UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2003
OR
For the transition period from to
Commission File Number: 1-11859
PEGASYSTEMS INC.
(Exact name of Registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
101 Main Street
Cambridge, MA
(617) 374-9600
(Registrant’s telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
There were 34,573,225 shares of the Registrant’s common stock, $.01 par value per share, outstanding on October 16,2003.
Index to Form 10-Q
Part I - Financial Information
Item 1.
Item 2.
Item 3.
Item 4.
Part II - Other Information
Item 5.
Item 6.
SIGNATURES
2
Condensed Consolidated Balance Sheets
(in thousands, except share-related amounts)
September 30,
2003
December 31,
2002
Assets
Current assets
Cash and cash equivalents
Trade accounts receivable, net of allowance for doubtful accounts of $418 in 2003 and $507 in 2002
Short-term license installments
Short-term investments
Prepaid expenses and other current assets
Total current assets
Long-term license installments, net of unearned interest income
Long-term investments
Equipment and improvements, net of accumulated depreciation and amortization
Acquired technology, net of accumulated amortization
Other assets
Goodwill
Total assets
Liabilities and Stockholders’ Equity
Current liabilities
Accrued payroll related expenses
Accounts payable and accrued expenses
Deferred revenue
Total current liabilities
Deferred income taxes
Other long-term liabilities
Total liabilities
Commitments and contingencies
Stockholders’ equity
Preferred stock, $0.01 par value, 1,000,000 shares authorized; no shares issued and outstanding
Common stock, $0.01 par value, 45,000,000 shares authorized; 34,571,655 shares and 34,291,389 shares issued and outstanding in 2003 and 2002, respectively
Additional paid-in capital
Stock warrants
Retained earnings
Accumulated other comprehensive income:
Net unrealized gain on investments available for sale
Foreign currency translation adjustments
Total stockholders’ equity
Total liabilities and stockholders’ equity
See notes to condensed consolidated financial statements.
3
Condensed Consolidated Statements of Operations
(in thousands, except per share amounts)
Three Months
Ended
Nine Months
Revenue
Software license
Services
Total revenue
Cost of revenue
Cost of software license
Cost of services
Total cost of revenue
Gross profit
Operating expenses
Research and development
Selling and marketing
General and administrative
Total operating expenses
Income from operations
Installment receivable interest income
Other interest income, net
Other income (expense), net
Income before provision for income taxes
Provision for income taxes
Net income
Earnings per share
Basic
Diluted
Weighted average number of common and common equivalent shares outstanding
4
Condensed Consolidated Statements of Cash Flows
(in thousands)
Nine Months Ended
Cash flows from operating activities
Adjustments to reconcile net income to net cash provided by operating activities:
Stock option income tax benefits
Deferred income tax
Depreciation and amortization
Reduction in allowance for doubtful accounts receivable
Changes in operating assets and liabilities:
Trade and installment accounts receivable
Net cash provided by operating activities
Cash flows from investing activities
Purchase of investments
Maturing investments
Acquisition of 1mind
Purchase of equipment and improvements
Other long-term assets and liabilities
Net cash used in investing activities
Cash flows from financing activities
Payments under capital lease obligation
Proceeds from sale of stock under Employee Stock Purchase Plan
Exercise of stock options
Net cash provided by financing activities
Effect of exchange rate on cash and cash equivalents
NET INCREASE IN CASH AND CASH EQUIVALENTS
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
CASH AND CASH EQUIVALENTS, END OF PERIOD
5
Notes to Condensed Consolidated Financial Statements
September 30, 2003
Note 1 - Basis of presentation
The unaudited condensed consolidated financial statements of Pegasystems Inc. (“we” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine month period ended September 30, 2003 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2003. We suggest that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2002, included in our 2002 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).
Note 2 – Significant accounting policies
(a) Business
We develop, market, license and support software that enables transaction intensive organizations to manage a broad array of business processes. We also offer consulting, training and maintenance support services to facilitate the installation and use of our products.
(b) Management estimates and reporting
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Significant assets and liabilities with reported amounts based on estimates include trade and installment accounts receivable, long term license installments, deferred income taxes and deferred revenue.
(c) Principles of consolidation
The consolidated financial statements include the accounts of Pegasystems Inc. and its wholly owned subsidiaries, Pegasystems Limited (a United Kingdom company), Pegasystems Company (a Canadian company), Pegasystems Worldwide Inc. (a United States corporation), Pegasystems Pty Ltd. (an Australian company), Pegasystems Investment Inc. (a United States corporation) and Pegasystems Private Limited (a Singapore company). All intercompany accounts and transactions have been eliminated in consolidation.
(d) Foreign currency translation
The translation of assets and liabilities of our foreign subsidiaries is made at period-end exchange rates, while revenue and expense accounts are translated at the average exchange rates during the period transactions occurred. The resulting translation adjustments are reflected in accumulated other comprehensive income. Realized and unrealized exchange gains or losses from transactions and adjustments are reflected in other income (expense), net, in the accompanying condensed consolidated statements of operations.
6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(e) Revenue recognition
Our revenue is derived from two primary sources: software license fees and service fees. We offer both perpetual and term software licenses. Perpetual license fees are generally payable at the time the software is delivered, and are generally recognized as revenue when the software is delivered, any acceptance required by contract is obtained, and no significant obligations or contingencies exist related to the software, other than maintenance support. Payments subject to refund are recognized in revenue as refund provisions lapse.
Term software license fees are generally payable on a monthly basis under license agreements that generally have a five-year term and may be renewed for additional years at the customer’s option. The present value of future license payments is generally recognized as revenue upon customer acceptance, provided that no significant obligations or contingencies exist related to the software, other than maintenance support. A portion of the license fees payable under each term license agreement (equal to the difference between the total license payments and the discounted present value of those payments) is initially deferred and recognized as installment receivable interest income (and is not part of total revenue) over the license term. Many of our license agreements provide for license fee increases based on inflation. When such an increase occurs, as determined by the terms of the license agreement, we recognize the present value of such increases as revenue; the remainder of the increase is recognized as installment receivable interest income over the remaining license term. For purposes of the present value calculations, the discount rates used are estimates of customers’ borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.25% and 8.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements would be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized with the same present value approach, when the customer becomes committed to the new license terms and no significant obligations or contingencies exist related to the software, other than maintenance support.
In certain circumstances, such as when license fees are not fixed and determinable, some term licenses are accounted for on a subscription basis, where revenue is recognized as payments become due over the term of the license.
