UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

For the quarterly period ended April 30, 2003

 

or

 

 

For the transition period from                              to                             

 

Commission file number 0-21342

 

 

WIND RIVER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

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 ý    No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes ý    No o

 

As of June 10, 2003, there were 79,821,158 shares of the registrant’s common stock outstanding.

 

 

WIND RIVER SYSTEMS, INC.
FORM 10-Q
FOR THE QUARTER ENDED APRIL 30, 2003

 

INDEX

 

		Page
Part I—Financial Information
	Item 1. Financial Statements (unaudited)
	Condensed Consolidated Statements of Operations for the three months ended April 30, 2003 and 2002	1
	Condensed Consolidated Balance Sheets as of April 30, 2003 and January 31, 2003	2
	Condensed Consolidated Statements of Cash Flows for the three months ended April 30, 2003 and 2002	3
	Notes to Condensed Consolidated Financial Statements	4
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
	Item 3. Quantitative and Qualitative Disclosures About Market Risk	34
	Item 4. Controls and Procedures	34
Part II—Other Information
	Item 1. Legal Proceedings	36
	Item 2. Changes in Securities and Use of Proceeds	36
	Item 3. Defaults Upon Senior Securities	36
	Item 4. Submission of Matters to a Vote of Security Holders	36
	Item 5. Other Information	36
	Item 6. Exhibits and Report on Form 8-K	36
Signature		37

 

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PART I—FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

WIND RIVER SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

 

		Three Months Ended April 30,
		2003			2002
Revenues, net:
Products		$	29,261		$	43,725
Services		19,282			22,634
Total revenues, net		48,543			66,359
Cost of revenues:
Products		3,159			5,473
Services		10,070			13,988
Total cost of revenues		13,229			19,461
Gross profit		35,314			46,898
Operating expenses:
Selling and marketing		23,444			33,815
Product development and engineering		14,349			20,622
General and administrative		7,489			9,284
Amortization of purchased intangibles		1,842			2,123
Total operating expenses		47,124			65,844
Loss from operations		(11,810		)	(18,946		)
Other income (expense):
Interest income		2,830			3,392
Interest expense		(1,711		)	(1,788		)
Other income (expense), net		553			(206		)
Total other income		1,672			1,398
Loss before provision for income taxes		(10,138		)	(17,548		)
Provision for income taxes		635			500
Net loss		$	(10,773	)	$	(18,048	)
Basic and diluted net loss per share		$	(0.14	)	$	(0.23	)
Shares used in basic and diluted per share calculation		79,619			78,767

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

1

 

WIND RIVER SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
(Unaudited)

 

		April 30, 2003			January 31, 2003
ASSETS
Current assets:
Cash and cash equivalents		$	25,903		$	31,938
Short-term investments		24,347			31,110
Accounts receivable, net		34,112			42,129
Prepaid and other current assets		10,211			11,763
Total current assets		94,573			116,940
Investments		160,712			161,575
Property and equipment, net		99,636			45,618
Goodwill		83,728			83,728
Other intangibles, net		8,792			10,648
Other assets		11,267			11,645
Restricted cash		46,136			60,300
Total assets		$	504,844		$	490,454
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	2,516		$	2,063
Accrued liabilities		18,688			19,230
Accrued restructuring costs		6,211			18,717
Accrued compensation		14,065			15,264
Income taxes payable		2,680			4,392
Deferred revenues		29,243			28,863
Total current liabilities		73,403			88,529
Convertible subordinated debt		150,000			150,000
Other long-term debt		40,000			—
Total liabilities		263,403			238,529
Stockholders’ equity:
Common stock, par value $0.001, 325,000 shares authorized; 81,972 and 81,775 shares issued as of April 30, 2003 and January 31, 2003, respectively; 79,736 and 79,539 shares outstanding as of April 30, 2003 and January 31, 2003, respectively		82			82
Additional paid-in-capital		748,277			747,642
Loan to stockholder		(1,919		)	(2,006		)
Treasury stock, 2,236 shares at cost at April 30, 2003 and January 31, 2003		(34,185		)	(34,185		)
Accumulated other comprehensive income		211			644
Accumulated deficit		(471,025		)	(460,252		)
Total stockholders’ equity		241,441			251,925
Total liabilities and stockholders’ equity		$	504,844		$	490,454

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

2

 

WIND RIVER SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

 

		Three Months Ended April 30,
		2003			2002
Cash flows from operating activities:
Net loss		$	(10,773	)	$	(18,048	)
Adjustments to reconcile net loss to net cash used in operations:
Depreciation and amortization		5,480			8,062
Non-cash compensation, including 401(k) match		607			757
Interest on loan to stockholder		87			(27		)
Gain on sale of technology		(416		)	—
Deferred income taxes		—			69
Changes in assets and liabilities:
Accounts receivable, net		8,017			14,237
Prepaid and other current assets		1,552			3,315
Accounts payable		453			(2,465		)
Accrued restructuring costs		(12,506		)	(1,087		)
Accrued liabilities		(542		)	(2,828		)
Accrued compensation		(1,199		)	(215		)
Income taxes payable		(1,712		)	(1,346		)
Deferred revenues		380			(2,973		)
Other assets and liabilities		392			87
Net cash used in operating activities		(10,180		)	(2,462		)
Cash flows from investing activities:
Acquisition of property and equipment		(57,656		)	(2,420		)
Purchase of investments		(60,113		)	(101,110		)
Net reduction in restricted cash		14,164			—
Sales of investments		39,909			37,458
Maturities of investments		27,228			11,346
Sale of technology		416			—
Net cash used in investing activities		(36,052		)	(54,726		)
Cash flows from financing activities:
Issuance of common stock		28			3,270
Repayment of line of credit		—			(2,083		)
Borrowings from loan facility		40,000			—
Net cash provided by financing activities		40,028			1,187
Effect of exchange rate changes on cash and cash equivalents		169			622
Net decrease in cash and cash equivalents		(6,035		)	(55,379		)
Cash and cash equivalents at beginning of period		31,938			131,067
Cash and cash equivalents at end of period		$	25,903		$	75,688

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

3

 

WIND RIVER SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1: Basis of Presentation

 

The accompanying condensed consolidated financial statements and related notes of Wind River Systems, Inc. are unaudited. However, in the opinion of management, all adjustments (consisting only of normal recurring adjustments) that are necessary for a fair presentation of the financial position as of April 30, 2003 and January 31, 2003, and the results of operations and cash flows for the three months ended April 30, 2003 and 2002 have been included. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended January 31, 2003 filed with the Securities and Exchange Commission (“2003 Form 10-K”). The results of operations for the three months ended April 30, 2003 are not necessarily indicative of results to be expected for the entire 2004 fiscal year, which ends on January 31, 2004, or for any future period.

 

In accordance with the rules and regulations of the Securities and Exchange Commission, unaudited condensed consolidated financial statements may omit or condense certain information and disclosures normally required for a complete set of financial statements prepared in accordance with United States generally accepted accounting principles (“GAAP”). Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. The consolidated balance sheet at January 31, 2003 was derived from audited financial statements, but does not include all disclosures required by GAAP. We believe that the notes to the condensed consolidated financial statements contain disclosures adequate to make the information presented not misleading.

 

The condensed consolidated financial statements include the financial information of Wind River and its subsidiaries. All significant inter-company accounts and transactions have been eliminated.

 

Certain amounts have been reclassified to conform to the presentation for the current period.

 

Note 2: Stock-Based Compensation

 

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock Based Compensation — Transition and Disclosure — an Amendment of SFAS No. 123” (“SFAS 148”), which amends SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) to provide alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation.  The transition and annual disclosure provisions of SFAS 148 are effective for fiscal years ending after December 15, 2002.  In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.  The interim disclosure provisions are effective for the first interim period beginning after December 15, 2002.  We adopted the interim disclosure provisions effective in our first quarter of fiscal 2004.  The pro forma disclosures required under SFAS 148 are included below.

 

SFAS 123, as amended by SFAS 148, permits companies to measure the compensation cost of stock-based awards based on their estimated fair value at the date of grant and recognize the amount over the related service period.  Therefore, as permitted by SFAS 123 and 148, we apply the existing accounting rules under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”

 

4

 

 (“APB 25”), and provide pro forma net income (loss) and pro forma net income (loss) per share disclosures for stock-based awards made during the three months ended April 30, 2003 and 2002, as if the fair-value-based method defined in SFAS 123 had been applied.

 

We account for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” We use the Black-Scholes option-pricing model to value options granted to non-employees.

 

Pro Forma Disclosures. Under SFAS 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants during the three months ended April 30, 2003 and 2002:

 

		Three Months Ended April 30,
		2003		2002
Risk free interest rates		2.88	%	5.82	%
Expected volatility		71.3	%	75.0	%
Expected option life (in years)		4.88		4.93
Expected dividends		—		—

 

The weighted average fair value per share of options granted during the three months ended April 30, 2003 and 2002 was $1.89 and $7.78, respectively.

 

We also estimate the fair value for the purchase rights under our 1993 Employee Stock Purchase Plan (the “Purchase Plan”) using the Black-Scholes option-pricing model for those periods in which purchase rights under the Purchase Plan are granted, typically the second and fourth fiscal quarters.  No purchase rights were granted in the three months ended April 30, 2003 and 2002.

 

Had compensation expense under these arrangements been determined pursuant to SFAS 123, our net loss and net loss per share for the three months ended April 30, 2003 and 2002 would have been:

 

		Three Months Ended April 30,
		2003			2002
		(In thousands, except per share amounts)
Net loss:
As reported		$	(10,773	)	$	(18,048	)
Less: Stock-based compensation expense determined under fair-value-based method for all awards		3,335			5,268
Pro forma		$	(14,108	)	$	(23,316	)
Basic and diluted net loss per share:
As reported		$	(0.14	)	$	(0.23	)
Pro forma		(0.18		)	(0.30		)

 

The pro forma amounts include compensation expense related to stock option grants and purchases of common stock under the Purchase Plan. The effects of applying SFAS 123 on pro forma disclosures of net loss and net loss per share in the three months ended April 30, 2003 and 2002 are not likely to be representative of the pro forma effects on net income (loss) and net income (loss) per share in future fiscal periods.

