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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 MARCH 31, 2004
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 [ ]
104,689,767 shares of the registrant's Common Stock, $0.001 par value, were
outstanding as of May 3, 2004.
SCANSOFT, INC.
FORM 10-Q
THREE MONTHS ENDED MARCH 31, 2004
INDEX
PAGE
PART I: FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
a) Consolidated Balance Sheets at March 31, 2004 and
December 31, 2003............................................ 3
b) Consolidated Statements of Operations for the three months
ended March 31, 2004 and March 31, 2003...................... 4
c) Consolidated Statements of Cash Flows for the three months
ended March 31, 2004 and March 31, 2003...................... 5
d) Notes to Consolidated Financial Statements.................... 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations......................................... 17
Item 3. Quantitative and Qualitative Disclosures about Market Risk........ 32
Item 4. Controls and Procedures........................................... 33
PART II: OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.................................. 33
Signatures................................................................. 34
Certifications............................................................. 35
Exhibit Index.............................................................. 37
2
SCANSOFT, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
MARCH 31, DECEMBER 31.
2004 2003
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents...................................................................... $ 50,130 $ 42,584
Accounts receivable, less allowances of $10,289 and
$10,200, respectively (Note 5).............................................................. 32,643 40,271
Receivables from related parties (Note 16)..................................................... 1,474 2,133
Inventory...................................................................................... 530 427
Prepaid expenses and other current assets...................................................... 7,482 9,264
------------ ------------
Total current assets........................................................................ 92,259 94,679
Goodwill....................................................................................... 243,508 243,266
Other intangible assets, net................................................................... 50,263 54,286
Property and equipment, net.................................................................... 6,740 6,977
Other assets................................................................................... 3,701 2,732
------------ ------------
Total assets................................................................................ $ 396,471 $ 401,940
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable............................................................................... $ 6,467 $ 7,244
Accrued compensation........................................................................... 7,575 7,871
Accrued expenses (Note 7)...................................................................... 10,889 13,481
Deferred revenue............................................................................... 10,341 13,672
Note payable (Note 11)......................................................................... 787 904
Deferred payment obligation for technology license............................................. 5,291 2,754
Other current liabilities...................................................................... 3,270 4,448
------------ ------------
Total current liabilities................................................................... 44,620 50,374
Deferred revenue................................................................................. 245 490
Long-term notes payable, net of current portion.................................................. 27,850 27,859
Deferred tax liability........................................................................... 1,680 1,264
Other liabilities................................................................................ 16,823 18,727
------------ ------------
Total liabilities........................................................................... 91,218 98,714
------------ ------------
Commitments and contingencies (Notes 6, 11 and 12)
Stockholders' equity:
Series B 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; 107,403,165 and 105,327,485 shares issued
and 104,667,699 and 102,592,019 shares outstanding,
respectively................................................................................ 107 105
Additional paid-in capital..................................................................... 472,533 464,350
Treasury stock, at cost (2,735,466 and 2,735,466 shares,
respectively)............................................................................... (10,925) (10,925)
Deferred compensation.......................................................................... (4,863) (1,743)
Accumulated other comprehensive loss........................................................... (973) (748)
Accumulated deficit............................................................................ (155,257) (152,444)
------------ ------------
Total stockholders' equity.................................................................. 305,253 303,226
------------ ------------
Total liabilities and stockholders' equity.................................................. $ 396,471 $ 401,940
============ ============
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)
THREE MONTHS ENDED
MARCH 31,
------------------------
2004 2003
----------- -----------
(AS RESTATED)
Revenue:
Product licenses ............................................................................ $ 30,856 $ 25,508
Professional services ....................................................................... 10,008 1,008
Related parties.............................................................................. 1,912 1,320
----------- -----------
Total revenue............................................................................ 42,776 27,836
----------- -----------
COSTS AND EXPENSES:
Cost of product licenses .................................................................. 3,476 3,270
Cost of professional services ............................................................. 6,726 1,032
-- stock based compensation.............................................................. 20 --
Cost of revenue from amortization of intangible assets..................................... 2,816 2,057
Research and development
-- stock based compensation.............................................................. 43 --
-- all other expenses.................................................................... 9,218 7,177
Selling, general and administrative
-- stock based compensation.............................................................. 256 26
-- all other expenses.................................................................... 21,715 13,235
Amortization of other intangible assets.................................................... 668 361
Restructuring and other charges............................................................ 801 529
----------- -----------
Total costs and expenses................................................................. 45,739 27,687
----------- -----------
Income (loss) from operations................................................................ (2,963) 149
Other income (expense):
Interest income............................................................................ 105 41
Interest expense........................................................................... (132) (80)
Other (expense) income, net................................................................ 476 61
----------- -----------
Income (loss) before income taxes............................................................ (2,514) 171
Provision for income taxes................................................................... 299 345
----------- -----------
Net loss..................................................................................... $ (2,813) $ (174)
=========== ===========
Net loss per share: basic and diluted ....................................................... $ (0.03) $ 0.00
=========== ===========
Weighted average common shares outstanding: basic and diluted................................ 102,847 64,127
=========== ===========
The accompanying notes are an integral part of these
consolidated financial statements.
4
SCANSOFT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
------------------------
2004 2003
-------- --------
(AS RESTATED)
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss ........................................................................... $(2,813) $ (174)
Adjustments to reconcile net loss to net cash provided by operating
activities:
Depreciation ................................................................... 979 415
Amortization of goodwill and other intangible assets ........................... 3,484 2,418
Accounts receivable allowances ................................................. 373 171
Stock-based compensation, including restructuring portion ...................... 714 26
Foreign exchange gain .......................................................... (112) (46)
Non-cash interest expense ...................................................... 89 9
Deferred tax provision ......................................................... 416 250
Changes in operating assets and liabilities, net of
effects from acquisitions:
Accounts receivable ............................................................ 8,042 (211)
Inventory ...................................................................... (106) 238
Prepaid expenses and other current assets ...................................... (1,473) 359
Other assets ................................................................... (398) (94)
Accounts payable ............................................................... (698) 1,309
Accrued expenses ............................................................... (2,764) (2,019)
Other liabilities .............................................................. (336) 271
Deferred revenue ............................................................... (2,742) (63)
------- -------
Net cash provided by operating activities ................................... 2,655 2,859
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures for property and equipment .................................. (775) (605)
Cash received (paid) for acquisitions, including transaction costs 2,451 (4,341)
------- -------
Net cash provided by (used in) investing activities ............................ 1,676 (4,946)
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES
Payment of note payable and deferred acquisition
payments ....................................................................... (225) (3,273)
Payments under deferred payment agreement ........................................ (410) (410)
Proceeds from issuance of common stock, net of issuance
costs -- 6,773
Proceeds from issuance of common stock under employee
stock compensation plans ....................................................... 3,800 531
------- -------
Net cash provided by financing activities ................................... 3,165 3,621
------- -------
Effects of exchange rate changes on cash and cash
equivalents ...................................................................... 50 (110)
------- -------
Net increase in cash and cash equivalents .......................................... 7,546 1,424
Cash and cash equivalents at beginning of year ..................................... 42,584 18,853
------- -------
Cash and cash equivalents at end of year ........................................... $50,130 $20,277
======= =======
The accompanying notes are an integral part of
these consolidated financial statements.
5
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 March 31, 2004 and the results of
operations for the three months ended March 31, 2004 and 2003 and cash flows for
the three months ended March 31, 2004 and 2003. 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, 2003 filed with the Securities and Exchange
Commission on March 15, 2004. The results for the three months ended March 31,
2004 are not necessarily indicative of the results that may be expected for the
year ending December 31, 2004, or any future period.
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
resulted from the Company's implementation of SFAS No. 142. Historically, the
Company had netted its deferred tax liability related to goodwill against its
deferred tax asset. Following the 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 as
follows:
THREE MONTHS ENDED
MARCH 31, 2003
--------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
AS
PREVIOUSLY AS
REPORTED RESTATED
------------ ----------
Statement of Operations:
Provision for income taxes ........ $ 95 $ 345
Net income (loss) ................. $ 76 $(174)
Net income (loss) per
share-basic and diluted ........... $0.00 $0.00
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Foreign Currency Translation
The functional currency of the Company's foreign subsidiaries is the local
currency, with the exception of the Company's subsidiary in Budapest, Hungary
for which the functional currency is the U.S. dollar. Assets and liabilities of
foreign subsidiaries that are denominated in foreign currencies are translated
into U.S. dollars at exchange rates in effect at the balance sheet date. Revenue
and
6
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
expense items are translated using the average exchange rates for the period.
Net unrealized gains and losses resulting from foreign currency translation are
included in other comprehensive income (loss), which is a separate component of
stockholders' equity, except for Budapest for which foreign currency translation
adjustments are recorded in other income (expense). Foreign currency transaction
gains and losses are included in results of operations. The Company reported in
other income, net foreign currency transaction gains and other translation gains
of $14,000 and $7,000 for the three-month periods ended March 31, 2004 and 2003,
respectively.
Capitalization of Internal Use Software Costs
The Company capitalizes development costs of software for internal use
required to be capitalized pursuant to Statement of Position No. 98-1,
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use". As of March 31, 2004, the Company had capitalized costs both
internal and external costs related to financial and human resource management
systems which are currently being customized to operate effectively on a
worldwide basis. The Company had capitalized costs of $1.2 million and $0.9
million, respectively, for the periods ended March 31, 2004 and December 31,
2003.
4. ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company accounts for stock-based awards to employees using the intrinsic
value method as prescribed in Accounting Principles Board ("APB") Opinion No.
25, "Accounting for Stock Issued to Employees" and related interpretations. The
Company follows the disclosure provisions of Statement of Accounting Standards
("SFAS") No. 123, "Accounting for Stock-Based Compensation". Deferred
compensation is recorded for restricted stock granted to employees based on the
fair value of the Company's common stock at the date of grant and is amortized
over the period in which the restrictions lapse. All stock-based awards to
non-employees are accounted for at their fair value in accordance with SFAS No.
123 and related interpretations.
Had compensation expense for the Company's stock-based compensation plans
been determined based on fair market value at the grant dates, as prescribed by
SFAS No. 123, the Company's net loss and pro forma net loss per share would have
been as follows (in thousands, except per share amounts):
THREE MONTHS ENDED
------------------
2004 2003
------- -------
Net loss -- as reported................................. $(2,813) $ (174)
Add back: Stock-based compensation included in net
loss, as reported..................................... 319 26
Deduct: Total stock-based employee compensation
expense determined under the fair
value-based-method,................................... (3,105) (2,336)
------- -------
Net loss -- pro forma................................... $(5,599) $(2,484)
======= =======
Net income (loss) per share -- as reported: basic
and diluted........................................... $ (0.03) $ 0.00
Net loss per share -- pro forma: basic and
diluted............................................... $ (0.05) $ (0.04)
5. ACCOUNTS RECEIVABLE
Accounts receivable consist of the following:
MARCH 31, DECEMBER 31,
2004 2003
--------- -----------
(IN THOUSANDS)
Accounts receivable.................................. $ 34,809 $ 41,066
Unbilled accounts receivable......................... 8,123 9,405
-------- --------
42,932 50,471
Less -- allowances................................... (10,289) (10,200)
-------- --------
$ 32,643 $ 40,271
======== ========
Unbilled accounts receivable relate primarily to revenues earned under
royalty-based arrangements for which billing occurs in the
7
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
month following receipt of the royalty report and to revenues earned under
customer contracts accounted for under the percentage-of-completion method that
have not yet been billed based on the terms of the specific arrangement.
6. OTHER INTANGIBLE ASSETS
Other intangible assets consist of the following (in thousands):
GROSS CARRYING ACCUMULATED NET CARRYING USEFUL LIVES
AMOUNT AMORTIZATION AMOUNT (IN YEARS)
-------------- ------------ ------------ ------------
MARCH 31, 2004
Patents and core technology ........... $53,643 $28,721 $24,922 1-9
Completed technology .................. 13,574 2,607 10,967 1-4
Tradenames and trademarks ............. 5,871 2,052 3,819 1-10
Non-competition agreement ............. 10 6 4 1
Customer relationships ................ 12,036 1,485 10,551 1-6
------- ------- ------- ----
$85,134 $34,871 $50,263
======= ======= =======
DECEMBER 31, 2003
Patents and core technology ........... $53,673 $26,718 $26,955
Completed technology .................. 14,081 1,928 12,153
Tradenames and trademarks ............. 5,871 1,874 3,997
Non-competition agreement ............. 10 4 6
Customer relationships ................ 12,438 1,263 11,175
------- ------- -------
$86,073 $31,787 $54,286
======= ======= =======
On March 31, 2003, the Company entered into an agreement that granted 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 Company made an additional payment of $2.8 million on
April 5, 2004 and is required to make a final payment totaling $2.8 million on
or before March 31, 2005. As of March 31, 2004, both of these payment amounts
(including a present value discount of $0.3 million) are classified as current
deferred payment obligation for technology license. Additionally, according to
the terms of the June 30, 2003, amendment the Company was entitled to receive a
cash refund on the license based on certain return levels of products previously
distributed. The Company was notified during the quarter ended March 31, 2004,
that a refund of approximately $0.5 million was due. As of March 31, 2004, this
was treated as a reduction of the license fee and is classified in other current
assets.
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. That amount is being amortized to cost of revenue 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 is being
charged to interest expense over the payment period.
Aggregate amortization expense for all amortizable intangible assets was
$3.5 million of which $2.8 million was included in cost of revenue for the three
month period ended March 31, 2004. Estimated amortization expense for each of
the five succeeding fiscal years as of March 31, 2004 is as follows (in
thousands):
8
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SELLING,
COST OF GENERAL AND
YEAR ENDING REVENUE ADMINISTRATIVE TOTAL
- ----------- ---------- -------------- -------
2004................................ $ 8,059 $ 2,097 $10,156
2005................................ 6,445 2,503 8,948
2006................................ 5,365 2,262 7,627
2007................................ 5,349 2,131 7,480
2008................................ 3,097 1,883 4,980
Thereafter.......................... 7,598 3,474 11,072
------ ------- -------
Total............................... $35,913 $14,350 $50,263
======= ======= =======
7. ACCRUED EXPENSES
Accrued expenses consist of the following (in thousands):
MARCH 31, DECEMBER 31,
2004 2003
---------- ------------
Accrued sales and marketing incentives............... $ 3,192 $ 2,540
Accrued restructuring and other charges.............. 1,749 1,861
Accrued royalties.................................... 478 510
Accrued professional fees............................ 1,330 1,735
Accrued acquisition liabilities...................... 109 143
Accrued transaction costs............................ 149 834
Accrued other........................................ 3,882 5,858
------- -------
$10,889 $13,481
======= =======
8. RESTRUCTURING AND OTHER CHARGES
During the three months ended March 31, 2004, the Company recorded a charge
of $0.8 million related to separation agreements with two former members of the
senior management team. Included in this amount are non-cash compensation
charges of $0.4 million related to the acceleration of restricted common stock
and stock options.
During the three months March 31, 2004, the Company paid a total of $0.5
million in severance payments, $0.4 million which relate to restructuring
actions taken during 2003 and $0.1 million relates to severance paid to the
former Caere President and CEO, pursuant to a 2000 restructuring charge.
At March 31, 2004, the remaining restructuring accrual from the current and
prior restructuring activities amounted to $1.7 million. The balance is
comprised of $0.2 million of lease exit costs and $1.5 million of
employee-related severance costs, of which $0.2 million are for severance to the
former Caere President and CEO, and $1.3 million are for severance costs related
to actions taken during 2004 and 2003.
The severance due to the former Caere President and CEO will be paid through
March 2005. The majority of severance costs related to employee termination
actions undertaken during 2003 will be paid through September 2004. Certain
other severance costs related to restructuring actions undertaken during 2003
will be paid through March 2009. Severance costs relating to the March 2004
separation agreements will be paid during 2004.
9
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table sets forth the 2004 and 2003 restructuring and other
charges accrual activity (in thousands):
LEASE
EMPLOYEE EXIT ASSET
RESTRUCTURING AND OTHER CHARGES ACCRUAL RELATED COSTS IMPAIRMENT TOTAL
- --------------------------------------- -------- ----- ---------- -------
Balance at December 31, 2002................ $ 446 $ 219 -- $ 665
Restructuring and other charges............. 3,267 337 89 3,693
Non-cash charges............................ -- -- (89) (89)
Cash payments............................... (2,161) (247) -- (2,408)
------- ----- ----- -------
Balance at December 31, 2003................ 1,552 309 $ -- 1,861
------- ----- ----- -------
Restructuring and other charges............. 801 -- -- 801
Non-cash charges ........................... (348) -- -- (348)
Cash payments............................... (544) (21) -- (565)
------- ----- ----- -------
Balance at March 31, 2004................... $ 1,461 $ 288 $ -- $ 1,749
======= ===== ===== =======
9. 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. 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. All potential dilutive common shares are excluded from the
computation of net loss per share for the three month periods ended March 31,
2004 and 2003, respectively, because they are antidilutive.
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
MARCH 31,
------------------
2004 2003
-------- -------
Basic net income (loss) per share:
Weighted average number of common shares
Outstanding, excluding unvested restricted stock.. 102,847 64,127
Assumed conversion of Series B Preferred
Stock............................................. -- --
------- ------
Weighted average common shares: basic................. 102,847 64,127
Effect of dilutive common equivalent shares:
Stock options..................................... -- --
Convertible debenture............................. -- --
Warrants.......................................... -- --
Unvested restricted stock......................... -- --
------- ------
Weighted average common shares: diluted............... 102,847 64,127
======= ======
For the three months periods ended March 31, 2004 and 2003, respectively,
stock options to purchase 5,179,852 and 5,930,663 shares of common stock were
not included in the calculation of diluted net loss per share because they were
antidilutive.
Potential weighted-average common shares, including stock options, unvested
restricted stock, preferred shares, convertible debt and warrants at March 31,
2004 and 2003, were 14,136,240 and 13,093,203, respectively. These potential
common shares were excluded from the calculation of diluted net loss per share
as their inclusion would have been antidilutive for the period presented.
In March 2004, the Emerging Issues Task Force ("EITF") reached a consensus
on EITF No. 03-06, "Participating Securities and Two-Class Method under FASB
Statement No 128, Earning per Share." EITF No. 03-06 addresses a number of
questions regarding the computation of earnings per share ("EPS") by companies
that have issued securities other than common stock that contractually entitle
the holder to participate in dividends and earnings of the company when, and if,
it declares dividends on its common stock. The issue also provides further
guidance in applying the two-class method of calculating EPS. It clarifies what
constitutes a SCANSOFT, INC.
