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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 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: 00-15997
FILENET CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 95-3757924 .
(State or other jurisdiction of (I.R.S. Employer
corporation or organization Identification No.)
3565 Harbor Boulevard, Costa Mesa, CA 92626 .
(Address of principal executive offices) (Zip code)
(714) 327-3400 .
(Registrant's telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the Registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the Registrant is an accelerated filer as defined in Rule
12b-2 of the Securities Exchange Act of 1934:
Yes |X| No |_|
As of November 5, 2004, there were 41,330,166 shares of the Registrant's common stock
outstanding.
FILENET CORPORATION
Index
Page
Number
PART I. FINANCIAL INFORMATION.
Item 1. Unaudited Condensed Consolidated Financial Statements ........ 3
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations .................................. 18
Item 3. Quantitative and Qualitative Disclosures about Market Risk..... 37
Item 4. Controls and Procedures........................................ 38
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.............................................. 39
Item 6. Exhibits....................................................... 39
SIGNATURE ............................................................... 40
INDEX TO EXHIBITS............................................................. 41
2
PART I. FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements
FILENET CORPORATION
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
September 30, December 31,
2004 2003
ASSETS
Current assets:
Cash and cash equivalents $ 213,146 $ 203,305
Short-term investments available for sale 78,825 32,286
Accounts receivable, net 41,462 38,096
Prepaid expenses and other current assets 12,128 13,174
Deferred income taxes 3,551 3,551
Total current assets 344,112 290,412
Property, net 23,369 26,922
Long-term investments available for sale 15,883 12,672
Goodwill 26,184 26,170
Intangible assets, net 6,455 7,979
Deferred income taxes 23,081 23,001
Other assets 2,894 4,692
Total assets $ 441,978 $ 391,848
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 7,931 $ 11,006
Accrued compensation and benefits 29,036 27,648
Customer deposits and advances 5,843 5,217
Unearned maintenance revenue 56,154 40,691
Other accrued liabilities 17,176 16,524
Total current liabilities 116,140 101,086
Unearned maintenance revenue and other liabilities 2,991 1,614
Commitments and contingencies (Note 11)
Stockholders' equity:
Preferred stock - $0.10 par value; 7,000,000 shares
authorized; none issued and outstanding
Common stock - $0.01 par value; 100,000,000 shares
authorized; 40,574,016 issued and 39,476,016
shares outstanding at September 30, 2004; and
38,906,640 shares issued and 37,808,640 shares
outstanding at December 31, 2003 256,023 234,025
Retained earnings 76,615 64,098
Accumulated other comprehensive income 4,776 5,592
Treasury stock, at cost; 1,098,000 shares (14,567) (14,567)
Net stockholders' equity 322,847 289,148
Total liabilities and stockholders' equity $ 441,978 $ 391,848
See accompanying notes to unaudited condensed consolidated financial statements.
3
FILENET CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
Revenue:
Software $ 35,447 $ 35,320 $ 109,475 $ 104,397
Customer support 47,510 41,907 139,852 123,063
Professional services and education 13,531 12,162 40,745 36,095
Total revenue 96,488 89,389 290,072 263,555
Costs:
Software 3,835 3,800 10,486 10,416
Customer support 9,891 10,487 30,125 31,026
Professional services and education 11,404 10,586 33,396 32,001
Total cost of revenue 25,130 24,873 74,007 73,443
Gross Profit 71,358 64,516 216,065 190,112
Operating expenses:
Sales and marketing 36,674 34,405 117,433 103,660
Research and development 19,664 19,049 59,469 58,031
General and administrative 8,509 8,241 27,136 24,393
Total operating expenses 64,847 61,695 204,038 186,084
Operating income 6,511 2,821 12,027 4,028
Other income, net 1,245 632 3,238 3,297
Income before income taxes 7,756 3,453 15,265 7,325
Provision for income taxes 1,396 967 2,748 2,051
Net income $ 6,360 $ 2,486 $ 12,517 $ 5,274
Earnings per share:
Basic $ 0.16 $ 0.07 $ 0.32 $ 0.15
Diluted $ 0.16 $ 0.06 $ 0.31 $ 0.14
Weighted-average shares outstanding:
Basic 39,284 36,588 38,806 36,234
Diluted 40,495 38,494 40,793 37,471
See accompanying notes to unaudited condensed consolidated financial statements.
4
FILENET CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS
(In thousands)
Three Months Ended Nine Months Ended
September 30, September 30, .
2004 2003 2004 2003
Net income $ 6,360 $ 2,486 $ 12,517 $ 5,274
Other comprehensive income (loss):
Foreign currency translation adjustments 1,746 1,582 (644) 6,942
Unrealized gain (loss) on securities:
Unrealized holding gain (loss), net of taxes 52 (23) (172) (61)
Total other comprehensive income (loss) 1,798 1,559 (816) 6,881
Comprehensive income $ 8,158 $ 4,045 $ 11,701 $ 12,155
See accompanying notes to unaudited condensed consolidated financial statements.
5
FILENET CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Nine Months Ended
September 30,
2004 2003
Cash flows from operating activities:
Net income $ 12,517 $ 5,274
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 12,419 14,759
Loss on sale of property 403 14
Provision for doubtful accounts 136 52
Deferred income taxes (80) 1,746
Stock option income tax benefit - 2,129
Changes in operating assets and liabilities, net of
the effects of acquisitions:
Accounts receivable (3,643) 2,871
Prepaid expenses and other current assets 888 2,423
Accounts payable (3,041) 2,026
Accrued compensation and benefits 1,494 1,840
Customer deposits and advances 625 3,264
Unearned maintenance revenue 16,902 2,916
Income taxes payable 3,066 (1590)
Other 789 (1,931)
Net cash provided by operating activities $ 42,475 $ 35,793
Cash flows from investing activities:
Capital expenditures (7,845) (6,809)
Proceeds from sale of property 104 129
Cash paid for acquisition - (8,073)
Purchases of marketable securities (84,822) (81,354)
Proceeds from sales and maturities of marketable securities 39,065 77,805
Net cash used in investing activities $ (53,498) $ (18,302)
Cash flows from financing activities:
Proceeds from issuance of common stock 21,543 9,485
Principal payments on lease obligation - (5)
Net cash provided by financing activities $ 21,543 $ 9,480
Effect of exchange rate changes on cash and cash equivalents (679) 5,146
Net increase in cash and cash equivalents $ 9,841 $ 32,117
Cash and cash equivalents, beginning of year 203,305 130,154
Cash and cash equivalents, end of period $ 213,146 $ 162,271
Supplemental cash flow information:
Interest paid $ 37 $ 36
Income taxes paid / (refunded) $ (423) $ 2,221
________________________________________________________________________________
See Notes 4 and 10 for additional non-cash disclosures.
See accompanying notes to unaudited condensed consolidated financial statements.
6
FILENET CORPORATION
Notes To Condensed Consolidated Financial Statements
(Unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited interim condensed consolidated financial
statements of FileNet Corporation and subsidiaries (the "Company" or
"FileNet") reflect all adjustments (consisting of normal recurring
adjustments) necessary to present fairly the financial position of the
Company at September 30, 2004, and the results of its operations, its
comprehensive operations and its cash flows for the three and nine months
ended September 30, 2004 and 2003. Certain information and footnote
disclosures normally included in financial statements have been condensed
or omitted pursuant to rules and regulations of the Securities and Exchange
Commission (the "SEC"), although the Company believes that the disclosures
in the condensed consolidated financial statements are adequate to ensure
the information presented is not misleading. These condensed consolidated
financial statements should be read in conjunction with the consolidated
financial statements and notes thereto contained in the Company's Annual
Report on Form 10-K for the fiscal year ended December 31, 2003 filed with
the SEC on March 12, 2004. The results of operations for the interim
periods are not necessarily indicative of the operating results for the
year, or any other future period.
Certain reclassifications have been made to prior years' balances to
conform to the current year's presentation.
2. NEW ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB issued FIN 46, "Consolidation of Variable
Interest Entities." In general, a variable interest entity is a
corporation, partnership, trust, or any other legal structure used for
business purposes that either (a) does not have equity investors with
voting rights or (b) has equity investors that do not provide sufficient
financial resources for the entity to support its activities. FIN 46
requires a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable
interest entity's activities or entitled to receive a majority of the
entity's residual returns or both. The consolidation requirements of FIN 46
apply immediately to variable interest entities created after January 31,
2003. With respect to variable interest entities created before January 31,
2003, in December 2003 the FASB issued FIN 46R, which, among other things,
revised the implementation date to the first fiscal years or interim
periods ending after March 15, 2004, with the exception of Special Purpose
Entities ("SPE"). The consolidated requirements apply to all SPE's in the
first fiscal year or interim period ending after December 15, 2003. The
Company has determined that it does not have any SPE's to which these
interpretations apply. The adoption of FIN 46R in 2004 has not had a
material impact on the Company's consolidated financial statements.
In May 2003, FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity."
SFAS No. 150 establishes standards for how an issuer classifies and
measures certain financial instruments with characteristics of both debt
and equity and requires an issuer to classify the following instruments as
liabilities in its balance sheet:
o a financial instrument issued in the form of shares that is
mandatorily redeemable and embodies an unconditional obligation
that requires the issuer to redeem it by transferring its assets
at a specified or determinable date or upon an event that is
certain to occur;
7
o a financial instrument, other than an outstanding share, that
embodies an obligation to repurchase the issuer's equity shares,
or is indexed to such an obligation, and requires the issuer to
settle the obligation by transferring assets; and
o a financial instrument that embodies an unconditional obligation
that the issuer must settle by issuing a variable number of its
equity shares if the monetary value of the obligation is based
solely or predominantly on (1) a fixed monetary amount, (2)
variations in something other than the fair value of the issuer's
equity shares, or (3) variations inversely related to changes in
the fair value of the issuer's equity shares.
In November 2003, the FASB issued FASB Staff Position (FSP) No. 150-3
which deferred the effective dates for applying certain provisions of SFAS
No. 150 related to mandatorily redeemable financial instruments of certain
nonpublic entities and certain mandatorily redeemable noncontrolling
interests for public and nonpublic entities.
For public entities, SFAS No. 150 is effective for mandatorily
redeemable financial instruments entered into or modified after May 31,
2003 and is effective for all other financial instruments as of the first
interim period beginning after June 15, 2003.
For mandatorily redeemable noncontrolling interests that would not
have to be classified as liabilities by a subsidiary under the exception in
paragraph 9 of SFAS No. 150, but would be classified as liabilities by the
parent, the classification and measurement provisions of SFAS No. 150 are
deferred indefinitely. For other mandatorily redeemable noncontrolling
interests that were issued before November 5, 2003, the measurement
provisions of SFAS No. 150 are deferred indefinitely. For those
instruments, the measurement guidance for redeemable shares and
noncontrolling interests in other literature shall apply during the
deferral period.
SFAS No. 150 is to be implemented by reporting the cumulative effect
of a change in accounting principle. The Company does not have financial
instruments with characteristics of both debt and equity and therefore the
adoption of SFAS No. 150 has not had a material impact on the Company's
consolidated financial statements.
In March 2004, The FASB issued EITF Issue No. 03-1 (EITF 03-1), "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments" which provides new guidance for assessing impairment losses on
investments. Additionally, EITF 03-1 includes new disclosure requirements
for investments that are deemed to be temporarily impaired. In September
2004, the FASB delayed the accounting provisions for EITF 03-1; however the
disclosure requirements remain effective for annual periods ending after
June 15, 2004. The Company will evaluate the impact of EITF 03-1 once final
guidance is issued.
3. STOCK BASED COMPENSATION
The Company accounts for stock based awards to employees using the
intrinsic value method in accordance with Accounting Principles Board (APB)
Opinion No. 25, "Accounting for Stock Issued to Employees." The following
table summarizes the Company's net income (loss) and net income (loss) per
share on a pro forma basis had compensation cost for the Company's
stock-based compensation plans been determined based on the provisions of
SFAS No. 123, Accounting for Stock Based Compensation", for the three and
nine months ended September 30, 2004 and 2003.
8
Three Months Ended Nine Months Ended
September 30, September 30, .
(In thousands, except per share amounts) 2004 2003 2004 2003
Net income, as reported $ 6,360 $ 2,486 $ 12,517 $ 5,274
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards, net
of related tax effects (1,969) (1,636) (5,644) (5,732)
Pro forma net income (loss) $ 4,391 $ 850 $ 6,873 $ (458)
Earnings (loss) per share:
Basic earnings per share - as reported $ 0.16 $ 0.07 $ 0.32 $ 0.15
Basic earnings (loss) per share - pro forma 0.11 0.02 0.18 (0.06)
Diluted earnings per share - as reported $ 0.16 $ 0.06 $ 0.31 $ 0.14
Diluted earnings (loss) per share - pro forma 0.11 0.02 0.17 (0.06)
For purposes of computing proforma net income (loss), the Company
estimates the fair value of each option grant and employee stock purchase
plan right on the date of grant using the Black-Scholes option-pricing
model. The Black-Scholes option-pricing model was developed for use in
estimating the value of traded options that have no vesting restrictions
and are fully transferable, while the options issued by the Company are
subject to both vesting and restrictions on transfer. In addition,
option-pricing models require input of highly subjective assumptions
including the expected stock price volatility. The Company uses projected
data for expected volatility and estimates the expected life of its stock
options based upon historical data.
