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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
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|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 (FEE REQUIRED)
For the Fiscal Year Ended September 30, 1999
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
For the transition period from ____________ to ____________ .
Commission File No. 000-23783
MICROMUSE INC.
(Exact name of registrant as specified in its charter)
Delaware 94-3288385
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
139 Townsend Street
San Francisco, California 94107
(415) 538-9090
(Address of Principal Executive Office, including ZIP code, and
telephone number)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
(Title of class)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |_|
The aggregate market value of the Registrant's common stock, $.01 par value,
held by non-affiliates of the Registrant on November 30, 1999 was approximately
$1.8 billion. As of November 30, 1999, there were 16,305,242 shares of
Registrant's common stock, $.01 par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Registrant's definitive proxy statement (the "Proxy Statement") to
be mailed to stockholders in connection with its 1999 annual meeting of
stockholders scheduled to be held on January 26, 2000, are incorporated by
reference into Part III of this report. Except as expressly incorporated by
reference, the Registrant's Proxy Statement shall not be deemed to be part of
this report.
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MICROMUSE INC.
TABLE OF CONTENTS
Page
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PART I
Item 1. Business 3
Item 2. Properties 9
Item 3. Legal Proceedings 9
Item 4. Submission of Matters to a Vote of Security Holders 9
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters 10
Item 6. Selected Financial Data 11
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 12
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
Derivatives and Financial Instruments 26
Item 8. Financial Statements and Supplementary Data 27
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosures 42
PART III
Item 10. Directors and Executive Officers of the Registrant 42
Item 11. Executive Compensation 43
Item 12. Security Ownership of Certain Beneficial Owners and Management 43
Item 13. Certain Relationships and Related Transactions 43
PART IV
Item 14 Exhibits, Financial Statement Schedule, and Reports on Form 8-K 43
Signatures 44
2
PART I
This document contains forward-looking statements that involve risks and
uncertainties. The Company's actual results may differ materially from the
results discussed in such forward-looking statements. Factors that might cause
such differences include, but are not limited to, fluctuations in customer
demand, the Company's ability to manage its growth, risks associated with
competition and risks identified in the Company's Securities and Exchange
Commission filings, including, but not limited to, those discussed elsewhere in
this Form 10-K under the heading "Risk Factors."
Item 1. Business
Micromuse develops, markets and supports a family of scalable, highly
configurable, rapidly deployable software solutions that enable fault and
Service-Level Management ("SLM") -- the effective monitoring and management of
multiple elements underlying an Information Technology infrastructure, including
network devices, computing systems and applications, and the mapping of these
elements to the business services they impact. Our Netcool(R) product suite
collects, normalizes and consolidates high volumes of event information from
heterogeneous network management environments into an active database that
de-duplicates and correlates the resulting data in real-time, and then rapidly
distributes graphical views of the information to operators and administrators
responsible for monitoring service levels. Netcool's unique architecture allows
for the rapid, programmerless association of devices and specific attributes of
those devices to the business services they impact. This readily enables
administrators to create and modify their service views during systems
operations to monitor particular business services, rapidly identify which users
are affected by which network faults, pinpoint sources of network problems,
automate operator responses, facilitate problem resolution and report on the
results. We market and distribute to customers through our own sales force,
OEMs, value-added resellers and systems integrators. We have distribution
agreements with Cisco Systems, CTC (Itochu), Datacraft, Ericsson Data Services,
Lucent Technologies, N.E.T., Unisphere (Siemens), and Vanstar. As of September
30, 1999, we had over 440 customers operating in and serving a variety of
industries. Customers include AirTouch, America Online, AT&T, BT, Cable &
Wireless, Cellular One, Charles Schwab, Deutsche Telekom, GEIS, GTE, ICG
Communications, ITC^DeltaCom, JC Penney, MCI Worldcom, MindSpring Enterprises
and a number of financial investment concerns.
Products and Technology
Micromuse provides a suite of software products that enable fault and SLM. Our
Netcool fault and SLM solution includes Netcool/OMNIbus and its components for
event management: Netcool/Reporter for service-level reporting; Netcool/Internet
Service Monitors for the proactive management of internet services;
Netcool/FireWall-1 for real-time security; Netcool/Fusion for cross-platform
fault isolation and to maintain the availability of mainframe-based services and
business processes; Netcool/NTSM for maintaining the availability of Microsoft
Windows NT(R) -based resources; Netcool/Impact for impact analysis and to
facilitate policy-based management and associated related technical services.
Netcool/OMNIbus for collection, consolidation, de-duplication and correlation of
information from a wide range of network management platforms and devices and
then presents user-configurable views of subsets of network data.
Netcool/Reporter uses this data to provide real-time and historical reporting.
Netcool/Internet Service Monitors collect response and availability data from
several frequently implemented Internet/Intranet services and forward this
information to Netcool/OMNIbus for integration with other service data. Since
customers can quickly associate each network element (a network device,
computing system or application) with a particular service, Netcool products
enable companies to efficiently set up, monitor, manage and report on Service
Level Agreements ("SLA").
Netcool/OMNIbus
Netcool/OMNIbus is based on a three-tier, client/server architecture and is a
core application of the product suite. Netcool/OMNIbus consists of four
components: Netcool/OMNIbus Probes, the Netcool/ OMNIbus ObjectServer,
Netcool/OMNIbus Desktops, and Netcool/OMNIbus Gateways. Probes collect event
information from existing network management systems, as well as event messages
from network devices, computing systems, applications or legacy systems. The
Probes then normalize and feed this event data into the ObjectServer, an
object-oriented, memory-resident active database. At the ObjectServer, the event
data is de-duplicated, correlated and associated with other event data. By
manipulating the data in the ObjectServer through the Desktops, users can design
customized views of event data to monitor segments of the network or services
that span the entire network. Gateways permit data to be shared between multiple
ObjectServers for load balancing or fail-over facilities, exported to common
relational database management systems (Oracle or Sybase) for historical service
level views, or integrated with other applications such as Remedy's helpdesk
application.
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Probes
Probes are the first tier of Netcool's three-tier architecture. Probes are
primarily passive software interfaces that collect network event data (including
messaged network data such as faults, alerts, and traps) from elements on the
network or from domain-based network management systems. These Probes can
collect information presented from either management platforms and devices
(e.g., HP OpenView, Cabletron SPECTRUM, Cisco StrataView Plus, and Newbridge
46020) and standard protocols such as screen oriented ASCII character streams,
application log files (e.g., syslog) TL1, SMNP, or any other method of
management information provision. They recognize Management Information Base
("MIB") information from switches and routers from leading vendors, including
Nortel, Cabletron, Cisco, 3Com and N.E.T. Probes use rules and lookup tables to
categorize and add information to events. As a result, network data collected by
the Probes is normalized into a common alert format and then passed to the
ObjectServer.
ObjectServer
The ObjectServer, which is the second tier of Netcool's three-tier architecture,
is a real-time, object-oriented, memory-resident, active database which stores
and manages the collected network events. The ObjectServer consolidates,
associates and de-duplicates normalized data from the Probes, converting events,
such as faults and alarms, into event objects that can be easily manipulated to
create associations and filters. The active components of the ObjectServer
include its de-duplication capability and its ability to correlate event objects
with other event objects, make decisions on information, automate operator
responses and facilitate problem resolution. The ObjectServer, which has been
designed and optimized for handling large volumes of events messages, can
process hundreds of alarms per second and can collect data from multiple Probes
concurrently. The ObjectServer architecture also permits multiple authenticated
users to view all the events throughout the enterprise. In addition, since one
network fault can impact several locations in a distributed environment and can
therefore trigger multiple events, the ObjectServer is designed to automatically
de-duplicate repeated events so that network operators can easily identify the
root cause. We believe that the ObjectServer architecture provides us with a
competitive advantage in both the speed with which it collects network events
and the ability to associate event information with the services it manages.
Desktops
The Desktop, the third tier in Netcool's three-tier architecture, is an
integrated suite of software tools designed for use by operators and
administrators to create filters, customize views of network event data, monitor
several services simultaneously, and automatically resolve service problems.
Network operators can quickly build filters by responding to simple onscreen
queries about user preferences. They can also associate events with services
through the use of simple "drag-and-drop" technology that automatically creates
the Boolean logic and SQL required to retrieve the data from the ObjectServer.
In this way, non-programmers can manipulate the data in the ObjectServer to
custom-design views of event data. In addition, each operator can use Desktops
to resolve element problems directly or automate responses to common network
problems when critical thresholds are reached.
Operators can use Desktops to monitor services through EventLists, the EventList
Console or ObjectiveView. The EventList presents a configurable spreadsheet-like
view of the de-duplicated faults and acts as the primary interface through which
operators access problem resolution tools. The EventList Console depicts a
concise view of the EventLists for several services while the ObjectiveView
provides a graphical view of the network or services that depend upon it.
Administrators can use Desktops to configure the ObjectServer and the operator's
desktop environments. Desktops run on multiple computing platforms, including
UNIX/ Motif, Microsoft Windows NT, or Web browsers via Java applications.
Gateways
Gateways are interfaces to other Micromuse products or to third-party
applications that allow sharing of Netcool event data. For example, multiple
Netcool ObjectServers can share data using a Gateway to offer customers
load-balancing and fail-over facilities. In addition, event data can be exported
through Gateways to databases such as Oracle or Sybase for historical analysis
and reporting or to trouble-ticketing packages such as Remedy's help desk
application.
Netcool/Reporter
Netcool/Reporter is a Java-based application that generates reports on the
real-time and historical availability of network services, applications,
business processes or any customer-defined grouping of IT resources (both
physical and logical). Netcool/Reporter is designed to leverage archived data
from service profiles created within Netcool/OMNIbus, and to allow operators to
report on SLA
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compliance. Netcool/ Reporter can produce availability data in several graphical
formats, including spreadsheets, 2D or 3D charts, and billing forms.
Netcool/Reporter provides both Service Level Reports and generic reports.
Service Level Reports allow operators to define individualized service levels by
designing their own report metrics. They can also be tailored to precisely match
the service level availability criteria described by SLAs. Generic reports are
pre-configured reports that use event time and frequency categories as the
primary variables.
Netcool/Internet Service Monitors
Netcool/Internet Service Monitors are software applications that collect and
analyze real-time response and availability data about internet services
including HTTP (Web servers), FTP (file transfer), SMTP and POP3 (e-mail), NNTP
(news), DNS (directory services), and RADIUS (dial-in security and accounting).
Netcool/Internet Service Monitors collect response and availability data,
compare it with user-defined threshold levels, and then forward fault
information to Netcool/ OMNIbus when thresholds are exceeded. The resulting
information can be combined with other network fault data to provide companies
with detailed information about services that incorporate Internet-based
elements. Netcool/Internet Service Monitors can be configured through the World
Wide Web through an HTML interface and are designed to integrate easily with
networks managed by Netcool/OMNIbus.
Netcool/FireWall-1
The Netcool/FireWall-1 Probe is a real-time security application designed to
help managers in secure operations centers resolve network-related events before
they disrupt business services or cause a security breach. By monitoring
operations, Netcool/FireWall-1 adds an extra layer of security to the NOC. In
addition, it supports existing enterprise-wide security management policies.
The Netcool/FireWall-1 Probe collects security information from Check Point
Software's FireWall-1 platform and integrates it with Netcool ObjectServer data
from other sources, providing a complete end-to-end view of enterprise events.
It lets security operations personnel view all security events together in
precise service-specific views. Netcool/FireWall-1 generates events when
security policy is changed on any firewall, if a new firewall is added, or if a
firewall is stopped or started.
Netcool/Fusion
Netcool/Fusion bridges the SLM gap between IBM mainframe environments and the
global Network Operations Center ("NOC"). It provides NOC operators with a
window into the mainframe's systems management, enabling them to perform
cross-platform fault isolation and maintain the availability of mainframe-based
services and business processes.
Micromuse designed Netcool/Fusion to streamline operations and reduce costs by
consolidating multiple, disparate event streams. Typically, IBM mainframe-type
alerts (from VTAM sessions, MVS subsystems, etc.) are consolidated with messages
other network-based services such as IP/SNMP traps, UNIX syslog messages, NT
events, and other sources.
Netcool/NTSM
The Netcool/NTSMs suite is designed to maintain the availability of Microsoft
Windows NT(R) -based resources. NT management architectures are typically
resource consumptive, difficult to deploy, and expensive, making resource
management difficult especially in organizations with large, distributed
networks.
Netcool/NTSMs collect NT events from the NOC in real-time. Specifically,
Netcool/NTSMs capture performance, availability, status, log, and security data
from NT applications and resources.
Netcool/Impact
Netcool/Impact is a new application that leverages the power of the Netcool
ObjectServer. It is designed to help Netcool EventList operators answer three
fundamental questions when faced with a critical event:
1) WHAT specific business processes, applications, and people are
affected? (Impact Analysis)
2) HOW do I prioritize work to handle the most critical tasks first?
(Response and Prioritization)
3) WHO is responsible at this moment in time for this problem and what
policy do they follow to fix it as rapidly as possible?
(Policy-Based Fault Management)
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Netcool/Impact provides impact analysis and facilitates policy-based management
of real-time events and operator-initiated queries by leveraging data from
different data sources and using it to define and enforce policies.
Sales and Marketing
We market our software and services primarily through our direct sales
organization with offices in San Francisco; Dallas; New York; Washington, D.C.;
London; Paris; Vienna, Austria; Frankfurt; and Sydney. Additionally, we have a
growing channel consisting of OEMs, value-added resellers and systems
integrators.
Typically, the sales process will include an initial sales presentation, a
product demonstration; at times a proof of concept evaluation, a closing meeting
and a purchase process. The sales process typically takes three to six months.
Companies often purchase Netcool products to manage their internal data network
initially and upon its demonstrated effectiveness subsequently make additional
and larger purchases. A majority of our sales are from repeat customers who
generally purchase additional software as their networks expand, or as
additional sites within a customer learn of the services provided by, and the
benefits of, Netcool.
We have a number of marketing programs designed to inform potential customers
about the capabilities and benefits of our products. Our marketing efforts
include technical leadership, participation in industry trade shows, technical
conferences and technology seminars, preparation of competitive analyses, sales
training, publication of technical and educational articles in industry journals
and advertising.
Although we increased the size of our sales organization during the year ended
September 30, 1999, we experienced difficulty in recruiting a sufficient number
of qualified sales people during that period. If we are to achieve significant
revenue growth in the future, we must both train successfully the members of our
existing sales force and recruit additional sales personnel. Competition for
such persons is intense, and there can be no assurance that we will be able to
either retain and adequately train our current sales force or attract qualified
sales personnel in the future. During the last fiscal year, we promoted Mike
Donahue to Senior Vice President, Sales and Business Operations, who is expected
to be heavily involved, among other things, in the recruitment of additional
sales personnel. Consequently, we are expected to have additional management
capacity to assist in the recruitment of additional sales personnel. If we are
unable to hire such people on a timely basis, our business, operating results or
financial condition could be adversely affected. See "Risk Factors -- We Need to
Expand and Improve the Productivity of Our Sales Force, Technical Services and
Customer Support Organization."
To achieve significant growth in revenues in the future we must continue to
improve the performance of our network of distribution partners. Our network of
distribution partners currently includes VARs, systems integrators and OEM
partners, including Cisco, CTC (Itochu), Datacraft, Ericsson Data Services,
Lucent Technologies, N.E.T., Unisphere (Siemens) and Vanstar Corporation. Such
partners license our products at a discount to list price for re-licensing and
may provide training, support and technical and customer services to the end
users of the our products. At times, members of our technical services
organization will assist a channel partner with training and technical support.
We offer a comprehensive channel-partnering program consisting of training,
certification, technical support, priority communications regarding upcoming
activities and products, and joint sales and marketing activities. There can be
no assurance that we will be able to continue to attract and retain VARs,
systems integrators and OEMs or that such organizations will be able to market
and sell our products effectively. In addition, there can be no assurance that
our existing or future channel partners will continue to represent our products.
See "Risk Factors -- We Need to Expand Our Distribution Channels; We Depend on
Third-Party Relationships."
Because we first sold our software in the United Kingdom and were previously
domiciled in London, sales of our software outside of the United States (i.e.,
"international sales") have historically comprised a significant portion of our
total revenue. International sales accounted for 29%, 39% and 48% of total
revenues in fiscal 1999, 1998 and 1997, respectively. We believe that a majority
of these international sales were made to customers in the United Kingdom and
Europe. While we believe there are significant opportunities in Europe, we
expect international revenues from Europe as a percentage of total revenues to
decline in future periods as we more fully exploit opportunities in the United
States and in the Pacific Rim. See "Risk Factors -- We have Risks Associated
With International Licensing and Operations."
Technical Services
Our technical services organization provides customers with a full range of
support services including pre-sales demonstrations, evaluations,
implementations, consulting services, training and ongoing technical support. In
addition, the technical services
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organization serves a variety of internal functions, including drafting support
and training documentation, product management, product testing, research and
development related to specific customer industries. We believe that superior
technical services and support are critical to customer satisfaction and the
development of customer relationships.
