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SECURITIES AND EXCHANGE
COMMISSION

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002

OR

FROM        TO        .

COMMISSION FILE NUMBER 0-28121

RETEK INC.

(Exact Name of Registrant as Specified in its Charter)

(Address, including zip code, and telephone number, including area code, of Registrant’s Principal Executive Offices)

         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 [ ]

         As of November 1, 2002, the number of shares of the Registrant’s common stock outstanding was 53,178,989.

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RETEK INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002

INDEX

SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION

         This Quarterly Report on Form 10-Q contains forward-looking statements in “Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Item 3 — Quantitative and Qualitative Disclosures About Market Risk,” and elsewhere. These statements relate to future events or our future financial performance. In some cases, forward-looking statements may be identified by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Such risks, uncertainties and other factors include, among other things, the matters described in “Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

         Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these statements. We are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform these statements to actual future results.

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PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

RETEK INC.
CONSOLIDATED BALANCE SHEET

(IN THOUSANDS, EXCEPT PER SHARE DATA)

See accompanying notes to consolidated financial statements.

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Retek Inc.

Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)

See accompanying notes to consolidated financial statements.

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Retek Inc.
Consolidated Statements of Cash Flows
(in thousands)
(unaudited)

See accompanying notes to consolidated financial statements.

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RETEK INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — The Company and its Significant Accounting Policies

The Company

         Retek Inc. and its wholly owned subsidiaries, Retek Information Systems, Inc., WebTrak Limited and HighTouch Technologies, Inc. (“we” “us” or the “Company”), develop application software that provides a complete information infrastructure solution to the global retail industry. Our offerings include traditional merchandising capabilities such as inventory management and purchasing; logistics capabilities including warehouse and distribution management; enhanced supply chain solutions such as forecasting, planning, and supply chain visibility; and customer relationship and order management applications. We also provide Internet-enabled business-to-business commerce applications that offer collaborative capabilities enabling retailers and their trading partners to interact in real-time on a wide variety of tasks. Many of our products incorporate proprietary neural-network predictive technology that enhances the usefulness, accuracy, and adaptability of our applications enabling better decision-making by retailers. We are headquartered in Minneapolis, Minnesota.

Basis of Presentation

         We have prepared the accompanying interim consolidated financial statements, without audit, in accordance with the instructions to Form 10-Q and, therefore, the accompanying interim consolidated financial statements do not necessarily include all information and footnotes necessary for a fair presentation of our financial position, results of operations and cash flows in accordance with accounting principles generally accepted in the United States of America.

         We believe the accompanying unaudited financial information for the interim periods presented reflects all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation. These consolidated financial statements and notes thereto should be read in conjunction with our audited financial statements and notes thereto presented in our Annual Report on Form 10-K for the fiscal year ended December 31, 2001. The interim financial information contained in this Quarterly Report on Form 10-Q is not necessarily indicative of the results to be expected for any other interim period or for an entire fiscal year.

Financial Statement Preparation

         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 reporting period. Actual results could differ from those estimates.

Note 2 — Comprehensive Loss

         Comprehensive loss includes unrealized gains (losses) on the Company’s available-for-sale securities and foreign currency translation adjustments. The components of comprehensive loss, net of related tax for 2001, for the nine-month periods ended September 30, 2002 and 2001 are as follows:

Note 3 — Accounting Changes

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         In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“FAS 142”). Under FAS 142, goodwill and intangible assets with indefinite lives are no longer amortized but are reviewed at least annually for impairment. We adopted FAS 142 effective January 1, 2002. As of the date of adoption, we increased the carrying value of goodwill by $298 related to the reclassification of the net book value of the assembled work force intangible asset on that date. Pursuant to FAS 142, we completed a test for goodwill impairment at the end of the second quarter of 2002 and determined that no impairment exists as of June 30, 2002. We will continue to test goodwill for impairment and if impairment is indicated we will record the impairment against the goodwill balance.

         Actual results of operations for the three months and nine months ended September 30, 2002, and pro forma results of operations for the three months and nine months ended September 30, 2001, had we applied the non-amortization provisions of FAS 142, follow (in thousands except per share data):

         Intangible assets as of September 30, 2002 and December 31, 2001 consisted of the following:

         Estimated amortization expense of identified intangible assets for the next five years are as follows (in thousands):

Note 4 — Per Share Data

         Basic earnings per share is calculated using the weighted average common shares outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average basic shares outstanding plus the dilutive effect of outstanding stock options and warrants using the treasury stock method.

         For the three and nine months ended September 30, 2002, the calculation of diluted loss per share excludes the impact of the potential exercise of 10,251 stock options and a warrant to purchase 750 shares of our common stock because the effect would be antidilutive.

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Note 5 — Asset Acquisition

         On March 31, 2002, we acquired the intellectual property of Chelsea Market Systems, LLC (“Chelsea”) and certain other assets and liabilities for a net cash purchase price of $8.9 million, of which $8.9 million has been allocated to purchased software, an intangible asset. This purchased software is stated at the lower of cost or net realizable value and is being amortized using the straight-line method over 36 months.

Note 6 — Reclassifications

         Certain prior period amounts have been reclassified to conform with current period presentation.

