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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
---------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004.
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE TRANSITION PERIOD FROM _________ TO _________
COMMISSION FILE NUMBER 1-10139
NETEGRITY, INC.
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 04-2911320
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)
201 JONES ROAD
WALTHAM, MA 02451
(Address of Principal Executive Offices) (Zip Code)
(781) 890-1700
(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such other shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
As of July 30, 2004 there were 38,305,973 shares of Common Stock outstanding,
exclusive of treasury shares.
QUARTERLY REPORT ON FORM 10-Q
QUARTER ENDED JUNE 30, 2004
TABLE OF CONTENTS
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003 (unaudited).. 3
Condensed Consolidated Statements of Operations for the three months ended June 30, 2004
and 2003 (unaudited)......................................................................... 4
Condensed Consolidated Statements of Operations for the six months ended
June 30, 2004 and 2003 (unaudited)........................................................... 5
Condensed Consolidated Statements of Cash Flows for the six months ended
June 30, 2004 and 2003 (unaudited)........................................................... 6
Notes to Condensed Consolidated Financial Statements......................................... 7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........ 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk................................... 29
Item 4. Controls and Procedures...................................................................... 29
PART II OTHER INFORMATION............................................................................ 30
Item 4. Submission of Matters to a Vote of Security Holders.......................................... 30
Item 6. Exhibits and Reports on Forms 8-K............................................................ 30
SIGNATURES........................................................................................... 31
2
PART I. - FINANCIAL INFORMATION
NETEGRITY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
JUNE 30, DECEMBER 31,
2004 2003
------------ ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents............................................ $ 22,961 $ 20,123
Short-term available-for-sale securities............................. 44,244 51,557
Accounts receivable--trade, net of allowances of $1,063 at
June 30, 2004 and $829 at December 31, 2003......................... 20,584 14,340
Prepaid expenses and other current assets............................ 3,555 2,513
Restricted cash...................................................... -- 538
------------ ------------
Total Current Assets................................................ 91,344 89,071
Long-term available-for-sale securities............................... 21,805 19,401
Property and equipment, net........................................... 4,639 4,848
Restricted cash....................................................... 1,337 767
Goodwill.............................................................. 34,503 34,503
Other intangible assets, net.......................................... 6,480 7,500
Other assets.......................................................... 1,094 1,134
------------ ------------
Total Assets........................................................ $ 161,202 $ 157,224
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable--trade............................................... $ 3,100 $ 1,415
Accrued compensation and benefits.................................... 5,558 5,947
Other accrued expenses............................................... 7,786 16,273
Deferred revenue..................................................... 23,632 18,503
------------ ------------
Total Current Liabilities........................................... 40,076 42,138
------------ ------------
Commitments and Contingencies
STOCKHOLDERS' EQUITY:
Common stock, voting, $.01 par value; 135,000 shares authorized;
38,288 shares issued and 38,250 shares outstanding at June 30,
2004; 37,577 shares issued and 37,539 shares outstanding at
December 31, 2003.................................................... 383 375
Additional paid-in capital............................................ 229,044 226,019
Accumulated other comprehensive loss ................................. (337) (137)
Accumulated deficit................................................... (107,781) (110,971)
Loan to officer....................................................... (99) (116)
------------ ------------
121,210 115,170
Less--Treasury stock, at cost: 38 shares.............................. (84) (84)
------------ ------------
Total Stockholders' Equity............................................ 121,126 115,086
------------ ------------
Total Liabilities and Stockholders' Equity............................ $ 161,202 $ 157,224
============ ============
The accompanying notes are an integral part of the condensed
consolidated financial statements.
3
NETEGRITY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE THREE MONTHS
ENDED JUNE 30,
-------------------------
2004 2003
---------- ----------
Revenues:
Software licenses................................. $ 13,585 $ 10,714
Services.......................................... 10,344 7,500
Other............................................. 392 650
---------- ----------
Total revenues................................... 24,321 18,864
---------- ----------
Cost of Revenues:
Cost of software licenses......................... 227 376
Non-cash cost of software licenses................ 510 2,699
Cost of services.................................. 3,532 2,760
Cost of other..................................... 301 390
---------- ----------
Total cost of revenues........................... 4,570 6,225
---------- ----------
Gross profit....................................... 19,751 12,639
Selling, general and administrative expenses....... 12,118 10,493
Research and development expenses.................. 5,862 5,036
---------- ----------
Income (loss) from operations...................... 1,771 (2,890)
Other income, net.................................. 287 417
---------- ----------
Income (loss) before provision for income taxes.... 2,058 (2,473)
Provision for income taxes......................... 153 59
---------- ----------
Net income (loss).................................. $ 1,905 $ (2,532)
========== ==========
Net income (loss) per share:
Basic and diluted................................ $ 0.05 $ (0.07)
Weighted average shares outstanding:
Basic............................................ 37,985 34,416
Diluted.......................................... 40,789 34,416
The accompanying notes are an integral part of the condensed
consolidated financial statements.
4
NETEGRITY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE SIX MONTHS
ENDED JUNE 30,
-------------------------
2004 2003
---------- ----------
Revenues:
Software licenses................................. $ 26,442 $ 19,132
Services.......................................... 19,868 15,129
Other............................................. 1,046 1,281
---------- ----------
Total revenues................................... 47,356 35,542
---------- ----------
Cost of Revenues:
Cost of software licenses......................... 541 867
Non-cash cost of software licenses................ 1,020 5,398
Cost of services.................................. 6,662 5,748
Cost of other..................................... 720 752
---------- ----------
Total cost of revenues........................... 8,943 12,765
---------- ----------
Gross profit....................................... 38,413 22,777
Selling, general and administrative expenses....... 23,655 20,989
Research and development expenses.................. 11,848 9,910
---------- ----------
Income (loss) from operations...................... 2,910 (8,122)
Other income, net.................................. 609 791
---------- ----------
Income (loss) before provision for income taxes.... 3,519 (7,331)
Provision for income taxes......................... 328 59
---------- ----------
Net income (loss).................................. $ 3,191 $ (7,390)
========== ==========
Net income (loss) per share:
Basic and diluted................................ $ 0.08 $ (0.22)
Weighted average shares outstanding:
Basic............................................ 37,798 34,367
Diluted.......................................... 40,841 34,367
The accompanying notes are an integral part of the condensed
consolidated financial statements.
5
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
FOR THE SIX MONTHS
ENDED JUNE 30,
-------------------------
2004 2003
---------- ----------
OPERATING ACTIVITIES:
Net income (loss)................................................ $ 3,191 $ (7,390)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization................................... 2,634 7,650
Provision for doubtful accounts................................. 462 190
Non-cash interest expense....................................... 867 238
Gain on sale of marketable securities........................... (22) (41)
Changes in operating assets and liabilities:
Accounts receivable - trade..................................... (6,139) 5,171
Prepaid expenses and other current assets....................... (611) 550
Other assets.................................................... 270 4
Accounts payable - trade........................................ 1,685 515
Accrued compensation and benefits............................... (389) (1,017)
Other accrued expenses.......................................... (919) (31)
Deferred revenue................................................ 5,128 1,802
---------- ----------
Net cash provided by operating activities........................ 6,157 7,641
---------- ----------
INVESTING ACTIVITIES:
Proceeds from sales of marketable securities..................... 21,243 17,577
Proceeds from maturities of marketable securities................ 12,607 12,407
Purchases of marketable securities............................... (30,135) (48,924)
Purchases of property and equipment.............................. (1,405) (1,444)
Cash used for acquisition, net of cash acquired.................. (8,255) --
Restricted cash.................................................. (570) 307
---------- ----------
Net cash used for investing activities........................... (6,515) (20,077)
---------- ----------
FINANCING ACTIVITIES:
Proceeds from issuance of common stock under stock plans......... 3,032 484
Proceeds from repayment of loan to officer....................... 17 --
---------- ----------
Net cash provided by financing activities........................ 3,049 484
---------- ----------
Effect of exchange rate changes on cash and cash equivalents..... 147 6
---------- ----------
Net change in cash and cash equivalents.......................... 2,838 (11,946)
Cash and cash equivalents at beginning of period................. 20,123 25,707
---------- ----------
Cash and cash equivalents at end of period....................... $ 22,961 $ 13,761
========== ==========
The accompanying notes are an integral part of the condensed
consolidated financial statements.
6
NETEGRITY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Basis of Presentation and Principles of Consolidation
The accompanying unaudited condensed consolidated financial statements
include the accounts and operations of Netegrity, Inc. and its wholly owned
subsidiaries ("Netegrity", "we" or "our") and have been prepared pursuant to the
rules and regulations of the Securities and Exchange Commission regarding
interim financial reporting. Accordingly, they do not include all of the
information and notes required by accounting principles generally accepted in
the United States of America for complete financial statements and thus should
be read in conjunction with the audited consolidated financial statements
included in our Annual Report on Form 10-K filed on March 1, 2004. In the
opinion of management, the accompanying unaudited condensed consolidated
financial statements contain all adjustments, consisting only of those of a
normal recurring nature, necessary for a fair presentation of the Company's
financial position, results of operations and cash flows at the dates and for
the periods indicated. The results of operations for the three and six months
ended June 30, 2004 are not necessarily indicative of the results expected for
the remainder of the year ending December 31, 2004.
All significant intercompany accounts and transactions have been
eliminated in consolidation.
(b) Revenue Recognition
Our revenues are primarily generated from the sale of perpetual licenses
for our proprietary SiteMinder, IdentityMinder Web Edition, IdentityMinder
eProvision and TransactionMinder products and related services. We generate our
services revenues from consulting and training services performed for customers
and from the maintenance and support of our products. As described below,
significant management judgments and estimates must be made and used in
connection with the revenues recognized in any accounting period. Management
analyzes various factors in making these judgments and estimates, including
specific terms and conditions of a transaction, historical experience, credit
worthiness of customers and current market and economic conditions. Changes in
judgments based upon these factors could impact the timing and amount of
revenues and cost recognized.
We generally license our software products on a perpetual basis. We apply
the provisions of Statement of Position No. 97-2, "Software Revenue
Recognition," as amended by Statement of Position No. 98-9, "Software Revenue
Recognition, with Respect to Certain Transactions," to all transactions
involving the sale of software products. We recognize revenues from the sale of
software licenses when persuasive evidence of an arrangement exists, the product
has been delivered, the fees are fixed or determinable and collection of the
resulting receivable is reasonably assured. This policy is applicable to all
sales, including sales to resellers and end users. We typically do not offer a
right of return on our products.
For all sales, we use a license agreement signed by both parties and/or a
purchase order with binding terms and conditions as evidence of an arrangement.
For arrangements with multiple obligations (for example, software license,
undelivered maintenance and support, training and consulting), we allocate
revenues to each component of the arrangement using the residual value method
based on the fair value of the undelivered elements. We defer revenue from the
arrangement equivalent to the fair value of the undelivered elements. Fair value
for each component is either the price we charge when the same component is sold
separately or the price established by the members of our management who have
the relevant authority to set prices for an element not yet sold separately.
