UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

(Mark One)

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

 

For the quarterly period ended October 31, 2004

 

OR

 

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

 

For the transition period from                        to                       

 

Commission file number  0-22823

 

QAD Inc.

(Exact name of Registrant as specified in its charter)

 

Delaware		77-0105228
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

 

6450 Via Real, Carpinteria, California  93013

(Address of principal executive offices)

 

(805) 684-6614

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  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.

 

The number of shares outstanding of the issuer’s common stock as of November 30, 2004 was 33,751,675.

 

 

QAD INC.

INDEX

 

PART I
	FINANCIAL INFORMATION
	ITEM 1	Financial Statements (unaudited)
		Condensed Consolidated Balance Sheets as of October 31, 2004 and January 31, 2004
		Condensed Consolidated Statements of Operations for the Three and Nine Months Ended October 31, 2004 and 2003
		Condensed Consolidated Statements of Cash Flows for the Nine Months Ended October 31, 2004 and 2003
		Notes to Condensed Consolidated Financial Statements
	ITEM 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	ITEM 3	Quantitative and Qualitative Disclosures About Market Risk
	ITEM 4	Controls and Procedures
PART II
	OTHER INFORMATION
	ITEM 2	Unregistered Sales of Equity Securities and Use of Proceeds
	ITEM 6	Exhibits
		SIGNATURES

 

2

 

PART I

 

ITEM 1 – FINANCIAL STATEMENTS

 

QAD INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

 

		October 31, 2004			January 31, 2004
Assets
Current assets:
Cash and equivalents		$	57,496		$	59,784
Accounts receivable, net		48,315			65,455
Other current assets		11,362			13,352
Total current assets		117,173			138,591
Property and equipment, net		39,271			34,485
Capitalized software costs, net		3,168			2,966
Goodwill		11,296			11,306
Other assets, net		2,438			2,480
Total assets		$	173,346		$	189,828
Liabilities and stockholders’ equity
Current liabilities:
Current portion of long-term debt		$	1,706		$	11,987
Accounts payable		8,476			12,553
Deferred revenue		56,022			69,252
Other current liabilities		31,723			38,821
Total current liabilities		97,927			132,613
Long-term debt		24,344			7,720
Other liabilities		367			1,882
Minority interest		571			500
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.001 par value. Authorized 5,000,000 shares; none issued and outstanding		—			—
Common stock, $0.001 par value. Authorized 150,000,000 shares; issued 35,337,192 and 35,334,291 shares at October 31, 2004 and January 31, 2004, respectively		35			35
Additional paid-in capital		119,308			119,411
Treasury stock, at cost (1,620,372 and 1,561,056 shares at October 31, 2004 and January 31, 2004, respectively)		(10,138		)	(8,100		)
Accumulated deficit		(52,967		)	(58,038		)
Unearned compensation – restricted stock		(440		)	—
Accumulated other comprehensive loss		(5,661		)	(6,195		)
Total stockholders’ equity		50,137			47,113
Total liabilities and stockholders’ equity		$	173,346		$	189,828

 

See accompanying notes to condensed consolidated financial statements.

 

3

 

QAD INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

		Three Months Ended October 31,						Nine Months Ended October 31,
		2004			2003			2004			2003
Revenue
License fees		$	13,892		$	15,517		$	42,497		$	48,607
Maintenance and other		28,348			28,617			84,857			85,358
Services		13,213			11,681			43,126			34,104
Total revenue		55,453			55,815			170,480			168,069
Costs and expenses:
Cost of license fees		2,212			2,140			6,059			7,400
Cost of maintenance, service and other revenue		20,274			20,174			62,673			59,240
Sales and marketing		12,879			14,114			42,973			44,402
Research and development		7,829			8,991			25,444			27,325
General and administrative		6,931			5,965			19,579			18,153
Amortization of intangibles from acquisitions		150			279			402			826
Restructuring		—			(346		)	—			(346		)
Total costs and expenses		50,275			51,317			157,130			157,000
Operating income		5,178			4,498			13,350			11,069
Other (income) expense:
Interest income		(193		)	(151		)	(518		)	(396		)
Interest expense		564			328			1,315			874
Other (income) expense, net		641			(154		)	453			(1,794		)
Total other (income) expense		1,012			23			1,250			(1,316		)
Income before income taxes		4,166			4,475			12,100			12,385
Income tax expense		1,050			900			1,425			2,400
Net income		$	3,116		$	3,575		$	10,675		$	9,985
Basic net income per share		$	0.09		$	0.11		$	0.31		$	0.30
Diluted net income per share		$	0.09		$	0.10		$	0.30		$	0.29

 

See accompanying notes to condensed consolidated financial statements.

