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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the Quarterly Period Ended September 30,
2003.
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File Number: 000-31146
724 SOLUTIONS INC.
(Exact Name of Registrant as Specified in its Charter)
Ontario Inapplicable
------- ------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
4101 Yonge Street, Suite 702
Toronto, Ontario M2P 1N6
---------------------------- -----------
(Address of Principal Executive Office) (Zip Code)
(416) 226-2900
--------------
(Registrant's Telephone Number, Including Area Code).
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes No X
--- ---
Common Shares, no par value - 5,983,349 shares outstanding as
of November 3, 2003
(together with associated rights to purchase additional Common Shares)
724 SOLUTIONS INC.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION.............................................................................1
Item 1. Financial Statements.....................................................................1
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...12
Item 3. Quantitative and Qualitative Disclosures About Market Risk..............................22
Item 4. Controls and Procedures.................................................................22
PART II. OTHER INFORMATION................................................................................23
Item 1. Legal Proceedings.......................................................................23
Item 2. Changes in Securities...................................................................23
Item 3. Defaults Upon Senior Securities.........................................................24
Item 4. Submission of Matters to a Vote of Security Holders.....................................24
Item 5. Other Information.......................................................................24
Item 6. Exhibits and Reports on Form 8-K........................................................24
(a) Exhibits:.........................................................................24
(b) Reports on Form 8-K:..............................................................24
SIGNATURES.................................................................................................25
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
724 SOLUTIONS INC.
Consolidated Balance Sheets
(In thousands of U.S. dollars)
September 30, 2003 and December 31, 2002
=============================================================================================
2003 2002
- ---------------------------------------------------------------------------------------------
(Unaudited)
Assets
Current assets:
Cash and cash equivalents (note 2) $ 16,973 $ 19,129
Short-term investments (note 2) 975 18,562
Restricted cash (note 2) 962 962
Accounts receivable - trade, net of allowance
of $60 (December 31, 2002 - $150) 2,372 2,211
Prepaid expenses and other receivables 810 819
----------------------------------------------------------------------------------------
22,092 41,683
Fixed assets 711 1,418
Goodwill 9,097 9,097
Other intangible assets - 3,468
- ---------------------------------------------------------------------------------------------
$ 31,900 $ 55,666
=============================================================================================
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 378 $ 1,253
Accrued liabilities 4,457 9,892
Note payable - 600
Deferred revenue 648 1,217
Deferred consideration 491 1,415
----------------------------------------------------------------------------------------
5,974 14,377
Shareholders' equity:
Share capital (note 4):
Authorized:
Unlimited common shares
Unlimited preferred shares
Issued and outstanding:
5,983,349 common shares
(December 31, 2002 - 5,983,349) 764,508 764,508
Deferred stock-based compensation - (1,616)
Accumulated deficit (738,600) (721,560)
Cumulative translation adjustment 18 (43)
- ---------------------------------------------------------------------------------------------
Contingent liabilities (note 8) 25,926 41,289
- ---------------------------------------------------------------------------------------------
$ 31,900 $ 55,666
The historic common share numbers have been adjusted to reflect the 10 for 1
share consolidation completed in the second quarter of 2003.
See accompanying notes to consolidated financial statements.
724 SOLUTIONS INC.
Consolidated Statements of Operations
(In thousands of U.S. dollars, except per share amounts)
================================================================================================================
Three months ended Nine months ended
Sept. 30, Sept. 30,
2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
Revenue:
Product $ 1,676 $ 1,743 $ 5,321 $ 5,870
Services 1,437 3,809 4,317 9,203
-----------------------------------------------------------------------------------------------------------
3,113 5,552 9,638 15,073
Operating expenses:
Cost of revenue 1,458 1,625 4,454 5,997
Research and development 2,008 3,761 7,513 13,619
Sales and marketing 1,370 3,419 5,727 14,137
General and administrative 846 1,708 3,082 5,654
Depreciation 178 1,334 740 4,494
Amortization of intangible assets 1,156 1,011 3,468 3,175
Stock-based compensation:
Cost of revenue - 54 8 254
Research and development - 1,879 1,211 8,876
Sales and marketing - 662 282 3,129
General and administrative - 482 115 2,275
Restructuring costs (note 5) - 3,662 300 20,649
Write-down of fixed assets - 2,205 - 6,339
-----------------------------------------------------------------------------------------------------------
7,016 21,802 26,900 88,598
- ----------------------------------------------------------------------------------------------------------------
Loss from operations (3,903) (16,250) (17,262) (73,525)
Interest income, net 44 60 222 585
- ----------------------------------------------------------------------------------------------------------------
(3,859) (16,190) (17,040) (72,940)
- ----------------------------------------------------------------------------------------------------------------
Write-down of
Long-term investments - (5,280) - (5,280)
- ----------------------------------------------------------------------------------------------------------------
Loss for the period $(3,859) $(21,470) $(17,040) $(78,220)
================================================================================================================
Basic and diluted loss per share $ (0.64) $ (3.60) $ (2.85) $ (13.19)
================================================================================================================
Weighted average number of shares
used in computing basic and diluted
loss per share (in thousands) 5,983 5,965 5,983 5,930
================================================================================================================
The historic common share numbers have been adjusted to reflect the 10 for 1
share consolidation completed in the second quarter of 2003.
Certain comparative figures for 2002 have been reclassified to conform to the
financial statement presentation adopted in the current year.
See accompanying notes to consolidated financial statements.
2
724 SOLUTIONS INC.
Consolidated Statements of Shareholders' Equity
(In thousands of U.S. dollars, except number of common shares)
Nine months ended September 30, 2003 and 2002
(Unaudited)
===========================================================================================================================
Deferred
stock-based
compensation Cumulative Total
Common shares related to stock Accumulated translation shareholders'
Number Amount options deficit adjustment equity
===========================================================================================================================
Balances,
December 31, 2001 5,837,576 $ 763,033 $ (19,582) $ (634,153) $ (52) $ 109,246
Loss for the period - - - (78,220) - (78,220)
Cumulative translation
adjustment - - - - 3 3
Deferred stock-based
compensation - (163) 163 - - -
Amortization of
deferred stock-based
compensation - - 14,534 - - 14,534
Issuance for cash on
exercise of options 25,919 144 - - - 144
Issuance of common
shares 101,169 1,415 - - - 1,415
- ---------------------------------------------------------------------------------------------------------------------------
Balances,
September 30, 2002 5,964,664 $ 764,429 $ (4,885) $ (712,373) $ (49) $ 47,122
===========================================================================================================================
Balances,
December 31, 2002 5,983,349 $ 764,508 $ (1,616) $ (721,560) $ (43) $ 41,289
Loss for the period - - - (17,040) - (17,040)
Cumulative translation
adjustment - - - - 61 61
Amortization of
deferred stock-based
compensation - - 1,616 - - 1,616
- ---------------------------------------------------------------------------------------------------------------------------
Balances,
September 30, 2003 5,983,349 $ 764,508 $ - $ (738,600) $ 18 $ 25,926
===========================================================================================================================
The historic common share numbers have been adjusted to reflect the 10 for 1
share consolidation completed in the second quarter of 2003.
