior fiscal years from settlement of audits with alliance partners. Revenues from credit account management services delivered through third-party processors in the most recent three months were 17 percent higher than in the corresponding period of fiscal 1997. Revenues from credit bureau-related services have increased rapidly in each of the last three fiscal years and accounted for approximately 35 percent of revenues in fiscal 1997. Revenues from services provided through bankcard processors also increased in each of these years, due primarily to increases in the number of accounts at each of the major processors. 10
Revenues derived from alliances with credit bureaus and credit card processors have accounted for much of the Company's revenue growth and improvement in operating margins over the last three fiscal years. While the Company has been very successful in extending or renewing such agreements in the past, and believes it will generally be able to do so in the future, the loss of one or more such alliances could have a significant impact on revenues and operating margin. Revenues generated through the Company's alliances with Equifax, Inc., Experian Information Solutions, Inc. (formerly TRW Information Systems & Services), and Trans Union Corporation each accounted for approximately eight to ten percent of the Company's total revenues in fiscal 1996 and 1997. On November 14, 1996, it was announced that Experian had been acquired by CCN Group Ltd., a subsidiary of Great Universal Stores, PLC. CCN is the Company's largest competitor, worldwide, in the area of credit scoring. TRW/Experian has offered scoring products developed by CCN in competition with those of the Company for several years. The acquisition has had no apparent impact on the Company's revenues from Experian. On September 30, 1997, amendments to the federal Fair Credit Reporting Act became effective. The Company believes these changes to the federal law regulating credit reporting will be favorable to the Company and its clients. Among other things, the new law expressly permits the use of credit bureau data to prescreen consumers for offers of credit and insurance and allows affiliated companies to share consumer information with each other subject to certain conditions. There is also a seven-year moratorium on new state legislation on certain issues. However, the states remain free to regulate the use of credit bureau data in connection with insurance underwriting. The Company believes enacted or proposed state regulation of the insurance industry has had a negative impact on its efforts to sell insurance risk scores through credit reporting agencies. Since its acquisition, DynaMark has taken on an increasing share of the mainframe batch processing requirements of the Company's other business units. During fiscal 1997, such intercompany revenue represented more than fourteen percent of DynaMark's total revenues. Accordingly, DynaMark's externally reported revenues tend to understate DynaMark's growth and contribution to the Company as a whole. The increase in DynaMark's revenues shown in the foregoing table, which excludes such intercompany revenues, was due primarily to increased revenues from customers in the financial services industry. RMT's revenues decreased in the three- and nine-month periods ended June 30, l998 compared to the same periods in fiscal 1997 due to the impact of bank consolidations. The increases in Insurance revenues for the three- and nine-months ended June 30, 1998, compared with the same periods in fiscal 1997, were due primarily to continuing strong growth in insurance scoring services offered through consumer reporting agencies. In the quarter and nine-months ended June 30, 1998, the Company's newest business unit, Healthcare Information, derived revenues from providing analytical marketing services to a large pharmaceuticals manufacturer to help improve customer relationships and management of prescription compliance (i.e., patient's fulfillment of prescriptions and taking them to completion). The corresponding periods in fiscal 1997 included some revenues for earlier quarters due to timing of revenue recognition. Revenues derived from outside of the United States represented approximately 18 percent of total revenues in the quarter and nine-months ended June 30, 1998, compared with 15 percent of total revenues in the quarter and nine-months ended June 30, 1997. Revenues from software maintenance and consulting services each accounted for less than 10 percent of revenues in each of the three years in the period ended September 30, 1997, and in the nine-months ended June 30, 1998. The Company does not expect revenues from either of these sources to exceed 10 percent of revenues in the foreseeable future. During the period since 1990, while the rate of account growth in the U.S. bankcard industry has been slowing and many of the Company's largest institutional clients have merged and consolidated, the Company has generated above-average growth in revenues--even after adjusting for the effect of acquisitions--from its bankcard-related scoring and account management business by deepening its penetration of large banks and other credit issuers. The Company believes much of its future growth prospects will rest on its ability to: (1) develop new, high-value products, (2) increase its penetration of established or emerging credit markets outside the U.S. and Canada and (3) expand--either directly or through further acquisitions--into relatively undeveloped or underdeveloped markets for its products and services, such as direct marketing, insurance, small business lending and healthcare information management. 11
