QUEST SOFTWARE INC - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2004

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

For the transition period from to

COMMISSION FILE NO. 000-26937

QUEST SOFTWARE, INC.

(Exact name of registrant as specified in its charter)


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

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

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

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

Indicate by check mark whether the 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, no par value, as of November 2, 2004, was 94,985,332.

QUEST SOFTWARE, INC.

FORM 10-Q

TABLE OF CONTENTS


		Page Number
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)

	Condensed Consolidated Balance Sheets as of December 31, 2003 and September 30, 2004	2

	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2003 and 2004	3

	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2004	4

	Condensed Consolidated Statements of Comprehensive Operations for the Three and Nine Months Ended September 30, 2003 and 2004	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	29

Item 4.	Controls and Procedures	30

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	31

Item 6.	Exhibits	32

SIGNATURES		33

PART I—FINANCIAL INFORMATION

Item 1: Financial Statements

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)


	December 31, 2003			September 30, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	67,470		$	89,384
Short-term marketable securities		26,736			56,163
Accounts receivable, net		58,535			66,610
Prepaid expenses and other current assets		6,846			11,097
Deferred income taxes		15,074			3,994

Total current assets		174,661			227,248
Property and equipment, net		31,950			51,003
Long-term marketable securities		184,160			126,544
Goodwill		239,840			326,324
Amortizing intangible assets, net		25,159			44,881
Deferred income taxes		10,126			11,219
Other assets		1,915			2,511

Total assets	$	667,811		$	789,730

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,180		$	5,533
Obligation under repurchase agreement		—			27,492
Accrued compensation		17,384			21,325
Other accrued expenses		27,939			30,445
Income taxes payable		9,082			18,929
Current portion of deferred revenue		73,957			87,630

Total current liabilities		132,542			191,354
Long-term liabilities:
Long-term portion of deferred revenue		9,416			13,696
Other long-term liabilities		1,677			1,984

Total long-term liabilities		11,093			15,680
Commitments and contingencies (Notes 3, 5 and 10)
Shareholders’ equity:
Preferred stock, no par value, 10,000 shares authorized; no shares issued or outstanding		—			—
Common stock, no par value, 150,000 shares authorized; 93,309 and 94,990 shares issued and outstanding at December 31, 2003 and September 30, 2004, respectively		588,203			617,407
Accumulated deficit		(47,073	)		(13,129	)
Accumulated other comprehensive (loss) income		260			(431	)
Unearned compensation		—			(3,937	)
Note receivable from sale of common stock		(17,214	)		(17,214	)

Net shareholders’ equity		524,176			582,696

Total liabilities and shareholders’ equity	$	667,811		$	789,730

See accompanying notes to condensed consolidated financial statements.

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2004		2003		2004
Revenues:
Licenses	$	41,423	$	53,539	$	125,310	$	151,762
Services		31,841		43,200		89,988		119,651

Total revenues		73,264		96,739		215,298		271,413
Cost of revenues:
Licenses		1,026		764		3,098		2,835
Services		5,267		7,973		15,805		21,739
Amortization of purchased technology		1,899		2,269		6,391		5,980

Total cost of revenues		8,192		11,006		25,294		30,554

Gross profit		65,072		85,733		190,004		240,859
Operating expenses:
Sales and marketing		34,418		42,876		106,457		120,193
Research and development		16,415		19,868		50,589		58,381
General and administrative		7,438		8,876		21,285		25,661
Amortization of other purchased intangible assets		889		1,568		2,643		3,861
In-process research and development		—		—		—		6,980
Litigation loss provision		—		—		—		5,000

Total operating expenses		59,160		73,188		180,974		220,076
Gain on sale of Vista Plus product suite		—		29,574		—		29,574

Income from operations		5,912		42,119		9,030		50,357
Other income, net		1,308		2,723		7,156		2,884

Income before income tax provision		7,220		44,842		16,186		53,241
Income tax provision		2,782		13,901		6,148		19,285

Net income	$	4,438	$	30,941	$	10,038	$	33,956

Net income per share:
Basic	$	0.05	$	0.33	$	0.11	$	0.36

Diluted	$	0.05	$	0.32	$	0.11	$	0.35

Weighted average shares:
Basic		92,550		94,737		91,737		94,306
Diluted		94,213		96,608		93,571		97,691

See accompanying notes to condensed consolidated financial statements.

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Nine Months Ended September 30,
	2003			2004
Cash flows from operating activities:
Net income	$	10,038		$	33,956
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		20,654			20,560
Compensation expense associated with stock options		796			1,266
Deferred income taxes		(459	)		612
Gain on sale of Vista Plus product suite		—			(29,574	)
Provision for bad debts		23			112
In-process research and development		—			6,980
Litigation loss provision		—			5,000
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable		3,204			(6,070	)
Prepaid expenses and other current assets		2,653			(276	)
Other assets		(99	)		(376	)
Accounts payable		(44	)		702
Accrued compensation		1,003			2,041
Other accrued expenses		(3,379	)		(5,633	)
Income taxes payable		8,634			12,760
Deferred revenue		4,200			15,754
Other liabilities		(277	)		307

Net cash provided by operating activities		46,947			58,121
Cash flows from investing activities:
Purchases of property and equipment		(5,387	)		(28,010	)
Cash paid for acquisitions, net of cash acquired		(4,746	)		(96,364	)
Proceeds from sale of Vista Plus product suite		—			22,515
Purchases of marketable securities		(107,491	)		(7	)
Sales and maturities of marketable securities		93,460			27,498

Net cash used in investing activities		(24,164	)		(74,368	)
Cash flows from financing activities:
Repayment of notes payable		(1,336	)		(769	)
Proceeds from repurchase agreement		—			67,581
Repayment of repurchase agreement		—			(40,512	)
Repayment of capital lease obligations		(255	)		(275	)
Proceeds from the exercise of stock options		5,388			7,028
Proceeds from employee stock purchase plan		4,631			4,797

Net cash provided by financing activities		8,428			37,850
Effect of exchange rate changes on cash and cash equivalents		(1,103	)		311

Net increase in cash and cash equivalents		30,108			21,914
Cash and cash equivalents, beginning of period		64,283			67,470

Cash and cash equivalents, end of period	$	94,391		$	89,384

Supplemental disclosures of condensed consolidated cash flow information:
Cash paid for:
Interest	$	51		$	44

Income taxes	$	380		$	4,542

Supplemental schedule of non-cash investing and financing activities:
Unrealized loss on available-for-sale securities	$	(447	)	$	(691	)

Tax benefit related to stock option exercises	$	5,701		$	2,799

See Note 3 for details of assets acquired and liabilities assumed in acquisitions.

See accompanying notes to condensed consolidated financial statements.

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS

(In thousands)

(Unaudited)


	Three Months Ended September 30,					Nine Months Ended September 30,
	2003			2004		2003			2004
Net income	$	4,438		$	30,941	$	10,038		$	33,956
Other comprehensive gain (loss):
Unrealized gain (loss) on available-for-sale securities, net of tax		(277	)		1,057		(447	)		(691	)

Comprehensive income	$	4,161		$	31,998	$	9,591		$	33,265

See accompanying notes to condensed consolidated financial statements.

QUEST SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Basis of Presentation

Our accompanying unaudited condensed consolidated financial statements as of September 30, 2004 and for the three and nine months ended September 30, 2003 and 2004, reflect all adjustments (consisting of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These financial statements should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003. The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period.

Recent Accounting Pronouncement

In March 2004, the Emerging Issues Task Force (EITF), ratified EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF Issue No. 03-1 provides a three step process for determining whether investments, including debt securities, are other than temporarily impaired and requires additional disclosures in annual financial statements. We are in the process of evaluating the impact of adopting the measurement and recognition guidance of EITF Issue No. 03-1 but do not believe it will have a material impact on our consolidated financial position or results of operations because we have the ability and intent to hold any marketable securities with gross unrealized losses until a recovery of fair value can be realized. In September 2004, the Financial Accounting Standards Board (FASB) approved the issuance of FASB Staff Positions EITF 03-1-1, which delays the effective date of the measurement and recognition provisions of EITF 03-1 to investments in securities that are impaired.

2. Stock Based Awards

We account for stock-based awards to employees using the intrinsic value method, as prescribed by Accounting Principles Board (APB) Opinion No. 25 “Accounting for Stock Issued to Employees” and interpretations thereof. Under APB Opinion No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise price. Generally, the exercise price of options granted under our stock option plans is equal to the market value of the underlying stock on the date of grant. We value stock options assumed in purchase business combinations at the date of acquisition at their fair value calculated using the Black-Scholes option-pricing model. The purchase price of these business combinations includes the fair value of assumed options while the intrinsic value attributable to unvested options is recorded as unearned compensation and amortized over the remaining vesting period of the stock options.

