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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 September 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 34,216,579 shares of the Registrant's common stock, $.01 par value
per share, outstanding on October 17, 2002.
1
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 September 30, 2002
and December 31, 2001 3
Condensed Consolidated Statements of Operations for the three and nine
months ended September 30, 2002 and 2001 4
Condensed Consolidated Statements of Cash Flows for the nine
months ended September 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
Item 4. Controls and Procedures 22
Part II - Other Information
Item 1. Legal Proceedings 23
Item 2. Changes in Securities and Use of Proceeds 23
Item 3. Defaults upon Senior Securities 23
Item 4. Submission of Matters to a Vote of Security Holders 23
Item 5. Other Information 23
Item 6. Exhibits and Reports on Form 8-K 23
SIGNATURES 24
CERTIFICATIONS 25
2
PEGASYSTEMS INC.
Condensed Consolidated Balance Sheets
(in thousands, except share-related amounts)
September 30, December 31,
2002 2001
------------- ------------
Assets
Current assets
Cash and cash equivalents .............................................. $ 52,263 $ 33,017
Trade accounts receivable, net of allowance for doubtful accounts
of $858 in 2002 and $1,034 in 2001 (Note 4) ........................ 3,580 9,592
Short-term license installments ........................................ 35,008 31,359
Investments-held to maturity ........................................... 3,024 --
Prepaid expenses and other current assets .............................. 1,340 2,286
----------- -----------
Total current assets .......................................... 95,215 76,254
Long-term license installments, net ............................................. 46,121 43,155
Investments-held to maturity .................................................... 1,776 --
Equipment and improvements, net ................................................. 2,087 3,053
Acquired technology, net (Note 3) ............................................... 1,167 --
Purchased software and other assets, net ........................................ 858 2,610
Goodwill (Note 3) ............................................................... 3,167 --
----------- -----------
Total assets ........................................................... $ 150,391 $ 125,072
=========== ===========
Liabilities and stockholders' equity
Current liabilities
Accrued payroll expenses ............................................... $ 8,228 $ 7,940
Accounts payable and accrued other expenses ............................ 4,417 4,900
Deferred revenue ....................................................... 9,997 6,176
Current portion of capital lease obligation ............................ -- 81
----------- -----------
Total current liabilities ..................................... 22,642 19,097
Commitments and contingencies (Note 6)
Deferred income taxes ........................................................... 1,000 1,000
Other long-term liabilities ..................................................... 284 17
----------- -----------
Total liabilities ............................................. 23,926 20,114
Stockholders' equity
Preferred stock, $0.01 par value, 1,000,000 share authorized; no
shares issued and outstanding ....................................... -- --
Common stock, $0.01 par value, 45,000,000 shares authorized;
34,215,579 shares and 32,754,648 shares issued and outstanding
in 2002 and 2001, respectively ...................................... 342 328
Additional paid-in capital ............................................. 108,665 101,318
Stock warrants ......................................................... 3,271 2,897
Retained earnings ...................................................... 13,625 757
Accumulated other comprehensive income (loss) .......................... 562 (342)
----------- -----------
Total stockholders' equity .................................... 126,465 104,958
----------- -----------
Total liabilities and stockholders' equity ........... $ 150,391 $ 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 Nine Months Ended
September 30, September 30,
2002 2001 2002 2001
-------- -------- -------- --------
Revenue
Software license .......................................... $ 16,902 $ 10,629 $ 52,273 $ 30,163
Services .................................................. 8,663 13,258 24,170 40,845
-------- -------- -------- --------
Total revenue ........................................... 25,565 23,887 76,443 71,008
-------- -------- -------- --------
Cost of revenue
Cost of software license .................................. 672 585 1,988 2,464
Cost of services .......................................... 7,352 9,293 22,245 29,438
-------- -------- -------- --------
Total cost of revenue ................................... 8,024 9,878 24,233 31,902
-------- -------- -------- --------
Gross profit 17,541 14,009 52,210 39,106
-------- -------- -------- --------
Operating expenses
Research and development .................................. 5,349 5,386 16,703 15,372
Selling and marketing ..................................... 6,296 3,960 18,003 13,100
General and administrative ................................ 1,871 2,419 7,383 7,515
-------- -------- -------- --------
Total operating expenses ................................ 13,516 11,765 42,089 35,987
-------- -------- -------- --------
Income from operations ....................................... 4,025 2,244 10,121 3,119
-------- -------- -------- --------
Installment receivable interest income ....................... 1,258 1,450 3,774 4,350
Other interest income, net ................................... 218 211 541 658
Other (expense) income, net .................................. (373) 229 (816) 228
-------- -------- -------- --------
Income before provision for income taxes ..................... 5,128 4,134 13,620 8,355
Provision for income taxes ................................... 302 250 752 725
-------- -------- -------- --------
Net income ................................................... $ 4,826 $ 3,884 $ 12,868 $ 7,630
======== ======== ======== ========
Earnings per share
Basic ..................................................... $ 0.14 $ 0.12 $ 0.38 $ 0.23
======== ======== ======== ========
Diluted ................................................... $ 0.13 $ 0.12 $ 0.35 $ 0.23
======== ======== ======== ========
Weighted average number of common and common
equivalent shares outstanding
Basic ..................................................... 34,176 32,695 33,956 32,649
======== ======== ======== ========
Diluted ................................................... 36,275 33,420 36,292 33,398
======== ======== ======== ========
See notes to condensed consolidated financial statements.