 

5

 

A summary of option activity for the three months ended April 30, 2003 and 2002 is as follows:

 

		Three Months Ended April 30,
		2003					2002
		Number of Shares		Weighted Average Price per Share			Number of Shares		Weighted Average Price per Share
		(In thousands, except for per share amounts)
Beginning balance		19,433		$	17.92		18,504		$	21.62
Granted		78		3.22			426		11.98
Exercised		(20	)	1.47			(311	)	10.50
Canceled		(8,624	)	25.00			(450	)	23.04
Ending Balance		10,867		12.23			18,169		21.55

 

Options outstanding and exercisable as of April 30, 2003 from all option plans are as follows by exercise price ranges:

 

		Options Outstanding							Options Exercisable
Range of Exercise Prices		Number Outstanding		Weighted Average Remaining Contractual Life (in Years)		Weighted Average Exercise Price			Number Exercisable		Weighted Average Exercise Price
		(In thousands, except exercise price and contractual life data)
$0.21 - $4.71		523		3.65		$	3.23		443		$	3.27
4.21 - 5.00		3,663		4.20		4.99			35		4.69
5.28 - 10.25		1,282		6.54		8.41			729		8.70
10.27 - 10.40		1,687		8.39		10.40			750		10.40
10.96 - 15.00		775		7.00		13.89			533		13.49
15.00 - 16.00		1,100		6.40		15.96			967		15.97
16.19 - 34.75		1,282		6.05		26.97			1,135		27.16
35.13 - 48.63		553		7.31		39.02			491		38.94
48.88 - 48.88		1		6.88		48.88			1		48.88
60.50 - 60.50		1		6.84		60.50			1		60.50
0.21 - 60.50		10,867		5.90		12.23			5,085		17.40

 

As of April 30, 2002, options to purchase 9.8 million shares of common stock were exercisable at a weighted average exercise price of $22.33.  As of April 30, 2003, an aggregate of 10.6 million shares were available for grant under all of our option plans.

 

On March 21, 2003, we announced a voluntary stock option exchange program for employees. Under the program, eligible employees were offered the opportunity to exchange outstanding options to purchase 7.7 million shares of our common stock with exercise prices equal to or greater than $11.00 per share for new stock options to be granted at least six months and one day after the existing options were cancelled.  The number of shares subject to the new options is dependant on the applicable exchange ratio

 

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determined by the exercise price of the exchanged stock options and the number of participating employees. Participating employees will receive new stock options in exchange for outstanding stock options at an exchange ratio of either 3 for 4, 1 for 2, or 1 for 3, depending on exercise price of the exchanged stock option. In accordance with the program, on April 18, 2003, we cancelled outstanding options to purchase approximately 7.4 million shares of our common stock. We expect to grant new options to purchase a total of approximately 3.8 million shares of our common stock no earlier than October 20, 2003, which is the first business day that is six months and one day after the cancellation of the exchanged options, but no later than November 30, 2003. The exercise price per share of the new options will be equal to the fair market value of our common stock on the date of grant as determined in accordance with our applicable option plans. The new stock options represent approximately 4.7% of the total shares of our common stock outstanding as of June 10, 2003, and could have a dilutive impact on our future earnings per share to the extent that the market price of our common stock exceeds the exercise price of the new stock options to be granted.  We do not expect to record compensation expense resulting from the exchange program.

 

Note 3: Goodwill and Other Intangible Assets

 

We refer you to Note 3, “Acquisitions and Dispositions,” of Notes to Consolidated Financial Statements in our 2003 Form 10-K for further details of acquisitions completed during the fiscal years ended January 31, 2002, 2001 and 2000.

 

Information regarding our goodwill and other intangible assets is as follows:

 

		Goodwill			Purchased Technologies			Trademarks and Other Intangibles			Total
		(In thousands)
Gross Carrying Amount:
Balance as of January 31, 2003		$	83,728		$	32,621		$	9,501		$	125,850
Additions		—			—			—			—
Impairments		—			—			—			—
Balance as of April 30, 2003		83,728			32,621			9,501			125,850
Accumulated Amortization, Foreign Translation and Other Adjustments:
Balance as of January 31, 2003		$	—		$	(24,316	)	$	(7,158	)	$	(31,474	)
Additions		—			(1,465		)	(377		)	(1,842		)
Foreign translation and other adjustments		—			—			(14		)	(14		)
Balance as of April 30, 2003		—			(25,781		)	(7,549		)	(33,330		)
Net Book Value:		$	83,728		$	6,840		$	1,952		$	92,520

 

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The estimated future amortization expense of purchased intangible assets is as follows:

 

 

Note 4: Restricted Cash

 

As of April 30, 2003, restricted cash consists of investments held as collateral under our loan facility. See Note 7, “Other Borrowings,” below.  As of January 31, 2003, restricted cash consisted of the investments held as collateral under the synthetic leases for our headquarters buildings in Alameda, California. See Note 10, “Commitments and Contingencies,” below.

 

Note 5: Derivative Financial Instruments

 

We enter into foreign currency forward exchange contracts to manage foreign currency exposures related to certain foreign currency denominated inter-company balances. Additionally, we may adjust our foreign currency hedging position by taking out additional contracts or by terminating or offsetting existing forward contracts. These adjustments may result from changes in the underlying foreign currency exposures or from fundamental shifts in the economics of particular exchange rates. Gains and losses on terminated forward contracts, or on contracts that are offset, are recognized in income in the period of contract termination or offset. As of April 30, 2003, we had outstanding contracts with the following terms:

 

Buy/Sell:		Sell		Sell		Sell
Currency:		GBP		EURO		JPY
Amount:		450,000		750,000		460,000,000
Rate:		1.5608		1.0745		120.1000
USD Equivalent:		$701,000		$805,000		$3,835,000
Maturity Date:		5/12/03		5/12/03		5/12/03

 

Contract amounts are representative of the expected amounts to be paid under the terms of these instruments.  We do not enter into derivative financial instruments for trading or speculative purposes.  As of April 30, 2003, the fair value of our outstanding contracts was not significant.

 

Note 6: Restructuring Costs

 

As a result of the decisions to restructure our business during fiscal 2003 and 2002, we recorded net restructuring charges of $32.7 million and $21.7 million, respectively, which in each case were classified as operating expenses. As of January 31, 2003, there were no remaining restructuring liabilities related to our restructuring plans for fiscal 2002. As of April 30, 2003, our total restructuring liabilities related to our restructuring plans for fiscal 2003 were $6.2 million.  The following table provides detailed restructuring liabilities for fiscal 2002 and 2003, the cash payments made during the quarter ended April 30, 2003 and the aggregate remaining restructuring liabilities as of April 30, 2003:

 

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		Work Force Reduction			Consolidation of Excess Facilities			Other			Total
		(In thousands)
Fiscal Year 2002:
Cash charges		$	19,367		$	8,383		$	—		$	27,750
Non-cash charges		765			100			—			865
Reversals		—			(6,947		)	—			(6,947		)
Total charges		20,132			1,536			—			21,668
Cash payments		(15,073		)	(487		)	—			(15,560		)
Non-cash write-offs		(765		)	(100		)	—			(865		)
Restructuring liabilities as of January 31, 2002		4,294			949			—			5,243
Fiscal Year 2003:
Cash charges		26,457			3,246			1,353			31,056
Non-cash charges		206			355			2,119			2,680
Reversals		(994		)	(76		)	—			(1,070		)
Total charges		25,669			3,525			3,472			32,666
Cash payments		(14,602		)	(1,454		)	(456		)	(16,512		)
Non-cash write-offs		(206		)	(355		)	(2,119		)	(2,680		)
Restructuring liabilities as of January 31, 2003		15,155			2,665			897			18,717
Fiscal Quarter Ended April 30, 2003:
Cash payments		(11,643		)	(589		)	(274		)	(12,506		)
Restructuring liabilities as of April 30, 2003		$	3,512		$	2,076		$	623		$	6,211

 

The worldwide workforce reductions implemented as a result of the restructuring plan announced in the fourth quarter of fiscal 2003 will be substantially completed during the first half of fiscal 2004.

 

Note 7: Other Borrowings

 

In April 2003, we entered into a loan facility with a financial institution in the aggregate principal amount of $57.4 million, consisting of a non-revolving loan commitment of $37.4 million and a term loan of $20.0 million, both of which mature in April 2005. During the quarter ended April 30, 2003, we borrowed $40.0 million against the loan facility. The unused commitment is subject to a fee equal to 0.10% per annum on the average daily-unused amount of the loan commitment.

 

Interest, which is payable monthly in arrears, is calculated at either a floating rate equivalent to the prime rate or a fixed rate equal to the London Interbank Offering Rate, or LIBOR, plus 0.40%. At our option, the rate may be fixed for periods of 1, 2, 3, 6, 9 or 12 months, or the Fixed Rate Term. We elected an initial Fixed Rate Term of 12 months. As of April 30, 2003, borrowings under the facility bear interest at the rate of 1.84% per annum.

 

If, during a Fixed Rate Term, we elect to prepay a portion or all of the outstanding principal due under the facility, then we must pay the bank a fee equivalent to the difference between the interest which would have been due on the principal repaid for the remaining portion of the Fixed Rate Term and the interest which would have been paid based on the LIBOR rate for a hypothetical loan of the same principal amount for the remaining period of the Fixed Rate Term.

 

Our restricted cash balance consists of $46.1 million in marketable securities held as collateral (the “Securities Collateral”) in order to secure the performance of our obligations under the loan facility.

 

9

 

In addition, we are required to maintain liquidity of at least $100.0 million.  Under the facility agreement, liquidity is defined as the aggregate of our unencumbered and unrestricted cash, cash equivalents and readily marketable securities acceptable to the bank.

 

In the event that we meet certain financial performance and debt security ratios, as defined in the facility agreement, we may elect to release the Securities Collateral and replace it with a first priority mortgage on our headquarters property located in Alameda, California.  In such event, we would be required to maintain liquidity of at least $150.0 million. Furthermore, we would be required to maintain tangible net worth of not less than $280.0 million through to and including January 31, 2004, and tangible net worth of not less than $300.0 million as of and after February 1, 2004. Under the facility agreement, tangible net worth is defined as the aggregate of total stockholders’ equity plus subordinated debt less any intangible assets.

 

The facility agreement contains customary events of defaults, including payment defaults, breaches of representations and warranties, covenant defaults, certain events of bankruptcy, insolvency and change of control, material judgments, and a cross-default to other material agreements and debt where we have incurred any liability in excess of $3.0 million.  If an event of default occurs, and we do not or cannot cure the default within the time periods specified in the facility agreement, the lender would be entitled to terminate the facility and declare the outstanding amounts under the loan facility to be immediately due and payable.

 

As of April 30, 2002, we had United States dollar equivalent net borrowings of $12.9 million from a line of credit obtained through our Japanese subsidiary for up to 2.1 billion Japanese yen, which represents approximately $16.4 million. During the third quarter of fiscal 2003, we repaid the entire line of credit obtained through our Japanese subsidiary.

 

Note 8: Comprehensive Loss

 

Comprehensive loss is defined as the change in equity of a company during a period from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. The difference between net loss and comprehensive loss for us results from foreign currency translation adjustments, mark-to-market adjustments on interest rate swaps and unrealized gains and losses on available-for-sale securities, net of taxes.