Pro forma information regarding net income and earnings per share is required by Statement of Financial Accounting Standard (SFAS) No. 123 “Accounting for Stock Based Compensation.” This information is required to be determined as if we had accounted for our employee stock options and stock purchase plans under the fair value based method of SFAS No. 123, as amended. Had compensation cost been determined using the fair value method our net income would have been adjusted to the pro forma net income (loss) amounts indicated below (in thousands, except per share data):


	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2004			2003			2004
Net income – as reported	$	4,438		$	30,941		$	10,038		$	33,956
Add: Stock-based compensation expense included in reported net income, net of related tax effects		78			361			490			815
Deduct: Total stock-based compensation determined under fair value based method for all awards, net of related tax effects		(6,663	)		(7,346	)		(19,920	)		(21,681	)

Net income (loss) – pro forma	$	(2,147	)	$	23,956		$	(9,392	)	$	13,090

Basic net income (loss) per share:
As reported	$	0.05		$	0.33		$	0.11		$	0.36
Pro forma	$	(0.02	)	$	0.25		$	(0.10	)	$	0.14
Diluted net income (loss) per share:
As reported	$	0.05		$	0.32		$	0.11		$	0.35
Pro forma	$	(0.02	)	$	0.25		$	(0.10	)	$	0.13

For purposes of estimating the compensation cost of our option grants the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. These fair value calculations are based on the following assumptions:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2004		2003		2004
Risk-free interest rates	4	%	3.4	%	4	%	3.6	%
Expected life (in years)	5		5		5		5
Expected stock volatility	64	%	49	%	55	%	50	%
Expected dividends	None		None		None		None

In January 2004, 345,083 shares of common stock were purchased under our Employee Stock Purchase Plan (“ESPP”) at a price of $7.98 per share. In July 2004, 202,336 shares of common stock were purchased under the ESPP at a price of $10.25 per share. The ESPP was terminated effective July 31, 2004.

3. Acquisitions and Disposition

On September 15, 2004, pursuant to an Asset Purchase Agreement with Open Text Corporation (“Open Text”), we sold our Vista Plus output management product line and related assets and certain customer support obligations to Open Text for approximately $24.5 million in cash, of which $2.0 million is held in escrow to satisfy certain indemnification obligations of Quest. The decision to sell this line of products was made because the products did not fit in with our primary product portfolio focus, which is to provide solutions for application, database and Windows management. The assets sold primarily consisted of intellectual property, a customer list, contracts, certain receivables and fixed assets. Open Text assumed certain customer support obligations of the Vista Plus output management product line, which result in an approximately $6.2 million reduction in deferred revenues on the date of sale. The sale resulted in a pretax gain of $29.6 million. The Vista Plus output management product line generated approximately $17.6 million in total revenues in 2003 and $10.6 million in the eight and a half months ended September 15, 2004, respectively, the bulk of which was maintenance and support revenue.

On April 8, 2004, we acquired the outstanding shares of Lecco Technology Limited (“LECCOTECH”), a provider of database management solutions, to supplement our solutions for Oracle, DB2, UDB, SQL Server and Sybase. The purchase price for LECCOTECH was $1.8 million, consisting of $1.6 million in cash and direct acquisition costs of $0.2 million. Goodwill in the amount of $1.2 million and $0.4 million was assigned to the license and service segments, respectively, of our business and is not expected to be deductible for tax purposes. Goodwill allocation of 75% to licenses and 25% to services is based on both historical and projected relative contribution from licenses and services revenues.

The acquisition was accounted for as a purchase with the purchase price of $1.8 million allocated as follows (in thousands):


Tangible assets acquired	$	440
Goodwill		1,554
Developed technology with an estimated useful life of 4 years		990
Customer list with an estimated useful life of 4 years		460
Maintenance contracts with an estimated useful life of 4 years		400
In-process research and development		280
Deferred taxes		(740	)
Deferred revenue		(529	)
Liabilities assumed		(1,080	)

	$	1,775

On March 17, 2004, we acquired Aelita Software Corporation, a leading provider of systems management solutions for Microsoft Active Directory and Microsoft Exchange products. The acquisition expands our product portfolio of solutions to simplify, automate and secure increasingly complex Microsoft infrastructures. The purchase price for Aelita was $117.3 million, consisting of $102.0 million in cash, the assumption of Aelita stock options valued at $13.4 million using the Black-Scholes option pricing model and direct acquisition costs of $1.9 million. The intrinsic value of unvested stock options of $4.0 million has been allocated to unearned compensation and will be recognized as non-cash compensation expense over the remaining future vesting period of four years. Of the cash paid for this acquisition, $15.8 million was deposited in escrow to satisfy certain indemnification obligations of the selling shareholders. Goodwill in the amount of $66.2 million and $18.7 million was assigned to the license and service segments, respectively, of our business and is not expected to be deductible for tax purposes. Goodwill allocation of 78% to licenses and 22% to services is based on both historical and projected relative contribution from licenses and services revenues.

The acquisition was accounted for as a purchase with the purchase price of $117.3 million allocated as follows (in thousands):


Current assets	$	12,079
Fixed assets		1,468
Other non-current assets		178
Goodwill		84,932
Acquired technology with estimated useful lives of 1 – 5 years		16,500
Customer list with an estimated useful life of 2 years		5,100
Maintenance contracts with an estimated useful life of 5 years		2,600
Non-compete agreements with an estimated useful life of 4 years		3,000
Trademark with an estimated useful life of 2 years		600
In-process research and development		6,700
Deferred taxes		(8,620	)
Deferred revenue		(7,811	)
Other liabilities		(3,438	)
Unearned compensation		4,008

	$	117,296

The merger agreement requires us to make certain payments to the former shareholders of Aelita in the event assumed Aelita options are prematurely forfeited within eighteen months of the acquisition date. The amount of these payments are equal to 50% of the aggregate value of the spread between the exercise price per share of each forfeited option as of the date of forfeiture and the lower of the price of our common stock as reported on the Nasdaq National Market on either (a) the acquisition closing date, or (b) the trading day immediately preceding the date which the option was forfeited. As of September 30, 2004, no payments have been made associated with forfeited Aelita options.

In connection with the acquisition, we recognized approximately $1.0 million as liabilities representing estimated severance related charges for affected Aelita employees. Based on a subsequent review of headcount and resource needs, we reduced this estimated liability by $290,000 and $170,000 during the quarters ended September 30, 2004 and June 30, 2004, respectively, which also reduced goodwill. We do not expect any future changes to the estimated severance liability. As of September 30, 2004, the remaining unpaid liability was approximately $170,000, the majority of which we expect to pay in the fourth quarter of 2004.

In connection with the Aelita acquisition, $6.7 million of the purchase price was allocated to In-Process Research and Development (IPR&D) and expensed immediately upon completion of the acquisition (as a charge not deductible for tax purposes), because the technological feasibility of products under development had not been established and no future alternative uses existed. We identified and valued seven IPR&D projects. Four of the projects were over 75% complete and the remaining three were less than 30% complete at the date of acquisition and the estimated cost to complete all projects was $1.2 million. Four projects were directed toward the development of improvements to an existing product and the others for products that were in pre-production. The IPR&D for the improvements to the existing products represented 69% of the total value of IPR&D acquired, while the products in pre-production represented the balance of 31%. At the date of acquisition, improvements to the existing products were anticipated to be completed during the remaining three quarters of 2004 while the pre-production products were expected to be completed by the beginning of 2005. Through September 30, 2004 actual results do not materially differ from the estimates used in valuations of IPR&D.

The fair value of the IPR&D was determined using the income approach. Under the income approach, expected future after-tax cash flows from each of the projects or product families (projects) under development are estimated and discounted to their net present value at an appropriate risk-adjusted rate of return. Each project was analyzed to determine the technological innovations included in the project; the existence and utilization of core technology; the complexity, cost and time to complete the remaining development efforts; the existence of any alternative future use or current technological feasibility; and the stage of completion in development. Future cash flows for each project were estimated based on forecasted revenues and costs, taking into account the expected life cycles

of the products and the underlying technology, relevant market sizes and industry trends. Future cash flows from the significant acquired projects were expected to commence at various dates within three to twelve months of acquisition. The estimated future cash flows for each were discounted to approximate fair value. Discount rates, ranging from 25% to 30% for developed technology and IPR&D, were derived from a weighted average cost of capital analysis, adjusted upward to reflect additional risks inherent in the development process, including the probability of achieving technological success and market acceptance. The IPR&D charge includes the fair value of the portion of IPR&D completed as of the date of acquisition.

