VERITY INC \DE\ - 10-Q Quarterly Report

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Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

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

The number of shares outstanding of the Registrant’s Common Stock, $0.001 par value, was 37,843,732 as of December 31, 2003.

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

The unaudited condensed consolidated financial statements for Verity, Inc. (the “Company” or “Verity”) as of November 30, 2003 and for the three and six months ended November 30, 2003 and 2002 have been prepared on the same basis as the Company’s audited financial statements and, in the opinion of management, include all material adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the financial position and results of operations in accordance with generally accepted accounting principles. Although certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission, the Company believes the disclosures made are adequate to make the information presented not misleading. The accompanying financial statements should be read in conjunction with the Company’s annual financial statements contained in the Company’s Annual Report on Form 10-K for the year ended May 31, 2003.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management’s estimates, judgments and assumptions are continually evaluated based on available information and experience; however, actual amounts could differ from those estimates. Certain prior period balances have been reclassified to conform to current period presentation.

The consolidated financial statements include the accounts of Verity, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

The Company’s balance sheet as of May 31, 2003 was derived from the Company’s audited financial statements, but does not include all disclosures necessary for the presentation to be in accordance with generally accepted accounting principles.

2. Accounting for Computation of Net Income (Loss) and Net Income (Loss) Per Share and Stock-Based Compensation

Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed using the weighted average number of common and common equivalent shares outstanding during the period. Dilutive common equivalent shares consist of “in-the-money” stock options. “In-the-money” options are those for which the exercise price is lower than the average market price being used to determine the value. The Company’s average market price for the second quarter in fiscal year 2004 was $14.1832. As of November 30, 2003 and 2002, 10,705,517 and 12,472,342 anti-dilutive weighted shares have been excluded from the common equivalents calculation.

The Company accounts for stock-based employee compensation arrangements under compensatory plans using the intrinsic value method, which calculates compensation expense based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the option exercise price.

Generally accepted accounting principles require companies who choose to account for stock option grants using the intrinsic value method to also determine the fair value of option grants using a stock option pricing model such as the Black-Scholes model and to disclose the impact of fair value accounting in a note to the

financial statements. The impact of recognizing the fair value of option grants and stock grants under the Company’s employee stock option and stock purchase plans as an operating expense would have reduced the Company’s net income to a net loss, as follows (in thousands, except per share amounts):

The Company calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing model. The following weighted average assumptions were used for each respective period:

As of November 30, 2003 and May 31, 2003, available-for-sale securities consist of the following (in thousands):

On December 17, 2002, the Company completed the purchase of certain assets and obligations of Inktomi Corporation’s enterprise search software business. Of the total purchase price, the Company deferred $3.0 million in order to secure Inktomi’s indemnification obligations under the Purchase Agreement. On June 17, 2004, the Company is obligated to pay Inktomi an amount equal to the sum of (1) $3.0 million plus (2) simple interest thereon calculated from the December 17, 2002 through the date of payment at an annual rate of 1.5%. The Company has the right to withhold or deduct from the deferred payment amount any sum that may be owed to it by Inktomi pursuant to Inktomi’s indemnification obligations under the Purchase Agreement. The Company believes the likelihood of indemnification is remote.

At November 30, 2003, the deferred purchase payment was categorized as a short-term liability as the payment was due within twelve months of this date. At May 31, 2003, the deferred purchase payment was categorized as a long-term liability as the payment was due greater than twelve months from this date.

Comprehensive income is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources, such as foreign currency translation gains and losses and unrealized gains and losses on available-for-sale securities that are reflected in stockholders’ equity instead of net income. The following table sets forth the calculation of comprehensive income (in thousands):

Substantially all of the Company’s revenues result from the sale of the Company’s software products and related services. Accordingly, the Company considers itself to be in a single reporting segment, specifically the license, implementation and support of its software. The Company’s chief operating decision-making group reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance.

The Company also has sales and marketing operations located in the Netherlands, the United Kingdom, France, Germany, South Africa, Mexico, Australia, Japan, a joint investment partnership in Brazil and a development and technical support operation in Canada. Foreign branch and subsidiary revenues consist primarily of maintenance and consulting services and are being allocated based on foreign branch and subsidiary location. Disclosed in the table below is geographic information for any individual country comprising greater than 10% of the Company’s total revenues or greater than 10% of the Company’s long-lived assets. Rest of world (“ROW”) includes Australia, Brazil, Canada, Japan, Mexico and South Africa.

Long-lived assets of geographic areas are those assets used in the Company’s operations in each area.

Of the total $9.4 million, $8.7 million, $18.4 million and $16.6 million of revenues outside the U.S. for the three and six month periods ended November 30, 2003 and 2002, respectively, there were $4.8 million, $5.0 million, $9.6 million and $9.3 million of export sales (shipped from the U.S. to non-U.S. locations) and $4.6 million, $3.7 million, $8.8 million and $7.3 million of sales derived from the Company’s foreign operations, respectively.

No single customer accounted for more than 10% of the Company’s total revenues for the three and six month periods ended November 30, 2003 and 2002. Revenues derived from sales to the United States government and its agencies were 9.8% and 11.1% of the Company’s total revenues for the three month periods ended November 30, 2003 and 2002, respectively, and 10.6% and 10.1% of the Company’s total revenues for the six month periods ended November 30, 2003 and 2002, respectively.

On June 24, 2003, the Company announced the continuation of its stock repurchase program. The continuation calls for the additional repurchase of outstanding shares of the Company’s common stock up to an aggregate value of $50.0 million. The program will terminate at the end of the fiscal year ending May 31, 2004 unless amended by the Board of Directors. Through November 30, 2003, the Company repurchased and retired 1,190,987 shares of its common stock through open market transactions, at an aggregate cost of approximately $17.0 million.

During each of the periods ended November 30, 2003 and November 30, 2002, the Company executed restructuring efforts designed to reduce costs and to better align its expense levels with current revenue levels and ensure conservative spending during the current period of economic uncertainty, as described below.

With respect to the restructuring executed during the quarter ended November 30, 2003, the Company implemented this worldwide restructuring plan to focus on reducing expenses and improving efficiency due to continued macro-economic and capital spending issues affecting the software industry. In connection with the restructuring, the Company recorded in the quarter ended November 30, 2003, a $0.97 million restructuring charge, of which approximately $0.9 million was related to severance costs associated with the reduction in the worldwide workforce by approximately 40 employees and approximately $0.07 million to legal and other outside services costs associated with the restructuring. The restructuring impacted operations in the U.S., Canada and Europe and was across all functional areas of the company.

Of the total $0.97 million restructuring charge, approximately $0.05 million remains unpaid at November 30, 2003. Of the $0.05 million, approximately $0.02 million relates to severance costs to be paid in future quarters and approximately $0.03 million to legal and other outside services costs associated with the restructuring. The unpaid amount will be paid out over the next two quarters.

With respect to the restructuring executed during the quarter ended November 30, 2002, the Company implemented this worldwide restructuring and recorded a $0.99 million restructuring charge, of which approximately $0.72 million was related to severance costs associated with the reduction in the worldwide workforce by 50 employees, approximately $0.10 million to legal and other outside services in connection with the restructuring and approximately $0.17 million to other costs associated with the restructuring. The restructuring impacted operations in the U.S., Canada, the U.K., Germany, France, the Netherlands, Sweden and South Africa.

At November 30, 2003, $0.18 million of the restructuring executed during the quarter ended November 30, 2002 remains unpaid and is mostly related to a facilities lease and will be paid out ratably over the remaining life of the lease, which terminates in October 2005.

Regent Pacific Management Corporation (“Regent Pacific”) has been providing management services to the Company pursuant to a Retainer Agreement between the Company and Regent Pacific dated July 31, 1997, as amended, (as amended, the “Retainer Agreement”). In January 2004, the Company and Regent Pacific entered into an amendment to the Retainer Agreement providing for a 75% reduction in weekly fees payable by the Company under the Retainer Agreement, beginning in March 2004, as well as an extension of the non-cancelable period of the Retainer Agreement from February 28, 2004 to February 28, 2005. As a result of the amendment, the services to be rendered by Regent Pacific to the Company under the Retainer Agreement will be reduced. In addition, pursuant to the amendment, Gary J. Sbona will continue to serve as the Company’s Executive Chairman of the Board, but Stephen W. Young will cease to serve as the Company’s Chief Operating Officer effective as of March 1, 2004.

In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for Asset Retirement Obligations.” This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The liability is accreted to its present value each period while the cost is depreciated over its useful life. The Company’s adoption of SFAS No. 143 in its fiscal year 2002 did not have a significant impact on the Company’s financial position or results of operations.

In August 2001, the FASB issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 supersedes “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (SFAS No. 121), however it retains the fundamental provisions of SFAS No. 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and used and (2) the measurement of long-lived assets to be disposed of by sale. SFAS No. 144 develops a single accounting model for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired assets and consequently amends Accounting Principles Board Opinion No. 30, “Reporting Results of Operations - Reporting the Effects of Disposal of a Division of a Business.” Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for the Company’s fiscal year beginning June 1, 2002. The adoption of SFAS No. 144 did not have a significant impact on the Company’s financial position or results of operations.

