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EX-32.1 - EXHIBIT 32.1 - QAD INCex32-1.htm
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EX-31.1 - EXHIBIT 31.1 - QAD INCex31-1.htm

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

(Mark One)

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

 

For the quarterly period ended October 31, 2016

 

OR

 

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

 

For the transition period from ____________________ to _________________________

 

Commission file number  0-22823

 

QAD Inc.

(Exact name of Registrant as specified in its charter)

 

Delaware

77-0105228

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)

100 Innovation Place, Santa Barbara, California  93108

(Address of principal executive offices)

(805) 566-6000

(Registrant's telephone number, including area code)

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☑  No ☐.

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check One):

 

Large accelerated filer ☐

Accelerated filer ☑

Non-accelerated filer ☐  (Do not check if a smaller reporting company)

Smaller reporting company ☐

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ☐  No ☑.

 

As of November 30, 2016, there were 15,794,532 shares of the Registrant’s Class A common stock outstanding and 3,207,849 shares of the Registrant’s Class B common stock outstanding.

 

 
 

 

 

QAD INC.

INDEX

 

  Page

PART I - FINANCIAL INFORMATION

 

 

 

 

 

 

ITEM 1.

Financial Statements (unaudited)

 

 

 

 

 

 

 

Condensed Consolidated Balance Sheets as of October 31, 2016 and January 31, 2016

1

 

 

 

 

 

 

Condensed Consolidated Statements of Operations and Comprehensive Income for the Three and Nine Months Ended October 31, 2016 and 2015

2

 

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended October 31, 2016 and 2015

3

 

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements

4

 

 

 

 

 

ITEM 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

15

 

 

 

 

 

ITEM 3.

Quantitative and Qualitative Disclosures About Market Risk

32

 

 

 

 

 

ITEM 4.

Controls and Procedures

33

 

 

 

 

PART II - OTHER INFORMATION

 

 

 

 

 

 

ITEM 1.

Legal Proceedings

33

 

 

 

 

 

ITEM 1A.

Risk Factors

34

 

 

 

 

 

ITEM 2.

Unregistered Sales of Equity Securities and Use of Proceeds

34

 

 

 

 

 

ITEM 3.

Defaults Upon Senior Securities

34

 

 

 

 

 

ITEM 4.

Mine Safety Disclosure

34

 

 

 

 

 

ITEM 5.

Other Information

34

 

 

 

 

 

ITEM 6

Exhibits

34

 

 

 

 

 

SIGNATURES

35

 

 
 

 

 

PART I

 

ITEM 1 – FINANCIAL STATEMENTS

 

QAD INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

 

   

October 31,

2016

   

January 31,

2016

 

Assets

               

Current assets:

               

Cash and equivalents

  $ 135,689     $ 137,731  

Accounts receivable, net of allowances of $2,298 and $2,642 at October 31, 2016 and January 31, 2016, respectively

    39,100       65,512  

Deferred tax assets, net

    8,543       8,203  

Other current assets

    17,271       16,024  

Total current assets

    200,603       227,470  

Property and equipment, net

    30,995       32,080  

Capitalized software costs, net

    934       1,553  

Goodwill

    10,657       10,645  

Deferred tax assets, net

    12,758       12,914  

Other assets, net

    2,135       2,679  

Total assets

  $ 258,082     $ 287,341  
                 

Liabilities and Stockholders’ Equity

               

Current liabilities:

               

Current portion of long-term debt

  $ 441     $ 422  

Accounts payable

    7,694       10,811  

Deferred revenue

    73,982       97,911  

Other current liabilities

    29,558       31,535  

Total current liabilities

    111,675       140,679  

Long-term debt

    13,877       14,191  

Other liabilities

    4,650       4,465  

Commitments and contingencies

               

Stockholders’ equity:

               
Preferred stock, $0.001 par value. Authorized 5,000,000 shares; none issued or outstanding                

Common stock:

               

Class A, $0.001 par value. Authorized 71,000,000 shares; issued 16,605,173 shares and 16,603,729 shares at October 31, 2016 and January 31, 2016, respectively

    16       16  

Class B, $0.001 par value. Authorized 4,000,000 shares; issued 3,537,380 shares and 3,537,366 shares at October 31, 2016 and January 31, 2016, respectively

    4       4  

Additional paid-in capital

    196,382       195,808  

Treasury stock, at cost 1,153,155 shares and 1,365,885 shares at October 31, 2016 and January 31, 2016, respectively)

    (15,497

)

    (18,717

)

Accumulated deficit

    (44,637

)

    (40,376

)

Accumulated other comprehensive loss

    (8,388

)

    (8,729

)

Total stockholders’ equity

    127,880       128,006  

Total liabilities and stockholders’ equity

  $ 258,082     $ 287,341  

  

See Accompanying Notes to Condensed Consolidated Financial Statements.

 

 
1

 

 

QAD INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

(in thousands, except per share data)

(unaudited)

 

   

Three Months Ended

   

Nine Months Ended

 
   

October 31,

   

October 31,

 
   

2016

   

2015

   

2016

   

2015

 
                                 

Revenue:

                               

License fees

  $ 4,323     $ 6,350     $ 14,686     $ 21,761  

Subscription fees

    13,678       9,659       37,487       28,223  

Maintenance and other

    32,552       33,395       98,654       100,611  

Professional services

    18,981       18,633       53,882       57,998  

Total revenue

    69,534       68,037       204,709       208,593  
                                 

Costs of revenue:

                               

License fees

    582       827       2,072       2,728  

Subscription fees

    7,145       5,134       20,085       15,360  

Maintenance and other

    7,480       7,924       22,991       23,608  

Professional services

    17,850       17,120       52,851       54,035  

Total cost of revenue

    33,057       31,005       97,999       95,731  
                                 

Gross profit

    36,477       37,032       106,710       112,862  
                                 

Operating expenses:

                               

