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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 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
COMMISSION FILE NUMBER 0-27038
SCANSOFT, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 94-3156479
(STATE OR OTHER JURISDICTION (IRS EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
9 CENTENNIAL DRIVE
PEABODY, MA 01960
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICE)
(978) 977-2000
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12-b-2 of the Securities Exchange Act of 1934). Yes [X] No [ ]
99,610,689 shares of the registrant's Common Stock, $0.001 par value, were
outstanding as of October 31, 2003.
SCANSOFT, INC.
FORM 10-Q
SEPTEMBER 30, 2003
INDEX
PAGE
----
PART I: FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
a) Consolidated Balance Sheets at September 30, 2003 and
December 31, 2002 3
b) Consolidated Statements of Operations for the three and
nine months ended September 30, 2003 and
September 30, 2002 4
c) Consolidated Statements of Cash Flows for the nine months
ended September 30, 2003 and September 30, 2002 5
d) Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 22
Item 3. Quantitative and Qualitative Disclosures about Market Risk 39
Item 4. Controls and Procedures 39
PART II: OTHER INFORMATION
Item 1. Legal Proceedings 40
Item 4. Submission of Matters to a Vote of Security Holders 40
Item 6. Exhibits and Reports on Form 8-K 40
Signatures 41
Exhibit Index 42
2
SCANSOFT, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
ASSETS
Current assets:
Cash and cash equivalents ............................................. $ 47,485 $ 18,853
Marketable securities ................................................. 553 --
Accounts receivable, less allowances of $6,887 and $5,903, respectively 30,216 15,650
Receivables from related party ........................................ 1,630 1,518
Inventory ............................................................. 619 1,241
Prepaid expenses and other current assets ............................. 6,523 3,167
--------- ---------
Total current assets ............................................... 87,026 40,429
Goodwill ................................................................ 225,080 63,059
Other intangible assets, net ............................................ 55,227 33,823
Property and equipment, net ............................................. 6,028 2,846
Other assets ............................................................ 2,980 3,533
--------- ---------
Total assets ....................................................... $ 376,341 $ 143,690
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ...................................................... $ 5,862 $ 7,085
Accrued compensation .................................................. 7,624 2,122
Accrued other expenses ................................................ 15,019 7,651
Deferred revenue ...................................................... 8,283 1,790
Notes payable ......................................................... 6,746 3,273
Deferred payment obligation for business acquisition .................. 1,150 --
Deferred payment obligation for technology license .................... 2,617 --
Other current liabilities ............................................. 3,350 1,666
--------- ---------
Total current liabilities .......................................... 50,651 23,587
Deferred revenue ........................................................ 359 244
Long-term notes payable ................................................. 28,085 --
Deferred tax liabilities ................................................ 1,441 --
Other liabilities ....................................................... 7,293 481
--------- ---------
Total liabilities .................................................. 87,829 24,312
--------- ---------
Commitments and contingencies (Notes 6, 7 and 17) Stockholders' equity:
Preferred stock, $0.001 par value; 40,000,000 shares authorized;
3,562,238 shares issued and outstanding
(liquidation preference $4,631) ..................................... 4,631 4,631
Common stock, $0.001 par value; 140,000,000 shares authorized;
101,708,053 and 65,540,154 shares issued and 99,176,975 and
63,422,776 shares outstanding, respectively ......................... 102 66
Additional paid-in capital ............................................ 449,846 269,858
Treasury stock, at cost (2,531,078 and 2,117,378 shares, respectively) (9,863) (8,031)
Deferred compensation ................................................. (1,930) (173)
Accumulated other comprehensive loss .................................. (500) (47)
Accumulated deficit ................................................... (153,774) (146,926)
--------- ---------
Total stockholders' equity ......................................... 288,512 119,378
--------- ---------
Total liabilities and stockholders' equity ......................... $ 376,341 $ 143,690
========= =========
The accompanying notes are an integral part of these
consolidated financial statements.
3
SCANSOFT, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ------------------------
2003 2002 2003 2002
-------- -------- -------- --------
Revenue, third parties ........................ $ 31,179 $ 27,101 $ 84,214 $ 74,598
Revenue, related parties ...................... 1,771 1,134 4,315 3,586
-------- -------- -------- --------
Total revenue ............................ 32,950 28,235 88,529 78,184
Costs and expenses:
Cost of revenue ........................ 6,768 4,199 15,643 12,937
Cost of revenue from amortization of
intangible assets .................... 2,752 1,976 7,481 7,494
Research and development ............... 9,543 7,257 25,070 21,310
Selling, general and administrative .... 15,624 11,386 42,702 31,975
Non-cash stock compensation ............ 104 26 155 76
Amortization of other intangible assets 662 236 1,446 1,446
Restructuring and other charges ........ 1,719 -- 3,065 1,041
-------- -------- -------- --------
Total costs and expenses ............ 37,172 25,080 95,562 76,279
-------- -------- -------- --------
Income (loss) from operations ................. (4,222) 3,155 (7,033) 1,905
Other income (expense):
Interest income ............................. 189 66 288 296
Interest expense ............................ (170) (85) (421) (261)
Other income(expense), net .................. 229 (149) 791 (213)
-------- -------- -------- --------
Income (loss) before income taxes ............. (3,974) 2,987 (6,375) 1,727
Provision for (benefit from) income taxes ..... (243) 162 473 (166)
-------- -------- -------- --------
Net income (loss) ............................. $ (3,731) $ 2,825 $ (6,848) $ 1,893
======== ======== ======== ========
Net income (loss) per share: basic ............ $ (0.04) $ 0.04 $ (0.10) $ 0.03
======== ======== ======== ========
Net income (loss) per share: diluted .......... $ (0.04) $ 0.04 $ (0.10) $ 0.03
======== ======== ======== ========
Weighted average common shares: basic ......... 83,694 67,865 71,286 67,116
======== ======== ======== ========
Weighted average common shares: diluted ....... 83,694 74,787 71,286 72,451
======== ======== ======== ========
The accompanying notes are an integral part of these
consolidated financial statements.
4
SCANSOFT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------
2003 2002
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) .......................................................................... $ (6,848) $ 1,893
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation .......................................................................... 1,549 1,535
Amortization of intangible assets ..................................................... 8,927 8,940
Allowances for bad debts .............................................................. 540 1,246
Non-cash portion of restructuring charges ............................................. 69 113
Stock-based compensation .............................................................. 155 77
Foreign exchange loss ................................................................. (71) --
Non-cash interest expense ............................................................. 168 --
Deferred tax provision ................................................................ 1,441 --
Gain on disposal or sale of property and equipment ..................................... -- (30)
Changes in operating assets and liabilities, net of effects from business acquisitions:
Accounts receivable ................................................................ (1,151) (4,234)
Inventory .......................................................................... 1,010 (1,003)
Prepaid expenses and other current assets .......................................... (917) (1,189)
Other assets ....................................................................... (371) (273)
Accounts payable ................................................................... (2,720) (292)
Accrued expenses ................................................................... 810 2,162
Other liabilities .................................................................. (143) --
Deferred revenue ................................................................... 536 (2,682)
-------- --------
Net cash provided by operating activities ........................................... 2,984 6,263
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures for property and equipment .......................................... (1,441) (2,090)
Proceeds from sale of property and equipment ............................................. -- 42
Cash expenditures for licensing agreements ............................................... (6,113) --
Cash received (paid) for acquisitions, including transaction costs ....................... 31,347 (2,860)
-------- --------
Net cash provided by (used in) investing activities ................................... 23,793 (4,908)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Payment of note payable .................................................................. (3,273) --
Payments of capital lease obligation ..................................................... -- (238)
Purchase of treasury stock ............................................................... (1,832) (7,000)
Payments of notes payable related to acquisition ......................................... -- (586)
Payments under deferred payment obligation ............................................... (1,230) (1,824)
Proceeds from issuance of common stock, net of issuance costs ............................ 6,767 5,690
Proceeds from issuance of common stock under employee stock compensation plans ........... 2,053 2,545
-------- --------
Net cash provided by (used in) financing activities ................................. 2,485 (1,413)
-------- --------
Effects of exchange rate changes on cash and cash equivalents .............................. (630) 116
-------- --------
Net increase in cash and cash equivalents .................................................. 28,632 58
Cash and cash equivalents at beginning of period ........................................... 18,853 14,324
-------- --------
Cash and cash equivalents at end of period ................................................. $ 47,485 $ 14,382
======== ========
The accompanying notes are an integral part of these
consolidated financial statements.
5
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of ScanSoft,
Inc. (the "Company" or "ScanSoft") have been prepared in accordance with
accounting principles generally accepted in the United States of America. In the
opinion of management, these interim consolidated financial statements reflect
all adjustments, consisting of normal recurring adjustments, necessary for a
fair presentation of the financial position at September 30, 2003 and the
results of operations for the three and nine months ended September 30, 2003 and
2002 and cash flows for the nine months ended September 30, 2003 and 2002.
Although the Company believes that the disclosures in these financial statements
are adequate to make the information presented not misleading, certain
information normally included in the footnotes prepared in accordance with
generally accepted accounting principles has been condensed or omitted as
permitted by the rules and regulations of the Securities and Exchange
Commission. The accompanying financial statements should be read in conjunction
with the audited financial statements and notes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2002 filed
with the Securities and Exchange Commission on March 28, 2003 and all other
subsequent periodic filings including Form 10-Q for the three months ended March
31, 2003 and June 30, 2003 filed on May 15, 2003 and August 14, 2003,
respectively. The results for the three and nine months ended September 30, 2003
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2003, or any future period.
On August 11, 2003, the Company acquired all of the outstanding stock of
SpeechWorks International, Inc. ("SpeechWorks"), a leading provider of software
products and professional services that enable enterprises, carriers and
government organizations to offer automated, speech-activated services over any
telephone. The results of operations of the acquired business have been included
in the financial statements of the Company as of August 11, 2003, the date of
acquisition.
On January 30, 2003, the Company completed the acquisition of the Philips
Speech Processing Telephony and Voice Control business units of Royal Philips
Electronics N.V. ("Philips"), and related intellectual property (the "Philips
acquisition"). The Telephony business unit offers speech-enabled services
including directory assistance, interactive voice response and voice portal
applications for enterprise customers, telephony vendors and carriers. The Voice
Control business unit offers a product portfolio including small footprint
speech recognition engines for embedded applications such as voice-controlled
climate, navigation and entertainment features in automotive vehicles, as well
as voice dialing for mobile phones. The results of operations of the acquired
business have been included in the financial statements of the Company as of
January 30, 2003, the date of acquisition.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities on the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. The most significant estimates and assumptions included in the financial
statements are revenue recognition, including estimating valuation allowances,
specifically sales returns and other allowances, the recoverability of
intangible assets, including goodwill, and valuation allowances for deferred tax
assets. Actual amounts could differ significantly from these estimates.
Certain prior year financial statement amounts have been reclassified to
conform with the current year presentation.
2. RESTATEMENT OF TAX PROVISION
In connection with the third quarter of 2003, the Company determined that
an adjustment was required to properly reflect its tax provisions in the
Company's financial statements as presented in Form 10-Q as filed for the
quarterly periods ended March 31, 2003 and June 30, 2003. These non-cash tax
adjustments result from the Company's implementation of SFAS No. 142.
Historically, the Company has netted its deferred tax liability related to
goodwill against its deferred tax asset. Following adoption of SFAS No. 142, the
temporary differences created by different treatment for book and tax of the
Company's goodwill can no longer be assumed to offset deductible temporary
differences which create deferred tax assets. Therefore, the Company was
required to record an additional tax expense to increase its deferred tax asset
valuation allowance in its financial statements for the three month period
ending March 31, 2003 and the three and six month periods ended June 30, 2003 as
follows:
6
- --------------------------------------------------------------------------------------------------------------------
(IN THOUSANDS, EXCEPT PER THREE MONTHS ENDED THREE MONTHS ENDED SIX MONTHS ENDED
SHARE DATA) MARCH 31, 2003 JUNE 30, 2003 JUNE 30, 2003
----------------------------------------------------------------------------------------
AS AS AS
PREVIOUSLY AS PREVIOUSLY AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED REPORTED RESTATED
- --------------------------------------------------------------------------------------------------------------------
Statement of Operations:
- --------------------------------------------------------------------------------------------------------------------
Provision for income taxes $ 95 $ 345 $ 67 $ 371 $ 162 $ 716
- --------------------------------------------------------------------------------------------------------------------
Net income/(loss) $ 76 $(174) $(2,639) $(2,943) $(2,563) $(3,117)
- --------------------------------------------------------------------------------------------------------------------
Net income/(loss) per
share-Basic and diluted $0.00 $0.00 $ (0.04) $ (0.04) $ (0.04) $ (0.05)
- --------------------------------------------------------------------------------------------------------------------
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Revenue Recognition
The Company recognizes revenue in accordance with Statement of Position
97-2, Software Revenue Recognition ("SOP 97-2"), as amended by Statement of
Position 98-9, and the Securities and Exchange Commission's Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements. Revenue from the
sale of licenses to end users, value-added resellers and system integrators to
use the Company's software products is recognized upon delivery, provided that
the arrangement does not require significant modification or customization of
the software, any services included in the arrangement are not considered
essential to the functionality of the software, evidence of the arrangement
exists, the fees are fixed or determinable, and collectibility is reasonably
assured.
Sales of the Company's software products through certain distributors and
value-added resellers provide rights of return for as long as the distributors
or resellers hold the inventory. As a result, the Company recognizes revenues
from sales to these distributors and resellers only when the distributors or
resellers have sold products to retailers and end-users. Title and risk of loss
pass to the distributor or reseller upon shipment, at which time the transaction
is invoiced and payment is due. Based on reports from distributors and resellers
of their inventory balances at the end of each period, the Company records an
allowance against accounts receivable for the sales price of all inventories
subject to return. If the Company experiences significant returns from
distributors or resellers, the Company's liquidity may be adversely impacted.
The Company makes an estimate of sales returns by retailers or end users
directly or through its distributors or resellers based on historical returns
experience. The provision for these estimated returns is recorded as a reduction
of revenue at the time that the related revenue is recorded. Historically, the
Company has not experienced significant returns from retailers or end-users. If
actual returns differ significantly from its estimates, such differences could
have a material impact on its results of operations for the period in which the
actual returns become known.
Revenue from royalties on sales of the Company's products by OEMs to third
parties, where no services are included, is typically recognized upon delivery
to the third party when such information is available, or when the Company is
notified by the OEM that such royalties are due as a result of a sale, provided
that all other revenue recognition criteria are met.
7
When the Company provides professional services such as custom applications
and other services considered essential to the functionality of the software for
a fixed fee, it recognizes revenue from the fees for such services and any
related software licenses as it completes the project using the percentage-of-
completion method. The Company generally determines the percentage-of-completion
by comparing the labor hours it has incurred to date to the estimate of the
total labor hours required to complete the project based on regular discussions
with its project managers. This method is used because the Company considers
expended labor hours to be the most reliable, available measure of progress on
these projects. Adjustments to contract estimates are made in the periods in
which facts resulting in a change become known. When the estimate indicates a
loss, such loss is provided for in its entirety. Significant judgments and
estimates are involved in determining the percent complete of each contract.
Different assumptions could yield materially different results.
Other professional services not considered essential to the functionality
of the software are limited and primarily include training and feasibility
studies. When the Company provides services on a time and materials basis, it
recognizes revenue as it performs the services based on actual time incurred.
When the Company provides support and maintenance services, it recognizes
the revenue ratably over the term of the related contracts, typically one year.
The Company may sell, under one contract or related contracts, software
licenses, custom software applications and other services considered essential
to the functionality of the software and a maintenance and support arrangement.
The total contract value is attributed first to the maintenance and support
arrangement based on its fair value, equal to its stated list price as a fixed
percentage of the related software product's price. The remainder of the total
contract value is then attributed to the software license and related
professional services, which are typically recognized as revenue using the
percentage-of-completion method. As a result, discounts inherent in the total
contract value are attributed to the software license and related professional
services. The Company may sell, under one contract or related contracts,
software licenses, a maintenance and support arrangement and professional
services not considered essential to the functionality of the software. In those
arrangements, the total contract value is attributed first to the undelivered
elements of maintenance and support and professional services based on their
fair values, as described above. The remainder of the contract value is
attributed to the software licenses, which are typically recognized as revenue
upon delivery, provided all other revenue recognition criteria are met. As a
result, discounts inherent in the total contract value are attributed to the
software licenses.
The Company follows the guidance of Emerging Issues Task Force issue No.
01-09, Accounting for Consideration Given by a Vendor to a Customer or a
Reseller of the Vendor's Products ("EITF 01-09"), in determining whether
consideration, including equity instruments, given to a customer should be
recorded as an operating expense or a reduction of revenue recognized from that
same customer. Consideration given to a customer is recorded as a reduction of
revenue unless both of the following conditions are met:
o The Company receives an identifiable benefit in exchange for the
consideration, and the identified benefit is sufficiently separable
from the customer's purchase of the Company's products and services
such that the Company could have purchased the products from a third
party, and
o The Company can reasonably estimate the fair value of the benefit
received.
If both of the conditions are met, the Company records consideration paid
to customers as an expense. Consideration, including equity instruments, not
meeting the above criteria, is recorded as a reduction of revenue, to the extent
the Company has recorded cumulative revenue from the customer or reseller.
The Company records reimbursements received for out-of-pocket expenses as
revenue, with offsetting costs recorded as cost of revenue. Out-of-pocket
expenses generally include, but are not limited to, expenses related to
airfare, hotel stays and out-of-town meals.
