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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File No.
000-27607

CYSIVE, INC.
(Exact name of registrant as specified in its charter).

10790 Parkridge Blvd.
Suite 400
Reston, Virginia 20191
(Address of principal executive offices) (Zip Code).

(703) 259-2300
(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, and (2) has been subject to such filing requirements for the past 90 days.

Yes    X    No        

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes        No    X   

As of November 12, 2003, 29,286,641 shares of common stock were outstanding.

CYSIVE, INC.

FORM 10-Q

TABLE OF CONTENTS

PART I — FINANCIAL INFORMATION

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PART I.
FINANCIAL INFORMATION

ITEM 1.  Financial Statements

CYSIVE, INC.

Balance Sheets
(In thousands, except share and per share data)

See accompanying notes

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CYSIVE, INC.

Statements of Operations
(In thousands, except share and per share data)
(Unaudited)

See accompanying notes

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CYSIVE, INC.

Statements of Cash Flows
(In thousands)
(Unaudited)

See accompanying notes

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CYSIVE, INC.

Notes to Financial Statements

(Unaudited)

1.  Basis of presentation

     The accompanying financial statements of Cysive, Inc. (“Cysive” or the “Company”) are unaudited and, in the opinion of management, reflect all normal and recurring adjustments that are necessary for a fair presentation as of the dates and for the periods presented. The financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information. Consequently, these financial statements do not include all of the disclosures normally required by generally accepted accounting principles for annual financial statements. Accordingly, these financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto for the period ended December 31, 2002, included in the Annual Report on Form 10-K filed by the Company with the Securities and Exchange Commission on March 19, 2003. The results of operations for the three and nine months ended September 30, 2003 are not necessarily indicative of results for the full year.

     Certain amounts in the prior period financial statements have been reclassified to conform to the current quarter presentation.

  Stock-Based Compensation

     The Company accounts for its stock-based compensation in accordance with Accounting Principles Board Opinion (“APB”) No. 25 “Accounting for Stock Issued to Employees” using the intrinsic value method. The pro forma disclosures required by Statement of Financial Accounting Standards (“SFAS”) No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure” using the fair value method appear in the table below.

     Had compensation expense related to stock option plans been determined based on the fair value at the grant date for options granted after 1995 consistent with the provisions of SFAS No. 148, the Company’s pro forma net loss and loss per share would have been as follows (in thousands, except per share data):

     The effects of applying SFAS No. 148 on the Company’s net losses for the periods shown above are not necessarily representative of the effects on reported net loss for future periods due to, among other things, the vesting period of the stock options, the fair value of future grants of stock options and the potential issuance of restricted stock.

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  Restructuring

     In June 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities,” which requires restructurings initiated after December 31, 2002 to be accounted for using the provisions therein, with earlier application encouraged. The Company accounted for a restructuring related to the closure of its New York office in the second quarter of 2003 and a restructuring related to the termination of employees and the closure of its Atlanta office in the third quarter of 2003 in accordance with the provisions of SFAS No. 146. The Company accounted for restructurings initiated prior to December 31, 2002 using the accounting provisions of Emerging Issues Task Force (“EITF”) Issue No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”). Under SFAS No. 146, the accounting provisions of EITF 94-3 will continue to apply to restructurings initiated prior to December 31, 2002, and therefore, the adoption of this standard has no impact on the Company’s financial statements with respect to these restructurings.

2.  Revenue recognition

     The Company accounts for the licensing of software in accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” (as amended by SOP 98-4 and SOP 98-9) and related interpretations. The Company recognizes revenue when (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred or services have been rendered; (iii) the sales price is fixed or determinable; and (iv) collectibility is reasonably assured. Maintenance and term license revenues are generally recognized ratably over the contract period. For software arrangements with multiple elements, revenue recognition is dependent upon whether vendor-specific objective evidence (“VSOE”) of fair value exists for each of the elements and whether or not significant customization services are required. When significant customization services are not required and VSOE does not exist for all the elements of a software arrangement and the only undelivered element is maintenance, the entire licensing fee is recognized ratably over the contract period. When significant customization services are required in conjunction with software license sales, the software license fees and the related consulting services revenues are recognized in accordance with AICPA SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” using the percentage-of-completion method based on hours-worked as compared with estimated total hours-worked at completion.