 

4

 

QAD INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

		Nine Months Ended October 31,
		2004			2003
Cash flows from operating activities:
Net income		$	10,675		$	9,985
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		5,824			6,393
Provision for (recovery of) doubtful accounts and sales adjustments		328			(113		)
(Gain) loss on disposal of property and equipment		120			(1,545		)
Restructuring					(346		)
Other, net		137			131
Changes in assets and liabilities, net of effects from acquisitions:
Accounts receivable		17,224			12,181
Other assets		1,085			3,036
Accounts payable		(4,155		)	(1,444		)
Deferred revenue		(13,444		)	(14,638		)
Other liabilities		(8,751		)	(5,568		)
Net cash provided by operating activities		9,043			8,072
Cash flows from investing activities:
Purchase of property and equipment		(9,042		)	(12,400		)
Restricted cash under construction loan		—			1,016
Capitalized software costs		(787		)	(478		)
Acquisitions of businesses, net of cash acquired		(766		)	(445		)
Proceeds from sale of property and equipment		29			3,394
Net cash used in investing activities		(10,566		)	(8,913		)
Cash flows from financing activities:
Proceeds from construction loan		3,870			7,749
Repayment of construction loan		(14,338		)	—
Repayments of long-term debt		(1,189		)	(1,625		)
Proceeds from issuance of common stock		2,520			6,524
Proceeds from notes payable, net of fees		17,843			—
Repurchase of common stock		(5,581		)	(15,239		)
Dividends paid		(4,277		)	—
Net cash used in financing activities		(1,152		)	(2,591		)
Effect of exchange rates on cash and equivalents		387			1,087
Net decrease in cash and equivalents		(2,288		)	(2,345		)
Cash and equivalents at beginning of period		59,784			50,188
Cash and equivalents at end of period		$	57,496		$	47,843

 

See accompanying notes to condensed consolidated financial statements.

 

5

 

QAD INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

1.   BASIS OF PRESENTATION

 

In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments necessary to present fairly the financial information contained therein.  These statements do not include all disclosures required by accounting principles generally accepted in the United States of America for annual financial statements and should be read in conjunction with the audited financial statements and related notes included in QAD’s (the company) Annual Report on Form 10-K for the year ended January 31, 2004.  The results of operations for the three and nine months ended October 31, 2004 are not necessarily indicative of the results to be expected for the year ending January 31, 2005.

 

2.   RECENT ACCOUNTING PRONOUNCEMENTS

 

On October 22, 2004, the American Jobs Creation Act (“the AJCA”) was signed into law. The AJCA includes a provision allowing a deduction of 85% of certain foreign earnings that are repatriated, as defined in the AJCA. The company may elect to apply this provision to qualifying earnings repatriations in either the balance of fiscal 2005 or in fiscal 2006. The company will evaluate the effects of the repatriation provision and the possible range of amounts that the company may consider for repatriation under the provision, but does not expect to be able to complete this evaluation until after Congress or the Treasury Department provides additional clarifying language on key elements of the provision.

 

On March 31, 2004, the Financial Accounting Standards Board (FASB) issued an exposure draft, “Share-Based Payment, an Amendment of SFAS No. 123 and 95.”  The exposure draft proposes to expense the fair value of share-based payments to employees and is effective for annual or interim periods beginning after June 15, 2005.  The company is currently evaluating the impact of this proposed standard on its financial statements.

 

In January 2003, the FASB issued Financial Interpretation No. (FIN) 46, “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin (ARB) No. 51”, which addresses consolidation by business enterprises of variable interest entities (“VIEs”) either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest.  In December 2003, the FASB issued Revised Financial Interpretation No. 46 (FIN 46R), resulting in multiple effective dates based on the nature as well as the creation date of the VIE.  As of the effective date of FIN 46R, an enterprise must evaluate its involvement with all entities or legal structures created before February 1, 2003, to determine whether the consolidation requirements of FIN 46R apply to those entities.  There is no grandfathering of existing entities.  Public companies must apply either FIN 46 or FIN 46R immediately to entities created after December 15, 2003, and for entities considered to be special purpose entities, no later than the end of the first reporting period that ends after March 15, 2004.  The adoption of FIN 46 and FIN 46R had no effect on the company’s financial condition or results of operations.

