UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
---------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004.
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _________ TO _________
COMMISSION FILE NUMBER 1-10139
NETEGRITY, INC.
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 04-2911320
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)
201 JONES ROAD
WALTHAM, MA 02451
(Address of Principal Executive Offices) (Zip Code)
(781) 890-1700
(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 other 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 [ ]
As of May 3, 2004 there were 37,865,440 shares of Common Stock outstanding,
exclusive of treasury shares.
QUARTERLY REPORT ON FORM 10-Q
QUARTER ENDED MARCH 31, 2004
TABLE OF CONTENTS
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of March 31, 2004 and
December 31, 2003 (unaudited)................................................................ 3
Condensed Consolidated Statements of Operations for the three months ended
March 31, 2004 and 2003 (unaudited).......................................................... 4
Condensed Consolidated Statements of Cash Flows for the three months ended
March 31, 2004 and 2003 (unaudited).......................................................... 5
Notes to Condensed Consolidated Financial Statements......................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........ 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk................................... 26
Item 4. Controls and Procedures...................................................................... 27
PART II OTHER INFORMATION............................................................................ 27
Item 1. Legal Proceedings............................................................................ 27
Item 6. Exhibits and Reports on Forms 8-K............................................................ 27
SIGNATURES.............................................................................................. 29
2
PART I. - FINANCIAL INFORMATION
NETEGRITY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
MARCH 31, DECEMBER 31,
2004 2003
------------ ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents.................................................. $ 15,653 $ 20,123
Short-term available-for-sale securities................................... 47,498 51,557
Accounts receivable--trade, net of allowances of $942 at
March 31, 2004 and $829 at December 31, 2003.............................. 16,438 14,340
Prepaid expenses and other current assets.................................. 3,526 2,513
Restricted cash............................................................ - 538
------------ ------------
Total Current Assets...................................................... 83,115 89,071
Long-term available-for-sale securities..................................... 21,743 19,401
Property and equipment, net................................................. 4,520 4,848
Restricted cash............................................................. 771 767
Goodwill.................................................................... 34,503 34,503
Other intangible assets, net................................................ 6,990 7,500
Other assets................................................................ 879 1,134
------------ ------------
Total Assets.............................................................. $ 152,521 $ 157,224
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable--trade.................................................... $ 2,062 $ 1,415
Accrued compensation and benefits.......................................... 3,847 5,947
Other accrued expenses..................................................... 7,868 16,273
Deferred revenue........................................................... 21,394 18,503
------------ ------------
Total Current Liabilities................................................. 35,171 42,138
------------ ------------
Commitments and Contingencies
STOCKHOLDERS' EQUITY:
Common stock, voting, $.01 par value; 135,000 shares authorized;
37,768 shares issued and 37,730 shares outstanding at March 31,
2004; 37,577 shares issued and 37,539 shares outstanding at
December 31, 2003.......................................................... 378 375
Additional paid-in capital.................................................. 226,700 226,019
Accumulated other comprehensive income (loss)............................... 142 (137)
Accumulated deficit......................................................... (109,686) (110,971)
Loan to officer............................................................. (100) (116)
------------ ------------
117,434 115,170
Less--Treasury stock, at cost: 38 shares.................................... (84) (84)
------------ ------------
Total Stockholders' Equity.................................................. 117,350 115,086
------------ ------------
Total Liabilities and Stockholders' Equity.................................. $ 152,521 $ 157,224
============ ============
The accompanying notes are an integral part of the condensed
consolidated financial statements.
3
NETEGRITY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE THREE MONTHS
ENDED MARCH 31,
-------------------------
2004 2003
---------- ----------
Revenues:
Software licenses................................ $ 12,857 $ 8,418
Services......................................... 9,525 7,630
Other............................................ 653 631
---------- ----------
Total revenues.................................. 23,035 16,679
---------- ----------
Cost of Revenues:
Cost of software licenses........................ 314 491
Non-cash cost of revenues........................ 510 2,699
Cost of services................................. 3,130 2,987
Cost of other.................................... 419 363
---------- ----------
Total cost of revenues.......................... 4,373 6,540
---------- ----------
Gross profit...................................... 18,662 10,139
Selling, general and administrative expenses...... 11,537 10,496
Research and development expenses................. 5,986 4,874
---------- ----------
Income (loss) from operations..................... 1,139 (5,231)
Other income, net................................. 322 374
---------- ----------
Income (loss) before provision for income taxes... 1,461 (4,857)
Provision for income taxes........................ 175 --
---------- ----------
Net income (loss)................................. $ 1,286 $ (4,857)
========== ==========
Net income (loss) per share:
Basic and diluted................................. $ 0.03 $ (0.14)
Weighted average shares outstanding:
Basic............................................. 37,611 34,318
Diluted........................................... 40,851 34,318
The accompanying notes are an integral part of the condensed
consolidated financial statements.
4
NETEGRITY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
FOR THE THREE MONTHS
ENDED MARCH 31,
--------------------------
2004 2003
----------- ----------
OPERATING ACTIVITIES:
Net income (loss)................................................ $ 1,286 $ (4,857)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization................................... 1,380 3,826
Provision for doubtful accounts................................. 230 45
Non-cash interest (income) expense.............................. 426 95
Loss on sale of marketable securities........................... (20) --
Changes in operating assets and liabilities:
Accounts receivable - trade..................................... (2,327) 7,027
Prepaid expenses and other current assets....................... (89) 1,120
Other assets.................................................... (8) 6
Accounts payable - trade........................................ 647 96
Accrued compensation and benefits............................... (2,100) (1,905)
Other accrued expenses.......................................... (998) (1,391)
Deferred revenue................................................ 2,890 599
----------- ----------
Net cash provided by operating activities........................ 1,317 4,661
----------- ----------
INVESTING ACTIVITIES:
Proceeds from sales of marketable securities..................... 9,632 8,035
Proceeds from maturities of marketable securities................ 2,000 7,320
Purchases of marketable securities............................... (10,210) (21,822)
Purchases of property and equipment.............................. (541) (625)
Cash used for acquisition, net of cash acquired.................. (7,530) --
Restricted cash.................................................. (4) (4)
----------- ----------
Net cash used for investing activities........................... (6,653) (7,096)
----------- ----------
FINANCING ACTIVITIES:
Proceeds from issuance of common stock under stock plans......... 683 47
Proceeds from repayment of loan to officer....................... 16 --
----------- ----------
Net cash provided by financing activities........................ 699 47
----------- ----------
Effect of exchange rate changes on cash and cash equivalents..... 167 (10)
----------- ----------
Net change in cash and cash equivalents.......................... (4,470) (2,398)
Cash and cash equivalents at beginning of period................. 20,123 25,707
----------- ----------
Cash and cash equivalents at end of period....................... $ 15,653 $ 23,309
=========== ==========
The accompanying notes are an integral part of the condensed
consolidated financial statements.
5
NETEGRITY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Basis of Presentation and Principles of Consolidation
The accompanying unaudited condensed consolidated financial statements
include the accounts and operations of Netegrity, Inc. and its wholly owned
subsidiaries ("Netegrity", "we" or "our") and have been prepared pursuant to the
rules and regulations of the Securities and Exchange Commission regarding
interim financial reporting. Accordingly, they do not include all of the
information and notes required by accounting principles generally accepted in
the United States of America for complete financial statements and thus should
be read in conjunction with the audited consolidated financial statements
included in our Annual Report on Form 10-K filed on March 1, 2004. In the
opinion of management, the accompanying unaudited condensed consolidated
financial statements contain all adjustments, consisting only of those of a
normal recurring nature, necessary for a fair presentation of the Company's
financial position, results of operations and cash flows at the dates and for
the periods indicated. The results of operations for the three months ended
March 31, 2004 are not necessarily indicative of the results expected for the
remainder of the year ending December 31, 2004.
All significant intercompany accounts and transactions have been eliminated
in consolidation.
(b) Revenue Recognition
Our revenues are primarily generated from the sale of perpetual licenses for
our proprietary SiteMinder, IdentityMinder Web Edition, IdentityMinder
eProvision and TransactionMinder products and related services. We generate our
services revenues from consulting and training services performed for customers
and from the maintenance and support of our products. As described below,
significant management judgments and estimates must be made and used in
connection with the revenues recognized in any accounting period. Management
analyzes various factors, including specific terms and conditions of a
transaction, historical experience, credit worthiness of customers and current
market and economic conditions. Changes in judgments based upon these factors
could impact the timing and amount of revenues and cost recognized.
We generally license our software products on a perpetual basis. We apply
the provisions of Statement of Position No. 97-2, "Software Revenue
Recognition," as amended by Statement of Position No. 98-9, "Software Revenue
Recognition, with Respect to Certain Transactions," to all transactions
involving the sale of software products. We recognize revenues from the sale of
software licenses when persuasive evidence of an arrangement exists, the product
has been delivered, the fees are fixed or determinable and collection of the
resulting receivable is reasonably assured. This policy is applicable to all
sales, including sales to resellers and end users. We do not offer a right of
return on our products.
For all sales, we use a license agreement signed by both parties and/or a
purchase order with binding terms and conditions as evidence of an arrangement.
For arrangements with multiple obligations (for example, software license,
undelivered maintenance and support, training and consulting), we allocate
revenues to each component of the arrangement using the residual value method
based on the fair value of the undelivered elements. We defer revenue from the
arrangement equivalent to the fair value of the undelivered elements. Fair value
for each component is either the price we charge when the same component is sold
separately or the price established by the members of our management who have
the relevant authority to set prices for an element not yet sold separately.
At the time of the transaction, we assess whether the fee associated with
the transaction is fixed or determinable based on the payment terms associated
with the transaction. If a significant portion of the fee is due after our
normal payment terms, which are generally 30 to 90 days from invoice date, we
account for the fee as not being fixed or determinable. In those cases, we
recognize revenues as the fees become due. In addition, we assess whether
collection is probable based on the credit worthiness of the customer. Initial
credit worthiness is assessed through Dun & Bradstreet or similar credit rating
agencies. Credit worthiness for follow-on transactions is assessed through a
review of the transaction history with the customer. We do not typically request
collateral from our customers. If we determine that collection of a fee is not
reasonably assured, we defer the fee and recognize revenues at the time
collection becomes reasonably assured, which is generally upon receipt of cash.
Installation by Netegrity is not considered essential to the functionality
of our products as these services do not alter the product capabilities, do not
require specialized skills and may be performed by the customer or other
vendors. Revenues for maintenance and support are recognized ratably over the
term of the support period. Revenues from consulting and training services
generally are
6
recognized as the services are performed.
