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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
---------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003.
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE TRANSITION PERIOD FROM ________________ TO ________________
COMMISSION FILE NUMBER 1-10139
NETEGRITY, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 04-2911320
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
201 JONES ROAD
WALTHAM, MA 02451
(Address of principal executive offices) (Zip Code)
(781) 890-1700
(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such other shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
As of October 24, 2003 there were 34,729,656 shares of Common Stock outstanding,
exclusive of treasury stock.
QUARTERLY REPORT ON FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2003
TABLE OF CONTENTS
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002 (unaudited)....... 3
Consolidated Statements of Operations for the three months ended September 30, 2003 and
2002 (unaudited)............................................................................. 4
Consolidated Statements of Operations for the nine months ended September 30, 2003 and
2002 (unaudited)............................................................................. 5
Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and
2002 (unaudited)............................................................................. 6
Notes to Consolidated Financial Statements................................................... 7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........ 15
Item 3. Quantitative and Qualitative Disclosures About Market Risk................................... 30
Item 4. Controls and Procedures...................................................................... 30
PART II OTHER INFORMATION............................................................................ 32
Item 6. Exhibits and Reports on Form on 8-K.......................................................... 32
SIGNATURES ............................................................................................. 33
2
PART I. - FINANCIAL INFORMATION
NETEGRITY, INC.
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents ....................................... $ 10,005 $ 25,707
Available-for-sale securities ................................... 27,083 48,361
Accounts receivable--trade, net of allowances of $1,007 at
September 30, 2003 and $922 at December 31, 2002 ............... 11,240 15,046
Prepaid expenses and other current assets ....................... 2,501 2,949
Restricted cash ................................................. -- 281
------------- ------------
Total Current Assets .......................................... 50,829 92,344
Available-for-sale securities ................................... 55,986 12,655
Property and equipment, net ..................................... 5,380 6,837
Restricted cash ................................................. 768 790
Other intangible assets, net .................................... -- 5,398
Other assets .................................................... 336 338
------------- ------------
Total Assets .................................................. $ 113,299 $ 118,362
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable--trade ......................................... $ 2,430 $ 1,906
Accrued compensation and benefits ............................... 4,387 4,293
Other accrued expenses .......................................... 4,899 6,530
Deferred revenue ................................................ 16,585 14,875
------------- ------------
Total Current Liabilities ..................................... 28,301 27,604
------------- ------------
Commitments and Contingencies
STOCKHOLDERS' EQUITY:
Common stock, voting, $.01 par value; 135,000 shares authorized;
34,767 shares issued and 34,729 shares outstanding at September
30, 2003; 34,346 shares issued and 34,308 shares outstanding at
December 31, 2002 ............................................. 348 343
Additional paid-in capital ...................................... 198,364 197,250
Accumulated other comprehensive income (loss) ................... (43) 106
Accumulated deficit ............................................. (113,471) (106,741)
Loan to officer ................................................. (116) (116)
------------- ------------
85,082 90,842
Less--Treasury stock, at cost: 38 shares ........................ (84) (84)
------------- ------------
Total Stockholders' Equity ...................................... 84,998 90,758
------------- ------------
Total Liabilities and Stockholders' Equity ...................... $ 113,299 $ 118,362
============= ============
The accompanying notes are an integral part of the consolidated
financial statements.
3
NETEGRITY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE THREE MONTHS
ENDED SEPTEMBER 30,
---------------------
2003 2002
-------- --------
Revenues:
Software licenses ............................ $ 11,404 $ 6,457
Services ..................................... 8,144 7,885
Other ........................................ 849 836
-------- --------
Total revenues .............................. 20,397 15,178
-------- --------
Cost of Revenues:
Cost of software licenses .................... 483 715
Non-cash cost of software licenses ........... -- 917
Cost of services ............................. 2,791 3,272
Cost of other ................................ 567 517
-------- --------
Total cost of revenues ...................... 3,841 5,421
-------- --------
Gross profit .................................. 16,556 9,757
Selling, general and administrative expenses .. 10,857 13,262
Research and development expenses ............. 5,381 5,794
Impairment charge ............................. -- 57,374
-------- --------
Income (loss) from operations ................. 318 (66,673)
Other income, net ............................. 404 521
-------- --------
Income (loss) before provision for income taxes 722 (66,152)
Provision for income taxes .................... 63 --
-------- --------
Net income (loss) ............................. $ 659 $(66,152)
======== ========
Net income (loss) per share:
Basic ........................................ $ 0.02 $ (1.94)
Diluted ...................................... $ 0.02 $ (1.94)
Weighted average shares outstanding:
Basic ........................................ 34,621 34,180
Diluted ...................................... 38,006 34,180
The accompanying notes are an integral part of the consolidated
financial statements.
4
NETEGRITY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
---------------------
2003 2002
-------- --------
Revenues:
Software licenses ............................ $ 30,536 $ 27,743
Services ..................................... 23,274 22,957
Other ........................................ 2,130 2,257
-------- --------
Total revenues .............................. 55,940 52,957
-------- --------
Cost of Revenues:
Cost of software licenses .................... 1,350 1,680
Non-cash cost of software licenses ........... 5,398 2,750
Cost of services ............................. 8,539 10,704
Cost of other ................................ 1,319 1,359
-------- --------
Total cost of revenues ...................... 16,606 16,493
-------- --------
Gross profit .................................. 39,334 36,464
Selling, general and administrative expenses... 31,845 40,791
Research and development expenses ............. 15,292 18,330
Impairment charge ............................. -- 57,374
Restructuring charges ......................... -- 689
-------- --------
Loss from operations .......................... (7,803) (80,720)
Other income, net ............................. 1,195 1,900
-------- --------
Loss before provision for income taxes ........ (6,608) (78,820)
Provision for income taxes .................... 122 40
-------- --------
Net loss ...................................... $ (6,730) $(78,860)
======== ========
Net loss per share:
Basic and diluted ............................ $ (0.20) $ (2.32)
Weighted average shares outstanding:
Basic and diluted ............................ 34,453 34,020
The accompanying notes are an integral part of the consolidated
financial statements.
5
NETEGRITY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
------------------------
2003 2002
--------- ---------
OPERATING ACTIVITIES:
Net loss ...................................................... $ (6,730) $ (78,860)
Adjustments to reconcile net loss to net cash
provided by (used for) operating activities:
Depreciation, amortization and impairment .................... 8,767 63,640
Gain on sale of marketable securities ........................ (42) (4)
Other ........................................................ 509 154
Changes in operating assets and liabilities:
Accounts receivable - trade .................................. 3,806 4,894
Prepaid expenses and other current assets .................... 448 (380)
Other assets ................................................. 2 812
Accounts payable - trade ..................................... 524 200
Accrued compensation and benefits ............................ 94 (662)
Other accrued expenses ....................................... (1,631) (3,356)
Deferred revenue ............................................. 1,710 (617)
--------- ---------
Net cash provided by (used for) operating activities .......... 7,457 (14,179)
--------- ---------
INVESTING ACTIVITIES:
Proceeds from sales of marketable securities .................. 17,577 141,713
Proceeds from maturities of marketable securities ............. 19,921 6,665
Purchases of marketable securities ............................ (60,196) (144,253)
Purchases of property and equipment ........................... (1,912) (1,931)
Restricted cash ............................................... 303 (439)
--------- ---------
Net cash provided by (used for) investing activities .......... (24,307) 1,755
--------- ---------
FINANCING ACTIVITY:
Proceeds from issuance of common stock under stock plans ...... 1,119 564
--------- ---------
Net cash provided by financing activity ....................... 1,119 564
--------- ---------
Effect of exchange rate changes on cash and cash equivalents... 29 (26)
Net change in cash and cash equivalents ....................... (15,702) (11,886)
Cash and cash equivalents at beginning of period .............. 25,707 26,332
--------- ---------
Cash and cash equivalents at end of period .................... $ 10,005 $ 14,446
========= =========
The accompanying notes are an integral part of the consolidated
financial statements
6
NETEGRITY, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Basis of Presentation and Principles of Consolidation
The accompanying unaudited consolidated financial statements include the
accounts of Netegrity, Inc. and its wholly owned subsidiaries ("Netegrity", "we"
or "our") and have been prepared pursuant to the rules and regulations of the
Securities and Exchange Commission regarding interim financial reporting.
Accordingly, they do not include all of the information and notes required by
accounting principles generally accepted in the United States of America for
complete financial statements and should be read in conjunction with the audited
consolidated financial statements included in our Annual Report on Form 10-K/A
filed on March 6, 2003. The results of operations for the three and nine months
ended September 30, 2003 are not necessarily indicative of the results expected
for the remainder of the year ending December 31, 2003.
The consolidated financial statements of Netegrity include the accounts and
operations of our wholly owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation.
(b) Revenue Recognition
Our revenues are primarily generated from the sale of perpetual licenses
for our proprietary SiteMinder(R), IdentityMinder(TM) and TransactionMinder(R)
products and related services. We generate our services revenues from consulting
and training services performed for customers and from the maintenance and
support of our products. As described below, significant management judgments
and estimates must be made and used in connection with the revenues recognized
in any accounting period. Management analyzes various factors, including
specific transactions, historical experience, credit worthiness of customers and
current market and economic conditions. Changes in judgments based upon these
factors could impact the timing and amount of revenues and cost recognized.
We generally license our software products on a perpetual basis. We apply
the provisions of Statement of Position No. 97-2, "Software Revenue
Recognition," as amended by Statement of Position No. 98-9, "Software Revenue
Recognition, with Respect to Certain Transactions," to all transactions
involving the sale of software products. We recognize revenues from the sale of
software licenses when persuasive evidence of an arrangement exists, the product
has been delivered, the fees are fixed or determinable and collection of the
resulting receivable is reasonably assured. This policy is applicable to all
sales, including sales to resellers and end users. We do not offer a right of
return on our products.
For all sales, we use a signed license agreement and/or a purchase order
with binding terms and conditions as evidence of an arrangement. For
arrangements with multiple obligations (for example, software license,
undelivered maintenance and support, training and consulting), we allocate
revenues to each component of the arrangement using the residual value method
based on the fair value of the undelivered elements. We defer revenue from the
arrangement equivalent to the fair value of the undelivered elements. Fair value
for each component is either the price we charge when the same component is sold
separately or the price established by the members of our management who have
the relevant authority to set prices for an element not yet sold separately.
At the time of the transaction, we assess whether the fee associated with
the transaction is fixed or determinable based on the payment terms associated
with the transaction. If a significant portion of the fee is due after our
normal payment terms, which are generally 30 to 90 days from invoice date, we
account for the fee as not being fixed or determinable. In those cases, we
recognize revenues as the fees become due. In addition, we assess whether
collection is probable based on the credit worthiness of the customer. Initial
credit worthiness is assessed through Dun & Bradstreet or similar credit rating
agencies. Credit worthiness for follow-on transactions is assessed through a
review of the transaction history with the customer. We do not typically request
collateral from our customers. If we determine that collection of a fee is not
reasonably assured, we defer the fee and recognize revenues at the time
collection becomes reasonably assured, which is generally upon receipt of cash.
Installation by Netegrity is not considered essential to the functionality
of our products as these services do not alter the product capabilities, do not
require specialized skills and may be performed by the customer or other
vendors. Revenues for maintenance and support are recognized ratably over the
term of the support period. Revenues from consulting and training services
generally are recognized as the services are performed.
