VERITY INC \DE\ - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended February 28, 2005

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

For the transition period from to

Commission File Number: 0-26880

VERITY, INC.

(Exact name of registrant as specified in its charter)

Delaware

77-0182779

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

894 Ross Drive

Sunnyvale, California 94089

(408) 541-1500

(Address, including zip code, and telephone number, including area code of principal executive offices)

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

Indicate by check mark whether 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, $0.001 par value, was 37,591,866 of March 31, 2005.

VERITY, INC.

FORM 10-Q

TABLE OF CONTENTS


		Page
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements	3

	Condensed Consolidated Balance Sheets — As of February 28, 2005 and May 31, 2004	3

	Condensed Consolidated Statements of Operations — For the Three Month Periods Ended February 28, 2005 and February 29, 2004, and the Nine Month Periods Ended February 28, 2005 and February 29, 2004	4

	Condensed Consolidated Statements of Cash Flows — For the Nine Month Periods Ended February 28, 2005 and February 29, 2004	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	34

Item 4.	Controls and Procedures	35

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	36

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	36

Item 3.	Defaults upon Senior Securities	36

Item 4.	Submission of Matters to a Vote of Security Holders	36

Item 5.	Other Information	36

Item 6.	Exhibits	36

Signature		37

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

VERITY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

( In thousands, except per share data, unaudited)


	February 28,			May 31,
	2005			2004
ASSETS
Current assets:
Cash and cash equivalents	$	40,502		$	38,995
Short-term investments		85,976			78,506
Trade accounts receivable, net of allowance for doubtful accounts of $1,477 and $2,131		30,890			31,807
Deferred tax assets		2,697			2,482
Prepaid and other assets		4,693			3,197

Total current assets		164,758			154,987

Property and equipment, net		6,634			4,272
Long-term investments		75,715			84,248
Deferred tax assets		14,053			17,884
Intangible assets, net		24,458			24,854
Goodwill		59,658			55,824
Other assets		2,799			2,012

Total assets	$	348,075		$	344,081

LIABILITIES
Current liabilities:
Accounts payable	$	2,782		$	2,855
Accrued compensation		11,056			10,086
Income tax payable		5,625			4,214
Deferred purchase payment		570			3,066
Other accrued liabilities		7,116			5,043
Deferred revenue		22,827			21,421

Total current liabilities		49,976			46,685

Non-current liabilities:
Deferred purchase payment		—			570

Total liabilities		49,976			47,255

STOCKHOLDERS’ EQUITY
Preferred stock, $0.001 par value:
Authorized: 2,000 shares
Issued and outstanding: none
Common stock, $0.001 par value:
Authorized: 200,000 shares; issued and outstanding: 37,318 shares as of February 28, 2005 and 37,280 shares as of May 31, 2004		37			37
Additional paid-in capital		253,066			259,245
Accumulated other comprehensive income		2,346			2,249
Deferred stock compensation		(74	)		(88	)
Retained earnings		42,724			35,383

Total stockholders’ equity		298,099			296,826

Total liablities and stockholders’ equity	$	348,075		$	344,081

VERITY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data, unaudited)


	Three Months Ended					Nine Months Ended
	February 28, 2005			February 29, 2004		February 28, 2005		February 29, 2004
Revenues:
Software products	$	18,759		$	17,795	$	60,554	$	48,199
Service and other		15,177			12,746		45,640		37,843

Total revenues	$	33,936		$	30,541	$	106,194	$	86,042

Costs of revenues:
Software products		682			368		2,266		1,135
Service and other		5,048			3,260		15,097		9,936
Amortization of purchased intangible assets		1,936			645		5,315		1,935

Total costs of revenues		7,666			4,273		22,678		13,006

Gross profit		26,270			26,268		83,516		73,036

Operating expenses:
Research and development		6,020			4,346		17,560		14,581
Marketing and sales		14,919			12,109		44,854		35,928
General and administrative		4,475			2,451		12,321		8,051
In-process research and development		950			—		950		—
Restructuring charges		—			—		377		972

Total operating expenses		26,364			18,906		76,062		59,532

Income (loss) from operations		(94	)		7,362		7,454		13,504

Other income, net		953			564		3,595		3,520

Income before provision for income taxes		859			7,926		11,049		17,024
Provision for income taxes		393			3,170		3,708		6,810

Net income	$	466		$	4,756	$	7,341	$	10,214

Net income per share — basic	$	0.01		$	0.13	$	0.20	$	0.27

Net income per share — diluted	$	0.01		$	0.12	$	0.19	$	0.26

Number of shares — basic		37,443			37,942		37,381		37,675

Number of shares — diluted		38,365			40,568		38,391		39,902

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

VERITY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands, unaudited)


	Nine Months Ended
	February 28, 2005			February 29, 2004
Cash flow from operating activities:
Net income	$	7,341		$	10,214
Adjustment to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		7,496			4,504
Allowance for doubtful accounts		(229	)		(86	)
Deferred income taxes		1,570			751
Amortization of premium on securities, net		544			704
Amortization of deferred stock-based compensation		14			—
Write-off of in-process research and development		950			—
Changes in operating assets and liabilities:
Trade accounts receivable		2,627			301
Prepaid and other assets		(2,246	)		(1,049	)
Accounts payable		(96	)		7
Accrued compensation		708			888
Other accrued liabilities		3,887			563
Restructuring obligations		(41	)		57
Deferred revenue		840			(331	)

Net cash provided by operating activities		23,365			16,523

Cash flows from investing activities:
Acquisition of property and equipment		(4,440	)		(1,346	)
Purchases of marketable securities		(164,930	)		(543,550	)
Maturity of marketable securities		49,104			246,017
Proceeds from sale of marketable securities		116,040			322,420
Cash paid for purchase of business		(11,150	)		—

Net cash provided by (used) in investing activities		(15,376	)		23,541

Cash flows from financing activities:
Proceeds from the sale of common stock, net of issuance costs		17,111			20,843
Repurchases of common stock		(23,755	)		(17,005	)

Net cash provided (used) in financing activities		(6,644	)		3,838
Effect of exchange rate changes on cash		162			687

Net increase in cash and cash equivalents		1,507			44,589

Cash and cash equivalents-beginning of period		38,995			25,487

Cash and cash equivalents-end of period	$	40,502		$	70,076

Supplemental disclosures of cash flow information:
Cash paid for interest	$	68		$	6

Cash paid (refund received) for income taxes	$	(323	)	$	1,278

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

VERITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Information as of February 28, 2005 and for the three and nine months ended February 28, 2005 and the three and nine months ended February 28, 2004 is unaudited)

1. Interim Financial Data

The unaudited condensed consolidated financial statements for Verity, Inc. (the “Company” or “Verity”) as of February 28, 2005 and May 31, 2004 and for the three and nine month periods ended February 28, 2005 and 2004 have been prepared on the same basis as the Company’s audited financial statements and, in the opinion of management, include all material adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the financial position and results of operations in accordance with generally accepted accounting principles. Although certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission, the Company believes the disclosures made are adequate to make the information presented not misleading. The accompanying financial statements should be read in conjunction with the Company’s annual financial statements contained in the Company’s Annual Report on Form 10-K for the year ended May 31, 2004.

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

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

The Company’s condensed consolidated balance sheet as of May 31, 2004 was derived from the Company’s audited financial statements, but does not include all disclosures necessary for the presentation to be in accordance with generally accepted accounting principles.

Reclassifications

Certain prior period balances have been reclassified to conform to the current period presentation. The Company reclassified auction rate securities of $53.3 million as of May 31, 2004 from cash and cash equivalents to short-term investments on its consolidated balance sheet. The Company has reclassified the purchases and sales of these auction rate securities in its consolidated statements of cash flows, which decreased cash flows from investing activities by $54.3 million for the nine-months ended February 29, 2004. The following table summarizes the impact of the auction rate securities reclassification for the last three quarters (in thousands, unaudited):


	Pre-reclassification						Post-reclassification
	Cash & Cash Equivalents		Short-term Investments		Total		Cash & Cash Equivalents		Short-term Investments		Total
May 31, 2004	$	92,245	$	25,256	$	117,501	$	38,995	$	78,506	$	117,501
August 31, 2004		75,862		31,347		107,209		41,212		65,997		107,209
November 30, 2004		76,207		52,573		128,780		46,707		82,073		128,780

In addition, the Company reclassified certain prepaid and other asset as reported on the condensed consolidated balance sheet as of May 31, 2004 to conform to the current year presentation as capitalized software development costs included in other assets. The following table summarizes the impact of the capitalized software development reclassification for the last three quarters (in thousands, unaudited):


	Pre-reclassification						Post-reclassification
	Prepaid and Other assets		Other Assets		Total		Prepaid and Other assets		Other Assets		Total
May 31, 2004	$	4,636	$	573	$	5,209	$	3,197	$	2,012	$	5,209
August 31, 2004		4,475		573		5,048		3,162		1,886		5,048
November 30, 2004		6,396		573		6,969		4,770		2,199		6,969

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

Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common and potential common shares outstanding during the period. Dilutive potential common shares consist of “in-the-money” stock options. “In-the-money” options are those for which the exercise price is lower than the average market price of the Company’s common stock during the period. For the three months ended February 28, 2005 and February 29, 2004, 14,595,122 and 7,358,512 anti-dilutive weighted potential shares have been excluded from the diluted net income per share calculation. For the nine months ended February 28, 2005 and February 29, 2004, 14,661,127 and 9,300,186 anti-dilutive weighted potential shares have been excluded from the diluted net income per share calculation.