4
PEGASYSTEMS INC.
Condensed Consolidated Statements of Cash Flows
(in thousands)
Nine Months Ended
September 30,
-------------------------
2002 2001
---- ----
Cash flows for operating activities
Net income .................................................................................... $ 12,868 $ 7,630
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization ........................................................... 3,512 5,012
Non-cash compensation ................................................................... -- 73
Changes in operating assets and liabilities:
Trade and installment accounts receivable .......................................... (306) (6,488)
Prepaid expenses and other current assets .......................................... 974 (353)
Accounts payable and accrued expenses .............................................. (151) 2,067
Deferred revenue ................................................................... 3,762 1,381
-------- --------
Net cash provided by operating activities ....................................... 20,659 9,322
-------- --------
Cash flows from investing activities
Purchase of investments held to maturity ...................................................... (4,800) --
Acquisition of 1mind (Note 3) ................................................................. (573) --
Purchase of equipment and improvements ........................................................ (558) (432)
Other long-term assets and liabilities ........................................................ (3) 302
-------- --------
Net cash used in investing activities ................................................ (5,934) (130)
-------- --------
Cash flows from financing activities
Payments of capital lease obligation .......................................................... (81) (240)
Proceeds from sale of stock under employee stock purchase plan ................................ 177 164
Exercise of stock options ..................................................................... 3,887 55
-------- --------
Net cash provided by financing activities ............................................ 3,983 (21)
-------- --------
Effect of exchange rate changes on cash and cash equivalents ....................................... 538 (259)
-------- --------
NET INCREASE IN CASH AND CASH EQUIVALENTS .......................................................... 19,246 8,912
-------- --------
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ..................................................... 33,017 17,339
-------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD ........................................................... $ 52,263 $ 26,251
======== ========
See notes to condensed consolidated financial statements.
5
PEGASYSTEMS INC.
Notes to Condensed Consolidated Financial Statements
September 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
nine-month periods ended September 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 Abstract No. 01-14; in prior periods the
reimbursements had been reflected as reduction of cost of services.
Three Months Nine Months
Ended Ended
September 30, September 30,
(in thousands, except per share data) 2001 2001
------------- -------------
Services revenue as reported previously ................ $12,478 $38,617
Add: reimbursements for out-of-pocket expenses ......... 780 2,228
------- -------
Services revenue, reclassified ......................... $13,258 $40,845
======= =======
Cost of services as reported previously ................ $ 8,513 $27,210
Add: reimbursements for out-of-pocket expenses ......... 780 2,228
------- -------
Cost of services, reclassified ......................... $ 9,293 $29,438
======= =======
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. Estimates which effect significant assets and liabilities include
estimates with respect to allowance for doubtful accounts, the relative fair
value of deliverables under revenue contracts, deferred income taxes, 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 to the extent that
payments are not subject to refund. Payments subject to refund are recognized as
revenue as refund provisions lapse.
Term software license fees are generally payable on a monthly basis under
license agreements that generally have a five-year term and may be renewed for
additional years at the customer's option. The present value of future license
payments is generally recognized as revenue upon customer acceptance. A portion
of the license fees payable under each term license agreement is treated as
imputed interest deferred and recognized as installment receivable interest
income over the license term. Many of our license agreements provide for license
fee increases based on inflation. The present value of such increases is
recognized when the inflation 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 3.25% and 8.0% for the past few years. As a result, revenue that
we recognize relative to these types of license arrangements may be impacted by
changes in market interest rates. For term license agreement renewals, license
revenue is recognized when the customer becomes committed to the new license
terms.
In certain circumstances, such as when license fees are not fixed and
determinable, some licenses are accounted for on a subscription basis, where
revenue is recognized as payments become due over the term of the license.