7
(c) Cash and Cash Equivalents and Restricted Cash
Cash and cash equivalents include cash, money market investments and other
highly liquid investments with original maturities of three months or less at
the date of purchase. Restricted cash represents time deposits held at financial
institutions in connection with the lease of our office space. As of September
30, 2003, restricted cash is security for an outstanding letter of credit which
expires in February 2004, but has an automatic renewal clause.
(d) Marketable Securities
Investments, which primarily consist of debt securities, are accounted for
under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting
for Certain Investments in Debt and Equity Securities" issued by the Financial
Accounting Standards Board (FASB). Pursuant to the provisions of SFAS No. 115,
we have classified our investment portfolio as "trading", "available-for-sale"
or "held to maturity". Trading securities are bought and held principally for
the purpose of selling them in the near term and are recorded at fair value.
Fair value is based upon quoted market prices. Unrealized gains and losses on
trading securities are included in the determination of net earnings.
Available-for-sale securities include debt securities that are being held for an
unspecified period of time and may be used for liquidity or other corporate
purposes and are recorded at fair value. Unrealized gains and losses on
available-for-sale securities are reported as a separate component of
comprehensive income (loss) in stockholders' equity. Held to maturity securities
are debt securities that we intend to hold to maturity and are recorded at
amortized cost.
As of September 30, 2003, based on management's intentions, all marketable
securities have been classified as available-for-sale. Net realized gains
(losses) from the sales and maturities of marketable securities amounting to $0
and $14,000 for the three months ended September 30, 2003 and 2002,
respectively, and $42,000 and $4,000 for the nine months ended September 30,
2003 and 2002, respectively, are included in other income, net in the
accompanying consolidated statements of operations. The unrealized holding gains
(losses) of $(1,000) and $178,000 have been included in accumulated other
comprehensive income (loss) in the consolidated financial statements as of
September 30, 2003 and December 31, 2002, respectively.
(e) Intangible Assets and Other Long-Lived Assets
We review the valuation of long-lived assets, including property and
equipment and capitalized software, under the provisions of SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets" and SFAS No.
86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or
Otherwise Marketed." We are required to assess the recoverability of long-lived
assets and purchased software on an interim basis whenever events and
circumstances indicate that the carrying value may not be recoverable. Factors
we consider important that could trigger an interim impairment review include
the following:
- significant underperformance relative to expected historical or
projected future operating results;
- significant changes in the manner of our use of the acquired assets or
the strategy of our overall business;
- significant negative industry or economic trends;
- significant decline in our stock price for a sustained period; and
- our market capitalization relative to net book value.
In accordance with SFAS No. 144, when we determine that the carrying value
of applicable long-lived assets may not be recoverable based upon the existence
of one or more of the above indicators of impairment, we evaluate whether the
carrying amount of the asset exceeds the sum of the undiscounted cash flows
expected to result from the use and eventual disposition of that asset. If such
a circumstance exists, we would measure an impairment loss to the extent the
carrying amount of the particular long-lived asset or group exceeds its fair
value. We would determine the fair value based on a projected discounted cash
flow method using a discount rate determined by our management to be
commensurate with the risk inherent in our current business model. In accordance
with SFAS No. 86, when we determine that the carrying value of certain other
types of long-lived assets may not be recoverable we evaluate whether the
unamortized cost exceeds the expected future net realizable value of the
products. If the unamortized costs exceed the expected future net realizable
value of the products, the excess amount is written off. Changes in judgments on
any of these factors could impact the value of the asset being evaluated.
8
Other intangible assets, net, at December 31, 2002, consisted of acquired
technology that resulted from the acquisition of DataChannel during 2001. We
account for these intangible assets in accordance with SFAS No. 86. During the
fourth quarter of 2002, we determined that there had been a change in the
estimated useful life of the acquired technology and, therefore, it was
appropriate that the acquired technology be amortized over a nine month period
starting at the beginning of the fourth quarter of 2002 (the period during which
the change in estimated life was identified). Prior to this change, the acquired
technology long-lived asset was being amortized on a straight line basis over
three years. As a result of this change, the acquired technology became fully
amortized on June 30, 2003, and as a result the quarterly amortization expense
related to the acquired technology decreased from approximately $917,000 in the
three months ended September 30, 2002 to $0 in the three months ended September
30, 2003. The amortization expense related to the acquired technology increased
from $2.8 million in the nine months ended September 30, 2002 to approximately
$5.4 million for the nine months ended September 30, 2003. This increase was the
result of the change in the estimated useful life.
(f) Comprehensive Income (Loss)
The components of comprehensive income (loss) are as follows:
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
---------------------- ----------------------
2003 2002 2003 2002
-------- -------- -------- --------
(IN THOUSANDS)
Net income (loss) .................................. $ 659 $(66,152) $ (6,730) $(78,860)
Net unrealized holding gain (loss) arising during
the period ......................................... (84) 35 (136) 28
Reclassification adjustment for net realized (gains)
losses included in net loss ........................ -- 14 (42) 4
-------- -------- -------- --------
(84) 49 (178) 32
Net unrealized foreign currency translation
adjustment arising during the period ............... 18 11 29 (26)
-------- -------- -------- --------
Comprehensive income (loss) ........................ $ 593 $(66,092) $ (6,879) $(78,854)
======== ======== ======== ========
The components of accumulated other comprehensive income (loss) as of
September 30, 2003 and December 31, 2002 are as follows:
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
(IN THOUSANDS)
Net unrealized holding gain (loss)....................... $ (1) $ 178
Net unrealized foreign currency translation adjustment... (42) (72)
------------- ------------
Accumulated other comprehensive income (loss)........... $ (43) $ 106
============= ============
(g) Net Earnings (Loss) Per Share
Basic net earnings (loss) per share (EPS) is calculated by dividing net
income (loss) by the weighted average number of shares of common stock
outstanding during the period. Diluted EPS is calculated by dividing net income
(loss) by the weighted average number of shares outstanding plus the dilutive
effect, if any, of the outstanding stock options and warrants using the
"treasury stock" method. During periods of net loss, diluted net loss per share
does not differ from basic net loss per share because potential shares of common
stock from stock options and warrants are anti-dilutive and therefore are
excluded from the calculation.
Outstanding options to purchase a total of approximately 222,000 and
394,000 shares of common stock for the three and nine months ended September 30,
2003, respectively, and a total of 6.3 million and 5.5 million shares of common
stock for the three and nine months ended September 30, 2002, respectively, were
excluded in the computation of diluted EPS because the effect on EPS was
anti-dilutive.
9
The reconciliation of the denominators of the basic and diluted net income
(loss) per share computations for the Company's reported net income (loss) is as
follows:
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- -------------------
2003 2002 2003 2002
-------- -------- -------- -------
(IN THOUSANDS)
Weighted average number of shares outstanding - basic ........... 34,621 34,180 34,453 34,020
Weighted average number of dilutive common stock equivalents
outstanding ..................................................... 3,385 -- -- --
-------- -------- -------- -------
Weighted average number of shares outstanding - diluted ......... 38,006 34,180 34,453 34,020
-------- -------- -------- -------
(h) Stock-Based Compensation
We account for our stock option plans under the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees, and
Related Interpretations." No stock-based compensation cost is reflected in net
income (loss) for these plans, as all options granted under these plans had an
exercise price equal to the market value of the underlying common stock on the
date of grant. The following table illustrates the effect on net income (loss)
and income (loss) per share if we had applied the fair value recognition
provisions of FASB Statement No. 123, "Accounting for Stock Based Compensation,"
to stock-based compensation (in thousands, except per share data):
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
(UNAUDITED) (UNAUDITED)
-------------------- ---------------------
2003 2002 2003 2002
-------- -------- -------- ---------
Net income (loss), as reported................................ $ 659 $(66,152) $ (6,730) $ (78,860)
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all
awards, net of related tax effects............................ (1,255) (7,623) (8,278) (83,139)
-------- -------- -------- ---------
Net income (loss), pro-forma.................................. $ (596) $(73,775) $(15,008) $(161,999)
======== ======== ======== =========
Income (loss) per share:
Basic -- as reported........................................ $ 0.02 $ (1.94) $ (0.20) $ (2.32)
Diluted -- as reported...................................... $ 0.02 $ (1.94) $ (0.20) $ (2.32)
Basic and diluted - pro-forma............................... $ (0.02) $ (2.16) $ (0.44) $ (4.76)
(i) Recent Accounting Pronouncements
In November 2002, the Emerging Issues Task Force (EITF) issued EITF No.
00-21, "Revenue Arrangements with Multiple Deliverables," which provides
guidance on the timing and method of revenue recognition for sales arrangements
that include the delivery of more than one product or service. EITF No. 00-21 is
effective prospectively for arrangements entered into in fiscal periods
beginning after June 15, 2003. The adoption of EITF No. 00-21 did not have a
significant impact on our consolidated financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure." SFAS No. 148 amends SFAS No. 123, to
provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. In
addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The transition guidance and
annual disclosure provisions of SFAS No. 148 are effective for fiscal years
ending after December 15, 2002. The interim disclosure provisions are effective
for financial reports containing financial statements for interim periods
beginning after December 15, 2002. As we did not make a voluntary change to the
fair value based method of accounting for stock-based employee compensation in
2002, the adoption of SFAS No. 148 did not have any impact on our financial
position and results of operations.
In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities," which clarifies the application
of Accounting Research Bulletin No. 51, "Consolidated Financial Statements,"
relating to consolidation of certain entities. First, FIN 46 will require
identification of the Company's participation in variable interest entities
("VIE"), which are defined
10
as entities with a level of invested equity that is not sufficient to fund
future activities to permit them to operate on a stand alone basis, or whose
equity holders lack certain characteristics of a controlling financial interest.
For entities identified as VIE, FIN 46 sets forth a model to evaluate potential
consolidation based on an assessment of which party to the VIE, if any, bears a
majority of the exposure to its expected losses, or stands to gain from a
majority of its expected returns. FIN 46 also sets forth certain disclosure
requirements regarding interests in VIE that are deemed significant, even if
consolidation is not required. For certain VIEs created before February 1, 2003,
FIN 46 applies to interim periods ending after December 15, 2003. The Company
believes the adoption of FIN 46 will not have any impact on its consolidated
financial position or results of operations.
In May 2003, the FASB issued SFAS 150, "Accounting For Certain Financial
Instruments with Characteristics of Both Liabilities and Equity" which
establishes standards for how an issuer of financial instruments classifies and
measures certain financial instruments with characteristics of both liabilities
and equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances) if, at
inception, the monetary value of the obligation is based solely or predominantly
on a fixed monetary amount known at inception, variations in something other
than the fair value of the issuer's equity shares or variations inversely
related to changes in the fair value of the issuer's equity shares. SFAS No. 150
was effective for financial instruments entered into or modified after May 31,
2003, and otherwise was effective at the beginning of the first interim period
beginning after June 15, 2003. The adoption of SFAS 150 did not have any impact
on our financial position or results of operations.