In November 2001, the Emerging Issues Task Force (“EITF”) of the FASB reached a consensus on Issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products.” EITF No. 01-09 addresses whether consideration from a vendor to a reseller of the vendor’s products is an adjustment to the selling prices of the vendor’s products and, therefore, should be deducted from revenue when recognized in the vendor’s results of operations, or a cost incurred by the vendor for assets or services received from the reseller and, therefore, should be an expense when recognized in the vendor’s results of operations. EITF No. 01-09 is effective for the Company beginning November 1, 2001. The Company’s adoption of EITF No. 01-09 did not have a significant impact on the Company’s financial position or results of operations.

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 nullifies the guidance of the EITF in EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Under EITF Issue No. 94-3, an entity recognized a liability for an exit cost on the date that the entity committed itself to an exit plan. In SFAS No. 146, the FASB acknowledges that an entity’s commitment to a plan does not, by itself, create a present obligation to other parties that meets the definition of a liability and requires that a liability for a cost that is associated with an exit or disposal activity be recognized when the liability is incurred. It also establishes that fair value is the objective for the initial measurement of the liability. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The Company’s adoption of SFAS No. 146 did not have a significant impact on the Company’s financial position or results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45

requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee. The initial recognition and measurement requirement of FIN 45 is effective for guarantees issued or modified after December 31, 2002. As of November 30, 2003, the Company’s guarantees that were issued or modified after December 31, 2002 were not material.

The Company enters into standard indemnification provisions within its software license agreements with its customers and technology partners. Pursuant to these provisions, the Company typically indemnifies, defends and holds harmless the indemnified party for losses suffered or incurred by the indemnified party in connection with any U.S. patent, copyright or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification provisions is generally perpetual any time after execution of the license agreement. The maximum potential amount of future payments that the Company could be required to make under these indemnification provisions is unlimited.

The Company generally warrants that its software products will perform in all material respects in accordance with its standard published specifications. Historically, costs related to this warranty have not been significant.

The Company has agreements in place with its directors and officers whereby it indemnifies them for certain events or occurrences while the officer and director is, or was, serving at the Company’s request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a director and officer insurance policy, which may enable it to recover a portion of any future amounts paid.

In November 2002, the EITF reached a consensus on Issue No. 00-21 (“Issue 00-21”), “Revenue Arrangements with Multiple Deliverables.” Issue 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of Issue 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of Issue 00-21 did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

In November 2002 the EITF reached a consensus opinion on EITF No. 02-16, “Accounting by a Customer (including a reseller) for Certain Consideration Received from a Vendor.” EITF No. 02-16 requires that cash payments, credits, or equity instruments received, as consideration by a customer from a vendor should be presumed to be a reduction of cost of sales when recognized by the customer in the income statement. In certain situations, the presumption could be overcome and the consideration recognized either as revenue or a reduction of a specific cost incurred. The consensus applies prospectively to new or modified arrangements entered into after December 31, 2002. At November 30, 2003, the Company was not a party to transactions contemplated by EITF 02-16.

method of accounting for stock-based employee compensation and will continue to apply the intrinsic-value based method. The Company has determined the fair value of option grants using the Black-Scholes stock option pricing model and has provided this pro forma disclosure of the impact of fair value accounting in note 2 to the financial statements, “Accounting for Stock-Based Compensation.”

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. FIN 46 is effective February 28, 2004. The Company does not have any interests in variable interest entities.

On April 30, 2003, the FASB issued Statement No. 149 (“Statement 149”), Amendment of Statement 133 on Derivative Instruments and Hedging Activities. Statement 149 is intended to result in more consistent reporting of contracts as either freestanding derivative instruments subject to Statement 133 in its entirety, or as hybrid instruments with debt host contracts and embedded derivative features. In addition, Statement 149 clarifies the definition of a derivative by providing guidance on the meaning of initial net investments related to derivatives. Statement 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of Statement 149 did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

On May 15, 2003, the FASB issued Statement No. 150 (“Statement 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” Statement 150 establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. Statement 150 represents a significant change in practice in the accounting for a number of financial instruments, including mandatorily redeemable equity instruments and certain equity derivatives that frequently are used in connection with share repurchase programs. The Company does not use such instruments in its share repurchase program. Statement 150 is effective for all financial instruments created or modified after May 31, 2003, and to other instruments as of September 1, 2003. The adoption of Statement 150 did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

In July 2003, the EITF reached a consensus on Issue No. 03-05, “Applicability of AICPA SOP 97-2 to Non Software Deliverables in an Arrangement Containing More Than Incidental Software.” The consensus opinion in EITF No. 03-05 clarifies the guidance in EITF 00-21 and was reached on July 31, 2003. The adoption of Issue No. 03-05 did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

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

The following discussion should be read in conjunction with the consolidated financial statements and related notes, which appear in our Annual Report on Form 10-K for the fiscal year ended May 31, 2003. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly under the heading “Risk Factors” below.

We offer products and technology that address the business portal, e-commerce, and knowledge management markets, which we define broadly as intellectual capital management. The intellectual capital management market includes enterprise intranets and corporate portals used for sharing information within an enterprise, e-commerce sites for online selling, and extranets for business-to-business activities. Intellectual capital management solutions provide secure, personalized access to information for employees, partners, customers and suppliers, wherever that information may reside in the enterprise. We expect that for the foreseeable future we will continue to derive the largest portion of our revenues from licensing our technology for enterprise and e-commerce applications and intellectual capital management solutions.

In December 2002, we completed the acquisition of the enterprise search assets of Inktomi Corporation, further expanding our product portfolio to include solutions for smaller organizations and departments within larger enterprises. In addition to addressing these markets, the acquired enterprise search software, re-branded Verity Ultraseek, is in use at a number of larger enterprises for search-only applications as well. We are continuing development and support of the Ultraseek product line, and believe that the larger enterprises in the installed base represent an upgrade opportunity to our broader intellectual capital management solutions as their needs grow.

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of assets and liabilities. On an on-going basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, bad debts, income taxes and intangible assets. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on form 10-K for the fiscal year ended May 31, 2003.

Regent Pacific Management Corporation (“Regent Pacific”) has been providing management services to Verity pursuant to a Retainer Agreement between Verity and Regent Pacific dated July 31, 1997, as amended, (as amended, the “Retainer Agreement”). In January 2004, Verity and Regent Pacific entered into an amendment to the Retainer Agreement providing for a 75% reduction in weekly fees payable by Verity under the Retainer Agreement, beginning in March 2004, as well as an extension of the non-cancelable period of the Retainer Agreement from February 28, 2004 to February 28, 2005. As a result of the amendment, the services to be rendered by Regent Pacific to Verity under the Retainer Agreement will be reduced. In addition, pursuant to the amendment, Gary J. Sbona will continue to serve as our Executive Chairman of the Board, but Stephen W. Young will cease to serve as our Chief Operating Officer effective as of March 1, 2004. Messrs. Sbona and Young are both officers of Regent Pacific. As a result of the amendment, we will continue to incur operating expenses of approximately $162,500 per quarter under this agreement, which will be approximately $487,500 per

quarter less than we have been incurring since July 1997. These operating expenses will continue to be allocated to all functional areas based on headcount.

The following table sets forth the percentage of total revenues represented by certain items in our Condensed Consolidated Statements of Operations for the periods indicated:

Prior period financials have been reclassified to conform to presentations adopted in fiscal year 2004.

The increase in total revenues for the three month period ended November 30, 2003, compared with the same period a year ago, was due to a $3.3 million increase in our software product revenues and to a $2.7 million increase in our service and other revenues. The increase in total revenues for the six month period ended November 30, 2003, compared with the same period a year ago, was due to a $5.1 million increase in our software product revenues and to a $5.5 million increase in our service and other revenues.

The three and six month periods ended November 30, 2003 results include the addition of our Ultraseek product, which came from the purchase of assets and assumption of obligations of Inktomi Corporation’s enterprise search software business (“Enterprise”) in December 2002. Additionally, the six month period ended November 30, 2003 includes a payment in the first quarter from BroadVision of past royalties in connection with the settlement of outstanding litigation, and was less than 5% of revenues in the six-month period.

Revenues derived from foreign operations accounted for 16.0% and 16.1% of total revenues for the three month periods ended November 30, 2003 and 2002, respectively, and 15.8% and 16.3% of total revenues for the six month periods ended November 30, 2003 and 2002, respectively. Our export sales consist of products licensed for delivery outside of the United States. For the three month periods ended November 30, 2003 and 2002, export sales accounted for 16.4% and 21.9% of total revenues, respectively. For the six month periods ended November 30, 2003 and 2002, export sales accounted for 17.3% and 20.7% of total revenues, respectively.

No single customer accounted for more than 10% of our total revenues for the three and six month periods ended November 30, 2003 and 2002. Revenues derived from sales to the federal government and its agencies were 9.8% and 11.1% of our total revenues for the three month periods ended November 30, 2003 and 2002, respectively, and 10.6% and 10.1% of our total revenues for the six month periods ended November 30, 2003 and 2002, respectively.

We saw an increase in demand for our software products in the three and six month periods ended November 30, 2003, compared with the same periods a year ago. The increases in software product revenues in the three and six month periods ended November 30, 2003 were the result of increased sales to our OEM customers and from the addition of sales of our Ultraseek product, which we did not have prior to our acquisition of Enterprise in December 2002. Software product revenues from our non-Ultraseek products for the six month period ended November 30, 2003 included the recognition of revenue in the first quarter of past royalties in connection with our confidential settlement with BroadVision relative to our outstanding litigation. This revenue accounted for less than 5% of total revenues in the six month period.