     Deferred revenues are comprised of deferrals for license fees, maintenance and services billed to customers in advance of the related revenue recognition.

3.  Software development costs

     SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” requires the capitalization of certain software development costs subsequent to the establishment of technological feasibility. Based on the Company’s product development process, technological feasibility is established upon the completion of a working model. Costs incurred by the Company between the completion of the working model and the point at which the product is ready for general release have been insignificant. Accordingly, the Company has charged all such costs to research and development expense in the period incurred.

4.  Stock compensation expense

     In 1999, prior to its initial public offering, the Company granted stock options to purchase shares of common stock at exercise prices deemed below fair market value of the common stock on the date of grant. In 2000, the Company granted non-qualified stock options to purchase shares of common stock at a

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15% discount from the fair market value. The Company recorded deferred stock compensation for the difference between the grant price and fair market value of the options granted. The deferred stock compensation had been amortized ratably on a quarterly basis over the period in which the remaining options vested, which extended through September 2003, less the benefit of any stock options cancelled. Stock options granted subsequent to 2000 were at exercise prices equal to the fair market value of the common stock on the date of grant, and therefore, no compensation expense has been recognized related to these grants.

     During the three and nine months ended September 30, 2003, the Company recognized $7,000 and $309,000 of stock compensation expense, respectively, related to outstanding stock options issued with exercise prices below fair market value. The deferred stock compensation component of stockholders’ equity was further reduced by $50,000 during the nine months ended September 30, 2003 due to the cancellation of stock options as a result of employee terminations.

     During the three and the nine months ended September 30, 2002, the Company recognized $211,000 and $4,201,000 of stock compensation expense, respectively. During the first quarter of 2002, the Company cancelled certain employee-held stock options, resulting in an acceleration of compensation expense related to the value of these options, and the Company recognized $2,208,000 of expense related to these cancellations. Additionally, in January 2002, the Company purchased certain shares of common stock from employees within six months of issuance as a result of stock option exercises, and the Company recognized stock compensation expense of $132,000 related to these purchases. Also during the quarter ended March 31, 2002, the Company recognized $40,000 of stock compensation expense related to certain restricted stock granted in 2001.

5.  Restructuring expense

     On August 14, 2003, the Company took specific actions to reduce its overall cost structure. The Company eliminated 26 positions, consisting of engineering, sales and general and administrative employees, and closed its Atlanta office. As a result, the Company recorded a pretax restructuring charge of $591,000 for severance, rent expense and other associated costs in the third quarter of 2003.

     In April 2003, the Company executed a termination agreement on its office space in New York City. As a result, the Company was relieved from a future lease obligation of approximately $1.7 million in exchange for a payment of $690,000 and the transfer of its New York office furniture and leasehold improvements, which had a combined net book value of $286,000. After giving consideration to accrued rent of $33,000 for this office space, the Company recorded restructuring expense of $943,000 relating to this lease termination.

     During the first quarter of 2003, the Boston office space associated with the fourth quarter 2000 restructuring was sublet from April 2003 through the remaining term with sublease payments commencing June 1, 2003. Sublease payments were estimated to total $315,000, net of brokerage commissions, over the remaining term. Principally as a result of this sublease, the Company reduced the accrued liability for this restructuring by $337,000 through a credit to restructuring expense

6.  Loss per share

     The Company presents basic and diluted loss per share as one line item. Basic and diluted loss per share is based on the weighted average number of shares outstanding during the period. Common stock equivalents are excluded from the calculation of diluted loss per share, as their effect would be anti-dilutive.