Our services revenue is comprised of fees for software implementation, consulting, maintenance and training services. Our software implementation and consulting agreements typically require us to provide services for a fixed fee or at an hourly rate. Revenues for time and material projects are recognized as fees are billed. Until the fair value of the elements of a contract can be determined, the recognition of services revenue for fixed-price projects is limited to amounts equal to direct costs incurred, resulting in no gross profit. We do not have a reliable track record for accurately estimating the time and resources needed to complete fixed-price service projects. As a result, determination of the fair values of the elements of the contract has generally occurred late in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. If the fair values of the elements of a contract are then apparent, the remaining revenue and profit associated with the fixed-price services elements will be recognized when the project is completed. To the extent that a software license is included in the contract, any residual amounts remaining after revenue is allocated to the services elements are recorded as license revenues. All costs of services are expensed as incurred.
Software license customers are offered the option to enter into a maintenance contract, which usually requires the customer to pay a monthly maintenance fee over the term of the maintenance agreement, typically renewable annually. Prepaid maintenance fees are deferred and are recognized evenly over the term of the maintenance agreement. We generally recognize training fees revenue as the services are provided.
We reduce revenue for estimates of the fair values of potential concessions, such as disputed services, when revenue is initially recorded. These estimated amounts are deferred or reserved until the related elements of the agreement are completed and provided to the customer or the dispute is resolved.
7
Our agreements with customers generally require us to indemnify the customer against claims that our software infringes third party patent, copyright, trademark or other proprietary rights. Such indemnification obligations are generally limited in a variety of industry-standard respects, including our right to replace an infringing product. As of September 30, 2003, we had not experienced any material losses related to these indemnification obligations and no material claims with respect thereto were outstanding. We do not expect significant claims related to these indemnification obligations, and consequently, we have not established any related reserves.
(f) Cash and cash equivalents and investments
Amortized
Cost
Unrealized
Gains
Losses
Fair
Value
Debt securities – Held-to-maturity investments
Debt securities – Available-for-sale investments
We consider debt securities with maturities of three months or less, when purchased, to be cash equivalents. Securities that we have the ability and intent to hold until maturity are carried at amortized cost, which approximates fair value. Investments classified as available-for-sale are carried at fair value with unrealized gains and losses recorded as a component of accumulated other comprehensive income. Management determines the appropriate classification of its investment in debt securities at the time of purchase and re-evaluates such determination at each balance sheet date. There have been no reclassifications between investment categories. As of September 30, 2003, remaining maturities of marketable debt securities ranged from October 2003 to August 2005. As of December 31, 2002, remaining maturities of marketable debt securities ranged from January 2003 to January 2004. We hold $1.2 million of restricted cash, invested in money market funds, as collateral for a letter of credit in accordance with an office lease arrangement. As of September 30, 2003, this balance was classified as a cash and cash equivalent.
(g) Concentration of credit risk
Financial instruments that potentially subject us to a concentration of credit risk consist of short-term cash investments, trade accounts receivable and license installments receivable. We record long-term license installments in accordance with our revenue recognition policy, which results in long-term installment receivables from customers (due in periods exceeding one year from the reporting date, primarily from large organizations with strong credit ratings). We grant credit to customers who are located throughout the world. We perform credit evaluations of customers and generally do not request collateral from customers. Amounts due under long-term license installments are as follows:
8
For the calendar year
Remainder of 2003
2004
2005
2006
2007
2008 and thereafter
Deferred license interest income
Total license installments receivable,net
(h) Equipment and improvements, net of accumulated depreciation and amortization
Equipment and improvements are recorded at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets, which are three years for equipment and five years for furniture and fixtures. Leasehold improvements and equipment under capital lease are amortized over the lesser of the life of the lease or the useful life of the asset. Repairs and maintenance costs are expensed as incurred.
(i) Impairment of long-lived assets
We evaluate our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Impairment is generally assessed by comparison of cash flows expected to be generated by an asset to its carrying value, with the exception that goodwill impairment is assessed by use of a fair value model. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value.
(j) Research and development and software costs
Research and development costs, other than certain software related costs, are expensed as incurred. Capitalization of software costs begins upon the establishment of technical feasibility, generally demonstrated by a working model or an operative version of the computer software product. Such costs have not been material to date and, as a result, no internal costs were capitalized during the three and nine months ended September 30, 2003 and 2002.
Amortization of capitalized software is included in the cost of software license. No amortization expense for internally developed capitalized software costs was charged to cost of software license revenue during the three and nine months ended September 30, 2003 and 2002.
(k) Earnings per share
Basic earnings per share are computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share includes, to the extent inclusion of such shares would be dilutive to earnings per share, the effect of outstanding options and warrants, computed using the treasury stock method.
9
Weighted average common shares outstanding
Basic earnings per share
Effect of assumed exercise of stock options and warrants
Weighted average common shares outstanding, assuming dilution
Diluted earnings per share
Outstanding options excluded as impact would be anti-dilutive
(l) Segment reporting
We currently operate in one operating segment – rules based business process management, or BPM, software. We derive substantially all of our operating revenue from the sale and support of one group of similar products and services. Substantially all of our assets are located within the United States. During the three and nine months ended September 30, 2003 and 2002, we derived our operating revenue from the following geographic areas (sales outside the United States are principally through export from the United States):
Three months ended
Nine months ended
United States
United Kingdom
Europe
Other
During the three months ended September 30, 2003, two customers represented 22% and 15% of our total revenue. During the three months ended September 30, 2002, four customers represented 24%, 12%, 10% and 10% of our total revenue. During the nine months ended September 30, 2003, two customers accounted for approximately 19% and 15% of our total revenue. During the nine months ended September 30, 2002, one customer accounted for approximately 28% of our total revenue.
(m) Stock options
We periodically grant stock options for a fixed number of shares to employees, directors and non-employee contactors with an exercise price equal to the fair market value of the shares at the date of the grant. We account for stock option grants to employees and directors using the intrinsic value method and intend to continue to do so. Under the intrinsic value method, compensation associated with stock awards to employees is determined as the difference, if any, between the current fair value of the underlying common stock on the date compensation is measured and the price an employee must pay to exercise the award. The measurement date for employee awards is generally the date of grant.
