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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended June 30, 2002
or
[_] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
------- --------
Commission File Number: 1-11859
PEGASYSTEMS INC.
------------------------------------------------------
(Exact name of Registrant as specified in its charter)
Massachusetts 04-2787865
-------------------------------- ---------------------------------
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization )
101 Main Street
Cambridge, MA 02142-1590
- ---------------------------------------- ----------
(Address of principal executive offices) (zip code)
(617) 374-9600
---------------------------------------------------
(Registrant's telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
------- -------
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
There were 34,136,434 shares of the Registrant's common stock, $.01 par value
per share, outstanding on July 18, 2002.
PEGASYSTEMS INC. AND SUBSIDIARIES
Index to Form 10-Q
Page
----
Part I - Financial Information
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets at June 30, 2002
and December 31, 2001 3
Condensed Consolidated Statements of Operations for the three
and six months ended June 30, 2002 and 2001 4
Condensed Consolidated Statements of Cash Flows for the six
months ended June 30, 2002 and 2001 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk 21
Part II - Other Information
Item 1. Legal Proceedings 22
Item 2. Changes in Securities and Use of Proceeds 22
Item 3. Defaults upon Senior Securities 22
Item 4. Submission of Matters to a Vote of Security Holders 22
Item 5. Other Information 22
Item 6. Exhibits and Reports on Form 8-K 22
SIGNATURES 23
2
PEGASYSTEMS INC.
Condensed Consolidated Balance Sheets
(in thousands, except share-related amounts)
June 30, December 31,
2002 2001
-------- --------
ASSETS
Current assets:
Cash and cash equivalents $ 49,020 $ 33,017
Trade accounts receivable, net of allowance for
doubtful accounts of $1,038 in 2002 and $1,034
in 2001 4,790 9,592
Short-term license installments, net 35,733 31,359
Prepaid expenses and other current assets 663 2,286
-------- --------
Total current assets 90,206 76,254
Long-term license installments, net 45,088 43,155
Equipment and improvements, net 2,325 3,053
Acquired technology, net (Note 3) 1,254 --
Purchased software and other assets, net 1,443 2,610
Goodwill (Note 3) 3,167 --
-------- --------
Total assets $143,483 $125,072
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accrued payroll expenses $7,313 $7,940
Accounts payable and accrued other expenses 4,820 4,900
Deferred revenue 9,033 6,176
Current portion of capital lease obligations -- 81
-------- --------
Total current liabilities 21,166 19,097
Commitments and contingencies (Note 5)
Deferred income taxes 1,000 1,000
Other long-term liabilities 202 17
-------- --------
Total liabilities 22,368 20,114
Stockholders' equity:
Preferred stock, $.01 par value, 1,000,000
shares authorized; no shares issued and
outstanding -- --
Common stock, $.01 par value, 45,000,000 shares
authorized; 34,135,434 shares and 32,754,648
shares issued and outstanding in 2002 and 2001,
respectively 341 328
Additional paid-in capital 108,407 101,318
Stock warrants 3,271 2,897
Retained earnings 8,798 757
Accumulated other comprehensive income (loss) 298 (342)
-------- --------
Total stockholders' equity 121,115 104,958
-------- --------
Total liabilities and stockholders' equity $143,483 $125,072
======== ========
See notes to condensed consolidated financial statements.
3
PEGASYSTEMS INC.
Condensed Consolidated Statements of Operations
(in thousands, except per share amounts)
Three Months Ended Six Months Ended
June 30, June 30,
------------------ ------------------
2002 2001 2002 2001
---- ---- ---- ----
Revenue:
Software license $19,105 $ 8,653 $35,371 $19,534
Services 7,562 14,862 15,507 27,585
-------- -------- -------- --------
Total revenue 26,667 23,515 50,878 47,119
-------- -------- -------- --------
Cost of revenue:
Cost of software license 673 1,231 1,316 1,878
Cost of services 7,601 9,900 14,893 20,144
-------- -------- -------- --------
Total cost of revenue 8,274 11,131 16,209 22,022
-------- -------- -------- --------
Gross Profit 18,393 12,384 34,669 25,097
Operating expenses:
Research and development 5,604 4,995 11,354 9,986
Selling and marketing 5,979 4,231 11,708 9,140
General and administrative 3,103 2,106 5,512 5,096
-------- -------- -------- --------
Total operating expenses 14,686 11,332 28,574 24,222
-------- -------- -------- --------
Income from operations 3,707 1,052 6,095 875
Installment receivable interest income 1,258 1,450 2,516 2,900
Other interest income, net 180 234 323 448
Other income (expense), net (292) 141 (443) (2)
-------- -------- -------- --------
Income before provision for income taxes 4,853 2,877 8,491 4,221
Provision for income taxes 250 225 450 475
-------- -------- -------- --------
Net income $ 4,603 $ 2,652 $ 8,041 $ 3,746
======== ======== ======== ========
Earnings per share:
Basic $0.14 $0.08 $0.24 $0.11
===== ===== ===== =====
Diluted $0.13 $0.08 $0.22 $0.11
===== ===== ===== =====
Weighted average number of common and
common equivalent shares outstanding:
Basic 33,738 32,655 33,442 32,625
====== ====== ====== ======
Diluted 36,819 33,379 35,900 33,371
====== ====== ====== ======
See notes to condensed consolidated financial statements.
4
PEGASYSTEMS INC.
Condensed Consolidated Statements of Cash Flows
(in thousands)
Six Months Ended
June 30,
-------------------
2002 2001
---- ----
Cash Flows from Operating Activities:
Net income $ 8,041 $ 3,746
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 2,504 3,539
Changes in operating assets and liabilities:
Trade and installment accounts receivable (1,208) (3,575)
Prepaid expenses and other current assets 1,650 337
Accounts payable and accrued expenses (946) 1,531
Deferred revenue 2,798 1,889
------- -------
Net cash provided by operating activities 12,839 7,467
------- -------
Cash Flows from Investing Activities:
Acquisition of 1mind (See note 3) (573) --
Purchase of equipment and improvements (291) (252)
Other long term assets and liabilities (3) 173
------- -------
Net cash used in investing activities (867) (79)
------- -------
Cash Flows from Financing Activities:
Payments of capital lease obligations (81) (159)
Proceeds from sale of stock under employee stock
purchase plan 177 164
Exercise of stock options 3,631 49
------- -------
Net cash provided by financing
activities 3,727 54
------- -------
Effect of exchange rate changes on cash and cash
equivalents 304 (192)
------- -------
NET INCREASE IN CASH AND CASH EQUIVALENTS 16,003 7,250
------- -------
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 33,017 17,339
------- -------
CASH AND CASH EQUIVALENTS, END OF PERIOD $49,020 $24,589
------- -------
See notes to condensed consolidated financial statements.
5
PEGASYSTEMS INC.