Over the long term, in addition to the factors discussed above, the Company's rate of revenue growth--excluding growth due to acquisitions--is limited by the rate at which it can recruit and absorb additional professional staff. Management believes this constraint will continue to exist indefinitely. On the other hand, despite the high penetration the Company has already achieved in certain markets, the opportunities for application of its core competencies are much greater than it can pursue. Thus, the Company believes it can continue to grow revenues, within the personnel constraint, for the foreseeable future. At times management may forego short-term revenue growth in order to devote limited resources to opportunities that it believes have exceptional long-term potential. This occurred in the period from 1988 through 1990 when the Company devoted significant resources to developing the usage-priced services distributed through credit bureaus and third-party processors. Expenses <TABLE> The following table sets forth for the periods indicated (a) the percentage of revenues represented by certain line items in the Company's consolidated statements of income and (b) the percentage change in such items from the same periods in the prior fiscal year. <CAPTION> Nine Months Three Months Ended Percentage Ended Percentage June 30, Change June 30, Change -------- ------ -------- ------ 1998 1997 1998 1997 ---- ---- ---- ---- <S> <C> <C> <C> <C> <C> <C> Revenues 100% 100% 25% 100% 100% 27% Costs and expenses: Cost of revenues 36 37 20% 34 37 18% Sales and marketing 15 15 25% 14 16 15% Research and development 12 9 64% 11 10 39% General and administrative 21 20 31% 23 20 37% Amortization of intangibles 1 1 2% 1 1 33% --- --- ---- ---- Total costs and expenses 85 82 28% 83 84 25% --- --- ---- ---- Income from operations 15 18 6% 17 16 36% Other income and expense -- 1 (143%) 0 (2) (98%) --- --- ---- ---- Income before income taxes 15 17 14% 17 14 52% Provision for income taxes 6 7 19% 7 6 56% --- --- ---- ---- Net income 9% 10% 10% 10% 8% 49% === === ==== ==== </TABLE> Cost of Revenues Cost of revenues consists primarily of personnel, travel, and related overhead costs; costs of computer service bureaus; and the amounts paid by the Company to credit bureaus for scores and related information in connection with the ScoreNet(R) service. The cost of revenues, as a percentage of revenues, declined in the three- and nine-months ended June 30, 1998, as compared with the same periods a year earlier, principally because certain personnel whose primary assignment had been production and delivery have been reassigned to research and development activities. Sales and Marketing Sales and marketing expenses consist principally of personnel, travel, overhead, advertising and other promotional expenses. As a percentage of revenues, these expenses were essentially unchanged in the nine-month period ended June 30, 1998, compared with the same period in fiscal 1997. These expenses, as a percentage of revenues, declined for the quarter ended June 30, 1998, due largely to the offset of income in excess of expenses generated by the Company's InterAct`98 conference for clients, as compared with losses from the Company's conference in Barcelona in the same period a year earlier. 12
Research and Development Research and development expenses include the personnel and related overhead costs incurred in developing products, researching mathematical and statistical algorithms, and developing software tools that are aimed at improving productivity and management control. Research and development expenses for fiscal 1998 increased significantly over the corresponding nine-month period and slightly over the corresponding three-month period of fiscal 1997. After several years of concentrating on developing new markets--either geographical or by industry--for its existing technologies, the Company has increased emphasis on developing new technologies, especially in the area of software development. Research and development expenditures in the three- and nine-months ended June 30, l998 were primarily related to new bankruptcy scoring products for Visa (Integrated Solutions Concept) and Trans Union, new fraud detection