10
Stock options granted to non-employee contractors are accounted for using the fair value method. Under the fair value method, compensation associated with stock awards to non-employees is determined based on the estimated fair value of the award itself, measured using either current market data or an established option pricing model. The measurement date of non-employee awards is generally the date performance of services is complete.
Stock options summary
The following table presents combined activity for stock options for the three and nine months ended September 30, 2003:
September 30,2003
Number of
Options
Weighted
Average
Exercise
Price
Outstanding options at beginning of period
Granted
Exercised
Canceled
Outstanding options at end of period
Exercisable options at end of period
Weighted average fair value of options granted during the period
The following table presents weighted average price and life information about significant option groups outstanding and exercisable at September 30, 2003:
Options Outstanding
Options Exercisable
Range of
Exercise Prices
Number
Outstanding
Remaining
Contractual Life
(years)
Exercise Price
Exercisable
$ 0.33 - 4.11
4.13 - 6.68
6.69 - 7.84
7.85 -25.75
11
The following are the pro forma net income and income per share, as if compensation expense for the option plans had been determined based on the fair value at the date of grant:
Net income, as reported
less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
Pro forma net income
Earnings per share:
Basic—as reported
Basic—pro forma
Diluted—as reported
Diluted—pro forma
The fair value of options at the date of grant were estimated using the Black-Scholes option pricing model with the following assumptions:
Volatility
Expected option life-years from vest
Interest rate (risk free)
Dividends
The effects on three and nine months ended September 30, 2003 and 2002 pro forma net income and net income per share of the estimated fair value of stock options and shares are not necessarily representative of the effects on the results of operations in the future. In addition, the estimates utilize a pricing model developed for traded options with relatively short lives; our option grants typically have a life of up to ten years and are not transferable. Therefore, the actual fair value of a stock option grant may be different from our estimates. We believe that our estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded stock options.
(n) Fair value of financial instruments
The principal financial instruments held consist of cash and cash equivalents, investments, accounts receivable and payable, capital lease obligations and license installment receivables arising from license transactions. The carrying values of cash and cash equivalents, investments, accounts receivable and accounts payable approximate their fair value due to the relatively short-term nature of the accounts. Using current market rates, the fair value of license installment receivables approximates carrying value at September 30, 2003 and 2002.
(o) Intangible assets and goodwill
Intangible assets are recorded at cost and principally represent technology acquired in business combinations or from third parties. Amortization is provided on a straight-line basis over the assets’ estimated useful lives. As of September 30, 2003, intangible assets consisted of technology acquired in a business combination with a carrying value of $0.8 million and accumulated amortization of $0.6 million. Amortization expense was $0.1 and $0.3 million for the three and nine months ended September 30, 2003, respectively. We expect to recognize approximately $0.4 million of annual amortization expense related to those assets yearly until January 2006.
12
Goodwill represents the residual purchase price given in the business combination after all identified assets have been recorded. Goodwill is not amortized, but is tested annually for impairment by comparing the fair value to its carrying value. During the first quarter of 2003, we made a claim against all of the 155,760 common shares in escrow from the acquisition of 1mind. In April 2003, the shares were subsequently retired and cancelled. This resulted in a $0.9 million reduction of goodwill and additional paid in capital.
(p) Deferred taxes
Deferred taxes are provided for differences in the bases of our assets and liabilities for book and tax purposes and loss carry forwards based on tax rates expected to be in effect when these items reverse. Valuation allowances are provided to the extent it is more likely than not that some portion of the deferred tax assets will not be realized.
(q) Common stock and additional paid-in capital
On February 6, 2002, we acquired substantially all of the assets of 1mind Corporation for initial consideration valued at $3.7 million, consisting of 569,949 shares of our common stock (155,760 shares of which were deposited into escrow to secure the indemnity obligations of 1mind’s equity holders relating to the transaction) and warrants to purchase for nominal consideration 83,092 shares of our common stock. During the first quarter of 2003, we made a claim against all of the shares in escrow. In April 2003, the shares were subsequently retired and cancelled. This resulted in a $0.9 million reduction of goodwill and additional paid in capital.
Note 3 – Valuation and qualifying accounts
We maintain allowances for bad debts based on factors such as the composition of accounts receivable, historical bad debt experience, and current economic trends. These allowances are adjusted periodically to reflect changes in facts and circumstances. The following is a roll forward of the allowance for doubtful accounts:
Description
Balance
At
January
1, 2003
Additions
(deductions)
charged to
costs and
expenses
Foreign
Exchange
Gain
September30, 2003
Allowance for doubtful accounts:
Nine months ended September 30, 2003
Note 4 – Comprehensive income
The components of comprehensive income are as follows:
Three months
ended
Nine months
Foreign currency translation adjustments, net of income taxes
Comprehensive income
13
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Results of Operations
Overview
Total revenue decreased to $25.1 million in the third quarter of 2003 from $25.6 million in the third quarter of 2002 due to a decrease in license revenue, which was partially offset by an increase in services revenue. We have signed more new customer license business in the first three quarters of 2003 than in the first three quarters of 2002. However, a substantial majority of our license revenue in the third quarter of 2003 continued to be from existing customers who chose to renew, add on to, or extend their use of our software. The increase in services revenue in the third quarter was primarily due to implementation projects associated with recent new customer license signings. Most of those implementation projects are not yet complete and therefore the associated license revenue has not yet been recognized. Profit before taxes, increased to $5.2 million in the third quarter of 2003 from $5.1 million in the third quarter of 2002 primarily due to an improvement in service margins. However, net income for the third quarter of 2003 decreased to $3.4 million from $4.8 million for the third quarter of 2002 because of increased provisions for income taxes. We generated $15.7 million in positive cash flow during the first three quarters of 2003, and ended the period with $82.0 million in cash and marketable debt securities and $84.5 million in combined short and long-term license installment receivables.
Three and Nine Months Ended September 30, 2003 Compared to Three and Nine Months Ended September 30, 2002
Our total revenue for the third quarter of 2003 decreased 2% to $25.1 million from $25.6 million for the third quarter of 2002. The decrease was due to a $3.3 million decrease in license revenue, partially offset by a $2.8 million increase in services revenue. Our total revenue for the first three quarters of 2003 decreased slightly to $76.2 million from $76.4 million for the first three quarters of 2002. The decrease was due to a $6.5 million decrease in license revenue, partially offset by a $6.3 million increase in services revenue. The following table summarizes our revenue composition:
License revenue
Term license renewals, extensions and additions
Perpetual and subscription licenses
Total license revenue
Services revenue
Implementation, consulting and training services
Maintenance
Total services revenue
Software license revenue for the third quarter of 2003 decreased to $13.6 million from $16.9 million for the third quarter of 2002 due to a $3.5 million decrease in term license renewals, extensions and additions, partially offset by a $0.2 million increase in perpetual and subscription licenses. Software license revenue for the first three quarters of 2003 decreased to $45.7 million from $52.2 million for the first three quarters of 2002. The decrease in total license revenue for the first three quarters was the result of a $9.0 million decrease in perpetual and subscription licenses, partially offset by a $2.5 million increase in term license renewals, extensions and additions.