At the time of the transaction, we assess whether the fee associated with
the transaction is fixed or determinable based on the payment terms associated
with the transaction. If a significant portion of the fee is due after our
normal payment terms, which are generally 30 to 90 days from invoice date, we
account for the fee as not being fixed or determinable. In those cases, we
recognize revenues as the fees become due. In addition, we assess whether
collection is probable based on the credit worthiness of the customer. Initial
credit worthiness is assessed through Dun & Bradstreet or similar credit rating
agencies. Credit worthiness for follow-on transactions is assessed through a
review of the transaction history with the customer. We do not typically request
collateral from our customers. If we determine that collection of a fee is not
reasonably assured, we defer the fee and recognize revenues at the time
collection becomes reasonably assured, which is generally upon receipt of cash.
Installation by Netegrity is not considered essential to the functionality
of our products as these services do not alter the product capabilities, do not
require specialized skills and may be performed by the customer or other
vendors. Revenues for maintenance and
7
support are recognized ratably over the term of the support period. Revenues
from consulting and training services generally are recognized as the services
are performed.
(c) Cash and Cash Equivalents
Cash and cash equivalents include cash, money market investments and other
highly liquid investments with original maturities of three months or less.
(d) Restricted Cash
Long term restricted cash represents two time deposits held at financial
institutions. One, in the amount of $771,000, is held in connection with the
lease of the Company's office space and has an expiration date of August 2004;
however it has a clause that provides that the time deposit will be
automatically renewed. The other in the amount of $566,000, which is held in
connection with a prepaid maintenance contract, has an expiration date of
December 2012 and is reduced ratably over the term of the contract.
(e) Marketable Securities
Investments, which primarily consist of debt securities, are accounted for
under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting
for Certain Investments in Debt and Equity Securities" issued by the Financial
Accounting Standards Board (FASB). Pursuant to the provisions of SFAS No. 115,
the Company has classified its investment portfolio as "available-for-sale".
"Available-for-sale" securities include debt securities that are being held for
an unspecified period of time and may be used for liquidity or other corporate
purposes and are recorded at fair value. Unrealized gains and losses on
available-for-sale securities are reported as a separate component of
accumulated other comprehensive income (loss) in stockholders' equity, net of
related taxes.
(f) Other Intangible Assets, net
The Company accounts for purchased technology and software development
costs in accordance with SFAS No. 86, "Accounting for the Costs of Computer
Software to Be Sold, Leased, or Otherwise Marketed". Under SFAS No. 86, the
Company is required to test for recoverability of its capitalized software costs
as of each balance sheet date or an interim period if events and circumstances
indicate that the carrying amount may not be recoverable. Impairment is recorded
as the excess of the unamortized cost over the expected future net realizable
value of the products.
Software development costs subsequent to the establishment of
technological feasibility are capitalized and amortized to non-cash cost of
software. Based on the Company's product development process, technological
feasibility is established upon completion of all planning, designing, coding
and testing activities. Such costs are amortized over the estimated life of the
product. During the three and six months ended June 30, 2004, costs incurred by
the Company between completion of all planning, designing, coding and testing
activities and the point at which the product is ready for general release were
insignificant and, therefore, no such costs have been capitalized during this
time period.
(g) Goodwill
The Company reviews the valuation of goodwill in accordance with SFAS No.
142 "Goodwill and Other Intangible Assets." Under the provisions of SFAS No.
142, goodwill is required to be tested for impairment annually in lieu of being
amortized. This testing is done in the fourth quarter of each year. Furthermore,
goodwill is required to be tested for impairment on an interim basis if an event
or circumstance indicates that it is more likely than not that an impairment
loss has been incurred. An impairment loss is recognized to the extent that the
carrying amount of goodwill exceeds its implied fair value. Impairment losses
are recognized in operations. The Company's valuation methodology for assessing
impairment requires management to make judgments and assumptions based on
historical experience and projections of future operating performance.
Management predominantly uses third party valuation reports to assist in its
determination of the fair value. If these assumptions differ materially from
future results, the Company may record impairment charges in the future.
(h) Comprehensive Income (Loss)
8
Comprehensive income (loss) is defined as the change in equity of a
business enterprise during a period from transactions and other events and
circumstances from non-owner sources, including foreign currency translation
adjustments and unrealized gains and losses on marketable securities held as
"available-for-sale". The components of comprehensive income (loss) were as
follows (in thousands):
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
------------------- ---------------------
2004 2003 2004 2003
--------- -------- ---------- ---------
Net income (loss)................................... $ 1,905 $ (2,532) $ 3,191 $ (7,390)
Net unrealized holding loss arising during
the period, net of related tax effects............ (456) (60) (325) (53)
Reclassification adjustment for net realized gains
included in net income (loss) net of related tax
effects............................................. (2) (42) (22) (41)
--------- -------- ---------- ---------
(458) (102) (347) (94)
Net unrealized foreign currency translation
adjustment arising during the period net of
related tax effects................................. (21) 16 147 5
--------- -------- ---------- ---------
Comprehensive income (loss)......................... $ 1,426 $ (2,618) $ 2,991 $ (7,479)
========= ========= ========== ==========
The components of accumulated other comprehensive income (loss) as of June
30, 2004 and December 31, 2003 were as follows (in thousands):
JUNE 30, 2004 DECEMBER 31, 2003
------------- -----------------
Net unrealized holding loss.............................. $ (435) $ (88)
Net unrealized foreign currency translation adjustment... 98 (49)
------- -------
Accumulated other comprehensive loss..................... $ (337) $ (137)
======= =======
(i) Earnings (Loss) Per Share
Basic earnings (loss) per share (EPS) is calculated by dividing net income
(loss) by the weighted average number of shares outstanding during the period.
Diluted EPS is calculated by dividing net income (loss) by the weighted average
number of shares outstanding plus the dilutive effect, if any, of outstanding
stock options and warrants using the "treasury stock" method. During periods of
net loss, diluted net loss per share does not differ from basic net loss per
share since potential shares of common stock from stock options and warrants are
anti-dilutive and therefore are excluded from the calculation. The following
table presents the calculation for both basic and diluted EPS (in thousands,
except per share data):
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Net income (loss).............................. $ 1,905 $ (2,532) $ 3,191 $ (7,390)
---------- ---------- ---------- ----------
Basic weighted average shares outstanding...... 37,985 34,416 37,798 34,367
Dilutive effect of stock options and warrants.. 2,804 - 3,043 -
---------- ---------- ---------- ----------
Diluted shares outstanding..................... 40,789 34,416 40,841 34,367
========== ========== ========== ==========
Basic and diluted EPS.......................... $ 0.05 $ (0.07) $ 0.08 $ (0.22)
Outstanding options to purchase a total of approximately 1.8 million and
1.7 million shares of common stock for the three and six months ended June 30,
2004, respectively, and a total of 344,000 and 1.2 million shares of common
stock for the three and six months ended June 30, 2003, respectively, were
excluded in the computation of diluted EPS because the effect on EPS was
anti-dilutive.
9
(j) Stock-Based Compensation
The Company accounts for its stock option plans under the recognition and
measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related Interpretations. No stock-based compensation cost is
reflected in net income (loss) for these plans, as all options granted under
these plans had exercise prices equal to the fair market value of the underlying
common stock on the date of grant. The following table illustrates the effect on
net income (loss) and earnings (loss) per share if the Company had applied the
fair value recognition provisions of FASB Statement No. 123, "Accounting for
Stock Based Compensation," to stock based compensation (in thousands, except per
share data):
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
-------------------- ---------------------
2004 2003 2004 2003
---------- -------- ---------- ---------
Net income (loss), as reported........................ $ 1,905 $ (2,532) $ 3,191 $ (7,390)
Add: Stock-based employee compensation expense not
included in reported net income (loss), net of
related tax effects...... ........................... (2,060) (4,147) (3,986) (7,023)
--------- --------- --------- ---------
Pro-forma net loss.................................... $ (155) $ (6,679) $ (795) $ (14,413)
========= ========= ========= =========
Earnings (loss) per share:
Basic and diluted--as reported...................... $ 0.05 $ (0.07) $ 0.08 $ (0.22)
Basic and diluted--pro-forma........................ $ 0.00 $ (0.19) $ (0.02) $ (0.42)
At the annual meeting of stockholders held in May 2004, the Company's
stockholders approved the 2004 Stock Incentive Plan (the "2004 Plan") pursuant
to which 4.0 million shares of common stock are reserved for issuance to the
Company's or it's subsidiaries' employees, officers, directors, consultants and
advisors. The 2004 Plan provides for the grant of incentive stock options,
non-statutory stock options, restricted stock, stock appreciation rights and
other stock based awards.
(k) Recent Accounting Pronouncements
In December 2003, the Financial Accounting Standards Board (FASB) FASB
revised Interpretation No. 46, Consolidation of Variable Interest Entities, an
Interpretation of ARB No. 51 (FIN 46R), which addresses how a business
enterprise should evaluate whether it has a controlling interest in an entity
through means other than voting rights and accordingly should consolidate the
entity. FIN 46R replaces FASB Interpretation No. 46, which was issued in
January 2003. Before concluding that it is appropriate to apply the voting
interest consolidation model to an entity, an enterprise must first determine
that the entity is not a variable interest entity or a special purpose entity.
FIN 46R became effective in March 2004 and the adoption of this statement did
not have a material impact on the Company's financial position or results of
operations.
In March 2004, the Emerging Issues Task Force (EITF) of the FASB reached
a consensus on Issue No. 03-6, "Participating Securities and the Two-Class
Method under FASB Statement No. 128, Earnings per Share." Statement 128
indicates that participating securities should not be included in basic earnings
per share (EPS), if the effect is dilutive, using either the two-class method or
the if-converted method. The issue is how to determine whether a security should
be considered a "participating security" for purposes of computing EPS and how
earnings should be allocated to a participating security when using the
two-class method for computing basic EPS. The consensus is effective for
reporting periods beginning after March 31, 2004. The adoption of this Issue
during the second quarter of 2004 did not have a material impact on the
Company's financial position or results of operations.
In April 2004, the FASB issued FASB Staff Position No. 129-1,
"Disclosure Requirements under FASB Statement No. 129, Disclosure of
Information about Capital Structure, Relating to Contingently Convertible
Securities", which indicates that FASB Statement No. 129 applies to all
contingently convertible securities, including those with contingent conversion
requirements that have not been met and are not otherwise required to be
included in the computation of dilute EPS in accordance with FASB Statement No.
128 Earnings Per Share. This staff position became effective in April 2004 and
the adoption of this position did not have a material impact on the Company's
financial position or results of operations.
NOTE 2: Acquisition
Business Layers
On December 30, 2003, the Company acquired Business Layers, Inc., a
Delaware corporation (Business Layers) and a provider of provisioning solutions,
through a merger of Business Layers and a subsidiary of the Company. In
conjunction with the acquisition, Business Layers became a wholly-owned
subsidiary of the Company. The aggregate consideration of $42.5 million included
approximately $15.0 million in cash, reimbursement of $920,000 in acquisition
costs and 2,556,940 shares of the Company's common stock valued at approximately
$26.6 million. A portion of the purchase price consideration, comprised of
approximately 358,000 shares of Netegrity common stock and approximately
$400,000 of cash, has been placed in escrow for up to one year from the
acquisition date to secure the indemnification obligations of certain former
employees and the stockholders of Business Layers under the merger agreement.
The acquisition was accounted for using the purchase method of accounting. The
results of operations of Business Layers from the acquisition date are included
in the Company's consolidated results of operations for the three and six months
ended June 30, 2004.