(c) Cash and Cash Equivalents
Cash and cash equivalents include cash, money market investments and other
highly liquid investments with original maturities or remaining original
maturities at date of purchase of three months or less.
(d) Restricted Cash
Long term restricted cash represents a time deposit held at financial
institutions in connection with the lease of the Company's office space. This
time deposit has an expiration date of August 2004, however it has an automatic
renewal clause.
(e) Marketable Securities
Investments, which primarily consist of debt securities, are accounted for
under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting
for Certain Investments in Debt and Equity Securities" issued by the Financial
Accounting Standards Board (FASB). Pursuant to the provisions of SFAS No. 115,
the Company has classified its investment portfolio as "trading",
"available-for-sale" or "held to maturity". "Trading" securities are bought and
held principally for the purpose of selling them in the near term and are
recorded at fair value. Fair value is based upon quoted market prices.
Unrealized gains and losses on trading securities are included in the
determination of net income (loss). "Available-for-sale" securities include debt
securities that are being held for an unspecified period of time and may be used
for liquidity or other corporate purposes and are recorded at fair value.
Unrealized gains and losses on available-for-sale securities are reported as a
separate component of accumulated other comprehensive income (loss) in
stockholders' equity, net of related taxes.
(f) Other Intangible Assets, net
The Company accounts for purchased technology and software development costs
in accordance with SFAS No. 86, "Accounting for the Costs of Computer Software
to Be Sold, Leased, or Otherwise Marketed". Under SFAS No. 86, the Company is
required to test for recoverability of its capitalized software costs as of each
balance sheet date or an interim period if events and circumstances indicate
that the carrying amount may not be recoverable. Impairment is recorded as the
excess of the unamortized cost over the expected future net realizable value of
the products.
Software development costs subsequent to the establishment of technological
feasibility are capitalized and amortized to non-cash cost of software. Based on
the Company's product development process, technological feasibility is
established upon completion of all planning, designing, coding and testing
activities. Such costs are amortized over the estimated life of the product.
During the first quarter of 2004, costs incurred by the Company between
completion of all planning, designing, coding and testing activities and the
point at which the product is ready for general release were insignificant and,
therefore, no such costs have been capitalized during this time period.
(g) Goodwill
The Company reviews the valuation of goodwill in accordance with SFAS No.
142 "Goodwill and Other Intangible Assets." Under the provisions of SFAS No.
142, goodwill is required to be tested for impairment annually in lieu of being
amortized. This testing is done in the fourth quarter of each year. Furthermore,
goodwill is required to be tested for impairment on an interim basis if an event
or circumstance indicates that it is more likely than not that an impairment
loss has been incurred. An impairment loss is recognized to the extent that the
carrying amount of goodwill exceeds its implied fair value. Impairment losses
are recognized in operations. The Company's valuation methodology for assessing
impairment requires management to make judgments and assumptions based on
historical experience and projections of future operating performance.
Management predominantly uses third party valuation reports to assist in its
determination of the fair value. If these assumptions differ materially from
future results, the Company may record impairment charges in the future.
7
(h) Comprehensive Income (Loss)
Comprehensive income (loss) is defined as the change in equity of a business
enterprise during a period from transactions and other events and circumstances
from non-owner sources, including foreign currency translation adjustments and
unrealized gains and losses on marketable securities held as
"available-for-sale". The components of comprehensive income (loss) were as
follows (in thousands):
FOR THE THREE
MONTHS ENDED
MARCH 31,
--------------------------
2004 2003
---- ----
Net income (loss)..................................... $ 1,286 $ (4,857)
Net unrealized holding gain (loss) arising during
the period.......................................... 131 8
Reclassification adjustment for net realized gains
included in net income (loss)....................... (20) --
---------- ----------
111 8
Net unrealized foreign currency translation
adjustment arising during the period................ 168 (10)
---------- ----------
Comprehensive income (loss)........................... $ 1,565 $ (4,859)
========== ==========
The components of accumulated other comprehensive income (loss) as of March
31, 2004 and December 31, 2003 were as follows (in thousands):
MARCH 31, 2004 DECEMBER 31, 2003
-------------- -----------------
Net unrealized holding gain (loss)....................... $ 23 $ (88)
Net unrealized foreign currency translation adjustment... 119 (49)
------ ------
Accumulated other comprehensive income (loss)............ $ 142 $ (137)
====== ======
(i) Earnings (Loss) Per Share
Basic earnings (loss) per share (EPS) is calculated by dividing net income
(loss) by the weighted average number of shares outstanding during the period.
Diluted EPS is calculated by dividing net income (loss) by the weighted average
number of shares outstanding plus the dilutive effect, if any, of outstanding
stock options and warrants using the "treasury stock" method. During periods of
net loss, diluted net loss per share does not differ from basic net loss per
share since potential shares of common stock from stock options and warrants are
anti-dilutive and therefore are excluded from the calculation. The following
table presents the calculation for both basic and diluted EPS (in thousands,
except per share data):
FOR THE THREE
MONTHS ENDED
MARCH 31,
--------------------------
2004 2003
---- ----
Net income (loss)............................... $ 1,286 $ (4,857)
Basic weighted average shares outstanding....... 37,611 34,318
Dilutive effect of stock options and warrants... 3,240 --
----------- -----------
Diluted shares outstanding...................... 40,851 34,318
Basic EPS....................................... $ 0.03 $ (0.14)
Diluted EPS..................................... $ 0.03 $ (0.14)
Options to purchase a total of 1.6 million and 500,000 shares of common
stock for the three months ended March 31, 2004, and 2003, respectively, were
excluded from the computation of diluted EPS because the impact was
anti-dilutive.
8
(j) Stock-Based Compensation
The Company accounts for its stock option plans under the recognition and
measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related Interpretations. No stock-based compensation cost is
reflected in net income (loss) for these plans, as all options granted under
these plans had exercise prices equal to the fair market value of the underlying
common stock on the date of grant. The following table illustrates the effect on
net income (loss) and earnings (loss) per share if the Company had applied the
fair value recognition provisions of FASB Statement No. 123, "Accounting for
Stock Based Compensation," to stock based compensation (in thousands, except per
share data):
FOR THE THREE
MONTHS ENDED
MARCH 31,
---------------------------
2004 2003
------------ ------------
Net income (loss), as reported............................ $ 1,286 $ (4,857)
Add: Stock-based employee compensation expense
not included in reported net income, net of related
tax effects............................................. (1,926) (2,876)
------------ ------------
Pro-forma net loss........................................ $ (640) $ (7,733)
============ ============
Earnings (loss) per share:
Basic and diluted--as reported.......................... $ 0.03 $ (0.14)
Basic and diluted--pro-forma............................ $ (0.02) $ (0.23)
The fair value of each stock option is estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted average
assumptions:
FOR THE THREE
MONTHS ENDED
MARCH 31,
------------------
2004 2003
------- -------
Risk-free interest rate............. 2.79% 2.78%
Expected dividend yield............. 0.0% 0.0%
Expected volatility................. 114% 138%
Expected life (years)............... 5.0 5.0
Weighted average fair value of
options granted during the period... $ 6.69 $ 3.22
(k) Recent Accounting Pronouncements
In November 2003, the Emerging Issues Task Force (EITF) of the Financial
Accounting Standards Board (FASB) reached a consensus on certain disclosure
provisions under Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment
and Its Application to Certain Investments." The disclosure provisions indicate
that certain quantitative and qualitative disclosures are required for debt and
marketable equity securities classified as available-for-sale or
held-to-maturity under SFAS Nos. 115 and 124 that are impaired at the balance
sheet date but for which an other-than-temporary impairment has not been
recognized. The EITF has not reached a consensus on the proposed models for
evaluating impairment of equity securities and debt securities. The consensus on
the required quantitative and qualitative disclosures is effective for fiscal
years ending after December 15, 2003. Adoption of the consensus did not have a
material impact on the Company's financial position or results of operations for
the quarter ended March 31, 2004.
NOTE 2: Acquisition
Business Layers
On December 30, 2003, the Company acquired Business Layers, Inc., a Delaware
corporation (Business Layers) and a provider of provisioning solutions, through
a merger of Business Layers and a subsidiary of the Company. In conjunction with
the acquisition, Business Layers became a wholly-owned subsidiary of the
Company. The aggregate consideration of $42.5 million included approximately
$15.0 million in cash, reimbursement of $920,000 in acquisition costs and
2,556,940 shares of the Company's common stock valued at approximately $26.6
million. A portion of the purchase price consideration, comprised of
approximately 358,000
9
shares of Netegrity common stock and approximately $400,000 of cash, has been
placed in escrow for up to one year from the acquisition date to secure the
indemnification obligations of certain former employees and the stockholders of
Business Layers under the merger agreement. The acquisition was accounted for
using the purchase method of accounting. The results of operations of Business
Layers from the acquisition date are included in the Company's consolidated
results of operations for the full quarter ended March 31, 2004.
In connection with the acquisition, the Company initiated an overall
integration plan that included the elimination of redundant headcount and
facilities. The Company accrued approximately $1.4 million of costs related to
the integration plan, consisting of approximately $545,000 of facilities costs
and approximately $888,000 for planned workforce reductions primarily of
duplicative selling, general and administrative employees. The Company paid the
majority of these costs prior to March 31, 2004, although the facilities costs
will not be paid in full until April 2006.
The Company engaged a third-party appraiser to conduct a valuation of the
intangible assets and to assist in the determination of useful lives for such
assets. Based on the appraisal, approximately $7.5 million of the purchase price
was allocated to developed technology and $3.8 million was allocated to
in-process research and development, which was expensed upon closing of the
transaction. The amount allocated to developed technology is being amortized
over its estimated useful life ranging from two to five years.
The valuation of in-process research and development was determined using
the income method. Revenue and expense projections for the in-process research
and development project were prepared by management. The value was determined
using the present value of the cash flows from the projections using a 30%
discount rate. As of March 31, 2004, the technologies under development were
approximately 75% complete based on project duration and costs. In the event
that the project is not completed and technological feasibility is not achieved,
there is no alternative future use for the in-process technology.
In accordance with SFAS No. 142, the total goodwill of approximately $34.5
million related to the acquisition will not be amortized. In lieu of being
amortized, goodwill is required to be tested for impairment annually or on an
interim basis if an event or circumstance indicates that it is more likely than
not that an impairment loss has been incurred.