Our service and other revenues consist primarily of fees for software maintenance, consulting and training.

The increase in service and other revenues for the three month period ended November 30, 2003, compared with the same period a year ago, was due to $0.2 million in increased sales of consulting and training services and to $2.5 million in increased maintenance revenues which results primarily from maintenance contracts

acquired as part of the Enterprise purchase and increased maintenance contracts associated with our increase in software product revenues. The increase in service and other revenues for the six month period ended November 30, 2003, compared with the same period a year ago, was due to $0.7 million in increased sales of consulting and training services and to $4.8 million in increased maintenance revenues which results primarily from maintenance contracts acquired as part of the Enterprise purchase and increased maintenance contracts associated with our increase in software product revenues.

Costs of software products consist primarily of product media, duplication, manuals, packaging materials, shipping expenses, employee compensation expenses, royalties paid to third-party vendors, and in certain instances, licensing of third-party software incorporated in our products. We believe that costs of software products will increase in absolute dollars in the quarter ending February 29, 2004, primarily as a result of increased royalties paid to third-party software vendors.

The increase in costs of software products in absolute dollars for the three and six month periods ended November 30, 2003, compared with the same period a year ago, was primarily attributable to a $0.1 million increase in costs of third party software components and from increased costs for manuals and product media associated with the recent product release of Verity K2 Enterprise 5.0. The increase in costs of software products as a percentage of software product revenues for the three month period ended November 30, 2003, compared with the same period a year ago, was attributable to the increase in absolute costs, offset in part by the increase in software product revenues. During the three and six month periods ended November 30, 2003 and 2002, we did not capitalize any software development costs.

Costs of service and other consists of costs incurred in providing consulting services, customer training, telephone support and product upgrades to customers. Significant cost components include personnel-related and third-party contractor costs, facilities costs, travel expenses associated with training and consulting implementation services, depreciation expense and corporate overhead allocations. We believe that costs of service and other will decrease slightly in absolute dollars in the quarter ending February 29, 2004, resulting from modest seasonality associated with the calendar year-end.

The increase in absolute dollars for the three and six month periods ended November 30, 2003, compared with the same period a year ago, was due primarily to a $0.2 million increase in costs associated with the use of third-party consultants in connection with an increased demand for services, and, in the six month period, to a $0.6 million increase in compensation and other employee related expenses resulting from an approximately 6%

higher average headcount. The higher average headcount results from the addition of personnel necessary to respond to increased demand for services and in connection with the Enterprise purchase in December 2002. The decrease as a percentage of service and other revenues, compared with the same periods a year ago, results from higher utilization of personnel resulting from the increase in services rendered being greater than the increase in personnel.

During the three and six month periods ended November 30, 2003, we amortized $0.6 million and $1.3 million, respectively, of the purchased intangible assets in connection with acquired technology, patents and maintenance agreements from our Enterprise purchase. We will record quarterly amortization expenses of $0.6 million associated with the purchased intangible assets of Enterprise over the estimated useful life of 5 years from the quarter ended February 28, 2003.

Research and development expenses consist primarily of employee compensation and benefits, payments to outside contractors, depreciation on equipment used for development and corporate overhead allocations. We believe that research and development is essential to maintaining our competitive position and we will continue to make significant investments in research and development with the goal of continuing to align research and development expenses with anticipated revenues. We believe that research and development expenses will increase slightly in absolute dollars in the quarter ending February 29, 2004, primarily resulting from the effect of annual salary increases.

The increases in research and development expenses in absolute dollars for the three and six month periods ended November 30, 2003, compared with the same periods in the prior year, were primarily due to a net $0.3 million and $0.3 million increase, respectively, in bonuses payable, resulting from an accrual in the three month period ended November 30, 2003 compared with no accrual in the prior year period, combined with a less than $0.1 million and $0.1 million increase, respectively, in compensation costs associated with the effect of annual salary increases in the three and six month periods ended November 30, 2003.

Marketing and sales expenses consist primarily of employee compensation, including sales commissions and benefits, tradeshows, outbound marketing and other lead generation activities, public relations, travel expenses associated with our sales staff and corporate overhead allocations. We anticipate that we will continue to make significant investments in marketing and sales with the goal of continuing to align marketing and sales expenses with anticipated revenues. We believe that marketing and sales expenses will remain approximately flat as a percentage of total revenues in the quarter ending February 29, 2004.

The increase in marketing and sales expenses in absolute dollars for the three month period ended November 30, 2003, compared with the same period a year ago, was due to a $0.8 million increase in the use of external sales and marketing professional services, a $0.5 million increase in sales commissions resulting from the combination of higher revenue and an increased payout rate, a $0.3 million increase in compensation and other employee related expenses resulting from marginally higher average headcount and annual salary increases, a $0.3 million increase in overall marketing program spending, primarily attributable to the addition of the Enterprise product, and a $0.1 million increase in depreciation expenses.

The increase in marketing and sales expenses in absolute dollars for the six month period ended November 30, 2003, compared with the same period a year ago, was due to a $1.3 million increase in sales commissions resulting from the combination of higher revenue and an increased payout rate, a $0.9 million increase in compensation and other employee related expenses resulting from marginally higher average headcount and annual salary increases, a $0.7 million increase in overall marketing program spending, primarily attributable to the addition of the Enterprise product, a $0.2 million increase in the use of external sales and marketing professional services, and a $0.1 million increase in depreciation expenses.

General and administrative expenses consist primarily of personnel costs for finance, legal, human resources and general management, provisions for doubtful accounts, insurance, fees for external professional advisors and corporate overhead allocations. We believe that general and administrative expenses will remain approximately flat in the quarter ending February 29, 2004.

The increase in general and administrative expenses in absolute dollars for the three month period ended November 30, 2003, compared with the same period a year ago, was primarily related to a $0.4 million increase in employee related expenses associated with marginally higher headcount, offset in part by a $0.2 million decrease in bad debt expense.

The increase in general and administrative expenses in absolute dollars for the six month period ended November 30, 2003, compared with the same period a year ago, was primarily related to a $0.7 million increase in employee related expenses associated with marginally higher headcount, a $0.1 million increase in expenses for outside professional services, a $0.1 million increase in corporate overhead allocations, offset in part by a $0.4 million decrease in bad debt expense.

During each of the periods ended November 30, 2003 and November 30, 2002, we executed restructuring efforts designed to reduce costs and to better align our expense levels with current revenue levels and ensure conservative spending during the current period of economic uncertainty.

During the quarter ended November 30, 2003, we implemented a worldwide restructuring plan to focus on reducing expenses and improving efficiency due to continued macro-economic and capital spending issues affecting the software industry. In connection with the restructuring, we recorded in the quarter ended November 30, 2003, a $1.0 million restructuring charge, of which approximately $0.9 million was related to severance costs associated with the reduction in the worldwide workforce by approximately 40 employees, and approximately $0.1 million was related to legal and other outside services costs associated with the restructuring. The restructuring impacted operations in the U.S., Canada and Europe and was across all functional areas of the company.

Of the total $1.0 million restructuring charge, approximately $0.05 million remains unpaid at November 30, 2003. Of the $0.05 million, approximately $0.01 million relates to severance costs to be paid in future quarters and approximately $0.04 million to costs associated with legal and other outside services. The unpaid amount will be paid out over the next two quarters.

During the quarter ended November 30, 2002, we implemented a worldwide restructuring and recorded a $1.0 million restructuring charge, of which approximately $0.7 million was related to severance costs associated with the reduction in the worldwide workforce by 50 employees, approximately $0.1 million to legal and other outside services in connection with the restructuring and approximately $0.2 million to other costs associated with the restructuring. The restructuring impacted operations in the U.S., Canada and the Netherlands and was concentrated in research and development and, to a lesser extent, sales and marketing. At November 30, 2003, $0.2 million of the restructuring implemented in the quarter ended November 30, 2002 remains unpaid and is mostly related to a facilities lease and will be paid out ratably over the remaining life of the lease, which terminates in October 2005.

Interest income, net consists primarily of interest income, net and realized gains (losses) from our investments in marketable securities.

The decreases in interest income, net in absolute dollars for the three and six month periods ended November 30, 2003, compared with the same period a year ago, were primarily due to decreasing overall yields on our portfolio of marketable securities caused by the decreasing interest rate environment, partially mitigated by a slightly higher balance of marketable securities.

Other income (loss), net consists of gains (losses) on our foreign currency forward contracts.

Income tax provision includes U.S. and foreign income taxes. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of this difference is reported as deferred income taxes.

We expect tax savings for fiscal 2004 due to research and development tax credits to decline relative to our historical experience and expect to realize an effective tax rate of 40.0% for the fiscal year. In our first fiscal quarter ended August 31, 2003, we applied an effective tax rate of 38.0%. In order to realize a 40.0% year-to-date effective tax rate, we applied a 40.95% effective tax rate to the results of our quarter ended November 30, 2003. We will continue to reassess the impact of our research and development expenses on our effective tax rate in future periods. In the comparative periods of fiscal 2003 we applied a 38% effective tax rate.

As of November 30, 2003, we had $249.3 million in cash and cash equivalents and available-for-sale securities compared to $250.7 million at May 31, 2003. At November 30, 2003, our principal sources of liquidity were our cash and cash equivalents and short-term investments of $154.3 million. As of November 30, 2003, we had no outstanding debt obligations.