The assumptions used to value the option grants and the purchase
rights are stated as follows:
Three and Nine Months Ended
September 30, .
2004 2003 .
Expected life (in years) 5.28 5
Expected volatility 67% 63%
Risk free interest rates 3.5% 3.15%
Expected dividend 0% 0%
4. ACQUISITIONS
On April 2, 2003, the Company completed a stock purchase acquisition
of 100% of Shana Corporation ("Shana"), an electronic forms management
company. This strategic acquisition provided technology and experience to
expand the Company's Enterprise Content Management ("ECM") offering with
electronic Forms Management capability, which contributed to the purchase
price and resulted in goodwill. The purchase price for the acquisition
consisted of $8.55 million in cash consideration, less $938,000 of acquired
cash, plus $184,000 in acquisition expenses and $277,000 paid for
Non-Compete Agreements.
9
In accordance with SFAS No. 141, "Business Combinations," this
acquisition was accounted for under the purchase method of accounting. The
purchase price was allocated as follows:
(In thousands) .
Shana Corporation April 2, 2003
Net tangible assets $ 2,725
Goodwill 3,103
Acquired technology 4,000
Technical manuals and design documents 600
Customer maintenance relationships 800
Non-compete agreements 277
Liabilities assumed (2,494)
Total purchase price $ 9,011
Less cash acquired (938)
Net cash paid $ 8,073
The Company allocated the purchase price for this acquisition based on
fair value. Statement of Financial Accounting Concepts No. 7 defines fair
value as the amount at which an asset (or liability) could be bought or
sold in a current transaction between willing parties, that is, other than
in a forced or liquidation sale.
The acquisition of Shana resulted in acquired technology, technical
manuals and design documents, and customer maintenance relationships. Since
Shana had recently completed Version 4.1 of its eForms product, there was
no in-process research and development underway at the time of the
acquisition. Shana's technology manuals and design documents are the
"roadmaps" for the eForms technology and will be used by FileNet in its
product development. Recurring maintenance revenues are expected and
estimable for Shana's customers based on the older and newer versions of
eForms technology. The acquired technology of $4.0 million, the technical
manuals and design documents of $600,000, and the customer maintenance
relationships of $800,000 were assigned a useful life of five years.
Although the goodwill stemming from the Shana stock purchase is
non-deductible for Canadian tax purposes, a Section 338(g) election was
claimed resulting in deductible goodwill for U.S. tax purposes.
5. GOODWILL AND PURCHASED INTANGIBLE ASSETS
In acquisitions accounted for using the purchase method, goodwill is
recorded as the difference, if any, between the aggregate consideration
paid for an acquisition and the fair value of the net tangible and
identified intangible assets acquired. Goodwill and indefinite life
intangibles are not amortized, but are reviewed at least annually for
possible impairment. Intangible assets with definite lives must be
amortized over their estimated useful lives. Goodwill is recorded at cost
and is not amortized. Goodwill is tested for impairment at least annually
and written down when impaired. Effective the first day of July of each
year, goodwill is tested for impairment by determining if the carrying
value of each reporting unit exceeds its fair value. The Company also
periodically evaluates whether events and circumstances have occurred in
between annual testing dates that indicate the carrying value of goodwill
may not be recoverable. The Company performed an impairment analysis as of
July 1, 2004 in accordance with SFAS 142. The results indicated there was
no impairment of goodwill in any of the three reporting units. As of
September 30, 2004, there have been no indicators of impairment, and no
impairment of goodwill has been recognized. If estimates change, a
materially different impairment conclusion could result.
10
The following table presents the changes in goodwill by reporting
segment during the nine months ended September 30, 2004:
(In thousands) .
Balance at Foreign Balance at
December 31, Currency September 30,
Goodwill by Reporting Segment 2003 Change 2004
Software $ 15,144 $ 7 $ 15,151
Customer Support 5,858 3 5,861
Professional Services and Education 5,168 $ 4 $ 5,172
Total $ 26,170 $ 14 $ 26,184
Foreign currency change relates to the impact of translation on the
portion of goodwill that was booked to the Company's Ireland and Canada
subsidiaries.
Intangible assets subject to amortization consist of the following:
(In thousands) September 30, 2004 December 31, 2003 .
Gross Accumulated Gross Accumulated
Intangible Assets Asset Amortization Net Asset Amortization Net
Acquired technology and other
intangibles $ 10,111 (3,795) $ 6,316 $ 10,020 (2,272) $ 7,748
Non-compete agreements 323 (184) 139 317 (90) 227
Patents 28 (28) - 28 (24) 4
Total $ 10,462 (4,007) $ 6,455 $ 10,365 (2,386) $ 7,979
Acquired technology and other intangibles are being amortized over a
useful life of five years, and non-compete agreements are being amortized
over three years. Amortization expense for intangible assets was $518,000
for the three months ended September 30, 2004 compared to $500,000 for the
comparable period in 2003. Amortization expense for amortizing intangible
assets was $1,558,000 for the nine months ended September 30, 2004 compared
to $1,177,000 for the comparable period in 2003.
Estimated future amortization expense (assuming no foreign exchange
effect) of purchased intangible assets as of September 30, 2004 is as
follows:
(In thousands) .
Fiscal Year Amount
(Remainder) 2004 $ 536
2005 2,111
2006 2,042
2007 1,451
2008 315
Thereafter -
$ 6,455
11
6. EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income for the
period by the weighted-average number of common shares outstanding during
the period. Diluted earnings per share is computed by dividing net income
by the weighted-average number of common shares outstanding plus the
dilutive effect of outstanding stock options, shares issuable under the
employee stock purchase plan and restricted stock issued to key executive
management using the treasury stock method. The number of anti-dilutive
options excluded from the EPS calculation for the three and nine-month
period ended September 30, 2004 were 2,780,900 and 1,371,049 shares,
compared to 1,993,320 and 3,286,127 for the comparable periods in 2003. The
following table sets forth the computation of basic and diluted earnings
per share for the three and nine-month period ended September 30, 2004 and
2003:
Three Months Ended Nine Months Ended
September 30, September 30,
(In thousands, except per share amounts) 2004 2003 2004 2003
Net Income $ 6,360 $ 2,486 $ 12,517 $ 5,274
Shares used in computing
basic earnings per share 39,284 36,588 38,806 36,234
Dilutive effect of stock plans 1,211 1,906 1,987 1,237
Shares used in computing
diluted earnings per share 40,495 38,494 40,793 37,471
Earnings per basic share $ 0.16 $ 0.07 $ 0.32 $ 0.15
Earnings per diluted share $ 0.16 $ 0.06 $ 0.31 $ 0.14
7. ACCUMULATED OTHER COMPREHENSIVE INCOME
Accumulated other comprehensive income, net of taxes, for the nine
months ended September 30, 2004 is comprised of the following:
(In thousands) .
Foreign Unrealized Accumulated
Currency Holding Other
Translation Loss on Comprehensive
Adjustment Securities Income
Balance, December 31, 2003 $ 5,645 $ (53) $ 5,592
Nine month period changes (644) (172) (816)
Balance, September 30, 2004 $ 5,001 $ (225) $ 4,776
12
8. OPERATING SEGMENT DATA
The Company has prepared operating information in accordance with SFAS
No. 131, "Disclosures about Segments of an Enterprise and Related
Information," to report components that are evaluated regularly by the
Company's chief operating decision maker, or decision making group, in
deciding how to allocate resources and in assessing performance. The
Company is organized geographically and by line of business. The line of
business management structure is the primary basis for which financial
performance is assessed and resources allocated.
The Company's reportable operating segments effective January 1, 2004
include Software, Customer Support, and Professional Services and
Education. The residual operating activity of the previously reported
Hardware reporting segment has been combined with the Customer Support
reporting segment. There have been no new hardware sales; only spare parts
and supplies. Prior year hardware amounts have been reclassified into
customer service to conform to the new segment presentation.
The Software operating segment develops, markets, and sells a unified
platform and framework for ECM software and solutions. The Customer Support
segment provides after-sale support for software, as well as providing
software upgrades, on a when and if available basis, under the Company's
right to new versions program. The Customer Support segment also provides
operating supplies and spare parts for the installed base of Optical
Storage and Retrieval ("OSAR") libraries, the remaining portion of the
previous hardware business. The Professional Services and Education segment
provides fee-based implementation and technical consulting services related
to the Company's standard products and post-implementation training
services.
The accounting policies of the Company's operating segments are the
same as those for the Company as a whole - except that the disaggregated
financial results of the segments reflect allocation of certain functional
expense categories consistent with the basis and manner in which Company
management internally disaggregates financial information for the purpose
of assisting in making internal operating decisions. The Company evaluates
performance based on stand-alone segment operating income. Because the
Company does not evaluate performance based on the return on assets or on
interest income at the operating segment level, assets and interest income
are not tracked internally by segment. Therefore, such information is not
presented.
13
Operating segments data for the three and nine months ended September
30, 2004 and 2003 are as follows:
Three months ended Nine months ended
September 30, September 30, .
(In thousands) 2004 2003 2004 2003
Software
Revenue $ 35,447 $ 35,320 $ 109,475 $ 104,397
Operating loss (17,609) (15,028) (56,405) (46,891)
Customer Support
Revenue $ 47,510 $ 41,907 $ 139,852 $ 123,063
Operating income 23,617 17,836 66,273 51,472
Professional Services and Education
Revenue $ 13,531 $ 12,162 $ 40,745 $ 36,095
Operating income (loss) 503 13 2,159 (553)
Total
Revenue $ 96,488 $ 89,389 $ 290,072 $ 263,555
Operating income 6,511 2,821 12,027 4,028
9. STOCK OPTIONS
The following is a summary of stock option transactions regarding all
stock option plans for the three months ended September 30, 2004:
.
Weighted
Number of Average
Options Exercise Price
Balance, June 30, 2004 6,955,996 $ 18.08
Granted (weighted-average fair value of $10.75) 79,000 21.16
Exercised (83,760) 11.85
Canceled (36,718) 18.36
Balance, September 30, 2004 6,914,518 $ 18.26
14
The following table summarizes information concerning outstanding and
exercisable stock options at September 30, 2004:
.
Options Outstanding Options Exercisable .
Weighted
Average Weighted Weighted
Remaining Average Average
Range of Exercise Number Contractual Exercise Number Exercise
Price Outstanding Life (Years) Price Exercisable Price
$ 1.39 - 9.50 767,938 3.17 $ 7.98 764,416 $ 7.98
9.75 - 12.86 1,110,384 7.13 12.35 606,180 12.06
12.97 - 14.19 1,084,042 6.67 13.47 703,126 13.52
14.39 - 18.45 1,089,323 6.66 16.89 783,402 16.98
18.75 - 25.00 1,270,550 6.01 22.68 1,129,811 22.92
25.28 - 41.84 1,592,281 7.90 28.00 485,886 28.79 .
$ 1.39 - 41.84 6,914,518 6.52 $ 18.26 4,472,821 $ 17.00 .
10. ISSUANCE OF RESTRICTED STOCK
The Company awarded 25,000 shares of restricted stock to eight members
of the research and development team on July 14, 2004. These shares of
restricted stock vest at a rate of 25% annually over a four-year period and
contain no accelerated vesting features. These shares were valued at
$519,000 based on the July 14, 2004 closing price of $20.76 per share.
As previously reported, the Company awarded 132,500 shares of
restricted stock to ten members of the senior management team on March 9,
2004. These shares of restricted stock vest December 31, 2008, and include
a feature that allows the stock to vest on an accelerated basis provided
certain performance targets are achieved. These shares were valued at
approximately $3.6 million based on the March 9, 2004 closing price of
$27.47 per share.
Both of these awards were made under the 2002 Incentive Award Plan.
The grant value of the restricted stock award is recorded in the equity
section of the balance sheet as an increase in common stock and a
contra-equity offset to deferred compensation. Expense related to the
shares is amortized on a straight-line basis over the vesting period.
Recognition of expense may be accelerated if it becomes probable that
certain performance targets will be achieved that trigger accelerated
vesting for those shares that contain the acceleration feature.
Approximately $218,205 and $452,161 of compensation expense was recognized
in the three and nine-month periods ended September 30, 2004, respectively,
for these restricted stock awards with no acceleration.
15
11. COMMITMENTS AND CONTINGENCIES
Leases
The Company leases its corporate offices, sales offices, development
and manufacturing facilities, and other equipment under non-cancelable
operating leases, some of which have renewal options and generally provide
for escalation of the annual rental amount. Amounts related to deferred
rent are recorded in other accrued liabilities on the consolidated balance
sheet. Future annual minimum lease payments under all non-cancelable
operating leases with an initial term in excess of one year as of September
30, 2004 were as follows:
(In thousands) .