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

Generally accepted accounting principles require companies that choose to account for stock option grants using the intrinsic value method also to determine the fair value of option grants using a stock option pricing model such as the Black-Scholes model and to disclose the impact of fair value accounting in a note to the financial statements. The impact of recognizing the fair value of option grants and stock grants under the Company’s employee stock option and stock purchase plans as an operating expense would have reduced the Company’s net income to a net loss, as follows (in thousands, except per share amounts):


	Three Months Ended						Nine Months Ended
	February 28, 2005			February 29, 2004			February 28, 2005			February 29, 2004
Net income
Net income — as reported	$	466		$	4,756		$	7,341		$	10,214

Deduct: Total SFAS 123 stock-based employee compensation expense, net of related tax effects		(3,510	)		(11,259	)		(12,984	)		(38,593	)

Add: Stock compensation expense included in reported net income, net of related tax effects		2			—			14			—

Net loss — pro forma	$	(3,042	)	$	(6,503	)	$	(5,629	)	$	(28,379	)

Earnings per share
Net income per share — basic — as reported	$	0.01		$	0.13		$	0.20		$	0.27

Net loss per share — basic — pro forma	$	(0.08	)	$	(0.17	)	$	(0.15	)	$	(0.75	)

Net income per share — diluted — as reported	$	0.01		$	0.12		$	0.19		$	0.26

Net loss per share — diluted — pro forma	$	(0.08	)	$	(0.17	)	$	(0.15	)	$	(0.75	)

Number of shares used in basic — as reported calculation		37,443			37,942			37,381			37,675

Number of shares used in diluted— as reported calculation		38,365			40,568			38,391			39,902

Number of shares used in basic and diluted — pro forma calculation		37,443			37,942			37,381			37,675

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


	Three Months Ended				Nine Months Ended
	February 28, 2005		February 29, 2004		February 28, 2005		February 29, 2004
Stock Option Plans
Expected volatility	69	%	84	%	76	%	89	%
Risk-free interest rate	3.51	%	2.85	%	3.24	%	2.11	%
Expected life	4.11 years		4.09 years		4.09 years		4.06 years


	Three Months Ended				Nine Months Ended
	February 28, 2005		February 29, 2004		February 28, 2005		February 29, 2004
Expected dividend yield	0.00	%	0.00	%	0.00	%	0.00	%

Stock Purchase Plan
Expected volatility	39	%	70	%	49	%	76	%
Risk-free interest rate	1.95	%	1.14	%	1.60	%	1.38	%
Expected life	0.76 year		1.00 year		0.81 year		1.00 year
Expected dividend yield	0.00	%	0.00	%	0.00	%	0.00	%

In December 2004, the FASB issued SFAS No. 123 ( Revised 2004) “Share-Based Payment” (“SFAS 123R”), which requires public companies to comply as of the first interim or annual reporting period beginning after June 15, 2005. In the second quarter of the Company’s fiscal year 2006, the Company will then be required to record compensation expense for all forms of share-based payment awards using the fair value method.

3. Investments

The Company maintains investment portfolio holdings of various issuers, types and maturities. These investments consist of corporate obligations that include corporate notes, market auction securities and United States and other government agency securities. These securities are classified as “available-for-sale” and are carried at fair value based on quoted market prices. These securities are subject to interest rate risk and will decline in value if market interest rates increase. Consequently, they are recorded on the consolidated balance sheet at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income in stockholders’ equity.

These securities are not leveraged and are held for purposes other than trading. Additionally, the Company has the ability to hold these investments until maturity and, therefore, the Company would not expect to recognize an adverse impact on income or cash flows. The Company recorded no impairment losses for the three and nine months ended February 28, 2005.

As of February 28, 2005, available-for-sale securities consist of the following (in thousands):


	Amortized Cost		Net Unrealized Losses			Fair Value
Short-term investments:
Market auction securities	$	71,350	$	—		$	71,350
Municipal securities		1,375		(15	)		1,360
Corporate notes		4,833		(22	)		4,811
Government securities		8,500		(45	)		8,455

Short-term investments		86,058		(82	)		85,976

Long-term investments:
Municipal securities		1,000		(26	)		974
Corporate notes		8,337		(122	)		8,215
Government securities		67,512		(986	)		66,526

Long-term investments		76,849		(1,134	)		75,715

Total investments	$	162,907	$	(1,216	)	$	161,691

At February 28, 2005, scheduled maturities of investments classified as available-for-sale are as follows (in thousands):


Within one year	$	30,126
After one year through two years		56,941
After two years through three years		25,024
After three years		49,600

	$	161,691

As of May 31, 2004, available-for-sale securities consist of the following (in thousands):


	Amortized Cost		Net Unrealized Gains (Losses)			Fair Value
Short-term investments:
Market auction securities	$	58,250	$	—		$	58,250
Corporate notes		13,729		40			13,769
Government securities		6,500		(13	)		6,487

Short-term investments		78,479		27			78,506

Long-term investments:
Municipal securities		2,375		(36	)		2,339
Corporate notes		6,122		(64	)		6,058
Government securities		76,506		(655	)		75,851

Long-term investments		85,003		(755	)		84,248

Total investments	$	163,482	$	(728	)	$	162,754

At May 31, 2004, scheduled maturities of investments classified as available-for-sale are as follows (in thousands):


Within one year	$	20,256
After one year through two years		37,177
After two years through three years		49,071
After three years		56,250

	$	162,754

4. Deferred Purchase Payment

On December 17, 2002, the Company completed the purchase of certain assets and obligations of Inktomi Corporation’s enterprise search software business. Of the total purchase price, the Company deferred $3.0 million in order to secure Inktomi’s indemnification obligations under the Purchase Agreement. On June 17, 2004, the Company made the obligated payment to Inktomi/Yahoo! of approximately $3.1 million representing the sum of (i) $3.0 million plus (ii) $0.06 million in simple interest thereon calculated from December 17, 2002 through the date of payment at an annual rate of 1.5%.

On March 3, 2004, the Company completed the NativeMinds strategic asset purchase for $3.9 million. Of the total purchase, the Company deferred $0.8 million to secure NativeMinds’ indemnification obligations under the Purchase Agreement. The Company paid $0.2 million of this deferred payment obligation in the fourth quarter of fiscal 2004 and believes that NativeMinds will meet the remaining indemnification obligations under the agreement and the Company will be obligated to pay the remaining $0.6 million in September of 2005.

As of February 28, 2005, the remaining deferred purchased payment was categorized as a short-term liability as the payment was due less than twelve months from this date.

5. Comprehensive Income

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


	February 28, 2005			February 29, 2004		February 28, 2005			February 29, 2004
	February 28, 2005			February 29, 2004		February 28, 2005			February 29, 2004
Net Income	$	466		$	4,756	$	7,341		$	10,214
Foreign currency translation gain (loss)		(129	)		384		401			612
Unrealized gain (loss) on available-for-sale investments, net of taxes		(219	)		168		(304	)		(761	)

Comprehensive income	$	118		$	5,308	$	7,438		$	10,065

6. Business Segment

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

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


	Three Months Ended				Nine Months Ended
	February 28 2005		February 29 2004		February 28 2005		February 29 2004
	February 28 2005		February 29 2004		February 28 2005		February 29 2004
Revenues:
USA	$	21,627	$	19,138	$	71,057	$	56,267
United Kingdom		2,585		4,096		8,864		9,783
Other Europe		6,428		4,947		18,212		13,160
ROW		3,296		2,360		8,061		6,832

Consolidated	$	33,936	$	30,541	$	106,194	$	86,042

Long-lived assets of geographic areas are those assets used in the Company’s operations in each area and exclude financial instruments and deferred tax assets. (in thousands):


	February 28, 2005
Long-lived assets:
USA	$	92,298
United Kingdom		276
Other Europe		294
Canada		663
ROW		18

Consolidated	$	93,549

Total revenues outside the U.S., which are summarized in the following table, consist of export sales (shipped from the U.S. to non-U.S. locations) and sales derived from the Company’s foreign operations. (in thousands):


	Three Months Ended				Nine Months Ended
	February 28 2005		February 29 2004		February 28 2005		February 29 2004
	February 28 2005		February 29 2004		February 28 2005		February 29 2004
Revenues outside the US:
Export	$	7,408	$	6,536	$	20,441	$	16,162
Foreign Operations		4,901		4,867		14,696		13,613

Total	$	12,309	$	11,403	$	35,137	$	29,775

No single customer accounted for more than 10% of the Company’s total revenues for the three and nine periods ended February 28, 2005 and February 29, 2004. The percentage of total revenues derived from sales to the United States federal and state governments and their agencies were:


	Three Months Ended				Nine Months Ended
	February 28 2005		February 29 2004		February 28 2005		February 29 2004
	February 28 2005		February 29 2004		February 28 2005		February 29 2004
Percentage of total revenues	9.4	%	8.7	%	9.9	%	10.0	%

7. Stock Repurchase Program

In June 2003, the Company announced a stock repurchase program of up to $50 million to repurchase shares of its common stock during its fiscal year ended May 31, 2004. On June 22, 2004, the Company’s Board of Directors approved a new stock repurchase program authorizing the repurchase of up to $50 million of common stock in fiscal 2005. The Company repurchased and retired 653,896 shares, valued at approximately $7.9 million in the three month period ended February 28, 2005. The Company repurchased and retired 1,884,587 and 1,190,987 shares, valued at approximately $23.8 million and $17.0 million in the nine month periods ended February 28, 2005 and February 29, 2004, respectively. The new program will terminate at the end of the fiscal year ending May 31, 2005 unless amended by the Board of Directors.

8. Restructuring Costs

During the three month period ended August 31, 2004, the Company incurred a facility restructuring charge of $0.1 million related to the closing of its UK Cardiff facility in July of 2004. The employees and operations of the Cardiff UK office were moved and consolidated into the Company’s existing facility in the UK. Additionally, during the three month period ended November 30, 2004, the Company incurred a facility restructuring charge of $0.3 million related to the consolidation and subletting of approximately 14,000 square feet in its San Diego facility formerly occupied by Cardiff. In the three month period ended February 28, 2005, there were no incremental restructuring charges.