Cash provided by operating activities for the six month period ended November 30, 2003 was $3.3 million, primarily due to our net income of $5.5 million, which reflected among other non-cash charges a charge for depreciation and amortization of $3.5 million, which we add back to reconcile net income to net cash provided by operating activities. Cash provided by operating activities also included a $0.3 million increase in deferred revenues, but was reduced by a $2.5 million increase in accounts receivable, a $1.6 million decrease in accounts payable, a $1.1 million decrease in accrued compensation and other accrued liabilities, and a $0.7 million increase in prepaid and other current assets.

Cash used in investing activities for the six month period ended November 30, 2003 was $8.4 million as a result of capital expenditures of $1.0 million and purchases, net of sales and maturities, of marketable securities of $7.4 million.

Cash used in financing activities for the six month period ended November 30, 2003 was $2.5 million, due to $17.0 million in repurchases of our common stock through our stock repurchase program, partially offset by $14.5 million in proceeds from the sale of common stock as a result of stock option exercises.

Our principal commitments as of November 30, 2003 consist of obligations under operating leases, totaling $9.2 million over the life of these leases.

On December 17, 2002, we completed the purchase of certain assets and obligations of Inktomi Corporation’s enterprise search software business. Of the total purchase price, we deferred $3.0 million in order to secure Inktomi’s indemnification obligations under the Purchase Agreement. On June 17, 2004, we are obligated to pay Inktomi an amount equal to the sum of (1) $3.0 million plus (2) simple interest thereon calculated from the December 17, 2002 through the date of payment at an annual rate of 1.5%. We have the right to withhold or deduct from the deferred payment amount any sum that may be owed to us by Inktomi pursuant to Inktomi’s indemnification obligations under the Purchase Agreement. We believe the likelihood of indemnification is remote.

On June 24, 2003, we announced the continuation of our stock repurchase program. The continuation calls for the additional repurchase of outstanding shares of our common stock up to an aggregate value of $50.0 million. The program will terminate at the end of the fiscal year ending May 31, 2004 unless amended by the Board of Directors. Through November 30, 2003, we repurchased and retired 1,190,987 shares of our common stock through open market transactions, at an aggregate cost of approximately $17.0 million.

We believe that our current cash and cash equivalents, interest income and cash generated from operations, if any, will provide adequate liquidity to meet our working capital and operating resource expenditure requirements through at least fiscal 2004. If the global economy weakens further, our cash, cash equivalents and investments balances may decline. As a result, or if our spending plans materially change, we may find it necessary to seek to obtain additional sources of financing to support our capital needs, but we cannot assure you that a financing will be available on commercially reasonable terms, or at all.

In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for Asset Retirement Obligations.” This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The liability is accreted to its present value each period while the cost is depreciated over its useful life. The adoption of SFAS No. 143 in our fiscal year 2002 did not have a significant impact on our financial position or results of operations.

In August 2001, the FASB issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 supersedes “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (SFAS No. 121), however it retains the fundamental provisions of SFAS No. 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and used and (2) the measurement of long-lived assets to be disposed of by sale. SFAS No. 144 develops a single accounting model for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired assets and consequently amends Accounting Principles Board Opinion No. 30, “Reporting Results of Operations—Reporting the Effects of Disposal of a Division of a Business.” Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for our fiscal year beginning June 1, 2002. The adoption of SFAS No. 144 did not have a significant impact on our financial position or results of operations.

In November 2001, the Emerging Issues Task Force (“EITF”) of the FASB reached a consensus on Issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products.” EITF No. 01-09 addresses whether consideration from a vendor to a reseller of the vendor’s products is an adjustment to the selling prices of the vendor’s products and, therefore, should be deducted from revenue when recognized in the vendor’s results of operations, or a cost incurred by the vendor for assets or services received from the reseller and, therefore, should be an expense when recognized in the vendor’s results of operations. EITF No. 01-09 is effective for us beginning November 1, 2001. The adoption of EITF No. 01-09 did not have a significant impact on our financial position or results of operations.

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 nullifies the guidance of the EITF in EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Under EITF Issue No. 94-3, an entity recognized a liability for an exit cost on the date that the entity committed itself to an exit plan. In SFAS 146, the FASB acknowledges that an entity’s commitment to a plan does not, by itself, create a present obligation to other parties that meets the definition of a liability and requires that a liability for a cost that is associated with an exit or disposal activity be recognized when the liability is incurred. It also establishes that fair value is the objective for the initial measurement of the liability. SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a significant impact on our financial position or results of operations.

In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of certain guarantees or indemnifications. In addition, FIN 45 requires disclosures about the guarantees or indemnifications that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees or indemnifications issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The

disclosure requirements are effective for financial statements for interim or annual periods issued after December 15, 2002. We have adopted the disclosure provisions of FIN 45 and evaluated the impact of the measurement provisions on the our financial position and results of operations. As of November 30, 2003, our guarantees that were issued or modified after December 31, 2002 were not material.

We enter into standard indemnification provisions within our software license agreements with our customers and technology partners. Pursuant to these provisions, we typically indemnify, defend and hold harmless the indemnified party for losses suffered or incurred by the indemnified party in connection with any U.S. patent, copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification provisions is generally perpetual any time after execution of the license agreement. The maximum potential amount of future payments that we could be required to make under these indemnification provisions is unlimited.

We generally warrant that our software products will perform in all material respects in accordance with our standard published specifications. Historically, costs related to this warranty have not been significant.

We have agreements in place with our directors and officers whereby we indemnify them for certain events or occurrences while the officer and director is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy, which may enable us to recover a portion of any future amounts paid.

In November 2002, the EITF reached a consensus on Issue No. 00-21 (“Issue 00-21”), “Revenue Arrangements with Multiple Deliverables.” Issue 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of Issue 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of Issue 00-21 did not have a material effect on our consolidated financial position, results of operations or cash flows.

In November 2002 the EITF reached a consensus opinion on EITF No. 02-16, “Accounting by a Customer (including a reseller) for Certain Consideration Received from a Vendor.” EITF No. 02-16 requires that cash payments, credits, or equity instruments received, as consideration by a customer from a vendor should be presumed to be a reduction of cost of sales when recognized by the customer in the income statement. In certain situations, the presumption could be overcome and the consideration recognized either as revenue or a reduction of a specific cost incurred. The consensus applies prospectively to new or modified arrangements entered into after December 31, 2002. At November 30, 2003, we were not a party to any transactions contemplated by EITF 02-16.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” SFAS No. 148 amends certain provisions of SFAS No. 123 and is effective for financial statements for fiscal years ending after December 15, 2002. It provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires the disclosure of the pro forma effects on an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. We do not currently intend to adopt the fair value based method of accounting for stock-based employee compensation and will continue to apply the intrinsic-value based method. We have determined the fair value of option grants using the Black-Scholes stock option pricing model and have provided this pro forma disclosure of the impact of fair value accounting in note 2 to the financial statements, “Accounting for Stock-Based Compensation.”

assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. FIN 46 is effective February 28, 2004. We do not have any interests in variable interest entities.

On April 30, 2003, the FASB issued Statement No. 149 (“Statement 149”), Amendment of Statement 133 on Derivative Instruments and Hedging Activities. Statement 149 is intended to result in more consistent reporting of contracts as either freestanding derivative instruments subject to Statement 133 in its entirety, or as hybrid instruments with debt host contracts and embedded derivative features. In addition, Statement 149 clarifies the definition of a derivative by providing guidance on the meaning of initial net investments related to derivatives. Statement 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of Statement 149 did not have a material effect on our consolidated financial position, results of operations or cash flows.

On May 15, 2003, the FASB issued Statement No. 150 (“Statement 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” Statement 150 establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. Statement 150 represents a significant change in practice in the accounting for a number of financial instruments, including mandatorily redeemable equity instruments and certain equity derivatives that frequently are used in connection with share repurchase programs. We do not use such instruments in our share repurchase program. Statement 150 is effective for all financial instruments created or modified after May 31, 2003, and to other instruments as of September 1, 2003. The adoption of Statement 150 did not have a material effect on our consolidated financial position, results of operations or cash flows.

In July 2003, the EITF reached a consensus on Issue No. 03-05, “Applicability of AICPA SOP 97-2 to Non Software Deliverables in an Arrangement Containing More Than Incidental Software.” The consensus opinion in EITF No. 03-05 clarifies the guidance in EITF 00-21 and was reached on July 31, 2003. The adoption of Issue No. 03-05 did not have a material effect on our consolidated financial position, results of operations or cash flows.

The risks and uncertainties described below are not the only risks and uncertainties we face. Additional risks and uncertainties not currently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks actually occur, our business, results of operations and financial condition would suffer. In that event, the trading price of our common stock could decline, and our stockholders may lose all or part of their investment in our common stock. The discussion below and elsewhere in this report also includes forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements as a result of the risks discussed below.

We have sustained quarterly and annual losses in the past and may not be able to maintain profitability

We have incurred net losses in the past and, although we reported net income in fiscal year 2003 and the first two quarters of fiscal year 2004, we may not be able to maintain profitability. In the future, our revenues may decline, remain flat, or grow at a rate slower than was experienced in the first two quarters of fiscal year 2004, especially in light of the current economic environment. To achieve revenue growth and maintain fiscal year profitability, we must:

We cannot assure you that we will be successful in achieving any of these goals or that we will experience increased revenues, positive cash flows, or achieve long-term profitability.