 

3.   ACCOUNTING FOR STOCK-BASED COMPENSATION

 

The company accounts for its employee stock option grants in accordance with the provisions of Accounting Principles Board Opinion No. (APB) 25, “Accounting for Stock Issued to Employees”, and related interpretations including FIN 44, “Accounting for Certain Transactions Involving Stock Compensation.” As such, compensation expense is generally recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price or in connection with the modification to outstanding awards or changes in grantee status.  No employee stock option compensation expense is reflected in the company’s results of operations, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant.

 

Compensation expense related to stock options granted to non-employees is accounted for under Statement of Financial Accounting Standards No. (SFAS) 123, “Accounting for Stock-Based Compensation” and Emerging Issues Task Force (EITF) 96-18, “Accounting for Equity Instruments that are Issued to Other than

 

6

 

Employees for Acquiring, or in conjunction with Selling, Goods, or Services,” which require entities to recognize an expense, based on the fair value of the related awards.  SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123” amended 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 company is not currently required to transition to use a fair value method of accounting for stock-based employee compensation.  Instead, the company has elected to provide the required disclosures as if it had transitioned.  The following table illustrates the effect on net income and basic and diluted net income per share as if the company had applied the fair value recognition provisions of SFAS 123, as amended, to stock-based employee compensation.

 

		Three Months Ended October 31,						Nine Months Ended October 31,
		2004			2003			2004			2003
		(in thousands, except per share data)
Net income, as reported		$	3,116		$	3,575		$	10,675		$	9,985
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		27			—			55			—
Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		754			521			2,060			1,536
Pro forma net income		$	2,389		$	3,054		$	8,670		$	8,449
Basic and diluted net income per share:
As reported
Basic		$	0.09		$	0.11		$	0.31		$	0.30
Diluted		$	0.09		$	0.10		$	0.30		$	0.29
Pro forma
Basic		$	0.07		$	0.09		$	0.25		$	0.26
Diluted		$	0.07		$	0.09		$	0.25		$	0.24

 

The fair value of stock options and stock purchased under our employee stock purchase plan (ESPP) at date of grant was estimated using the Black-Scholes pricing model with the following assumptions for the nine months ended

October 31, 2004 and 2003:

 

 

7

 

4.  CHANGES IN STOCKHOLDERS’ EQUITY

 

Stock Repurchase

 

On June 15, 2004, the company’s Board of Directors approved an open market stock repurchase program authorized for one year to buy up to one million shares of the company’s common stock.  During the three months ended October 31, 2004, the company repurchased approximately 597,000 shares at an average price of $6.87 per share.  For the nine months ended October 31, 2004 the company repurchased approximately 742,000 shares of its common stock at an average repurchase price of $7.52 per share.  As a result, stockholders’ equity was reduced for the nine months ended October 31, 2004 by $5.6 million.

 

Dividends

 

On June 15, 2004, the company’s Board of Directors approved a one-time special dividend of $0.10 per share of common stock payable August 10, 2004 to the company’s shareholders of record at the close of business on July 19, 2004.  In addition, the company’s Board of Directors approved an initial quarterly cash dividend of $0.025 per share of common stock payable September 20, 2004 to the company’s shareholders of record at the close of business on August 23, 2004.  The one-time special dividend and the initial quarterly dividend, for a total of $4.3 million, were paid during the third quarter of fiscal 2005.

 

On September 9, 2004, the company’s Board of Directors approved the payment of a quarterly cash dividend of $0.025 per share of common stock to shareholders of record at the close of business on November 22, 2004, payable December 20, 2004, thereby reducing stockholders’ equity for the three months ended October 31, 2004 by $0.8 million.

 

Total dividends declared in the nine months ended October 31, 2004 were $5.1 million, of which $4.3 million was paid by October 31, 2004.