NOTE 2: TENDER OFFER
On August 23, 2002, we filed a tender offer statement with the Securities
and Exchange Commission in connection with certain stock options outstanding
under non-director stock plans (the "Offer to Exchange"). Under the Offer to
Exchange, we offered to exchange certain employee options to purchase shares of
our common stock for new options to purchase shares of our common stock. The
Offer to Exchange excluded directors and non-employees of Netegrity, expired on
September 23, 2002 and provided for the grant of new options on two different
dates. We granted 50% of the new options on March 25, 2003 and 50% of the new
options on April 25, 2003 to employees that were continuously and actively
employed from the date the employee tendered eligible options for exchange to
the date of the grant of the new options. The number of shares underlying the
new options was equal to the number of shares underlying the cancelled eligible
options, except that certain options granted to certain executive officers were
exchanged at a rate of one share underlying a new option for each two shares
underlying the tendered options. The exercise price per share of the new options
was equal to the fair market value of one share of common stock on the date of
grant of the new options as determined in accordance with the applicable option
plans. Each new option will vest in accordance with a schedule tied to the
length of time of an individual's employment with Netegrity.
On March 25, and April 25, 2003, we granted options to purchase an
aggregate of 2,155,910 and 2,138,604 shares, respectively, of our common stock
at fair market value in connection with the Offer to Exchange. In accordance
with FASB Interpretation No. 44, since the replacement options were granted more
than six months and one day after cancellation of the old options, the new
options were considered a fixed award and, therefore, did not result in any
compensation expense.
11
NOTE 3: OPERATING SEGMENTS AND GEOGRAPHICAL INFORMATION
Based on the information provided to our chief operating decision maker for
purposes of making decisions about allocating resources and assessing
performance, our continuing operations have been classified into a single
segment. We primarily operate in the United States, Europe and Asia Pacific.
Revenues (based on the location of the customer) and long-lived assets by
geographic region are as follows (in thousands):
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
------------------- -------------------
2003 2002 2003 2002
------- ------- ------- -------
Revenues:
United States of America $15,432 $11,729 $42,676 $42,022
Europe ................. 3,887 2,403 8,613 7,851
Asia Pacific ........... 893 861 4,258 2,242
Other .................. 185 185 393 842
------- ------- ------- -------
Total .................. $20,397 $15,178 $55,940 $52,957
======= ======= ======= =======
AS OF SEPTEMBER 30,
-------------------
2003 2002
------- -------
Long-Lived Assets:
United States of America... $ 5,883 $15,586
Europe..................... 269 400
Asia Pacific............... 328 429
Other...................... 4 2
------- -------
Total...................... $ 6,484 $16,417
======= =======
NOTE 4: RELATED PARTY TRANSACTIONS
LOAN TO OFFICER
The consolidated balance sheets as of September 30, 2003 and December 31,
2002 include a $116,000 loan to an officer of Netegrity issued in connection
with the exercise of stock options in 1996. The loan is reflected as a reduction
of stockholders' equity in the accompanying consolidated balance sheets. The
loan is payable upon demand and bears interest at 7% per annum. The loan was
originally represented by a secured note; however, in May 2002, the note was
amended such that it became a full recourse unsecured note.
MARKETING SERVICES
During the three and nine months ended September 30, 2003 we paid
approximately $32,000 and $74,000, respectively, and during the three and nine
months ended September 30, 2002 we paid approximately $16,000 and $79,000,
respectively, to a company for marketing services. The principal shareholder of
such company is the son-in-law of one of the members of our Board of Directors.
We have similar arrangements with other marketing services firms and believe the
arrangement was entered into on substantially the same terms and conditions as
our arrangements with such other firms.
12
NOTE 5: COMMITMENTS AND CONTINGENCIES
We have commitments that expire at various times through 2010. Operating
leases shown below are primarily for facility costs for our corporate
headquarters and worldwide sales offices. Other contractual obligations
primarily consist of minimum royalty fees payable by Netegrity in connection
with a software license and distribution agreement, which we entered into in
January 2003.
LESS
THAN 1 AFTER 5
TOTAL YEAR 1-3 YEARS 4-5 YEARS YEARS
------- ------- --------- --------- -------
(IN THOUSANDS)
Operating Leases ............... $10,087 $ 2,750 $ 3,449 $ 3,467 $ 421
Other Contractual Obligations .. 3,325 1,375 1,950 -- --
------- ------- -------- --------- -------
Total .......................... $13,412 $ 4,125 $ 5,399 $ 3,467 $ 421
======= ======= ======== ========= =======
Included in the operating lease commitments above is approximately $400,000
related to excess facilities which have been accrued in purchase accounting and
are payable through April 2004.
We incurred total operating lease expense, primarily related to certain
facilities and equipment under non-cancelable operating leases, of approximately
$1.0 million and $3.0 million for the three and nine months ended September 30,
2003, respectively.
In April 2002, we entered into an agreement with a system integrator to
assist us in the development and launch of one of our products. Under the terms
of the agreement, for consideration of the system integrator's time in assisting
with the development of the product, we agreed to promote the system integrator
as an integrator of the developed product. Our obligation under the agreement
will be considered satisfied once the system integrator receives consulting
revenues totaling approximately $3.9 million from our customers, or by April
2004, whichever occurs first. In the event that we recommend a competitor of the
system integrator to perform the integration work for a customer, we could
potentially owe a royalty to the system integrator based on the net license fee.
As of September 30, 2003, no royalties were due to the system integrator.
In August 2002, we entered into a five year non-cancelable operating lease
for an office building for our corporate headquarters. We moved into the new
facility in March 2003. In connection with the lease agreement, we delivered an
irrevocable, unconditional, negotiable letter of credit in the amount of
$800,000 as a security deposit. Additionally, we spent approximately $1.0
million in leasehold improvements to build out the new facility in the nine
months ended September 30, 2003.
In January 2003, we entered into a software license and distribution
agreement, as amended in March 2003, under which we were granted the right to
sublicense the use of a provisioning application software program. In addition,
we were granted certain rights to integrate or combine the software into our
existing products. In exchange for these rights, we have agreed to pay a
quarterly royalty fee based on a percentage of the net license fees we charge
our customers for the software. The minimum royalty fees due in the first,
second and third years of the agreement are approximately $1.0 million, $1.4
million and $1.6 million, respectively. The initial term of this agreement is
three years. After the first year of the agreement, we have the right to
terminate the agreement without cause. As of September 30, 2003, we became
obligated to pay $675,000 in royalties under this agreement, of which $450,000
had been paid and $225,000 was accrued.
We enter into standard indemnification agreements with our business
partners or customers in our ordinary course of business. Pursuant to these
agreements, we agree to repair or replace the product, pay royalties for a right
to use, or reimburse the indemnified party for actual damages awarded by a court
against the indemnified party for an intellectual property infringement claim by
a third party with respect to our products. The term of these indemnification
agreements is generally perpetual. The maximum potential amount of future
payments we could be required to make under these indemnification agreements is
unlimited. We have never incurred costs to defend lawsuits or settle claims
related to these indemnification agreements. As a result, we believe the
estimated fair value of these agreements is minimal. Accordingly, we have no
liabilities recorded for these agreements as of September 30, 2003.
We enter into standard indemnification agreements with our customers,
whereby we indemnify them for certain damages, such as personal property damage,
which may be caused in connection with consulting services performed at a
customer site by our employees or our subcontractors. The maximum potential
amount of future payments we could be required to make under these
indemnification agreements is unlimited. However, we have general and umbrella
insurance policies that enable us to recover a portion of any amounts paid. We
have never incurred costs to defend lawsuits or settle claims related to these
indemnification
13
agreements. As a result, we believe the estimated fair value of these agreements
is minimal. Accordingly, we have no liabilities recorded for these agreements as
of September 30, 2003.
We generally warrant for ninety days from delivery to a customer that our
software products will perform free from material errors which prevent
performance in accordance with user documentation. Additionally, we warrant that
our consulting services will be performed consistent with generally accepted
industry standards. We have never incurred significant expense under our product
or service warranties. As a result, we believe the estimated fair value of these
agreements is minimal. Accordingly, we have no liabilities recorded for these
agreements as of September 30, 2003.
We have entered into employment and executive retention agreements with
certain employees and executive officers, which, among other things, include
certain severance and change of control provisions. We have also entered into
agreements whereby we indemnify our officers and directors for certain events or
occurrences while the officer or director is, or was, serving at our request in
such capacity.
From time to time, we are involved in litigation relating to claims arising
out of our operations in the normal course of business. We are not presently a
party to any legal proceedings, the adverse outcome of which, in our opinion,
would have a material adverse effect on our results of operations or financial
position.
NOTE 6: SUBSEQUENT EVENT
Pursuant to the terms of an asset purchase agreement dated October 10,
2003, we sold certain assets and liabilities related to our portal technology
for approximately $5.1 million in cash. In conjunction with this sale, we also
closed our Bellevue facility and consolidated our research and development
operations in Waltham. As a result of these transactions, we expect to report a
net gain in the range of $4.0 - $4.5 million during the fourth quarter of 2003.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements about our plans, objectives,
expectations and intentions. You can identify these statements by words such as
"expect," "anticipate," "intend," "plan," "believe," "seek," "estimate," "may,"
"will" and "continue" or similar words. You should read statements that contain
these words carefully. They discuss our future expectations, contain projections
of our future results of operations or our financial condition or state other
forward-looking information, and may involve known and unknown risks over which
we have little or no control. You should not place undue reliance on
forward-looking statements. We cannot guarantee any future results, levels of
activity, performance or achievements. Moreover, we assume no obligation to
update forward-looking statements or update the reasons actual results could
differ materially from those anticipated in forward-looking statements, except
as required by law. The factors discussed in the sections captioned
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Certain Factors that May Affect Future Results," in this report
identify important factors that may cause our actual results to differ
materially from the expectations we describe in our forward-looking statements.
OVERVIEW
Netegrity is a leading provider of security software solutions that
securely manage identities and their access to enterprise information assets.
Our flexible, standards-based offerings increase security, reduce administrative
costs and enable revenue enhancement. Our products help companies ensure that
only the people or business processes that are entitled to access corporate
resources and applications access them. Our products also enable customers to
manage the user population that needs to access those resources and
applications. In addition, our products provide a more automated way to grant,
modify or revoke account access to applications and resources.
We derive our revenues primarily from our core products, SiteMinder(R),
IdentityMinder(TM), and TransactionMinder(R), which are integrated into an
identity and access management solution to provide Web access control and
management, user administration, provisioning and de-provisioning of account
access. Our solution supports a broad range of technology environments, and aims
to ensure that companies optimize their existing information technology
investments while incorporating new technologies. We also offer various levels
of consulting and support services that enable our customers to successfully
implement our products in their organizations.
We believe sales of our products will be driven by customers' desire for
increased security, reduced costs, and regulatory compliance across large,
heterogeneous environments. We are beginning to see customers' interest shifting
away from network security and towards enterprise security, as customers'
objectives change from keeping people out to letting them in, and secure
management of access to corporate information. As a result, we expect that
companies will spend their discretionary information technology dollars on
technology that will help them drive revenue and reduce costs while mitigating
risk. The combined impact of a broadened product portfolio as well as the focus
of our direct sales resources on larger companies has enabled us to continue to
drive business through our installed base while at the same time adding new
customers. However, information technology spending has sharply decreased in the
past two years and information technology budgets remained constrained, which
has had and could continue to have a direct effect on the sale of our products.
Our software products are generally sold on a perpetual license basis.
Customers enter into an annual support agreement for their software license at
the time of initial purchase and typically renew this support agreement
annually. Our support agreement entitles customers to software upgrades and
support.
Our professional services group provides customers with project management,
architecture and design, custom development services and training.