See accompanying notes to consolidated financial statements.
3
724 SOLUTIONS INC.
Consolidated Statements of Cash Flows
(In thousands of U.S. dollars)
===============================================================================================================
Three months ended Nine months ended
Sept. 30, Sept. 30,
2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
Cash flows from operating activities:
Loss for the period $ (3,859) $ (21,470) $ (17,040) $ (78,220)
Items not affecting cash:
Depreciation and amortization 1,334 2,345 4,208 7,669
Stock-based compensation - 3,077 1,616 14,534
Other non-cash expenses (34) (54) 9 (40)
Write-down of long-term investments - 5,280 - 5,280
Write-down of fixed assets - 2,205 - 6,339
Change in operating assets and liabilities:
Accounts receivable 146 418 (161) 6,031
Prepaid expenses and
other receivables 281 1,239 9 1,145
Accrued interest on short-term
investments - 189 - 346
Accounts payable (561) (746) (875) (1,883)
Accrued liabilities (3,234) (8,422) (5,435) (2,856)
Deferred consideration (492) - (866) -
Deferred revenue (4) (773) (569) (132)
----------------------------------------------------------------------------------------------------------
Net cash flows used in operating activities (6,423) (16,712) (19,104) (41,787)
Cash flows from financing activities:
Principal repayment of notes payable - (884) (600) (2,217)
Issuance of common shares - - - 144
----------------------------------------------------------------------------------------------------------
Net cash flows used in
financing activities - (884) (600) (2,073)
Cash flows from investing activities:
Purchase of fixed assets 49 (363) (39) (701)
Sale of short-term investments, net 1,783 (3,101) 17,587 11,843
Restricted cash 668 1,984 - (962)
Purchase of intangible and other assets - - - (457)
----------------------------------------------------------------------------------------------------------
Net cash flows from investing activities 2,500 (1,480) 17,548 9,723
Foreign exchange loss on cash held
in foreign currency - (48) - (39)
- ---------------------------------------------------------------------------------------------------------------
Increase (decrease) in cash and
cash equivalents (3,923) (19,124) (2,156) (34,176)
Cash and cash equivalents, beginning
of period 20,896 45,227 19,129 60,279
- ---------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of period $ 16,973 $ 26,103 $ 16,973 $ 26,103
Supplemental disclosure of non-cash
investing and financing activities:
Interest received $ 62 $ 301 $ 294 $ 1,148
Interest paid - 52 7 216
Common shares issued upon
settlement of contingent
consideration - - - 1,415
- ---------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
4
1. BASIS OF PRESENTATION:
The accompanying consolidated financial statements include the accounts
of 724 Solutions Inc. and its wholly owned subsidiaries (collectively
referred to as the "Company"). Intercompany transactions and balances
are eliminated on consolidation.
The consolidated financial statements are stated in U.S. dollars,
except as otherwise noted. They have been prepared in accordance with
Canadian generally accepted accounting principles, which conform, in
all material respects, with U.S. generally accepted accounting
principles. The interim financial statements follow the same accounting
policies and methods of application as the most recent annual financial
statements. For further information, reference should be made to the
audited annual consolidated financial statements for the year ended
December 31, 2002 that are included in the Company's Annual Report
filed with the Canadian Securities Administrators on March 31, 2003 and
with the Securities and Exchange Commission on Form 10-K filed on March
31, 2003.
The information furnished for the three and nine months ended September
30, 2003 and September 30, 2002 reflect, in the opinion of management,
all adjustments, consisting only of normal recurring adjustments,
necessary for a fair presentation of the results of the interim periods
presented. Interim results are not necessarily indicative of results
for a full year.
2. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS:
All short-term investments are classified as held-to-maturity because
the Company has the positive intent and ability to hold the securities
to maturity. Held-to-maturity securities are stated at amortized cost,
adjusted for amortization of premiums and accretion discounts to
maturity. The Company owns no short-term investments that are
considered to be trading securities or available-for-sale securities.
The components of cash and cash equivalents and short-term investments
are as follows:
==========================================================================================
September 30, December 31,
2003 2002
------------------------------------------------------------------------------------------
Cash and cash equivalents:
Cash $ 16,973 $ 6,375
Cash equivalents:
Government treasury bills - 1,554
Corporate bonds - 11,200
------------------------------------------------------------------------------------------
$ 16,973 $ 19,129
==========================================================================================
Short-term investments:
Held-to-maturity:
Term deposits 975 4,681
Corporate bond - 13,881
------------------------------------------------------------------------------------------
$ 975 $ 18,562
==========================================================================================
The Company has entered into letters of credit in the aggregate amount
of $962,000 (December 31, 2002 - $962,000). See note 7(c) for further
details.
5
3. SEGMENTED INFORMATION:
The Company operates in a single reportable operating segment, that is,
the design and delivery of an Internet infrastructure platform and
related applications that enable mobile network operators, financial
institutions and other customers to deliver information and services to
a range of Internet-enabled devices. The single reportable operating
segment derives its revenue from the sale of software and related
services. Information about the Company's geographical revenue and
assets is set forth below:
========================================================================================================
Three months ended Nine months ended
September 30, September 30,
2003 2002 2003 2002
--------------------------------------------------------------------------------------------------------
Net revenue by geographic location:
North America $ 2,845 $ 4,729 $ 8,380 $ 12,653
Europe 249 642 1,077 1,569
Asia Pacific 19 181 181 851
--------------------------------------------------------------------------------------------------------
$ 3,113 $ 5,552 $ 9,638 $ 15,073
========================================================================================================
For the nine months ended September 30, 2003, two customers accounted
for 54% and 11% of revenue. For the nine months ended September 30,
2002, three customers accounted for 27%, 20% and 11% of revenue.
For the nine months ended September 30, 2003, one customer accounted
for 72% of accounts receivable. For the nine months ended September 30,
2002, three customers accounted for 25%, 19% and 11% of accounts
receivable.
========================================================================================================
September 30, 2003 December 31, 2002
--------------------------------------------------------------------------------------------------------
Goodwill Goodwill
and other and other
Fixed intangible Fixed intangible
assets assets assets assets
--------------------------------------------------------------------------------------------------------
North America $ 328 $ 9,097 $ 596 $ 12,565
Europe 383 - 797 -
Asia Pacific - - 25 -
--------------------------------------------------------------------------------------------------------
$ 711 $ 9,097 $ 1,418 $ 12,565
========================================================================================================
6
4. SHARE CAPITAL:
(a) Reverse stock split
On April 24, 2003 the Company's shareholders approved a ten for one
reverse stock split of the Company's common shares. As a result, the
historic number of shares, historic loss per share and the weighted
average number of shares used in compiling basic and diluted loss per
share have been restated for all periods presented to reflect the
reverse stock split.