14
The increase in perpetual and subscription licenses of $0.2 million for the third quarter was due to an increase in the average deal size for perpetual licenses. The decrease in perpetual and subscription licenses of $9.0 million for the first three quarters of 2003 was due to a reduction in revenue from First Data Resources (“FDR”). Under the terms of the perpetual license agreement entered into during the second quarter of 2002, when we restructured our arrangement with FDR, FDR is required to make monthly payments through December 2003. These payments total $3.54 million in each of the four quarters of 2003. We recognize revenue under the FDR agreement as earned, which is three months in advance of receipt of payments, because while FDR has the contractual right to terminate the agreement, FDR is required to provide us with at least three months advance notice. As a result, as the cancellation rights expire, amounts payable over the subsequent three months are no longer forfeitable and are due in full on scheduled payment dates. We recognized $3.54 million in revenue from the FDR perpetual license in the third quarter of 2003 and expect to recognize no license revenue from that license in the fourth quarter of 2003.
The following table summarizes the revenue we have recognized under the FDR perpetual license and the prior agreements with FDR:
Term license revenue in the first three quarters of 2003 reflects two subsidiaries of one large financial institution renewing and extending their use of Pegasystems software, representing 19% of total revenue in the first three quarters of 2003. Discount rates used to recognize term license revenue vary directly with market interest rates. The discount rates used to recognize term license revenue reflect the estimated borrowing rates of our customers, and averaged 3.25% in the third quarter of 2003. Decreases in the average discount rate, versus rates used in the comparable periods of 2002, resulted in an increase in license revenue of approximately $0.1 million for third quarter 2003 and approximately $1.4 million for the first three quarters of 2003. If interest rates increase and in turn the discount rates we use to recognize term license revenue increase, we would defer as installment receivable interest a greater portion of the revenue from such arrangements and recognized license revenue would decrease by the same amount.
Our current sales strategy is to sell perpetual licenses to new customers, and therefore we expect to enter into more perpetual license transactions than term licenses with new customers, the effect of which may be to increase our license revenue and cash flow in the short term and to decrease the amount of revenue and cash flow from the renewal of term software license agreements. In the past few years, a significant portion of our license revenue has been from renewals of term software license agreements.
Services revenue for the third quarter of 2003 increased 33% to $11.5 million from $8.7 million for the third quarter of 2002. Implementation, consulting and training services increased 34% to $8.6 million from $6.4 million for the third quarter of 2002. Services revenue for the first three quarters of 2003 increased 26% to $30.5 million from $24.2 million for the first three quarters of 2002. Implementation, consulting and training services increased 29% to $22.4 million from $17.4 million for the first three quarters of 2002. Such increases were primarily due to implementation projects associated with recent new customer signings. Most of those implementation projects are not yet complete and therefore the associated license revenue has not yet been recognized. Typically, we derive substantial revenue from services provided in connection with the implementation of software licensed by new customers. Going forward, as we continue to complement our direct selling and support efforts with those of our alliance partners, we do not expect to sustain these rates of services revenue growth. Maintenance revenue for the first three quarters of 2003 increased 19% to $8.1 million from $6.8 million for the first three quarters of 2002 due primarily to the larger installed base of our software.
Deferred revenue at September 30, 2003 consisted primarily of billed fees from arrangements, for which acceptance of the software license or service milestone had not occurred, advance payment of maintenance fees and the unearned portion of services revenue. Deferred revenue balances increased to $14.2 million as of September 30, 2003 from $12.1 million as of December 31, 2002. The increase was primarily due to advance payments of license and maintenance fees and an increase in the unearned portion of services revenue related to new software implementations.
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International revenues were 36% of total consolidated revenues for the third quarter of 2003 and 25% for the third quarter of 2002. International revenues were 22% of total consolidated revenues for the first three quarters of 2003 and 2002. Our international revenues may fluctuate in the future because such revenues are generally dependent upon a small number of product acceptances by our customers during a given period. Historically, most of our contracts have been denominated in U.S. dollars. We expect, however, that in the future due to competition from vendors who will do business in foreign currencies, more of our contracts may be denominated in foreign currencies which may expose us to increased currency exchange risk.
Cost of services consists primarily of the costs of providing implementation, consulting, maintenance, and training services. Cost of services for the third quarter of 2003 remained flat at $7.4 million compared to the third quarter of 2002. Cost of services as a percentage of services revenue decreased to 64% for the third quarter of 2003 from 85% for the third quarter of 2002. The percentage decrease was due to increased implementation and consulting services revenue. Service gross margin was $4.1 million for the third quarter of 2003, versus $1.3 million for the third quarter of 2002.
Cost of services for the first three quarters of 2003 decreased 9% to $20.3 million from $22.2 million for the first three quarters of 2002, primarily due to reduced staff costs. Cost of services as a percentage of services revenue decreased to 67% for the first three quarters of 2003 from 92% for the first three quarters of 2002. The percentage decrease was due to increased services revenue coupled with reduced staff costs. Service gross margin was $10.2 million for the first three quarters of 2003, as compared to $1.9 million for the first three quarters of 2002.
The increase in services gross margins reflects improved utilization of our professional services staff achieved in part through the increased use of third party contractors when necessary to meet higher demand.
Research and development expenses for the third quarter of 2003 were flat with the third quarter of 2002, at $5.3 million. As a percentage of total revenue, research and development expenses for the third quarter of 2003 equaled 21%, the same as the third quarter of 2002. Research and development expenses for the first three quarters of 2003 decreased 7% to $15.5 million from $16.7 million for the same period of 2002, and those expenses as percentages of corresponding revenues were 20% for 2003 and 22% for 2002. These decreases were primarily due to reduced staff and related expenses. We expect that investments in research and development expenses will increase during the fourth quarter of 2003.