Note 7 — Deferred Tax Assets

         FAS No. 109 “Accounting for Income Taxes” requires that a valuation allowance be established when it is “more likely than not” that all or a portion of deferred tax assets will not be realized. A review of all available positive and negative evidence needs to be considered. As of September 30, 2002, we determined that it was appropriate to record a full valuation allowance for our deferred tax assets. The establishment of a full deferred tax valuation allowance was determined to be appropriate in light of the magnitude of the revenue decreases in the third quarter of 2002, our operating losses for the three and nine months ended September 30, 2002, our expectation of a significant loss for the full year 2002 and the added uncertainty of the market in which we operate. This full valuation allowance resulted in an increase to the income tax provision of $74.9 million. Despite the full valuation allowance, the income tax benefits related to these deferred tax assets will remain available to offset future taxable income.

Note 8 — Recent Accounting Pronouncements

         In June 2002, the FASB issued SFAS No. 146, “Accounting for Exit or Disposal Activities”. SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for under EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The scope of SFAS 146 also includes costs related to terminating a contract that is not a capital lease and termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002 but early application is encouraged. The provisions of EITF No. 94-3 shall continue to apply for an exit activity initiated under an exit plan that met the criteria of EITF No. 94-3 prior to the adoption of SFAS 146. Adopting the provisions of SFAS 146 will change, on a prospective basis, the timing of when restructuring charges are recorded from a commitment date approach to when the liability is incurred.

Note 9 — Asset Write-offs

         In April 2001, we signed a stock purchase agreement, a warrant agreement and a software development and distribution agreement with Henderson Ventures, Inc. (“Henderson”). In connection with these agreements, we issued a warrant to purchase 750 shares of our common stock in exchange for an ownership interest of approximately 7.7% of the outstanding common stock of Henderson and a distribution agreement to resell the developed software. Under the software development and distribution agreement, we are required to pay royalties to Henderson for any software sold by us that we developed in conjunction with Henderson. The fair value of the warrant of $12.1 million at that time was calculated using the Black-Scholes valuation model and $0.4 million was considered to be the value of the Henderson common stock.

         We evaluate the recoverability of our intangible assets for potential impairment when events or changes in circumstances warrant. Because our relationship with Henderson has not generated software sales for us to-date, the increasing uncertainty about retailers’ future capital investments and other factors, we determined that an evaluation of the recoverability of the intangible asset related to Henderson was appropriate. As a result of information obtained subsequent to the quarter ended September 30, 2002, we determined that no significant future cash flows are probable from our relationship with Henderson and the net book value of the intangible asset related to the software development and distribution agreement of $8.7 million was impaired and was written off as of September 30,2002. In addition, we concluded that our cost method investment in Henderson of $0.4 million was impaired and was also written off as of September 30,2002. The aggregate write-off of $9.1 million is a non-cash expense and is reflected as a component of general and administrative expense for the three and nine months ended September 30, 2002.

Note 10 — Subsequent Events

         On October 16, 2002, we announced a restructuring plan intended to bring expenses in line with expected revenues. As part of the restructuring plan, we plan to reduce headcount by approximately 15% or about 130 people, and reduce our discretionary spending. The workforce reductions will be implemented throughout the fourth quarter. As a result, we have identified approximately $5 million to $6 million in restructuring charges to cover severance and other costs associated with the restructuring plan. As of the date of this filing, we were still assessing our restructuring plan and may incur additional restructuring charges during the fourth quarter of 2002.

         Between October 30, 2002 and November 8, 2002, several similar shareholder class action suits were filed in federal district court in Minnesota. The complaints allege, among other things, violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against us and certain of our officers and directors. Discussion of these and other legal matters are included in this Quarterly Report on Form 10-Q in Part II — Item 1: Legal Proceedings, and should be considered an integral part of the consolidated financial statements and related notes.

Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

         The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes, and the other financial information included in this Quarterly Report on Form 10-Q. This

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discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of specified factors, including those set forth in the section below entitled “Factors That May Impact Future Results of Operations” and elsewhere in this Quarterly Report on Form 10-Q.

Overview

         We generate revenue from the sale of software licenses, maintenance and support contracts, and professional consulting and contract development services. We generally provide technical advisory services after the delivery of our products to help customers exploit the full value and functionality of our products. Revenue from the sale of software licenses under agreements with technical advisory services is recognized over the period the technical advisory services are performed if all other criteria for recognition of revenue are met. These periods of technical advisory services generally range from 12 to 24 months, as determined by each customer’s objectives. Deferred revenue consists principally of the unrecognized portion of amounts received under license and maintenance service agreements. Deferred license revenue is recognized ratably over the technical advisory period (if applicable), or on a percentage of completion basis, or when all criteria for recognition of revenue are met based on the contract terms. Revenue from contracts without technical advisory services is recognized when all other criteria for recognition of revenue are met. Deferred maintenance revenue is recognized ratably over the term of the service agreement.

         Customers who license our software generally purchase maintenance contracts, typically covering renewable annual periods. In addition, customers may purchase consulting services, which are customarily billed at a fixed daily rate plus out-of-pocket expenses.

         Contract development services, including new product development services, are typically performed for a fixed fee. We also offer training services that are billed on a per student or per class session basis.

         The growth of our customer base is primarily attributable to our increased market penetration and our expanding product offering. Our investments in research and development, and recent acquisitions and alliances have helped us bring new software solutions to market. These investments produced a suite of decision support solutions in 1997; the retooling of our applications for the web in 1998; the delivery of Internet-enabled business-to-business collaborative planning, critical path and product design solutions in 1999; several additional collaborative offerings available for delivery through public marketplaces, private exchanges and Retek’s own hosted service through 2000 and message-based integration in 2001 that enables near real time visibility to inventory and sales, reduced application complexity, maintenance and upgrade overhead, and rapid deployment of new modules. To support our growth during these periods, we also continued to invest in internal infrastructure by hiring employees across various departments.