software products, joint product development projects with Deluxe Financial Services, Inc., healthcare receivables management products and Year 2000 conversion work. General and Administrative General and administrative expenses consist mainly of compensation expenses for certain senior management, corporate facilities expenses, the costs of administering certain benefit plans, legal expenses, expenses associated with the exploration of new business opportunities and the costs of operating administrative functions such as finance and computer information systems. As a percentage of revenues, these expenses increased in the three- and nine-month periods ended June 30, 1998, compared with the same periods in fiscal 1997, principally because of additional bad debt allowances, higher performance incentives and telecommunications upgrades and computer information systems conversions. Amortization of intangibles The Company is amortizing the intangible assets arising from various acquisitions over periods ranging from two to fifteen years. The level of amortization expense in future years will depend, in part, on the amount of additional payments (earnouts) to the former shareholders of Credit & Risk Management Associates, Inc., a privately held company acquired in 1996. Other income and expense Interest income, derived from the investment of funds surplus to the Company's immediate operating requirements, was essentially the same as in the three- and nine-month periods a year earlier. In the corresponding three- and nine-months periods in the prior fiscal year the Company recorded costs related to the acquisition of RMT and losses related to its equity investment in an early stage development company that has since been sold. Provision for income taxes The Company's effective tax rate increased to 42.7% and 41.8%, respectively, in the three- and nine-month periods ended June 30, 1998, from 41.5% and 40.0%, respectively, in the corresponding periods of fiscal 1997, due to lower effective tax rate for RMT in the 1997 periods resulting from utilization of net operating loss carryforwards. Financial Condition Working capital increased from $47,727,000 at September 30, 1997 to $59,753,000 at June 30, 1998. Cash and marketable investments increased from $27,941,000 at September 30, 1997, to $44,266,000 at June 30, 1998. On December 1, 1997, the Company exercised an option to purchase undeveloped land in San Rafael, California, with the intention of constructing an office complex to accommodate future growth. Development has commenced, and as of May 15, 1998 the Company entered into a synthetic lease arrangement, which will materially increase the Company's future operating lease expenses. Rental payments will commence upon completion of construction which is expected to be in January, 2001. With this external financing, the Company believes that the cash and marketable securities on hand, along with cash expected to be generated by operations, will be adequate to meet its capital and liquidity needs for both the current year and the foreseeable future. 13
Interim Periods The Company believes that all the necessary adjustments have been included in the amounts shown in the consolidated financial statements contained in Item 1 above for the three- and nine-month periods ended June 30, 1998 and 1997, to state fairly the results for such interim periods. This includes all normal recurring adjustments that the Company considers necessary for a fair statement thereof, in accordance with generally accepted accounting principles. This report should be read in conjunction with the Company's 1997 Form 10-K. Quarterly results may be affected by fluctuations in revenues associated with credit card solicitations, by the timing of orders for and deliveries of certain ASAP and TRIAD systems, and by the seasonality of ScoreNet purchases. With the exception of the cost of ScoreNet data purchased by the Company, most of its operating expenses are not affected by short-term fluctuations in revenues; thus short-term fluctuations in revenues may have a significant impact on operating results. However, in recent years, these fluctuations were generally offset by the strong growth in revenues from services delivered through credit bureaus and third-party bankcard processors. Management believes that neither the quarterly variation in revenues and net income, nor the results of operations for any particular quarter, are necessarily indicative of results of operations for full fiscal years. Accordingly, management believes that the Company's results should be evaluated on an annual basis. YEAR 2000 The Company is performing Year 2000 conversion work on its software products marketed to customers. The updated versions of most of its software products currently being shipped to customers are Year 2000 compliant. Certain international versions of the Company's software products are not yet Year 2000 compliant, but the Company expects