Notes to Condensed Consolidated Financial Statements
June 30, 2002
Note 1 - Basis of Presentation
The unaudited condensed consolidated financial statements of Pegasystems
Inc. (the "Company") have been prepared in accordance with accounting principles
generally accepted in the United States of America and with the instructions to
Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all
adjustments (consisting of normal recurring accruals) considered necessary for a
fair presentation have been included. Operating results for the three month and
six month periods ended June 30, 2002 are not necessarily indicative of the
results that may be expected for the full year ending December 31, 2002. We
suggest that these condensed consolidated financial statements be read in
conjunction with the consolidated financial statements and notes thereto for the
year ended December 31, 2001, included in our 2001 Annual Report on Form 10-K
filed with the Securities and Exchange Commission ("SEC").
Certain amounts in the 2001 consolidated financial statements were
reclassified to be consistent with the current presentation. Reimbursements
received for out-of-pocket expenses have been reflected as services revenue, in
compliance with Emerging Issues Task Force No. 01-14; in prior periods the
reimbursements had been reflected as reduction of cost of services.
(in thousands, except per share data) Three Months Six Months
Ended June 30, Ended June 30,
2001 2001
-------------- --------------
Services revenue as reported previously $14,203 $26,138
Add: Reimbursements for out-of-pocket expenses 659 1,447
------- -------
Services revenue, reclassified $14,862 $27,585
======= =======
Cost of services as reported previously $ 9,241 $18,697
Add: Reimbursements for out-of-pocket expenses 659 1,447
------- -------
Cost of services, reclassified $ 9,900 $20,144
======= =======
Note 2 - Significant Accounting Policies
(a) Business
We develop, market, license and support software that enables transaction
intensive-organizations to manage a broad array of customer interactions. We
also offer consulting, training, maintenance and support services to facilitate
the installation and use of our products.
(b) Management Estimates and Reporting
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the periods presented. Actual results could differ from those
estimates. Significant assets and liabilities with reported amounts based on
estimates include trade and installment accounts receivable, long term license
installments and deferred revenue.
6
(c) Principles of Consolidation
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries, Pegasystems Limited (a United Kingdom
company), Pegasystems Company (a Canadian company), Pegasystems Worldwide Inc.
(a United States corporation), Pegasystems Pty. Ltd. (an Australian company),
Pegasystems Investment Inc. (a United States corporation), and Pegasystems
Private Limited (a Singapore company). All intercompany accounts and
transactions have been eliminated in consolidation.
(d) Foreign Currency Translation
The translation of assets and liabilities of our foreign subsidiaries is
made at period-end exchange rates, while equity accounts are translated at
historic exchange rates, and revenue and expense accounts are translated at the
average exchange rates during the period transactions occurred. The resulting
translation adjustments are reflected as a separate component of accumulated
other comprehensive income (loss). Realized and unrealized exchange gains or
losses from transactions and adjustments are reflected in other income
(expense), net, in the accompanying consolidated statements of operations.
(e) Revenue Recognition
Our revenue is derived from two primary sources: software license fees and
service fees. We offer both perpetual and term software licenses. Perpetual
license fees are generally payable at the time the software is delivered, and
are generally recognized as revenue upon customer acceptance.
Term software license fees are generally payable on a monthly basis under
license agreements that generally have a five-year term and may be renewed for
additional years at the customer's option. The present value of future license
payments is generally recognized as revenue upon customer acceptance and
commitment to the contractual payment stream. A portion of the fee from each
arrangement is initially deferred and recognized as installment receivable
interest income over the license term. In addition, many of our license
agreements provide for license fee increases based on inflation. The present
value of such increases is recognized when the increases become known. For
purposes of the present value calculations, the discount rates used are
estimates of customers' borrowing rates at the time of recognition, typically
below prime rate, and have varied between 3.5% and 8.0% for the past few years.
As a result, revenue that we recognize relative to these types of license
arrangements can be impacted by changes in market interest rates. For term
license agreement renewals, license revenue is recognized upon customer
commitment to the new license terms.
Our service revenue is comprised of fees for software implementation,
consulting, maintenance, and training services. Our software implementation and
consulting agreements typically require us to provide a specified level of
implementation services for a specified fee, with additional consulting services
available at an hourly rate. Revenues for time and material projects are
recognized as fees are billed. Revenues for fixed price projects are recognized
as services are delivered once the fair value of services and any other elements
to be delivered under the arrangement can be determined. All costs of services
are expensed as incurred. Historically, we have had difficulty accurately
estimating the time and resources needed to complete fixed price projects. As a
result, determination of the fair value of the elements of the contract has
generally occurred later in the implementation process, typically when
implementation is complete and remaining services are no longer significant to
the project. Prior to the point at which the fair value of the elements of a
contract can be determined, revenue recognition for fixed price projects is
limited to amounts equal to costs incurred, resulting in no gross profit. Once
the fair values of the elements of a contract are apparent, profit associated
with the fixed price services elements will begin to be recognized. Software
license customers are offered the option to enter into a maintenance contract,
which requires the customer to pay a monthly maintenance fee over the term of
the maintenance agreement, typically renewable annually. Prepaid maintenance
fees are deferred and are recognized evenly over the term of the maintenance
agreement. We generally recognize training fees revenue as the services are
provided.
7
We reduce revenue for estimates of the fair value of potential concessions
when revenue is initially recorded. These estimated amounts are deferred or
reserved until the related elements of the agreement are completed and provided
to the customer.
(f) Concentration of Credit Risk
Financial instruments that potentially subject us to a concentration of
credit risk consist of short-term cash investments, trade accounts receivable,
and long-term license installments receivable. We record long-term license
installments in accordance with our revenue recognition policy, which results in
receivables from customers due in periods exceeding one year from the reporting
date, primarily from large organizations with strong credit ratings. We grant
credit to customers who are located throughout the world. We perform credit
evaluations of customers and generally do not request collateral from customers.
Amounts due under long-term license installments are expected to be received as
follows:
License Installments
Years ended December 31, (in thousands)
Remainder of 2002 $ 20,000
2003 26,375
2004 18,585
2005 14,574
2006 9,995
2007 2,594
2008 974
---------
93,097
Deferred license interest income (12,276)
---------
Total license installments receivable $ 80,821
=========
(g) Cash and Cash Equivalents
We consider all highly liquid investments with remaining maturities of
three months or less at the date of purchase to be cash equivalents.
(h) Equipment and Improvements
Equipment and improvements are recorded at cost. Depreciation is computed
using the straight-line method over the estimated useful lives of the assets,
which are three years for equipment and five years for furniture and fixtures.
Leasehold improvements and equipment under capital leases are amortized over the
term of the lease or the useful life of the asset, whichever is less. Repairs
and maintenance costs are expensed as incurred.
(i) Impairment of Long-Lived Assets
We evaluate our long-lived assets for impairment whenever events or changes
in circumstances indicate that the carrying amount of such assets may not be
recoverable. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the asset
exceeds the fair value of the asset.