CRITICAL ACCOUNTING POLICIES AND SIGNIFICANT JUDGMENTS AND ESTIMATES
The discussion and analysis of our financial condition and results of
operations are based on our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities
at the date of the financial statements as well as the reported
15
revenues and expenses during the reporting periods. On an ongoing basis,
management evaluates its estimates and judgments, including those related to
revenue recognition, accounts receivable reserves, marketable securities,
valuation of long-lived and intangible assets and goodwill, income taxes and
stock based compensation. Management bases its estimates on historical
experience and on various other factors that are believed to be reasonable under
the circumstances, the results of which form the basis for making judgments
about the carrying value of assets and liabilities that are not readily apparent
from other sources. Actual results may differ from these estimates under
different assumptions or conditions.
The significant accounting policies that management believes are most
critical to aid in fully understanding and evaluating our reported financial
results include the following:
REVENUE RECOGNITION
Our revenues are primarily generated from the sale of perpetual licenses
for our proprietary SiteMinder(R), IdentityMinder(TM) and TransactionMinder(R)
products and related services. We generate our services revenues from consulting
and training services performed for customers and from maintenance and support
of our products. As described below, significant management judgments and
estimates must be made and used in connection with the revenues recognized in
any accounting period. Management analyzes various factors, including a review
of specific transactions, historical experience, credit worthiness of customers
and current market and economic conditions. Changes in judgments based upon
these factors could impact the timing and amount of revenues and cost
recognized.
We generally license our software products on a perpetual basis. We apply
the provisions of Statement of Position No. 97-2, "Software Revenue
Recognition," as amended by Statement of Position No. 98-9, "Software Revenue
Recognition, with Respect to Certain Transactions," to all transactions
involving the sale of software products. We recognize revenues from the sale of
software licenses when persuasive evidence of an arrangement exists, the product
has been delivered, the fees are fixed or determinable and collection of the
resulting receivable is reasonably assured. This policy is applicable to all
sales, including sales to resellers and end users. We do not offer a right of
return on our products.
For all sales, we use a signed license agreement and/or a purchase order
with binding terms and conditions as evidence of an arrangement. For
arrangements with multiple obligations (for example, software license,
undelivered maintenance and support, training and consulting), we allocate
revenues to each component of the arrangement using the residual value method
based on the fair value of the undelivered elements. We defer revenue from the
arrangement equivalent to the fair value of the undelivered elements. Fair
values for each component are either the price we charge when the same component
is sold separately or the price established by the members of our management,
who have the relevant authority to set prices, for an element not yet sold
separately.
At the time of the transaction, we assess whether the fee associated with
the transaction is fixed or determinable based on the payment terms associated
with the transaction. If a significant portion of the fee is due after our
normal payment terms, which are generally 30 to 90 days from invoice date, we
account for the fee as not being fixed or determinable. In these cases, we
recognize revenues as the fees become due. In addition, we assess whether
collection is probable or not based on the credit worthiness of the customer.
Initial credit worthiness is assessed through Dun & Bradstreet or similar credit
rating agencies. Credit worthiness for follow-on transactions is assessed
through a review of the transaction history with the customer. We do not
typically request collateral from our customers. If we determine that collection
of a fee is not reasonably assured, we defer the fee and recognize revenues at
the time collection becomes reasonably assured, which is generally upon receipt
of cash.
Installation by Netegrity is not considered essential to the functionality
of our products as these services do not alter the product capabilities, do not
require specialized skills and may be performed by the customer or other
vendors. Revenues for maintenance and support are recognized ratably over the
term of the support period. Revenues from consulting and training services
generally are recognized as the services are performed.
ACCOUNTS RECEIVABLE RESERVES
Accounts receivable are reduced by an allowance for amounts that may become
uncollectible in the future. The estimated allowance for uncollectible amounts
is based primarily on a specific analysis of accounts in the receivable
portfolio and a general reserve based on the aging of receivables and historical
write-off experience. While management believes the allowance to be adequate, if
the financial condition of our customers were to deteriorate, resulting in
impairment of our customers' ability to make payments, additional allowances may
be required which could materially impact our financial position and results of
operations.
16
MARKETABLE SECURITIES
Investments, which primarily consist of debt securities, are accounted for
under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting
for Certain Investments in Debt and Equity Securities" issued by the Financial
Accounting Standards Board (FASB). Pursuant to the provisions of SFAS No. 115,
we have classified our investment portfolio as "trading", "available-for-sale"
or "held to maturity". Trading securities are bought and held principally for
the purpose of selling them in the near term and are recorded at fair value.
Fair value is based upon quoted market prices. Unrealized gains and losses on
trading securities are included in the determination of net earnings.
Available-for-sale securities include debt securities that are being held for an
unspecified period of time and may be used for liquidity or other corporate
purposes and are recorded at fair value. Unrealized gains and losses on
available-for-sale securities are reported as a separate component of
comprehensive income (loss) in stockholders' equity. Held to maturity securities
are debt securities that we intend to hold to maturity and are recorded at
amortized cost. As of September 30, 2003, all of our investments have been
classified as available-for-sale.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL
We review the valuation of long-lived assets, including property and
equipment and capitalized software, under the provisions of SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets" and SFAS No.
86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or
Otherwise Marketed." We are required to assess the recoverability of long-lived
assets and purchased software on an interim basis whenever events and
circumstances indicate that the carrying value may not be recoverable. Factors
we consider important that could trigger an interim impairment review include
the following:
- significant underperformance relative to expected historical or
projected future operating results;
- significant changes in the manner of our use of the acquired assets or
the strategy of our overall business;
- significant negative industry or economic trends;
- significant decline in our stock price for a sustained period; and
- our market capitalization relative to net book value.
In accordance with SFAS No. 144, when we determine that the carrying value
of applicable long-lived assets may not be recoverable based upon the existence
of one or more of the above indicators of impairment, we evaluate whether the
carrying amount of the asset exceeds the sum of the undiscounted cash flows
expected to result from the use and eventual disposition of that asset. If such
a circumstance exists, we would measure an impairment loss to the extent the
carrying amount of the particular long-lived asset or group exceeds its fair
value. We would determine the fair value based on a projected discounted cash
flow method using a discount rate determined by our management to be
commensurate with the risk inherent in our current business model. In accordance
with SFAS No. 86, when we determine that the carrying value of certain other
types of long-lived assets may not be recoverable we evaluate whether the
unamortized cost exceeds the expected future net realizable value of the
products. If the unamortized costs exceed the expected future net realizable
value of the products, the excess amount is written off. Changes in judgments on
any of these factors could impact the value of the asset being evaluated.
ACCOUNTING FOR INCOME TAXES
The preparation of our consolidated financial statements require us to
estimate our income taxes in each of the jurisdictions in which we operate,
including those outside the United States, which may be subject to certain risks
that ordinarily would not be expected in the United States. The income tax
accounting process involves estimating our actual current exposure together with
temporary differences resulting from differing treatment of items, such as
deferred revenue, for tax and accounting purposes. These differences result in
the recognition of deferred tax assets and liabilities. We then record a
valuation allowance to reduce our deferred tax assets to the amount that is more
likely than not to be realized.
Significant management judgment is required in determining our provision
for income taxes, our deferred tax assets and liabilities and any valuation
allowance recorded against deferred tax assets. We have recorded a full
valuation allowance against our net deferred tax assets as of September 30,
2003, due to uncertainties related to our ability to utilize some of our
deferred tax assets, primarily consisting of certain net operating losses
carried forward, before they expire. The valuation allowance is based on our
estimates of taxable income by jurisdiction in which we operate and the period
over which our deferred tax assets will be recoverable. In the event
17
that actual results differ from these estimates or we adjust these estimates in
future periods we may need to adjust our valuation allowance, which could
materially impact our financial position and results of operations.
STOCK-BASED COMPENSATION
Our stock option program is a broad-based, long-term retention program that
is intended to contribute to the success of Netegrity by attracting, retaining
and motivating talented employees and to align employee interests with the
interests of our existing stockholders. Stock options are typically granted to
employees when they first join Netegrity and typically on an annual basis
thereafter. Stock options are also granted when there is a significant change in
an employee's responsibilities and, occasionally, to achieve equity within a
peer group. The Compensation Committee of the Board of Directors is responsible
for the review and approval of the granting of stock options to employees and
consultants. The Compensation Committee recommends the compensation of executive
management to the Board of Directors which has authority to approve stock option
grants. All members of the Compensation Committee are independent directors, as
defined in the current rules for issuers traded on The NASDAQ Stock Market. See
the "Report of the Compensation Committee" in our 2003 proxy statement for
further information regarding the policies and procedures of Netegrity and the
Compensation Committee regarding the grant of stock options.
Under our stock option plans, participants may be granted options to
purchase shares of Netegrity stock and substantially all of our employees and
directors participate in at least one of our plans. Options issued under these
plans generally have exercise prices equal to the fair market value at the date
of grant, become exercisable at varying rates, generally over four to five
years, and generally expire seven to ten years from the date of grant.
We account for our stock option plans under the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees, and
Related Interpretations." No stock-based compensation cost is reflected in net
income (loss) for these plans, as all options granted under these plans had an
exercise price equal to the market value of the underlying common stock on the
date of grant.
On August 23, 2002, we filed a tender offer statement with the Securities
and Exchange Commission in connection with certain stock options outstanding
under non-director stock plans (the "Offer to Exchange"). Under the Offer to
Exchange, we offered to exchange certain employee options to purchase shares of
our common stock for new options to purchase shares of our common stock. The
Offer to Exchange excluded directors and non-employees of Netegrity, expired on
September 23, 2002 and provided for the grant of new options on two different
dates. We granted 50% of the new options on March 25, 2003 and 50% of the new
options on April 25, 2003 to employees that were continuously and actively
employed from the date the employee tendered eligible options for exchange to
the date of the grant of the new options. The number of shares underlying the
new options was equal to the number of shares underlying the cancelled eligible
options, except that certain options granted to certain executive officers were
exchanged at a rate of one share underlying a new option for each two shares
underlying the tendered options. The exercise price of the new options was equal
to the fair market value of one share of common stock on the date of grant of
the new options as determined in accordance with the applicable option plans.
Each new option will vest in accordance with a schedule tied to the length of
time of an individual's employment with Netegrity.
On March 25 and April 25, 2003, we granted options to purchase an aggregate
of 2,155,910 and 2,138,604 shares, respectively, of our common stock at fair
market value in connection with the Offer to Exchange. In accordance with FASB
Interpretation No. 44, since the replacement options were granted more than six
months and one day after cancellation of the old options, the new options were
considered a fixed award and therefore did not result in any compensation
expense.