Foreign Currency Risk Management
In certain circumstances, the Company enters into forward exchange
contracts to hedge against foreign currency fluctuations. These contracts are
used to reduce the Company's risk associated with exchange rate movements, as
the gains or losses on these contracts are intended to offset the exchange rate
losses or gains on the underlying exposures. The Company does not engage in
foreign currency speculation. Hedges of underlying exposures are designated and
documented at the inception of the hedge and are evaluated for effectiveness
monthly. Forward exchange contracts hedging firm commitments qualify for hedge
accounting when they are designated as a hedge of the foreign currency exposure
and they are effective in minimizing such exposure. Gains and losses on forward
exchange contracts that qualify for hedge accounting are recognized as other
comprehensive income (loss), along with the associated losses and gains on the
hedged item. As the terms of the forward exchange contract and underlying
exposure are matched generally at inception, hedging effectiveness is calculated
by comparing the change in fair value of the contract to the change in fair
value of the underlying exposure.
8
On January 30, 2003, the Company entered into a forward exchange contract
to hedge the foreign currency exposure of its 5.0 million euro note payable to
Philips. The contract and the note payable each have a term that expires on
December 31, 2003. Based upon period-end exchange rates, the Company estimates
the fair value of the forward exchange contract approximates the fair value of
the note payable. For the three and nine months ended September 30, 2003, the
Company recorded a net exchange rate loss of approximately $(3,000) and a net
exchange rate gain of approximately $4,000, respectively, in other comprehensive
income on the note payable and associated forward exchange contract. On August
26, 2003, the Company entered into a forward exchange contract to hedge the
foreign currency exposure of its 1.0 million euro payable to Philips. The
contract and the payable each have a term that expires on December 31, 2003.
Based upon period-end exchange rates, the Company estimates the fair value of
the forward exchange contract approximates the fair value of the payable. For
the three and nine months ended September 30, 2003 the Company recorded a net
exchange rate loss of approximately $(2,000) in other comprehensive income on
the payable and associated forward exchange contract.
Recently Issued Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity." SFAS 150 establishes standards for how an issuer classifies and
measures certain financial instruments with characteristics of both liabilities
and equity. SFAS 150 was originally effective for financial instruments entered
into or modified after May 31, 2003, and otherwise effective at the beginning of
the first interim period beginning after June 15, 2003, however certain elements
of SFAS No. 150 have been deferred. The adoption of the provisions of SFAS No.
150 not deferred did not have a material impact on the Company's financial
position or results of operations and the Company does not expect the adoption
of the deferred elements of SFAS No. 150 to have a material impact on its
financial position or results of operations.
In April 2003, the FASB issued Statement of Financial Accounting Standards
No. 149 ("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities." SFAS 149 amends and clarifies financial accounting and
reporting for derivative instruments, including certain derivative instruments
embedded in other contracts (collectively referred to as derivatives), and for
hedging activities under FASB Statement No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS 149 was effective for contracts
entered into or modified after June 30, 2003 and for hedging relationships
designated after June 30, 2003. The adoption of SFAS No. 149 did not have a
material impact on the Company's current financial position and results of
operations.
In November 2002, the Emerging Issues Task Force ("EITF") of the FASB
issued EITF No. 00-21, "Accounting for Revenue Arrangements with Multiple
Deliverables." EITF No. 00-21 addresses certain aspects of the accounting by a
vendor for arrangements under which it will perform multiple revenue-generating
activities. EITF No. 00-21 establishes three principles: revenue should be
recognized separately for separate units of accounting, revenue for a separate
unit of accounting should be recognized only when the arrangement consideration
is reliably measurable and the earnings process is substantially complete, and
consideration should be allocated among the separate units of accounting in an
arrangement based on their fair value. EITF No. 00-21 is effective for all
revenue arrangements entered into on or after July 1, 2003. The adoption of EITF
00-21 did not have a material impact on the Company's results of operations or
financial position. In May 2003, as a result of questions raised regarding
applicability of EITF No. 00-21 to software revenue recognition arrangements,
the EITF reached a consensus regarding the application of the provisions of SOP
97-2 to arrangements containing software deliverables and non-software
deliverables. The consensus reached in May 2003 was confirmed in July 2003 and
was issued as Issue 03-05, "Applicability of AICPA Statement of Position 97-2 to
Non-Software Deliverables in an Arrangement Containing More-Than-Incidental
Software" ("EITF No. 03-05"). EITF No. 03-05 concludes that software-related
elements include software-related products and services such as those listed in
paragraph 9 of SOP 97-2, as well as other deliverables for which the software is
essential to their functionality (e.g., computer hardware). Elements included in
arrangements that do not qualify as software-related elements are to be
accounted for under the guidance of EITF No. 00-21 and not SOP 97-2. EITF No.
03-05 is effective for all new revenue arrangements entered into after October
1, 2003. The adoption of EITF No. 03-05 is not expected to have a material
impact on the Company's results of operations or financial position.
4. ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company recognizes compensation costs for stock-based awards to
employees using the intrinsic value-based method described in Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees". The
following table illustrates the effect on net income (loss) and basic and
diluted net income (loss) per share as if the fair value method prescribed in
Statement of Financial Accounting Standards No. 123, "Accounting For Stock-Based
Compensation", had been applied for the Company's employee stock-based
compensation and recorded in the consolidated financial statements:
9
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
(IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2002 2003 2002
- ------------------------------------------------------------- ------- ------- -------- -------
Net income (loss) -- as reported ............................ $(3,731) $ 2,825 $ (6,848) $ 1,893
Add back: Stock-based compensation included in net income
(loss), as reported ......................................... 104 27 155 77
Deduct: Total stock-based employee compensation expense
determined under the fair value-based-method ................ (2,639) (2,708) (7,177) (6,643)
------- ------- -------- -------
Net loss -- pro forma ....................................... $(6,266) $ 144 $(13,870) $(4,673)
======= ======= ======== =======
Net income (loss) per share -- as reported: basic and diluted $ (0.04) $ 0.04 $ (0.10) $ 0.03
Net loss per share - pro forma: basic and diluted ........... $ (0.07) $ 0.00 $ (0.19) $ (0.07)
5. INVENTORY
Inventory consists of the following (in thousands):
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
Raw materials... $ 12 $ 26
Finished goods.. 607 1,215
------- ---------
$ 619 $ 1,241
======= =========
6. ACQUISITION OF SPEECHWORKS INTERNATIONAL, INC.
On August 11, 2003, the Company acquired all of the outstanding stock of
SpeechWorks International, Inc. ("SpeechWorks"), a leading provider of software
products and professional services that enable enterprises, carriers and
government organizations to offer automated, speech-activated services over any
telephone.
The acquisition of SpeechWorks enhances the ability of the combined company
to promote its products and comprehensively address the needs of the system
integrators in the United States telephony markets. The addition of SpeechWorks'
professional services organization will enable the combined company to support
major accounts, channel partners and telecommunications firms, as well as
provide the ability to deliver complete solutions. In addition, the acquisition
enhances the combined company's strengths in key vertical markets, including
multiple deployments in travel/hospitality, financial services and government,
thereby expanding the combined company's market share in these key markets and
expertise in developing applications and solutions for these industries. These
incremental intangible benefits, which are reflected in the purchase
consideration, resulted in goodwill.
The results of operations of the acquired business have been included in
the financial statements of the Company since the date of acquisition.
In connection with the acquisition of SpeechWorks, ScanSoft exchanged 0.860
of a share of its common stock for each outstanding share of SpeechWorks stock.
This transaction resulted in the issuance of approximately 32.5 million shares
of ScanSoft common stock, representing approximately 33% of the outstanding
common stock of ScanSoft after the completion of the acquisition. The
SpeechWorks purchase price of $175.5 million includes the value of the ScanSoft
common stock issued at a per share value of $5.26 (the average closing price of
ScanSoft common stock for a total of five days immediately prior to and
subsequent to the announcement of the acquisition) and transaction costs of $4.5
million. Included in the transaction costs is a warrant, valued at $0.2 million,
for the purchase of 150,000 shares of ScanSoft's common stock (Note 18). In
addition, the purchase price also includes the value of 184,786 shares of
restricted ScanSoft common stock issued by ScanSoft, in replacement of
previously outstanding SpeechWorks unvested restricted common stock, of $0.7
million based on the closing price of ScanSoft common stock on the acquisition
date. The value of the unvested restricted common stock has been recorded as
deferred compensation (Note 19).
10
The preliminary purchase price allocation is as follows: (in thousands):
Total purchase consideration:
Common stock and restricted stock issued $ 170,950
Transaction costs 4,500
---------
Total purchase consideration $ 175,450
=========
Preliminary allocation of the purchase consideration:
Assets acquired:
Cash $ 39,953
Marketable securities 553
Accounts receivable 10,064
Other current assets 938
Property and equipment 2,840
Other long term assets 1,048
Identifiable intangible assets 13,310
Goodwill 128,395
---------
Total assets acquired 197,101
---------
Deferred compensation for unvested restricted common
stock 724
Liabilities assumed:
Accounts payable (1,610)
Accrued expenses (9,487)
Deferred revenue (5,034)
Other long term liabilities (4,704)
Note payable (1,540)
---------
Total liabilities assumed: (21,651)
---------
$ 175,450
=========
Current assets acquired primarily relate to cash, marketable securities and
accounts receivable. Current liabilities assumed primarily relate to accounts
payable, accrued expenses and deferred revenue. In December 2002, SpeechWorks
committed to a restructuring plan to vacate two office locations during 2003. In
connection with this restructuring plan, SpeechWorks recorded a charge of $5.9
million. As of the acquisition date, the balance of this accrual was $5.4
million, which has been included in other long-term liabilities. The Company
reduced the recorded accrual by $1.0 million to record such obligation at its
net present value, using a discount rate of 3%. The $1.0 million difference
between the lease obligations and the recorded accrual will be recognized as
incremental rent expense over the remaining life of the lease. These assumed
leases extend through 2010 and 2016, respectively, unless the Company is able to
negotiate earlier termination dates. The Company anticipates that the
facilities-related accrual will be expended equally over the remaining life of
the leases.
The amount assigned to identifiable intangible assets acquired was based on
their respective fair values determined as of the acquisition date. The Company
did not attribute any value to "in-process research and development" projects in
connection with this acquisition. The Company believes that these identified
intangible assets have no residual value. The excess of the purchase price over
the tangible and identifiable intangible assets was recorded as goodwill and
amounted to approximately $128.4 million. In accordance with current accounting
standards, the goodwill is not being amortized and will be tested for impairment
as required by SFAS No. 142. Goodwill and all other identifiable intangible
assets acquired by SpeechWorks previously may be deductible for tax purposes.
The Company is in the process of completing the purchase price allocation,
which is subject to adjustment as a result of pending analysis of lease
obligations as well as litigation which arose just prior to the acquisition
date. As discussed more fully in Note 17, the Company assumed significant lease
obligations in connection with the acquisition and is in the process of
reviewing these leases based on the provisions of the lease agreements and the
Company's expectations for post-acquisition operations. The Company expects to
complete the assessment of assumed lease obligations prior to the issuance of
the financial statements on Form 10-K for the year ending December 31, 2003. Any
adjustment resulting from the assessment would result in an adjustment to
goodwill. (See Note 17)
In connection with the SpeechWorks acquisition, the Company eliminated 54
SpeechWorks former employees. In connection with this action, a liability of
$1.3 million, representing severance and related benefits, has been included in
the purchase price allocation. Of this balance, $0.8 million has been paid as of
September 30, 2003 and the remainder is expected to be paid within the next 12
months and will be funded from working capital.
11
The following are the identifiable intangible assets acquired and the
respective periods over which the assets will be amortized on a straight-line
basis:
AMOUNT AMORTIZATION
(IN THOUSANDS) PERIOD (IN YEARS)
-------------- -----------------
Patents and core technology.. $ 1,300 10
Completed technology ........ 2,200 5
Customer relationships ...... 9,000 6
Trade names and trademarks... 800 5
Non-compete agreements ...... 10 1
-------
$13,310 6.5
=======
7. ACQUISITION OF PHILIPS SPEECH PROCESSING TELEPHONY AND VOICE CONTROL BUSINESS
On January 30, 2003, the Company completed the acquisition of the Philips
Speech Processing Telephony and Voice Control business units of Royal Philips
Electronics N.V. ("Philips"), and related intellectual property. The Telephony
business unit offers speech-enabled services including directory assistance,
interactive voice response and voice portal applications for enterprise
customers, telephony vendors and carriers. The Voice Control business unit
offers a product portfolio including small footprint speech recognition engines
for embedded applications such as voice-controlled climate, navigation and
entertainment features in automotive vehicles, as well as voice dialing for
mobile phones.
The acquisition of the Philips Speech Processing Telephony and Voice
Control business enhances the Company's market share in key markets and gives
the Company additional competitive momentum in its target markets, specifically
the telephony, automotive and embedded markets. In addition, it enhances the
distribution channel adding new reference accounts for both customer
relationships and technology partners. These incremental intangible benefits
attributed to excess purchase consideration resulting in goodwill.
The results of operations of the acquired business have been included in
the financial statements of the Company since the date of acquisition.
Consideration for the acquisition, before any purchase price adjustment to
be determined by the parties as described below, totaled $39.5 million,
including transaction costs of $2.1 million. The consideration consisted of 3.1
million euros ($3.4 million) in cash paid at closing, subject to adjustment in
accordance with the provisions of the purchase agreement, as amended; a deferred
payment of 1.0 million euros in cash due no later than December 31, 2003, a 5.0
million euro note due December 31, 2003; bearing 5.0% interest per annum; and a
$27.5 million three-year, zero-interest subordinated debenture, convertible at
any time at Philips' option into shares of common stock at $6.00 per share. The
fair value of the convertible debenture was determined to be $27.5 million based
on the present value of the expected cash outflows using an incremental
borrowing rate of 12% and the fair value of the conversion feature based on the
Black-Scholes option pricing model using the following assumptions: the fair
value of the Company's common stock of $3.62 per share, the closing price of the
Company's common stock on the day the parties entered into the acquisition
agreement; volatility of 100%; risk-free interest rate of 2.16%; no dividends
and an expected term of 3 years.
The purchase price is subject to adjustment based on a calculation set
forth in the purchase agreement, as amended, which must be agreed upon by the
parties and which may result in an adjustment either to increase or decrease the
total purchase consideration. Upon final determination of the purchase price
adjustment, a corresponding adjustment will be recorded to goodwill.
12
The preliminary purchase price allocation is as follows (in thousands):
Total purchase consideration:
Cash $ 3,350
Other current liability (1.0 million euro payable) 1,080
Note payable 5,410
Convertible debenture 27,520
Transaction costs 2,100
--------
Total purchase consideration $ 39,460
========
Allocation of the purchase consideration:
Current assets $ 3,930
Property and equipment 310
Identifiable intangible assets 5,650
Goodwill 33,699
--------
Total assets acquired 43,589
--------
Current liabilities (4,129)
--------
$ 39,460
========
Current assets acquired primarily relate to accounts receivable, and
current liabilities assumed primarily relate to accounts payable and assumed
contractual liabilities related to development work with customers which were
agreed to prior to the acquisition date. In determining the preliminary purchase
price allocation, the Company established a liability related to an assumed
contractual relationship which related to a project for the development of
speech and language databases with the European Union. During the quarter ended
September 30, 2003, the Company determined that based on the contractual nature
of the assignability of these contracts, there is no related liability. This
determination resulted in an adjustment to the liability established in the
preliminary purchase price allocation and a corresponding adjustment to goodwill
of $431,000, which has been reflected in the table above.
The following are the identifiable intangible assets acquired and the
respective periods over which the assets will be amortized on a straight-line
basis:
AMOUNT AMORTIZATION
(IN THOUSANDS) PERIOD (IN YEARS)
-------------- -----------------
Patents and core technology.... $ 3,990 10
Completed technology........... 460 5.5
Customer relationships......... 1,030 1.8
Trade names and trademarks..... 170 5
--------
$ 5,650 9.3
========
The amount assigned to identifiable intangible assets acquired was based on
their respective fair values determined as of the acquisition date. The Company
did not attribute any value to in-process research and development projects in
connnection with this acquisition. The Company believes that these identified
intangible assets have no residual value. The excess of the purchase price over
the tangible and identifiable intangible assets was recorded as goodwill and
amounted to approximately $33.7 million. In accordance with current accounting
standards, the goodwill is not being amortized and will be tested for impairment
as required by SFAS No. 142. All goodwill and other identifiable intangible
assets are deductible for tax purposes.
Under the terms of the purchase agreement, as amended, Philips agreed to
reimburse the Company for the costs, up to 5.0 million euros, associated with
certain restructuring actions taken through December 31, 2003, primarily
headcount and facilities related charges associated with operations based in
Germany. To the extent that the total reimbursable costs exceed 5.0 million
euros as of or at any time prior to December 31, 2003, Philips will reimburse
the Company for one-third of the excess and the Company will be responsible for
the remaining two-thirds of any excess. To the extent that the total
reimbursable costs are less than 5.0 million euros at December 31, 2003, Philips
will pay to the Company an amount equal to two-thirds of such difference. Any
adjustment will either increase or decrease the total purchase consideration and
a corresponding adjustment will be recorded to goodwill. Through September 30,
2003, the Company entered into severance agreements with a total of 70 employees
of Philips, resulting in severance costs totaling $1.3 million. Of this amount,
severance costs of $1.0 million were subject to reimbursement to the Company by
Philips pursuant to the purchase agreement. During the three months ended
September 30, 2003, the Company was reimbursed $0.9 million by Philips. The
remainder ($0.3 million of the total severance costs) was recorded by the
Company as a current liability as part of the purchase price allocation in
accordance with EITF 95-3, "Recognition of Liabilities in Connection with a
Purchase Business Combination."
13
The final purchase price, adjusted for the matters described in this
Note 7, is expected to be determined no later than December 31, 2003.