(j) Research and Development and Software Costs
Research and development costs, other than certain software related costs,
are expensed as incurred. Capitalization of software costs begins upon the
establishment of technical feasibility, generally demonstrated by a working
model or an operative version of the computer software product that is completed
in the same
8
language and is capable of running on all of the platforms as the product to be
ultimately marketed. Such costs have not been material to date, and as a result,
no internal costs were capitalized during the three and six months ended
June 30, 2002 and 2001.
Software costs are included in cost of software license revenue. No
amortization expense for internally developed capitalized software costs was
charged to cost of software license revenue during the three and six months
ended June 30, 2002 and 2001.
(k) Net Earnings Per Share
Basic earnings per share are computed based on the weighted average number
of common shares outstanding during the period. Diluted earnings per share
includes, to the extent inclusion of such shares would be dilutive to earnings
per share, the effect of outstanding options and warrants, computed using the
treasury stock method.
(in thousands, except per share data) Three Months Ended Six Months Ended
June 30, June 30,
---------------------- --------------------
2002 2001 2002 2001
---- ---- ---- ----
Basic
- -----
Net income $ 4,603 $ 2,652 $8,041 $ 3,746
======= ======= ====== =======
Weighted average common shares outstanding 33,738 32,655 33,442 32,625
======= ======= ====== =======
Basic earnings per share $0.14 $0.08 $0.24 $0.11
======= ======= ====== =======
Diluted
- -------
Net income $ 4,603 $ 2,652 $8,041 $ 3,746
======= ======= ====== =======
Weighted average common shares outstanding 33,738 32,655 33,442 32,625
Effect of assumed exercise of stock options 3,081 724 2,458 746
------- ------- ------- -------
Weighted average common shares
Outstanding, assuming dilution 36,819 33,379 35,900 33,371
======= ======= ====== =======
Diluted earnings per share $0.13 $0.08 $0.22 $0.11
======= ======= ====== =======
Outstanding options and warrant excluded as
impact would be anti-dilutive 2,025 8,007 4,128 7,530
======= ======= ====== =======
(l) Segment Reporting
We currently operate in one operating segment, customer service software.
We derive substantially all of our operating revenue from the sale and support
of one group of similar products and services. Substantially all of our assets
are located within the United States. For the three and six months ending June
30, 2002 and 2001, we derived our operating revenue from the following
countries, principally through export from the United States of America:
9
Three Months Ended Six Months Ended
June 30, June 30,
-------- --------
(in $ thousands) 2002 2001 2002 2001
---- ---- ---- ----
United States $21,224 80% $17,494 74% $ 40,582 80% $34,815 74%
United Kingdom 4,232 16% 3,589 15% 7,878 15% 6,928 15%
Europe 258 1% 1,173 5% 1,156 2% 3,738 8%
Other 953 3% 1,259 6% 1,262 3% 1,638 3%
------- ------- -------- -------
$26,667 100% $23,515 100% $ 50,878 100% $47,119 100%
During the three months ended June 30, 2002 and 2001, one customer
accounted for approximately 23% and 16% of our total revenue, respectively.
During the six months ended June 30, 2002 and 2001, one customer accounted for
approximately 31% and 10% of our total revenue, respectively. At June 30, 2002,
one customer represented 10% of outstanding accounts receivable and one customer
represented 13% of long and short-term license installments.
(m) Stock Options
We periodically grant stock options for a fixed number of shares to
employees and directors with an exercise price equal to the fair market value of
the shares at the date of the grant. We account for such stock option grants
using the intrinsic value method in accordance with APB Opinion No. 25,
"Accounting for Stock Issued to Employees", and intend to continue to do so.
Stock options granted to non-employee contractors are accounted for using the
fair value method in accordance with Statement of Financial Accounting Standards
("SFAS") No. 123, "Accounting for Stock-Based Compensation". We have adopted the
disclosure provisions of SFAS No. 123, "Accounting for Stock-Based
Compensation," relative to the impact of the fair value method.
(n) Fair Value of Financial Instruments
The principal financial instruments held consist of cash and equivalents,
accounts receivable and payable, capital lease obligations, and license
installment receivables arising from license transactions. The carrying values
of cash and equivalents, accounts receivable, accounts payable, and capital
lease obligations approximates their fair value due to the short-term nature of
the accounts. Using current market rates, the fair value of license installment
receivables approximates carrying value at June 30, 2002 and 2001.
(o) Legal Costs
We expense litigation costs as incurred.
(p) New Accounting Standards
We have adopted the Financial Accounting Standards Board ("FASB") SFAS No.
141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible
Assets." These pronouncements provide guidance on how to account for the
acquisition of businesses and intangible assets, including goodwill, which arise
from such activities. SFAS No.141 affirms that only one method of accounting may
be applied to a business combination, the purchase method. SFAS No. 141 also
provides guidance on the allocation of purchase price to the assets acquired.
SFAS No. 142 provides that goodwill resulting from business combinations no
longer be amortized to expense, but rather requires an annual assessment of
impairment and, if necessary, adjustments to the carrying value of goodwill.
10
We have adopted SFAS No. 143, "Accounting for Obligations Associated with
the Retirement of Long-Lived Assets and SFAS No. 144 "Accounting for the
Impairment of Disposal of Long-Lived Assets. SFAS No.143 establishes accounting
standards for the recognition and measurement of an asset retirement obligation
and its associated asset retirement cost. It also provides guidance for legal
obligations associated with the retirement of tangible long-lived assets. SFAS
No. 144 establishes a single accounting model for the impairment or disposal of
long-lived assets, including discontinued operations. Adoption of these
pronouncements is not expected to have a significant effect on our consolidated
financial statements.
Note 3 - Acquisition
On February 6, 2002, we acquired substantially all of the assets of 1mind
Corporation ("1mind") for initial consideration value of $3.7 million. Depending
upon the achievement of specified milestones by the acquired business in 2002
and validation of the negotiated value of 1mind, we may pay up to approximately
$6 million in additional consideration substantially in the form of shares of
our common stock. We believe that the acquisition will help increase our
penetration of the healthcare and insurance markets, strengthen our management
and delivery teams and deepen our product offerings. The acquisition of 1mind
has been accounted for as purchase and the operations of 1mind have been
included in our consolidated financial statements from the date of acquisition.
Results of operations would not have changed materially for 2001 or the current
year if 1mind had been acquired on January 1, 2001 and 2002, respectively. The
cash flow impact of $573 thousand from this acquisition was transaction costs of
$614 thousand less cash acquired of $41 thousand. We have not yet completed the
process of appraising the fair values of 1mind assets, and therefore, the
allocation of the purchase price in the condensed consolidated financial
statements is based on estimates, and is subject to change.