NOTE 3: OPERATING SEGMENTS AND GEOGRAPHICAL INFORMATION
Based on the information provided to our chief operating decision maker for
purposes of making decisions about allocating resources and assessing
performance, our continuing operations have been classified into a single
segment. We primarily operate in the United States, Europe, the Middle East and
Asia Pacific. Revenues (based on the location of the customer) and long-lived
assets by geographic region are as follows (in thousands):
FOR THE THREE MONTHS
ENDED MARCH 31,
----------------------------
2004 2003
------------ ------------
Revenues:
United States of America...... $ 17,878 $ 12,083
Europe and the Middle East.... 3,401 3,469
Asia Pacific.................. 1,135 949
Canada........................ 621 178
------------ ------------
Total......................... $ 23,035 $ 16,679
============ ============
MARCH 31, DECEMBER 31,
------------ ------------
2004 2003
------------ ------------
Long-Lived Assets:
United States of America...... $ 45,372 $ 46,367
Europe and the Middle East.... 1,331 1,407
Asia Pacific.................. 187 211
Other......................... 2 0
------------ ------------
Total......................... $ 46,892 $ 47,985
============ ============
NOTE 4: RELATED PARTY TRANSACTIONS
LOAN TO OFFICER
The condensed consolidated balance sheets as of March 31, 2004 and December
31, 2003 include $100,000 and $116,000,
10
respectively, in loans to an officer of Netegrity issued in connection with the
exercise of stock options in 1996. The loan is reflected as a reduction of
stockholders' equity in the accompanying condensed consolidated balance sheets.
The loan is payable upon demand and bears interest at 7% per annum. The loan was
originally represented by a secured note; however, in May 2002, the note was
amended such that it became a full recourse unsecured note.
MARKETING SERVICES
During the three months ended March 31, 2004 and 2003, we paid approximately
$33,000 and $5,300, respectively, for marketing services to a company, the
principal shareholder of which is the son-in-law of one of the members of our
Board of Directors. We have similar arrangements with other marketing services
firms and believe the arrangement was entered into on substantially the same
terms and conditions as our arrangements with such other firms.
NOTE 5: COMMITMENTS AND CONTINGENCIES
The Company has commitments that expire at various times through 2010.
Non-cancelable operating leases shown below are primarily for facility costs for
the Company's corporate headquarters customer service, research and development
and world-wide sales offices. Other contractual obligations primarily consist of
minimum guaranteed payments to a software service provider for various
development projects (in thousands).
2004 (nine months ending) . $ 4,613
2005....................... 2,032
2006....................... 1,814
2007....................... 1,750
2008....................... 1,107
Thereafter................. 262
----------
$ 11,578
==========
Included in the operating lease commitments above is approximately $520,000
related to excess facilities which have been accrued in purchase accounting
related to our acquisitions and are payable through April 2006.
We incurred total operating lease expense, primarily related to certain
facilities and equipment under non-cancelable operating leases, of $790,000 and
$1.1 million for the quarters ended March 31, 2004 and 2003, respectively.
In April 2002, we entered into an agreement with a system integrator to
assist us in the development and launch of one of our products. Under the terms
of the agreement, as consideration for the system integrator's time in assisting
with the development of the product, we agreed to promote the system integrator
as an integrator of the developed product. Our obligation under the agreement
will be considered satisfied once the system integrator receives consulting
revenues totaling approximately $3.9 million from our customers, or by May 2004,
whichever occurs first. In the event that we recommend a competitor of the
system integrator to perform the integration work for a customer, we could
potentially owe a royalty to the system integrator based on the net license fee.
As of March 31, 2004, no royalties were due to the system integrator under this
agreement.
In August 2002, we entered into a five year non-cancelable operating lease
for an office building for our corporate headquarters. We occupied the new
facility in March 2003. In connection with the lease agreement, we delivered an
irrevocable, unconditional, negotiable letter of credit in the amount of
$771,000 as a security deposit.
In February 2004, we entered into an agreement with a software service
provider located in India under which we have guaranteed to pay this software
service provider a minimum of $4.0 million annually for various product
development projects. The initial term of this agreement expires in December
2004. The agreement provides for an annual renewal upon the agreement of both
parties. During the quarter ended March 31, 2004, approximately $1.2 million had
been paid to this software service provider.
We enter into standard indemnification agreements with our business partners
and customers in our ordinary course of business. Pursuant to these agreements,
we agree to repair or replace the product, pay royalties for a right to use, or
reimburse the indemnified party for actual damages awarded by a court against
the indemnified party for a intellectual property infringement claim by a third
party with respect to our products. The term of these indemnification agreements
is generally perpetual. The maximum potential amount of future payments we could
be required to make under these indemnification agreements is unlimited. We have
never incurred costs to defend lawsuits or settle claims related to these
indemnification agreements. As a result, we believe the estimated fair value of
these agreements is minimal. Accordingly, we have no liabilities recorded for
these agreements as of March 31, 2004.
11
We enter into standard indemnification agreements with our customers,
whereby we indemnify them for certain damages, such as personal property damage,
which may be incurred in connection with consulting services performed at a
customer location by our employees or our subcontractors. The potential amount
of future payments we could be required to make under these indemnification
agreements is unlimited. However, we have general and umbrella insurance
policies that enable us to recover a portion of any amounts paid. We have never
incurred costs to defend lawsuits or settle claims related to these
indemnification agreements. As a result, we believe the estimated fair value of
these agreements is minimal. Accordingly, we have no liabilities recorded for
these agreements as of March 31, 2004.
We generally warrant for ninety days from delivery to a customer that our
software products will perform free from material errors which prevent
performance in accordance with user documentation. Additionally, we warrant that
our consulting services will be performed consistent with generally accepted
industry standards. We have never incurred significant expense under our product
or service warranties. As a result, we believe the estimated fair value of these
agreements is minimal. Accordingly, we have no liabilities recorded for these
agreements as of March 31, 2004.
We have entered into employment and executive retention agreements with
certain employees and executive officers which, among other things, include
certain severance and change of control provisions. We have also entered into
agreements whereby we indemnify our officers and directors for certain events or
occurrences while the officer or director is, or was, serving at our request in
such capacity.
From time to time, we are involved in litigation relating to claims arising
out of our operations in the normal course of business. We are not presently a
party to any legal proceedings, the adverse outcome of which, in our opinion,
would have a material adverse effect on our results of operations or financial
position.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements about our plans, objectives,
expectations and intentions. You can identify these statements by words such as
"expect," "anticipate," "intend," "plan," "believe," "seek," "estimate," "may,"
"will" and "continue" or similar words. You should read statements that contain
these words carefully. They discuss our future expectations, contain projections
of our future results of operations or our financial condition or state other
forward-looking information, and may involve known and unknown risks over which
we have no control. You should not place undue reliance on forward-looking
statements. We cannot guarantee any future results, levels of activity,
performance or achievements. Moreover, we assume no obligation to update
forward-looking statements or update the reasons actual results could differ
materially from those anticipated in forward-looking statements, except as
required by law. The factors discussed in the sections captioned "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
"Certain Factors that May Affect Future Results," in this report identify
important factors that may cause our actual results to differ materially from
the expectations we describe in our forward-looking statements.
OVERVIEW
Netegrity's objective is to be a leading provider of enterprise security
software solutions specifically for managing user identities and access. Our
identity and access management product line provides companies a secure way to
make corporate information assets and resources available online. We believe
open, protected access is essential as companies seek to leverage the Web to
grow their businesses.
With Netegrity identity and access management products, companies are able
to securely use the Web -- Internet, Intranet or Extranet -- to meet the
information access needs of partners, suppliers, customers and employees.
Netegrity solutions are designed to enable businesses to ensure that the right
people have the right access to the right information across a variety of
applications, business systems and computing architectures. This enables more
business to be more securely conducted online, providing opportunities to
improve customer service and productivity, increase sales of products and
services and create business partnership value chains.
We derive our revenues primarily from our core products, SiteMinder,
IdentityMinder Web Edition, IdentityMinder eProvision and TransactionMinder,
which offer a single source solution for integrated, centralized identity
management, user access and administration and account provisioning/de-
provisioning. Our solution supports a broad range of technology environments,
and aims to ensure that companies optimize their existing information technology
investments while incorporating new technologies. We also offer various levels
of consulting and support services that enable our customers to successfully
implement our products in their organizations.
Our products are generally sold on a perpetual license basis. Customers
typically place an initial order for a limited number of users and purchase
additional users as their need for our products within their enterprise
increases. We believe that our product line synergies and the strength of our
customer base create opportunities to sell additional products to existing
customers. Customers also enter into an annual support agreement for their
software license at the time of initial purchase and typically renew this
support agreement annually. Our support agreement entitles customers to software
license updates and telephone support.
12
We believe sales of our products will be driven by customers' desires for a
comprehensive single-source identity access management solution whose key
benefits include reduced costs by reducing information technology complexity,
increased revenue potential by improving customer service online, expanded
business opportunities by creating real-time business networks and support for
regulatory compliance and risk mitigation. As a result, we expect that companies
will spend their discretionary information technology dollars on technology that
will help them drive revenue and reduce costs while mitigating risk. The
combined impact of a broadened product portfolio as well as the focus of our
direct sales resources on larger companies in selected industries has enabled us
to continue to drive business through our installed base while at the same time
adding new customers. However, information technology spending has sharply
decreased in the past two years and information technology budgets remained
constrained, which has had and could continue to have a direct effect on the
sale of our products. We believe that spending on technology will accelerate
slowly for the remainder of 2004 and we believe that as information technology
spending increases from current levels our revenues will increase.
Some of our products contain technology that is licensed from third parties.
Our cost of license revenue consists primarily of royalty fees that we pay for
the licensed technology. Cost of license revenue also includes amortization of
acquired software and product fulfillment costs. Cost of services includes
salaries and related expenses for our consulting, education and technical
support services organizations, and the associated cost of training facilities.
Our professional services group provides customers with project management,
architecture and design, custom development services and training. Our customers
typically pay for professional services at an hourly rate for the time it takes
us to complete the project. We strive to maintain effective staffing levels and
to limit the amount of turnover of our professional services staff. If we are
not successful in maintaining effective staffing levels, our ability to achieve
our service revenue and profitability objectives may be adversely affected.
The majority of our sales are made directly with customers. Our direct sales
to customers in countries outside of the United States are denominated in U.S.
dollars and local currency, with the majority of our sales denominated in U.S.
dollars. Our sales through indirect distribution channels are generally
denominated in U.S. dollars. For countries outside of the United States, we
generally pay our operating expenses in local currency. Where we do invoice
customers in local currency, we are exposed to foreign exchange rate
fluctuations from the time the contract is signed until collection occurs. We
are also exposed to foreign currency fluctuations between the time we collect in
U.S. dollars and the time we pay our operating expenses in local currency.