Sales and marketing

    15,312       15,531       49,544       49,658  

Research and development

    10,807       10,193       33,019       31,440  

General and administrative

    7,934       7,676       24,423       24,719  

Amortization of intangibles from acquisitions

    165       165       496       495  

Total operating expenses

    34,218       33,565       107,482       106,312  
                                 

Operating income (loss)

    2,259       3,467       (772

)

    6,550  
                                 

Other (income) expense:

                               

Interest income

    (184

)

    (80

)

    (515

)

    (224

)

Interest expense

    168       171       503       544  

Other (income) expense, net

    (413

)

    61       24       (471

)

Total other (income) expense

    (429

)

    152       12       (151

)

                                 

Income (loss) before income taxes

    2,688       3,315       (784

)

    6,701  

Income tax expense (benefit)

    1,155       729       (493

)

    1,935  
                                 

Net income (loss)

  $ 1,533     $ 2,586     $ (291

)

  $ 4,766  
                                 

Basic net income (loss) per share

                               

Class A

  $ 0.08     $ 0.14     $ (0.02

)

  $ 0.26  

Class B

  $ 0.07     $ 0.12     $ (0.01

)

  $ 0.22  

Diluted net income (loss) per share

                               

Class A

  $ 0.08     $ 0.14     $ (0.02

)

  $ 0.25  

Class B

  $ 0.07     $ 0.12     $ (0.01

)

  $ 0.21  
                                 

Net income (loss)

  $ 1,533     $ 2,586     $ (291

)

  $ 4,766  

Other comprehensive income (loss), net of tax:

                               

Foreign currency translation adjustment

    (20

)

    (466

)

    341       (1,138

)

Total comprehensive income

  $ 1,513     $ 2,120     $ 50     $ 3,628  

  

See Accompanying Notes to Condensed Consolidated Financial Statements.

 

 
2

 

 

QAD INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

   

Nine Months Ended

October 31,

 
   

2016

   

2015

 
                 

Cash flows from operating activities:

               

Net (loss) income

  $ (291

)

  $ 4,766  

Adjustments to reconcile net (loss) income to net cash provided by operating activities:

               

Depreciation and amortization

    4,530       4,324  

Provision for doubtful accounts and sales adjustments

    157       623  

Stock compensation expense

    5,521       5,618  

Change in fair value of derivative instrument

    (31

)

    (164

)

Other, net

    10       10  

Changes in assets and liabilities:

               

Accounts receivable

    26,494       35,517  

Other assets

    (1,692

)

    1,960  

Accounts payable

    (3,098

)

    (4,113

)

Deferred revenue

    (23,743

)

    (31,587

)

Other liabilities

    (2,386

)

    (6,789

)

Net cash provided by operating activities

    5,471       10,165  

Cash flows from investing activities:

               

Purchase of property and equipment

    (2,166

)

    (2,641

)

Capitalized software costs

    (109

)

    (70

)

Net cash used in investing activities

    (2,275

)

    (2,711

)

Cash flows from financing activities:

               

Repayments of debt

    (326

)

    (305

)

Tax payments, net of proceeds, related to stock awards

    (1,726

)

    (2,419

)

Payment of contingent liability associated with acquisitions

          (750

)

Proceeds from issuance of common stock, net of issuance costs

          8,365  

Cash dividends paid

    (3,970

)

    (3,922

)

Net cash (used in) provided by financing activities

    (6,022

)

    969  
                 

Effect of exchange rates on cash and equivalents

    784       (2,328

)

                 

Net (decrease) increase in cash and equivalents

    (2,042

)

    6,095  
                 

Cash and equivalents at beginning of period

    137,731       120,526  
                 

Cash and equivalents at end of period

  $ 135,689     $ 126,621  

 

See Accompanying Notes to Condensed Consolidated Financial Statements.

 

 
3

 

 

QAD INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

 

1.   BASIS OF PRESENTATION AND RECENT ACCOUNTING PRONOUNCEMENTS

 

Basis of Presentation

 

In the opinion of management, the accompanying unaudited Condensed Consolidated Financial Statements fairly present the financial information contained therein. These statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In management’s opinion, all necessary adjustments, consisting of normal, recurring and non-recurring adjustments, have been included in the accompanying Condensed Consolidated Financial Statements to present fairly the financial position and operating results of QAD Inc. (“QAD” or the “Company”). The Condensed Consolidated Financial Statements do not include all disclosures required by accounting principles generally accepted in the United States of America for annual financial statements and should be read in conjunction with the audited financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended January 31, 2016. The Condensed Consolidated Financial Statements include the results of the Company and its wholly owned subsidiaries. The results of operations for the three and nine months ended October 31, 2016 are not necessarily indicative of the results to be expected for the year ending January 31, 2017.

 

Recent Accounting Pronouncements

 

With the exception of those discussed below, there have been no recent changes in accounting pronouncements issued by the Financial Accounting Standards Board (“FASB”) or adopted by the Company during the nine months ended October 31, 2016, that are of significance, or potential significance, to the Company.

 

Accounting Standards Adopted

 

In March 2016, the FASB issued Accounting Standards Update No. 2016-09 ("ASU 2016-09") regarding ASC Topic 718, “Improvements to Employee Share-Based Payment Accounting.” The new guidance requires excess tax benefits and tax deficiencies to be recorded in the income statement when the awards vest or are settled. In addition, cash flows related to excess tax benefits will no longer be separately classified as a financing activity apart from other income tax cash flows. The standard also increases the amount of shares an employer can withhold for tax purposes without triggering liability accounting, clarifies that all cash payments made on an employee's behalf for withheld shares should be presented as a financing activity in the statements of cash flows, and provides an entity-wide accounting policy election to account for forfeitures as they occur.

 

QAD elected to early adopt the new guidance in the third quarter of fiscal year 2017 which requires us to reflect any adjustments as of February 1, 2016, the beginning of the annual period that includes the interim period of adoption. The primary impact of adoption was the recognition of excess tax benefits in our provision for income taxes rather than paid-in capital for all periods in fiscal year 2017. Additional amendments to the accounting for income taxes resulted in the recognition of prior year unrealized excess tax benefits. This recognition resulted in an increase to our deferred tax assets of $2.2 million, an increase to valuation allowance $1.2 million and an offset to opening accumulated deficit of $1.0 million.