2004 (remaining 3 months) $ 3,216
2005 11,719
2006 11,132
2007 10,174
2008 8,950
2009 6,818
Thereafter 5,928
Total $ 57,937
Product Warranties
The Company provides a 90-day warranty for its software products
against substantial nonconformance to the published documentation at time
of delivery. For software products, the Company records the estimated cost
of technical support during the warranty period. A provision for these
estimated warranty costs is recorded at the time of sale or license. If the
Company were to experience an increase in warranty claims compared with
historical experience, or costs of servicing warranty claims were greater
than the expectations on which the accrual had been based, gross margins
could be adversely affected.
The following table represents the warranty accrual for the nine
months ended September 30, 2004 and 2003:
.
(In thousands) 2004 2003
Beginning balance at January 1 $ 479 $ 728
Additions 851 678
Deductions (967) (916)
Ending balance at September 30 $ 363 $ 490 .
Guarantees and Indemnities
The Company has made guarantees and indemnifications, under which it
may be required to make payments to a guaranteed or indemnified party, in
relation to certain transactions. In connection with the sales of its
products, the Company provides intellectual property indemnities to its
customers and may also provide indemnification against legal claims that
the Company's software products infringe certain third-party intellectual
property rights. Guarantees and indemnities to customers in connection with
product sales and service generally are subject to limits based upon the
16
amount of the related product sales or service. Payment by the Company is
conditioned upon the other party filing a claim pursuant to the terms and
conditions of the agreement. The Company may challenge this claim and may
also have recourse against third parties for certain payments made by the
Company. Predicting the maximum potential future payment under these
agreements is not possible due to the unique facts and circumstances
involved with each agreement. Historically, payments by the Company under
these agreements have been immaterial.
In connection with certain facility leases and other performance
guarantees, the Company has guaranteed payments on behalf of some of its
domestic and foreign subsidiaries. To provide subsidiary guarantees, the
Company obtains unsecured bank guarantees from local banks. These bank
guarantees totaled an equivalent of approximately $2.5 million as of
September 30, 2004. Approximately $1.5 million was issued in local currency
in Europe and Asia, while the balance was issued in the United States.
Approximately $0.4 million of the $2.5 million is secured by cash deposit.
The Company indemnifies its directors and officers to the maximum
extent permitted under the laws of the State of Delaware.
The Company has not recorded a liability for the guarantees and
indemnities described above in the accompanying consolidated balance sheet,
as the estimated fair value of these items is de minimis. Also, the maximum
amount of potential future payments under such guarantees and indemnities
is not determinable, other than as described above. The Company's product
warranty liability as of September 30, 2004 is disclosed in this item under
the heading "Product Warranties."
Legal Proceedings
In the normal course of business, the Company is subject to ordinary
routine litigation and claims incidental to its business. While the results
of litigation and claims cannot be predicted with certainty, management
believes that the final outcome of these matters will not have a materially
adverse effect on the Company's consolidated results of operations or
financial condition.
12. FOREIGN CURRENCY TRANSACTIONS
The Company is exposed to foreign exchange rate fluctuations due to
intercompany accounts between the U.S. parent company and the foreign
subsidiaries. The Company is also exposed to foreign exchange rate
fluctuations as the financial statements of foreign subsidiaries are
translated into U.S. dollars for consolidation purposes. The Company
purchases foreign exchange contracts to mitigate the effect of exchange
gains and losses on recorded foreign currency denominated monetary assets
and liabilities. The Company does not use foreign exchange contracts for
speculative or trading purposes. All outstanding forward contracts are
marked-to-market on a monthly basis with gains and losses included in
interest and other income, net. As of September 30, 2004, the Company had
forward foreign exchange contracts outstanding totaling approximately $3.1
million in 10 currencies. These contracts were opened on the last business
day of the quarter and mature within three months. Accordingly, the fair
value of such contracts is zero at September 30, 2004.
13. INCOME TAXES
The Company's combined federal, state and foreign annual effective tax
rate for the three months ended September 30, 2004 is 18% compared to 28%
for the comparable period in 2003. The Company's combined federal, state
and foreign annual effective tax rate for the nine months ended September
30, 2004 is 18% compared to 28% for the comparable period in 2003. The
provision for income taxes differs from the tax computed at the federal
17
statutory income tax rate due primarily to earnings considered as
permanently reinvested in foreign operations with lower tax rates and
reductions in the domestic deferred tax valuation allowance as net
operating loss carryforwards were utilized. The decreased tax rate in the
nine months ended September 30, 2004 was primarily due to the mix of income
earned by domestic operations versus the foreign subsidiaries.
The Company is continually assessing the valuation allowance related
to its deferred tax assets. As of September 30, 2004, the Company has a net
tax deferred asset of approximately $26.6 million and valuation allowance
of approximately $24.3 million. The Company will continue weighing various
factors throughout the balance of the year to assess the need for any
valuation allowance. Recoverability of the deferred tax assets is dependent
on continued profitability from operations, as well as the geographic
region generating the profits. Should the Company's level of domestic
profitability continue at the current rate, it would likely remove the
entire valuation allowance associated with net operating loss carryforwards
and other temporary differences by the end of 2004. A one-time, non-cash
benefit would be realized by decreasing tax expense (causing an increase in
earnings) by approximately $8.0 million to $11.0 million. Additionally,
approximately $9.0 million of valuation allowance related to stock option
deductions would be evaluated for potential reversal, which could be
credited to additional paid in capital.
14. RELATED-PARTY TRANSACTIONS
In July 2001, the Compensation Committee of the Company's Board of
Directors (the "Board") entered into discussions with Lee Roberts, the
Company's Chief Executive Officer, regarding a secured loan by the Company
to Mr. Roberts for $1.9 million to enable him to purchase a home in Orange
County, California. The note bears interest at 2.89% per annum. On June 5,
2002, the Board approved the loan.
Mr. Roberts is current with all payments and obligations of this
agreement. Mr. Roberts made two payments, of $37,000 in February 2003 and
$53,000 in February 2004, toward the accrued interest balance in accordance
with the terms and conditions of the loan agreement. Mr. Roberts also made
two payments in December 2003 and June 2004 of approximately $294,000 and
$331,000, respectively, toward the principal loan balance of $1.9 million.
As of September 30, 2004, the outstanding balance on the secured note
receivable from Mr. Roberts is approximately $1.275 million and is included
in other assets on the consolidated balance sheet. The accrued interest
balance as of September 30, 2004 was approximately $36,248. Please
reference Note 4 of the December 31, 2003 financial statements included in
our Annual Report on Form 10-K for additional details of the terms and
conditions of this loan.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995,
Section 21E of the Securities and Exchange Act of 1934, as amended, and
Section 27A of the Securities Act of 1933, as amended, and is subject to
the safe harbors created by those sections. Words such as "anticipates,"
"expects," "intends," "plans," "believes," "seeks," "estimates," "may,"
"will" and variations of these words or similar expressions are intended to
identify forward-looking statements. In addition, any statements that refer
to expectations, projections or other characterizations of future events or
circumstances, including any underlying assumptions, are forward-looking
statements. These statements are not guarantees of future performance and
are subject to risks, uncertainties and assumptions that are difficult to
predict. Therefore, our actual results could differ materially and
adversely from those expressed in any forward-looking statements as a
result of various factors. We undertake no obligation to revise or publicly
18
release the results of any revisions to these forward-looking statements.
Readers should carefully review the risk factors described below under the
heading "Risk Factors That May Affect Future Results" and in other
documents we file from time to time with the Securities and Exchange
Commission, including our Annual Report on Form 10-K for the fiscal year
ended December 31, 2003. Our filings with the Securities and Exchange
Commission, including our Annual Reports on Form 10-K, Quarterly Reports on
Form 10-Q, Current Reports on Form 8-K and amendments to those filings,
pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of
1934, are available free of charge at www.filenet.com, when such reports
are available at the Securities and Exchange Commission Web site.
Overview
We develop, market, sell and support a software platform and framework
for Enterprise Content Management. This platform, called FileNet P8,
provides a flexible and scaleable framework for developing solutions, which
allow our customers a competitive advantage by managing content throughout
their organizations, and streamlining their business processes. Enterprise
Content Management, or ECM, refers to the broad range of functions used by
organizations of all types, including businesses and governmental agencies,
to control and track the information, or content, that is important to the
organization's operations, whether that information is used internally,
such as sales data or product specifications, or externally, such as
content provided to customers through a Web site. The content our software
manages, commonly called unstructured content, includes, but is not limited
to: Web pages, word processing documents, spreadsheets, HTML, XML, PDF,
document images, email messages and other electronic content. Our software
offers customers the ability to configure, design, build and deploy ECM
solutions to meet the needs of their particular business or organization.
These solutions allow customers to manage content throughout their
organizations, automate and streamline their business processes, and
provide the broad-spectrum of connectivity needed to support their critical
and everyday decision-making.
We generate revenue by selling software licenses, delivering
implementation and education services, and by providing technical support
to our customers. Software revenue consists of fees earned from the
licensing of our software products to our customers. Implementation and
education services are sold on a fee for service basis, and technical
support and software maintenance are generally provided pursuant to service
contracts of a one-year duration. Annual fees for software technical
support and software maintenance are generally received in advance and
recognized as revenue over the duration of the contract. Since our
operations are not capital or equipment intensive, and cost of goods sold
is relatively small, employee compensation is the largest single operating
expense for FileNet. Future profitability is contingent upon strategic
investments in internally developed or acquired software technologies that
are accepted by the market and result in software license and service
revenue. This investment is the key factor in achieving our long-term
business strategy.
Software
The FileNet P8 architecture offers our customers enterprise-level
scalability and flexibility to handle demanding content challenges, complex
business processes, and integration to existing systems. The FileNet P8
architecture provides a framework for functional expansion to provide
enhanced content and process management across an enterprise through
pre-packaged suites, each emphasizing a different aspect of the ECM
solution set, with functions grouped in a logical order that are designed
to meet a customer's individual ECM needs. Each suite can be implemented by
a customer individually, but remains expandable to include all FileNet ECM
capabilities. FileNet ECM solutions are designed to manage content;
allowing organizations to capture, create, use, and activate that content
in order to make decisions faster and bring control and consistency to
business processes, to improve efficiency and address compliance
requirements.
19
Services and Support
We operate service and support organizations on a global basis to
provide both pre-sales and post-sales services to ensure successful
implementation of our products and customer satisfaction. Due to the highly
configurable nature of our products, many of our product sales are coupled
with contracts for continuing support services. Our worldwide Customer
Service and Support organization provides comprehensive support
capabilities including electronic and real-time phone support and global
call tracking for customers and partners on support programs. System
engineers deliver support coverage on multiple platforms with 24-hour call
handling. Our Web site offers the ability to open cases, search our
knowledge base and review related status reports. Our manufacturing
facilities in Costa Mesa, California and Dublin, Ireland, conduct software
manufacturing and distribution, localization, integration, test and quality
control.
Professional Services and Education
Our worldwide professional services organization provides consulting,
development, architecture and other technical services and training
services to our licensed customers and authorized ValueNet Partners and
Global System Integrators. These services are provided through in-house
employees and through a network of qualified partners. Our worldwide
professional services organization offers a comprehensive methodology to
architect, install, integrate, customize and deploy our products. These
services range from the management of large-scale implementations of our
products to prepackaged standard services such as software installation,
but do not include modifications to the standard software. Our educational
curriculum includes training courses for end users, application developers
and system administrators through media-based and instructor-led training.
Research and Development
We have made and expect to continue to make substantial investments in
research and development, primarily through internal and offshore
development activities, third party licensing agreements and through
technology acquisitions. Our development efforts focus on our unified
FileNet P8 ECM architecture as we continue to develop and enhance our ECM
capabilities. Additionally, we license and embed third party software that
enhances the functionality of our products through a variety of agreements
with the producers of this software.
Critical Accounting Policies and Estimates
The consolidated financial statements of FileNet are prepared in
conformity with accounting principles generally accepted in the United
States of America. The consolidated financial statements include our
accounts and the accounts of our wholly owned subsidiaries. All
intercompany balances and transactions have been eliminated. The
preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities at the date of the financial statements
and the reported amounts of revenue and expenses during the reporting
period. Actual amounts could differ from estimates. The significant
accounting policies we believe are most critical to aid in fully
understanding and evaluating our reported financial results include the
following:
Revenue Recognition. FileNet accounts for the licensing of software in
accordance with the American Institute of Certified Accountants ("AICPA")
Statement of Position ("SOP") 97-2, "Software Revenue Recognition." We
enter into contracts for the sale of our products and services. Certain of
these contracts relate to single elements and contain standard terms and
conditions, while other agreements contain multiple elements or
20
non-standard terms and conditions. Contract interpretation is sometimes
required to determine the appropriate accounting, including how the price
should be allocated among the deliverable elements and when to recognize
revenue.