10
In connection with the acquisition, the Company initiated an overall
integration plan that included the elimination of redundant headcount and
facilities. The Company accrued approximately $1.4 million of costs related to
the integration plan, consisting of approximately $545,000 of facilities costs
and approximately $888,000 for planned workforce reductions primarily of
duplicative selling, general and administrative employees. The Company paid the
majority of these costs during the six months ended June 30, 2004, although the
facilities costs will not be paid in full until April 2006.
The Company engaged a third-party appraiser to conduct a valuation of the
intangible assets and to assist in the determination of useful lives for such
assets. Based on the appraisal, approximately $7.5 million of the purchase price
was allocated to developed technology and $3.8 million was allocated to
in-process research and development, which was expensed upon closing of the
transaction. The amount allocated to developed technology is being amortized
over its estimated useful life ranging from two to five years. Amortization
expense was $510,000 and $1.0 million for the three and six months ended June
30, 2004, respectively. Accumulated amortization as of June 30, 2004 was $1.0
million.
The valuation of in-process research and development was determined using
the income method. Revenue and expense projections for the in-process research
and development project were prepared by management. The value was determined
using the present value of the cash flows from the projections using a 30%
discount rate. As of June 30, 2004, the technologies under development were
completed.
In accordance with SFAS No. 142, the total goodwill of approximately $34.5
million related to the acquisition will not be amortized. In lieu of being
amortized, goodwill is required to be tested for impairment annually or on an
interim basis if an event or circumstance indicates that it is more likely than
not that an impairment loss has been incurred.
NOTE 3: OPERATING SEGMENTS AND GEOGRAPHICAL INFORMATION
Based on the information provided to the Company's chief operating
decision maker for purposes of making decisions about allocating resources and
assessing performance, the Company's continuing operations have been classified
into a single segment. The Company primarily operates in the United States,
Europe, the Middle East and Asia Pacific. Revenues (based on the location of the
customer) and long-lived assets by geographic region are as follows (in
thousands):
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
------------------------ -------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Revenues:
United States of America...... $ 14,934 $ 15,163 $ 32,812 $ 27,243
Europe and the Middle East.... 8,306 1,256 11,708 4,726
Asia Pacific.................. 857 2,416 1,991 3,365
Canada........................ 224 29 845 208
---------- ---------- ---------- ----------
Total......................... $ 24,321 $ 18,864 $ 47,356 $ 35,542
========== ========== ========== ==========
JUNE 30, DECEMBER 31,
---------- ------------
2004 2003
---------- ------------
Long-Lived Assets:
United States of America...... $ 44,987 $ 46,365
Europe and the Middle East.... 1,592 1,407
Asia Pacific.................. 135 211
Canada........................ 2 2
---------- ----------
Total......................... $ 46,716 $ 47,985
========== ==========
NOTE 4: RELATED PARTY TRANSACTIONS
LOAN TO OFFICER
The condensed consolidated balance sheets as of June 30, 2004 and December
31, 2003 include $99,000 and $116,000, respectively, in a loan to an officer of
Netegrity issued in connection with the exercise of stock options in 1996. The
loan is reflected as a reduction of stockholders' equity in the accompanying
condensed consolidated balance sheets. The loan is payable upon demand
11
and bears interest at 7% per annum. The loan was originally represented by a
secured note; however, in May 2002, the note was amended such that it became a
full recourse unsecured note.
MARKETING SERVICES
During the three and six months ended June 30, 2004 the Company paid
approximately $30,000 and $63,000, respectively, and during the three and six
months ended June 30, 2003, the Company paid approximately $37,000 and $42,000,
respectively, to a company for marketing services. The principal shareholder of
that Company is the son-in-law of a former member of the Company's Board of
Directors, whose term expired in May 2004. The Company has similar arrangements
with other marketing services firms and believes the arrangement was entered
into on substantially the same terms and conditions as its arrangements with
such other firms.
SOFTWARE LICENSE AGREEMENT
On June 30, 2004 the Company entered into a software license agreement
with a third party under which the Company purchased software for its internal
use. The Vice President of Client Services of this third party is the brother of
an officer of Netegrity. The Company has similar arrangements with other
software providers and believes the arrangement was entered into on
substantially the same terms and conditions as its arrangements with such other
firms.
NOTE 5: COMMITMENTS AND CONTINGENCIES
The Company has commitments that expire at various times through 2010.
Non-cancelable operating leases shown below are primarily for facility costs for
the Company's corporate headquarters, customer service, research and development
and world-wide sales offices. Other contractual obligations shown below
primarily consist of minimum guaranteed payments to a software service provider
for various development projects. (In thousands)
2004 (six months ending) ...... $ 3,294
2005........................... 2,630
2006........................... 2,328
2007........................... 2,223
2008........................... 1,389
Thereafter..................... 712
---------
$ 12,576
Included in the operating lease commitments above is approximately
$397,000 related to excess facilities which have been accrued in purchase
accounting related to the Company's acquisition of Business Layers and are
payable through April 2006.
The Company incurred total operating lease expense, primarily related to
certain facilities and equipment under non-cancelable operating leases, of
approximately $751,000 and $1.5 million for the three and six months ended June
30, 2004, respectively, and approximately $1.0 million and $2.0 million for the
three and six months ended June 30, 2003, respectively.
In April 2002, the Company entered into an agreement with a system
integrator to assist the Company in the development and launch of one of its
products. Under the terms of the agreement, as consideration for the system
integrator's time in assisting with the development of the product, the Company
agreed to promote the system integrator as an integrator of the developed
product. The Company's obligation under the agreement would have been considered
satisfied once the system integrator received consulting revenues totaling
approximately $3.9 million from the Company's customers, or by the expiration
date of this contract. This agreement expired in May 2004. No royalties were due
to the system integrator under this agreement during its term.
In August 2002, the Company entered into a five year non-cancelable
operating lease for an office building for its corporate headquarters. The
Company occupied the new facility in March 2003. In connection with the lease
agreement, the Company delivered an irrevocable, unconditional, negotiable
letter of credit in the amount of $771,000 as a security deposit.
In February 2004, the Company entered into an agreement with a software
service provider located in India under which the Company has guaranteed to pay
this software service provider a minimum of $4.0 million annually for various
product development
12
projects. The initial term of this agreement expires in December 2004. As of
June 30, 2004, approximately $2.3 million had been paid to this software service
provider.
In June 2004, the Company entered into a letter of credit with a financial
institution. The letter of credit in the amount of $566,000, which is held in
connection with a pre-paid maintenance contract, has an expiration date of
December 2012 and is reduced ratably over the term of the contract.
The Company enters into standard indemnification agreements with its
business partners and customers in the ordinary course of business. Pursuant to
these agreements, the Company agrees to repair or replace the product, pay
royalties for a right to use, or reimburse the indemnified party for actual
damages awarded by a court against the indemnified party for an intellectual
property infringement claim by a third party with respect to products. The term
of these indemnification agreements is generally perpetual. The maximum
potential amount of future payments the Company could be required to make under
these indemnification agreements is unlimited. The Company has never incurred
costs to defend lawsuits or settle claims related to these indemnification
agreements. As a result, the Company believes the estimated fair value of these
agreements is minimal. Accordingly, the Company had no liabilities recorded for
these agreements as of June 30, 2004.
The Company enters into standard indemnification agreements with its
customers, whereby the Company indemnifies them for certain damages, such as
personal property damage, which may be incurred in connection with consulting
services performed at a customer location by the Company's employees or
subcontractors. The potential amount of future payments the Company could be
required to make under these indemnification agreements is unlimited. However,
the Company has general and umbrella insurance policies that enable it to
recover a portion of any amounts paid. The Company has never incurred costs to
defend lawsuits or settle claims related to these indemnification agreements. As
a result, the Company believes the estimated fair value of these agreements is
minimal. Accordingly, the Company has no liabilities recorded for these
agreements as of June 30, 2004.
The Company generally warrants for ninety days from delivery to a customer
that its software products will perform free from material errors which prevent
performance in accordance with user documentation. Additionally, the Company
warrants that its consulting services will be performed consistent with
generally accepted industry standards. The Company has never incurred
significant expense under its product or service warranties. As a result, the
Company believes the estimated fair value of these agreements is minimal.
Accordingly, the Company has no liabilities recorded for these agreements as of
June 30, 2004.
The Company has entered into employment and executive retention agreements
with certain employees and executive officers which, among other things, include
certain severance and change of control provisions. The Company has also entered
into agreements whereby the Company indemnifies its officers and directors for
certain events or occurrences while the officer or director is, or was, serving
at the Company's request in such capacity.
From time to time, The Company is involved in litigation relating to
claims arising out of the Company's operations in the normal course of business.
The Company is not presently a party to any legal proceedings, the adverse
outcome of which, in the Company's opinion, would have a material adverse effect
on the Company's results of operations or financial position.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements about our plans,
objectives, expectations and intentions. You can identify these statements by
words such as "expect," "anticipate," "intend," "plan," "believe," "seek,"
"estimate," "may," "will" and "continue" or similar words. You should read
statements that contain these words carefully. They discuss our future
expectations, contain projections of our future results of operations or our
financial condition or state other forward-looking information, and may involve
known and unknown risks over which we have no control. You should not place
undue reliance on forward-looking statements. We cannot guarantee any future
results, levels of activity, performance or achievements. Moreover, we assume no
obligation to update forward-looking statements or update the reasons actual
results could differ materially from those anticipated in forward-looking
statements, except as required by law. The factors discussed in the sections
captioned "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Certain Factors that May Affect Future Results," in
this report identify important factors that may cause our actual results to
differ materially from the expectations we describe in our forward-looking
statements.
OVERVIEW
13
Netegrity's objective is to be a leading provider of enterprise security
software solutions specifically for managing user identities and access. Our
identity and access management product line provides companies a secure way to
make corporate information assets and resources available online. We believe
open, protected access is essential as companies seek to leverage the Web to
grow their businesses.
With Netegrity identity and access management products, companies are able
to securely use the Web -- Internet, Intranet or Extranet -- to meet the
information access needs of partners, suppliers, customers and employees.
Netegrity solutions are designed to enable businesses to ensure that the right
people have the right access to the right information across a variety of
applications, business systems and computing architectures. This enables more
business to be more securely conducted online, providing opportunities to
improve customer service and productivity, increase sales of products and
services and enhance business partnerships.
We derive our revenues from our core products, SiteMinder, IdentityMinder
Web Edition, IdentityMinder eProvision and TransactionMinder, which offer a
single source solution for integrated, centralized identity management, user
access and administration and account provisioning/de-provisioning. Our solution
supports a broad range of technology environments, and aims to ensure that
companies optimize their existing information technology investments while
incorporating new technologies. We also offer various levels of consulting and
support services that enable our customers to successfully implement our
products in their organizations.
Our products are generally sold on a perpetual license basis. Customers
typically place an initial order for a limited number of users and purchase
additional users as their need for our products within their enterprise
increases. We believe that our product line synergies and the strength of our
customer base create opportunities to sell additional products to existing
customers. Customers also enter into an annual support agreement for their
software license at the time of initial purchase and typically renew this
support agreement annually. Our support agreement entitles customers to software
license updates, telephone support and online support.