         We market our software solutions worldwide through direct and indirect sales channels. Indirect sales channels represent sales contracted by other entities on our behalf. Revenue generated from our direct sales channel accounted for approximately 97% and 98% of total revenue for the three and nine-month periods ended September 30, 2002, compared to 99% and 97% for the corresponding prior year periods.

         Revenue attributable to customers outside of North America accounted for approximately 33% and 34% of total revenue for the three and nine-month periods ended September 30, 2002, compared to 43% and 36% for the corresponding prior year periods, respectively. Approximately 22% and 24% of our sales were denominated in currencies other than the U.S. dollar for the three and nine-month periods ended September 30, 2002, compared to 39% and 32% for the corresponding prior year periods.

Acquisitions and Strategic Relationships

         On March 31, 2002, we acquired the intellectual property of Chelsea Market Systems, LLC (“Chelsea”) and certain other assets and liabilities for a net cash purchase price of $8.9 million, of which $8.9 million has been allocated to purchased software, an intangible asset. This purchased software is stated at the lower of cost or net realizable value and is being amortized using the straight-line method over 36 months.

         On May 16, 2001, we established a strategic relationship with Accenture LLP (“Accenture”) pursuant to which Accenture became a development partner for our predictive applications. In connection with entering into this relationship, we issued 976 shares of our common stock valued at $30.2 million to Proquire LLC (“Proquire”), an affiliate of Accenture, in exchange for the license from Proquire to us of certain intellectual property that will enable us to enhance our suite of retail-specific software. The common stock issued to Proquire was valued at the average closing price of our common stock for the two days before, the day of, and the two days following the announcement of the Accenture arrangement, or $33.69 per share.

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         The agreement with Accenture also requires us to issue to Accenture warrants to purchase our common stock upon our achievement of certain revenue milestones in fiscal years 2002, 2003, 2004, and 2005. The maximum number of warrants to be issued in each fiscal year is limited to 2% of the number of shares of our common stock then outstanding. For any amounts earned by Accenture in excess of 2% of our common stock then outstanding, we may elect to pay in cash, rather than issue additional warrants. To date no warrants have been issued and no amounts have been paid to Accenture under this agreement.

         On April 2, 2001, we signed a stock purchase agreement, a warrant agreement, and a software development and distribution agreement with Henderson Ventures, Inc. (“Henderson”), a retail enterprise solution developer. In connection with these agreements, we issued a warrant to purchase 750 shares of our common stock in exchange for an ownership interest of approximately 7.7% of the outstanding common stock of Henderson and a distribution agreement to resell the developed software. Under the software development and distribution agreement, we will pay royalties to Henderson for any software sold by us that we developed in conjunction with Henderson.

         The warrant issued to Henderson is fully vested with a term of five years and is exercisable at $18.625 per share. The fair value of the warrant of $12.1 million was calculated using the Black-Scholes valuation model using the following assumptions: dividend yield of 0%, risk-free interest rate of 5.83%, contractual life of five years and a volatility of 137.27%. We evaluate the recoverability of our intangible assets for potential impairment when events or changes in circumstances warrant. Because our relationship with Henderson has not generated software sales for us to-date, the increasing uncertainty about retailers’ future capital investments and other factors, we determined that an evaluation of the recoverability of the intangible asset related to Henderson was appropriate. As a result of information obtained subsequent to the quarter ended September 30, 2002, we determined that no significant future cash flows are probable from our relationship with Henderson and the net book value of the intangible asset related to the software development and distribution agreement of $8.7 million was impaired and was written off as of September 30,2002. In addition, we concluded that our cost method investment in Henderson of $0.4 million was impaired and was also written off as of September 30,2002. The aggregate write-off of $9.1 million is a non-cash expense and is reflected as a component of general and administrative expense for the three and nine months ended September 30, 2002.

         On September 5, 2000, we entered into a strategic relationship with International Business Machines Corporation (“IBM”). Pursuant to this relationship, Retek and IBM agreed to jointly market, sell, and service a comprehensive retail e-business solution consisting of Retek applications and IBM software and hardware technologies. The Stock Purchase Agreement also requires us to issue shares of our common stock to IBM upon reaching certain revenue targets related to our software applications sold under the joint marketing and selling arrangements through 2003. The Stock Purchase Agreement obligates us to pay IBM $10 million and $15 million related to 2002 and 2003, respectively, in shares of our common stock if annual revenue targets, as stated in the Stock Purchase Agreement, are met. The Stock Purchase Agreement provides for increases or decreases of the amounts to be paid to IBM in the event these revenue targets are exceeded or are partially met. To date, no amounts have been paid to IBM under this agreement.

Critical Accounting Policies and Estimates

         For discussion on critical accounting policies and estimates, see our Annual Report on Form 10-K for the fiscal year ended December 31, 2001.

Results of Operations

         The following table presents selected financial data for the periods indicated as a percentage of our total revenue. Our historical reporting results are not necessarily indicative of the results to be expected for any future period.

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Three Months and Nine Months ended September 30, 2002 and 2001

Revenue

         Total Revenue. Total revenue decreased 15% to $40.5 million for the three months ended September 30, 2002, from $47.5 million for the corresponding prior year period.