10
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
participating security and how to apply the two class method of computing EPS
once it is determined that a security is participating, including how to
allocate undistributed earning to such a security. The consensuses reached on
EITF No. 03-06 is effective for fiscal periods beginning after March 31, 2004.
Prior period earnings per share amounts will be restated to conform to the
consensuses to ensure comparability year over year. The Company is still
evaluating the impact, if any, the adoption of EITF No. 03-06 would have on its
results of operations or financial condition.
10. COMPREHENSIVE INCOME (LOSS)
Total comprehensive income (loss), net of taxes, was ($3.0) million and
($0.2) million for the three months ended March 31, 2004 and 2003, respectively.
Total comprehensive income for the three months ended March 31, 2004, consisted
of net loss of $2.8 million and foreign currency translation adjustments of
approximately ($0.2) million. Total comprehensive income for the three months
ended March 31, 2003, consisted of net loss of $0.2 million, foreign currency
translation adjustments of approximately ($13,000) and approximately $7,000
related to the forward foreign exchange hedge on the 5 million euro promissory
note to Philips.
11. DEBT AND CREDIT FACILITIES
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 March
31, 2004, for the period through March 31, 2006. Under this amendment, the
Company must comply with both a minimum adjusted quick ratio and minimum
tangible net worth calculation, as defined in the Loan Agreement. Depending on
the Company's adjusted quick ratio, borrowings under the Credit Facility bear
interest at the Bank's prime rate plus 0.0% or 0.75%, (4.0% at March 31, 2004),
as defined in the Loan Agreement. The maximum aggregate amount of borrowings
outstanding at any one time was amended to the lesser of $20.0 million or a
borrowing base equal to the aggregate amounts un-drawn on outstanding letters of
credit, minus 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 March 31, 2004, the Company
was in compliance with all covenants.
As of March 31, 2004, no amounts were outstanding under the Credit Facility
and $15.6 million was available for borrowing in addition to approximately $1.4
million committed under this line of credit for outstanding Letters of Credit.
The Company can make no guarantees as to its ability to satisfy its future
financial covenant calculations.
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 March 31, 2004,
a balance of $1.1 million remains outstanding. Borrowings under this line are
collateralized by the fixed assets purchased and bear interest at the bank's
prime rate (4.0% at March 31, 2004), 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 March 31, 2004, principal payments of $0.7 million are due
during the year ending December 31, 2004, $0.3 million are due during the year
ending December 31, 2005 and $0.1 million 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 March 31, 2004.
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. 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 Note contains a provision in which all amounts
11
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
unpaid at maturity will bear interest at a rate of 3% per quarter until paid.
The Convertible Note contains 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 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 did not result in a Change in Control.
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. These claims have been referred to counsel, and they
are in various stages of evaluation and negotiation. 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 the Company's intellectual property rights,
whether developed, purchased or licensed by the Company. In response to any such
circumstance, the Company has counsel investigate the matter thoroughly and the
Company takes all appropriate action to defend its rights in these matters.
On April 23, 2004, Millennium L.P. sued the Company in the United States
District Court for the Southern District of New York for patent infringement. In
the lawsuit, Millennium alleges that the Company is infringing United States
Patent No. 5,258,855 entitled "Information Processing Methodology"; No.
5,369,508 entitled "Information Processing Methodology"; No. 5,625,465 entitled
"Information Processing Methodology"; No. 5,768,416 entitled "Information
Processing Methodology"; and No. 6,094,505 entitled "Information Processing
Methodology." The Company has not yet evaluated the merits of this lawsuit.
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 that tend to be
erroneously matched and linked error templates that are linked to specified
reference templates that are stored for comparison. In addition, on November 26,
2003, Davis filed an action against the Company in the United States District
Court for the Western District for New York (Buffalo) claiming that the Company
infringed the '231 Patent. Damages are sought in an unspecified amount. Although
ScanSoft has, both prior to and as a result of the SpeechWorks acquisition,
several products in the speech recognition technology field, ScanSoft believes
that the products do not infringe the '231 Patent because neither the Company
nor SpeechWorks use the claimed techniques. SpeechWorks filed an Answer and
Counterclaim to Davis's Complaint in its case on August 25, 2003 and the Company
filed an Answer and Counterclaim to Davis's Complaint in its case on December
22, 2003. The Company believes Davis's claims have no merit and intends to
defend the actions 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 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
12
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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 August 16, 2001, Horst Froessl sued the Company in the United States
District Court for the Northern District of California for patent infringement.
That action has been resolved for an immaterial amount, and the Company was
dismissed from the action on March 24, 2004.
The Company believes that the final outcome of the current litigation
matters described above will not have a significant adverse effect on its
financial position and results of operations. However, even if the Company's
defense is successful, the litigation could require significant management time
and will be costly. Should the Company not prevail in these litigation matters,
its operating results, financial position and cash flows could be adversely
impacted.
Guarantees and Other
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.
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. 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 five years from the acquisition date. As a
result, the Company recorded a liability related to the fair value of the
obligation of $1.0 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.
In accordance with the provisions of FASB issued FASB Interpretation No. 45
("FIN 45"), Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others, the following table
represents the deferred revenue activity related to the Company's obligations
under maintenance and support contracts for the three month period ended March
31, 2004 (in thousands):
Beginning balance as of December 31, 2003........................... $4,056
Additions due to new billings during 2004........................... 1,809
Maintenance revenue recognized during the 2004...................... (974)
------
Ending balance as of March 31, 2004................................. $4,891
======
12. STOCKHOLDERS' EQUITY
Preferred Stock
The Company is authorized to issue up to 40,000,000 shares of preferred
stock, par value $0.001 per share. The Company has designated 100,000 shares as
Series A Preferred Stock and 15,000,000 as Series B Preferred Stock. In
connection with the acquisition of ScanSoft, the Company issued 3,562,238 shares
of Series B Preferred Stock to Xerox Corporation ("Xerox"). On March 19, 2004,
13
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the Company announced that Warburg Pincus, a global private equity firm, had
agreed to purchase all outstanding shares of the Company's stock held by Xerox
Corporation for approximately $80 million, including the 3,562,238 shares of
Series B preferred stock. The Series B Preferred Stock is convertible into
shares of common stock on a one-for-one basis. The Series B Preferred Stock has
a liquidation preference of $1.30 per share plus all declared but unpaid
dividends. The Series B Preferred Stock holders are entitled to non-cumulative
dividends at the rate of $0.05 per annum per share, payable when, as and if
declared by the Board of Directors. To date no dividends have been declared by
the Board of Directors. Holders of Series B Preferred Stock have no voting
rights, except those rights provided under Delaware law. The undesignated shares
of preferred stock will have rights, preferences, privileges and restrictions,
including voting rights, dividend rights, conversion rights, redemption
privileges and liquidation preferences, as shall be determined by the Board of
Directors upon issuance of the preferred stock. The Company has reserved
3,562,238 shares of its common stock for issuance upon conversion of the Series
B Preferred Stock.
Common Stock Warrants
The Company issued Xerox a ten-year warrant with an exercise price for each
warrant share of $0.61. Pursuant to the terms of this warrant, it is exercisable
for the purchase of 525,732 shares of the Company's common stock. On March 19,
2004, the Company announced that Warburg Pincus, a global private equity firm
had agreed to purchase all outstanding shares of the Company's stock held by
Xerox Corporation, including the warrant referenced above, for approximately $80
million. In connection with this transaction, Warburg Pincus acquired warrants
to purchase 2.5 million additional shares of the Company's common stock for
total consideration of $0.6 million. The warrants have a six year life and a
exercise price of $4.94. As of March 31, 2004, this balance is classified as
other assets.
In connection with the March 31, 2003 acquisition of the certain
intellectual property assets related to multimodal speech technology, 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, 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.
In connection with the acquisition of SpeechWorks, the Company assumed the
remaining outstanding warrants issued by SpeechWorks to America Online ("AOL")
to purchase up to 219,421 shares, as converted, of common stock in connection
with a long-term marketing arrangement. The warrant is currently exercisable at
a price of $14.49 per share and expires on June 30, 2007. The value of the
warrant was insignificant.
On December 17, 2003, pursuant to a letter agreement, dated October 17,
2003, the Company issued a warrant to a former employee of SpeechWorks, expiring
December 17, 2004, for the purchase of 11,180 shares of its common stock at an
exercise price of $7.70 per share, and 2,552 shares of its common stock at an
exercise price of $5.64 per share. The warrant was valued at approximately
$18,000 based upon the Black-Scholes option pricing model with the following
assumptions: expected volatility of 80%, a risk-free interest rate of 1.63%, an
expected term of 1 year, no dividends and a stock price of $5.62 based on the
Company's stock price at the time of issuance.
Stock Repurchase
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 following
12 months, however, the Company may suspend or discontinue the repurchase
program at any time. From August 6, 2003 through December 31, 2003, the Company
repurchased 618,088 common shares at a purchase price of $2.9 million; the
Company records treasury stock at cost. The Company did not repurchase any
common stock during the three month period ended March 31, 2004.
14
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
As of March 31, 2004, the Company had repurchased a total of 2,735,466
common shares under its repurchase programs. The Company intends to use the
repurchased shares for its employee stock plans and for potential future
acquisitions.