18
RESULTS OF OPERATIONS
The following table presents statement of operations data as a percentage of
total revenues for the periods indicated:
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------- ----------------
2003 2002 2003 2002
------ ------ ------ ------
STATEMENT OF OPERATIONS DATA:
Revenues:
Software licenses............................. 56% 43% 55% 53%
Services...................................... 40 52 41 43
Other......................................... 4 5 4 4
------ ------ ------ ------
Total revenues............................. 100 100 100 100
Cost of revenues:
Cost of software licenses..................... 2 5 3 3
Non-cash cost of software licenses............ -- 6 10 5
Cost of services.............................. 14 22 15 20
Cost of other................................. 3 3 2 3
------ ------ ------ ------
Total cost of revenues..................... 19 36 30 31
------ ------ ------ ------
Gross profit.................................... 81 64 70 69
Selling, general and administrative expenses.... 53 87 57 77
Research and development expenses............... 26 38 27 35
Impairment charges.............................. -- 378 -- 108
Non-recurring charges........................... -- -- -- 1
------ ------ ------ ------
Income (loss) from operations................... 2 (439) (14) (152)
Other income, net............................... 2 3 2 4
------ ------ ------ ------
Income (loss) before provision for income taxes 4 (436) (12) (148)
Provision for income taxes...................... -- -- -- --
------ ------ ------ ------
Net income (loss)............................... 4% (436)% (12)% (148)%
------ ------ ------ ------
THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THE THREE AND
NINE MONTHS ENDED SEPTEMBER 30, 2002
The following discussion reviews the results of operations for the three
and nine months ended September 30, 2003 (the "2003 Quarter" and "2003 Period",
respectively) compared to the three and nine months ended September 30, 2002
(the "2002 Quarter" and "2002 Period", respectively).
Revenues. Total revenues increased by $5.2 million or 34%, to $20.4 million
in the 2003 Quarter, from $15.2 million in the 2002 Quarter, and increased by
$2.9 million or 5%, to $55.9 million in the 2003 Period, from $53.0 million in
the 2002 Period. The increase in both the 2003 Quarter and the 2003 Period as
compared to the 2002 Quarter and 2002 Period, respectively, was primarily due to
an increase in software license revenues and an increase in maintenance and
support revenues, partially offset by a decrease in consulting and training
revenues. Overall, we believe that revenue growth will be modest over the next
couple of quarters as constraints on technology spending continue. However, we
believe that as information technology spending increases from the current
levels our revenues will increase. We also believe that our focus on expanding
our leadership position in the identity and access management market with our
new IdentityMinder and TransactionMinder product offerings and continuing to use
the leverage we have built with our partners to provide integration services
directly to our customers will enable us to acquire new customers and sell
additional products to our existing customers.
Software license revenues increased by $4.9 million or 75%, to $11.4
million in the 2003 Quarter, from $6.5 million in the 2002 Quarter, and
increased by $2.8 million or 10%, to $30.5 million in the 2003 Period, from
$27.7 million in the 2002 Period. The increase was primarily due to the sale of
our new product offerings, increased sales to our existing customers and
improved sales execution. Additionally, although the European economy continued
to be weak in the 2003 Quarter, we saw an increase in European sales activity
within certain market segments on which we have been focusing our selling and
marketing resources during 2003.
19
While the number of new name deals decreased from 33 in the 2002 Quarter to 30
in the 2003 Quarter and the average size of new name deals decreased from
approximately $111,000 in the 2002 Quarter to approximately $105,000 in the 2003
Quarter, the number of follow on deals increased from 54 in the 2002 Quarter to
79 in the 2003 Quarter and the average size of follow on deals increased from
approximately $70,000 in the 2002 Quarter to approximately $130,000 in the 2003
Quarter. The number of new name deals decreased from 128 in the 2002 Period to
81 in the 2003 Period; however the average size of new name deals increased from
approximately $111,000 in the 2002 Period to approximately $130,000 in the 2003
Period. The number of follow on deals increased from 144 in the 2002 Period to
182 in the 2003 Period and the average size of follow on deals increased from
approximately $122,000 in the 2002 Period to approximately $142,000 in the 2003
Period. Overall, the increase in the total number of deals and the average deal
size was primarily due to our ability to continue to sell additional products to
existing customers, which included two deals that were each over $1 million in
the 2003 Quarter, and due to sales of our IdentityMinder(TM) and
TransactionMinder(R) products, which were introduced in late 2002, to both new
and existing customers.
Services revenues increased by $200,000 or 3%, to $8.1 million in the 2003
Quarter, from $7.9 million in the 2002 Quarter, and increased by $300,000 or 1%,
to $23.3 million in the 2003 Period, from $23.0 million in the 2002 Period. The
increases are primarily due to an increase in maintenance and support revenues
offset by a decline in consulting and training revenues. Maintenance and support
revenues increased by $1.1 million in the 2003 Quarter as compared to 2002
Quarter and by $4.2 million in the 2003 Period as compared to the 2002 Period
resulting from the increasing of the existing maintenance customer base.
Consulting and training revenues decreased by $900,000 in the 2003 Quarter as
compared to 2002 Quarter and by $3.9 million in the 2003 Period as compared to
the 2002 Period as a result of both broad-based economic weakness and the
continued leveraging of our partners to provide integration services directly to
our customers. In connection with this leveraged model, the cumulative number of
consultants we have trained at our affiliated partners increased from
approximately 850 in the 2002 Quarter to over 1,200 in the 2003 Quarter.
Other revenues remained relatively flat at $800,000 in both the 2003 and
2002 Quarter, and decreased by $200,000 or 9%, to $2.1 million in the 2003
Period, from $2.3 million in the 2002 Period. These other revenues are derived
from our Firewall legacy business. This business has remained relatively flat
and is not expected to have a significant impact in future periods.
Cost of revenues. Total cost of revenues decreased by $1.6 million or 30%,
to $3.8 million in the 2003 Quarter, from $5.4 million in the 2002 Quarter and
by $0.1 million or 1%, to $16.6 million in the 2003 Period, from $16.5 million
in the 2002 Period. The decrease in the 2003 Quarter is primarily a result of
the decrease in non-cash cost of software licenses as the purchased software
acquired in the DataChannel acquisition was fully amortized at the end of the
second quarter of 2003. This decrease was slightly offset by the cost of third
party software products that enhance and enable our products and increased
investment in our technical support organization. Overall, we believe that gross
profit will remain relatively consistent with the level of the 2003 Quarter as a
percentage of revenue in future periods as we increase our software license
revenues, which typically have higher gross profits than our service offerings.
Cost of software license revenues decreased by $1.1 million or 69%, to
$500,000 in the 2003 Quarter, from $1.6 million in the 2002 Quarter and
increased by $2.3 million or 52%, to $6.7 million in the 2003 Period from $4.4
million in the 2002 Period. The decrease in the 2003 Quarter is primarily a
result of the decrease in non-cash cost of software licenses as the purchased
software acquired in the DataChannel acquisition was fully amortized at the end
of the second quarter of 2003. This decrease was slightly offset by the cost of
third party software products that enhance and enable our products. The increase
in the 2003 Period is primarily the result of the acceleration of the
amortization in the third quarter of 2002.
Cost of services decreased by $0.5 million or 15%, to $2.8 million in the
2003 Quarter, from $3.3 million in the 2002 Quarter and by $2.2 million or 21%,
to $8.5 million in the 2003 Period, from $10.7 million in the 2002 Period. The
decrease is primarily due to the leveraging of our system integrator partner
relationships which allowed us to reduce headcount in our professional services
organization by 54% from September 30, 2002 to September 30, 2003 resulting in a
decrease in salaries and related expenses. The cumulative number of billable
consultants we have trained at our affiliated partners increased from
approximately 850 at the end of the 2002 Quarter to over 1,200 at the end of the
2003 Quarter. The decrease in cost of services was partially offset by increased
investment in both personnel and customer support systems within our technical
support organization during the 2003 Period in order to enhance overall customer
satisfaction.
Cost of other revenues increased by $100,000 or 20%, to $600,000 in the
2003 Quarter, from $500,000 in the 2002 Quarter, and decreased by $100,000 or
7%, to $1.3 million in the 2003 Period, from $1.4 million in the 2002 Period.
These costs are related to our Firewall legacy business. This business has
remained relatively flat and is not expected to have a significant impact in
future periods.
20
Selling, general and administrative expenses. Selling, general and
administrative expenses decreased by $2.4 million or 18%, to $10.9 million in
the 2003 Quarter, from $13.3 million in the 2002 Quarter and by $9.0 million or
22%, to $31.8 million in the 2003 Period, from $40.8 million in the 2002 Period.
The decrease in both the 2003 Quarter and 2003 Period is attributable to (i) a
decrease in salaries and related expenses due to reduced headcount of 14% from
the 2002 Quarter to the 2003 Quarter (including reductions in force implemented
in April and October of 2002 and January 2003), (ii) reduced marketing and
travel related expenses, (iii) reduced legal fees, and (iv) reduced facility
related expenses, including office rent, depreciation and utilities primarily
resulting from the consolidation of field offices and the move of the corporate
headquarters to a new facility. As we continue to realize the savings from the
consolidations of office space and continue to scrutinize all discretionary
expenses and evaluate reductions in non-strategic programs, we anticipate
selling, general and administration expenses as a percentage of total revenues
will remain flat or decrease in future periods.
Research and development costs. Research and development costs decreased by
$400,000 or 7%, to $5.4 million in the 2003 Quarter, from $5.8 million in the
2002 Quarter and by $3.0 million or 16%, to $15.3 million in the 2003 Period,
from $18.3 million in the 2002 Period. The decrease in both the 2003 Quarter and
2003 Period was primarily due to a decrease in salaries and related expenses due
to the reductions in force implemented in April and October of 2002, which
reduced headcount by 26% in these departments from the 2002 Quarter to the 2003
Quarter. These reductions were primarily related to the decision not to continue
developing, marketing or selling the PortalMinder product. The decrease was
partially offset by an increase in consulting expenses related to the continued
leverage of offshore third-party contractors used to perform certain testing of
our products. We recognize that our investment in research and development is
required to remain competitive and, therefore, we expect that our research and
development expenses may increase in future periods due to the continued
development of our products and services.
Other income, net. Other income, net, which is comprised primarily of
interest income earned on our cash and marketable securities, decreased by
$100,000 or 20%, to $400,000 in the 2003 Quarter, from $500,000 in the 2002
Quarter and by $700,000 or 37%, to $1.2 million in the 2003 Period, from $1.9
million in the 2002 Period. The decrease in both the 2003 Quarter and 2003
Period was attributable primarily to a decline in the average interest rates
earned on our marketable securities balances coupled with slightly lower average
cash and marketable securities balances as compared to the prior year.
Provision for income taxes. The provision for income taxes was $63,000 in
the 2003 Quarter as compared to $0 in the 2002 Quarter and was $122,000 in the
2003 Period and $40,000 in the 2002 Period. The increase in both the 2003
Quarter and 2003 Period was attributable to an increase in state and foreign
taxes in the current periods over the same periods of the prior year.
LIQUIDITY AND CAPITAL RESOURCES
Cash provided by operating activities in the 2003 Period was $7.5 million,
primarily due to a decrease in accounts receivable as the result of strong cash
collections in the 2003 Period and an increase in deferred revenue as a result
of an increase in maintenance renewals, partially offset by the net loss for the
period and a decrease in accrued expenses primarily related to the timing of
payments.
Cash used in investing activities was $24.3 million in the 2003 Period.
Investing activities for the period consisted primarily of the purchases of
marketable securities of approximately $60.2 million, and the purchase of $1.9
million of property and equipment, primarily computer related equipment and
software, offset by the proceeds from sales and maturities of marketable
securities of approximately $37.5 million.
Cash provided by financing activities in the 2003 Period was approximately
$1.1 million, which related to the exercise of employee stock options and stock
purchased by employees as part of the employee stock purchase plan.
As of September 30, 2003, we had cash and cash equivalents totaling $10.0
million, short-term available-for-sale securities of approximately $27.1 million
and working capital of $22.5 million. In addition, we had long-term
available-for-sale securities totaling $56.0 million as of September 30, 2003.