We believe sales of our products will be driven by customers' desires for
a comprehensive single-source identity access management solution whose key
benefits include reduced costs by reducing information technology complexity,
increased employee productivity, increased revenue potential by improving
customer service online, expanded business opportunities by creating real-time
business networks and support for regulatory compliance and risk mitigation. As
a result, we expect that companies will spend their discretionary information
technology dollars on technology that will help them drive revenue and reduce
costs while mitigating risk. The combined impact of the high growth potential of
the identity and access management market, our broadened product portfolio and
the focus of our direct sales resources on larger companies in selected
industries has enabled us to continue to drive business through our installed
base while at the same time adding new customers. However, information
technology spending continues to be modest and information technology budgets
remained constrained, which has had and could continue to have a direct effect
on the sale of our products. We believe that spending on technology will be
moderate for the remainder of 2004 and we believe that as information technology
spending increases from current levels our revenues will increase.
Some of our products contain technology that is licensed from third
parties. Our cost of software licenses consists primarily of royalty fees that
we pay for the licensed technologies well as product fulfillment costs. Non Cash
cost of software licenses include amortization of acquired software. Cost of
services includes salaries and related expenses for our consulting, training and
technical support services organizations, and the associated cost of training
facilities.
Our professional services group provides customers with project
management, deployment, architecture and design, custom development services and
training. Our customers typically pay for professional services at an hourly
rate for the time it takes us to complete the project. We strive to maintain
effective staffing levels and to limit the amount of turnover of our
professional services staff. If we are not successful in maintaining effective
staffing levels, our ability to achieve our service revenue and profitability
objectives may be adversely affected.
The majority of our sales are made directly with customers. Our direct
sales to customers in countries outside of the United States are denominated in
U.S. dollars and local currency, with the majority of our sales denominated in
U.S. dollars. Our sales through indirect distribution channels are generally
denominated in U.S. dollars. For countries outside of the United States, we
generally pay our operating expenses in local currency. Where we do invoice
customers in local currency, we are exposed to foreign exchange rate
fluctuations from the time the contract is signed until collection occurs. We
are also exposed to foreign currency fluctuations between the time we collect in
U.S. dollars and the time we pay our operating expenses in local currency.
Fluctuations in currency exchange rates could affect the profitability and cash
flows in U.S. dollars of our products sold in international markets. To date,
these fluctuations have not been significant.
14
Our future revenues and operating results may also fluctuate from quarter
to quarter based on the number and size of license deals and the size and scope
of the professional service projects in which we are engaged. In addition,
license revenues from a large customer deal may constitute a significant portion
of our total revenues in a particular quarter. Any such deal may result in
increased royalty payments and commission expenses. Any decline in our revenues
will have a significant impact on our financial results, particularly because a
significant portion of our operating costs, such as personnel, rent and
depreciation, are fixed in advance of a particular quarter. As a result, despite
cost savings realized to date, our costs for services personnel, sales and
marketing and general and administrative could increase as a percentage of
revenue, thereby adversely affecting our operating results.
CRITICAL ACCOUNTING POLICIES AND SIGNIFICANT JUDGMENTS AND ESTIMATES
Our discussion and analysis of our financial condition and results of
operations are based on our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements requires
our management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements as well as the reported
revenues and expenses during the reporting periods. On an ongoing basis, our
management evaluates its estimates and judgments, including those related to
revenue recognition, accounts receivable reserves, valuation of long-lived and
intangible assets, goodwill, in-process research and development, and income
taxes. Our management bases its estimates on historical experience and on
various other factors that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying value of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.
We believe there have been no significant changes in our critical
accounting policies during the six months ended June 30, 2004 as compared to
what was previously disclosed in Management's Discussion and Analysis of
Financial Condition and Results of Operations included in our Annual Report on
Form 10-K for the year ended December 31, 2003.
RESULTS OF OPERATIONS
THE THREE AND SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO THE THREE AND SIX
MONTHS ENDED JUNE 30, 2003
The following discussion reviews the results of operations for the three
and six months ended June 30, 2004 (the "2004 Quarter" and "2004 Period",
respectively) compared to the three and six months ended June 30, 2003 (the
"2003 Quarter" and "2003 Period", respectively).
REVENUES ($ IN MILLIONS)
THREE MONTHS ENDED
------------------
JUNE 30, 2004 JUNE 30, 2003
------------------ -------------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
------- -------- ------- -------- ------------ ------------
Software licenses $ 13.6 56% $ 10.7 57% $ 2.9 27%
Services 10.3 42% 7.5 40% 2.8 38%
Other 0.4 2% 0.7 3% (0.3) (40)%
------- --- ------- --- ------ ===
Total revenues $ 24.3 100% $ 18.9 100% $ 5.4 29%
======= === ======= === ====== ===
SIX MONTHS ENDED
----------------
JUNE 30, 2004 JUNE 30, 2003
------------------ -------------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
------- -------- ------- -------- ------------ ------------
Software licenses $ 26.4 56% $ 19.1 54% $ 7.3 38%
Services 19.9 42% 15.1 43% 4.8 31%
Other 1.0 2% 1.3 3% (0.3) (18)%
------- --- ------- --- ------ ---
Total revenues $ 47.3 100% $ 35.5 100% $ 11.8 33%
======= === ======= === ====== ===
15
Revenues. The increase in total revenues in both the 2004 Quarter and the
2004 Period as compared to the same periods in the prior year was primarily due
to increases in software license revenues from the sale of our SiteMinder
product, as well as sales generated by our new product offerings, IdentityMinder
Web Edition, IdentityMinder eProvision and TransactionMinder. In addition, in
both the 2004 Quarter and the 2004 Period, we experienced increased revenues
from the sale of our service offerings, which include consulting, training,
maintenance and support. Overall, we saw a modest improvement in market
conditions in the first half of 2004. The third quarter has historically been a
slower quarter due to seasonality trends, particularly in Europe, however
spending historically increases in the fourth quarter as customers spend their
remaining fiscal budgets. We expect these trends to continue and therefore
expect the growth in overall information technology spending for the remainder
of 2004 to be moderate and we believe that as information technology spending
increases from current levels our revenues will increase. We expect to continue
to generate revenue from our SiteMinder product as we continue to enhance
SiteMinder to meet changing market needs and continue to sell licenses for
additional users to our existing customers. We also believe that our focus on
becoming a leader in the identity and access management market with our new
IdentityMinder Web Edition, IdentityMinder eProvision and TransactionMinder
product offerings and continuing to leverage the relationships we have built
with our partners to provide integration services directly to our customers will
enable us to acquire new customers and sell these new products to our existing
customers. Furthermore, we expect our revenue from our service offerings to
increase as customers increase their demand for our specialized on-site support
services and our professional services.
Software license revenues increased in both the 2004 Quarter and 2004
Period as compared to the same periods in the prior year primarily due to the
sale of our new product offerings. Software license revenues in the 2004 Quarter
were driven by strong sales in Europe as we closed several large deals in
Europe, including one that was in excess of $1.0 million. During the 2004
Quarter we closed 100 deals, 18 (or 18%) of which were with new customers. This
compares to 88 deals closed in the 2003 Quarter, 28 (or 32%) of which were with
new customers. The average deal size in the 2004 Quarter was $160,000 as
compared to an average deal size of $144,000 in the 2003 Quarter. The increase
in the number of deals and the average deal size was primarily due to the sale
of our new products in general, and specifically, due to a single large
transaction for the purchase of your complete line of products in the 2004
Quarter which was in excess of $1.0 million. Overall, during the 2004 Period we
closed 205 deals, 46 (or 22%) of which were with new customers. This compares to
154 deals closed in the 2003 Period, 51 (or 33%) of which were with new
customers. The average deal size in the 2004 Period was $153,000 as compared to
an average deal size of $149,000 in the 2003 Period.
Services revenues increased in both the 2004 Quarter and the 2004 Period
as compared to the same periods in the prior year, primarily due to an increase
in maintenance revenue and to a lesser extent an increase in consulting and
training revenue. The increase in maintenance revenue of $2.1 million and $3.5
million in the 2004 Quarter and the 2004 Period, respectively, as compared to
the same periods in the prior year is attributable (1) to an increase in the
license revenue base, (2) a significant number of maintenance renewals by our
existing customer base, some of which were delayed renewals from the fourth
quarter of 2003 and the first quarter of 2004 and (3) an increase in the sale of
our specialized, on-site support services. Consulting revenue increased by
$600,000 and $900,000 in the 2004 Quarter and 2004 Period, respectively, as
compared to the same periods in the prior year, primarily due to increased
demand for our design in architecture services resulting in our higher
utilization rates of our professional services employees. Training revenue
increased by $100,000 and $300,000 in the 2004 Quarter and 2004 Period,
respectively, as compared to the same periods in the prior year primarily due to
increased focus on selling the value of our training courses to our new and
existing customers, particularly our customers outside of the United Stated
Other revenues, which are derived from our Firewall legacy business,
decreased in both the 2004 Quarter and the 2004 Period as compared to the same
periods in the prior year due to our decision during the 2004 Quarter to
reallocate the resources previously used in this business in order to focus them
on our core identity management business. While we plan to support the existing
Firewall customers through the end of their current support term, we will no
longer sell these products.
16
GROSS PROFIT ($ IN MILLIONS)
THREE MONTHS ENDED
------------------
JUNE 30, 2004 JUNE 30, 2003
------------------ -----------------
GROSS GROSS $ CHANGE % CHANGE
$ PROFIT % $ PROFIT % 2003 TO 2004 2003 TO 2004
------- -------- ------- -------- ------------ ------------
Gross profit - software
licenses $ 12.8 95% $ 7.6 71% $ 5.2 68%
Gross profit - services 6.8 66% 4.7 63% 2.1 44%
Gross profit - other 0.1 23% 0.3 40% (0.2) (65)%
------- ------- ------
Total gross profit $ 19.7 81% $ 12.6 67% $ 7.1 56%
======= === ======= === ====== ===
SIX MONTHS ENDED
----------------
JUNE 30, 2004 JUNE 30, 2003
----------------- ----------------
GROSS GROSS $ CHANGE % CHANGE
$ PROFIT % $ PROFIT % 2003 TO 2004 2003 TO 2004
------- -------- ------- -------- ------------ ------------
Gross profit - software
licenses $ 24.9 94% $ 12.9 67% $ 12.0 93%
Gross profit - services 13.2 66% 9.4 62% 3.8 41%
Gross profit - other 0.3 31% 0.5 41% (0.2) (38)%
------- ------- ------
Total gross profit $ 38.4 81% $ 22.8 64% $ 15.6 69%
======= === ======= === ====== ====
Gross profit. Gross profit is calculated as revenues less cost of
revenues. Cost of revenues includes, among other things, royalties due to third
parties for technology included in our products, amortization of capitalized
software, product fulfillment costs, salaries and related expenses for our
consulting, education and technical support services organizations, and the
associated cost of training facilities. Historically, we have realized overall
gross profit margins of between 60% and 80%. The wide range in these percentages
is the result of significant software amortization expenses being included in
certain periods. Gross profit margins on license revenue in periods where there
has not been significant amortization of capitalized software are typically in
excess of 90% and gross profit margins on services revenue are typically in
excess of 50%. Overall, we believe that the cost of revenues in dollars will
increase slightly in the remainder of 2004 due to an increase in the cost of
third party software products that enhance and enable additional functionality
in our products, increased investment in our technical support organization and
an increase in staff levels in our professional services organization. We expect
that these increases will be partially offset by increases in revenues, and
therefore, we anticipate gross profit margin to be approximately 77-80% for the
remainder of 2004.