     Based on the closing price of $3.20 per share for the Company’s common stock on September 30, 2003, and using the treasury stock method for determining the amount of common stock equivalents, the

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number of common stock equivalent shares related to stock options outstanding as of September 30, 2003 was 4,000,638.

7.  Comprehensive loss

     Comprehensive loss includes net loss and unrealized gains and losses on investments. For the three and nine months ended September 30, 2003, comprehensive loss was $4.5 million and $12.7 million, respectively. For the three and nine months ended September 30, 2002, comprehensive loss was $9.2 million and $23.1 million, respectively.

8.  Interest-bearing investments

     Investments are generally comprised of variable rate securities that provide for optional or early redemption within twelve months, and the contractual maturities are generally greater than twelve months. Investments with effective maturity dates of one year or less at the balance sheet date are classified as current, and investments with effective maturity dates of more than one year are classified as non-current. There may be significant changes on a quarterly basis in the amounts classified as current or non-current based on the effective maturity dates of the particular investments at the balance sheet dates.

     The Company classifies its investments as available-for-sale. Investments in securities that are classified as available-for-sale and have readily determinable fair values are measured at fair market value in the balance sheets. Any unrealized gains or losses are reported as a separate component of stockholders’ equity, if deemed material. Realized gains and losses and declines in market value judged to be other than temporary are included in investment income. Interest and dividends are also included in investment income.

9.  Other assets

     On July 1, 2003, a note receivable for $65,000 from a former employee was amended to delete a provision requiring the repayment of the outstanding principal and interest upon the termination of his employment with the Company. As a result, the note receivable will be due and payable on December  31, 2005 and has been classified as long-term other assets on the balance sheet as of September 30, 2003.

     Subsequent to September 30, 2003, the Company agreed to amend two notes receivable totaling $350,000 from a former employee to reflect the following terms: (a) the former employee will grant the Company a security interest in certain real property as collateral for the notes receivable; (b) the interest rate will be increased from 2.74% to 4.0%; and (c) the maturity date will be extended to the earlier of December 31, 2004 or the sale of the real property securing the notes receivable. The Company and the former employee are negotiating the amendment and no definitive amendment has been executed. As a result, the notes receivables have been classified as other current assets on the balance sheet as of September  30, 2003.

10.  Accrued restructuring

     During the fourth quarter of 2000, the Company took specific actions to reduce its overall cost structure in anticipation of declining sales. As a result, the Company recorded a $4.7 million pre-tax restructuring expense primarily related to 1) the elimination of certain non-technical support roles, resulting in severance costs; 2) the closing of a satellite office, resulting in the write-down of assets; and 3) the accrual for professional fees related to the office closing or potential claims from severed employees. During the first quarter of 2003, the office space was sublet from April 2003 through the remaining term with sublease payments commencing June 1, 2003 and estimated to total $315,000, net of brokerage commissions, over the remaining term. Principally as a result of this sublease, the Company reduced the accrued liability for this restructuring by $337,000 through a credit to restructuring expense. During the three and nine months ended September 30, 2003, the Company paid approximately $37,000 and $240,000, respectively, for facility costs related to this restructuring. Cumulative lease obligation and related facility costs incurred as of September 30, 2003 totaled $923,000. As of September 30, 2003, estimated amounts remaining to be paid total $286,000 and are for rents payable, net of sublease income, through August 2005.

     During the third quarter of 2002, the Company approved a restructuring plan which included the following: the termination of 49 employees, consisting of engineering, sales and general and administrative employees; the closing of three satellite offices; and the intent to sublet, if possible, significant portions of its office space. As a result, the Company recorded a $5.9 million pre-tax restructuring expense during the third quarter of 2002 to cover severance costs ($873,000), estimated remaining lease obligations net of estimated sublet income ($4,241,000), the write-off of leasehold improvements ($457,000), and the write-down of furniture and equipment to net realizable value ($374,000). During the three and nine months ended September 30, 2003, the Company paid approximately $532,000 and $937,000, respectively, for facilities costs related to this restructuring. Furthermore, the Company reduced accrued restructuring by $31,000, net, relating to the write-off of certain furniture and equipment and accrued rent. Cumulative lease obligation and related facilities costs incurred as of September 30, 2003 totaled

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$1,460,000. Estimated amounts remaining to be paid as of September 30, 2003, total $2.9 million and are for rents payable, net of estimated sublease income, through April 2010.