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 of $2.4 million, the net proceeds to
the Company amounted to approximately $5.5 million.
Other
On April 12, 2002, the Company completed a private placement of 1.0 million
shares of common stock at a purchase price of $6.00 per share with SF Capital
Partners Ltd. ("SF Capital"), resulting in proceeds, net of issuance costs, of
$5.6 million. In purchasing these shares, SF Capital was provided with certain
registration rights which required that the shares be registered no later than
August 10, 2002. The shares held by SF Capital were registered on February 14,
2003, however no penalty for late registration was enforced.
In connection with the agreement 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) entered into by the Company in September 2002, the Company
agreed to issue an additional 150,000 shares of its common stock to L&H if it
did not complete an underwritten public offering of the shares held by L&H by
December 15, 2002. The Company further agreed to issue an additional 150,000
shares of its common stock to L&H if it did not complete an underwritten public
offering by February 15, 2003. The Company also would be required to issue an
additional 100,000 shares of its common stock to L&H if, by February 15, 2003,
it failed to file a registration statement to register the shares remaining
unsold. The value ascribed to the potential right to acquire additional shares
of the Company's common stock was valued at $0.3 million using a probability-
weighted, Black-Scholes valuation model and recorded as a credit to additional
paid-in capital, with a corresponding reduction in additional paid-in capital
because the Company has an accumulated deficit. Accordingly, the right had no
net effect on the Company's financial position or results of operations. The
Company completed the public offering on February 14, 2003. Because the offering
was not completed by December 15, 2002, the Company issued L&H 150,000 shares of
common stock on December 18, 2002.
13. RESTRICTED COMMON STOCK
On February 24, 2004, the Company issued 647,291 shares of restricted common
stock to members of the Company's senior management team. 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
difference between the purchase price and the fair value of the Company's common
stock on the date of issue based on the listed exchange price of $3.7 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 $0.1 million of stock compensation expense
during the three month period ended March 31, 2004.
15
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. SEGMENT AND GEOGRAPHIC INFORMATION
The Company operates in a single segment. The following table presents
total revenue information by geographic area and principal product line (in
thousands):
THREE MONTHS ENDED
MARCH 31,
------------------------
2004 2003
--------- ---------
North America............. $ 29,431 $ 20,608
Other foreign countries... 13,345 7,228
--------- ---------
Total................... $ 42,776 $ 27,836
========= =========
THREE MONTHS ENDED
MARCH 31,
------------------------
2004 2003
--------- ---------
Digital Capture......... $ 14,461 $ 12,587
Speech.................. 28,315 15,249
--------- ---------
Total................. $ 42,776 $ 27,836
========= =========
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.
A number of the Company's North American OEM customers distribute products
throughout the world but because these customers do not provide the geographic
dispersion of their product sales, the Company recorded the revenue in the North
America category. However, based on an estimate that factors the Company's OEM
partners' geographical revenue mix to the Company's revenue generated from these
OEM partners, international revenue would have represented approximately 34% and
33% of the Company's consolidated revenue for the quarters ended March 31, 2004
and March 31, 2003, respectively.
15. PRO FORMA RESULTS
The following table reflects unaudited pro forma results of operations of
the Company assuming that the Philips, SpeechWorks and LocusDialog acquisitions
had occurred on January 1, 2003 (in thousands, except per share data):
THREE MONTHS
ENDED MARCH 31,
---------------
2003
--------
Revenues..................................................... $38,272
Net loss..................................................... $(9,701)
Net loss per basic and diluted share......................... $ (0.11)
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 this period.
16. RELATED PARTIES
On March 19, 2004, the Company announced that Warburg Pincus, a global
private equity firm, had agreed to purchase all outstanding shares of the
Company's stock held by Xerox Corporation for approximately $80 million. At
December 31, 2003, Xerox owned approximately 15% of the Company's outstanding
common stock and all of the Company's outstanding Series B Preferred Stock. In
addition, Xerox had the opportunity to acquire additional shares of common stock
pursuant to a warrant (Note 12).
The Company and Xerox have entered into multiple non-exclusive agreements
in which the Company grants Xerox the royalty-bearing right to copy and
distribute certain versions of the Company's software programs with Xerox's
multi-function peripherals. Xerox accounted for 4%, and 5% of the Company's
total net revenues during each of the three month periods ended March 31, 2004
and 2003, respectively. As of March 31, 2004 and 2003, Xerox owed the Company
$1.3 million and $1.2 million, respectively, pursuant to these
16
SCANSOFT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
agreements, which are included in receivables from related parties.
As a result of the Xerox and Warburg Pincus transaction, Xerox is no longer
a related party as of March 31, 2004. The Company does not engage in
transactions in the normal course of its business with Warburg Pincus.
In connection with the Caere acquisition in the first quarter of 2000 and
pursuant to a concurrent non-competition and consulting agreement, the Company
agreed to pay in cash to the former Caere President and CEO, a current member of
the Board of Directors of the Company, on the second anniversary of the merger,
March 13, 2002, the difference between $13.50 and the closing price per share of
ScanSoft common stock at that time, multiplied by 486,548. On March 5, 2002, the
Company negotiated a deferred payment agreement with the former Caere President
and CEO to terminate this agreement. Under the terms of the deferred payment
agreement, the Company paid $1.0 million in cash on March 5, 2002 and agreed to
make future cash payments totaling $3.3 million, with such amounts payable in
equal quarterly installments of approximately $0.4 million over the following
two years. During the three months ended March 31, 2004, the Company paid a
quarterly installment under this agreement of $0.4 million. The total
consideration of this agreement was accounted for in the original Caere purchase
price and had no effect on the results of operations. There is no remaining
liability as of March 31, 2004.
At March 31, 2004, a member of the Company's Board of Directors, and a
former member of the SpeechWorks Board of Directors, is a senior executive at
Convergys Corporation. The Company and Convergys have entered into multiple
non-exclusive agreements in which Convergys resells the Company's software.
During the three months ended March 31, 2004, Convergys accounted for
approximately $0.1 million in total net revenues. As of March 31, 2004,
Convergys owed the Company $0.1 million, pursuant to these agreements, which are
included in receivables from related parties.
17. SUBSEQUENT EVENT
On May 6, 2004, the Company announced that it had signed an agreement to
acquire Telelogue, Inc, a developer of speech-enabled, directory assistance
automation applications, based in Iselin, New Jersey.
The Company believes the acquisition of Telelogue will enhance the Company's
competitive position in key markets, specifically the directory assistance
market. In addition, the Company believes the acquisition enhances the existing
directory assistance distribution channel, adding key customer and partner
relationships, and several patents that are used in the automation of directory
assistance services.
The transaction is expected to close by the end of May 2004, subject to
customary closing conditions.
Consideration for the transaction comprised $2.0 million in cash to be paid
at closing along with additional contingent consideration up to a maximum of
$2.0 million dependent on the achievement of certain market and revenue
milestones.
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 FUTURE REVENUES, COST OF REVENUES, RESEARCH AND DEVELOPMENT
EXPENSES, SELLING, GENERAL AND ADMINISTRATIVE EXPENSES, AMORTIZATION OF
OTHER INTANGIBLE ASSETS AND GROSS MARGIN;
-- OUR STRATEGY RELATING TO SPEECH AND LANGUAGE TECHNOLOGIES;
-- THE POTENTIAL OF FUTURE PRODUCT RELEASES;
-- OUR PRODUCT DEVELOPMENT PLANS AND INVESTMENTS IN RESEARCH AND
DEVELOPMENT;
17
-- FUTURE ACQUISITIONS;
-- INTERNATIONAL OPERATIONS AND LOCALIZED VERSIONS OF OUR PRODUCTS; AND
-- LEGAL PROCEEDINGS AND LITIGATION MATTERS.
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.
OVERVIEW OF THE BUSINESS
ScanSoft is a leading provider of software that allows users to incorporate
documents, images and speech into digital applications. Our products and
technologies automate manual processes and help enterprises, professionals and
consumers increase productivity, reduce costs and save time. Our products are
built upon digital capture and speech technologies, and are sold as solutions
into the financial, legal, healthcare, government, telecommunications and
automotive 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,
services, channels and business processes.
On March 30, 2004, we amended our loan and security agreement with Silicon
Valley Bank for a revolving loan in a principal amount not to exceed $20.0
million, collateralized by substantially all of our personal property, but not
our intellectual property. At the date of this quarterly report on Form 10-Q, no
amounts were outstanding under the Credit Facility and $15.6 million was
available for borrowing, with approximately $1.4 million committed under this
line of credit for in outstanding Letters of Credit.
On January 30, 2003, we completed the acquisition of the Speech Processing
Telephony and Voice Control business units of Royal Philips Electronics N.V.
("Philips"), and related intellectual property, on the terms set forth in the
purchase agreement dated October 7, 2002, as amended. 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 these business units and intellectual property, 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 prior to December 31, 2003,
issued a 5.0 million euro note payable 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. Prior to December 31, 2003, we paid both
the 5.0 million euro promissory note and 1.0 million euro note payable in
accordance with the provisions of the purchase agreement. In addition, prior to
December 31, 2003, in accordance with provisions of the purchase agreement, the
parties agreed upon a purchase price adjustment resulting in a decrease to the
total purchase consideration, and a payment to be made by Philips to ScanSoft of
approximately $3.0 million. ScanSoft received this payment on January 5, 2004.