 

5.   COMPREHENSIVE INCOME

 

Comprehensive income includes changes in the balances of items that are reported directly as a separate component of stockholders’ equity in the company’s Condensed Consolidated Balance Sheets.  The components of comprehensive income are as follows:

 

 

8

 

6.   COMPUTATION OF NET INCOME PER SHARE

 

The following table sets forth the computation of basic and diluted net income per share:

 

		Three Months Ended October 31,						Nine Months Ended October 31,
		2004			2003			2004			2003
		(in thousands, except per share data)
Net income		$	3,116		$	3,575		$	10,675		$	9,985
Weighted average shares of common stock outstanding - basic		33,935			32,892			34,025			32,996
Weighted average shares of common stock equivalents issued using the treasury stock method		906			1,782			1,296			1,635
Weighted average shares of common stock and common stock equivalents outstanding - diluted		34,841			34,674			35,321			34,631
Basic net income per share		$	0.09		$	0.11		$	0.31		$	0.30
Diluted net income per share		$	0.09		$	0.10		$	0.30		$	0.29

 

Common stock equivalent shares consist of the shares issuable upon the exercise of stock options and warrants using the treasury stock method.  For the three and nine months ended October 31, 2004, shares of common stock equivalents of approximately 2.0 million and 0.6 million, respectively, were not included in the diluted calculation because they were anti-dilutive.  For the three and nine months ended October 31, 2003, shares of common stock equivalents of approximately 0.4 million and 0.6 million, respectively, were not included in the diluted calculation because they were anti-dilutive.

 

7.   BUSINESS COMBINATIONS

 

Oxford Consulting Group, Inc.

 

On April 30, 2004, the company acquired certain assets and liabilities of Oxford Consulting Group, Inc. (Oxford) located in the United States.  Oxford’s business primarily focused on electronic data interchange (EDI) systems design, installation and services in connection with the MFG/PRO software owned and licensed by the company.

 

Under the terms of the asset purchase agreement, the company paid $0.8 million in cash upon consummation and issued 40,000 shares of restricted common stock.  The approximate value of the shares ($0.4 million) at the date of acquisition was included as outstanding stock with an equal offset as “Unearned compensation – restricted stock,” within stockholders’ equity in the company’s Condensed Consolidated Balance Sheet at April 30, 2004.  The shares vest ratably in equal portions over four years on each anniversary date of the acquisition.  As such, the company is expensing the unearned compensation straight-line over four years.  An additional $0.4 million in cash is payable to Oxford through February 2006.  Both the potential future cash payments and vesting of common stock are contingent on the future employment of certain employees of Oxford.  Therefore, and in accordance with accounting principles generally accepted in the United States of America, the cash payments and fair value of common stock are considered future compensation expense, not an increase to the purchase price.

 

9

 

The acquisition was accounted for as a business combination and, accordingly, the total purchase price was allocated to the acquired assets, including identifiable intangible assets and liabilities at their fair values as of April 30, 2004.  The $0.8 million purchase price was mainly allocated to intellectual property ($0.6 million), a customer list ($0.1million) and customer contracts ($0.1 million).  The company is amortizing the intellectual property over three years, the customer list over one year and the customer contracts over six months.  The intellectual property was primarily comprised of certain EDI libraries developed by Oxford that are complimentary to MFG/PRO.  Based on the purchase price allocation, no goodwill was recorded in connection with this transaction.

 

TRW ISCS

 

During the fourth quarter of fiscal 2003, the company acquired TRW Integrated Supply Chain Solutions (TRW ISCS).  In connection with the acquisition, the company implemented a plan to eliminate redundant positions and facilities within TRW ISCS.  Accordingly, the company recognized certain liabilities in accordance with EITF 95-3 “Recognition of Liabilities in Connection with a Purchase Business Combination.”  The related actions resulted in a $4.4 million increase to the acquisition cost, which included a reduction of approximately 40 employees across most functions  (approximately $2.8 million) and facility consolidations related to certain former TRW ISCS locations  (approximately $1.6 million).  As of October 31, 2004, $3.8 million of the $4.4 million acquisition-related restructuring charge was utilized and $0.1 million was adjusted downwards due to a change in estimate.  The remaining balance of $0.5 million, consisting mainly of lease obligations, includes payments scheduled through fiscal 2017.