(in thousands)
Shares issued (a) $ 3,295
Warrants issued (b) 374
-------
Total purchase price $ 3,669
=======
Current assets, including cash of $41 $ 339
Equipment and improvements 143
Acquired existing technology (c) 1,400
Goodwill and other intangibles (d) 3,167
Current liabilities (571)
Long term liabilities (195)
Transaction costs (614)
-------
$ 3,669
=======
(a) 569,949 common shares of Pegasystems Inc. valued at approximately $5.78 per
share, the average of closing prices as reported by Nasdaq for the three
days before and after January 29, 2002, the date of agreement.
(b) Warrants to purchase, for nominal consideration, 83,092 common shares of
Pegasystems Inc., valued at approximately $4.50 per warrant using a
Black-Scholes model.
(c) Acquired existing technology results from a preliminary appraisal report of
1mind intangible assets.
(d) Any additional consideration paid will be recorded as goodwill.
11
Note 4 - Comprehensive Income
The components of comprehensive income are as follows:
(in thousands) Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ---------------------
2002 2001 2002 2001
---- ---- ---- ----
Net income $4,603 $2,652 $8,041 $3,746
Foreign currency translation adjustments, net of
income taxes 652 (15) 640 (107)
------ ------ ------ ------
Comprehensive income $5,255 $2,637 $8,681 $3,639
====== ====== ====== ======
Note 5 - Commitments and Contingencies
Company Litigation
Qwest Arbitration. On January 17, 2002, we filed a demand for arbitration with
the American Arbitration Association in Denver, Colorado against Qwest
Corporation, successor in interest to US West Business Resources, Inc.
("Qwest"). We are seeking monetary damages in the arbitration relating to
Qwest's termination of a software license and service agreement with us. On
February 8, 2002, Qwest filed a counterclaim against us seeking unspecified
monetary damages for alleged breach by us of that agreement and software
royalties in an unspecified amount. An arbitration hearing is currently
scheduled for August, 2002.
Ernst and Young Arbitration.
On June 9, 2000, the Company and two of its officers filed a complaint against
Ernst & Young LLP and Alan B. Levine (a former partner of Ernst & Young) in
Massachusetts state court. The Complaint alleges that the defendants committed
professional malpractice, breached contractual and fiduciary duties owed to the
Company, and issued false and misleading public statements, in connection with
advice that Ernst & Young rendered to the Company to record $5 million in
revenue in its financial statements for the second fiscal quarter ended June 30,
1997 pursuant to a series of contracts between the Company and First Data
Resources, Inc. The complaint sought compensatory damages, including
contribution for losses and other costs incurred in connection with certain
class action securities litigation, which has been settled.
On April 5, 2001, the Court dismissed the Complaint, finding that it was
subject to the dispute resolution procedures set forth in an engagement letter
between the Company and Ernst & Young. The parties agreed to submit this dispute
to arbitration, the evidence phase of which concluded in June, 2002.
Post-hearing argument is currently scheduled for August 6, 2002.
Acquisition
Under the agreement for acquisition of 1mind, depending upon the
achievement of specified milestones by the acquired business in 2002 and
validation of the negotiated value of 1mind, we may pay up to approximately $6
million in additional consideration, substantially in the form of shares of our
common stock.
12
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Critical Accounting Policies
In connection with the discussion that follows, you are encouraged to read
Notes 2 and 3 of the notes to our condensed consolidated financial statements
included elsewhere in this report.
Our revenue is derived from two primary sources: software license fees and
service fees. We offer both perpetual and term software licenses. Perpetual
license fees are generally payable at the time the software is delivered, and
are generally recognized as revenue upon customer acceptance.
Term software license fees are generally payable on a monthly basis under
license agreements that generally have a five-year term and may be renewed for
additional years at the customer's option. The present value of future license
payments is generally recognized as revenue upon customer acceptance and
commitment to the contractual payment stream. A portion of the fee from each
arrangement is initially deferred and recognized as installment receivable
interest income over the license term. In addition, many of our license
agreements provide for license fee increases based on inflation. The present
value of such increases is recognized when the increases become known. For
purposes of the present value calculations, the discount rates used are
estimates of customers' borrowing rates at the time of recognition, typically
below prime rate, and have varied between 3.5% and 8.0% for the past few years.
As a result, revenue that we recognize relative to these types of license
arrangements can be impacted by changes in market interest rates. For term
license agreement renewals, license revenue is recognized upon customer
commitment to the new license terms.
Our service revenue is comprised of fees for software implementation,
consulting, maintenance, and training services. Our software implementation and
consulting agreements typically require us to provide a specified level of
implementation services for a specified fee, with additional consulting services
available at an hourly rate. Revenues for time and material projects are
recognized as fees are billed. Revenues for fixed price projects are recognized
as services are delivered once the fair value of services and any other elements
to be delivered under the arrangement can be determined. All costs of services
are expensed as incurred. Historically, we have had difficulty accurately
estimating the time and resources needed to complete fixed price projects. As a
result, determination of the fair value of the elements of the contract has
generally occurred later in the implementation process, typically when
implementation is complete and remaining services are no longer significant to
the project. Prior to the point at which the fair value of the elements of a
contract can be determined, revenue recognition for fixed price projects is
limited to amounts equal to costs incurred, resulting in no gross profit. Once
the fair values of the elements of a contract are apparent, profit associated
with the fixed price services elements will begin to be recognized. Software
license customers are offered the option to enter into a maintenance contract,
which requires the customer to pay a monthly maintenance fee over the term of
the maintenance agreement, typically renewable annually. Prepaid maintenance
fees are deferred and are recognized evenly over the term of the maintenance
agreement. We generally recognize training fees revenue as the services are
provided.
We reduce revenue for estimates of the fair value of potential concessions
when revenue is initially recorded. These estimated amounts are deferred or
reserved until the related elements of the agreement are completed and provided
to the customer.
Three and Six Months Ended June 30, 2002 Compared to Three and Six Months Ended
June 30, 2001
Revenue
Our total revenue for the three-month period ended June 30, 2002 ("the
second quarter of 2002") increased 13% to $26.7 million from $23.5 million for
the three month period ended June 30, 2001 ("the second quarter
13
of 2001"). The increase was due to a $10.5 million increase in software license
revenue partially offset by a $7.3 million decrease in services revenue. Total
revenue for the six months ended June 30, 2002 ("first half of 2002) increased
8% to $50.9 million from $47.1 million in the six months ended June 30, 2001
("first half of 2001"). The following table summarizes our revenue composition:
(in millions) Three Months Ended Six Months Ended
June 30, June 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
License revenue
---------------
Term license renewals, extensions and additions $ 11.8 $ 6.9 $ 16.5 $ 14.4
Perpetual and subscription licenses 7.3 1.7 18.9 5.1
------ ------ ------ ------
Total license revenue 19.1 8.6 35.4 19.5
Services Revenue
----------------
Consulting services 5.4 12.9 11.1 23.7
Maintenance 2.2 2.0 4.4 3.9
------ ------ ------ ------
Total services revenue 7.6 14.9 15.5 27.6
------ ------ ------ ------
Total revenue $ 26.7 $ 23.5 $ 50.9 $ 47.1
====== ====== ====== ======
Software license revenue for the second quarter of 2002 increased 121% to
$19.1 million from $8.6 million for the second quarter of 2001. The $5.6 million
increase in perpetual and subscription licenses was due to a $4.3 million
increase in net license revenue from First Data Resources ("FDR"), and a $1.3
million increase in other subscription revenue. Term software license renewals,
extensions, and additions increased by $4.9 million. Discount rates used to
recognize term license revenue vary directly with overall interest rate levels.