During the second quarter of 2003, we acquired the outstanding shares of eCritical Inc., a provider of performance management solutions for network-enabled applications, and Discus Data Solutions, Inc., a provider of infrastructure management solutions for the Microsoft environment. The aggregate purchase price for these acquisitions was $10.2 million.

Actual results of operations of the companies acquired in 2003 and 2004 are included in the condensed consolidated financial statements from the dates of acquisition. The pro forma results of operations data for the three and nine months ended September 30, 2003 and 2004 presented below assume that the acquisitions made in 2003 and 2004 had been made on January 1, 2003 and 2004, respectively, and include amortization of identified intangibles, unearned compensation charges and in-process research and development from that date. The pro forma data is presented for informational purposes only and is not necessarily indicative of the results of future operations nor of the actual results that would have been achieved had the acquisitions taken place at the beginning of each fiscal year (in thousands, except per share data):


	Three Months Ended September 30,					Nine Months Ended September 30,
	2003			2004		2003			2004
Revenues	$	79,194		$	96,739	$	234,512		$	278,829
Net income (loss)	$	(203	)	$	30,941	$	(11,429	)	$	28,895
Net income (loss) per share – basic	$	—		$	0.33	$	(0.12	)	$	0.31
Net income (loss) per share – diluted	$	—		$	0.32	$	(0.12	)	$	0.30

4. Goodwill and Amortizing Intangible Assets

Amortizing intangible assets as of December 31, 2003 and September 30, 2004, respectively, are comprised of the following (in thousands):


	December 31, 2003								September 30, 2004
	Gross Carrying Amount		Accumulated Amortization			Net		Weighted Average Amortization Period	Gross Carrying Amount		Accumulated Amortization			Net		Weighted Average Amortization Period
Purchased technology	$	50,062	$	(28,639	)	$	21,423	4.5	$	65,809	$	(32,963	)	$	32,846	5.4
Customer lists		6,351		(3,944	)		2,407	3.2		11,911		(6,573	)		5,338	2.6
Existing maintenance contracts		—		—			—	—		3,000		(327	)		2,673	4.9
Non-compete agreements		2,325		(2,108	)		217	2.2		5,325		(2,634	)		2,691	3.2
Trademarks		1,450		(338	)		1,112	5.0		2,050		(717	)		1,333	4.1

	$	60,188	$	(35,029	)	$	25,159		$	88,095	$	(43,214	)	$	44,881

Amortization expense for amortizing intangible assets was $3.8 million and $9.9 million for the three and nine months ended September 30, 2004, respectively. Estimated annual amortization expense related to amortizing intangible assets by fiscal year is as follows: remaining quarter of 2004—$3.5 million; 2005—$13.1 million; 2006—$10.5 million; 2007—$8.9 million; 2008—$6.9 million; 2009—$2.0 million. All intangible assets currently recorded will be fully amortized by the end of 2009.

The changes in the carrying amount of goodwill by reportable operating segment for the nine months ended September 30, 2004 are as follows (in thousands):


	Licenses			Services			Total
Balance as of December 31, 2003	$	182,623		$	57,217		$	239,840
Goodwill from acquisition of Aelita		66,606			18,786			85,392

Balance as of March 31, 2004	$	249,229		$	76,003		$	325,232
Goodwill from acquisition of LECCOTECH		1,166			388			1,554
Adjustment for Aelita severance costs and other		(137	)		(37	)		(174	)

Balance as of June 30, 2004	$	250,258		$	76,354		$	326,612
Adjustment for Aelita severance costs and other		(224	)		(64	)		(288	)

Balance as of September 30, 2004	$	250,034		$	76,290		$	326,324

5. Obligation Under Repurchase Agreement

We entered into a repurchase agreement in March 2004, utilizing $67.6 million of our investment securities as collateral. The cash proceeds of this transaction were used to provide funding for our acquisition of Aelita and our purchase of a new office facility. The repurchase agreement both entitles and obligates us to repurchase the securities from the transferee (“buyer-lender”) and the buyer-lender does not have a right to pledge or sell the collateralized securities to a third party. Accordingly, our obligations under the repurchase agreement are accounted for as short-term borrowings and recorded as a liability on the balance sheet. Our obligations under the repurchase agreement bear interest at a weighted average interest rate of 1.9% and will mature in the fourth quarter of 2004 (subject to extension at rates to be determined if extended), and require maintenance of a customary market collateral margin. We used $40.5 million cash to repurchase securities held as collateral as part of this repurchase agreement in the quarter ended September 30, 2004. Our obligation under this agreement as of September 30, 2004, was $27.5 million, which includes $0.2 million of accrued interest.

6. Income Tax Provision

The effective income tax rate for the three months ended September 30, 2004 was 31.0% compared to 38.5% in the comparable period of 2003. The reduction in the effective income tax rate for the quarter is primarily a result of favorable tax treatment associated with the sale of the Vista Plus output management product line and the conclusion of the Internal Revenue Service examination of our federal income tax returns through December 31, 2001 which resulted in the reduction of our accrued income taxes payable balance and, consequently, a decrease to income tax expense.

7. Foreign Currency Translation

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 52, “Foreign Currency Translation,” the United States Dollar is considered to be the functional currency for our foreign subsidiaries, as such subsidiaries act primarily as an extension of our parent company’s operations. Assets and liabilities in these subsidiaries are re-measured at current exchange rates, except for property and equipment, deferred revenue, depreciation and investments, which are translated at historical exchange rates. Revenues and expenses are translated at weighted average exchange rates in effect during the year, except for costs related to those balance sheet items, which are translated at historical rates. Foreign currency translation gains and losses are included in “other income, net” in the consolidated statements of operations. For the three and nine months ended September 30, 2004 we recorded a net foreign currency translation gain of $1.6 million and a loss of $1.3 million, respectively. The net foreign currency translation gain was $0.1 million and $3.6 million in the comparable three and nine month periods of 2003, respectively.

8. Net Income Per Share

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

The following table summarizes our earnings per share computation for the three and nine months ended September 30, 2003 and 2004 (in thousands, except per share data):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2004		2003		2004
Net income	$	4,438	$	30,941	$	10,038	$	33,956

Weighted average shares – basic		92,550		94,737		91,737		94,306
Incremental common shares attributable to shares issuable under employee stock plans		1,663		1,871		1,834		3,385

Weighted average shares – diluted		94,213		96,608		93,571		97,691

Net income per share:
Basic	$	0.05	$	0.33	$	0.11	$	0.36

Diluted	$	0.05	$	0.32	$	0.11	$	0.35

For the three and nine months ended September 30, 2004 options to purchase 16.3 million and 7.9 million shares of common stock with weighted average exercise prices of $15.97 and $20.66, respectively, were anti-dilutive because the exercise price of the options was greater than the average fair market value of our common stock for the period then ended.

9. Geographic and Segment Information

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

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

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

Reportable segment data for the three and nine months ended September 30, 2003 and 2004, is as follows (in thousands):


	Licenses		Services		Total
Three months ended September 30, 2003
Revenues	$	41,423	$	31,841	$	73,264
Cost of Revenues		2,925		5,267		8,192

Gross profit	$	38,498	$	26,574	$	65,072

Three months ended September 30, 2004
Revenues	$	53,539	$	43,200	$	96,739
Cost of Revenues		3,033		7,973		11,006

Gross profit	$	50,506	$	35,227	$	85,733

Nine months ended September 30, 2003
Revenues	$	125,310	$	89,988	$	215,298
Cost of Revenues		9,489		15,805		25,294

Gross profit	$	115,821	$	74,183	$	190,004

Nine months ended September 30, 2004
Revenues	$	151,762	$	119,651	$	271,413
Cost of Revenues		8,815		21,739		30,554

Gross profit	$	142,947	$	97,912	$	240,859

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


	North America (1)		Europe (2)		Other International			Total
Three months ended September 30, 2003
Revenues	$	53,293	$	17,877	$	2,094		$	73,264
Gross profit		49,949		14,558		565			65,072
Income (loss) from operations		4,902		3,877		(2,867	)		5,912
Long-lived assets		447,648		2,685		7,031			457,364
Three months ended September 30, 2004
Revenues	$	67,774	$	25,548	$	3,417		$	96,739
Gross profit		63,017		21,405		1,311			85,733
Income (loss) from operations		37,019		8,176		(3,076	)		42,119
Long-lived assets		550,992		3,847		7,643			562,482
Nine months ended September 30, 2003
Revenues	$	158,380	$	50,579	$	6,339		$	215,298
Gross profit		140,042		45,755		4,207			190,004
Income (loss) from operations		3,208		11,947		(6,125	)		9,030
Long-lived assets		447,648		2,685		7,031			457,364
Nine months ended September 30, 2004
Revenues	$	191,797	$	71,801	$	7,815		$	271,413
Gross profit		173,894		61,840		5,125			240,859
Income (loss) from operations		35,702		22,521		(7,866	)		50,357
Long-lived assets		550,992		3,847		7,643			562,482

(1)	Principally represents operations in the United States.