Pursuant to the terms of an asset purchase agreement dated October 10,
2003, we sold certain assets and liabilities related to our portal technology
for approximately $5.1 million in cash. In conjunction with this sale, we also
closed our Bellevue facility and consolidated our research and development
operations in Waltham. As a result of these transactions, we expect to
report a net gain in the range of $4.0 - $4.5 million during the fourth quarter
of 2003.
Any increase or decrease in our accounts receivable balance and accounts
receivable days outstanding (calculated as net accounts receivable divided by
revenue per day) will affect our cash flow from operations and liquidity. Our
accounts receivable and accounts
21
receivable days outstanding may increase due to changes in factors such as the
timing of when sales are invoiced and length of customers' payment cycles. We
also record deferred maintenance billings as accounts receivable, and the timing
of these billings affects the accounts receivable days outstanding.
Historically, international and indirect customers pay at a lower rate than
domestic and direct customers. An increase in revenues generated from
international and indirect customers may increase our accounts receivable days
outstanding and accounts receivable balance. Due to the current economic
climate, we may observe an increase in the length of our customers' payment
cycles and as a result our days sales outstanding may increase in future
periods. To the extent that our accounts receivable balance increases, we may
incur increased bad debt expense and will be subject to greater general credit
risks.
In the past, we experienced a period of rapid growth, which resulted in
significant increases in our operating expenses. Over the past two years, due to
the effects of general economic conditions, we have made considerable efforts to
reduce our operating expenses through constrained spending, reductions in
workforce and better alignment of our cost structure to our revenues. While we
anticipate that our operating expenses and capital expenditures will constitute
a material use of our cash resources, we may also utilize cash resources to fund
acquisitions or investments in businesses, technologies, products or services
that are complementary to our business. We believe that our existing cash and
cash equivalent balances together with our available-for-sale securities will be
sufficient to meet our anticipated cash requirements for working capital and
capital expenditures for at least the next twelve months.
COMMITMENTS, CONTRACTUAL OBLIGATIONS, AND OFF-BALANCE SHEET ARRANGEMENTS
We have commitments that expire at various times through 2010. Operating
leases shown below are primarily for facility costs for our corporate
headquarters and worldwide sales offices. Other contractual obligations
primarily consist of minimum royalty fees payable by Netegrity in connection
with a software license and distribution agreement, which we entered into in
January 2003. There were no off-balance sheet arrangements as of September 30,
2003.
LESS
THAN 1 AFTER 5
TOTAL YEAR 1-3YEARS 4-5 YEARS YEARS
------- ------- -------- --------- -------
(IN THOUSANDS)
Operating Leases................ $10,087 $ 2,750 $ 3,449 $ 3,467 $ 421
Other Contractual Obligations... 3,325 1,375 1,950 -- --
------- ------- -------- --------- -------
Total........................... $13,412 $ 4,125 $ 5,399 $ 3,467 $ 421
======= ======= ======== ========= =======
Included in the operating lease commitments above is approximately $400,000
related to excess facilities which have been accrued in purchase accounting and
are payable through April 2004.
We incurred total operating lease expense, primarily related to certain
facilities and equipment under non-cancelable operating leases, of approximately
$1.0 million and $3.0 million for the three and nine months ended September 30,
2003, respectively.
In April 2002, we entered into an agreement with a system integrator to
assist us in the development and launch of one of our products. Under the terms
of the agreement, for consideration of the system integrator's time in assisting
with the development of the product, we agreed to promote the system integrator
as an integrator of the developed product. Our obligation under the agreement
will be considered satisfied once the system integrator receives consulting
revenues totaling approximately $3.9 million from our customers, or by April
2004, whichever occurs first. In the event that we recommend a competitor of the
system integrator to perform the integration work for a customer, we could
potentially owe a royalty to the system integrator based on the net license fee.
As of September 30, 2003, no royalties were due to the system integrator.
In August 2002, we entered into a five year non-cancelable operating lease
for an office building for our corporate headquarters. We moved into the new
facility in March 2003. In connection with the lease agreement, we delivered an
irrevocable, unconditional, negotiable letter of credit in the amount of
$800,000 as a security deposit. Additionally, we spent approximately $1.0
million in leasehold improvements to build out the new facility in the nine
months ended September 30, 2003.
In January 2003, we entered into a software license and distribution
agreement, as amended in March 2003, under which we were granted the right to
sublicense the use of a provisioning application software program. In addition,
we were granted certain rights to integrate or combine the software into our
existing products. In exchange for these rights, we have agreed to pay a
quarterly royalty fee based on a percentage of the net license fees we charge
our customers for the software. The minimum royalty fees due in the first,
second and third years of the agreement are approximately $1.0 million, $1.4
million and $1.6 million, respectively. The initial term of this agreement is
three years. After the first year of the agreement, we have the right to
terminate the agreement without cause. As of
22
September 30, 2003, we became obligated to pay $675,000 in royalties under this
agreement, of which $450,000 had been paid and $225,000 was accrued.
We enter into standard indemnification agreements with our business
partners or customers in our ordinary course of business. Pursuant to these
agreements, we agree to repair or replace the product, pay royalties for a right
to use, or reimburse the indemnified party for actual damages awarded by a court
against the indemnified party for an intellectual property infringement claim by
a third party with respect to our products. The term of these indemnification
agreements is generally perpetual. The maximum potential amount of future
payments we could be required to make under these indemnification agreements is
unlimited. We have never incurred costs to defend lawsuits or settle claims
related to these indemnification agreements. As a result, we believe the
estimated fair value of these agreements is minimal. Accordingly, we have no
liabilities recorded for these agreements as of September 30, 2003.
We enter into standard indemnification agreements with our customers,
whereby we indemnify them for certain damages, such as personal property damage,
which may be caused in connection with consulting services performed at a
customer site by our employees or our subcontractors. The maximum potential
amount of future payments we could be required to make under these
indemnification agreements is unlimited. However, we have general and umbrella
insurance policies that enable us to recover a portion of any amounts paid. We
have never incurred costs to defend lawsuits or settle claims related to these
indemnification agreements. As a result, we believe the estimated fair value of
these agreements is minimal. Accordingly, we have no liabilities recorded for
these agreements as of September 30, 2003.
We generally warrant for ninety days from delivery to a customer that our
software products will perform free from material errors which prevent
performance in accordance with user documentation. Additionally, we warrant that
our consulting services will be performed consistent with generally accepted
industry standards. We have never incurred significant expense under our product
or service warranties. As a result, we believe the estimated fair value of these
agreements is minimal. Accordingly, we have no liabilities recorded for these
agreements as of September 30, 2003.
We have entered into employment and executive retention agreements with
certain employees and executive officers, which, among other things, include
certain severance and change of control provisions. We have also entered into
agreements whereby we indemnify our officers and directors for certain events or
occurrences while the officer or director is, or was, serving at our request in
such capacity.
From time to time, we are involved in litigation relating to claims arising
out of our operations in the normal course of business. We are not presently a
party to any legal proceedings, the adverse outcome of which, in our opinion,
would have a material adverse effect on our results of operations or financial
position.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
WE HAVE INCURRED SUBSTANTIAL LOSSES AND MAY NOT BE PROFITABLE IN THE FUTURE.
In recent years, we have incurred substantial operating losses. While we
recently returned to profitability, we cannot predict if we will maintain
profitability for any substantial period of time. To sustain operating
profitability on a quarterly and annual basis, we will need to continue to
increase our revenues, particularly our license revenues. Failure to maintain
levels of profitability as expected by investors may adversely affect the market
price of our common stock. In the nine months ended September 30, 2003, we had a
net loss of $6.7 million and an accumulated deficit of $113.5 million as of
September 30, 2003.
OUR QUARTERLY RESULTS MAY FLUCTUATE WIDELY.
Our quarterly revenues and operating results are difficult to predict and
may continue to fluctuate significantly from quarter to quarter for several
reasons, including, but not limited to, the following:
- customers choosing to delay their purchase commitments or purchase in
smaller than expected quantities due to a general slowdown in the
economy or in anticipation of the introduction of new products by us
or our competitors;
- market acceptance of our SiteMinder(R), IdentityMinder(TM)and
TransactionMinder(R)products;
23
- our success in obtaining follow-on sales to existing customers;
- the long sales and deployment cycle of our products;
- our ability to hire and retain personnel, particularly in development,
services and sales and marketing;
- the loss of or changes in key management personnel;
- the timing of the release of new versions of SiteMinder,
IdentityMinder and TransactionMinder products or other products;
- pricing pressures that result in increased discounts or changes in our
or competitors' pricing policies;
- changes in our operating expenses;
- the development of our direct and indirect distribution channels;
- integration issues with acquired technology; and
- general economic conditions.
In addition, because our revenues from services, particularly maintenance
revenues, are largely correlated with our software revenues, a decline in
software revenues could also cause a decline in our services revenues in the
same quarter or in subsequent quarters. Other factors, many of which are outside
our control, could also cause variations in our quarterly revenues and operating
results.
Most of our expenses, such as employee compensation and rent, are
relatively fixed. As a result, any shortfall in revenues in relation to our
expectations could cause significant changes in our operating results from
quarter to quarter and could result in future losses.
OUR SUCCESS WILL DEPEND ON OUR ABILITY TO MARKET OUR PRODUCTS AND RELATED
SERVICES SUCCESSFULLY.
Our revenues are primarily generated from the sale of perpetual licenses
for our proprietary SiteMinder(R), IdentityMinder(TM) and TransactionMinder(R)
products and related services. Broad market acceptance of our products will
depend on the continued development of a market for identity and access
management, the education of our customers on the use of business software
applications in general and the relevance of our products specifically. Market
acceptance for our products, and customer demand for the services they provide,
may not develop.
We have recently released several new product offerings. If we fail to gain
market acceptance for these products, it could have a material adverse effect on
our business, operating results and financial position. Additionally, with the
reduction in information technology spending in all industries we will need to
be successful in conveying the value of our products to customers who may be
hesitant to replace a "homegrown" system due to the costs involved with
switching to a purchased solution.
Our ability to succeed in the market for our products depends in part on
our ability to provide support services on a 24 hour per day, seven-day per week
basis. Any damage or disruptions to our service centers, including our service
center in Malaysia, whether as a result of employee attrition, acts of terrorism
or some other cause, or language barriers, could seriously impact our ability to
provide the necessary service to our customers and fulfill our service
contracts.
OUR SUCCESS IS DEPENDENT ON OUR ABILITY TO ENHANCE OUR PRODUCT LINES AND DEVELOP
NEW PRODUCTS.
We believe our success is dependent, in large part, on our ability to
enhance and broaden our product lines to meet the evolving needs of the business
market. We may be unable to respond effectively to technological changes or new
industry standards or developments. Although we recently released two new
products on time, product development cycles are unpredictable and in the past,
we have delayed the introduction of several new product versions due to delays
in development of these versions.
24
We have arrangements with a third party located in India to perform certain
testing of our products and with third party software vendors who provide
software which is embedded in our products. Any adverse change in our
relationship with these third parties could result in delays in the release of
our products. In the future, we could be adversely affected and be at a
competitive disadvantage if we incur significant delays or are unsuccessful in
enhancing our product lines or developing new products, or if any of our
enhancements or new products do not gain market acceptance.
Additionally, as we continue to release new versions of our existing
software we may be required to assist customers in migrating to the latest
version once a product is announced to be at the end of its life. We could be
adversely affected if there are significant migration issues and a decline in
customer satisfaction related to such transitions.