8. PRO FORMA RESULTS (UNAUDITED)
The following table reflects unaudited pro forma results of operations of
the Company assuming that the Philips and SpeechWorks acquisitions had occurred
on January 1, 2002 (in thousands, except per share data):
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
2003 2002 2003 2002
-------- -------- --------- ---------
Revenues ............. $ 36,674 $ 39,757 $ 113,448 $ 116,982
Net loss ............. $(14,612) $(12,950) $ (36,097) $ (41,040)
Net loss per basic and
diluted
share ................ $ (0.15) $ (0.13) $ (0.37) $ (0.43)
The unaudited pro forma results of operations are not necessarily
indicative of the actual results that would have occurred had the transactions
actually taken place at the beginning of these periods.
9. GOODWILL
As a result of the SpeechWorks acquisition (Note 6) on August 11, 2003 and
the Philips acquisition (Note 7) on January 30, 2003, goodwill increased by
$128.4 million and $33.7 million, respectively.
10. OTHER INTANGIBLE ASSETS
Other intangible assets consist of the following (in thousands):
GROSS NET
CARRYING ACCUMULATED CARRYING
AMOUNT AMORTIZATION AMOUNT
-------- ------------ --------
SEPTEMBER 30, 2003
Patents and core technology.. $ 55,380 $26,543 $28,837
Completed technology ........ 30,371 17,608 12,763
Trademarks .................. 6,471 2,262 4,209
Non-competition agreement.... 4,058 4,049 9
Acquired favorable lease..... 553 553 --
Customer relationships ...... 11,130 1,721 9,409
Other ....................... 200 200 --
-------- ------- -------
$108,163 $52,936 $55,227
======== ======= =======
DECEMBER 31, 2002
Patents and core technology.. $ 50,090 $20,331 $29,759
Completed technology ........ 16,340 16,340 --
Trademarks .................. 5,501 1,725 3,776
Non-competition agreement.... 4,048 4,048 --
Acquired favorable lease .... 553 553 --
Customer relationships ...... 1,100 812 288
Other ....................... 200 200 --
-------- ------- -------
$ 77,832 $44,009 $33,823
======== ======= =======
On March 31, 2003, the Company entered into an agreement that grants an
exclusive license to the Company to resell, in certain geographies worldwide,
certain productivity applications. The period of exclusivity expires after seven
years, unless terminated earlier as permitted under the agreement. Total
consideration to be paid by the Company for the license was $13.0 million. On
June 30, 2003, the terms and conditions of the agreement were amended, resulting
in a $1.2 million reduction in the license fee. The initial payment of $6.4
million due on or before June 30, 2003 was paid in accordance with the terms of
the license agreement. The two remaining payments totaling $5.6 million will be
paid as follows: 1) $2.8 million on March 31, 2004 and 2) $2.8 million on March
31, 2005.
14
Based on the net present value of the deferred payments due in 2004 and 2005,
using an interest rate of 7.0%, the Company recorded $11.4 million as completed
technology, which will be amortized to cost of goods sold based on the greater
of (a) the ratio of current gross revenue to total current and expected future
revenues for the products or (b) the straight-line basis over the period of
expected use, five years. The $0.6 million difference between the stated payment
amounts and the net present value of the payments, will be charged to interest
expense over the payment period. As of September 30, 2003, payments due on or
before June 30, 2004, and the remaining balance due, have been classified as
deferred payment for technology license and other liabilities, long-term
respectively.
On March 31, 2003, the Company acquired certain intellectual property
assets related to multimodal speech technology, in exchange for $0.1 million in
cash and the issuance of a warrant valued at $0.1 million (Note 18). The
purchase price was recorded as completed technology and will be amortized over
three years.
Aggregate amortization expense was $3.4 million and $8.9 million for the
three and nine months ended September 30, 2003, respectively. Of these amounts,
$2.7 million and $7.5 million, respectively, were included in cost of revenue
and $0.7 million and $1.4 million, respectively, were recorded in operating
expenses. Aggregate amortization expense was $2.2 million and $8.9 million for
the three and nine months ended September 30, 2002, respectively. Of these
amounts, $2.0 million and $7.5 million, respectively, were included in cost of
revenue and $0.2 million and $1.4 million, respectively, were recorded in
operating expenses. Amortization expense for the remaining period of fiscal year
2003, the four succeeding fiscal years and thereafter as of September 30, 2003
is as follows (in thousands):
OTHER
COST OF OPERATING
YEAR ENDING REVENUE EXPENSES TOTAL
--------------- ---------- -------- ----------
2003........ $ 2,814 $ 731 $ 3,545
2004........ 10,813 2,749 13,562
2005........ 6,412 2,249 8,661
2006........ 5,332 2,034 7,366
2007........ 5,317 1,904 7,221
Thereafter.. 10,912 3,960 14,872
---------- -------- ----------
Total....... $ 41,600 $ 13,627 $ 55,227
========== ======== ==========
11. ACCRUED OTHER EXPENSES
Accrued other expenses consist of the following (in thousands):
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
Sales and marketing incentives .. $ 2,231 $ 1,802
Restructuring and other charges.. 1,987 665
Royalties........................ 435 238
Professional fees................ 1,438 472
Acquisition liabilities.......... 2,066 1,654
Other............................ 6,862 2,820
--------- ---------
$ 15,019 $ 7,651
========= =========
12. RESTRUCTURING AND OTHER CHARGES
In January 2002, the Company announced, and in March 2002 completed, a
restructuring plan to consolidate facilities, worldwide sales organizations,
research and development teams and other personnel following the December 12,
2001 L&H acquisition. As a result, the Company exited facilities in both North
America and Europe, eliminating 21 employee positions, including 12 in research
and development and 9 in selling, general and administrative functions. In the
first quarter of 2002, the Company recorded a restructuring charge in the amount
of $0.6 million for severance payments to these employees, and a restructuring
charge of $0.4 million for certain termination fees to be incurred as a result
of exiting the facilities, including the write-off of previously recorded
assembled workforce of $0.1 million.
In connection with the Philips acquisition (Note 7), the Company eliminated
25 ScanSoft personnel across all functional areas, resulting in a charge of
approximately $0.5 million in severance-related restructuring costs in the three
month period ended March 31, 2003.
During the three months ended June 30, 2003, the Company committed to a
plan to transfer certain research and development activities currently located
at its corporate headquarters to Budapest resulting in the elimination of 21
employees. The Company
15
recorded a restructuring charge in the amount of $0.4 million for severance
payments to these employees. In addition, the Company recorded a charge in the
amount of $0.4 million for severance payments to a former member of the senior
management team.
During the three months ended September 30, 2003, the Company eliminated 81
ScanSoft employees as a result of the SpeechWorks acquisition across all
functional areas, resulting in a charge of $1.5 million for severance costs,
representing the ratable recognition of expenses from the date the plan was
announced through September 30, 2003. Certain of these employees have
termination dates after September 30, 2003 and, as required by SFAS 112, the
Company expects to record $0.5 million of additional severance expense during
the three months ended December 31, 2003.
In addition, during the three month period ended September 30, 2003, the
Company accrued $0.2 related to the closing of certain ScanSoft offices as a
result of the SpeechWorks acquisition and related expenses.
At September 30, 2003, the remaining restructuring accrual from the current
and prior restructuring activities amounted to $2.0 million. The balance is
comprised of $0.1 million of lease exit costs and $1.9 million of
employee-related severance costs, of which $0.3 million are for severance to the
former Caere President and CEO, $0.1 million are for severance costs related to
the 2003 Philips related restructuring actions and $0.6 million and $0.9 million
are for severance costs related to the actions taken during the three months
ended June 30, 2003 and September 30, 2003, respectively, as noted above. The
lease exit costs and severance due to the former Caere President and CEO will be
paid through January 2004 and March 2005, respectively. Severance costs related
to the 2003 Philips related restructuring actions will be paid through December
31, 2003. Severance costs related to restructuring actions undertaken during the
quarter ended June 30, 2003 will be paid through March 2009. Severance costs
related to employee termination actions undertaken during the three month period
ended September 30, 2003, including the additional $0.5 million expected to be
recorded during the three months ended December 31, 2003, will be paid through
September 2004.
The following table sets forth the restructuring and other charges accrual
activity (in thousands):
FACILITIES RETIREMENT
EMPLOYEE EXIT OF
RESTRUCTURING AND OTHER CHARGES ACCRUAL RELATED COSTS FIXED ASSETS TOTAL
- ---------------------------------------- ------- --------- ------------ -------
Balance at December 31, 2001 ........... $ 634 $ -- $ -- $ 634
Restructuring and other charges ........ 576 465 -- 1,041
Non-cash write-off ..................... -- (113) -- (113)
Cash payments .......................... (764) (133) -- (897)
------- ----- ---- -------
Balance at December 31, 2002 ........... 446 219 -- 665
Restructuring and other charges ........ 2,856 120 89 3,065
Non-cash write-off ..................... -- -- (89) (89)
Cash payments .......................... (1,407) (247) -- (1,654)
------- ----- ---- -------
Balance at September 30, 2003 .......... $ 1,895 $ 92 $ -- $ 1,987
======= ===== ==== =======
13. OTHER LIABILITIES
Other liabilities consist of the following (in thousands):
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------ -----------
Facilities operating lease obligations ...... $4,377 $ --
Deferred payments for technology license .... 2,588 --
Caere acquisition related costs ............. -- 409
Other ....................................... 328 72
------ ----
$7,293 $481
====== ====
14. NET INCOME (LOSS) PER SHARE
Basic net income (loss) per share is computed using the weighted average
number of common shares outstanding during the period. Basic net income per
share for the three and nine months ended September 30, 2002 includes the
assumed conversion
16
of the Series B Preferred Stock, which participates in dividends with common
stock when and if declared, as well as the weighted average impact of vested
shares of restricted stock. Diluted net income (loss) per share is computed
based on (i) the weighted average number of common shares outstanding, (ii) the
assumed conversion of the Series B Preferred Stock, and (iii) the effect, when
dilutive, of outstanding stock options, the convertible debenture, warrants, and
unvested shares of restricted stock using the treasury stock method.
The following is a reconciliation of the shares used in the computation of
basic and diluted net income (loss) per share (in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- -------------------
2003 2002 2003 2002
------- ------- ------ ------
Weighted average number of common shares
outstanding.................................. 83,694 64,303 71,286 63,554
Assumed conversion of Series B Preferred
stock.................................... -- 3,562 -- 3,562
------ ------ ------ ------
Weighted average common shares: basic......... 83,694 67,865 71,286 67,116
Effect of dilutive common equivalent shares:
Stock options.............................. -- 6,362 -- 4,772
Convertible debenture...................... -- -- -- --
Warrants................................... -- 463 -- 468
Unvested restricted stock.................. -- 97 -- 95
------ ------ ------ ------
Weighted average common shares: diluted....... 83,694 74,787 71,286 72,451
====== ====== ====== ======
For the three and nine months ended September 30, 2003, diluted net loss
per share excludes 14,355,733 and 14,284,081 common share equivalents because
their effect would be antidilutive. For the three and nine months ended
September 30, 2002, stock options to purchase 3,383,559 and 1,655,604 shares,
respectively, of common stock were outstanding but were excluded from the
calculation of diluted net income per share because the options' exercise prices
were greater than the average market price of the Company's common stock during
the periods.
15. COMPREHENSIVE INCOME (LOSS)
Total comprehensive income (loss), net of taxes, was ($3.9) million and
($7.3) million for the three and nine months ended September 30, 2003,
respectively, and was $3.0 million and $2.4 million for the three and nine
months ended September 30, 2002, respectively. Total comprehensive loss for
the nine months ended September 30, 2003, consisted of net loss of ($6.8)
million and foreign currency translation losses of ($0.5) million partially
offset by a net $2,000 foreign exchange gain related to the forward hedges on
the 5.0 million promissory note and 1.0 million payable to Philips (Note 16).
16. DEBT
Credit Facility
On October 31, 2002, the Company entered into a two year Loan and Security
Agreement (as amended, the "Loan Agreement") with Silicon Valley Bank (the
"Bank") that consisted of a $10.0 million revolving loan (the "Credit
Facility"). The Company amended this Loan and Security Agreement, as of
September 30, 2003, for the period September 30, 2003 through December 31, 2003,
removing the fixed charge coverage ratio covenant and replacing it with an
adjusted quick ratio covenant. Borrowings under the Credit Facility bear
interest at the Bank's prime rate plus 0.375% or 0.75%, (4.875% at September 30,
2003) which is determined by the Company's adjusted quick ratio, as defined in
the Loan Agreement. The maximum aggregate amount of borrowings outstanding at
any one time is limited to the lesser of $10.0 million or a borrowing base equal
to either 80% or 70% of eligible accounts receivable, as defined in the Loan
Agreement, based on the Company's adjusted quick ratio. Borrowings under the
Loan Agreement cannot exceed the borrowing base and must be repaid in the event
they exceed the calculated borrowing base or upon expiration of the two-year
loan term. Borrowings under the Loan Agreement are collateralized by
substantially all of the Company's personal property, predominantly its accounts
receivable, but not its intellectual property.
As of September 30, 2003, based upon the calculated borrowing base,
available borrowings totaled approximately $9.7 million. The Company can make no
guarantees as to its ability to satisfy its future financial covenant
calculations. As of September 30, 2003, there was no outstanding balance under
this Credit Facility.
17
The Loan Agreement also contains a restrictive covenant regarding the
payment or declaring of any dividends on the Company's capital stock during the
term of the agreement (except for dividends payable solely in capital stock)
without the Bank's prior written consent. As of September 30, 2003, the Company
was in compliance with all covenants.
Equipment Line of Credit
In connection with the acquisition of SpeechWorks, the Company assumed $1.5
million of principal amounts outstanding under a one-year equipment
line-of-credit with a bank which expired on June 30, 2003. As of September 30,
2003, assumed balance of $1.5 million remains outstanding. Borrowings under this
line are collateralized by the fixed assets purchased and bear interest at the
bank's prime rate (5.0% at September 30, 2003), which is payable in equal
monthly payments over a period of 36 months. In accordance with the terms of the
equipment line of credit, as of September 30, 2003, principal payments of
$226,000 are due in the year ended December 31, 2003, $904,000 are due during
the year ending December 31, 2004, $293,000 are due during the year ending
December 31, 2005 and $44,000 are due during the year ended December 31, 2006.
Under the financing agreement, the Company is obligated to comply with certain
financial covenants related to total tangible net assets; and was in compliance
as of September 30, 2003.
Notes Payable
In connection with the L&H acquisition, the Company issued a $3.5 million
promissory note (the "Note") to Lernout & Hauspie Speech Products, N.V. The Note
had a stated maturity date of December 15, 2004 and bore interest at 9% per
annum. Payments of principal and interest in the amount of $133,000 were due
quarterly commencing on March 15, 2002, for a total of eleven payments. During
the year ended December 31, 2002, four quarterly payments were made in
accordance with the terms of the promissory note. In connection with an
agreement entered into by the Company in September 2002 to repurchase 1,461,378
shares of common stock from L&H Holdings USA, Inc. and Lernout & Hauspie Speech
Products N.V. (collectively, "L&H") and to register in an underwritten offering
the remaining shares held by L&H, the terms of the Note were amended to provide
for the acceleration of the maturity date of the outstanding principal and
interest to January 1, 2003 if consummation of the underwritten public offering
did not occur by January 1, 2003. The Company did not complete the offering by
January 1, 2003 and, accordingly, the debt became immediately due and payable.
To fulfill this obligation, on January 3, 2003, the Company paid $3.3 million in
full settlement of all outstanding principal and accrued interest under the
Note. In connection with the Philips acquisition on January 30, 2003, the
Company issued a 5.0 million euro promissory note (the "Philips Note") to
Philips. The unsecured Philips Note matures on December 31, 2003 and bears
interest at 5% per annum. Payments of principal and accrued interest are due at
maturity. The Philips Note may be prepaid by the Company at any time without
penalty. In connection with the issuance of the Philips Note, the Company
entered into a forward foreign currency exchange contract on January 31, 2003 to
hedge the foreign exchange exposure on the Philips Note. The amount of the
forward foreign currency exchange contract is equivalent to the principal amount
of the Philips Note, and the duration of the forward contract coincides with the
maturity date of the Philips Note. The foreign exchange hedge on the Philips
Note resulted in a foreign exchange gain of approximately $0.1 million, which
will be recorded in income over the term of the forward contract. At September
30, 2003, the promissory note was valued at $5.8 million and was recorded as a
note payable due currently.
Convertible Debenture
On January 30, 2003, the Company issued a $27.5 million three-year,
zero-interest convertible subordinated debenture due January 2006 (the
"Convertible Note") to Philips in connection with the Philips acquisition (Note
6). The Convertible Note is convertible into shares of the Company's common
stock at $6.00 per share at any time until maturity at Philips' option. The
conversion rate may be subject to adjustments from time to time as provided in
the Convertible Note. The Convertible Debenture contains a provision in which
all amounts unpaid at maturity will bear interest at a rate of 3% per quarter
until paid.
The Convertible Note contains restrictive covenants that place restrictions
on the declaration or payment of dividends or distributions (other than
distributions of equity securities of the Company) on, or the redemption or
purchase of, any shares of the Company's capital stock while the Convertible
Note is outstanding. This restriction terminates when one-half or more of the
principal amount of the Convertible Note is converted by Philips into common
stock. The Convertible Note contains a restrictive provision, which provides
Philips the right to require the Company to redeem the Convertible Note or any
remaining portion of the principal amount, on the date a "Change in Control"
occurs. The Convertible Note provides that a "Change in Control" is deemed to
have occurred when any person or entity acquires beneficial ownership of shares
of capital stock of the Company entitling such person or entity to exercise 40%
or more of the total voting power of all shares of capital stock of the Company,
or the Company sells all or substantially all of its assets, subject to certain
exceptions. The Company's acquisition of SpeechWorks (Note 6) did not result in
a Change in Control.
