QUEST SOFTWARE INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2003

OR

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________ to __________

COMMISSION FILE NO. 000-26937

QUEST SOFTWARE, INC.
(Exact name of registrant as specified in its charter)

California		33-0231678
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

8001 Irvine Center Drive Irvine, California		92618
(Address of principal executive offices)		(Zip code)

Registrant’s telephone number, including area code: (949) 754-8000

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 o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

Yes x

No o

The number of shares outstanding of the Registrant’s Common Stock, no par value, as of May 8, 2003 was 91,752,226.

QUEST SOFTWARE, INC.

FORM 10-Q

TABLE OF CONTENTS

		Page Number

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements

	Condensed Consolidated Balance Sheets as of December 31, 2002 and March 31, 2003 (unaudited)	2

	Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2002 and 2003 (unaudited)	3

	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2002 and 2003 (unaudited)	4

	Condensed Consolidated Statements of Comprehensive Operations for the Three Months Ended March 31, 2002 and 2003 (unaudited)	5

	Notes to Condensed Consolidated Financial Statements (unaudited)	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	22

Item 4.	Controls and Procedures	22

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	24

Item 6.	Exhibits and Reports on Form 8-K	24

SIGNATURES		25
CERTIFICATIONS		26

PART I—FINANCIAL INFORMATION

Item 1: Financial Statements

QUEST SOFTWARE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)

	December 31, 2002			March 31, 2003

ASSETS
Current assets:
Cash and cash equivalents	$	64,283		$	65,407
Short-term marketable securities		27,841			44,831
Accounts receivable, net		40,330			29,464
Prepaid expenses and other current assets		9,653			8,659
Deferred income taxes		9,563			9,471

Total current assets		151,670			157,832
Property and equipment, net		44,616			43,539
Long-term marketable securities		115,422			118,164
Goodwill		231,717			231,717
Amortizing intangible assets, net		31,116			28,096
Deferred income taxes		14,960			14,975
Other assets		2,341			1,496

Total assets	$	591,842		$	595,819

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	5,308		$	5,502
Accrued compensation		13,900			12,880
Other accrued expenses		23,703			18,326
Income taxes payable		1,323			1,662
Deferred revenue		63,128			65,966

Total current liabilities		107,362			104,336
Long-term liabilities and other		5,941			5,797
Commitments and contingencies (Notes 11 and 12)
Shareholders’ equity:
Preferred stock, no par value, 10,000 shares authorized; no shares issued or outstanding		—			—
Common stock, no par value, 150,000 shares authorized; 90,715 and 91,127 issued and outstanding at December 31, 2002 and March 31, 2003, respectively		562,517			566,948
Accumulated deficit		(68,073	)		(65,187	)
Accumulated other comprehensive income		1,309			1,139
Notes receivable from sale of common stock		(17,214	)		(17,214	)

Net shareholders’ equity		478,539			485,686

Total liabilities and shareholders’ equity	$	591,842		$	595,819

See accompanying notes to condensed consolidated financial statements.

QUEST SOFTWARE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

	Three Months Ended March 31,

	2002		2003

Revenues:
Licenses	$	37,490	$	42,970
Services		21,903		28,991

Total revenues		59,393		71,961
Cost of revenues:
Licenses		724		686
Services		4,371		5,195
Amortization of purchased intangible assets		1,402		2,130

Total cost of revenues		6,497		8,011

Gross profit		52,896		63,950
Operating expenses:
Sales and marketing		30,151		36,221
Research and development		15,168		17,185
General and administrative		5,926		6,655
Intangible asset amortization		385		867

Total operating expenses		51,630		60,928

Income from operations		1,266		3,022
Other income, net		1,617		1,613

Income before income tax provision		2,883		4,635
Income tax provision		1,162		1,748

Net income	$	1,721	$	2,887

Net income per share:
Basic and Diluted	$	0.02	$	0.03

Weighted average shares:
Basic		89,748		90,974
Diluted		93,808		92,922

See accompanying notes to condensed consolidated financial statements.

QUEST SOFTWARE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

	Three Months Ended March 31,

	2002			2003

Cash flows from operating activities:
Net income	$	1,721		$	2,887
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		5,302			6,871
Compensation expense associated with stock option grants		925			495
Accrued interest receivable from shareholders		(275	)		—
Deferred income taxes		1,097			94
Provision for bad debts		146			138
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable		8,432			10,673
Prepaid expenses and other current assets		52			991
Other assets		(67	)		948
Accounts payable		(510	)		89
Accrued compensation		(618	)		(1,101	)
Other accrued expenses		(4,057	)		(5,274	)
Income taxes payable		744			1,866
Deferred revenue		4,796			2,681
Other liabilities		(59	)		(145	)

Net cash provided by operating activities		17,629			21,213
Cash flows from investing activities:
Purchases of property and equipment		(3,051	)		(2,867	)
Cash paid for acquisition, net of cash acquired		(4,063	)		—
Purchases of marketable securities		(21,823	)		(42,375	)
Sales and maturities of marketable securities		9,455			22,475

Net cash used in investing activities		(19,482	)		(22,767	)
Cash flows from financing activities:
Repayment of notes payable		(191	)		—
Repayment of capital lease obligations		(27	)		(91	)
Proceeds from the exercise of stock options		615			195
Proceeds from employee stock purchase plan		2,522			2,286

Net cash provided by financing activities		2,919			2,390
Effect of exchange rate changes on cash and cash equivalents		(350	)		288

Net increase in cash and cash equivalents		716			1,124
Cash and cash equivalents, beginning of period		30,279			64,283

Cash and cash equivalents, end of period	$	30,995		$	65,407

Supplemental disclosures of condensed consolidated cash flow information:
Cash paid for:
Interest	$	13		$	22

Income taxes	$	2		$	60

Supplemental schedule of non-cash investing and financing activities:
Unrealized loss on available-for-sale securities	$	(846	)	$	(170	)

Tax benefit related to stock option exercises	$	1,128		$	1,510

See accompanying notes to condensed consolidated financial statements.

QUEST SOFTWARE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS
(In thousands)
(Unaudited)

	Three Months Ended March 31,

	2002			2003

Net income	$	1,721		$	2,887
Other comprehensive loss:
Unrealized loss on available-for-sale securities		(846	)		(170	)

Comprehensive income	$	875		$	2,717

See accompanying notes to condensed consolidated financial statements.

QUEST SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Basis of Presentation

Our accompanying unaudited condensed consolidated financial statements as of March 31, 2003 and for the three months ended March 31, 2002 and 2003, reflect all adjustments (consisting of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

These financial statements should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2002.