 

The following table presents the plan activities for the nine months ended October 31, 2004:

 

 

8.   CAPITALIZED SOFTWARE COSTS

 

Capitalized software costs and accumulated amortization at October 31, 2004 and January 31, 2004 were as follows:

 

 

10

The increase in capitalized software costs is primarily attributable to intellectual property acquired in connection with the Oxford business combination during the fiscal 2005 first quarter.  For further discussion of the business combination, see note 7 within these Notes to Condensed Consolidated Financial Statements.

 

Amortization of capitalized software costs was $1.2 million for both the nine months ended October 31, 2004 and 2003, and is included in “Cost of license fees” in the accompanying Condensed Consolidated Statements of Operations.  It is the company’s policy to write-off capitalized software development costs once fully amortized.  These write-offs do not impact “Capitalized software costs, net.”

 

9.   GOODWILL AND INTANGIBLE ASSETS

 

Goodwill

 

For the applicable reporting units, the changes in the carrying amount of goodwill for the nine months ended October 31, 2004 were as follows (reporting unit regions are defined in note 12 within these Notes to Condensed Consolidated Financial Statements):

 

 

The company is required to analyze goodwill for impairment on at least an annual basis.  The company chose November 30^th as its annual test date.

 

Intangible Assets

 

 

Intangible assets are included in “Other assets, net” in the company’s Condensed Consolidated Balance Sheets. The change in amortizable intangible assets from January 31, 2004 to October 31, 2004 includes the removal of $8.5 million of “amortizable intangible assets” being removed from the balance sheet. It is the company’s policy to write-off intangible assets once fully amortized.  Accordingly, the corresponding $8.5 million of “accumulated amortization” was also removed from the balance sheet.  These write-offs do not impact “Net amortizable intangible assets”, nor are they reflected as a charge to expense on the Condensed Consolidated Statements of Operations.  This decrease in the gross intangible asset balance was partially offset by the acquisition of certain intangible assets related to the Oxford business combination.  For further discussion of the Oxford business combination, see note 7 within these Notes to Condensed Consolidated Financial Statements.

 

11

 

As of October 31, 2004 and January 31, 2004, excluding goodwill, all of the company’s intangible assets were determined to have definite useful lives, and therefore were subject to amortization.  The aggregate amortization expense related to amortizable intangible assets was $0.2 million and $0.4 million for the three and nine months ended October 31, 2004, respectively, and $0.3 million and $0.8 million for the three and nine months ended October 31, 2003, respectively.

 

The estimated remaining amortization expense related to amortizable intangible assets for the years ended January 31, 2005, 2006 and 2007 is $115,000, $269,000 and $47,000, respectively.  No additional amortization of these assets is estimated in fiscal 2008 and thereafter.

 

10.  LONG-TERM DEBT

 

 

Notes Payable

 

On July 28, 2004, QAD Ortega Hill, LLC, a wholly owned subsidiary of the company, entered into a loan agreement with Mid-State Bank & Trust.  The loan has a principal amount of $18.0 million and bears interest at a fixed rate of 6.5%.  This is a non-recourse loan, which is secured by real property located in Summerland, California.  The loan matures in ten years (principal and interest).  Over the terms of the loan, the company shall make 119 monthly payments of $115,000 and one final payment of $15.4 million.  Total proceeds were $17.8 million, which was net of transaction fees of $0.2 million.  A portion of these proceeds were used to repay the existing construction loan.

 

Construction Loan

 

In connection with the construction of the company’s new headquarters located in Summerland, California, and in accordance with the provisions of the construction loan agreement with Santa Barbara Bank and Trust (SBB&T), the company received $3.9 million to fund qualified expenditures made during the six months ended July 31, 2004.  Total borrowings under the construction loan agreement were $14.3 million.  On July 28, 2004, the company repaid the construction loan in full.  Interest expense incurred through April 1, 2004 (the approximate date the company moved into the new facility) was capitalized and included in “Property and equipment, net” on the company’s Condensed Consolidated Balance Sheets.  Interest expense in the amount of $0.2 million which was incurred from April 1, 2004 through July 28, 2004 was expensed to “Interest expense” on the company’s Condensed Consolidated Income Statements.