Our revenues and operating results may fluctuate in future periods, which could adversely affect our stock price

The results of operations for any quarter are not necessarily indicative of results to be expected in future periods. We expect our stock price to vary with our operating results and, consequently, any adverse fluctuations in our operating results could have an adverse effect on our stock price. Our operating results have in the past been, and will continue to be, subject to quarterly fluctuations as a result of a number of factors. These factors include:

Any of the factors, some of which are discussed in more detail below, could materially and adversely impact our operations and financial results, and consequently cause our stock price to fall.

Our expenditures are tied to anticipated revenues, and therefore imprecise forecasts may result in poor operating results

Revenues are difficult to forecast because the market for search and retrieval software is uncertain and evolving. Because we generally ship software products within a short period after receipt of an order, we typically do not have a material backlog of unfilled orders, and revenues in any quarter are substantially dependent on orders booked in that quarter. In addition, a portion of our revenues is derived from royalties based upon sales by third-party vendors of products incorporating our technology. These revenues may be subject to extreme fluctuation and are difficult for us to predict. Our expense levels are based, in part, on our expectations as to future revenues and are to a large extent fixed in the short term. Therefore, we may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Any significant shortfall of demand in relation to our expectations or any material delay of customer orders would have an almost immediate adverse affect on our operating results and on our ability to achieve profitability.

Demand for our products may be adversely affected if unfavorable economic and market conditions do not improve or continue to decline

Adverse economic conditions worldwide have contributed to slowdowns in the software information technology spending environment and may continue to impact our business, resulting in reduced demand for our products as a result of a decrease in capital spending by our customers, increased price competition for our products and higher overhead costs as a percentage of revenues. Decreased demand for our products would result in decreased revenues, which could harm our operating results and cause the price of our common stock to fall.

Our future effective tax rates could be adversely affected by changes in the valuation of our deferred tax assets and liabilities, and changes in U.S. or foreign tax laws or interpretations thereof.

The size and timing of large orders may materially affect our quarterly operating results

The size and timing of individual orders may cause our operating results to fluctuate significantly. Our operating results for a quarter could be materially and adversely affected if one or more large orders are either not received or are delayed or deferred by customers. A significant portion of our revenues in recent quarters has been derived from these relatively large sales to a limited number of customers, and we currently anticipate that future quarters will continue to reflect this trend. Sales cycles for these customers can be up to nine months or longer. In addition, customer order deferrals in anticipation of new products may cause our operating results to fluctuate. Like many software companies, we have generally recognized a substantial portion of our revenues in

the last month of each quarter, with these revenues concentrated in the last weeks of the quarter. Accordingly, the cancellation or deferral of even a small number of purchases of our products could harm our business in any particular quarter. In addition, to the extent that the significant sales occur earlier than expected, operating results for subsequent quarters may fail to keep pace or even decline.

Any delay in sales of our products and services could cause our quarterly revenue and operating results to fluctuate. The typical sales cycle of our products is lengthy, generally between six to eighteen months, unpredictable, and involves significant investment decisions by prospective customers, as well as our education of potential customers regarding the use and benefits of our products. Our customers spend a substantial amount of time before purchasing our products in performing internal reviews and obtaining capital expenditure approvals. We believe our sales cycle lengthened in 2002 and 2003 as a result of macro-economic factors and we cannot be certain that this cycle will not continue to lengthen in the future.

Historically, our foreign operations and export sales account for a significant portion of our annual revenues. Our international business activities are subject to a number of risks, each of which could impose unexpected costs on us that would have an adverse effect on our operating results. These risks include:

We currently engage in only limited hedging activities to protect against the risk of currency fluctuations. Fluctuations in currency exchange rates could cause sales denominated in U.S. dollars to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. Also, these fluctuations could cause sales denominated in foreign currencies to affect a reduction in the current U.S. dollar revenues derived from sales in a particular country. Furthermore, future international activity may result in increased foreign currency denominated sales and, in this event, gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute significantly to fluctuations in our results of operations. The financial stability of foreign markets could also affect our international sales. In addition, income earned in various countries where we do business may be subject to taxation by more than one jurisdiction, thereby adversely affecting our consolidated after-tax earnings. We cannot assure you that any of these factors will not have an adverse effect on the revenues from our future international sales and, consequently, our results of operations.

Service and other revenues derived from foreign operations accounted for 15.8% and 15.0% of total revenues for the six month period ended November 30, 2003, and fiscal year 2003, respectively. Our export sales consist primarily of products licensed for delivery outside of the United States. For the six month period ended November 30, 2003 and fiscal year 2003, export sales accounted for 17.3% and 22.4% of total revenues, respectively. We expect that revenues derived from foreign operations and export sales will continue to account

for a significant percentage of our revenues for the foreseeable future. These revenues may fluctuate significantly as a percentage of revenues from period to period. In addition, a portion of these revenues was derived from sales to foreign government agencies, which may be subject to risks similar to those described immediately below.

A portion of our revenues is derived from sales to the U.S. federal government, which are subject to budget cuts and, consequently, the potential loss of revenues upon which we have historically relied

Revenues derived from sales to the U.S. federal and state governments and their agencies were 10.6% and 9.8% of total revenues for the six month period ended November 30, 2003 and fiscal year 2003, respectively. Future reductions in government spending on information technologies could harm our operating results. In recent years, budgets of many governments and/or their agencies have been reduced, causing certain customers and potential customers of our products to re-evaluate their needs. These budget reductions are expected to continue over at least the next several years.

Almost all of our government contracts contain termination clauses, which permit contract termination upon our default or at the option of the other contracting party. We cannot assure you a cancellation will not occur in the future, and any termination would adversely affect our operating results.

We must successfully introduce new products or our customers will purchase our competitors products

During the past few years, management and other personnel have focused on modifying and enhancing our core technology to support a broader set of search and retrieval solutions for use on enterprise-wide systems, over online services, over the Internet and on CD-ROM. In order for our strategy to succeed and to remain competitive, we must continue to leverage our core technology to develop new product offerings by us and by our OEM customers that address the needs of these new markets or we must acquire new technology. The development of new products, whether by leveraging our core technology or by acquiring new technology, is expensive. If these products do not generate substantial revenues, our business and results of operations will be adversely affected. We cannot assure you that any of these products will be successfully developed and completed on a timely basis or at all, will achieve market acceptance or will generate significant revenues.

Our future operating results will depend upon our ability to increase the installed base of our information retrieval technology and to generate significant product revenues from our core products. Our future operating results will also depend upon our ability to successfully market our technology to online and Internet publishers who use this technology to index their published information in our format. To the extent that customers do not adopt our technology for indexing their published information, it will limit the demand for our products.

If we are unable to enhance our existing products to conform to evolving industry standards in our rapidly changing markets, our products may become obsolete

The computer software industry is subject to rapid technological change, changing customer requirements, frequent new product introductions, and evolving industry standards that may render existing products and services obsolete. As a result, our position in our existing markets or other markets that we may enter could be eroded rapidly by any of these factors, including product advancements by competitors. If we are unable to develop and introduce products in a timely manner in response to changing market conditions or customer requirements, our financial condition and results of operations would be materially and adversely affected.

The life cycles of our products are difficult to estimate. Our future success will depend upon our ability to keep pace with technological developments, conform to evolving industry standards, particularly client/server and Internet communication and security protocols, as well as publishing formats such as HTML and XML, and address increasingly sophisticated customer needs. We cannot assure you that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of new products, or that new products and product enhancements will meet the requirements of the marketplace and achieve market acceptance.

We strive to achieve compatibility between our products and the text publication formats we believe are or will become popular and widely adopted. We invest substantial resources in development efforts aimed at achieving compatibility. Any failure by us to anticipate or respond adequately to technology or market developments could result in a loss of competitiveness or revenue. For instance, to date we have focused our efforts on integration with the Adobe PDF and Lotus Notes environments and, more recently, the Microsoft Exchange environment. Should any of these products or technologies lose or fail to achieve acceptance in the marketplace or be replaced by other products or technologies, our business could be materially and adversely affected.

We embed our basic search engine in key OEM application products and, therefore, our sales of information retrieval products depend on our ability to maintain compatibility with these OEM applications. We cannot assure you that we will be able to maintain compatibility with these vendors’ products or continue to be the search technology of choice for OEMs. The failure to maintain compatibility with or be selected by OEMs would materially and adversely affect our sales. Further, the failure of the products of our key OEM partners to achieve market acceptance could harm our results of operations.

Our software products are complex and may contain errors that could damage our reputation and decrease sales

Our complex software products may contain errors that may be detected at any point in the products’ life cycles. We have in the past discovered software errors in some of our products and have experienced delays in shipment of products during the periods required to correct these errors. We cannot assure you that, despite our testing and quality assurance efforts and similar efforts by current and potential customers, errors will not be found. The discovery of an error may result in loss of or delay in market acceptance and sales, diversion of development resources, injury to our reputation, or increased service and warranty costs, any of which could harm our business. Although we generally attempt by contract to limit our exposure to incidental and consequential damages, and to cap our liabilities to our proceeds under the contract, if a court fails to enforce the liability limiting provisions of our contracts for any reason, or if liabilities arise which are not effectively limited, our operating results could be harmed.