The following table sets forth the components of the accrued restructuring charges included within the other accrued liabilities on the condensed consolidated Balance Sheet for the nine months ended February 28, 2005 (in thousands):


	Involuntary Termination			Facilities and other			Legal and outside services		Total
At May 31, 2004	$	259		$	103		$	—	$	362

Charges		—			98			—		98
Payments		—			(11	)		—		(11	)
At August 31, 2004		259			190			—		449

Charges		—			331			—		331
Payments		—			(77	)		—		(77	)
Adjustment		—			(52	)		—		(52	)
At November 30, 2004		259			392			—		651

Charges		—			—			—		—
Payments		(259	)		(71	)		—		(330	)
At February 28, 2005	$	—		$	321		$	—	$	321

The following tables sets forth the components of the accrued restructuring charges for the nine months ended February 29, 2004 (in thousands):


	Involuntary Termination			Facilities and other			Legal and outside services			Total
At May 31, 2003	$	50		$	163		$	—		$	213

Charges		—			—			—			—
Payments		(16	)		(13	)		—			(29	)
At August 31, 2003		34			150			—			184

Charges		906			—			66			972
Payments		(872	)		(13	)		(38	)		(923	)
Adjustments		(5	)		—			—			(5	)
At November 30, 2003		63			137			28			228

Charges		—			—			—			—
Payments		(17	)		(13	)		—			(30	)
Adjustments		(5	)		—			(28	)		(33	)
At February 29, 2004	$	41		$	124		$	—		$	165

9. Acquisitions, Goodwill and Other Intangible Assets

2005 Acquisitions

Acquisition of Dralasoft, Inc.

On December 16, 2004, the Company acquired Dralasoft, Inc., a privately held software company, headquartered in Colorado. Dralasoft is a leading innovator of Java-based technology for Business Process Management (BPM). The acquired technology portfolio originally named Dralasoft Workflow, re-branded Verity LiquidBPM, is a comprehensive enterprise BPM suite that features a high-performance and scalable orchestration engine with a suite of graphical tools. In addition, LiquidBPM is an embedded application found in many leading software products used in several vertical markets, such as manufacturing, government, retailing, telecommunications, defense, law, education, entertainment and agriculture.

The total purchase price for Dralasoft is as follows (in thousands):


Cash	$	8,214
Acquisition costs		133

Total purchase price	$	8,347

In accordance with SFAS No.141, “Business Combinations,” the Company accounted for the Dralasoft transaction as a purchase, and the total purchase consideration of approximately $8.3 million (including cash and acquisition costs) was allocated to net tangible and identifiable intangible assets based upon their estimated fair value as of the date of completion and the residual of $3.9 million was recorded as goodwill. The $8.3 million of total purchase consideration includes approximately $1.2 million paid to a third party escrow agent and to be paid to Dralasoft’s shareholders in installments over 18 months from the acquisition. The future payments are subject to no breaches of the representations and warranties set forth in the definitive merger agreement. The Company believes that it will not discover any breaches and therefore has recorded the entire $1.2 million as purchase consideration.

The purchase price was allocated as follows (in thousands):


Identifiable intangible assets acquired (Useful life (years))
Developed technology (4)	$	4,030
Customer relationships (5)		890

Total amortizable intangible assets		4,920
In-process technology		950
Fair value of net tangible assets acquired		586
Deferred tax liability assumed		(2,022	)
Goodwill		3,913

Total purchase price (including transaction costs)	$	8,347

The following table presents details of these amortizable intangible assets as of February 28, 2005 (in thousands):


	Gross		Accumulated Amortization		Net
Developed technology	$	4,030	$	210	$	3,820
Customer relationships		890		37		853

Purchased intangible assets, net	$	4,920	$	247	$	4,673

The amount of the purchase price allocated to in process-research and development was based on established valuation techniques used in the high-technology and the computer software industry. The fair value assigned to the acquired in-process research and development was determined using the income approach, which discounts expected future cash flows to present value. The key assumptions used in the valuation include, among others, the expected completion date of the in-process projects identified as of the acquisition date, the estimated costs to complete the projects, revenue contributions and expense projections assuming the resulting product have entered the market, and the discount rate based on the risks associated with the development life cycle of the in-process technology acquired. The discount rate used in the present value calculations are normally obtained from a weighted-average cost of capital analysis, adjusted upward to account for the inherent uncertainties surrounding the successful development of the in-process research and development, the expected profitability levels of such technology, and the uncertainty of technological advances that

could potentially impact the estimates. The Company assumes the pricing model for the resulting product of the acquired in process research and technology to be standard within its industry. The Company, however, did not take into consideration any consequential amount of expense reductions from integrating the acquired in-process technology with other existing in-process or completed technology. Therefore, the valuation assumptions do not include significant anticipated cost savings.

The key assumptions underlying the valuation of acquired in-process research and development from Dralasoft are as follows (in thousands):


IPR&D Product	Leverage Factor		Discount Rate		Expected Revenue
BPM	50	%	25	%	Q1 2006

Goodwill and Other Intangible Assets

In accordance with SFAS 142, the Company no longer amortizes goodwill but will test it for impairment annually or whenever events or changes in circumstances suggest that the carrying amount may not be recoverable. The Company prepared its annual impairment analysis during the quarter ended February 28, 2005, and concluded that no impairment had occurred.

The following table sets forth the carrying amount of goodwill (in thousands).


	Februray 28, 2005

Goodwill:
Beginning amount	$	55,824
Add: acquisitions		3,913
Less: adjustments		(79	)

Ending amount of goodwill	$	59,658

The following tables set forth the carrying amount of other intangible assets that will continue to be amortized (in thousands).


	February 28, 2005
	Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount
Developed Technology	$	30,498	$	9,270	$	21,228
Customer Base-Relationship		3,378		638		2,740
Tradename		644		154		490

Total other intangible assets	$	34,520	$	10,062	$	24,458


	May 31, 2004
	Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount
Developed Technology	$	26,468	$	4,578	$	21,890
Customer Base-Relationship		2,488		134		2,354
Tradename		644		34		610

Total other intangible assets	$	29,600	$	4,746	$	24,854

Total amortization expense of intangible assets related to acquisitions is set forth in the table below (in thousands):


	Three Months ended				Nine Months ended
	February 28, 2005		February 29, 2004		February 28, 2005		February 29, 2004
	February 28, 2005		February 29, 2004		February 28, 2005		February 29, 2004
Developed Technology	$	1,703	$	645	$	4,691	$	1,935
Customer Base-Relationship		193		—		503		—
Tradename		40		—		121		—

Total other intangible assets	$	1,936	$	645	$	5,315	$	1,935

The total expected future annual amortization of intangible assets related to acquisition is set forth in the table below (in thousands):



	Future Amortization
	Future Amortization
2005 (3 months)	$	1,986
2006		7,943
2007		7,943
2008		5,766
2009		724
2010		96

TOTAL	$	24,458

10. Legal Proceedings

On October 22, 2004, Inxight Software, Inc., a privately held company, filed a complaint in the Superior Court of California for the County of Santa Clara against the Company alleging, among other things, breach of contract and trade secret misappropriation, and that the Company had otherwise exceeded its rights under its license agreement with Inxight. Inxight is seeking, among other things, monetary damages of at least $1 million and injunctive relief commanding the Company to cease distributing Inxight’s product to the Company K2 product-line OEM customers.

On December 3, 2004, the Company filed an answer and cross-complaint against Inxight, in response to Inxight’s complaint that was filed on October 22. The Company’s answer and cross-complaint seek a declaration that the Company has acted within its rights under the license agreement, and that Inxight’s purported termination of the license subsequent to the filing of its complaint was invalid. In addition, the Company’s cross-claim alleges that Inxight itself has breached the license by purporting to terminate the parties’ license without cause, and that it has wrongfully interfered in the Company’s business operations, and that such breach and wrongful conduct has caused injury to the Company in excess of $1 million. The Company also alleges that Inxight wrongfully induced one of the Company’s former employees, who is now employed at Inxight, to breach certain confidentiality obligations related to confidential and proprietary information of the Company.

The Company believes that its legal positions are meritorious, and it intends to vigorously prosecute the litigation in order to confirm its rights. In addition, on November 29, 2004, the Company entered into license agreements with two software companies providing technology that is substantially similar to that provided by Inxight. Accordingly, the Company does not expect that this dispute with Inxight will have a material effect on its results of operations.

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

The following discussion should be read in conjunction with the consolidated financial statements and related notes, which appear in our Annual Report on Form 10-K for the fiscal year ended May 31, 2004. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly under the heading “Risks Relating to Our Operations” below.

Overview

We are a leading provider of intellectual capital management software that enables our customers to maximize their return on their information assets. The intellectual capital management software market is in great part the convergence of many core markets in which we have participated for years, including search, corporate portals, and e-commerce, as well as markets that we have recently entered, including question and answer interfaces, and content capture and process automation, among others.

We develop, market and support two product families: intelligent content services (which we refer to as “ICS”), and content capture and process automation. Intelligent content services are search, classification, recommendation, monitoring/alerting, and question and answer infrastructure products for corporate intranets, extranets, web sites, corporate portals, business applications, online publishers and e-commerce providers and original equipment manufacturer (“OEM”) toolkits for independent software vendors. Our comprehensive and integrated ICS product family enables numerous enterprise-wide functionalities, all from the same underlying Verity information index. Our ICS products organize and provide simple, single-point access to information across the entire enterprise. In doing so, our products can be used to create or enhance business portals and standalone applications that leverage the value of existing investments in intranets and business applications. Content capture and process automation applications enable the information on paper and electronic forms to be captured in electronic form, and for manual processes that utilize that information to be automated over corporate networks. Our content capture and process automation products include capabilities for forms design, scanning, optical character recognition, forms recognition, validation, verification, workflow and routing.

Our software has been licensed to over 11,500 corporations, government agencies, software developers, information publishers and e-commerce vendors. We pursue sales opportunities within corporations and government agencies through the efforts of our direct sales force and through a network of value added resellers and system integrators. We also sell OEM toolkits to independent software vendors that embed Verity technology in their products or services.

During our third fiscal quarter of 2005, we saw a decrease in demand for our products across all product lines as compared to fiscal Q2, 2005. We also witnessed an elongated purchase approval process on the part of our customers, particularly with respect to large transactions. We attribute this elongation to an uncertain economic environment, forcing prospects to carefully weigh purchases of software. In addition, more extensive purchase process procedures implemented by many of our customers, due in part to the documentation requirements of Section 404 of the Sarbanes-Oxley Act, tended to delay purchasing decisions. As a result of the uncertain general economic environment, we believe that the demand for our products will not grow as quickly as we had earlier anticipated, and therefore we expect our revenue growth will be flat to moderate for the foreseeable future.