Our recent growth and the expansion of the customer base of Netcool have
increased the demands on our technical services organization. Competition for
qualified technical personnel is intense. There can be no assurance that the
current resources in our technical services organization will be sufficient to
manage any future growth in our business. The failure to expand our technical
services organization at least commensurate with the expansion in the installed
base of Netcool products would have a material adverse effect on our business,
operating results and financial condition. See "Risk Factors -- We Need to
Expand and Improve the Productivity of Our Sales Force, Technical Services and
Customer Support Organization" and "-- We Depend on Key Personnel."
Customer Support
The customer support organization is responsible for providing ongoing technical
support for our customers after implementation of the product and for training
the next generation of our software engineers and technical services personnel.
Based on feedback by customers, we believe that the quality and responsiveness
of our customer support organization provides it with a significant competitive
advantage.
For an annual fee, a customer will receive toll-free telephone and email
support, as well as new releases of our products. We offer two support packages
to our customers: 8 hours a day, 5 days a week support or 24 hours a day, 7 days
a week support. While support personnel generally answer the technical support
calls and resolve most problems over the phone, we will deploy any one of our
technical support personnel in the event that an on-site visit is necessary.
Research and Development
We believe that our future success depends in large part on our ability to
continue to enhance existing products and develop new products that maintain
technological and operational competitiveness and leadership and deliver rapid
ROI to our customers. We have historically developed and expect to continue to
develop our products in conjunction with our existing and potential customers.
Extensive product development input is obtained through customers, through our
monitoring of end-user needs and changes in the marketplace and through
partnerships with leading research institutes such as Cambridge University
Centre for Communication Systems Research.
Our research and development organization is composed of two related engineering
groups. The core technology group is responsible for the enhancement of
Netcool/OMNIbus, including our real-time technologies and the exploration of new
directions and applications of our core ObjectServer, Probe, Gateway and Desktop
technologies. The application development group is responsible for designing and
developing off-the-shelf products that leverage the technologies developed by
the core technology group. While both groups work closely with customers, the
application development group depends on customer contact and partnerships for
the rapid development of new fault and SLM products. Both research and
development groups work closely with our technical services organization and our
marketing organization to incorporate customer feedback and market requirements
into their product development agendas.
We have made and intend to continue to make substantial investments in research
and development. Our total expenses for research and development for fiscal
1999, 1998 and 1997 were $9.5 million, $5.5 million and $2.0 million,
respectively. Since we anticipate that we will continue to commit substantial
resources to research and development in the future, product development
expenses are expected to increase in absolute dollars in future periods. To
date, our development efforts have not resulted in any capitalized software
development costs.
The market for our products is characterized by rapidly changing technologies,
evolving industry standards, changing regulatory environments, frequent new
product introductions and rapid changes in customer requirements. The
introduction or announcement of products by the Company or our competitors
embodying new technologies and the emergence of new industry standards and
practices can render existing products obsolete and unmarketable. As a result,
the life cycles of our products are difficult to estimate. Our future success
will depend on our ability to enhance our existing products and to develop and
introduce, on a timely and cost-effective basis, new products and product
features that keep pace with technological developments and emerging industry
standards and that address the increasingly sophisticated needs of our
customers. There can be no assurance that we will be successful in developing
and marketing new products or product features that respond to technological
change or evolving industry standards, that we will not experience difficulties
that could delay or prevent the successful development, introduction and
marketing of these new products and
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features, or that our new products or product features will adequately meet the
requirements of the marketplace and achieve market acceptance. In particular,
the widespread adoption of the Telecommunications Management Network ("TMN")
architecture for managing telecommunications networks would force us to adapt
our products to such standard, and there can be no assurance that this could be
done on a timely or cost-effective basis, if at all. In addition, to the extent
that any product upgrade or enhancement requires extensive installation and
configuration, current customers may postpone or forgo the purchase of new
versions of our products. If we are unable, for technological or other reasons,
to develop and introduce enhancements of existing products or new products in a
timely manner, our business, operating results and financial condition will be
materially adversely affected. See "Risk Factors --We Need to Manage New
Products, Transitions and Rapid Technological Change; We Depend on Third-Party
Software Platforms." In addition, software products as complex ours may contain
defects or failures when introduced or when new versions or enhancements are
released. For example, the initial commercial release of Netcool/Reporter had
features and performance characteristics that had limited market appeal. See
"Risk Factors -- Product Defects Would Impair Our Business."
Competition
Our products are designed for use in the evolving SLM and enterprise network
management markets. Competition in these markets is intense and is characterized
by rapidly changing technologies, new and evolving industry standards, frequent
new product introductions and rapid changes in customer requirements. Our
current and prospective competitors offer a variety of solutions to address the
SLM and enterprise network management markets and generally fall within the
following five categories: (i) customer's internal design and development
organizations that produce SLM and network management applications for their
particular needs, in some cases using multiple instances of products from
hardware and software vendors such as Sun Microsystems, Inc. ("Sun"),
Hewlett-Packard Company ("HP") and Cabletron Systems, Inc. ("Cabletron"); (ii)
vendors of network and systems management frameworks including Computer
Associates International, Inc. ("CA"), Compaq TeMIP and International Business
Machines Corporation ("IBM"); (iii) vendors of network and systems management
applications including HP, BMC Software, Inc, Sun and IBM; (iv) providers of
specific market applications; and (v) systems integrators serving the
telecommunications industry which primarily provide programming services to
develop customer specific applications including TCSI Corporation (formerly
Teknekron Communications Systems, Inc.) and Objective Systems Integrators, Inc.
("OSI"). In the future, as we enter new markets, we expect that such markets
will have additional, market-specific competitors. In addition, because there
are relatively low barriers to entry in the software market, we have become
aware of new and potential entrants in portions of our market space and we
expect additional competition from these and other established and emerging
companies. Increased competition may result in price reductions and may result
in reduced gross margins and loss of market share, any of which could materially
adversely affect our business, operating results or financial condition.
Some of our existing and potential customers and distributors continuously
evaluate whether to design and develop their own network operations support and
management applications or purchase them from outside vendors. Sometimes these
customers internally design and develop their own software solutions for their
particular needs and therefore may be reluctant to purchase products offered by
independent vendors such as ours. As a result, we must continuously educate
existing and prospective customers as to the advantages of our products versus
internally developed network operations support and management applications.
Many of our current and potential competitors have longer operating histories
and have significantly greater financial, technical, sales, marketing and other
resources, as well as greater name recognition and a larger customer base, than
we do. As a result, they may be able to devote greater resources to the
development, promotion, sale and support of their products or to respond more
quickly to new or emerging technologies and changes in customer requirements
than we can. Existing competitors could also increase their market share by
bundling products having management functionality offered by our products with
their current applications. Moreover, our current and potential competitors may
increase their share of the SLM market by strategic alliances and/or the
acquisition of competing companies. In addition, network operating system
vendors could introduce new or upgrade and extend existing operating systems or
environments that include management functionality offered by our products,
which could render our products obsolete and unmarketable. There can be no
assurance that we will be able to compete successfully against current or future
competitors or that competitive pressures faced by us will not materially
adversely affect our business, operating results or financial condition.
Intellectual Property and Other Proprietary Rights
Our success and ability to compete is dependent in significant part upon our
proprietary software technology. We rely on a combination of trade secret,
copyright and trademark laws, nondisclosure and other contractual agreements and
technical measures to protect our proprietary rights and, in the future,
patents.. Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy aspects of our products or to obtain and use
information that we regard as proprietary. There can be no assurance that the
steps taken by us to protect our proprietary technology will prevent
misappropriation of such technology, and such protections may
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not preclude competitors from developing products with functionality or features
similar to our products. In addition, effective copyright and trade secret
protection may be unavailable or limited in certain foreign countries. While we
believe that our products and trademarks do not infringe upon the proprietary
rights of third parties, there can be no assurance that we will not receive
future communications from third parties asserting that our products infringe,
or may infringe, the proprietary rights of third parties. We expect that
software product developers will be increasingly subject to infringement claims
as the number of products and competitors in our industry segment grows and the
functionality of products in different industry segments overlaps. Any such
claims, with or without merit could be time-consuming, result in costly
litigation and diversion of technical and management personnel, cause product
shipment delays or require us to develop non-infringing technology or enter into
royalty or licensing agreements. Such royalty or licensing agreements, if
required, may not be available on terms acceptable to us or at all. In the event
of a successful claim of product infringement against us and our failure or
inability to develop non-infringing technology or license the infringed or
similar technology, our business, operating results or financial condition could
be materially adversely affected.
We rely on certain software that we license from third parties, including
software that is integrated with internally developed software and used in our
products to perform key functions. There can be no assurance that these
third-party software licenses will continue to be available to us on
commercially reasonable terms or at all. Although we believe alternative
software is available from other third-party suppliers, the loss of or inability
to maintain any of these software licenses or the inability of the third parties
to enhance in a timely and cost-effective manner their products in response to
changing customer needs, industry standards or technological developments could
result in delays or reductions in our product shipments until equivalent
software could be developed internally or identified, licensed and integrated,
which would have a material adverse effect on our business, operating results
and financial condition. See "Risk Factors -- We Rely Upon Proprietary
Technology; We Risk Third-Party Claims of Infringement."
Employees
As of September 30, 1999, we had 321 employees. None of our employees are
represented by a collective bargaining agreement, nor have we experienced work
stoppages. We believe that our relations with our employees are good.
We believe that our future success will depend in large part on our ability to
attract and retain highly-skilled managerial, sales, technical services,
customer support and product development personnel. We have at times experienced
and continue to experience difficulty in recruiting qualified personnel.
Competition for qualified personnel in the software industry is intense, and
there can be no assurance that we will be successful in attracting and retaining
such personnel. Failure to attract and retain key personnel could materially
adversely affect on our business, operating results or financial condition. See
"Risk Factors -- We Need to Manage Growth; We Need to Improve Our
Infrastructure," "-- We Need to Expand and Improve Productivity of Our Sales
Force, Technical Services and Customer Support Organization" and "-- We Depend
on Key Personnel."
Item 2. Properties
Our headquarters are located in 11,235 square feet of office space in San
Francisco, under a lease that expires in April 2002. Our principal product
development operations as well as our European headquarters are located in
approximately 30,077 square feet of office space in London pursuant to a lease
that expires in April 2009. We also maintain offices in New York City; Dallas;
Washington D.C.; Paris; Vienna, Austria; Frankfurt and Sydney. We believe that
our current facilities are adequate for our needs through the next twelve
months, and that, should it be needed, suitable additional space will be
available to accommodate expansion of our operations on commercially reasonable
terms, although there can be no assurance in this regard. See Note 10 of Notes
to Consolidated Financial Statements.
Item 3. Legal Proceedings
The Company is not a party to any material legal proceeding.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the fourth
quarter of the fiscal year ended September 30, 1999.
9
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters
Price Range of Common Stock
Our common stock is traded publicly on the Nasdaq National Market under the
symbol "MUSE." The following table sets forth for the periods indicated the high
and low closing prices of the common stock since the Company went public at
$12.00 per share on February 13, 1999*:
1999 1998
---------------------- ----------------------
High Low High Low
---------- ---------- ---------- ----------
September 30 $66.00 $44.50 $41.13 $13.75
June 30 51.25 32.63 40.81 21.50
March 31* 46.00 20.56 26.63 18.88
December 31* 23.88 8.00
On November 30, 1999, the closing price of the common stock on the Nasdaq
National Market was $114.38 per share. As of November 30, 1999, there were
approximately 93 holders of record (not including beneficial holders of stock
held in street name) of the common stock.
Dividend Policy
We did not declare or pay any cash dividends on our capital stock during fiscal
1999, 1998 and 1997 and do not expect to do so in the foreseeable future. We
anticipates that all future earnings, if any, generated from operations will be
retained by us to develop and expand our business. Any future determination with
respect to the payment of dividends will be at the discretion of the Board of
Directors and will depend upon, among other things, our operating results,
financial condition and capital requirements, the terms of then-existing
indebtedness, general business conditions and such other factors as the Board of
Directors deems relevant.
10
Item 6. Selected Financial Data
Consolidated Statements of Operations Data:
(In thousands, except per share amounts)
Year ended September 30,
--------------------------------------------------------
Revenues: 1999 1998 1997 1996 1995
--------------------------------------------------------
License $ 43,692 $ 22,432 $ 6,968 $ 3,374 $ 1,077
Maintenance and services 14,378 5,829 2,324 1,141 369
--------------------------------------------------------
Total revenues 58,070 28,261 9,292 4,515 1,446
Cost of revenues:
License 2,379 1,320 523 311 163
Maintenance and services 7,465 3,491 1,042 384 102
--------------------------------------------------------
Total cost of revenues 9,844 4,811 1,565 695 265
--------------------------------------------------------
Gross profit 48,226 23,450 7,727 3,820 1,181
Operating expenses:
Sales and marketing 27,420 15,710 8,970 1,768 728
Research and development 9,453 5,535 2,042 1,582 708
General and administrative 5,998 4,521 4,244 996 584
Executive recruiting costs 720 -- -- -- --
--------------------------------------------------------
Total operating expenses 43,591 25,766 15,256 4,346 2,020
--------------------------------------------------------
Income (loss) from operations 4,635 (2,316) (7,529) (526) (839)
Other income (expense):
Interest income 3480 1,840 64 8 --
Interest expense (341) (312) (1,268) (212) (106)
Other 952 100 (200) 25 --
--------------------------------------------------------
Income (loss) before income taxes 8,726 (688) (8,933) (705) (945)
Income taxes 840 150 -- 100 --
--------------------------------------------------------
Income (loss) from continuing operations 7,886 (838) (8,933) (805) (945)
Discontinued operations:
Income (loss) from discontinued operations -- -- (104) 569 711
Gain on disposition -- -- 1,161 -- --
--------------------------------------------------------
Net income (loss) 7,886 (838) (7,876) (236) (234)
Accretion on redeemable convertible preferred stock -- (1,334) (755) -- --
========================================================
Net income (loss) applicable to holders of common stock $ 7,886 $ (2,172) $ (8,631) $ (236) $ (234)
========================================================
Per share data:
Basic net income (loss) from continuing operations
applicable to holders of common stock $ 0.50 $ (0.07) $ (1.52) $ (0.14) $ (0.17)
Diluted net income (loss) from continuing operations
applicable to holders of common stock $ 0.45 $ (0.07) $ (1.52) $ (0.14) $ (0.17)
Basic net income (loss) applicable to holders of common
stock $ 0.50 $ (0.18) $ (1.35) $ (0.04) $ (0.04)
Diluted net income (loss) applicable to holders of
common stock $ 0.45 $ (0.18) $ (1.35) $ (0.04) $ (0.04)
Weighted average shares used in computing:
Basic net income (loss) per share from continuing
operations applicable to holders of common stock 15,909 11,794 6,373 5,954 5,498
Diluted net income (loss) per share from continuing
operations applicable to holders of common stock 17,504 11,794 6,373 5,954 5,498
Basic net income (loss) per share applicable to holders
of common stock 15,909 11,794 6,373 5,954 5,498
Diluted net income (loss) per share applicable to
holders of common stock 17,504 11,794 6,373 5,954 5,498
11
Consolidated Balance Sheet Data:
(In thousands)
As of September 30,
------------------------------------------------------
1999 1998 1997 1996 1995
------------------------------------------------------
Cash and cash equivalents $ 35,058 $ 22,798 $ 13,741 $ 594 $ 12
Working capital (deficiency) 62,991 58,193 13,181 (847) (383)
Total assets 90,605 80,644 22,740 9,107 5,767
Redeemable convertible preferred stock -- -- 22,865 -- --
Total stockholders' equity (deficit) 70,006 67,718 (7,234) (222) (203)
Quarterly Financial Data:
(In thousands, except per share amounts)
1999: 4th Quarter 3rd Quarter 2nd Quarter 1st Quarter
--------------------------------------------------------
Revenues $ 19,196 $ 15,422 $ 12,624 $ 10,828
Gross profit 15,903 12,847 10,465 9,011
Income from operations 2,513 1,348 224 550
Net income applicable to holders of common stock 2,142 2,377 2,048 1,319
Diluted net income per share $ 0.12 $ 0.14 $ 0.12 $ 0.08
1998: 4th Quarter 3rd Quarter 2nd Quarter 1st Quarter
--------------------------------------------------------
Revenues $ 9,644 $ 7,593 $ 6,195 $ 4,829
Gross profit 8,139 6,478 5,081 3,752
Income (loss) from operations 150 (357) (756) (1,353)
Net income (loss) applicable to holders of common stock 900 161 (1,040) (2,193)
Diluted net income (loss) per share $ 0.05 $ 0.01 $ (0.10) $ (0.35)
1997: 4th Quarter 3rd Quarter 2nd Quarter 1st Quarter
--------------------------------------------------------
Revenues $ 3,671 $ 2,684 $ 1,711 $ 1,226
Gross profit 3,079 2,226 1,423 999
Loss from operations (3,492) (798) (2,464) (775)
Net loss applicable to holders of common stock (3,249) (1,528) (2,985) (869)
Diluted net loss per share $ (0.50) $ (0.23) $ (0.49) $ (0.13)
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis should be read in conjunction with
"Selected Financial Data" and our Consolidated Financial Statements and Notes
thereto included elsewhere in this Form 10-K. This document contains
forward-looking statements that involve risks and uncertainties. Our actual
results may differ materially from the results discussed in such forward-looking
statements. Factors that might cause such differences include, but are not
limited to, fluctuations in customer demand, our ability to manage our growth,
risks associated with competition and risks identified in our most recent
Securities and Exchange Commission filings, including, but not limited to, those
discussed in this Form 10-K under the heading "Risk Factors."