18
17. COMMITMENTS AND CONTINGENCIES
Operating Leases
The Company has various operating leases for office space around the world.
In connection with the acquisition of SpeechWorks, ScanSoft assumed all its
lease obligations. Among these obligations are lease payments related to two
office locations vacated during 2003 and one associated with office space which
will become available beginning in January 2005. Gross lease payments associated
with these office locations amounting to $10.1 million and $13.4 million,
respectively, have been included in the table below. No amounts have been
recorded in the Company's purchase price allocation in connection with the
facility which becomes available in January 2005. ScanSoft's plans with respect
to these operating leases, as well as all SpeechWorks facilities, are being
assessed in connection with the integration plan. These obligations extend
through 2016. The following table outlines the Company's future minimum payments
under operating leases as of September 30, 2003 (in thousands):
PAYMENTS DUE BY PERIOD,
Within one year.......................... $ 5,290
Year 2 .................................. 5,246
Year 3................................... 4,412
Year 4................................... 2,823
Year 5................................... 2,565
Thereafter............................... 17,980
--------
Total.................................... $ 38,316
========
Total future lease obligations in the table above do not reflect future minimum
sub-lease rentals of approximately $6.8 million.
Litigation and Other Claims
Like many companies in the software industry, the Company has from time to
time been notified of claims that it may be infringing certain intellectual
property rights of others. Where appropriate these claims have been referred to
counsel, and they are in various stages of evaluation and negotiation or have
been resolved. If it appears necessary or desirable, the Company may seek
licenses for these intellectual property rights. There is no assurance that
licenses will be offered by all claimants, that the terms of any offered
licenses will be acceptable to the Company or that in all cases the dispute will
be resolved without litigation, which may be time consuming and expensive, and
may result in injunctive relief or the payment of damages by the Company.
From time to time, the Company receives information concerning possible
infringement by third parties of our intellectual property rights, whether
developed, purchased or licensed by us. In response to any such circumstance,
the Company's counsel investigates the matter thoroughly and the Company takes
all appropriate action to defend our rights in these matters.
On July 15, 2003, Elliott Davis ("Davis") filed an action against
SpeechWorks in the United States District Court for the Western District for New
York (Buffalo) claiming patent infringement. Damages are sought in an
unspecified amount. In the lawsuit, Davis alleges that SpeechWorks is infringing
United States Patent No. 4,802,231 entitled "Pattern Recognition Error Reduction
System" (the "`231 Patent"). The '231 Patent generally discloses techniques for
a pattern recognition system and method wherein errors are reduced by creating
independent error templates that correspond to patterns which tend to be
erroneously matched and linked error templates which are linked to specified
reference templates which are stored for comparison. Although ScanSoft has, as a
result of the SpeechWorks acquisition has several products in the speech
recognition technology field, ScanSoft believes that the products do not
infringe the '231 Patent because SpeechWorks does not use the claimed
techniques. The Company filed an Answer and Counterclaim to Davis's Complaint on
August 25, 2003. The Company believes Davis's claim has no merit and intends to
defend the action vigorously.
On November 27, 2002, AllVoice Computing plc filed an action against the
Company in the United States District Court for the Southern District of Texas
claiming patent infringement. In the lawsuit, AllVoice alleges that the Company
is infringing United States Patent No. 5,799,273 entitled "Automated
Proofreading Using Interface Linking Recognized Words to Their Audio Data While
Text Is Being Changed" (the "'273 Patent"). The '273 Patent generally discloses
techniques for manipulating audio data associated with text
19
generated by a speech recognition engine. Although the Company has several
products in the speech recognition technology field, the Company believes that
its products do not infringe the '273 Patent because, in addition to other
defenses, they do not use the claimed techniques. Damages are sought in an
unspecified amount. The Company filed an Answer on December 23, 2002. The
Company believes this claim has no merit and intends to defend the action
vigorously.
On December 28, 2001, the Massachusetts Institute of Technology and
Electronics For Imaging, Inc. sued the Company in the United States District
Court for the Eastern District of Texas for patent infringement. The patent
infringement claim was filed against more than 200 defendants. In their lawsuit,
MIT and EFI allege that the Company is infringing United States Patent No.
4,500,919 entitled "Color Reproduction System" (the "'919 Patent"). MIT and EFI
allege that the '919 Patent discloses a system for adjusting the colors of a
scanned image on a television screen and outputting the modified image to a
device. The Company has several products that permit a user to adjust the color
of an image on a computer monitor. The Company has asserted that its products do
not infringe the '919 Patent because its products do not contain all elements of
the structure required by the claimed invention and because its products do not
perform all of the steps required by the claimed method. Further, the Company
believes there may be prior art that would render the '919 Patent invalid. The
'919 Patent expired on May 6, 2002. Damages are sought in an unspecified amount.
The Company filed an Answer and Counterclaim on June 28, 2002. The Company
believes this claim has no merit and intends to defend the action vigorously.
On August 16, 2001, Horst Froessl sued the Company in the United States
District Court for the Northern District of California for patent infringement.
In his lawsuit, Froessl alleges that the Company is infringing United States
Patent No. 4,553,261 entitled "Document and Data Handling and Retrieval System"
(the "'261 Patent"). Froessl alleges that the '261 Patent discloses a system for
receiving and optically scanning documents, converting selected segments of the
digitalized scan data into machine code, and storing and retrieving the
documents and the digitalized and converted segments. Although the Company has
several products in the scanning technology field, the Company has asserted that
its products do not infringe the '261 Patent because its products do not contain
all elements of the structure required by the claimed invention and because its
products do not perform all of the steps required by the claimed method.
Further, the Company believes there may be prior art that would render the '261
Patent invalid. The '261 Patent expired on May 31, 2003. Damages are sought in
an unspecified amount. The Company filed an Answer and Counterclaim on September
19, 2001. The Company believes this claim has no merit and intends to defend the
action vigorously.
The Company believes that the final outcome of these matters will not have
a significant adverse effect on its financial position, results of operations or
cash flows and the Company believes it will not be required to expend a
significant amount of resources defending such claims. However, should the
Company not prevail in any such litigation, its operating results, financial
position and cash flows could be adversely impacted.
Guarantees and Other
The Company has entered into agreements to indemnify its directors and
officers to the fullest extent authorized or permitted under applicable law.
These agreements, among other things, provide for the indemnification of its
directors and officers for expenses, judgments, fines, penalties and settlement
amounts incurred by any such person in his or her capacity as a director or
officer of the company, whether or not such person is acting or serving in any
such capacity at the time any liability or expense is incurred for which
indemnification can be provided under the agreements. The Company has a Director
and Officer insurance policy in effect that reduces its exposure under these
agreements and enables it to recover a portion of any future amounts paid. While
the maximum potential amount of any future payments under these agreements is
uncertain, as a result of its insurance coverage, the Company believes the
estimated fair value of these agreements is minimal.
The Company currently includes indemnification provisions in the contracts
it enters with its customers and business partners. Generally, these provisions
require the Company to defend claims arising out of its products' infringement
of third-party intellectual property rights, breach of contractual obligations
and/or unlawful or otherwise culpable conduct on its part. The indemnity
obligations imposed by these provisions generally cover damages, costs and
attorneys' fees arising out of such claims. In most, but not all, cases, the
Company's total liability under such provisions is limited to either the value
of the contract or a specified, agreed upon, amount. In some cases its total
liability under such provisions is unlimited. In many, but not all, cases, the
term of the indemnity provision is perpetual. While the maximum potential amount
of future payments the Company could be required to make under all the
indemnification provisions in its contracts with customers and business partners
is unlimited, it believes that the estimated fair value of these provisions is
minimal due to the low frequency with which these provisions have been
triggered.
20
In accordance with the terms of the SpeechWorks merger agreement, the
Company is required to indemnify the former members of the SpeechWorks board of
directors, on similar terms as described above, for a period of six months from
the acquisition date. As a result, the Company recorded a liability related to
the fair value of the obligation of $0.3 million in connection with the purchase
accounting for the acquisition. Additionally in accordance with the terms of the
merger agreement, the Company purchased a director and officer insurance policy
related to this obligation for a period of three years from the date of
acquisition.
18. EQUITY TRANSACTIONS
Acquisition of SpeechWorks International, Inc.
On August 11, 2003, the Company acquired all of the outstanding stock of
SpeechWorks (Note 6). In connection with the acquisition of SpeechWorks, the
Company exchanged 0.860 of a share of its common stock for each outstanding
share of SpeechWorks stock. This transaction resulted in the issuance of
approximately 32.5 million shares of its' common stock, representing
approximately 33% of the outstanding common stock of the Company after the
completion of the acquisition.
Shares Repurchase Program
On August 6, 2003, the Company's board of directors authorized the
repurchase of up to $25 million of the Company's common stock over the next 12
months, however, the Company may suspend or discontinue the repurchase program
at any time. From August 6, 2003 through September 30, 2003, the Company
repurchased 413,700 common shares at a purchase price of $1.8 million; the
Company records treasury stock at cost. The Company intends to use the
repurchased shares for its employee stock plans and for potential future
acquisitions.
Common Stock Warrants
In connection with the March 31, 2003 acquisition of the certain
intellectual property assets related to multimodal speech technology (Note 9),
the Company issued a warrant, expiring October 31, 2005, for the purchase of
78,000 shares of ScanSoft common stock at an exercise price of $8.10 per share.
The warrant was immediately exercisable and was valued at $0.1 million based
upon the Black-Scholes option pricing model with the following assumptions:
expected volatility of 80%, a risk-free rate of 1.87%, an expected term of 2.5
years, no dividends and a stock price of $4.57 based on the Company's stock
price at the time of issuance.
In connection with the SpeechWorks acquisition (Note 6), the Company issued
a warrant to its investment banker, expiring on August 11, 2009, for the
purchase of 150,000 shares of ScanSoft common stock at an exercise price of
$3.98 per share. The warrant does not become exercisable until August 11, 2005
and was valued at $0.2 million based upon the Black-Scholes option pricing model
with the following assumptions: expected volatility of 60%, a risk-free interest
rate of 4.03%, an expected term of 8 years, no dividends and a stock price of
$3.92 based on the Company's stock price at the time of issuance.
Underwritten Public Offering
During the three months ended March 31, 2003, the Company completed an
underwritten public offering of 8,256,906 shares of the Company's common stock
at $3.80 per share. Of the total shares sold, 6,184,406 shares were sold on
behalf of Lernout & Hauspie Speech Products N.V. and L&H Holdings USA, Inc. The
Company sold 2,072,500 common shares and received gross proceeds of $7.9
million. After considering offering costs, the net proceeds amounted to
approximately $5.5 million.
19. RESTRICTED COMMON STOCK
On August 11, 2003, the Company issued 300,000 shares of restricted common
stock to the Company's Chief Executive Officer. Unvested restricted shares may
not be sold, transferred or assigned. Of these restricted common shares, 100,000
vest on each of August 31, 2004, 2005 and 2006. Except as otherwise specified in
the restricted stock agreement, in the event that the executive's employment
with the Company terminates, any unvested shares of the restricted stock shall
be forfeited and revert to the Company. The purchase price of the shares equaled
the par value of the shares, aggregating $300. The difference between the
purchase price and the fair value of the Company's common stock on the date of
issue of $1.2 million has been recorded as deferred compensation and additional
paid-in-capital. The deferred compensation is being recognized as compensation
expense ratably over the vesting period resulting in $53,600 of stock
compensation expense during the three months ended September 30, 2003.
21
In connection with the SpeechWorks acquisition (Note 6), the Company issued
184,786 shares of restricted common stock in replacement of previously
outstanding SpeechWorks unvested restricted common stock. Unvested restricted
common stock may not be sold, transferred or assigned and are subject to
forfeiture in the event an employee ceases to be employed by the Company. The
restricted common stock vests no later than March 25, 2007. Deferred
compensation of $0.7 million was recorded associated with the issuance of these
restricted shares which is equal to the closing price of ScanSoft common stock
on the acquisition date. The deferred compensation is being recognized as
compensation expense ratably over the vesting period resulting in $25,000 of
stock compensation expense during the three months ended September 30, 2003.
20. SEGMENT AND GEOGRAPHIC INFORMATION
The Company operates in a single industry segment. The following table
presents total revenue information by geographic area and principal product line
(in thousands):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
2003 2002 2003 2002
------- ------- ------- -------
North America ........... $24,075 $20,824 $64,227 $58,029
Other foreign countries.. 8,875 7,411 24,302 20,155
------- ------- ------- -------
Total ................. $32,950 $28,235 $88,529 $78,184
======= ======= ======= =======
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
2003 2002 2003 2002
------- ------- ------- -------
Digital Capture ..... $13,553 $16,660 $38,695 $45,915
Speech .............. 19,397 11,575 49,834 32,269
------- ------- ------- -------
Total ............. $32,950 $28,235 $88,529 $78,184
======= ======= ======= =======
Revenue classification above is based on the country in which the sale
originates or is invoiced. Revenue in other countries predominately relates to
sales to customers in Asia and Europe. Intercompany sales are insignificant as
products sold outside of the United States or Europe are sourced within Europe
or the United States.
21. INCOME TAXES
The provision for (benefit from) income taxes for the three and nine months
ended September 30, 2003 reflects a $0.9 million deferred tax provision
associated with differences between book and tax amortization for certain
goodwill. Of this amount $0.5 million relates to fiscal year 2002. The provision
also includes the impact of a $1.4 million federal tax refund relating to a use
of net operating losses in a prior period.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and related notes thereto, located in Item 1 of this quarterly
report.
FORWARD-LOOKING STATEMENTS
This quarterly report contains forward-looking statements. These
forward-looking statements include predictions regarding:
-- OUR STRATEGY RELATING TO SPEECH AND LANGUAGE TECHNOLOGIES;
-- OUR EXPECTATIONS REGARDING OUR ACQUISITION OF SPEECHWORKS AND CERTAIN
ASSETS FROM PHILIPS;
-- THE POTENTIAL OF FUTURE PRODUCT RELEASES;
-- OUR PRODUCT DEVELOPMENT PLANS AND INVESTMENTS IN RESEARCH AND
DEVELOPMENT;
-- FUTURE ACQUISITIONS;
-- INTERNATIONAL OPERATIONS AND LOCALIZED VERSIONS OF OUR PRODUCTS; AND
-- LEGAL PROCEEDINGS AND LITIGATION MATTERS.
22
You can identify these and other forward-looking statements by the use of
words such as "may," "will," "should," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "intends," "potential," "continue" or the
negative of such terms, or other comparable terminology. Forward-looking
statements also include the assumptions underlying or relating to any of the
foregoing statements.
Our actual results could differ materially from those anticipated in these
forward-looking statements as a result of various factors, including those set
forth in this quarterly report under the heading "Factors That May Affect our
Future Results of Operations." All forward-looking statements included in this
document are based on information available to us on the date hereof. We assume
no obligation to update any forward-looking statements.
RECENT DEVELOPMENTS
On January 3, 2003, we paid $3.3 million in full settlement of all
principal and accrued interest on a promissory note issued in connection with
the L&H acquisition on December 12, 2001.
On January 30, 2003, we completed the acquisition of the Philips Speech
Processing Telephony and Voice Control business units of Royal Philips
Electronics N.V. ("Philips"), and related intellectual property. The Telephony
business unit offers speech-enabled services including directory assistance,
interactive voice response and voice portal applications for enterprise
customers, telephony vendors and carriers. The Voice Control business unit
offers a product portfolio including small footprint speech recognition engines
for embedded applications such as voice-controlled climate, navigation and
entertainment features in automotive vehicles, as well as voice dialing for
mobile phones. As consideration for the business, we paid 3.1 million euros
($3.4 million) in cash at closing, subject to adjustment in accordance with the
provisions of the purchase agreement, as amended, and agreed to pay an
additional 1.0 million euros in cash due no later than December 31, 2003, issued
a 5.0 million euro note due December 31, 2003 and bearing 5.0% interest per
annum and issued a $27.5 million three-year, zero-interest subordinated
debenture, convertible at any time at Philips' option into shares of our common
stock at $6.00 per share. The purchase price is subject to adjustment. We
anticipate that all related adjustments will be completed no later than December
31, 2003 and all adjustments arising from contingencies that existed at the
closing and as of March 31, 2003 will be recorded as adjustments to goodwill. In
connection with the acquisition we hired 116 employees.
During the three months ended March 31, 2003, the Company completed an
underwritten public offering of 8,256,906 shares of the Company's common stock
at $3.80 per share. Of the total shares sold, 6,184,406 shares were sold on
behalf of Lernout & Hauspie Speech Products N.V., and L&H Holdings USA, Inc. The
Company sold 2,072,500 common shares and received gross proceeds of $7.9
million. After deducting offering costs, the net proceeds amounted to
approximately $5.5 million.
On August 11, 2003, the Company acquired all of the outstanding stock of
SpeechWorks International, Inc. ("SpeechWorks"), a leading provider of software
products and professional services that enable enterprises, carriers and
government organizations to offer automated, speech-activated services over any
telephone, in exchange for 0.860 of a share of ScanSoft common stock for each
outstanding share of SpeechWorks stock. This transaction resulted in the
issuance of approximately 32.5 million shares of ScanSoft common stock,
representing approximately 33% of the outstanding common stock of ScanSoft after
the completion of the acquisition. The purchase price of approximately $175.5
million, including transaction costs of $4.5 million was determined based on the
shares of ScanSoft common stock issued multiplied by $5.26 per share (the
average closing price of ScanSoft common stock for a total of five days,
immediately prior and subsequent to the announcement of the acquisition). The
acquisition of SpeechWorks did not result in a Change in Control as defined by
the Philips subordinated debenture.