Fluctuations in currency exchange rates could affect the profitability and cash
flows in U.S. dollars of our products sold in international markets. To date,
these fluctuations have not been material.
Our future revenues and operating results may also fluctuate from quarter to
quarter based on the number and size of license deals and the size and scope of
the professional service projects in which we are engaged. In addition, license
revenues from a large customer deal may constitute a significant portion of our
total revenues in a particular quarter. Any such deal may result in increased
royalty payments and commission expenses. Any decline in our revenues will have
a significant impact on our financial results, particularly because a
significant portion of our operating costs, such as personnel, rent and
depreciation, are fixed in advance of a particular quarter. As a result, despite
cost savings realized to date, our costs for services personnel, sales and
marketing and general and administrative could increase as a percentage of
revenue, thereby affecting our operating results.
CRITICAL ACCOUNTING POLICIES AND SIGNIFICANT JUDGMENTS AND ESTIMATES
Our discussion and analysis of our financial condition and results of
operations are based on our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements requires
our management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements as well as the reported
revenues and expenses during the reporting periods. On an ongoing basis, our
management evaluates its estimates and judgments, including those related to
revenue recognition, accounts receivable reserves, valuation of long-lived and
intangible assets, goodwill, in-process research and development, and income
taxes. Our management bases its estimates on historical experience and on
various other factors that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying value of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.
We believe there have been no significant changes in our critical accounting
policies during the three months ended March 31, 2004 as compared to what was
previously disclosed in Management's Discussion and Analysis of Financial
Condition and Results of Operations included in our Annual Report on Form 10-K
for the year ended December 31, 2003.
13
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2004 COMPARED TO THREE MONTHS ENDED MARCH 31, 2003
REVENUES ($ IN MILLIONS)
MARCH 31, 2004 MARCH 31, 2003
-------------- --------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
- ---------- - ---------- ------------ ------------
Software licenses $ 12.9 56% $ 8.4 51% $ 4.5 53%
Services 9.5 41% 7.6 46% 1.9 25%
Other 0.6 3% 0.7 3% (0.1) (14%)
---------- --- ------ --- ------------
Total revenues $ 23.0 100% $ 16.7 100% $ 6.3 38%
========== === ====== === ============
Revenues. The increase in total revenues in the quarter ended March 31, 2004
from the quarter ended March 31, 2003 was primarily due to increases in software
license revenues from the sale of our SiteMinder product, as well as sales
generated by our new product offerings, IdentityMinder Web Edition,
IdentityMinder eProvision and TransactionMinder, in the quarter ended March 31,
2004. In addition, in the quarter ended March 31, 2004, we experienced increased
revenues from the sale of our service offerings which include consulting,
training, maintenance and support. Overall, we saw a modest improvement in
market conditions in the first quarter of 2004 as evidenced by a continued
increase in information technology spending in the United States and emerging
demand in Europe. We expect this growth in overall information technology
spending will accelerate slowly in the remainder of 2004 and we believe that as
information technology spending increases from current levels our revenues will
increase. We expect to continue to generate revenue from our SiteMinder product
as we continue to enhance SiteMinder to meet
14
changing market needs. We also believe that our focus on expanding our
leadership position in the identity and access management market with our new
IdentityMinder Web edition, IdentityMinder eProvision and TransactionMinder
product offerings and continuing to leverage the relationships we have built
with our partners to provide integration services directly to our customers will
enable us to acquire new customers and sell additional products to our existing
customers.
The increase in software license revenue in the quarter ended March 31,
2004 from the quarter ended March 31, 2003 was primarily due to the sale of our
SiteMinder product, sales of our new product offerings, which typically result
in larger average deal sizes, increased sales to our existing customers and
improved sales execution in the quarter ended March 31, 2004. Average deal size
and the type of customer (new name versus follow-on) are important metrics of
our business as these metrics assist us in measuring our market penetration as
well as our penetration into our existing customer base. The number of new name
deals increased to 28 in the quarter ended March 31, 2004 compared to 23 in the
quarter ended March 31, 2003 and the average size of new name deals increased to
approximately $159,000 in the quarter ended March 31, 2004 from approximately
$141,000 in the quarter ended March 31, 2003. The number of follow-on deals
increased to 77 in the quarter ended March 31, 2004 compared to 43 in the
quarter ended March 31, 2003, however the average size of follow-on deals
decreased to approximately $142,000 in the quarter ended March 31, 2004 from
approximately $163,000 in the quarter ended March 31, 2003. The increase in the
number of follow-on deals resulted from an increased focus on selling to our
existing customers, resulting in these customers buying additional user licenses
of our SiteMinder product as well as licenses for our new products. The decrease
in the average size of follow-on deals in the quarter ended March 31, 2004
versus the quarter ended March 31, 2003 was due to the increase in the number of
follow-on deals partially offset by the inclusion of two large deals, each in
excess of $1.5 million, in the quarter ended March 31, 2004.
The increase in services revenues in the quarter ended March 31, 2004 from
the quarter ended March 31, 2003 was primarily attributable to an increase of
$1.4 million in maintenance and support revenue in the quarter ended March 31,
2004. This increase resulted from an increase in maintenance associated with a
larger license revenue base, a significant number of maintenance renewals by our
existing customer base and an increase in the number of premium maintenance
services sold. The remaining increase in service revenue was related to an
increase of $232,000 in consulting revenue and $248,000 in training revenue.
Other revenues are derived from the Firewall legacy business. This business
remained relatively flat in the quarter ended March 31, 2004 and is not expected
to significantly increase in future periods.
GROSS PROFIT ($ IN MILLIONS)
MARCH 31, 2004 MARCH 31, 2003
-------------- --------------
GROSS GROSS $ CHANGE % CHANGE
$ PROFIT % $ PROFIT % 2003 TO 2004 2003 TO 2004
- -------- - -------- ------------ ------------
Gross profit - software
licenses $12.0 94% $ 5.2 62% $ 6.8 130%
Gross profit - services 6.4 67% 4.6 61% 1.8 38%
Gross profit - other 0.2 36% 0.3 42% (0.0) (13%)
----- ----- ------------
Total Gross Profit $18.6 81% $10.1 61% $ 8.5 84%
===== == ===== == ============ ===
Gross Profit. Gross profit is calculated as revenues less cost of revenues.
Cost of revenues includes, among other things, royalties due to third parties
for technology included in our products, amortization of capitalized software,
product fulfillment costs, salaries and related expenses for our consulting,
education and technical support services organizations, and the associated cost
of training facilities. Historically, we have realized overall gross profit
percentages of between 60% and 80%. In the quarter ended March 31, 2003 cost of
revenues included $2.7 million of amortization of capitalized software. Gross
profit percentages on license revenue, excluding the impact of amortization of
capitalized software, are typically in excess of 90% and gross profit
percentages on services revenue are typically in excess of 50%. Overall, we
believe that the cost of revenues in dollars will increase slightly in the
remainder of 2004 due to an increase in the cost of third party software
products that enhance and enable additional functionality in our products,
increased investment in our technical support organization and an increase in
staff levels in our professional services organization. We expect that these
increases will be offset by increases in revenues, and therefore, we anticipate
gross margin percentages to be approximately 75-80% for the remainder of 2004.
The increase in gross profit on software licenses is due to an increase in
license revenue and a significant decrease in the cost of
15
software licenses, which includes non-cash cost of software amortization, in the
quarter ended March 31, 2004 compared to the quarter ended March 31, 2003.
Non-cash cost of software licenses decreased by approximately $2.2 million as a
result of the impact of the sale of the portal technology and partially offset
by the addition of the newly acquired technology from Business Layers, both of
which occurred in the fourth quarter of 2003. The non-cash cost of software
licenses was $2.7 million in the quarter ended March 31, 2003, which represented
the amortization of purchased software related to the portal technology which
was recorded in connection with the acquisition of DataChannel. This acquired
technology was fully amortized as of June 30, 2003. On December 30, 2003, we
acquired Business Layers, Inc., and as a result of the transaction we recorded
assets related to the capitalized software acquired. These capitalized software
assets are being amortized over their estimated useful lives of two to five
years. As a result, we expect amortization expense to be approximately $2.0
million in 2004. Overall, we expect that gross profits on software licenses will
remain consistent through the remainder of 2004.
Gross profits on our services revenue are primarily driven by gross profits
on maintenance revenue and by gross profits on our consulting revenue contracts.
We experienced an increase in gross profit on services revenues in the quarter
ended March 31, 2004 as compared to the quarter ended March 31, 2003 due to an
increase in service revenue with only a slight increase in the corresponding
cost of providing these services. The cost of services increased slightly due to
an investment in the technical support organization during 2003 in order to
enhance overall customer satisfaction. This increase was partially offset by a
decrease in headcount in our training organization, a reduction in the cost paid
to third party consultants and the leveraging of our system integrator partner
relationships. The cumulative number of consultants we have trained at our
affiliated partners increased to over 1,200 at the end of the first quarter of
2004 as compared over 1,100 in the same period of 2003. We anticipate a decrease
in the gross profit percentage of our professional services organization over
the remainder of 2004 due to anticipated increases in staff levels and a
decrease in utilization rates, which were unusually high in the first quarter of
2004. For the remainder of 2004, we anticipate maintaining our historical gross
profit percentage on maintenance revenue since increased revenues will be offset
by increased investment in the technical support organization.
Gross profit on other is derived from the Firewall legacy business. This
business remained flat in 2004 and is not expected to significantly increase in
future periods.
OPERATING EXPENSES ($ IN MILLIONS)
MARCH 31, 2004 MARCH 31, 2003
-------------- --------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
- ---------- -------- ------------ ------------
Selling, general and
administrative expenses $ 11.5 50% $10.5 63% $ 1.0 10%
Research and development
expenses 6.0 26% 4.9 29% 1.1 23%
------- -- ----- -- ------------
Total operating expenses $ 17.5 76% $15.4 92% $ 2.1 14%
======= == ===== == ============ ==
Selling, General and Administrative Expenses. Selling, general and
administrative expenses consist primarily of salaries and other related costs
for selling, administrative and marketing personnel, sales commissions, travel,
legal and accounting services, public relations, marketing materials, trade
shows and certain facilities-related expenses. The increase in selling, general
and administrative expenses in the quarter ended March 31, 2004 from the quarter
ended March 31, 2003 was primarily attributable to increased salaries and
related expenses as a result of transition related costs incurred in connection
with the acquisition of Business Layers and an increase in the provision for bad
debts. These expenses were partially offset by reduced legal fees, insurance
expenses and reduced facility-related expenses, including office rent,
depreciation and utilities, primarily resulting from the consolidation of field
offices and the move of our corporate headquarters to a new facility. As we
continue to scrutinize discretionary expenses and evaluate reductions in
non-strategic programs, we anticipate selling, general and administrative
expenses as a percentage of total revenues will remain flat or increase slightly
in future periods to accommodate our revenue growth. We do not anticipate
significant increases in selling, general and administrative expenses as a
result of the acquisition of Business Layers because these functions have been
consolidated with our existing operations and duplicate positions were
eliminated.