(b) Stock options
At September 30, 2003 and December 31, 2002, there were options
outstanding to acquire 844,848 and 748,408 common shares of the
Company, respectively.
On July 30, 2003, the Company granted an additional 214,400 options
with an exercise price of CDN $4.08 or U.S. $2.96 to employees,
officers, directors and consultants.
The following table summarizes the Company's options as of September
30, 2003
=================================================================================================================
Weighted average
remaining Number of
Weighted average contractual life options Weighted average
Exercise price ranges Number of options exercise price (years) exerciseable exercise price
-----------------------------------------------------------------------------------------------------------------
$ - $ 5.00 455,649 $3.85 9.1 40,092 3.15
5.01 10.00 215,170 6.55 8.8 110,310 5.84
10.01 20.00 44,187 21.64 6.0 41,201 17.79
20.01 50.00 19,018 48.02 6.3 18,655 38.45
50.01 100.00 52,039 96.01 6.8 43,000 93.58
100.01 600.00 58,785 271.30 7.2 24,267 293.69
-----------------------------------------------------------------------------------------------------------------
844,848 $ 30.75 8.5 277,525 $ 48.18
=================================================================================================================
(c) Loss per share
The Company has excluded from the calculation of diluted earnings per
share all common shares potentially issuable upon the exercise of stock
options and other potentially convertible instruments that could dilute
basic earnings per share in the future, because to do so would have
been anti-dilutive.
(d) Pro forma disclosure for stock-based compensation and other
stock-based payments:
For companies electing not to adopt the fair value measurement for
stock-based compensation, Canadian and US GAAP requires the disclosure
of pro forma net income (loss) and net income (loss) per share
information. The Company has presented this pro forma information as if
the Company had accounted for its stock options issued from inception
on July 28, 1997 under the fair value method. A summary of the pro
forma disclosure and the impact on the consolidated statement of
operations is presented in the following table:
7
========================================================================================================
Three months ended Nine months ended
September 30, September 30, September 30, September 30,
2003 2002 2003 2002
--------------------------------------------------------------------------------------------------------
Loss for the period $ (3,859) $ (21,470) $ (17,040) $ (78,220)
Compensation expense related
to the fair value of stock options
In excess of amounts recognized (3,735) (2,760) (11,961) (10,416)
--------------------------------------------------------------------------------------------------------
Pro forma loss for the period $ (7,594) $ (24,230) $ (29,001) $ (88,636)
========================================================================================================
Pro forma loss per share:
Basic and diluted $ (1.27) $ (4.06) $ (4.85) $ (14.95)
========================================================================================================
The fair value of each option granted in the period ended September 30,
2003 has been estimated at the date of grant using the Black-Scholes
option pricing model under the following assumptions: dividend yield of
zero, expected volatility of 100%, risk-free rate of return of 3.66%
and an expected life of the option of five years. The fair value of
each option granted prior to January 1, 2003, has been estimated at the
date of grant using the Black-Scholes option pricing model with the
assumptions disclosed in note 9(v) of the annual consolidated financial
statements.
The Company has assumed no forfeiture rate, as adjustments for actual
forfeitures are made in the period they occur. The weighted average
grant date fair value of options issued in three months ended September
30, 2003 was $2.23 (2002 - $3.88).
5. RESTRUCTURING COSTS:
The restructuring charge recorded in the second quarter of 2003 was
related to the termination of twenty-six employees, the closure of one
office and the partial closure of two other offices. It was partially
offset by an adjustment to the Hosting exit costs reserve. There was no
restructuring charge in the quarter ended September 30, 2003.
Nine months ended September 30, 2002
========================================================================================================
Severance Lease exit Hosting exit Write-down
costs costs of inventory Total
--------------------------------------------------------------------------------------------------------
Provision,
December 31, 2001 $ 2,331 $ 6,593 $ - $ - $ 8,924
Activity during the nine
month period ended
September 30, 2002
Restructuring charges 7,991 4,163 5,747 2,748 20,649
Cash payments (7,960) (6,489) (3,746) - (18,195)
Non-cash charges - (2,271) 1,691 (2,748) (3,328)
--------------------------------------------------------------------------------------------------------
Provision,
September 30, 2002 $ 2,362 $ 1,996 $ 3,692 $ - $ 8,050
--------------------------------------------------------------------------------------------------------
8
Nine months ended September 30, 2003
========================================================================================================
Severance Lease exit Hosting exit Write-down
costs costs of inventory Total
--------------------------------------------------------------------------------------------------------
Provision,
December 31, 2002 $ 967 $ 1,528 $ 2,487 $ - $ 4,982
Activity during the period
ended September 30, 2003
Cash payments (1,415) (1,358) (812) - (3,585)
Restructuring charges 525 175 (400) 300
--------------------------------------------------------------------------------------------------------
Provision,
September 30, 2003 $ 77 $ 345 $ 1,275 $ - $ 1,697
--------------------------------------------------------------------------------------------------------
6. STATEMENT OF COMPREHENSIVE LOSS:
Comprehensive loss generally encompasses all changes in shareholders'
equity except those arising from transactions with shareholders.
========================================================================================================
Three months ended Sept. 30, Nine months ended Sept. 30,
2003 2002 2003 2002
--------------------------------------------------------------------------------------------------------
Loss for the period $ (3,859) $ (21,470) $ (17,040) $ (78,220)
Other comprehensive loss,
net of income taxes:
Cumulative translation adjustment (33) 9 61 3
--------------------------------------------------------------------------------------------------------
Comprehensive loss
based on U.S. GAAP $ (3,892) $ (21,461) $ (16,979) $ (78,217)
========================================================================================================
7. GUARANTEES
(a) General indemnities
In the normal course of operations, the Company provides
indemnification agreements to counterparties in transactions such as
purchase contracts, service agreements, and leasing transactions. These
indemnification agreements sometimes require the Company to compensate
the counterparties for costs incurred as a result of changes in laws
and regulations (including tax legislation) or as a result of
litigation claims or statutory sanctions that may be suffered by the
counterparty as a consequence of the transaction. The terms of these
indemnification agreements will vary based upon the contract. The
nature of the indemnification agreements prevents the Company from
making a reasonable estimate of the maximum potential amount the
Company could be required to pay to counterparties. Historically, the
Company has not made any significant payments under such
indemnification. No amount has been accrued in the consolidated
financial statements with respect to these indemnification agreements.
9
(b) Product warranties
The Company's software license agreements generally include certain
provisions for indemnifying customers against liabilities if the
Company's software products infringe a third party's intellectual
property rights. To date, the Company has not incurred any material
costs as a result of such indemnifications and has not accrued any
liabilities related to such obligations in the Company's consolidated
financial statements.
The Company's software license agreements also generally include a
warranty that the Company's software products will substantially
operate as described in the applicable program documentation for a
specified period after delivery. The Company also warrants that
services the Company performs will be provided in a manner consistent
with industry standards and in accordance with applicable
specifications for a specified period from performance of the service.
To date, the Company has not incurred any material costs associated
with these warranties.