The discount rates used to recognize term license revenue in the second quarter
of 2002 averaged 4.26%. Of the increase in license revenue for the second
quarter versus prior year, approximately $0.6 million was due to reduced
discount rates on term license revenue. Software license revenue for the first
half of 2002 increased 81% to $35.4 million from $19.5 million in the first half
of 2001, due primarily to increased revenue from perpetual licenses. Of the
increase in license revenue for the first half versus prior year, approximately
$0.9 million was due to reduced discount rates on term license revenue.
Of the increase in revenue from perpetual licenses in the first half of
2002, $12.8 million was due to the sale to First Data Resources ("FDR") of a
perpetual license that replaced the prior term license subscription which was
due to expire in December 2002. Software license revenue recognized under the
FDR agreements was $8.6 million in Q1 of 2002, and $5.85 million in Q2 of 2002.
Under the terms of the FDR perpetual license agreement, FDR is required to make
monthly payments through December 2003. These payments total $5.85 million in
each of the third and fourth quarters of 2002 and $3.54 million in each of the
four quarters of 2003. We recognize revenue three months in advance of payments
per the cancellation provisions of the agreement. We expect to recognize as
revenue from the FDR perpetual license $5.85 million in the third quarter of
2002, and $3.54 million in the fourth quarter of 2002 and each of the first
three quarters of 2003.
In the future, we expect to enter into more perpetual license transactions,
the effect of which may be to increase our license revenue and cash flow in the
short term and to decrease the amount of revenue and cash flow from the renewal
of term software license agreements. Historically, a significant portion of our
license revenue has been from renewals of term software license agreements.
License transactions with new customers have slowed significantly since the
latter part of 2001.
Services revenue for the second quarter of 2002 decreased 49% to $7.6
million from $14.9 million for the second quarter 2001. Services revenue for the
first half of 2002 decreased 44% to $15.5 million from $27.6 million in the
first half of 2001. The decreases were due primarily to delayed customer
spending and a decrease in new customer license transactions, which we believe
were caused by the current generally weak economic conditions. Typically, we
derive substantial revenue from services provided in connection with the
implementation of software licensed by new customers.
14
Deferred revenue at June 30, 2002 consisted primarily of billed fees from
arrangements for which acceptance of the software license or service milestone
had not occurred, the unearned portion of services revenue and advance payment
of maintenance fees. Deferred revenue balances increased to $9.0 million as of
June 30, 2002 from $6.2 million as of December 31, 2001, due to advance payment
of maintenance fees and software licenses, and an increase in the unearned
portion of services revenue due to service milestones.
International revenues were 20% of total consolidated revenues for the
first half of 2002 and 26% for the first half of 2001. Our international
revenues may fluctuate in the future because such revenues generally result from
a small number of product acceptances during a given period. Historically, most
of our contracts have been denominated in U.S. dollars. However, more of our
contracts in the future may be denominated in foreign currencies, thereby
exposing us to increased currency exchange risk.
Cost of revenue
Costs of software license includes the amortization associated with a stock
purchase warrant we issued in September 1997 under an agreement with First Data
Resources and the amortization of the intellectual property we purchased from
1mind. Cost of software license revenue for the second quarter of 2002 decreased
45% to $0.7 million from $1.2 million for the second quarter of 2001. As a
percentage of software license revenue, cost of software license revenue
decreased to 4% for the second quarter of 2002 from 14% for the second quarter
of 2001. Cost of software licenses for the first half of 2002 decreased 30% to
$1.3 million from $1.9 million for the first half of 2001. As a percentage of
software license revenue, cost of software license revenue decreased to 4% for
the first half of 2002 from 10% for the first half of 2001. Such decreases were
attributable to a $0.6 million charge taken in the second quarter of 2001 and
the increase in software license revenue. The charge was for software acquired
by the Company in the fourth quarter of 2000 which, after initially being
amortized, was expensed in-full in the second quarter of 2001 because the
productive use of this software was no longer anticipated.
Cost of services consists primarily of the costs of providing
implementation, consulting, maintenance, and training services. Cost of services
for the second quarter of 2002 decreased 23% to $7.6 million from $9.9 million
for the second quarter of 2001, primarily due to reduced staff costs and lower
contractor costs. Cost of services as a percentage of service revenue increased
to 101% for the second quarter of 2002 from 67% for the second quarter of 2001.
Cost of services for the first half of 2002 decreased 26% to $14.9 million from
$20.1 million for the first half of 2001. Cost of services as a percentage of
services revenue increased to 96% for the first half of 2002 from 73% for the
first half of 2001. The percentage increase was primarily due to the reduction
in services revenue, which was only partially offset by reduced staff costs.
Service gross margin was negative $39 thousand for the second quarter of 2002.
We will continue to review resource requirements to ensure appropriate alignment
with revenue expectations.
Operating expenses
Research and development expenses for the second quarter of 2002 increased
12% to $5.6 million from $5.0 million for 2001. As a percentage of total
revenue, research and development expenses remained approximately flat at 21%
for the second quarter of 2002 compared to the second quarter of 2001. Research
and development expenses for the first half of 2002 increased 14% to $11.4
million from $10.0 million for the first half of 2001. As a percentage of total
revenue, research and development expenses increased to 22% for the first half
of 2002 from 21% for the first half of 2001.This increase was the result of
growth in staffing costs including compensation and benefits, travel, and
increased use of third party consultants to support investment in PegaRULES
technology as well as other product developments and enhancements.
Selling and marketing expenses for the second quarter of 2002 increased 41%
to $6.0 million from $4.2 million for the second quarter of 2001. As a
percentage of total revenue, selling and marketing expenses increased to 22% for
the second quarter of 2002 from 18% for the second quarter of 2001. Selling and
marketing expenses for the first half of 2002 increased 28% to $11.7 million
from $9.1 million for the first half of 2001. As a percentage of total revenue,
selling and marketing expenses increased to 23% for the first half of 2002 from
19% for the first half of 2001. These increases were due to increased staff and
marketing programs spending in our application business and investment in the
emerging PegaRULES business.
15
General and administrative expenses for the second quarter of 2002
increased 47% to $3.1 million from $2.1 million for the second quarter of 2001.
As a percentage of total revenue, general and administrative expenses increased
to 12% for the second quarter of 2002 from 9% for the second quarter of 2001.