Research and Development Expenses. Research and development expenses consist
primarily of personnel and outside contractor
16
costs to support product development. The increase in research and development
expenses in the quarter ended March 31, 2004 from the quarter ended March 31,
2003 was primarily due to an increase in staff and related expenses resulting
from the 32 research and development employees located in Israel that were
acquired from Business Layers in December 2003. Additionally, we continue to
increase consulting expenses related to the continued leverage of offshore
third-party contractors used to perform certain testing and porting of our
products. We recognize that our investment in research and development is
required to remain competitive and, therefore, our research and
development expenses in dollars may increase in future periods due to the
continued development of our products and services.
Other Income, Net. Other income, net, decreased slightly in the quarter
ended March 31, 2004, compared to the quarter ended March 31, 2003. This
decrease was primarily attributable to lower interest income earned due to lower
average cash, cash equivalents and marketable securities balances in the quarter
ended March 31, 2004. The asset balances decreased as a result of cash payments
made as part of the purchase price for Business Layers. Our portfolio is
generally comprised of highly liquid, high quality investments, and therefore we
do not expect significant fluctuations in other income as a result of changes in
investment yields.
Provision for Income Taxes. The provision for income taxes for the quarter
ended March 31, 2004 was approximately $175,000 compared with a provision of
approximately $0 for the quarter ended March 31, 2003. The 2004 provision
relates to estimated federal alternative minimum taxes, state taxes and foreign
taxes on income generated in the quarter end March 31, 2004. Our policy is to
provide for income taxes in our interim financial statements at an effective
rate based upon our estimate of full year earnings and projected tax expense. We
have recorded a full valuation allowance against deferred tax assets as of March
31, 2004 due to uncertainties related to our ability to utilize some of our
deferred tax assets, primarily consisting of certain net operating losses
carried forward before they expire.
LIQUIDITY AND CAPITAL RESOURCES
We have primarily funded our operations with cash flows generated from
operations in the current and prior years and the proceeds of our equity
issuances. We invest our cash primarily in instruments that are highly liquid,
investment grade securities. As of March 31, 2004, we had cash and cash
equivalents totaling $15.7 million, short-term marketable securities of $47.5
million and working capital of $47.9 million, compared to cash and cash
equivalents totaling $20.1 million, short-term marketable securities of $51.6
million and working capital of $46.9 million as of December 31, 2003. In
addition, we had long-term marketable securities totaling $21.7 million as of
March 31, 2004 and $19.4 million as of December 31, 2003.
Cash provided by operating activities for the quarter ended March 31, 2004
was $1.3 million. This resulted primarily from net income of $1.3 million, which
included non-cash charges for depreciation and amortization of $1.4 million, and
an increase in deferred revenue, offset by decreases in accrued compensation and
benefits and an increase in accounts receivable. Deferred revenue increased as
a result of strong maintenance renewals in the first quarter of 2004 and as a
result of a significant increase in the number of premium maintenance contracts
sold. Accrued compensation and benefits decreased due to the payment of 2003
commissions and corporate bonuses in the first quarter of 2004, and, although we
experienced a significant number of collection results in the quarter, accounts
receivable increased due to the increase in revenue and an increase in
maintenance renewals. The increase in accounts receivable resulted in an
increase of our days sales outstanding to 65 days in the quarter ended March 31,
2004 from 53 days in the quarter ended December 31, 2003.
Cash used for investing activities was $6.7 million for the quarter ended
March 31, 2004. Investing activities consisted primarily of $7.5 million of net
cash used for the payment of the remaining purchase consideration and
transaction costs associated with the acquisition of Business Layers offset by
sales and maturities of marketable securities of approximately $11.6 million and
the purchases of marketable securities of approximately $10.2 million.
Cash provided by financing activities in the quarter ended March 31, 2004
was $700,000 primarily related to proceeds received from the exercise of stock
options.
Any increase or decrease in our accounts receivable balance and accounts
receivable days outstanding (calculated as net accounts receivable divided by
revenue per day) affects our cash flow from operations and liquidity. Our
accounts receivable and accounts receivable days outstanding may increase due to
changes in factors such as the timing of when sales are invoiced and the length
of our customers' payment cycles. We also record deferred maintenance billings
as accounts receivable, and the timing of these billings can affect the accounts
receivable days outstanding, as it did in the quarter ended March 31, 2004.
Historically, international and indirect customers pay at a slower rate than
domestic and direct customers. An increase in revenues generated from
international and indirect customers may increase our accounts receivable
balance and accounts receivable days outstanding. Due to the current economic
climate, we may observe an increase in the length of our customers' payment
cycles and as a result our days sales outstanding may increase in future
periods. To the extent that our accounts receivable balance increases, we may
incur increased bad debt expense and will be subject to greater general credit
risks.
17
In the past, we experienced a period of rapid growth, which resulted in
significant increases in our operating expenses. Over the past two years, due to
the effects of general economic conditions, we have made considerable efforts to
reduce our operating expenses through constrained spending, reductions in
workforce and better alignment of our cost structure to our revenues. We
anticipate our short-term cash requirements to primarily include the continued
funding of our operating expenses and to a lesser extent the funding of capital
expenditures. We believe that our existing cash and cash equivalent balances
together with our marketable securities will be sufficient to meet these
requirements over at least the next twelve months. We anticipate our long-term
cash requirements to primarily include the funding of acquisitions or
investments in businesses, technologies, products or services that are
complementary to our business.
COMMITMENTS, CONTRACTUAL OBLIGATIONS, AND OFF-BALANCE SHEET ARRANGEMENTS
We have commitments that expire at various times through 2010. Operating
lease commitments as of March 31, 2004 shown below are primarily for facility
costs for our corporate headquarters, customer service, research and development
and world-wide sales offices. Other contractual obligations primarily consist of
minimum guaranteed payments to a software service provider for various
development projects (in thousands).
PAYMENTS DUE BY PERIOD
----------------------
LESS THAN AFTER 5
CONTRACTUAL OBLIGATION TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS YEARS
---------- --------- --------- --------- ----------
Operating leases........... $ 11,578 $ 5,185 $ 5,464 $ 929 $ --
---------- --------- --------- --------- ----------
$ 11,578 $ 5,185 $ 5,464 $ 929 $ --
========== ========= ========= ========= ==========
Included in the operating lease commitments above is approximately $520,000
related to excess facilities which have been accrued in purchase accounting
related to our acquisitions and are payable through April 2006.
We incurred total operating lease expense, primarily related to certain
facilities and equipment under non-cancelable operating leases, of $790,000 for
the quarter ended March 31, 2004.
In April 2002, we entered into an agreement with a system integrator to
assist us in the development and launch of one of our products. Under the terms
of the agreement, in consideration for the system integrator's time in assisting
with the development of the product, we agreed to promote the system integrator
as an integrator of the developed product. Our obligation under the agreement
will be considered satisfied once the system integrator receives consulting
revenues totaling approximately $3.9 million from our customers, or by May 2004,
whichever occurs first. In the event that we recommend a competitor of the
system integrator to perform the integration work for a customer, we could
potentially owe a royalty to the system integrator based on the net license fee.
As of March 31, 2004, no royalties were due under this agreement to the system
integrator.
In February 2004, we entered into an agreement with a software service
provider located in India under which we have guaranteed to pay this software
service provider a minimum of $4.0 million annually for various product
development projects. The initial term of this agreement expires in December
2004. The agreement provides for an annual renewal upon the agreement of both
parties. During the quarter ended March 31, 2004, $1.2 million had been paid to
this software service provider.
We enter into standard indemnification agreements with our business partners
and customers in our ordinary course of business. Pursuant to these agreements,
we agree to repair or replace the product, pay royalties for a right to use, or
reimburse the indemnified party for actual damages awarded by a court against
the indemnified party for a intellectual property infringement claim by a third
party with respect to our products. The term of these indemnification agreements
is generally perpetual. The maximum potential amount of future payments we could
be required to make under these indemnification agreements is unlimited. We have
never incurred costs to defend lawsuits or settle claims related to these
indemnification agreements. As a result, we believe the estimated fair value of
these agreements is minimal. Accordingly, we have no liabilities recorded for
these agreements as of March 31, 2004.
We enter into standard indemnification agreements with our customers whereby
we indemnify them for certain damages, such as personal property damage, which
may be caused in connection with consulting services performed at a customer
location by our employees or our subcontractors. The maximum potential amount of
future payments we could be required to make under these indemnification
agreements is unlimited. However, we have general and umbrella insurance
policies that enable us to recover a portion of any amounts paid. We have never
incurred costs to defend lawsuits or settle claims related to these
indemnification agreements. As a result, we believe the estimated fair value of
these agreements is minimal. Accordingly, we have no liabilities recorded for
these agreements as of March 31, 2004.
18
We generally warrant for ninety days from delivery to a customer that our
software products will perform free from material errors which prevent
performance in accordance with user documentation. Additionally, we warrant that
our consulting services will be performed consistent with generally accepted
industry standards. We have never incurred significant expense under our product
or service warranties. As a result, we believe the estimated fair value of these
agreements is minimal. Accordingly, we have no liabilities recorded for these
agreements as of March 31, 2004.
We have entered into employment and executive retention agreements with
certain employees and executive officers which, among other things, include
certain severance and change of control provisions. We have also entered into
agreements whereby we indemnify our officers and directors for certain events or
occurrences while the officer or director is, or was, serving at our request in
such capacity.