We are dependent on proprietary technology licensed from third parties, the loss of which could delay shipments of products incorporating this technology and could be costly

Some of the technology used by our products is licensed from third parties, generally on a nonexclusive basis. We believe that there are alternative sources for each of the material components of technology we license from third parties. However, the termination of any of these licenses, or the failure of the third-party licensors to adequately maintain or update their products, could result in delay in our ability to ship these products while we seek to implement technology offered by alternative sources. Any required replacement licenses could prove costly. Also, any delay, to the extent it becomes extended or occurs at or near the end of a fiscal quarter, could harm our quarterly results of operations. While it may be necessary or desirable in the future to obtain other licenses relating to one or more of our products or relating to current or future technologies, we cannot assure you that we will be able to do so on commercially reasonable terms or at all.

Our ability to compete successfully will depend, in part, on our ability to protect our intellectual property rights, which we may not be able to protect

We rely on a combination of patent, trade secrets, copyright and trademark laws, nondisclosure agreements and other contractual provisions and technical measures to protect our intellectual property rights. The source code for our proprietary software is protected both as a trade secret and as a copyrighted work. Policing unauthorized use of our products, however, is difficult. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Litigation could result in substantial costs and diversion of resources and could harm our business regardless of the outcome of the litigation.

Effective copyright and trade secret protection may be unavailable or limited in some foreign countries. To license our products, we frequently rely on “shrink wrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of several jurisdictions. In addition, employees, consultants and others who participate in the development of our products may breach their agreements with us regarding our intellectual property, and we may not have adequate remedies for any such breach. We also realize that our trade secrets may become known through other means not currently foreseen by us. Notwithstanding our efforts to protect our intellectual property, our competitors may be able to develop products that are equal to or superior to our products without infringing on any of our intellectual property rights.

Our products employ technology that may infringe on the proprietary rights of third parties, which may expose us to litigation

Third parties may assert that our products infringe their proprietary rights, or may assert claims for indemnification resulting from infringement claims against us. Any such claims may cause us to delay or cancel shipment of our products, which could harm our business. In addition, irrespective of the validity or the successful assertion of claims, we could incur significant costs in defending against claims. To date, no third party has asserted such claims against us.

We have been sued in the past and are at risk of future securities class action litigation, due to our past and expected stock price volatility

In the past, securities class action litigation has often been brought against companies following a decline in the market price of their securities. For example, in December 1999 our stock price dramatically declined and a number of lawsuits were filed against us. Because we expect our stock price to continue to fluctuate significantly, we may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and resources, and could seriously harm our business.

If we lose key personnel, or are unable to attract additional qualified personnel, our ability to conduct and grow our business will be impaired

We believe that hiring and retaining qualified individuals at all levels is essential to our success, and we cannot assure you that we will be successful in attracting and retaining the necessary personnel. In addition, we are highly dependent on our direct sales force for sales of our products as we have limited distribution channels. Continuity of technical personnel is an important factor in the successful completion of development projects, and any turnover of our research and development personnel could harm our development and marketing efforts.

Our future success also depends on our continuing ability to identify, hire, train and retain other highly qualified sales, technical and managerial personnel. Competition for this type of personnel is intense, and we cannot assure you that we will be able to attract, assimilate or retain other highly qualified technical and managerial personnel in the future. The inability to attract, hire or retain the necessary sales, technical and managerial personnel could harm our business.

We face intense competition from companies with significantly greater financial, technical, and marketing resources, which could adversely affect our ability to maintain or increase sales of our products

The information retrieval, classification and recommendation software markets are intensely competitive and we cannot assure you that we will maintain our current position or market share. A number of companies offer competitive products addressing these markets. In the enterprise market, we compete with Autonomy, Convera, Endeca, FAST, Google, Hummingbird, iPhrase, Mercado, Microsoft, Open Text and Thunderstone, among others. Plumtree is on occasion a competitor, but is viewed primarily as our partner and customer. In the Internet/publishing market, we compete with Autonomy, Convera, Dataware, FAST, iPhrase, Lotus and

Microsoft, among others. We also compete indirectly with database vendors, such as Oracle, that offer information search and retrieval capabilities with their core database products, as well as with ERP (Enterprise Resource Planning) vendors, such as SAP, that offer these capabilities as part of their overall solution.

In the future, we may encounter competition from a number of companies. Many of our existing competitors, as well as a number of other potential new competitors, have significantly greater financial, technical and marketing resources than we do. Because the success of our strategy is dependent in part on the success of our strategic customers, competition between our strategic customers and the strategic customers of our competitors, or failure of our strategic customers to achieve or maintain market acceptance could harm our competitive position. Although we believe that our products and technologies compete favorably with competitive products, we cannot assure you that we will be able to compete successfully against our current or future competitors or that competition will not harm our business.

Our recent acquisition of the Inktomi enterprise search software assets and other potential acquisitions may have unexpected consequences or impose additional costs on us

Our business is highly competitive and our growth is dependent upon market growth and our ability to enhance our existing products and introduce new products on a timely basis. One of the ways we may address the need to develop new products is through acquisitions of complementary businesses and technologies, such as our acquisition of Inktomi’s enterprise search software assets. From time to time, we consider and evaluate potential business combinations both involving our acquisition of another company and transactions involving the sale of Verity through, among other things, a possible merger or consolidation of our business into that of another entity. Acquisitions involve numerous risks, including the following:

We cannot assure you that our acquisition of Inktomi’s enterprise search software assets and future acquisitions will be successful and will not adversely affect our business. We must also maintain our ability to manage any growth effectively. Failure to manage growth effectively and successfully integrate acquisitions we make could harm our business.

If we account for employee stock option and employee stock purchase plans using the fair value method, it could significantly reduce our net income and earnings per share

There has been ongoing public debate whether employee stock option and employee stock purchase plans shares should be treated as a compensation expense and, if so, how to properly value such charges. If we elected or were required to record an expense for our stock-based compensation plans using the fair value method, we could have significant accounting charges. For example, in the second quarter of fiscal year 2004, had we accounted for stock-based compensation plans using the fair-value method prescribed in FASB Statement No. 123 as amended by Statement 148, earnings per share would have been reduced by $0.32 per share and we would have reported a $0.23 loss per share. Although we are not currently required to record any compensation expense using the fair value method in connection with option grants to employees that have an exercise price at or above fair market value at the grant date and for shares issued under our employee stock purchase plan, it is possible that future laws or regulations will require us to treat all stock-based compensation as an expense using the fair value method. See Note 2 to Consolidated Financial Statements for a more detailed presentation of accounting for stock-based compensation plans.

We depend on increasing use of the Internet, intranets, extranets and portals and on the growth of electronic commerce. If the use of the Internet, intranets, extranets and portals and electronic commerce do not grow as anticipated, our business will be seriously harmed

The products of most of our customers depend on the increased acceptance and use of the Internet as a medium of commerce and on the development of corporate intranets, extranets and portals. As a result, acceptance and use may not continue to develop at historical rates and a sufficiently broad base of business customers may not adopt or continue to use the Internet as a medium of commerce. The lack of such development would impair demand for our products and would adversely affect our ability to sell our products. Demand and market acceptance for recently introduced services and products over the Internet and the development of corporate intranets, extranets and portals are subject to a high level of uncertainty, and there exist few proven services and products.

The business of many of our customers, and consequently our ability to sell our products, would be seriously harmed if:

Capacity constraints may restrict the use of the Internet as a commercial marketplace, which would restrict our growth

The Internet may not be accepted as a viable long-term commercial marketplace for a number of reasons. These include:

Our ability to grow our business is dependent on the growth of the Internet and, consequently, any adverse events would impair our ability to grow our business.

Security risks and concerns may deter the use of the Internet for conducting electronic commerce, which would adversely affect the demand for our products

A significant barrier to electronic commerce and communications is the secure transmission of confidential information over public networks. Advances in computer capabilities, new discoveries in the field of cryptography or other events or developments could result in compromises or breaches of our security systems or those of other web sites to protect proprietary information. If any well-publicized compromises of security were to occur, it could have the effect of substantially reducing the use of the Internet for commerce and communications, resulting in reduced demand for our products, thus adversely affecting our revenues.

Anyone who circumvents our security measures could misappropriate proprietary information or cause interruptions in our services or operations. The Internet is a public network, and data is sent over this network from many sources. In the past, computer viruses, software programs that disable or impair computers, have been distributed and have rapidly spread over the Internet. We may be required to expend significant capital and other resources to protect against the threat of security breaches or to alleviate problems caused by breaches. To the extent that our activities may involve the storage and transmission of proprietary information, such as credit card numbers, security breaches could expose us to a risk of loss or litigation and possible liability. Our security measures may be inadequate to prevent security breaches, and our business would be harmed if we do not prevent them.

The market price of our common stock will fluctuate and you may lose all or part of your investment

Our common stock is quoted for trading on the Nasdaq National Market. The market price for our common stock has been, and may continue to be, highly volatile for a number of reasons including:

In addition, stock prices for many technology companies fluctuate widely for reasons, which may be unrelated to operating results. These fluctuations, as well as general economic, market and political conditions such as recessions, terrorist attacks or military conflicts, may materially and adversely affect the market price of our common stock.