(2)

Our subsidiary located in the United Kingdom accounted for $8.1 million and $22.6 million of total European revenues during the three and nine months ended September 30, 2003, respectively, and $12.2 million and $34.2 million of total European revenues during the three and nine months ended September 30, 2004, respectively.

10. Commitments and Contingencies

On July 2, 2002, Computer Associates International, Inc. (“CA”) filed a complaint against us and four of our employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in connection with the development of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. The complaint was amended in May 2003 to add another Quest employee as a defendant and to assert breach of contract claims against three of the individual defendants. In July 2004, the Court entered an order preliminarily enjoining our use, marketing, licensing or distribution of Quest Central for DB2, pending trial, based upon its determination that CA is likely to prove its claims of copyright infringement or trade secret misappropriation. We are permitted by the terms of the order to continue providing technical support and product maintenance to existing users of Quest Central for DB2. Our appeal of the preliminary injunction order is pending. The related products accounted for approximately 3% of total revenues in the six months ended June 30, 2004 and the year ended December 31, 2003. We have established a loss contingency reserve in the amount of $5.0 million dollars, which reflects our current estimate of liability we may incur as a result of this litigation matter.

After we announced on July 23, 2003 that we would restate certain financial results as a result of our discovery of a computational error relating to an error in the method used to translate foreign currency denominated accounts into U.S. Dollars at historical rates, numerous separate complaints purporting to be class actions were filed in the United States District Court for the Central District of California alleging that we and some of our officers and directors violated provisions of the Securities Exchange Act of 1934. Orders designating a lead plaintiff and consolidating the federal class action complaints were issued by the U. S. District Court in late October 2003, and an amended consolidated class action complaint was filed in January 2004. On May 10, 2004, the U.S. District Court granted our motion to dismiss the amended consolidated class action complaint without prejudice. A second amended class action complaint was filed in U.S. District Court in early July 2004. Our motion to dismiss the second amended class action complaint was filed in August 2004, and is scheduled to be heard by the U.S. District Court in November 2004.

A complaint purporting to be a derivative action has been filed in California state court against some of our directors and officers. This complaint is based on the same facts and circumstances described in the initial class action complaints discussed above and generally alleges that the named directors and officers breached their fiduciary duties by failing to oversee adequately our financial reporting. Our motion to dismiss the derivative action is scheduled to be heard by the California Superior Court in November 2004. The amended class action complaint and the derivative complaint generally seek an unspecified amount of damages and remain in the preliminary stages. We are continuing to vigorously defend these claims; however, it is not possible for us to quantify the extent of our potential liability, if any. Accordingly, no amounts have been accrued in the accompanying financial statements.

An unfavorable outcome in any of these cases could have a material adverse effect on our business, financial condition, results of operations and cash flow. In addition, we will continue to incur substantial legal expenses in the defense of these claims, which may also divert management’s attention from the day-to-day operations of our business.

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

In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, and (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in the accompanying consolidated balance sheets as the fair value of these obligations issued during the quarter ended September 30, 2004 was not significant to our financial position, results of operations, or cash flows.

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

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

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

Overview

We develop, distribute, support and maintain software products that maximize the availability, performance and manageability of our customers’ business critical applications and their associated databases and other components. Many of our products also increase the cost effectiveness of a customer’s IT investments, including personnel, software and hardware.

Our revenues consist of software license fees and service fees. Our software-licensing model is primarily based on perpetual license fees, and our license fees are calculated either on a per-server basis or per seat basis, depending on the product. Service revenues primarily represent the ratable recognition of software maintenance contract fees, which entitle a customer to technical support via telephone and the internet and product enhancements on a when and if available basis. These maintenance contracts have annual terms. Customers purchase a software maintenance contract for the first year when they license a product and have the option of renewing the maintenance contract annually thereafter. A majority of our customers renew their software maintenance contracts. Service revenues also include revenues from consulting and training services.

Acquisition of Aelita Software Corporation

In March 2004, we completed the acquisition of Aelita Software Corporation, a privately-held software vendor. The acquisition of Aelita added depth and breadth to our Microsoft expertise and product portfolio allowing us to deliver a more comprehensive set of product solutions that enable customers to manage today’s complex Microsoft infrastructure through their entire lifecycle. Results of operations from Aelita and other acquisitions are included in our consolidated statements of operations from the respective dates of acquisition. For more information concerning our acquisitions during the periods presented herein, see Note 3 of “Notes to Condensed Consolidated Financial Statements.”

Sale of Vista Plus Product Suite

In September 2004, we sold our Vista Plus output management product line and related assets and certain customer support obligations to Open Text Corporation (“Open Text”), for approximately $24.5 million in cash. The assets sold were primarily comprised of intellectual property, a customer list, contracts, certain receivables and fixed assets. Open Text assumed certain customer support obligations of the Vista Plus output management product line, which result in an approximately $6.2 million reduction in deferred revenues on our September 30, 2004 balance sheet. The sale resulted in a pretax gain of approximately $29.6 million. The Vista Plus output management product line generated approximately $17.6 million and $10.6 million in total revenues in 2003 and 2004, respectively, the bulk of which was maintenance and support revenue.

Impact of Foreign Exchange Rates

For the three and nine months ended September 30, 2004, foreign exchange rate fluctuations contributed approximately $2.3 million, or 9.7%, and $5.7 million, or 10.2%, to growth in total revenues, respectively, and $1.6 million, or 10.2%, and $5.2 million, or 13.8%, to growth in total expenses, respectively, due to generally stronger foreign currency rates versus the U.S. Dollar.

Results of Operations

Except as otherwise indicated, the following are percentage of total revenues:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2004		2003		2004
Revenues:
Licenses	56.5	%	55.3	%	58.2	%	55.9	%
Services	43.5		44.7		41.8		44.1

Total revenues	100.0		100.0		100.0		100.0
Cost of revenues:
Licenses	1.4		0.8		1.4		1.0
Services	7.2		8.2		7.3		8.0
Amortization of purchased technology	2.6		2.3		3.0		2.2

Total cost of revenues	11.2		11.3		11.7		11.2

Gross profit	88.8		88.7		88.3		88.8
Operating expenses:
Sales and marketing	47.0		44.3		49.4		44.3
Research and development	22.4		20.5		23.5		21.5
General and administrative	10.2		9.2		9.9		9.5
Amortization of other purchased intangible assets	1.2		1.6		1.2		1.4
In-process research and development ⁽¹⁾	—		—		—		2.6
Litigation loss provision ⁽²⁾	—		—		—		1.8

Total operating expenses	80.8		75.6		84.0		81.1
Gain on sale of Vista Plus product suite ⁽¹⁾	—		30.6		—		10.9

Income from operations	8.0		43.7		4.3		18.6
Other income, net	1.8		2.8		3.3		1.1

Income before income taxes	9.8		46.5		7.6		19.7
Income tax provision	3.8		14.4		2.9		7.1

Net income	6.0	%	32.1	%	4.7	%	12.6	%

As a percentage of related revenues:
Cost of licenses	2.5	%	1.4	%	2.5	%	1.9	%
Cost of services	16.5	%	18.5	%	17.6	%	18.2	%

(1)	See Note 3 to the “Notes to Condensed Consolidated Financial Statements”

(2)	See Note 10 to the “Notes to Condensed Consolidated Financial Statements”

Comparison of Three and Nine Months Ended September 30, 2003 and 2004

Revenues

Total revenues and year-over-year changes are as follows (in thousands, except for percentages):


	Three Months Ended September 30,				Increase				Nine Months Ended September 30,				Increase
	2003		2004		Dollars		Percentage		2003		2004		Dollars		Percentage
Revenues:
Licenses	$	41,423	$	53,539	$	12,116	29.2	%	$	125,310	$	151,762	$	26,452	21.1	%
Services		31,841		43,200		11,359	35.7	%		89,988		119,651		29,663	33.0	%

Total revenues	$	73,264	$	96,739	$	23,475	32.0	%	$	215,298	$	271,413	$	56,115	26.1	%

Geographic Revenues:
North America:
Licenses	$	29,284	$	35,696	$	6,412	21.9	%	$	89,992	$	102,814	$	12,822	14.3	%
Services		24,009		32,078		8,069	33.6	%		68,388		88,985		20,597	30.2	%