From time to time, we are involved in litigation relating to claims arising
out of our operations in the normal course of business. We are not presently a
party to any legal proceedings, the adverse outcome of which, in our opinion,
would have a material adverse effect on our results of operations or financial
position.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
We caution you that the following important factors, among others, in the
future could cause our actual results to differ materially from these expressed
in forward-looking statements made by us or on our behalf in filings with the
Securities and Exchange Commission, press releases, communications with
investors and oral statements. Any or all of our forward-looking statements in
this Quarterly Report on Form 10-Q and in any other public statements we make
may turn out to be wrong. They can be affected by inaccurate assumptions we
might make or by known or unknown risks and uncertainties. Many factors
mentioned in the discussion below will be important in determining future
results. Consequently, no forward-looking statement can be guaranteed. Actual
future results may vary materially. We undertake no obligation to update any
forward-looking statements, whether as a result of new information, future
events or otherwise. You are advised, however, to consult any further disclosure
we make in our reports filed with the Securities and Exchange Commission.
ALTHOUGH WE ARE NOW PROFITABLE, WE HAVE INCURRED SUBSTANTIAL LOSSES IN THE PAST
AND MAY NOT CONTINUE TO BE PROFITABLE IN THE FUTURE.
In recent years, we have incurred substantial operating losses. While we
recently returned to profitability on a quarterly basis, we cannot predict if we
will maintain profitability for any substantial period of time. To sustain
operating profitability on a quarterly and annual basis, we will need to
continue to increase our revenues, particularly our license revenues. Failure to
maintain levels of profitability as expected by investors may adversely affect
the market price of our common stock. We had an accumulated deficit of $109.7
million as of March 31, 2004.
OUR QUARTERLY RESULTS MAY FLUCTUATE WIDELY.
Our quarterly revenues and operating results are difficult to predict and
may continue to fluctuate significantly from quarter to quarter for several
reasons, including, but not limited to, the following:
- customers choosing to delay their purchase commitments or
purchase in smaller than expected quantities due to a general
slowdown in the economy or in anticipation of the introduction
of new products by us or our competitors;
- market acceptance of our SiteMinder, IdentityMinder Web
Edition, IdentityMinder eProvision and TransactionMinder
products;
- our ability to obtain follow-on sales from existing customers;
- the long sales and deployment cycle of our products;
- our ability to hire and retain personnel, particularly in
development, services and sales and marketing;
- the loss of or changes in key management personnel;
19
- the timing of the release of new versions of our SiteMinder,
IdentityMinder Web Edition, IdentityMinder eProvision and
TransactionMinder or other products;
- pricing pressures that result in increased discounts or
changes in our or competitors' pricing policies;
- changes in our operating expenses;
- the development of our direct and indirect distribution
channels;
- integration issues with acquired technology and businesses;
and
- general economic conditions.
In addition, because our revenues from services, particularly maintenance
revenues, are largely correlated with our software revenues, a decline in
software revenues could also cause a decline in our services revenues in the
same quarter or in subsequent quarters. Other factors, many of which are outside
our control, could also cause variations in our quarterly revenues and operating
results.
Most of our expenses, such as employee compensation and rent, are relatively
fixed. As a result, any shortfall in revenues in relation to our expectations
could cause significant changes in our operating results from quarter to quarter
and could result in future losses.
OUR SUCCESS WILL DEPEND ON OUR ABILITY TO MARKET OUR PRODUCTS AND RELATED
SERVICES SUCCESSFULLY.
Our revenues are primarily generated from the sale of perpetual licenses for
our proprietary SiteMinder, IdentityMinder Web Edition, IdentityMinder
eProvision, TransactionMinder and related services. Broad market acceptance of
our products will depend on the continued development of a market for identity
and access management, the education of our customers on the use of business
software applications in general and the relevance of our products specifically.
Market acceptance of our products, and customer demand for the services they
provide, may not develop.
We have released several new product offerings in the past 18 months. If we
fail to gain market acceptance for these products, our business, operating
results and financial position could be materially adversely affected.
Additionally, with the continued constraints in information technology spending
in all industries we will need to be successful in conveying the value of our
products to customers who may be hesitant to replace a "homegrown" system due to
the costs involved with switching to a purchased solution.
Our ability to succeed in the market for our products depends in part on our
ability to provide support services on a 24 hour per day, seven day per week
basis. Any damage or disruptions to our service centers, including our service
centers in Malaysia and Israel, whether as a result of employee attrition, acts
of terrorism, language barriers, or some other cause, could seriously impact our
ability to provide the necessary service to our customers and fulfill our
service contracts.
OUR SUCCESS IS DEPENDENT ON OUR ABILITY TO ENHANCE OUR PRODUCT LINES AND DEVELOP
NEW PRODUCTS.
We believe our success is dependent, in large part, on our ability to
enhance and broaden our product lines to meet the evolving needs of the business
market. We may not be able efficiently to integrate recently acquired
technologies into our products. We may be unable to respond effectively to
technological changes or new industry standards or developments. Product
development cycles are unpredictable and, in the past, we have delayed the
introduction of several new product versions due to delays in development.
We have arrangements with a third party located in India to perform certain
testing of our products, as well as internationalization and porting of our
products to new platforms, and with third party software vendors who provide
software which is embedded in our products. Any adverse change in our
relationship with these third parties could result in delays in the release of
our products. In the future, we could be adversely affected and be at a
competitive disadvantage if we incur significant delays or are unsuccessful in
20
enhancing our product lines or developing new products, or if any of our
enhancements or new products do not gain market acceptance.
As we continue to release new versions of our existing software, we may be
required to assist customers in migrating to the latest version once we announce
the end of life of the previous version. Additionally, we may be required to
assist Business Layers customers in migrating to more standardized versions of
the provisioning product. We could be adversely affected if we experience
significant migration issues and a decline in customer satisfaction related to
such transitions.
OUR ACQUISITION OF BUSINESS LAYERS AND OTHER COMPANIES MAY INCREASE THE RISKS WE
FACE.
We recently acquired Business Layers. In the future, we may pursue other
acquisitions to obtain complementary products, services and technologies. These
acquisitions may not produce the revenues, earnings or business synergies that
we anticipate, and an acquired product, service or technology might not perform
as we expect. In pursuing any acquisition, our management could spend a
significant time and effort in identifying and completing the acquisition. We
will have to devote significant management resources to integrate with our
existing businesses the business we acquired from Business Layers and any other
business we might acquire. We might not be able to successfully transfer the
knowledge of the employees or integrate the operations of acquired businesses,
including Business Layers. As a result of acquisitions, we might assume
contracts and other agreements that subject us to burdensome liabilities,
including obligations to indemnify third parties, or impose unfavorable terms on
us, including significant royalty obligations and termination fees. We may not
be able to renegotiate these agreements. To pay for an acquisition, we might use
our stock or cash. Alternatively, we might borrow money from a bank or other
lender. If we use our stock, our stockholders would experience dilution of their
ownership interests. If we use cash or debt financing, our financial liquidity
will be reduced.
OUR PERFORMANCE DEPENDS ON OUR ABILITY TO WIN BUSINESS AND OBTAIN FOLLOW-ON
SALES IN PROFITABLE SEGMENTS.
Customers typically place small initial orders for our products to allow
them to evaluate our products' performance. A key element of our strategy is to
pursue more significant follow-on sales after these initial installations. Our
financial performance depends on successful initial deployments of our products
that, in turn, lead to follow-on sales. If the initial deployments of our
products are not successful or if our customers do not remain satisfied with our
products and services, we may be unable to obtain follow-on sales. In addition,
even if initial deployments are successful, we cannot assure you that customers
will choose to make follow-on purchases, which could have a material adverse
effect on our ability to generate revenues.
WE FACE SIGNIFICANT COMPETITION FROM OTHER TECHNOLOGY COMPANIES AND WE MAY NOT
BE ABLE TO COMPETE EFFECTIVELY.
The market for identity and access management is highly competitive. We
expect the level of competition to increase as a result of the anticipated
growth of the identity and access management market. Our primary competitor in
the identity and access management market is the Tivoli Division of IBM. We also
compete against traditional security and software companies, such as Oblix, RSA
and Novell, and stack vendors such as Sun MicroSystems. In addition, a number of
other security and software companies, including appliance vendors, are
beginning to offer products that may compete with our identity and access
management solution. Competition may also develop as the market matures and
other companies begin to offer similar products, and as our product offerings
expand to other segments of the marketplace. We also face competition from Web
development professional services organizations. We expect that additional
competitors will emerge in the future. Current and potential competitors have
established, or may in the future establish, cooperative selling relationships
with third parties to increase the distribution of their products to the
marketplace. Accordingly, it is possible that new competitors may emerge and
acquire significant market share. If we fail to establish our leadership in the
identity and access management market we may not be able to compete effectively.
It is possible that current and potential competitors may attempt to hire our
employees and although we have non-compete agreements in place with most of our
employees they may or may not be enforceable. It is possible that new
competitors or alliances may emerge and rapidly acquire significant market
share. Today, many of our competitors have shorter operating histories and fewer
financial and technical resources than we have. In addition, these smaller
competitors have smaller customer bases. Some of our competitors, however, are
larger companies who have large financial resources, well-established
development and support teams, and large customer bases. These larger
competitors may initiate pricing policies that would make it more difficult for
us to maintain our competitive position against these companies. It is also
possible that current and potential competitors may be able to respond more
quickly to new or emerging technologies or customer requirements, resulting in
increased market share. If, in the future, a competitor chooses to bundle a
competing point product with other applications within a suite, the demand for
our products might be substantially reduced. Because
21
of these factors, many of which are outside of our control, we may be unable to
maintain or enhance our competitive position against current and future
competitors.
REGULATIONS OR CONSUMER CONCERNS REGARDING THE USE OF "COOKIES" ON THE INTERNET
COULD REDUCE THE EFFECTIVENESS OF OUR SOFTWARE PRODUCTS.
Certain of our products use cookies to support their single sign-on
functionality. A cookie is information keyed to a specific user that is stored
on the hard drive of the user's computer, typically without the user's
knowledge. Cookies are generally removable by the user, and can be refused by
the user at the point at which the information would not be stored on the user's
hard drive. A number of governmental bodies and commentators in the United
States and abroad have urged passage of laws limiting or abolishing the use of
cookies. The passage of laws limiting or abolishing the use of cookies, or the
widespread deletion or refusal of cookies by Web site users, could reduce or
eliminate the effectiveness of our single sign-on functionality and could reduce
market demand for our products.
WE MAY BE UNABLE TO HIRE AND RETAIN SKILLED PERSONNEL.
Qualified personnel are in great demand throughout the software industry.
Our success depends, in large part, upon our ability to attract, train, motivate
and retain highly skilled employees, particularly software engineers,
professional services personnel, sales and marketing personnel and other senior
personnel. Our failure to attract and retain the highly trained technical
personnel that are integral to our product development, professional services
and direct sales teams, particularly software engineers, may limit the rate at
which we can generate sales, develop new products or product enhancements or
transfer technical knowledge across our employee base. A change in key
management could result in transition and attrition in the affected department.