As more fully discussed in Note 2 of the Notes to Unaudited Consolidated
Financial Statements, the Company is restating its consolidated financial
statements as of and for the three month periods ended March 31, 2003 and June
30, 2003 and the six months ended June 30, 2003 to increase its deferred tax
asset valuation allowance and to record deferred tax liabilities for certain
differences between book and tax goodwill amortization. As a result of this
restatement, our reported net income for the three month periods ended March 31,
2003 decreased from $76,000 to a net loss of $174,000; for the three month
period ended June 30, 2003 the net loss increased from $2,639,000 to $2,943,000;
and the net loss for the six months ended June 30, 2003 increased from
$2,563,000 to $3,117,000. There was no impact to our reported earnings per share
in the three month periods ended March 31, 2003 and June 30, 2003. Our reported
loss per share increased from $0.04 to $0.05 per share for the six months ended
June 30, 2003. The restatement had no effect on our reported cash flows from
operations. The accompanying Management's Discussion and Analysis has been
revised to reflect the impact of this restatement.
23
OVERVIEW
ScanSoft is a leading provider of technologies, applications and services
allow users to incorporate speech, documents and images into digital
applications and automate business processes. Our solutions help enterprises,
professionals and consumers increase productivity, reduce costs and save time.
Our products are built upon speech and digital capture technologies, and are
sold as solutions into the financial, legal, healthcare, government,
telecommunications, automotive, and travel and entertainment industries. We
focus on markets where we can exercise market leadership, where significant
barriers to entry exist and where we possess competitive advantages because of
the strength of our technologies, products, channels and business processes.
RESULTS OF OPERATIONS
The following table presents, as a percentage of total revenue, certain
selected financial data for the three and nine months ended September 30, 2003
and 2002:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
2003 2002 2003 2002
------ ----- ----- -----
Total revenue................................ 100.0% 100.0% 100.0% 100.0%
Cost and expenses:
Cost of revenue ........................ 20.5% 14.9% 17.6% 16.6%
Cost of revenue from amortization of
intangible assets .................... 8.4% 7.0% 8.5% 9.6%
Total cost of revenue ....................... 28.9% 21.9% 26.1% 26.2%
Gross profit................................. 71.1% 78.1% 73.9% 73.8%
Operating expenses:
Research and development................. 29.0% 25.7% 28.3% 27.3%
Selling, general and administrative...... 47.4% 40.3% 48.2% 40.9%
Non-cash stock compensation ............. 0.3% 0.1% 0.2% 0.1%
Amortization of other intangible assets.. 2.0% 0.8% 1.6% 1.8%
Restructuring and other charges.......... 5.2% --% 3.5% 1.3%
------ ----- ----- -----
Total costs and expenses.......... 112.8% 88.8% 107.9% 97.6%
----- ----- ----- -----
Income (loss) from operations................. (12.8)% 11.2% (7.9)% 2.4%
----- ----- ----- -----
Other income (expense), net................... 0.8% (0.6)% 0.7% (0.2)%
----- ------ ----- -----
Income (loss) before income taxes............. (12.0)% 10.6% (7.2)% 2.2%
Provision for (benefit from) income taxes..... (0.7)% 0.6% 0.5% (0.2)%
------ ----- ----- -----
Net income (loss)............................. (11.3)% 10.0% (7.7)% 2.4%
===== ===== ===== =====
GENERAL
We derive our revenue from sales of our software products to customers
through distribution partners and value-added resellers, royalty revenues from
OEM partners, license fees from sales of our products to customers and from
professional services, which include, but are not limited to, custom software
applications and other services considered essential to the functionality of the
software, training, and maintenance associated with software license
transactions.
Our products and solutions can be grouped in three areas: network speech
solutions, embedded speech solutions and productivity applications. Network
speech solutions include speech recognition, text to speech (TTS) and speaker
verification, as well as auto-attendant, directory assistance and other
applications. Embedded speech solutions include speech recognition, TTS and
speaker verification technologies used in automobiles, mobile devices, games and
consumer electronics. Productivity applications are based on capture and
dictation technologies and include solutions for networked scanning, document
conversion, personal document management, PDF creation, dictation and electronic
forms.
Sales of our software products through certain distributors and value-added
resellers provide rights of return for as long as the distributors or resellers
hold the inventory. As a result, we recognize revenues from sales to
distributors and resellers only when the distributors or resellers have sold
products to retailers and end-users. Title and risk of loss pass to the
distributor or reseller upon shipment, at which time the transaction is invoiced
and payment is due. Based on reports from distributors and resellers of their
inventory balances at the end of each period, we record an allowance against
accounts receivable for the sales price of all inventories subject to return. If
we experience significant returns from distributors or resellers, our liquidity
may be adversely impacted. We make an estimate of sales returns by retailers or
end users to us directly or through our distributors or resellers based on
historical returns experience. The provision for these estimated returns is
recorded as a reduction of revenue at the time that the related revenue is
recorded. Historically, we have not experienced significant returns from
retailers or end-users. If actual returns differ significantly from our
estimates, such differences could have a material impact on our results of
operations for the period in which the actual returns become known.
24
Royalty revenue derived from sales to OEM customers is recognized when
software copies are deployed based upon reports of actual deployments received
from OEM customers and payment is due.
We generate revenue from professional services, provided that evidence of
the arrangement exists, the fees are fixed or determinable and collectibility is
reasonably assured. When we provide professional services such as custom
applications and other services considered essential to the functionality of the
software for a fixed fee, we recognize revenue from the fees for such services
and any related software licenses as we complete the project using the
percentage-of-completion method. We generally determine the
percentage-of-completion by comparing the labor hours we have incurred to date
to our estimate of the total labor hours required to complete the project based
on regular discussions with our project managers. This method is used because we
consider expended labor hours to be the most reliable, available measure of
progress on these projects. Adjustments to contract estimates are made in the
periods in which facts resulting in a change become known. When the estimate
indicates a loss, such loss is provided for in its entirety. Significant
judgments and estimates are involved in determining the percent complete of each
contract. Different assumptions could yield materially different results.
Other professional services not considered essential to the functionality
of the software are limited and primarily include training and feasibility
studies. When we provide services on a time and materials basis, we recognize
revenue as we perform the services based on actual time incurred.
We may sell, under one contract or related contracts, software licenses,
custom software applications and other services considered essential to the
functionality of the software and a maintenance and support arrangement. The
total contract value is attributed first to the maintenance and support
arrangement based on its fair value, equal to its stated list price as a fixed
percentage of the related software product's price. The remainder of the total
contract value is then attributed to the software license and related
professional services, which are typically recognized as revenue using the
percentage of completion method. As a result, discounts inherent in the total
contract value are attributed to the software license and related professional
services. We may sell, under one contract or related contracts, software
licenses, a maintenance and support arrangement and professional services not
considered essential to the functionality of the software. In those
arrangements, the total contract value is attributed first to the undelivered
elements of maintenance and support and professional services based on their
fair values, as described above. The remainder of the contract value is
attributed to the software licenses, which are typically recognized as revenue
upon delivery, provided all other revenue recognition criteria are met. As a
result, discounts inherent in the total contract value are attributed to the
software licenses.
Under our maintenance and support arrangements, we offer unspecified
upgrades and enhancements on software products only on a when-and-if-available
basis. Typically, we do not contract in advance for specified upgrades,
enhancements or additional software products. When we provide support and
maintenance services, we recognize the revenue ratably over the term of the
related contracts, typically one year.
We characterize our revenues in three ways: Direct, VAR/Retail, and OEM.
Direct revenue consists of sales of our Capture and Dictation products through
our e-Commerce channels, as well as revenue recognized from volume sales of our
Capture and Dictation products directly to the end user. VAR/Retail is made up
of revenue recognized from sales of our Capture and Dictation products through
our two-tiered distribution/reseller channels. This includes, but is not limited
to, sales to retailers, VAR's and Corporate Resellers. OEM revenues consist of
all licensing revenues recognized from third party royalties due the Company.
Cost of revenue consists primarily of material and fulfillment costs,
third-party royalties, salaries for product support personnel and engineering
costs associated with contracts which are accounted for under the
percentage-of-completion method of accounting.
Cost of revenue from amortization of intangible assets includes the
amortization of acquired patents and core and completed technology.
Research and development expenses consist primarily of salary and benefits
costs of engineers. We believe that the development of new products and the
enhancement of existing products are essential to our success. Accordingly, we
plan to continue to invest in research and development activities. To date, we
have not capitalized any development costs as the cost incurred after
technological feasibility but before release of product has not been
significant.
Selling expenses include salaries, commissions, advertising, direct mail,
public relations, trade shows, travel and other related sales and marketing
expenses. General and administrative expenses include personnel costs for
administration, finance, human resources, information systems and general
management, in addition to legal and accounting expenses and other professional
services. We attempt to control selling, general and administrative expenses;
however, if revenue continues to grow, we expect selling, general and
administrative expenses to increase to support our growing operations. In
addition, we may increase selling, general and administrative expenses in
advance of revenue to support expected future revenue growth in specific product
lines or geographic regions.
Amortization of other intangible assets excludes amortization of acquired
patents and core and completed technology, which is included in cost of revenue
from amortization of intangible assets.
25
Total Revenue
Total revenue for the three months ended September 30, 2003 increased by
$4.7 million or 17% from the comparable period in 2002. This growth in revenue
is attributed to a $7.8 million growth in our Speech and Language revenues,
offset by an overall decrease of $3.1 million in our Digital Capture revenues
from the comparable period 2002. The increase in our Speech and Language
revenues are imputed to a $7.1 million increase in our networked solution
technologies, as well as a $1.3 million increase in our embedded speech
technologies, from the comparable period 2002. The growth in these sectors was
partially offset by a small seasonal decrease in our dictation product lines.
The overall decrease in our Digital Capture products can be solely attributed to
a decrease in revenues recognized from our OCR products. This overall decrease
is the result of the timing of the launch of OmmiPage Pro 12.0 in Q3 2002. The
decrease in the OCR revenues was offset to some extent by an overall
strengthening of our other Digital Capture product lines, in particular,
PaperPort, as well as the revenues from the launch of our new product, PDF
Converter.
Total revenue for the nine months ended September 30, 2003 increased by
$10.3 million or 13% from the comparable period in 2002. The increase in revenue
from the comparable period 2002 is ascribed to a $17.5 million increase in our
Speech and Language revenues, offset by a decline in our overall Digital Capture
revenues of $7.2 million. The growth in Speech and Language revenues is
accredited to growth in all three of our speech and language categories,
networked, embedded, and dictation. Networked solutions saw an increase for the
nine months ended September 30, 2003 of $12.3 million from the comparable period
2002, dictation productivity applications increased $3.6 million year over year,
and while our embedded Text-to-Speech (TTS) product experienced considerable
softening in the Asian market, our other embedded speech applications revenues
were able to counterbalance resulting in an overall $1.6 million increase. The
overall decrease in our Digital Capture revenues from 2002 was due primarily to
lower sales of our OCR product line of which the timing of the September 2002
launch of OmmiPage 12 was a major factor, as well as the recognition in the
first quarter 2002 of revenue previously deferred associated with completed OEM
services. A strengthening in our Pager Management products offset these
decreases to some extent, of which the launch of PaperPort 9.0 in March 2003 was
the primary factor, as well as the initial launch of our PDF Converter product.
Geographic revenue classification is based on the country in which the sale
is invoiced. Revenue for the three months ended September 30, 2003 was 73% North
America and 27% international versus 70% and 30%, respectively for the
comparable period in 2002. Revenue for the nine months ended September 30, 2003
was 73% North America and 27% international, versus 74% North America and 26%
international for the comparable period in 2002.
A number of the Company's OEM partners distribute their products throughout
the world and do not provide us with the geographical dispersion of their
products. We believe, if provided with this information, our geographical
revenue classification would indicate a higher international percentage. Based
on an estimate that factors our OEM partners' geographical revenue mix to our
revenues generated from these OEM partners, revenue for the three months ended
September 30, 2003 is approximately 66% North America and 34% international,
compared to 62% and 38%, respectively, for the comparable period in 2002. The
decrease in the international revenues for the three months ended September 30,
as a percent of total revenues, is primarily driven by the SpeechWorks
acquisition, whose product revenues are heavily weighted to the domestic market.
Revenue for the nine months ended September 30, 2003, based on the
above-mentioned estimate, is approximately 65% North America and 35%
international, compared to 69% North America and 31% international. The increase
in our international revenue is driven primarily from Europe. The increase is
the result of increased sales and marketing resources, the addition of
resellers, the release of Dragon Naturally Speaking 7.0 increased demand from
OEMs for our RealSpeak product (TTS), as well as the continued growth of our
PaperPort 9.0 in the international market space.
The following table presents the breakdown of our revenue by distribution
channel:
THREE MONTHS NINE MONTHS ENDED
ENDED SEPTEMBER 30, SEPTEMBER 30,
------------------- --------------------
2003 2002 2003 2002
---------- ------- --------- -------
VAR/Retail.... 30% 44% 34% 43%
Direct........ 21% 27% 26% 23%
OEM........... 49% 29% 40% 34%
--- --- --- ---
100% 100% 100% 100%
==== === === ===
26
The increase in our OEM revenues and the corresponding decrease in our
other sales channels, as a percentage of revenue, for the three and nine months
ended September 30, 2003 as compared to the same period 2002, was primarily due
to the Philips and SpeechWorks acquisitions.
Cost of Revenue
Cost of revenue for the three months ended September 30, 2003 was $6.8
million or 20.5% of total revenue, compared to $4.2 million or 14.9% in the
comparable period of 2002. Cost of revenue for the nine months ended September
30, 2003 was $15.6 million or 17.6% of total revenue, compared to $12.9 million
or 16.6% for the same period in 2002. The increase in cost of revenue in
absolute dollars and as a percentage of revenue for the three and nine months
ended September 30, 2003 is attributable to an increase in engineering costs
related to professional services revenue resulting from the Philips and
SpeechWorks acquisitions and increased technical support costs primarily related
to the creation of a customer service department in Europe, partially offset by
an increase in higher-margin license revenue. The Company expects gross margins
will decline slightly over the remainder of the fiscal year due to an increase
of professional services revenue as a percentage of total revenue.
Cost of Revenue from Amortization of Intangible Assets
Cost of revenue from amortization of intangible assets for the three months
ended September 30, 2003 was $2.8 million or 8.4% of revenue, compared to $2.0
million or 7.0% for the comparable period in 2002. The increase in cost of
revenue from amortization of intangible assets for the three months ended
September 30, 2003 was due to $0.6 million of amortization related to an
exclusive worldwide license to resell certain desktop dictation products and
technologies acquired by the Company during the first quarter of 2003,
amortization of intangibles of $0.1 million related to the Philips acquisition
which was completed on January 30, 2003 and $0.1 million related to the
SpeechWorks acquisition which was completed on August 11, 2003. Cost of revenue
from amortization of intangible assets for the nine months ended September 30,
2003 was $7.5 million or 8.5% of revenue, compared to $7.5 million or 9.6% for
the same period in 2002. The cost of revenue from amortization of intangible
assets for the nine months ended September 30, 2003 of $7.5 million includes
$1.1 million of amortization related to the exclusive worldwide license to
certain desktop dictation products and technologies, $0.3 million related to the
Philips acquisition which was completed on January 30, 2003 and $0.1 million
related to the SpeechWorks acquisition which was completed on August 11, 2003.
The comparable period in 2002 includes $1.6 million of intangible assets that
became fully amortized during fiscal year 2002.
Research and Development Expense
Research and development expenses were $9.5 million or 29.0% of revenue for
the three months ended September 30, 2003, compared to $7.3 million or 25.7% of
revenue for the comparable period in 2002. Research and development costs for
the nine months ended September 30, 2003 were $25.1 million or 28.3% of revenue,
compared to $21.3 million or 27.3% for the comparable period in 2002. The
increase in research and development expenses for both the three and nine months
ended September 30, 2003 is the result of increased headcount and related costs
associated with both the Philips and SpeechWorks acquisitions. The Company
expects research and development expenses as a percentage of revenue to decline
over the remainder of the fiscal year due to an increase in revenue and the
realization of operational synergies.
Selling, General and Administrative Expense
Selling, general and administrative expenses for the three months ended
September 30, 2003 were $15.6 million or 47.4% of revenue, compared to $11.4
million or 40.3% of revenue for the same period in 2002. Selling, general and
administrative expenses for the nine months ended September 30, 2003 were $42.7
million or 48.2% of revenue, compared to $32.0 million or 40.9% for the nine
months ended September 30, 2002. The increase in selling, general and
administrative expenses in absolute dollars for the three and nine months ended
September 30, 2003 was the result of increased compensation costs of
approximately $3.5 million and $6.6 million, respectively, resulting from the
addition of 58 sales and marketing employees and 23 general and administrative
employees primarily due to the Philips and SpeechWorks acquisitions. The
remaining increase in selling, general and administrative expenses for the three
and nine months ended September 30, 2003, is due primarily to increased channel
marketing expenses of $0.1 million and $1.0 million, respectively, increased
professional fees of approximately $0.6 million and $1.5 million, respectively,
bad debt expense of $0.1 million and $0.4 million, respectively, and transition
expenses associated with the Philips integration. The Company expects selling,
general and administrative expenses as a percentage of revenue to decline
slightly over the remainder of the fiscal year.
27
Amortization of Other Intangible Assets
Amortization of other intangible assets for the three months ended
September 30, 2003 was $0.7 million compared to $0.2 million for the comparable
period in 2002. Amortization of other intangible assets for each of the nine
months ended September 30, 2003 and 2002 was $1.4 million. Amortization of other
intangible assets for the nine months ended September 30, 2003 of $1.4 million
includes $0.5 million related to the Philips acquisition which was completed on
January 30, 2003 and $0.2 million related to the SpeechWorks acquisition which
was completed on August 11, 2003. The comparable period in 2002 includes $0.7
million of amortization expense related to intangible assets that were fully
amortized during fiscal year 2002.