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 services for a fee, or 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 and 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 service projects. As a
result, determination of the fair value of the elements of the contract has
generally occurred late in the implementation process, typically when
implementation is complete and remaining services are no longer significant to
the project. Until 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 value 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,
such as disputed services, when revenue is initially recorded. These estimated
amounts are deferred or reserved until the related elements of the agreement are
completed and provided to the customer.
(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 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 license installments are expected to be received as follows:
License Installments
Years ending December 31, (in thousands)
Remainder of 2002 ................. $ 12,035
2003 ................. 27,234
2004 ................. 20,184
2005 ................. 16,168
2006 ................. 11,480
2007 ................. 3,391
2008 ................. 982
---------
91,474
Deferred license interest income .......... (10,345)
----------
Total license installments receivable ..... $ 81,129
=========
(g) Cash and cash equivalents and investments held-to-maturity
We consider all highly liquid investments with remaining maturities of
three months or less at the date of purchase to be cash equivalents. Cash
equivalents principally consist of US Treasury bills and short-term debt
securities. We account for investments under Statement for Financial Accounting
Standards ("SFAS") No. 115, Accounting for Certain Investment in Debt and
Equity Securities. Under SFAS No. 115, investments with remaining maturities of
longer than three months when purchased and which we intend to hold until
maturity are reported at amortized cost, which approximates fair market value.
(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.
8
(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 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 nine
months ended September 30, 2002 and 2001.
Amortization of capitalized software is 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 nine months ended September 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.
Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands, except per share data) 2002 2001 2002 2001
----------- ------------ ------------ ------------
Basic
- -----
Net income ..................................... $ 4,826 $ 3,884 $ 12,868 $ 7,630
=========== ============ ============ ============
Weighted average common shares outstanding ..... 34,176 32,695 33,956 32,649
=========== ============ ============ ============
Basic earnings per share ....................... $ 0.14 $ 0.12 $ 0.38 $ 0.23
=========== ============ ============ ============
Diluted
- -------
Net income $ 4,826 $ 3,884 $ 12,868 $ 7,630
=========== ============ ============ ============
Weighted average common shares outstanding ..... 34,176 32,695 33,956 32,649
Effect of assumed exercise of stock options .... 2,099 725 2,336 749
----------- ------------ ------------ ------------
Weighted average common shares outstanding,
assuming dilution ........................... 36,275 33,420 36,292 33,398
=========== ============ ============ ============
Diluted earnings per share ..................... $ 0.13 $ 0.12 $ 0.35 $ 0.23
=========== ============ ============ ============
Outstanding options and warrant excluded as
impact would be anti-dilutive ............... 4,454 7,914 4,115 7,605
=========== ============ ============ ============
9
(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 nine months ending
September 30, 2002 and 2001, we derived our operating revenue from the following
geographic areas (sales outside the United States are principally through export
from the United States):
Three Months Ended Nine Months Ended
September 30, September 30,
------------ ------------
(in thousands) 2002 2001 2002 2001
------ ------ ------ ------
United States ....... $ 19,205 75% $ 20,485 86% $ 59,787 78% $ 55,302 78%
United Kingdom ...... 3,942 16% 1,492 6% 11,821 15% 8,420 12%
Europe .............. 800 3% 970 4% 1,955 3% 4,708 7%
Other ............... 1,618 6% 940 4% 2,880 4% 2,578 3%
-------- -------- -------- --------
$ 25,565 100% $ 23,887 100% $ 76,443 100% $ 71,008 100%
======== ======== ======== ========
(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 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 SFAS No. 123, "Accounting for Stock-Based
Compensation". We have adopted the disclosure provisions of SFAS No. 123,
relative to the impact of the fair value method.
(n) Fair value of financial instruments
The principal financial instruments held consist of cash and cash
equivalents, investments held to maturity, accounts receivable and payable,
capital lease obligations, and license installment receivables arising from
license transactions. The carrying values of cash and cash equivalents,
investments held to maturity, accounts receivable, and accounts payable,
approximate their fair value due to the relatively short-term nature of the
accounts. Using current market rates, the fair value of license installment
receivables approximates carrying value at September 30, 2002 and 2001.
(o) New accounting standards
We have adopted the 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.
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 has not had a significant effect on our consolidated financial
statements.
10
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. The preliminary purchase price
allocation is based on the report of an independent appraiser. 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 an appraisal report of 1mind
intangible assets. This asset is being amortized over its expected
useful life of four years.
(d) Any additional consideration paid will be recorded as goodwill. These
amounts are considered to have an indeterminate life and amortization
is not provided. These assets will be subject to an annual impairment
test.
Note 4 - Valuation and qualifying accounts - allowance for doubtful accounts
Our allowance for doubtful accounts was $858 thousand at September 30,
2002, down from $1.0 million at December 31, 2001. For the nine months ended
September 30, 2002 and 2001, no provision for doubtful accounts was recorded.