On August 11, 2003, we acquired all of the outstanding stock of SpeechWorks
International, Inc. ("SpeechWorks"), a leading provider of software products and
professional services that enable enterprises, telecommunications carriers and
government organizations to offer automated, speech-activated services over any
telephone, in exchange for 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
18
common stock, representing approximately 33% of our outstanding common stock
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 our common stock. In addition, the purchase price includes the
value of 184,850 shares of restricted common stock issued to replace previously
outstanding SpeechWorks restricted common stock, of $0.7 million, based on the
closing price of our common stock on the date of acquisition. The value of the
unvested restricted common stock has been recorded as deferred compensation.
On December 19, 2003, we acquired all of the outstanding shares of
LocusDialog Inc. ("LocusDialog'), a leader in speech-enabled, auto-attendant
applications, based in Montreal, Canada. LocusDialog's applications are widely
recognized as superior call routing and auto-attendant solutions in the market,
with nearly 1,000 installations worldwide, handling approximately 500 million
calls annually. Consideration for the transaction comprised 2.3 million shares
of our common stock at a per share value of $5.31 (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) having a value of $12.4
million and transaction costs of $0.7 million.
OVERVIEW OF RESULTS OF OPERATIONS
The following table presents, as a percentage of total revenue, certain
selected financial data for each of the three month periods ended March 31:
THREE MONTHS ENDED
MARCH 31,
------------------
2004 2003
------ ------
Revenues:
Product licenses............................................... 76.6% 96.4%
Professional services ......................................... 23.4 3.6
------ ------
Total revenue................................................ 100.0% 100.0%
------ ------
Cost of revenues:
Cost of product licenses....................................... 8.1 11.7
Cost of professional services -- non cash stock compensation... -- --
-- all other expenses ................................. 15.7 3.8
Cost of revenue from amortization of intangible assets(1)...... 6.6 7.4
------ ------
Total cost of revenues................................. 30.4 22.9
------ ------
Research and development
-- stock based compensation............................ -- --
-- all other expenses.................................. 21.6 25.8
Selling, general and administrative
-- stock based compensation............................ 0.6 --
-- all other expenses.................................. 50.8 47.6
Amortization of goodwill and other intangible assets(1)........ 1.6 1.3
Restructuring and other charges, net(2)........................ 1.9 1.9
------ ------
Total costs and expenses..................................... 106.9 99.5
====== ======
Income (loss) from operations..................................... (6.9) 0.5
Other income (expense), net.................................... 1.0 0.0
------ ------
Income (loss) before income taxes................................. (5.9) 0.5
Provision for income taxes..................................... 0.7 1.2
------ ------
Net loss.......................................................... (6.6)% (0.7)%
====== ======
- ----------------
(1) See Note 6 of Notes to Consolidated Financial Statements.
(2) See Note 8 of Notes to Consolidated Financial Statements.
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
19
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 speech
technologies enable voice-activated services over a telephone, transform speech
into text and text into speech, and permit voice control of devices and
applications. Our digital capture technologies transform text, images and files
into various digital formats. During the three month period ended March 31,
2004, Speech and Digital Capture represented approximately 66% and 34%,
respectively, of our net revenue.
Cost of product license revenue consists primarily of material and
fulfillment costs and third party royalties paid to other vendors.
Cost of professional services revenue consists primarily of engineering
costs associated with certain contracts which are accounted for under the
percentage-of-completion method of accounting and project-specific travel
expenses.
Cost of revenue from amortization of intangible assets consists of the
amortization of acquired patents and core and completed technology.
Research and development expense consists 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 internal 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 expense;
however, if revenue continues to grow, we expect selling, general and
administrative expense 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.
Stock-based compensation expenses result from non-cash charges for common
shares issued with exercise or purchase prices that are less than the fair
market value of the common stock on the date of grant.
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.
Total Revenue
Total revenue for the three months ended March 31, 2004 increased by $14.9
million or 54% from the comparable period in 2003. The overall growth in revenue
is attributed to $5.9 million growth from our product revenue and $9.0 million
in growth from professional services.
Geographic revenue classification is based on the country in which the sale
is invoiced. Revenue for the three months ended March 31, 2004 was 69% North
America and 31% international versus 74% and 26%, respectively for the
comparable period in 2003.
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
March 31, 2004 is approximately 66% North America and 34% international,
compared to 67% and 33%, respectively, for the comparable period in 2003.
For fiscal year 2004, we expect revenue growth of 37% to 48% from the
fiscal year 2003 total. We believe that growth will occur throughout all of our
product lines.
Within the networked speech market, our anticipated growth is attributable
to certain competitive advantages, such as superior products, channel
expertise, packaged applications and professional services. By leveraging our
advantages, we expect to gain additional share in the financial services,
healthcare, utilities, government, and travel and entertainment markets.
Within the embedded speech market, we anticipate continued growth,
specifically in the automotive, electronic games and handsets markets,
resulting in a significant increase over 2003 revenues. Additionally, we intend
to extend our solutions further in the learning and accessibility markets.
Within our productivity applications, we expect to benefit from three
important trends -- IT spending in healthcare, networked scanning, and PDF
solutions. We expect to invest in and see growth from opportunities in
healthcare organizations looking for productivity solutions that can automate
processes, cut costs, and offer an alternative to outsourcing with the use of
our dictation applications. In digital capture, our OmniPage and PaperPort
products are positioned to take advantage of the growing networked scanning
markets through our major OEM partners. Within the PDF market, we have seen
early success from our PDF Converter line, and expect to see growth as we
continue to invest in PDF solutions.
Product Revenue
Product revenue for the three months ended March 31, 2004 increased by $5.9
million or 22% from the comparable period in 2003. The increase in revenue from
the comparable period in 2003 is ascribed to a $4.5 million increase in speech
revenue, as well as a $1.4 million increase in digital capture revenue.
The growth in speech revenue is accredited to growth and increased demand in
all speech segments - enterprise, telephony, embedded, and dictation - and to
the acquisition of SpeechWorks and LocusDialog. The increased demand and
acquisitions contributed approximately $6.4
20
million in revenue, an increase of 60% for solutions across enterprise,
telephony and embedded markets. This increase was partially offset in comparison
by a $3.0 million decrease in our revenue, due to a large OEM transaction with
one customer in March 2003, and was not repeated again this quarter. In
addition, our dictation productivity applications increased $0.6 million in the
three months ended March 31, 2004, despite the first quarter 2003 product launch
of Dragon Naturally Speaking 7.0.
The $1.4 million increase in our digital capture revenue for the three
months ended March 31, 2004, was due primarily to sales from our PDF Converter
product line, which was launched in September 2003.
Service Revenue
Service revenue for the three months ended March 31, 2004 increased by $9.0
million from the comparable period in 2003. Prior to the acquisition of
Speechworks, our service revenues were not significant. The substantial increase
in service revenue from the comparable period 2003 is attributed to the
formation of a professional services organization in conjunction with the
acquisition of SpeechWorks, which was completed in August 2003. Additionally, we
saw a $0.4 million increase in service revenue from our digital capture
products, as well as a $0.1 million increase in service revenue from our
dictation product lines.
Cost of Product License Revenue
Cost of product license revenue for the three months ended March 31, 2004
was $3.5 million or 10.6% of product license revenue, compared to $3.3 million
or 12.2% for the comparable period in 2003. The increase in cost of product
license revenue in absolute dollars for the three-month period ended March 31,
2004 was directly attributable to the overall increase in our product license
revenue. The decrease in cost of product license revenue as a percentage of
revenue was due to the increase in product license revenue, as well as,
productivity gains in our manufacturing and fulfillment operations. For the
remainder of 2004, we expect cost of product license revenue, as a percentage of
revenue, to be consistent with the three months ended March 31, 2004.
Cost of Professional Services Revenue
Cost of professional services revenue for the three months ended March 31,
2004 was $6.7 million or 67.2% of professional services revenue, compared to
$1.0 million or 102% for the comparable period in 2003. The increase in cost of
professional services revenue in absolute dollars for the three-month period
ended March 31, 2004 was directly attributable to the 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. We expect cost of
revenues as a percentage of total revenues to increase by about 2 percentage
points during the second quarter, as we increased professional services staffing
to meet our solutions demand. But, we expect this ratio to decrease, thereafter,
by about 2 to 3 percentage points per quarter during both the third and fourth
quarter. This improvement will result from higher utilization of our new
services personnel and other process improvements we have underway. Cost of
revenue - stock based compensation, is related to the issuance of common stock
to certain Company executives with exercise or purchase prices that are less
than the fair market value of the common stock on the date of grant.
Cost of Revenue from Amortization of Intangible Assets
Cost of revenue from amortization of intangible assets for the three months
ended March 31, 2004 was $2.8 million or 6.6% of total revenue, compared to $2.1
million or 7.4% for the comparable period in 2003. The increase in cost of
revenue from amortization of intangible assets in absolute dollars is
attributable to $0.5 million of amortization related to the exclusive worldwide
license of certain desktop dictation products and technologies, $0.1 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, partially offset by $0.1 million of intangible assets that
became fully amortized during fiscal year 2003. During 2004, we expect cost of
revenue from amortization of intangible assets to be approximately $11.0 million
based on our current level of intangible assets.