Software license revenue generated from sales through direct and
indirect channels, which do not contain multiple elements, are recognized
upon shipment and passage of title of the related product, if the
requirements of SOP 97-2, are met. If the requirements of SOP 97-2,
including evidence of an arrangement, delivery, fixed or determinable fee,
collectibility and vendor specific evidence about the value of an element,
are not met at the date of shipment, revenue is not recognized until these
elements are known or resolved. Fees are deemed to be fixed and
determinable for transactions with a set price that is not subject to
refund or adjustment and payment is due within 90 days from the invoice
date. Software license revenue from channel partners is not recognized
until the sale by the channel partner to a specified end user is confirmed.
For arrangements with multiple elements, we allocate revenue to each
element of a transaction based upon its fair value as determined in
reliance on vendor specific objective evidence using the residual method.
This evidence of fair value for all elements of an arrangement is based on
the normal pricing and discounting practices for those products and
services when sold separately. If fair value of any undelivered element
cannot be determined objectively, we defer the revenue until all elements
are delivered, services have been performed or until fair value can
objectively be determined.
Customer support contracts are renewable on an annual basis and
provide after-sale support for our software, as well as software upgrades
under our right to new versions program, on a when-and-if-available basis.
Revenue from post-contract customer support is recognized ratably over the
term of the arrangement, which is typically 12 months.
Professional services revenue consists of consulting and
implementation services provided to end users of our software products and
technical consulting services provided to our resellers. Consulting
engagements average from one to three months. Revenue from these services
and from training classes is recognized as such services are delivered and
accepted by the customer. Professional services are not required for the
software to function. We do not make changes to the standard software code
in the field.
Allowance for Doubtful Accounts and Sales Returns. We evaluate the
creditworthiness of our customers prior to order fulfillment, and we
perform ongoing credit evaluations of our customers to adjust credit limits
based on payment history and the customer's current creditworthiness. We
monitor collections from our customers and maintain an allowance for
estimated credit losses that is based on historical experience and on
specific customer collection issues. While credit losses have historically
been within our expectations and the provisions established in our
financial statements, we cannot guarantee that we will continue to
experience the same credit loss rates that we have in the past. Since our
revenue recognition policy requires customers to be creditworthy, our
accounts receivable are based on customers whose payment is reasonably
assured. Our accounts receivable are derived from sales to a wide variety
of customers. We do not believe a change in liquidity of any one customer
or our inability to collect from any one customer would have a material
adverse impact on our consolidated financial position. Based on historical
experience, we also maintain a sales return allowance for the estimated
amount of returns. While product returns have historically been minimal and
within our expectations, and we are not legally required to accept returns
of non-defective products, we cannot guarantee that we will continue to
experience the same return rates that we have in the past.
21
Goodwill. Goodwill is recorded at cost and is not amortized. Goodwill
is tested for impairment at least annually and written down when impaired.
Effective the first day of July of each year, goodwill is tested for
impairment by determining if the carrying value of each reporting unit
exceeds its fair value. We also periodically evaluate whether events and
circumstances have occurred in between annual testing dates that indicate
the carrying value of goodwill may not be recoverable. We performed an
impairment analysis as of July 1, 2004 in accordance with SFAS 142. The
results indicated there was no impairment of goodwill in any of the three
reporting units. As of September 30, 2004, there have been no indicators of
impairment, and no impairment of goodwill has been recognized. If estimates
change, a materially different impairment conclusion could result.
Long-Lived Assets. Property, plant and equipment and identified
intangible assets are recorded at cost less accumulated depreciation or
amortization. They are amortized using the straight-line method over
estimated useful lives of generally three to five years. The determination
of useful lives and whether or not these assets are impaired involves
judgment. Long-lived assets are reviewed for impairment whenever events or
circumstances indicate that the carrying amount of such assets may not be
recoverable. We evaluate the carrying value of long-lived assets and
certain identifiable intangible assets for impairment of value based on
undiscounted future cash flows resulting from the use of the asset and its
eventual disposition, which require significant estimates and judgments. If
impairment were indicated, we would be required to write the related assets
down to their fair values. While we have not experienced impairment of
intangible assets in prior periods, we cannot guarantee that there will not
be impairment in the future.
Deferred Income Taxes. Deferred income taxes reflect the net tax
effects of temporary differences between the carrying amounts of assets and
liabilities for financial reporting purposes and the amounts used for
income tax purposes. We maintain a valuation allowance against a portion of
the deferred tax asset (related to domestic operations) due to uncertainty
regarding the future realization based on historical taxable income,
projected future taxable income, and the expected timing of the reversals
of existing temporary differences. If we operate at a loss or are unable to
generate sufficient future taxable income, we could be required to increase
the valuation allowance against all or a significant portion of our
deferred tax assets, which would result in a substantial increase to our
effective tax rate and could result in a material adverse impact on our
operating results. Conversely, if we continue to generate profits and
ultimately determine that it is more likely than not that all or a portion
of the remaining deferred tax assets will be utilized to offset future
taxable income, the valuation allowance could be decreased or eliminated
all together, thereby resulting in a substantial temporary decrease to our
effective tax rate and an increase to additional paid-in capital.
We are continually assessing the valuation allowance related to our
deferred tax assets. As of September 30, 2004, we have a net tax deferred
asset of approximately $26.6 million and valuation allowance of
approximately $24.3 million. We will continue weighing various factors
throughout the balance of year to assess the need for any valuation
allowance. Recoverability of the deferred tax assets is dependent on
continued profitability from operations, as well as the geographic region
generating the profits. Should our level of domestic profitability continue
at the current rate, we would likely remove the entire valuation allowance
associated with net operating loss carryforwards and other temporary
differences by the end of 2004. We would realize a one-time, non-cash
benefit by decreasing our tax expense (causing an increase in earnings) by
approximately $8.0 million to 11.0 million. Additionally, approximately
$9.0 million of valuation allowance related to stock option deductions
would be evaluated for potential reversal, which could be credited to
additional paid in capital.
Research and Development Costs. We expense research and development
costs as incurred. No amounts are required to be capitalized in accordance
with SFAS No. 86, "Accounting for the Costs of Computer Software to Be
Sold, Leased, or Otherwise Marketed," because our software is substantially
completed concurrently with the establishment of technological feasibility.
22
Results of Operations
The following table sets forth certain consolidated statements of
operations data as a percentage of total revenue for the periods indicated:
Three Months Ended September Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
Revenue:
Software 36.8 % 39.5 % 37.8 % 39.6 %
Customer support 49.2 46.9 48.2 46.7
Professional services and education 14.0 13.6 14.0 13.7
Total Revenue 100.0 100.0 100.0 100.0
Cost of revenue:
Software 4.0 4.3 3.6 4.0
Customer support 10.3 11.7 10.4 11.8
Professional services and education 11.8 11.8 11.5 12.1
Total cost of revenue 26.1 27.8 25.5 27.9
Gross Profit 73.9 72.2 74.5 72.1
Operating expenses:
Sales and marketing 38.0 38.5 40.5 39.3
Research and development 20.4 21.3 20.5 22.0
General and administrative 8.8 9.2 9.3 9.3
Total operating expenses 67.2 69.0 70.3 70.6
Operating income 6.7 3.2 4.2 1.5
Other income, net 1.3 0.7 1.1 1.3
Income before income tax 8.0 % 3.9 % 5.3 % 2.8 %
23
Revenue
As more fully discussed below, total revenue increased by 7.9% in the
quarter ended September 30, 2004 compared to the same period in 2003 and
increased 10.1% in the nine-month period ended September 30, 2004 compared
to the same period in 2003. We believe this revenue growth is due to our
customers placing importance on our products and services to improve their
business processes and manage their unstructured content within their
organizations. All three of our revenue segments showed growth year to year
for the nine-month period ended September 30, 2004.
Revenue by Geography. The following table sets forth total revenue by
geography and as a percentage of total revenue for the periods indicated:
Revenue by Geography
Three Months Ended Nine Months Ended
September 30, September 30, .
(In thousands) % %
Increase/ Increase/
2004 2003 decrease 2004 2003 decrease
$ Total Revenue
Total United States Revenue $ 64,532 $ 65,318 (1.2%) $ 198,820 $ 182,483 9.0%
Europe, Middle East and Africa 23,366 18,601 25.6% 70,908 64,256 10.4%
Canada, Latin America and Asia 8,590 5,470 57.0% 20,344 16,816 21.0%
Total International Revenue 31,956 24,071 32.8% 91,252 81,072 12.6%
Total Revenue $ 96,488 $ 89,389 7.9% $ 290,072 $ 263,555 10.1%
% of Total Revenue
United States Revenue 66.9% 73.1% 68.5% 69.3%
International Revenue 33.1% 26.9% 31.5% 30.7%
Total Revenue Contribution 100.0% 100.0% 100.0% 100.0%
Revenue generated in the United States grew by 9.0% in the first nine
months of 2004 compared to the same period in 2003 and decreased marginally
by 1.2% in the third quarter of 2004 over the comparable prior year
quarter. This increase during the nine-month period is primarily due to the
increase in service revenue. The factors driving software license and
service revenue growth will be more fully discussed in the Revenue by
Reporting Segment section below. The revenue growth in the United States
was complemented by increased international revenue in the three and
nine-month periods of 2004 compared to the same quarter a year ago.
International revenue represented approximately 31.5% of total revenue in
the first nine months of 2004 compared to approximately 30.7% for the same
nine months in 2003.
We believe that process improvement and content management
requirements are global in nature and international customers also view our
products as essential to solving their business and content problems.
Revenue growth in the long term appears to be non-regional in nature, but
is subject to periodic fluctuations. Furthermore, international revenues
will be adversely affected if the U.S. dollar strengthens against certain
major international currencies or if international economic conditions
weaken.
24
Revenue by Reporting Segment. The following table sets forth total
revenue by reporting segment and as a percentage of total revenue for the
periods indicated:
Revenue by Reporting Segment
Three Months Ended Nine Months Ended
September 30, September 30, .
% Increase/ % Increase/
(In thousands) 2004 2003 (decrease) 2004 2003 (decrease)
$ Total Revenue
Software $ 35,447 $ 35,320 0.4% $ 109,475 $ 104,397 4.9%
Customer Support 47,510 41,907 13.4% 139,852 123,063 13.6%
Professional Services and
Education 13,531 12,162 11.3% 40,745 36,095 12.9%
Total Revenue $ 96,488 $ 89,389 7.9% $ 290,072 $ 263,555 10.1%
% of Total Revenue
Software 36.7% 39.5% (2.8) 37.7% 39.6% (1.9)
Customer Support 49.2% 46.9% 2.4 48.2% 46.7% 1.5
Professional Services and
Education 14.1% 13.6% 0.4 14.1% 13.7% 0.4
Total Revenue Contribution
100.0% 100.0% 100.0% 100.0%
Software. Software revenue consists of fees earned from the licensing
of our software products to our customers. Demand was relatively stable for
our products for the comparable three and nine-month periods in 2004 and
2003. As we have seen in prior quarters this year, fluctuation in buying
patterns and the general market climate has affected our level of software
sales quarter to quarter, creating an environment that is unpredictable. We
believe this environment will continue in the near term. In the longer term
we believe spending on enterprise content management and business process
management software will be a priority as companies look to automate
regulatory and compliance requirements. Additionally, we believe there will
be increased demand for our ECM products driven by the need for large
organizations to manage their unstructured content.
Customer Support. Customer support revenue consists of revenue from
software maintenance contracts, time and material revenues and the sale of
spare parts and supplies. Maintenance contracts entitle our customers to
receive technical support, enhancements and upgrades to new versions of
software releases if and when available. Time and material revenue is
derived from services provided to the customer that are not included in
their maintenance contract entitlements. Customer support revenue is
generated from new maintenance contracts for current year software sales
and from the renewal of existing maintenance contracts for previously sold
software licenses on installed systems. Customer support revenue increased
by 13.4% in the three-month period ended September 30, 2004 compared to the
same period in 2003 and increased 13.6% in the nine-month period ended
September 30, 2004 compared to the same period in 2003. We have
historically experienced a high contract maintenance renewal rate and
continue to see this same high level of renewal, but are continuing to
encounter pricing pressures from our customers during contract negotiation
and renewal. Accordingly, the rate of software revenue growth may not
directly correlate to the same growth for customer support revenue
experienced in the past.
Professional Services and Education. Professional services and
education revenue is generated from consulting and implementation services
to end users of our software products, technical consulting services
provided to our resellers, and training services. No modifications are made
to our standard base product code once the software has been sold.
Professional services and education revenue increased by 11.3% in the three
month period ended September 30, 2004 compared to the same period in 2003
25
and 12.9% in the nine-month period ended September 30, 2004 compared to the
same period in 2003. Professional services revenue is dependent on the
level and the nature of software sales in prior periods. Professional
services revenue grows more rapidly when customers purchase new systems for
a large scale implementation or purchase our FileNet P8 product to replace
legacy systems, as opposed to existing customers purchasing add-on licenses
for installed systems. The increase in professional services revenue we
experienced in the first nine months of 2004 compared to the same period in
2003 was primarily attributable to an increased demand for consulting
services to existing customers that migrated their custom applications to
the new FileNet P8 platform. Based on software revenue sales for the past
two quarters we do not believe the level of demand for professional
services and education services will change significantly from current
levels.