Recent Acquisitions

Dralasoft Inc. On December 16, 2004, we acquired Dralasoft, Inc., a privately held software company and a leading innovator of Java-based technology for Business Process Management (BPM). The acquired technology portfolio originally named Dralasoft Workflow, re-branded Verity LiquidBPM, is a comprehensive enterprise BPM suite that features a high-performance and scalable orchestration engine with a suite of graphical tools. In addition, LiquidBPM is an embedded application found in many leading software products used in several vertical markets, such as manufacturing, government, retailing, telecommunications, defense, law, education, entertainment and agriculture.

In accordance with SFAS No. 141, “Business Combinations,” we accounted for the Dralasoft transaction as a purchase, and the total purchase consideration of approximately $8.3 million (including cash and acquisition costs) was allocated to net tangible and identifiable intangible assets based upon their estimated fair value as of the date of completion and the residual of $3.9 million was recorded as goodwill. The $8.3 million of total purchase consideration includes approximately $1.2 million was paid to a third party escrow agent and to be paid to Dralasoft’s shareholders in installments over 18 months from the acquisition. The future payments are subject to no breaches of the representations and warranties set forth in the definitive merger agreement. We believe that we will not discover any breaches and therefore have recorded the entire $1.2 million as purchase consideration.

Cardiff Software Inc. On March 15, 2004, we acquired Cardiff Software Inc., a privately held software company. Cardiff Software technology enables the automated capture of dynamic business information. Although the Cardiff Software corporate brand has been discontinued, we have retained the product names and rebranded them as Verity TeleForm^®, Verity LiquidOffice^{^™}, Verity LiquidCapture^{^™}, and Verity MediClaim. This acquisition further expanded our offerings with the content capture and process

automation product family. The acquired rebranded software is in use by companies and government organizations of all sizes. We are continuing development, support and maintenance of these products, and believe that the larger enterprises in the installed base represent an upgrade opportunity to our broader intellectual capital management solutions as their needs grow.

In accordance with SFAS No. 141, “Business Combinations,” we accounted for the Cardiff Software transaction as a purchase, and the total purchase consideration of approximately $65.6 million (including cash, deferred payments, stock options assumed and acquisition costs) was allocated to net tangible and identifiable intangible assets based upon their estimated fair value as of the date of completion of the acquisition and the residual of $38.4 million was recorded as goodwill. The $65.6 million of total purchase consideration, includes approximately $11.9 million placed into a third party escrow account to be paid to Cardiff Software’s shareholders in installments over 24 months from the acquisition. These future payments are subject to no breaches of the representations and warranties and covenants set forth in the definitive merger agreement. We believe that we will not discover any breaches and therefore the entire $11.9 million has been recorded as purchase consideration.

NativeMinds Inc. On March 3, 2004, we acquired the intellectual property, customer agreements and other selected strategic assets from NativeMinds Inc., a privately held software company and provider of integrated self-service solutions. The acquired technology portfolio originally named vRep, re-branded Verity Response, is an integrated set of tools designed to provide a single interface for internal and external customer inquiries through a natural language dialog. Verity Response includes technology that manages the interaction between a customer and a virtual representative and a set of reporting and analysis tools to help assess performance, identify content opportunities and gather valuable customer insight. We are continuing development and support of the products acquired and believe that the larger enterprises in the installed base represent an upgrade opportunity to our broader intellectual capital management solution as their needs grow.

In accordance with SFAS No.141, “Business Combinations,” we accounted for the NativeMinds transaction as a purchase, and the total purchase consideration of approximately $3.9 million (including cash, deferred payments, and acquisition costs) was allocated to net tangible and identifiable intangible assets based upon their estimated fair value as of the date of completion and the residual of $2.2 million was recorded as goodwill. The $3.9 million of total purchase consideration includes approximately $0.8 million to be paid to NativeMind’s shareholders in installments over 18 months from the acquisition. These future payments are subject to no breaches of the representations and warranties set forth in the definitive merger agreement. Of this $0.8 million, $0.6 million has been paid through the third fiscal quarter of 2005. We believe that we will not discover any breaches and therefore have recorded the entire $0.8 million as purchase consideration.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of assets and liabilities. On an on-going basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, bad debts, income taxes and intangible assets. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on form 10-K for the fiscal year ended May 31, 2004.

Results of Operations

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


	Three Months Ended				Nine Months Ended
	February 28, 2005		February 29, 2004		February 28, 2005		February 29, 2004
	(unaudited)				(unaudited)
Revenues:
Software products	55.3	%	58.3	%	57.0	%	56.0	%
Service and other	44.7		41.7		43.0		44.0

Total revenues	100.0		100.0		100.0		100.0

Costs of revenues:
Software products	2.0		1.2		2.1		1.3
Service and other	14.9		10.7		14.3		11.6
Amortization of purchased intangible assets	5.7		2.1		5.0		2.2

Total costs of revenues	22.6		14.0		21.4		15.1

Gross profit	77.4		86.0		78.6		84.9

Operating expenses:
Research and development	17.7		14.2		16.5		16.9
Marketing and sales	44.0		39.7		42.2		41.8
General and administrative	13.2		8.0		11.6		9.4
In-process research and development	2.8		—		0.9		—
Restructuring charges	—		—		0.4		1.1

Total operating expenses	77.7		61.9		71.6		69.2

Income (loss) from operations	(0.3	)	24.1		7.0		15.7
Other income, net	2.8		1.9		3.4		4.1
Income before provision for income taxes	2.5		26.0		10.4		19.8
Provision for income taxes	1.2		10.4		3.5		7.9

Net income	1.3	%	15.6	%	6.9	%	11.9	%

Quarters and Nine Months Ended February 28, 2005 and February 29, 2004

Prior period financials have been reclassified to conform to third fiscal quarter 2005 presentation.

Revenues


Total revenues	February 28, 2005		February 29, 2004		Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	33.9	$	30.5	$	3.4	11.1	%
Nine months ended:	$	106.2	$	86.0	$	20.2	23.5	%

The increases in total revenues for the three and nine month periods ended February 28, 2005, compared with the same periods a year ago, were a result of increases in both our software product revenues and our service and other revenues.

In practice, we most closely track and calculate our average selling prices only for those deals which total $40,000 or more in total deal size (product and services). The increase in total revenues in our third quarter and first nine months of fiscal 2005 as compared to the comparable periods a year ago was due to an increase in total number of customer transactions for deal sizes greater than $40,000. Our fiscal 2005 results include the addition of our suite of content capture products, which were derived from the purchase of Cardiff Software in March 2004 and, to a much lesser extent, the Verity Response product that was derived from the purchase of NativeMinds in March 2004 and to products derived from the purchase of Dralasoft in December 2004.

In our most recent quarter ended February 28, 2005 we saw a decrease in total revenues from our quarter ended November 30, 2004 resulting from both a decline in the total number of customer transactions for deal sizes greater than $40,000 and in the average selling prices of those transactions. Overall, we saw developments that indicated a more difficult economic environment. We expect volumes of transactions and total revenues to be flat to moderately up in our fourth quarter of fiscal 2005 as compared with our most recent quarter ended February 28, 2005. These expectations are based on assumptions we believe are reasonable, but actual results may differ from our expectations as a result of the risks set forth in “Risks Relating to Our Operations” at the end of this Item 2. of this form 10-Q.

Revenues derived outside of the U.S. accounted for 36.3% and 37.3% of total revenues for the three month periods ended February 28, 2005 and February 29, 2004, respectively. Revenues derived outside of the U.S. accounted for 33.1% and 34.6% of total revenues for the nine month periods ended February 28, 2005 and February 29, 2004, respectively. Our export sales consist of products licensed for delivery outside of the United States. In the three month periods ended February 28, 2005 and February 29, 2004, export sales accounted for 21.8% and 21.4% of total revenues, respectively. In the nine month periods ended February 28, 2005 and February 29, 2004, export sales accounted for 19.3% and 18.8% of total revenues, respectively.

No single customer accounted for 10% or more of our revenues during the three month and nine month periods ended February 28, 2005 and February 29, 2004. Revenues derived from sales to the federal government and its agencies were 9.4% and 8.7% of total revenues in the three month periods ended February 28, 2005 and February 29, 2004, respectively. Revenues derived from sales to the federal government and its agencies were 9.9% and 10.0% of total revenues in the nine month periods ended February 28, 2005 and February 29, 2004, respectively. We expect total revenues to government agencies will continue to fluctuate as a percentage of revenues in the future.


Software product revenues	February 28, 2005			February 29, 2004			Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	18.8		$	17.8		$	1.0	5.6	%
Percentage of total revenues:		55.3	%		58.3	%
Nine months ended:	$	60.6		$	48.2		$	12.4	25.7	%
Percentage of total revenues:		57.0	%		56.0	%

Our license revenues for our software products increased by $1.0 million for the fiscal quarter ended February 28, 2005 compared to the same period in the prior year. However, excluding the sales of our products which were acquired from Cardiff and Dralasoft and which did not form part of our license revenues in the third fiscal quarter of 2004, we witnessed a material decrease in license revenues in the third fiscal quarter of 2005 compared to the same period in 2004. Excluding these content capture products, we witnessed a moderate decrease in license revenues for the nine month period ended February 28, 2005 compared to the same period in the previous year. The decrease in the sales of our software products we experienced in our third fiscal quarter of 2005 was due, we believe, to the factors discussed above in “Overview.”

Software product revenues in the first nine months of fiscal 2004 included the recognition of past royalties in connection with our confidential settlement with BroadVision related to our outstanding litigation. This revenue accounted for less than 5% of total revenues in the period.