General and administrative expenses for the first half of 2002 increased 8% to
$5.5 million from $5.1 million for the first half of 2001. As a percentage of
total revenue, general and administrative expenses remained approximately flat
at 11% for the first half of 2002 compared to the first half of 2001. These
increases were due to legal and professional services fees related to the Qwest
and Ernst & Young arbitrations.
Installment receivable interest income
Installment receivable interest income, which consists of the portion of
all term license fees under software license agreements that is attributable to
the time value of money, decreased in the second quarter of 2002 to $1.3 million
from $1.5 million for the second quarter of 2001. Installment receivable
interest income for the first half of 2002 decreased to $2.5 million from $2.9
million for the first half of 2001. The decrease was due to a lower average
discount rate for our portfolio of term software licenses. A portion of the fee
from each term license arrangement is initially deferred and recognized as
installment receivable interest income over the remaining term of the license.
For purposes of the present value calculations, the discount rates used are
estimates of customers' borrowing rates, typically below prime rate, and have
varied between 3.5% and 8.0% during the past few years.
Other interest income, net
Other interest income, net decreased 23% to $0.18 million for the second
quarter of 2002 from $0.23 million for the second quarter of 2001. Other
interest income, net, decreased to $0.32 million for the first half of 2002 from
$0.45 million for the second half of 2001. The decreases were due to lower
interest rates, partially offset by larger invested cash balances.
Other income (expense), net
Other income (expense), net, which consists primarily of currency exchange
losses and reseller development funds received from third-party vendors of
computer hardware products, was ($0.3) million for the second quarter of 2002
versus $0.1 million for the second quarter of 2001. Other income (expense), net
was ($0.4) million for the first half of 2002 compared to two thousand dollars
for the first half of 2001. The decreases were due to lower partner commissions
and greater currency exchange losses.
Income before provision for income taxes
Income before provision for income taxes increased to $4.9 million for the
second quarter of 2002 from $2.9 million for the second quarter of 2001. This
$2.0 million improvement was due primarily to a $11.0 million improvement in
software license gross margin from increased revenues, partially offset by a
$5.0 million reduction in services gross margin due to lower services revenues,
increased operating expenses of $3.4 million, reduction in installment
receivable interest income, and greater currency losses.
Provision for income taxes
The provision for the second quarter of 2002 consists of current taxes
provided on foreign subsidiary income. The tax provision for the first half of
2002 and the first half of 2001 was $0.5 million. Provisions have not been
recorded for U.S. federal and state taxes due to the availability of loss
carryforwards, the recognition of which would offset any tax provision recorded.
16
Liquidity and Capital Resources
We have funded our operations primarily from cash flow from operations and
the proceeds of our public stock offerings. At June 30, 2002, we had cash and
cash equivalents of $49.0 million and working capital of $69.0 million.
Net cash provided by operations for the first half of 2002 was $12.8
million compared with $7.5 million for the first half of 2001. The increase was
due to a $4.3 million improvement in profitability and a $2.4 million
improvement in the collections of accounts receivable, primarily from perpetual
licenses. These improvements were partially offset by net changes in accrued
expenses, prepaid expenses, other current assets, and deferred revenues.
Net cash used in investing activities for the first half of 2002 was $0.9
million compared with $0.1 million for the first half of 2001. The increased use
of cash was primarily due to transaction costs associated with the 1mind
acquisition.
On February 6, 2002, we acquired substantially all of the assets of 1mind
for initial consideration valued at $3.7 million, consisting of 569,949 shares
of our common stock and warrants to purchase for nominal consideration 83,092
shares of our common stock. Depending upon the achievement of specified
milestones by the acquired business in 2002 and validation of the negotiated
value of 1mind, we may pay up to approximately $6 million in additional
consideration substantially in the form of shares of our common stock. (See Note
3 of notes to condensed consolidated financial statements.)
Net cash provided by financing activities for the first half of 2002 was
$3.7 million compared with $0.1 million in the first half of 2001. The increase
was primarily due to proceeds from employee stock option exercises.
We believe that current cash, cash equivalents, and cash flow from ongoing
operations will be sufficient to fund our operations for the coming year.
Material risks to additional cash flow from operations include a further decline
in services revenue and delayed or reduced cash payments accompanying sales of
new licenses. There can be no assurance that changes in our plans or other
events affecting our operations will not result in materially accelerated or
unexpected expenditures. In addition, there can be no assurance that additional
capital if needed will be available on reasonable terms, if at all, at such time
as we require.
Inflation
Inflation has not had a significant impact on our operating results to
date, and we do not expect it to have a significant impact in the future. Our
agreements with customers typically provide for annual increases in term license
and maintenance fees based on recognized inflation indexes.
Forward-looking statements
This Report contains certain forward-looking statements. For this purpose,
any statements contained herein that are not statements of historical fact may
be deemed to be forward-looking statements. Without limiting the generality of
the foregoing, the words "believes", "anticipates", "plans", "expects", and
similar expressions are intended to identify forward-looking statements. There
are a number of important factors that could cause our actual results to differ
materially from those indicated by forward-looking statements made in this
report and presented elsewhere by management from time to time. Some of the
important risks and uncertainties that may cause our operating results to differ
materially or adversely are discussed below.
Our stock price has been volatile. Quarterly results have fluctuated and
are likely to continue to fluctuate significantly. The market price of our
common stock has been and may continue to be highly volatile. Factors that are
difficult to predict, such as quarterly revenues and operating results,
statements and ratings by financial analysts, and overall market performance,
will have a significant effect on the price for shares of our common
17
stock. Revenues and operating results have varied considerably in the past from
period to period and are likely to vary considerably in the future. We plan
product development and other expenses based on anticipated future revenue. If
revenue falls below expectations, financial performance is likely to be
adversely affected because only small portions of expenses vary with revenue. As
a result, period-to-period comparisons of operating results are not necessarily
meaningful and should not be relied upon to predict future performance.
The timing of license revenues is related to the completion of
implementation services and product acceptance by the customer, the timing of
which has been difficult to predict accurately. There can be no assurance that
we will be profitable on an annual or quarterly basis or that earnings or
revenues will meet analysts' expectations. Fluctuations may be particularly
pronounced because a significant portion of revenues in any quarter is
attributable to product acceptance or license renewal by a relatively small
number of customers. Fluctuations also reflect a policy of recognizing revenue
upon product acceptance or license renewal in an amount equal to the present
value of the total committed payments due during the term. Customers generally
do not accept products until the end of a lengthy sales cycle and an
implementation period, typically ranging from one to six months but in some
cases significantly longer. In addition, we are more focused on closing larger
but fewer license transactions than in the past. This may increase the
volatility in our quarterly operating results. Risks over which we have little
or no control, including customers' budgets, staffing allocation, and internal
authorization reviews, can significantly affect the sales and acceptance cycles.
Changes dictated by customers may delay product implementation and revenue
recognition.