Cost of Revenue
Cost of Revenue by Reporting Segment. The following table sets forth
total cost of revenue by reporting segment and as a percentage of revenue
by reporting segment for the periods indicated:
Cost of Revenue by Reporting Segment
Three Months Ended Nine Months Ended
September 30, September 30, .
% Increase/ % Increase/
(In thousands) 2004 2003 (decrease) 2004 2003 (decrease)
$ Total Cost of Revenue
Software 3,835 3,800 0.9% 10,486 10,416 0.7%
Customer Support 9,891 10,487 (5.7)% 30,125 31,026 (2.9)%
Professional Services and
Education 11,404 10,586 7.7% 33,396 32,001 4.4%
Total Cost of Revenue 25,130 24,873 1.0% 74,007 73,443 0.8%
% Total Cost of Revenue
Software 10.8% 10.8% - 9.6% 10.0% (0.4)
Customer Support 20.8% 25.0% (4.2) 21.5% 25.2% (3.7)
Professional Services and
Education 84.3% 87.0% (2.8) 82.0% 88.7% (6.7)
Total Cost of Revenue
as a % of Revenue 26.0% 27.8% 25.5% 25.3%
Software. Cost of software revenue includes royalties paid to third
parties for technology used in our products to enhance features and
functionality, partner fees, amortization of acquired technology, media
costs, and the cost to manufacture and distribute software. The cost of
software revenue in absolute dollars increased minimally by 0.9% when
comparing the three months ended September 30, 2004 to the same three
months in 2003. The nine-month comparison for these two years resulted in a
0.7% increase. The cost of software revenue as a percent of software
revenue was unchanged in the three month period comparison and decreased a
small 0.4 percentage point in the nine-month period ended September 30,
2004, compared to the same period in 2003. While these costs will fluctuate
period to period based on the mix of products sold containing third party
product, our royalty costs have remained flat or decreased slightly due to
more favorable royalty rates that have been negotiated during the renewal
process over the past year. The volume of sales influenced by partners that
requires a partner fee also fluctuates quarter to quarter. However, going
forward we anticipate the cost of software revenue to remain at
approximately 10% of software revenue as we continue to integrate
third-party technology with our products.
26
Customer Support. Cost of customer support revenue includes the cost
of compensation and benefits paid to customer support personnel, facility
and technology infrastructure expenses in our call centers, supplies and
spare parts. The cost of customer support revenue as a percent of customer
support revenue decreased by 4.2 percentage points and 3.7 percentage
points in the three and nine-month periods ended September 30, 2004
compared to the same periods in 2003. The cost of customer support revenue
in absolute dollars also decreased in these comparable periods due to
continuing cost containment programs. The reduction in cost of customer
support revenue, as a percentage of the revenue is attributable to
efficiencies in the delivery of technical support, which allows for
increased revenue without a comparable increase in cost. We expect the cost
of customer support revenue to remain fairly constant as a percent of
customer support revenue for the near future.
Professional Services and Education. Cost of professional services and
education revenue consists primarily of the costs of professional services
personnel, training personnel, and third-party contractors. The cost of
professional services and education revenue, as a percent of professional
services and education revenue, decreased by 2.8 percentage points and 6.7
percentage points in the three and nine-month periods ended September 30,
2004 as compared to the same periods in 2003. This decrease in cost of
professional services and education revenue as a percent of professional
services and education revenue is primarily attributable to higher
professional services and education revenue in 2004 compared to 2003,
together with lower costs associated with reduced employee headcount and
lower variable employee compensation. We expect professional services and
education costs as a percentage of professional services and education
revenue to vary from period to period depending on the utilization rates of
internal resources, the level of revenue and the mix between internal and
external service providers.
Operating Expenses
Total Operating Expenses. The following table sets forth total
operating expense by function and as a percentage of total revenue for the
periods indicated:
Operating Expenses
Three Months Ended Nine Months Ended
September 30, September 30, .
% Increase/ % Increase/
(In thousands) 2004 2003 (decrease) 2004 2003 (decrease)
$ Total Operating Expenses
Research and Development $ 19,664 $ 19,049 3.2% $ 59,469 $ 58,031 2.5%
Marketing and Sales 36,674 34,405 6.6% 117,433 103,660 13.3%
General and Administrative 8,509 8,241 3.3% 27,136 24,393 11.2%
Total Operating Expenses $ 64,847 $ 61,695 5.1% $ 204,038 $ 186,084 9.6%
% Total Operating Expenses
Research and Development 20.4% 21.3% (0.9) 20.5% 22.0% (1.5)
Marketing and Sales 38.0% 38.5% (0.5) 40.5% 39.3% 1.2
General and Administrative 8.8% 9.2% (0.4) 9.4% 9.2% 0.1
Operating Expense as a % of
Revenue 67.2% 69.0% 70.3% 70.6%
27
Research and Development. Our research and development efforts are
focused on enhancing and maintaining our Enterprise Content Management
capabilities within the FileNet P8 product line. We delivered version 3.0
of our FileNet P8 platform in the third quarter of 2004. Our efforts also
focus on our product suites including Business Process Manager, Web Content
Manager, Records Manager, Forms Manager, Team Collaboration Manager and
other capabilities. We delivered our Records Manager suite in the third
quarter of 2004 and plan the availability of Team Collaboration Manager
suite during the fourth quarter of 2004.
Our research and development expense consists primarily of personnel
costs for internal software development, third party contracted development
resources and related facilities costs. Research and development expense
increased 3.2% and 2.5% in the three and nine-month periods ended September
30, 2004 compared to the same periods in 2003 due primarily to employee
merit increases and increased offshore consulting expense. However,
research and development expense decreased as a percent of revenue by 0.9
percentage points and 1.5 percentage points for the three and nine months
ended September 30, 2004 compared to the same periods in 2003. This
decrease is primarily attributable to increased revenue levels without a
corresponding expense increase. Lower internal personnel and facility
expense resulting from decreased headcount partially offset increased
offshore development expense. The expense mix continues to change with
lower internal personnel costs and higher offshore development expense. The
number of internal research and development personnel was 430 on September
30, 2004 compared to 464 on September 30, 2003. We currently have 99
contract workers in India developing software compared to 62 one year ago.
We believe we will be able to further decrease our per-developer cost
through the expanded use of offshore resources, however in the near term,
some duplicate expenses will be incurred as our development programs are
transitioned to these offshore development resources. We believe that
research and development expenditures, including compensation of technical
personnel, are essential to maintaining our competitive position. We expect
research and development expense to be at approximately 20% of revenue for
the near term.
Selling and Marketing. We sell our products through a direct sales
force and our indirect channel sales partners. The majority of our selling
and marketing expense is salaries, benefits, sales commissions and other
expenses related to the direct and indirect sales force, and personnel cost
for marketing and market development programs. Selling and marketing
expense as a percent of revenue decreased by 0.5 percentage points and
increased by 1.2 percentage points for the three and nine-months ended
September 30, 2004 compared to the same period in 2003. In absolute dollars
selling and marketing expense increased by 6.6% and 13.3% for the three and
nine-month periods ended September 30, 2004 compared to 2003. Approximately
$13.3 million, or 95%, of the year to date increase is attributable to
organizational changes that resulted in higher salaries, higher variable
compensation and associated benefits. We expect selling and marketing
expense to remain at approximately 39% of revenue in the near-term.
General and Administrative. Our general and administrative expense
consists primarily of salaries, benefits, and other expenses related to
personnel costs for finance, information technology, legal, human resources
and general management and the cost of outside professional services.
General and administrative expense as a percent of revenue decreased 0.4
percentage points and increased 0.1 percentage points in the three and
nine-month periods ended September 30, 2004 compared to the same periods in
2003. In absolute dollars general and administrative expenses increased
3.3% and 11.2% in the three and nine-month periods ended September 30, 2004
compared to the same periods in 2003. The increases in general and
administrative expense between the comparative periods are attributed to
higher salary costs and benefits due to increased headcount and merit
increases as well as increased legal and accounting fees associated with
compliance to meet recently mandated corporate governance regulations. We
expect general and administrative expense to remain at approximately 10% of
revenue in the near-term.
Other Income, Net. Other income, net consists primarily of interest
income earned on our cash and investments, and other items including
realized foreign exchange gains and losses and interest expense. Other
income, net of other expenses, was $1.2 million and $3.2 million for the
three and nine-month periods ended September 30, 2004 compared to $0.6
million and $3.3 million during for the three and nine-month periods ended
28
September 30, 2003. The weighted average interest rate earned on cash, cash
equivalents and investments was 1.88% during the nine months ended
September 30, 2004 compared to 1.35% for the same period in 2003.
Provision for Income Taxes. Our combined federal, state and foreign
annual effective tax rate for the three and a nine-month period ended
September 30, 2004 was 18%, compared to 28% for the comparable periods in
2003. The provision for income taxes differs from the tax computed at the
federal statutory income tax rate due primarily to earnings considered as
permanently reinvested in foreign operations with lower tax rates and
reductions in our domestic deferred tax valuation allowance. The decreased
tax rate in the three and nine-month period ended September 30, 2004 was
primarily due to the mix of income earned by our domestic operations versus
the foreign subsidiaries.
Liquidity and Capital Resources
At September 30, 2004, combined cash, cash equivalents and investments
totaled $302.9 million, an increase of $54.6 million and $3.3 million from
December 31, 2003 and June 30, 2004, respectively.
Cash provided by operating activities during the nine month period
ended September 30, 2004 totaled $42.5 million and resulted primarily from:
an increase in unearned maintenance revenue related to prepaid maintenance
contracts of $16.9 million; depreciation and amortization expense of $12.4
million; and net income of $12.5 million. The increase in unearned
maintenance revenue is primarily the result of the growth in our base of
annual support contracts resulting from new customer sales and sales of
additional products to the existing base. Additionally, a significant
number of maintenance contracts renew early in the year and are amortized
ratably throughout the year resulting in a lower balance in unearned
maintenance by December 31.
Cash provided by financing activities totaled $21.5 million and was a
result of proceeds received from the exercise of employee stock options and
stock purchases under the employee stock purchase plan.
Net cash used in investing activities was $53.5 million comprised of
$45.8 million for the purchase of marketable securities in excess of
proceeds from the sales of marketable securities and $7.8 million for
capital expenditures.
Contractual cash obligations of significance include non-cancelable
operating leases for our corporate offices, sales offices, development and
manufacturing facilities and other equipment, some of which have renewal
options and generally provide for escalation of the annual rental amount.
(See Note No. 11 to the Notes to Unaudited Condensed Consolidated Financial
Statements for additional details.)
We believe that our present cash balances together with internally
generated funds will be sufficient to meet our working capital and capital
expenditure needs for at least the next 12 months.
Other Financial Instruments
We conduct business on a global basis in several currencies.
Accordingly, we are exposed to movements in foreign currency exchange
rates. We enter into forward foreign exchange contracts to minimize the
short-term impact of currency fluctuations on monetary assets and
liabilities denominated in currencies other than the functional currency of
the relevant entity. We do not enter into foreign exchange forward
contracts for trading purposes. Gains and losses on these contracts, which
equal the difference between the forward contract rate and the prevailing
market spot rate at the time of valuation, are recognized as other income
(expense) in the consolidated statements of operations. We open new hedge
contracts on the last business day of each quarter that will mature at the
end of the following quarter. The counterparties to these contracts are
major financial institutions. We use commercial rating agencies to evaluate
the credit quality of the counterparties and do not anticipate
nonperformance by any counterparties. We do not anticipate a material loss
resulting from any credit risks related to any of these institutions.
29
New Accounting Pronouncements
In January 2003, the FASB issued FIN 46, "Consolidation of Variable
Interest Entities." In general, a variable interest entity is a
corporation, partnership, trust, or any other legal structure used for
business purposes that either (a) does not have equity investors with
voting rights or (b) has equity investors that do not provide sufficient
financial resources for the entity to support its activities. FIN 46
requires a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable
interest entity's activities or entitled to receive a majority of the
entity's residual returns or both. The consolidation requirements of FIN 46
apply immediately to variable interest entities created after January 31,
2003. With respect to variable interest entities created before January 31,
2003, in December 2003 the FASB issued FIN 46R, which, among other things,
revised the implementation date to the first fiscal years or interim
periods ending after March 15, 2004, with the exception of Special Purpose
Entities ("SPE"). The consolidated requirements apply to all SPE's in the
first fiscal year or interim period ending after December 15, 2003. We have
determined that we do not have any SPE's to which these interpretations
apply. The adoption of FIN 46R in 2004 has not had a material impact on our
consolidated financial statements.
In May 2003, FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity."