During the nine months ended September 30, 2002 we wrote off $180 thousand of
receivables due from a bankrupt customer in South Africa.
11
Note 5 - Comprehensive income
The components of comprehensive income are as follows:
(in thousands) Three Months Ended Nine Months Ended
September 30, September 30,
2002 2001 2002 2001
-------- -------- -------- --------
Net income ....................................... $ 4,826 $ 3,884 $ 12,868 $ 7,630
Foreign currency translation adjustments,
net of income taxes ........................... 265 4 904 (103)
-------- -------- -------- --------
Comprehensive income ............................. $ 5,091 $ 3,888 $ 13,772 $ 7,527
======== ======== ======== ========
Note 6 - Commitments and contingencies
Litigation
Qwest Arbitration.
In August 2002, we settled our arbitration dispute with Qwest Corporation
relating to Qwest's termination of a software license and service agreement with
us described in our previous reports filed with the SEC. Pursuant to the
settlement, Qwest paid us $2.4 million, the termination of the agreement was
acknowledged and the parties entered into a mutual release agreement. We expect
to recognize the cash received pursuant to the settlement as revenue in the
fourth quarter of 2002.
Ernst & Young Arbitration.
On September 9, 2000, Pegasystems 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, alleging, among other things, that the defendants
committed professional malpractice in connection with advice that Ernst & Young
rendered to us concerning the proper accounting treatment for revenue in the
quarter ended June 30, 1997 under a series of contracts between us and First
Data Resources, Inc.
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
us and Ernst & Young. The parties submitted this dispute to arbitration. On
August 13, 2002, the arbitration panel denied Pegasystems' claims with respect
to the allegations in the complaint.
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
Note 2 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 to the extent that
payments are not subject to refund. Payments subject to refund are recognized as
revenue as refund provisions lapse.
Term software license fees are generally payable on a monthly basis under
license agreements that generally have a five-year term and may be renewed for
additional years at the customer's option. The present value of future license
payments is generally recognized as revenue upon customer acceptance. A portion
of the license fees payable under each term license agreement is treated as
imputed interest and recognized as installment receivable interest income over
the license term. Many of our license agreements provide for license fee
increases based on inflation. The present value of such increases is recognized
when the inflation 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 3.25% and 8.0% for the past few years. As a result, revenue that we
recognize relative to these types of license arrangements may be impacted by
changes in market interest rates. For term license agreement renewals, license
revenue is recognized when the customer becomes committed to the new license
terms.
In certain circumstances, such as when license fees are not fixed and
determinable, some licenses are accounted for on a subscription basis, where
revenue is recognized as payments become due over the term of the license.
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 services for a fixed fee
or 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 and 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 service projects. As a
result, determination of the fair value of the elements of the contract has
generally occurred late in the implementation process, typically when
implementation is complete and remaining services are no longer significant to
the project. Until 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 value 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,
such as disputed services, when revenue is initially recorded. These estimated
amounts are deferred or reserved until the related elements of the agreement are
completed and provided to the customer. In addition, we maintain an allowance
for doubtful accounts using estimates that we make based on factors such as
13
the composition of the accounts receivable aging, historical bad debts, changes
in payment patterns, customer creditworthiness and current economic trends. If
we used different estimates, or if the financial condition of customers were to
deteriorate, resulting in an impairment of their ability to make payments,
additional provisions for doubtful accounts would be required and would increase
bad debt expense.
Three and Nine Months Ended September 30, 2002 Compared to Three and Nine Months
Ended September 30, 2001
Revenue
Total revenue for the three-month period ended September 30, 2002 ("the
third quarter of 2002") increased 7% to $25.6 million from $23.9 million for the
three-month period ended September 30, 2001 ("the third quarter of 2001"). Total
revenue for the nine months ended September 30, 2002 ("first nine months of
2002") increased 8% to $76.4 million from $71.0 million in the nine months ended
September 30, 2001 ("first nine months of 2001"). The increases were due to
increases in software license revenue, which were partially offset by decreases
in services revenue. Signing of license contracts with new customers has slowed
significantly since the latter part of 2001 due in large part, we believe, to
continued weakness in spending by our target customers. Revenue from new
customers was 11% of total revenue for the first nine months of 2002, compared
with 13% for the first nine months of 2001. The decrease in license contracts
with new customers has adversely impacted our services business because we
derive a substantial portion of our services revenue from implementation of
software licensed by new customers. The following table summarizes our revenue
composition:
Three Months Ended Nine Months Ended
(in millions) September 30, September 30,
2002 2001 2002 2001
--------- --------- --------- ---------
License revenue
---------------
Perpetual licenses and licenses accounted for
on a subscription basis ....................... $ 10.1 $ 2.3 $ 28.9 $ 7.4
Term licenses, including renewals, extensions and
additions (and not included above) ............ 6.8 8.3 23.3 22.8
------ ------ ------ ------
Total license revenue .............................. 16.9 10.6 52.2 30.2
Services revenue
----------------
Implementation, consulting and training services ... 6.4 11.3 17.4 34.9
Maintenance ........................................ 2.3 2.0 6.8 5.9
------ ------ ------ ------
Total services revenue ............................. 8.7 13.3 24.2 40.8
------ ------ ------ ------
Total revenue ...................................... $ 25.6 $ 23.9 $ 76.4 $ 71.0
====== ====== ====== ======
Software license revenue for the third quarter of 2002 increased 59% to
$16.9 million from $10.6 million for the third quarter of 2001. Software license
revenue for the first nine months of 2002 increased 73% to $52.3 million from
$30.2 million for the same period in 2001. License revenue from new customers
was 5% of total license revenue in the first nine months of 2002.