     During the third quarter of 2003, the Company approved a restructuring plan which included the following: the termination of 26 employees, consisting of engineering, sales and general and administrative employees, and the closing of its Atlanta office. As a result, the Company recorded a $591,000 pre-tax restructuring expense during the third quarter of 2003 to cover severance costs ($525,000), estimated remaining lease obligations ($61,000), and the write-down of furniture and equipment ($5,000). During the three months ended September 30, 2003, the Company paid approximately $446,000 and $7,000 for severance and facilities costs, respectively, related to this restructuring. Estimated amounts remaining to be paid as of September 30, 2003, total $138,000 and are for a combination of remaining severance and rents payable through September 2004. All employees related to this restructuring have been terminated.

11.  Mergers and Acquisitions

     On May 13, 2003, the Company announced that it had retained Broadview International LLC to assist the Company in considering strategic alternatives, including a possible sale of the Company. The Company further announced that it was in discussions with various third parties regarding a possible acquisition of the Company and that it had formed a special committee of independent directors for the purpose of evaluating strategic alternatives and any offers the Company may receive. There can be no assurance, however, that any transaction will occur, and, if any transaction does occur, what the structure or terms would be of such transaction.

     On May 30, 2003, the Company entered into an Agreement and Plan of Merger with Snowbird Holdings, Inc. (“Snowbird”), a newly formed entity owned by Nelson A. Carbonell, Jr., Chairman of the Board of Directors, President and Chief Executive Officer of the Company. The merger agreement provided that, at the closing of the merger, each outstanding share of the Company’s common stock (other than Company common stock owned by Snowbird) would be converted into the right to receive $3.22 in cash. All outstanding stock options would be assumed by Snowbird.

     On September 15, 2003, the Company entered into an amendment to the previously announced Agreement and Plan of Merger, dated as of May 30, 2003, between the Company and Snowbird. The amendment provides for, among other things, an increase in the merger consideration to be received by the Company’s stockholders (other than Snowbird and Nelson A. Carbonell, Jr.) from $3.22 per share to $3.23 per share. There can be no assurance, however, that the merger agreement will be consummated.

     The Company has scheduled a special meeting of stockholders to be held on November 28, 2003 to approve the merger agreement with Snowbird.

12.  Litigation

     On May 30, 2003 and over the following week, four putative class action complaints were filed in the Chancery Court of the State of Delaware, County of New Castle, by certain named plaintiffs and an alleged class of unaffiliated Cysive stockholders. The complaints named the Company, its directors and (except for one complaint) Snowbird as defendants and alleged that the Company’s directors had engaged in acts of self dealing and had violated fiduciary duties of due care and loyalty owed to unaffiliated Cysive stockholders in connection with the merger. The complaints further alleged that the merger consideration was inadequate and unfair to the putative class and that the Company and its directors failed to make adequate good faith efforts to obtain a better price. Trial commenced on July 22, 2003, and concluded on July 24, 2003. During the two weeks following the conclusion of trial, the parties filed post-trial briefs with the Court and on August 15, 2003, the Court issued its opinion, ruling in favor of the defendants on all counts and dismissing the plaintiffs’ claims in their entirety. The plaintiffs had until September 25, 2003 to appeal the ruling. The plaintiffs did not appeal the ruling.

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13.  Subsequent event

     In October 2003, the Company entered into a letter of intent to sublease up to 24,000 square feet of office space in the Reston, VA facility. The sublease is currently under negotiation. No adjustment has been made to the restructuring accrual in connection with this proposed sublease. The Company will record an adjustment to the accrual if and when a sublease is executed.