         Total revenue increased 21% to $154.8 million for the nine months ended September 30, 2002, from $128.2 million for the corresponding prior year period.

         License and maintenance revenue. License and maintenance decreased 29% to $24.8 million for the three months ended September 30, 2002, from $35.1 million for the corresponding prior year period. This decrease in license and maintenance revenue is primarily due to a decrease in the number of deals signed as a result of the lengthening of sales cycles and the delaying of investing decisions by retailers. License and maintenance revenue increased 21% to $112.2 million for the nine months ended September 30, 2002, from $92.9 million for the corresponding prior year period. The increase in license and maintenance revenue was primarily due to sales to new customers, and additional sales to existing customers through the first six months of 2002 as well as the introduction of new products.

         Services and other revenue. Services and other revenue increased 26% and 21% to $15.7 million and $42.5 million for the three and nine-month periods ended September 30, 2002, respectively, from $12.4 million and $35.2 million for the corresponding prior year periods. The increase in services and other revenue was due to our expanding customer base. Consulting revenues increased $4.0 and $8.1 million for the three and nine month periods ended September 30, 2002, respectively. During the third quarter of 2002, we continued to expand our consulting services business by increasing the number of personnel to 172 as of September 30, 2002 from 153 as of September 30, 2001.

         Non-Cash Charges. Non-cash charges included with cost of sales, research and development, sales and marketing and general and administrative are amortization of stock-based compensation and amortization of certain purchased intangible assets. Deferred stock-based compensation represents the difference between the exercise price and fair value of our common stock for accounting purposes on the date that certain stock options were granted. This amount is included as a component of stockholders’ equity and is being amortized on an accelerated basis by charges to operations over the vesting period of the options, consistent with the method described in Financial Accounting Standards Board Interpretation No. 28. Amortization of stock-based compensation was $0.8 million and $1.5 million for the three-month periods ended September 30, 2002 and 2001, respectively, and $2.4 million and $4.4 million for the nine month periods ended September 30, 2002 and 2001, respectively. Amortization of certain purchased intangible assets stems from our purchase of certain core technologies as a result of our acquisitions of WebTrak, Inc. and HighTouch Technologies, Inc., and the acquisition of substantially all of the assets of Chelsea. Amortization of certain purchased intangible assets is included in non-cash cost of license and maintenance revenues and was $1.1 million and $0.8 million for the three month periods ended September 30, 2002 and 2001, respectively, and $3.4 million and $2.5 million for the nine month periods ended September 30, 2002 and 2001, respectively.

         Cost of Revenue

         Cost of license and maintenance revenue. Cost of license and maintenance revenue consists primarily of fees for third party software products that are integrated into our products; third party license consultant costs; salaries and related expenses of our customer support organization; and an allocation of our facilities and depreciation expense. Cost of license and maintenance revenue decreased 11% to $10.1 million for the three months ended September 30, 2002, from $11.4 million for the corresponding prior year period. The decrease in cost of license and maintenance revenue was primarily due to a $1.6 million decrease in third-party consultant costs. In addition, there was a $1.7 million decrease due to the asset impairment charges related to the move to our new corporate facilities in the prior year. These decreases were offset by an increase in

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personnel and related costs, primarily due to the increased custom software development projects. Cost of license and maintenance revenue increased 12% to $32.4 million for the nine months ended September 30, 2002, from $28.9 million for the corresponding prior year period. Personnel and related costs increased $4.7 million for the nine-month period ended September 30, 2002, due to the increase in custom software development projects. This increase was offset by a $1.7 million decrease in third party consulting as we utilized more internal resources and a $1.7 million decrease due to the asset impairment charges related to our move to our new corporate facilities in prior year. We expect the cost of license and maintenance revenue to continue to increase in absolute dollars as license and maintenance revenue increases and as we continue to increase custom software development projects.

         Cost of services and other revenue. Cost of services and other revenue includes salaries and related expenses of our consulting organization; costs of third parties contracted to provide consulting services to our customers; and an allocation of facilities and depreciation expense. Cost of services and other revenue increased 24% and 17% to $11.7 million and $31.3 million for the three and nine-month periods ended September 30, 2002, respectively, from $9.4 million and $26.8 million for the corresponding prior year periods. The increase in cost of services and other revenue for the three-month period ended September 30, 2002 was due to a $3.3 million increase in personnel and related costs, which was partially offset by a $1.1 million decrease in consulting expenses. The increase for the nine-month period ended September 30, 2002 was due to a $5.6 million increase in personnel related costs, which was partially offset by a $0.7 million decrease in consulting expenses. For both the three and nine month periods ended September 30, 2002, we continued to expand our employee base and utilized fewer third party consultants. As a percentage of services and other revenue, cost of services and other revenue was 75% and 76% for the three-month periods ended September 30, 2002 and 2001, respectively, and 74% and 76% for the nine month periods ended September 30, 2002 and 2001, respectively. The increase in margins for the three and nine months ended September 30, 2002, was due to the continued expansion of our service organization and an increase in higher margin consulting services being completed by our personnel versus third party consultants.