to ship upgrade "patches" for these products by the end of calendar 1998. The Year 2000 conversion work for most earlier versions of the Company's software installed at customer sites will be performed as part of the Company's normal upgrade and maintenance process. The Company has decided to discontinue support for some software products prior to the end of calendar 1999, and Year 2000 upgrades for these products will not be available. Revenues from such products are not significant. The Company does not expect to incur significant expenses or disruptions in revenues in connection with Year 2000 issues related to its own software products. Additionally, the Company has substantially completed its Year 2000 audit of internal systems and applications and determined that approximately 95 percent of its internally developed systems are Year 2000 compliant. Applications supplied by third parties are either Year 2000 compliant or have "patches" currently available to bring them into compliance. The Company expects all major internal systems to be fully compliant by the end of fiscal l998. The Company is still in the process of inventorying and testing desktop and other secondary internal systems for Year 2000 compliance. Based on its current assessment of Year 2000 testing and conversion work for internal systems the Company estimates that costs of Year 2000 compliance for such systems will not have a material effect on the Company's business, results of operations or financial condition. The Company has also initiated communications with third parties on which it is dependent for essential services and for the distribution of its services to determine how they are addressing Year 2000 issues and to evaluate any impact on the Company's operations. Although the Company intends to work with these third parties to resolve Year 2000 issues, the lack of resolution of Year 2000 issues by these parties--especially the credit bureaus and credit card processors through which the Company distributes credit scoring and account management services--could have a significant negative impact on the Company's future business operations, financial condition and results of operations. At this time the Company cannot quantify the potential impact of the third-party Year 2000 issues, nor has it developed contingency plans for the possibility that one or more of such third parties experiences a significant disruption due to Year 2000 issues. Since the Company currently does not expect significant disruption of its revenues or operations from the Year 2000 issues associated with its products or its internal systems, it has not made an assessment of the potential impact of failing to complete its own Year 2000 conversion work nor has it developed any contingency plans for such event. 14
PART II - OTHER INFORMATION ITEM 6. Exhibits and Reports on Form 8-K. (a) Exhibits: 10.37A Chase Database Agreement, dated October 29, 1997, by and among Dynamark, Inc. and Chase Manhattan Bank USA, National Association. Confidential treatment has been requested for certain portions for this document. Such portions have been omitted from the filing and have been filed separately with the Commission. 24.1 Power of Attorney (see page 16 of this Form 10-Q). 27.1 Financial Data Schedule (b) Reports on Form 8-K: One report on Form 8-K was filed during the quarter ended June 30,1998. On June 12 , 1998, the Company filed a report announcing that it had entered into a synthetic lease agreement to lease undeveloped land in San Rafael, California and improvements comprising the first phase of an office facility to be constructed on this land. The office complex facility is intended to accommodate future growth of the Company. 15
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. FAIR, ISAAC AND COMPANY, INCORPORATED DATE: August 13, 1998 By PETER L. MCCORKELL ----------------------------------- Peter L. McCorkell Senior Vice President and Secretary POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that the person whose signature appears below constitutes and appoints PETER L. McCORKELL his attorney-in-fact, with full power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-Q and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following person on behalf of the registrant and in the capacities and on the date indicated. DATE: August 13, 1998 By PATRICIA COLE ----------------------------------- Patricia Cole Senior Vice President and Chief Financial Officer 16
<TABLE> EXHIBIT INDEX TO FAIR, ISAAC AND COMPANY, INCORPORATED REPORT ON FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 1998 <CAPTION> Sequentially Exhibit No. Exhibit Numbered Page - ----------- ------- ------------- <S> <C> <C> 10.37A Chase Database Agreement, dated October 29, 1997, by and 18 among Dynamark, Inc. and Chase Manhattan Bank USA, National Association. (Confidential Treatment Requested) 24.1 Power of Attorney 16 27.1 Financial Data Schedule 50 </TABLE> 17