(c) Letters of credit
The Company has entered into letters of credit in the aggregate amount
of $962,000 to guarantee future payments under contractual commitments
(December 31, 2002 - $962,000). The commitments include $286,000
related to insurance premiums, $491,000 related to deferred
consideration and $185,000 to secure Company credit cards. The
insurance and deferred compensation amounts will be paid by the end of
2003 and the Company can cancel the credit card commitment at any time.
The letters of credit are secured by segregated short-term investments
and are disclosed as restricted cash on the consolidated balance sheet.
8. CONTINGENT LIABILITIES
The Company has been named in several class actions filed in federal
court in the Southern District of New York between approximately June
13, 2001 and June 28, 2001 (collectively the "IPO Allocation
Litigation"). The IPO Allocation Litigation was filed on behalf of
purported classes of plaintiffs who acquired the Company's common
shares during certain periods. These lawsuits have since been
consolidated into a single action and an amended complaint was filed on
or about April 19, 2002. Similar actions have or since been filed
against over 300 other issuers that have had initial public offerings
since 1998 and all are included in a single coordinated proceeding in
the Southern District of New York.
The amended complaint in the IPO Allocation Litigation names as
defendants, in addition to the Company, some or all of the current or
former directors and officers of the Company (the "Individual
Defendants") and certain underwriters of the Company's initial public
offering of securities (the "Underwriter Defendants"). In general, the
amended complaint alleges that the Underwriter Defendants: (1)
allocated shares of the Company's offering of equity securities to
certain of their customers, in exchange for which these customers
agreed to pay the Underwriter Defendants extra commissions on
transactions in other securities; and (2) allocated shares of the
Company's initial public offering to certain of the Underwriter
Defendants' customers, in exchange for which the customers agreed to
purchase additional common shares of the Company in the after-market at
certain pre-determined prices. The amended complaint also alleges that
the Company and the Individual Defendants failed to disclose these
facts and that the Company and the Individual Defendants were aware of,
or disregarded, the Underwriter Defendants' conduct. In October 2002,
the Individual Defendants were dismissed from the IPO Allocation
Litigation without prejudice.
10
In July 2003, a committee of the Company's Board of Directors
conditionally approved a proposed partial settlement with the
plaintiffs in this matter. The settlement would provide, among other
things, a release of the Company and of the Individual Defendants for
the conduct alleged in the action to be wrongful in the amended
complaint. The Company would agree to undertake other responsibilities
under the partial settlement, including agreeing to assign away, not
assert, or release certain potential claims the Company may have
against its underwriters. Any direct financial impact of the proposed
settlement is expected to be borne by the Company's insurers. The
committee agreed to approve the settlement subject to a number of
conditions, including the participation of a substantial number of
other issuer defendants in the proposed settlement, the consent of the
Company's insurers to the settlement, and the completion of acceptable
final settlement documentation. Furthermore, the settlement is subject
to a hearing on fairness and approval by the Court overseeing the IPO
Allocation Litigation.
If the proposed settlement is not consummated, the Company intends to
continue to vigorously defend itself and the Individual Defendants
against these claims. However, due to the inherent uncertainties of
litigation, and because the IPO Litigation is at a preliminary stage,
we cannot accurately predict the ultimate outcome IPO Allocation
Litigation.
11
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
OVERVIEW
724 Solutions Inc. is a leading provider of next-generation IP-based network and
data services. We were incorporated in 1997, and in 1999 we introduced our
initial products and solutions for the financial services industry. In 2001, we
began offering our Actionable Alerts and Mobile Internet Gateway products to
mobile network operators (MNO's). In October 2002, our products and solutions
for the mobile network operators were brought under the umbrella of our X-treme
Mobility Suite of products. Through our family of products, 724 Solutions
delivers reliable, scalable technology and solutions that allow mobile network
operators to rapidly deploy flexible and open, next-generation IP-based network
and data services.
Financial institutions (FI's) use 724's pro-active, alerts-based solutions to
offer services across a broad range of channels, including the mobile channel,
to their consumer customers and internal enterprise users, allowing these
organizations to improve customer satisfaction and retention while at the same
time lowering operating costs.
Our customers currently include leading mobile network operators and financial
institutions. With our corporate office in Toronto, Canada, we have development
and sales offices around the world, including Hong Kong, Germany, Switzerland,
the United Kingdom and the United States.
CRITICAL ACCOUNTING POLICIES
We periodically review our financial reporting and disclosure practices and
accounting policies to ensure they provide accurate and transparent information
relative to the current economic and business environment. As part of this
process, we have reviewed our selection, application and communication of
critical accounting policies and financial disclosures. We have determined that
the critical accounting policies relating to our core ongoing business
activities are primarily those that relate to revenue recognition. Other
important accounting policies are described in Note 2 to our audited annual
consolidated financial statements set forth in our annual report on form 10-K,
which we encourage you to read.
REVENUE RECOGNITION
SOURCES OF REVENUE
We derive revenue from licensing our products and providing related services,
including installation, integration, training, maintenance and support, and
application hosting services. We recognize revenue from our license agreements
when all the following conditions are met:
o We have an executed license agreement with the customer;
o We have delivered the software product to the customer;
o The amount of the fees to be paid by the customer is fixed and
determinable; and
o Collection of these fees is deemed probable.
Typically, software license agreements are multiple element arrangements that
include related maintenance and implementation fees. Accordingly, the fee is
allocated to each element in the arrangement based on the respective vendor
specific objective evidence of value (VSOE) of each element. For those contracts
for which we do not have sufficient VSOE, we use the residual method to record
12
revenues. Under this method, if we have VSOE for all undelivered elements
(typically, services and maintenance) we can record the remaining value of the
contract as license revenue after allocating full value to the undelivered
elements.
For license and services agreements that provide significant commitments to
refunds and/or penalties on the services and/or license components should the
system not perform according to documented specifications, we defer recognition
of revenue for the amount subject to refund or penalty until we achieve
contractually defined milestones or until customer acceptance has occurred, as
the case may be for such agreements.
PRODUCT REVENUE
Product revenue consists of the following:
o Fixed License Fee Arrangement - a one-time license fee for a fixed
number or copies of unlimited use of the software with a perpetual
term. We typically recognize the upfront fees in the period the
contract is executed or shortly thereafter.
o Variable License Fee Arrangement - a variable license fee based on the
numbers of users in a period. Revenue is recognized on an ongoing
basis and will vary with the number of our customers' end users.
o Reseller Arrangement - the reseller typically pays a non-refundable
licensing fee for our software and/or a royalty fee based on the
related number of users. We recognize revenue associated with
non-refundable license fees when we have met our revenue recognition
criteria for license agreements as outlined above.
o Solutions Arrangement - there are two key factors that distinguish
what we consider to be a solutions sale versus a software and services
sale. Firstly, in a solutions sale, there may initially be a higher
mix of revenue for services than in a software sale. Secondly, in a
solutions sale the services include the development and implementation
of customized software code and more complex interfaces than in a
software sale, where the contracted services are primarily
installation services. Recognition of revenue from such contracts will
primarily be based on the percentage of work completed as described
below under service revenue.