 

QAD elected to account for forfeitures as they occur using a modified retrospective transition method, which resulted in a cumulative-effect adjustment of $0.4 million to reduce the February 1, 2016 opening accumulated deficit. Additional amendments to the accounting for minimum statutory withholding tax requirements had no impact to opening accumulated deficit as of February 1, 2016 as QAD does not withhold more than the minimum statutory requirements.

 

We elected to apply the presentation requirements for cash flows related to excess tax benefits retrospectively to all periods presented which resulted in an increase to net cash provided by operating activities and a decrease to net cash used in financing of $0.3 million for the six months ended July 31, 2016. The presentation requirements for cash flows related to employee taxes paid for withheld shares had no impact to any of the periods presented in our consolidated cash flows statements since such cash flows have historically been presented as a financing activity.

 

 
4

 

 

With the adoption of the new standard we are required to revise our reported quarterly results for the six months ended July 31, 2016. Accordingly, this table reflects the retrospective adjustments made to beginning accumulated deficit and to the previously reported results for the six months ended July 31, 2016:

 

Condensed Consolidated Balance Sheets

 
         

ASU 2016-09 Adoption Adjustments

       

(in thousands)

 

As Reported

July 31, 2016

   

February 1, 2016

   

For The Six

Months Ended

July 31, 2016

   

As Adjusted

July 31, 2016

 

Other current assets

  $ 18,369     $     $ (104 )   $ 18,265  

Deferred tax assets, net

    12,156       995             13,151  

Additional paid-in capital

    194,943       388       (422 )     194,909  

Accumulated deficit

  $ (45,767 )   $ 607     $ 318     $ (44,842 )

 

 

Condensed Consolidated Statements of Operations

 

(in thousands, except per share data)

 

As Reported

Six Months Ended

July 31, 2016

   

ASU 2016-09

Adoption

Adjustments

   

As Adjusted

Six Months Ended

July 31, 2016

 
                         

Cost of revenue:

                       

Subscription fees

  $ 12,945     $ (5 )   $ 12,940  

Maintenance and other

    15,532       (21 )     15,511  

Professional services

    35,048       (47 )     35,001  

Total cost of revenue

    65,015       (73 )     64,942  

Gross profit

    70,160       73       70,233  

Operating expenses:

                       

Sales and marketing

    34,322       (90 )     34,232  

Research and development

    22,283       (71 )     22,212  

General and administrative

    16,526       (37 )     16,489  

Total operating expenses

    73,462       (198 )     73,264  

Operating loss

    (3,302 )     271       (3,031 )

Loss before income taxes

    (3,743 )     271       (3,472 )

Income tax benefit

    (1,601 )     (47 )     (1,648 )

Net loss

  (2,142 )   318     (1,824 )

Basic and diluted weighted average shares outstanding:

                       

Class A

    15,644             15,644  

Class B

    3,204             3,204  

Basic and diluted net loss per share:

                       

Class A

  (0.12 )   0.02     (0.10 )

Class B

  (0.10 )   0.02     (0.08 )

 

 
5

 

 

In April 2015, the FASB issued ASU 2015-03 - Interest - Imputation of Interest (Subtopic 2015-03): Simplifying the Presentation of Debt Issuance Costs which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the related debt liability instead of being presented as an asset, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by ASU 2015-03. This ASU is effective for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years and is to be implemented retrospectively. The Company adopted the provisions of this ASU in the first quarter of fiscal 2017. Adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

 

In August 2015, the FASB issued ASU 2015-15, Interest-Imputation of Interest (Subtopic 835-30): Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line of Credit Arrangements, given that the authoritative guidance within ASU 2015-03 for debt issuance costs does not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements. The SEC staff would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. The Company adopted the provisions of this ASU in the first quarter of fiscal 2017. Adoption of this ASU did not have an impact on the Company’s consolidated financial statements.

 

Accounting Standards Not Yet Adopted

 

In May 2014, the FASB issued accounting standard update, or ASU, 2014-09, Revenue from Contracts with Customers. The standard was issued to provide a single framework that replaces existing industry and transaction specific U.S. GAAP with a five-step analysis of transactions to determine when and how revenue is recognized. The accounting standard update will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, to defer the effective date of ASU 2014-09 by one year. Therefore, ASU 2014-09 will become effective for the Company beginning in fiscal year 2019. Early adoption would be permitted for the Company beginning in fiscal year 2018. The standard permits the use of either the retrospective or cumulative transition method. The Company is currently evaluating the accounting, transition and disclosure requirements of the standard and cannot currently estimate the financial statement impact of adoption. 

 

In November 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes which requires deferred tax liabilities and assets be presented as noncurrent on the classified statement of financial position. ASU 2015-17 will be effective for the Company’s fiscal year beginning February 1, 2017. The standard permits the use of either prospective or retrospective application to all periods presented. The Company does not expect this adoption to have a significant impact on its consolidated financial statements.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842)  ASU 2016-02 requires companies to generally recognize on the balance sheet operating and financing lease liabilities and corresponding right-of-use assets. ASU 2016-02 is effective for the Company in its first quarter of fiscal 2020 on a modified retrospective basis and earlier adoption is permitted. The Company is currently evaluating the impact of the pending adoption of ASU 2016-02 on its consolidated financial statements and currently expects that most of its operating lease commitments will be subject to the new standard and recognized as operating lease liabilities and right-of-use assets upon adoption of ASU 2016-02.

 

In October 2016, the FASB issued ASU 2016-16, Income Taxes: Intra-Entity Transfers of Assets Other than Inventory which requires that entities recognize the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. ASU 2016-16 will be effective for the Company's fiscal year beginning February 1, 2018. The standard is required to be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The Company is currently evaluating the accounting, transition, and disclosure requirements of the standard.