Restructuring and Other Charges
During the three months ended September 30, 2003, we eliminated 81 ScanSoft
employees as a result of the SpeechWorks acquisition across all functional
areas, resulting in a charge of $1.5 million for severance costs, representing
the ratable recognition of expenses from the date the plan was announced through
September 30, 2003. Certain of these employees have termination dates after
September 30, 2003 and we expect to record $0.5 million of additional severance
expense during the three months ended December 31, 2003. However, as employees
will not receive the related termination benefits if such employees voluntarily
leave prior to their expected termination dates, the $0.5 million of additional
severance expense may be reduced.
In addition, during the three month period ended September 30, 2003, we
accrued $0.2 related to the closing of certain ScanSoft offices as a result of
the SpeechWorks acquisition and other restructuring related expenses.
In connection with the SpeechWorks acquisition, the Company eliminated 54
SpeechWorks former employees. In connection with this action, a liability of
$1.3 million, representing severance and related benefits, has been included in
the purchase price allocation. Of this balance, $0.8 million has been paid as of
September 30, 2003 and the remainder is expected to be paid within the next 12
months and will be funded from working capital. As a result of ongoing
restructuring activities, which include these employee termination actions, we
estimate full year operating synergies of approximately $27.0 million. Reduced
employee compensation costs resulting from employee termination actions account
for approximately $16.7 million of this total. We expect that the remaining
synergies will be achieved through reductions in redundant marketing programs,
travel expenses, professional services and facilities related expenses.
During the three month period ended June 30, 2003, the Company committed to
a plan to transfer certain research and development activities currently located
at the corporate headquarters to Budapest resulting in the elimination of 21
employees. The Company recorded a restructuring charge in the amount of $0.4
million for severance payments to these employees. In addition, the Company
recorded a charge in the amount of $0.4 million for severance payments to a
former member of the senior management team.
In connection with the Philips acquisition, we eliminated 25 ScanSoft
personnel across all functional areas resulting in approximately $0.5 million in
severance related restructuring costs in the three month period ended March 31,
2003.
In January 2002, the Company announced and in March 2002 completed a
restructuring plan to consolidate facilities, worldwide sales organizations,
research and development teams and other personnel following the December 12,
2001 L&H acquisition. As a result, the Company exited facilities in both North
America and Europe, eliminating 21 employee positions including 12 in research
and development and 9 in selling, general and administrative functions. In the
first quarter of 2002, the Company recorded a restructuring charge in the amount
of $0.6 million for severance payments to these employees, and a restructuring
charge of $0.4 million for certain termination fees to be incurred as a result
of exiting the facilities, including the write-off of previously recorded
assembled workforce of $0.1 million.
For the nine months ended September 30, 2003, the Company paid a total of
$1.4 million in severance payments, of which $0.5 million relates to the March
2002 restructuring and $0.1 million relates to severance paid to the former
Caere President and CEO, pursuant to a 2000 restructuring charge.
28
At September 30, 2003, the remaining restructuring accrual from the current
and prior restructuring activities amounted to $2.0 million. The balance is
comprised of $0.1 million of lease exit costs and $1.9 million of
employee-related severance costs, of which $0.3 million are for severance to the
former Caere President and CEO, $0.1 million are for severance costs related to
the 2003 Philips related restructuring actions and $0.6 million and $0.9 million
are for severance costs related to actions taken during the quarters ended June
30, 2003 and September 30, 2003, respectively.
The lease exit costs and severance due to the former Caere President and
CEO will be paid through January 2004 and March 2005, respectively. Severance
costs related to the 2003 Philips related restructuring actions will be paid
through December 31, 2003. Severance costs related to restructuring actions
undertaken during the three month period ended June 30, 2003 will be paid
through March 2009. Severance costs related to employee termination actions
undertaken during the three month period ended September 30, 2003, including the
additional $0.5 million expected to be recorded during the three months ended
December 31, 2003, will be paid through September 2004.
Income (Loss) from Operations
As a result of the above factors, loss from operations was $(4.2) million
for the three months ended September 30, 2003 or (12.8)% of revenue, compared to
income of $3.2 million or 11.2% of revenue for the comparable period in 2002.
Loss from operations was $(7.0) million for the nine months ended September 30,
2003 or (7.9)% of revenue, compared to income of $1.9 million or 2.4% of revenue
for the comparable period in 2002.
Other Income (Expense), Net
Other income (expense), net consists primarily of interest earned on cash
and cash equivalents, offset by interest incurred for borrowings under notes
payable, and foreign currency exchange gains and losses. Other income (expense),
net was $0.3 million for the three months ended September 30, 2003, compared to
$(0.2) million for the same period in 2002. Other income (expense), net was $0.7
million for the nine months ended September 30, 2003 compared to $(0.2) million
for the same period in 2002. The change in other income (expense), net for the
three months ended September 30, 2003 from the comparable period of 2002 is the
result of higher interest income and foreign currency gains, offset by higher
interest expense. The change in other income (expense), net for the nine months
ended September 30, 2003 from the comparable period of 2002 is the result of
higher foreign currency gains, offset by higher interest expense.
Income (Loss) Before Income Taxes
Income (loss) before income taxes was $(4.0) million for the three months
ended September 30, 2003 or (12.0)% of revenue, compared to $3.0 million or
10.6% of revenue for the comparable period in 2002. Loss before income taxes was
$(6.4) million for the nine months ended September 30, 2003 or (7.2)% of
revenue, compared to income before income taxes of $1.7 million or 2.2% of
revenue for the comparable period in 2002.
Income Taxes
The (benefit from) income taxes was $(0.2) million for the three months
ended September 30, 2003 and consists of a $1.4 million federal tax refund
relating to the carryback of net operating losses to a prior period and a $0.9
million deferred tax provision associated with differences between the book and
tax amortization for certain goodwill, of which $0.5 million relates to 2002.
The remainder of the provision includes foreign income and foreign withholding
taxes. The provision for income taxes was $0.2 million for the three months
ended September 30, 2002 and consisted of foreign and state tax provisions for
which no operating loss carryforwards are available to offset the related
taxable income.
The provision for income taxes was $0.5 million for the nine months ended
September 30, 2003 and consisted of foreign income taxes, foreign withholding
taxes and a $1.4 million deferred tax provision associated with differences
between the book and tax amortization for certain goodwill, of which $0.5
million relates to 2002. The provision also includes the impact of a $1.4
million federal tax refund relating to the carryback of net operating losses to
a prior period net operating loss refund.
The (benefit from) income taxes of ($0.2) million for the nine months ended
September 30, 2002 consisted of foreign and state tax provisions, offset by a
federal tax benefit of ($0.9) million, related to a refund of taxes paid by
Caere Corporation prior to its acquisition by us.
29
Net Income (Loss)
As a result of all these factors, net loss totaled $(3.7) million or
(11.3)% of revenue for the three months ended September 30, 2003, compared to
net income of $2.8 million or 10.0% of revenue for the comparable period in
2002. Net loss totaled $(6.8) million or (7.7)% of revenue for the nine months
ended September 30, 2003, compared to net income of $1.9 million or 2.4% of
revenue for the comparable period in 2002
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 2003, we had cash, cash equivalents and marketable
securities of $48.0 million and working capital of $36.4 million as compared to
$18.9 million in cash and cash equivalents and working capital of $16.8 million
at December 31, 2002.
Net cash provided by operating activities for the nine months ended
September 30, 2003 was $3.0 million compared to $6.3 million for the comparable
period in 2002. Cash provided by operations in the 2003 period came primarily
from income from operations, after adjustments for non-cash amortization and
depreciation, lower inventory balances and increases in other liabilities,
partially offset by payments of accounts payable including those assumed in the
Philips and SpeechWorks acquisitions, an increase in accounts receivable
balances and an increase in prepaid expenses and other current assets.
Net cash provided by investing activities for the nine months ended
September 30, 2003 was $23.8 million compared to cash used in investing
activities of $4.9 million for the comparable period in 2002. Net cash provided
by investing activities during the 2003 period consisted $40.0 million acquired
in the SpeechWorks transaction, partially offset by $1.4 million in capital
expenditures, which included costs to build-out facilities in both North America
and Europe, $8.6 million of payments associated with acquisitions and $6.1
million of payments associated with an exclusive licensing agreement. Net cash
used in investing activities during 2002 consisted of $2.1 million in capital
expenditures to build-out facilities in both North America and Europe and $2.9
million associated with acquisitions.
Net cash provided by financing activities for the nine months ended
September 30, 2003 was $2.5 million compared to net cash used in financing
activities of $1.4 million for the comparable period in 2002. Net cash provided
by financing activities during the nine months ended September 30, 2003
consisted of proceeds of $2.0 million from the issuance of common stock in
connection with employee stock compensation plans and net proceeds of $6.8
million, excluding offering costs of $1.3 million paid in the prior year, from
the underwritten offering of our common stock. This was offset by a $1.2 million
payment to the former Caere President and CEO in connection with the settlement
of the non-competition and consulting agreement, the payment of the $3.3 million
note payable related to the acquisition of Lernout & Hauspie assets during 2001,
and $1.8 million of payments to repurchase outstanding common shares. Net cash
used in financing activities during 2002 consisted of net proceeds of $5.7
million from the private placement of our common stock and $2.5 million from the
exercise of stock options, offset by a $0.2 million payment on our capital lease
obligation, a $7.0 million payment to repurchase shares of our treasury stock
held by L&H, a $0.6 million principal payment on a note payable that was issued
in connection with the acquisition of the L&H assets and a $1.8 million payment
to the former Caere President and CEO in connection with the settlement of the
non-competition and consulting agreement.
On August 11, 2003, we completed the SpeechWorks acquisition. As
consideration for the acquisition, we exchanged 0.860 of a share of our common
stock for each outstanding share of SpeechWorks stock. This transaction resulted
in the issuance of approximately 32.5 million shares of our common stock. In
addition, we assumed significant lease obligations totaling $30.9 million, an
equipment line of credit of $1.5 million, standby letters of credit of $1.5
million, royalty commitments of $1.1 million and purchase commitments of $0.5
million. Assumed lease obligations of $30.9 million does not reflect future
minimum sub-lease rentals of approximately $6.8 million.
On January 30, 2003, we completed the Philips acquisition. As consideration
for the acquisition, we paid 3.1 million euros ($3.4 million) in cash at
closing, subject to adjustment in accordance with the provisions of the purchase
agreement, as amended, and agreed to pay an additional 1.0 million euros in cash
due no later than December 31, 2003, issued a 5.0 million euro note due December
31, 2003 and bearing 5.0% interest per annum and issued a $27.5 million
three-year, zero-interest subordinated debenture, convertible at any time at
Philips' option into shares of our common stock at $6.00 per share.
30
The following table outlines our contractual payment obligations as of
September 30, 2003:
PAYMENTS DUE BY PERIOD
--------------------------------------------------------------
MORE
LESS THAN 1-3 3-5 THAN 5
CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR YEARS YEARS YEARS
- ------------------------------------------------------ ------- -------- ------- ------ -------
(IN THOUSANDS)
Convertible debenture ............................... $27,524 -- $27,524 -- $ --
Deferred payment associated with Philips acquisition,
including imputed interest ........................ 1,150 1,150 -- -- --
Euro denominated note (5 million) associated with
Philips acquisition ............................... 5,843 5,843 -- -- --
Deferred payments for technology license ............ 5,205 2,617 2,588 -- --
Operating leases .................................... 38,316 5,290 9,658 5,388 17,980
Caere acquisition related costs ..................... 847 847 -- -- --
Equipment line of credit ............................ 1,467 1,130 293 44 --
Standby letters of credit ........................... 1,460 366 44 44 1,006
Royalty commitments ................................. 1,080 50 820 60 150
Purchase commitments ................................ 527 527 -- -- --
Imputed interest .................................... 409 197 212 -- --
------- ------- ------- ------ -------
Total contractual cash obligations .................. $83,828 $18,017 $41,139 $5,536 $19,136
======= ======= ======= ====== =======
Total future lease obligations in the table above do not reflect future
minimum sub-lease rentals of approximately $6.8 million.
Through September 30, 2003, we have not entered into any off balance sheet
arrangements or transactions with unconsolidated entities or other persons.
Historically and through December 31, 2001 we sustained recurring losses
from operations in each reporting period. We reported net income (loss) of $6.3
million for 2002 and $(6.8) million for the nine months ended September 30,
2003, and have an accumulated deficit of $153.8 million at September 30, 2003.
We believe that we have the ability to maintain operating expenses at levels
commensurate with revenues to maintain positive cash flows from operations. We
also believe that our existing working capital, including the cash received in
connection with the SpeechWorks acquisition, cash flows from future operations
and available borrowings under our line of credit facility, as amended, will be
sufficient to meet our operating, investing and financing needs, for at least
the next twelve months, including the integration and debt obligations incurred
in connection with the Philips and SpeechWorks acquisition and the planned
repurchase of up to $25 million of our common stock.
FOREIGN OPERATIONS
We develop and sell our products throughout the world. As a result of the
Caere acquisition in March 2000, the L&H acquisition in December 2001, and our
Philips and SpeechWorks acquisitions, we significantly increased our presence in
Europe and added operations in Asia. With our increased international presence
in a number of geographic locations and with international revenues projected to
increase in 2003 and thereafter, we are exposed to changes in foreign currencies
including the euro and Japanese yen. Changes in the value of the euro or other
foreign currencies relative to the value of the United States dollar could
adversely affect future revenues and operating results. We do not generally
hedge any of our foreign-currency denominated transactions or expected cash
flows. However, in connection with the Philips acquisition on January 30, 2003,
we entered into a forward hedge in the amount of $5.3 million to meet our
obligation to pay the 5.0 million euro promissory note issued as part of the
acquisition. On August 26, 2003, we entered into a forward hedge in the amount
of $1.1 million to meet our obligation to pay the 1.0 million euro note payable
to Philips issued as part of the acquisition
RECENT ACCOUNTING PRONOUNCEMENTS
In May 2003, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity." SFAS 150 establishes standards for how an issuer classifies and
measures certain financial instruments with characteristics of both liabilities
and equity. SFAS 150 was originally effective for financial instruments entered
into or modified after May 31, 2003, and otherwise effective at the beginning of
the first interim period beginning after June 15, 2003, however certain elements
of SFAS No. 150 have been deferred. The adoption of the provisions of SFAS No.
150 not deferred did not have a material impact on the Company's financial
position or results of operations and the Company does not expect the adoption
of the deferred elements of SFAS No. 150 to have a material impact on its
financial position or results of operations.
In April 2003, the FASB issued Statement of Financial Accounting Standards
No. 149 ("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities." SFAS 149 amends and clarifies financial accounting and
reporting for
31
derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives), and for hedging
activities under FASB Statement No. 133, "Accounting for Derivative Instruments
and Hedging Activities." SFAS 149 was effective for contracts entered into or
modified after June 30, 2003 and for hedging relationships designated after June
30, 2003. The adoption of SFAS No. 149 did not have a material impact on our
current financial position and results of operations.
In November 2002, the Emerging Issues Task Force ("EITF") of the FASB
issued EITF No. 00-21, "Accounting for Revenue Arrangements with Multiple
Deliverables." EITF No. 00-21 addresses certain aspects of the accounting by a
vendor for arrangements under which it will perform multiple revenue-generating
activities. EITF No. 00-21 establishes three principles: revenue should be
recognized separately for separate units of accounting, revenue for a separate
unit of accounting should be recognized only when the arrangement consideration
is reliably measurable and the earnings process is substantially complete, and
consideration should be allocated among the separate units of accounting in an
arrangement based on their fair value. EITF No. 00-21 is effective for all
revenue arrangements entered into in fiscal periods beginning after June 15,
2003, with early adoption permitted. In May 2003, as a result of questions
raised regarding applicability of EITF No. 00-21 to software revenue recognition
arrangements, the EITF reached a consensus regarding the application of the
provisions of SOP 97-2 to arrangements containing software deliverables and
non-software deliverables. The consensus reached in May 2003 was confirmed in
July 2003 and was issued as Issue 03-05, "Applicability of AICPA Statement of
Position 97-2 to Non-Software Deliverables in an Arrangement Containing
More-Than-Incidental Software" ("EITF No. 03-05"). EITF No. 03-05 concludes that
software-related elements include software-related products and services such as
those listed in paragraph 9 of SOP 97-2, as well as other deliverables for which
the software is essential to their functionality (e.g., computer hardware).
Elements included in arrangements that do not qualify as software-related
elements are to be accounted for under the guidance of EITF No. 00-21 and not
SOP 97-2. Adoption of EITF No. 03-05 would require a cumulative catch-up
adjustment and may be applied to new revenue arrangements entered into after the
beginning of an entity's next reporting period beginning after August 13, 2003.
The adoption of EITF No. 00-21 and EITF No. 0-05 did not have a material impact
on our results of operations or financial condition.
FACTORS THAT MAY AFFECT FUTURE RESULTS
ScanSoft operates in an intensely competitive environment and operations
are subject to risks and uncertainties. Such risks and uncertainties include,
but are not limited to (1) the loss of, or a significant curtailment of,
purchases by any one or more principal customers; (2) the cyclical nature of the
retail software industry; (3) the inability to protect ScanSoft's proprietary
technology and intellectual property; (4) the inability to attract or retain
skilled employees; (5) technological obsolescence of current products and the
inability to develop new products; (6) the inability to respond to competitive
technology and competitive pricing pressures; and (7) the ability to sustain
product revenues upon the introduction of new products. Our quarterly operating
results may fluctuate and differ materially from one quarter to the next, which
could have an impact on our stock price.