Overview
Micromuse develops, markets and supports a family of scalable, highly
configurable, rapidly deployable software solutions that enable fault and SLM.
The Company was founded in 1989 in London, England, and initially operated a
systems integration business, reselling computer hardware and software products
and providing consulting services, principally for managing networks. Leveraging
our expertise in network management, we developed our Netcool/OMNIbus software,
which we began shipping in January 1995. In March 1997, the Company was
reorganized in Delaware and relocated its headquarters from London to San
Francisco. In connection with the reorganization, we raised $4.9 million through
the sale of equity securities and arranged a $3.0 million credit facility. In
September 1997, we raised an additional $15.9 million through the sale of equity
securities and sold our systems integration business for approximately $400,000,
net of fees. In order to further the growth of the Netcool business, we
completed an initial public offering of common stock on February 12, 1998,
raising approximately $34.2 million, net of fees and expenses. With the proceeds
from the
12
financings and the sale of the systems integration business, we expanded
operations and substantially increased development, sales and administrative
headcount for the Netcool business. On July 28, 1998, we completed a follow-on
offering of common stock, raising approximately $22.9 million, net of fees and
expenses. To accommodate recent growth, to compete effectively and manage future
growth, if any, we will be required to continue to implement and improve
operational, financial and management information systems, procedures and
controls on a timely basis and to expand, train, motivate and manage our
workforce.
Our consolidated financial statements have been restated to reflect the
discontinuation of the operations associated with our systems integration
business. In connection with such sale, the purchaser indemnified us for
work-in-process under existing contracts, warranty claims under completed
contracts and maintenance agreements, but we retained liability for completed
contracts. See Note 2 of Notes to Consolidated Financial Statements for
information concerning this restatement.
Other than those from discontinued operations, all of our revenues have been
derived from licenses for our Netcool family of products and related
maintenance, training and consulting services. We currently expect that
Netcool-related revenues will continue to account for all or substantially all
of our revenues for the foreseeable future. As a result, our future operating
results are dependent upon continued market acceptance of our Netcool products
and enhancements thereto.
As of September 30, 1999, we had licensed our Netcool products to more than 440
customers worldwide. We license our software through our direct sales force,
OEMs and value-added resellers. License revenues from OEMs and resellers
combined, which are recognized upon the shipment to the OEMs and value-added
reseller, accounted for approximately 34%, 26% and 11% of our total license
revenues for fiscal 1999, 1998 and 1997, respectively. Our ability to achieve
significant additional revenue growth in the future will depend substantially on
our success in recruiting and training sufficient sales and technical services
personnel, maintaining our current distribution relationships and establishing
additional relationships with OEMs, resellers and systems integrators.
As a result of our multinational operations and sales, our operating results are
subject to significant fluctuations based upon changes in the exchange rates of
certain currencies, particularly the British pound, in relation to the U.S.
dollar. For example, while our United States headquarters is located in San
Francisco, California, our principal product development operations are located
in London, England. As a result, a substantial portion of our costs and expenses
are denominated in currencies other than the U.S. dollar. For the fiscal years
ended September 30, 1999, 1998 and 1997, license, maintenance and service
revenues outside of the United States accounted for 29%, 39% and 48% of our
total revenues, respectively. See Note 8 of Notes to Consolidated Financial
Statements. Although we will continue to monitor our exposure to currency
fluctuations, there can be no assurance that exchange rate fluctuations will not
have a material adverse effect on our business and operating results.
Subsequent Event
On November 2, 1999, the Company entered into, and subsequently closed, an
agreement to acquire Calvin Alexander Networking, Inc. ("CAN"), a privately-held
company that develops leading-edge network auto-discovery technology. Under the
terms of the acquisition agreement, Micromuse will issue approximately $42
million worth of its common stock to acquire CAN, based on the closing price on
November 2, 1999. The transaction is to be accounted for under the purchase
method of accounting and is to be treated as a tax-free reorganization for
federal income tax purposes. Certain agreements have been made to promote the
retention and motivation of CAN employees. A portion of the consideration for
the transaction is subject to a one-year lock-up agreement and a one-year price
guarantee.
13
Results of Operations
The following table sets forth certain items in our consolidated statements of
operations as a percentage of total revenues, except as indicated:
Year ended September 30,
----------------------------
As a Percentage of Total Revenues: 1999 1998 1997
----------------------------
Revenues:
License 75.2% 79.4% 75.0%
Maintenance and services 24.8% 20.6% 25.0%
----------------------------
Total revenues 100.0% 100.0% 100.0%
Cost of revenues:
License 4.1% 4.7% 5.6%
Maintenance and services 12.9% 12.3% 11.2%
----------------------------
Total cost of revenues 17.0% 17.0% 16.8%
----------------------------
Gross profit 83.0% 83.0% 83.2%
Operating expenses:
Sales and marketing 47.2% 55.6% 96.5%
Research and development 16.3% 19.6% 22.0%
General and administrative 10.3% 16.0% 45.7%
Executive recruiting costs 1.2% -- --
----------------------------
Total operating expenses 75.0% 91.2% 164.2%
----------------------------
Income (loss) from operations 8.0% (8.2)% (81.0)%
Other income (expense):
Interest income 6.0% 6.5% 0.7%
Interest expense (0.6)% (1.1)% (13.6)%
Other 1.6% 0.4% (2.2)%
----------------------------
Income (loss) before income taxes 15.0% (2.4)% (96.1)%
Income taxes 1.4% 0.6% 0.0%
----------------------------
Income (loss) from continuing operations 13.6% (3.0)% (96.1)%
Discontinued operations:
Income (loss) from discontinued operations 0.0% 0.0% (1.1)%
Gain on disposition 0.0% 0.0% 12.4%
----------------------------
Net income (loss) 13.6% (3.0)% (84.8)%
Accretion on redeemable convertible preferred stock 0.0% (4.7)% (8.1)%
----------------------------
Net income (loss) applicable to holders of common stock 13.6% (7.7)% (92.9)%
============================
As a Percentage of Related Revenues:
Cost of license revenues 5.4% 5.9% 7.5%
Cost of maintenance and services revenues 51.9% 59.9% 44.8%
Revenues
Our total revenues are derived from license revenues for our Netcool family of
products, as well as associated maintenance, consulting and training services
revenues. License revenues are recognized upon the acceptance of a purchase
order and shipment of the software provided that the fee is fixed and
determinable, the arrangement does not involve significant customization of the
software and collection of the resulting receivable is probable. Allowances for
credit losses and for estimated future returns are provided for upon shipment.
Credit losses and returns to date have not been material. Maintenance revenues
from ongoing customer support and product upgrades are deferred and recognized
ratably over the term of the maintenance agreement, typically twelve months.
Payments for maintenance fees (on initial order or on renewal) are generally
made in advance and are nonrefundable. Revenues for consulting and training
services are recognized as the services are performed. See Note 1 of Notes to
Consolidated Financial Statements. We have recognized revenue, for all periods
prior to and including September 30, 1997, in accordance with the American
Institute of Certified
14
Public Accountants ("AICPA") Statement of Position ("SOP") No. 91-1 entitled
Software Revenue Recognition. For the fiscal years ended September 30, 1999 and
1998, we have recognized revenue in accordance with AICPA SOP No. 97-2 entitled
Software Revenue Recognition. There was no material change to our accounting for
revenue as a result of the adoption of AICPA SOP No. 97-2.
Our total revenues increased to $58.1 million in fiscal 1999 from $28.3 million
in fiscal 1998 and $9.3 million in fiscal 1997. License revenues increased to
$43.7 million in fiscal 1999 from $22.4 million in fiscal 1998 and $7.0 million
in fiscal 1997, primarily as a result of an increase in the number of product
licenses sold and in average transaction size, reflecting the increased
acceptance of Netcool/OMNIbus, the expansion of our sales organization and the
growing sales of Netcool/Internet Service Monitors, Netcool/Impact and
Netcool/Reporter . Maintenance and services revenues increased to $14.4 million
in fiscal 1999 from $5.8 million in fiscal 1998 and $2.3 million in fiscal 1997,
as a result of providing maintenance and services to a larger installed base in
each successive year. The percentage of our total revenues attributable to
software was 75%, 79% and 75% in fiscal 1999, 1998 and 1997, respectively.
Maintenance and services revenues accounted for 25%, 21% and 25% in fiscal 1999,
1998 and 1997, respectively.
Revenues from U.S. operations were 71%, 61% and 45% of total revenues in fiscal
1999, 1998 and 1997, respectively, reflecting the expansion of our U.S.
operations. International revenues include all revenues other than those from
the United States. See Note 8 of Notes to Consolidated Financial Statements.
To date, our revenues have resulted primarily from sales to the
telecommunications industry, ISPs and investment banks. License revenues from
telecommunications industry customers and ISPs combined accounted for 79%, 68%
and 58% of our total license revenues in fiscal 1999, 1998 and 1997,
respectively. License revenues from investment banks accounted for 7%, 12% and
15% of total license revenues in fiscal 1999, 1998 and 1997, respectively. No
one customer accounted for more than 10% of total revenue in fiscal 1999.
Cost of Revenues
Cost of license revenues consists primarily of technology license fees paid to
third-party software vendors and the costs of software media, packaging and
production. Cost of license revenues decreased as a percentage of license
revenues to 5% in fiscal 1999 from 6% in fiscal 1998 and 8% in fiscal 1997, as a
result of economies of scale.
Cost of maintenance and service revenues consists primarily of personnel-related
costs incurred in providing maintenance, consulting and training to customers.
Cost of maintenance and service revenues decreased as a percentage of
maintenance and service revenues to 52% in fiscal 1999 from 60% in fiscal 1998,
principally due to economies of scale. The increase from 1997 to 1998 was
primarily due to increased personnel, facilities and travel costs associated
with growth in the customer support and technical services organization. We
expect that maintenance and services costs will continue to increase in dollar
amounts in future periods as we continue to hire additional customer support and
technical services personnel and expand our maintenance, consulting and training
activities.
Sales and Marketing Expenses
Sales and marketing expenses consist primarily of salaries, commissions and
bonuses earned by personnel engaged in sales, technical presales and marketing
activities, as well as the costs of trade shows, public relations, marketing
materials and other marketing activities. Sales and marketing expenses increased
to $27.4 million in fiscal 1999 from $15.7 million in fiscal 1998 and $9.0
million in fiscal 1997. The increases in both fiscal 1999 and fiscal 1998
reflected the hiring of additional personnel in connection with the building of
our sales force. Sales and marketing expenses represented 47%, 56% and 97% of
total revenues in fiscal 1999, 1998 and 1997, respectively. These percentage
reductions were primarily due to the increased scale of operations. We expect
that sales and marketing expenses will continue to increase in absolute dollar
amounts in future periods as we continue to hire additional sales, technical
services and marketing personnel, to increase marketing activities and to build
our indirect sales channel.
Research and Development Expenses
Research and development expenses consist primarily of salaries and other
personnel-related expenses and costs of computer systems and software
development tools. Research and development expenses increased to $9.5 million
in fiscal 1999 from $5.5 million in fiscal 1998 and $2.0 million in fiscal 1997.
The increase in research and development expenses in each year was primarily
attributable to increased personnel, additional facilities and an increase in
the computer systems and software development tools required by the additional
personnel. In addition to expanding our research and development facility in
London, we established a research and
15
development team focused on application development in our New York office in
fiscal 1997. Research and development expenses represented 16%, 20% and 22% of
total revenues in fiscal 1999, 1998 and 1997, respectively. These percentage
reductions were primarily due to the increased scale of operations. We expect
that our research and development costs will increase in absolute dollar amounts
as we continue to enhance and extend our core technologies and product lines. To
date, all research and development costs have been expensed as incurred. See
Note 1 of Notes to Consolidated Financial Statements.
General and Administrative Expenses
General and administrative expenses consist primarily of personnel costs for
administration, finance, information systems and human resources, as well as
professional fees. General and administrative expenses increased to $6.0 million
in fiscal 1999 from $4.5 million in fiscal 1998 and $4.2 million in fiscal 1997.
These increases in each year were primarily due to increased staffing,
facilities costs and associated expenses necessary to manage and support our
increased scale of operations and, in fiscal 1997, an additional increase was
due to compensation expenses related to bonus shares issued. General and
administrative expenses as a percentage of total revenues were 10%, 16% and 46%
in fiscal 1999, 1998 and 1997, respectively. The decreases in general and
administrative expenses as a percentage of total revenues in fiscal 1999 and
1998 were primarily attributable to the growth in total revenues and a reduction
in professional fees related to the reorganization in fiscal 1997. We expect
that our general and administrative expenses will increase in absolute dollar
amounts as we expand our administrative staff, add infrastructure and incur
additional costs related to the growth of our business.
Executive Recruiting Costs
The executive recruiting costs include a charge related to the fair value of the
warrant issued to the executive search firm to purchase 26,667 shares of our
common stock at a price of $29.63 per share, cash fees paid to the executive
search firm and certain relocation costs.
Other Income (Expense)
Other income in fiscal 1999 includes the interest earned from the proceeds
raised from the public offerings, foreign exchange gains and losses, and the
insurance proceeds related to the death of the former Chairman and Chief
Executive Officer. The interest earned in fiscal 1998 was partially offset by
the imputed interest expense related to the fiscal 1997 issuance of a warrant to
purchase 1.5 million shares of Series A preferred stock at a per share exercise
price of $2.00 issued in connection with the provision of a line of credit to
the Company. See Note 5 of Notes to Consolidated Financial Statements.
Income Taxes
The fiscal 1999 income tax provision reflects the utilization of prior years'
net operating loss carryforwards. The fiscal 1998 income tax provision consisted
primarily of state and local taxes.
Discontinued Operations
In July 1997, the Company adopted a formal plan to discontinue its Systems
Integration division based in England. In September 1997, the Company sold the
division for approximately $400,000 in cash, net of fees. The disposition of the
division has been accounted for as a discontinued operation in accordance with
Accounting Principles Board Opinion No. 30 and prior consolidated financial
statements have been restated to reflect the discontinuation of the Systems
Integration business. Revenue from discontinued operations was $15.7 million and
$14.0 million, respectively, in fiscal 1997 and 1996. The income (loss) from
discontinued operations of ($104,000) and $569,000 in fiscal 1997 and 1996,
respectively, represents the operation's operating income, net of taxes. The
gain on disposal of discontinued operations of $1.2 million in fiscal 1997
represents the gain on disposal of the operation including net income from
operations of $256,000 from the measurement date to the disposal date. See Note
2 of Notes to Consolidated Financial Statements.
Liquidity and Capital Resources
As of September 30, 1999, we had $35.1 million in cash and cash equivalents and
$34.7 million in marketable securities. The net increase in cash and cash
equivalents in fiscal 1999 was due primarily to net income of $7.9 million, the
net proceeds from the maturity and purchase of investments, and the increase in
accounts payable, accrued expenses and deferred revenues. These sources of cash
and
16
cash equivalents were partially offset by the purchase of treasury stock,
capital expenditures, and the increase in accounts receivable and prepaid
expenses and other current assets. The increase in accounts receivable, accounts
payable and accrued expenses reflects the growth in the business while the
increase in prepaid expense and other current assets includes a prepayment of
technology license fees to a third-party software vendor, rental deposits and
prepaid value added taxes.
The net increase in cash and cash equivalents in fiscal 1998 was due primarily
to the proceeds from the issuance of common stock, the increase in deferred
revenues and the repayment of a related-party loan. These increases were
partially offset by the purchase of marketable securities, treasury stock,
capital expenditures, and the net loss of $0.8 million. The increase in deferred
revenues includes additional maintenance plans related to the growing installed
base of customers. Net cash used in operating activities in fiscal 1997 was
primarily attributable to a net loss of $7.9 million offset partially by the
proceeds from the issuance of redeemable convertible preferred stock.
As of September 30, 1999, the Company's principal commitments consisted of
obligations under operating leases. See Note 9 of Notes to Consolidated
Financial Statements.
We believe that our current cash balances and the cash flows generated by
operations, if any, will be sufficient to meet our anticipated cash needs for
working capital and capital expenditures for the next 12 months. Thereafter, if
cash generated from operations is insufficient to satisfy our liquidity
requirements, we may seek to sell additional equity or convertible debt
securities or obtain credit facilities. The decision to sell additional equity
or debt securities could be made at anytime and would likely result in
additional dilution to our stockholders. A portion of our cash may be used to
acquire or invest in complementary businesses or products or to obtain the right
to use complementary technologies. From time to time, in the ordinary course of
business, we evaluate potential acquisitions of such businesses, products or
technologies.
Year 2000 Compliance and Euro Conversion
We have designed and tested our products to be Year 2000 compliant. However,
there can be no assurance that our current products do not contain undetected
errors or defects associated with Year 2000 date functions that may result in
material costs to us. In addition, certain components of our products process
timestamp information from third-party applications or local operating systems.
As a result, if such third-party applications or local operating systems are not
Year 2000 compliant, our products that process such timestamp information may
not be Year 2000 compliant. Our evaluation of Year 2000-related risks and
corrective actions in connection with such third-party applications, internally
developed products and local operating systems is largely completed but will be
ongoing.