 

Credit Facility

 

During June 2004, the company amended its credit facility with Wells Fargo Foothill, Inc. Through the amendment, Wells Fargo Foothill, Inc. consented to: 1) a one-time cash dividend of $0.10 per share, to shareholders of record at the close of business on July 19, 2004 and payable on August 10, 2004; 2) an ongoing quarterly cash dividend of $0.025 per

 

12

 

share; 3) the implementation of a dividend reinvestment plan; and 4) the repurchase of up to one million shares of the company’s common stock.

 

Subsequent to quarter-end, but effective October 31, 2004, the company amended its credit facility with Wells Fargo Foothill, Inc. to adjust the minimum tangible net worth covenant based on current forecast, including the impact of the share repurchase program and the dividend program.  As of October 31, 2004, the company was in compliance with the debt covenants, as amended.

 

11.  COMMITMENTS AND CONTINGENCIES

 

Indemnifications

 

The company sells software licenses and services to its customers under written agreements.  Each agreement contains the relevant terms of the contractual arrangement with the customer, and generally includes certain provisions for indemnifying the customer against losses, expenses and liabilities from damages that may be awarded against the customer in the event the software is found to infringe upon certain intellectual property rights of a third party.  The agreement generally limits the scope of and remedies for such indemnification obligations in a variety of industry-standard respects, including but not limited to, certain time- and geography-based scope limitations and a right to replace an infringing product.  The company believes its internal development processes and other policies and practices limit its exposure related to the indemnification provisions of the agreements.  For several reasons, including the lack of prior indemnification claims and the lack of a monetary liability limit for certain infringement cases under the agreements, the company cannot determine the maximum amount of potential future payments, if any, related to such indemnification provisions.

 

12.  BUSINESS SEGMENT INFORMATION

 

The company operates in geographic business segments.  The North America business segment includes the United States and Canada.  The EMEA business segment includes Europe, the Middle East and Africa.  The Asia Pacific business segment includes Asia and Australia.  The Latin America business segment includes South America, Central America and Mexico.

 

The geographic business segments derive revenue from the sale of licenses, maintenance and services to third-party customers.  License revenue is assigned to the business segments based on the proportion of commission earned by each business segment, maintenance revenue is allocated to the business segment where the end user customer is located and services revenue is assigned based on the business segment where the services are performed.

 

13

 

Operating income attributable to each business segment is based upon management’s assignment of revenue and costs.  Business segment cost of revenue includes the cost of goods produced or procured by the company’s manufacturing operations at the price charged to the distribution operation.  Income from manufacturing operations and research and development costs are included in the Corporate business segment.  Identifiable assets are assigned by business segment based upon the location of each legal entity.

 

 

 

13. SUBSEQUENT EVENT

 

On December 1, 2004, QAD entered into a sub-lease agreement to sublease approximately 60% of its leased office space in Carpinteria, California, which it vacated when the company moved to its new offices in Summerland, California.  The sublease commenced on December 1, 2004 and ends on the date QAD’s lease terminates with the lessor in August 2011.  Under the terms of the sublease agreement, the sublessee shall pay QAD a monthly rental amount which is less than the current monthly lease payment QAD pays to the lessor.  In accordance with Financial Accounting Standards Board Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities, the company expensed the present value of the expected loss from the sublease arrangement.  Expense of approximately $0.6 million was incurred on December 1, 2004 and will be reflected in the Consolidated Statement of Operations during the period ended January 31, 2005.

 

14

 

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

 

FORWARD-LOOKING STATEMENTS

 

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements.  These statements typically are preceded or accompanied by words like “believe,” “anticipate,” “expect” and words of similar meaning.  These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in these forward-looking statements.  Factors that might cause such a difference include, but are not limited to, those discussed in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as other information detailed in our Annual Report on Form 10-K for the year ended January 31, 2004.  These include, but are not limited to, evolving demand for the company’s software products and products that operate with the company’s products; the company’s ability to sustain strong licensing demand; the company’s ability to sustain customer renewal rates at current levels; the publication of opinions by industry analysts about the company, its products and technology; the entry of new competitors and their technological advances; delays in localizing the company’s products for new markets; delays in sales as a result of lengthy sales cycles; the company’s changes in operating expenses, pricing, timing of new product releases, the company’s method of product distribution or product mix; general economic conditions, exchange rate fluctuations and the global political environment.  Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s opinions only as of the date hereof.