 
6

 

 

2.   COMPUTATION OF NET INCOME (LOSS) PER SHARE

 

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

 

   

Three Months Ended

   

Nine Months Ended

 
   

October 31,

   

October 31,

 
   

2016

   

2015

   

2016

   

2015

 
   

(in thousands, except per share data)

   

(in thousands, except per share data)

 

Net income (loss)

  $ 1,533     $ 2,586     $ (291

)

  $ 4,766  

Less: Dividends declared

    (1,328

)

    (1,313

)

    (3,970

)

    (3,922

)

Undistributed net income (loss)

  $ 205     $ 1,273     $ (4,261

)

  $ 844  
                                 

Net income (loss) per share – Class A Common Stock

                               

Dividends declared

  $ 1,136     $ 1,121     $ 3,393     $ 3,346  

Allocation of undistributed net income (loss)

    175       1,087       (3,638

)

    721  

Net income (loss) attributable to Class A common stock

  $ 1,311     $ 2,208     $ (245

)

  $ 4,067  
                                 

Weighted average shares of Class A common stock outstanding—basic

    15,773       15,559       15,687       15,431  

Weighted average potential shares of Class A common stock

    829       749             777  

Weighted average shares of Class A common stock and potential common shares outstanding—diluted

    16,602       16,308       15,687       16,208  
                                 

Basic net income (loss) per Class A common share

  $ 0.08     $ 0.14     $ (0.02

)

  $ 0.26  

Diluted net income (loss) per Class A common share

  $ 0.08     $ 0.14     $ (0.02

)

  $ 0.25  
                                 

Net income (loss) per share – Class B Common Stock

                               

Dividends declared

  $ 192     $ 192     $ 577     $ 576  

Allocation of undistributed net income (loss)

    30       186       (623

)

    123  

Net income (loss) attributable to Class B common stock

  $ 222     $ 378     $ (46

)

  $ 699  
                                 

Weighted average shares of Class B common stock outstanding—basic

    3,206       3,203       3,205       3,200  

Weighted average potential shares of Class B common stock

    95       83             83  

Weighted average shares of Class B common stock and potential common shares outstanding—diluted

    3,301       3,286       3,205       3,283  
                                 

Basic net income (loss) per Class B common share

  $ 0.07     $ 0.12     $ (0.01

)

  $ 0.22  

Diluted net income (loss) per Class B common share

  $ 0.07     $ 0.12     $ (0.01

)

  $ 0.21  

 

Potential common shares consist of the shares issuable upon the release of restricted stock units (“RSUs”) and the exercise of stock options and stock appreciation rights (“SARs”). The Company’s unvested RSUs and unexercised SARs are not considered participating securities as they do not have rights to dividends or dividend equivalents prior to release or exercise.

 

The following table sets forth the number of potential common shares not included in the calculation of diluted earnings per share because their effects were anti-dilutive:

 

   

Three Months Ended

   

Nine Months Ended

 
   

October 31,

   

October 31,

 
   

2016

   

2015

   

2016

   

2015

 
   

(in thousands)

   

(in thousands)

 

Class A

    1,135       640       1,029       490  

Class B

    180       120       151       92  

  

3.   FAIR VALUE MEASUREMENTS

 

When determining fair value, the Company uses a three-tier value hierarchy which prioritizes the inputs used in measuring fair value. Whenever possible, the Company uses observable market data. The Company relies on unobservable inputs only when observable market data is not available. Classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. The assessment of the significance of a particular item to the fair value measurement in its entirety requires judgment, including the consideration of inputs specific to the asset or liability.

 

 
7

 

 

 The following table sets forth the financial assets and liabilities, measured at fair value, as of October 31, 2016 and January 31, 2016:

 

   

Quoted Prices in

Active Markets for

Identical Assets

(Level 1)

   

Significant

Other

Observable

Inputs

(Level 2)

 

Significant

Unobservable

Inputs

(Level 3)

    (in thousands)
Money market mutual funds as of October 31, 2016 (a)   $ 110,735            
Money market mutual funds as of January 31, 2016 (a)   $ 113,984            
Liability related to the interest rate swap as of October 31, 2016 (b)           $ (644 )  
Liability related to the interest rate swap as of January 31, 2016 (b)           $ (675 )  

___________________________

(a) Money market mutual funds are recorded at fair value based upon quoted market prices.

(b) The liability related to the interest rate swap is recorded at fair value based upon a valuation model that uses relevant observable market inputs at quoted intervals, such as forward yield curves.

 

Money market mutual funds are classified as part of “Cash and equivalents” in the accompanying Condensed Consolidated Balance Sheets. The amount of cash and equivalents deposited with commercial banks was $25 million and $24 million as of October 31, 2016 and January 31, 2016, respectively.

 

The Company’s line of credit and notes payable both bear a variable market interest rate commensurate with the Company’s credit standing. Therefore, the carrying amounts outstanding under the line of credit and note payable reasonably approximate fair value based on Level 2 inputs.

 

There have been no transfers between fair value measurements levels during the nine months ended October 31, 2016.

 

Derivative Instruments

 

The Company entered into an interest rate swap in May 2012 to mitigate the exposure to the variability of one month LIBOR for its floating rate debt described in Note 6 “Debt” within these Notes to Condensed Consolidated Financial Statements. The fair value of the interest rate swap is reflected as a liability in the Condensed Consolidated Balance Sheets and the change in fair value is reported in “Other (income) expense” in the Condensed Consolidated Statements of Operations and Comprehensive Income. The fair value of the interest rate swap is estimated as the net present value of projected cash flows based upon forward interest rates at the balance sheet date.

 

 

The fair values of the derivative instrument at October 31, 2016 and January 31, 2016 were as follows (in thousands):

 

 

(Liability) Derivative

 
     

Fair Value

 
 

Balance Sheet

Location

 

October 31,

2016

   

January 31,

2016

 

Derivative instrument:

                 

Interest rate swap

Other liabilities

  $ (644

)

  $ (675

)

Total

  $ (644

)

  $ (675

)

 

The change in fair value of the interest rate swap recognized in the Condensed Consolidated Statements of Operations and Comprehensive Income for the nine months ended October 31, 2016 and 2015 was $31,000 and $164,000 respectively.