In our standard license agreements, we provide certain warranties to licensees
that our software routines and programs are Year 2000 compliant. If any of our
licensees experience Year 2000 problems, such licensees could assert claims for
damages against us. Any such claims or litigation could result in substantial
costs and diversion of our resources even if ultimately decided in our favor.
Some commentators have stated that a significant amount of litigation will arise
out of Year 2000 compliance issues, and we are aware of a growing number of
lawsuits against other software vendors. Because of the unprecedented nature of
such litigation, it is uncertain to what extent we may be affected by it.
Based on work done to date and our best estimates, we have not incurred material
costs and do not expect to incur future material costs in addressing the Year
2000 issue in our systems and products.
Our Year 2000 internal readiness program primarily covers: information
technology-based office facilities, data and voice communications, building
management and security systems, taking inventory of hardware, software and
embedded systems, assessing business and customer satisfaction risks associated
with such systems, creating action plans to address known risks, executing and
monitoring action plans, and contingency planning. Although we do not currently
believe that we will experience material disruptions in our business associated
with preparing our internal systems for the Year 2000, there can be no
assurances that we will not experience serious unanticipated negative
consequences and/or material costs caused by undetected errors or defects in the
technology used in our internal systems, which are composed of third-party
software, third-party hardware that contains embedded software and our own
software products. The most reasonably likely worst case scenarios would
include: (i) corruption of data contained in our internal information systems,
(ii) hardware failure and (iii) the failure of infrastructure services provided
by government agencies and other third parties (e.g., electricity, phone
service, water transport, internet services, etc.). Contingency plans to
include, among other things, manual "work-arounds" for software and hardware
failures, as well as substitution of systems, if necessary.
17
Various European countries introduced a single currency (known as the Euro) in
January 1999. We have conducted a review of our internal information systems to
identify the systems that could be affected by such Year 2000 and Euro
conversion requirements. Further, to accommodate our recent growth, we will be
required to continue to implement and improve a variety of operational,
financial and management information systems, procedures and controls on a
timely basis. In particular, we will be required to improve our accounting and
financial reporting systems, which currently require substantial management
effort and will be required to implement a U.S.-based financial and accounting
system.
RISK FACTORS
In addition to the other information in this Form 10-K, the following risk
factors should be considered carefully in evaluating the Company and our
business. The following factors, in addition to the other information contained
in this Form 10-K, should be considered carefully in evaluating the Company and
our prospects. This Form 10-K (including without limitation the following Risk
Factors) contains forward-looking statements (within the meaning of Section 27A
of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934) regarding the Company and our business, financial condition, results of
operations and prospects. Words such as "expects," "anticipates," "intends,"
"plans," "believes," "seeks," "estimates" and similar expressions or variations
of such words are intended to identify forward-looking statements, but are not
the exclusive means of identifying forward-looking statements in this Form 10-K.
Additionally, statements concerning future matters such as the development of
new products, enhancements or technologies, possible changes in legislation and
other statements regarding matters that are not historical are forward-looking
statements.
Although forward-looking statements in this Form 10-K reflect the good faith
judgment of our management, such statements can only be based on facts and
factors we currently know about. Consequently, forward-looking statements are
inherently subject to risks and uncertainties, and actual results and outcomes
may differ materially from the results and outcomes discussed in the
forward-looking statements. Factors that could cause or contribute to such
differences in results and outcomes include, but are not limited to, those
discussed below and in "Management's Discussion and Analysis of Financial
Condition and Results of Operations" as well as those discussed elsewhere in
this Form 10-K. Readers are urged not to place undue reliance on these
forward-looking statements, which speak only as of the date of the this Form
10-K. We undertake no obligation to revise or update any forward-looking
statements in order to reflect any event or circumstance that may arise after
the date of the Form 10-K.
We have a Limited Operating History as a Software Company and are Uncertain of
Future Operating Results
Although we began offering services for the network and systems integration
market in 1989, we first shipped our internally developed software product,
Netcool/OMNIbus, for the fault and SLM market in January 1995. Accordingly, we
have only a limited operating history as a developer and provider of SLM
software upon which an evaluation of our business and prospects can be based.
Only recently has our software business been profitable. Our limited operating
history and rapidly changing product development, installation, maintenance and
market dynamics make the prediction of future results of operations difficult if
not impossible. The Company's prospects must be considered in light of the
risks, costs and difficulties frequently encountered by emerging companies,
particularly companies in the competitive software industry. Although we have
achieved recent revenue growth, there can be no assurance that we can generate
substantial additional revenue growth on a quarterly or annual basis, or that
any revenue growth that is achieved can be sustained. In addition, we have
increased, and plan to increase further, our operating expenses in order to hire
experienced senior managers, develop new distribution channels, increase our
sales and marketing efforts, implement and improve operational, financial and
management information systems, broaden technical services and customer support
capabilities, fund higher levels of research and development and expand
administrative resources in anticipation of future growth. To the extent that
increases in such expenses are not subsequently followed by increased revenues,
our business, operating results and financial condition would be materially
adversely affected. In view of the rapidly evolving nature of our business and
markets and our limited operating history in historic and newly evolving
markets, we believe that period-to-period comparisons of financial results are
not necessarily meaningful and should not be relied upon as an indication of
future performance. As of September 30, 1999, we had an accumulated deficit of
$3.5 million. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
We have Experienced Variability of Quarterly Operating Results; Seasonality
We continue to realize a significant portion of license revenues in the last
month of a quarter, frequently in the last weeks or even days of a quarter. As a
result, license revenues in any quarter are difficult to forecast because it is
substantially dependent on orders booked and shipped in that quarter. Moreover,
our sales cycles, from initial evaluation to delivery of software, vary
substantially from customer to customer. In addition, our expense levels are
based in part on our expectations of future orders and sales, which, given our
limited operating history, are extremely difficult to predict. A substantial
portion of our operating expenses is related to personnel,
18
facilities, and sales and marketing programs. The level of spending for such
expenses cannot be adjusted quickly and is, therefore, relatively fixed in the
short term. If revenues fall below our expectations in a particular quarter, our
operating results could be materially adversely affected. See "We have a Lengthy
Sales Cycle."
The number and timing of large individual sales has been difficult for us to
predict, and large individual sales have, in some cases, occurred in quarters
subsequent to those we anticipated, or have not occurred at all. There can be no
assurance that the loss or deferral of one or more significant sales would not
have a material adverse effect on our quarterly operating results. In addition,
our business has experienced and may continue to experience significant
seasonality. Historically, a disproportionate amount of our annual revenues have
been generated by sales of our products during our fourth fiscal quarter. There
can be no assurance that this trend will or will not continue.
Significant components of our quarterly operating results have fluctuated
significantly at times in the past, and will likely fluctuate significantly at
some times in the future, as a result of a number of factors, many of which are
outside our control. These factors include changes in the demand for our
software products and services; the size and timing of specific sales; the
timing of new hires; the level of product and price competition that we
encounter; changes in the mix of, and lack of demand from, distribution channels
through which products are sold; the length of sales cycles; spending patterns
and budgetary resources of our customers on network management software
solutions; the success of our new customer generation activities; introductions
or enhancements of products, or delays in the introductions or enhancements of
our products and those of our competitors; market acceptance of new products;
our ability to anticipate and effectively adapt to developing markets and
rapidly changing technologies; the mix of products and services sold; changes in
our sales incentives; changes in the renewal rate of support agreements; the mix
of international and domestic revenue; product life cycles; software defects and
other product quality problems; our ability to attract, retain and motivate
qualified personnel; changes in the mix of sales to new and existing customers;
the extent of industry consolidation; expansion of our international operations;
and general domestic and international economic and political conditions.
Based on all of the foregoing, we believe that future revenue, expenses and
operating results are likely to vary significantly from quarter-to-quarter. As a
result, quarter-to-quarter comparisons of operating results are not necessarily
meaningful or indicative of future performance. Furthermore, we believe it is
possible that in some future quarter our operating results will be below the
expectations of public market analysts or investors. In such event, or in the
event that adverse conditions prevail, or are perceived to prevail, with respect
to our business or generally, the market price of our Common Stock would likely
be materially adversely affected. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
We Need to Manage Growth; We Need to Improve Our Infrastructure
We have recently experienced a period of rapid revenue and customer growth and a
substantial expansion in the number of our personnel and in the scope and the
geographic area of our operations. We have grown from 176 employees on September
30, 1998 to 321 employees on September 30, 1999 and currently plan to continue
to recruit more staff. This growth has resulted in new and increased
responsibilities for management personnel and has placed and continues to place
a significant strain upon our management, operating and financial systems and
resources. Moreover, members of our management team, including, without
limitation, the Chairman and Chief Executive Officer, President and Chief
Financial Officer, Senior Vice President, Sales and Business Operations, Senior
Vice President, General Counsel and Secretary and Senior Vice President, Human
Resources have been in their current positions with the Company for a limited
period of time. To accommodate recent growth, to compete effectively and manage
future growth, if any, we will be required to continue to implement and improve
a variety of operational, financial and management information systems,
procedures and controls on a timely basis and to expand, train, motivate and
manage our work force. In particular, we will be required to improve our
accounting and financial reporting systems, which currently require substantial
management effort, and to successfully manage an increasing number of
relationships with customers, suppliers and employees. These demands will
require the addition of new management personnel, and we are currently in the
process of recruiting individuals to fill important management positions such as
the Vice President, Marketing. Further, we are will need to continue to develop
a U.S.-based financial and accounting system. Our future success will depend to
a significant extent on the recruitment and retention of these key personnel,
the implementation and improvement of operational, financial and management
systems and the ability of our current and future executive officers to operate
effectively, both independently and as a group. There can be no assurance that
we will be able to execute on a timely and cost-effective basis all that is
necessary to successfully manage any growth, and any failure to do so could have
a material adverse effect on our business, operating results or financial
condition.
19
We Need to Expand and Improve the Productivity of Our Sales Force, Technical
Services and Customer Support Organization
To increase market penetration, we continue to hire additional sales personnel.
Based on our experience, such personnel are in high demand, difficult to recruit
and retain and it takes at least nine months, if not longer, for a salesperson
to become fully productive. Although we increased the size of our sales
organization during fiscal 1999, we experienced difficulty in recruiting a
sufficient number of qualified sales people during the period. There can be no
assurance that we will be successful in recruiting additional sales personnel or
increasing the productivity of our sales personnel, and the failure to do so
could have a material adverse effect on our business, financial condition or
results of operations. As a result of the recent expansion of the installed base
of Netcool/OMNIbus and the release of our Netcool/Reporter, Netcool/Internet
Service Monitors, Netcool/FireWall-1, Netcool/Fusion, Netcool/NTSM, and
Netcool/Impact, the demands on our technical services and customer support
resources have grown rapidly. See "Product Defects Would Impair our Business."
We believe that a high level of technical services, training and customer
support is essential to maintaining our competitive position. We will be
required to significantly expand our technical services and customer support
organizations and similar third-party capabilities if we are to achieve
significant additional revenue growth. Competition for additional qualified
technical personnel to perform the required functions is intense. There can be
no assurance that our technical services and customer support resources will be
sufficient to manage any future growth in our business, and any failure to
expand our technical services and customer support organizations commensurate
with any expansion of the installed base of the above products would have a
material adverse effect on our business, operating results and financial
condition.
We Need to Expand Our Distribution Channels; We Depend on Third-Party
Relationships
A key element of our business strategy is to develop relationships with leading
network equipment and telecommunications providers and to expand the third-party
channel of distribution. We are currently investing, and plan to continue to
invest, significant resources to develop these relationships and channels of
distribution, which could adversely affect our ability to generate profits.
Third-party distributors accounted for approximately 34%, 26% and 11% of our
total revenues in fiscal 1999, 1998 and 1997, respectively. There can be no
assurance that we will be able to attract additional distributors that will be
able to market our products effectively. Many of our agreements with third-party
distributors are nonexclusive, and many of the companies with which we have
agreements also have similar agreements with our competitors or potential
competitors. Our third-party distributors have significantly greater sales and
marketing resources than we do, and there can be no assurance that their sales
and marketing efforts will not conflict with our direct sales efforts. In
addition, although sales through third-party distributors result in reduced
sales and marketing expense with respect to such sales, we sell our products to
third-party distributors at reduced prices, resulting in lower gross margins on
such third-party sales. We believe that our success in penetrating markets for
our fault and SLM applications depends substantially on our ability to maintain
our current distribution relationships, in particular, those with Cisco Systems
("Cisco"), Lucent Technologies ("Lucent") Unishpere (Siemens) and others, to
cultivate additional distribution relationships and to cultivate alternative
distribution relationships if distribution channels change. There can be no
assurance that network equipment and telecommunications providers and
distributors will not discontinue their relationships with us, compete directly
with us or form additional competing arrangements with our competitors or that
we will be able to expand our distribution relationships beyond what currently
exists. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations."
We Operate in an Emerging Market; We Rely on Telecommunication Carriers and
Other Service Providers; We are Uncertain of the Demand for Fault and SLM
Products
The market for our products is in an early stage of development and is very
dynamic. Although the rapid expansion and increasing complexity of computer
networks in recent years and the resulting emergence of SLAs has increased the
demand for fault and SLM software products, the awareness of and the need for
such products is a recent development. Because the market for these products is
only beginning to develop, it is difficult to assess the size of this market,
the appropriate features and prices for products to address this market, the
optimal distribution strategy and the competitive environment that will develop.
Failure of the SLM market to grow at anticipated rates or our failure to
properly assess and address the demands from such market would have a material
adverse effect on our business, operating results and financial condition.
Telecommunications carriers, including ISPs, that deliver advanced
communications services to their customers have accounted for approximately 79%,
68% and 58% of our total revenues in fiscal 1999, 1998 and 1997, respectively.
In addition, these providers are the central focus of our sales strategy. There
can be no assurance that telecommunications carriers and other service providers
will be able to market their communications services successfully, that SLM will
gain widespread market acceptance or that telecommunications carriers and other
service providers will use our products in the deployment of their services.
Delays in the introduction of advanced services, such as network management
outsourcing, failure of such services to gain widespread market acceptance or
the decision of telecommunications carriers and other service providers not to
use our products in the deployment of these services would have a material
adverse effect on our business, operating results and financial condition. There
can be no assurance we will be able to penetrate these markets further. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations".
20
Our Markets are Extremely Competitive
Our products are designed for use in the evolving fault and SLM and enterprise
network management markets. Competition in these markets is intense and is
characterized by rapidly changing technologies, new and evolving industry
standards, frequent new product introductions and rapid changes in customer
requirements. Our current and prospective competitors offer a variety of
solutions to address the fault and SLM and enterprise network management markets
and generally fall within the following five categories: (i) customer's internal
design and development organizations that produce SLM and network management
applications for their particular needs, in some cases using multiple instances
of products from hardware and software vendors such as Sun Microsystems, Inc.
("Sun"), Hewlett-Packard Company ("HP") and Cabletron Systems, Inc.
("Cabletron"); (ii) vendors of network and systems management frameworks
including Computer Associates International, Inc. ("CA") and International
Business Machines Corporation ("IBM"); (iii) vendors of network and systems
management applications including HP, BMC Software, Inc, Sun and IBM; (iv)
providers of specific market applications; and (v) systems integrators serving
the telecommunications industry which primarily provide programming services to
develop customer specific applications including TCSI Corporation (formerly
Teknekron Communications Systems, Inc.) and Objective Systems Integrators, Inc.
("OSI"). As we enter new markets, we have seen that such markets have
additional, market-specific competitors. In addition, because there are
relatively low barriers to entry in the software market, we have become aware of
new and potential entrants in portions of our market space and we expect
additional competition from these and other established and emerging companies.
Increased competition is likely to result in price reductions and may result in
reduced gross margins and loss of market share, any of which could materially
adversely affect our business, operating results or financial condition.
Many of our existing and potential customers and distributors continuously
evaluate whether to design and develop their own network operations support and
management applications or purchase them from outside vendors. Sometimes these
customers internally design and develop their own software solutions for their
particular needs and therefore may be reluctant to purchase products offered by
independent vendors such as ours. As a result, we must continuously educate
existing and prospective customers as to the advantages of our products versus
internally developed network operations support and management applications.
Many of our current and potential competitors have longer operating histories
and have significantly greater financial, technical, sales, marketing and other
resources, as well as greater name recognition and a larger customer base, than
we do. As a result, they may be able to devote greater resources to the
development, promotion, sale and support of their products or to respond more
quickly to new or emerging technologies and changes in customer requirements
than we can. Existing competitors could also increase their market share by
bundling products having management functionality offered by our products with
their current applications. Moreover, our current and potential competitors may
increase their share of the fault and SLM market by strategic alliances and/or
the acquisition of competing companies. In addition, network operating system
vendors could introduce new or upgrade and extend existing operating systems or
environments that include management functionality offered by our products,
which could render our products obsolete and unmarketable. There can be no
assurance that we will be able to compete successfully against current or future
competitors or that competitive pressures faced by us will not materially
adversely affect our business, operating results or financial condition.