There can be no assurance that any cash generated by operations will be
sufficient to satisfy our liquidity requirements, and we may be required to sell
additional equity or debt securities, or obtain additional lines of credit. The
sale of additional equity or convertible debt securities may result in
additional dilution to our stockholders. It may be difficult to sell additional
equity or obtain debt financing, and this could result in significant
constraints on ScanSoft's ongoing investments to grow revenue and develop new
products.
You should also carefully consider the additional risks described below
when evaluating our company. The risks described below are not the only ones
facing us. Additional risks not presently known to us or that we currently deem
immaterial may also impair our business operations and financial situation. Our
business, financial condition and results of operations could be seriously
harmed by any of these risks.
OUR QUARTERLY OPERATING RESULTS ARE SUBJECT TO FLUCTUATIONS AND
SEASONALITY. IF WE FAIL TO MEET THE EXPECTATIONS OF SECURITIES ANALYSTS OR
INVESTORS, OUR SHARE PRICE MAY DECREASE SIGNIFICANTLY. Our revenue and operating
results have fluctuated in the past and may not meet the expectations of
securities analysts or investors in the future. If this occurs, the price of our
stock would likely decline. Factors that may cause fluctuations in our operating
results include the following:
-- SLOWING SALES BY OUR DISTRIBUTION AND FULFILLMENT PARTNERS TO THEIR
CUSTOMERS, WHICH MAY PLACE PRESSURE ON THESE PARTNERS TO REDUCE
PURCHASES OF OUR PRODUCTS;
-- VOLUME, TIMING AND FULFILLMENT OF CUSTOMER ORDERS;
32
-- CUSTOMERS DELAYING THEIR PURCHASE DECISIONS IN ANTICIPATION OF NEW
VERSIONS OF PRODUCTS;
-- CUSTOMERS DELAYING, CANCELING OR LIMITING THEIR PURCHASES AS RESULT OF
THE THREAT OR RESULTS OF TERRORISM OR MILITARY ACTIONS TAKEN BY THE
UNITED STATES OR ITS ALLIES;
-- INTRODUCTION OF NEW PRODUCTS BY US OR OUR COMPETITORS;
-- SEASONALITY;
-- REDUCTION IN THE PRICES OF OUR PRODUCTS IN RESPONSE TO COMPETITION OR
MARKET CONDITIONS;
-- RETURNS AND ALLOWANCE CHARGES IN EXCESS OF RECORDED AMOUNTS;
-- TIMING OF SIGNIFICANT MARKETING AND SALES PROMOTIONS;
-- INCREASED EXPENDITURES INCURRED PURSUING NEW PRODUCT OR MARKET
OPPORTUNITIES;
-- INABILITY TO ADJUST OUR OPERATING EXPENSES TO COMPENSATE FOR
SHORTFALLS IN REVENUE AGAINST FORECAST;
-- DEMAND FOR PRODUCTS; AND
-- GENERAL ECONOMIC TRENDS AS THEY AFFECT RETAIL AND CORPORATE SALES.
Due to the foregoing factors, among others, our revenue and operating
results are difficult to forecast. Our expense levels are based in significant
part on our expectations of future revenue. Therefore, our failure to meet
revenue expectations would seriously harm our business, operating results,
financial condition and cash flows. Further, an unanticipated decline in revenue
for a particular quarter may disproportionately affect our profitability because
a relatively small amount of our expenses are intended to vary with our revenue
in the short term.
WE HAVE A HISTORY OF LOSSES. WE MAY INCUR LOSSES IN THE FUTURE. We
sustained recurring losses from operations in each reporting period through
December 31, 2001. We reported net losses of $(3.7) million and $(2.9) million,
and $(0.2) million in the quarters ended September 30, 2003, June 30, 2003 and
March 31, 2003 and net income of $6.3 million for the fiscal year ended December
31, 2002, respectively. If we are unable to regain profitability, the market
price for our stock may decline, perhaps substantially.
OUR BUSINESS COULD BE HARMED IF WE DO NOT SUCCESSFULLY MANAGE THE
INTEGRATION OF THE BUSINESSES THAT WE ACQUIRE, INCLUDING OUR RECENTLY COMPLETED
ACQUISITION OF SPEECHWORKS. As part of our business strategy, we have in the
past acquired, and expect to continue to acquire, other businesses and
technologies. Our acquisition of the speech and language technology operations
of Lernout & Hauspie Speech Products N.V. and certain of its affiliates,
including L&H Holdings USA, Inc. (collectively, L&H) and our acquisition of the
Speech Processing Telephony and Voice Control business units from Philips
required substantial integration and management efforts. Our recently completed
acquisition of SpeechWorks International, Inc., will pose similar, and
potentially greater, challenges. Acquisitions of this nature involve a number of
risks, including:
-- DIFFICULTY IN TRANSITIONING AND INTEGRATING THE OPERATIONS AND
PERSONNEL OF THE ACQUIRED BUSINESSES;
-- POTENTIAL DISRUPTION OF OUR ONGOING BUSINESS AND DISTRACTION OF
MANAGEMENT;
-- POTENTIAL DIFFICULTY IN SUCCESSFULLY IMPLEMENTING, UPGRADING AND
DEPLOYING IN A TIMELY AND EFFECTIVE MANNER NEW OPERATIONAL INFORMATION
SYSTEMS AND UPGRADES OF OUR FINANCE, ACCOUNTING AND PRODUCT
DISTRIBUTION SYSTEMS;
-- DIFFICULTY IN INCORPORATING ACQUIRED TECHNOLOGY AND RIGHTS INTO OUR
PRODUCTS AND TECHNOLOGY;
33
-- UNANTICIPATED EXPENSES AND DELAYS IN COMPLETING ACQUIRED DEVELOPMENT
PROJECTS AND TECHNOLOGY INTEGRATION;
-- MANAGEMENT OF GEOGRAPHICALLY REMOTE UNITS BOTH IN THE UNITED STATES
AND INTERNATIONALLY;
-- IMPAIRMENT OF RELATIONSHIPS WITH PARTNERS AND CUSTOMERS;
-- ENTERING MARKETS OR TYPES OF BUSINESSES IN WHICH WE HAVE LIMITED
EXPERIENCE; AND
-- POTENTIAL LOSS OF KEY EMPLOYEES OF THE ACQUIRED COMPANY.
As a result of these and other risks, we may not realize anticipated
benefits from our acquisitions. Any failure to achieve these benefits or failure
to successfully integrate acquired businesses and technologies could seriously
harm our business. The size of the SpeechWorks acquisition significantly
increases both the scope and consequences of our integration risks.
OUR OPERATING RESULTS COULD BE ADVERSELY AFFECTED AS A RESULT OF PURCHASE
ACCOUNTING TREATMENT, AND THE CORRESPONDING IMPACT OF AMORTIZATION OF OTHER
INTANGIBLES RELATING TO OUR RECENTLY COMPELTED ACQUISITION OF SPEECHWORKS, IF
OUR RESULTS OF THE COMBINED COMPANY DO NOT OFFSET THESE ADDITIONAL EXPENSES.
Under accounting principles generally accepted in the United States of America,
ScanSoft has accounted for the acquisition of SpeechWorks using the purchase
method of accounting. Under purchase accounting, ScanSoft has recorded the
market value of its common stock issued in connection with the acquisition and
the amount of direct transaction costs as the cost of acquiring SpeechWorks.
ScanSoft has allocated that cost to the individual assets acquired and
liabilities assumed, including various identifiable intangible assets such as
acquired technology, acquired trade names and acquired customer relationships
based on their respective fair values. Intangible assets generally will be
amortized over a five to ten year period. The amount of purchase price allocated
to goodwill is approximately $128.4 million and the amount allocated to
identifiable intangible assets is approximately $13.3 million. Goodwill is not
subject to amortization but is subject to at least an annual impairment
analysis, which may result in an impairment charge if the carrying value exceeds
its implied fair value. As a result, purchase accounting treatment of the
acquisition could decrease net income for ScanSoft in the foreseeable future,
which could have a material and adverse effect on the market value of ScanSoft
common stock.
THE COMBINED COMPANY WILL BE MANAGED BY A MANAGEMENT TEAM CONSISTING OF
CURRENT SCANSOFT AND FORMER SPEECHWORKS EXECUTIVES, AND THIS MANAGEMENT TEAM MAY
UNDERTAKE A STRATEGY AND BUSINESS DIRECTION WHICH IS DIFFERENT FROM THAT WHICH
WOULD BE UNDERTAKEN BY SCANSOFT'S CURRENT MANAGEMENT TEAM. The new management
team of the combined company will consist of certain current ScanSoft and
SpeechWorks executives. The manner in which the new management team conducts the
business of the combined company, and the direction in which the new management
team moves the business, may differ from the manner and direction in which the
current management of either ScanSoft or SpeechWorks would direct the combined
or separate companies on a stand-alone basis. Such control by the new management
team, together with the effects of future market factors and conditions, could
ultimately evolve into an integration and business strategy that, when
implemented, differs from the strategy and business direction currently
recommended by ScanSoft's or SpeechWorks' current respective management and
board of directors. The new management team, and any change in business or
direction, may not improve, and could adversely impact, the combined company's
financial condition and results of operations.
A LARGE PART OF OUR REVENUE IS DEPENDENT ON CONTINUED DEMAND FOR OUR
PRODUCTS FROM OEM PARTNERS. A SIGNIFICANT REDUCTION IN OEM REVENUE WOULD
SERIOUSLY HARM OUR BUSINESS, RESULTS OF OPERATIONS, FINANCIAL CONDITION AND
STOCK PRICE. Many of our technologies are licensed to partners that incorporate
our technologies into solutions that they sell to their customers. The
commercial success of these licensed products depends to a substantial degree on
the efforts of these licensees in developing and marketing products
incorporating our technologies. The integration of our technologies into their
products takes significant time, effort and investment, and products
incorporating our technologies may not be successfully implemented or marketed
by our licensees.
OEM revenue represented 34% and 40% of our consolidated revenue for the
year ended December 31, 2002 and for the nine months ended September 30, 2003,
respectively. A select few of our OEM partners account for a majority of our OEM
revenues. Our partners are not required to continue to bundle or embed our
software, and they may choose the software products of our competitors
34
in addition to, or in place of, our products. A significant reduction in OEM
revenue would seriously harm our business, results of operations, financial
condition and our stock price.
SPEECH TECHNOLOGIES MAY NOT ACHIEVE WIDESPREAD ACCEPTANCE BY BUSINESSES,
WHICH COULD LIMIT OUR ABILITY TO GROW OUR SPEECH BUSINESS. The market for speech
technologies is relatively new and rapidly evolving. Our ability to increase
revenue in the future depends in large measure on acceptance by both our
customers and the end users of speech technologies in general and our products
in particular. The continued development of the market for our current and
future speech solutions will also depend on the following factors:
-- WIDESPREAD DEPLOYMENT AND ACCEPTANCE OF SPEECH TECHNOLOGIES;
-- CONSUMER DEMAND FOR SPEECH-ENABLED APPLICATIONS;
-- DEVELOPMENT BY THIRD-PARTY VENDORS OF APPLICATIONS USING SPEECH
TECHNOLOGIES; AND
-- CONTINUOUS IMPROVEMENT IN SPEECH TECHNOLOGY.
Sales of our speech products would be harmed if the market for speech
software does not continue to develop or develops more slowly than we expect,
and, consequently, our business could be harmed.
WE HAVE GROWN AND MAY CONTINUE TO GROW, THROUGH ACQUISITIONS, WHICH MAY
RESULT IN SIGNIFICANT INTANGIBLE ASSETS, DILUTION OF OUR EXISTING STOCKHOLDERS,
USE OF CASH AND OTHER RISKS. We have recently completed the purchase of certain
businesses and intellectual property from Philips and completed the acquisition
of SpeechWorks on August 11, 2003, and may acquire additional complementary
assets, technologies or businesses in the future. Our past acquisitions have
given rise to, and future acquisitions may result in, substantial levels of
intangible assets that will be amortized or subject to impairment analyses in
future years, and our future results will be adversely affected if we do not
achieve benefits from these acquisitions commensurate with amortization and
potential impairment charges. For example, our acquisition of Caere Corporation
included a substantial write-off of acquired in-process research and development
costs, and this also may occur as a result of other acquisitions.
In connection with the Caere, the L&H and SpeechWorks acquisitions, we
issued 19.0 million, 7.4 million and 32.5 million shares of our common stock
respectively. We may continue to issue equity securities for future acquisitions
and working capital purposes that could dilute our existing stockholders. In
connection with the L&H acquisition, we issued a promissory note for $3.5
million. Under the terms of the Philips acquisition, we paid 3.1 million euros
in cash at closing, subject to adjustment in accordance with the provisions of
the purchase agreement, as amended, and agreed to pay an additional 1.0 million
euros in cash prior to December 31, 2003, issued a 5.0 million euro note due
December 31, 2003 and bearing 5.0% interest per annum and issued a $27.5 million
three-year, zero-interest subordinated debenture, convertible at any time at
Philips' option into shares of our common stock at $6.00 per share. Future
acquisitions may also require us to expend significant funds or incur debt. If
we expend funds or incur additional debt, our ability to obtain financing for
working capital or other purposes could decrease.
SALES OF OUR DOCUMENT AND PDF CONVERSION PRODUCTS AND OUR DIGITAL PAPER
MANAGEMENT PRODUCTS REPRESENTED APPROXIMATELY 51% AND 40%, RESPECTIVELY, OF OUR
REVENUE FOR THE YEAR ENDED DECEMBER 31, 2002 AND FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 2003. ANY REDUCTION IN REVENUE FROM THESE PRODUCT AREAS COULD
SERIOUSLY HARM OUR BUSINESS. Historically, a few product areas have generated a
substantial portion of our revenues. For the year ended December 31, 2002, our
document and PDF conversion products represented approximately 39% of our
revenue and our digital paper management products represented approximately 12%
of our revenue. For the nine months ended September 30, 2003, our document and
PDF conversion products represented approximately 26% of our revenue, and our
digital paper management products represented approximately 14% of our revenue.
A significant reduction in the revenue contribution from these product areas
could seriously harm our business, results of operations, financial condition,
cash flows and stock price.
THE PROTECTION OF OUR PROPRIETARY TECHNOLOGY AND INTELLECTUAL PROPERTY IS
KEY TO OUR SUCCESS. We rely heavily on our proprietary technology, trade secrets
and other intellectual property. Unauthorized parties may attempt to copy
aspects of our products or to obtain and use information that we regard as
proprietary. Policing unauthorized use of our products is difficult and we may
not be able to protect our technology from unauthorized use. Additionally, our
competitors may independently develop technologies that are substantially the
same or superior to ours. In addition, the laws of some foreign countries
35
do not protect our proprietary rights to the same extent as the laws of the
United States. Although the source code for our proprietary software is
protected both as a trade secret and as a copyrighted work, litigation may be
necessary to enforce our intellectual property rights, to protect our trade
secrets, to determine the validity and scope of the proprietary rights of
others, or to defend against claims of infringement or invalidity. Litigation,
regardless of the outcome, can be very expensive and can divert management
efforts.
THIRD PARTIES HAVE CLAIMED AND MAY CLAIM IN THE FUTURE THAT WE ARE
INFRINGING THEIR INTELLECTUAL PROPERTY. WE COULD BE EXPOSED TO SIGNIFICANT
LITIGATION OR LICENSING EXPENSES OR BE PREVENTED FROM SELLING OUR PRODUCTS IF
SUCH CLAIMS ARE SUCCESSFUL. Like other technology companies, from time to time,
we are subject to claims that we or our customers may be infringing or
contributing to the infringement of the intellectual property rights of others.
We may be unaware of intellectual property rights of others that may cover some
of our technologies and products. If it appears necessary or desirable, we may
seek licenses for these intellectual property rights. However, we may not be
able to obtain licenses from some or all claimants, the terms of any offered
licenses may not be acceptable to us, and we may not be able to resolve disputes
without litigation. Any litigation regarding intellectual property could be
costly and time-consuming and could divert the attention of our management and
key personnel from our business operations. In the event of a claim of
intellectual property infringement, we may be required to enter into costly
royalty or license agreements. Third parties claiming intellectual property
infringement may be able to obtain injunctive or other equitable relief that
could effectively block our ability to develop and sell our products.
On July 15, 2003, Elliott Davis filed an action against SpeechWorks in the
United States District Court for the Western District for New York (Buffalo)
claiming patent infringement. Damages are sought in an unspecified amount. We
filed an answer and CounterClaim to Davis's Complaint on August 25, 2003. We
believe Davis's claim has no merit, and we intend to defend the action
vigorously.
On November 27, 2002, AllVoice Computing plc filed an action against us in
the United States District Court for the Southern District of Texas claiming
patent infringement. Damages are sought in an unspecified amount. We filed an
Answer on December 23, 2002. We believe this claim has no merit and we intend to
defend the action vigorously.
On December 28, 2001, we were sued for patent infringement initiated by the
Massachusetts Institute of Technology and Electronics For Imaging, Inc. We were
one of more than 200 defendants named in this suit. Damages are sought in an
unspecified amount. We filed an Answer and Counterclaim on June 28, 2002. We
believe this claim has no merit and we intend to defend the action vigorously.
On August 16, 2001, we were sued by Horst Froessl for patent infringement.
Damages are sought in an unspecified amount. We filed an Answer and Counterclaim
on September 19, 2001. We believe this claim has no merit and we intend to
defend the action vigorously.
We believe that the final outcome of the current litigation matters
described above will not have a significant adverse effect on our financial
position and results of operations and we believe that we will not be required
to expend a significant amount of resources defending such claims. However,
should we not prevail in these litigation matters or if we are required to
expend a significant amount of resources defending such claims, our operating
results, financial position and cash flows could be adversely impacted. If any
third parties are successful in intellectual property infringement claims
against us, we may be subject to significant damages or injunctions and our
operating results and financial position could be harmed.