Operating results for the three months ended March 31, 2003 are not necessarily indicative of the results that may be expected for any future period.

2. New Accounting Pronouncements

In November 2002, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others.” FIN 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. We adopted the disclosure provisions of FIN 45 during the fourth quarter of fiscal 2002 and we provided the required disclosures in Note 12. We adopted the recognition provisions of FIN 45 effective January 1, 2003 and such adoption did not have an impact on our condensed consolidated results of operations or financial position.

In December 2002, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 148, “Accounting for Stock-Based Compensation— Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods for voluntary transition to SFAS No. 123’s fair value method of accounting for stock-based employee compensation (“the fair value method”). SFAS No. 148 also requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income (loss) and earnings (loss) per share in annual and interim financial statements. We adopted the provisions of SFAS No. 148 effective January 1, 2003 and have provided the disclosures required under SFAS No. 148 herein. Adoption of SFAS No. 148 did not impact our consolidated results of operations and financial position since we have not adopted the fair value method. However, should we be required to adopt the fair value method in the future, such adoption could have a material impact on our consolidated results of operations or financial position.

We account for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” As permitted by SFAS No. 123, as amended by SFAS No. 148, we have chosen to continue to account for our stock-based compensation plans under APB Opinion No. 25 and provide the expanded disclosures specified in SFAS No. 123, as amended by SFAS No. 148. Had compensation cost been determined using the fair value method our net income would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data):

	Three Months Ended March 31,

	2002			2003

Net income (loss):
As reported	$	1,721		$	2,887
Add: Stock-based compensation expense included in reported net income, net of related tax effects		555			307
Deduct: Total stock-based compensation determined under fair value based method for all awards, net of related tax effects		(5,558	)		(6,624	)

Pro forma	$	(3,282	)	$	(3,430	)

Basic and diluted net income (loss) per share:
As reported		0.02			0.03
Pro forma		(0.04	)		(0.04	)

For purposes of estimating the compensation cost of our option grants in accordance with SFAS No. 123, as amended by SFAS No. 148, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. Weighted-average assumptions used for the three months ended March 31, 2002 and 2003 were as follows:

	Three Months Ended March 31,

	2002			2003

Risk-free interest rates		5	%		4	%
Expected life (in years)		5			5
Expected stock volatility		77	%		54	%

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. We adopted the provisions of FIN 46 effective January 1, 2003. We do not have any variable interest entities; thus adoption of FIN 46 did not have an impact on our consolidated results of operations or financial position.

3. Amortizing Intangible Assets

Amortizing intangible assets as of December 31, 2002 and March 31, 2003, respectively, are comprised of the following (in thousands):

			December 31, 2002									March 31, 2003

	Gross Carrying Amount		Accumulated Amortization			Net		Weighted Average Amortization Period		Gross Carrying Amount		Accumulated Amortization			Net		Weighted Average Amortization Period

Acquired technology	$	44,017	$	(18,785	)	$	25,232		4.4	$	44,017	$	(20,915	)	$	23,102		4.4
Customer list		5,101		(1,945	)		3,156		2.7		5,101		(2,464	)		2,637		2.7
Non-compete agreement		2,200		(1,008	)		1,192		2.0		2,200		(1,282	)		918		2.0
Trademark		1,450		(48	)		1,402		5.0		1,450		(120	)		1,330		5.0
Other		2,264		(2,130	)		134		2.3		2,264		(2,155	)		109		2.3

	$	55,032	$	(23,916	)	$	31,116			$	55,032	$	(26,936	)	$	28,096

Amortization expense for amortizing intangible assets was $1.9 million and $3.1 million for the three months ended March 31, 2002 and 2003, respectively. Estimated annual amortization expense related to intangible assets acquired prior to March 31, 2003 by fiscal year is as follows: 2003—$10.7 million; 2004—$5.7 million; 2005—$4.0 million; 2006—$3.7 million; 2007—$3.0 million; thereafter—$4.0 million. All intangible assets currently recorded will be fully amortized by the end of 2009.

4. Acquisitions

We acquired the outstanding shares of BB4 Technologies, Inc., a provider of systems availability monitoring solutions in February 2002 and Sitraka, Inc., a leading developer of application server performance management products in November 2002. Actual results of operations of these companies acquired are included in the condensed consolidated financial statements from the dates of acquisition. Our financial results for the three months ended March 31, 2003 include actual results of these acquisitions for the full period. The pro forma results of operations data for the same period of 2002 presented below assume that the acquisitions had been made at the beginning of fiscal 2002 and include amortization of identified intangibles from that date. The pro forma data is presented for informational purposes only and is not necessarily indicative of the results of future operations nor of the actual results that would have been achieved had the acquisitions taken place at the beginning of fiscal 2002 (in thousands):

	Three Months Ended March 31, 2002

Revenues	$	63,006
Net income		23
Net income per share—basic and diluted		0.00

5. Other Compensation Costs

We record compensation expense for options granted to purchase common stock if the related exercise price of the option is below fair market value. The expense equals the difference between the fair market value of our common stock on the grant or assumption date and the exercise price of the stock options. We assumed certain stock options in connection with various acquisitions. We also record compensation costs from additional payroll taxes incurred when employees exercise stock options based on the difference between the exercise price and the market price on the date of exercise.

The following table shows the allocation to Cost of Services Revenues, Sales and Marketing, Research and Development, and General and Administrative expenses of such costs based on the related headcount for the three months ended March 31, 2002 and 2003 (in thousands):

	Three Months Ended March 31,

	2002		2003

Cost of services revenues	$	60	$	28
Sales and marketing		457		233
Research and development		333		181
General and administrative		75		53

Total other compensation costs	$	925	$	495

We expect to amortize at least $0.3 million per quarter throughout 2003, and insignificant amounts through 2004, which corresponds to the remaining vesting periods of the related options.

6. Net Income Per Share

We compute net income per share in accordance with SFAS No. 128, “Earnings per Share.” Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities by including other common stock equivalents, including stock options, in the weighted-average number of common shares outstanding for a period, if dilutive.

The following table summarizes our earnings per share computation for the three months ended March 31, 2002 and 2003 (in thousands, except per share data):

	Three Months Ended March 31,

	2002		2003

Net income	$	1,721	$	2,887

Basic net income per share – weighted average shares		89,748		90,974
Incremental common shares attributable to shares issuable under employee stock plans		4,060		1,948

Diluted net income per share – weighted average shares		93,808		92,922

Net income per share – basic and diluted	$	0.02	$	0.03

7. Shareholders’ Equity

In January 2003, 286,815 shares of common stock were purchased under our Employee Stock Purchase Plan at a price of $7.97 per share.