Total North America	$	53,293	$	67,774	$	14,481	27.2	%	$	158,380	$	191,799	$	33,419	21.1	%

Rest of World:
Licenses	$	12,139	$	17,843	$	5,704	47.0	%	$	35,318	$	48,948	$	13,630	38.6	%
Services		7,832		11,122		3,290	42.0	%		21,600		30,666		9,066	42.0	%

Total Rest of World	$	19,971	$	28,965	$	8,994	45.1	%	$	56,918	$	79,614	$	22,696	39.9	%

License Revenues— Growth in license revenues on a year-over-year basis for both periods presented is primarily a result of robust sales of our Microsoft Infrastructure Management and Development and Deployment product lines. The license revenue contribution from the acquired Aelita products has become less identifiable because we have created product packages comprising both Aelita and Quest Microsoft management products and because in some cases Aelita products have replaced comparable Quest products. We nonetheless estimate that acquired Aelita products contributed approximately 50% to 60% to license revenues growth in the three months ended September 30, 2004. We also noted particular strength of the sales of Aelita products in EMEA during both the three and nine month periods of 2004. Our products for the Microsoft platforms now represent approximately 34.3% and 32.9% of total software license sales for the three and nine months ended September 30, 2004, respectively. Software license sales of our Development and Deployment products increased 26% and 23% in the three and nine months ended September 30, 2004, respectively, compared to the same periods in 2003, and these products also showed particular strength in Europe. A major new release of our TOAD Oracle development product was a primary driver of license revenues growth in this product line. In the three and nine months ended September 30, 2004, foreign currency movements contributed approximately $1.5 million and $4.0 million, respectively, to the year over year increase in license revenues.

Service Revenues— Three factors were the primary contributors to year over year service revenues growth, which consist primarily of software maintenance. First, Aelita contributed approximately $4.9 million and $9.7 million in service revenues for the three and nine month periods, respectively. Second, support renewals of our existing software maintenance customer base are continuing to grow well. Third, revenues from post-sales consulting and training increased 92.0% and 56.5% in the three and nine month periods, respectively. Post-sales consulting and training as a percentage of total service revenues represented 12.9% and 11.7% in the three and nine months ended September 30, 2004, respectively, compared to 9.1% and 9.9% in the comparable periods of 2003. Growth in our post-sale consulting and training revenues is primarily due to the revenue contribution from Aelita and to an increased focus on selling service engagements using internal programs designed to encourage the sales force to sell post-sale consulting and training with the initial software license sale. In the three and nine months ended September 30, 2004, foreign currency movements contributed approximately $800,000 and $1.8 million, respectively, to the year over year increase in service revenues.

As our software maintenance customer base grows, the renewal rate has a larger influence on the software maintenance revenue growth rate and the amount of new software license revenues has a diminishing effect. Therefore, the growth rate of software maintenance revenues does not necessarily correlate directly to the growth rate of new software license revenues. For example, if new software license revenues remained constant, software maintenance revenues would continue to grow as a result of the incremental software maintenance revenues associated with new software license revenues, assuming renewal rates stayed relatively constant. We believe that software maintenance revenues will continue to grow as we anticipate that a majority of our customers will renew their software maintenance contracts and the sale of new software licenses will increase our customer base.

Cost of Revenues

Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages):


	Three Months Ended September 30,				Increase/(Decrease)					Nine Months Ended September 30,				Increase/(Decrease)
	2003		2004		Dollars			Percentage		2003		2004		Dollars			Percentage
Cost of revenues:
Licenses	$	1,026	$	764	$	(262	)	(25.5	)%	$	3,098	$	2,835	$	(263	)	(8.5	)%
Services		5,267		7,973		2,706		51.4	%		15,805		21,739		5,934		37.5	%
Amortization of purchased technology		1,899		2,269		370		19.5	%		6,391		5,980		(411	)	(6.4	)%

	$	8,192	$	11,006	$	2,814		34.4	%	$	25,294	$	30,554	$	5,260		20.8	%

Cost of Licenses—Cost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, delivery and personnel. Cost of licenses as a percentage of license revenues was 1.4% and 1.9% for the three and nine months ended September 30, 2004, respectively, compared to 2.5% in the comparable periods of 2003. The percentage of revenue decrease is primarily the result of reduced license sales of royalty-bearing products.

Cost of Services—Cost of services primarily consists of personnel, outside consultants, facilities and systems costs used in providing support, consulting and training services. The increase in cost of services is primarily due to an increase in fees paid to outside professional services consultants in support of product deployments and to headcount growth, including the additional headcount from the acquisition of Aelita. Cost of services as a percentage of service revenues increased to 18.5% and 18.2% in the three and nine months ended September 30, 2004, respectively, from 16.5% and 17.6% in the comparable periods of 2003.

Amortization of Purchased Technology—Amortization of purchased technology includes amortization of the fair value of acquired technology associated with acquisitions made from 2001 through the third quarter of 2004. We expect amortization of purchased technology to be at least $2.0 million in the fourth quarter of 2004.

Operating Expenses

Total operating expenses and year-over-year changes are as follows (in thousands, except for percentages):


	Three Months Ended September 30,				Increase				Nine Months Ended September 30,				Increase
	2003		2004		Dollars		Percentage		2003		2004		Dollars		Percentage
Operating expenses:
Sales and marketing	$	34,418	$	42,876	$	8,458	24.6	%	$	106,457	$	120,193	$	13,736	12.9	%
Research and development		16,415		19,868		3,453	21.0	%		50,589		58,381		7,792	15.4	%
General and administrative		7,438		8,876		1,438	19.3	%		21,285		25,661		4,376	20.6	%
Amortization of other purchased intangible assets		889		1,568		679	76.4	%		2,643		3,861		1,218	46.1	%
In-process research and development		—		—		—	—	%		—		6,980		6,980	—	%
Litigation loss provision		—		—		—	—	%		—		5,000		5,000	—	%

Total operating expenses	$	59,160	$	73,188	$	14,028	23.7	%	$	180,974	$	220,076	$	39,102	21.6	%

Sales and Marketing—Sales and marketing expenses consist primarily of the following types of costs related to our sales and marketing activities: compensation and benefits; sales commissions; facilities and systems; trade shows; travel and entertainment; and marketing communications. The increase in sales and marketing expense for both periods is primarily attributable to additional headcount from the Aelita acquisition, which contributed approximately $4.3 million and $8.9 million in the three and nine months, respectively, to sales and marketing expenses, and increased commission expense as a result of higher license revenues. Sales and marketing expenses as a percentage of total revenues were 44.3% in the three and nine months ended September 30, 2004, compared to 47.0% and 49.4% in the comparable periods of 2003, respectively. The decline in expenses as a percentage of total revenues for both periods presented is primarily attributable to our holding core Quest sales and marketing headcount flat year over year. In the future, we intend to increase marketing communications and program expenses.

Research and Development—Research and development expenses consist primarily of compensation and benefit costs for software developers, software product managers, quality assurance and technical documentation personnel, associated facilities and systems costs and payments made to outside software development consultants in connection with our ongoing efforts to enhance our core technologies and develop additional products. Research and development expenses as a percentage of total revenues were 20.5% and 21.5% in the three and nine months ended September 30, 2004, respectively, compared to 22.4% and 23.5% in the comparable periods of 2003. The increase in research and development expenses is primarily due to increased headcount associated with the Aelita acquisition. Aelita contributed $2.2 million and $4.1 million to research and development costs in the three and nine months ended September 30, 2004, respectively. The decline in expenses as a percentage of total revenues for both periods presented is primarily attributable to our holding core Quest research and development headcount flat year over year.

General and Administrative—General and administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, administrative and information services personnel, professional fees, and associated facilities and systems costs. General and administrative expenses as a percentage of total revenues were 9.2% and 9.5% in the three and nine months ended September 30, 2004, respectively, compared to 10.2% and 9.9% in the comparable periods of 2003. The increase in general and administrative costs in both periods is primarily due to higher compensation costs, increased accounting fees associated with Sarbanes-Oxley compliance efforts and increased litigation defense costs associated with ongoing litigation.

Amortization of Other Purchased Intangible Assets—Amortization of other purchased intangible assets includes the amortization of customer lists, trademarks, non-compete agreements and maintenance contracts associated with acquisitions. The increase in

amortization expense in both the three and nine months ended September 30, 2004 is due to the purchase of intangible assets in conjunction with acquisitions during the first two quarters of 2004. We expect amortization of other purchased intangible assets to be at least $1.4 million in the fourth quarter of 2004.