Selling and marketing expense for the third quarter of 2003 decreased 5% to $6.0 million from $6.3 million for the third quarter of 2002. The decrease was due to a reduction in compensation related expenses, partially offset by increased marketing and sales programs and service activities for pre-sales support such as software demonstrations. As a percentage of total revenue, selling and marketing expenses decreased to 24% for the third quarter of 2003 compared to 25% for the third quarter of 2002, due to the decrease in selling and marketing expenses partially offset by the decline in revenue. For the first three quarters of 2003, selling and marketing expenses decreased 1% to $17.9 million from $18.0 million for the first three quarters of 2002. The decrease was due to a reduction in sales staff compensation, partially offset by increases in marketing and sales programs, service activities for pre-sales support such as software demonstrations, and marketing salaries. As a percentage of total revenue, selling and marketing expenses decreased to 23% for the first three quarters of 2003 compared to 24% for the first three quarters of 2002, due to the decrease in selling and marketing expenses.
General and administrative expenses for the third quarter of 2003 increased 48% to $2.8 million from $1.9 million for the third quarter of 2002. As a percentage of total revenue, general and administrative expenses increased to 11% for the third quarter of 2003 compared to 7% for the third quarter 2002. General and administrative expenses for the first three quarters of 2003 increased 10% to $8.2 million from $7.4 million for the first three quarters of 2002. As a percentage of total revenue, general and administrative expenses increased to 11% for the first three quarters of 2003 compared to 10% for the first three quarters of 2002. The increases were due to higher employee compensation related expenses and corporate governance programs and initiatives.
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Installment receivable interest income, which consists of the portion of all term license fees under software license agreements attributable to the time value of money, increased in the third quarter of 2003 to $1.4 million from $1.3 million for the third quarter of 2002. Installment receivable interest income for the first three quarters of 2003 increased to $3.9 million from $3.8 million for the first three quarters of 2002. The increases were due to growth in our portfolio of term licenses, partially offset by lower average discount rates. A portion of the fee from each term license arrangement is initially deferred and recognized as installment receivable interest income over the remaining term of the license. For purposes of the present value calculations, the discount rates used are estimates of customers’ borrowing rates, typically below prime rate, and have varied between 3.25% and 8.0% during the past few years.
Other interest income of $0.2 million for the third quarter of 2003 remained unchanged from the third quarter of 2002. Other interest income of $0.5 million for the first three quarters of 2003 remained unchanged from the first three quarters of 2002. Increases in balances of cash and cash equivalents and investments were offset by decreases in market interest rates, resulting in no changes in interest income.
Other income (expense), net, which consists mostly of currency exchange gain and losses, was $0.1 million income for the third quarter of 2003 versus ($0.4) million expense for the third quarter of 2002. Other income (expense), net, was $0.3 million income for the first three quarters of 2003 compared to ($0.8) million expense for the first three quarters of 2002. The increase was due to currency exchange gains in 2003 versus losses in 2002.
Income before provision for income taxes increased to $5.2 million for the third quarter of 2003 from $5.1 million for the third quarter of 2002. This $0.1 million improvement was due to a $2.8 million improvement in service gross margin from increased revenues and a $0.5 million in currency exchange improvements, offset by a $2.7 decrease in software license gross margin and increased operating expenses of $0.5 million.
The provision for income taxes for the third quarter of 2003 was $ 1.8 million compared to $ 0.3 million for the third quarter of 2002. The tax provision for the first three quarters of 2003 was $ 4.7 million and for the first three quarters of 2002 was $ 0.8 million. The 2002 tax provision was related to the profitability of our foreign operations. The 2003 tax provision related to current year profitability of our U.S. and foreign operations. Minimal provisions for U.S. federal and state income taxes were made in 2002 due to the availability of loss carry forwards to offset current period taxable income. The increase in income tax provision during 2003 was due to reversals in 2002 of valuation allowances related to our loss carry forwards and other deferred tax assets, which reduced our effective U.S. income tax provision in 2002.
We continue to maintain a valuation allowance with respect to certain deferred tax assets based on an assessment of the likelihood of their realization. We have not yet reversed this valuation allowance related to certain deferred tax assets because we do not yet have sufficient positive evidence of the likelihood of realization of those deferred tax assets. Should we continue to generate more positive evidence, through continued profitable operations, approximately $1.8 million of this valuation allowance, related to deferred federal income tax credits, may be reversed in future periods, resulting in a reduction of our income tax provision in the period that reversal occurs.
Liquidity and capital resources
We have funded our operations primarily from cash flow from operations and the proceeds of our public stock offerings. At September 30, 2003, we had cash and cash equivalents of $73.1 million, investments of $8.8 million and working capital of $92.4 million.
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Net cash provided by operations for the first three quarters of 2003 was $17.1 million compared with $20.7 million for the first three quarters of 2002. The decrease was primarily due to increases in accounts receivable.
Net cash used in investing activities for the first three quarters of 2003 was $(3.1) million primarily due to purchases of investments during 2003. This compares with ($5.9) million used in the first three quarters of 2002 primarily for purchases of investments.
On February 6, 2002, we acquired substantially all of the assets of 1mind Corporation for initial consideration valued at $3.9 million, consisting of 569,949 shares of our common stock (155,760 shares of which were deposited into escrow to secure the indemnity obligations of 1mind’s equity holders relating to the transaction) and warrants to purchase for nominal consideration 83,092 shares of our common stock. During the first quarter of 2003, we made a claim against all of the shares in escrow. In April 2003, these shares were subsequently retired and cancelled. This resulted in a $0.9 million reduction of goodwill and additional paid in capital.
Net cash provided by financing activities for the first three quarters of 2003 was $1.2 million compared with $4.0 million in the first three quarters of 2002. The decrease was primarily due to lower proceeds from employee stock option exercises.
We believe that current cash and cash equivalents, investments and cash flow from ongoing operations will be sufficient to fund our operations for the coming year. Material risks to additional cash flow from operations include declines in services revenue and delayed or reduced cash payments accompanying sales of new licenses. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected expenditures. In addition, there can be no assurance that additional capital if needed will be available on reasonable terms, if at all, at such time as we require.