8. Stock Option Plans

The following table summarizes information about stock options outstanding as of March 31, 2003 (in thousands, except for per share data):

	Number of Shares			Weighted-Average Exercise Price

Balance at December 31, 2002		19,710		$	13.28
Granted		496			10.12
Exercised		(122	)		1.60
Canceled		(375	)		14.69

Balance at March 31, 2003		19,709			13.24

Options exercisable as of March 31, 2003		5,505			13.00

Weighted-average fair value of options granted during the three months ended March 31, 2003					5.14

9. Geographic and Segment Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by our chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our operating segments are managed separately because each segment represents a strategic business unit that offers different products or services.

Our reportable operating segments are Licenses and Services. The Licenses segment develops and markets licenses to use our software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to our software products.

We do not separately allocate operating expenses to these segments, nor do we allocate specific assets to these segments. Therefore, segment information reported includes only revenues, cost of revenues, and gross profit, as this information and the geographic information described below are the only information provided to the chief operating decision maker on a segment basis.

Reportable segment data for the three months ended March 31, 2002 and 2003, is as follows (in thousands):

	Licenses		Services		Total

Three months ended March 31, 2002
Revenues	$	37,490	$	21,903	$	59,393
Cost of Revenues		2,126		4,371		6,497

Gross profit	$	35,364	$	17,532	$	52,896

Three months ended March 31, 2003
Revenues	$	42,970	$	28,991	$	71,961
Cost of Revenues		2,816		5,195		8,011

Gross profit	$	40,154	$	23,796	$	63,950

Revenues are attributed to geographic areas primarily based on the location of the entity to which the products or services were delivered. Revenues, gross profit, income (loss) from operations and long-lived assets concerning principal geographic areas in which we operate are as follows (in thousands):

	North America (1)		Europe			Other International		Total

Three months ended March 31, 2002
Revenues	$	46,509	$	11,320		$	1,564	$	59,393
Gross profit		44,560		7,432			904		52,896
Income (loss) from operations		2,386		(1,362	)		242		1,266
Long-lived assets		443,852		1,872			1,298		447,022
Three months ended March 31, 2003
Revenues	$	53,953	$	15,870		$	2,138	$	71,961
Gross profit		51,601		10,906			1,443		63,950
Income (loss) from operations		3,152		(1,196	)		1,066		3,022
Long-lived assets		433,818		3,304			865		437,987

(1) Principally represents operations in the United States.

10. Investments

We have classified all debt securities with original maturities of greater than three months as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income. The cost basis for realized gains and losses on available-for-sale securities is determined on a specific identification basis. We have classified available-for-sale securities as current or long-term based primarily on the maturity date of the related securities.

We have a venture capital investment in a private equity fund for business and strategic purposes, and may make additional investments of this nature in the future. At March 31, 2003, we valued this cost basis investment at $0.6 million. In addition, we have committed to make additional capital contributions to this private equity fund totaling $2.2 million. If the companies in which we make direct or indirect investments in do not complete initial public offerings or are not acquired by publicly traded companies or for cash, we may not be able to sell these investments. In addition, even if we are able to sell these investments we cannot assure that we will be able to sell them at a gain or even recover our investment. We do not believe that any impairment exists for the three months ended March 31, 2003.

12. Commitments and Contingencies

On July 2, 2002, Computer Associates International, Inc. filed a complaint against us and four of our employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in connection with the development of the database administration component of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. We will vigorously defend CA’s claims and do not believe that this matter will have a material adverse effect on our results of operations or financial condition.

We are a party to other litigation, which we consider to be routine and incidental to our business. Management does not expect the results of any of these actions to have a material adverse effect on our results of operations or financial condition.

In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, and (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in the accompanying consolidated balance sheets as the fair value of these obligations issued during the three months ended March 31, 2003 was not significant to our financial position, results of operations, or cash flows.

Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations also should be read in conjunction with the consolidated financial statements and notes to those statements included elsewhere in this Report. Certain statements in this Report, including statements regarding our business strategies, operations, financial conditions and prospects, are forward-looking statements. Use of the words “believe,” “expect,” “anticipate,” “will,” “contemplate,” “would” and similar expressions that contemplate future events may identify forward-looking statements.

Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures made in this report, including those described under “Risk Factors,” and in other filings with the SEC, that attempt to advise interested parties of certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect management’s opinions only as of the date thereof. We do not assume any obligation to revise or update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.

Overview

We provide application management software solutions that maximize the availability, performance and manageability of our customer’s business critical applications and their underlying databases and other associated components. Many of our products also increase the cost effectiveness of a customer’s IT investments, including personnel, software and hardware.

Our revenues consist of software license fees and service fees. Our software-licensing model is primarily based on perpetual license fees, and our licenses are either server-based or, for our SQL development, report management and Microsoft administration tools, user-based. Service revenues primarily represent the ratable recognition of software maintenance contract fees, which entitle a customer to technical support via telephone and the internet and product enhancements. These maintenance contracts all have annual terms. Customers purchase a software maintenance contract for the first year when they license a product and have the option of renewing the maintenance contract annually thereafter. Service revenues also include revenues from consulting and training services.

Results of Operations

The following table sets forth certain condensed consolidated statement of operations data as a percentage of total revenues, except as indicated:

	Three Months Ended March 31,

	2002			2003

Revenues:
Licenses		63.1	%		59.7	%
Services		36.9			40.3

Total revenues		100.0			100.0
Cost of revenues:
Licenses		1.2			1.0
Services		7.4			7.2
Amortization of purchased intangible assets		2.4			3.0

Total cost of revenues		11.0			11.2

Gross profit		89.0			88.8
Operating expenses:
Sales and marketing		50.8			50.3
Research and development		25.5			23.9
General and administrative		10.0			9.2
Intangible asset amortization		0.6			1.2

Total operating expenses		86.9			84.6

Income from operations		2.1			4.2
Other income, net		2.7			2.2

Income before income taxes		4.8			6.4
Income tax provision		2.0			2.4

Net income		2.8	%		4.0	%

As a percentage of related revenues:
Cost of licenses		1.9	%		1.6	%
Cost of services		20.0	%		17.9	%

Three Months Ended March 31, 2002 and 2003

Revenues

Total revenues increased 21.2% to $72.0 million for the three months ended March 31, 2003 from $59.4 million in the comparable period of 2002.