The increase in perpetual license revenue for the third quarter of 2002 and
for the first nine months of 2002 was primarily due to a perpetual license
agreement entered into with First Data Resources ("FDR") in the first quarter of
2002. That perpetual license agreement replaced a prior term license agreement
with FDR under which revenue was being recognized on a subscription basis and
which was due to expire in December 2002. Of the $7.8 million increase in
perpetual and subscription license revenue for the third quarter of 2002, $4.2
million was due to the FDR perpetual license agreement and $2.5 million was due
to perpetual licenses to new customers. Of the $21.5 million increase in
perpetual and subscription license revenue for the first nine months of 2002,
$15.6 million was due to the FDR perpetual license agreement. The following
table summarizes the revenue we have recognized under the FDR perpetual license
and the prior agreements with FDR:
Three Months Ended Nine Months Ended
(in millions) September 30, September 30,
2002 2001 2002 2001
--------- --------- --------- ---------
Perpetual licenses and licenses accounted for
on a subscription basis ........................ $ 5.9 $ 1.7 $ 20.3 $ 4.7
Implementation, consulting and training services .... - 1.5 0.7 4.5
Maintenance ......................................... 0.2 0.2 0.7 0.7
----- ----- ------ -----
Total revenue ....................................... $ 6.1 $ 3.4 $ 21.7 $ 9.9
===== ===== ====== =====
Under the terms of the FDR perpetual license agreement, FDR is required to
make monthly payments through December 2003. These payments totaled $5.85
million in the third quarter of 2002 and will total $5.85 million in the fourth
quarter of 2002 and $3.54 million in each of the four quarters of 2003. We
recognize revenue three months in advance of receipt of payments, because the
termination of the agreement requires three months advance notice. We expect to
recognize as revenue from the FDR perpetual license $3.54 million in the fourth
quarter of 2002 and each of the first three quarters of 2003.
14
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. In recent history, a significant portion of
our license revenue has been from renewals of term software license agreements.
Revenues from term software licenses, renewals, extensions, and additions
decreased by $1.5 million to $6.8 million from $8.3 million for the third
quarter of 2001. Included in term software license revenue for the third quarter
of 2002 is $2.4 million from a customer that converted to a term license from a
license accounted for on a subscription basis, following revision of the license
agreement to fix the amount of the license fee. Discount rates used to recognize
term license revenue vary directly with market interest rates. The discount
rates used to recognize term license revenue in the third quarter of 2002
averaged 3.40%. Decreases in the average discount rate resulted in an increase
in license revenue of approximately $0.2 million for the third quarter of 2002
and approximately $1.1 million for the first nine months of 2002 versus
comparable periods in 2001. If interest rates increase and in turn the discount
rates we use to recognize term license revenue increase, we would be required to
defer as installment receivable interest a greater portion of the revenue from
such arrangements.
Services revenue for the third quarter of 2002 decreased 35% to $8.7
million from $13.3 million for the third quarter 2001. Services revenue for the
first nine months of 2002 decreased 41% to $24.2 million from $40.8 million in
the first nine months 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. New customer
implementations continue to be significantly below last year. The current rate
of signing new customers indicates that growth in services revenue will continue
to be a challenge.
Deferred revenue balances increased to $10.0 million as of September 30,
2002, from $6.2 million as of December 31, 2001, due to $2.4 million received
from a customer resolving a dispute which is subject to possible forfeiture,
increases in advance maintenance fees and the unearned portion of services
revenue.