  

4. CAPITALIZED SOFTWARE COSTS

 

Capitalized software costs and accumulated amortization at October 31, 2016 and January 31, 2016 were as follows:

 

   

October 31,

2016

   

January 31,

2016

 
   

(in thousands)

 

Capitalized software costs:

               

Acquired software technology

  $ 3,458     $ 3,458  

Capitalized software development costs

    772       1,029  

Total capitalized software costs

    4,230       4,487  

Less accumulated amortization

    (3,296

)

    (2,934

)

Capitalized software costs, net

  $ 934     $ 1,553  

 

 
8

 

 

Acquired software technology costs relate to technology purchased as a result of the Company’s fiscal 2013 acquisitions of DynaSys and CEBOS. In addition to the acquired software technology, the Company has capitalized costs related to translations and localizations of QAD Enterprise Applications.

 

It is the Company’s policy to write off capitalized software development costs once fully amortized. Accordingly, during the first nine months of fiscal 2017, approximately $0.4 million of costs and accumulated amortization were removed from the balance sheet.

 

Amortization of capitalized software costs was $0.7 million and $0.8 million for the nine months ended October 31, 2016 and 2015, respectively. Amortization of capitalized software costs is included in “Cost of license fees” in the accompanying Condensed Consolidated Statements of Operations and Comprehensive Income.

  

The following table summarizes the estimated amortization expense relating to the Company’s capitalized software costs as of October 31, 2016:

 

Fiscal Years

 

(in thousands)

 

2017 remaining

  $ 241  

2018

    598  

2019

    74  

2020

    21  

Total

  $ 934  

 

5.   GOODWILL AND INTANGIBLE ASSETS

 

Goodwill

 

The changes in the carrying amount of goodwill for the nine months ended October 31, 2016 were as follows:

 

   

Gross Carrying

Amount

   

Accumulated

Impairment

   

Goodwill, Net

 
   

(in thousands)

 

Balance at January 31, 2016

  $ 26,253     $ (15,608

)

  $ 10,645  

Impact of foreign currency translation

    12             12  

Balance at October 31, 2016

  $ 26,265     $ (15,608

)

  $ 10,657  

 

The Company performed its annual goodwill impairment review during the fourth quarter of fiscal 2016. The analysis compared the Company’s market capitalization to its net assets as of the test date, November 30, 2015. As the market capitalization significantly exceeded the Company’s net assets, there was no indication of goodwill impairment for fiscal 2016. The Company monitors the indicators for goodwill impairment testing between annual tests. No adverse events occurred during the nine months ended October 31, 2016, that would cause the Company to test goodwill for impairment.

 

Intangible Assets

 

   

October 31,

2016

   

January 31,

2016

 
   

(in thousands)

 

Amortizable intangible assets

               

Customer relationships (1)

  $ 2,754     $ 2,749  

Trade name

    515       515  

Total amortizable intangible assets

    3,269       3,264  

Less: accumulated amortization

    (2,688

)

    (2,191

)

Net amortizable intangible assets

  $ 581     $ 1,073  

______________________

(1)

Customer relationships include the impact of foreign currency translation.

 

 
9

 

 

The Company’s intangible assets are related to the DynaSys and CEBOS acquisitions completed in fiscal 2013. Intangible assets are included in “Other assets, net” in the accompanying Condensed Consolidated Balance Sheets. As of October 31, 2016, all of the Company’s intangible assets were determined to have finite useful lives, and therefore were subject to amortization.

 

Amortization of intangible assets was $0.5 million for each of the nine months ended October 31, 2016 and 2015. The following table summarizes the estimated amortization expense relating to the Company’s intangible assets as of October 31, 2016:

 

Fiscal Years

 

(in thousands)

 

2017 remaining

  $ 164  

2018

    417  

Total

  $ 581  

 

6.   DEBT

 

   

October 31,

2016

   

January 31,

2016

 
   

(in thousands)

 

Note payable

  $ 14,377     $ 14,680  

Less current maturities

    (441

)

    (422

)

Less loan origination costs, net

    (59

)

    (67

)

Long-term debt

  $ 13,877     $ 14,191  

 

 Note Payable

 

Effective May 30, 2012 QAD Ortega Hill, LLC, wholly owned by the Company, entered into a variable rate credit agreement (the “2012 Mortgage”) with Rabobank, N.A., to refinance a pre-existing mortgage. The 2012 Mortgage has an original principal balance of $16.1 million and bears interest at the one month LIBOR rate plus 2.25%. One month LIBOR was 0.53% at October 31, 2016. The 2012 Mortgage matures in June 2022 and is secured by the Company’s headquarters located in Santa Barbara, California. In conjunction with the 2012 Mortgage, QAD Ortega Hill, LLC entered into an interest rate swap with Rabobank, N.A. The swap agreement has an initial notional amount of $16.1 million and a schedule matching that of the underlying loan that synthetically fixes the interest rate on the debt at 4.31% for the entire term of the 2012 Mortgage. The terms of the 2012 Mortgage provide for QAD Ortega Hill, LLC to make net monthly payments of $88,100 consisting of principal and interest and one final payment of $11.7 million. The unpaid balance as of October 31, 2016 was $14.4 million.

  

 

Credit Facility

 

 

The Company has an unsecured credit agreement with Rabobank, N.A. (the “Facility”). The Facility provides a commitment through July 15, 2017 for a $20 million line of credit for working capital or other business needs. The Company pays a commitment fee of 0.25% per annum of the daily average of the unused portion of the $20 million Facility. Borrowings under the Facility bore interest at a rate equal to one month LIBOR plus 0.75%. At October 31, 2016, the effective borrowing rate would have been 1.28%.

 

The Facility provides that the Company maintain certain financial and operating ratios which include, among other provisions, minimum liquidity on a consolidated basis of $25 million in cash and equivalents at all times, a current ratio (calculated using current liabilities excluding deferred revenue) of not less than 1.3 to 1.0 determined at the end of each fiscal quarter, a leverage ratio of not more than 1.5 to 1.0 determined at the end of each fiscal quarter, and a debt service coverage ratio of not less than 1.5 to 1.0 determined at the end of each fiscal year. The Facility also contains customary covenants that could restrict the Company’s ability to incur additional indebtedness.