SFAS No. 150 establishes standards for how an issuer classifies and
measures certain financial instruments with characteristics of both debt
and equity and requires an issuer to classify the following instruments as
liabilities in its balance sheet:
o a financial instrument issued in the form of shares that is
mandatorily redeemable and embodies an unconditional obligation
that requires the issuer to redeem it by transferring its assets
at a specified or determinable date or upon an event that is
certain to occur;
o a financial instrument, other than an outstanding share, that
embodies an obligation to repurchase the issuer's equity shares,
or is indexed to such an obligation, and requires the issuer to
settle the obligation by transferring assets; and
o a financial instrument that embodies an unconditional obligation
that the issuer must settle by issuing a variable number of its
equity shares if the monetary value of the obligation is based
solely or predominantly on (1) a fixed monetary amount, (2)
variations in something other than the fair value of the issuer's
equity shares, or (3) variations inversely related to changes in
the fair value of the issuer's equity shares.
In November 2003, the FASB issued FASB Staff Position (FSP) No. 150-3
which deferred the effective dates for applying certain provisions of SFAS
No. 150 related to mandatorily redeemable financial instruments of certain
nonpublic entities and certain mandatorily redeemable noncontrolling
interests for public and nonpublic entities.
For public entities, SFAS No. 150 is effective for mandatorily
redeemable financial instruments entered into or modified after May 31,
2003 and is effective for all other financial instruments as of the first
interim period beginning after June 15, 2003.
For mandatorily redeemable noncontrolling interests that would not
have to be classified as liabilities by a subsidiary under the exception in
paragraph 9 of SFAS No. 150, but would be classified as liabilities by the
parent, the classification and measurement provisions of SFAS No. 150 are
deferred indefinitely. For other mandatorily redeemable noncontrolling
interests that were issued before November 5, 2003, the measurement
provisions of SFAS No. 150 are deferred indefinitely. For those
instruments, the measurement guidance for redeemable shares and
noncontrolling interests in other literature shall apply during the
deferral period.
SFAS No. 150 is to be implemented by reporting the cumulative effect
of a change in accounting principle. We do not have financial instruments
with characteristics of both debt and equity and therefore, the adoption of
SFAS No. 150 has not had a material impact on our consolidated financial
statements.
30
In March 2004, The FASB issued EITF Issue No. 03-1 (EITF 03-1), "The
Meaning of Other Than-Temporary Impairment and Its Application to Certain
Investments" which provides new guidance for assessing impairment losses on
investments. Additionally, EITF 03-1 includes new disclosure requirements
for investments that are deemed to be temporarily impaired. In September
2004, the FASB delayed the accounting provisions for EITF 03-1; however the
disclosure requirements remain effective for annual periods ending after
June 15, 2004. We will evaluate the impact of EITF 03-1 once final guidance
is issued.
Other Matters
Environmental Matters. We are not aware of any issues related to
environmental matters that have, or are expected to have, a material affect
on our business.
Risk Factors That May Affect Future Results
Except for the historical information and discussions contained
herein, statements contained in this Form 10-Q may constitute "forward
looking statements" within the meaning of the Private Securities Litigation
Reform Act of 1995. These statements are based on current expectations and
assumptions that involve a number of risks, uncertainties and other factors
that could cause actual results to differ materially from recent results or
from our anticipated future results. We operate in a rapidly changing
economic and technological environment that presents numerous risks.
Prospective and existing investors are strongly urged to carefully consider
the various cautionary statements and risks set forth in this quarterly
report and our other public filings. Many of these risks are beyond our
control and are driven by factors that we cannot predict. The following
discussion highlights some of these risks:
Our quarterly operating results may fluctuate in future periods and
are not predictable and, as a result, we may fail to meet expectations of
investors and analysts, causing our stock price to fluctuate or decline.
Our operating results have fluctuated in the past and we anticipate our
future operating results will continue to fluctuate due to many factors,
some of which are largely beyond our control. Consequently, our prior
operating results should not necessarily be considered indicative of future
operating results.
Factors that may cause our operating results to fluctuate, include,
but are not limited to, the following:
o Information Technology spending trends;
o general domestic and international economic and political
conditions;
o the discretionary nature of our customers' budget and purchase
cycles and the absence of long-term customer purchase
commitments;
o the tendency to realize a substantial percentage of our revenue
in the last weeks, or even days, of each quarter;
o the potential for delays or deferrals of customer orders;
o the size, complexity and timing of individual transactions;
o the length of our sales cycle;
o the level of software sales and price competition;
o the timing of new software introductions and software
enhancements by us and our competitors; or,
o seasonality in technology purchases.
The decision to implement our products is subject to each customer's
resources and budget availability. Our quarterly sales generally include a
mix of medium sized orders, along with several large individual orders, and
as a result, the loss or delay of an individual large order could have a
significant impact on our quarterly operating results and revenue. Our
operating expenses are based on projected revenue trends and are generally
fixed. Therefore, any shortfall from projected revenue may cause
significant fluctuations in operating results from quarter to quarter. As a
result of these factors, revenue and operating results for any quarter are
subject to fluctuations and are not predictable with any significant degree
of accuracy. Therefore, we believe that period-to-period comparisons of our
results of operations should not be relied upon as indications of future
performance. Moreover, such factors could cause our operating results in a
given quarter to be below the expectations of public market analysts and
investors. In either case, the price of our common stock could decline
materially.
31
The markets in which we operate are highly competitive and we cannot
be sure that we will be able to continue to compete effectively, which
could result in lost market share and reduced revenue. The markets we serve
are highly competitive and we expect competition to intensify with the
consolidation of the ECM market. We have multiple competitors and there may
be future competitors, some of which have or may have substantially greater
sales, marketing, development and financial resources. As a consequence,
our present or future competitors may be able to develop software products
comparable or superior to those offered by us, offer lower priced products
or adapt more quickly than we do to new technologies or evolving customer
requirements.
Other competitive risks include, but are not limited to:
o We anticipate significant future consolidation as the software
industry matures. Large well-established software firms like
Oracle, IBM and Adobe may enter our market by adding content
management features to their existing suite of products. In
addition, large hardware firms may enter our market by acquiring
our competitors to pursue revenue growth opportunities;
o Many of our competitors are also our distribution channel
partners. For example, IBM competes with us in the content
management market, but also implements our software solutions
through its IBM Global Services business unit. Our customers may
view this type of vertical integration of software development
and system integration capabilities as a key competitive
advantage.
We cannot predict new competitors entering our market through
acquisitions or other alliances. In order to be successful in the future,
we must respond to technological change, customer requirements and
competitors' current software products and innovations. We may not be able
to compete effectively in our target markets. In addition, current and
potential competitors have established or may establish cooperative
relationships among themselves or with third parties to increase the
ability of their products to address the needs of the markets we serve.
Accordingly, it is possible that new competitors or alliances among
competitors may emerge and rapidly acquire significant market share.
Increased competition may result in price reductions, reduced gross margins
and loss of market share that could result in reduced revenue.
A significant portion of our revenue is derived internationally and we
are subject to many risks internationally, which could put our revenue at
risk. Historically, we have derived approximately 30% of our total revenue
from international sales through our worldwide network of subsidiaries and
channel partners. This contribution percentage will fluctuate quarter to
quarter. International business is subject to certain risks including, but
not limited to, the following:
o political and economic instability;
o tariffs and trade barriers;
o varying technical standards and requirements for localized
products;
o reduced protection for intellectual property rights in certain
countries;
o difficulties in staffing and maintaining foreign operations;
o difficulties in managing foreign distributors;
o multiple overlapping tax regimes;
o currency restrictions and currency exchange fluctuations;
o the burden of complying with a wide variety of complex foreign
laws, regulations and treaties;
o spreading our management resources to cover multiple countries;
or,
o longer collection cycles and higher risk of non-collection and
bad debt expense.
Any of these factors could reduce the amount of revenue we realize
from our international operations in the future.
32
The market for content management solutions may not grow as we
anticipate, and may decline, and our products may not gain acceptance
within this market, resulting in reduced revenue. Our future financial
performance will depend primarily on the continued growth of the markets
for our software products and services as well as our ability to capture a
larger share of those markets. Our primary product offerings address the
enterprise content management solutions market. This market is developing
rapidly, and while we believe this market is growing and will continue to
grow, particularly as new regulations are introduced that focus on
controlling the flow of information within organizations to ensure
compliance with disclosure and other obligations, these markets may not
continue to grow as we anticipate, or our products and solutions may not
gain acceptance within these markets. If the markets we serve, particularly
the market for enterprise content management solutions, fail to grow or
grow more slowly than we currently anticipate, or if our products and
solutions do not gain acceptance within these markets, our business,
financial condition and operating results would be harmed.
We must develop and sell new products to keep up with rapid
technological change in order to achieve future revenue growth and
profitability. The market for our software and services is characterized by
rapid technological developments, evolving industry standards, changes in
customer requirements and frequent new product introductions and
enhancements. Our ability to continue to sell products will be dependent
upon our ability to continue to enhance our existing software and services
offerings, develop and introduce, in a timely manner, new software products
incorporating technological advances and respond to customer requirements.
For example, two new product suites that we predict will address new
markets include Records Manager and Team Collaboration Manager. The Records
Manager Suite was released in the third quarter of 2004 and provides
customers with the capability to systematically apply record management
principles to content. The Team Collaboration Manager Suite that enables
customers to initiate collaborative tasks at any point in a process is
expected to be available in late 2004 or early 2005.
We may not be successful in developing, marketing and releasing new
products or new versions of our products that respond to technological
developments, evolving industry standards or changing customer
requirements. We may also experience technical difficulties that could
delay or prevent the successful development, introduction, sale and
implementation of these products and enhancements. In the past, we have
experienced delays in the release dates of enhancements and new releases to
our products and we may experience significant future delays in product
introduction. From time to time, our competitors or we may announce new
software products, capabilities or technologies that have the potential to
replace or shorten the life cycles of our existing software products.
Announcements of currently planned or other new software products may cause
customers to delay their purchasing decisions in anticipation of such
software products, and such delays could have a material adverse effect on
our sales. In addition, our ability to generate revenues from the sale of
customer support, education and professional services is substantially
dependent on our ability to generate new sales of our software products.
We are dependent upon customers concentrated in a small number of
industries. A significant decline in one of those industries could result
in reduced revenue. Our customers are concentrated in the insurance,
financial services, government, manufacturing, telecommunications and
utilities industries. We may not be successful in obtaining significant new
customers in different industry segments and we expect that sales of our
products to customers in a limited number of industry segments will
continue to account for a large portion of our revenue in the future. If we
are not successful at obtaining significant new customers or if a small
number of customers cancel or delay their orders for our products, then we
could fail to meet our revenue objectives. Consolidation within the
financial services and insurance industry could further reduce our
customers and future prospects. As many of our significant customers are
concentrated in a small number of industry segments, if business conditions
in one of those industry segments decline, then orders for our products
from that segment may decrease, which could negatively impact our business,
financial condition and operating results and cause the price of our common
stock to fall.
33
We must devote substantial resources to software development, and we
may not realize revenue from our development efforts for a substantial
period of time. Introducing new products that rapidly address changing
market demands requires a continued high level of investment in research
and development. We expect to invest approximately 20% of annual revenue in
research and development efforts in the near term. The majority of our
investment in new and existing market opportunities must be made prior to
our ability to generate revenue from these new opportunities. These
investments of money and resources must be made based on our prediction of
new products and services that the market needs and will accept. As a
result, our operating results could be adversely affected if our
predictions of market demand are incorrect and we are not able to realize
the level of revenues we expect from new products or if that revenue is
significantly delayed due to revenue recognition rules that require new
products be tested in the market to validate pricing and acceptance.
We are increasing our use of third party software developers and may
have difficulty enforcing or managing our agreements with them, which could
delay new product introductions and reduce revenue. To help manage costs,
we have contracted with third party software development companies
overseas, particularly in India, where labor costs are lower, to perform an
increasing portion of our software development and software localization
work. As a result, we will become increasingly dependent on these third
party developers for continued development and maintenance of several of
our key products. If any of these third party developers were to terminate
their relationship with us, our efforts to develop new products and improve
existing products could be significantly delayed and our ability to provide
product support to our customers could be impaired. In addition, since the
majority of these third party developers are located outside the United
States, our ability to enforce our agreements with them may be limited.
We must retain and attract key executives and personnel who are
essential to our business, which could result in increased personnel
expenses. Our success depends to a significant degree upon the continued
contributions of our key management, as well as other marketing, technical
and operational personnel. The loss of the services of one or more key
employees could have a material adverse effect on our operating results. We
do not have employment agreements with any of the members of our United
States-based senior management. We do have employment contracts with
members of our international management that commit them to a notification
period.
We believe our future success will depend in large part upon our
ability to attract and retain additional highly skilled management,
technical, marketing, product development and operational personnel and
consultants. There is competition for such personnel; particularly software
developers, professional services consultants and other technical
personnel. We may not be successful in attracting and retaining such
personnel in the future.