License Revenues—License revenues increased 14.6% to $43.0 million for the three months ended March 31, 2003 from $37.5 million in the comparable period of 2002. License revenues represented 59.7% of total revenues for the three months ended March 31, 2003, compared to 63.1% for the same period of 2002. License revenues outside of North America accounted for 24.9% and 25.3% of total license revenues for the three months ended March 31, 2002 and 2003, respectively. License revenue growth from the prior year primarily derived from the acquisition of Sitraka, Inc. in November 2002 which contributed $2.6 million to license revenues and to the impact of favorable foreign exchange rate fluctuations.

Service Revenues—Service revenues increased by 32.4% to $29.0 million for the three months ended March 31, 2003 from $21.9 million for the same period in 2002. Service revenues outside of North America accounted for 16.2% and 24.5% of total service revenues for the three months ended March 31, 2002 and 2003, respectively. Higher renewal maintenance fees derived from improved maintenance renewal rates, growth in the base of installed products and, we believe, from improved support renewal billing processes. Support revenues from the acquired base of Sitraka, Inc. customers also contributed $1.7 million to the increase in service revenues. Professional services as a percentage of total service revenues represented 11.7% and 8.8% for the three months ended March 31, 2002 and 2003, respectively.

Cost of Revenues

Cost of Licenses—Cost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, and amortization of purchased software rights. Cost of licenses as a percentage of license revenues was 1.9% and 1.6% for the three months ended March 31, 2002 and 2003, respectively. We expect that cost of licenses as a percentage of license revenues will remain relatively constant throughout 2003.

Cost of Services—Cost of services primarily consists of personnel, facilities and systems costs used in providing support, consulting and training services. Cost of services increased by $0.8 million to $5.2 million for the three months ended March 31, 2003 from $4.4 million in the same period of 2002, representing an increase of 18.9%. Cost of services as a percentage of service revenues declined to 17.9% in the first quarter of 2003, compared to 20.0% in the same quarter of 2002. The increase in cost of services is due to an increase in the number of technical support personnel and consultants, primarily from the acquisition of Sitraka. The margin improvement is primarily due to our continued increase in customer maintenance and support revenues with a lower associated increase in headcount.

Amortization of Purchased Intangible Assets—Amortization of purchased intangible assets increased 51.9% to $2.1 million for the three months ended March 31, 2003 from $1.4 million in the same period of 2002. The increase is primarily due to amortization of purchased intangible assets related to the acquisition of Sitraka in 2002, offset slightly by purchased intangible assets from acquisitions made in 2000 that were fully amortized by the end of 2002. See Note 3 of the “Notes to Condensed Consolidated Financial Statements” for discussion of estimated future amortization expense. The useful lives of the acquired technologies range from one to seven years. See “Critical Accounting Policies and Estimates” for additional discussion regarding accounting for intangible assets.

Operating Expenses

Sales and Marketing— Sales and marketing expenses consist primarily of the following types of costs related to our sales and marketing activities: compensation and benefits; sales commissions; facilities and systems; recruiting; trade shows; travel and entertainment; and marketing communications. Sales and marketing expenses increased 20.1% to $36.2 million for the three months ended March 31, 2003 from $30.2 million in the same period of 2002. The increase in sales and marketing expenses resulted from increased labor expenses, primarily due to additional headcount from our acquisition of Sitraka, and the impact of unfavorable foreign exchange rate fluctuations. Higher sales commission expenses from increased license revenues and changes to sales compensation also contributed to the increase.

Research and Development— Research and development expenses consist primarily of compensation and benefit costs for software developers, software product managers, quality assurance and technical documentation personnel, associated facilities and systems costs and payments made to outside software development consultants. Research and development expenses increased 13.3% to $17.2 million for the three months ended March 31, 2003 from $15.2 million in the comparable period of 2002, and declined as a percentage of total revenues to 23.9% from 25.5%. The increase in research and development expenses

resulted largely from additional headcount as a result of our acquisition of Sitraka and severance and idle facility charges of $0.2 million incurred from closing one of our Canadian offices.

We believe significant expenditures in research and development are required to remain competitive, and expect that research and development expenses will continue to represent approximately 20-25% of total revenues for the foreseeable future.

General and Administrative— General and administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, administrative and information services personnel, professional fees, and associated facilities and systems costs. General and administrative expenses increased to $6.7 million for the three months ended March 31, 2003 from $5.9 million in the same period of 2002, representing an increase of $0.7 million or 12.3%. The increase is primarily attributable to increased legal expenses, directors’ and officers’ liability insurance premiums and the inclusion of Sitraka’s general and administrative expenses.

Intangible Asset Amortization—Intangible asset amortization includes the amortization of customer lists, trademarks and a non-compete agreement, associated with acquisitions made during 2000, 2001 and 2002. As a result of the acquisition of Sitraka, these costs increased to $0.9 million for the three months ended March 31, 2003 from $0.4 million in the same period of 2002. All intangible assets are amortized over their estimated useful lives ranging from two to seven years and are assessed for impairment under Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

Other Income (Expense), Net—Other income (expense), net consists primarily of interest income and expense and gain (loss) on equity investments. Other income (expense), net was $1.6 million for the three months ended March 31, 2003 and 2002. Interest income for the three months ended March 31, 2003, decreased from the previous year as a result of lower reinvestment rates. This decline was offset primarily by foreign exchange rate gains. The average interest rates of our investments are summarized under “Item 3: Quantitative and Qualitative Disclosures About Market Risks—Interest Rate Risk.”

Income Taxes—Provision for income taxes was $1.7 million for the three months ended March 31, 2003 compared with $1.2 million for the comparable period of 2002, representing effective rates for these periods of 40% and 38%, respectively. The decline in the effective tax rate is primarily the result of increased research and development tax credits as a percentage of income before income tax provision.

Liquidity and Capital Resources

As of March 31, 2003, liquidity is provided by cash, cash equivalents and short-term marketable securities totaling $110.2 million and $118.2 million in long-term investment grade corporate and government securities.

Net cash provided by operating activities increased by $3.6 million to $21.2 million for the three months ended March 31, 2003 from $17.6 million for the comparable period in 2002. The increase in cash provided by operating activities in the three months ended March 31, 2003 was driven primarily by strong cash collections on fourth quarter 2002 transactions as well as higher net income and income taxes payable, and was offset slightly by a slowdown in the rate of growth of deferred revenue.

Investing activities used $22.8 million during the three months ended March 31, 2003, consisting of $19.9 million net cash paid for purchases of marketable securities and $2.9 million in capital expenditures. Net cash used in investing activities was $19.5 million in the three months ended March 31, 2002, consisting of $12.4 million net cash paid for purchases of marketable securities, $3.1 million in capital expenditures and $4.1 million for an acquisition. Capital expenditures primarily consisted of information technology hardware and software purchases.