 

As of October 31, 2016, there were no borrowings under the Facility and the Company was in compliance with all financial covenants.

 

 
10

 

 

7.  ACCUMULATED OTHER COMPREHENSIVE LOSS

 

The components of accumulated other comprehensive loss, net of taxes, were as follows:

 

 

   

Foreign

Currency

Translation

Adjustments

 
   

(in thousands)

 

Balance as of January 31, 2016

  $ (8,729

)

Other comprehensive income

    341  

Amounts reclassified from accumulated other comprehensive loss

     

Net current period other comprehensive income

    341  

Balance as of October 31, 2016

  $ (8,388

)

 

During the first nine months of fiscal 2017 there were no reclassifications from accumulated other comprehensive loss.

 

8.  INCOME TAXES

 

The Company’s income tax provision for each of the third quarters of fiscal 2017 and fiscal 2016 reflects estimates of the effective tax rates expected to be applicable for the full fiscal years, adjusted for any discrete events which are recorded in the period they occur.

 

The Company recorded income tax (benefit) expense of $(0.5) million and $1.9 million for the first nine months of fiscal 2017 and 2016, respectively. The Company’s effective tax rate increased to 63% from 29% for the same period in the prior year. The increase in the annual effective tax rate is primarily due to substantially lower forecasted and actual book income in fiscal 2017.

 

The Company recorded income tax expense of $1.2 million and $0.7 million in the third quarter of fiscal 2017 and fiscal 2016, respectively. The Company’s effective tax rate increased to 43% during the third quarter of fiscal 2017 compared to 22% for the same period in the prior year. The increase in rates is due to lower forecasted and actual book income in fiscal 2017.

  

The gross amount of unrecognized tax benefits was $1.4 million at October 31, 2016, including interest and penalties. As a result of adoption of ASU 2013-11, the Company reduced its unrecognized tax benefits by $1.0 million with an accompanying reduction of deferred tax assets by $1.0 million. The entire amount of unrecognized tax benefits, if recognized, will impact the Company’s effective tax rate. This liability is classified as long-term unless the liability is expected to conclude within twelve months of the reporting date. In the next twelve months, due to potential settlements with domestic tax authorities related to tax credits and lapse in statute of limitations, an estimated $0.1 million of gross unrecognized tax benefits may be recognized.

 

The Company’s policy is to recognize interest and penalties, if any, related to unrecognized tax benefits as a component of income tax expense. As of October 31, 2016, the Company has accrued approximately $0.2 million of interest and penalty expense relating to unrecognized tax benefits.

 

The Company files U.S. federal, state, and foreign tax returns that are subject to audit by various tax authorities. The Company is currently under audit in:

 

 

India for fiscal years ended March 31, 1998, 1999, 2010, 2013 and 2014

 

France for fiscal year ended January 31, 2013

 

Canada for fiscal year ended January 31, 2014

 

Iowa for fiscal year ended January 31, 2014

 

 

During fiscal year 2017, QAD has settled the following audits with immaterial or no adjustments made as a result of the settlements:

 

 

Italy for the fiscal years ended January 31, 2011 and 2012

 

Wisconsin for the fiscal years ended January 31, 2012, 2013 and 2014

 

Thailand for fiscal year ended January 31, 2014

  India for fiscal year ended March 31, 2009 and 2012
  Japan for fiscal years ended January 31, 2013, 2014, 2015 and 2016 through July 31, 2016

 

 
11

 

 

9.  STOCKHOLDERS’ EQUITY

 

Issuance of Common Stock

 

On January 22, 2015, the Company closed an offering of 2,000,000 shares of Class A common stock. The net proceeds to the Company from the sale of the stock were $37.0 million after deducting underwriting discounts and commissions and offering expenses. On February 18, 2015 the offering underwriters exercised in full an option to purchase additional shares. As a result, 450,000 shares of Class A common stock were issued generating approximately $8.4 million in additional net proceeds.

 

Dividends

 

The following table sets forth the dividends that were declared by the Company during the first nine months of fiscal 2017:

 

Declaration

Date

Record Date

Payable

 

Dividend

Class A

   

Dividend

Class B

   

Amount

 

9/14/2016

9/28/2016

10/5/2016

  $ 0.072     $ 0.06     $ 1,328,000  

6/14/2016

6/28/2016

7/7/2016

  $ 0.072     $ 0.06     $ 1,326,000  

4/12/2016

4/26/2016

5/3/2016

  $ 0.072     $ 0.06     $ 1,316,000  

 

 

10.  STOCK-BASED COMPENSATION

 

The Company’s equity awards consist of SARs and RSUs. For a description of the Company’s stock-based compensation plans, see Note 5 “Stock-Based Compensation” in Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended January 31, 2016.

 

Stock-Based Compensation

 

The following table sets forth reported stock-based compensation expense for the three and nine months ended October 31, 2016:

 

 

   

Three Months Ended

October 31,

   

Nine Months Ended

October 31,

 
   

2016

   

2015

   

2016

   

2015

 
   

(in thousands)

   

(in thousands)

 

Cost of subscription

  $ 32     $ 21     $ 81     $ 55  

Cost of maintenance and other revenue

    80       69       219       202  

Cost of professional services

    232       189       618       542  

Sales and marketing

    306       350       904       1,040  

Research and development

    262       227       748       665  

General and administrative

    908       1,025       2,951       3,114  

Total stock-based compensation expense

  $ 1,820     $ 1,881     $ 5,521     $ 5,618  

 

 SAR Information

 

The weighted average assumptions used to value SARs granted in the nine months ended October 31, 2016 and 2015 are shown in the following table:

 

   

Nine Months Ended

October 31,

 
   

2016

   

2015

 

Expected life in years (1)

    5.25       5.00  

Risk free interest rate (2)

    1.16

%

    1.64

%

Volatility (3)

    36

%

    41

%

Dividend rate (4)

    1.51

%

    1.10

%

 

____________________________ 

(1)

The expected life of SARs granted under the stock-based compensation plans is based on historical vested SAR exercise and post-vest forfeiture patterns and includes an estimate of the expected term for SARs that were fully vested and outstanding.