We have implemented certain anti-takeover provisions that may prevent or delay an acquisition of Verity that might be beneficial to our stockholders

Provisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could make it more difficult for a third-party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:

We also have in place a Share Purchase Rights Plan, commonly referred to as a “poison pill.” In addition, the anti-takeover provisions of Section 203 of the Delaware General Corporations Law and the terms of our stock option plan may discourage, delay or prevent a change in control of Verity.

Interest Rate Risk. The primary objective of our investment activities is to preserve the principal while at the same time maximize yields without significantly increasing our risk. To achieve this objective, we maintain our portfolio of cash equivalents and investments in a variety of securities, including both government and corporate obligations and money market funds. As of November 30, 2003, approximately 62% of our portfolio matures in one year or less, with the remainder maturing in less than three years. We do not use derivative financial instruments in our investment portfolio. We place our investments with high credit quality issuers and, by policy, limit the amount of credit exposure to any one issuer.

The following table presents the amounts of our cash, cash equivalents and investments that are subject to interest rate risk by year of expected maturity and average interest rates as of November 30, 2003:

This compares to our cash equivalents and investments that were subject to interest rate risk by year of expected maturity and average interest rates as of May 31, 2003 as follows:

The total dollar value of our portfolio decreased by only $1.5 million from May 31, 2003 to November 30, 2003. However, between these dates, the composition of our portfolio changed significantly, as follows:

As a result of the decrease in the amount of fixed-rate securities, the amount of interest we earn on our portfolio as of November 30, 2003 will be more responsive to interest rate fluctuations as compared to May 30, 2003, but the value of the portfolio will be less responsive to interest rate fluctuations.

Foreign Currency Risk. We transact business in various foreign currencies, including the Euro, the British pound, the Canadian dollar, the Australian dollar, the Swedish krona, the South African rand, the Mexican peso, the Brazilian real, the Japanese yen and the Singaporean dollar. We have established a foreign currency hedging program utilizing foreign currency forward exchange contracts to offset the risk associated with the effects of certain foreign currency transaction exposures. Under this program, increases or decreases in our foreign currency transactions are in part offset by gains and losses on the forward contracts, so as to mitigate the possibility of foreign currency transaction gains and losses. These foreign currency transactions typically arise from intercompany transactions.

Our forward contracts generally have terms of 90 days or less. We do not use forward contracts for trading purposes. All foreign currency transactions and all outstanding forward contracts (non equity hedges) are marked to market at the end of the period with any changes in market value included in Other income (loss), net. 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. Net foreign exchange transaction gain included in Other income, net in the accompanying consolidated of operations was $174,000 in the six month period ended November 30, 2003. The fair value of the foreign currency exchange contracts was not material to our consolidated financial statements.

Limitations on the Effectiveness of Controls. Our management, including the Chief Executive Officer and Chief Financial Officer, believes that our disclosure controls and procedures and our internal control over financial reporting will provide reasonable assurance that all errors will be detected, but does not expect that our disclosure controls and procedures or our internal control over financial reporting will provide absolute assurance

that all errors will be detected. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Verity have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

Evaluation of Disclosure Controls and Procedures. An evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of November 30, 2003. Based on that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of November 30, 2003, to provide reasonable assurance that the information required to be disclosed by us in this Quarterly Report on Form 10-Q was recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and Form 10-Q.

Changes in Internal Control over Financial Reporting. During the three month period ended November 30, 2003, there were no changes in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

The Company’s Annual Meeting of Stockholders was held on October 23, 2003. Proxies for the meeting were solicited pursuant to Regulation 14A. At the meeting, management’s nominees for two director positions to serve until the Company’s 2006 annual meeting of stockholders were submitted to the stockholders of the Company. Management’s nominees for director were elected by the following vote:

Gary J. Sbona, Steven M. Krausz, Charles P. Waite, Jr., Stephen A. MacDonald, Victor A. Cohn, John G. Schwarz, Karl C. Powell and Anthony J. Bettencourt continued to serve as directors of the Company after the annual meeting. Mr. Sbona will continue to serve as the Executive Chairman of the Board, and Mr. Powell and Mr. Schwarz will continue to serve as directors until the Annual Meeting of Stockholders to be held in 2004. Mr. Krausz, Mr. Cohn and Mr. Waite will continue to serve until the Annual Meeting of Stockholders to be held in 2005. Mr. Bettencourt and Mr. MacDonald will continue to serve until the Annual Meeting of Stockholders to be held in 2006.

A previous proposal to ratify the selection of PricewaterhouseCoopers LLP as independent auditors of the Company for its fiscal year ending May 31, 2004 was withdrawn.

A. Exhibits — See Exhibit Index following the signature page to this report, which is incorporated by reference here.

Pursuant to the requirements 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.

VERITY, INC.
(Registrant)

By:		/s/ STEVEN R. SPRINGSTEEL
		Steven R. Springsteel Senior Vice President of Finance and Administration and Chief Financial Officer

		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)	3
	Condensed Consolidated Balance Sheets — As of November 30, 2003 and May 31, 2003	3
	Condensed Consolidated Statements of Operations — For the Three Month Periods Ended November 30, 2003 and November 30, 2002, and the Six Month Periods Ended November 30, 2003 and November 30, 2002	4
	Condensed Consolidated Statements of Cash Flows — For the Six Month Periods Ended November 30, 2003 and November 30, 2002	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36
Item 4.	Controls and Procedures	37

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	39
Item 2.	Changes in Securities and Use of Proceeds	39
Item 3.	Defaults upon Senior Securities	39
Item 4.	Submission of Matters to a Vote of Security Holders	39
Item 5.	Other Information	39
Item 6.	Exhibits and Reports on Form 8-K	40
Signature		41

	November 30, 2003		May 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	78,274	$	85,672
Short-term investments		75,988		52,993
Trade accounts receivable, net of allowance for doubtful accounts of $1,479 and $1,540		25,311		22,597
Deferred tax assets		3,916		3,916
Prepaid and other		5,523		4,719

Total current assets		189,012		169,897
Property and equipment, net		4,487		5,168
Long-term investments		95,005		112,079
Deferred tax assets		18,176		18,176
Intangible assets, net		10,320		11,610
Goodwill		15,145		15,145
Other assets		451		460

Total assets	$	332,596	$	332,535

LIABILITIES
Current liabilities:
Accounts payable	$	3,956	$	5,541
Accrued compensation		8,215		8,518
Income tax payable		3,541		3,493
Deferred purchase payment		3,049		—
Other accrued liabilities		699		1,457
Deferred revenue		19,255		18,874

Total current liabilities		38,715		37,883

Deferred purchase payment		—		3,021

Total liabilities		38,715		40,904

STOCKHOLDERS’ EQUITY
Common stock, $0.001 par value:
Authorized: 200,000 shares; issued and outstanding: 37,690 shares as of November 30, 2003; and 37,560 shares as of May 31, 2003		38		38
Additional paid-in capital		262,138		264,645
Other comprehensive income		2,472		3,174
Retained earnings		29,233		23,774

Total stockholders’ equity		293,881		291,631

Total liabilities and stockholders’ equity	$	332,596	$	332,535

	Three Months Ended November 30,					Six Months Ended November 30,
	2003		2002			2003		2002
Revenues:
Software products	$	16,227	$	12,949		$	30,404	$	25,255
Service and other		12,672		9,942			25,098		19,646

Total revenues		28,899		22,891			55,502		44,901

Costs of revenues:
Software products		429		291			768		681
Service and other		3,288		3,078			6,676		5,821
Amortization of purchased intangible assets		645		—			1,290		—

Total costs of revenues		4,362		3,369			8,734		6,502

Gross profit		24,537		19,522			46,768		38,399

Operating expenses:
Research and development		4,773		4,481			10,234		9,789
Marketing and sales		11,687		9,678			23,820		20,249
General and administrative		2,712		2,462			5,600		5,136
Restructuring charge		972		993			972		993

Total operating expenses		20,144		17,614			40,626		36,167

Income from operations		4,393		1,908			6,142		2,232

Interest income, net		1,376		2,034			2,782		4,064
Other income (loss), net		394		(130	)		174		(256	)

Income before provision for income taxes		6,163		3,812			9,098		6,040
Provision for income taxes		2,524		1,449			3,639		2,296

Net income	$	3,639	$	2,363		$	5,459	$	3,744

Net income per share — basic	$	0.10	$	0.07		$	0.15	$	0.11

Net income per share — diluted	$	0.09	$	0.07		$	0.14	$	0.10

Number of shares — basic		37,579		34,699			37,542		35,123

Number of shares — diluted		39,475		35,766			39,569		36,206

	Six Months Ended November 30,
	2003			2002
Cash flows from operating activities:
Net income	$	5,459		$	3,744
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization		3,031			1,726
Allowance for doubtful accounts		—			463
Deferred income taxes		—			1,928
Amortization of premium on securities, net		512			771
Changes in operating assets and liabilities:
Trade accounts receivable		(2,515	)		2,883
Prepaid and other assets		(713	)		(490	)
Accounts payable		(1,623	)		(769	)
Accrued compensation and other accrued liabilities		(1,109	)		(1,942	)
Deferred revenue		270			(2,309	)

Net cash provided by operating activities		3,312			6,005

Cash flows from investing activities:
Acquisition of property and equipment		(1,015	)		(598	)
Purchases of marketable securities		(213,149	)		(244,761	)
Maturity of marketable securities		89,926			88,051
Proceeds from sale of marketable securities		115,860			151,813