Service and other revenues	February 28, 2005			February 29, 2004			Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	15.2		$	12.7		$	2.5	18.9	%
Percentage of total revenues:		44.7	%		41.7	%
Nine months ended:	$	45.6		$	37.8		$	7.8	20.6	%
Percentage of total revenues:		43.0	%		44.0	%

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

The increase in service and other revenues for the three month period ended February 28, 2005, compared with the same period a year ago, was due to $1.7 million in increased maintenance revenues and to a $0.8 million increase in sales of consulting services. The increase in maintenance revenues resulted primarily from increased maintenance contracts entered into on new licensing agreements and renewals on a larger installed base. The increase in consulting service revenue is primarily due to the increased number of consulting engagements associated with the increased number of new license transactions.

The increase in service and other revenues for the nine month period ended February 28, 2005, compared with the same period a year ago, was due to $4.1 million in increased maintenance revenues and to a $3.7 million increase in sales of consulting and training services. The increase in maintenance revenues resulted primarily from increased maintenance contracts entered into on new licensing agreements and renewals on a larger installed base. The increase in consulting service revenue is primarily due to the increased number of consulting engagements associated with the increased number of new license transactions.

Costs of Revenues


Cost of software products	February 28, 2005			February 29, 2004			Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	0.7		$	0.4		$	0.3	75.0	%
Percentage of software product revenues:		3.7	%		2.1	%
Nine months ended:	$	2.3		$	1.1		$	1.2	109.1	%
Percentage of software product revenues:		3.8	%		2.4	%

Costs of software products consist primarily of product media, duplication, manuals, packaging materials, shipping expenses, employee compensation expenses, and in certain instances, the licensing of third-party software incorporated in our products. Also included in costs of software products, to a much lesser extent, is the cost of the hardware scanners which we began selling as a result of the acquisition of Cardiff Software beginning March 15, 2004.

The increase in costs of software products in absolute dollars and as a percentage of license revenue for the three and nine month periods ended February 28, 2005, as compared with the same period a year ago, was primarily attributable to increased third party royalties associated with the incremental sales of our content capture products which we had began selling in March of 2004 and to higher product costs associated with a higher volume of product sales.


Cost of service and other	February 28, 2005			February 29, 2004			Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	5.0		$	3.3		$	1.7	51.5	%
Percentage of service and other revenues:		33.3	%		25.6	%
Nine months ended:	$	15.1		$	9.9		$	5.2	52.5	%
Percentage of service and other revenues:		33.1	%		26.3	%

Costs of service and other consists of costs incurred in providing consulting services, customer training, telephone support and product upgrades to customers. Significant cost components include personnel-related and third-party contractor costs, facilities costs, travel expenses associated with training and consulting implementation services, depreciation expense and corporate overhead allocations.

The increase in costs of service and other in absolute dollars for the three month period ended February 28, 2005, as compared with the same period a year ago, was primarily due to a $1.5 million increase in cost of professional services driven by increased headcount and contractor costs to support increased volumes of professional service engagements, and to a lesser extent, to a $0.3 million increase in support costs primarily as a result of increased headcount required to support our content capture products.

The increase in costs of service and other in absolute dollars for the nine month period ended February 28, 2005, as compared with the same period a year ago, was due to a $4.4 million increase in cost of professional services driven by increased headcount and contractor costs to support increased volumes of professional service engagements, and to a lesser extent, a $0.8 million increase in support costs primarily as a result of increased headcount required to support our content capture products.


Amortization of purchased intangible assets	February 28, 2005			February 29, 2004			Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	1.9		$	0.6		$	1.3	216.7	%
Percentage of total revenues:		5.7	%		2.1	%
Nine months ended:	$	5.3		$	1.9		$	3.4	178.9	%
Percentage of total revenues:		5.0	%		2.2	%

During each of our first and second fiscal quarters of 2005, we amortized $1.7 million of the purchased intangible assets in connection with acquired developed technology, patents, customer relationships, tradenames, and maintenance agreements associated with all previous acquisitions, except Dralasoft, which closed in December of 2004. During our third fiscal quarter of 2005, we amortized $1.9 million of the purchased intangible assets in connection with acquired developed technology, patents, customer relationships, tradenames, and maintenance agreements associated with all previous acquisitions, including Dralasoft. The increase in amortization of purchased intangible assets in the first and second fiscal quarters of 2005 as compared to the first and second fiscal quarters of 2004 was attributable to $1.1 million increased quarterly amortization of purchased intangible assets associated with our Cardiff and NativeMinds acquisitions which we completed in March of 2004. The increase in amortization of purchased intangible assets in the third fiscal quarter of 2005 as compared to the third fiscal quarter of 2004 was attributable to $1.3 million increased quarterly amortization of purchased intangible assets associated with our Cardiff, NativeMinds and Dralasoft acquisitions, scheduled amortization of purchased intangible assets from this acquisitions is discussed in Note 9 “Acquisitions, Goodwill and Other Intangible Assets” to the unaudited Consolidated Financial Statements included in this report.

Operating Expenses


Research and development	February 28, 2005			February 29, 2004			Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	6.0		$	4.3		$	1.7	39.5	%
Percentage of total revenues:		17.7	%		14.2	%
Nine months ended:	$	17.6		$	14.6		$	3.0	20.5	%
Percentage of total revenues:		16.5	%		16.9	%

Research and development expenses consist primarily of employee compensation and benefits, payments to outside contractors, depreciation on equipment used for development and corporate overhead allocations. We believe that research and development is essential to maintaining our competitive position and we will continue to make significant investments in research and development with the goal of continuing to align research and development expenses with anticipated revenues.

The increase in research and development expenses in absolute dollars from the third fiscal quarter of 2004 to the third fiscal quarter of 2005 was primarily due to $1.3 million in increased compensation and other employee related expenses on increased headcount, resulting primarily from our acquisitions of Cardiff, NativeMinds and Dralasoft, and $0.4 million in increased allocations for both MIS and facilities resulting from an increased share of these shared services based on the increased headcount.

The increase in research and development expenses in absolute dollars for the nine month period ended February 28, 2005, compared with the same period in the prior year was primarily due to $2.4 million in increased compensation and other employee related expenses on increased headcount, resulting primarily from our acquisitions of Cardiff, NativeMinds and Dralasoft, and $1.1 million in increased allocations for both MIS and facilities resulting from an increased share of these shared services based on the increased headcount. These increases were partially offset by reductions in contracted outside services of $0.3 million due to a decrease in overall consulting services used by the Company, due to normal variance in our use of outside contracting services.


Marketing and sales	February 28, 2005			February 29, 2004			Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	14.9		$	12.1		$	2.8	23.1	%
Percentage of total revenues:		44.0	%		39.7	%
Nine months ended:	$	44.9		$	35.9		$	9.0	25.1	%
Percentage of total revenues:		42.2	%		41.8	%

Marketing and sales expenses consist primarily of employee compensation, including sales commissions and benefits, tradeshows, outbound marketing and other lead generation activities, public relations, travel expenses associated with our sales staff and corporate overhead allocations. We anticipate that marketing and sales expenses will increase in our fourth fiscal quarter as a result of increased commission expense on higher total revenues and higher lead generation activities necessary to support our increased revenue projection.

The increase in marketing and sales expense in absolute dollars from the third fiscal quarter of 2004 to the third fiscal quarter of 2005 was primarily due to $2.2 million in increased compensation and other employee related expenses on increased headcount, resulting primarily from our acquisitions of Cardiff, NativeMinds and Dralasoft. The increase in headcount and product lines also caused an increase of $0.3 million in increased lead generation and advertising expenses, and $0.3 million in increased allocations for both MIS and facilities resulting from an increased share of these shared services.

The increase in marketing and sales expense in absolute dollars for the nine month period ended February 28, 2005, compared with the same period in the prior year, was primarily due to $5.8 million in increased compensation and other employee related expenses on increased headcount, resulting primarily from our acquisitions of Cardiff, NativeMinds and Dralasoft, $1.7 million in increased sales commissions resulting from higher total revenues, $0.9 million in increased allocations for both MIS and facilities resulting from an increased share of these shared services based on the increased headcount, and an increase of $0.3 million in lead generation and advertising expense due to an increase in product lines and number of marketing events.


General and administrative	February 28, 2005			February 29, 2004			Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	4.5		$	2.5		$	2.0	80.0	%
Percentage of total revenues:		13.2	%		8.0	%
Nine months ended:	$	12.3		$	8.1		$	4.2	51.9	%
Percentage of total revenues:		11.6	%		9.4	%

General and administrative expenses consist primarily of personnel costs for finance, legal, human resources and general management, provisions for doubtful accounts, insurance, fees for external professional advisors and corporate overhead allocations.

The increase in general and administrative expenses in absolute dollars from the third fiscal quarter of 2004 to the third fiscal quarter of 2005 was primarily due to a $0.9 million increase in compensation and other employee related expenses associated with increased headcount resulting from our acquisitions, a $0.4 million increase in outside services and legal fees primarily to support the Sarbanes Oxley project and merger and acquisition related activity, and a $0.3 million increase in audit and tax costs primarily due to the need to support growing and more complex infrastructure.

The increase in general and administrative expenses in absolute dollars for the nine month period ended February 28, 2005, compared with the same period in the prior year, was primarily due to a $2.1 million increase in compensation and other employee related expenses associated with increased headcount to support a growing and more complex infrastructure, a $1.3 million increase in outside services and legal fees primarily to support the Sarbanes Oxley project and merger and acquisition related activity, and a $0.6 million increase in audit and tax costs primarily due to more complexity resulting from our acquisitions.


In-process research and development	February 28, 2005			February 29, 2004	Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	1.0		$0.0	$	1.0	nm
Percentage of total revenues:		2.8	%	0.0%
Nine months ended:	$	1.0		$0.0	$	1.0	nm
Percentage of total revenues:		0.9	%	0.0%

The total in-process research and development expense of $1.0 million for the quarter ended February 28, 2005, was attributable solely to the Dralasoft purchase. The methodology for allocating the purchase price to in-process research and development is determined through established valuation techniques as outlined in the In-Process R&D Practice Aid published by the American Institute of Certified Public Accountants, Inc. (“AICPA”), as more fully discussed in Note 9 “Acquisitions, Goodwill and Other Intangible Assets” to the Consolidated Financial Statements included in this report.