 

Comprehensive loss for the three months ended April 30, 2003 and 2002 is as follows:

 

		Three Months Ended April 30,
		2003			2002
		(In thousands)
Net loss		$	(10,773	)	$	(18,048	)
Other comprehensive income (loss):
Foreign currency translation adjustments		169			622
Unrealized loss on investments		(602		)	(121		)
Fair value measurement of interest rate swaps		—			(80		)
Other comprehensive income (loss)		(433		)	421
Total comprehensive loss		$	(11,206	)	$	(17,627	)

 

10

 

Note 9: Net Loss Per Share Computation

 

In accordance with the SFAS No. 128, “Earnings Per Share,” the calculation of shares used in basic and diluted net loss per share computation for the three months ended April 30, 2003 and 2002 is presented below:

 

		Three Months Ended April 30,
		2003		2002
		(In thousands)
Shares used in basic net loss per share computation		79,619		78,767
Effect of dilutive potential common shares		—		—
Shares used in diluted net loss per share computation		79,619		78,767

 

The effect of assumed conversion of the 3.75% convertible subordinated notes for shares of 6.2 million for both the three months ended April 30, 2003 and 2002 is anti-dilutive, and is, therefore, excluded from the above computation. If we had recorded net income for the three months ended April 30, 2003 and 2002, we would have included in the computation dilutive potential common shares from outstanding stock options totaling approximately 60,000 and 1.3 million as of April 30, 2003 and 2002, respectively. Because we recorded a net loss for the three months ended April 30, 2003 and 2002, there is no difference between basic and diluted net loss per share.

 

Note 10: Commitments and Contingencies

 

From time to time, we are subject to legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of patents and other intellectual property rights. We are not currently aware of any legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse affect on our financial position, results of operations or cash flows.

 

In September 1997 and November 1999, we entered into operating leases for our headquarters facility constructed on land owned by us in Alameda, California. After considering various financing alternatives for the construction of our headquarters buildings on land owned by us, the related economic impact of each alternative and the ability to retain control of the property, we chose a form of financing that we believed offered beneficial economic terms, commonly referred to as a “synthetic lease.” These leases were treated as operating leases for accounting purposes and financing leases for tax purposes. A synthetic lease is a form of off-balance sheet financing under which an unrelated third party funds 100% of the costs for the acquisition and/or construction of the property and leases the asset back to the company, as lessee. None of our officers or employees had any financial interest in these synthetic lease arrangements.

 

In January 2003, we notified the lessor of our intent to exercise the purchase option under the leases and purchase the buildings.  In April 2003, we completed the exercise of the purchase options and acquired the buildings for a purchase price of $57.4 million.  We reflect the buildings as an asset on our balance sheet. Additionally, the restricted cash of $60.3 million held to secure our obligations under the synthetic leases was released. Prior to the exercise of the purchase options, we reflected lease payments as a rental expense in our statement of operations. Having acquired the buildings, we no longer record lease expense for the buildings and, commencing in the first quarter of fiscal 2004, we will record depreciation expense for the buildings over their estimated useful lives of 30 years.

 

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Note 11: Segment and Geographic Information

 

We report in one industry segment—technology for embedded operating systems. We market our products and related services to customers in four geographic regions: North America (the United States and Canada), Japan, EMEA (Europe, the Middle East and Africa) and Asia Pacific. Internationally, we market our products and services primarily through our subsidiaries and various distributors. Revenues are attributed to geographic areas based on the country in which the customer is domiciled. The distribution of revenues and long-lived assets, net of depreciation and amortization, by geographic location is as follows:

 

		Revenues
		Three Months Ended April 30,						Long-lived Assets
								As of			As of
		2003			2002			April 30, 2003			January 31, 2003
		(In thousands)						(In thousands)
North America		$	28,742		$	40,295		$	193,539		$	140,823
Japan		5,367			5,909			3,509			3,906
EMEA		10,733			14,469			6,034			6,523
Asia Pacific		3,701			5,686			341			387
Consolidated		$	48,543		$	66,359		$	203,423		$	151,639

 

Revenue information on a product and services basis is as follows:

 

		Three Months Ended April 30,
		2003			2002
		(In thousands)
Software licenses		$	16,001		$	26,249
Production license revenues		13,260			17,476
Maintenance revenues		12,380			12,612
Other service revenues		6,902			10,022
Total		$	48,543		$	66,359

 

No single customer accounted for more than 10% of our total revenues in the three months ended April 30, 2003 or 2002.

 

Note 12: Recent Accounting Pronouncements

 

In May 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 provides for certain changes in the accounting treatment of derivative contracts. SFAS 149 is effective for contracts entered into or modified after June 30, 2003, except for certain provisions that relate to SFAS No. 133 implementation issues that have been effective for fiscal quarters that begin prior to June 15, 2003, which would continue to be applied in accordance with their respective effective dates.  The guidance should be applied prospectively.  We do not anticipate that the adoption of SFAS 149 will have a material impact on our consolidated financial statements.

 

Also in May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (“SFAS 150”).  SFAS 150 changes the accounting for

 

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certain financial instruments that under previous guidance issuers could account for as equity.  It requires that those instruments be classified as liabilities in balance sheets. Most of the guidance in SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of our third fiscal quarter of fiscal 2004.  We do not anticipate that the adoption of SFAS 150 will have a material impact on our consolidated financial statements.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward Looking Statements

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include the sentence in the fourth paragraph under “Results of Operations—Revenues” regarding expectations for maintenance revenue; the sentence in the fifth paragraph under “Results of Operations—Revenues” regarding expectations for international sales; the sentences in the sixth paragraph under “Results of Operations—Revenues” regarding expectations for revenue levels for the second quarter of fiscal 2004; the sentences in the second and third paragraphs under “Results of Operations—Cost of Revenues” regarding factors that may affect product related costs of revenues in the future and our expectations regarding cost of service revenues in absolute dollars and as a percentage of revenue; the sentences in the first, second and third paragraphs under “Results of Operations—Operating Expenses” regarding our expectations about sales and marketing expenses, product development and engineering expenses, and general and administrative expenses, respectively; the sentence in the second paragraph under “Results of Operations—Other Income (Expense)” regarding  our expectation for near term interest expense; the sentences in the last paragraph of “Liquidity and Capital Resources” regarding our beliefs about future liquidity and capital requirements; and the statements under “Recent Accounting Pronouncements” regarding the impact of the adoption of the pronouncements discussed thereunder.

 

These forward-looking statements are based on current expectations and involve known and unknown risks and uncertainties that may cause the results, levels of activity, performance or achievements of Wind River or its industry to be materially different from those expressed or implied by the forward-looking statements. The cautionary statements set forth below and in “Factors that May Affect Future Results” identify important factors that could cause actual results to differ materially from those in any such forward-looking statements. Additionally, see our Annual Report on Form 10-K for the fiscal year ended January 31, 2003 (“2003 Form 10-K”) for further discussion of these factors. We do not intend to update any of the forward-looking statements contained in this report to reflect any future events or developments unless required by law. The following discussion should be read in conjunction with the condensed consolidated financial statements and notes included elsewhere in this report.

 

Overview

 

Wind River is a leading supplier of embedded software and services for embedded systems. An embedded system consists of a microprocessor, or a series of microprocessors, and related software and is used to control, monitor or assist the operation of electronic devices, equipment and machinery. Embedded systems are used in diverse products such as digital imaging products, auto braking systems, internet routers, jet fighter control panels and factory automation devices. Our products help customers to enhance product performance, standardize designs across projects, reduce research and development costs and shorten product development cycles. We sell our products to customers in a variety of markets, including the aerospace and defense, automotive, digital consumer, industrial measurement and networking markets.

 

During the fourth quarter of fiscal 2003, we introduced our Integrated Embedded Platforms, in which we bundle our software technology into market specific platforms and license these platforms using an enterprise license model. These market specific platforms include a combination of development tools, an operating system and various protocols and interfaces. Under the enterprise license model, we license these market specific platforms under an annual subscription-based development license and aggregated production licenses, while eliminating our traditional “project” and “site” restrictions.  See “—Factors That May Affect Future Results — In late fiscal 2003, we introduced a new business model,

 

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including a new type of licensing arrangement, and cannot be sure that the new model will be successful.  Additionally, we expect the transition to the new model will impact the timing of our reported revenues.”

 

During the transition of our business model from project-based licensing to the enterprise license model, we expect the timing of our reported revenue to be impacted because revenue is recognized ratably over the subscription period under the enterprise license model. At the end of the subscription period the customer’s usage rights to the products expire unless renewed. By contrast, our traditional project-based license requires a majority of license revenue to be recognized in the quarter in which the products are delivered and a much smaller amount relating to the fair value of the maintenance to be deferred and recognized subsequently over the maintenance period. Therefore, an order for a subscription license will result in lower current-quarter revenue than an equal-sized order for a project-based license. As a result, the impact on near-term and deferred revenue will depend on the rate at which customers transition from our project-based model to our enterprise license model.  Since the introduction of the Integrated Embedded Platforms, the rate at which customers have transitioned to the enterprise license model has been substantially in line with our expectations.  However, we cannot be sure that the adoption rate will continue as we anticipate and, to the extent that the adoption rate is higher or lower than we expect, our revenue and deferred revenue will be impacted.

 

Management’s discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles, or GAAP.  We review the accounting policies we use in reporting our results on a regular basis.  The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, as well as the disclosure of contingent assets and liabilities.  In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require our judgment in its applications.  There are also areas in which our judgments in selecting among available accounting alternatives would not produce a materially different result.  We have identified certain policies as critical to our business operation and to the understanding of our financial condition and results of operations and our senior management has reviewed these critical accounting policies and related disclosures with our Audit Committee.  Those policies and estimates that we believe are most critical to an understanding of our financial results and condition and that require a higher degree of judgment and complexity are:

 

•                  Revenue recognition

•                  Estimating sales returns and other allowances, and allowance for doubtful accounts

•                  Valuation of investments and long-lived assets, including goodwill and purchased intangibles

•                  Restructuring charges

•                  Accounting for income taxes

 

For a more comprehensive discussion of our critical accounting policies, please see “—Critical Accounting Policies,” under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 2003 Form 10-K.

 

Results of Operations

 

During the second quarter of fiscal 2002, we began to be significantly impacted by the continuing economic downturn in the high-technology sector. The downturn in the high-technology sector, as well as the adverse impact on us, has continued into the first quarter of fiscal 2004. For the quarter ended April 30, 2003, our revenues were $48.5 million compared to $66.4 million for the quarter ended April 30, 2002, reflecting a 27% decrease. Net loss was $10.8 million, or $0.14 per share, for the quarter ended April 30, 2003, compared to $18.0 million, or $0.23 per share, for the quarter ended April 30, 2002.