SERVICE REVENUE
IMPLEMENTATION AND CUSTOMER SERVICE FEES
Revenue from implementation and customer services includes fees for
implementation of our product offerings, consulting and training services.
Customers are charged a fee based on time and expenses. Revenue from
implementation and customer service fees is recognized as the services are
performed or deferred until we achieve contractually defined milestones or until
customer acceptance has occurred, as the case may be, for such contracts.
MAINTENANCE FEES
We receive revenue from maintaining and servicing our products for customers.
The maintenance fee is typically equal to a specified percentage of the
customer's license fee. If associated with the fixed fee license model, the
maintenance revenues received will be recorded as deferred revenue and
recognized on a straight-line basis over the contract period. When associated
with the variable fee license model, any maintenance payments will be recognized
on a monthly basis as earned.
13
HOSTING FEES
We no longer provide hosting services directly. Instead, we have arranged an
alliance with Computer Sciences Corporation (CSC), whereby CSC is our preferred
hosting partner for current and future customer deployments where hosting is or
will be required. Under our existing hosting contracts, we typically charge
customers a monthly flat fee or a monthly fee based on the number of users. The
fees are recognized on a monthly basis.
For a more detailed description of our revenue recognition policies, please
refer to note 2(c) of our annual audited consolidated financial statements for
the year ended December 31, 2002.
RESULTS OF OPERATIONS
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THREE AND NINE MONTHS
ENDED SEPTEMBER 30, 2002
Our consolidated financial statements have been prepared in accordance with
Canadian generally accepted accounting principles. These principles conform in
all material respects with U.S. generally accepted accounting principles.
REVENUE
PRODUCT REVENUE
In the three months ended September 30, 2003, product revenue was $1.7 million,
unchanged from the same period in 2002. In the nine months ended September 30,
2003, product revenue decreased to $5.3 million, including $860,000 related to a
contract cancellation fee in the first quarter of 2003, from $5.9 million for
the corresponding period in 2002. Due to continuing poor economic conditions,
our FI customers were reluctant to make large upfront commitments on license
fees as they had done in previous years. In addition, our change in strategy to
focus more on sales to MNO's, who typically have a longer sales cycle, has
resulted in a decrease in license revenue in 2003 compared to 2002.
SERVICE REVENUE
Service revenue decreased to $1.4 million and $4.3 million for the three and
nine months ended September 30, 2003, respectively, compared to $3.8 million and
$9.2 million in the corresponding periods in 2002. Service revenue declined in
2003 because there were fewer projects and the projects completed were, on
average, smaller than those completed in the previous year.
OPERATING EXPENSES
COST OF REVENUE
Cost of revenue (COR) consists primarily of personnel costs associated with
customer support, training, and implementations as well as amounts paid to
third-party consulting firms for those services, together with an allocation of
expenses for our facilities and administration.
Cost of revenue was $1.5 million and $4.5 million for the three and nine months
ended September 30, 2003, respectively, compared to $1.6 million and $6.0
million for the corresponding periods in 2002. COR has decreased in 2003 because
we have completed fewer projects and they have tended to be
14
narrower in scope than those completed in 2002 and because we have eliminated
costs not essential to our focus on the mobile network operator and financial
institution markets. Cost of revenue as a percentage of revenue, was 47% for the
three months ended September 30, 2003 and 46% for the nine months ended
September 30, 2003, compared to 29% and 40% for the corresponding periods in
2002.
RESEARCH AND DEVELOPMENT
Research and development expenses include compensation of software development
teams working on the continuing enhancement of our products as well as our
quality assurance and testing activities. These expenses also include the cost
of retaining independent contractors and consultants, software licensing
expenses, and allocated operating expenses.
Research and development (R&D) decreased to $2.0 million and $7.5 million for
the three and nine months ended September 30, 2003, respectively, compared to
$3.8 million and $13.6 million for the corresponding periods in 2002. The
decrease is a result of our restructuring initiatives that have reduced our R&D
headcount as we developed a more streamlined, integrated and focused product
road map and reduced duplication in the R&D process. We continue to evaluate our
R&D expenditure needs based on our new product architecture and services and the
current market environment. R&D expense, as a percentage of revenue, was 65% and
78% for the three months and the nine months ended September 30, 2003,
respectively, compared to 68% and 90% for the same periods in 2002.
SALES AND MARKETING
Sales and marketing expenses include compensation of sales and marketing
personnel, public relations and advertising, trade shows, marketing materials
and allocated operating expenses.
Sales and marketing (S&M) expenses were $1.4 and $5.7 million for the three and
nine months ended September 30, 2003, respectively, compared to $3.4 million and
$14.1 million for the corresponding periods in 2002. The decrease is a result of
the reduction in the number of sales and marketing personnel and reduced
spending on discretionary marketing programs. We continue to monitor our sales
and marketing expenditures to ensure that they remain aligned with our targeted
opportunities as well as prevailing market conditions. S&M expense, as a
percentage of revenue, was 44% and 59% for the three months and the nine months
ended September 30, 2003, respectively, compared to 62% and 94% for the same
periods in 2002.
GENERAL AND ADMINISTRATIVE
General and administrative (G&A) expenses include salaries and benefits for
corporate personnel and other general and administrative expenses such as
facilities, travel and professional consulting costs. Our corporate staff
includes executive officers and business development, financial planning and
control, legal, human resources and corporate administration staff.
G&A expenses decreased to $846,000 and $3.1 million for the three and nine
months ended September 30, 2003, respectively, compared to $1.7 million and $5.7
million for the corresponding periods in 2002. The decrease in G&A expenses
reflects our restructuring initiatives that have reduced complexity in our
business in order to align our infrastructure with the current market
environment.
DEPRECIATION AND AMORTIZATION
Depreciation expense was $178,000 and $740,000 in the three and nine months
ended September 30, 2003, respectively, compared to $1.3 million and $4.5
million in the corresponding periods in 2002.
15
Depreciation is down significantly because we have decommissioned redundant
fixed assets and reduced our capital expenditure budgets as part of our
restructuring initiatives.
Amortization expense was $1.2 million and $3.5 million for the three and nine
months ended September 30, 2003, respectively, compared to $1.0 million and $3.2
million in the corresponding periods in 2002. The amortization expense recorded
in 2003 and 2002 represents the amortization of acquired technology, which is
being amortized over a period of two to five years. At September 30, 2003, the
carrying value of our depreciable intangible assets is nil.
STOCK-BASED COMPENSATION
Stock-based compensation was nil and $1.6 million in the three and nine months
ended September 30, 2003, respectively, compared to $3.1 million and $14.5
million in the corresponding periods in 2002. The 2002 nine month expense
included significant charges related to the immediate recognition of deferred
stock-based compensation associated with employees who were terminated as part
of our restructuring plan as well as the immediate recognition of the
unamortized portion of the deferred stock compensation for those employees who
tendered their options as part of our stock option exchange initiative in
January 2002. In addition, the deferred stock compensation associated with the
Tantau acquisition was higher in 2002 as it was fully amortized by the end of
January 2003. There is currently no Deferred Stock-based Compensation to be
amortized.