We lease certain equipment and office space under non-cancelable operating leases with various extension dates through 2013. Rent expense under operating leases is recognized on a straight-line basis. Future minimum rental payments required under operating leases with non-cancelable terms in excess of one year at September 30, 2003 are as follows:
Our liquidity is affected by the manner in which we collect cash for certain types of license transactions. Historically, our term licenses have provided for monthly license payments, generally over five years. The following amounts of cash are due for receipt over the next six years in connection with our existing term license agreements:
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Critical accounting policies and estimates
Management’s discussion and analysis of the financial condition and results of operations is based upon the condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. We consider the following accounting policies to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment. If actual results differ significantly from management’s estimates and projections, there could be a material effect on our financial statements.
Revenue recognition
Term software license fees are generally payable on a monthly basis under term license agreements that generally have a five-year term and may be renewed for additional years at the customer’s option. The present value of future license payments is generally recognized as revenue upon customer acceptance, provided that no significant obligations or contingencies exist related to the software, other than maintenance support. A portion of the license fees payable under each term license agreement (equal to the difference between the total license payments and the discounted present value of those payments) is initially deferred and recognized as installment receivable interest income (and is not part of total revenue) over the license term. Many of our license agreements provide for license fee increases based on inflation. When such an increase occurs, as determined by the terms of the license agreement, we recognize the present value of such increases as revenue; the remainder of the increase is recognized as installment receivable interest income over the remaining license term. For purposes of the present value calculations, the discount rates used are estimates of customers’ borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.25% and 8.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements would be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized with the same present value approach, when the customer becomes committed to the new license terms and no significant obligations or contingencies exist related to the software, other than maintenance support.
Our services revenue is comprised of fees for software implementation, consulting, maintenance, and training services. Our software implementation and consulting agreements typically require us to provide services for a fixed fee or at an hourly rate. Revenues for time and material projects are recognized as fees are billed. Until the fair value of the elements of a contract can be determined, the recognition of services revenue for fixed-price projects is limited to amounts equal to direct costs incurred, resulting in no gross profit. We do not have a reliable track record for accurately estimating the time and resources needed to complete fixed price service projects. As a result, determination of the fair value of the elements of the contract has generally occurred late in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. If the fair values of the elements of a contract are then apparent, the remaining revenue and profit associated with the fixed price services elements will be recognized when the project is completed. To the extent that a software license is included in the contract, any residual amounts remaining after revenue is allocated to the services elements are recorded as license revenues. All costs of services are expensed as incurred.
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Deferred revenue consists primarily of billed fees from arrangements, for which acceptance of the software license or service milestone has not occurred, the unearned portion of services revenue and advance payment of maintenance fees. We estimate the value of committed and undelivered services to be delivered after license implementation, and defer that amount until the related elements of the agreement are completed and provided to the customer. We base these estimates on our historical experience. The timing of revenue recognized under our arrangements with customers is impacted by these estimates, but the total value of revenue recognized during the arrangements is not.
Allowance for doubtful accounts
We maintain an allowance for doubtful accounts using estimates that we make based on factors we believe appropriate such as the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, customer creditworthiness and current economic trends. If we used different assumptions, or if the financial condition of customers were to deteriorate, resulting in an impairment of their ability to make payments, additional provisions for doubtful accounts would be required and would increase bad debt expense.
Accounting for income taxes
We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, or FAS 109, “Accounting for Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. FAS 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. We evaluate the realizability of our deferred tax assets quarterly by assessing our valuation allowance and by adjusting the amount of such allowance, if necessary. At September 30, 2003, we had net deferred tax assets primarily resulting from temporary differences between the book and tax bases of assets and liabilities, and loss and credit carry forwards. We continue to provide a valuation allowance on certain deferred tax assets based on an assessment of the likelihood of their realization. In reaching our conclusion, we evaluated certain relevant criteria including deferred tax liabilities that can be used to offset deferred tax assets, estimates of future taxable income of appropriate character within the carry forward period available under the tax law, and tax planning strategies. We have not yet reversed this valuation allowance related to certain deferred tax assets because we do not yet have sufficient positive evidence of the likelihood of realization of those deferred tax assets. Should we continue to generate more positive evidence, through continued profitable operations, approximately $1.8 million of this valuation allowance, related to deferred federal income tax credits, may be reversed in a future period, resulting in a reduction of our income tax provision in the period that reversal occurs.
Except for the potential reversal of the valuation allowance, we expect our provision for income taxes in future periods to reflect an effective tax rate significantly higher than earlier periods. Our judgments regarding future taxable income may change due to market conditions, changes in U.S. or international tax laws, and other factors. These changes, if any, may require material adjustments to these deferred tax assets, resulting in either a tax benefit, if it is estimated that future taxable income is likely, or a reduction in the value of the deferred tax assets, if it is determined that their value is impaired, resulting in a reduction in net income or an increase in net loss in the period when such determinations are made.
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In addition, we have provided for potential tax liabilities due in foreign jurisdictions. Judgment is required in determining our worldwide income tax expense provision. In the ordinary course of conducting a global business enterprise, there are many transactions and calculations undertaken whose ultimate tax outcome cannot be certain. Some of these uncertainties arise as a consequence of transactions and arrangements made among related parties. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from what is reflected in our historical income tax provisions and accruals. Such differences could have a material impact on our income tax provision and operating results in the period in which such a determination is made.
Contingencies
From time to time, we are threatened with or become party to litigation. We periodically assess each matter in order to determine if a contingent liability in accordance with Statement of Financial Accounting Standards No. 5, or SFAS 5, “Accounting for Contingencies,” should be recorded. In making this determination, we may, depending on the nature of the matter, consult with internal and external legal counsel and technical experts. Based on the information we obtain, combined with our judgment regarding all the facts and circumstances of each matter, we determine whether it is probable that a contingent loss may be incurred and whether the amount of such loss can be estimated. Should a loss be probable and estimable, we record a contingent loss in accordance with SFAS 5. In determining the amount of a contingent loss, we consider advice received from experts in the specific matter, current status of legal proceedings, settlement negotiations that may be ongoing, prior case history and other factors. Should the judgments and estimates made by us be incorrect, we may need to record additional contingent losses that could materially adversely impact our results of operations.
Inflation
Inflation has not had a significant impact on our operating results to date, and we do not expect it to have a significant impact in the future. Our unbilled license and maintenance fees are typically subject to annual increases based on recognized inflation indexes.
Significant customers
First Data Resources accounted for 15% and 28% of our total consolidated revenue for the nine months ended September 30, 2003 and 2002, respectively. Another customer accounted for 19% of total revenue for the nine months ended September 30, 2003.