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     ITEM 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion and analysis compares the three and nine months ended September 30, 2003 to the corresponding periods ended September 30, 2002 for Cysive and should be read together with our financial statements and notes thereto appearing elsewhere in this Form 10-Q and with our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 19, 2003.

     Certain statements contained in this Quarterly Report on Form 10-Q, including information with respect to the Company’s future business plans, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. 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 foregoing, the words “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other comparable terminology are intended to identify forward-looking statements. These factors may cause our actual results to differ materially from a forward-looking statement. There are a number of important factors that could cause the results of the Company to differ materially from those indicated by such forward-looking statements, including, but not limited to, our continued significant losses; the failure of our stockholders to approve the proposed merger or the failure of any party to the merger agreement to satisfy a condition for the closing of the merger on or prior to November 30, 2003; the implementation of our new unproven business model; uncertain demand for our product; our ability to manage growth and attract and retain highly trained and experienced employees; increased competition in the electronic business industry; and our ability to respond to new technological advances in the software products industry. Additional information concerning these and other risks and uncertainties is contained from time to time in our filings with the Securities and Exchange Commission. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise, until the effective date of our future reports required by applicable securities laws.

Recent Developments

     On May 13, 2003, the Company announced that it had retained Broadview International LLC to assist the Company in considering strategic alternatives, including a possible sale of the Company. The Company further announced that it was in discussions with various third parties regarding a possible acquisition of the Company and that it had formed a special committee of independent directors for the purpose of evaluating strategic alternatives and any offers the Company may receive. There can be no assurance, however, that any transaction will occur, and, if any transaction does occur, what the structure or terms would be of such transaction.

     On May 30, 2003, the Company entered into an Agreement and Plan of Merger with Snowbird Holdings, Inc. (“Snowbird”), a newly formed entity owned by Nelson A. Carbonell, Jr., Chairman of the Board of Directors, President and Chief Executive Officer of the Company. The merger agreement provided that, at the closing of the merger, each outstanding share of the Company’s common stock (other than Company common stock owned by Snowbird) would be converted into the right to receive $3.22 in cash. All outstanding stock options would be assumed by Snowbird.

     On September 15, 2003, the Company entered into an amendment to the previously announced Agreement and Plan of Merger, dated as of May 30, 2003, between the Company and Snowbird. The amendment provides for, among other things, an increase in the merger consideration to be received by the Company’s stockholders (other than Snowbird and Nelson A. Carbonell, Jr.) from $3.22 per share to $3.23 per share There can be no assurance, however, that the merger agreement will be consummated.

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     The Company has scheduled a special meeting of stockholders to be held on November 28, 2003 to approve the merger agreement with Snowbird.

Overview

     Cysive is a provider of interaction server technology through its software product, Cysive Cymbio Interaction Server™, or Cysive Cymbio®. Cysive develops and delivers software that enables users to interact with enterprises over multiple communications channels and devices such as Web browsers, Web Services, rich client applications, mobile phones, PDA’s, and voice. The Cysive Cymbio Interaction Server creates a seamless user experience for interactions that range from simple requests for information, to complex, multi-step business processes and long-running transactions that interact with many enterprise systems.

     Historically, nearly all of our revenues have resulted from the delivery of custom software and services solutions to our customers. From commencement of operations in 1994 through 1997, we built large scale, distributed systems using approaches and technologies that are the foundations for current Internet applications. At that time, our advanced technology focus required a sales effort led by technology savvy project managers. In late 1996 and early 1997, we evaluated and developed software prototypes using key Internet technologies such as Java, XML and CORBA. After successfully deploying our first electronic business system in mid-1997, we began to target customers who were making significant investments in their electronic business applications. As a result, there was a fundamental shift in our business strategy away from general purpose distributed systems to customized electronic business applications. As part of this strategy, in the fourth quarter of 1997 and the first half of 1998, we spent considerable resources to accomplish two specific goals. Our first goal was to train all of our software engineers with advanced Internet technologies. Our second goal was to deploy a direct sales force capable of selling electronic business applications. These initiatives significantly impacted our results of operations for these three quarters. Specifically, the generation of a sales pipeline of electronic business applications and the deployment of our sales force affected our revenues and sales and marketing expenses. In addition, the completion of two of our largest distributed systems combined with the extensive training of our software engineers caused our utilization rates and gross margins to decline during these quarters. These investments positioned us to emerge in the second half of 1998 as a leading electronic business engineering firm from the third quarter of 1998 to the second quarter of 2000.