Product Defects Would Impair Our Business
Software products as internally complex as those identified in this Report
frequently contain errors or defects, especially when first introduced or when
new versions or enhancements are released. Despite our extensive product
testing, we have in the past released versions of Netcool/OMNIbus with defects
and have discovered software errors in certain of our products after their
introduction. For example, version 3.0 of Netcool/OMNIbus, released in 1996, had
a number of material defects. Version 1.0 of Netcool/Reporter, released in 1998,
had features and performance characteristics that limited market acceptance. A
significant portion of our technical personnel resources were required to
address these defects. We could continue to experience delays in or failure of
market acceptance of products, or damage to our reputation or relationships with
our customers, any of which could have a material adverse effect on our
business, operating results or financial condition. See "We Need to Expand and
Improve the Productivity of Sales Force, Technical Services and Customer Support
Organization." Additionally, there can be no assurance that, despite our testing
and that by current and potential customers, defects and errors will not be
found in new versions or enhancements of our products after commencement of
commercial shipments which could have a material adverse effect upon our
business, operating results or financial condition. See "Year 2000 and Euro
Conversion Issues Could Impair Our Business".
Since our products are used by our customers to monitor and address network
problems and avoid failures of the network to support critical business
functions, any design defects, software errors, misuse of our products,
incorrect data from network elements or other potential problems within or out
of our control that may arise from the use of our products could result in
financial or other damages to our customers. Such customers could seek damages
from us for any such losses, which, if successful, could have a material adverse
21
effect on our business, operating results or financial condition. Although we
maintain product liability insurance, there can be no assurance that such
insurance will adequately cover, if at all, any such claims. Further, although
our license agreements with our customers typically contain provisions designed
to limit our exposure to potential claims as well as any liabilities arising
from such claims, such provisions may not effectively protect us against such
claims and the liability and costs associated therewith. Accordingly, any such
claim could have a material adverse effect upon our business, results of
operations or financial condition.
We have a Lengthy Sales Cycle
Our software is generally used for division- or enterprise-wide,
business-critical purposes and involves significant capital commitments by
customers. Potential customers generally commit significant resources to an
evaluation of available enterprise software and require us to expend substantial
time, effort and money educating them about the value of our solutions.
Licensing of our software products often require an extensive sales effort
throughout a customer's organization because decisions to license such software
generally involve the evaluation of the software by a significant number of
customer personnel in various functional and geographic areas, each often having
specific and conflicting requirements. A variety of factors, including actions
by competitors and other factors over which we have little or no control, may
cause potential customers to favor a particular supplier or to delay or forego a
purchase. As a result of these and other factors, the sales cycle for our
products are long, typically about three to nine months. As a result of the
length of the sales cycle for our software products, our ability to forecast the
timing and amount of specific sales is limited, and the delay or failure to
complete one or more large license transactions could have a material adverse
effect on our business, operating results or financial condition and cause our
operating results to vary significantly from quarter to quarter. See "We Have
Experienced Variability of Quarterly Operating Results; Seasonality".
We Depend on Key Personnel
Our success is substantially dependent upon a limited number of key management,
sales, product development, technical services and customer support personnel.
The loss of the services of one or more of such key employees could have a
material adverse effect on our business, financial condition or results of
operations. We do not generally have employment contracts with key personnel. In
addition, our success will be dependent upon our continuing ability to attract,
train and retain additional highly qualified management, sales, product
development, technical services and customer support personnel. We have at times
and continue to experience difficulty in recruiting qualified personnel. Because
we face intense competition in our recruiting activities, there can be no
assurance that we will be able to attract and/or retain qualified personnel.
Failure to attract and retain the necessary qualified personnel on a timely
basis could have a material adverse effect on our business, operating results or
financial condition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
We Must Successfully Integrate Acquisitions
On November 2, 1999, we entered into an agreement to acquire Calvin Alexander
Networking, Inc., a developer of network autodiscovery technology. Acquisitions
of companies, products or technologies entail numerous risks, including: an
inability to successfully assimilate acquired operations and products; diversion
of management's attention; loss of key employees of acquired companies;
substantial transaction costs; and substantial additional costs charged to
operations as a result of the failure to consummate acquisitions. Some of the
products we acquire may require significant additional development before they
can be marketed and may not generate revenue at levels we anticipate. Moreover,
our future acquisitions, if any, may result in dilutive issuances of our equity
securities, the incurrence of debt, large one-time write-offs and creation of
goodwill or other intangible assets that could result in amortization expense.
We cannot guarantee that our efforts to consummate or integrate acquisitions
will be successful. If our efforts are not successful, our business, financial
condition and results of operations could be seriously harmed.
We Rely on a Specific Product
All of our revenues have been derived from licenses for our Netcool family of
products and related maintenance, training and consulting services. We currently
expect that Netcool/OMNIbus-related revenues will continue to account for a
substantial percentage of our revenues beyond fiscal 2000 and for the
foreseeable future thereafter. Although we've introduced Netcool/Reporter,
Netcool/Internet Service Monitors, Netcool/FireWall-1, Netcool/Fusion,
Netcool/NTSM, and Netcool/Impact, our future operating results, particularly in
the near term, are significantly dependent upon the continued market acceptance
of Netcool/OMNIbus, improvements to Netcool/OMNIbus and new and enhanced
Netcool/OMNIbus applications. There can be no assurance that Netcool/OMNIbus
will continue to achieve market acceptance or that we will be successful in
developing, introducing or marketing improvements to Netcool/OMNIbus or new or
enhanced products. The life cycles of Netcool/OMNIbus, including the
Netcool/OMNIbus applications, are difficult to estimate due in large part to the
recent emergence of many of our markets, the effect of future product
enhancements and competition. A decline in the demand for Netcool/OMNIbus as a
result of competition, technological change or other factors would have a
material adverse effect on our business, operating results and financial
condition. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations".
We Rely on Certain Customers
To date, a significant portion of our revenues in any particular period has been
attributable to a limited number of customers. Although no one customer
accounted for more than 10% of revenues in fiscal 1999, entities affiliated with
MCI/WorldCom accounted for 10% and 18% of our total revenue in fiscal 1998 and
1997, respectively. We expect that we will continue to be dependent upon a
limited number of customers for a significant portion of our revenues in future
periods. As a result of this concentration of sales, our business, operating
results or financial condition could be materially adversely affected by the
failure of anticipated orders from significant customers to materialize or by
deferrals or cancellations of orders by significant customers. In addition,
there can be no assurance that revenues from customers that have accounted for
significant revenues in past periods, individually or as a group, will continue,
or if continued, will reach or exceed historical levels in any future period.
The terms of our agreements with our customers typically contain
22
a one-time license fee and a prepayment of one year of maintenance fees. The
maintenance agreement is renewable annually at the option of the customer and
there are no minimum payment obligations or obligations to license additional
software. Therefore, there can be no assurance that any of our current customers
will generate significant revenues in future periods. For example, pre-existing
customers may be part of, or become part of, large organizations that
standardize using a competitive product. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations".
We have Risks Associated With International Licensing and Operations
License, maintenance and service revenues outside of the United States accounted
for 29%, 39% and 48% of our total revenues in fiscal 1999, 1998 and 1997,
respectively. We expect that international license, maintenance and consulting
revenues will continue to account for a significant portion of our total
revenues in future periods. Currency exchange fluctuations in countries in which
we license our products or conducts operations historically have had, and in the
future could continue to have, a material adverse effect on our business,
operating results or financial condition by resulting in pricing levels that are
not competitive or expense levels that adversely impact profitability. In such
event, gains and losses on the conversion to United States dollars of accounts
receivable and accounts payable arising from international operations may
contribute to fluctuations in our operating results. We intend to enter into
additional international markets and to continue to expand our operations
outside of the United States by expanding our direct sales force and pursuing
additional strategic relationships. Such expansion will require significant
management attention and expenditure of significant financial resources and
could adversely affect our ability to generate profits. To the extent that we
are unable to establish additional foreign operations in a timely manner, our
growth, if any, in international sales will be limited, and our business,
operating results or financial condition could be materially adversely affected.
We maintain a significant portion of our operations, including the bulk of our
software development operations, in the United Kingdom. Our international
operations and revenues involve a number of inherent risks, including longer
receivables collection periods and greater difficulty in accounts receivable
collection, difficulty in staffing and managing foreign operations, an even
lengthier sales cycle than with domestic customers, the impact of possible
recessionary environments in economies outside the United States, unexpected
changes in regulatory requirements, including a slowdown in the rate of
privatization of telecommunications service providers, reduced protection for
intellectual property rights in some countries and tariffs and other trade
barriers. There can be no assurance that we will be able to sustain or increase
revenues derived from international licensing and service or that the foregoing
factors will not have a material adverse effect on our future international
license, service and other revenue, and, consequently, on our business,
operating results or financial condition. We pay the expenses of our
international operations in local currencies and do not currently engage in
hedging transactions with respect to such obligations. In addition, sales in
Europe and certain other parts of the world typically are adversely affected in
the quarter ending September 30, as many customers reduce their business
activities during the summer months. If our international sales become a greater
component of total revenue, these seasonal factors may have a more pronounced
effect on our operating results. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations".
We Need to Manage New Products, Transitions and Rapid Technological Change; We
Depend on Third-Party Software Platforms
The market for our products is characterized by rapidly changing technologies,
evolving industry standards, changing regulatory environments, frequent new
product introductions and rapid changes in customer requirements. The
introduction or announcement of products by the Company or our competitors
embodying new technologies and the emergence of new industry standards and
practices can render existing products obsolete and unmarketable. As a result,
the life cycles of our products are difficult to estimate. Our future success
will depend on our ability to enhance our existing products and to develop and
introduce, on a timely and cost-effective basis, new products and product
features that keep pace with technological developments and emerging industry
standards and address the increasingly sophisticated needs of our customers.
Historically, we have used our close working relationship with large customers
to define our product development direction. There can be no assurance that we
will be successful in developing and marketing new products or product features
that respond to technological change or evolving industry standards, that we
will not experience difficulties that could delay or prevent the successful
development, introduction and marketing of these new products and features, or
that our new products or product features will adequately meet the requirements
of the marketplace and achieve market acceptance. In particular, the widespread
adoption of the TMN architecture for managing telecommunications networks would
force us to adapt our products to such standard, and there can be no assurance
that this could be done on a timely or cost-effective basis, if at all. In
addition, to the extent that any product upgrade or enhancement requires
extensive installation and configuration, current customers may postpone or
forgo the purchase of new versions of our products. If we are unable, for
technological or other reasons, to develop and introduce enhancements of
existing products or new products in a timely manner, our business, operating
results and financial condition will be materially adversely affected. In
addition, there can be no assurance that the introduction or announcement of new
product offerings by us or one or more of our competitors will not cause
customers to defer licensing of our existing products. Any such deferment of
purchases could have a material adverse effect on our business, operating
results or financial condition.
23
Our products are designed to operate on a variety of hardware and software
platforms employed by our customers in their networks. We must continually
modify and enhance our products to keep pace with changes in hardware and
software platforms and database technology. As a result, uncertainties related
to the timing and nature of new product announcements, introductions or
modifications by systems vendors, particularly Sun, IBM, HP, Cabletron and Cisco
and by vendors of relational database software, particularly Oracle Corporation
("Oracle") and Sybase, Inc. ("Sybase"), could materially adversely impact our
business, operating results or financial condition. For example, we are
modifying certain of our products to operate with the Linux operating system.
The failure of our products to operate effectively across the various existing
and evolving versions of hardware and software platforms and database
environments employed by customers could have a material adverse effect on our
business, operating results or financial condition.
We Rely Upon Proprietary Technology; We Risk Third-Party Claims of Infringement
Our success and ability to compete is dependent in significant part upon our
proprietary software technology. We rely on a combination of trade secret,
copyright and trademark laws, nondisclosure and other contractual agreements and
technical measures to protect our proprietary rights. Despite our efforts to
protect our proprietary rights, unauthorized parties may attempt to copy aspects
of our products or to obtain and use information that we regard as proprietary.
There can be no assurance that the steps taken by us to protect our proprietary
technology will prevent misappropriation of such technology, and such
protections may not preclude competitors from developing products with
functionality or features similar to our products. In addition, effective
copyright and trade secret protection may be unavailable or limited in certain
foreign countries. While we believe that our products and trademarks do not
infringe upon the proprietary rights of third parties, there can be no assurance
that we will not receive future communications from third parties asserting that
our products infringe, or may infringe, the proprietary rights of third parties.
We expect that software product developers will be increasingly subject to
infringement claims as the number of products and competitors in our industry
segment grows and the functionality of products in different industry segments
overlaps. Any such claims, with or without merit could be time-consuming, result
in costly litigation and diversion of technical and management personnel, cause
product shipment delays or require us to develop non-infringing technology or
enter into royalty or licensing agreements. Such royalty or licensing
agreements, if required, may not be available on terms acceptable to us or at
all. In the event of a successful claim of product infringement against us and
our failure or inability to develop non-infringing technology or license the
infringed or similar technology, our business, operating results or financial
condition could be materially adversely affected.
We have Risks Associated With Third-Party Licenses
We rely on certain software that we license from third parties, including
software that is integrated with internally developed software and used in our
products to perform key functions. There can be no assurance that these
third-party software licenses will continue to be available to us on
commercially reasonable terms or at all. Although we believe that alternative
software is available from other third-party suppliers, the loss of or inability
to maintain any of these software licenses or the inability of the third parties
to enhance in a timely and cost-effective manner their products in response to
changing customer needs, industry standards or technological developments could
result in delays or reductions in product shipments by us until equivalent
software could be developed internally or identified, licensed and integrated,
which would have a material adverse effect on our business, operating results
and financial condition.
Year 2000 and Euro Conversion Issues Could Impair Our Business
We have designed and tested our products to be Year 2000 compliant. However,
there can be no assurance that our current products do not contain undetected
errors or defects associated with Year 2000 date functions that may result in
material costs to us. In addition, certain components of our products process
timestamp information from third-party applications or local operating systems.
As a result, if such third-party applications or local operating systems are not
Year 2000 compliant, our products that process such timestamp information may
not be Year 2000 compliant. Our evaluation of Year 2000-related risks and
corrective actions in connection with such third-party applications, internally
developed products and local operating systems is largely completed but will be
ongoing.
In our standard license agreements, we provide certain warranties to licensees
that our software routines and programs are Year 2000 compliant. If any of our
licensees experience Year 2000 problems, such licensees could assert claims for
damages against us. Any such claims or litigation could result in substantial
costs and diversion of our resources even if ultimately decided in our favor.
Some commentators have stated that a significant amount of litigation will arise
out of Year 2000 compliance issues, and we are aware of a growing number of
lawsuits against other software vendors. Because of the unprecedented nature of
such litigation, it is uncertain to what extent we may be affected by it.
24
Based on work done to date and our best estimates, we have not incurred material
costs and do not expect to incur future material costs in addressing the Year
2000 issue in our systems and products.
Our Year 2000 internal readiness program primarily covers: information
technology-based office facilities, data and voice communications, building
management and security systems, taking inventory of hardware, software and
embedded systems, assessing business and customer satisfaction risks associated
with such systems, creating action plans to address known risks, executing and
monitoring action plans, and contingency planning. Although we do not currently
believe that we will experience material disruptions in our business associated
with preparing our internal systems for the Year 2000, there can be no
assurances that we will not experience serious unanticipated negative
consequences and/or material costs caused by undetected errors or defects in the
technology used in our internal systems, which are composed of third-party
software, third-party hardware that contains embedded software and our own
software products. The most reasonably likely worst case scenarios would
include: (i) corruption of data contained in our internal information systems,
(ii) hardware failure and (iii) the failure of infrastructure services provided
by government agencies and other third parties (e.g., electricity, phone
service, water transport, internet services, etc.). Contingency plans to
include, among other things, manual "work-arounds" for software and hardware
failures, as well as substitution of systems, if necessary.
Various European countries introduced a single currency (known as the Euro) in
January 1999. We have conducted a review of our internal information systems to
identify the systems that could be affected by such Year 2000 and Euro
conversion requirements. Further, to accommodate our recent growth, we will be
required to continue to implement and improve a variety of operational,
financial and management information systems, procedures and controls on a
timely basis. In particular, we will be required to improve our accounting and
financial reporting systems, which currently require substantial management
effort and will be required to implement a U.S.-based financial and accounting
system.
Our Stock Price is Volatile
The market price of our Common Stock has been and is likely to continue to be
highly volatile and may be significantly affected by factors such as actual or
anticipated fluctuations in our operating results, announcements of
technological innovations, new products or new contracts by us or our
competitors, developments with respect to copyrights or proprietary rights,
adoption of new accounting standards affecting the software industry, general
market conditions and other factors. In addition, the stock market has from time
to time experienced significant price and volume fluctuations that have
particularly affected the market price for the common stock of technology
companies. These types of broad market fluctuations may adversely affect the
market price of our Common Stock. In the past, following periods of volatility
in the market price of a company's securities, securities class action
litigation has often been initiated against such company. Such litigation could
result in substantial costs and a diversion of management's attention and
resources that could have a material adverse effect upon our business, operating
results or financial condition.
General Economic and Market Conditions May Impair Our Business
Segments of the software industry have experienced significant economic
downturns characterized by decreased product demand, price erosion, work
slowdowns and layoffs. Our operations may in the future experience substantial
fluctuations from period to period as a consequence of general economic
conditions affecting the timing of orders from major customers and other factors
affecting capital spending. Although we have a diverse client base, we target
certain vertical markets. Therefore, any economic downturns in general or in the
targeted vertical segments in particular would have a material adverse effect on
our business, operating results and financial condition.