OUR PERFORMANCE DEPENDS ON OUR ABILITY TO WIN BUSINESS AND OBTAIN FOLLOW-ON
SALES IN PROFITABLE SEGMENTS.
Customers typically place small initial orders for our products to allow
them to evaluate our products' performance. A key element of our strategy is to
pursue more significant follow-on sales after these initial installations. Our
financial performance depends on successful initial deployments of our products
that, in turn, lead to follow-on sales. If the initial deployments of our
products are not successful or if our customers do not remain satisfied with our
products and services, we may be unable to obtain follow-on sales. In addition,
even if initial deployments are successful, there can be no assurances that
customers will choose to make follow-on purchases, which could have a material
adverse effect on our ability to generate revenues.
WE FACE SIGNIFICANT COMPETITION FROM OTHER TECHNOLOGY COMPANIES AND WE MAY NOT
BE ABLE TO COMPETE EFFECTIVELY.
The market for identity and access management is highly competitive. We
expect the level of competition to increase as a result of the anticipated
growth of the identity and access management market. Our primary competitor in
the identity and access management market is the Tivoli Division of IBM. We also
compete against traditional security and software companies and stack vendors
such as Oblix, RSA, Novell, Waveset and Sun MicroSystems. In addition, a number
of other security and software companies are beginning to offer products that
may compete with our identity and access management solution. Competition may
also develop as the market matures and other companies begin to offer similar
products, and as our product offerings expand to other segments of the
marketplace. We also face competition from Web development professional services
organizations. We expect that additional competitors will emerge in the future.
Current and potential competitors have established, or may in the future
establish, cooperative selling relationships with third parties to increase the
distribution of their products to the marketplace. Accordingly, it is possible
that new competitors may emerge and acquire significant market share. It is
possible that current and potential competitors may attempt to hire our
employees and although we have non-compete agreements in place with most of our
employees they may or may not be enforceable. It is possible that new
competitors or alliances may emerge and rapidly acquire significant market
share. Today, many of our competitors have shorter operating histories and fewer
financial and technical resources than we have. In addition, these smaller
competitors have smaller customer bases. Some of our other competitors, however,
are larger companies who have large financial resources, well-established
development and support teams, and large customer bases. These larger
competitors may initiate pricing policies that would make it more difficult for
us to maintain our competitive position against these companies. It is also
possible that current and potential competitors may be able to respond more
quickly to new or emerging technologies or customer requirements, resulting in
increased market share. If, in the future, a competitor chooses to bundle a
competing point product with other applications within a suite, the demand for
our products might be substantially reduced. Because of these factors, many of
which are out of our control, we may be unable to maintain or enhance our
competitive position against current and future competitors.
REGULATIONS OR CONSUMER CONCERNS REGARDING THE USE OF "COOKIES" ON THE INTERNET
COULD REDUCE THE EFFECTIVENESS OF OUR SOFTWARE PRODUCTS.
Certain of our products use cookies to support their single sign-on
functionality. A cookie is information keyed to a specific user that is stored
on the hard drive of the user's computer, typically without the user's
knowledge. Cookies are generally removable by the user, and can be refused by
the user at the point at which the information would not be stored on the user's
hard drive. A number of governmental bodies and commentators in the United
States and abroad have urged passage of laws limiting or abolishing the use of
cookies. The passage of laws limiting or abolishing the use of cookies, or the
widespread deletion or refusal of cookies by Web site users, could reduce or
eliminate the effectiveness of our single sign-on functionality and could reduce
market demand for our products.
25
WE MAY BE UNABLE TO HIRE AND RETAIN SKILLED PERSONNEL.
Qualified personnel are in great demand throughout the software industry.
Our success depends, in large part, upon our ability to attract, train, motivate
and retain highly skilled employees, particularly software engineers,
professional services personnel, sales and marketing personnel and other senior
personnel. Our failure to attract and retain the highly trained technical
personnel that are integral to our product development, professional services
and direct sales teams, particularly software engineers, may limit the rate at
which we can generate sales, develop new products or product enhancements or
transfer technical knowledge across our employee base. A change in key
management could result in transition and attrition in the affected department.
This could have a material adverse effect on our business, operating results and
financial condition.
OUR SUCCESS DEPENDS ON OUR ABILITY TO OPTIMIZE OUR DIRECT SALES AND INDIRECT
DISTRIBUTION CHANNELS.
To increase our revenues, we must optimize our direct sales force and
continue to enhance relationships with systems integrators, resellers and
technology partners to increase the leverage of our partner channel. There is
intense competition for sales personnel in our business, and we cannot be sure
that we will be successful in attracting, integrating, motivating and retaining
sales personnel. In addition, we must effectively leverage our relationships
with our strategic partners and other third-party system integrators, vendors of
Internet-related systems and application software and resellers in order to
reach a larger customer population than we could reach alone through our direct
sales and marketing efforts.
We may not be able to find appropriate strategic partners or may not be
able to enter into relationships on commercially favorable terms, particularly
if these partners decide to compete directly in the identity and access
management market. Furthermore, the relationships we do enter into may not be
successful. Our strategic relationships are generally non-exclusive, and
therefore, our strategic partners may decide to pursue alternative technologies
or to develop alternative products in addition to or instead of our product,
either on their own or in collaboration with our competitors.
WE RELY ON THIRD PARTY TECHNOLOGY TO ENHANCE OUR PRODUCTS.
We incorporate into our products software licensed from third party
software companies that enhances, enables or provides functionality for our
products and, therefore, we need to create relationships with third parties,
including some of our competitors, to ensure that our products will interoperate
with the third parties' products. Third party software may not continue to be
available on commercially reasonable terms or with acceptable levels of support
or functionality, or at all. Failure to maintain those license arrangements,
failure of the third party vendors to provide updates, modifications or future
versions of their software or defects and errors in or infringement claims
against those third party products could delay or impair our ability to develop
and sell our products and potentially cause us to incur additional cost. In
addition, if we discover that third party products are no longer available as a
result of changes in the third party's operations or financial position, there
can be no assurance that we would be able to offer our product without
substantial reengineering, or at all.
Often these third party software companies require prepayment of royalties
on their products and, in the past, we have had to expense these prepaid
royalties to cost of sales when it was determined that they may not have future
realizable value.
OUR FAILURE TO EXPAND OUR RELATIONSHIP WITH GLOBAL SYSTEMS INTEGRATORS COULD
LIMIT OUR ABILITY TO SUPPORT OUR CUSTOMERS' DEPLOYMENT OF OUR PRODUCTS.
Our professional services organization and our relationship with global
systems integrators provide critical support to our customers' installation and
deployment of our products. If we fail to adequately develop our relationship
with global systems integrators, our ability to increase products sales may be
limited. In addition, if we or our partners cannot adequately support product
installations, our customers may not be able to use our products, which could
harm our reputation and hurt our business.
OUR LENGTHY SALES CYCLE MAKES IT DIFFICULT TO PREDICT OUR QUARTERLY OPERATING
RESULTS.
The length of our sales cycle varies depending on the size, type and
complexity of the customer contemplating a purchase, whether we have conducted
business with a potential customer in the past and the size of the deal. In
addition, some of our customers may also need to invest substantial resources
and modify their computer network infrastructures to take advantage of our
products. As a result, these potential customers frequently need to obtain
approvals from multiple decision makers prior to making purchase decisions, a
26
process that has been, at times, further lengthened as a result of the current
market conditions surrounding technology spending. Our long sales cycle, which
can range from several weeks to several months or more, makes it difficult to
predict the quarter in which sales will occur. Delays in sales could cause
significant variability in our revenues and operating results for any particular
quarterly period. Our sales cycle is subject to a number of uncertainties such
as:
- the need to educate potential customers regarding the benefits of our
products;
- customers' budgetary constraints;
- the timing of customers' budget cycles;
- customers' willingness to make changes in their network
infrastructures; and
- delays caused by customers' internal review processes.
OUR FAILURE TO EFFECTIVELY MANAGE CHANGES IN THE BUSINESS ENVIRONMENT IN WHICH
WE OPERATE COULD HURT OUR BUSINESS.
Our failure to effectively manage changes in the business environment in
which we operate could have a material adverse effect on the quality of our
products, our ability to retain key personnel and our business, operating
results and financial condition. Historically, we experienced a period of rapid
growth that placed a significant strain on all of our resources. Over the past
two years, based upon economic factors beyond our control, we implemented
reductions in workforce. We may experience similar changes in the future.
Additionally, we may experience disruptions as a result of attacks from
electronic viruses which could result in reduced productivity. To effectively
manage changes in the business environment in which we operate we must maintain
and enhance our financial and accounting systems and controls, maintain the
security of our infrastructure, maintain our ability to retain key personnel,
integrate new personnel and manage operations.
IF WE LOSE THE SERVICES OF BARRY BYCOFF OR ANY OTHER MEMBER OF OUR MANAGEMENT
TEAM, OUR BUSINESS COULD SUFFER.
Our future success depends, to a significant degree, on the skill,
experience and efforts of Barry Bycoff, our chief executive officer, and the
rest of our management team. A change in our management team or the inability of
our officers and key employees to work effectively as a team could have a
material adverse effect on our business, operating results and financial
condition.
AS WE CONTINUE TO OPERATE IN INTERNATIONAL MARKETS, WE WILL FACE CONTINUED RISKS
TO OUR SUCCESS.
At the current time, we have no plans to significantly expand beyond our
current international operations. However, if in the future we decide to expand
our international operations, the expansion will require additional resources
and management attention, and will subject us to increased regulatory, economic
and political risks. We have limited experience in international markets and we
cannot be sure that our continued expansion into global markets will be
successful. In addition, we will face increased risks in conducting business
internationally, including the ability to develop, market and distribute
localized versions of our products in a timely manner or at all. These risks
could reduce demand for our products and services, increase the prices at which
we can sell our products and services, or otherwise have an adverse effect on
our operating results. Among the risks we believe are most likely to affect us
are:
- longer decision making cycles;
- longer payment cycles and problems in collecting accounts receivable;
- adverse changes in trade and tax regulations, including restrictions
on the import and export of sensitive technologies, such as encryption
technologies, that we use or may wish to use in our software products;
- the absence or significant lack of legal protection for intellectual
property rights;
- selling under contracts governed by local law;
27
- difficulties in managing an organization spread over multiple
countries, including complications arising from cultural, language and
time differences that may lengthen sales and implementation cycles and
delay the resolution of customer support issues;
- currency risks, including fluctuations in exchange rates;
- political and economic instability;
- localization of technology, including delays in localizing the most
recent versions of our products;
- increased use of contractors on a global basis for both professional
services and development, that may result in increased cost of
services and/or less direct control; and
- disruption caused by terrorist activities in various regions around
the world.
OUR SUCCESS DEPENDS ON OUR ABILITY TO PROTECT OUR PROPRIETARY RIGHTS.
Our success depends to a significant degree upon the protection of our
software and other proprietary technology. The unauthorized reproduction or
other misappropriation of our proprietary technology could enable third parties
to benefit from our technology without paying us for it. This could have a
material adverse effect on our business, operating results and financial
condition. We depend upon a combination of patent, trademark, trade secret and
copyright laws, license agreements and non-disclosure and other contractual
provisions to protect proprietary and distribution rights in our products. In
addition, we attempt to protect our proprietary information and the proprietary
information of our vendors and partners through confidentiality and/or license
agreements with our employees and others. Although we have taken steps to
protect our proprietary technology, they may be inadequate and the unauthorized
use of our source code could have an adverse effect on our business. Existing
trade secret, copyright and trademark laws offer only limited protection.