 

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See “—Revenues” and “—Factors That May Affect Future Results—The continuing economic downturn has adversely impacted, and may continue to adversely impact, our revenues and earnings,” for a further discussion regarding the impact of the economic downturn on our financial condition and results of operations.

 

The following table sets forth certain consolidated statement of operations data as a percentage of revenues for the periods indicated:

 

		Three Months Ended April 30,
		2003		2002
Revenues, net:
Products		60	%	66	%
Services		40		34
Total revenues, net		100		100
Cost of revenues:
Products		6		8
Services		21		21
Total cost of revenues		27		29
Gross profit		73		71
Operating expenses:
Selling and marketing		48		51
Product development and engineering		30		31
General and administrative		15		14
Amortization of purchased intangibles		4		3
Total operating expenses		97		99
Loss from operations		(24	)	(28	)
Other income (expense):
Interest income		6		5
Interest expense		(4	)	(3	)
Other income (expense), net		1		—
Total other income		3		2
Loss before provision for income taxes		(21	)	(26	)
Provision for income taxes		1		1
Net loss		(22	)%	(27	)%

 

Revenues

 

Revenues consist of product revenues and service revenues, net of sales returns and other allowances. Product revenues consist of revenues from production licenses (sometimes referred to as royalties) and fees for integrated embedded platforms, operating systems, hardware, licenses, and fees for the use of development tools. Service revenues are derived from fees from professional services, which include design and development fees, software maintenance contracts, and customer training and consulting. We accrue for sales returns and other allowances based on historical experience. Total

 

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revenues were $48.5 million and $66.4 million for the three months ended April 30, 2003 and 2002, respectively, reflecting a decrease of 27%.

 

Our product revenues, excluding revenue from production licenses, decreased 39% to $16.0 million in the three months ended April 30, 2003, compared to $26.2 million in the three months ended April 30, 2002. Revenue from production licenses declined 24% to $13.3 million in the three months ended April 30, 2003, compared to $17.5 million in the three months ended April 30, 2002. Product revenues accounted for approximately 60% and 66% of total revenues in the three months ended April 30, 2003 and 2002, respectively. The general decline in product revenues is primarily due to lower customer demand for hardware and software products, including revenues from production licenses, which are generally tied to the number of products deployed.  This lower customer demand is primarily a result of the current economic downturn in the high-technology sector. This downturn has affected us both directly, by decreasing our sales, and indirectly, because our products are incorporated into our customers’ products, and as our customers’ sales decline, our production license revenue declines as well. Our product revenues have also been affected as the result of the transition of some of our customers to the enterprise license model, in which revenue is recognized ratably as opposed to being recognized immediately under our existing perpetual license model.  See “—Factors That May Affect Future Results — In late fiscal 2003, we introduced a new business model, including a new type of licensing arrangement, and cannot be sure that the new model will be successful.  Additionally, we expect the transition to the new model will impact the timing of our reported revenues.”

 

During the first quarter of fiscal 2004 and during fiscal 2003 and 2002, some of our customers have (i) decreased research and development budgets, (ii) sought to increase the value they receive from vendors, including us, (iii) attempted to leverage a more competitive bidding process when spending research and development budgets, and/or (iv) deferred or canceled projects, in whole or in part. As a result of these factors, we believe that some of our customers have undertaken development in-house, selected solutions they perceive to be less expensive or have relied on existing licenses rather than making new product purchases from us. Also, we cannot anticipate or calculate the potential adverse impact of open source or in-house software on our revenues or market share particularly where our customers’ budget constraints may make such software, which is royalty-free, more appealing than our products for their initial project development.

 

Service revenues decreased 15% to $19.3 million in the three months ended April 30, 2003, compared to $22.6 million in the three months ended April 30, 2002.  Service revenues accounted for approximately 40% and 34% of total revenues in the three months ended April 30, 2003 and 2002, respectively.  Excluding maintenance revenues, service revenues declined 31% to $6.9 million in the three months ended April 30, 2003, compared to $10.0 million in the three months ended April 30, 2002.  This decline was a result of the disruption to our services backlog that arose from the reorganization of our sales force as part of the restructuring plan announced in the fourth quarter of fiscal 2003 as well as the economic downturn in the high technology sector.  During the three months ended April 30, 2003, we generated $3.6 million in revenue from fixed-price services contracts accounted for under the percentage-of-completion method of accounting.  Maintenance revenues decreased 2% to $12.4 million in the three months ended April 30, 2003, compared to $12.6 million in the three months ended April 30, 2002.  We expect maintenance revenues will continue to decline as our customers transition to our enterprise license model, which includes maintenance as a part of the subscription fee.

 

Revenues from international sales decreased by 24% to $19.8 million in the three months ended April 30, 2003, compared to $26.1 million in the three months ended April 30, 2002. The overall decrease was due to a 9% decline in revenues from Japan, a 26% decrease in revenues from Europe, the Middle East and Africa (“EMEA”), and a 35% decrease in revenues from Asia Pacific. Revenues in Japan were $5.4 million in the three months ended April 30, 2003, compared to $5.9 million in the three months

 

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ended April 30, 2002. Revenues in EMEA were $10.7 million in the three months ended April 30, 2003, compared to $14.5 million in the three months ended April 30, 2002. Revenues from Asia Pacific were $3.7 million in the three months ended April 30, 2003, compared to $5.7 million in the three months ended April 30, 2002. The decrease in international revenues resulted primarily from macroeconomic factors that have caused our customers to reduce their research and development spending and purchase fewer of our products and services. Additionally, many of our customers are large multinational corporations that have reduced capital spending across all geographic regions.  Our international revenues have also been affected as the result of the transition of some of our customers to the enterprise license model, in which revenue is recognized ratably as opposed to being recognized immediately under our existing perpetual license model.  Overall, however, international sales were not as adversely affected by the decrease in customer spending as were sales in North America during the three months ended April 30, 2003. As a result, international revenues accounted for 41% of total revenues in the three months ended April 30, 2003, compared to 39% of total revenues the three months ended April 30, 2002. We expect international sales to continue to represent a significant portion of revenues, although the actual percentage may fluctuate from period to period. Our international sales are mostly denominated in local currencies.

 

As a result of our transition to the enterprise license model, the continuing decline in general economic factors affecting the high-technology sector and the impact of the reorganization of our sales force on services backlog, we believe that our reported revenue will not increase, and may decrease, in the second quarter of fiscal 2004, which ends on July 31, 2003, as compared to both the quarter ended April 30, 2003, and the second quarter of fiscal 2003, which ended July 31, 2002. We cannot predict how long or severe the current economic downturn will be or whether any actions taken by any government will be effective to bolster the United States or global economy. As a result of this uncertainty, forecasting and financial and strategic planning are more difficult than usual. If the downturn continues for an extended period or becomes more severe, our business will suffer and we may experience additional declines in sales, as well as continued losses, as our customers attempt to limit their spending. In addition, the adverse impact of the downturn on the capital markets could impair our ability to raise capital as needed and impede our ability to expand our business. For further discussion about factors affecting our revenues see “— Factors That May Affect Future Results.”

 

Cost of Revenues

 

The overall cost of products and services as a percentage of total revenues was 27% in the three months ended April 30, 2003, compared to 29% in the three months ended April 30, 2002.

 

Cost of products was $3.2 million and $5.5 million in the three months ended April 30, 2003 and 2002, respectively, reflecting a decrease of 42%. Product-related cost of revenues as a percentage of product revenues was 11% in the three months ended April 30, 2003, compared to 13% in the three months ended April 30, 2002.  Product-related costs consist primarily of salaries and benefits for production employees, other direct production costs, amortization of capitalized software development costs, royalty payments to third parties for the use of their software, and shipping costs. The decline in product-related costs in absolute dollars in the three months ended April 30, 2003 was primarily due to lower direct production costs, which were $1.9 million and $3.3 million for three months ended April 30, 2003 and 2002, respectively.  Amortization of capitalized software development costs for the three months ended April 30, 2003 and 2002 amounted to $182,000 and $231,000, respectively; and third-party royalty costs for the three months ended April 30, 2003 and 2002 were $885,000 and $1.7 million, respectively. Product-related cost of revenues may be affected in the future by the amortization of capitalized software development costs, costs of distribution related to the introduction of new products and by royalty costs for use of third-party software in our products.

 

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Cost of services was $10.1 million and $14.0 million in the three months ended April 30, 2003 and 2002, respectively, reflecting a decrease of 28%. Service-related cost of revenues as a percentage of service revenues was 52% in the three months ended April 30, 2003, compared to 62% in the three months ended April 30, 2002. Service-related cost of revenues consist primarily of personnel related costs associated with providing services, including consulting services, to customers and the infrastructure to manage a services organization, as well as costs to recruit, develop, and retain services professionals. The decrease in absolute dollars of service costs in the three months ended April 30, 2003, compared to the three months ended April 30, 2002, was primarily due to reduced use of outside consultants and a reduction of full-time employees as part of the restructuring plan we implemented in fiscal 2003.  Due to our restructuring plan, we realized cost reductions of $2.3 million in professional services costs, $943,000 in maintenance costs and $630,000 in training costs in the quarter ended April 30, 2003, compared to the quarter ended April 30, 2002. We expect cost of services to continue to fluctuate as a percentage of service revenue based on our ability to fully utilize our professional services organization.

 

Operating Expenses

 

Selling and Marketing.  Selling and marketing expenses were $23.4 million and $33.8 million in the three months ended April 30, 2003 and 2002, respectively, reflecting a decrease of 31%. As a percentage of total revenues, selling and marketing expenses were 48% in the three months ended April 30, 2003, compared to 51% in the three months ended April 30, 2002.  The decrease in absolute dollars of selling and marketing expenses was attributable to lower sales commission expenses as a result of decreased sales volume and the impact of our restructuring plan implemented during fiscal 2003, including reduced expenditures for salaries and related fringe costs and travel costs. Due to our restructuring plan implemented in fiscal 2003 and the general decline in sales, we realized cost reductions of $2.6 million in sales commissions, $3.2 million in the area of payroll-related costs and $1.2 million in travel costs together with smaller savings achieved in various other areas in the quarter ended April 30, 2003, compared to the quarter ended April 30, 2002.  In addition, in the three months ended April 30, 2003 compared to the three months ended April 30, 2002, depreciation expense decreased $1.4 million due to a lower depreciable base of our fixed assets and bad debt expense decreased $1.1 million due to improved collections.  We believe selling and marketing expenses in absolute dollars will not increase significantly in the short term. However, we do expect an increase in absolute dollars in the long term, as we continue to focus on long-term growth in the areas of sales and marketing personnel and marketing and advertising programs.