The increase in gross profit on software licenses in both the 2004 Quarter
and 2004 Period as compared to the same periods in the prior year is due to an
increase in license revenue and a significant decrease in the cost of software
licenses, which includes non-cash cost of software licenses. Non-cash cost of
software licenses in the 2004 Quarter and 2004 Period decreased by approximately
$2.2 million and $4.4 million, respectively, as compared to the same periods in
the prior years due to the purchased software related to the portal technology,
which was recorded in connection with the acquisition of Data Channel, being
fully amortized as of June 30, 2003. The non-cash cost of software licenses was
$2.7 million and $5.4 million in the 2003 Quarter and 2003 Period, respectively.
This decrease was slightly offset by an increase in non-cash cost of software
licenses related to the amortization of capitalized software acquired from
Business Layers, Inc. These capitalized software assets are being amortized over
their estimated useful lives of two to five years and resulted in non-cash cost
of software licenses of $500,000 and $1.0 million in the 2004 Quarter and 2004
Period, respectively. We
17
expect total amortization expense to be approximately $2.0 million in 2004.
Overall, we expect that gross profits on software licenses will remain
relatively consistent through the remainder of 2004.
Gross profits on our services revenue are primarily driven by gross
profits on maintenance and professional services revenue. We experienced an
increase in gross profit on services revenues in both the 2004 Quarter and 2004
Period as compared to the same periods in the prior year as a result of an
increase in service revenue with only a slight increase in the corresponding
cost of providing these services. Although the cost of maintenance revenue did
not increase as a result of the delayed renewals from the fourth quarter of
2003 and the first quarter of 2004, the cost did increase slightly due to an
investment in the technical support organization during the second half of 2003
in order to enhance overall customer satisfaction. This increase was partially
offset by a decrease in the cost of professional services revenue resulting from
a reduction in the cost paid to third party consultants and the use of our
system integrator partner relationships. We anticipate maintaining our
historical gross profit percentage on maintenance revenue as we expect any
increases in revenues will be partially offset by increases in our investment in
the technical support organization. Conversely, we anticipate a decrease in the
gross profit percentage of our professional services organization over the
remainder of 2004 due to an anticipated increase in staff levels and a decrease
in utilization rates of our professional service employees, which were
atypically high in the first half of 2004. Overall, we expect this will result
in a slight decrease in the gross profits on our services revenue through the
remainder of 2004.
Gross profits on Other, which is derived from our Firewall legacy
business, decreased in both the 2004 Quarter and the 2004 Period as compared to
the same periods in the prior year due to a decrease in revenue from this
business attributable to our decision to reallocate the resources previously
used in this business in order to focus them on our core identity management
business. While we plan to support the existing Firewall customers through the
end of their current support term, we will no longer sell these products.
OPERATING EXPENSES ($ IN MILLIONS)
THREE MONTHS ENDED
------------------
JUNE 30, 2004 JUNE 30, 2003
------------------- ------------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
---- ---------- ---- ---------- ------------ ------------
Selling, general and
administrative expenses $ 12.1 50% $ 10.5 55% $ 1.6 15%
Research and development
expenses 5.9 24% 5.0 27% 0.9 16%
------ -- ------ -- ------
Total operating expenses $ 18.0 74% $ 15.5 82% $ 2.5 16%
====== == ====== == ====== ==
SIX MONTHS ENDED
----------------
JUNE 30, 2004 JUNE 30, 2003
------------------- ------------------
% OF TOTAL % OF TOTAL $ CHANGE % CHANGE
$ REVENUES $ REVENUES 2003 TO 2004 2003 TO 2004
---- ---------- ---- ---------- ------------ ------------
Selling, general and
administrative expenses $ 23.7 49% $ 21.0 59% $ 2.7 13%
Research and development
expenses 11.8 25% 10.0 28% 1.8 20%
------ -- ------ -- ------
Total operating expenses $ 35.5 74% $ 31.0 87% $ 4.5 14%
====== == ====== == ====== ==
Selling, General and Administrative Expenses. Selling, general and
administrative expenses consist primarily of salaries and other related costs
for selling, administrative and marketing personnel, sales commissions, travel,
legal and accounting services, public relations, marketing materials, trade
shows and certain facilities-related expenses. The increase in selling, general
and administrative expenses in the 2004 Quarter and 2004 Period as compared to
the same periods in the prior year was primarily attributable to increased
commission expense resulting from increased revenue and increased salaries and
related expenses as a result of the acquisition of Business Layers (including
transition related costs). These increases were partially offset by reduced
legal fees, insurance expenses and facility-related expenses, including office
rent, depreciation and utilities, primarily resulting from the consolidation of
field offices and the move of our corporate headquarters to a new facility in
March 2003. Although we continue to scrutinize discretionary expenses and
evaluate reductions in non-strategic programs, we anticipate selling, general
and administrative
18
expenses as a percentage of total revenues will remain flat or increase slightly
in future periods to accommodate our revenue growth and to comply with
regulatory requirements such as Sarbanes-Oxley.
Research and Development Expenses. Research and development expenses
consist primarily of personnel and outside contractor costs to support product
development. The increase in research and development expenses in both the 2004
Quarter and 2004 Period as compared to the same periods in the prior year was
primarily due to an increase in staff and related expenses incurred as a result
of the addition of approximately 30 research and development employees located
in Israel that were added as part of the acquisition and integration of Business
Layers, in December 2003. Additionally, we continue to increase consulting
expenses related to the continued leverage of offshore and other third-party
contractors used to perform certain development, testing and porting of our
products. We recognize that our investment in research and development is
required to remain competitive and, therefore, our research and development
expenses in dollars may increase in future periods due to the continued
development of our products and services.
Other Income, Net. The decrease in Other income, net, in both the 2004
Quarter and the 2004 Period as compared to the same periods in the prior year
was primarily attributable to lower interest income earned due to lower average
cash, cash equivalents and marketable securities balances in the 2004 Quarter
and 2004 Period. Our asset balances decreased as a result of cash payments made
as part of the purchase price for Business Layers. Our portfolio is generally
comprised of highly liquid, high quality investments, and therefore we do not
expect significant fluctuations in other income as a result of changes in
investment yields.
Provision for Income Taxes. The provision for income taxes for the 2004
Quarter and the 2004 Period was $153,000 and $328,000, respectively, as compared
with a provision of approximately $59,000 for both 2003 Quarter and 2003 Period.
The 2004 provision reflects estimated federal alternative minimum taxes and
foreign taxes on income generated in the 2004 Period. Our policy is to provide
for income taxes in our interim financial statements at an effective rate based
upon our estimate of full year earnings and projected tax expense. We have
recorded a full valuation allowance against deferred tax assets as of June 30,
2004 due to uncertainties related to our ability to utilize some of our deferred
tax assets, primarily consisting of certain net operating losses carried
forward, before they expire.
LIQUIDITY AND CAPITAL RESOURCES
In the current and prior years we have primarily funded our operations
with cash flows generated from operations and the proceeds of our equity
issuances. We invest our cash primarily in instruments that are highly liquid,
investment grade securities. As of June 30, 2004, we had cash and cash
equivalents totaling $23.0 million, short-term marketable securities of $44.2
million and working capital of $51.3 million, compared to cash and cash
equivalents totaling $20.1 million, short-term marketable securities of $51.6
million and working capital of $46.9 million as of December 31, 2003. In
addition, we had long-term marketable securities totaling $21.8 million and
$19.4 million as of June 30, 2004 and December 31, 2003, respectively.
Cash provided by operating activities for the 2004 Period was $6.2
million. This resulted primarily from net income of $3.2 million, which included
non-cash charges for depreciation and amortization of $2.6 million, an increase
in deferred revenue of $5.1 million and an increase in accounts payable of $1.7
million, partially offset by an increase in accounts receivable of $6.1 million.
Deferred revenue increased as a result of increased revenue and strong
maintenance renewals in the first half of 2004. Accounts payable increased due
to the timing of vendor payments experienced in the ordinary course of business.
Finally, while we continued to experience strong collection results in the 2004
Period, accounts receivable increased due to the increase in revenue, the
linearity of this revenue and a strong period of maintenance renewals. The
increase in accounts receivable resulted in an increase of our day's sales
outstanding to 77 days in the quarter ended June 30, 2004 from 65 days in the
quarter ended March 31, 2004 and from 53 days in the quarter ended December 31,
2003.
Cash used for investing activities was $6.5 million for the 2004 Period.
Investing activities consisted primarily of $8.3 million of net cash used for
the payment of the remaining purchase consideration and transaction costs
associated with the acquisition of Business Layers and the purchases of
marketable securities of approximately $30.1 million, offset by sales and
maturities of marketable securities of approximately $33.9 million.
Cash provided by financing activities in the period ended June 30, 2004
was $3.0 million primarily related to proceeds received from the exercise of
stock options in the 2004 Period and the issuance of shares in connection with
our employee stock purchase plan during May 2004.
Any increase or decrease in our accounts receivable balance and accounts
receivable days outstanding (calculated as net accounts receivable divided by
revenue per day) affects our cash flow from operations and liquidity. Our
accounts receivable and accounts
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receivable days outstanding may increase due to changes in factors such as the
timing of when sales are invoiced and the length of our customers' payment
cycles. We also record deferred maintenance billings as accounts receivable, and
the timing of these billings can affect the accounts receivable days
outstanding, as it did in the 2004 Period. Historically, international and
indirect customers pay at a slower rate than domestic and direct customers. An
increase in revenues generated from international and indirect customers may
increase our accounts receivable balance and accounts receivable days
outstanding. Due to the current economic climate, we may observe an increase in
the length of our customers' payment cycles and as a result our day's sales
outstanding may increase in future periods. To the extent that our accounts
receivable balance increases, we may incur increased bad debt expense and will
be subject to greater general credit risks.
In the past, we experienced a period of rapid growth, which resulted in
significant increases in our operating expenses. Over the past two years, due to
the effects of general economic conditions, we have made considerable efforts to
reduce our operating expenses through constrained spending, reductions in
workforce and better alignment of our cost structure to our revenues. We
anticipate our short-term cash requirements to primarily include the continued
funding of our operating expenses and to a lesser extent the funding of capital
expenditures. We believe that our existing cash and cash equivalent balances
together with our marketable securities will be sufficient to meet these
requirements over at least the next twelve months. We anticipate our long-term
cash requirements to primarily include the funding of acquisitions or
investments in businesses, technologies, products or services that are
complementary to our business.
COMMITMENTS, CONTRACTUAL OBLIGATIONS, AND OFF-BALANCE SHEET ARRANGEMENTS
In April 2002, we entered into an agreement with a system integrator to
assist us in the development and launch of one of our products. Under the terms
of the agreement, as consideration for the system integrator's time in assisting
with the development of the product, we agreed to promote the system integrator
as an integrator of the developed product. Our obligation under the agreement
would have been considered satisfied once the system integrator received
consulting revenues totaling approximately $3.9 million from our customers, or
by the expiration date of this contract. This agreement expired in May 2004. No
royalties were due to the system integrator under this agreement during its
term.
In February 2004, we entered into an agreement with a software service
provider located in India under which we have guaranteed to pay this software
service provider a minimum of $4.0 million annually for various product
development projects. The initial term of this agreement expires in December
2004. As of June 30, 2004, approximately $2.3 million had been paid to this
software service provider.
In June 2004, we entered into a letter of credit with a financial
institution. The letter of credit in the amount of $566,000, which is held in
connection with a pre-paid maintenance contract, has an expiration date of
December 2012 and is reduced ratably over the term of the contract.