Moreover, the laws of other countries in which we market our products may afford
little or no effective protection of our intellectual property. If we resort to
legal proceedings to enforce our intellectual property rights, the proceedings
could be burdensome and expensive, even if we were to prevail.
CLAIMS BY OTHER COMPANIES THAT WE INFRINGE THEIR PROPRIETARY TECHNOLOGY COULD
HURT OUR FINANCIAL CONDITION.
If we discover that any of our products or third party products embedded in
our products violates third-party proprietary rights, there can be no assurance
that we would be able to reengineer our product or to obtain a license on
commercially reasonable terms to continue offering the product without
substantial reengineering. We do not conduct comprehensive patent searches to
determine whether the technology used in our products infringes patents held by
third parties. In addition, product development is inherently uncertain in a
rapidly evolving technology environment in which there may be numerous patent
applications pending for similar technologies, many of which are confidential
when filed. Any claim of infringement, even if invalid, could cause us to incur
substantial costs defending against the claim and could distract our management
from our business. Furthermore, a party making such a claim could secure a
judgment that requires us to pay substantial damages. A judgment could also
include an injunction or other court order that could prevent us from selling
our products. Any of these events could have a material adverse effect on our
business, operating results and financial condition.
OUR BUSINESS COULD BE ADVERSELY AFFECTED IF OUR PRODUCTS CONTAIN ERRORS OR
FLAWS.
Software products as complex as ours may contain undetected errors or
"bugs" that result in product failures. The occurrence of errors could result in
loss of, or delay in, revenues, loss of market share, failure to achieve market
acceptance, diversion of development resources, injury to our reputation, or
damage to our efforts to build brand awareness, any of which could have a
material adverse effect on our business, operating results and financial
condition. Additionally, the security features included in our products to
prevent unauthorized access to the application may not meet all of our
customers' requirements.
WE COULD INCUR SUBSTANTIAL COSTS RESULTING FROM PRODUCT LIABILITY CLAIMS
RELATING TO OUR CUSTOMERS' USE OF OUR PRODUCTS.
Many of the business applications supported by our products are critical to
the operations of our customers' businesses. Any failure in a customer's Web
site or application caused or allegedly caused by our products could result in a
claim for substantial damages
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against us, regardless of our responsibility for the failure. Although we
maintain general liability insurance, including coverage for errors and
omissions, and contractually attempt to limit liability, we cannot be sure that
our existing coverage will continue to be available on reasonable terms or will
be available in amounts sufficient to cover one or more large claims, or that
the insurer will not disclaim coverage as to any future claim.
INCREASED UTILIZATION AND COSTS OF OUR TECHNICAL SUPPORT SERVICES AND INCREASED
DEMANDS ON OUR OTHER TECHNICAL RESOURCES MAY ADVERSELY AFFECT OUR FINANCIAL
RESULTS.
Our products involve very complex technology and the failure or inability
of our technical support staff to meet customer expectations in a timely manner
or customer dissatisfaction with our product functionality or performance could
result in loss of revenues, loss of market share, failure to achieve market
acceptance, injury to our reputation, liability for service or warranty costs
and claims and other increased costs. We may be unable to respond to
fluctuations in customer demand for support services as well as resolve customer
issues in a manner that is timely and satisfactory to them. We also may be
unable to modify the format of our support services to compete with changes in
support services provided by competitors.
As we win business from larger, more complex customers there may be an
increased demand on our resources, particularly product management and support,
which may affect the allocation of our resources. Additionally, as we continue
to sell our new products to existing customers our customers will expect us to
provide the same level of product support on the new products as we do on the
old products. This may put increased demand on our product support resources.
OUR ACQUISITION OF OTHER COMPANIES MAY INCREASE THE RISKS WE FACE.
In the future, we may pursue acquisitions to obtain complementary products,
services and technologies. Any such acquisition may not produce the revenues,
earnings or business synergies that we anticipated, and an acquired product,
service or technology might not perform as we expected. In pursuing any
acquisition, our management could spend a significant amount of time and effort
in identifying and completing the acquisition. If we complete an acquisition, we
would probably have to devote a significant amount of management resources to
integrate the acquired business with our existing business. To pay for an
acquisition, we might use our stock or cash. Alternatively, we might borrow
money from a bank or other lender. If we use our stock, our stockholders would
experience dilution of their ownership interests. If we use cash or debt
financing, our financial liquidity will be reduced.
THE MARKET PRICE OF OUR COMMON STOCK HAS BEEN AND MAY CONTINUE TO BE VOLATILE.
Our stock price, like that of other technology companies, has been
extremely volatile. The announcement of new products, services, technological
innovations, customers or distribution partners by us or our competitors,
quarterly variations in our operating results, changes in coverage by securities
analysts, changes in revenues or earnings estimates by securities analysts,
speculation in the press or investment community and overall economic conditions
are among the factors affecting our stock price.
In addition, the stock market in general and the market prices for
technology companies in particular have experienced extreme volatility that
often has been unrelated to the operating performance of these companies. These
broad market and industry fluctuations may adversely affect the market price of
our common stock, regardless of our operating performance. Recently, when the
market price of a stock has been volatile, holders of that stock have often
instituted securities class action litigation against the company that issued
the stock. If any of our stockholders brought a lawsuit against us, we could
incur substantial costs defending the lawsuit. The lawsuit could also divert the
time and attention of our management.
The general economic uncertainties in the United States and abroad continue
to cause significant volatility in the stock markets. The continued threat of
terrorism in the United States and abroad and the ongoing military action and
heightened security measures undertaken in response to that threat can be
expected to cause continued volatility in securities markets. In addition,
foreign political unrest may continue to adversely affect the economy.
WE MAY LOSE MONEY ON FIXED-PRICE CONSULTING CONTRACTS.
Although the majority of our services are performed on a time and material
basis, we have in the past performed services under fixed price contracts at the
request of a customer. In the future, it is possible that an increased portion
of our services revenues could be derived from fixed-price contracts. We work
with complex technologies in compressed time frames and it can be difficult to
judge the time and resources necessary to complete a project. If we miscalculate
the resources or time we need to complete work under fixed-price contracts, our
operating results could be materially adversely affected.
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CONTINUED WEAKNESS IN THE GLOBAL ECONOMY MAY ADVERSELY AFFECT OUR BUSINESS
The global economy is still weak and may continue to be weak in the
foreseeable future. In addition, the United States' continued involvement in
Iraq, as well as the political unrest in other parts of the world, have
contributed to global economic uncertainty. We believe the current economic
slowdown has caused some potential or current customers to defer purchases. In
response to the current economic conditions, many companies have reduced their
spending budgets for information technology products and services, which could
reduce or eliminate potential sales of our products and services.
CERTAIN PROVISIONS OF OUR CHARTER AND OF DELAWARE LAW MAKE A TAKEOVER OF OUR
COMPANY MORE DIFFICULT.
Our corporate documents and Delaware law contain provisions that might
enable us to resist a takeover of our company. These provisions might discourage
or delay a change in the control of Netegrity or a change in our management.
These provisions could also discourage proxy contests and make it more difficult
for you and other stockholders to elect directors and take other corporate
actions. The existence of these provisions could limit the price that investors
might be willing to pay in the future for shares of our common stock.
Additionally, we have entered into employment and executive retention agreements
with certain employees and executive officers which, among other things, include
certain severance and change of control provisions that may have similar
effects.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
FOREIGN CURRENCY
In both the three and nine months ended September 30, 2003, we generated
approximately 24% of our revenues outside of the United States. International
sales are typically denominated in U.S. dollars. Our foreign subsidiaries incur
most of their expenses in the local currency. Accordingly, all of our foreign
subsidiaries use the local currency as their functional currency. Translation
losses (which were $42,000 as of September 30, 2003) are deferred and
accumulated as a separate component of stockholders' equity (accumulated other
comprehensive income (loss)). Net gains resulting from foreign exchange
transactions, which were $20,000 and $26,000, respectively, for the three and
nine months ended September 30, 2003, are included in other income, net, in the
accompanying consolidated statements of operations. A 10% change in the
valuation of the functional currencies relative to the U.S. dollar as of
September 30, 2003 would not have a material impact on our results of operations
for the three and nine months ended September 30, 2003.
INTEREST RATES
We invest our cash in a variety of financial instruments including floating
rate bonds, municipal bonds, asset-backed securities and money market
instruments in accordance with an investment policy approved by our Board of
Directors. These investments are denominated in U.S. dollars. Cash balances in
foreign currencies overseas are operating balances and are only invested in
short-term deposits of the local operating bank.
Investments in both fixed rate and floating rate interest earning
instruments carry a degree of interest rate risk. However, due to the
conservative nature of our investment portfolio, a sudden change in interest
rates would not have a material effect on the value of the portfolio. We
estimate that if the average yield of our investments had decreased by 100 basis
points, our interest income for the three and nine months ended September 30,
2003 would have decreased by less than $100,000. This estimate assumes that the
decrease occurred on the first day of the year and reduced the yield of each
investment instrument by 100 basis points. The same 100 basis point change in
interest rates would not have a material impact on the fair value of the
investment portfolio. The impact on our future interest income and future
changes in investment yields will depend largely on the gross amount of our
investment portfolio.
ITEM 4. CONTROLS AND PROCEDURES
Our management evaluated, with the participation of our Chief Executive
Officer and Chief Financial Officer, the effectiveness of our disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934 (the "Exchange Act")) as of September 30, 2003.
Based on such evaluation, our Chief Executive Officer and Chief Financial
Officer have concluded that, as of such date, our disclosure controls and
procedures are (1) designed to ensure that material information relating to
Netegrity, including our consolidated subsidiaries, is made known to our Chief
Executive Officer and Chief Financial Officer by
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others within those entities, particularly during the period in which this
report was being prepared and (2) effective, in that they provide reasonable
assurance that information required to be disclosed by us in the reports that we
file or submit under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in the SEC's rules and regulations
and forms.
No change in our internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) occurred during
the fiscal quarter ended September 30, 2003 that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
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PART II. - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EXHIBIT
ITEM NO. ITEM AND REFERENCE
- -------- ------------------------------------------------------------------
10.1 Executive Retention Agreement entered into by and between
Netegrity, Inc., and Steven McLaughlin dated August 29, 2003.
31.1 Rule 13a-14(a)/15d-14(a) Certification of President and Chief
Executive Officer.
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
and Treasurer.
32.1 Section 1350 Certification of President and Chief Executive
Officer.
32.2 Section 1350 Certification of Chief Financial Officer and
Treasurer.
(b) Reports on Form 8-K
On July 23, 2003, we furnished a Current Report on Form 8-K dated July 23,
2003 under Item 9 containing a copy of our earnings release for the period ended
June 30, 2003 pursuant to Item 12 (Results of Operations and Financial
Condition).
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
NETEGRITY, INC.
Date: October 28, 2003 By: /s/ Barry N. Bycoff
--------------------------------------
Barry N. Bycoff
President, Chief Executive Officer,
Director and Chairman of the Board
Date: October 28, 2003 By: /s/ Regina O. Sommer
--------------------------------------
Regina O. Sommer
Chief Financial Officer and Treasurer
(Principal Financial Officer and
Principal Accounting Officer)
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