If our products contain errors, we could incur unplanned expenses and
delays that could result in reduced revenue, lower profits, and harmful
publicity. Software, services and products, as complex as those we sell,
are susceptible to errors or failures, especially when first introduced or
deployed. Our software products are often intended for use in applications
that are critical to a customer's business. As a result, our customers may
rely on the effective performance of our software to a greater extent than
the market for software products generally. Despite internal testing and
testing by current and potential customers, new products or enhancements
may contain undetected errors or performance problems that are discovered
only after a product has been installed and used by customers. Errors or
performance problems could cause delays in product introduction and
shipments or could require design modifications, either of which could lead
to a loss in or delay of revenue. These problems could cause a diversion of
development resources, harm our reputation or result in increased service
or warranty costs, or require the payment of monetary damages. While our
license agreements with customers typically contain provisions designed to
limit our exposure to potential product liability claims, it is possible
that such limitation of liability provisions may not be effective under the
laws of certain jurisdictions.
34
The limitation of liability provisions contained in our license
agreements may not be effective as a result of existing or future federal,
state or local laws or ordinances or unfavorable judicial decisions. Our
license agreements with our customers typically contain provisions designed
to limit our exposure to potential product liability claims. Although
product liability claims to date have been immaterial, the sale and support
of our products entails the risk of such claims, which could be substantial
in light of our customers' use of such products in mission-critical
applications. If a claimant brings a product liability claim against us, it
could have a material adverse effect on our business, results of operations
and financial condition. Even if our software is not at fault, we could
suffer material expense and material diversion of management time in
defending any such lawsuits.
Acquisitions of companies or technologies may result in disruptions to
our business and diversion of management attention, which could cause our
financial performance to suffer. As part of our business strategy, we
frequently evaluate strategic acquisition opportunities. We anticipate that
our future growth may depend in part on our ability to identify and acquire
complementary businesses, technologies or product lines. Acquisitions
involve significant risks and could divert management's attention from the
day-to-day operations of our ongoing business. Additionally, such
acquisitions may include numerous other risks, including, but not limited
to, the following:
o difficulties in the integration of the operations, products and
personnel of the acquired companies;
o the incurrence of debt;
o liabilities and risks that are not known or identifiable at the
time of the acquisition;
o difficulties in retaining the acquired company's customer base;
o valuations of acquired assets or businesses that are less than
expected; or
o the potential loss of key personnel of the acquired company.
If we fail to successfully manage future acquisitions or fully
integrate future acquired businesses, products or technologies with our
existing operations, we may not receive the intended benefits of the
acquisitions and such acquisitions may harm our business and financial
results.
Our business is highly automated for the execution of marketing,
selling and technical support functions. We depend on the integrity of our
information systems network connectivity to perform these business
functions. Significant business interruption could occur at our Costa Mesa
headquarters facility due to a natural disaster such as earthquake, which
could cause a prolonged power outage and the inability for key personnel to
perform their job functions.
Protection of our intellectual property and other proprietary rights
is limited, which could result in the use of our technology by competitors
or other third parties. There is risk of third-party claims of
infringement, which could expose us to litigation and other costs. Our
success depends, in part, on our ability to protect our proprietary rights
to the technologies used in our principal products. We rely on a
combination of copyrights, trademarks, trade secrets, patents,
confidentiality procedures and contractual provisions to protect our
proprietary rights in our software products. Our existing or future
copyrights, trademarks, trade secrets, patents or other intellectual
property rights may not have sufficient scope or strength to provide
meaningful protection or a commercial advantage to us. Intellectual
property rights often cannot be enforced without engaging in litigation,
which involves devotion of significant resources, can divert management
attention and has uncertain outcomes. In addition, the laws of some foreign
countries do not protect our proprietary rights to the same extent, as do
the laws of the United States. Any inability to protect our intellectual
property may harm our business and competitive position.
We may, from time to time, be notified that we are infringing certain
patent or intellectual property rights of others, which could expose us to
litigation and other costs. While there are no material actions currently
pending against us for infringement of patent or other proprietary rights
of third parties, we cannot assure that third parties will not initiate
infringement actions against us in the future. Combinations of technology
acquired through past or future acquisitions and our technology will create
new software products and technology that also may give rise to claims of
infringement. Infringement actions can result in substantial costs and
35
diversion of resources, regardless of the merits of the actions. If we were
found to infringe upon the rights of others, we may not be able to redesign
the infringing products to avoid further infringement or obtain necessary
licenses to use the infringed rights on acceptable terms, or at all.
Additionally, significant damages for past infringement could be assessed
or future litigation relative to any such licenses or usage could occur. An
adverse disposition of any claims or the advent of litigation arising out
of any claims of infringement could result in significant costs or reduce
our ability to market any affected products.
We depend on certain strategic relationships in order to license
third-party products and revenue related to these products could be at risk
if we were unable to maintain these relationships. In order to expand the
distribution of our products and broaden our product offerings, we have
established strategic relationships with a number of indirect channel
partners and other consultants that provide marketing and sales
opportunities for us. We have entered into key formal and informal
agreements with other companies such as BEA Systems Inc., EMC Corporation,
ILOG Corporation and Verity, Inc. Certain of these agreements have minimum
purchase requirements and/or require prepayments which usage is limited to
a specific timeframe, while others do not have minimum purchase
requirements and/or are cancelable at will. We cannot assure that these
companies will not reduce or discontinue their relationships with, or
support of, FileNet and our products. If we fail to maintain these
relationships, or to establish new relationships in the future, it could
harm our business, financial condition and results of operations.
We currently license certain software from third parties, including
software that is integrated with internally developed software and used in
our products to perform key functions. We would be unable to sell theses
products if we do not maintain these licenses, which would result in
reduced revenue. In the past, we have had difficulty renewing certain
licenses. The failure to continue to maintain these licenses would prohibit
us from selling certain products. We cannot assure that such third parties
will remain in business, that they will continue to support their software
products or that their software products will continue to be available to
us on acceptable terms. The loss or inability to maintain any of these
software licenses could result in shipment delays or reductions in software
shipments until equivalent software can be developed, identified, licensed,
and integrated. In addition, it is possible that as a consequence of a
merger or acquisition transaction involving one of these third parties,
certain restrictions could be imposed on our business that had not been
imposed prior to the transaction. This could adversely affect our sales.
Our stock price has been and may continue to be volatile causing
fluctuations in the market price of our stock, which would impact
shareholder value. The trading price of our common stock has fluctuated in
the past and is subject to significant fluctuations in response to the
following factors, among others, some of which are beyond our control:
o variations in quarterly operating results;
o fluctuations in our order levels;
o announcements of technological innovations or new products or
product enhancements by us or our competitors;
o key management changes;
o changes in accounting regulations;
o changes in joint marketing and development programs;
o developments relating to patents or other intellectual property
rights or disputes;
o developments in our relationships with our customers, resellers
and suppliers;
o our announcements of significant contracts, acquisitions,
strategic partnerships or joint ventures;
o general conditions in the software and computer industries;
o fluctuations in general stock market prices and volume, which are
particularly common among highly volatile securities of Internet
and software companies;
o acquisitions in the past have been primarily cash based
transactions. Future acquisitions may include stock, which could
dilute EPS and possibly reduce shareholder value;
o we may not be able to hedge all foreign exchange risk due to the
significant fluctuation of the Euro to the US Dollar and our
ability to predict the mix of sales orders denominated in the
Euro at the end of each fiscal quarter;
36
o reduced stock value may restrict our access to equity financing
to fund further acquisitions using stock;
o industry analyst opinions may increase our stock price volatility
and reduce shareholder value; and,
o other general economic and political conditions.
In recent years, the stock market, in general, has experienced extreme
price and volume fluctuations that have affected the market price for many
companies in industries similar to ours. Some of these fluctuations have
been unrelated to the operating performance of the affected companies.
These market fluctuations may decrease the market price of our common stock
in the future.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk
Our exposure to market rate risk for changes in interest rates relates
primarily to our investment portfolio. We have not used derivative
financial instruments in our investment portfolio. We place our investments
with high-quality issuers and, by policy, limit the amount of credit
exposure to any one issuer. We protect and preserve our invested funds by
limiting default, market and reinvestment risk. Our investments in
marketable securities consist primarily of high-grade corporate and
government securities with maturities of less than three years. Investments
purchased with an original maturity of three months or less are considered
to be cash equivalents. We classify all of our investments as
available-for-sale. Available-for-sale securities are carried at fair
value, with unrealized gains and losses, net of tax, reported in a separate
component of stockholders' equity. Average maturity of our investment
portfolio is 111 days; therefore, the movement of interest rates should not
have a material impact on our balance sheet or income statement.
At any time, a significant increase/decrease in interest rates will
have an impact on the fair market value and interest earnings of our
investment portfolio. We do not currently hedge this interest rate
exposure. We have performed a sensitivity analysis as of September 30, 2004
and 2003, using a modeling technique that measures the change in the fair
values arising from a hypothetical 50 basis points and 100 basis points
adverse movement in the levels of interest rates across the entire yield
curve, which are representative of historical movements in the Federal
Funds Rate with all other variables held constant. The analysis covers our
investment and is based on the weighted-average maturity of our investments
as of September 30, 2004 and 2003. The sensitivity analysis indicated that
a hypothetical 50 basis points adverse movement in interest rates would
result in a loss in the fair values of our investment instruments of
approximately $341,000 at September 30, 2004 and approximately $258,000 at
September 30, 2003. Similarly a hypothetical 100 basis points adverse
movement in interest rates would result in a loss in the fair values of our
investments of approximately $681,000 at September 30, 2004 and
approximately $515,000 at September 30, 2003.
The following table provides information about our investment
portfolio at September 30, 2004:
.
Estimated Fair
(In thousands) Cost Value
Debt Securities
Due in one year or less:
Short-term munis-taxable $ 8,500 $ 8,500
Corporate 8,545 8,533
Governments/Agencies 57,009 56,792
Total due in one year 74,054 73,825
Due in one to three years:
Corporate 2,087 2,079
Government/Agencies 13,860 13,804
Total due in three years 15,947 15,883
Grand total $ 90,001 $ 89,708
37
Actual maturities may differ from contractual maturities because the
issuer of the securities may have the right to repurchase such securities.
We classify investments maturing in less than one year in current assets
and investments maturing greater than one year are classified as long-term
investments.
Foreign Currency Fluctuations and Inflation
Our performance can be affected by changes in foreign currency values
relative to the U.S. dollar in relation to our revenue and operating
expenses. We have entered into forward foreign exchange contracts primarily
to hedge amounts due from and the net assets of selected subsidiaries
denominated in foreign currencies (mainly in Europe and Asia Pacific)
against fluctuations in exchange rates. We have not entered into forward
foreign exchange contracts for speculative or trading purposes. Our
accounting policies for these contracts are based on our designation of the
contracts as hedging transactions. The criteria we use for designating a
contract as a hedge include the contract's effectiveness in risk reduction
and one-to-one matching of derivative instruments to underlying
transactions. Gains and losses on foreign exchange contracts are recognized
in income in the same period as gains and losses on the underlying
transactions. If an underlying hedged transaction were terminated earlier
than initially anticipated, the offsetting gain or loss on the related
forward foreign exchange contract would be recognized in income in the same
period. In addition, since we enter into forward contracts only as a hedge,
any change in currency rates would not result in any material net gain or
loss, as any gain or loss on the underlying foreign currency denominated
balance would be offset by the gain or loss on the forward contract. Our
forward contracts generally have an original maturity of three months. As
of September 30, 2004, we had forward foreign exchange contracts
outstanding totaling approximately $3.1 million in ten currencies. These
contracts were opened on the last business day of the quarter and mature
within three months.
Cumulative other comprehensive income or loss is incurred when account
balances denominated in a foreign currency are translated into U.S. dollars
in accordance with FASB No. 52, or when investments are revalued to current
fair market value in accordance with FASB No. 115. Our cumulative other
comprehensive income and loss is due primarily to translation. The
resulting gains or losses from translation are charged or credited to other
comprehensive income and are accumulated and reported in the stockholders
equity section of our consolidated balance sheet.
Other cumulative comprehensive income increased $1.8 million during
the three-month period ended September 30, 2004 due to a temporary
strengthening of the U.S. dollar to the Euro. However, cumulative other
comprehensive income decreased by $0.8 million during the nine-month period
ended September 30, 2004, due to the general weakening of the U.S. dollar
to the Euro over this extended period.
Management believes that inflation has not had a significant impact on
the prices of our products, the cost of our materials, or our operating
results for the three and nine-month period ended September 30, 2004.
Item 4. Controls and Procedures
We maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our Exchange Act
reports are recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission's rules and
forms and that such information is accumulated and communicated to the our
management, including our Chief Executive Officer and Chief Financial
Officer, as appropriate, to allow for timely decisions regarding required
disclosure. In designing and evaluating the disclosure controls and
procedures, management recognizes that any controls and procedures, no
matter how well designed and operated, can provide only reasonable
assurance of achieving the desired control objectives, and in reaching a
reasonable level of assurance, management necessarily was required to apply
its judgment in evaluating the cost-benefit relationship of possible
controls and procedures.