 

Product Development and Engineering.  Product development and engineering expenses were $14.3 million and $20.6 million in the three months ended April 30, 2003 and 2002, respectively, reflecting a decrease of 30%. As a percentage of total revenues, product development and engineering expenses were 30% in the three months ended April 30, 2003, compared to 31% in the three months ended April 30, 2002. The decrease in product development and engineering expenses in absolute dollars in the quarter ended April 30, 2003, compared to the quarter ended April 30, 2002, was primarily due to our implementation of cost-control measures related to our restructuring plan implemented in fiscal 2003.  Due to this restructuring plan, we realized cost reductions of $3.2 million in payroll-related costs, together with smaller savings achieved in various other areas, in the quarter ended April 30, 2003, compared to the quarter ended April 30, 2002. We believe that product development and engineering expenses in absolute dollars will not increase significantly in the short term. However, we do expect an increase in absolute dollars in the long term, as we continue to focus on long-term growth in the areas of research and development. In addition, we received $1.2 million and $1.1 million of funded research and development related to our Center of Excellence program and other similar initiatives in the three months ended April 30, 2003 and 2002, respectively, which offset a portion of our gross research and development expenses.

 

General and Administrative.  General and administrative expenses were $7.5 million and $9.3 million in the three months ended April 30, 2003 and 2002, respectively, reflecting a decrease of 19%. As a percentage of total revenues, general and administrative expenses were 15% in the three

 

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months ended April 30, 2003, compared to 14% in the three months ended April 30, 2002. The decline in general and administrative expenses in absolute dollars was the result of an overall decline in expenses due to our implementation of cost-control measures related to our restructuring plan implemented in fiscal 2003 and a reduction in legal costs.  Due to our restructuring plan, we realized $472,000 in payroll-related cost reductions and $854,000 in consulting costs.  Additionally, our legal costs for the quarter ended April 30, 2003 were $1.2 million lower than for the quarter ended April 30, 2002, primarily as a result of incurring $800,000 in the quarter ended April 30, 2002 relating to an employee litigation matter as well as due to lower legal costs as a result of cost-control measures implemented as part of our restructuring plans, offset in part by accounting, legal and printing costs relating to the option exchange program initiated in the quarter ended April 30, 2003.  We believe that general and administrative expenses will not increase significantly in absolute dollars in the short term as a result of the restructuring plans discussed above. However, we do expect an increase in absolute dollars in the long term, as we invest in worldwide staff and infrastructure in the areas of information systems and finance and administration.

 

We allocate the total costs for information technology, facilities and fixed asset depreciation to each of the functional areas based on certain headcount data. Information technology allocated costs include salaries, information technology, project costs, communication costs and depreciation expense for fixed assets. Facilities allocated costs include facility rent for the corporate offices as well as shared function offices, property taxes, depreciation expenses for office furniture and other department operating costs. Fixed asset depreciation allocated costs include straight-line depreciation expense on buildings, leasehold improvements, computer equipment, software, furniture and office equipment.

 

Amortization of Purchased Intangibles.  Amortization of purchased intangibles totaled $1.8 million and $2.1 million in the three months ended April 30, 2003 and 2002, respectively.

 

Other Income (Expense)

 

Interest Income.  Interest income was $2.8 million and $3.4 million for the three months ended April 30, 2003 and 2002, respectively. The decrease in interest income was primarily due to lower invested balances, lower interest earned on our investments as a result of lower interest rates, and higher amortization expense related to our fixed-income securities. Total cash and cash equivalents, investments and restricted cash totaled $257.1 million and $336.9 million as of April 30, 2003 and 2002, respectively.

 

Interest Expense.  Interest expense was $1.7 million and $1.8 million for the three months ended April 30, 2003 and 2002, respectively.  We pay interest on our outstanding 3.75% convertible subordinated notes semi-annually and record the amortization of certain issuance costs associated with these notes as other expense. In the near term, we expect interest expense to increase due to the loan facility we entered into during the quarter ended April 30, 2003.  Based on current interest rates associated with such facility, we expect additional quarterly interest of approximately $184,000.

 

Other Income (Expense).  Other income (expense), net, was income of $553,000 for the three months ended April 30, 2003 and expense of $206,000 for the three months ended April 30, 2002. The increase in other income is due to a gain on the sale of a piece of technology of approximately $416,000 for the three months ended April 30, 2003.

 

Provision For Income Taxes

 

Despite consolidated net losses in the three months ended April 30, 2003 and 2002, we had a tax provision of $635,000 and $500,000 in the three months ended April 30, 2003 and 2002, respectively,

 

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representing effective tax rates of 6.3% and 2.8%, respectively.  Our tax provision is based on estimates for full year foreign and withholding taxes that we expect to incur during the year.  In both fiscal 2003 and 2002, we recorded a valuation allowance based on management’s determination that it is more likely than not that our deferred tax assets as of January 31, 2003 and 2002 will not be realized.  In the event that our estimates change, our effective tax rate will fluctuate from period to period.

 

Restructuring Costs

 

The following table provides detailed restructuring liabilities for fiscal 2002 and 2003, the cash payments made during the quarter ended April 30, 2003 and the aggregate remaining restructuring liabilities as of April 30, 2003:

 

		Work Force Reduction			Consolidation of Excess Facilities			Other			Total
		(In thousands)
Fiscal Year 2002:
Cash charges		$	19,367		$	8,383		$	—		$	27,750
Non-cash charges		765			100			—			865
Reversals		—			(6,947		)	—			(6,947		)
Total charges		20,132			1,536			—			21,668
Cash payments		(15,073		)	(487		)	—			(15,560		)
Non-cash write-offs		(765		)	(100		)	—			(865		)
Restructuring liabilities as of January 31, 2002		4,294			949			—			5,243
Fiscal Year 2003:
Cash charges		26,457			3,246			1,353			31,056
Non-cash charges		206			355			2,119			2,680
Reversals		(994		)	(76		)	—			(1,070		)
Total charges		25,669			3,525			3,472			32,666
Cash payments		(14,602		)	(1,454		)	(456		)	(16,512		)
Non-cash write-offs		(206		)	(355		)	(2,119		)	(2,680		)
Restructuring liabilities as of January 31, 2003		15,155			2,665			897			18,717
Fiscal Quarter Ended April 30, 2003:
Cash payments		(11,643		)	(589		)	(274		)	(12,506		)
Restructuring liabilities as of April 30, 2003		$	3,512		$	2,076		$	623		$	6,211

 

The worldwide workforce reductions implemented as a result of the restructuring plan announced in the fourth quarter of fiscal 2003 will be substantially completed during the first half of fiscal 2004.

 

Liquidity and Capital Resources

 

Cash Flows

 

As of April 30, 2003, we had working capital of approximately $21.2 million, and cash, cash equivalents and investments of approximately $211.0 million, which included $24.3 million of short-term investments and $160.7 million of investments with maturities of greater than one year, but excluded restricted cash of $46.1 million associated with our loan facility discussed below under “—Commitments.” We invest primarily in highly liquid, investment-grade instruments. We have substantial

 

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debt service and principal repayment obligations, which could affect our liquidity, cash reserves and ability to obtain additional financing if we need to do so.

 

Operating activities primarily include the net loss for the quarter, non-cash charges such as depreciation and amortization expense and changes in assets and liabilities. In the three months ended April 30, 2003, our operating activities used net cash of $10.2 million compared to $2.5 million in the three months ended April 30, 2002.  Net cash used in operating activities for the three months ended April 30, 2003 consisted of cash used by operations of $5.0 million and a decrease in cash of $5.2 million arising from changes in assets and liabilities, primarily as a result of payments of accrued restructuring costs offset by a decrease in accounts receivable. Accounts receivable decreased by $8.0 million due primarily to the lower sales volume in the three months ended April 30, 2003, and to an increased rate of collections. During the quarter ended April 30, 2003, we also made payments of $12.5 million associated with the restructuring plan announced in the fourth quarter of fiscal 2003.  Net cash used in operating activities for the three months ended April 30, 2002 consisted of a decrease in cash used by operations of $9.2 million offset by an increase in cash of $6.7 million arising from changes in assets and liabilities, primarily accounts receivable, which decreased by $14.2 million.  Cash from operations includes net loss of $10.8 million and $18.0 million offset primarily by depreciation and amortization of $5.5 million and $8.1 million in the three months ended April 30, 2003 and 2002, respectively. Our operating cash flows depend heavily on the level of our sales.  To a large extent, our sales depend on general economic conditions affecting us and our customers, as well as the timing of new product introductions, other competitive factors and our ability to control expenses successfully.

 

Our investing activities used net cash of $36.1 million and $54.7 million in the three months ended April 30, 2003 and 2002, respectively. Investing activities generally relate to the purchase of investments, business acquisitions and property and equipment purchases, partially offset by cash provided from the sale and maturity of investments.  Acquisitions of property and equipment totaled $57.7 million in the three months ended April 30, 2003, of which $57.4 million represented the purchase price of our headquarters buildings, which we acquired upon exercise of the purchase options associated with the synthetic leases covering our headquarters buildings. See “—Commitments” below for further information on the exercise of the purchase options.  In the three months ended April 30, 2002, purchases of property and equipment totaled $2.4 million.  During the quarter ended April 30, 2003, the net decrease in our restricted cash was $14.2 million as a result of the release of restricted cash associated with our the synthetic leases offset by the restricted cash being held to secure the loan facility that we entered into in the same quarter.

 

In the three months ended April 30, 2003, our financing activities provided net cash of $40.0 million compared to $1.2 million in the three months ended April 30, 2002. During the three months ended April 30, 2003, the primary source of cash was the $40.0 million that we borrowed under our loan facility, which we entered into in the same quarter.  In the three months ended April 30, 2002, the primary source of cash was $3.3 million received from the issuance of common stock from employee stock option exercises, offset by $2.1 million in repayment of a line of credit at our Japanese subsidiary.

 

Convertible Subordinated Notes

 

In December 2001, we issued $150.0 million of 3.75% convertible subordinated notes due December 2006. The notes are unsecured, subordinated to all existing and future senior debt and convertible into shares of our common stock at an initial conversion price of $24.115 per share. The notes mature on December 15, 2006, unless earlier redeemed or converted. Interest is payable in cash semi-annually in arrears on June 15 and December 15 of each year, commencing June 15, 2002. At the option of the holder, the notes may be converted into our common stock at any time at the then-current

 

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conversion price. We may redeem all or a portion of the notes for cash at a redemption price of 100.75% of the principal amount between December 15, 2004 and December 14, 2005, and 100.0% of the principal amount beginning December 15, 2005 and thereafter. Additionally, under specified circumstances we may redeem the notes prior to 2004.