We enter into standard indemnification agreements with our business
partners and customers in the ordinary course of business. Pursuant to these
agreements, we agree to repair or replace the product, pay royalties for a right
to use, or reimburse the indemnified party for actual damages awarded by a court
against the indemnified party for an intellectual property infringement claim by
a third party with respect to our products. The term of these indemnification
agreements is generally perpetual. The maximum potential amount of future
payments we could be required to make under these indemnification agreements is
unlimited. We have never incurred costs to defend lawsuits or settle claims
related to these indemnification agreements. As a result, we believe the
estimated fair value of these agreements is minimal. Accordingly, we have no
liabilities recorded for these agreements as of June 30, 2004.
We enter into standard indemnification agreements with our customers,
whereby we indemnify them for certain damages, such as personal property damage,
which may be incurred in connection with consulting services performed at a
customer location by our employees or subcontractors. The potential amount of
future payments we could be required to make under these indemnification
agreements is unlimited. However, we have general and umbrella insurance
policies that enables us to recover a portion of any amounts paid. We have never
incurred costs to defend lawsuits or settle claims related to these
indemnification agreements. As a result, we believe the estimated fair value of
these agreements is minimal. Accordingly, we have no liabilities recorded for
these agreements as of June 30, 2004.
We generally warrant for ninety days from delivery to a customer that our
software products will perform free from material errors which prevent
performance in accordance with user documentation. Additionally, we warrant that
our consulting services will be
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performed consistent with generally accepted industry standards. We have never
incurred significant expense under our product or service warranties. As a
result, we believe the estimated fair value of these agreements is minimal.
Accordingly, we have no liabilities recorded for these agreements as of June 30,
2004.
We have entered into employment and executive retention agreements with
certain employees and executive officers which, among other things, include
certain severance and change of control provisions. We have also entered into
agreements whereby we indemnify our officers and directors for certain events or
occurrences while the officer or director is, or was, serving at our request in
such capacity.
From time to time, we are involved in litigation relating to claims
arising out of our operations in the normal course of business. We are not
presently a party to any legal proceedings, the adverse outcome of which, in our
opinion, would have a material adverse effect on our results of operations or
financial position.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
We caution you that the following important factors, among others, in the
future could cause our actual results to differ materially from these expressed
in forward-looking statements made by us or on our behalf in filings with the
Securities and Exchange Commission, press releases, communications with
investors and oral statements. Any or all of our forward-looking statements in
this Quarterly Report on Form 10-Q and in any other public statements we make
may turn out to be wrong. They can be affected by inaccurate assumptions we
might make or by known or unknown risks and uncertainties. Many factors
mentioned in the discussion below will be important in determining future
results. Consequently, no forward-looking statement can be guaranteed. Actual
future results may vary materially. We undertake no obligation to update any
forward-looking statements, whether as a result of new information, future
events or otherwise. You are advised, however, to consult any further disclosure
we make in our reports filed with the Securities and Exchange Commission.
ALTHOUGH WE ARE NOW PROFITABLE, WE HAVE INCURRED SUBSTANTIAL LOSSES IN THE PAST
AND MAY NOT CONTINUE TO BE PROFITABLE IN THE FUTURE.
In recent years, we have incurred substantial operating losses. While we
recently returned to profitability on a quarterly basis, we cannot predict if we
will maintain profitability for any substantial period of time. To sustain
operating profitability on a quarterly and annual basis, we will need to
continue to increase our revenues, particularly our license revenues. Failure to
maintain levels of profitability as expected by investors may adversely affect
the market price of our common stock. We had an accumulated deficit of $107.8
million as of June 30, 2004.
OUR QUARTERLY RESULTS MAY FLUCTUATE WIDELY.
Our quarterly revenues and operating results are difficult to predict and
may continue to fluctuate significantly from quarter to quarter for several
reasons, including, but not limited to, the following:
- customers choosing to delay their purchase commitments or purchase
in smaller than expected quantities due to a general slowdown in the
economy or in anticipation of the introduction of new products by us
or our competitors;
- market acceptance of our SiteMinder, IdentityMinder Web Edition,
IdentityMinder eProvision and TransactionMinder products;
- the timing and size of orders from our customers, including the
tendency for a significant amount of our sales to occur in the final
two weeks of each fiscal quarter;
- increased dependency on large transactions as more customers make
enterprise wide purchased of our products;
- our ability to obtain follow-on sales from existing customers;
- the long sales and deployment cycle of our products;
- our ability to hire and retain personnel, particularly in
development, services and sales and marketing;
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- the loss of or changes in key management personnel;
- the timing of the release of new versions of our SiteMinder,
IdentityMinder Web Edition, IdentityMinder eProvision and
TransactionMinder or other products;
- pricing pressures that result in increased discounts or changes in
our or competitors' pricing policies;
- changes in our operating expenses;
- the development of our direct and indirect distribution channels;
- integration issues with acquired technology and businesses; and
- general economic conditions.
In addition, because our revenues from services, particularly maintenance
revenues, are largely correlated with our software revenues, a decline in
software revenues could also cause a decline in our services revenues in the
same quarter or in subsequent quarters. Other factors, many of which are outside
our control, could also cause variations in our quarterly revenues and operating
results.
Most of our expenses, such as employee compensation and rent, are
relatively fixed. As a result, any shortfall in revenues in relation to our
expectations could cause significant changes in our operating results from
quarter to quarter and could result in future losses.
OUR SUCCESS WILL DEPEND ON OUR ABILITY TO MARKET OUR PRODUCTS AND RELATED
SERVICES SUCCESSFULLY.
Our revenues are primarily generated from the sale of perpetual licenses
for our proprietary SiteMinder, IdentityMinder Web Edition, IdentityMinder
eProvision, TransactionMinder and related services. Broad market acceptance of
our products will depend on the continued development of a market for identity
and access management, the education of our customers on the use of business
software applications in general and the relevance of our products specifically.
Market acceptance of our products, and customer demand for the services they
provide, may not develop.
We have released several new product offerings in the past 18 months. If
we fail to gain market acceptance for these products, our business, operating
results and financial position could be materially adversely affected.
Additionally, with the continued constraints in information technology spending
in all industries we will need to be successful in conveying the value of our
products to customers who may be hesitant to replace a "homegrown" system due to
the costs involved with switching to a purchased solution.
Our ability to succeed in the market for our products depends in part on
our ability to provide support services on a 24 hour per day, seven day per week
basis. Any damage or disruptions to our service centers, including our service
centers in Malaysia and Israel, whether as a result of employee attrition, acts
of terrorism, language barriers, or some other cause, could seriously impact our
ability to provide the necessary service to our customers and fulfill our
service contracts.
OUR SUCCESS IS DEPENDENT ON OUR ABILITY TO ENHANCE OUR PRODUCT LINES AND DEVELOP
NEW PRODUCTS.
We believe our success is dependent, in large part, on our ability to
enhance and broaden our product lines to meet the evolving needs of the business
market. Our success also depends on the ability of our customers to link our
software to their existing systems and applications through various connectors
and agents that we have developed. We may not be able to efficiently integrate
recently acquired technologies into our products or provide the most effective
connector or agent. We may be unable to respond effectively to technological
changes or new industry standards or developments. Product development cycles
are unpredictable and, in the past, we have delayed the introduction of several
new product versions due to delays in development.
22
We have arrangements with a third party located in India to perform certain
testing of our products, as well as internationalization and porting of our
products to new platforms, and with third party software vendors who provide
software which is embedded in our products. Any adverse change in our
relationship with these third parties could result in delays in the release of
our products. In the future, we could be adversely affected and be at a
competitive disadvantage if we incur significant delays or are unsuccessful in
enhancing our product lines or developing new products, or if any of our
enhancements or new products do not gain market acceptance.
As we continue to release new versions of our existing software, we may be
required to assist customers in migrating to the latest version once we announce
the end of life of the previous version. Additionally, we may be required to
assist Business Layers customers in migrating to more standardized versions of
the provisioning product. We could be adversely affected if we experience
significant migration issues and a decline in customer satisfaction related to
such transitions.
OUR ACQUISITION OF BUSINESS LAYERS AND OTHER COMPANIES MAY INCREASE THE RISKS WE
FACE.
We recently acquired Business Layers. In the future, we may pursue other
acquisitions to obtain complementary products, services and technologies. These
acquisitions may not produce the revenues, earnings or business synergies that
we anticipate, and an acquired product, service or technology might not perform
as we expect. In pursuing any acquisition, our management could spend
significant time and effort in identifying and completing the acquisition. We
will have to devote significant management resources to integrate with our
existing businesses the business we acquired from Business Layers and any other
business we might acquire. We might not be able to successfully transfer the
knowledge of the employees or integrate the operations of acquired businesses,
including Business Layers. As a result of acquisitions, we might assume
contracts and other agreements that subject us to burdensome liabilities,
including obligations to indemnify third parties, or impose unfavorable terms on
us, including significant royalty obligations and termination fees. We may not
be able to renegotiate these agreements. To pay for an acquisition, we might use
our stock or cash. Alternatively, we might borrow money from a bank or other
lender. If we use our stock, our stockholders would experience dilution of their
ownership interests. If we use cash or debt financing, our financial liquidity
will be reduced.
OUR PERFORMANCE DEPENDS ON OUR ABILITY TO WIN BUSINESS AND OBTAIN FOLLOW-ON
SALES IN PROFITABLE SEGMENTS.
Customers typically place small initial orders for our products to allow
them to evaluate our products' performance. A key element of our strategy is to
pursue more significant follow-on sales after these initial installations. Our
financial performance depends on successful initial deployments of our products
that, in turn, lead to follow-on sales. If the initial deployments of our
products are not successful or if our customers do not remain satisfied with our
products and services, we may be unable to obtain follow-on sales. In addition,
even if initial deployments are successful, we cannot assure you that customers
will choose to make follow-on purchases, which could have a material adverse
effect on our ability to generate revenues.
WE FACE SIGNIFICANT COMPETITION FROM OTHER TECHNOLOGY COMPANIES AND WE MAY NOT
BE ABLE TO COMPETE EFFECTIVELY.
The market for identity and access management is highly competitive. We expect
the level of competition to increase as a result of the anticipated growth of
the identity and access management market. Our primary competitor in the
identity and access management market is the Tivoli Division of IBM. We also
compete against traditional security and software companies, such as Oblix, RSA
and Novell, and stack vendors such as Sun MicroSystems. In addition, a number of
other security and software companies, including appliance vendors, are
beginning to offer products that may compete with our identity and access
management solution. Competition may also develop as the market matures and
other companies begin to offer similar products, and as our product offerings
expand to other segments of the marketplace. We also face competition from Web
development professional services organizations. We expect that additional
competitors will emerge in the future. Current and potential competitors have
established, or may in the future establish, cooperative selling relationships
with third parties to increase the distribution of their products to the
marketplace. Accordingly, it is possible that new competitors may emerge and
acquire significant market share. If we fail to establish our leadership in the
identity and access management market we may not be able to compete effectively.