RESTRUCTURING COSTS
With the downturn in general economic conditions, in the second quarter of 2001
we began to identify areas to reduce costs by eliminating duplicate resources
and positions, narrowing our product offerings and streamlining our operating
processes. We will continue to evaluate our costs on an ongoing basis.
Net restructuring charges were nil and $300,000 in the three and nine months
ended September 30, 2003, respectively, compared to $3.7 million and $20.6
million in the corresponding periods in 2002. Additionally, in the three and
nine month periods ended September 30, 2002, we recorded charges related to the
decommissioning of redundant fixed assets of $2.2 million and $6.3 million,
respectively. There have been no fixed assets write-downs in 2003.
The $300,000 net charge in the second quarter of 2003 included $525,000 related
to severance costs and $175,000 related to lease exit costs. These charges were
partially offset by a $400,000 reduction to our hosting provision. Included in
our "Accrued Liabilities" as at September 30, 2003 is approximately $1.7 million
in restructuring reserves. This includes severance costs of $77,000, lease exit
costs of $345,000 and hosting exit costs of $1.3 million. See note 5 to our
consolidated financial statements for the three and nine months ended September
30, 2003 for further details.
INTEREST INCOME
Interest income decreased to $44,000 and $222,000 for the three and nine months
ended September 30, 2003, respectively, compared to $60,000 and $585,000 in the
corresponding periods in 2002. Interest was derived from cash and cash
equivalent balances and short-term investments. Interest income is net of
interest expense relating to our note payable. The note was fully repaid by the
end of the first quarter of 2003. Interest income decreased in the three and
nine months ended September 30, 2003 compared to the same periods in 2002 due to
declining interest rates and because we have reduced holdings of cash and cash
equivalent balances and short-term investments.
16
NET LOSS
Our net loss decreased to $3.9 million and $17.0 million for the three and nine
months ended September 30, 2003, respectively, compared to $21.5 million and
$78.2 million in the corresponding periods in 2002.
Our net loss has decreased due to a number of factors. We incurred significant
restructuring charges and write downs of intangible and fixed assets in 2002
related to our restructuring efforts. Stock-based compensation charges and
depreciation expense are down significantly in 2003 and our restructuring
initiatives have resulted in significantly lower operating costs.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operating activities decreased to $6.4 million and $19.1
million for the three and nine months ended September 30, 2003, respectively,
compared to $16.8 million and $41.8 million for the corresponding periods in
2002, as we have significantly reduced our workforce and expense structure as a
result of our restructuring efforts. Net cash used in operating activities for
the three months ended September 30, 2003 consisted of our net loss of $3.9
million plus cash outflows of $3.7 million related to non-recurring severance,
historic acquisition, hosting exit and deferred consideration payments and
$100,000 related to other working capital changes offset by non-cash items,
primarily depreciation and amortization charges of $1.3 million.
As at September 30, 2003, we had commitments to make $670,000 in minimum lease
payments through 2005, primarily related to our facilities and equipment
rentals. As a result of our restructuring initiatives, we have vacated some of
our premises and we have been successful in reducing our future lease
commitments with our landlords.
Cash used in financing activities was nil and $600,000 for the three and nine
month periods ending September 30, 2003, respectively, compared to $884,000 and
$2.1 million in the corresponding periods in 2002. The $600,000 represents the
final two payments of our note payable that was repaid in the first quarter of
2003. There have been no common share issuances in 2003. In the nine months
ended September 30, 2002, principal payments on the note totaled $1.3 million
and we had a cash source of $144,000 resulting from the exercise of options.
Excluding the sale (purchase) of short-term investments and restricted cash
changes, we had a cash source of $49,000 from investing activities, resulting
from the sale of redundant fixed assets, in the three months ended September 30,
2003 compared to a cash use of $363,000 in the same period in 2002. For the nine
months ended September 30, 2003, cash used in investing activities not related
to short-term investments and restricted cash changes was $39,000 compared to
$1.2 million in the same period of 2002. We have significantly reduced our
capital assets budget.
Total cash used, excluding the sale (purchase) of short-term investments and
restricted cash changes, was $6.4 million and $19.7 million for the three and
nine month periods ending September 30, 2003, respectively, compared to $18.0
million and $45.0 million in the corresponding periods in 2002. This was mainly
due to our significantly lower operating costs.
17
Due to the operational savings resulting from our restructuring and based on
current estimates, we expect that cash from the sales of our products and our
existing cash and cash equivalents and short-term investments will be sufficient
to cover our cash requirements, including planned capital expenditures, for at
least the next 12 months. We may require additional financing if we expand our
operations at a faster rate than currently expected, if our costs unexpectedly
increase, or if we seek to effect one or more significant acquisitions.
RECENT ACCOUNTING PRINCIPLES
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure, an amendment of FASB Statement No.
123." This Statement amends FASB Statement No. 123, "Accounting for Stock-Based
Compensation," to provide alternative methods of transition for a voluntary
change to the fair value method of accounting for stock-based employee
compensation. In addition, this Statement amends the disclosure requirements of
Statement No. 123 to require prominent disclosure of the pro forma impact of
fair value accounting for stock options in both annual and interim financial
statements. Certain of the disclosure modifications are required for fiscal
years ending after December 15, 2002 and are included in the notes to these
consolidated financial statements.
Effective January 1, 2003, the Company adopted the initial recognition and
measurement provisions of FASB interpretation No. 45 "Guarantees, Including
Indirect Guarantees of Indebtedness of Others," which apply on a prospective
basis to certain guarantees issued or modified after December 31, 2002. FIN 45
requires that a liability be recognized for the estimated fair value of the
guarantee at its inception. The Company has entered into agreements that contain
features which meet the definition of a guarantee under FIN 45 as described in
note 7. Historically, the Company has not made significant payments related to
these guarantees. The adoption of FIN 45 did not have a material impact on the
business, results of operations and financial condition of the Company.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities, an interpretation of ARB No. 51." This
Interpretation addresses the consolidation by business enterprises of variable
interest entities as defined in the Interpretation. The Interpretation applies
to variable interests in variable interest entities created after January 31,
2003, and to variable interests in variable interest entities obtained after
January 31, 2003. The interpretation must be applied by the Company in its 2003
annual reporting period. The Interpretation requires certain disclosures in
financial statements issued after December 15, 2003 if it is reasonably possible
that the Company will consolidate or disclose information about variable
interest entities when the Interpretation becomes effective. The application of
this Interpretation will not have a material effect on the Company's financial
statements.
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
Statements contained in this report which are not historical facts are
forward-looking statements within the meaning of Section 21E of the U.S.