 

In addition, revenue and earnings in the enterprise resource planning (ERP) software applications industry are subject to fluctuations.  Software license revenue, in particular, is subject to variability with a significant proportion of revenue earned in the last month of each quarter.  Given the high margins associated with license revenue, modest fluctuations can have a substantial impact on net income.  Investors should not use any one quarter’s results as a benchmark for future growth.  The company undertakes no obligation to revise, update or publicly release the results of any revision or update to these forward-looking statements.  Readers should carefully review the risk factors described in other documents the company files from time to time with the Securities and Exchange Commission.

 

INTRODUCTION

 

The following discussion should be read in conjunction with the information included within our Annual Report on Form 10-K for the year ended January 31, 2004 and the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q.

 

BUSINESS OVERVIEW

 

QAD Inc., a Delaware Corporation (QAD), was founded in 1979 and is a global provider of enterprise resource planning (ERP) software applications for multi-national, large and mid-range manufacturing and distribution companies.  QAD serves the specific needs of the automotive, consumer products, electronics, food and beverage, industrial and medical industries.  We market, distribute, implement and support our products worldwide.  Our enterprise applications provide functionality for managing manufacturing resources and operations within and beyond the enterprise, enabling global manufacturers to collaborate with their customers, suppliers and partners to improve delivery performance and reduce production and inventory costs.

 

CRITICAL ACCOUNTING POLICIES

 

We consider certain accounting policies related to revenue recognition, accounts receivable allowances, impairment of long-lived assets, capitalized software costs, valuation of deferred tax assets and accounting for stock-based compensation to be critical policies due to the significance of these items to our operating results and the estimation processes and management’s judgment involved in each.  For a complete discussion of these policies, see the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” within our Annual Report on Form 10-K for the year ended January 31, 2004.

 

15

 

Revenue Recognition

 

We license our software under non-cancelable license agreements including third-party software sold in conjunction with our software, provide customer support and provide services including technical, implementation and training.  Revenue is recognized in accordance with the American Institute of Certified Public Accountant’s Statement of Position (SOP) No. 97-2, “Software Revenue Recognition,” as modified by SOP No. 98-9, “Modification of SOP No. 97-2, Software Revenue Recognition with Respect to Certain Transactions” and Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition.” Our revenue recognition policy is as follows:

 

License Revenue.  We recognize revenue from license contracts when a non-cancelable, non-contingent license agreement has been signed, the software product has been delivered, no uncertainties exist surrounding product acceptance, fees from the agreement are fixed or determinable, and collection is probable.  Our typical payment terms vary by region.  While most of our arrangements are within our normal payment terms, we have provided extended terms on occasion.  Terms granted are always less than one year and we have established a history of collection, without concessions on these receivables.  Provided all other revenue recognition criteria have been met, we recognize license revenue for these arrangements on delivery.  We use the residual method to recognize revenue when a license agreement includes one or more elements to be delivered at a future date if vendor-specific, objective evidence of the fair value of all undelivered elements exists.  The fair value of the undelivered elements is determined based on the historical evidence of stand-alone sales of these elements to customers.  Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue.  If evidence of the fair value of the undelivered elements does not exist, revenue is deferred and recognized when delivery occurs.  Subscription license revenue from our hosted MFGx.net product offerings is recognized ratably over the contract period.  Our standard products do not require significant production, modification or customization of software or services that are essential to the functionality of the software.  Certain judgments affect the application of our license revenue recognition policy, such as the assessment of collectibility for which we review a customer’s credit worthiness and our historical experience with that customer, if applicable.

 

Maintenance Revenue.  Revenue from ongoing customer support and product updates is recognized ratably over the term of the maintenance period, which in most instances is one year.

 

Services Revenue.  Revenue from technical and implementation services is recognized as services are performed for time-and-materials contracts.  Although infrequent, we do at times enter into fixed price services contracts for which we recognize the services revenue on the percentage-of-completion method as prescribed by Accounting Research Bulletin No. 45, “Long-term Construction-Type Contracts”, and in SOP No. 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.”  Revenue from training services is recognized as the services are performed.