Other Income, Net

Other income, net includes interest income on our investment portfolio, and gains and losses from foreign exchange fluctuations, as well as gains or losses on other financial assets. Other income, net increased by $1.4 million to $2.7 million in the third quarter of 2004 compared to $1.3 million in the comparable period of 2003. This increase is primarily due to interest income of $1.7 million in the third quarter of 2004, compared to $1.2 million in the comparable period of 2003, in addition to an increase in foreign currency gain from $0.1 million to $1.6 million in the third quarter of 2004. During the nine months ended September 30, 2004, other income, net decreased by $4.3 million to $2.9 million compared to $7.2 million in the comparable period of 2003. This decrease is primarily due to foreign currency losses in 2004 resulting from translation losses on accounts receivable, cash and intra-company receivables denominated in the Australian Dollar, Euro, and the British Pound.

Income Tax Provision

During the three months ended September 30, 2004, the provision for income taxes increased to $13.9 million from $2.8 million in the comparable period of 2003, representing an increase of $11.1 million. The effective income tax rate for the three months ended September 30, 2004 was 31.0% compared to approximately 38.5% in the comparable period of 2003. The reduction in the effective income tax rate for the quarter is primarily a result of favorable tax treatment associated with the sale of the Vista Plus output management product line and the conclusion of the Internal Revenue Service examination of our federal income tax returns through December 31, 2001 which resulted in the reduction of our accrued income taxes payable balance and, consequently, a decrease to income tax expense. During the nine months ended September 30, 2004, the provision for income taxes increased to $19.3 million from $6.1 million in the comparable period of 2003, representing an increase of $13.2 million. The effective income tax rate for the nine months ended September 30, 2004 was 36.2% compared to approximately 38.0% in the comparable period of 2003.

Liquidity and Capital Resources

As of September 30, 2004, cash and cash equivalents and short-term marketable securities were $145.5 million and we held $126.5 million of long-term investment grade corporate and government securities.

Operating Activities

Our primary source of operating cash flows is cash collections from our customers following the purchase of new software licenses, post-contract customer support and post-sale consulting and training. Our primary uses of cash from operating activities are for personnel related expenditures. Net cash provided by operating activities increased to $58.1 million in the nine months ended September 30, 2004, compared with $46.9 million in the comparable period of 2003. The increase in cash from operating activities in the 2004 period was driven primarily by an increase in license and service revenues as well as higher deferred revenues from an increase in support and maintenance renewal bookings, offset partially by a decrease to accounts receivable.

Investing Activities

We used $74.3 million in investing activities in the nine months ended September 30, 2004, consisting primarily of $96.4 million net cash paid for acquisitions and $28.0 million in capital expenditures, partially offset by $27.5 million net cash received from sales and maturities of marketable securities and cash proceeds of $22.5 million received from the sale of our Vista Plus output management product line as described in Note 3 to the “Notes to Condensed Consolidated Financial Statements.” Cash provided by investing activities in the 2003 period consists of $4.7 million net cash paid for acquisitions, $5.4 million in capital expenditures and $14.0 million net cash paid for marketable securities. Capital expenditures in the nine months ended September 30, 2004 consisted of $14.9 million to purchase a building and the remainder for information technology hardware and software purchases.

In March 2004, we purchased a building in Aliso Viejo, California comprising approximately 78,000 square feet. We also entered into an agreement to lease approximately 57,000 square feet of space in an adjacent building for a ten-year term commencing in December 2005. The lease agreement includes an option, exercisable until November 15, 2004, to purchase this building for a purchase price of approximately $18.6 million. We intend to move all of our Irvine operations into these two buildings in stages over the next four quarters. Cash paid for relocation costs and costs of improvements related to the first building were approximately $7.7 million through the nine months ended September 30, 2004. We expect relocation costs and costs of improvements related to the second building to be approximately $12.0 million to $15.0 million.

In the future, we expect cash will continue to be generated from our operations. We plan to use cash generated from operations to reduce our existing position under our repurchase agreement and invest the remaining cash in short and long-term marketable securities consistent with past investment practices. We will continue to evaluate a variety of other strategic investment and acquisition opportunities.

Financing Activities

Financing activities generated $37.9 million in the nine months ended September 30, 2004, primarily from net proceeds of $27.1 million from a repurchase agreement as described in Note 5 of the “Notes to Condensed Consolidated Financial Statements” and $11.8 million from issuances of our common stock under employee stock option and stock purchase plans. Financing activities generated $8.4 million in the comparable period of 2003, of which $10.0 million was generated from issuances of our common stock under employee stock option and stock purchase plans, offset by the use of $1.6 million for repayment of notes payable and capital lease obligations. In April 2004, our Board of Directors elected to terminate the employee stock purchase plan effective July 31, 2004.

We entered into a repurchase agreement in March 2004, utilizing $67.6 million of our investment securities as collateral. The cash proceeds of this transaction were used to provide funding for our acquisition of Aelita and our purchase of a new office facility. Our obligations under the repurchase agreement bear interest at a weighted average interest rate of 1.9% and will mature in the fourth quarter of 2004 (subject to extension at rates to be determined if extended), and require maintenance of a customary market collateral margin. We used $40.5 million cash to repurchase securities held as collateral as part of this repurchase agreement in the quarter ended September 30, 2004. Our obligation under this agreement as of September 30, 2004, was $27.5 million, which includes $0.2 million of accrued interest. For more information concerning our obligation under this repurchase agreement, see Note 5 of “Notes to Condensed Consolidated Financial Statements.”

Our Board of Directors authorized a stock repurchase program for up to five million shares of our common stock. As of September 30, 2004, we had repurchased approximately 1.7 million shares of our common stock under this program for an aggregate cost of approximately $58.0 million. No shares of common stock were repurchased under this plan during the first three quarters of 2003 or 2004.

Based on our current operating plan, we believe that our existing cash, cash equivalents and investment balances and cash flows from operations will be sufficient to finance our working capital, debt service and capital expenditure requirements through at least the next 12 months. If we are not able to generate or sustain positive cash flow from operations, we would be required to use existing cash, cash equivalents and investment balances to support our working capital. Our ability to generate cash from operations is subject to substantial risks described below under the caption “Risk Factors.”

Critical Accounting Policies and Estimates

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

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

Revenue Recognition

We derive revenues from two primary sources: (1) software licenses and (2) services, which include post-contract customer support, consulting and education. We utilize written contracts as the means to establish the terms and conditions by which our products and services are sold to our customers. We license our products primarily through our direct sales force and indirectly through resellers.

We recognize revenue in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” and related interpretations, SOP 98-9 “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 104 (“SAB 104”), “Revenue Recognition in Financial Statements,” and other related pronouncements. Based on our reading and interpretation of SOP 97-2, SOP 98-9, SAB 104 and other related pronouncements, we believe that our current sales contract terms and business arrangements have been properly reported. The AICPA and its Software Revenue Recognition Task Force continue to issue interpretations and guidance for applying the relevant standards to a wide range of sales contract terms and business arrangements that are prevalent in the software industry. Future interpretations of existing accounting standards or changes in our business practices could result in future changes in our revenue accounting policies that could have a material adverse effect on our business, financial condition and results of operations.

Our software products are “off-the-shelf” products that do not require modification or customization. Revenues from sales of software licenses to customers are recognized when:

(1)

Persuasive evidence of an arrangement exists—We consider a written contract, signed by both the customer and us, to be persuasive evidence of an arrangement;

(2)

Delivery has occurred—We deem delivery to have occurred when all products or services that are essential to the functionality are delivered to the customer;

(3)

The fee is fixed or determinable—We deem our fee to be fixed or determinable when we have a signed contract that states the agreed upon fee for our software and/or services. We consider arrangements with 80% or more of the payments due within six months and the balance due within the next six months to be fixed and determinable. Arrangements with payment terms extending beyond these customary payment terms are considered neither to be fixed nor determinable, and revenue from such arrangements is recognized as payments are received. We do not grant customers a right of return; and

(4)

Collection is probable—We assess the probability of collection on a customer-by-customer basis, based on the customer’s payment history and our evaluation of the customer’s financial position. If we determine that collection is not probable, we recognize revenue upon receipt of payment.

Our software license sales include an implicit first year annual customer support fee, which is recognized ratably over the one-year term of the arrangement. A customer’s renewal of annual customer support is priced as a percentage of the net software license fees, generally 20% to 25% of the initial purchase price.

We also offer product implementation and training services, which are sold separately under consulting engagement contracts. Revenues from these arrangements are accounted for separately from new software license revenues because the arrangements qualify as service transactions as defined in SOP 97-2 and are recognized as the services are performed.