Securities Exchange Act of 1934, as amended. A forward-looking statement may
contain words such as "anticipate that," "believes," "continue to," "estimates,"
"expects to," "hopes," "intends," "plans," "to be," "will be," "will continue to
be," or similar words. These forward-looking statements include the statements
herein regarding: future developments in the financial services and mobile
network industries; our estimated cost reductions; our future ability to fund
our operations and become profitable; our development of new products and
relationships; our plans to operate in the mobile network operator and financial
institutions markets; the rate at which consumers will adopt wireless
applications; our ability to increase our customer base; the services that we or
our customers will introduce and the benefits that end users will receive from
these services; the impact of entering new markets; our plans to use or not to
use certain types of technologies in the future; our future
18
cost of revenue, gross margins and net losses; our future restructuring,
research and development, sales and marketing, general and administrative,
stock-based compensation, depreciation and amortization expenses; our future
interest income; the value of our goodwill and other intangible assets; our
future capital expenditures and capital requirements; and the anticipated impact
of changes in applicable accounting rules.
The accuracy of these statements may be impacted by a number of business risks
and uncertainties that could cause actual results to differ materially from
those projected or anticipated. These risks include the risks described in our
SEC filings, including our annual report on Form 10-K. These risks are also
described in our filings with the Canadian Securities Administrators, including
our prospectuses, material change reports, Annual Information Form and
Management Information Circular. We encourage you to carefully review these
risks in order to evaluate an investment in our securities. Some of the key
risks that could cause actual results to differ materially from those projected
or anticipated also include the risks discussed below. We do not undertake any
obligation to update this forward-looking information, except as required under
applicable law.
GENERAL INDUSTRY, ECONOMIC AND MARKET CONDITIONS
Our future revenues and operating results are dependent to a large extent upon
general economic conditions, conditions in the wireless market and within that
market our primary target markets of mobile network operators and financial
institutions. As economic activity slowed in these markets beginning in 2001,
our customers began deferring their spending on our products and our revenues
began to decline. Our sales cycle has lengthened significantly as potential
customers have reduced their spending commitments and their willingness to make
investments in new wireless services. Moreover, adoption of wireless services
has not proceeded as rapidly as we previously anticipated. For example, in 2002,
Bank of Montreal and Wells Fargo, two of our initial customers, ceased offering
their wireless banking and/or brokerage services. If general economic conditions
continue to be adverse, if the economies in which our target customers are
located enter into a recession, or if demand for our solutions does not expand,
our ability to increase our customer base may be limited, and our revenue may
decrease further.
ENTERING NEW MARKETS
We have made mobile network operators an important focus of our activities. In
order to encourage these potential customers to adopt and implement our
solutions, we may incur higher costs than we have in the past, and we may not be
able to attract a large number of these customers. Mobile network operators may
not be successful in rolling out our services, and subscribers to these services
may not seek to use them. Any developments of this kind could limit our ability
to sell our solutions to companies in this industry, may increase our expenses
and may damage our reputation.
INTERNATIONAL MARKETS
In December 2000, we first recognized revenues from sales in international
markets. We had expected that sales in these regions would be a major factor in
our growth, particularly since the use of wireless networks and wireless devices
have generally proceeded more rapidly outside North America. However, some key
countries in these regions have experienced decreasing economic activity, and
our sales to these regions declined beginning in the third quarter of 2001. This
trend did not reverse in 2002 nor in the first nine months of 2003 and it may
not reverse in the fourth quarter of 2003 or thereafter, resulting in us not
being able to increase our customer base, and accordingly, limited growth from
these markets.
LIQUIDITY
In order to help ensure that we would have sufficient capital to take advantage
of our core business opportunities, we have taken significant actions since the
second quarter of 2001 to reduce our operating expenses. However, most of our
operating expenses, such as employee compensation and lease payments
19
for facilities and equipment, are relatively stable, and these expense levels
are based in part on our expectations regarding future revenues. As a result,
any sustained shortfall in our revenues relative to our expectations would
negatively impact our operating results. Accordingly, if the cost-cutting
actions that we have taken are insufficient, we may not have sufficient capital
to fund our operations, and additional capital may not be available on
acceptable terms, if at all. Any of these outcomes could adversely impact our
ability to respond to competitive pressures or could prevent us from conducting
all or a portion of our planned operations. We may need to undertake additional
measures to reduce our operating expenses in the future.
INVESTMENTS IN OTHER COMPANIES
For year ended December 31, 2001, we realized a loss of $4.6 million on sales of
our long-term investments and recorded a loss provision of $10.0 million against
these investments as they have experienced a significant other than temporary
decline in their value. In addition, in the third quarter of 2002, we recorded
an additional loss provision of $5.3 million. Because of the continuing
volatility in the financial markets, as well as other factors, we expect to
limit the extent to which we make equity investments in other non-core companies
during the next few fiscal quarters, and possibly longer. As a result, we may
not take advantage of investment opportunities that could provide significant
financial benefits to our company, or that could provide us with the opportunity
to build relationships with other companies in our industry and target markets.
INVESTMENTS IN NEW TECHNOLOGIES
During fiscal 2001, we made significant investments in new technology assets to
help expedite customer adoption of our solutions, including interactive voice
response technology, technologies relating to short messaging services and
technology to allow mobile applications to be executed with real-time
interaction. In accordance with our accounting policy, we review the carrying
value of these assets, considering key factors such as our estimate of customer
demand for these assets and the assets' fit with our product strategy. For the
year ended December 31, 2002, we recorded a charge of $2.7 million relating to
our decision not to use these assets that we purchased to resell to our
customers. In the future, if there are any circumstances in which there is a
decline in the carrying value of these assets or if we decide not to pursue
these technologies if we determine that customer demand for them is not
substantial, we may need to record additional charges.
RECEIVABLES
A significant portion of our receivables are derived from companies in foreign
countries. Due to varying economic conditions and business practices in these
countries, our collections cycle from these customers may be longer than our
past experience. As adverse economic conditions persist, there is a greater risk
that our customers will have difficulties in paying us in accordance with the
terms of their contracts, and our risk of bad debt may increase substantially in
future fiscal periods.
HOSTING SERVICES
In January 2002, we formalized our plan to transfer the management of our
application hosting services to Computer Sciences Corporation ("CSC"). We will
continue to be dependent on CSC to provide secure hosting services for our
software products. If CSC becomes unable to deliver these services, or other
circumstances occur that affect CSC or its computer systems, our hosting
services may be substantially impaired. If any of these circumstances occur and
cause us to fail to deliver our hosting services, we may lose customers, our
reputation may suffer, and our ability to attract new customers may be damaged.
EMPLOYEES
Our ability to execute our business successfully depends in large part upon our
ability to have a sufficient number of qualified employees to achieve our goals.
However, if our workforce is not properly sized to
20
meet our operating needs, our ability to achieve and maintain profitability is
likely to suffer. As indicated in this report, we have substantially reduced the
number of our employees. This means that we use a smaller number of employees to
conduct some of the operations that were previously performed by a larger
workforce, which could cause disruption of our business. In addition, the morale
of our current employees may have been adversely affected by previous workforce
reductions, reducing their performance. Our ability to attract potential new
employees in the future may suffer if our reputation suffers as a result of
these staffing reductions.