In the future, we expect cash will continue to be generated from our operations unless revenues were to decline. We do not expect to spend significant amounts of additional cash to acquire property and equipment in the near term and therefore the level of cash used in investing activities to acquire property and equipment should remain constant with that used in the three months ended March 31, 2003. We do, however, currently plan to reinvest our cash generated from operations in new short and long term marketable securities consistent with past investment practices, and continue to evaluate a variety of strategic investment and acquisition opportunities. Therefore, net cash used in investing activities may increase.

Financing activities generated $2.9 million and $2.4 million in the three months ended March 31, 2002 and 2003, respectively, primarily from issuance of our common stock under the employee stock purchase plan.

In December 2000, our Board of Directors authorized a stock repurchase program under which Quest may purchase up to two million shares of its common stock. Under the repurchase program, we may purchase shares from time to time at varying prices in open market or private transactions. In October 2001, our Board of Directors increased the total number of shares

authorized for repurchase under the stock repurchase program from two million shares to five million. As of March 31, 2003, we had repurchased approximately 1.7 million shares of our common stock under this program for an aggregate cost of approximately $58.0 million. Repurchases help offset dilution from stock issued under our stock option and stock purchase plans. No shares of common stock were repurchased under this plan during the three months ended March 31, 2002 or 2003.

As of March 31, 2003, our only significant contractual obligations or commercial commitments consisted of our facility lease commitments and operating leases for office facilities and certain items of equipment, and the remaining balance of certain indebtedness assumed in connection with our acquisition of FastLane in September 2000. These commitments will require cash payments of $14.5 million in 2003, $9.8 million in 2004, $8.1 million in 2005, $4.0 million in 2006 and $2.2 million thereafter. In addition, we have committed to make additional capital contributions to a private equity fund totaling $2.2 million as capital calls are made. We do not have any off-balance sheet arrangements that could reduce our liquidity. We would be required to use existing cash, cash equivalents and investment balances to support our working capital balances if we are not able to generate or sustain positive cash flow from operations. Our ability to generate cash from operations is subject to substantial risks described below under the caption “Risk Factors.”

Based on our current operating plan, we believe that our existing cash, cash equivalents and investment balances and cash flows from operations will be sufficient to finance our working capital and capital expenditure requirements through at least the next 12 months. However, if our revenues fall substantially below our expectations for a sustained period or if we use a significant amount of cash to pursue acquisition opportunities, we may require additional funds to support our working capital requirements or for other purposes and may seek to raise additional funds through public or private equity or debt financing or from other sources. If additional financing is needed, we can not assure you that such financing will be available to us on commercially reasonable terms or at all.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, accounts receivable, intangible assets and deferred income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies and the related judgments and estimates affect the preparation of our condensed consolidated financial statements.

Revenue Recognition

We derive revenues from two primary sources: (1) software licenses and (2) services, which include customer support, consulting and education. We license our products through our direct sales force and indirectly through resellers. We recognize revenue in accordance with the American Institute of Certified Public Accountants (AICPA) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” and related interpretations, and SOP 98-9 “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” Based on our reading and interpretation of SOP 97-2 and SOP 98-9, we believe that our current sales contract terms and business arrangements have been properly reported. The AICPA and its Software Revenue Recognition Task Force continue to issue interpretations and guidance for applying the relevant standards to a wide range of sales contract terms and business arrangements that are prevalent in the software industry. Also, the Securities and Exchange Commission (SEC) has issued Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements,” which provides guidance related to revenue recognition based on interpretations and practices followed by the SEC. Future interpretations of existing accounting standards or changes in our business practices could result in future changes in our revenue accounting policies that could have a material adverse effect on our business, financial condition and results of operations.

Revenues from sales of software licenses, which generally do not contain multiple elements, are recognized when: (1) we enter into a legally binding arrangement with a customer; (2) we deliver the products; (3) customer payment is deemed fixed or determinable and free of contingencies or significant uncertainties; and (4) collection is probable. If all the requirements of SOP 97-2, SOP 98-9 and SAB 101 have not been met, revenue recognition is deferred until such items are known or resolved. Revenue from post-sale customer support is deferred and recognized ratably over the term of the support contract. Revenues from consulting and training services are recognized as the services are performed.

For arrangements with multiple elements, we allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor-specific objective evidence.” Vendor-specific objective evidence of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold

separately. If we cannot objectively determine the fair value of any undelivered element included in bundled software and service arrangements, we defer revenue until all elements are delivered, services have been performed or until fair value can objectively be determined.

Accounts Receivable

We maintain allowances for sales returns and doubtful accounts for estimated losses resulting from the unwillingness or inability of our customers to make required payments. The amount of our reserves is based on historical experience and our analysis of the accounts receivable. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such determination was made. Additionally, if significant product performance issues were to arise resulting in our accepting sales returns, additional allowances may be required which would result in a reduction of revenue in the period such determination was made. Our standard licensing agreement does not permit customers to return products except in situations where the product does not perform in accordance with established product requirements and we are unable to remedy the outstanding issues. While such amounts have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past.

Intangible Assets

In July 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. We adopted SFAS No. 141 at the beginning of the third quarter of 2001 and adopted SFAS No. 142 at the beginning of the first quarter of 2002. As required by SFAS No. 142, we discontinued amortizing the remaining balances of goodwill as of the beginning of fiscal 2002. As a result, our annual amortization expense decreased approximately $56.0 million. All remaining and future acquired goodwill will be subject to impairment tests annually, or earlier if indicators of potential impairment exist, using a fair-value-based approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

Under SFAS No. 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. In conjunction with the implementation of SFAS No. 142, we performed our initial impairment review in the fourth quarter of 2002 and as a result determined that the carrying value of goodwill was less than the estimated fair value. In calculating the fair value of the reporting units (licenses and services), the Market Approach (Guideline Company Method) was the methodology deemed the most reliable and used for impairment analysis. We will perform subsequent annual impairment reviews during the fourth quarter of each year, or earlier if indicators of potential impairment exist. Future impairment reviews may result in charges against earnings to write down the value of goodwill.

Purchased intangible assets are recorded at the appraised value and amortized using the straight-line method over estimated useful lives of one to seven years. The net carrying amount of purchased intangible assets was considered recoverable at March 31, 2003. We will continue to evaluate the value of our purchased intangible assets on a periodic basis. Recoverability of these assets is determined based upon the forecasted undiscounted future net cash flows from the operations to which the assets relate, utilizing our best estimates, appropriate assumptions and projections at the time. These projected future cash flows may significantly vary over time as a result of increased competition, changes in technology, and fluctuations in demand. In the event that in the future it is determined that the purchased intangible assets value has been impaired, an adjustment will be made resulting in a charge for the write-down in the period in which the determination is made.