Research and Development Expense
Research and development expense for the three months ended March 31, 2004
was $9.2 million or 21.6% of total revenue, compared to $7.2 million or 25.8%
for the comparable period in 2003. The increase in research and development
expenses in absolute dollars is due to increased speech and language development
efforts associated with increased headcount and related costs of
21
approximately $2.0 million resulting from both the Philips and SpeechWorks
acquisitions. This increase is partially offset by a reduction of headcount and
related costs in imaging development efforts of approximately $0.5 million
resulting from the transfer of certain research and development activities from
our corporate headquarters to Budapest during the three month period ended June
30, 2003. While we will continue to invest significantly in research and
development, we expect research and development expenses as a percentage of
revenue to continue to decline in 2004 due to an increase in revenue. Research
and development expenses-stock based compensation is related to the issuance
of common stock to certain Company executives with exercise or purchase prices
that are less than the fair market value of the common stock on the date of
grant.
Selling, General and Administrative Expense
Selling, general and administrative expense for the three months ended
March 31, 2004 was $21.7 million or 50.8% of total revenue, compared to $13.2
million or 47.6% for the comparable period in 2003. The increase in selling,
general and administrative expense in absolute dollars and as a percentage of
revenue was the result of increased compensation costs of approximately $5.0
million resulting from the addition of 48 sales and marketing employees and 20
general and administrative employees primarily due to the SpeechWorks
acquisition. The remaining increase in selling, general and administrative
expenses is due primarily to increased facilities charges of $1.9 million
resulting from increased rent and related insurance expenses, increased channel
marketing expenses of $0.4 million, increased professional fees of approximately
$0.4 million and travel expenses of $0.9 million. We expect selling, general and
administrative expenses as a percentage of revenue to decline as a percentage of
revenue over the remainder of 2004 as revenue increases. In addition, we expect
to incur approximately $1.0 million related to compliance with recently issued
regulatory requirements. Selling, general and administrative expenses-stock
based compensation of approximately $0.3 million is related to the issuance of
common stock to certain Company executives with exercise or purchase prices that
are less than the fair market value of the common stock on the date of grant.
Amortization of Other Intangible Assets
Amortization of other intangible assets for the three months ended March 31,
2004, was $0.7 million or 1.6% of total revenue, compared to $0.4 million or
1.3% for the comparable period in 2003. The increase in cost of revenue from
amortization of intangible assets is attributable to $0.1 million related to the
Philips acquisition which was completed on January 30, 2003, $0.4 million
related to the SpeechWorks acquisition which was completed on August 11, 2003,
and $0.1 million related to the LocusDialog acquisition which was completed on
December 19, 2003, partially offset by $0.2 million of intangible assets that
became fully amortized during fiscal year 2003. During 2004, we expect
amortization of other intangible assets to be approximately $2.7 million based
on our current level of intangible assets.
Restructuring and Other Charges, Net
During the three months ended March 31, 2004, we recorded a charge of $0.8
million related to separation agreements with two former members of our senior
management team. Included in this amount are non-cash compensation charges of
$0.4 million related to the acceleration of restricted common stock and stock
options.
In connection with the Philips acquisition, we 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.
Income (Loss) from Operations
As a result of the above factors, loss from operations was ($3.0) million
for the three months ended March 31, 2004 or 6.9% of total revenue, compared
with income from operations of $0.1 million or 0.5% for the comparable period in
2003.
Other Income (Expense), Net
Interest income was $105,000 and $41,000 for the three months ended March
31, 2004 and 2003, respectively. Interest expense was $132,000 and $80,000 for
the three months ended March 31, 2004 and 2003, respectively. Other income of
$476,000 for the three months ended March 31, 2004 consists primarily of receipt
of $0.4 million in settlement of a previously written off receivable balance
related to the Philips acquisition.
22
Income (Loss) Before Income Taxes
Loss before income taxes was ($2.5) million for the three months ended
March 31, 2004 or 5.9% of total revenue, compared with income of $0.2 million or
0.5% for the comparable period in 2003.
Income Taxes
The provision for income taxes for the three months ended March 31, 2004
was $0.3 million or 0.7% of total revenue, compared to $0.3 million or 1.2% in
the comparable period for 2003. The March 31, 2004 provision for income taxes
consists primarily of a foreign tax benefit of $0.3 million relating primarily
to tax credits and losses benefited in Canada, foreign withholding taxes of
$0.1 million and deferred tax provisions of $0.4 million arising out of
differences between the tax and financial statement treatment of goodwill.
Net Income (Loss)
As a result of all these factors, net loss totaled ($2.8) million or (6.6%)
for the three months ended March 31, 2004, compared with a loss of ($0.2)
million or (0.7%) for the comparable period in 2003.
LIQUIDITY AND CAPITAL RESOURCES
As of March 31, 2004, we had cash and cash equivalents of $50.1 million and
net working capital of $47.3 million as compared to $42.6 million in cash and
cash equivalents and net working capital of $44.3 million at December 31, 2003.
Net cash provided by operating activities for the three months ended March
31, 2004 was $2.7 million compared to $2.9 million for the comparable period in
2003. Cash provided by operations in the 2004 period came primarily from income
from operations, after adjustments for non-cash amortization, depreciation and
stock based compensation, significant collections of accounts receivable, offset
by payments of accounts payable, accrued expenses and a decrease in deferred
revenue. Cash provided by operations in the 2003 period came primarily from
operating income, net of non-cash adjustments, and an increase in accounts
payable, offset by payments of accrued expenses assumed in the Philips
acquisition.
Net cash provided by investing activities for the three months ended March
31, 2004 was $1.7 million compared to cash used of $4.9 million for the
comparable period in 2003. Net cash provided by investing activities during 2004
consisted of a $3.1 million payment received due to a final purchase price
adjustment related to the Philips acquisition, partially offset by $0.6 million
of transaction costs and $0.8 million in capital expenditures. Net cash used in
investing activities during 2003 consisted of $0.6 million in capital
expenditures and $4.3 million associated with acquisitions.
Net cash provided by financing activities for the three months ended March
31, 2004 was $3.2 million compared to $3.6 million for the comparable period in
2003. Net cash provided by financing activities during the three months ended
March 31, 2004 consisted of proceeds of $3.8 million from the issuance of common
stock in connection with employee stock compensation plans. This was offset by a
$0.4 million payment to the former Caere President and CEO in connection with
the settlement of the non-competition and consulting agreement, and $0.2 million
related to payments on outstanding equipment lines of credit. Net cash provided
by financing activities of $3.6 million during the three months ended March 31,
2003 consisted of proceeds of $0.5 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 public issuance of our common stock. This was offset by a $0.4 million
payment to the former Caere President and CEO in connection with the settlement
of the non-competition and consulting agreement, and the payment of the $3.3
million note payable related to the acquisition of Lernout & Hauspie assets
during 2001.
Although we generated $2.7 million and $5.2 million of cash from operations
during the three month period ended March 31, 2004 and the fiscal year ended
2003, respectively, and exited the quarter with a cash and cash equivalents
balance of $50.1 million, there can be no assurance that we will be able to
continue to generate cash from operations or secure additional equity or debt
financing if required. The large increase in our cash balance has come primarily
from the SpeechWorks acquisition. In connection with the Philips Speech
Processing Telephony and Voice Control Business Unit acquisition, we issued a
$27.5 million, zero interest convertible debenture due January 2006. In
connection with the SpeechWorks acquisition we acquired certain long-term lease
obligations that begin to come due in the next 12-24 months. Additionally, in
connection with the exclusive license agreement entered into on March 31, 2003,
we made a payment of $2.8 million on April 5, 2004 and are required to make a
final payment totaling $2.8 million on or before March 31, 2005. We have
sustained recurring losses from operations in each reporting period through
December 31, 2001. We have reported a net loss of $(2.8) million and $(5.5)
million for the three month period ended March 31, 2004 and the
23
fiscal year ended December 31, 2003, respectively. We had an accumulated deficit
of $155.3 million at March 31, 2004. We believe that the actions taken in
connection with our acquisitions, including restructuring actions and other cost
reduction initiatives, have reduced operating expenses to levels which, in
combination with expected future revenues, will continue to generate positive
cash flow. Therefore, we believe that cash flows from future operations in
addition to cash on hand and amounts available under our line of credit will be
sufficient to meet our working capital, investing, financing and contractual
obligations, including the debt obligation issued in connection with the Philips
acquisition, and the lease obligations assumed in the SpeechWorks acquisition,
as they become due for the foreseeable future.
The following table outlines our contractual payment obligations as of
March 31, 2004:
PAYMENTS DUE BY PERIOD
--------------------------------------------------------
MORE
LESS THAN 2-3 4-5 THAN 5
CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR YEARS YEARS YEARS
---------------------------------------------- -------- --------- -------- ------- ---------
(IN THOUSANDS)
Convertible debenture......................... $ 27,524 -- $ 27,524 -- $ --
Deferred payments for technology license...... 5,428 5,428 -- -- --
Operating leases.............................. 35,180 5,144 8,441 5,136 16,459
Equipment line of credit...................... 989 728 261 -- --
Standby letters of credit..................... 1,438 344 46 46 1,002
Royalty commitments........................... 1,030 260 620 70 80
Purchase commitments.......................... 583 583 -- -- --
Imputed interest.............................. 172 172 -- -- --
-------- -------- -------- ------- ---------
Total contractual cash obligations............ $ 72,344 $ 12,659 $ 36,892 $ 5,252 $ 17,451
======== ======== ======== ======= =========
Through March 31, 2004, we have not entered into any off balance sheet
arrangements or transactions with unconsolidated entities or other persons.