  

 
12

 

 

(2)

The risk-free interest rate is based on the U.S. Treasury yield for a term consistent with the expected life of SARs in effect at the time of grant.

 

(3)

The Company estimates the volatility of its common stock at the date of grant based on the historical volatility of the Company’s common stock for a period equivalent to the expected life of the SARs, which it believes is representative of the expected volatility over the expected life of the SARs.

 

(4)

The Company expects to continue paying quarterly dividends at the same rate as the nine months ending on October 31, 2016.

 

The following table summarizes the activity for outstanding SARs for the nine months ended October 31, 2016:

 

   

SARs

(in

thousands)

   

Weighted

Average

Exercise

Price per

Share

   

Weighted

Average

Remaining

Contractual

Term (years)

   

Aggregate

Intrinsic

Value

(in thousands)

 

Outstanding at January 31, 2016

    2,596     $ 14.74                  

Granted

    380       18.64                  

Exercised

    (97

)

    10.94                  

Expired

    (17

)

    12.56                  

Forfeited

    (6

)

    12.16                  

Outstanding at October 31, 2016

    2,856       15.41       4.6     $ 24,198  

Vested and exercisable at October 31, 2016

    1,863       12.86       3.6     $ 20,304  

 

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the aggregate difference between the closing stock price of the Company’s common stock based on the last trading day as of October 31, 2016, and the exercise price for in-the-money SARs) that would have been received by the holders if all SARs had been exercised on October 31, 2016. The total intrinsic value of SARs exercised in the nine months ended October 31, 2016 was $0.9 million.

 

The number of SARs exercised includes shares withheld on behalf of employees to satisfy minimum statutory tax withholding requirements.  During the three months ended October 31, 2016, the Company withheld 4,200 shares for payment of these taxes at a value of $96,000. During the nine months ended October 31, 2016, the Company withheld 13,000 shares for payment of these taxes at a value of $266,000.

 

At October 31, 2016, there was approximately $5.6 million of total unrecognized compensation cost related to unvested SARs. This cost is expected to be recognized over a weighted-average period of approximately 2.6 years.

  

RSU Information

 

The estimated fair value of RSUs was calculated based on the closing price of the Company’s common stock on the date of grant, reduced by the present value of dividends foregone during the vesting period.

 

 
13

 

 

The following table summarizes the activity for RSUs for the nine months ended October 31, 2016:

 

   

RSUs

   

Weighted

Average

Grant Date

Fair Value

 
   

(in thousands)

         
                 

Restricted stock at January 31, 2016

    617     $ 20.91  

Granted

    307       18.54  

Released (1)

    (258

)

    18.95  

Forfeited

    (35

)

    20.79  

Restricted stock at October 31, 2016

    631     $ 20.56  

_________________________

(1)

The number of RSUs released includes shares withheld on behalf of employees to satisfy the minimum statutory tax withholding requirements.

 

The Company withholds, at the employee’s election, a portion of the released shares as consideration for the Company’s payment of applicable employee income taxes. During the three months ended October 31, 2016, the Company withheld 2,200 shares for payment of these taxes at a value of $46,000. During the nine months ended October 31, 2016, the Company withheld 74,700 shares for payment of these taxes at a value of $1.5 million.

  

Total unrecognized compensation cost related to RSUs was approximately $11.2 million as of October 31, 2016. This cost is expected to be recognized over a weighted-average period of approximately 2.8 years. 

 

11. DEFERRED REVENUES

 

Deferred revenues consisted of the following:

 

   

October 31,

2016

   

January 31,

2016

 
   

(in thousands)

 

Deferred maintenance revenue

  $ 52,817     $ 79,533  

Deferred subscription revenue

    17,873       14,194  

Deferred services revenue

    2,331       2,332  

Deferred license revenue

    854       1,549  

Deferred other revenue

    107       303  

Deferred revenues, current

    73,982       97,911  

Deferred revenues, non-current (in Other liabilities)

    2,039       1,690  

Total deferred revenues

  $ 76,021     $ 99,601  

 

Deferred maintenance and subscription revenues represent customer payments made in advance for support and subscription contracts. Support and subscription are billed in advance with corresponding revenues being recognized ratably over the support and subscription periods. Support is typically billed annually while subscription is billed quarterly or annually. Deferred services revenues represent both prepayments for our professional services where revenues for these services are generally recognized as the Company completes the performance obligations for the prepaid services; and services already provided but deferred due to software revenue recognition rules. Deferred license revenues result from undelivered products or specified enhancements, customer specific acceptance provisions and software license transactions that cannot be segmented from undelivered consulting or other services.

 

12.  COMMITMENTS AND CONTINGENCIES

 

Indemnifications

 

The Company sells software licenses and services to its customers under written agreements. Each agreement contains the relevant terms of the contractual arrangement with the customer and generally includes certain provisions for indemnifying the customer against losses, expenses and liabilities from damages that may be awarded against the customer in the event the Company’s software is found to infringe upon certain intellectual property rights of a third party. The agreements generally limit the scope of and remedies for such indemnification obligations in a variety of industry-standard respects.

 

The Company believes its internal development processes and other policies and practices limit its exposure related to the indemnification provisions of the agreements. For several reasons, including the lack of prior indemnification claims and the lack of a monetary liability limit for certain infringement cases under the agreements, the Company cannot determine the maximum amount of potential future payments, if any, related to such indemnification provisions.

 

Legal Actions

 

The Company is subject to various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on the Company’s consolidated results of operations, financial position or liquidity.