If existing customers do not renew their term licenses, our financial
results may suffer. A significant portion of total revenue has been attributable
to term license renewals. While historically a majority of customers have
renewed their term licenses, there can be no assurance that a majority of
customers will continue to renew expiring term licenses. A decrease in term
license renewals absent offsetting revenue from other sources would have a
material adverse effect on future financial performance. In addition, transition
to prepaid perpetual licenses may have a material adverse impact on the amount
of term license renewal revenues in future periods.
We will need to develop new products, evolve existing ones, and adapt to
technology change. Technical developments, customer requirements, programming
languages and industry standards change frequently in our markets. As a result,
success in current markets and new markets will depend upon our ability to
enhance current products, to develop and introduce new products that meet
customer needs, keep pace with technology changes, respond to competitive
products, and achieve market acceptance. Product development requires
substantial investments for research, refinement and testing. There can be no
assurance that we will have sufficient resources to make necessary product
development investments. We may experience difficulties that will delay or
prevent the successful development, introduction or implementation of new or
enhanced products. Inability to introduce or implement new or enhanced products
in a timely manner would adversely affect future financial performance. Our
products are complex and may contain errors. Errors in products will require us
to ship corrected products to customers. Errors in products could cause the loss
of or delay in market acceptance or sales and revenue, the diversion of
development resources, injury to our reputation, or increased service and
warranty costs which would have an adverse effect on financial performance.
We have historically sold to the financial services market. This market is
consolidating rapidly, and faces uncertainty due to many other factors. We have
historically derived a significant portion of our revenue from customers in the
financial services market, and our future growth depends, in part, upon
increased sales to this market. Competitive pressures, industry consolidation,
decreasing operating margins within this industry, currency fluctuations,
geographic expansion and deregulation affect the financial condition of our
customers and their willingness to pay. In addition, customers' purchasing
patterns are somewhat discretionary. As a result, some or all of the factors
listed above may adversely affect the demand by customers. The financial
services market is undergoing intense domestic and international consolidation.
In recent years, several customers have been merged or consolidated. Future
mergers or consolidations may cause a decline in revenues and adversely affect
our future financial performance.
18
We depend on certain key personnel, and must be able to attract and retain
qualified personnel in the future. The business is dependent on a number of key,
highly skilled technical, managerial, consulting, sales, and marketing
personnel, including Mr. Trefler, our Chief Executive Officer. The loss of key
personnel could adversely affect financial performance. We do not have any
significant key-man life insurance on any officers or employees and do not plan
to obtain any. Our success will depend in large part on the ability to hire and
retain qualified personnel. The number of potential employees who have the
extensive knowledge of computer hardware and operating systems needed to
develop, sell and maintain our products is limited, and competition for their
services is intense, and there can be no assurance that we will be able to
attract and retain such personnel. If we are unable to do so, our business,
operating results, and financial condition could be materially adversely
affected.
The market for our offerings is increasingly and intensely competitive,
rapidly changing, and highly fragmented. The market for customer relationship
management software and related implementation, consulting and training services
is intensely competitive and highly fragmented. We currently encounter
significant competition from internal information systems departments of
potential or existing customers that develop custom software. We also compete
with companies that target the customer interaction and workflow markets and
professional service organizations that develop custom software in conjunction
with rendering consulting services. Competition for market share and pressure to
reduce prices and make sales concessions are likely to increase. Many
competitors have far greater resources and may be able to respond more quickly
and efficiently to new or emerging technologies, programming languages or
standards or to changes in customer requirements or preferences. Competitors may
also be able to devote greater managerial and financial resources to develop,
promote and distribute products and provide related consulting and training
services. There can be no assurance that we will be able to compete successfully
against current or future competitors or that the competitive pressures faced by
us will not materially adversely affect our business, operating results, and
financial condition.
We must manage increased business complexity and growth effectively. Our
business has grown in size, geographic scope and complexity and we have expanded
our product offerings and customer base. This growth and expansion has placed,
and is expected to continue to place, a significant strain on management,
operations and capital needs. Continued growth will require us to hire, train
and retrain many employees in the United States and abroad, particularly
additional sales and financial personnel. We will also need to enhance our
financial and managerial controls and reporting systems. We cannot assure that
we will attract and retain the personnel necessary to meet our business
challenges. Failure to manage growth effectively may materially adversely affect
future financial performance.
We rely on certain third-party relationships. We have a number of
relationships with third parties that are significant to sales, marketing and
support activities, and product development efforts. We rely on relational
database management system applications and development tool vendors, software
and hardware vendors, and consultants to provide marketing and sales
opportunities for the direct sales force and to strengthen our products through
the use of industry-standard tools and utilities. We also have relationships
with third parties that distribute our products. In particular, we rely on our
relationship with First Data Resources for the distribution of products to the
credit card market and with PFPC Inc. for distribution of products to the mutual
fund market. There can be no assurance that these companies, most of which have
significantly greater financial and marketing resources, will not develop or
market products that compete with ours in the future or will not otherwise end
their relationships with or support of us.
We may face product liability and warranty claims. Our license agreements
typically contain provisions intended to limit the nature and extent of our risk
of product liability and warranty claims. There is a risk that a court might
interpret these terms in a limited way or could hold part or all of these terms
to be unenforceable. Also, there is a risk that these contract terms might not
bind a party other than the direct customer. Furthermore, some of our licenses
with our customers are governed by non-U.S. law, and there is a risk that
19
foreign law might give us less or different protection. Although we have not
experienced any material product liability claims to date, a product liability
suit or action claiming a breach of warranty, whether or not meritorious, could
result in substantial costs and a diversion of management's attention and our
resources.
We face risks from operations and customers based outside of the U.S. Sales
to customers headquartered outside of the United States represented
approximately 23%, 26% and 21% of our total revenue in 2001, 2000 and 1999,
respectively. We, in part through our wholly-owned subsidiaries based in the
United Kingdom, Singapore, Canada, and Australia, market products and render
consulting and training services to customers based in Canada, the United
Kingdom, France, Germany, the Netherlands, Belgium, Switzerland, Austria,
Ireland, Sweden, South Africa, Mexico, Australia, Hong Kong, and Singapore. We
have established offices in continental Europe, Australia, and Asia. We believe
that our continued growth will necessitate expanded international operations
requiring a diversion of managerial attention and financial resources. We
anticipate hiring additional personnel to accommodate international growth, and
we may also enter into agreements with local distributors, representatives, or
resellers. If we are unable to do one or more of these things in a timely
manner, our growth, if any, in our foreign operations will be restricted, and
our business, operating results, and financial condition could be materially and
adversely affected.