In addition, we may experience attrition by employees we acquire as a result of
acquisitions of other companies if those employees experience difficulties in
integrating with our existing employees and management. This could have a
material adverse effect on our business, operating results and financial
condition.
OUR SUCCESS DEPENDS ON OUR ABILITY TO OPTIMIZE OUR DIRECT SALES AND INDIRECT
DISTRIBUTION CHANNELS.
To increase our revenues, we must optimize our direct sales force and
continue to enhance relationships with systems integrators, resellers and
technology partners to increase the leverage of our partners. There is intense
competition for sales personnel in our business, and we cannot be sure that we
will be successful in attracting, integrating, motivating and retaining sales
personnel. In addition, we must effectively leverage our relationships with our
strategic partners and other third-party system integrators, vendors of
Internet-related systems and application software and resellers in order to
reach a larger customer population than we could reach alone through our direct
sales and marketing efforts.
We may not be able to find appropriate strategic partners or may not be able
to enter into relationships on commercially favorable terms, particularly if
these partners decide to compete directly in the identity and access management
market. Furthermore, the relationships we do enter into may not be successful.
Our strategic relationships are generally non-exclusive, and therefore, our
strategic partners may decide to pursue alternative technologies or to develop
alternative products in addition to or instead of our products, either on their
own or in collaboration with our competitors.
WE RELY ON THIRD PARTY TECHNOLOGY TO ENHANCE OUR PRODUCTS.
We incorporate into our products software licensed from third party software
companies that enhances, enables or provides functionality for our products and,
therefore, we need to create relationships with third parties, including some of
our competitors, to ensure that our products will interoperate with the third
parties' products. Third party software may not continue to be available on
commercially reasonable terms or with acceptable levels of support or
functionality, or at all. Failure to maintain those license arrangements,
failure of the third party vendors to provide updates, modifications or future
versions of their software or defects and errors in or infringement claims
against those third party products could delay or impair our ability to develop
and sell our products and potentially cause us to incur additional costs. Third
party products are also incorporated into the provisioning products that we
recently acquired from Business Layers. We expect to renegotiate some of the
terms of the licensing arrangements for these products. There can be no
assurance that we will be able to renegotiate those agreements on commercially
favorable terms. In addition, if we discover that third party products are no
longer available as a result of changes in a third party's operations or
financial position, there can be no assurance that we would be able to offer our
product without substantial reengineering, or at all.
22
Often these third party software companies require prepayment of royalties
on their products and, in the past, we have had to expense these prepaid
royalties to cost of sales when it was determined that they may not have future
realizable value.
OUR FAILURE TO EXPAND OUR RELATIONSHIP WITH GLOBAL SYSTEMS INTEGRATORS COULD
LIMIT OUR ABILITY TO SUPPORT OUR CUSTOMERS' DEPLOYMENT OF OUR PRODUCTS.
Our professional services organization and our relationship with global
systems integrators provide critical support to our customers' installation and
deployment of our products. If we fail to adequately develop our relationship
with global systems integrators, our ability to increase products sales may be
limited. In addition, if we or our partners cannot adequately support product
installations, our customers may not be able to use our products, which could
harm our reputation and hurt our business.
OUR LENGTHY SALES CYCLE MAKES IT DIFFICULT TO PREDICT OUR QUARTERLY OPERATING
RESULTS.
The length of our sales cycle varies depending on the size, type and
complexity of the customer contemplating a purchase, whether we have conducted
business with a potential customer in the past and the size of the deal. In
addition, some of our customers may also need to invest substantial resources
and modify their computer network infrastructures to take advantage of our
products. As a result, these potential customers frequently need to obtain
approvals from multiple decision makers prior to making purchase decisions, a
process that has been, at times, further lengthened as a result of market
conditions surrounding technology spending. Our long sales cycle, which can
range from several weeks to several months or more, makes it difficult to
predict the quarter in which sales will occur. Delays in sales could cause
significant variability in our revenues and operating results for any particular
quarterly period. Our sales cycle is subject to a number of uncertainties such
as:
- the need to educate potential customers regarding the benefits
of our products;
- customers' budgetary constraints;
- the timing of customers' budget cycles;
- customers' willingness to make changes in their network
infrastructures; and
- delays caused by customers' internal review processes.
OUR FAILURE TO EFFECTIVELY MANAGE CHANGES IN THE BUSINESS ENVIRONMENT IN WHICH
WE OPERATE COULD HARM OUR BUSINESS.
Our failure to effectively manage changes in the business environment in
which we operate could have a material adverse effect on the quality of our
products, our ability to retain key personnel and our business, operating
results and financial condition. In the past, we have experienced periods of
rapid growth as well as periods of economic slowdown which have resulted in
reductions in workforce. Both of these situations have placed a significant
strain on our resources. We may experience similar changes in the future.
Additionally, we may experience disruptions as a result of attacks from
electronic viruses which could result in reduced productivity. To effectively
manage changes in the business environment in which we operate we must maintain
and enhance our financial and accounting systems and controls, maintain the
security of our infrastructure, maintain our ability to retain key personnel,
integrate new personnel and manage operations.
IF WE LOSE THE SERVICES OF BARRY BYCOFF OR ANY OTHER MEMBER OF OUR MANAGEMENT
TEAM, OUR BUSINESS COULD SUFFER.
Our future success depends, to a significant degree, on the skill,
experience and efforts of Barry Bycoff, our chief executive officer, and the
rest of our management team. A change in our management team or the inability of
our officers and key employees to work effectively as a team could have a
material adverse effect on our business, operating results and financial
condition.
AS WE CONTINUE TO OPERATE IN INTERNATIONAL MARKETS, WE WILL FACE CONTINUED RISKS
TO OUR SUCCESS.
23
We operate in several international markets, including Israel as a result of
our recent acquisition of Business Layers. Our international operations are
subject to increased regulatory, economic and political risks. We have limited
experience in international markets and we cannot be sure that our continued
expansion into global markets will be successful. In addition, we will face
increased risks in conducting business internationally, including the ability to
develop, market and distribute localized versions of our products in a timely
manner or at all. These risks could reduce demand for our products and services,
increase the prices at which we can sell our products and services or otherwise
have an adverse effect on our success in international markets. If we are not
successful in increasing our international revenues we may experience an adverse
affect on our operating results. Among the risks related to international
operations we believe are most likely to affect us are:
- longer decision making cycles;
- longer payment cycles and problems in collecting accounts
receivable;
- adverse changes in trade and tax regulations, including
restrictions on the import and export of sensitive
technologies, such as encryption technologies, that we use or
may wish to use in our software products;
- the absence or significant lack of legal protection for
intellectual property rights;
- selling under contracts governed by local law;
- difficulties in managing an organization spread over multiple
countries, including complications arising from cultural,
language and time differences that may lengthen development,
sales and implementation cycles and delay the resolution of
customer support issues;
- currency risks, including fluctuations in exchange rates;
- political and economic instability;
- localization of technology, including delays in localizing the
most recent versions of our products;
- increased use of contractors on a global basis for both
professional services and development, that may result in
increased cost of services and less direct control; and
- disruption caused by terrorist activities in various regions
around the world.
OUR SUCCESS DEPENDS ON OUR ABILITY TO PROTECT OUR PROPRIETARY RIGHTS.
Our success depends to a significant degree upon the protection of our
software and other proprietary technology. The unauthorized reproduction or
other misappropriation of our proprietary technology would enable third parties
to benefit from our technology without paying us for it. This could have a
material adverse effect on our business, operating results and financial
condition. We depend upon a combination of patent, trademark, trade secret and
copyright laws, license agreements and non-disclosure and other contractual
provisions to protect proprietary and distribution rights in our products. In
addition, we attempt to protect our proprietary information and the proprietary
information of our vendors and partners through confidentiality and/or license
agreements with our employees and others. Although we have taken steps to
protect our proprietary technology, they may be inadequate and the unauthorized
use of our source code could have an adverse effect on our business. Existing
trade secret, copyright and trademark laws offer only limited protection.
Moreover, the laws of other countries in which we market our products may afford
little or no effective protection of our intellectual property. If we resort to
legal proceedings to enforce our intellectual property rights, the proceedings
could be burdensome and expensive, even if we were to prevail.
CLAIMS BY OTHER COMPANIES THAT WE INFRINGE THEIR PROPRIETARY TECHNOLOGY COULD
HURT OUR FINANCIAL CONDITION.
If we discover that any of our products or third party products embedded in
our products violates third party proprietary rights, there can be no assurance
that we would be able to reengineer our product or to obtain a license on
commercially reasonable terms to
24
continue offering the product without substantial reengineering. We do not
conduct comprehensive patent searches to determine whether the technology used
in our products infringes patents held by third parties. In addition, product
development is inherently uncertain in a rapidly evolving technology environment
in which there may be numerous patent applications pending for similar
technologies, many of which are confidential when filed. Any claim of
infringement, even if invalid, could cause us to incur substantial costs
defending against the claim and could distract our management from our business.
Furthermore, a party making such a claim could secure a judgment that requires
us to pay substantial damages. A judgment could also include an injunction or
other court order that could prevent us from selling our products. Any of these
events could have a material adverse effect on our business, operating results
and financial condition.
OUR BUSINESS COULD BE ADVERSELY AFFECTED IF OUR PRODUCTS CONTAIN ERRORS OR
FLAWS.
Software products as complex as ours may contain undetected errors or "bugs"
that result in product failures. The occurrence of errors could result in loss
of, or delay in, revenues, loss of market share, failure to achieve market
acceptance, diversion of development resources, injury to our reputation, or
damage to our efforts to build brand awareness, any of which could have a
material adverse effect on our business, operating results and financial
condition. Additionally, the security features included in our products to
prevent unauthorized access to the application may not meet all of our
customers' requirements.
WE COULD INCUR SUBSTANTIAL COSTS RESULTING FROM PRODUCT LIABILITY CLAIMS
RELATING TO OUR CUSTOMERS' USE OF OUR PRODUCTS.
Many of the business applications supported by our products are critical to
the operations of our customers' businesses. Any failure in a customer's Web
site or application caused or allegedly caused by our products could result in a
claim for substantial damages against us, regardless of our responsibility for
the failure. Although we maintain general liability insurance, including
coverage for errors and omissions, and contractually attempt to limit liability,
we cannot be sure that our existing coverage will continue to be available on
reasonable terms or will be available in amounts sufficient to cover one or more
large claims, or that the insurer will not disclaim coverage as to any future
claim.