Net cash used in investing activities		(8,378	)		(5,495	)

Cash flows from financing activities:
Proceeds from the sale of common stock, net of issuance costs		14,498			3,020
Repurchases of common stock		(17,005	)		(16,558	)

Net cash used in financing activities		(2,507	)		(13,538	)

Effect of exchange rate changes on cash		175			500

Net decrease in cash and cash equivalents		(7,398	)		(12,528	)
Cash and cash equivalents, beginning of period		85,672			52,803

Cash and cash equivalents, end of period	$	78,274		$	40,275

	Three Months Ended November 30,						Six Months Ended November 30,
	2003			2002			2003			2002
Net income
Net income — as reported	$	3,639		$	2,363		$	5,459		$	3,744

Deduct: Total SFAS 123 stock-based employee compensation expense, net of related tax effects		(12,324	)		(15,354	)		(27,334	)		(33,039	)

Net loss — pro forma	$	(8,685	)	$	(12,991	)	$	(21,875	)	$	(29,295	)

Earnings per share
Net income per share — basic — as reported	$	0.10		$	0.07		$	0.15		$	0.11

Net loss per share — basic — pro forma	$	(0.23	)	$	(0.37	)	$	(0.58	)	$	(0.83	)

Net income per share — diluted — as reported	$	0.09		$	0.07		$	0.14		$	0.10

Net loss per share — diluted — pro forma	$	(0.23	)	$	(0.37	)	$	(0.58	)	$	(0.83	)

Number of shares used in basic — as reported calculation		37,579			34,699			37,542			35,123

Number of shares used in diluted — as reported calculation		39,475			35,766			39,569			36,206

Number of shares used in basic and diluted — pro forma calculation		37,579			34,699			37,542			35,123

	Three Months Ended November 30,		Six Months Ended November 30,
	2003	2002	2003	2002
Stock Option Plans
Expected volatility	93%	80%	89%	80%
Risk-free interest rate	2.20%	2.18%	2.07%	2.97%
Expected life	4.00 years	4.29 years	4.00 years	2.80 years
Expected dividend yield	0.00%	0.00%	0.00%	0.00%

Stock Purchase Plan
Expected volatility	68%	90%	76%	90%
Risk-free interest rate	1.38%	1.93%	1.38%	1.93%
Expected life	1.00 year	1.00 year	1.00 year	1.00 year
Expected dividend yield	0.00%	0.00%	0.00%	0.00%

	November 30, 2003							May 31, 2003
	Amortized Cost		Gross Unrealized Gains (Losses)			Fair Value		Amortized Cost		Gross Unrealized Gains		Fair Value
*Short-term*
Corporate	$	38,422	$	291		$	38,713	$	48,592	$	788	$	49,380
Government		5,000		—			5,000		1,000		13		1,013
Other		32,275		—			32,275		2,600		—		2,600

Total short-term	$	75,697	$	291		$	75,988	$	52,192	$	801	$	52,993

*Long-Term*
Corporate	$	9,986	$	(8	)	$	9,978	$	14,031	$	290	$	14,321
Government		82,925		(235	)		82,690		95,965		413		96,378
Other		2,375		(38	)		2,337		1,375		5		1,380

Total long-term		95,286		(281	)		95,005		111,371		708		112,079

Total investments	$	170,983	$	10		$	170,993	$	163,563	$	1,509	$	165,072

	November 30, 2003
	(in thousands)
Long-lived assets:
USA	$	29,209
Europe		456
Canada		722

Other ROW		16

Consolidated	$	30,403

Restructuring charges: (three and six month periods ended)	November 30, 2003		November 30, 2002
	(in millions)
Severance costs	$	0.90	$	0.72
Legal and other outside services costs		0.07		0.10
Other charges		0.00		0.17

Total restructuring charges	$	0.97	$	0.99

Quarter Ended November 30, 2003	Workforce Reduction			Legal and Other Outside Services			Other		Total
	(in millions)
Restructuring provision	$	0.90		$	0.07		$	0.00	$	0.97
Cash payments		(0.88	)		(0.04	)		0.00		(0.92	)

Balance at November 30, 2003	$	0.02		$	0.03		$	0.00	$	0.05

	Three Months Ended November 30,				Six Months Ended November 30,
	2003		2002		2003		2002
	(unaudited)				(unaudited)
Revenues:
Software products	56.2	%	56.6	%	54.8	%	56.2	%
Service and other	43.8		43.4		45.2		43.8

Total revenues	100.0		100.0		100.0		100.0

Costs of revenues:
Software products	1.5		1.3		1.4		1.5
Service and other	11.4		13.4		12.0		13.0
Amortization of purchased intangible assets	2.2		—		2.3		—

Total costs of revenues	15.1		14.7		15.7		14.5

Gross profit	84.9		85.3		84.3		85.5

Operating expenses:
Research and development	16.5		19.6		18.4		21.8
Marketing and sales	40.4		42.3		42.9		45.1
General and administrative	9.4		10.8		10.1		11.4
Restructuring charge	3.4		4.3		1.8		2.2

Total operating expenses	69.7		77.0		73.2		80.5

Income from operations	15.2		8.3		11.1		5.0
Interest income, net	4.7		8.9		5.0		9.1

Other income (loss), net	1.4		(0.5	)	0.3		(0.6	)

Income before provision for income taxes	21.3		16.7		16.4		13.5
Provision for income taxes	8.7		6.3		6.6		5.1

Net income	12.6	%	10.4	%	9.8	%	8.4	%

	November 30, 2003		November 30, 2002		Change
	(dollar amounts in millions)
Three months ended	$	28.9	$	22.9	26.2	%
Six months ended	$	55.5	$	44.9	23.6	%

	November 30, 2003			November 30, 2002			Change
	(dollar amounts in millions)
Three months ended	$	0.4		$	0.3		47.4	%
Percentage of software product revenues		2.6	%		2.2	%
Six months ended	$	0.8		$	0.7		12.8	%
Percentage of software product revenues		2.5	%		2.7	%

Restructuring charges: (three and six month periods ended)	November 30, 2003		November 30, 2002
	(in millions)
Severance costs	$	0.9	$	0.7
Legal and other outside services costs		0.1		0.1
Other charges		0.0		0.2

Total restructuring charges	$	1.0	$	1.0

Six month periods ended	November 30, 2003			November 30, 2002
	(in millions)
Net cash provided by operating activities	$	3.3		$	6.0
Net cash used in investing activities	$	(8.4	)	$	(5.5	)
Net cash used in financing activities	$	(2.5	)	$	(13.5	)

Fiscal Year Ending May 31,	Rental Payments
2004	$	1,657
2005		2,755
2006		1,482
2007		1,434
2008 and thereafter		1,861

	$	9,189

	FY2004			FY2005			FY2006			FY2007			Total			Fair Value
	(Dollars in thousands)
Cash and cash equivalents	$	78,274			—			—			—		$	78,274		$	78,274
Average interest rate		1.2	%		—			—			—			1.2	%		1.2	%
Fixed-rate securities	$	33,196		$	28,057		$	44,640		$	32,825		$	138,718		$	138,718
Average interest rate		4.4	%		2.5	%		2.3	%		2.5	%		2.9	%		2.9	%
Variable-rate securities	$	32,275			—			—			—		$	32,275		$	32,275
Average interest rates		1.2	%		—			—			—			1.2	%		1.2	%

	Shares
Nominee	Voting For	Withheld
Anthony J. Bettencourt	34,083,680	560,796
Stephen A. MacDonald.	28,726,483	5,917,993

Date		Item Reported On
September 10, 2003		We reported under Item 12 a press release we issued on September 10, 2003, announcing financial results for fiscal quarter ended August 31, 2003.

October 23, 2003		We reported on Item 9 that PricewaterhouseCoopers LLP has ceased to be our independent public accountants.

October 29, 2003		We reported on Item 4 the engagement of KPMG LLP to serve as our principal auditors, replacing PricewaterhouseCoopers LLP.

October 31, 2003		We reported an amendment to the Form 8-K filed on October 29, 2003, relating to the change of independent public accountants, to change the ending date of the interim period referred to in the last paragraph of Item 4.

Exhibit Number		Description of Document
2.1		Asset Purchase Agreement among Inktomi Corporation, Quiver, Inc., Ultraseek Corporation, Quiver Ltd. and the Company, dated November 13, 2002. (1)

2.2		Amendment No. 1 to Asset Purchase Agreement among Inktomi Corporation, Inktomi Quiver Corporation, Ultraseek Corporation, Quiver Ltd. and the Company, dated December 17, 2002, amending Asset Purchase Agreement dated November 13, 2002. (1)

3.1		Restated Certificate of Incorporation of the Company. (2)

3.2		By-Laws. (2)

4.1		Amended and Restated Rights Agreement dated August 1, 1995, as amended. (3)

4.2		Form of Rights Agreement between Verity, Inc. and First National Bank of Boston dated September 18, 1996. (4)

4.3		First Amendment to Rights Agreement dated as of July 23, 1999 among Verity, Inc. and BankBoston, N.A. (5)

10.41		Seventh Amendment to Retainer Agreement between Regent Pacific Management Corporation and Verity, Inc. dated January 9, 2004.

31.1		Certification of Anthony J. Bettencourt.

31.2		Certification of Steven R. Springsteel.

32		Certification of Chief Executive Officer and Chief Financial Officer.