International revenues were 22% of total consolidated revenues for the
first nine months of 2002 and 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
purchased software and a stock purchase warrant we issued in September 1997,
under an agreement with FDR and the amortization of the intellectual property we
purchased from 1mind. Cost of software license revenue for the third quarter of
2002 increased 15% to $0.7 million from $0.6 million for the third quarter of
2001. As a percentage of software license revenue, cost of software license
revenue decreased to 4% for the third quarter of 2002 from 6% for the third
quarter of 2001. Cost of software licenses for the first nine months of 2002
decreased 19% to $2.0 million from $2.5 million for the first nine months of
2001. As a percentage of software license revenue, cost of software license
revenue decreased to 4% for the first nine months of 2002 from 8% for the first
nine months 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
15
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 third quarter of 2002 decreased 21% to $7.4 million from $9.3 million
for the third quarter of 2001, primarily due to reduced staff costs and reduced
spending on consultants. Cost of services as a percentage of service revenue
increased to 85% for the third quarter of 2002 from 70% for the third quarter of
2001. Cost of services for the first nine months of 2002 decreased 24% to
$22.2 million from $29.4 million for the first nine months of 2001. Cost of
services as a percentage of services revenue increased to 92% for the first nine
months of 2002 from 72% for the first nine months of 2001. The increased
percentages were primarily due to the reduction in services revenue, which was
only partially offset by reduced staff costs. Service gross margin was $1.3
million for the third quarter of 2002. Due to our current expectation of future
services revenues, based in part on expected move to partner-based sales of our
PegaRULES product, we intend to reduce services headcount in the fourth 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 third quarter of 2002 decreased
1% to $5.3 million from $5.4 million for the third quarter of 2001. As a
percentage of total revenue, research and development expenses decreased to 21%
for the third quarter of 2002 compared to 23% for the third quarter of 2001.
Research and development expenses for the first nine months of 2002 increased 9%
to $16.7 million from $15.4 million for the first nine months of 2001. The
increase in spending was primarily due to increased staff and staff related
expenses. As a percentage of total revenue, research and development expenses
held steady at 22% for the first nine months of 2002 compared to the first nine
months of 2001.
Selling and marketing expenses for the third quarter of 2002 increased 59%
to $6.3 million from $4.0 million for the third quarter of 2001. As a percentage
of total revenue, selling and marketing expenses increased to 25% for the third
quarter of 2002 from 17% for the third quarter of 2001. Selling and marketing
expenses for the first nine months of 2002 increased 37% to $18.0 million from
$13.1 million for the first nine months of 2001. As a percentage of total
revenue, selling and marketing expenses increased to 24% for the first nine
months of 2002 from 18% for the first nine months of 2001. These increases were
due to increased staff and marketing programs spending in our application
business and investment in the emerging PegaRULES business.
General and administrative expenses for the third quarter of 2002 decreased
23% to $1.9 million from $2.4 million for the third quarter of 2001. As a
percentage of total revenue, general and administrative expenses decreased to 7%
for the third quarter of 2002 from 10% for the third quarter of 2001. General
and administrative expenses for the first nine months of 2002 decreased 2% to
$7.4 million from $7.5 million for the first nine months of 2001. As a
percentage of total revenue, general and administrative expenses decreased to
10% for the first nine months of 2002 from 11% of the first nine months of 2001.
These decreases were due to reduced employee compensation related expenses.
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 third quarter of 2002 to $1.3 million
from $1.5 million for the third quarter of 2001. Installment receivable interest
income for the first nine months of 2002 decreased to $3.8 million from $4.4
million for the first nine months of 2001. The decreases were 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 3.25% and 8.0% during the past few years.
16
Other interest income, net
Other interest income, net increased 3% to $0.2 million for the third
quarter of 2002 from $0.2 million for the third quarter of 2001. Other interest
income, net, decreased to $0.5 million for the first nine months of 2002 from
$0.7 million for the first nine months of 2001. The decrease was 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 ($0.4) million for the third quarter of 2002
versus $0.2 million for the third quarter of 2001. Other income (expense), net
was ($0.8) million for the first nine months of 2002 compared to $0.2 million
for the first nine months of 2001. The decreases were due to greater currency
exchange losses and lower reseller development funds.
Income before provision for income taxes
Income before provision for income taxes increased to $5.1 million for the
third quarter of 2002 from $4.1 million for the third quarter of 2001. This $1.0
million improvement was due primarily to a $6.2 million improvement in software
license gross margin from increased revenues, partially offset by a $2.7 million
reduction in services gross margin due to lower services revenues, increased
operating expenses of $1.8 million, greater currency losses and reduction in
installment receivable interest income.