It is possible that current and potential competitors may attempt to hire our
employees and although we have non-compete agreements in place with most of our
employees they may or may not be enforceable. It is possible that new
competitors or alliances may emerge and rapidly acquire significant market
share. Today, many of our competitors have shorter operating histories and fewer
financial and technical resources than we have. In addition, these smaller
competitors have smaller customer bases. Some of our competitors, however, are
larger companies who have large financial resources, well-established
development and support teams, and large customer bases. These larger
competitors may initiate pricing policies for their software products or
services that would make it more difficult for us to maintain
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our competitive position against these companies. It is also possible that
current and potential competitors may be able to respond more quickly to new or
emerging technologies or customer requirements, resulting in increased market
share. If, in the future, a competitor chooses to bundle a competing point
product with other applications within a suite, the demand for our products
might be substantially reduced. Because of these factors, many of which are
outside of our control, we may be unable to maintain or enhance our competitive
position against current and future competitors.
REGULATIONS OR CONSUMER CONCERNS REGARDING THE USE OF "COOKIES" ON THE INTERNET
COULD REDUCE THE EFFECTIVENESS OF OUR SOFTWARE PRODUCTS.
Certain of our products use cookies to support their single sign-on
functionality. A cookie is information keyed to a specific user that is stored
on the hard drive of the user's computer, typically without the user's
knowledge. Cookies are generally removable by the user, and can be refused by
the user at the point at which the information would not be stored on the user's
hard drive. A number of governmental bodies and commentators in the United
States and abroad have urged passage of laws limiting or abolishing the use of
cookies. The passage of laws limiting or abolishing the use of cookies, or the
widespread deletion or refusal of cookies by Web site users, could reduce or
eliminate the effectiveness of our single sign-on functionality and could reduce
market demand for our products.
WE MAY BE UNABLE TO HIRE AND RETAIN SKILLED PERSONNEL.
Qualified personnel are in great demand throughout the software industry.
Our success depends, in large part, upon our ability to attract, train, motivate
and retain highly skilled employees, particularly software engineers,
professional services personnel, sales and marketing personnel and other senior
personnel. Our failure to attract and retain the highly trained technical
personnel that are integral to our product development, professional services
and direct sales teams, particularly software engineers, may limit the rate at
which we can generate sales, develop new products or product enhancements or
transfer technical knowledge across our employee base. A change in key
management could result in transition and attrition in the affected department.
In addition, we may experience attrition by employees we acquire as a result of
acquisitions of other companies if those employees experience difficulties in
integrating with our existing employees and management. This could have a
material adverse effect on our business, operating results and financial
condition.
OUR SUCCESS DEPENDS ON OUR ABILITY TO OPTIMIZE OUR DIRECT SALES AND INDIRECT
DISTRIBUTION CHANNELS.
To increase our revenues, we must optimize our direct sales force and
continue to enhance relationships with systems integrators, resellers and
technology partners to increase the leverage of our partners. There is intense
competition for sales personnel in our business, and we cannot be sure that we
will be successful in attracting, integrating, motivating and retaining sales
personnel. In addition, we must effectively leverage our relationships with our
strategic partners and other third-party system integrators, vendors of
Internet-related systems and application software and resellers in order to
reach a larger customer population than we could reach alone through our direct
sales and marketing efforts.
We may not be able to find appropriate strategic partners or may not be
able to enter into relationships on commercially favorable terms, particularly
if these partners decide to compete directly in the identity and access
management market. Furthermore, the relationships we do enter into may not be
successful. Our strategic relationships are generally non-exclusive, and
therefore, our strategic partners may decide to pursue alternative technologies
or to develop alternative products in addition to or instead of our products,
either on their own or in collaboration with our competitors.
WE RELY ON THIRD PARTY TECHNOLOGY TO ENHANCE OUR PRODUCTS.
We incorporate into our products software licensed from third party
software companies that enhances, enables or provides functionality for our
products and, therefore, we need to create relationships with third parties,
including some of our competitors, to ensure that our products will interoperate
with the third parties' products. Third party software may not continue to be
available on commercially reasonable terms or with acceptable levels of support
or functionality, or at all. Failure to maintain those license arrangements,
failure of the third party vendors to provide updates, modifications or future
versions of their software or defects and errors in or infringement claims
against those third party products could delay or impair our ability to develop
and sell our products and potentially cause us to incur additional costs. Third
party products are also incorporated into the provisioning products that we
recently acquired from Business Layers. We expect to renegotiate some of the
terms of the licensing arrangements for these products.
24
There can be no assurance that we will be able to renegotiate those agreements
on commercially favorable terms. In addition, if we discover that third party
products are no longer available as a result of changes in a third party's
operations or financial position, there can be no assurance that we would be
able to offer our product without substantial reengineering, or at all.
Often these third party software companies require prepayment of royalties
on their products and, in the past, we have had to expense these prepaid
royalties to cost of sales when it was determined that they may not have future
realizable value.
OUR FAILURE TO EXPAND OUR RELATIONSHIP WITH GLOBAL SYSTEMS INTEGRATORS COULD
LIMIT OUR ABILITY TO SUPPORT OUR CUSTOMERS' DEPLOYMENT OF OUR PRODUCTS.
Our professional services organization and our relationship with global
systems integrators provide critical support to our customers' installation and
deployment of our products. If we fail to adequately develop our relationship
with global systems integrators, our ability to increase products sales may be
limited. In addition, if we or our partners cannot adequately support product
installations, our customers may not be able to use our products, which could
harm our reputation and hurt our business.
OUR LENGTHY SALES CYCLE MAKES IT DIFFICULT TO PREDICT OUR QUARTERLY OPERATING
RESULTS.
The length of our sales cycle varies depending on the size, type and
complexity of the customer contemplating a purchase, whether we have conducted
business with a potential customer in the past and the size of the deal. In
addition, some of our customers may also need to invest substantial resources
and modify their computer network infrastructures to take advantage of our
products. As a result, these potential customers frequently need to obtain
approvals from multiple decision makers prior to making purchase decisions, a
process that has been, at times, further lengthened as a result of market
conditions surrounding technology spending. Our long sales cycle, which can
range from several weeks to several months or more, makes it difficult to
predict the quarter in which sales will occur. Delays in sales could cause
significant variability in our revenues and operating results for any particular
quarterly period. Our sales cycle is subject to a number of uncertainties such
as:
- the need to educate potential customers regarding the benefits of
our products;
- customers' budgetary constraints;
- the timing of customers' budget cycles;
- customers' willingness to make changes in their network
infrastructures; and
- delays caused by customers' internal review processes.
OUR FAILURE TO EFFECTIVELY MANAGE CHANGES IN THE BUSINESS ENVIRONMENT IN WHICH
WE OPERATE COULD HARM OUR BUSINESS.
Our failure to effectively manage changes in the business environment in
which we operate could have a material adverse effect on the quality of our
products, our ability to retain key personnel and our business, operating
results and financial condition. In the past, we have experienced periods of
rapid growth as well as periods of economic slowdown which have resulted in
reductions in workforce. Both of these situations have placed a significant
strain on our resources. We may experience similar changes in the future.
Additionally, we may experience disruptions as a result of attacks from
electronic viruses which could result in reduced productivity. To effectively
manage changes in the business environment in which we operate we must maintain
and enhance our financial and accounting systems and controls, maintain the
security of our infrastructure, maintain our ability to retain key personnel,
integrate new personnel and manage operations.
IF WE LOSE THE SERVICES OF BARRY BYCOFF OR ANY OTHER MEMBER OF OUR MANAGEMENT
TEAM, OUR BUSINESS COULD SUFFER.
Our future success depends, to a significant degree, on the skill,
experience and efforts of Barry Bycoff, our chief executive officer, and the
rest of our management team. A change in our management team or the inability of
our officers and key employees to work effectively as a team could have a
material adverse effect on our business, operating results and financial
condition.
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AS WE CONTINUE TO OPERATE IN INTERNATIONAL MARKETS, WE WILL FACE CONTINUED RISKS
TO OUR SUCCESS.
We operate in several international markets, including Israel as a result
of our recent acquisition of Business Layers. Our international operations are
subject to increased regulatory, economic and political risks. We have limited
experience in international markets and we cannot be sure that our continued
expansion into global markets will be successful. In addition, we will face
increased risks in conducting business internationally, including the ability to
develop, market and distribute localized versions of our products in a timely
manner or at all. These risks could reduce demand for our products and services,
increase the prices at which we can sell our products and services or otherwise
have an adverse effect on our success in international markets. If we are not
successful in continuing to increase our international revenues we may
experience an adverse affect on our operating results. Among the risks related
to international operations we believe are most likely to affect us are:
- longer decision making cycles;
- longer payment cycles and problems in collecting accounts
receivable;
- adverse changes in trade and tax regulations, including restrictions
on the import and export of sensitive technologies, such as
encryption technologies, that we use or may wish to use in our
software products;
- the absence or significant lack of legal protection for intellectual
property rights;
- selling under contracts governed by local law;
- difficulties in managing an organization spread over multiple
countries, including complications arising from cultural, language
and time differences that may lengthen development, sales and
implementation cycles and delay the resolution of customer support
issues;
- currency risks, including fluctuations in exchange rates;
- political and economic instability;
- localization of technology, including delays in localizing the most
recent versions of our products;
- increased use of contractors on a global basis for both professional
services and development, that may result in increased cost of
services and less direct control; and
- disruption caused by terrorist activities in various regions around
the world.
OUR SUCCESS DEPENDS ON OUR ABILITY TO PROTECT OUR PROPRIETARY RIGHTS.
Our success depends to a significant degree upon the protection of our
software and other proprietary technology. The unauthorized reproduction or
other misappropriation of our proprietary technology would enable third parties
to benefit from our technology without paying us for it. This could have a
material adverse effect on our business, operating results and financial
condition. We depend upon a combination of patent, trademark, trade secret and
copyright laws, license agreements and non-disclosure and other contractual
provisions to protect proprietary and distribution rights in our products. In
addition, we attempt to protect our proprietary information and the proprietary
information of our vendors and partners through confidentiality and/or license
agreements with our employees and others. Although we have taken steps to
protect our proprietary technology, they may be inadequate and the unauthorized
use of our source code could have an adverse effect on our business. Existing
trade secret, copyright and trademark laws offer only limited protection.
Moreover, the laws of other countries in which we market our products may afford
little or no effective protection of our intellectual property. If we resort to
legal proceedings to enforce our intellectual property rights, the proceedings
could be burdensome and expensive, even if we were to prevail.
CLAIMS BY OTHER COMPANIES THAT WE INFRINGE THEIR PROPRIETARY TECHNOLOGY COULD
HURT OUR FINANCIAL CONDITION.
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If we discover that any of our products or third party products embedded
in our products violates third party proprietary rights, there can be no
assurance that we would be able to reengineer our product or to obtain a license
on commercially reasonable terms to continue offering the product without
substantial reengineering. We do not conduct comprehensive patent searches to
determine whether the technology used in our products infringes patents held by
third parties. In addition, product development is inherently uncertain in a
rapidly evolving technology environment in which there may be numerous patent
applications pending for similar technologies, many of which are confidential
when filed. Any claim of infringement, even if invalid, could cause us to incur
substantial costs defending against the claim and could distract our management
from our business. Furthermore, a party making such a claim could secure a
judgment that requires us to pay substantial damages. A judgment could also
include an injunction or other court order that could prevent us from selling
our products. Any of these events could have a material adverse effect on our
business, operating results and financial condition.
OUR BUSINESS COULD BE ADVERSELY AFFECTED IF OUR PRODUCTS CONTAIN ERRORS OR
FLAWS.