FOREIGN OPERATIONS
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. In certain circumstances, we have entered into forward exchange
contracts to hedge against foreign currency fluctuations on intercompany
balances with our foreign subsidiaries. We use these contracts to reduce our
risk associated with exchange rate movements, as the gains or losses on these
contracts are intended to offset any exchange rate losses or gains on the hedged
transaction. We do not engage in foreign currency speculation. Hedges 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.
On November 3, 2003, we entered into a forward exchange contract to hedge
our foreign currency exposure related to 3.5 million euros of intercompany
receivables from our Belgian subsidiary. The contract has a one year term that
expires on November 1, 2004. For the three month period ended March 31, 2004, we
recorded a net exchange rate gain of approximately $70,000 in other
comprehensive income on the intercompany receivable and associated forward
exchange contract. On November 5, 2003, we entered into a forward exchange
contract to hedge our foreign currency exposure related to 7.5 million Singapore
dollars of intercompany receivables from our Singapore subsidiary. The contract,
as amended, expires on July 31, 2004. For the three month period ended March 31,
2004, we recorded a net exchange rate gain of approximately $0.1 million on the
intercompany receivable and associated forward exchange contract.
With our increased international presence in a number of geographic
locations and with international revenues projected to increase in 2004, we are
exposed to changes in foreign currencies including the euro, Canadian dollar,
Japanese yen and the Hungarian forint. Changes in the value of the euro or other
foreign currencies relative to the value of the U.S. dollar could adversely
affect future revenues and operating results.
RECENT ACCOUNTING PRONOUNCEMENTS
In March 2004, the Emerging Issues Task Force ("EITF") reached a consensus
on EITF No. 03-06, "Participating Securities and Two-Class Method under FASB
Statement No 128, Earning Per Share." EITF No. 03-06 addresses a number of
questions regarding the computation of earnings per share ("EPS") by companies
that have issued securities other than common stock that contractually entitle
the holder to participate in dividends and earnings of the company when, and if,
it declares dividends on its common stock.
24
The issue also provides further guidance in applying the two-class method of
calculating EPS. It clarifies what constitutes a participating security and how
to apply the two class method of computing EPS once it is determined that a
security is participating, including how to allocate undistributed earning to
such a security. The consensus reached on EITF No. 03-06 is effective for fiscal
periods beginning after March 31, 2004. Prior period earnings per share amounts
should be restated to conform to the consensus to ensure comparability year over
year. We are still evaluating the impact, if any, the adoption of EITF No. 03-06
will have on our results of operations or financial condition.
RISK FACTORS
We operate in an intensely competitive environment and our 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 of our principal customers; (2) the cyclical nature of the
retail software industry; (3) the inability to protect our 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 our ability 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;
-- CONCENTRATION OF OPERATIONS WITH ONE MANUFACTURING PARTNER AND ABILITY
TO CONTROL EXPENSES RELATED TO THE MANUFACTURE, PACKAGING AND SHIPPING
OF OUR BOXED SOFTWARE PRODUCTS
-- CUSTOMERS DELAYING THEIR PURCHASE DECISIONS IN ANTICIPATION OF NEW
VERSIONS OF PRODUCTS;
-- 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;
25
-- 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 a net loss of $(2.8) million and $(5.5) million for the three
month period ended March 31, 2004 and the fiscal year ended December 31, 2003,
respectively. We had an accumulated deficit of $155.3 million at March 31, 2004.
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. 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), our
acquisition of the Speech Processing Telephony and Voice Control business units
from Philips, our acquisition of SpeechWorks International, Inc. and our
acquisition of LocusDialog, Inc. required substantial integration and management
efforts. Acquisitions of this nature involve a number of risks, including:
-- DIFFICULTY IN TRANSITIONING AND INTEGRATING THE OPERATIONS AND PERSONNEL
OF THE ACQUIRED BUSINESSES, INCLUDING DIFFERENT AND COMPLEX ACCOUNTING
AND FINANCIAL REPORTING SYSTEMS;
-- 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;
-- 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.
26
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 ACQUISITIONS COMPLETED DURING 2003. Under accounting
principles generally accepted in the United States of America, we have accounted
for these acquisitions using the purchase method of accounting. Under purchase
accounting, we have recorded the market value of our common stock or other form
of consideration issued in connection with the acquisition and the amount of
direct transaction costs as the cost of acquiring the company or business. We
have 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. 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 these acquisitions could decrease our
net income in the foreseeable future, which could have a material and adverse
effect on the market value of our common stock.
A LARGE PART OF OUR PRODUCT 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 42% and 34% of our consolidated revenue for the
three month period ended March 31, 2004 and 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 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 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. During 2003, we purchased certain businesses and
intellectual property from Philips and completed the acquisitions of SpeechWorks
and LocusDialog, Inc. We 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.
27
In connection with the Caere, L&H, SpeechWorks and LocusDialog acquisitions,
we issued 19.0 million, 7.4 million, 32.5 million and 2.3 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, 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.
In accordance with the provisions of the agreement, we agreed to a final
purchase price adjustment with Philips of approximately $4.1 million, resulting
in a corresponding reduction in goodwill. We received $1.1 million of the
purchase price adjustment prior to December 31, 2003. The remaining $3.0 million
(2.5 million euros) was received on January 5, 2004. While we satisfied our
payment obligations related to the additional 1.0 million euros and 5.0 million
euro note prior to December 31, 2003, 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.
THE FAILURE TO SUCCESSFULLY IMPLEMENT, UPGRADE AND DEPLOY IN A TIMELY AND
EFFECTIVE MANNER NEW INFORMATION SYSTEMS AND UPGRADES OF OUR FINANCE AND
ACCOUNTING SYSTEMS TO ADDRESS CERTAIN ISSUES IDENTIFIED IN CONNECTION WITH OUR
FISCAL 2003 YEAR-END AUDIT COULD HARM OUR BUSINESS. In connection with its audit
of our 2003 consolidated financial statements, PricewaterhouseCoopers LLP
("PwC"), our independent auditors, advised in a management letter to our Audit
Committee of four conditions that could adversely affect our ability to
initiate, record, process and report financial data consistent with management's
assertions. These conditions include: (i) we may lack the necessary corporate
accounting resources to meet the accelerated filing deadline requirements in
2004 mandated by the SEC, while at the same time staffing the demands of our
worldwide Oracle implementation and Sarbanes-Oxley requirements; and (ii) we
have a dependence on key personnel in our finance and accounting organization,
the loss of whom could impair our ability to perform timely financial reporting,
especially prior to the completion of our worldwide Oracle implementation and
our readiness efforts related to our obligations under Section 404 of the
Sarbanes-Oxley Act of 2002. In addition, we discuss the other two conditions
raised by PwC later in this document (see page 33).
From 1997 through December 31, 2003, we have made seven significant business
acquisitions. As a result, we continue to have several financial systems in use
in the company. The incompatibility between these systems requires significant
manual efforts within finance and accounting to complete our financial
reporting. Therefore, substantial knowledge of our policies and procedures and
the process for initiating, recording, processing, summarizing and reporting
financial information is resident in the knowledge of personnel involved in the
financial reporting process.
To improve the efficiency and quality of our accounting and financial
reporting systems, we commenced, in the third quarter of 2003, a worldwide
implementation of the Oracle e-Business suite. In addition, we have retained a
third-party consulting firm that is assisting management and staff to formalize
and document our business and financial processes and controls in preparation
for our compliance with Section 404 of the Sarbanes-Oxley Act of 2002. While we
believe that these actions will address the conditions raised in PwC's letter,
we have been and will continue to be required to devote substantial resources to
these activities during 2004. Failure to successfully implement these systems or
formalize and document these processes and controls in a timely, effective and
efficient manner could result in the disruption of our operations, our inability
to comply with our Sarbanes-Oxley obligations and the inability to report our
financial results in a timely manner.
SALES OF OUR DOCUMENT AND PDF CONVERSION PRODUCTS AND OUR DIGITAL PAPER
MANAGEMENT PRODUCTS REPRESENTED APPROXIMATELY 31% AND 42%, OF OUR REVENUE FOR
THE THREE MONTH PERIODS ENDED MARCH 31, 2004 AND 2003, RESPECTIVELY. 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 three months ended March 31, 2004, our document and PDF
conversion products represented approximately 20% of our revenue and our digital
paper management products represented approximately 11% of our revenue. For the
three months ended March 31, 2003, our document and PDF conversion products
represented approximately 26% of our revenue and our digital paper management
products represented approximately 16% 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
28
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 April 23, 2004, we were sued by Millennium L.P. in the United States
District Court for the Southern District of New York for patent infringement. In
the lawsuit, Millennium alleges that we are infringing United States Patent No.
5,258,855 entitled "Information Processing Methodology"; No. 5,369,508 entitled
"Information Processing Methodology"; No. 5,625,465 entitled "Information
Processing Methodology"; No. 5,768,416 entitled "Information Processing
Methodology"; and No. 6,094,505 entitled "Information Processing Methodology."
We have not yet evaluated the merits of this lawsuit.