         Operating Expenses

         Research and development. Research and development expenses, which are expensed as incurred, consist primarily of salaries and related costs of our engineering organization; fees paid to third-party consultants; and an allocation of facilities and depreciation expenses. Research and development expenses decreased $0.2 million to $10.7 million for the three months ended September 30, 2002, from $10.9 million for the corresponding prior year period. For the nine months ended September 30, 2002, research and development expenses increased 18% to $37.0 million from $31.3 million for the corresponding prior year period. Research and development costs increased for the nine months ended September 30, 2002 due to a $3.2 million increase in third party consulting expenses and a $1.8 million increase in personnel related costs. The increase in third party consulting costs and personnel related costs were due to expenses incurred to support the development and introduction of Retek 10, along with later capability enhancements. In addition, occupancy charges were higher for the nine months ended September 30, 2002, due to the move to our new corporate facilities. We believe that research and development expenditures are essential to maintaining our competitive position and we expect these costs to continue to constitute a significant percentage of our revenues.

         Sales and marketing. Sales and marketing expenses consist primarily of salaries and related costs of the sales and marketing organization; sales commissions; costs of marketing programs, including public relations, advertising, trade shows and sales collateral; and an allocation of facilities and depreciation expenses. Sales and marketing expenses decreased 9% to $13.1 million for the three months ended September 30, 2002, from $14.3 million for the corresponding prior year period. The decrease in sales and marketing expense for the three months ended September 30, 2002, was primarily due to a decrease in personnel related costs as fewer bonuses and commissions were paid. This decrease was partially offset by an increase in expenses related to the expansion of our sales presence in several international locations including Korea, Hong Kong and Japan. For the nine months ended September 30, 2002, sales and marketing increased 4% to $40.9 million from $39.4 million for the corresponding prior year period. The increase in sales and marketing expense for the nine months ended September 30, 2002, was primarily due to increased facilities and occupancy costs associated with the move to our new corporate facilities and the expansion of our international sales presence in Korea, Hong Kong and Japan. These increases were partially offset by a decrease in personnel related costs.

         General and administrative. General and administrative expenses consist primarily of costs from our finance and human resources organizations; legal and other professional service fees; and an allocation of facilities costs and depreciation expenses. General and administrative expenses increased 24% and 23% to $12.6 million and $20.6 million for the three and nine-month periods ended September 30, 2002, respectively, from $10.2 million and $16.8 million for the corresponding prior year periods. This increase is primarily due to the $9.1 million asset impairment charge for assets related to Henderson. As of September 30, 2002 we wrote off $8.7 million in intangible assets for our software development and distribution rights with Henderson as well as our $0.4 million cost method investment in Henderson. This increase was partially offset by the $6.5 million impairment and lease termination charge that was recorded during the third quarter of 2001.

         Acquisition-related amortization of intangibles. Acquisition-related amortization of intangibles decreased to $2.9 million for the three month period ended September 30, 2002, from $3.5 million for the corresponding prior year period. The decrease is attributable

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to our adoption of FAS 142, which requires goodwill and intangible assets with indefinite lives are no longer amortized but reviewed at least annually for impairment. Acquisition-related amortization of intangibles increased to $7.4 million for the nine-month period ending September 30, 2002, from $7.3 million for the corresponding prior year period. The increase was primarily due to the increase in intangible assets created from our purchase of substantially all the assets of Chelsea, which was partially offset by our adoption of FAS 142.

         Other income, net. Other income, net was $0.6 and $1.8 million for the three and nine-month periods ended September 30, 2002, respectively, compared to $0.6 and $1.1 million for the corresponding prior year periods. The increase for the nine-month period was primarily due to the interest earned on our higher average cash, cash equivalents and investment balances.

         Income tax provision (benefit). The income tax provision was $75.0 and $78.0 million for the three and nine month periods ended September 30, 2002, respectively, compared to a $4.8 and $6.3 million benefit for the corresponding prior year periods. As of September 30, 2002, we determined that it was appropriate to record a full valuation allowance for our deferred tax assets. The establishment of a full deferred tax valuation allowance was determined to be appropriate in light of the magnitude of the revenue decreases in the third quarter of 2002, our operating losses for the three and nine months ended September 30, 2002, our expectation of a significant loss for the full year 2002 and the added uncertainty of the market in which we operate. This full valuation allowance resulted in an increase to the income tax provision of $74.9 million. Despite the full valuation allowance, the income tax benefits related to these deferred tax assets will remain available to offset future taxable income. We expect to record a full valuation allowance on future tax benefits until we can sustain an appropriate level of profitability and until such time, we would not expect to recognize any significant tax benefits in our future results of operations.

         Prior to the quarter ended September 30, 2002, tax amounts are based upon management’s estimates of the effective tax rates to be incurred by us during those respective full fiscal years.

Liquidity and Capital Resources

         At September 30, 2002, our balance of cash, cash equivalents, and investments was $88.0 million.

         Net cash provided by operating activities was $2.5 million for the nine-month period ended September 30, 2002, compared to $17.9 million for the corresponding prior year period. Cash provided by operating activities for the nine-month period ended September 30, 2002 was due to operating cash flow adjustments for depreciation and amortization expense, deferred income taxes, asset impairment and amortization of stock based compensation. Cash used in operating activities resulted primarily from the net loss for the nine-month period ended September 30, 2002 along with a decrease in deferred revenue.

         Net cash used in investing activities was $16.7 million for the nine month period ended September 30, 2002, compared to $3.1 million used in investing activities for the corresponding prior year period. Cash used in investing activities for the nine-months ended September 30, 2002 was for asset acquisitions, acquisitions of property and equipment and net purchases of investments for sale. The increase in purchases of investments was due to our investing cash in higher yielding investments. We purchased investments designed to protect our capital investment. We purchase primarily short-term investments that have low risk of capital loss, such as US government securities, major corporation commercial paper, money market securities and tax exempt municipal securities.