Software products as complex as ours may contain undetected errors or
"bugs" that result in product failures. The occurrence of errors could result in
loss of, or delay in, revenues, loss of market share, failure to achieve market
acceptance, diversion of development resources, injury to our reputation, or
damage to our efforts to build brand awareness, any of which could have a
material adverse effect on our business, operating results and financial
condition. Additionally, the security features included in our products to
prevent unauthorized access to the application may not meet all of our
customers' requirements.
WE COULD INCUR SUBSTANTIAL COSTS RESULTING FROM PRODUCT LIABILITY CLAIMS
RELATING TO OUR CUSTOMERS' USE OF OUR PRODUCTS.
Many of the business applications supported by our products are critical
to the operations of our customers' businesses. Any failure in a customer's Web
site or application caused or allegedly caused by our products could result in a
claim for substantial damages against us, regardless of our responsibility for
the failure. Although we maintain general liability insurance, including
coverage for errors and omissions, and contractually attempt to limit liability,
we cannot be sure that our existing coverage will continue to be available on
reasonable terms or will be available in amounts sufficient to cover one or more
large claims, or that the insurer will not disclaim coverage as to any future
claim.
OUR FORMER INDEPENDENT PUBLIC ACCOUNTANT, ARTHUR ANDERSEN LLP, HAS BEEN FOUND
GUILTY OF A FEDERAL OBSTRUCTION OF JUSTICE CHARGE, AND YOU MAY BE UNABLE TO
EXERCISE EFFECTIVE REMEDIES AGAINST ARTHUR ANDERSEN IN ANY LEGAL ACTION.
Our former independent public accountant, Arthur Andersen LLP, provided us
with auditing services during the year ended December 31, 2001, including
issuing an audit report with respect to our audited consolidated financial
statements as of and for the year ended December 31, 2001. On June 15, 2002, a
jury in Houston, Texas found Arthur Andersen guilty of a federal obstruction of
justice charge arising from the federal government's investigation of Enron
Corp. On August 31, 2002, Arthur Andersen ceased practicing before the SEC.
We were unable to obtain Arthur Andersen's consent to include its report
with respect to our audited consolidated financial statements as of and for the
year ended December 31, 2001 in our Annual Reports on Form 10-K for the years
ended December 31, 2003 and 2002. Rule 437a under the Securities Act of 1933, or
the Securities Act, permits us to dispense with the requirement to file Arthur
Andersen's consent. As a result, you may not have an effective remedy against
Arthur Andersen in connection with a material misstatement or omission with
respect to our audited consolidated financial statements. In addition, even if
you were able to assert such a claim, as a result of its conviction and other
lawsuits, Arthur Andersen may fail or otherwise have insufficient assets to
satisfy claims made by investors or by us that might arise under federal
securities laws or otherwise relating to any alleged material misstatement or
omission with respect to our audited consolidated financial statements.
INCREASED UTILIZATION AND COSTS OF OUR TECHNICAL SUPPORT SERVICES AND INCREASED
DEMANDS ON OUR OTHER TECHNICAL RESOURCES MAY ADVERSELY AFFECT OUR FINANCIAL
RESULTS.
Our products involve very complex technology and the failure or inability of
our technical support staff to meet customer expectations in a timely manner or
customer dissatisfaction with our product functionality or performance could
result in loss of revenues, loss of market share, failure to achieve market
acceptance, injury to our reputation, liability for service or warranty costs
and claims and other increased costs. We may be unable to respond to
fluctuations in customer demand for support services as well as
27
resolve customer issues in a manner that is timely and satisfactory to them. We
also may be unable to modify the format of our support services to compete with
changes in support services provided by competitors.
As we win business from larger, more complex customers with highly
customized environments there may be an increased demand on our resources,
particularly product development and support, which may affect the allocation of
our resources. Additionally, as we continue to sell our new products to existing
customers, our customers might expect us to provide the same level of product
support on the new products as we do on the old products. This could increase
demand on our product support resources beyond levels we could provide.
THE MARKET PRICE OF OUR COMMON STOCK HAS BEEN AND MAY CONTINUE TO BE VOLATILE.
Our stock price, like that of other technology companies, has been
extremely volatile. The announcement of new products, services, technological
innovations, customers or distribution partners by us or our competitors,
quarterly variations in our operating results, changes in coverage by securities
analysts, changes in revenues or earnings estimates by securities analysts,
speculation in the press or investment community and overall economic conditions
are among the factors affecting our stock price.
In addition, the stock market in general and the market prices for
technology companies in particular have experienced extreme volatility that
often has been unrelated to the operating performance of these companies. These
broad market and industry fluctuations may adversely affect the market price of
our common stock, regardless of our operating performance. Recently, when the
market price of a stock has been volatile, holders of that stock have often
instituted securities class action litigation against the company that issued
the stock. If any of our stockholders brought a lawsuit against us, we could
incur substantial costs defending the lawsuit. The lawsuit could also divert the
time and attention of our management.
The general economic uncertainties in the United States and abroad
continue to cause significant volatility in the stock markets. The continued
threat of terrorism in the United States and abroad and the ongoing military
action and heightened security measures undertaken in response to that threat
can be expected to cause continued volatility in securities markets. In
addition, foreign political unrest may continue to adversely affect the economy.
WE MAY LOSE MONEY ON FIXED-PRICE CONSULTING CONTRACTS.
Although the majority of our services have historically been performed on
a time and material basis, we have in the past performed services under fixed
price contracts at the request of a customer. In the future, it is possible that
an increased portion of our services revenues could be derived from fixed-price
contracts, particularly since we assumed several fixed-price contract
obligations as a result of the Business Layers acquisition. We work with complex
technologies in compressed time frames and it can be difficult to judge the time
and resources necessary to complete a project. If we miscalculate the resources
or time we need to complete work under fixed-price contracts, we may suffer
losses, and our operating results could be materially adversely affected.
CONTINUED WEAKNESS IN THE GLOBAL ECONOMY MAY ADVERSELY AFFECT OUR BUSINESS.
The global economy is still weak and may continue to be weak in the
foreseeable future. In addition, the United States' continued involvement in
Iraq, as well as the political unrest in other parts of the world, have
contributed to global economic uncertainty. We believe the current economic
slowdown has caused some potential or current customers to defer purchases. In
response to the current economic conditions, many companies have reduced their
spending budgets for information technology products and services, which could
reduce or eliminate potential sales of our products and services.
CERTAIN PROVISIONS OF OUR CHARTER AND OF DELAWARE LAW MAKE A TAKEOVER OF OUR
COMPANY MORE DIFFICULT.
Our corporate documents and Delaware law contain provisions that might
enable us to resist a takeover of our company. These provisions might discourage
or delay a change in the control of Netegrity or a change in our management.
These provisions could also discourage proxy contests and make it more difficult
for you and other stockholders to elect directors and take other corporate
actions. The existence of these provisions could limit the price that investors
might be willing to pay in the future for shares of our common stock.
Additionally, we have entered into employment and executive retention agreements
with certain employees and executive officers which, among other things, include
certain severance and change of control provisions that may have similar
effects.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency
In the three and six months ended June 30, 2004, we generated
approximately 39% and 31%, respectively, of our revenues outside of the United
States. Our international sales are typically denominated in U.S. dollars. Our
foreign subsidiaries incur most of their expenses in the local currency.
Accordingly, all foreign subsidiaries use the local currency as their functional
currency. Translation gains and (losses) (which were $98,000 as of June 30,
2004) are deferred and accumulated as a separate component of stockholders'
equity (accumulated other comprehensive income (loss)). Net gains and (losses)
resulting from foreign exchange transactions, which were ($14,000) and ($2,800)
for the three and six months ended June 30, 2004, respectively, are included in
other income, net in the accompanying condensed consolidated statements of
operations. A 10% change in the valuation of the functional currencies relative
to the U.S. dollar as of June 30, 2004 would not have a material impact on our
results of operations for the three and six months ended June 30, 2004.
Interest Rates
We invest our cash in a variety of financial instruments including
floating rate bonds, municipal bonds, asset-backed securities and money market
instruments in accordance with an investment policy approved by our Board of
Directors. These investments are denominated in U.S. dollars. Cash balances in
foreign currencies overseas are operating balances and are only invested in
short-term deposits of the local operating bank.
Investments in both fixed rate and floating rate interest earning
instruments carry a degree of interest rate risk. However, due to the
conservative nature of our investment portfolio, a sudden change in interest
rates would not have a material effect on the value of the portfolio. We
estimate that if the average yield of our investments had decreased by 100 basis
points, our interest income for the quarter ended June 30, 2004 would have
decreased by less than $100,000. This estimate assumes that the decrease
occurred on the first day of the year and reduced the yield of each investment
instrument by 100 basis points. The same 100 basis point change in interest
rates would not have a material impact on the fair value of the investment
portfolio. The impact on our future interest income and future changes in
investment yields will depend largely on the gross amount of our investment
portfolio.
ITEM 4. CONTROLS AND PROCEDURES
Our management, with the participation of our Chief Executive Officer and
Chief Financial Officer, evaluated the effectiveness of our disclosure controls
and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange
Act) as of June 30, 2004. Based on such evaluation, our Chief Executive Officer
and Chief Financial Officer have concluded that, as June 30, 2004, our
disclosure controls and procedures were (1) designed to ensure that material
information relating to Netegrity, including our consolidated subsidiaries, is
made known to our Chief Executive Officer and Chief Financial Officer by others
within those entities, particularly during the period in which this report was
being prepared and (2) effective, in that they provide reasonable assurance that
information required to be disclosed by us in the reports that we file or submit
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the SEC's rules and forms.
No change in our internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal
quarter ended June 30, 2004 that has materially affected or is reasonably likely
to materially affect, our internal control over financial reporting.
29
PART II. - OTHER INFORMATION
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 26, 2004, we held our 2004 Annual Meeting of Stockholders. At the
meeting, all of the nominees for director were elected. The votes cast for the
election of directors were as follows:
DIRECTOR VOTES FOR VOTES WITHHELD
- ---------------------------- ------------- --------------
Barry N. Bycoff 33,271,936 743,327
Eric R. Giler 24,821,645 9,193,618
Lawrence D. Lennihan, Jr. 32,682,982 1,332,281
Ralph B. Wagner 32,409,172 1,606,091
Ronald T. Maheu 33,248,017 767,246
Sandra E. Bergeron 32,440,824 1,574,439
Also at the meeting, our 2004 Stock Incentive Plan was approved. The votes
cast for the approval of the 2004 Stock Incentive Plan were as follows:
ADOPTION OF 2004 STOCK BROKER
INCENTIVE PLAN VOTES FOR VOTES AGAINST ABSTENTIONS NON-VOTES
------------ -------------- ------------ -----------
19,373,927 5,849,003 53,931 8,738,402
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EXHIBIT
ITEM NO. ITEM AND REFERENCE
- -------- --------------------------------------------------------------------------------
31.1 Rule 13a-14(a)/15d-14(a) Certification of President and Chief Executive Officer.
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer and Treasurer.
32.1 Section 1350 Certification of President and Chief Executive Officer.
32.2 Section 1350 Certification of Chief Financial Officer and Treasurer.
(b) Reports on Form 8-K
None.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: August 3, 2004 By: /s/ Barry N. Bycoff
-------------------
Barry N. Bycoff
President, Chief Executive Officer,
Director and Chairman of the Board
Date: August 3, 2004 By: /s/ Regina O. Sommer
----------------------
Regina O. Sommer
Chief Financial Officer and
Treasurer (Principal Financial
Officer and Principal Accounting
Officer)
31