Anti-takeover Effects of Certificate of Incorporation; Bylaws and Delaware Law
Certain provisions of our Restated Certificate of Incorporation and Bylaws and
certain provisions of Delaware law could delay or make difficult a merger,
tender offer or proxy contest involving us. Our authorized but unissued capital
stock includes 5.0 million shares of preferred stock. The Board of Directors is
authorized to provide for the issuance of such preferred stock in one or more
series and to fix the designations, preferences, powers and relative,
participating, optional or other rights and restrictions thereof. Accordingly,
we may in the future issue a series of preferred stock, without further
stockholder approval, that will have preference over the Common Stock with
respect to the payment of dividends and upon liquidation, dissolution or
winding-up of the Company. Further, Section 203 of the General Corporation Law
of the State of Delaware (as amended from time to time, the "DGCL"), which is
applicable to us, prohibits certain business combinations with certain
stockholders for a period of three years after they acquire 15% or more of the
outstanding voting stock of a corporation. In addition, the Restated Certificate
of Incorporation provides that the Board of Directors is divided into two
classes of directors with each class serving a staggered two-year term. The
classification of the Board of Directors has the effect of generally requiring
at least two annual stockholder meetings, instead of one, to replace a majority
of the
25
Board members. Any of the foregoing could adversely affect holders of the Common
Stock or discourage or make difficult any attempt to obtain control of us.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk Derivatives
and Financial Instruments
Foreign Currency Hedging Instruments
We transact business in various foreign currencies. Accordingly, we are subject
to exposure from adverse movements in foreign currency exchange rates. This
exposure is primarily related to local currency denominated revenues and
operating expenses in the U.K. However, as of September 30, 1999, no hedging
contracts were outstanding.
We currently do not use financial instruments to hedge local currency
denominated operating expenses in the U.K. Instead, we believe that a natural
hedge exists, in that local currency revenues will substantially offset the
local currency denominated operating expenses. We assess the need to utilize
financial instruments to hedge currency exposures on an ongoing basis.
We do not use derivative financial instruments for speculative trading purposes,
nor do we hedge our foreign currency exposure in a manner that entirely offsets
the effects of changes in foreign exchange rates. We regularly review our
hedging program and may as part of this review determine at any time to change
our hedging program.
Fixed Income Investments
Our exposure to market risks for changes in interest rates relate primarily to
investments in debt securities issued by U.S. government agencies and corporate
debt securities. We place our investments with high credit quality issuers and,
by policy, limits the amount of the credit exposure to any one issuer.
Our general policy is to limit the risk of principal loss and ensure the safety
of invested funds by limiting market and credit risk. All highly liquid
investments with less than three months to maturity are considered to be cash
equivalents; investments with maturities between three months or less are
considered cash equivalents; investments with maturities between three and
twelve months are considered to be short-term investments; investments with
maturities in excess of twelve months are considered to be long-term
investments. The weighted average pre-tax interest rate on the investment
portfolio is approximately 5.5%. We do not expect any material loss with respect
to our investment portfolio.
26
Item 8. Financial Statements and Supplementary Data
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
ASSETS
As of September 30,
--------------------
1999 1998
-------- --------
Current assets:
Cash and cash equivalents $ 35,058 $ 22,798
Short-term investments 34,689 40,452
Accounts receivable 9,613 6,495
Prepaid expenses and other current assets 3,871 1,374
Deferred income taxes 359 --
-------- --------
Total current assets 83,590 71,119
Property and equipment, net 5,984 2,968
Long-term investments -- 6,557
Deferred income taxes 1,031 --
-------- --------
$ 90,605 $ 80,644
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 4,210 $ 2,073
Accrued expenses 4,798 3,327
Income taxes payable 1,919 --
Deferred revenue 9,672 7,526
-------- --------
Total current liabilities 20,599 12,926
Commitments and contingencies
Stockholders' equity:
Preferred stock; $0.01 par value; 5,000 shares authorized;
no shares issued and outstanding -- --
Common stock; $0.01 par value; 60,000 shares authorized; 16,163 and
16,049 shares outstanding as of September 30, 1999
and 1998, respectively 162 160
Additional paid-in capital 73,747 79,159
Deferred compensation (103) (159)
Accumulated other comprehensive losses (286) (42)
Accumulated deficit (3,514) (11,400)
-------- --------
Total stockholders' equity 70,006 67,718
-------- --------
$ 90,605 $ 80,644
======== ========
See Accompanying Notes to Consolidated Financial Statements.
27
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Year ended September 30,
--------------------------------
Revenues: 1999 1998 1997
--------------------------------
License $ 43,692 $ 22,432 $ 6,968
Maintenance and services 14,378 5,829 2,324
--------------------------------
Total revenues 58,070 28,261 9,292
Cost of revenues:
License 2,379 1,320 523
Maintenance and services 7,465 3,491 1,042
--------------------------------
Total cost of revenues 9,844 4,811 1,565
--------------------------------
Gross profit 23,450 7,727 48,226
Operating expenses:
Sales and marketing 27,420 15,710 8,970
Research and development 9,453 5,535 2,042
General and administrative 5,998 4,521 4,244
Executive recruiting costs 720 -- --
--------------------------------
Total operating expenses 43,591 25,766 15,256
--------------------------------
Income (loss) from operations (2,316) (7,529) 4,635
Other income (expense):
Interest income 3480 1,840 64
Interest expense (341) (312) (1,268)
Other 952 100 (200)
--------------------------------
Income (loss) before income taxes (688) (8,933) 8,726
Income taxes 840 150 --
--------------------------------
Income (loss) from continuing operations (838) (8,933) 7,886
Discontinued operations:
Income (loss) from discontinued operations -- -- (104)
Gain on disposition -- -- 1,161
--------------------------------
Net income (loss) (838) (7,876) 7,886
Accretion on redeemable convertible preferred stock -- (1,334) (755)
--------------------------------
Net income (loss) applicable to holders of common stock $ 7,886 $ (2,172) $ (8,631)
================================
Per share data:
Basic net income (loss) from continuing operations applicable to
holders of common stock $ 0.50 $ (0.07) $ (1.52)
Diluted net income (loss) from continuing operations applicable
to holders of common stock $ 0.45 $ (0.07) $ (1.52)
Basic net income (loss) applicable to holders of common stock $ 0.50 $ (0.18) $ (1.35)
Diluted net income (loss) applicable to holders of common stock $ 0.45 $ (0.18) $ (1.35)
Weighted average shares used in computing:
Basic net income (loss) per share from continuing operations
applicable to holders of common stock 15,909 11,794 6,373
Diluted net income (loss) per share from continuing operations
applicable to holders of common stock 17,504 11,794 6,373
Basic net income (loss) per share applicable to holders of
common stock 15,909 11,794 6,373
Diluted net income (loss) per share applicable to holders of
common stock 17,504 11,794 6,373
See Accompanying Notes to Consolidated Financial Statements.
28
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(In thousands)
Total
Common stock Additional Treasury stock Deferred Cumulative stockholders'
----------------- paid-in ------------------- stock translation Accumulated equity
Shares Amount capital Shares Amount Compensation adjustment deficit (deficit)
-----------------------------------------------------------------------------------------------------
Balance as of September 30,
1996 6,100 $ 61 $ 264 -- $ -- $ -- $ 50 $ (597) $ (222)
Bonus shares issued 450 5 1,138 -- -- -- -- -- 1,143
Stock options exercised 36 -- 130 -- -- -- -- -- 130
Compensation expense
related to stock transfer -- -- 210 -- -- -- -- -- 210
Treasury stock purchased -- -- -- (120) (300) -- -- -- (300)
Issuance of common stock 120 1 419 -- -- -- -- -- 420
Deferred compensation
related to grants of stock
options -- -- 229 -- -- (229) -- -- --
Amortization of deferred
employee compensation -- -- -- -- -- 14 -- -- 14
Foreign currency
translation adjustment -- -- -- -- -- -- 2 -- 2
Net loss -- -- -- -- -- -- -- (7,876) (7,876)
Accretion on redeemable
convertible preferred stock -- -- -- -- -- -- -- (755) (755)
-----------------------------------------------------------------------------------------------------
Balance as of September 30, 6,706 67 2,390 (120) (300) (215) 52 (9,228) (7,234)
1997
Stock options exercised 120 1 261 -- -- -- -- -- 262
Issuance of common stock
under stock purchase plan 62 1 628 -- -- -- -- -- 629
Issuance of common stock in
public offerings, net of
related costs 3,332 33 51,739 898 5,300 -- -- -- 57,072
Treasury stock purchased -- -- -- (778) (5,000) -- -- -- (5,000)
Conversion of Series B and
C preferred stock 4,488 45 22,566 -- -- -- -- -- 22,611
Exercise of Series A
warrants 1,341 13 1,575 -- -- -- -- -- 1,588
Amortization of deferred
employee compensation -- -- -- -- -- 56 -- -- 56
Foreign currency
translation adjustment -- -- -- -- -- -- (94) -- (94)
Net loss -- -- -- -- -- -- -- (838) (838)
Accretion on redeemable
convertible preferred stock -- -- -- -- -- -- -- (1,334) (1,334)
-----------------------------------------------------------------------------------------------------
Balance as of September 30,
1998 16,049 160 79,159 -- -- (159) (42) (11,400) 67,718
Stock options exercised 111 1 (5,403) 378 7,215 -- -- -- 1,813
Issuance of common stock
under stock purchase plan 3 1 (874) 122 2,325 -- -- -- 1,452
Treasury stock purchased -- -- -- (500) (9,540) -- -- -- (9,540)
Compensation expense
related to issuance of a
warrant -- -- 462 -- -- -- -- -- 462
Tax benefit related to the
exercise of stock options -- -- 403 -- -- -- -- -- 403
Amortization of deferred
employee compensation -- -- -- -- -- 56 -- -- 56
Foreign currency
translation adjustment -- -- -- -- -- -- (244) -- (244)
Net income -- -- -- -- -- -- -- 7,886 7,886
-----------------------------------------------------------------------------------------------------
Balance as of September 30, 16,163 $ 162 $ 73,747 -- $ -- $ (103) $ (286) $ (3,514) $ 70,006
=====================================================================================================
See Accompanying Notes to Consolidated Financial Statements.
29
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Year ended September 30,
------------------------------
1999 1998 1997
------------------------------
Cash flows from operating activities:
Net income (loss) $ 7,886 $ (838) $ (7,876)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization 1,580 1,201 669
Loss on disposal of assets -- -- 51
Debt issuance costs -- -- 1,350
Amortization of deferred compensation 56 56 14
Compensation expense related to stock transfers -- -- 330
Compensation expense related to bonus shares issued -- -- 1,143
Compensation expense related to issuance of warrant 462 -- --
Tax benefit related to the exercise of stock options 403 -- --
Changes in operating assets and liabilities:
Accounts receivable (3,118) (2,034) 1,221
Inventories -- -- 399
Prepaid expenses and other current assets (2,582) (354) 315
Related party loan 85 1,068 (994)
Deferred income taxes (1,390) -- --
Accounts payable 2,137 (581) (1,394)
Accrued expenses 1,471 194 2,162
Income tax liability 1,919 -- --
Deferred revenues 2,146 6,204 150
------------------------------
Cash provided by (used in) operating activities 11,055 4,916 (2,460)
Cash flows from investing activities:
Capital expenditures (4,596) (1,719) (2,147)
Purchase of investments (58,552) (57,831) --
Proceeds from the maturity of investments 70,872 10,822 --
------------------------------
Cash provided by (used in) investing activities 7,724 (48,728) (2,147)
Cash flows from financing activities:
Bank overdraft -- -- (1,351)
Proceeds from short-term notes -- -- 2,500
Payment of short-term notes -- -- (3,775)
Payment of long-term notes -- -- (268)
Payment of capital lease obligations -- -- (244)
Proceeds from issuance of common stock, net 3,265 57,963 430
Purchase of treasury stock (9,540) (5,000) (300)
Proceeds from issuance of redeemable convertible preferred stock -- -- 20,760
------------------------------
Cash provided by (used in) financing activities (6,275) 52,963 17,752
Effects of exchange rate changes on cash and cash equivalents (244) (94) 2
------------------------------
Net increase in cash and cash equivalents 12,260 9,057 13,147
Cash and cash equivalents at beginning of year 22,798 13,741 594
------------------------------
Cash and cash equivalents at end of year $ 35,058 $ 22,798 $ 13,741
==============================
Supplemental disclosures of cash flow information:
Cash paid during the year-- interest $ 51 $ 36 $ 154
Noncash financing activities:
Accretion of redeemable convertible preferred stock $ -- $ 1,334 $ 755
Exercise of warrants to purchase redeemable convertible Series A
preferred stock for common stock $ -- $ 1,588 $ --
Conversion of redeemable convertible Series B and C preferred stock to
common stock $ -- $ 22,611 $ --
See Accompanying Notes to Consolidated Financial Statements.
30
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Description of Business and Summary of Significant Accounting Policies
Description of Business
Micromuse Inc. and its subsidiaries (the "Company") develops, markets and
supports a family of scaleable, highly configurable, rapidly deployable software
solutions for the effective monitoring and management of multiple elements
underlying an enterprise's information technology infrastructure. The Company
maintains its U.S. headquarters in California and its European headquarters in
London, England.
Micromuse plc was incorporated in England in 1989 and operated in the United
States through its subsidiary, Micromuse USA Inc., a Texas corporation. In 1997,
Micromuse plc became a subsidiary of Micromuse Inc., a Delaware corporation. The
Company entered into a stock exchange agreement with the stockholders of the
English corporation in March 1997. The Company's Board of Directors approved an
exchange of one share in the English corporation for 5.9365 shares in the
Delaware corporation. The Certificate of Incorporation of the Delaware
corporation authorized 60.0 million shares of common stock at $0.01 par value
per share and approximately 6.0 million shares of preferred stock at $0.01 par
value per share. The accompanying consolidated financial statements have been
retroactively restated to give effect to the reorganization and exchange of
common stock.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries. All significant intercompany balances and
transactions have been eliminated.
Use of Estimates
The preparation of condensed consolidated financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the condensed consolidated financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from these estimates.
Cash Equivalents
The Company considers all highly liquid instruments with a purchased maturity of
90 days or less to be cash equivalents.
Concentration of Credit Risk
Financial instruments that potentially expose the Company to credit risk consist
of cash and cash equivalents, investments and accounts receivable. At September
30, 1999, the Company had investments in excess of insured amounts of
approximately $34.0 million. Trade receivables potentially subject the Company
to concentrations of credit risk. The Company closely monitors extensions of
credit and has not experienced significant credit losses in the past. Credit
losses have been provided for in the consolidated financial statements and have
been within management's expectations.
Fair Value of Financial Instruments
The fair value of cash and cash equivalents, investments, accounts receivable
and accounts payable approximates their respective carrying amounts defined as
the amount at which the instrument could be exchanged in a current transaction
between willing parties.
31
Investments
The Company has invested in certain marketable securities that are categorized
as held-to-maturity. At September 30, 1999, the Company had invested $18.3
million in cash and money market funds, $13.6 million in debt securities issued
by U.S. government corporations and agencies and $37.8 million in equity
securities. The aggregate fair value of these investments, which are accounted
for using the amortized cost-basis of accounting, approximates their respective
carrying value defined as the amount at which the instrument could be exchanged
in a current transaction between willing parties. Securities with maturities
between three and twelve months are considered to be short-term investments,
while securities with maturities in excess of twelve months are considered to be
long-term investments.
Property and Equipment
Property and equipment are recorded at cost less accumulated depreciation.
Depreciation is calculated using the straight-line method over the estimated
useful lives of the assets, typically three years for equipment and furniture.
Leasehold improvements are amortized over the shorter of the estimated useful
lives of the respective assets or the lease term.
Revenue Recognition
License revenues are recognized upon the acceptance of a purchase order and
shipment of the software provided that the fee is fixed and determinable, the
arrangement does not involve significant customization of the software and
collection of the resulting receivable is probable. Allowances for credit losses
and for estimated future returns are provided for upon shipment. Credit losses
and returns to date have not been material. Maintenance revenues from ongoing
customer support and product upgrades are deferred and recognized ratably over
the term of the maintenance agreement, typically twelve months. Payments for
maintenance fees (on initial order or on renewal) are generally made in advance
and are nonrefundable. Revenues for consulting and training services are
recognized as the services are performed. In October 1997, the American
Institute of Certified Public Accountants issued Statement of Position No. 97-2,
Software Revenue Recognition ("SOP 97-2"). SOP 97-2 generally requires revenue
earned on software arrangements involving multiple elements, such as software
products, upgrades, enhancements, post-contract customer support, installation
and training, to be allocated to each element based on the relative fair value
of the elements. The fair value of an element must be based on evidence that is
specific to the vendor. The revenue allocated to software products, including
specified upgrades or enhancements, generally is recognized upon delivery of the
products. The revenue allocated to post-contract customer support generally is
recognized ratably over the term of the support, and revenue allocated to
service elements generally is recognized as the services are performed. If
evidence of the fair value for all element arrangement does not exist, all
revenue from the arrangement is deferred until such evidence exists or until all
elements are delivered. SOP 97-2 was adopted effective October 1, 1997. There
was no material change to the Company's accounting for revenue as a result of
the adoption of SOP 97-2.