         Net cash provided by financing activities was $11.7 million for the nine-month period ended September 30, 2002, compared to $17.5 million for the corresponding prior year period. The significant items that affected our net cash provided by financing activities for the nine months ended September 30, 2002 were net proceeds from the exercise of stock options and proceeds from the sale of shares through our Employee Stock Purchase Program.

         We believe that our current cash, cash equivalents, investments and net cash provided by operating activities, will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. One of the major components of our positive operating cash flow is our collection on receivables from our customers. Operating cash flows would be negatively impacted if we were unable to sign new customer contracts or if a significant number of customers were unable to pay for our solutions and services. Consumer spending, consumer confidence and other economic measures in the U.S. economy impact our customer base in the retail industry and negative trends in these measures may impact the amount and type of capital expenditures made by them.

         Management intends to invest our cash in excess of current operating requirements in short-term, interest-bearing, investment-grade securities.

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         A portion of our cash could also be used to acquire or invest in complementary businesses or products or otherwise to obtain the right to use complementary technologies or data. We regularly evaluate, in the ordinary course of business, potential acquisitions of such businesses, products, technologies or data.

Accounting Pronouncements

         In June 2002, the FASB issued SFAS No. 146, “Accounting for Exit or Disposal Activities”. SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for under EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The scope of SFAS 146 also includes costs related to terminating a contract that is not a capital lease and termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002 but early application is encouraged. The provisions of EITF No. 94-3 shall continue to apply for an exit activity initiated under an exit plan that met the criteria of EITF No. 94-3 prior to the adoption of SFAS 146. Adopting the provisions of SFAS 146 will change, on a prospective basis, the timing of when restructuring charges are recorded from a commitment date approach to when the liability is incurred.

Factors That May Impact Future Results of Operations

         An investment in our common stock involves a high degree of risk. Investors evaluating us and our business should carefully consider the factors described below and all other information contained in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended December 31, 2001, before purchasing our common stock. Any of the following factors could materially harm our business, operating results and financial condition. Additional factors and uncertainties not currently known to us or that we currently consider immaterial could also harm our business, operating results and financial condition. Investors could lose all or part of their investment as a result of these factors.

IF WE DO NOT RESPOND ADEQUATELY TO OUR INDUSTRY’S RAPID PACE OF CHANGE, SALES OF OUR PRODUCTS MAY DECLINE.

         If we are unable to develop new software solutions or enhancements to our existing products on a timely and cost-effective basis, or if new products or enhancements do not achieve market acceptance, our sales may decline. The life cycles of our products are difficult to predict because the market for our products is characterized by rapid technological change and changing customer needs. The introduction of products employing new technologies could render our existing products or services obsolete and unmarketable.

         In developing new products and services, we may:

	•		fail to respond to technological changes in a timely or cost-effective manner;
	•		encounter products, capabilities or technologies developed by others that render our products and services obsolete or noncompetitive or that shorten the life cycles of our existing products and services;
	•		experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products and services; or
	•		fail to achieve market acceptance of our products and services.

FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS COULD CAUSE OUR STOCK PRICE TO DECLINE.

         Our quarterly operating results have fluctuated in the past and are expected to continue to fluctuate in the future. If our quarterly operating results fail to meet analysts’ expectations, the trading price of our common stock could decline. In addition, significant fluctuations in our quarterly operating results may harm our business operations by making it difficult to implement our budget and business plan. Factors, many of which are outside of our control, which could cause our operating results to fluctuate include:

•

the size and timing of customer orders, which can be affected by customer budgeting and purchasing cycles;

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	•		the demand for and market acceptance of our software solutions;
	•		competitors’ announcements or introductions of new software solutions, services or technological innovations;
	•		our ability to develop, introduce and market new products on a timely basis;
	•		customer deferral of material orders in anticipation of new releases or new product introductions;
	•		our success in expanding our sales and marketing programs;
	•		technological changes or problems in computer systems; and
	•		general economic conditions which may affect our customers’ capital investment levels.

         Additionally, our reporting period operating results would be impacted if our customers did not purchase technical advisory support with our software solutions. Since we sell solutions with technical advisory support, revenues are recognized ratably over the advisory period, if all other revenue recognition criteria are met. Without the advisory services, revenues would be recognized when we execute the license agreement or contract; deliver the software; determine that collections of the proceeds is probable; and VSOE exists to allocate revenue to undelivered elements of the arrangement. Using these criteria, rather than our current revenue recognition policy with advisory services, could materially impact period over period results in our consolidated financial statements.

         We have incurred, and will continue to incur, compensation expense in connection with our grants of options under our 1999 Equity Incentive Plan, our HighTouch Technologies, Inc. 1999 Stock Option Plan and our 1999 Directors Stock Option Plan. This expense will be amortized over the vesting period of these granted options, which is generally four years, resulting in lower quarterly income.

         Our quarterly expense levels are relatively fixed and are based, in part, on expectations as to future revenue. As a result, if revenue levels fall below our expectations, net income will decrease because only a small portion of our expenses varies with our revenue.

COMPETITIVE PRESSURES COULD REDUCE OUR MARKET SHARE OR REQUIRE US TO REDUCE OUR PRICES, WHICH WOULD REDUCE OUR REVENUE AND/OR OPERATING MARGINS.