In addition, there can be no assurance that we will be able to maintain or
increase international market demand for our products. Most of our international
sales are denominated in U.S. dollars. Accordingly, any appreciation of the
value of the U.S. dollar relative to the currencies of those countries in which
we distribute our products may place us at a competitive disadvantage by
effectively making our products more expensive as compared to those of our
competitors. Additional risks inherent in our international business activities
generally include unexpected changes in regulatory requirements, increased
tariffs and other trade barriers, the costs of localizing products for local
markets and complying with local business customs, longer accounts receivable
patterns and difficulties in collecting foreign accounts receivable,
difficulties in enforcing contractual and intellectual property rights,
heightened risks of political and economic instability, the possibility of
nationalization or expropriation of industries or properties, difficulties in
managing international operations, potentially adverse tax consequences
(including restrictions on repatriating earnings and the threat of "double
taxation"), enhanced accounting and internal control expenses, and the burden of
complying with a wide variety of foreign laws. There can be no assurance that
one or more of these factors will not have a material adverse effect on our
foreign operations, and, consequentially, our business, operating results, and
financial condition.
We face risks related to intellectual property claims or appropriation of
our intellectual property rights. We rely primarily on a combination of
copyright, trademark and trade secrets laws, as well as confidentiality
agreements to protect our proprietary rights. In October 1998, we were granted a
patent by the United States Patent and Trademark Office relating to the
architecture of our systems. We cannot assure that such patent will not be
invalidated or circumvented or that rights granted there under or the
description contained therein will provide competitive advantages to our
competitors or others. Moreover, despite our efforts to protect our proprietary
rights, unauthorized parties may attempt to copy aspects of our products or to
obtain the use of information that we regard as proprietary. In addition, the
laws of some foreign countries do not protect our proprietary rights to as great
an extent as do the laws of the United States. There can be no assurance that
our means of protecting our proprietary rights will be adequate or that our
competitors will not independently develop similar technology.
We are not aware that any of our products infringe the proprietary rights
of third parties. There can be no assurance, however, that third parties will
not claim infringement by us with respect to current or future products. We
expect that software product developers will increasingly be subject to
infringement claims as the number of products and competitors in our industry
segment grows and the functionality of products in different industry segments
overlaps. Any such claims, with or without merit, could be time-consuming,
result in costly litigation, cause product shipment delays, or require us to
enter into royalty or licensing agreements. Such royalty or licensing
agreements, if required, may not be available on terms acceptable to us or at
all, which could have a material adverse effect upon our business, operating
results, and financial condition.
20
We face risks related to the acquisition of 1mind. On February 6, 2002, we
acquired substantially all of the assets and specified liabilities of 1mind
Corporation and its wholly owned subsidiary (collectively, "1mind"). Following
the acquisition of 1mind, we intend to intensify our focus on marketing and
selling our products and services within the healthcare market. We face risks in
connection with integrating 1mind's technology and personnel into the combined
company. Additionally, we face risks involved with integrating and retaining key
former 1mind personnel. Managing these risks may result in undue cost or delay
and may require us to divert management time and attention from our primary
business operations. The result could adversely affect our financial results.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk represents the risk of loss that may affect us due to adverse
changes in financial market prices and rates. Our market risk exposure is
primarily fluctuations in foreign exchange rates and interest rates. We have not
entered into derivative or hedging transactions to manage risk in connection
with such fluctuations.
We derived approximately 20% of our total revenue in the first half of 2002
from sales to customers based outside of the United States. Certain of our
international sales are denominated in foreign currencies. The price in dollars
of products sold outside the United States in foreign currencies will vary as
the value of the dollar fluctuates against such foreign currencies. Although our
sales denominated in foreign currencies in the first half of 2002 were not
material, there can be no assurance that such sales will not be material in the
future and that there will not be increases in the value of the dollar against
such currencies that will reduce the dollar return to us on the sale of our
products in such foreign currencies.
We believe that at current market interest rates, the fair value of license
installments receivable approximates carrying value as reported on our balance
sheets. However, there can be no assurance that the fair value will approximate
the carrying value in the future. Factors such as increasing interest rates can
reduce the fair value of the license installments receivable. The carrying value
reflects a weighted average of historic discount rates. The average rate changes
with market rates as new license installment receivables are added to the
portfolio, which mitigates exposure to market interest rate risk.
21
Part II - Other Information:
Item 1. Legal Proceedings
Company Litigation
Qwest Arbitration. On January 17, 2002, we filed a demand for arbitration with
the American Arbitration Association in Denver, Colorado against Qwest
Corporation, successor in interest to US West Business Resources, Inc.
("Qwest"). We are seeking monetary damages in the arbitration relating to
Qwest's termination of a software license and service agreement with us. On
February 8, 2002, Qwest filed a counterclaim against us seeking unspecified
monetary damages for alleged breach by us of that agreement and software
royalties in an unspecified amount. An arbitration hearing is currently
scheduled for August, 2002.
Ernst & Young Arbitration.
On June 9, 2000, the Company and two of its officers filed a complaint against
Ernst & Young LLP and Alan B. Levine (a former partner of Ernst & Young) in
Massachusetts state court. The Complaint alleges that the defendants committed
professional malpractice, breached contractual and fiduciary duties owed to the
Company, and issued false and misleading public statements, in connection with
advice that Ernst & Young rendered to the Company to record $5 million in
revenue in its financial statements for the second fiscal quarter ended June 30,
1997 pursuant to a series of contracts between the Company and First Data
Resources, Inc. The complaint sought compensatory damages, including
contribution for losses and other costs incurred in connection with certain
class action securities litigation, which has been settled.
On April 5, 2001, the Court dismissed the Complaint, finding that it was
subject to the dispute resolution procedures set forth in an engagement letter
between the Company and Ernst & Young. The parties agreed to submit this dispute
to arbitration, the evidence phase of which concluded in June, 2002.
Post-hearing argument is currently scheduled for August 6, 2002.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
The annual meeting of shareholders was held on June 4, 2002. The following
matters were voted upon:
1. Edward Roberts, James O'Halloran, and Richard Jones were elected to serve
as Directors of the Company until the 2005 Annual Meeting of Stockholders
and until their successors are duly elected and qualified. Mr. Roberts was
elected with 32,531,496 votes "FOR" and 20,990 votes "ABSTAINING."
Mr. O'Halloran was elected with 32,514,528 votes "FOR" and 37,958 votes
"ABSTAINING." Mr. Jones was elected with 32,498,455 votes "FOR" and 54,031
votes "ABSTAINING."
2. The stockholders ratified the appointment by the Board of Directors of
Deloitte & Touche, LLP, independent public accountants, to audit the
financial statements of the Company for the fiscal year ending December 31,
2002 with 32,284,826 votes "FOR" and 9,420 votes "ABSTAINING."
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
On April 9, 2002, we filed a report with on Form 8-K with the Securities and
Exchange Commission reporting the termination by the Commission of its
investigation of the Company and certain individuals.
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Pegasystems Inc.
Date: July 24, 2002 /s/ Alan Trefler
-----------------------------------
Chairman and Chief Executive Officer
/s/ Christopher Sullivan
--------------------------------------
Treasurer and Chief Financial Officer
(principal financial officer and chief
accounting officer)
23