OUR FORMER INDEPENDENT PUBLIC ACCOUNTANT, ARTHUR ANDERSEN LLP, HAS BEEN FOUND
GUILTY OF A FEDERAL OBSTRUCTION OF JUSTICE CHARGE, AND YOU MAY BE UNABLE TO
EXERCISE EFFECTIVE REMEDIES AGAINST ARTHUR ANDERSEN IN ANY LEGAL ACTION.
Our former independent public accountant, Arthur Andersen LLP, provided us
with auditing services during the year ended December 31, 2001, including
issuing an audit report with respect to our audited consolidated financial
statements as of and for the year ended December 31, 2001. On June 15, 2002, a
jury in Houston, Texas found Arthur Andersen guilty of a federal obstruction of
justice charge arising from the federal government's investigation of Enron
Corp. On August 31, 2002, Arthur Andersen ceased practicing before the SEC.
We were unable to obtain Arthur Andersen's consent to include its report
with respect to our audited consolidated financial statements as of and for the
year ended December 31, 2001 in our Annual Reports on Form 10-K for the years
ended December 31, 2003 and 2002. Rule 437a under the Securities Act of 1933, or
the Securities Act, permits us to dispense with the requirement to file Arthur
Andersen's consent. As a result, you may not have an effective remedy against
Arthur Andersen in connection with a material misstatement or omission with
respect to our audited consolidated financial statements. In addition, even if
you were able to assert such a claim, as a result of its conviction and other
lawsuits, Arthur Andersen may fail or otherwise have insufficient assets to
satisfy claims made by investors or by us that might arise under federal
securities laws or otherwise relating to any alleged material misstatement or
omission with respect to our audited consolidated financial statements.
INCREASED UTILIZATION AND COSTS OF OUR TECHNICAL SUPPORT SERVICES AND INCREASED
DEMANDS ON OUR OTHER TECHNICAL RESOURCES MAY ADVERSELY AFFECT OUR FINANCIAL
RESULTS.
Our products involve very complex technology and the failure or inability of
our technical support staff to meet customer expectations in a timely manner or
customer dissatisfaction with our product functionality or performance could
result in loss of revenues, loss of market share, failure to achieve market
acceptance, injury to our reputation, liability for service or warranty costs
and claims and other increased costs. We may be unable to respond to
fluctuations in customer demand for support services as well as resolve customer
issues in a manner that is timely and satisfactory to them. We also may be
unable to modify the format of our support services to compete with changes in
support services provided by competitors.
25
As we win business from larger, more complex customers there may be an
increased demand on our resources, particularly product management and support,
which may affect the allocation of our resources. Additionally, as we continue
to sell our new products to existing customers, our customers might expect us to
provide the same level of product support on the new products as we do on the
old products. This would increase demand on our product support resources beyond
levels we could provide.
THE MARKET PRICE OF OUR COMMON STOCK HAS BEEN AND MAY CONTINUE TO BE VOLATILE.
Our stock price, like that of other technology companies, has been extremely
volatile. The announcement of new products, services, technological innovations,
customers or distribution partners by us or our competitors, quarterly
variations in our operating results, changes in coverage by securities analysts,
changes in revenues or earnings estimates by securities analysts, speculation in
the press or investment community and overall economic conditions are among the
factors affecting our stock price.
In addition, the stock market in general and the market prices for
technology companies in particular have experienced extreme volatility that
often has been unrelated to the operating performance of these companies. These
broad market and industry fluctuations may adversely affect the market price of
our common stock, regardless of our operating performance. Recently, when the
market price of a stock has been volatile, holders of that stock have often
instituted securities class action litigation against the company that issued
the stock. If any of our stockholders brought a lawsuit against us, we could
incur substantial costs defending the lawsuit. The lawsuit could also divert the
time and attention of our management.
The general economic uncertainties in the United States and abroad continue
to cause significant volatility in the stock markets. The continued threat of
terrorism in the United States and abroad and the ongoing military action and
heightened security measures undertaken in response to that threat can be
expected to cause continued volatility in securities markets. In addition,
foreign political unrest may continue to adversely affect the economy.
WE MAY LOSE MONEY ON FIXED-PRICE CONSULTING CONTRACTS.
Although the majority of our services have historically been performed on a
time and material basis, we have in the past performed services under fixed
price contracts at the request of a customer. In the future, it is possible that
an increased portion of our services revenues could be derived from fixed-price
contracts, particularly since we assumed several fixed-price contract
obligations as a result of the Business Layers acquisition. We work with complex
technologies in compressed time frames and it can be difficult to judge the time
and resources necessary to complete a project. If we miscalculate the resources
or time we need to complete work under fixed-price contracts, we may suffer
losses, and our operating results could be materially adversely affected.
CONTINUED WEAKNESS IN THE GLOBAL ECONOMY MAY ADVERSELY AFFECT OUR BUSINESS.
The global economy is still weak and may continue to be weak in the
foreseeable future. In addition, the United States' continued involvement in
Iraq, as well as the political unrest in other parts of the world, have
contributed to global economic uncertainty. We believe the current economic
slowdown has caused some potential or current customers to defer purchases. In
response to the current economic conditions, many companies have reduced their
spending budgets for information technology products and services, which could
reduce or eliminate potential sales of our products and services.
CERTAIN PROVISIONS OF OUR CHARTER AND OF DELAWARE LAW MAKE A TAKEOVER OF OUR
COMPANY MORE DIFFICULT.
Our corporate documents and Delaware law contain provisions that might
enable us to resist a takeover of our company. These provisions might discourage
or delay a change in the control of Netegrity or a change in our management.
These provisions could also discourage proxy contests and make it more difficult
for you and other stockholders to elect directors and take other corporate
actions. The existence of these provisions could limit the price that investors
might be willing to pay in the future for shares of our common stock.
Additionally, we have entered into employment and executive retention agreements
with certain employees and executive officers which, among other things, include
certain severance and change of control provisions that may have similar
effects.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency
In the quarter ended March 31, 2004, we generated approximately 22% of our
revenues outside of the United States. International
26
sales are typically denominated in U.S. dollars. Our foreign subsidiaries incur
most of their expenses in the local currency. Accordingly, all foreign
subsidiaries use the local currency as their functional currency. Translation
gains and (losses) (which were $119,000 as of March 31, 2004) are deferred and
accumulated as a separate component of stockholders' equity (accumulated other
comprehensive income (loss)). Net gains and (losses) resulting from foreign
exchange transactions, which were $24,700 for the quarter ended March 31, 2004,
are included in other income, net in the accompanying condensed consolidated
statements of operations. A 10% change in the valuation of the functional
currencies relative to the U.S. dollar as of March 31, 2004 would not have a
material impact on our results of operations for the quarter ended March 31,
2004.
Interest Rates
We invest our cash in a variety of financial instruments including floating
rate bonds, municipal bonds, asset-backed securities and money market
instruments in accordance with an investment policy approved by our Board of
Directors. These investments are denominated in U.S. dollars. Cash balances in
foreign currencies overseas are operating balances and are only invested in
short-term deposits of the local operating bank.
Investments in both fixed rate and floating rate interest earning
instruments carry a degree of interest rate risk. However, due to the
conservative nature of our investment portfolio, a sudden change in interest
rates would not have a material effect on the value of the portfolio. We
estimate that if the average yield of our investments had decreased by 100 basis
points, our interest income for the quarter ended March 31, 2004 would have
decreased by less than $100,000. This estimate assumes that the decrease
occurred on the first day of the year and reduced the yield of each investment
instrument by 100 basis points. The same 100 basis point change in interest
rates would not have a material impact on the fair value of the investment
portfolio. The impact on our future interest income and future changes in
investment yields will depend largely on the gross amount of our investment
portfolio.
ITEM 4. CONTROLS AND PROCEDURES
Our management with the participation of our Chief Executive Officer and
Chief Financial Officer, evaluated the effectiveness of our disclosure controls
and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange
Act) as of March 31, 2004. Based on such evaluation, our Chief Executive Officer
and Chief Financial Officer have concluded that, as March 31, 2004, our
disclosure controls and procedures were (1) designed to ensure that material
information relating to Netegrity, including our consolidated subsidiaries, is
made known to our Chief Executive Officer and Chief Financial Officer by others
within those entities, particularly during the period in which this report was
being prepared and (2) effective, in that they provide reasonable assurance that
information required to be disclosed by us in the reports that we file or submit
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the SEC's rules and forms.
No change in our internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal
quarter ended March 31, 2004 that has materially affected or is reasonably
likely to materially affect, our internal control over financial reporting.
PART II. - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EXHIBIT
ITEM NO. ITEM AND REFERENCE
-------- --------------------------------------------------------------------------------
10.1* Software Services Agreement by and between Infosys Technologies Limited and Netegrity, Inc.,
entered into on December 18, 2000, as amended.
31.1 Rule 13a-14(a)/15d-14(a) Certification of President and Chief Executive Officer.
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer and Treasurer.
32.1 Section 1350 Certification of President and Chief Executive Officer.
32.2 Section 1350 Certification of Chief Financial Officer and Treasurer.
* Confidential treatment requested as to certain portions, which portions have been filed separately with
the Securities and Exchange Commission.
27
(b) Reports on Form 8-K
On January 9, 2004, we filed a Current Report on Form 8-K dated December 30,
2003 reporting under Item 2, Acquisition or Disposition of Assets, that we had
completed our acquisition of Business Layers, Inc.
On February 6, 2004, we filed Amendment No. 1 to the Current Report on Form
8-K dated December 30, 2003 and filed on January 9, 2004, filing under Item 7,
Financial Statements, Unaudited Pro Forma Financial Information and Exhibits,
consolidated financial statements of Business Layers, Inc. and unaudited pro
forma combined financial information of Netegrity giving effect to the
acquisition of Business Layers.
On February 17, 2004, we filed a Current Report on Form 8-K dated February
17, 2004, reporting under Item 5, Other Events and Required Regulation FD
Disclosure, that we had issued a press release announcing the appointment of
Sandra England Bergeron to our Board of Directors.
28
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.
NETEGRITY, INC.
Date: May 7, 2004 By: /s/ Barry N. Bycoff
------------------------------------------
Barry N. Bycoff
President, Chief Executive Officer,
Director and Chairman of the Board
Date: May 7, 2004 By: /s/ Regina O. Sommer
------------------------------------------
Regina O. Sommer
Chief Financial Officer and Treasurer
(Principal Financial Officer and Principal
Accounting Officer)
29