For arrangements with multiple elements, we allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor-specific objective evidence,” or “VSOE.” VSOE of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately. When multiple elements are sold to a customer in a single contract, the revenues from such multiple-element arrangements are allocated to each element based upon the residual method. Under the residual method, revenue is recognized for all delivered elements when (1) there is VSOE of the fair values of all undelivered elements and (2) all revenue recognition criteria of SOP 97-2, as amended, are satisfied. Under the residual method of accounting, any discount in the arrangement is allocated to the delivered elements. If we cannot objectively determine the fair value of any undelivered element included in bundled software and service arrangements, we defer revenue until all elements are delivered, services have been performed or until fair value can objectively be determined.

We sell our products primarily through direct sales. For indirect sales transactions sold through distributors or resellers, we recognize revenue using the sell-through method, meaning recognized revenues are associated with specific end user customer orders. In addition, we defer recognition on indirect sales until receipt of payment unless we have a payment history with the reseller or distributor with no late payment experiences.

Accounts Receivable

We maintain allowances for sales returns and doubtful accounts for estimated losses resulting from the unwillingness or inability of our customers to make required payments. This requires us to make estimates of future product returns, annual support cancellations and write-offs of bad debt accounts related to current period revenues. The amount of our reserves is based on historical experience and our analysis of the accounts receivable.

If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such determination was made. Additionally, if significant product performance issues were to arise resulting in our accepting sales returns, additional allowances may be required which would result in a reduction of revenue in the period such determination was made. Our standard licensing agreement does not permit customers to return products unless we have breached the product warranty and are unable to cure the breach. Our product warranties are typical industry warranties that a product will perform in accordance with established product requirements. While such amounts have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past.

Intangible Assets

As required by Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” we do not amortize goodwill. All current and future acquired goodwill will be subject to impairment tests annually, or earlier if indicators of potential impairment exist, using a fair-value-based approach. All purchased technology and other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

Under SFAS No. 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. We performed our annual impairment review during the fourth quarter of 2003 and as a result determined that the carrying value of goodwill was less than the estimated fair value. In calculating the fair value of the reporting units (licenses and services), the Market Approach (Guideline Company Method) was the methodology deemed the most reliable and used for impairment analysis. We will perform subsequent annual impairment reviews during the fourth quarter of each year, or earlier if indicators of potential impairment exist. Future impairment reviews may result in charges against earnings to write down the value of goodwill.

Purchased technology and other intangible assets are recorded at the estimated fair value on the purchase date and amortized using the straight-line method over estimated useful lives of two years to seven years. The net carrying amount of these intangible assets was considered recoverable at September 30, 2004. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” purchased technology and other intangible assets are reviewed for events or changes in circumstances, which indicate that their carrying value may not be recoverable. We periodically review the carrying value of these assets to determine whether or not impairment to such value has occurred. In the event that in the future it is determined that the purchased technology and other intangible assets value has been impaired, an adjustment will be made resulting in a charge for the write-down in the period in which the determination is made.

Income Taxes

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

Accounting for Stock-Based Compensation


	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2004			2003			2004
Net income – as reported	$	4,438		$	30,941		$	10,038		$	33,956
Add: Stock-based compensation expense included in reported net income, net of related tax effects		78			361			490			815
Deduct: Total stock-based compensation determined under fair value based method for all awards, net of related tax effects		(6,663	)		(7,346	)		(19,920	)		(21,681	)

Net income (loss) – pro forma	$	(2,147	)	$	23,956		$	(9,392	)	$	13,090

Basic net income (loss) per share:
As reported	$	0.05		$	0.33		$	0.11		$	0.36
Pro forma	$	(0.02	)	$	0.25		$	(0.10	)	$	0.14
Diluted net income (loss) per share:
As reported	$	0.05		$	0.32		$	0.11		$	0.35
Pro forma	$	(0.02	)	$	0.25		$	(0.10	)	$	0.13

The fair value of options and shares issued pursuant to the Employee Stock Purchase Plan at the grant date was estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility rates trended into future years. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our options.

The effects of applying pro forma disclosures of net income and earnings per share are not likely to be representative of the pro forma effects on net income and earnings per share in future years, because the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.

Accounting for Contingencies

Under SFAS No. 5, “Accounting for Contingencies,” we are required to record an estimated loss from a loss contingency if we consider it probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a material loss has been incurred. For example, in the second quarter of 2004, we established a loss contingency reserve in the amount of $5.0 million dollars, reflecting our current estimate of liability we may incur as a result of our ongoing litigation with Computer Associates International, Inc. However, litigation is inherently uncertain and there can be no guarantee that this amount will be sufficient to cover our ultimate liability in this matter, if any. In making determinations as to the accrual and disclosure of loss contingencies, we assess various factors, including the degree of probability of an unfavorable outcome, the ability to reasonably estimate the amount of loss (or a range of loss), and the probability that the loss and defense costs are covered, either entirely or partially, by insurance. Changes in these factors or different judgments as to the application of these factors could materially impact our financial position or our results of operations.

Recent Accounting Pronouncement

In March 2004, the Emerging Issues Task Force (EITF) ratified EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF Issue No. 03-1 provides a three step process for determining whether investments, including debt securities, are other than temporarily impaired and requires additional disclosures in annual financial statements. We are in the process of evaluating the impact of adopting the measurement and recognition guidance of EITF Issue No. 03-1 but do not believe it will have a material impact on our consolidated financial position or results of operations because we have the ability and intent to hold any marketable securities with gross unrealized losses until a recovery of fair value can be realized. In September 2004, the Financial Accounting Standards Board (FASB) approved the issuance of FASB Staff Positions EITF 03-1-1, which delays the effective date of the measurement and recognition provisions of EITF 03-1 to investments in securities that are impaired.

RISK FACTORS

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

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

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

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

•

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

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

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

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

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

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

Many of our products are vulnerable to direct competition from Oracle

We compete with Oracle in the market for database management solutions and the competitive pressure continues to increase. We expect that Oracle’s commitment to and presence in the database management product market will increase in the future and therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its server software offerings, possibly at no additional cost to its users. Competition from Oracle with certain of our Database Management products including SharePlex and Quest Central for Oracle has increased over the last two years and continues to increase with Oracle’s introduction of the next version of its database, known as Oracle 10G. Oracle 10G is claimed to have enhanced capabilities in the functions competitive with Quest Central for Oracle and with the Oracle monitoring capabilities of Foglight. If Oracle 10G does provide capabilities closely equivalent to those of Quest Central for Oracle, our revenues from that product line would likely be materially adversely affected.

In some cases these platform vendor-provided tools are bundled with the platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of purchasing our products. Moreover, there is substantial risk that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.

Our software products for Microsoft’s Active Directory and Exchange are vulnerable to fluctuations in the rate at which customers of certain Microsoft products migrate to newer versions of such products

Our products for the migration, administration and management of Microsoft’s Active Directory and Exchange products currently contribute approximately one-third of our license revenues and have been the primary contributor to license revenue growth in fiscal 2003 and the first three quarters of 2004. Our ability to sell licenses for our Active Directory and Exchange migration products depends in part on the rate at which customers migrate to newer versions of Microsoft’s Windows 2000 or Windows XP operating system or to newer versions of Microsoft Exchange. If these migration rates were to materially decrease, our license revenues from these migration products would likely decline.

Many of our products are dependent on database or application technologies of others; if these technologies lose market share or become incompatible with our products, or if these vendors introduce competitive products or acquire or form strategic relationships with our competitors, the demand for our products could suffer

We believe that our success has depended in part, and will continue to depend in part for the foreseeable future, upon our relationships with providers of major database and enterprise software programs, including Oracle, IBM, Microsoft, SAP, Siebel and PeopleSoft. Our competitive advantage consists in substantial part on the integration between our products and products provided by these major software providers, and our extensive knowledge of their products and technologies. If these companies for any reason decide to promote technologies and standards that are not compatible with our technologies, or if they lose market share for their database or application products, our business, operating results and financial condition would be materially adversely affected. Furthermore, these major software vendors could attempt to increase their presence in the markets we serve by either introducing products that compete with our products or acquiring or forming strategic alliances with our competitors. These companies have longer operating histories, larger installed bases of customers and substantially greater financial, distribution, marketing and technical resources than we do, as well as well-established relationships with many of our present and potential customers, and may be in better position to withstand and respond to the current factors impacting this industry. As a result, we may not be able to compete effectively with these companies in the future, which could materially adversely affect our business, operating results and financial condition.