Forward-looking statements
This Report on Form 10-Q contains or incorporates forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which we operate and management’s beliefs and assumptions. In addition, other written or oral statements that constitute forward-looking statements may be made by or on our behalf. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate,” “may,” variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. We have included important factors in the cautionary statements below under the heading “Factors That May Affect Future Results” that we believe could cause our actual results to differ materially from the forward-looking statements we make. We do not intend to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
Factors that may affect future results
We need to close more new license transactions to grow or maintain our current revenue level. In recent years, a substantial majority of our license revenue has been derived from existing customers. We have been particularly dependent on First Data Resources (“FDR”) for a significant portion of our revenue during the past few years. With the perpetual license entered into with FDR in 2002, FDR is not likely to represent a large portion of our revenue after the third quarter of 2003. Therefore, it will be necessary for us to close more license transactions with new customers or expand our relationships with existing customers to replace the FDR revenue. In addition, because we derive a substantial portion of our services revenue from implementation of software licensed by new
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customers, we will need to close more license transactions with new customers if we are to maintain or grow our services revenue. While we have increased our new license bookings in 2003 as compared to 2002, we will need to continue with growth in bookings in the future for us to grow or maintain our current revenue level in 2004 and there can be no assurance that we will be successful in doing so.
The timing of license revenues is related to the completion of implementation services and product acceptance by the customer, the timing of which has been difficult to predict accurately. Quarterly results have fluctuated and are likely to continue to fluctuate significantly. There can be no assurance that we will be profitable on an annual or quarterly basis or that earnings or revenues will meet analysts’ expectations. Fluctuations may be particularly pronounced because a significant portion of revenues in any quarter is attributable to product acceptance or license renewal by a relatively small number of customers. Fluctuations also reflect our policy of recognizing revenue upon product acceptance or license renewal in an amount equal to the present value of the total committed payments due during the term. Customers generally do not accept products until the end of a lengthy sales cycle and an implementation period, typically ranging from six to twelve months but in some cases significantly longer. We are currently in the process of introducing new product technology and making material changes to our existing products. This may result in even lengthier sales and implementation cycles which may adversely affect our financial performance. This may increase the volatility in our quarterly operating results. Risks over which we have little or no control, including customers’ budgets, staffing allocation, and internal authorization reviews, can significantly affect the sales and acceptance cycles. Changes dictated by customers may delay product implementation and revenue recognition.
Our stock price has been volatile. Quarterly results have fluctuated and are likely to continue to fluctuate significantly. The market price of our common stock has been and may continue to be highly volatile. Factors that are difficult to predict, such as quarterly revenues and operating results, statements and ratings by financial analysts, and overall market performance, will have a significant effect on the price for shares of our common stock. Revenues and operating results have varied considerably in the past from period to period and are likely to vary considerably in the future. We plan product development and other expenses based on anticipated future revenue. If revenue falls below expectations, financial performance is likely to be adversely affected because only small portions of expenses vary with revenue. As a result, period-to-period comparisons of operating results are not necessarily meaningful and should not be relied upon to predict future performance.
If existing customers do not renew their term licenses, our financial results may suffer. Term license renewal negotiations have required more effort due to economic pressures and consolidation among our customers. A significant portion of total revenue has been attributable to term license renewals. While historically a majority of customers have renewed their term licenses, there can be no assurance that a majority of customers will continue to renew expiring term licenses. A decrease in term license renewals absent offsetting revenue from other sources would have a material adverse effect on future financial performance. In addition, we are currently entering into perpetual licenses with most of our new customers, the effect of which may be to increase our license revenue and cash flow in the short term but to decrease the amount of revenue and cash flow from the renewal of term license in the long term.
We will need to develop new products, evolve existing ones, and adapt to technology change. Technical developments, customer requirements, programming languages and industry standards change frequently in our markets. As a result, success in current markets and new markets will depend upon our ability to enhance current products, to develop and introduce new products that meet customer needs, keep pace with technology changes, respond to competitive products, and achieve market acceptance. Product development requires substantial investments for research, refinement and testing. There can be no assurance that we will have sufficient resources to make necessary product development investments. We may experience difficulties that will delay or prevent the successful development, introduction or implementation of new or enhanced products. Inability to introduce or implement new or enhanced products in a timely manner would adversely affect future financial performance. Our products are complex and may contain errors. Errors in products will require us to ship corrected products to customers. Errors in products could cause the loss of or delay in market acceptance or sales and revenue, the diversion of development resources, injury to our reputation, or increased service and warranty costs which would have an adverse effect on financial performance.
The market for our offerings is increasingly and intensely competitive, rapidly changing, and highly fragmented. The market for business process management software and related implementation, consulting and training services is intensely competitive and highly fragmented. We currently encounter significant competition from internal information systems departments of potential or existing customers that develop custom software. We
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also compete with companies that target the customer interaction and workflow markets and professional service organizations that develop custom software in conjunction with rendering consulting services. Competition for market share and pressure to reduce prices and make sales concessions are likely to increase. Many competitors have far greater resources and may be able to respond more quickly and efficiently to new or emerging technologies, programming languages or standards or to changes in customer requirements or preferences. Competitors may also be able to devote greater managerial and financial resources to develop, promote and distribute products and provide related consulting and training services. There can be no assurance that we will be able to compete successfully against current or future competitors or that the competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition.
We have historically sold to the financial services market. This market is continuing to consolidate, and faces uncertainty due to many other factors. We have historically derived a significant portion of our revenue from customers in the financial services market, and our future growth depends, in part, upon increased sales to this market. Competitive pressures, industry consolidation, decreasing operating margins within this industry, currency fluctuations, geographic expansion and deregulation affect the financial condition of our customers and their willingness to pay. In addition, customers’ purchasing patterns are somewhat discretionary. As a result, some or all of the factors listed above may adversely affect the demand by customers. The financial services market is undergoing intense domestic and international consolidation. In recent years, several customers have been merged or consolidated. Future mergers or consolidations may cause a decline in revenues and adversely affect our future financial performance.
We depend on certain key personnel, and must be able to attract and retain qualified personnel in the future. The business is dependent on a number of key, highly skilled technical, managerial, consulting, sales, and marketing personnel, including Mr. Trefler, our Chief Executive Officer. The loss of key personnel could adversely affect financial performance. We do not have any significant key-man life insurance on any officers or employees and do not plan to obtain any. Our success will depend in large part on the ability to hire and retain qualified personnel. The number of potential employees who have the extensive knowledge of computer hardware and operating systems needed to develop, sell and maintain our products is limited, and competition for their services is intense, and there can be no assurance that we will be able to attract and retain such personnel. If we are unable to do so, our business, operating results, and financial condition could be materially adversely affected.