 

The indenture under which the notes were issued provides that an event of default will occur if (i) we fail to pay principal or premium on the notes, (ii) we fail to pay interest on the notes and fail to cure such non-payment within 30 days, (iii) we fail to perform any other covenant required of us in the indenture and the failure is not cured or waived within 60 days, or (iv) we or one of our significant subsidiaries fails to pay, at final maturity or upon acceleration, any indebtedness for money borrowed in an outstanding principal amount in excess of $35.0 million, including lease commitments, and the indebtedness is not discharged, or the default is not cured, waived or rescinded within 60 days after written notice is provided in accordance with the terms of the indenture. If any of these events of default occurs, either the trustee or the holders of at least 25% of the outstanding notes may declare the principal amount of the notes to be due and payable. In addition, an event of bankruptcy, insolvency or reorganization (involving us or any of our significant subsidiaries) will constitute an event of default under the indenture and, in that case, the principal amount of the notes will automatically become due and payable.

 

Commitments

 

In September 1997 and November 1999, we entered into two operating leases for our headquarters facility constructed on land owned by us in Alameda, California. After consideration of various financing alternatives for the construction of our headquarters buildings on land owned by us, the related economic impact of each alternative and the ability to retain control of the property, we chose a form of financing that we believed offered beneficial economic terms, commonly referred to as a “synthetic lease.” These leases were treated as operating leases for accounting purposes and financing leases for tax purposes. A synthetic lease is a form of off-balance sheet financing under which an unrelated third party funds 100% of the costs for the acquisition and/or construction of the property and leases the asset back to the company, as lessee. None of our officers or employees had any financial interest in these synthetic lease arrangements.

 

In January 2003, we notified the lessor of our intent to exercise the purchase options under the synthetic leases.  In April 2003, we completed the transactions, terminated the synthetic leases and purchased the buildings for a purchase price of $57.4 million. As a result of our completion of the purchase options, we reflect the buildings as an asset on our balance sheet. Additionally, restricted cash of $60.3 million held under the leases was released. Prior to the exercise of the purchase options, we reflected lease payments as a rental expense in our statement of operations. Having acquired the buildings, we no longer record a lease expense for the buildings and we record depreciation expense for the buildings over their estimated useful lives of 30 years.

 

In connection with the termination of the synthetic leases, in April 2003, we entered into a loan facility for an aggregate principal amount of $57.4 million, consisting of a $37.4 million non-revolving loan commitment and $20.0 million term loan, both of which mature in April 2005. During the quarter ended April 30, 2003, we borrowed $40.0 million of the facility at an interest rate currently equal to 1.84%. Under the terms of the facility, we are holding $46.1 million in marketable securities as restricted cash to secure the performance of our obligations under the facility.  See Note 7, “Other Borrowings” in notes to consolidated financial statements for further information regarding the loan facility.  The facility agreement contains customary events of defaults, including payment defaults, breaches of representations and warranties, covenant defaults, certain events of bankruptcy, insolvency and change of control, material judgments, and a

 

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cross-default to other material agreements and debt where we have incurred any liability in excess of $3.0 million.  If an event of default occurs, and we do not or cannot cure the default within the time periods specified in the facility agreement, the lender would be entitled to terminate the facility and declare the outstanding amounts under the loan facility to be immediately due and payable.

 

As of April 30, 2003, our future financial commitments, including interest payments, are as set forth in the table below:

 

		Nine Months Ended January 31,				Year Ended January 31,
		2004				2005			2006			2007			2008			Thereafter			Total
		(In thousands)
3.75% subordinated convertible debt(1)		$	2,813			$	5,625		$	5,625		$	155,625		$	—		$	—		$	169,688
Loan facility(2)		565				753			40,155			—			—			—			41,473
Other operating leases(3)		8,129				7,455			3,881			2,007			1,683			10,230			33,385
Total		$		11,507		$	13,833		$	49,661		$	157,632		$	1,683		$	10,230		$	244,546

 

(1)          The $150.0 million 3.75% convertible subordinated notes mature in December 2006, but may be redeemed by us starting in 2004 or earlier if certain conditions are met. See “—Convertible Subordinated Notes” above.

(2)          We may prepay the loan facility at any time.

(3)          Minimum future sublease income to be received under noncancelable subleases is approximately $2.8 million. As part of our restructuring reserve, we have accrued approximately $1.4 million relating to future payments associated with leases for excess facilities.

 

We had no material planned capital commitments as of April 30, 2003. Our capital requirements depend on numerous factors including our research and development expenditures, expenses related to selling, general and administrative operations and working capital to support business growth. We anticipate that our operating and capital expenditures will constitute a material use of our cash resources. As a result, our net cash flows will depend heavily on (i) the level of our future sales (which depend, to a large extent, on general economic conditions affecting us and our customers, as well as the timing of new product introductions, the rate at which our customers transition to our enterprise license model and other competitive factors) and (ii) our ability to control expenses and realize the objectives of the restructuring plan we announced on fiscal 2003. Although it is difficult for us to predict future liquidity requirements with certainty, we believe that our current cash and cash equivalents will satisfy our cash requirements for planned expansion, product development and capital expenditures for at least the next twelve months and on a longer term basis. During or after this period, if cash generated by operations is insufficient to satisfy our liquidity requirements, we may need to sell additional equity or debt securities or obtain an additional credit facility. Our ability to obtain additional financing may be limited by the amount of indebtedness we have outstanding and/or our recent performance and financial condition, particularly if our bond rating is lowered or withdrawn, as well as general market conditions if the continuing economic downturn were to continue or become more serious. Recently, our corporate credit rating was downgraded by Standard & Poor’s from B+ to B.  Accordingly, there can be no assurance that additional financing will be available to us or, if available, that such financing will be available on favorable terms. If we were unable to obtain financing, we might be required to reduce our expenses, including product development and engineering expenses, which could have a material adverse effect on our business and results of operations.

 

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Recent Accounting Pronouncements

 

In May 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 provides for certain changes in the accounting treatment of derivative contracts. SFAS 149 is effective for contracts entered into or modified after June 30, 2003, except for certain provisions that relate to SFAS No. 133 implementation issues that have been effective for fiscal quarters that begin prior to June 15, 2003, which would continue to be applied in accordance with their respective effective dates.  The guidance should be applied prospectively.  We do not anticipate that the adoption of SFAS 149 will have a material impact on our consolidated financial statements.

 

Also in May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (“SFAS 150”).  SFAS 150 changes the accounting for certain financial instruments that under previous guidance issuers could account for as equity.  It requires that those instruments be classified as liabilities in balance sheets. Most of the guidance in SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of our third fiscal quarter of fiscal 2004.  We do not anticipate that the adoption of SFAS 150 will have a material impact on our consolidated financial statements.

 

Factors That May Affect Future Results

 

Our business faces significant risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently think are immaterial may also impair our business operations. If any of the events or circumstances described in the following risks actually occur, our business, financial condition or results of operations could suffer, and the trading price of our common stock could decline.

 

The economic downturn has adversely impacted and may continue to adversely impact our revenues and earnings. In addition, uncertainties associated with the downturn increase the difficulty of financial planning and forecasting.

 

We are currently in the midst of a general economic downturn that commenced in 2001 in the United States and expanded to many other regions of the world during 2002. The economic downturn has been especially pronounced in the high technology sector generally and the telecommunications sector in particular. Beginning in fiscal year 2002 and continuing through fiscal year 2003 and into the first quarter of fiscal 2004, we have experienced a decline in revenues and a loss of profitability, which we believe is attributable primarily to these downturns. Our total revenues decreased 29% in fiscal 2003, compared to fiscal 2002, and decreased 20% in fiscal 2002 compared to fiscal 2001. Our net loss was $106.9 million, or a net loss of $1.35 per share, for fiscal 2003, compared to a net loss of $375.6 million, or a net loss of $4.84 per share, for fiscal 2002 and a net loss of $76.4 million, or a net loss of $1.05 per share, for fiscal 2001. For the quarter ended April 30, 2003, our revenues were $48.5 million compared to $66.4 million for the quarter ended April 30, 2002, reflecting a 27% decrease. Net loss was $10.8 million, or $0.14 per share, for the quarter ended April 30, 2003, compared to $18.0 million, or $0.23 per share, for the quarter ended April 30, 2002.

 

Our decline in revenues during fiscal years 2002 and 2003, as well as the continuing adverse economic conditions, led us to implement restructuring plans in both fiscal 2002 and 2003 that included headcount reductions and other cost-control measures.  The restructuring plan announced in the fourth quarter of fiscal 2003 will be substantially completed during the first half of fiscal 2004.  Due to the

 

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restructuring plans we recorded charges for restructuring and impairment of acquired goodwill and other intangible assets during fiscal years 2002 and 2003.

 

We cannot predict how long or severe this downturn will be or whether any actions taken or proposed by any government will be effective to bolster the economy. As a result of this uncertainty, forecasting and financial and strategic planning are more difficult than usual. If the downturn continues for longer than we expect or becomes more severe, our business will continue to suffer and we may experience additional declines in sales, as well as continued losses, as our customers further reduce their spending. In addition, the adverse impact of the downturn on the capital markets could impair our ability to raise capital as needed and impede our ability to expand our business.

 

In late fiscal 2003, we introduced a new business model, including a new type of licensing arrangement, and cannot be sure that the new model will be successful. Additionally, we expect the transition to the new model will impact the timing of our reported revenues.

 

In November 2002, we introduced our enterprise license model, which includes technology integrated into market specific platforms and subscription-based licenses. While we believe that the introduction of the enterprise license model will have significant benefits for our customers, it is possible these benefits may not materialize. There is a risk that customers may not accept the new products we offered under our enterprise license model, or that they may reject the terms of the model itself. There is a risk that customers may delay or defer product ordering decisions, and that we may not be able to engage our customers at appropriate levels of management to make enterprise-wide subscription orders feasible. There is a further risk that we may remain dependent upon large end-of-quarter transactions, that our selling efforts in coming quarters could be disrupted, and that the transition to the enterprise license model could cause us to incur unanticipated administrative and other costs. In any such event, our revenue and earnings for a quarter could be below our expectations.

 

Although enterprise licenses represent a potential source of renewable license revenue, there is also a risk that customers will not renew their licenses at the end of the term. In addition, there is a risk that customers who purchase enterprise licenses may spend less in the aggregate over the term of the enterprise license than if they had been required to purchase perpetual licenses under our traditional project-based model. Also, because the enterprise license includes limited services, customers may purchase fewer stand-alone services from us, which could negatively impact our service revenues. Additionally, we expect maintenance revenues will decline as our customers transition to our enterprise license model, which includes maintenance as a part of the subscription fee. We expect many of our strategic and major customers to adopt our enterprise license model for their current needs, and that they may also transition existing perpetual development seats to enterprise license model terms.