The key assumptions underlying the valuations for our acquisitions primarily consisted of an expected completion date for the in-process research and development projects, estimated costs to complete these projects, revenue and expense projections assuming the products have entered the market, and discount rates based on the risks associated with the stage of completion of the in-process technology acquired.


Restructuring charge	February 28, 2005			February 29, 2004			Dollar Change			Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	0.0		$	0.0		$	0.0		nm
Percentage of total revenues:		0.0	%		0.0	%
Nine months ended:	$	0.4		$	1.0		$	(0.6	)	(60.0	)%
Percentage of total revenues:		0.4	%		1.1	%

During the three months periods ended August 31, 2004, we incurred a facility restructuring charge of $0.1 million related to the closing of our UK Cardiff facility in July of 2004. The employees and operations of the Cardiff UK office were moved and consolidated into our existing Verity facility in the UK. Additionally, during the three month period ended November 30, 2004, we incurred a facility restructuring charge of $0.3 million related to the consolidation and subletting of approximately 14,000 square feet in our San Diego facility formerly occupied by Cardiff.

The $1.0 million restructuring charge incurred in the nine month period ended February 29, 2004, related to efforts designed to reduce costs and better align our expense levels with revenue levels during a period of economic uncertainty.


Other income, net	February 28, 2005			February 29, 2004			Dollar Change		Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	1.0		$	0.6		$	0.4	66.7	%
Percentage of total revenues:		2.8	%		1.9	%
Nine months ended:	$	3.6		$	3.5		$	0.1	2.9	%
Percentage of total revenues:		3.4	%		4.1	%

Other income consists primarily of interest income and realized gains from our investments in marketable securities as well as transaction gains and losses associated with foreign currency fluctuations in our Benelux and Canadian subsidiaries offset by our foreign currency hedging activity. While we engage in simple hedging activities to minimize the impact of foreign currency fluctuation on our consolidated statements of operations, there is no assurance that a significant change in foreign currency exchange rates may not have a material adverse effect on our consolidated statements of operations in the future.

The increase in other income in absolute dollars for the three month period ended February 28, 2005 compared to the same period in the prior year. resulted from a smaller transaction loss associated with foreign currency fluctuations. Our interest income was consistent year over year, primarily due to higher overall yields caused by increasing interest rates year over year, offset by a decrease in our average overall portfolio levels of marketable securities due primarily to the expenditure of cash and equivalents to finance the acquisition of Cardiff Software, NativeMinds and Dralasoft.

Other income for the nine month period ended February 28, 2005 was flat with the prior year period, as the smaller transaction loss associated with foreign currency fluctuations was entirely offset by lower interest income in the current nine month period, primarily due to lower overall yields, in addition to a decrease in our average overall portfolio levels of marketable securities due primarily to the expenditure of cash and equivalents to finance the acquisition of Cardiff Software, NativeMinds and Dralasoft.


Income tax provision	February 28, 2005			February 29, 2004			Dollar Change			Percent Change
	*(dollar amounts in millions)*
Three months ended:	$	0.4		$	3.2		$	(2.8	)	(87.5	)%
Percentage of total revenues:		1.2	%		10.4	%
Nine months ended:	$	3.7		$	6.8		$	(3.1	)	(45.6	)%
Percentage of total revenues:		3.5	%		7.9	%

Our year-to-date effective tax rate for the nine month period ended February 28, 2005 was 33.6% as compared to a 40.0% effective rate we reported for the nine month period ended February 29, 2004. Additionally, in our nine month period ended February 28, 2005, we recognized the benefit of Investment Tax Credits received in Canada relating to returns filed in 1999 through 2004. This refund of $912,000 contributed substantially to the reduction of our year-to-date effective rate.

Excluding the one-time benefit relating to the Canadian Investment Tax Credits, our year-to-date effective tax rate decreased primarily from a benefit taken for current year federal and state tax credit related to qualified research and development activities.

Liquidity and Capital Resources

At February 28, 2005, our principal sources of liquidity were our cash and cash equivalents and short-term investments of $126.5 million and we had no outstanding long-term debt obligations. We also believe that due to the nature of our long term investments, we can readily convert these investments into cash, cash equivalents and short-term investments although we have not converted these investments to cash historically. As of February 28, 2005, we had $202.2 million in cash, cash equivalents, short- and long-term investments as compared to $269.0 million at February 29, 2004. Our management looks mainly to our cash, cash equivalents, short- and long-term investments to assess the strength of our financial position. For the first nine months of fiscal 2005, cash and cash equivalents, plus short- and long-term investments increased $0.4 million. We explain the major drivers in this change as follows:


Nine Months Ended:	February 28, 2005			February 29, 2004
	(in millions)
Net income adding back non-cash operating activities	$	17.7		$	16.1
Stock option exercises and proceeds from ESPP	$	17.1		$	20.8
Working capital changes	$	5.7		$	0.4
Repurchase of common stock	$	(23.8	)	$	(17.0	)
Purchase of business	$	(11.2	)	$	0.0
Capital Expenditures	$	(4.4	)	$	(1.3	)
Foreign Exchange / Others	$	(0.7	)	$	(0.8	)

Change in cash, cash equivalent, and total investment	$	0.4		$	18.2

Net income for the nine months ended February 28, 2005, after adding back non-cash operating activities including depreciation and amortization of $7.5 million, non-cash write off of in-process research and development of $1.0M, deferred income taxes of $1.6 million and other miscellaneous non-cash expenses, net of $0.3 million was $17.7. Management uses this amount as a measure to assess the contribution by our operations to the financial strength of our company. We believe that this number is also useful to investors so that investors can understand how our management assesses the contribution by our operations to the financial strength of our company.

Changes in working capital, driven primarily by the increase in other accrued liabilities generating $3.9 million, decrease in trade receivables of $2.7 million, increases in deferred revenue and accrued compensation totaling $1.5 million offset by reductions in prepaid and other assets, totaled $5.7 million for the nine month period ended February 28, 2005. The $2.7 million decrease in trade receivables was primarily a function of lower total revenue reported in Q3 of fiscal 2005 as compared to Q4 of fiscal 2004.

We repurchased $23.8 million of our common stock through our stock repurchase (see note 7 to the financial statements) in the nine months ending February 28, 2005, which was partially offset by $17.1 million in proceeds from the sale of common stock as a result of $15.3 million stock option exercises and $1.8 million from the issuance of common stock in connection with our Employee Stock Purchase Plan.

In our third fiscal quarter of 2005, we used $8.3 million of cash for the acquisition of Dralasoft (including $0.1 million of transaction fees) and we made our final payment to Inktomi/Yahoo! $3.0 million in our first fiscal quarter of 2005 related to the acquisition of selective assets of Inktomi.

Cash used to acquire capital equipment for the nine-month period ended February 28, 2005 was $4.4 million mainly of computer equipment and leasehold improvements associated with the renovation and expansion in our Ross Drive facilities in Sunnyvale.

Changes in our cash, cash equivalents, short- and long-term investments in future periods could vary widely due not only to variations in our operations, but also the extent that our employees exercise stock options and make purchases under our employee stock purchase plan, as well as our repurchase activity under our stock repurchase program. Our stock repurchase program will terminate at the end of the fiscal year ending May 31, 2005 unless extended by the Board of Directors.

Our principal commitments as of February 28, 2005 consist of obligations under operating leases, totaling $20.2 million over the life of these leases.

Under our operating leases, we have minimum rental payments as follows:


Fiscal Year Ending May 31,	Rental Payments		Sublease Income
	(dollar amounts in thousands)
2005	$	923	$	45
2006		4,051		128
2007		3,296		74
2008		3,265		0
2009 and thereafter		8,633		0

	$	20,168	$	247

In addition to the above operating capital commitment, we have as of February 28, 2005, a $0.6 million deferred payment obligation which we are obligated to pay in September 2005, assuming that we have no claims for indemnification under the NativeMinds purchase agreement.

In June, 2004, we announced the continuation of our stock repurchase program. The continuation calls for the additional repurchase of outstanding shares of our common stock up to an aggregate value of $50.0 million. The program will terminate at the end of the fiscal year ending May 31, 2005 unless amended by the Board of Directors. Through February 28, 2005, we repurchased and retired approximately 1,885,000 shares of our common stock through open market transactions, for cash consideration of approximately $23.8 million.

We believe that our current cash and cash equivalents, interest income and cash generated from operations, if any, will provide adequate liquidity to meet our working capital and operating resource expenditure requirements for the next 12 months. If the global economy weakens further, our cash, cash equivalents and investments balances may decline. As a result, or if our spending plans materially change, we may find it necessary to seek to obtain additional sources of financing to support our capital needs, and we cannot assure you that a financing will be available on commercially reasonable terms, or at all.

RISKS RELATING TO OUR OPERATIONS

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

Risks Related to Our Business

Our revenues and operating results are dependent on many factors, many of which are outside of our control and, as a result may fluctuate in future periods and be less than we or our investors anticipate

The results of operations for any quarter are not necessarily indicative of results to be expected in future periods. Our operating results have in the past been, and will continue to be, subject to quarterly fluctuations as a result of a number of factors, many of which are outside of our control. These factors include:

•

fluctuations in capital spending by customers;

•

the size and timing of orders;

•

changes in the budget or purchasing patterns of customers or potential customers, changes in foreign country exchange rates, or pricing pressures from competitors;

•

increased competition in the software and Internet industries;

•

the introduction and market acceptance of new technologies and standards in search and retrieval, Internet, document management, database, networking, and communications technology;

•

variations in sales channels, product costs, the mix of products sold, or the success of quality control measures;

•

the integration of people, operations, and products from acquired businesses and technologies;

•

changes in operating expenses and personnel;

•

changes in accounting principles, such as a requirement that stock options be included in compensation, which is widely expected to occur, which if adopted, would increase our compensation expenses and have a negative effect on our earnings;

•

the overall trend toward industry consolidation; and

•

changes in general economic and geo-political conditions and specific economic conditions in the computer and software industries.

Any of the factors, some of which are discussed in more detail below, could materially and adversely impact our operations and financial results, which could hurt our business. Any adverse impact our operations and financial results as a result of these or any other factors could cause our stock price to fall.