Research and Development Cost
Development costs related to software products are expensed as incurred until
the technological feasibility of the product has been established. Technological
feasibility in the Company's circumstances occurs when a working model is
completed. After technological feasibility is established, additional costs
would be capitalized. The Company believes its process for developing software
is essentially completed concurrent with the establishment of technological
feasibility, and, accordingly, no research and development costs have been
capitalized to date.
Income Taxes
Income taxes are recorded using the asset and liability method. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amount of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which the temporary differences are expected to
be recovered or settled. The measurement of deferred tax assets is reduced, if
necessary, by a valuation allowance for any tax benefits that are not expected
to be realized.
32
Stock-Based Compensation
The Company accounts for its stock-based compensation arrangements using the
intrinsic value method. As such, compensation expense is recorded when on the
date of grant the fair value of the underlying common stock exceeds the exercise
price for stock options or the purchase price for issuance or sales of common
stock.
Foreign Currency Translation
The functional currency of the Company's foreign subsidiaries is the local
currency. The Company translates the assets and liabilities of its foreign
subsidiaries to U.S. dollars at the rates of exchange in effect at the end of
the year. Revenues and expenses are translated at the average rates of exchange
for the year. Translation adjustments and the effects of exchange rate changes
on intercompany transactions of a long-term investment nature are included in
stockholders' equity (deficit) in the consolidated balance sheets. Gains and
losses resulting from foreign currency transactions denominated in a currency
other than the functional currency are included in income and have not been
significant to the Company's consolidated operating results in any year.
Per Share Data
Basic per share amounts are calculated using the weighted-average number of
common shares outstanding during the period. Diluted per share amounts are
calculated using the weighted-average number of common shares outstanding during
the period and, when dilutive, the weighted-average number of potential common
shares from the assumed conversion of the redeemable convertible preferred stock
and the exercise of outstanding options to purchase common stock using the
treasury stock method. Excluded from the computation of the diluted loss per
share for the years ended September 30, 1998 and 1997 were approximately 4.5
million shares of redeemable convertible preferred stock and options to acquire
1.5 million and 1.3 million shares of common stock, respectively, with a
weighted-average exercise price of $4.78 and $2.38 per share, respectively,
because their effect would be anti-dilutive. A reconciliation of the numerators
and denominators used in the basic and diluted net income (loss) per share
amounts for fiscal 1999 follows:
Year ended September 30,
---------------------------
1999 1998 1997
---------------------------
Numerator for basic and diluted net income (loss)
applicable to holders of common stock $ 7,886 $ (2,172) $(8,631)
===========================
Denominator for basic net income (loss) per
share - weighted-average shares outstanding 15,909 11,794 6,373
Dilutive effect of:
Common stock options 1,568 -- --
Warrant 27 -- --
---------------------------
Denominator for diluted net income (loss) per share 17,504 11,794 6,373
===========================
Comprehensive Income (Loss)
Effective October 1, 1998, the Company adopted the Financial Accounting
Standards Board's (the "FASB") Statement of Financial Accounting Standards
("SFAS") No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130
establishes new rules for the reporting and display of comprehensive income
(loss) and its components; however, the adoption of SFAS 130 had no impact on
our net income (loss) or stockholders' equity. This Statement requires foreign
currency translation adjustments, which prior to adoption were reported
separately in stockholders' equity (deficit), to be included in other
comprehensive income (loss). Prior year financial statements have been
reclassified to conform to the requirements of SFAS 130.
Recent Accounting Pronouncements
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 addresses the accounting for
derivative instruments, including certain derivative instruments embedded in
other contracts. Under SFAS
33
No. 133, entities are required to carry all derivative instruments in the
balance sheet at fair value. The accounting for changes in the fair value of a
derivative instrument depends on whether it has been designated and qualifies as
part of a hedging relationship and, if so, the reason for holding it. The
Company must adopt SFAS No. 133 by October 1, 2001. The Company does not
anticipate that SFAS No. 133 will have an effect on its financial statements.
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position No. 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use" ("SOP 98-1"). This SOP applies to
software that is acquired or developed solely for an entity's internal use and
requires the capitalization of qualifying costs in software application
development activities, which include design, coding, installation hardware and
testing. Capitalization of qualifying costs incurred in development stage
activities begins when the entity has committed to fund a particular internal
computer software project and the entity considers it probable that the
committed software will be used to perform the intended function, provided that
the entity has completed the preliminary project stage activities. Preliminary
project stage activities include the conceptual formulation and evaluation of
alternatives and the determination of the existence of needed technology.
Qualifying capitalizable computer software costs include the external direct
costs of materials and services and the payroll related costs of employees who
are directly involved with the internal project. All other costs related to the
project are expensed as incurred.
SOP 98-1 will be effective for internal use computer software costs incurred in
future years commencing with our fiscal year beginning October 1, 1999. The
Company has followed an accounting policy of expensing as incurred all costs
related to software developed for internal use and intends to continue this
policy until the effective date of SOP 98-1. The Company has not yet determined
whether the adoption of SOP 98-1 will have a material effect on our financial
position or results of operations.
In December 1998, the American Institute of Certified Public Accountants issued
Statement of Position No. 98-9, Software Revenue Recognition, with Respect to
Certain Arrangements ("SOP 98-9"), which requires the recognition of revenue
using the "residual method" in a multiple element arrangement when fair value
does not exist for one or more of the delivered elements in the arrangement.
Under the "residual method", the total fair value of the undelivered elements is
deferred and subsequently recognized in accordance with SOP 97-2. The Company
will adopt SOP 98-9 by October 1, 1999 and does not expect a material change to
its accounting for revenues as a result of the provisions of SOP 98-9.
Note 2. Discontinued Operations
In July 1997, the Company adopted a formal plan to discontinue its Systems
Integration division based in England. In September 1997, the Company sold the
division for approximately $400,000 in cash, net of fees. The disposition of the
division has been accounted for as a discontinued operation in accordance with
APB Opinion No. 30 and prior period consolidated financial statements have been
restated to reflect the discontinuation of the Systems Integration business.
Revenues from discontinued operations were $15.7 million in fiscal 1997. The
loss from discontinued operations of $104,000 in fiscal 1997 represents the
operation's operating loss. The gain on disposal of discontinued operations of
$1.2 million in fiscal 1997 represents the gain on disposal of the operation
including net income from operations of $256,000 from the measurement date to
the disposal date.
Note 3. Balance Sheet Components (in thousands):
As of September 30,
--------------------
Property and equipment: 1999 1998
--------------------
Computer equipment $ 6,413 $ 4,450
Furniture and fixtures 1,342 1,096
Leasehold improvements 1,507 138
Other 1,212 350
--------------------
10,474 6,034
Accumulated depreciation (4,490) (3,066)
--------------------
$ 5,984 $ 2,968
====================
Accrued expenses:
Payroll and commission related $ 2,844 $ 1,693
Other 1,954 1,634
--------------------
$ 4,798 $ 3,327
====================
34
Note 4. Related Party Transactions
In July 1997, the Company repurchased, from a stockholder who was an officer and
a director, 120,000 shares of common stock at $2.50 per share for a total price
of $300,000.
In November 1997, the Company repurchased, from a stockholder who was an officer
and a director, 777,605 shares of common stock at $6.43 per share for a total
price of $5.0 million. The stockholder used a portion of the proceeds to repay
an interest-free loan from the Company.
Note 5. Redeemable Convertible Preferred Stock and Stockholders' Equity
(Deficit)
Redeemable Convertible Preferred Stock
A $3.0 million line of credit was made available to the Company in March 1997.
Interest under the line of credit was at no more than prime plus 2% and funds
drawn were to be used to finance an acquisition or other vehicle of growth as
approved by the Board of Directors. The $3.0 million line of credit was
available as of September 30, 1997. If exercised, the line of credit became due
and payable upon the earliest of a qualified public offering, a qualified
acquisition, or expiration of the Series A warrant issued in conjunction with
the line of credit. During fiscal 1997, the Company drew down $1.0 million,
which was repaid as of September 30, 1997. The warrant expired on the earlier of
March 2002, or the closing date of a public offering, merger, or acquisition of
the Company. The warrant issued in conjunction with the line of credit allowed
the holder to purchase 1.5 million shares of the Series A preferred stock at an
exercise price of $2.00 per share. The warrant was initially recorded at fair
value of $1.4 million, which was included in the carrying value of the Series A
preferred stock and treated as a debt issuance cost. This cost was amortized to
interest expense over the period from the date of issuance to the anticipated
date of the initial public offering, which resulted in a non-cash interest
charge of $300,000 and $1.1 million in fiscal 1998 and 1997, respectively. Under
the terms of the initial public offering, all the outstanding shares of Series B
and Series C preferred stock were converted into 2.0 million shares and 2.4
million shares of common stock, respectively, upon the closing of the IPO. In
addition, a warrant to purchase Series A preferred stock was converted into 1.5
million shares of common stock.
Common Stock
In March 1997, approximately 450,000 shares of common stock were issued to
stockholders as bonuses. The Company recorded compensation expense of
approximately $1.1 million for the fair market value of such shares. During
fiscal 1997, the principal stockholders transferred shares of common stock to
certain employees. The Company recorded compensation expense of $210,000 for the
difference between the fair market value and the transfer price of the common
stock.
In February 1998, the Company raised $34.2 million of net proceeds from the sale
of 3.2 million shares of the Company's common stock pursuant to its IPO.
In July 1998, the Company raised $22.9 million of net proceeds from the sale of
1.0 million shares of the Company's common stock pursuant to a follow-on public
offering.
Treasury Stock
In July 1997, the Company repurchased, from a stockholder who is an officer and
a director, 120,000 shares of common stock at $2.50 per share for a total price
of $300,000.
In November 1997, the Company repurchased, from a stockholder who is an officer
and a director, 777,605 shares of common stock at $6.43 per share for a total
price of $5.0 million. The stockholder used a portion of the proceeds to repay
an interest-free loan from the Company.
In October 1998, the Board of Directors authorized the repurchase of up to 1.5
million shares, or approximately 9% of our outstanding common stock. As of
December 31, 1998, the Company had repurchased 0.5 million shares of its
outstanding common stock for approximately $9.5 million pursuant to the
repurchase program. The repurchased shares are held as treasury stock and are
available for
35
general corporate purposes including issuance under our stock option and
employee stock purchase plans. In January 1999, the Company announced the
termination of the repurchase program. As of September 30, 1999, all the shares
of treasury stock had been reissued.
Stock Option Plan
Under the Company's 1997 and 1998 Stock Option/Stock Issuance Plans (the
"Plans"), options to purchase shares of common stock may be granted to
employees, officers, directors and consultants (officers and directors are not
eligible for grants under the 1998 Plan). Because the warrant to purchase 1.5
million shares of Series A was exercised upon the IPO, options to purchase an
additional 166,666 shares of common stock were reserved under the Plans. The
Plans provides for the issuance of incentive and non-statutory options that must
be granted at an exercise price not less than 100% and 85% of the fair market
value of the common stock on the date of grant, respectively (110% if the person
to whom the option is granted is a 10% stockholder). Incentive options may only
be granted to employees under the 1997 Plan. Options generally vest over four
years from the date of grant. The options expire between five and ten years from
the grant date, and any vested options must normally be exercised within three
months after termination of employment. The Plans are administered by the
Company's Board of Directors and its Compensation Committee.
A summary of the status of the Company's options under the Plans is as follows:
Outstanding options
---------------------------------------------------
Number of Weighted-average Weighted-average
shares exercise price fair value
---------------------------------------------------
Balance as of September 30, 1996 575,379 $ 2.43 $ --
Granted at greater than market value 269,992 2.50 1.25
Granted at market value 640,856 2.55 0.43
Exercised (36,320) 3.50 --
Canceled (137,821) 3.31 --
---------------------------------------------------
Balance as of September 30, 1997 1,312,086 2.38 --
Granted at market value 465,924 10.86 6.76
Exercised (119,324) 2.06 --
Canceled (178,295) 4.88 --
---------------------------------------------------
Balance as of September 30, 1998 1,480,391 4.78 --
Granted at market value 2,241,963 27.50 15.87
Exercised (488,860) 3.76 --
Canceled (122,380) 12.12 --
---------------------------------------------------
Balance as of September 30, 1999 3,111,114 $ 21.02 $ --
===================================================
As of September 30, 1999, 1998 and 1997, there were 474,168; 502,094 and 267,687
fully vested and exercisable shares, with weighted-average exercise prices of
$6.51, $2.46 and $1.97, respectively. As of September 30, 1999, approximately
477,890 shares were available for grant. The following table summarizes
information concerning outstanding and exercisable options under the Plans
outstanding as of September 30, 1999:
Outstanding
------------------------------------- Exercisable
Weighted- Weighted- -------------------------
Range of Average average Weighted-
exercise Number of Remaining life exercise Number average
prices shares (in years) price of shares exercise price
- --------------------------------------------------------------------------------
$0.03 - $8.00 864,826 5.76 $ 4.00 407,080 $ 3.38
8.50 - 25.13 792,056 8.14 12.86 26,087 19.02
25.50 - 35.13 1,028,400 8.96 29.95 40,990 29.60
35.31 - 50.00 274,111 7.31 43.85 11 39.00
50.38 - 65.50 151,721 7.74 58.60 -- --
---------- --------
Total 3,111,114 7.66 $ 21.02 474,168 $ 6.51
========== ========
36
The Company uses the intrinsic value-based method to account for all of its
employee stock-based compensation plans. Accordingly, no compensation cost has
been recognized for its stock options in the accompanying consolidated financial
statements because the fair value of the underlying common stock equals or
exceeds the exercise price of the stock options at the date of grant, except
with respect to certain options issued in 1996 and during fiscal 1997. The
Company has recorded deferred stock compensation expense of $167,000 and
$229,000 for the difference at the grant date between the exercise price and the
fair value of the common stock underlying the options issued in September 1996
and fiscal 1997, respectively. The $167,000 was amortized in fiscal 1996 as the
options were fully vested upon issuance and $14,000, $56,000 and $56,000 of the
$229,000 was amortized in fiscal 1997, 1998 and 1999, respectively, as the
options vest over four years.
Had compensation cost for the Company's stock options been determined in a
manner consistent with SFAS No. 123, "Accounting for Stock-Based Compensation",
the Company's fiscal 1999 net income would have decreased by $4.7 million while
the fiscal 1998 and 1997 net loss would have increased by $733,000 and $47,000,
respectively, and the diluted earnings (loss) per share would have been $0.18,
$(0.25) and $(1.36) for fiscal 1999, 1998 and 1997, respectively.
The per share weighted-average fair value of stock options granted during 1999,
1998 and 1997 was $15.87, $6.76 and $0.67, respectively, on the date of grant
using the Black-Scholes pricing model (for fiscal 1999 and 1998) and the minimum
value method (for fiscal 1997), with the following weighted assumptions: 1999 --
expected dividend yield of 0.0%, risk-free interest rate of 5.8%, expected
volatility of 70%, expected forfeiture rate of 30% and expected life of four
years; 1998 -- expected dividend yield of 0.0%, risk-free interest rate of 5.6%,
expected volatility of 80%, expected forfeiture rate of 25% and expected life of
four years; 1997 -- expected dividend yield of 0.0%, risk-free interest rate of
6.28%, and expected life of three years.
The per share weighted-average fair values of Employee Stock Purchase Plan
shares granted during fiscal 1999 and 1998 were $6.41 and $4.88, respectively,
calculated using the Black-Scholes pricing model with the following weighted
assumptions: 1999 - expected dividend yield of 0.0%, risk-free interest rate of
5.3%, expected volatility of 70%, and expected life of 0.5 years; 1998 expected
dividend yield of 0.0%, risk-free interest rate of 5.2%, expected volatility of
80%, and expected life of 0.5 years.
In July 1997, 120,000 shares were issued to two directors at $2.50 per share,
under the 1997 Plan. The Company has recorded stock compensation expense of
$120,000, for the difference between the issuance price and the fair market
value of the common stock.
1998 Employee Stock Purchase Plan
In January 1998, the Board of Directors adopted the Company's 1998 Employee
Stock Purchase Plan (the "ESPP") to provide employees of the Company with an
opportunity to purchase common stock through payroll deductions. Under the ESPP
300,000 shares of common stock have been reserved for issuance as of September
30, 1999. The ESPP became effective at the time of the IPO. All full-time
regular employees who are employed by the Company are eligible to participate in
the.
Eligible employees may contribute up to 15% of their total cash compensation to
the ESPP. Amounts withheld are applied at the end of every six-month
accumulation period to purchase shares of common stock, but not more than 1,250
shares per accumulation period. The value of the common stock (determined as of
the beginning of the offering period) that may be purchased by any participant
in a calendar year is limited to $25,000. Participants may withdraw their
contributions at any time before stock is purchased.