         The market for our software solutions is highly competitive and subject to rapidly changing technology. Competition could seriously impede our ability to sell additional products and services on terms favorable to us. Competitive pressures could reduce our market share or require us to reduce prices, which would reduce our revenues and/or operating margins. Many of our competitors have substantially greater financial, marketing, development or other resources, and greater name recognition than us. In addition, these companies may adopt aggressive pricing policies that could compel us to reduce the prices of our products and services in response. Our competitors may also be able to respond more quickly than we can to new or emerging technologies and changes in customer requirements. Our current and potential competitors may:

	•		develop and market new technologies that render our existing or future products obsolete, unmarketable or less competitive;
	•		make strategic acquisitions or establish cooperative relationships among themselves or with other solution providers, which would increase the ability of their products to address the needs of our customers; and
	•		establish or strengthen cooperative relationships with our current or future strategic partners, which would limit our ability to sell products through these channels.

         As a result, we may not be able to maintain a competitive position against current or future competitors.

IN THE FOURTH QUARTER 2002, WE WILL RECORD RESTRUCTURING CHARGES AND ENACT CERTAIN COST REDUCTION MEASURES IN RESPONSE TO THE DOWNTURN IN OUR FINANCIAL RESULTS. IF OUR RESTRUCTURING PLANS AND OUR COST REDUCTION MEASURES FAIL TO ACHIEVE THE DESIRED RESULTS OR RESULT IN UNANTICIPATED NEGATIVE CONSEQUENCES, WE MAY SUFFER MATERIAL HARM TO OUR BUSINESS.

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         In response to the downturn in our financial performance, we are implementing restructuring plans and cost reduction measures to reduce our cost structure, which will include workforce and facilities reductions. These activities are inherently distracting to an organization and pose significant risks. Our cost reduction measures may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce, reduced employee morale and decreased productivity, and may result in incidental employment related litigation. The workforce reductions will impact employees directly responsible for sales and research and development, which may affect our ability to close revenue transactions with our customers and prospects as well as finish or delay development efforts on a timely basis. Further, sales force reductions will require an increase in sales resource productivity in order for us to achieve revenue projections. The failure to retain and effectively manage our remaining employees could increase our costs, hurt our development efforts and impact the quality of our customer service and products. Failure to achieve the desired results of our strategic initiatives or sufficiently reduce our workforce would harm our business, results of operations and financial condition.

IF WE LOSE KEY PERSONNEL OR ARE UNABLE TO ATTRACT AND RETAIN ADDITIONAL PERSONNEL, OUR ABILITY TO GROW OUR BUSINESS COULD BE HARMED.

         We believe that our future success will depend upon our ability to attract and retain highly skilled personnel, including Steven D. Ladwig, our chief executive officer and president; John L. Goedert, our chief operating officer, and Gregory A. Effertz, our vice president, finance and administration and chief financial officer. We currently do not have any key-man life insurance relating to key personnel, who are employees at-will and are not subject to employment contracts. The loss of the services of any one or more of these key persons could harm our ability to grow our business.

         We also must attract, integrate and retain skilled sales, research and development, marketing and management personnel. Competition for these types of employees is intense, particularly in our industry. Failure to hire and retain qualified personnel would harm our ability to grow the business.

         The recent trading levels of our stock have decreased the value of our stock options granted to employees under our stock option plans. As a result of these factors, our remaining personnel may seek alternate employment, such as with larger, more established companies or companies that they perceive as having less volatile stock prices. Continuity of personnel can be a very important factor in sales and implementation of our software and completion of our product development efforts. Attrition beyond our planned reduction in workforce could have a material adverse effect on our business, operating results, financial condition and cash flows.

IF WE FAIL TO ESTABLISH, MAINTAIN AND EXPAND OUR RELATIONSHIPS WITH THIRD PARTIES WHO IMPLEMENT OUR PRODUCTS, OUR ABILITY TO MEET OUR CUSTOMERS’ NEEDS COULD BE HARMED.

         We rely, and expect to continue to rely, on a number of third parties to implement our software solutions at customer sites. If we are unable to establish and maintain effective, long-term relationships with these implementation providers, or if these providers do not meet the needs or expectations of our customers, our revenue will be reduced and our customer relationships will be harmed. Our current implementation partners are not contractually required to continue to help implement our software solutions. If the number of product implementations continues to increase, we will need to develop new relationships with additional third-party implementation providers to provide these services.

         We may be unable to establish or maintain relationships with third parties having sufficient qualified personnel resources to provide the necessary implementation services to support our needs. If third-party services are unavailable, we will be required to provide these services internally, which would significantly limit our ability to meet customers’ implementation needs and would increase our operating expenses and could reduce gross margins. A number of our competitors have significantly more established relationships with these third parties and, as a result, these third parties may be more likely to recommend competitors’ products and services rather than our own. In addition, we cannot control the level and quality of service provided by our current and future implementation partners.

IF WE FAIL TO OBTAIN ACCESS TO THE INTELLECTUAL PROPERTY OF THIRD PARTIES, OUR BUSINESS AND OPERATING RESULTS COULD BE HARMED.

         We must now, and may in the future have to, license or otherwise obtain access to the intellectual property of third parties, including HNC Software, MicroStrategy, SeeBeyond IBM and Oracle. Our business would be seriously harmed if the providers from whom we license such software cease to deliver and support reliable products or enhance their current products. In addition, the third-party software may not continue to be available to us on commercially reasonable terms or prices or at all. Our inability to maintain or

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obtain this software could result in shipment delays or reduced sales of our products. Furthermore, we might be forced to limit the features available in our current or future product offerings. Either alternative could seriously harm business and operating results.