38
As of September 30, 2004, the end of the quarter covered by this
report, an evaluation was carried out under the supervision and with the
participation of our management, including our Chief Executive Officer and
our Chief Financial Officer, of the effectiveness of the design and
operation of our disclosure controls and procedures as required by SEC Rule
13a - 15(b). Based on the foregoing, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures
were effective at the reasonable assurance level. There has been no change
in our internal controls over financial reporting during our most recent
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, our internal controls over financial reporting.
Section 404 of the Sarbanes-Oxley Act. We have made our Section 404
compliance project to a top priority for the Company. However, the process
is on going and we cannot provide assurance that a weakness requiring
remediation will not be discovered and that such weakness, if discovered,
can be remediated prior to the compliance date of December 31, 2004.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
See Note 11 to Consolidated Financial Statements.
Item 6. Exhibits
(a) Exhibits:
1) The list of exhibits contained in the accompanying Index to
Exhibits is herein incorporated by reference.
39
SIGNATURE
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.
FILENET CORPORATION
November 8, 2004 By: /s/ Sam M. Auriemma .
Date Sam M. Auriemma, Executive Vice President
and Chief Financial Officer
(Principal Financial and Accounting Officer,
Authorized Signatory)
40
Index to Exhibits
Exhibit No. Exhibit Description
3.1* Restated Certificate of Incorporation, as amended (filed as Exhibit 3.1 to Registrant's Form S-4
filed on January 26, 1996; Registration No. 333-00676).
3.1.1* Certificate of Amendment of Restated Certificate of Incorporation (filed as Exhibit 3.1.1 to
Registrant's Form S-4 filed on January 26, 1996, Registration No. 333-00676).
3.2* Bylaws (filed as Exhibit 3.2 of the Registrant's registration statement on Form S-1, Registration No.
33-15004).
4.1* Form of certificate evidencing Common Stock (filed as Exhibit 4.1 to Registrant's registration
statement on Form S-1, Registration No. 33-15004).
4.2* Rights Agreement, dated as of November 4, 1988 between FileNet Corporation and the First National
Bank of Boston, which includes the form of Rights Certificate as Exhibit A and the Summary of Rights
to Purchase Common Shares as Exhibit B (filed as Exhibit 4.2 to Registrant's registration statement
on Form S-4 filed on January 26, 1996; Registration No. 333-00676).
4.3* Amendment One dated July 31, 1998 and Amendment Two dated November 9, 1998 to Rights Agreement dated
as of November 4, 1988 between FileNet Corporation and BANKBOSTON, N.A. formerly known as The First
National Bank of Boston (filed as Exhibit 4.3 to Registrant's registration statement on Form 10-Q for
the quarter ended September 30, 1998).
4.4* Amendment Three dated November 30, 2001 to Rights Agreement dated as of November 4, 1988 between
FileNet Corporation and Equiserve Trust Company, N.A., successors to BANKBOSTON, N.A. (filed as
Exhibit 4.4 to Registrant's Annual Report on Form 10-K filed for the year ended December 31, 2001).
10.2*+ Amended and Restated 1995 Stock Option Plan of FileNet (filed as Exhibit 99.1 to Registrant's
registration statement on Form S-8 filed on October 15, 2001; Registration No. 333-71598).
10.2.1*+ Amendment to the 1995 Stock Option Plan approved by Registrant's Board of Directors dated May 7, 2003
(filed as Exhibit 10.2.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30,
2003).
10.2.2*+ Amended Form of 1995 Executive Officer Stock Option Agreement (filed as Exhibit 10.2.2 to
Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).
10.3*+ Second Amended and Restated 1986 Stock Option Plan of FileNet Corporation, together with the forms of
Incentive Stock Option Agreement and Non-Qualified Stock Option Agreement (filed as Exhibits 4(a),
4(b) and 4(c), respectively, to the Registrant's registration statement on Form S-8, Registration No.
33-48499), the first Amendment thereto (filed as Exhibit 4(d) to the Registrant's registration
statement on Form S-8, Registration No. 33-69920), and the Second Amendment thereto (filed as
Appendix A to the Registrant's Proxy Statement for the Registrant's 1994 Annual Meeting of
Stockholders, filed on April 29, 1994).
10.4*+ Non-Statutory Stock Option Agreement (with Notice of Grant of Stock Option and Special Addendum)
between Registrant and Mr. Lee Roberts (filed as Exhibit 99.17 to Registrant's registration statement
on Form S-8 filed on August 20, 1997).
10.6*+ Amended and Restated FileNet Corporation 1998 Employee Stock Purchase Plan (filed as Appendix B to
Registrant's Definitive Proxy Statement on Schedule 14A, for the Registrant's 2002 Annual Meeting of
Stockholders, filed on April 18, 2002).
10.7*+ FileNet Corporation International Employee Stock Purchase Plan (filed as Appendix C to Registrant's
Definitive Proxy Statement on Schedule 14A, for the Registrant's 2002 Annual Meeting of Stockholders,
filed on April 18, 2002).
10.8* Lease between the Registrant and C. J. Segerstrom and Sons for the headquarters of the Company, dated
September 1, 1999 (filed as Exhibit 10.23 to Registrant's registration statement on Form 10-Q for the
quarter ended September 30, 1999).
10.10*+ Written Compensation Agreement and Non-Statutory Stock Option Agreement (with Notice of Grant of
Stock Option and Special Addendum) between Registrant and Mr. Sam Auriemma (filed as Exhibit 99.1 and
99.2 to Registrant's registration statement on Form S-8, filed on April 20, 2001; Registration No.
333-59274).
10.11* Asset Purchase Agreement dated April 2, 2002 by and between 3565 Acquisition Corporation and eGrail,
Inc. (filed as Exhibit 10.1 to Registrant's Current Report on Form 8-K, filed on April 12, 2002).
10.12*+ Secured Promissory Note between Registrant and Mr. Lee D. Roberts dated June 14, 2002 (filed as
Exhibit 10.12 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002).
10.13*+ Option Exchange Agreement between Registrant and Mr. Ron L. Ercanbrack, dated May 22, 2002, together
with form of Incentive Stock Option Agreement and Grant Notice (filed as Exhibit 10.13 to
Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2002).
41
10.14*+ The 2002 Incentive Award Plan, as approved by stockholders at the Registrant's Annual Meeting on May
22, 2002, together with the forms of Incentive Option Agreement and Non-Qualified Stock Option
Agreement for Independent Directors (filed as Exhibit 10.14 to Registrant's Quarterly Report on Form
10-Q for the quarter ended June 30, 2002).
10.14.1*+ Amended Form of 2002 Incentive Award Plan Incentive Option Agreement with Notice of Grant of Stock
Option (filed as Exhibit 10.14.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended
September 30, 2002).
10.14.2*+ Amended Form of 2002 Incentive Award Plan Non-Qualified Stock Option Agreement for Independent
Directors with Notice of Grant of Stock Option (filed as Exhibit 10.14.2 to Registrant's Quarterly
Report on Form 10-Q for the quarter ended September 30, 2002).
10.14.3*+ Amendment to the 2002 Incentive Award Plan dated May 7, 2003 (filed as Exhibit 10.14.3 to
Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).
10.14.4*+ Amended and Restated 2002 Incentive Award Plan of FileNet Corporation, (filed on April 1, 2004 as
Appendix B of Registrant's Definitive Proxy Statement for its 2004 Annual Meeting of Stockholders).
10.15* Stock Purchase Agreement dated April 2, 2003 by and among Registrant, FileNet Nova Scotia
Corporation, Shana Corporation and certain Sellers (filed as Exhibit 10.15 to Registrant's Quarterly
Report on Form 10-Q for the quarter ended June 30, 2003).
10.15.1* Escrow Agreement dated April 2, 2003 by and among FileNet Nova Scotia Corporation, certain Sellers
and Bennett Jones LLP (filed as Exhibit 10.15.1 to Registrant's Quarterly Report on Form 10-Q for the
quarter ended June 30, 2003).
10.16*+ Amended and Restated Letter Agreement dated May 15, 2003 by and between Registrant and Lee D.
Roberts, Chief Executive Officer (filed as Exhibit 10.16 to Registrant's Quarterly Report on Form
10-Q for the quarter ended June 30, 2003).
10.17*+ Form of Amended and Restated Letter Agreement, dated May 15, 2003, by and between Registrant and the
Chief Financial Officer and President (filed as Exhibit 10.17 to Registrant's Quarterly Report on
Form 10-Q for the quarter ended June 30, 2003) (1).
10.18*+ Form of Amended and Restated Letter Agreement by and among Registrant and certain Executive Officers
(filed as Exhibit 10.18 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30,
2003) (2).
10.19*+ CEO Severance Agreement together with Addendum II to Stock Option Agreement between Registrant and
Mr. Lee D. Roberts (filed as Exhibit 10.19 to Registrant's Quarterly Report on Form 10-Q for the
quarter ended June 30, 2003).
10.20*+ Form of Restricted Stock Agreement between Registrant and certain Executive Officers (filed as
Exhibit 10.21 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2004).
31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act.
31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act.
32.1 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act.
32.2 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act.
_________________________________________________________________________________________________________________________
* Incorporated herein by reference + Management contract, compensatory plan or arrangement
(1) Amended and Restated Letter Agreement, dated May 15, 2003 was entered into by and between
Registrant and Messrs. Sam Auriemma, Chief Financial Officer and Ron L. Ercanbrack, President
(2) Amended and Restated Letter Agreement, dated May 15, 2003 was entered into by and between
Registrant and Messrs. Martyn D. Christian, David D. Despard, Frederick P. Dillon, Karl J.
Doyle, Michael W. Harris, William J. Kreidler, Chas W. Kunkelmann, Philip Rugani, Daniel S.
Whelan, Franz X. Zihlmann, Ms. Katharina M. Mueller and Ms. Audrey N. Schaeffer. Mr.
Kenneth F. Fitzpatrick entered in a Letter Agreement, dated September 2, 2003 on
substantially the same terms and conditions.
42
Exhibit 31.1
Certification of Chief Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
I, Lee D. Roberts, certify that:
1. I have reviewed this quarterly report on Form 10-Q of FileNet
Corporation;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:
a) designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our supervision, to
ensure that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the end of
the period covered by this report based on such evaluation; and
c) disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the registrant's most
recent fiscal quarter (the registrant's fourth fiscal quarter in the case
of an annual report) that has materially affected, or is reasonably likely
to materially affect, the registrant's internal control over financial
reporting; and
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of the registrant's board of
directors (or persons performing the equivalent functions):
a) all significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to record,
process, summarize and report financial information; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
control over financial reporting.
Date: November 8, 2004
/s/ Lee D. Roberts .
Lee D. Roberts
Chief Executive Officer
Exhibit 31.2
Certification of Chief Financial Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
I, Sam M. Auriemma, certify that:
1. I have reviewed this quarterly report on Form 10-Q of FileNet
Corporation;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:
a) designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our supervision, to
ensure that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the end of
the period covered by this report based on such evaluation; and
c) disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the registrant's most
recent fiscal quarter (the registrant's fourth fiscal quarter in the case
of an annual report) that has materially affected, or is reasonably likely
to materially affect, the registrant's internal control over financial
reporting; and
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of the registrant's board of
directors (or persons performing the equivalent functions):
a) all significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to record,
process, summarize and report financial information; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
control over financial reporting.
Date: November 8, 2004
/s/ Sam M. Auriemma .
Sam M. Auriemma
Chief Financial Officer
2
Exhibit 32.1
Certification of Chief Executive Officer
Certification Pursuant To 18 U.S.C. Section 1350,
Created by Section 906
of The Sarbanes-Oxley Act of 2002
The undersigned officer of FileNET Corporation (the "Company"), hereby
certifies, to such officer's knowledge, that:
(i) the accompanying Quarterly Report on Form 10-Q of the Company for the
fiscal period ended September 30, 2004 (the "Report") fully complies with the
requirements of Section 13(a) or Section 15(d), as applicable, of the Securities
Exchange Act of 1934, as amended; and
(ii) the information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.
Dated: November 8, 2004
/s/ Lee D. Roberts .
Lee D. Roberts
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
Exhibit 32.2
Certification of Chief Financial Officer
Certification Pursuant To 18 U.S.C. Section 1350,
Created by Section 906
of The Sarbanes-Oxley Act of 2002
The undersigned officer of FileNET Corporation (the "Company"), hereby
certifies, to such officer's knowledge, that:
(i) the accompanying Quarterly Report on Form 10-Q of the Company for the
fiscal period ended September 30, 2004 (the "Report") fully complies with the
requirements of Section 13(a) or Section 15(d), as applicable, of the Securities
Exchange Act of 1934, as amended; and
(ii) the information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.
Dated: November 8, 2004
/s/ Sam M. Auriemma .
Sam M. Auriemma
Executive Vice President and
Chief Financial Officer
(Principal Financial Officer)
2