 

We believe that we are currently in compliance with the applicable accounting standards governing revenue recognition.  However, the accounting standard setting bodies continue to discuss various provisions of these guidelines with the objective of providing additional guidance on their future application.  These discussions and the issuance of new interpretations, once finalized, could lead to unanticipated changes in recognized revenue.  They could also drive significant adjustments to our business practices that could result in increased administrative costs, lengthened sales cycles and other changes that could affect our results of operations.

 

Valuation of Deferred Tax Assets

 

During the fiscal 2005 first quarter, we realized a $1.3 million benefit related to the reversal of a deferred tax asset valuation allowance.  The deferred tax asset valuation allowance that was reversed related to foreign subsidiaries with prior losses that have become profitable and are forecasting continued profitability.  In assessing the likelihood of realizing tax benefits associated with deferred tax assets and the need for a valuation allowance, we consider the weight of all available evidence, both positive and negative, including expected future taxable income and tax planning strategies that are both prudent and feasible.  At this time, we believe there is not a sufficient historical and current trend of profitability to reduce the remaining deferred tax asset valuation allowance.  However, this determination may be revised based upon additional periods of profitability as well as changes in forecasted trends of profitability.  Should we determine that we would be able to realize deferred tax assets in the future in excess of the

 

16

 

net recorded amount, an adjustment to deferred tax assets may decrease tax expense or impact the balance sheet in the period such determination was made.  Likewise, should we determine that we would not be able to realize all or part of the net deferred tax assets in the future, an adjustment to deferred tax assets may increase tax expense or impact the balance sheet in the period such determination was made.

 

RESULTS OF OPERATIONS

 

The following table sets forth, for the periods indicated, the percentage of total revenue represented by certain items reflected in our statements of operations:

 

		Three Months Ended October 31,				Nine Months Ended October 31,
		2004		2003		2004		2003
Revenue:
License fees		25	%	28	%	25	%	29	%
Maintenance and other		51		51		50		51
Services		24		21		25		20
Total revenue		100		100		100		100
Costs and expenses:
Cost of license fees		4		4		3		5
Cost of maintenance, service and other revenue		37		36		37		35
Sales and marketing		23		25		25		27
Research and development		14		16		15		16
General and administrative		13		11		12		11
Amortization of intangibles from acquisitions		—		—		—		—
Total costs and expenses		91		92		92		94
Operating income		9		8		8		6
Other (income) expense		1		—		1		(1	)
Income before income taxes		8		8		7		7
Income tax expense		2		2		1		1
Net income		6	%	6	%	6	%	6	%

 

Total Revenue.  Total revenue for the third quarter of fiscal 2005 was $55.5 million, a decrease of $0.3 million, or 1%, from $55.8 million in the third quarter of fiscal 2004.  Holding foreign currency exchange rates constant to those applicable in the third quarter of fiscal 2004, total revenue for the current quarter would have decreased $1.4 million to approximately $54.4 million.  When comparing categories within total revenue at constant rates, our current quarter results included lower license revenue and lower maintenance and other revenue, offset by higher services revenue.  International revenue as a percentage of total revenue was 57% in the third quarter of fiscal 2005, as compared to 63% in the same period of the prior fiscal year.  The percentage decrease internationally was largely due to increases in license and services revenue in North America.

 

Total revenue for the first nine months of fiscal 2005 was $170.5 million, an increase of $2.4 million, or 1%, from $168.1 million in the first nine months of fiscal 2004.  Holding foreign currency exchange rates constant to those applicable in the first nine months of fiscal 2004, total revenue for the current year would have been approximately $166.3 million representing a $1.8 million decline when compared to the same period last year.  When comparing categories within total revenue at constant rates, the nine months of fiscal 2005 included lower license revenue and lower maintenance and other revenue, which were partially offset by higher services revenue.  International revenue as a percentage of total revenue was 57% in the first nine months of fiscal 2005, as compared to 61% in the same period of the prior fiscal year.  The decrease in the proportion of international revenue was primarily due to increases in services revenue in North America.

 

License Revenue.  License revenue was $13.9 million for the third quarter of fiscal 2005, down $1.6 million, or 10%, from $15.5 million for the third quarter of fiscal 2004.  Holding foreign currency exchange rates constant to fiscal 2004, license revenue for the current quarter would have been approximately $13.8 million, representing a $1.7 million, or 11%, decrease from the same period last year.  EMEA, Asia Pacific and Latin America all experienced

 

17