We rely on certain third-party relationships. We have a number of relationships with third parties that are significant to sales, marketing and support activities, and product development efforts. We rely on relational database management system applications and development tool vendors, software and hardware vendors, and consultants to provide marketing and sales opportunities for the direct sales force and to strengthen our products through the use of industry-standard tools and utilities. We also have relationships with third parties that distribute our products. In particular, we benefit from our non-exclusive relationship with First Data Resources for the distribution of products to the credit card market and with PFPC Inc. for distribution of products to the mutual fund market. FDR can sell applications based on our software to their credit card customers who have less than an agreed number of active credit card accounts as identified in the perpetual license agreements, without paying an additional fee to us. There can be no assurance that these companies, most of which have significantly greater financial and marketing resources, will not develop or market products that compete with ours in the future or will not otherwise end their relationships with or support of us.
We may face product liability and warranty claims. Our license agreements typically contain provisions intended to limit the nature and extent of our risk of product liability and warranty claims. There is a risk that a court might interpret these terms in a limited way or could hold part or all of these terms to be unenforceable. Also, there is a risk that these contract terms might not bind a party other than the direct customer. Furthermore, some of our licenses with our customers are governed by non-U.S. law, and there is a risk that foreign law might give us less or different protection. Although we have not experienced any material product liability claims to date, a product liability suit or action claiming a breach of warranty, whether or not meritorious, could result in substantial costs and a diversion of management’s attention and our resources.
We face risks from operations and customers based outside of the U.S. Sales to customers headquartered outside of the United States represented approximately 22%, 23% and 26% of our total revenue in 2002, 2001 and 2000, respectively. We, in part through our wholly-owned subsidiaries based in the United Kingdom, Singapore, Canada, and Australia, market products and render consulting and training services to customers based in Canada, the United Kingdom, France, Germany, the Netherlands, Belgium, Switzerland, Austria, Ireland, Sweden, South Africa, Mexico, Australia, Hong Kong, and Singapore. We have established offices in continental Europe and
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Australia. We believe that growth will necessitate expanded international operations requiring a diversion of managerial attention and financial resources. We anticipate hiring additional personnel to accommodate international growth, and we may also enter into agreements with local distributors, representatives, or resellers. If we are unable to do one or more of these things in a timely manner, our growth, if any, in our foreign operations will be restricted, and our business, operating results, and financial condition could be materially and adversely affected.
In addition, there can be no assurance that we will be able to maintain or increase international market demand for our products. Most of our international sales are denominated in U.S. dollars. Accordingly, any appreciation of the value of the U.S. dollar relative to the currencies of those countries in which we distribute our products may place us at a competitive disadvantage by effectively making our products more expensive as compared to those of our competitors. Additional risks inherent in our international business activities generally include unexpected changes in regulatory requirements, increased tariffs and other trade barriers, the costs of localizing products for local markets and complying with local business customs, longer accounts receivable patterns and difficulties in collecting foreign accounts receivable, difficulties in enforcing contractual and intellectual property rights, heightened risks of political and economic instability, the possibility of nationalization or expropriation of industries or properties, difficulties in managing international operations, potentially adverse tax consequences (including restrictions on repatriating earnings and the threat of “double taxation”), enhanced accounting and internal control expenses, and the burden of complying with a wide variety of foreign laws. There can be no assurance that one or more of these factors will not have a material adverse effect on our foreign operations, and, consequentially, our business, operating results, and financial condition.
We face risks related to intellectual property claims or appropriation of our intellectual property rights. We rely primarily on a combination of copyright, trademark and trade secrets laws, as well as confidentiality agreements to protect our proprietary rights. In October 1998, we were granted a patent by the United States Patent and Trademark Office relating to the architecture of our systems. We cannot assure that such patent will not be invalidated or circumvented or that rights granted there under or the description contained therein will provide competitive advantages to our competitors or others. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain the use of information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology.
We are not aware that any of our products infringe the proprietary rights of third parties. There can be no assurance, however, that third parties will not claim infringement by us with respect to current or future products. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays, or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results, and financial condition.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. Our market risk exposure is primarily fluctuations in foreign exchange rates and interest rates. We have not entered into derivative or hedging transactions to manage risk in connection with such fluctuations.
We derived approximately 36% of our total revenue for the quarter ending September 30, 2003 from sales to customers based outside of the United States. Certain of our international sales are denominated in foreign currencies. The price in dollars of products sold outside the United States in foreign currencies will vary as the value of the dollar fluctuates against such foreign currencies. Although our sales denominated in foreign currencies historically have not been material, there can be no assurance that such sales will not be material in the future and that there will not be increases in the value of the dollar against such currencies that will reduce the dollar return to us on the sale of our products in such foreign currencies.
We believe that at current market interest rates, the fair value of license installments receivable approximates carrying value as reported on our balance sheets. However, there can be no assurance that the fair value will approximate the carrying value in the future. Factors such as increasing interest rates can reduce the fair
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value of the license installments receivable. The carrying value reflects a weighted average of historic discount rates. The average rate changes with market rates as new license installment receivables are added to the portfolio, which mitigates exposure to market interest rate risk. A 10% change in the market rates would not have a significant impact on the fair value of our license installments receivable.
Item 4. Controls and Procedures
(a) As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(3). Based upon the required evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective.
(b) There have been no changes in the Company’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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Part II - Other Information:
Item 1. Legal Proceedings
Not applicable.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
The exhibits listed in the Exhibit Index immediately preceding such exhibits are filed as part of this report.
The registrant furnished the following Current Report on Form 8-K during the three months ended September 30, 2003:
The registrant furnished a report on Form 8-K with the Securities and Exchange Commission on July 28, 2003 furnishing, pursuant to item 12 of Form 8-K, a copy of the press release issued by the registrant on July 28, 2003 announcing its results of operations for the three months ended, and financial condition as of, June 30, 2003.
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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.
Date: October 22, 2003
By:
/s/ Alan Trefler
Chairman and Chief Executive Officer
(principal executive officer)
/s/ Christopher Sullivan
Senior Vice President, Chief Financial Officer and Treasurer
(principal financial and accounting officer)
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PEGASYSTEMS, INC.
Exhibit Index
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