Deferred Taxes

We recognize deferred income tax assets and liabilities based upon the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Such deferred income taxes primarily relate to the timing of the recognition of certain revenue items and the timing of the deductibility of certain reserves and accruals for income tax purposes. We regularly review the deferred tax assets for recoverability and establish a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time periods within which the underlying timing differences become taxable or deductible, we could be required to establish an additional valuation allowance against the deferred tax assets which could result in a substantial increase in our effective tax rate and have a materially adverse impact on our operating results.

Recently Issued Accounting Pronouncements

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others.” FIN 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. We adopted the disclosure provisions of FIN 45 during the fourth quarter of fiscal 2002 and we provided the required disclosures in Note 12. We adopted the recognition provisions of FIN 45 effective January 1, 2003 and such adoption did not have an impact on our condensed consolidated results of operations or financial position.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation— Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods for voluntary transition to SFAS No. 123’s fair value method of accounting for stock-based employee compensation (“the fair value method”). SFAS No. 148 also requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income (loss) and earnings (loss) per share in annual and interim financial statements. We adopted the provisions of SFAS No. 148 effective January 1, 2003 and have provided the disclosures required under SFAS No. 148 in Note 2 of the “Notes to Condensed Consolidated Financial Statements”. Adoption of SFAS No. 148 did not have an adverse impact on our consolidated results of operations and financial position since we have not adopted the fair value method. However, should we be required to adopt the fair value method in the future, such adoption could have a material impact on our consolidated results of operations or financial position.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. We adopted the provisions of FIN 46 effective January 1, 2003. We do not have any variable interest entities; thus, adoption of FIN 46 did not have an impact on our consolidated results of operations and financial position.

RISK FACTORS

An investment in our shares involves risks and uncertainties. You should carefully consider the factors described below before making an investment decision in our securities. The risks described below are the risks that we currently believe are material risks of business and the industry in which we compete.

Our business, financial condition and results of operations could be adversely affected by any of the following risks. If we are adversely affected by such risks, then the trading price of our common stock could decline, and you could lose all or part of your investment.

Risks Related to Our Business

Our quarterly operating results may fluctuate in future periods and, as a result, we may fail to meet expectations of investors and analysts, causing our stock price to fluctuate or decline

Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors. These factors include the following:

	•	the size and timing of customer orders. See “— The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in our revenues.”

	•	the discretionary nature of our customers’ purchasing decisions and budget cycles;

	•	the timing of revenue recognition for sales of software products and services;

	•	the extent to which our customers renew their maintenance contracts with us;

	•	exposure to general economic conditions and reductions in corporate IT spending;

	•	changes in our level of operating expenses and our ability to control costs;

	•	our ability to attain market acceptance of new products and services and enhancements to our existing products;

	•	changes in our pricing policies or the pricing policies of our competitors;

	•	the relative growth rates of competing operating system, database and application platforms;

	•	the unpredictability of the timing and level of sales through our indirect sales channels;

	•	costs related to acquisitions of technologies or businesses, including amortization costs for intangible assets with indefinite lives; and

	•	the timing of releases of new versions of third-party software products that our products support or with which our products compete.

Fluctuations in our results of operations are likely to affect the market price of our common stock and may not be related to or indicative of our long-term performance.

The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in our revenues and operating results

Our license revenues in any quarter are substantially dependent on orders booked and shipped in that quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, or if the contract terms were to prevent us from recognizing revenue during that quarter. The sales cycles for certain of our software products, such as Vista Plus and SharePlex, can last from three to nine months and often require pre-purchase evaluation periods and customer education. Also, we have often booked a large amount of our sales in the last month, weeks or days of each quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each quarter is recognized from previously deferred revenue, our quarterly performance will depend primarily upon entering into new contracts to generate revenues for that quarter. These factors may cause significant periodic variation in our license revenues. In addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet expectations until the end of that quarter. Accordingly, if our

revenue growth rates slow or our revenues decline, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or quickly changed.

General economic conditions and reduced levels of corporate IT spending may continue to affect revenue growth rates and impact our business

Our business and operating results are subject to the effects of changes in general economic conditions. Recent unfavorable economic conditions have resulted in continued reduced corporate IT spending in the industries that we serve and a softening of demand for computer software, not only in the database and application market segments we support but also in the product segment in which we compete. If these economic conditions do not improve, or we experience continued deterioration in general economic conditions or further reduced corporate IT spending, our business and operating results could continue to be adversely impacted.

Many of our products are dependent on Oracle’s technologies; if Oracle’s technologies lose market share or become incompatible with our products, the demand for our products could suffer

We believe that our success has depended in part, and will continue to depend in part for the foreseeable future, upon our relationship with Oracle and our status as a complementary software provider for Oracle’s database and application products. Many versions of our products, including SharePlex and Quest Central for Oracle, and our Oracle development and deployment tools, are specifically designed to be used with Oracle databases. Although a number of our products work with other environments, our competitive advantage consists in substantial part on the integration between our products and Oracle’s products, and our extensive knowledge of Oracle’s technology. Currently, a significant portion of our total revenues is derived from products that specifically support Oracle-based products. If Oracle for any reason decides to promote technologies and standards that are not compatible with our technology, or if Oracle loses market share for its database products, our business, operating results and financial condition would be materially adversely affected.

Many of our products are vulnerable to direct competition from Oracle

We compete with Oracle in the market for database management solutions and the competitive pressure continues to increase. We expect that Oracle’s commitment to and presence in the database management product market will increase in the future and therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its server software offerings, possibly at no additional cost to its users. We believe that Oracle will also continue to enhance its database management technology. Furthermore, Oracle could attempt to increase its presence in this market by acquiring or forming strategic alliances with our competitors, and Oracle may be in better position to withstand and respond to the current factors impacting this industry. Oracle has a longer operating history, a larger installed base of customers and substantially greater financial, distribution, marketing and technical resources than we do. In addition, Oracle has well-established relationships with many of our present and potential customers. As a result, we may not be able to compete effectively with Oracle in the future, which could materially adversely affect our business, operating results and financial condition.

Our success depends on our ability to develop new and enhanced products that achieve widespread market acceptance

Our future success depends on our ability to address the rapidly changing needs of our customers by developing and introducing new products, product updates and services on a timely basis, by extending the operation of our products on new platforms and by keeping pace with technological developments and emerging industry standards. In order to grow our business, we are committing substantial resources to developing software products and services for the applications management market. If this market does not continue to develop as anticipated, or demand for our products in this market does not materialize or occurs more slowly than we expect, or if our development efforts are delayed or unsuccessful, we will have expended substantial resources and capital without realizing sufficient revenues, and our business and operating results could be adversely affected.