GROSS MARGINS
We believe that certain factors in the current market may contribute to the risk
that our gross margins will decrease in future fiscal quarters. We may have to
lower our prices, in order to accommodate our customers. In addition, due to the
downturn in the economy, many of our customers are reluctant to make a
commitment to pay a large upfront license fee, which could also cause our
revenues to decrease. With a greater percentage of our revenues coming from
services, if we are not successful in reducing our costs of sales, and our
customers continue to purchase licenses on an as-needed basis, we will
experience a decrease in our gross margins.
LITIGATION
The Company and certain of its present and former officers and directors were
named as defendants in a series of purported class actions relating to our
initial public offering. Litigation may be time consuming, expensive, and
distracting from the conduct of our business, and the outcome of litigation may
be difficult to predict. The adverse resolution of any of these proceedings
could have a material adverse effect on our business, results of operations, and
financial condition.
21
Item 3. Quantitative and Qualitative Disclosures About Market Risk
IMPACT OF INTEREST RATE EXPOSURE
As of September 30, 2003, we had approximately $18.9 million in cash, cash
equivalents, short-term investments and restricted cash, of which $1.9 million
consisted of short-term investments. A significant portion of the cash earns
interest at variable rates. In addition, although our short-term investments are
fixed-rate instruments, the average term is short. Accordingly, our interest
income is effectively sensitive to changes in the level of prevailing interest
rates. This is partially mitigated by the fact that we generally do not
liquidate our short-term investments before their maturity dates.
IMPACT OF FOREIGN EXCHANGE RATE EXPOSURE
Our functional currency is the U.S. dollar. In the past, the majority of our
non-US dollar denominated expenses were incurred in Canadian dollars. As a
result of our recent restructuring efforts, in the foreseeable future the
majority of our non-US dollar denominated expenses will be incurred in Euros.
Changes in the value of these currencies relative to the U.S. dollar may result
in currency gains and losses, which could affect our operating results. In the
three months ended September 30, 2003, we incurred realized and unrealized
foreign currency gains relating to the translation of our non-US denominated
monetary assets and liabilities of approximately $25,000.
Item 4. Controls and Procedures
Prior to the filing date of this report, management, including the Company's
Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness
and operation of the Company's disclosure controls and procedures. The Chief
Executive Officer and Chief Financial Officer concluded that, as of September
30, 2003, the disclosure controls and procedures were effective, in all material
respects, to ensure that information required to be disclosed in the reports the
Company files and submits under the Exchange Act is recorded, processed,
summarized and reported as and when required. There have been no significant
changes in the Company's internal controls or in other factors, which could
significantly affect internal controls subsequent to the date the Company
carried out its evaluation. There were no significant deficiencies or material
weaknesses identified in the evaluation and therefore, no corrective actions
were taken.
22
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The Company has been named in several class actions filed in federal
court in the Southern District of New York between approximately June 13, 2001
and June 28, 2001 (collectively the "IPO Allocation Litigation"). The IPO
Allocation Litigation was filed on behalf of purported classes of plaintiffs who
acquired the Company's common shares during certain periods. These lawsuits have
since been consolidated into a single action and an amended complaint was filed
on or about April 19, 2002. Similar actions have or since been filed against
over 300 other issuers that have had initial public offerings since 1998 and all
are included in a single coordinated proceeding in the Southern District of New
York.
The amended complaint in the IPO Allocation Litigation names as
defendants, in addition to the Company, some or all of the current or former
directors and officers of the Company (the "Individual Defendants") and certain
underwriters of the Company's initial public offering of securities (the
"Underwriter Defendants"). In general, the amended complaint alleges that the
Underwriter Defendants: (1) allocated shares of the Company's offering of equity
securities to certain of their customers, in exchange for which these customers
agreed to pay the Underwriter Defendants extra commissions on transactions in
other securities; and (2) allocated shares of the Company's initial public
offering to certain of the Underwriter Defendants' customers, in exchange for
which the customers agreed to purchase additional common shares of the Company
in the after-market at certain pre-determined prices. The amended complaint also
alleges that the Company and the Individual Defendants failed to disclose these
facts and that the Company and the Individual Defendants were aware of, or
disregarded, the Underwriter Defendants' conduct. In October 2002, the
Individual Defendants were dismissed from the IPO Allocation Litigation without
prejudice.
In July 2003, a committee of the Company's Board of Directors
conditionally approved a proposed partial settlement with the plaintiffs in this
matter. The settlement would provide, among other things, a release of the
Company and of the Individual Defendants for the conduct alleged in the action
to be wrongful in the amended complaint. The Company would agree to undertake
other responsibilities under the partial settlement, including agreeing to
assign away, not assert, or release certain potential claims the Company may
have against its underwriters. Any direct financial impact of the proposed
settlement is expected to be borne by the Company's insurers. The committee
agreed to approve the settlement subject to a number of conditions, including
the participation of a substantial number of other issuer defendants in the
proposed settlement, the consent of the Company's insurers to the settlement,
and the completion of acceptable final settlement documentation. Furthermore,
the settlement is subject to a hearing on fairness and approval by the Court
overseeing the IPO Allocation Litigation.
If the proposed settlement is not consummated, the Company intends to
continue to vigorously defend itself and the Individual Defendants against these
claims. However, due to the inherent uncertainties of litigation, and because
the IPO Litigation is at a preliminary stage, we cannot accurately predict the
ultimate outcome IPO Allocation Litigation.
Item 2. Changes in Securities
None.
23
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
On October 29, 2003, Mr. Lloyd Darlington resigned from the Company's
Board of Directors and its Corporate Governance Committee, Audit Committee and
Human Resources and Compensation Committee.
Item 6. Exhibits and Reports on Form 8-K
(A) EXHIBITS:
The following exhibits are filed with this Report:
NO. DESCRIPTION
--- -----------
31.1 Rule 13a-14(a)/15d-14(a) Certification of the Chief Executive Officer
31.2 Rule 13a-14(a)/15d-14(a) Certification of the Chief Financial Officer
32.1 Section 1350 Certification of the Chief Executive Officer
32.2 Section 1350 Certification of the Chief Financial Officer
(B) REPORTS ON FORM 8-K:
During the period covered by this Report, the Company furnished
one report on Form 8-K:
July 31, 2003: reporting the Company's results of operations
for the three months ended June 30, 2003.
24
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed by the following persons on behalf of the registrant
and in the capacities and on the dates indicated.
SIGNATURES TITLES DATE
---------- ------ ----
/S/ JOHN J. SIMS Chief Executive Officer (principal November 11, 2003
- ----------------------------------- executive officer)
John J. Sims
/S/ GLENN BARRETT Chief Financial Officer (principal November 12, 2003
- ------------------------------------ financial and accounting officer)
Glenn Barrett