IF OUR INTELLECTUAL PROPERTY IS NOT ADEQUATELY PROTECTED, OUR COMPETITORS MAY GAIN ACCESS TO OUR TECHNOLOGY AND WE MAY LOSE CUSTOMERS.

         We depend on our ability to develop and maintain the proprietary aspects of our technology. To protect proprietary technology, we rely primarily on a combination of contractual provisions, confidentiality procedures, trade secrets, and copyright and trademark laws.

         We seek to protect our software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection.

         Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult and expensive, and while we are unable to determine the extent to which piracy of our software products exists, software piracy may be a problem. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. We intend to vigorously protect intellectual property rights through litigation and other means. However, such litigation can be costly to prosecute and we cannot be certain that we will be able to enforce our rights or prevent other parties from developing similar technology, duplicating our products or designing around our intellectual property.

IF, IN THE FUTURE, THIRD PARTIES CLAIM THAT OUR PRODUCTS INFRINGE ON THEIR INTELLECTUAL PROPERTY, WE MAY INCUR SIGNIFICANT COSTS.

         There has been a substantial amount of litigation in the software industry and the Internet industry regarding intellectual property rights. It is possible that in the future third parties may claim that our current or potential future products infringe their intellectual property. We expect that software product developers and providers of electronic commerce solutions will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grow and the functionality of products in different industry segments overlap. Any 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. Royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could seriously harm our business.

OUR BUSINESS IS SUBJECT TO ECONOMIC, POLITICAL AND OTHER RISKS ASSOCIATED WITH INTERNATIONAL SALES.

         Since we sell products worldwide, our business is subject to risks associated with doing business internationally. To the extent that our sales are denominated in foreign currencies, the revenue we receive could be subject to fluctuations in currency exchange rates. If the effective price of the products we sell to our customers were to increase due to fluctuations in foreign currency exchange rates, demand for our technology could fall, which would, in turn, reduce our revenue. We have not historically attempted to mitigate the effect that currency fluctuations may have on our revenue through use of hedging instruments, and we do not currently intend to do so in the future.

         We anticipate that revenue from international operations will continue to represent a substantial portion of our total revenue. Accordingly, our future results could be harmed by a variety of factors, including:

	•		changes in foreign currency exchange rates;
	•		greater risk of uncollectable accounts;
	•		changes in a specific country’s or region’s political, legal or economic conditions, particularly in emerging markets;
	•		trade protection measures and import or export licensing requirements;
	•		potentially negative consequences from changes in tax laws;
	•		difficulty in staffing and managing widespread operations;

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	•		international variations in technology standards;
	•		differing levels of protection of intellectual property; and
	•		unexpected changes in regulatory requirements.

ERRORS AND DEFECTS IN OUR PRODUCTS COULD RESULT IN SIGNIFICANT COSTS TO US AND COULD IMPAIR OUR ABILITY TO SELL OUR PRODUCTS.

         Our products are complex and, accordingly, may contain undetected errors or failures when we first introduce them or as we release new versions. This may result in loss of, or delay in, market acceptance of our products and could cause us to incur significant costs to correct errors or failures or to pay damages suffered by customers as a result of such errors or failures. In the past, we have discovered software errors in new releases and new products after their introduction. We have incurred costs during the period required to correct these errors, although to date such costs, including costs incurred on specific contracts, have not been material. We may in the future discover errors in new releases or new products after the commencement of commercial shipments.

INCREASED OPERATING EXPENSES MAY IMPACT OUR PROFITABILITY.

         We may increase operating expenses as we:

	•		increase research and development activities;
	•		increase services activities;
	•		expand our distribution channels;
	•		increase sales and marketing activities, including expanding our direct sales force; and
	•		build our internal information technology system.

         We may incur expenses before we generate any revenue from an increase in spending. If we do not significantly increase revenue from these efforts, our business and operating results could be seriously harmed.

WE HAVE BEEN NAMED A DEFENDANT IN SECURITIES CLASS-ACTION LITIGATION AND WE MAY IN THE FUTURE BE NAMED IN ADDITIONAL LITIGATION, WHICH MAY RESULT IN SUBSTANTIAL COSTS AND DIVERT MANAGEMENT’S ATTENTION AND RESOURCES.

         As described in Part II — Item 1: Legal Proceedings below, a number of shareholder class action suits have been filed naming the Company and certain of our officers and directors as co-defendants. We intend to defend against these claims vigorously. We have just commenced our review of some of these complaints and can not yet determine the total expense or possible loss, if any, that may result from this litigation. Such litigation could result in substantial costs and could divert management’s attention and resources.

         More generally, securities class-action litigation has often been brought against a company following declines in the market price of its securities. This risk is greater for technology companies, which have experienced greater-than-average stock price declines in recent years and, as a result, have been subject to, on average, a greater number of securities class action claims than companies in other industries. While we maintain director and officer insurance, the amount of insurance coverage may not be sufficient for any such claim and the continued availability of such insurance cannot be assured. We may in the future be the target of this kind of litigation and such litigation could also result in substantial costs and divert management’s attention and resources.

Item 3: Quantitative and Qualitative Disclosures About Market Risk

         The following discusses our exposure to market risk related to changes in interest rates, foreign currency exchange rates and equity prices.

Interest Rate Risk

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