Acquisitions of companies or technologies may result in disruptions to our business and diversion of management attention

We have in the past made and we expect to continue to make acquisitions of complementary companies, products or technologies, including our recent acquisition of Sitraka, Inc. in November 2002. Any additional acquisitions will require us to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may subject us to liabilities and risks that are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert management’s attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. We may have to use cash, incur debt or issue equity

securities to pay for any future acquisitions. Use of cash or debt may affect our liquidity and use of cash would reduce our cash reserves. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for intangible assets with indefinite useful lives. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. Also, we may determine that the acquired company, product or technology does not further our business strategy or that the company, product or technology is ultimately worth less than the price we paid, either of which could generate a future impairment charge. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of acquisition.

Our efforts to constrain costs may strain our management, administrative, operational and financial infrastructure

We are experiencing slower growth and are focused on increasing our operating margins. These efforts place a strain on our management, administrative, operational and financial infrastructure. Our ability to manage our operations while reducing operating costs requires us to continue to improve our operational, financial and management controls and reporting systems and procedures. Although we have achieved increasing year over year margins from fiscal 2001 to 2002, we may not continue to be successful in achieving our profitability targets.

We may not generate increased business from our current customers, which could slow our revenue growth in the future

Most of our customers initially make a purchase of our products for a single department or location. Many of these customers may choose not to expand their use of our products. If we fail to generate expanded business from our current customers, our business, operating results and financial condition could be materially adversely affected. In addition, as we deploy new modules and features for our existing products or introduce new products, our current customers may choose not to purchase this new functionality or these new products. Moreover, if customers elect not to renew their maintenance agreements, our service revenues would be materially adversely affected.

Our international operations and our planned expansion of our international operations expose us to certain risks

We continue to expand our international sales activities as part of our business strategy. As a result, we face increasing risks from our international operations, including, among others:

	•	difficulties in staffing and managing foreign operations;

	•	longer payment cycles;

	•	seasonal reductions in business activity in Europe;

	•	increased financial accounting and reporting burdens and complexities;

	•	potentially adverse tax consequences;

	•	potential loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection;

	•	delays in localizing our products;

	•	political unrest or terrorism, particularly in areas in which we have facilities;

	•	compliance with a wide variety of complex foreign laws and treaties; and

	•	licenses, tariffs and other trade barriers.

In addition, because our international subsidiaries generally conduct business in the currency of the country in which they operate, our exposure to exchange rate fluctuations, which are outside of our control, will increase as our international operations expand. We have not yet entered into any hedging transactions to mitigate exposure to foreign currency fluctuations.

Operating in international markets also requires significant management attention and financial resources and will place additional burdens on our management, administrative, operational and financial infrastructure. We cannot be certain that our investments in establishing facilities in other countries will produce desired levels of revenue or profitability. In addition, we have limited experience in developing localized versions of our products and marketing and distributing them internationally.

Failure to develop strategic relationships could harm our business by denying us selling opportunities and other benefits

Our current collaborative relationships may not prove to be beneficial to us, and they may not be sustained. We also may not be able to enter into successful new strategic relationships in the future, which could have a material adverse effect on our business, operating results and financial condition. We could lose sales opportunities if we fail to work effectively with these parties. Moreover, we expect that maintaining and enhancing these and other relationships will become a more meaningful part of our business strategy in the future. However, many of our current partners are either actual or potential competitors with us. In addition, many of these third parties also work with competing software companies and we may not be able to maintain these existing relationships, due to the fact that these relationships are informal or, if written, are terminable with little or no notice.

Failure to adequately protect our intellectual property rights could harm our competitive position

Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology. We generally rely on a combination of trademark, trade secret, patent, copyright law and contractual restrictions to protect the proprietary aspects of our technology.

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. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any such resulting litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management and financial resources, which could harm our business.

Our means of protecting our proprietary rights may prove to be inadequate and competitors may independently develop similar or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services.

Third parties may claim that our software products or services infringe on their intellectual property rights, exposing us to litigation that, regardless of merit, may be costly to defend

Our success and ability to compete are also dependent on our ability to operate without infringing upon the proprietary rights of others. Third parties may claim that our current or future products infringe their intellectual property rights. Any such claim, with our without merit, could have a significant effect on our business and financial results. See “Legal Proceedings” in Part II, Item 1, of this report, for information concerning copyright infringement and trade secret misappropriation claims initiated against Quest by Computer Associates International, Inc. This and any future third party claim could be time consuming, divert management’s attention from our business operations and result in substantial litigation costs, including any monetary damages and customer indemnification obligations, which may result from such claims. In addition, parties making these claims may be able to obtain injunctive or other equitable relief affecting our ability to license the products that incorporate the challenged intellectual property. As a result of such claims, we may be required to obtain licenses from third parties, develop alternative technology or redesign our products. We cannot be sure that such licenses would be available on terms acceptable to us, if at all. If a successful claim is made against us and we are unable to develop or license alternative technology, our business and financial results and position could be materially adversely affected.

Our business will suffer if our software contains errors

The software products we offer are inherently complex. Despite testing and quality control, we cannot be certain that errors will not be found in current versions, new versions or enhancements of our products after commencement of commercial shipments. Significant technical challenges also arise with our products because our customers purchase and deploy our products across a variety of computer platforms and integrate it with a number of third-party software applications and databases. If new or existing customers have difficulty deploying our products or require significant amounts of customer support, our operating margins could be harmed. Moreover, we could face possible claims and higher development costs if our software contains undetected errors or if we fail to meet our customers’ expectations. As a result of the foregoing, we could experience:

	•	loss of or delay in revenues and loss of market share;

	•	loss of customers;

	•	damage to our reputation;

	•	failure to achieve market acceptance;

	•	diversion of development resources;

	•	increased service and warranty costs;

	•	legal actions by customers against us which could, whether or not successful, increase costs and distract our management; and

	•	increased insurance costs.

In addition, a product liability claim, whether or not successful, could harm our business by increasing our costs and distracting our management.

We incorporate software licensed from third parties into some of our products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for, or prevent the shipping of, our products

Certain of our software products contain components developed and maintained by third-party software vendors. We expect that we may have to incorporate software from third-party vendors in our future products. We may not be able to replace the functionality provided by the third-party software currently offered with our products if that software becomes obsolete, defective or incompatible with future versions of our products or is not adequately maintained or updated. Any significant interruption in the availability of these third-party software products or defects in these products could harm our sales unless and until we can secure an alternative source. Although we believe there are adequate alternate sources for the technology licensed to us, such alternate sources may not provide us with the same functionality as that currently provided to us.