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

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

Failure to maintain effective internal control over financial reporting could adversely affect the price of our common stock

Pursuant to rules adopted by the SEC implementing Section 404 of the Sarbanes-Oxley Act of 2002, we are required to assess the effectiveness of our internal controls over financial reporting and report whether such internal controls are effective. Our auditors must issue an attestation report on such assessment. Accordingly, we have undertaken to evaluate, test and remediate, if necessary, our internal controls pursuant to a clearly defined internal plan and schedule. Although we believe that our efforts will enable us to provide the required report and our independent auditors to provide the required attestation as of our fiscal year end, we can give no assurance that such efforts will be completed in a timely manner and on a successful basis. If this were to occur, we may be unable to assert that the internal controls over financial reporting are effective, or our auditors may not be able to render the required attestation concerning our assessment and effectiveness of internal controls over financial reporting, which could adversely affect the market price of our common stock.

Intense competition in the markets for our products could adversely affect our results of operations

The markets for our products are highly competitive. As a result, our future success will be affected by our ability to, among other things, outperform our competitors in meeting the needs of current and prospective customers and identifying and addressing new technological and market opportunities. Our competitors may develop more advanced technology, adopt more aggressive pricing policies and undertake more effective sales and marketing campaigns and may be able to leverage more extensive financial, technical or partner resources. If we are unable to maintain our competitive position, our revenues may decline and our operating results may be adversely affected.

Our operating results may be negatively impacted by fluctuations in foreign currency exchange rates

Our international operations are generally conducted through our international subsidiaries, with the associated revenues and related expenses, and balance sheets, denominated in the currency of the country in which the international subsidiaries operate. As a result, our operating results may be harmed by fluctuations in exchange rates between the U.S. Dollar and other foreign currencies. The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our exposure to fluctuations in foreign currency exchange rates.

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

We maintain research and development operations in Canada, Australia, Israel and Russia, and continue to expand our international sales activities as part of our business strategy. As a result, we face increasing risks from our international operations, including, among others:

•

difficulties in staffing and managing foreign operations;

•

longer payment cycles;

•

seasonal reductions in business activity in Europe;

•

increased financial accounting and reporting burdens and complexities;

•

potentially adverse tax consequences;

•

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

•

delays in localizing our products;

•

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

•

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

•

licenses, tariffs and other trade barriers.

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

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

We have in the past made and we expect to continue to make acquisitions of complementary companies, products or technologies, including our recent acquisition of Aelita. Any additional acquisitions will require us to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may subject us to liabilities and risks that are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert management’s attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. We may have to use cash, incur debt or issue equity securities to pay for any future acquisitions. Use of cash or debt may affect our liquidity and use of cash would reduce our cash reserves. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for intangible assets with indefinite useful lives. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of an acquisition.

We face risks associated with governmental contracting

We derive a portion of our revenues from contracts with the United States government and its agencies and from contracts with state and local governments or agencies. Demand and payment for our products and services are impacted by public sector budgetary cycles and funding availability, with funding reductions or delays adversely impacting public sector demand for our products and services. Public sector customers may also change the way they procure new contracts and may adopt new rules or regulations governing contract procurement, including required competitive bidding or use of “open source” products, where available. These factors may limit the growth of or reduce the amount of revenues we derive from the public sector, which could negatively affect our results of operations.

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

We are focused on increasing our operating margins. These efforts place a strain on our management, administrative, operational and financial infrastructure. Our ability to manage our operations while reducing operating costs requires us to continue to improve our operational, financial and management controls and reporting systems and procedures. Although we achieved a year over year increase in our margins from the third quarter of 2003 to the comparable quarter in 2004, there can be no guarantees that we will be successful in achieving our profitability targets in any future quarterly or annual period.

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

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

Our operating results may be affected if we are required to change our accounting for employee stock options

We currently account for the issuance of stock options under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB No. 25, no compensation expense is recognized for options granted to employees where the exercise price equals the market price of the underlying stock on the date of grant. Certain proposals related to treating the grant of an employee stock option as an expense are currently under consideration by accounting standards organizations and governmental authorities. If such proposals are adopted and we are required to change the way we account for stock options, our operating results could be negatively impacted as a result of the additional expenses associated with stock options. See Note 2 of the “Notes to Condensed Consolidated Financial Statements” for a more detailed presentation of our accounting for stock-based compensation plans.

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

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

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

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

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any such resulting litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management and financial resources, which could harm our business.

Our means of protecting our proprietary rights may prove to be inadequate and competitors may independently develop similar or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will

prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services.

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

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

An unfavorable outcome in our litigation with Computer Associates International, Inc. could negatively impact our business, financial condition and results of operations

In July 2002, Computer Associates International, Inc. (“CA”) initiated a lawsuit against us and certain of our employees alleging copyright infringement and trade secret misappropriation in connection with the development of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. In July 2004, the court entered an order enjoining our use, marketing, licensing or distribution of Quest Central for DB2, pending trial, based upon its determination that CA is likely to prove its claims of copyright infringement or trade secret misappropriation. In addition to the interruption of business and diversion of management’s attention caused by this injunction, our continuing defense of this lawsuit will be time-consuming for our senior management and is likely to result in significant litigation costs regardless of the outcome. An unfavorable outcome to this lawsuit may impose monetary damages. We have established a loss contingency reserve in the amount of $5.0 million dollars, reflecting our current estimate of liability we may incur as a result of this litigation matter. However, litigation is uncertain and there can be no guarantee that this amount will be sufficient to cover our ultimate liability in this matter, if any. In addition, the uncertainty created by the injunction or the lawsuit may negatively affect our relationships with existing customers or give rise to customer claims for indemnification and may discourage prospective customers, particularly those using DB2 UDB among other major database platforms and seeking a heterogeneous database management solution, from licensing our software products.

Our business will suffer if our software contains errors

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

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

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loss of customers;

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damage to our reputation;

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failure to achieve market acceptance;

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diversion of development resources;

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increased service and warranty costs;

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

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increased insurance costs.

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

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

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

Natural disasters or power outages could disrupt our business

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

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

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

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

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

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achieving market acceptance for our new products and product enhancements.

Failure to attract and retain personnel may negatively impact our business

Our ability to manage the operation of our business and our future success depend on our ability to attract, motivate and retain qualified employees. In addition, the success of our business is substantially dependent on the services of our Chief Executive Officer and other officers and key employees, many whom have recently joined our company. As our business grows, we will need to hire

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

We have historically used stock-based compensation as an important tool to attract and retain employees, generally through stock options granted under our stock incentive plans and the availability of discounted shares for purchase under our Employee Stock Purchase Plan. Our Employee Stock Purchase Plan was terminated at the end of July 2004. The number of options available for grant under our stock incentive plans is limited and any future increase would require shareholder approval. There can be no guarantees that we will be able to obtain shareholder approval for required future increases in the number of shares authorized under our stock incentive plans. In addition, if we are required to change the way we account for stock options as a result of proposed changes in accounting rules, we may reduce our reliance on the use of stock options, which may negatively affect our ability to recruit and retain qualified personnel.

Item 3: Quantitative and Qualitative Disclosures About Market Risks

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

Our exposure to foreign exchange risk is related to the magnitude of foreign net profits and losses denominated in currencies other than the U.S. Dollar, as well as our net position of monetary assets and monetary liabilities in non-U.S. Dollar currencies. These exposures have the potential to produce either gains or losses within our consolidated results. Our cumulative currency gains or losses in any given period may be lessened by the economic benefits of diversification.

The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for speculative trading purposes. We regularly monitor the potential cost and benefits of hedging foreign exchange exposures with derivatives and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.

Interest Rate Risk

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

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


	Amortized Book Value		Weighted Average Rate
Investments maturing by September 30,
2005 (a)	$	70,439	2.19	%
2006		58,363	2.78	%
2007		20,000	2.95	%
2008		35,132	4.51	%
Thereafter		13,489	4.57	%

Total portfolio	$	197,423	3.02	%

(a)	Includes cash and cash equivalents of $14.4 million.

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

Item 4: Controls and Procedures

Our management, with the participation of the chief executive officer and chief financial officer, has performed an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934). Based on such evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2004, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosure.

No changes in our internal control over financial reporting have come to our management’s attention that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II—OTHER INFORMATION

Item 1: Legal Proceedings

Item 6: Exhibits


Exhibit Number		Exhibit Title
10.1		Form of Stock Option agreement used under the Quest Software, Inc. 1999 Stock Incentive Plan.

31.1		Certification of the Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

31.2		Certification of the Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.

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

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

SIGNATURES

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


		QUEST SOFTWARE, INC.

Date: November 9, 2004		/s/ M. BRINKLEY MORSE
		M. Brinkley Morse Vice President, Finance and Operations and Chief Financial Officer

		/s/ KEVIN E. BROOKS
		Kevin E. Brooks Vice President and Corporate Controller

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