THE MARKETS IN WHICH WE OPERATE ARE HIGHLY COMPETITIVE AND RAPIDLY
CHANGING. WE MAY BE UNABLE TO COMPETE SUCCESSFULLY AGAINST NEW ENTRANTS AND
ESTABLISHED COMPANIES WITH GREATER RESOURCES. There are a number of companies
that develop or may develop products that compete in our targeted markets;
however, there is no one company that competes with us in all of our product
areas. The individual markets in which we compete are highly competitive, and
are rapidly changing. Within digital capture, we compete directly with ABBYY,
I.R.I.S. and NewSoft. Within speech, we compete with AT&T, IBM and Nuance
Communications. Vendors such as Adobe and Microsoft offer solutions that can be
considered alternatives to some of our solutions. In addition, a number of
smaller companies produce technologies or products that are in some markets
competitive with our solutions. Current and potential competitors have
established, or may establish, cooperative relationships among themselves or
with third parties to increase the ability of their technologies to address the
needs of our prospective customers.
The competition in these markets could adversely affect our operating
results by reducing the volume of the products we sell or the prices we can
charge. Some of our current or potential competitors have significantly greater
financial, technical and marketing
36
resources than we do. These competitors may be able to respond more rapidly than
we can to new or emerging technologies or changes in customer requirements. They
may also devote greater resources to the development, promotion and sale of
their products than we do. The price and performance of our products and
technologies may not be superior relative to the products of our competitors. As
a result, we may lose competitive position that could result in lower prices,
fewer customer orders, reduced revenue, reduced gross margins and loss of market
share. Our products and technologies may not achieve market acceptance or sell
at favorable prices, which could hurt our revenue, results of operations and the
price of our common stock. Some of our customers, such as Microsoft, have
developed or acquired products or technologies that compete with our products
and technologies. These customers may give higher priority to the sale of these
competitive products or technologies. To the extent they do so, market
acceptance and penetration of our products, and therefore our revenue, may be
adversely affected.
Our success will depend substantially upon our ability to enhance our
products and technologies and to develop and introduce, on a timely and
cost-effective basis, new products and features that meet changing customer
requirements and incorporate technological advancements. If we are unable to
develop new products and enhance functionalities or technologies to adapt to
these changes, or are unable to realize synergies among our acquired products
and technologies, our business will suffer.
OUR SOFTWARE PRODUCTS MAY HAVE BUGS, WHICH COULD RESULT IN DELAYED OR LOST
REVENUE, EXPENSIVE CORRECTION, LIABILITY TO OUR CLIENTS AND CLAIMS AGAINST US.
Complex software products such as ours may contain errors, defects or bugs.
Defects in the solutions or products that we develop and sell to our customers
could require expensive corrections and result in delayed or lost revenue,
adverse client reaction and negative publicity about us or our products and
services. Customers who are not satisfied with any of our products could bring
claims against us for damages, which, even if unsuccessful, would likely be
time-consuming to defend, and could result in costly litigation and payment of
damages. Such claims could harm our financial results and competitive position.
WE RELY ON A SMALL NUMBER OF DISTRIBUTION AND FULFILLMENT PARTNERS,
INCLUDING 1450, DIGITAL RIVER, INGRAM MICRO AND TECH DATA, TO DISTRIBUTE MANY OF
OUR PRODUCTS. ANY DISRUPTION IN THESE CHANNELS COULD HARM OUR RESULTS OF
OPERATIONS. Our products are sold through, and a substantial portion of our
revenue is derived from, a network of over 2000 channel partners, including
value-added resellers, computer superstores, consumer electronic stores, mail
order houses, office superstores and eCommerce Web sites. We rely on a small
number of distribution and fulfillment partners, including 1450, Digital River,
Ingram Micro and Tech Data to serve this network of channel partners. For the
year ended December 31, 2002, two distribution and fulfillment partners, Ingram
Micro and Digital River, accounted for 25% and 17% of our consolidated revenue,
respectively. During the nine-month period ended September 30, 2003, Ingram
Micro and Digital River accounted for 18% and 13% of our consolidated revenue,
respectively. A disruption in these distribution and fulfillment partner
relationships could negatively affect our results of operations in the short
term. Any disruption for which we are unable to compensate could have a more
sustained impact on our results of operations.
A SIGNIFICANT PORTION OF OUR ACCOUNTS RECEIVABLE IS CONCENTRATED AMONG OUR
THREE LARGEST DISTRIBUTION AND FULFILLMENT PARTNERS, INGRAM MICRO, INC., TECH
DATA CORPORATION, AND DIGITAL RIVER, INC. Our products are sold through, and a
substantial portion of our accounts receivable is derived from, three
distribution and fulfillment partners. At September 30, 2003, Ingram Micro, Tech
Data and Digital River represented 16%, 5% and 3% of our net accounts
receivable, respectively. At December 31, 2002, Ingram Micro, Tech Data and
Digital River represented 16%, 11% and 9%, of our net accounts receivable,
respectively. In addition, although we perform ongoing credit evaluations of our
distribution and fulfillment partners' financial condition and maintain reserves
for potential credit losses, we do not require collateral. While, to date, such
losses have been within our expectations, we cannot assure you that these
actions will be sufficient to meet future contingencies. If any of these
distribution and fulfillment partners were unable to pay us in a timely fashion
or if we were to experience significant credit losses in excess of our reserves,
our results of operations, cash flows and financial condition would be seriously
harmed.
A SIGNIFICANT PORTION OF OUR REVENUE IS DERIVED FROM SALES IN EUROPE AND
ASIA. OUR RESULTS COULD BE HARMED BY ECONOMIC, POLITICAL, REGULATORY AND OTHER
RISKS ASSOCIATED WITH THESE AND OTHER INTERNATIONAL REGIONS. Since we sell our
products worldwide, our business is subject to risks associated with doing
business internationally. We anticipate that revenue from international
operations will represent an increasing portion of our total revenue. Reported
international revenue for both the year ended December 31, 2002 and nine months
ended September 30, 2003 represented 27% of our consolidated revenue. Most of
these international revenues are produced by sales in Europe and Asia. A number
of our OEM partners distribute their products throughout the world and do not
provide us with the geographical dispersion of their products. However, based on
an estimate that factors our OEM partners' geographical revenue mix to our
revenue generated from these OEM partners, international revenue would have
represented approximately 33% and 35% of our consolidated revenue for the year
ended December 31, 2002 and nine months ended September 30, 2003, respectively.
37
Therefore, in addition to risks to our business based on a potential
downturn in the world economy, a region-specific downturn affecting countries in
Western Europe and/or Asia could have a negative effect on our future results of
operations.
In addition, some of our products are developed and manufactured outside
the United States. A significant portion of the development and manufacturing of
our speech products are completed in Belgium, and a significant portion of our
digital capture research and development is conducted in Hungary. In addition,
in connection with the Philips acquisition, we have added an additional research
and development location in Germany. Our future results could be harmed by a
variety of factors associated with international sales and operations,
including:
-- CHANGES IN A SPECIFIC COUNTRY'S OR REGION'S POLITICAL OR ECONOMIC
CONDITIONS;
-- TRADE PROTECTION MEASURES AND IMPORT OR EXPORT LICENSING REQUIREMENTS
IMPOSED BY THE UNITED STATES OR BY OTHER COUNTRIES;
-- NEGATIVE CONSEQUENCES FROM CHANGES IN APPLICABLE TAX LAWS;
-- DIFFICULTIES IN STAFFING AND MANAGING OPERATIONS IN MULTIPLE LOCATIONS
IN MANY COUNTRIES;
-- DIFFICULTIES IN COLLECTING TRADE ACCOUNTS RECEIVABLE IN OTHER
COUNTRIES; AND
-- LESS EFFECTIVE PROTECTION OF INTELLECTUAL PROPERTY.
WE ARE EXPOSED TO FLUCTUATIONS IN FOREIGN CURRENCY EXCHANGE RATES. Because
we have international subsidiaries and distributors that operate and sell our
products outside the United States, we are exposed to the risk of changes in
foreign currency exchange rates or declining economic conditions in these
countries. We generally do not engage in hedging transactions to manage our
exposure to currency fluctuations. However, in connection with the Philips
acquisition on January 30, 2003, we entered into a forward hedge in the amount
of $5.3 million to meet our obligation to pay the 5.0 million euro promissory
note (Philips Note) issued as part of the acquisition. On August 26, 2003, we
entered into a forward exchange contract to hedge the foreign currency exposure
of its 1.0 million euro note payable to Philips. Our exposure to currency rate
fluctuations could affect our results of operations and cash flows.
IF WE ARE UNABLE TO ATTRACT AND RETAIN TECHNICAL AND OPERATIONAL PERSONNEL,
OUR BUSINESS COULD BE HARMED. If any of our key employees were to leave us, we
could face substantial difficulty in hiring qualified successors and could
experience a loss in productivity while any successor obtains the necessary
training and experience. Our employment relationships are generally at-will and
we have had key employees leave us in the past. We cannot assure you that one or
more key employees will not leave us in the future. We intend to continue to
hire additional highly qualified personnel, including software engineers and
operational personnel, but we may not be able to attract, assimilate or retain
qualified personnel in the future. Any failure to attract, integrate, motivate
and retain these employees could harm our business.
THE STOCKHOLDINGS OF OUR TWO LARGEST STOCKHOLDERS MAY ENABLE THEM TO
INFLUENCE MATTERS REQUIRING STOCKHOLDER APPROVAL. As of September 30, 2003,
Xerox beneficially owned approximately 15.4% of our outstanding common stock,
including warrants exercisable for up to 525,732 shares of our common stock and
3,562,238 shares of our outstanding Series B Preferred Stock, each of which is
convertible into one share of our common stock. The number of shares of common
stock issuable upon exercise of the Xerox warrant may increase in accordance
with a formula defined in the warrant agreement. The State of Wisconsin
Investment Board (SWIB) is our second largest stockholder, owning approximately
11.5% of our common stock as of September 30, 2003. Because of their large
holdings of our capital stock relative to other stockholders, Xerox and SWIB,
acting individually or together, could have a strong influence over matters
requiring approval by our stockholders.
THE MARKET PRICE OF OUR COMMON STOCK HAS BEEN AND MAY CONTINUE TO BE
SUBJECT TO WIDE FLUCTUATIONS. Our stock price historically has been and may
continue to be volatile. Various factors contribute to the volatility of our
stock price, including, for example, quarterly variations in our financial
results, new product introductions by us or our competitors and general economic
and market conditions. While we cannot predict the individual effect that these
factors may have on the market price of our common stock, these factors, either
individually or in the aggregate, could result in significant volatility in our
stock price during any given period of time. Moreover, companies that have
experienced volatility in the market price of their stock
38
often are subject to securities class action litigation. If we were the subject
of such litigation, it could result in substantial costs and divert management's
attention and resources.
WE HAVE IMPLEMENTED ANTI-TAKEOVER PROVISIONS, WHICH COULD DISCOURAGE OR
PREVENT A TAKEOVER, EVEN IF AN ACQUISITION WOULD BE BENEFICIAL TO OUR
STOCKHOLDERS. Provisions of our amended and restated certificate of
incorporation, bylaws and Delaware law could make it more difficult for a third
party to acquire us, even if doing so would be beneficial to our stockholders.
These provisions include:
-- A PREFERRED SHARES RIGHTS AGREEMENT;
-- AUTHORIZED "BLANK CHECK" PREFERRED STOCK;
-- PROHIBITING CUMULATIVE VOTING IN THE ELECTION OF DIRECTORS;
-- LIMITING THE ABILITY OF STOCKHOLDERS TO CALL SPECIAL MEETINGS OF
STOCKHOLDERS;
-- REQUIRING ALL STOCKHOLDER ACTIONS TO BE TAKEN AT MEETINGS OF OUR
STOCKHOLDERS; AND
-- ESTABLISHING ADVANCE NOTICE REQUIREMENTS FOR NOMINATIONS OF DIRECTORS
AND FOR STOCKHOLDER PROPOSALS.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
FOREIGN CURRENCY RISK
The Company faces exposure to adverse movements in foreign currency
exchange rates, as a significant portion of its revenues, expenses, assets, and
liabilities are denominated in currencies other than the U.S. Dollar, primarily
the Euro Dollar. These exposures may change over time as business practices
evolve. The Company evaluates its foreign currency exposures on an ongoing basis
and makes adjustments to its foreign currency risk management program as
circumstances change.
In certain instances, the Company enters into forward exchange contracts to
hedge against foreign currency fluctuations. These contracts are used to reduce
the Company's risk associated with exchange rate movements, as the gains or
losses on these contracts are intended to offset the exchange rate losses or
gains on the underlying exposures. The Company does not engage in foreign
currency speculation. The success of the Company's foreign currency risk
management program depends upon the ability of the forward exchange contracts to
offset the foreign currency risk associated with the hedged transaction. To the
extent that the amount or duration of the forward exchange contract and hedged
transaction vary, the Company could experience unanticipated foreign currency
gains or losses that could have a material impact on the Company's results of
operations.
In January 2003, the Company entered into a forward exchange contract to
hedge the foreign currency exposure of its 5.0 million euro note payable to
Philips. A forward exchange contract to exchange a total of $5.3 million for 5.0
million Euros with a weighted-average settlement price of 1.0636 Euro/USD, with
an original term of 11 months, was outstanding at September 30, 2003. In August
2003, the Company entered into a forward exchange contract to hedge the foreign
currency exposure of its 1.0 million euro note payable to Philips. A forward
exchange contract to exchange a total of $1.1 million for 1.0 million Euros with
a weighted-average settlement price of 1.0820 Euro/USD, with an original term of
4 months, was outstanding at September 30, 2003.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures. Our management, with
the participation of our Chief Executive Officer and Chief Financial Officer,
evaluated the effectiveness of our disclosure controls and procedures (as
defined in Rule 13a-15(e) of the Exchange Act) as of the end of the period
covered by this report. Based on that evaluation, our Chief Executive Officer
and Chief Financial Officer concluded that, except as provided below, our
disclosure controls and procedures as of the end of the period covered by this
report were effective in ensuring that information required to be disclosed by
us in reports that we file or submit under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms. Subsequent to the end of
the third quarter of 2003, we determined that a deferred tax provision was
required in the first two quarters of 2003 to appropriately account for goodwill
that was created as a result of taxable acquisitions. As a result, we have
restated our results by increasing our tax provision by $250,000 for the first
quarter of 2003 and $304,000 for the second quarter of 2003. We believe that a
control system, no matter how well designed and operated, cannot provide
absolute assurance that the
39
objectives of the control system are met, and no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within a company have been detected.
(b) Changes in internal controls. There was no change in our internal
control over financial reporting (as defined in Rule 13a-15(f) of the Exchange
Act) that occurred during the period covered by this report that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting. Subsequent to the end of the third quarter of 2003,
we adopted additional controls and procedures related to accounting for income
taxes associated with acquisitions including involvement of our tax personnel
in the financial reporting process.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
This information is included in Note 17 ("Commitments and Contingencies") of the
Notes to the Unaudited Consolidated Financial Statements, which information is
incorporated herein by reference from Item 1 of Part I hereof.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On August 11, 2003 the Company held a Special Meeting of its stockholders. At
such meeting, the following actions were voted upon:
(a) To approve the issuance of shares of ScanSoft common stock in
connection with a merger of Spiderman Acquisition Corporation, a
wholly-owned subsidiary of the Company, with and into SpeechWorks
International, Inc.
- --------------------------------------------------------------------------
VOTES FOR VOTES AGAINST ABSTAINED BROKER NON-VOTES
- --------------------------------------------------------------------------
37,724,407 1,092,688 121,023 20,669,112
- --------------------------------------------------------------------------
(b) To approve the amendment of the Company's 1995 Employee Stock Purchase
Plan to increase the number of shares of ScanSoft common stock
reserved for issuance under the plan from 1,000,000 to 1,500,000.
- ----------------------------------------------------
VOTES FOR VOTES AGAINST ABSTAINED
- ----------------------------------------------------
56,852,697 2,579,417 175,116
- ----------------------------------------------------
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
The exhibits listed on the Exhibit Index hereto are filed or incorporated
by reference (as stated therein) as part of this report on Form 10-Q.
(b) Reports on Form 8-K
On August 22, 2003, ScanSoft filed a report on Form 8-K reporting under
Item 2 the acquisition of SpeechWorks International, Inc.
40
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report on Form 10-Q to be signed on its behalf
by the undersigned, thereunto duly authorized, in the City of Peabody, State of
Massachusetts, on November 14, 2003.
SCANSOFT, INC.
By: /s/ David A. Gerth
-----------------------------
David A. Gerth
Chief Financial Officer
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EXHIBIT
INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------------------------------------------------------------
2.1(1) Agreement and Plan of Reorganization, dated as of April 23, 2003,
by and among the Registrant, Spiderman Acquisition Corporation
and SpeechWorks International, Inc.
3.1(2) Amended and Restated Certificate of Incorporation of the
Registrant.
3.2(3) Amended and Restated Bylaws of the Registrant.
10.1** Employment Agreement, dated August 11, 2003, by and between the
Registrant and Paul A. Ricci.
10.2** Letter, dated May 23, 2003, from the Registrant to David A. Gerth
regarding certain employment matters.
31.1 Certification of Chief Executive Officer Pursuant to Rule
13a-14(a) or 15d-14(a).
31.2 Certification of Chief Financial Officer Pursuant to Rule
13a-14(a) or 15d-14(a).
32.1 Certification Pursuant to 18 U.S.C. Section 1350.
- ----------
** Denotes Management compensatory plan or arrangement.
(1) Incorporated by reference from the Registrant's Registration Statement on
Form S-4 (No. 33-106184) filed with the Commission on June 17, 2003.
(2) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended March 31, 2001, filed with the Commission
on May 11, 2001.
(3) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended March 31, 2003, filed with the Commission
on May 15, 2003.
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