Natural disasters or power outages could disrupt our business

A substantial portion of our operations are located in California, and we are subject to risks of damage and business disruptions resulting from earthquakes, floods and similar events, as well as from power outages. We have in the past experienced limited and temporary power losses in our California facilities due to power shortages, and we expect in the future to experience additional power losses. While the impact to our business and operating results has not been material, we cannot assure you that power losses will not adversely affect our business in the future, or that the cost of acquiring sufficient power to run our business will not increase significantly. Since we do not have sufficient redundancy in our networking infrastructure, a natural disaster or other unanticipated problem could have an adverse effect on our business, including both our internal operations and our ability to communicate with our customers or sell and deliver our products.

Risks Related to Our Industry

The demand for our products will depend on our ability to adapt to rapid technological change

Our future success will depend on our ability to continue to enhance our current products and to develop and introduce new products on a timely basis that keep pace with technological developments and satisfy increasingly sophisticated customer requirements. Rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and evolving industry standards characterize the market for our products and services. The introduction of products embodying new technologies and the emergence of new industry standards can render our existing products obsolete and unmarketable. As a result of the complexities inherent in today’s computing environments and the performance demanded by customers for embedded databases and Web-based products, new products and product enhancements can require long development and testing periods. As a result, significant delays in the general availability of such new releases or significant problems in the installation or implementation of such new releases could have a material adverse effect on our business, operating results and financial condition. We may not be successful in:

	•	developing and marketing, on a timely and cost-effective basis, new products or new product enhancements that respond to technological change, evolving industry standards or customer requirements;

	•	avoiding difficulties that could delay or prevent the successful development, introduction or marketing of these products; or

	•	achieving market acceptance for our new products and product enhancements.

We may not be able to attract and retain personnel

Our future success depends on the continued service of our executive officers and other key administrative, sales and marketing and support personnel, many of whom have recently joined our company. In addition, the success of our business is

substantially dependent on the services of our Chief Executive Officer and other executive officers. There has in the past been and there may in the future be a shortage of personnel that possess the technical background necessary to sell, support and develop our products effectively. Competition for skilled personnel is intense, and we may not be able to attract, assimilate or retain highly qualified personnel in the future. Our business may not be able to grow if we cannot attract qualified personnel. Hiring qualified sales, marketing, administrative, research and development and customer support personnel is very competitive in our industry, particularly in Southern California where Quest is headquartered.

Item 3: Quantitative and Qualitative Disclosures About Market Risks

We transact business in a number of different foreign countries around the world. In most instances, revenues are collected and operating expenses are paid in the local currency of the country in which we are transacting. Accordingly, we are exposed to incremental volatility in sales and earnings within these countries due to fluctuations in foreign exchange rates.

Our exposure to foreign exchange risk is directly proportional to the magnitude of foreign net profits and losses denominated in currencies other than the U.S. dollar, as well as our net foreign investment in non-U.S. dollar assets. These exposures have the potential to produce either gains or losses. Our cumulative currency gains or losses in any given period are typically lessened by the economic benefits of diversification and low correlation between different currencies, but there can be no assurance that this pattern will continue to be true in future periods.

The foreign currencies to which we currently have the most significant exposure are the Canadian dollar, the British pound, the Euro and the Australian dollar. Based on our overall currency rate exposure at March 31, 2003, a ten percent change in currency rates would not have a material effect on our consolidated financial position, results of operations or cash flows.

To date, we have not used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for speculative trading purposes. We regularly monitor the potential cost benefit of hedging foreign exchange exposures with derivatives and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.

Interest Rate Risk

Our exposure to market interest-rate risk relates primarily to our investment portfolio. We have not used derivative financial instruments to hedge the market risks of our investments. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer other than the United States government and its agencies. Our investments in marketable securities consist primarily of investment-grade bonds and United States government and agency securities. Investments purchased with an original maturity of three months or less are considered to be cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders’ equity.

Information about our investment portfolio is presented in the table below, which states the amortized book value and related weighted-average interest rates by year of maturity (in thousands):

	Amortized Book Value		Weighted Average Rate

Investments maturing by March 31,
2004	$	110,030		2.31	%
2005		39,406		3.29	%
2006		35,432		4.00	%
2007		15,000		3.08	%
Thereafter		27,395		4.50	%

Total portfolio	$	227,263		3.63	%

We maintain a level of cash and cash equivalents such that we have generally been able to hold our investments to maturity. Accordingly, changes in the market interest rate would not have a material effect on the fair value of such investments.

Item 4: Controls and Procedures

a) Evaluation of disclosure controls and procedures:

Within the ninety days prior to the date of this quarterly report and with the participation of our management, including the chief executive officer and principal financial officer, we performed an evaluation of our disclosure controls and procedures. Based on such evaluation, our chief executive officer and principal financial officer concluded that our disclosure controls and procedures were effective and sufficient to ensure that information

required to be disclosed by us in the reports that we file under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosure.

b) Changes in internal controls:

There have been no significant changes in our internal controls, or in other factors that could significantly affect these internal controls, subsequent to the date we completed our evaluation.

PART II—OTHER INFORMATION

Item 1: Legal Proceedings

On July 2, 2002, Computer Associates International, Inc. (CA) filed a complaint against us and four of our employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in connection with our development of the database administration component of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. We will vigorously defend CA’s claims and do not believe that this matter will have a material adverse effect on our results of operations or financial condition.

Item 6: Exhibits and Reports on Form 8-K

(a)

EXHIBITS

Exhibit Number		Exhibit Title

99.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certification of Vice President, Finance and Operations pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b)	REPORTS ON FORM 8-K

No reports on Form 8-K were filed during the three months ended March 31, 2003.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	QUEST SOFTWARE, INC.

	/s/ M. BRINKLEY MORSE
May 15, 2003
	M. Brinkley Morse Vice President, Finance and Operations

	/s/ KEVIN E. BROOKS

	Kevin E. Brooks Principal Accounting Officer

CERTIFICATIONS

I, Vincent C. Smith, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Quest Software, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: May 15, 2003

	/s/ VINCENT C. SMITH

	Vincent C. Smith Chief Executive Officer

I, M. Brinkley Morse, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Quest Software, Inc.;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

Date: May 15, 2003

	/s/ M. BRINKLEY MORSE

	M. Brinkley Morse, Vice President, Finance and Operations