 

During the transition of our business model from project-based licensing to the enterprise license model, we expect the timing of our reported revenue to be impacted because under the enterprise license model revenue is recognized ratably over the subscription period. By contrast, our traditional project-based license requires a majority of license revenue to be recognized in the quarter in which the products are delivered and a much smaller amount relating to the fair value of the maintenance being deferred and recognized subsequently over the maintenance period. Therefore, an order for a subscription license will result in lower current-quarter revenue than an equal-sized order for a project-based license. As a result, the impact on near-term and deferred revenue will depend on the rate at which customers transition from our project-based model to our enterprise license model. To the extent that the adoption rate is higher than we expect, we may experience a greater decline in near-term revenue, as well as an increase in deferred revenue.

 

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Our restructuring plans may not enable us to achieve profitability in a difficult economic environment or achieve our business objectives.

 

In response to market conditions and the decline in our revenues, in both fiscal 2002 and 2003, we implemented restructuring plans that were designed to align our anticipated revenues more closely with our cost structure. Our restructuring plans have been based on certain assumptions regarding the cost structure of our business and the nature and severity of the current industry adjustment and general economic trends. We cannot be certain that the assumptions underlying the restructuring plans will prove to be accurate. If they are not, our restructuring plans may not result in the correct alignment of our anticipated revenues and cost structure. Our restructuring plans involved the implementation of a number of initiatives, including significant headcount reductions, facilities closures, and other cost-control measures, that may adversely affect our ability to realize our current or future business objectives.  For example, the reorganization of our sales force disrupted our services backlog and adversely impacted our services revenues for the quarter ended April 30, 2003.  Additional restructuring actions may result in further cash and/or non-cash charges, which could have a material adverse effect on our business and results of operations. As a result, we cannot be sure that we will return to profitability as a result of our restructuring plans.

 

Numerous factors may cause our total revenues and operating results to fluctuate significantly from period to period. These fluctuations increase the difficulty of financial planning and forecasting and may result in decreases in our available cash and declines in the market price of our stock.

 

A number of factors, many of which are outside our control, may cause or contribute to significant fluctuations in our total revenues and operating results. These fluctuations make financial planning and forecasting more difficult. In addition, these fluctuations may result in unanticipated decreases in our available cash, which could negatively impact our operations. As discussed more fully below, these fluctuations also could increase the volatility of our stock price. Factors that may cause or contribute to fluctuations in our operating results and revenues include:

 

•                  implementation of our enterprise license model and use of subscription-based licenses, as discussed above;

 

•                  the number and timing of orders we receive, including disproportionately higher receipt and shipment of orders in the last month of the quarter;

 

•                  changes in the length of our products’ sales cycles, which increase as our customers’ purchase decisions become more strategic and are made at higher management levels;

 

•                  reductions in the number of engineering projects started by our customers due to their own difficult financial or economic conditions;

 

•                  the impact of impairment charges arising from past acquisitions;

 

•                  the success of our customers’ products from which we derive our production license revenue;

 

•                  the mix of our revenues as between sales of products and lower-margin sales of services;

 

•                  our ability to control our operating expenses, and fully realize the objectives of the restructuring plans we have implemented;

 

•                  our ability to continue to develop, introduce and ship competitive new products and product enhancements quickly;

 

•                  possible deferrals of orders by customers in anticipation of new product introductions;

 

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•                  announcements, product introductions and price reductions by our competitors;

 

•                  our ability to manage costs for fixed-price consulting agreements;

 

•                  seasonal product purchases by our customers, which historically have been higher in our fourth fiscal quarter;

 

•                  the impact of, and our ability to react to, natural disasters and/or events of terrorism;

 

•                  changes in business cycles that affect the markets in which we sell our products;

 

•                  economic, political and other conditions in the United States and internationally; and

 

•                  foreign currency exchange rates.

 

One or more of the foregoing factors may cause our operating expenses to be disproportionately high or may cause our net revenue and operating results to fluctuate significantly. Results from prior periods are thus not necessarily indicative of the results of future periods.

 

We have substantial commitments, which could make it difficult for us to obtain financing and deplete our cash reserves. Additionally, these commitments could be accelerated in certain circumstances, which could have a material adverse effect on our financial condition, results of operations and cash flows.

 

As of April 30, 2003, we had $150.0 million in outstanding indebtedness under our 3.75% convertible subordinated notes and $40.0 million in other long-term debt. As of April 30, 2003, we had cash and cash equivalents of $25.9 million, short-term investments of $24.3 million, investments with maturities of greater than one year of $160.7 million and restricted cash of $46.1 million.  The indenture under which our convertible subordinated notes were issued contains customary events of default, and also provides that an event of default occurs if we (or one of our significant subsidiaries) fail to pay, at final maturity or upon acceleration, any indebtedness for money borrowed in an outstanding principal amount in excess of $35.0 million, and the indebtedness is not discharged, or the default is not cured, waived or rescinded within 60 days after written notice is provided in accordance with the terms of the indenture. Similarly, our loan facility agreement contains customary events of default, including a cross-default to other material agreements and debt where we have incurred any liability in excess of $3.0 million.  Under the terms of our convertible subordinated notes and our loan facility, if an event of default were to occur for the aforementioned reasons or other reasons and we do not or cannot cure the event of default within specified periods, the lenders could in each case accelerate payment of the indebtedness.

 

We face intense competition in the embedded software industry, which could decrease demand for our products or cause us to reduce our prices.

 

The embedded software industry is characterized by rapid change, new and complex technology and intense competition. Our ability to maintain our current market share depends upon our ability to satisfy customer requirements, enhance existing products and develop and introduce new products. Due to the complexity of the markets in which we operate, where our customers often develop embedded systems in-house, it is difficult to assess the impact of competition on our business and our related share of the markets that we operate in. We have faced increasing competition in recent years as customers have decreased research and development budgets, sought to increase the value they receive from vendors, including us, attempted to leverage a more competitive bidding process when spending research and development budgets and/or deferred or canceled projects, in whole or in part. As a result, we believe that some customers have elected not to purchase our products and have chosen to undertake such development in-house, selected solutions they perceive to be less expensive or relied upon existing

 

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licenses from us rather than making new purchases. We expect the intensity of competition to increase in the future. Increased competitiveness may result in reductions in the prices of our products, decreased revenue from our production licenses and services, lower-than-expected gross margins or loss of market share, any of which would harm our business.

 

Our primary competition comes from internal research and development departments of companies that develop embedded systems in-house. In many cases, companies that develop embedded systems in-house have already made significant investments of time and effort in developing their own internal systems, making acceptance of our products as a replacement more difficult. Additionally, many of these in-house departments may increasingly choose to use open-source software, such as the Linux operating system. We also compete with independent software vendors and, to a limited extent, with open-source vendors. Some of the companies that develop embedded systems in-house and some of these independent software vendors, such as Microsoft Corporation, may have significantly greater financial, technical, marketing, sales and other resources and significantly greater name recognition than we do.

 

Demands for rapid change and the increasing complexity of the technology in our industry intensify the competition we face. In addition, our competitors may consolidate or establish strategic alliances to expand product offerings and resources or address new market segments. As a result, they may be able to respond more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the development, promotion, sale and support of their products. These factors favor larger competitors that have the resources to develop new technologies or to respond more quickly with new product offerings or product enhancements. We may be unable to meet the pace of rapid development set by our competitors or may incur additional costs attempting to do so, which may cause declines in our operating results. Our competitors may foresee the course of market developments more accurately than we do and could in the future develop new technologies that compete with our products or even render our products obsolete, any of which could adversely affect our competitive position.

 

If we do not continue to address new and rapidly changing markets and increasingly complex technologies successfully and deliver our products on a timely basis, our revenues and operating results will decline.

 

The market for embedded software is characterized by ongoing technological developments, evolving industry standards and rapid changes in customer requirements and product offerings in the embedded market. Our success depends upon our ability to adapt and respond to these changes in a timely and cost-effective manner. If we fail to continually update our existing products to keep them current with customer needs or to develop new or enhanced products to take advantage of new technologies, emerging standards and expanding customer requirements, our existing products could become obsolete and our financial performance would suffer. We have from time to time experienced delays in the commercial release of new technologies, new products and enhancements of existing products. These delays are commonplace in the software industry due to the complexity and unpredictability of the development work required. We must effectively market and sell new product offerings to key customers, because once a customer has designed a product with a particular operating system, that customer typically is reluctant to change its supplier due to the significant related costs. If we cannot adapt or respond in a cost-effective and timely manner to new technologies and new customer requirements, sales of our products could decline.

 

 

 

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The costs of software development can be high, and we may not realize revenues from our development efforts for a substantial period of time.

 

Introducing new products that rapidly address changing market demands requires a continued high level of investment in research and development.  Our product development and engineering expenses were $14.3 million, or 30% of total revenues, for the three months ended April 30, 2003, compared to $20.6 million, or 31% of total revenues, for the three months ended April 30, 2002. Our product development and engineering expenses were $74.0 million, or 30% of total revenues, for fiscal 2003, compared to $88.7 million, or 25% of total revenues, for fiscal year 2002. If we are required to undertake extensive capital outlays to address changes in the embedded software market, we may be unable to realize revenue as soon as we may expect. The costs associated with software development are increasing, including the costs of acquiring or licensing new technologies. Our investment in new and existing market opportunities prior to our ability to generate revenue from these new opportunities may adversely affect our operating results.

 

Because a significant portion of our revenue is derived from production licenses, we are dependent upon the ability of our customers to develop and penetrate new markets successfully.

 

Our operating systems and middleware products are embedded in end-user products developed and marketed by our customers, and we receive production license fees for each copy of our operating system and middleware products embedded in those products. Therefore, our production license revenues depend both upon our ability to successfully negotiate the production license agreements with our customers and, in turn, upon our customers’ successful commercialization of their underlying products. In particular, we derive significant revenue from customers that develop products in highly competitive and technologically complex markets such as the Internet infrastructure, servers and data storage, digital consumer, aerospace and defense, industrial control and automotive markets. If these customers sell fewer products or otherwise face significant economic difficulties, our revenues will decline. For example, during fiscal 2003, our revenues from production licenses declined 13% as compared to fiscal 2002, which we believe is primarily due to our customers’ response to the current market conditions in the high-technology sector. We cannot control our customers’ product development or commercialization or predict their success. In addition, we depend on our customers to accurately report the use of their products in order for us to collect our revenues from production licenses. If our customers are not successful with their products or do not accurately report use of their products to us, our production license revenues may decline significantly. Additionally, because Linux is royalty-free, we may be forced to reduce the prices of our production licenses, which may cause our revenues and profit margins to decline.

 

Our significant international business activities subject us to increased costs and economic risks.