Demand for our products may be adversely affected if economic and market conditions deteriorate

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

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

The size and timing of individual orders may cause our operating results to fluctuate significantly. In the period covered by this report, our operating results were less than expected because a number of large anticipated orders were either not received or were delayed or deferred by customers. A significant portion of our revenues in recent quarters has been derived from relatively large sales to a limited number of customers, and we currently anticipate that future quarters will continue to reflect this trend. Sales cycles for

these customers can be up to nine months or longer. In addition, customer order deferrals in anticipation of new products may cause our operating results to fluctuate. Like many software companies, we had generally recognized a substantial portion of our revenues in the last month of each quarter, with these revenues concentrated in the last weeks of the quarter. Accordingly, the cancellation or deferral of even a small number of purchases of our products could harm our business in any particular quarter. In addition, to the extent that the significant sales occur earlier than expected, operating results for subsequent quarters may fail to keep pace or even decline.

Our sales cycle is lengthy and unpredictable

Any delay in sales of our products and services could cause our quarterly revenue and operating results to fluctuate. The typical sales cycle of our products is lengthy, generally between six to eighteen months, unpredictable, and involves significant investment decisions by prospective customers, as well as our education of potential customers regarding the use and benefits of our products. Our customers spend a substantial amount of time before purchasing our products in performing internal reviews and obtaining capital expenditure approvals. We believe our sales cycle lengthened in 2003 and 2004 as a result of macro-economic factors and we cannot be certain that this cycle will not continue to lengthen in the future.

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

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

Changes in effective tax rates could affect our results

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

Our business may suffer due to risks associated with international sales

For the nine months period ended February 28, 2005 and 2004, international revenue represented 33.1% and 34.6% of our total revenues, respectively. We expect international revenues will continue to account for a significant percentage of our revenues for the foreseeable future. Our international business activities are subject to a number of risks, each of which could impose unexpected costs on us that would have an adverse effect on our operating results. These risks include:

•

difficulties in complying with regulatory requirements and standards;

•

tariffs and other trade barriers;

•

costs and risks of localizing products for foreign countries;

•

reliance on third parties to distribute our products;

•

longer accounts receivable payment cycles;

•

potentially adverse tax consequences;

•

limits on repatriation of earnings; and

•

burdens of complying with a wide variety of foreign laws.

We currently engage in only limited hedging activities to protect against the risk of currency fluctuations. Fluctuations in currency exchange rates could cause sales denominated in U.S. dollars to become relatively more expensive to customers in a particular country, leading to reduced sales or profitability in that country. Also, fluctuations in the opposite direction could cause sales denominated in foreign currencies to decrease U.S. dollar revenues derived from these sales. Furthermore, future international activity may result in increased foreign currency denominated sales and, in this event, gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute significantly to fluctuations

in our results of operations. The financial stability of foreign markets could also affect our international sales. In addition, income earned in various countries where we do business may be subject to taxation by more than one jurisdiction, thereby adversely affecting our consolidated after-tax earnings. Any of these factors could have an adverse effect on the revenues from our future international sales and, consequently, our results of operations.

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

Revenues derived from sales to the U.S. federal and state governments and their agencies were 9.9% and 10.0% of total revenues for the nine months period ended February 28, 2005 and 2004, respectively. As a result, any reductions in government spending on information technologies could harm our operating results. In recent years, budgets of many governments and/or their agencies have been reduced, causing certain customers and potential customers of our products to re-evaluate their needs. These budget reductions are expected to continue over at least the next several years.

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

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

During the past few years, our management and other personnel have focused on modifying and enhancing our core technology to support a broader set of search and retrieval solutions for use on enterprise-wide systems, over online services, over the Internet and on CD-ROM. In order for our strategy to succeed and to remain competitive, we must continue to leverage our core technology to develop new product offerings by us and by our OEM customers that address the needs of these new markets or we must acquire new technology, such as we did in our Cardiff Software and NativeMinds transactions in the latter half of fiscal 2004 and Dralasoft acquisition in the third quarter of fiscal 2005. The development of new products, whether by leveraging our core technology or by acquiring new technology, is expensive. If these products do not generate substantial revenues, our business and results of operations will be adversely affected. We cannot assure you that any of these products will be successfully developed and completed on a timely basis or at all, will achieve market acceptance or will generate significant revenues.

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

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

The computer software industry is subject to rapid technological change, changing customer requirements, frequent new product introductions, and evolving industry standards, each of which may render our existing products and services obsolete. As a result, our position in our existing markets or other markets that we may enter could be eroded rapidly by any of these factors. Our future success will also depend upon our ability to maintain compatibility between our products and the text publication formats we believe are or will become popular and widely adopted as well as the OEM application products in which our products are embedded. If we are unable to adapt to these rapid technological developments or customer requirements in a timely manner, our sales would diminish and our financial condition and results of operations would be materially and adversely affected.

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

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

We are in litigation with Inxight Software, Inc. in a dispute over our rights under a software license agreement and we may incur significant costs if we do not prevail in this litigation.

In October, 2004, Inxight Software, Inc., a privately held company, sued us alleging, among other things, that we had breached a license with them and misappropriated their trade secrets, and that we had otherwise exceeded its rights under our license agreement

with Inxight. Inxight is seeking, among other things, monetary damages of at least $1 million and injunctive relief commanding Verity to cease distributing Inxight’s product to Verity K2 product-line OEM customers. We have responded by an answer and countersuit seeking a declaration that we have acted within our rights under the license agreement, and that Inxight’s purported termination of the license subsequent to the filing of its complaint was invalid. In addition, we allege that Inxight itself has breached the license by purporting to terminate the parties’ license without cause, and that it has wrongfully interfered in Verity’s business operations, and that such breach and wrongful conduct has caused injury to Verity in excess of $1 million.

If we do not prevail in this litigation, we could be forced to pay significant damages, and we may be prohibited from continuing to distribute Inxight technology in some or all of our products. In order to mitigate such a risk, we entered into license agreements with two software companies providing technology that is substantially similar to that provided by Inxight. But there may be significant costs associated with entirely switching out the Inxight products, including development costs and additional support costs, which could impact our results of operations. In addition, whether or not we prevail in this litigation, we could incur significant costs in the form of legal fees, and our management’s attention could be diverted from the normal daily operations of our business.

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

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

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

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

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

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

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

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

In the past, securities class action litigation has often been brought against companies following a decline in the market price of their securities. For example, in December 1999 our stock price dramatically declined and a number of lawsuits were filed against us.

Because we expect our stock price to continue to fluctuate significantly, we may be the targets of similar litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and resources, and could seriously harm our business.

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

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

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

New legislation, higher insurance cost and potential new accounting pronouncements are likely to impact our future consolidated financial position and results of operations.

Recently, there have been significant regulatory changes, including the Sarbanes-Oxley Act of 2002, and there may be new accounting pronouncements or regulatory rulings that will have an impact on our future consolidated financial position and results of operations. The Sarbanes-Oxley Act of 2002 and other rule changes and proposed legislative initiatives following several highly publicized corporate accounting and corporate governance failures are likely to increase general and administrative costs. In addition, insurance companies significantly increased insurance rates as a result of higher claims over the past year, and our rates for our various insurance policies increased substantially. In December 2004, the FASB issued SFAS No. 123 ( Revised 2004) “Share-Based Payment” (“SFAS 123R”), which requires public companies to comply as of the first interim or annual reporting period beginning after June 15, 2005. In the second quarter of our fiscal year 2006, we will then be required to record a compensation expense for all forms of share-based payment awards using the fair value method. These and other potential changes could materially increase the expenses we report under accounting principles generally accepted in the United States of America and adversely affect our consolidated operating results.

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

A number of companies offer competitive products addressing certain of our target markets. In the ICS market, we compete primarily with Autonomy, Convera, Endeca, FAST, Google, Hummingbird, Inquira, iPhrase, Mercado, Microsoft, Open Text and Thunderstone. We also compete indirectly with database vendors, such as Oracle and IBM, that offer information search and retrieval capabilities with their core database products, as well as with ERP (Enterprise Resource Planning) vendors, such as SAP, that offer these capabilities as part of their overall solution.

In the content capture market, we compete with AnyDoc, Captiva, Datacap, Kofax, and Readsoft, among others. In the process automation market, we compete with Adobe, FileNet and PureEdge, among others. We also compete indirectly with content management vendors, such as FileNet, that offer content capture and workflow with their core content management products, as well as with platform vendors, such as Microsoft, that offer basic capabilities as part of their overall solution.

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

Our products contain open source software

Products or technologies acquired or developed by us may include so-called “open source” software. Open source software is typically licensed for use at no initial charge, but imposes on the user of the open source software certain requirements to license to others both the open source software as well as the software that relates to, or interacts with, the open source software. Our ability to commercialize products or technologies incorporating open source software or otherwise fully realize the anticipated benefits of any such acquisition may be restricted because, among other reasons:

•

open source license terms may be ambiguous and may result in unanticipated obligations regarding our products;

•

competitors will have improved access to information that may help them develop competitive products;

•

open source software cannot be protected under trade secret law;

•

it may be difficult for us to accurately determine the developers of the open source code and whether the acquired software infringes third party intellectual property rights; and

•

open source software potentially increases customer support costs because licensees can modify the software and potentially introduce errors.

Further, to the extent we utilize “open source” software we face risks. For example, the scope and requirements of the most common open source software license, the GNU General Public License (“GPL”), have not been interpreted in a court of law. Use of GPL software could subject certain portions of our proprietary software to the GPL requirements. Other forms of “open source” software licensing present license compliance risks, which could result in litigation or loss of the right to use this software.