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 addition, on November 26, 2003, Davis filed an action
against ScanSoft in the United States District Court for the Western District
for New York (Buffalo) also claiming patent infringement. Damages are sought in
an unspecified amount. SpeechWorks filed an Answer and Counterclaim to Davis's
Complaint in its case on August 25, 2003 and ScanSoft filed an Answer and
Counterclaim to Davis's Complaint in its case on December 22, 2003. We believe
these claims have no merit, and we intend to defend the actions 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 August 16, 2001, we were sued by Horst Froessl in the United States
District Court for the Northern District of California for patent infringement.
That action has been resolved for an immaterial amount, and we were dismissed
from the action on March 24, 2004.
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. However, even if our defense is successful,
the litigation could require significant management time and could be costly.
Should we not prevail in these litigation matters, our operating results,
financial position and cash flows could be adversely impacted.
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, Fonix, IBM, Nuance Communications and
Rhetorical. 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 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
29
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
three months ended March 31, 2004, two distribution and fulfillment partners,
Ingram Micro and Digital River, accounted for 14% and 8% of our consolidated
revenue, respectively. During the three months ended March 31, 2003, Ingram
Micro and Digital River, accounted for 25% and 17% 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 March 31, 2004, Ingram Micro, Tech
Data and Digital River represented 16%, 4% and 3%, of our net accounts
receivable, respectively. At December 31, 2003, Ingram Micro, Tech Data and
Digital River represented 20%, 5% and 5%, 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 three month periods ended March 31, 2004 and
2003 represented 31% and 26% of our consolidated revenue for those periods,
respectively. 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 34% and 34% of our
consolidated revenue for the three month periods ended March 31, 2004 and 2003,
respectively.
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.
30
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 connection
with the Philips acquisition, we have added an additional research and
development location in Germany. In connection with the acquisition of Locus
Dialog, we have added an additional research and development location in
Montreal, Canada. 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. In certain circumstances, we have entered into forward exchange
contracts to hedge against foreign currency fluctuations on intercompany
balances with our foreign subsidiaries. We use these contracts to reduce our
risk associated with exchange rate movements, as the gains or losses on these
contracts are intended to offset any exchange rate losses or gains on the hedged
transaction. We do not engage in foreign currency speculation. Hedges 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. With our
increased international presence in a number of geographic locations and with
international revenues projected to increase in 2004, we are exposed to changes
in foreign currencies including the euro, Canadian dollar, Japanese yen and the
Hungarian forint. Changes in the value of the euro or other foreign currencies
relative to the value of the U.S. dollar could adversely affect future revenues
and operating results.
IF WE ARE UNABLE TO ATTRACT AND RETAIN KEY 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. On March 19, 2004, Warburg
Pincus, a global private equity firm agreed to purchase all outstanding shares
of our stock held by Xerox Corporation for approximately $80 million. As of
March 31, 2004, Warburg Pincus beneficially owned approximately 11.3% of our
outstanding common stock, including warrants exercisable for up to 3,025,732
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 State of Wisconsin Investment Board (SWIB) is our second largest
stockholder, owning approximately 9.3% of our common stock as of March 31, 2004.
Because of their large holdings of our capital stock relative to other
stockholders, Warburg 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
31
stock price during any given period of time. Moreover, companies that have
experienced volatility in the market price of their stock 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.
COMPLIANCE WITH CHANGING REGULATION OF CORPORATE GOVERNANCE AND PUBLIC
DISCLOSURE MAY RESULT IN ADDITIONAL EXPENSES. Changing laws, regulations and
standards relating to corporate governance and public disclosure, including the
Sarbanes-Oxley Act of 2002, new regulations promulgated by the Securities and
Exchange Commission and Nasdaq National Market rules, are resulting in increased
general and administrative expenses for companies such as ours. These new or
changed laws, regulations and standards are subject to varying interpretations
in many cases, and as a result, their application in practice may evolve over
time as new guidance is provided by regulatory and governing bodies, which could
result in higher costs necessitated by ongoing revisions to disclosure and
governance practices. We are committed to maintaining high standards of
corporate governance and public disclosure. As a result, we intend to invest
resources to comply with evolving laws, regulations and standards, and this
investment may result in increased general and administrative expenses and a
diversion of management time and attention from revenue-generating activities to
compliance activities. If our efforts to comply with new or changed laws,
regulations and standards differ from the activities intended by regulatory or
governing bodies, our business may be harmed.
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
We face exposure to adverse movements in foreign currency exchange rates, as
a significant portion of our revenues, expenses, assets, and liabilities are
denominated in currencies other than the U.S. Dollar, primarily the euro, the
Canadian dollar, the Japanese yen and the Hungarian forint. These exposures may
change over time as business practices evolve. We evaluate our foreign currency
exposures on an ongoing basis and make adjustments to our foreign currency risk
management program as circumstances change.
In certain instances, we have entered into forward exchange contracts to
hedge against foreign currency fluctuations. These contracts are used to reduce
our 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. We do not engage in foreign currency speculation. The
success of our 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, we could experience
unanticipated foreign currency gains or losses that could have a material impact
on our results of operations. In addition, the failure to identify new exposures
and hedge them in a timely manner may result in material foreign currency gains
and losses.
On November 3, 2003, we entered into a forward exchange contract to hedge
our foreign currency exposure related to 3.5 million euros of inter-company
receivables from our Belgian subsidiary to the United States. The contract has a
one-year term that expires on November 1, 2004. On November 5, 2003, we entered
into a forward exchange contract to hedge our foreign currency exposure related
to 7.5 million Singapore dollars of inter-company receivables from our Singapore
subsidiary to the United States. The contract, as amended, expires on July 31,
2004.
32
While the contract amounts of derivative instruments provide one measure of
the volume of these transactions, they do not represent the amount of our
exposure to changes in foreign currency exchange rates. Because the terms of the
derivative instrument and underlying exposure are matched generally at
inception, changes in foreign currency exchange rates should not expose us to
significant losses in earnings or net cash outflows when exposures are properly
hedged.
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. We believe that a control
system, no matter how well designed and operated, cannot provide absolute
assurance that the 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 first quarter of 2004,
we adopted additional procedures related to our worldwide bank reconciliation
processes.
In connection with their audit of our 2003 consolidated financial
statements, PricewaterhouseCoopers LLP ("PwC"), our independent auditors,
advised in a management letter to management and our Audit Committee of four
conditions that could adversely affect our ability to initiate, record, process
and report financial data consistent with management's assertions. These
conditions include, in summary: (i) our significant accounting transactions,
including related judgments and estimates, may not be supported by a
sufficiently formal process or sufficiently comprehensive documentation; and
(ii) we had insufficiently documented our estimate of returns from second-tier
resellers. In addition, we have earlier in this document discussed the other two
conditions raised by PwC. (see page 28).
In the third quarter of 2003, we commenced the planning and worldwide
implementation of the Oracle e-Business suite, which we anticipate completing by
the end of fiscal year 2004. Simultaneously with the Oracle implementation, we
commenced our Section 404 (Sarbanes-Oxley Act of 2002) compliance efforts. In
conjunction with these efforts, we initiated the design, development and
implementation of processes and controls that we believe, will address the
conditions raised in PwC's management letter. We currently expect these efforts
to extend into the second half of fiscal 2004. To the knowledge of our Chief
Executive Officer and Chief Financial Officer, the financial statements, and
other financial information included in this report, fairly present in all
material respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this report.
PART II. OTHER INFORMATION
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 March 19, 2004, ScanSoft filed a report on Form 8-K announcing that the
Company's Chairman and Chief Executive Officer, intends to exercise options
to purchase as many as 750,000 shares of the Company's common stock.
33
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 May 10, 2004.
SCANSOFT, INC.
By: /s/ David A. Gerth
----------------------------------
David A. Gerth
Chief Financial Officer
34
EXHIBIT
INDEX
EXHIBIT
NUMBER DESCRIPTION
------- -----------
3.1(1) Amended and Restated Certificate of Incorporation of Registrant
3.2(2) Amended and Restated Bylaws of Registrant
4.1 Securities Purchase Agreement, dated March 19, 2004, by and
among Xerox Imaging Systems, Inc., Warburg Pincus Private Equity
VIII, L.P, Warburg Pincus Netherlands Private Equity VIII I C.V.,
Warburg Pincus Netherlands Private Equity VIII II C.V., Warburg
Pincus Germany Private Equity VIII K.G., and the Registrant
4.2 Stockholders Agreement, dated March 19, 2004, by and between the
Registrant and Warburg Pincus Private Equity VIII, L.P, Warburg Pincus
Netherlands Private Equity VIII I C.V., Warburg Pincus Netherlands
Private Equity VIII II C.V., and Warburg Pincus Germany Private Equity
VIII K.G.
4.3 Common Stock Purchase Warrants, dated March 15, 2004, issued to
Warburg Pincus Private Equity VIII, L.P., Warburg Pincus Netherlands
Private Equity VIII I C.V., Warburg Pincus Netherlands Private Equity
VIII II C.V., and Warburg Pincus Germany Private Equity VIII K.G.
10.1** Employee Separation Agreement, dated March 18, 2004, by and
between the Registrant and Stuart R. Patterson
10.2 Loan and Security Agreement, dated as of October 31, 2002, as amended
On March 31, 2004, between the Registrant and Silicon Valley Bank
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 Quarterly Report on Form
10-Q for the fiscal quarter ended March 31, 2001, filed with the Commission
on May 11, 2001.
(2) Incorporated by reference from the Registrant's Annual Report on Form 10-K
for the fiscal year ended December 31, 2003, filed with the Commission on
March 15, 2004.
35