     In the second half of 2000, we again identified a technology shift emerging as customers required an integrated solution for their Web, wireless and voice activated systems. As a result, we began focusing our non-utilized software engineering personnel on solving these complex development and integration issues. We then packaged the intellectual property rights retained from prior experience in selected vertical markets with the new solutions we were developing. During the second half of 2000, the general economic slow-down in conjunction with the rapidly changing technology environment caused our results from operations to significantly decline.

     Due to increasing competition, declining margins and business volatility, in 2001 we began the transition of our business model from a software engineering services model to a software product model. Accordingly, during 2001 we developed and introduced the Cysive Cymbio Interaction Server, a multi-channel, enterprise software product that uses widely supported technologies and open standards to enable users to interact with enterprises over multiple communications channels, devices and intermittent connections. The Cysive Cymbio Interaction Server enhances a user’s experience, improves return on existing information technology investments, and reduces call center, systems management and maintenance costs. At the conclusion of the year ended December 31, 2002, our business model transition was complete.

     We believe that after spending several years, and expending significant resources implementing numerous non-integrated and often incompatible software products, such as application servers, portals,

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enterprise application integration tools, business process management suites and Web Services platforms, enterprises continue to face key challenges in handling multi-channel interactions involving complex, multi-stage transactions, with intermittently connected users employing a myriad of access devices. We also believe enterprises are moving to a multi-channel access approach using Web, Web Services, wireless and voice to interact with their employees, customers, suppliers, partners and distributors. Enterprises often lack a facility to manage these disparate systems, resulting in increased costs for the enterprise, and a less satisfactory experience for the user. Technology advances, such as the Cysive Cymbio Interaction Server, enable companies to integrate complex interactions between users and enterprises via multiple channels and devices, providing an improved user experience more quickly and inexpensively.

     Our financial results may fluctuate from quarter-to-quarter based on factors such as the number of license sales, the amount and timing of our customers’ expenditures, and general economic conditions. Revenues from a few large customers may constitute a significant portion of our total revenues in a particular quarter or year. For example, for the three-month period ended September 30, 2003 our four largest customers represented 100.0% of our revenues and for the three-month period ended September 30, 2002, our five largest customers represented 95.3% of our revenues. For the nine-month periods ended September 30, 2003 and 2002, our five largest customers represented 100.0% and 87.4% of our revenues, respectively.

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Results of Operations

     The following table presents, for the periods indicated, the relative composition of revenues and selected statements of operations data as a percentage of revenues:

Revenues (in thousands):

     The decrease in services revenue for the three and nine months ended September 30, 2003 as compared to the same periods in 2002 was primarily due to our transition to a software license sales business model. As of the end of 2002, we exited the custom software engineering services business and concentrated our efforts on software sales and related maintenance and support services. Services revenue represented 66.7% and 70.8% of total revenues for the three and nine months ended September 30, 2003, respectively. Services revenue represented 93.7% and 95.6% of total revenues for the three and nine months ended September 30, 2002, respectively. As of September 30, 2003, we had no billable software engineers as compared to 10 as of September 30, 2002.

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     Software license revenues result from the licensing of our product, Cysive Cymbio. To date, we have sold only a limited number of Cysive Cymbio licenses. Demand for our product is uncertain and, therefore, the revenue stream from future license sales is also uncertain. Additionally, the timing of revenue recognition related to future software license sales is uncertain, as it is, in part, dependent on when vendor specific objective evidence for the value of maintenance services, included as a part of these sales, is established.