Our recent acquisitions of Cardiff Software, strategic assets of Native Minds and the Inktomi enterprise search software assets, as well as Dralasoft and future potential acquisitions, may have unexpected material adverse consequences

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

•

difficulties in integration of the operations, technologies, products and personnel of the acquired companies;

•

the risk of diverting management’s attention from normal daily operations of the business;

•

accounting consequences, including changes in purchased research and development expenses, resulting in variability in our quarterly earnings;

•

potential difficulties in completing projects associated with purchased in-process research and development;

•

risks of entering markets in which we have no or limited direct prior experience and where competitors in these markets have stronger market positions;

•

the potential loss of key employees of the acquired company;

•

the assumption of known and potentially unknown liabilities of the acquired company;

•

we may find that the acquired company or assets do not further our business strategy or that we paid more than what the company or assets are worth;

•

we may have product liability associated with the sale of the acquired company’s products;

•

we may have difficulty maintaining uniform standards, controls, procedures and policies;

•

our relationship with current and new employees and clients could be impaired;

•

the acquisition may result in litigation from terminated employees or third parties who believe a claim against us would be valuable to pursue;

•

our due diligence process may fail to identify significant issues with product quality, product architecture and legal contingencies, among other matters;

•

insufficient revenues to offset increased expenses associated with acquisitions;

•

inability to renew third-party software license agreements; and

•

market acceptance of new releases.

Acquisitions may also cause us to:

•

issue common stock that would dilute our current stockholders’ percentage ownership;

•

record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges;

•

incur amortization expenses related to certain intangible assets; or

•

incur large and immediate write-offs.

We cannot assure you that future acquisitions will be successful and will not adversely affect our business. We must also maintain our ability to manage any growth effectively. Failure to manage growth effectively and successfully integrate acquisitions could harm our business.

Our net income and earnings per share could be significantly reduced when we account for employee stock option and employee stock purchase plans using the fair value method

We could report significant accounting charges as a result of the requirement to record an expense for our stock-based compensation plans using the fair value method. For example, in fiscal year 2004, had we accounted for stock-based compensation plans using the fair-value method prescribed in FASB Statement No. 123 as amended by Statement 148, net income would have been reduced by $32.9 million. In December 2004, the FASB issued SFAS No. 123 ( Revised 2004) “Share-Based Payment” (“SFAS 123R”), which requires public companies to comply as of the first interim or annual reporting period beginning after June 15, 2005. In the second quarter of our fiscal year 2006, we will then be required to record a compensation expense for all forms of share-based payment awards using the fair value method.

See Note 2 to Condensed Consolidated Financial Statements for a more detailed presentation of accounting for stock-based compensation plans.

Risks Related to Our Industry

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

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

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

•

use of the Internet, the web and other online services does not continue to increase or increases more slowly than expected;

•

the infrastructure for the Internet, the web and other online services does not effectively support expansion that may occur; or

•

the Internet, the web and other online services do not create a viable commercial marketplace, inhibiting the development of electronic commerce and reducing the need for our products and services.

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

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

•

potentially inadequate development of the necessary communication and network infrastructure, particularly if rapid growth of the Internet continues;

•

delayed development of enabling technologies and performance improvements;

•

delayed development or adoption of new standards and protocols; and

•

increased governmental regulation.

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

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

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk. The primary objective of our investment activities is to preserve the principal while at the same time maximize yields without significantly increasing our risk. To achieve this objective, we maintain our portfolio of cash equivalents and investments in a variety of securities, including both government and corporate obligations and money market funds. As of February 28, 2005, approximately 21.4% of our portfolio matures in one year or less, with the remainder maturing in less than three years. We do not use derivative financial instruments in our investment portfolio. We place our investments with high credit quality issuers and, by policy, limit the amount of credit exposure to any one issuer.

The following table presents the amounts of our cash equivalents and investments that are subject to interest rate risk by year of expected maturity and average interest rates as of February 28, 2005. For purposes of this calculation we treat the auction rate securities as maturing within one year, due to our investment policies.


	FY2005			FY2006			FY2007			FY2008			FY2009	Total			Fair Value
	(Dollars in thousands)
Cash equivalents	$	5,765			—			—			—		—	$	5,765		$	5,765
Average interest rate		2.53	%		—			—			—		—		2.53	%		2.53	%
Fixed-rate securities	$	4,500		$	40,388		$	43,454		$	1,999		—	$	90,341		$	90,341
Average interest rate		1.36	%		2.37	%		2.65	%		2.70	%	—		2.46	%		2.46	%
Variable-rate securities	$	71,350			—			—			—		—	$	71,350		$	71,350
Average interest rate		2.63	%		—			—			—		—		2.63	%		2.63	%

The following table presents the amounts of our cash equivalents and investments that are subject to interest rate risk by year of expected maturity and average interest rates as of May 31, 2004.


	FY2005			FY2006			FY2007			FY2008	FY2009	Total			Fair Value
	(Dollars in thousands)
Cash equivalents	$	2,556			—			—		—	—	$	2,556		$	2,556
Average interest rate		0.94	%		—			—		—	—		0.94	%		0.94	%
Fixed-rate securities	$	20,256		$	37,177		$	47,071		—		$	104,504		$	104,504
Average interest rate		2.67	%		2.33	%		2.67	%				2.55	%		2.55	%
Variable-rate securities	$	58,250			—			—		—	—	$	58,250		$	58,250
Average interest rate		1.21	%		—			—		—	—		1.21	%		1.21	%

Foreign Currency Transaction Risk. We transact business in various foreign currencies and have established a program that primarily utilizes foreign currency forward contracts to offset the risk associated with the effects of certain foreign currency exposures. Under this program, increases or decreases in our foreign currency exposures are offset by gains or losses on the forward contracts, to mitigate the possibility of foreign currency transaction gains or losses. These foreign currency exposures typically arise from intercompany sublicense fees and other intercompany transactions. Our forward contracts generally have terms of 180 days or less. We do not use forward contracts for trading purposes. All foreign currency transactions and all outstanding forward contracts (non equity hedges) are marked to market at the end of the period with any changes in market value included in Other Income, net. Our ultimate realized gain or loss with respect to currency fluctuations will depend on the currency exchange rates and other factors in effect as the contracts mature. Net foreign exchange transaction gain (loss) included in Other Income, net in the accompanying condensed consolidated statements of operations was $205,000 in the nine month period ended February 28, 2005. The fair value of the foreign currency forward contracts represented a $0.04 million liability as of February 28, 2005 as compared to a $0.2 million liability at May 31, 2004.

As of February 28, 2005 and May 31, 2004, our forward contracts consisted solely of contracts for the exchange of Canadian Dollars for U.S. Dollars. As of these dates, the notional amounts (at contract exchange rates) and weighted average contractual foreign currency exchange rates for the outstanding forward contracts were $3.7 million and $2.9 million, and 1.22 and 1.29, respectively. Notional weighted average exchange rates are quoted using market conventions where the currency is expressed in currency units per United States dollar. All of our forward contracts mature in 180 days or less as of February 28, 2005.

Item 4. Controls and Procedures

Limitations on the Effectiveness of Controls. Our management, including the Chief Executive Officer and Chief Financial Officer, believes that our disclosure controls and procedures and our internal control over financial reporting will provide reasonable assurance that all errors will be detected, but does not expect that our disclosure controls and procedures or our internal control over financial reporting will provide absolute assurance that all errors will be detected. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Verity have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.

Evaluation of Disclosure Controls and Procedures. An evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of February 28, 2005. Based on that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of February 28, 2005, to provide reasonable assurance that the information required to be disclosed by us in reports we file with the Securities and Exchange Commission was recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules.

Changes in Internal Control over Financial Reporting. During the three month period ended February 28, 2005, there were no changes in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Not Applicable.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Item 2(a). The table below sets forth information regarding repurchases of Verity common stock by Verity during the three month period ended February 28, 2005.


Period	Total Number of Shares Purchased	Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Programs	Maximum Dollar Value of Shares that May Yet Be Purchased Under the Programs
December 1, 2004 through December 31, 2004	—	$	—	—	$	34,186,370
January 1, 2005 through January 31, 2005	653,896	$	12.15	653,896	$	26,244,673
February 1, 2005 through February 28, 2005	—		—	—	$	26,244,673
Total	653,896	$	12.15	653,896	$	26,244,673

On June 22, 2004 our Board of Directors approved our current stock repurchase program, in which we are authorized to repurchase up to $50 million of common stock in fiscal 2005. The program will terminate at the end of the fiscal year ending May 31, 2005 unless amended by the Board of Directors.

Item 3. Defaults upon Senior Securities

Not Applicable.

Item 4. Submission of Matters to a Vote of Security Holders

Not Applicable.

Item 5. Other Information

(a) None.

(b) None.

Item 6. Exhibits

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

SIGNATURE

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


VERITY, INC. (Registrant)

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

Dated: April 8, 2005

INDEX TO EXHIBITS


Exhibit Number		Description of Document
3.1		Restated Certificate of Incorporation of the Company. (1)

3.2		By-Laws. (1)

4.1		Amended and Restated Rights Agreement dated August 1, 1995, as amended. (2)

4.2		Form of Rights Agreement between Verity, Inc. and First National Bank of Boston dated September 18, 1996. (3)

4.3		First Amendment to Rights Agreement dated as of July 23, 1999 among Verity, Inc. and BankBoston, N.A. (4)

10.3		Amendment to Retainer Agreement between Regent Pacific Management Corporation and Verity, Inc. dated February 11, 2005. (5)

10.16		Executive Health Program

10.17		Executive Officer Summary Compensation Sheet

31.1		Certification of Anthony J. Bettencourt.

31.2		Certification of Steven R. Springsteel.

32		Certification of Chief Executive Officer and Chief Financial Officer.

(1)	Incorporated by reference from the exhibits with corresponding numbers from the Company’s Form 10-Q for the quarter ended November 30, 2000 with the Securities and Exchange Commission on January 10, 2001. (Commission No. 000-26880).

(2)	Incorporated by reference from the exhibits with corresponding numbers from the Company’s Registration Statement (No. 33-96228), declared effective on October 5, 1995.

(3)	Incorporated by reference from Exhibit No. 1 to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on October 10, 1996 (Commission No. 000-26880).

(4)	Incorporated by reference to Exhibit 99.2 from the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 29, 1999 (Commission No. 000-26880).

(5)	Incorporated by reference to Exhibit 99.1 from the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on February 15, 2005 (Commission No. 000-26880).

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