Provision for income taxes
The income tax provision for the third quarter of 2002 relates to the
operations of our foreign subsidiaries. The tax provision for the first nine
months of 2002 was $0.8 million, up from $0.7 million for the first nine months
of 2001. Provisions have not been recorded for U.S. federal and state taxes due
to the availability of net tax operating loss carryforwards.
Liquidity and Capital Resources
We have funded our operations primarily from cash flow from operations and
the proceeds of our public stock offerings. At September 30, 2002, we had cash
and cash equivalents of $52.3 million and working capital of $72.6 million.
Net cash provided by operations for the first nine months of 2002 was $20.7
million compared with $9.3 million for the first nine months of 2001. The
increase was due to a $6.2 million improvement in the collection of accounts
receivable, primarily from perpetual licenses, and a $5.2 million improvement in
profitability. Although we have been very successful in reducing receivables
through collections activity, should services revenue increase or customer
payments slow, it is reasonable to expect that receivables levels may increase
to a more normal level by the end of the year. This increase, in combination
with other working capital changes, could result in negative cash flow from
operations in the fourth quarter of 2002.
Net cash used in investing activities for the first nine months of 2002 was
$5.9 million compared with $0.1 million for the first nine months of 2001. The
increased use of cash was primarily due to a $4.8 million purchase of debt
securities investments, which we intend to hold to maturity, and 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.)
17
Net cash provided by financing activities for the first nine months of 2002
was $4.0 million compared with $21 thousand used in the first nine months 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.
We are having difficulty closing license transactions with new customers.
Due in large part, we believe, to continued weakness in spending by our target
customers, license transactions with new customers have decreased significantly
since the latter part of 2001. License revenue from new customers was 5% of
total license revenue in the first nine months of 2002. We believe that
obtaining new license customers will continue to be a challenge at least in the
near term. The decrease in license contracts with new customers has adversely
impacted and may continue to adversely impact our services business because we
derive a substantial portion of our services revenue from implementation of
software licensed by new customers.
Our stock price has been volatile. Quarterly results have fluctuated and
are likely to continue to fluctuate significantly. The market price of our
common stock has been and may continue to be highly volatile. Factors that are
difficult to predict, such as quarterly revenues and operating results,
statements and ratings by financial analysts, and overall market performance,
will have a significant effect on the price for shares of our common stock.
Revenues and operating results have varied considerably in the past from period
to period and are likely to vary considerably in the future. We plan product
development and other expenses based on anticipated future revenue. If revenue
falls below expectations, financial performance is likely to be adversely
affected because only small portions of expenses vary with revenue. As a result,
period-to-period comparisons of operating results are not necessarily meaningful
and should not be relied upon to predict future performance.
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 our policy of recognizing revenue
upon product acceptance or license renewal in an amount equal to the present
value of the total committed payments due during the term. Customers generally
do not accept products until the end of a lengthy sales cycle and an
implementation period, typically ranging from six to 12 months but in some
cases significantly longer. We are currently in the process of introducing new
product technology and making material changes to our existing products. This
may result in even lengthier sales and implementation cycles which may adversely
affect our financial performance. 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,
18
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. Term license renewal negotiations have required more effort
due to economic pressures and consolidation among our customers. A significant
portion of total revenue has been attributable to term license renewals. While
historically a majority of customers have renewed their term licenses, there can
be no assurance that a majority of customers will continue to renew expiring
term licenses. A decrease in term license renewals absent offsetting revenue
from other sources would have a material adverse effect on future financial
performance. In addition, we are currently entering into perpetual licenses with
most of our new customers, the effect of which may be to increase our license
revenue and cash flow in the short term but to decrease the amount of revenue
and cash flow from the renewal of term licenses in the long term.
We will need to develop new products, evolve existing ones, and adapt to
technology change. Technical developments, customer requirements, programming
languages and industry standards change frequently in our markets. As a result,
success in current markets and new markets will depend upon our ability to
enhance current products, to develop and introduce new products that meet
customer needs, keep pace with technology changes, respond to competitive
products, and achieve market acceptance. Product development requires
substantial investments for research, refinement and testing. There can be no
assurance that we will have sufficient resources to make necessary product
development investments. We may experience difficulties that will delay or
prevent the successful development, introduction or implementation of new or
enhanced products. Inability to introduce or implement new or enhanced products
in a timely manner would adversely affect future financial performance. Our
products are complex and may contain errors. Errors in products will require us
to ship corrected products to customers. Errors in products could cause the loss
of or delay in market acceptance or sales and revenue, the diversion of
development resources, injury to our reputation, or increased service and
warranty costs which would have an adverse effect on financial performance.