 

We develop and sell a substantial percentage of our products internationally. For the three months ended April 30, 2003, revenues from international sales were $19.8 million, or 41% of total revenue, compared to $26.1 million, or 39% of total revenue for the three months ended April 30, 2002.  For fiscal 2003, revenues from international sales were $103.6 million, or 42% of total revenue, as compared to $135.8 million, or 39% of total revenue for fiscal 2002. Additionally, we have investments in, or have made acquisitions of, companies located outside the United States. Over the long term, we expect to continue to make investments to further support and expand our international operations and increase our direct sales force and distribution network in EMEA, Japan and Asia Pacific. Risks inherent in international operations include:

 

•                  the imposition of governmental controls and regulatory requirements;

 

•                  the costs and risks of localizing products for foreign countries;

 

•                  differences in business cultures and sales cycles;

 

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•                  differences in operation and sales support expenses;

 

•                  unexpected changes in tariffs, import and export restrictions and other barriers and restrictions;

 

•                  greater difficulty in accounts receivable collection;

 

•                  restrictions on repatriation of earnings;

 

•                  exposure to adverse movements in foreign currency exchange rates;

 

•                  the burdens of complying with a variety of foreign laws;

 

•                  difficulties in staffing and managing foreign subsidiaries and branch operations;

 

•                  the costs and risks of operating in countries experiencing geopolitical conflict and/or terrorism;

 

•                  the effect of our adoption of global pricing models;

 

•                  difficulties in integrating products and operations from foreign acquisitions;

 

•                  the impact of local health or political crises that prohibit or severely limit travel or other interaction with a local economic market;

 

•                  exposure to local economic slowdowns; and

 

•                  the need to guarantee credit instruments extended to support foreign operations.

 

Any of these events, regionally and as a whole, could reduce our international sales and increase our costs of doing business internationally and have a material adverse effect on our gross margins and net operating results.

 

Our common stock price is subject to volatility.

 

In recent years, the stock markets in general and the shares of technology companies in particular have experienced extreme price fluctuations. These recent price fluctuations have often been unrelated or disproportionate to the operating performance of the companies affected. Our stock price has similarly experienced significant volatility. As reported on The Nasdaq National Market, during fiscal 2003, our stock had a high sales price of $18.35 and a low sales price of $2.03, and during the quarter ended April 30, 2003, had a high sales price of $4.21 and a low sales price of $2.71. The last sale price of our common stock as reported on The Nasdaq National Market on June 10, 2003 was $4.00. In recent fiscal quarters, we have experienced shortfalls in revenue and earnings from levels expected by securities analysts and investors, which have had an immediate and significant adverse effect on the trading price of our common stock. These factors relating to the fluctuations in our revenues and operating results may continue to affect our stock price. Comments by or changes in estimates from securities analysts as well as significant developments involving our competitors or our industry could also affect our stock price.

 

In addition, the market price of our common stock is affected by the stock performance of other technology companies generally, as well as companies in our industry and our customers in particular. Other broad market and industry factors may negatively affect our operating results or cause our stock price to decline, as may general political or economic conditions in the United States and globally, such as recessions, or interest rate or currency fluctuations. In particular, the stock market may be adversely impacted, or experience unusual volatility, as a result of the outbreak of armed conflict or hostilities involving the United States or incidences of terrorism in, or directed at, the United States or its allies.

 

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The rights we rely upon to protect the intellectual property underlying our products may not be adequate, which could enable third parties to use our technology and reduce our ability to compete.

 

Our success depends significantly upon the proprietary technology contained in our products. We currently rely on a combination of patents, copyrights, trademarks, trade secret laws, and contractual provisions to establish and protect our intellectual property rights in our technology and products. We cannot be certain that the steps we take to protect our intellectual property will adequately protect our rights, that others will not independently develop or otherwise acquire equivalent or superior technology, or that we can maintain our technology as trade secrets. In addition, discovery and investigation of unauthorized use of our intellectual property is difficult. We expect software piracy, which is difficult to detect, to be a persistent problem, particularly in those foreign countries where the laws may not protect our intellectual property as fully as in the United States. Employees, consultants, and others who participate in the development of our products may breach their agreements with us regarding our intellectual property.

 

We might not have adequate remedies for infringement or breach of our proprietary rights by third parties, employees or consultants. Further, we have in the past initiated, and in the future may initiate, claims or litigation against third parties for infringement or breach of our proprietary rights or to establish the validity of our proprietary rights. Whether or not such litigation is determined in our favor, such actions could result in significant expense to us, divert the efforts of our technical and management personnel from productive tasks or cause product shipment delays.

 

Patent, trademark or copyright infringement or product liability claims against us may result in costly litigation, cause product shipment delays or require us to expend significant resources. In addition, patent or copyright claims may require us to enter into royalty or licensing arrangements.

 

We occasionally receive communications from third parties alleging patent, trademark or copyright infringement or other intellectual property claims, and there is always the chance that third parties may assert infringement claims against us or against our customers under circumstances that might require us to provide indemnification. Additionally, because our products are increasingly used in applications, such as network infrastructure, transportation, medical and mission-critical business systems, in which the failure of the embedded system could cause property damage, personal injury or economic loss, we may face product liability claims.

 

Although our agreements with our customers typically contain provisions intended to limit our exposure to infringement and liability claims, these provisions may not be effective in doing so in all circumstances or in all jurisdictions. Any of these types of claims, with or without merit, could result in claims for indemnification by us or costly litigation, could require us to expend significant resources to develop non-infringing technology or remedy product defects, cause product shipment delays or require us to pay significant damages if the claims are successful. In the case of infringement of another party’s intellectual property, we may be required to enter into royalty or licensing agreements; however, we cannot be certain that the necessary licenses will be available or that they can be obtained on commercially reasonable terms. If we are not successful in defending these claims or, with respect to infringement claims, were to fail to obtain royalty or licensing agreements in a timely manner and on reasonable terms, our business, financial condition and results of operations would be materially adversely affected.

 

Legislative actions may cause our operating expenses to increase.

 

The Sarbanes-Oxley Act of 2002, the California Disclosure Act and newly proposed or enacted rules and regulations of the Securities and Exchange Commission or the National Association of

 

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Securities Dealers impose new duties on us and our executives, directors, attorneys and independent accountants.  In order to comply with the Sarbanes-Oxley Act and such new rules and regulations, we may be required to hire additional personnel and use additional outside legal, accounting and advisory services.  Any of these developments could materially increase our operating expenses and accordingly reduce our net income or increase our net losses.

 

Potential new accounting pronouncements may cause our net income to decrease or our net losses to increase.

 

We currently account for employee stock options using the intrinsic-value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, and have not recognized any compensation expense for awards of employee stock options in the months ended April 30, 2003 and 2002.  Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” or SFAS 123, permits us to continue accounting for stock-based compensation as set forth in APB 25, provided we disclose the pro forma affect on net income and earnings per share of using a fair-value method of accounting for stock-based employee compensation plans.  If we change our method of accounting for employee stock options, whether voluntarily or as a result of changes in accounting rules, our net income could materially decrease or our net losses could materially increase.  For example, had we recorded compensation expenses based on the estimated grant date fair value for awards under our stock option and stock purchase plans (as defined in SFAS 123) our pro forma net loss for the three months ended April 30, 2003 would have been $14.1 million, or $0.18 per share, instead of reported net loss of $10.8 million or $0.14 per share.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Interest Rate Sensitivity

 

Our exposure to market risk for changes in interest rates relate primarily to our investment portfolio and debt obligations. We place our investments with high quality credit issuers and, by policy, limit the amount of credit exposure to any one issuer. As stated in our policy, our first priority is to reduce the risk of principal loss. Consequently, we seek to preserve our invested funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in only high quality credit securities that we believe to be low risk and by positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer or guarantor.  During the quarter ended April 30, 2003, we entered into a loan facility for an aggregate principal amount of $57.4 million, of which we have borrowed $40.0 million.  As of April 30, 2003, borrowings under the facility bear interest at the rate of 1.84% per annum.

 

Foreign Currency Risk

 

We enter into foreign currency forward exchange contracts to manage foreign currency exposures related to certain foreign currency denominated inter-company balances. Additionally, we may adjust our foreign currency hedging position by taking out additional contracts or by terminating or offsetting existing forward contracts. These adjustments may result from changes in the underlying foreign currency exposures or from fundamental shifts in the economics of particular exchange rates. Gains and losses on terminated forward contracts, or on contracts that are offset, are recognized in other income (expense) in the period of contract termination or offset. Our ultimate realized gain or loss with respect to currency fluctuations will depend on the currency exchange rates and other factors in effect as the contracts mature. As of April 30, 2003, we had outstanding contracts with the following terms:

 

Buy/Sell:		Sell		Sell		Sell
Currency:		GBP		EURO		JPY
Amount:		450,000		750,000		460,000,000
Rate:		1.5608		1.0745		120.1000
USD Equivalent:		$701,000		$805,000		$3,835,000
Maturity Date:		5/12/03		5/12/03		5/12/03

 

Contract amounts are representative of the expected amounts to be paid under the terms of these instruments. As of April 30, 2003, the fair value of our outstanding contracts was not significant.

 

Equity Price Risk

 

There have been no material changes to our equity price risk since the fiscal year ended January 31, 2003.  See item 7A, “Quantitative And Qualitative Disclosures About Market Risk,” in our Annual Report on Form 10-K for the fiscal year ended January 31, 2003.

 

ITEM 4. CONTROLS AND PROCEDURES

 

(a) Evaluation of disclosure controls and procedures.

 

Wind River maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its filings under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the periods specified in the rules and forms of the

 

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Securities and Exchange Commission. Such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. Our management, including the principal executive officer and the principal financial officer, recognizes that any set of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.

 

Within 90 days prior to the filing date of this quarterly report on Form 10-Q, Wind River has carried out an evaluation, under the supervision and with the participation of its management, including Wind River’s principal executive officer and Wind River’s principal financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Based on such evaluation, our principal executive officer and principal financial officer concluded that Wind River’s disclosure controls and procedures are effective.

 

(b) Changes in internal controls.

 

There have been no significant changes in Wind River’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date of their evaluation in connection with the preparation of this quarterly report on Form 10-Q.

 

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PART II—OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

Not applicable.

 

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

 

Not applicable.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

Not applicable.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

Not applicable.

 

ITEM 5. OTHER INFORMATION

 

Not applicable.

 

ITEM 6. EXHIBITS AND REPORT ON FORM 8-K

 

(a) Exhibits

 

Exhibit No.		Description
99.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
99.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
99.3		Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350
99.4		Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350

 

(b) Report on Form 8-K

 

Wind River did not file a report on Form 8-K during the quarter ended April 30, 2003.

 

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SIGNATURE

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Dated: June 13, 2003		WIND RIVER SYSTEMS, INC.
		By:	/s/  MICHAEL W. ZELLNER
			Michael W. Zellner
			Vice President of Finance, Chief Financial Officer and Secretary
			(Principal Financial and Accounting Officer)

 

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