The purchase price is equal to 85% of the lower of (a) the market price of
common stock immediately before the beginning of the applicable offering period
or (b) the market price of common stock at the time of the purchase. In general,
each offering period is 24 months long, but a new offering period begins every
six months. Thus, up to four overlapping offering periods may be in effect at
the same time. An offering period continues to apply to a participant for the
full 24 months, unless the market price of common stock is lower when a
subsequent offering period begins. In that event, the subsequent offering period
automatically becomes the applicable period for purposes of determining the
purchase price. The first accumulation and offering periods commenced on
February 13, 1998, the effective date of the IPO. The first accumulation period
ended on July 31, 1998, and the first offering period will end on January 31,
2000. A total of 126,259 and 61,596 shares of the Company's common stock were
issued under the ESPP in fiscal 1999 and 1998, respectively, at prices ranging
from $10.20 per share to $ 25.98 per share.
37
Note 6. Income Taxes
The provision for income taxes was as follows (in thousands):
Year ended September 30,
--------------------------------
Current: 1999 1998 1997
--------------------------------
Federal $ 28 $ 83 $ --
State 73 67 --
Foreign 1,634 -- --
--------------------------------
Total Current $ 1,735 $ 150 $ --
Deferred:
Federal $ (712) $ -- $ --
State (41) -- --
Foreign (142) -- --
--------------------------------
Total Deferred $ (895) $ -- $ --
--------------------------------
$ 840 $ 150 $ --
================================
The tax effects of temporary differences that give rise to significant portions
of deferred tax assets are presented below (in thousands):
As of September 30,
------------------
1999 1998
------------------
Various accruals and reserves not deductible for tax purposes $ 295 $ 521
Net operating loss carry-forwards 3,794 2,448
Property and equipment 117 109
Other 64 177
AMT credit carry-forwards 126 58
------------------
Total deferred tax assets 4,396 3,313
Valuation allowance (3,006) (3,313)
------------------
Net deferred tax assets 1,390 $ --
==================
Income (loss) before income taxes was comprised as follows (in thousands):
Year ended September 30,
-------------------------------
1999 1998 1997
-------------------------------
United States $1,373 $ 667 $(4,931)
International 7,353 (1,355) (4,002)
-------------------------------
Total $8,726 $ (688) $(8,933)
===============================
Total income tax expense from continuing operations differs from expected income
tax expense (computed by applying the U.S. federal corporate income tax rate of
34% to profit (loss) before taxes), as follows (in thousands):
Year ended September 30,
------------------------
1999 1998 1997
------------------------
Income tax expense (benefit) at federal statutory rate $ 2,837 $(234) $(2,532)
State income taxes, net of federal income tax benefit 21 44 --
Permanent differences 63 56 --
(Utilized) unutilized losses (1,222) 284 2,514
Change in deferred tax asset (859) -- --
Other -- -- 18
------------------------
$ 840 $ 150 $ --
========================
38
As of September 30, 1999, the Company had net operating losses for federal and
state purposes of approximately $9.0 million and $6.0 million, respectively,
available to offset taxable income in future years. The federal net operating
losses will expire, if not utilized, in 2019. The state net operating losses
will expire, if not utilized, in 2004. Federal and state tax laws impose
substantial restrictions on the utilization of net operating loss carry-forwards
in the event of an "ownership change," as defined in Section 382 of the Internal
Revenue Code. The Company has not yet determined whether an ownership change
occurred due to significant stock transactions in each of the reporting years
disclosed. If an ownership change has occurred, utilization of the net operating
loss carry-forwards could be significantly reduced. Additionally, loss
carry-forwards of either Micromuse Inc. or Micromuse USA Inc. cannot be utilized
against future profits generated by the other company.
Note 7. Defined Contribution Plan
In February 1998, the Company adopted a defined contribution plan (the "Plan")
in the United States pursuant to Section 401(k) of the Internal Revenue Code
(the "Code"). All eligible full and part-time employees of the Company who meet
certain age requirements may participate in the Plan. Participants may
contribute up to 20% of their pre-tax compensation, but not in excess of the
maximum allowable under the Code. The Plan allows for discretionary
contributions by the Company. Such matching contributions vest based on the
participant's length of service. In addition, the Company may make
profit-sharing contributions at the discretion of the Board of Directors. The
Company made no contributions during fiscal 1999 and 1998.
Note 8. Geographic and Segment Information
During 1999 the Company adopted the provisions of SFAS No. 131, Disclosure about
Segments of an Enterprise and Related Information. SFAS No. 131 establishes
standards for the reporting by public business enterprises of information about
operating segments, products and services, geographic areas, and major
customers. The method for determining what information to report is based on the
way that management organizes the operating segments within the Company for
making operational decisions and assessments of financial performance.
The Company's chief operating decision-maker is considered to be the Company's
Chief Executive Officer ("CEO"). The CEO reviews financial information presented
on a consolidated basis accompanied by information by geographic region for
purposes of making operating decisions and assessing financial performance.
Therefore, the Company operates as a single operating segment: Fault and Service
Level Management Software.
The Company markets its products primarily from its operations in the United
States. International sales are primarily to customers in France, Germany and
the United Kingdom. Information regarding operations in different geographic
regions is as follows (in thousands):
Year ended September 30,
----------------------------
1999 1998 1997
----------------------------
Revenues:
United States $41,208 $ 17,242 $ 4,810
International 16,862 11,019 4,482
----------------------------
Total $58,070 $ 28,261 $ 9,292
============================
Income (loss) from continuing operations:
United States $ 2,297 $ 517 $ (4,931)
International 5,589 (1,355) (4,002)
----------------------------
Total $ 7,886 $ (838) $ (8,933)
============================
As of September 30,
----------------------------
1999 1998 1997
----------------------------
Identifiable assets:
United States $79,208 $ 71,377 $ 15,398
International 11,397 9,267 7,342
Assets related to discontinued operations -- -- --
----------------------------
Total $90,605 $ 80,644 $ 22,740
============================
Intercompany transfers between geographic areas are accounted for using the
transfer prices in effect for subsidiaries.
39
Note 9. Commitments
The Company leases its facilities and certain equipment under non-cancelable
operating leases. The lease agreements expire at various dates during the next
10 years.
Rent expense was approximately $1,408,800, $907,925 and $538,000 for the years
ended September 30, 1999, 1998 and 1997, respectively. Future minimum lease
payments under non-cancelable operating leases will be approximately $1.8
million, $1.6 million, $1.2 million, $937,000, $937,000 and $997,000 for each of
the years in the five-year period and thereafter, respectively.
Note 10. Management
In February 1999, the Company announced that Gregory Q. Brown would join the
Company as Chairman of the Board and Chief Executive Officer and on February 17,
1999, he joined the Company as a full-time employee. The Company incurred
approximately $0.7 million of executive recruiting costs related to the hiring
of Mr. Brown. Included in this amount was a charge related to the fair value of
the warrant issued to the executive search firm to purchase 26,667 shares of our
common stock at a price of $29.63 per share, cash fees paid to the executive
search firm and certain relocation costs. The charge for the warrant was
determined in a manner consistent with SFAS No. 123, "Accounting for Stock-Based
Compensation" by using the Black-Scholes pricing model with the following
assumptions: expected dividend yield of 0.0%, risk-free interest rate of 5.5%,
expected volatility of 50%, and expected life of seven years.
Note 11. Subsequent Event
On November 2, 1999, the Company entered into, and subsequently closed, an
agreement to acquire Calvin Alexander Networking, Inc. ("CAN"), a privately-held
company that develops leading-edge network auto-discovery technology. Under the
terms of the acquisition agreement, Micromuse will issue approximately $42
million worth of its common stock to acquire CAN, based on the closing price on
November 2, 1999. The transaction is to be accounted for under the purchase
method of accounting and is to be treated as a tax-free reorganization for
federal income tax purposes. Certain agreements have been made to promote the
retention and motivation of CAN employees. A portion of the consideration for
the transaction is subject to a one-year lock-up agreement and a one-year price
guarantee.
40
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Micromuse Inc.
We have audited the accompanying consolidated balance sheets of Micromuse Inc.
and subsidiaries as of September 30, 1999 and 1998, and the related consolidated
statements of operations, stockholders' equity (deficit), and cash flows for
each of the years in the three-year period ended September 30, 1999. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Micromuse Inc. and
subsidiaries as of September 30, 1999 and 1998, and the results of their
operations and their cash flows for each of the years in the three-year period
ended September 30, 1999, in conformity with generally accepted accounting
principles.
KPMG LLP
Mountain View, California
October 23, 1999, except as to Note 11 which is as of November 2, 1999
41
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosures
None.
PART III
Item 10. Directors and Executive Officers of the Registrant
The following table provides certain information regarding the executive
officers of the Company as of September 30, 1999:
Name Age Position
- ----------------- --- ----------------------------------------------------
Gregory Q. Brown 39 Chairman of the Board and Chief Executive Officer
Stephen A. Allott 41 President and Chief Financial Officer
James B. De Golia 50 Senior Vice President, General Counsel and Secretary
Michael Donohue 40 Senior Vice President, Sales and Business Operations
Peter Shearan 35 Senior Vice President, Technical Services
Gregory Q. Brown was named Chairman and CEO of Micromuse Inc. on February 17,
1999. His 19 years of high-tech experience includes leadership positions in the
telecommunications, data networking, cable TV and computer software industries.
From September 1996 until joining Micromuse Inc., Brown served as president of
Ameritech Custom Business Services, a unit of Ameritech Corporation that
provides large business customers with custom communications and information
technology. This $1.4 billion unit served many Fortune 500 companies as a single
source for the provisioning and management of network and desktop-based voice,
data, video, and local-access services. For the three years prior to his
position at Custom Business Services, Brown was president of Ameritech New Media
Inc. As president, Brown was responsible for all of Ameritech's consumer cable
TV operations. Additionally Brown was a member of the board of directors of
Americast, the video programming joint venture involving Ameritech, The Walt
Disney Company, GTE, Bell South, and Southern New England Telephone. Before
joining Ameritech in 1987, Brown held a variety of sales and marketing positions
with AT&T in Detroit Michigan for five years. He also worked for the IBM Company
in various sales and support capacities in the early 1980s. Mr. Brown received
his degree in Economics from Rutgers University in June 1982.
Stephen A. Allott was appointed to the Board of Directors and named President in
October 1998. Mr. Allott has served as Chief Financial Officer since July 1998.
Mr. Allott served as the Company's Senior Vice President, Finance from September
1997 to July 1998. From June 1997 to September 1997, Mr. Allott served as Vice
President, Global Telco Industry. From April 1996 to September 1997, Mr. Allott
served as Managing Director, Micromuse Europe. From September 1995 to April 1996
he served as the Company's Business Development Director. Mr. Allott has also
been a director of Micromuse plc since March 1996. Prior to joining the Company,
Mr. Allott served as a strategy consultant with McKinsey & Company from
September 1990 to September 1995. From May 1988 to September 1990, Mr. Allott
served as United Kingdom legal counsel for Sun Microsystems, UK. Mr. Allott
received his M.A., Law from Trinity College, Cambridge and was called to the
English Bar at Gray's Inn.
James B. De Golia became Senior Vice President in September 1999 having joined
Micromuse in January 1999 as Vice President, General Counsel and Secretary.
Previously, Mr. De Golia was Vice President and General Counsel of N.E.T. Prior
to that, Mr. De Golia was Counsel at Xerox Corporation. He received his B.A.
from the University of California at Irvine and his J.D. from the University of
California, Hastings College of the Law.
Michael Donohue, joined Micromuse as Vice President, Western Region Sales in
December 1998. He was promoted to his present position to direct Micromuse's
North American direct and channels sales forces in March 1999. Before joining
Micromuse, Mr. Donohue held senior vice president and corporate officer
positions at Computer Associates. At Computer Associates, Mr. Donohue was
responsible for selling to organizations with revenues in excess of $100 million
in the western states. In addition, he was part of the sales team that launched
the CA Unicenter(R) enterprise management software line.
Peter Shearan has served as the Company's Senior Vice President, Technical
Services since April 1998. From February 1996 to March 1998, Mr. Shearan served
as the Company's Vice President, Technical Services. From November 1995 to
February 1996, Mr. Shearan served as Senior Consultant in the Company's Netcool
Business Development department. Prior to joining the Company, Mr. Shearan
served as a systems manager for British Telecommunications from June 1984 to
November 1995. Mr. Shearan received his Qualifications in Computer Science from
Southbank University, London.
42
The information regarding Directors who are nominated for re-election required
by Item 10 is incorporated herein by reference from the section entitled
"Proposal No. 1 -- Election of Directors" of the Proxy Statement.
Item 11. Executive Compensation
The information required by Item 11 is incorporated herein by reference from the
section entitled "Executive Compensation" of the Proxy Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by Item 12 is incorporated herein by reference from the
section entitled "Security Ownership of Certain Beneficial Owners and
Management" of the Proxy Statement.
Item 13. Certain Relationships and Related Transactions
The information required by Item 13 is incorporated herein by reference from the
section entitled "Certain Relationships and Related Transactions" of the Proxy
Statement.
PART IV
Item 14. Exhibits, Financial Statements Schedule, and Reports on Form 8-K
(a)(1) Financial Statements
See the Consolidated Statements beginning on page 27 of this Form
10-K.
(2) Financial Statement Schedule
See the Financial Statement Schedule at page 45 of this Form 10-K.
(3) Exhibits
See Exhibit Index at page 46 of this Form 10-K.
(b) Current report on Form 8-K dated December 3, 1998.
(c) See Exhibit Index at page 46 of this Form 10-K.
(d) See the Consolidated Financial Statements beginning on page 27 and Financial
Statement Schedule at page 45 of this Form 10-K.
43
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) 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.
MICROMUSE INC.
By: /s/ Stephen A. Allott
-----------------------------------------------
Stephen A. Allott
Director, President and Chief Financial Officer
(Principal Financial Officer)
Date: December 28, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons, on behalf of the Registrant in
the capacities indicated:
Name Title Date
/s/ Gregory Q. Brown Chairman and Chief Executive Officer December 28, 1999
- ------------------------- (Principal Executive Officer)
(Gregory Q. Brown)
/s/ Stephen A. Allott Director, President and December 28, 1999
- ------------------------- Chief Financial Officer
(Stephen A. Allott) (Principal Financial Officer)
/s/ Michael E.W. Jackson Director December 28, 1999
- -------------------------
(Michael E.W. Jackson)
/s/ David C. Schwab Director December 28, 1999
- -------------------------
(David C. Schwab)
/s/ Kathleen M.H. Wallman Director December 28, 1999
- -------------------------
(Kathleen M.H. Wallman)
44
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
Year Ended September 30, 1999, 1998 and 1997
(In thousands)
Balance at Charged to Balance at
Beginning Costs and End of
Description of Period Expenses Deductions Period
- ------------------------------------------------------------------------------------------------
Year Ended September 30, 1999:
Allowance for doubtful accounts and returns $153 $411 $(282) $282
Year Ended September 30, 1998:
Allowance for doubtful accounts and returns -- 178 (25) 153
Year Ended September 30, 1997:
Allowance for doubtful accounts and returns -- -- -- --
45
EXHIBIT INDEX
Exhibit
Number Description
- ------ -----------
2.1+ Agreement for the sale of the systems integration business of
Micromuse plc by and among Micromuse plc, Horizon Open Systems (UK)
Limited and Horizon Computer Services Limited, dated as of September
16, 1997.
3.1++ Restated Certificate of Incorporation of the Registrant, as amended
to date.
3.2++ Amended and Restated Bylaws of the Registrant.
4.1++ Reference is made to Exhibits 3.1, 3.2 and 10.4.
4.2+ Specimen Common Stock certificate.
10.1+ Form of Indemnity Agreement entered into between the Registrant and
its directors and officers.
10.2 1997 Stock Option/Stock Issuance Plan and forms of agreements
thereunder, as amended.
10.3+ 1997 Employee Stock Purchase Plan.
10.4+ Amended and Restated Investors' Rights Agreement by and among the
Registrant and certain stockholders of the Registrant, dated as of
September 8, 1997.
10.5+ Office lease dated as of March 25, 1997, by and between the
Registrant and SOMA Partners, L.P.
10.6+ Office lease dated as of March 3, 1997, by and between Micromuse
plc, Marldown Limited and Christopher J. Dawes.
10.7+ Office lease dated as of March 3, 1993, by and between Micromuse
plc, Guildquote Limited and Christopher J. Dawes.
10.8+ Agreement for the sale of the systems integration business of
Micromuse plc dated as of September 16, 1997. Reference is made to
Exhibit 2.1.
10.9 1998 Non-Officer Stock Option/Stock Issuance Plan and forms of
agreements thereunder.
10.10 Employment Agreement as of February 17, 1999, by and between Gregory
Q. Brown and Micromuse Inc.
10.11 Agreement and Plan of Reorganization by and among Micromuse Inc.,
CAN Acquisition Corp. and Calvin Alexander Networking, Inc.
21.1+ Subsidiaries of the Registrant.
23.1 Report on Schedule and Consent of Independent Auditors 27.1
Financial Data Schedule
- ----------
+ Incorporated by reference from the exhibit of the same number in the
Registrant's Registration Statement on Form S-1 (Registration No.
333-42177) as filed with the SEC on February 12, 1998.
++ Incorporated by reference from the exhibit of the same number in the
Registrant's Registration Statement on Form S-1 (Registration No.
333-58975) as filed with the SEC on July 28, 1998.
46