We have historically sold to the financial services market. This market is
continuing to consolidate, and faces uncertainty due to many other factors. We
have historically derived a significant portion of our revenue from customers in
the financial services market, and our future growth depends, in part, upon
increased sales to this market. Competitive pressures, industry consolidation,
decreasing operating margins within this industry, currency fluctuations,
geographic expansion and deregulation affect the financial condition of our
customers and their willingness to pay. In addition, customers' purchasing
patterns are somewhat discretionary. As a result, some or all of the factors
listed above may adversely affect the demand by customers. The financial
services market is undergoing intense domestic and international consolidation.
In recent years, several customers have been merged or consolidated. Future
mergers or consolidations may cause a decline in revenues and adversely affect
our future financial performance.
We depend on certain key personnel, and must be able to attract and retain
qualified personnel in the future. The business is dependent on a number of key,
highly skilled technical, managerial, consulting, sales, and marketing
personnel, including Mr. Trefler, our Chief Executive Officer. The loss of key
personnel could adversely affect financial performance. We do not have any
significant key-man life insurance on any officers or employees and do not plan
to obtain any. Our success will depend in large part on the ability to hire and
retain qualified personnel. The number of potential employees who have the
extensive knowledge of computer hardware and operating systems needed to
develop, sell and maintain our products is limited, and competition for their
services is intense, and there can be no assurance that we will be able to
attract and retain such personnel. If we are unable to do so, our business,
operating results, and financial condition could be materially adversely
affected.
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
19
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 to respond to
significant growth. 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
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, and 22% for the nine months ended September 30, 2002. 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 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
20
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.
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 22% of our total revenue in the first nine months
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 nine months 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.
21
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.
Item 4. Controls and Procedures
(a) Disclosure controls and procedures. Within 90 days before filing this
report, we evaluated the effectiveness of the design and operation of our
disclosure controls and procedures. Our disclosure controls and procedures are
the controls and other procedures that we designed to ensure that we record,
process, summarize and report in a timely manner the information we must
disclose in reports that we file with or submit to the SEC. Alan Trefler, our
Chairman and Chief Executive Officer, and Christopher Sullivan, our Treasurer
and Chief Financial Officer, reviewed and participated in this evaluation. Based
on this evaluation, Messrs. Trefler and Sullivan concluded that, as of the date
of their evaluation, our disclosure controls were effective.
(b) Internal controls. Since the date of the evaluation described above,
there have not been any significant changes in our internal accounting controls
or in other factors that could significantly affect those controls.
22
Part II - Other Information:
Item 1. Legal Proceedings
Litigation
Qwest Arbitration. In August 2002, we settled our arbitration dispute with Qwest
Corporation relating to Qwest's termination of a software license and service
agreement with us described in our previous reports filed with the SEC. Pursuant
to the settlement, Qwest paid us $2.4 million, the termination of the agreement
was acknowledged and the parties entered into a mutual release agreement. We
expect to recognize the cash received pursuant to the settlement as revenue in
the fourth quarter of 2002.
Ernst & Young Arbitration.
On September 9, 2000, Pegasystems 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, alleging, among other things, that the defendants
committed professional malpractice in connection with advice that Ernst & Young
rendered to us concerning the proper accounting treatment for revenue in the
quarter ended June 30, 1997 under a series of contracts between us and First
Data Resources, Inc.
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
Pegasystems and Ernst & Young. The parties submitted this dispute to
arbitration. On August 13, 2002, the arbitration panel denied Pegasystems'
claims with respect to the allegations in the complaint.
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
None.
Item 5. Other Information
The Company's chief executive officer and chief financial officer have furnished
to the SEC the certification with respect to this Form 10-Q that is required by
Section 906 of the Sarbanes-Oxley Act of 2002.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
10.1 Executive employment agreement dated July 25, 2002 between the
Registrant and Henry Ancona
99.1 Certifying letter, Alan Trefler, Chairman and Chief Executive
Officer
99.2 Certifying letter, Christopher Sullivan, Treasurer and Chief
Financial Officer
(b) Reports on Form 8-K:
None.
23
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: October 22, 2002 /s/ Alan Trefler
-----------------------------------
Chairman and Chief Executive Officer
/s/ Christopher Sullivan
-----------------------------------
Treasurer and Chief Financial Officer
(principal financial officer and
chief accounting officer)
24
I, Alan Trefler, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Pegasystems Inc.;
2. Based on my knowledge, this quarterly 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 quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures 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 quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls;
and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: October 22, 2002
/s/ Alan Trefler
- --------------------------------
Chairman and Chief Executive Officer
25
I, Christopher Sullivan, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Pegasystems Inc.;
2. Based on my knowledge, this quarterly 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 quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures 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 quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls;
and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: October 22, 2002
/s/ Christopher Sullivan
- ------------------------
Treasurer and Chief Financial Officer
26