     Direct costs (in thousands):

     The decrease in direct costs from services for the three and nine months ended September 30, 2003 as compared to the same periods in 2002 was primarily due to the restructuring in the third quarter of 2002 resulting from our decision to exit the custom software engineering services business. Direct costs from software licenses represented third party technology license fees and product packaging. Third party license fees are generally amortized on a straight-line basis over the term of each license.

Operating expenses (in thousands):

     Sales and Marketing. The decrease in sales and marketing expenses for the three and nine months ended September 30, 2003 as compared to the same periods in 2002 was primarily due to a reduction in sales staff headcount, resulting in lower salaries and related benefits. For the three and nine months ended September 30, 2003, salary and related benefits decreased $410,000 and $1.6 million, respectively, as compared to the same periods in 2002. Spending on public relations, marketing events and meals and travel has also declined $90,000, $80,000 and $104,000, respectively, during the three months ended September 30, 2003 and $520,000, $185,000 and $342,000, respectively, during the nine months ended September 30, 2003 as compared to the same periods in 2002. As of September 30, 2003, we had seven sales and marketing staff, including two technical support personnel who conduct product demonstrations and address technical issues regarding our product. Sales and marketing expenses are expected to decline to a lower level than that experienced during the first three quarters of 2003.

     General and Administrative. The slight increase in general and administrative expenses for the three months ended September 30, 2003 as compared to the same period in 2002 was primarily due to an increase of $1.2 million in legal and professional fees related to the shareholders’ class action lawsuits and strategic alternatives pursued by the Company, as further discussed in Note 11 of the Unaudited Notes to the Financial Statements. This increase was offset by decreases in salary and related benefits, facilities costs, depreciation expense and office and equipment expense of $365,000, $290,000, $305,000 and $70,000, respectively, during the three months ended September 30, 2003. The decrease in general and administrative expenses for the nine months ended September 30, 2003 as compared to the same period in 2002 was primarily due to lower support staff headcount, as well as reductions in facilities costs, depreciation expense and office and equipment expense. Salary and related benefits, facilities costs, depreciation expense and office and equipment expense decreased $1.2 million, $790,000, $770,000 and $138,000, respectively, during the nine months ended September 30, 2003. These decreases were offset

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by an increase of $2.3 million during the nine months ended September 30, 2003, in legal and professional fees related to the shareholders’ class action lawsuits and strategic alternatives pursued by the Company. General and administrative expenses are expected to decline to a lower level than that experienced during the first three quarters of 2003.

     Research and Development. The decrease in research and development expenses for the three and nine months ended September 30, 2003 as compared to the same periods in 2002 was primarily due to a reduction in headcount, which resulted in lower salary and related benefits. As of September 30, 2003, we had nine personnel assigned to the product engineering team, as compared with 24 as of December 31, 2002. Research and development expenses are expected to decline to a lower level than that experienced during the first three quarters of 2003.

     Stock Compensation. The decrease in stock compensation expense for the three months ended September 30, 2003 as compared to the three months ended September 30, 2002 reflects a lower level of continuing stock compensation expense for stock options granted in 1999 and 2000. The decrease in stock compensation expense for the nine months ended September 30, 2003 as compared to the nine months ended September 30, 2002 was primarily due to the recognition of, on an accelerated basis, $2.0 million of expense related to the cancellation of certain officer and employee-held stock options during the first quarter of 2002. As of September 30, 2003, deferred stock compensation has been fully amortized.

     Restructuring. For the nine months ended September 30, 2003, we recognized restructuring expense of $591,000 relating to severance, rent expense and other associated costs. Additionally, we also recognized restructuring expense of $943,000 relating to the termination of our New York City office lease. These restructuring charges are further discussed in Note 5 and the prior year restructurings are discussed in Note 9 of the Unaudited Notes to the Financial Statements. Additionally, we recognized a benefit of $337,000 to restructuring due to a reduction in future net rent expense for lease obligations as a result of office space that was sublet during the first quarter of 2003.

Investment income, net (in thousands):