 

 
14

 

 

13.  BUSINESS SEGMENT INFORMATION

 

The Company markets its products and services worldwide, primarily to companies in the manufacturing industry, including automotive, consumer products, food and beverage, high technology, industrial products and life sciences industries. The Company sells and licenses its products through its direct sales force in four geographic regions: North America; Europe, the Middle East and Africa (“EMEA”); Asia Pacific; and Latin America and through distributors where third parties can extend sales reach more effectively or efficiently. The North America region includes the United States and Canada. The EMEA region includes Europe, the Middle East and Africa. The Asia Pacific region includes Asia and Australia. The Latin America region includes South America, Central America and Mexico. The Company’s Chief Operating Decision Maker, the Chief Executive Officer, reviews the consolidated results within one operating segment.

 

License revenue is assigned to the geographic regions based on the estimated proportion of users in each region at the time of sale. Maintenance and subscription revenues are allocated to the region where the end user customer is located. Services revenue is assigned based on the region where the services are performed.

 

   

Three Months Ended

October 31,

   

Nine Months Ended

October 31,

 
   

2016

   

2015

   

2016

   

2015

 
   

(in thousands)

   

(in thousands)

 

Revenue:

                               

North America (1)

  $ 33,413     $ 32,417     $ 95,747     $ 96,168  

EMEA

    19,334       19,376       58,961       62,730  

Asia Pacific

    11,932       11,813       35,749       35,135  

Latin America

    4,855       4,431       14,252       14,560  
    $ 69,534     $ 68,037     $ 204,709     $ 208,593  

____________________________ 

(1)

Sales into Canada accounted for 2% of North America total revenue in each of the three and nine months ended October 31, 2016 and 2015.

  

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

 

FORWARD-LOOKING STATEMENTS

 

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995. Any statements contained herein that are not statements of historical fact should be construed as forward looking statements, including statements that are preceded or accompanied by such words as “may,” “believe,” “could,” “anticipate,” “projects,” “estimates,” “will likely result,” “should,” “would,” “might,” “plan,” “expect,” “intend” and words of similar meaning or the negative of these terms or other comparable terminology. Forward-looking statements are based on the Company’s current expectations and assumptions regarding its business, the economy and future conditions. A number of risks and uncertainties could cause actual results to differ materially from those expressed or implied in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in Part I, Item 1A entitled “Risk Factors” within our Annual Report on Form 10-K for the year ended January 31, 2016. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s opinions, expectations and projections only as of the date hereof and are subject to risks, uncertainties and assumptions about our business. We undertake no obligation to revise or update or publicly release the results of any revision or update to these forward-looking statements except as required by applicable securities laws. Readers should carefully review the risk factors and other information described in other documents we file from time to time with the Securities and Exchange Commission (“SEC”).

 

INTRODUCTION

 

The following discussion should be read in conjunction with the information included within our Annual Report on Form 10-K for the year ended January 31, 2016, and the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q.

 

 
15

 

 

CRITICAL ACCOUNTING POLICIES

 

Our condensed consolidated financial statements are prepared applying certain critical accounting policies. The SEC defines “critical accounting policies” as those that require application of management’s most difficult, subjective, or complex judgments. Critical accounting policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or subject to variations and may significantly affect our reported results and financial position for the period or in future periods. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on our future financial condition and results of operations. Our financial statements are prepared in accordance with U.S. GAAP, and they conform to general practices in our industry. We apply critical accounting policies consistently from period to period and intend that any change in methodology occur in an appropriate manner. Accounting policies currently deemed critical, including a) revenue recognition; b) accounts receivable allowances for bad debt and sales returns; c) capitalized software development costs; d) impairment assessments on goodwill and intangible assets; e) business combinations; f) valuation of deferred tax assets and tax contingency reserves; and g) stock-based compensation are further discussed in our Annual Report on Form 10-K for the fiscal year ended January 31, 2016. There have been no significant changes to our accounting policies and estimates as discussed in our Annual Report on Form 10-K for the fiscal year ended January 31, 2016.

 

BUSINESS OVERVIEW

 

QAD Inc. (“QAD”, the “Company”, “we” or “us”) is a leading global provider of vertically-oriented, mission-critical enterprise software solutions for global manufacturing companies across the automotive, life sciences, consumer products, food and beverage, high technology and industrial products industries. Our mission is to deliver best-in-class software that enables our customers to operate more effectively on a global basis. QAD Enterprise Applications enables measurement and control of key business processes and supports operational requirements. We deliver our software solutions to our customers in a format that best meets their current and future needs - either in the cloud, on premise, or blended. Increasingly, our customers are selecting either a cloud-based deployment or a blended deployment, which is a combination of on-premise and cloud-based software, as they expand their businesses globally and as they recognize the benefits of full featured ERP cloud-based software.

 

 At the core of our solutions is our enterprise resource planning (“ERP”) suite called QAD Enterprise Applications or MFG/PRO. Our ERP suite is also deployed in the cloud as QAD Cloud ERP. QAD Enterprise Applications supports the core business processes of our global manufacturing customers, including key functions in the following areas: financials, customer management, manufacturing, demand and supply chain planning, supply chain execution, transportation management, service and support, enterprise asset management, analytics, enterprise quality management, interoperability, process and performance, and internationalization. We also focus on the foundation and technology of our applications, such as user interface and usability.

 

We have four principal sources of revenue:

 

 

·

License purchases of our Enterprise Applications;

 

 

·

Subscription of our Enterprise Applications through our cloud offering in a Software as a Service (“SaaS”) model as well as other hosted Internet applications;

 

 

·

Maintenance and support, including technical support, training materials, product enhancements and upgrades; and

 

 

·

Professional services, including implementations, technical and application consulting, training, migrations and upgrades.

 

We operate primarily in the following four geographic regions: North America, Latin America, EMEA and Asia Pacific. In the first nine months of fiscal 2017, approximately 47% of our total revenue was generated in North America, 29% in EMEA, 17% in Asia Pacific and 7% in Latin America. The majority of our revenue is generated from global customers who have operations in multiple countries throughout the world. License revenue is assigned to the geographic regions based on the estimated proportion of users in each region at the time of sale. Maintenance and subscription revenues are allocated to the region where the end user is located. Services revenue is assigned based on the region where the services are performed. A significant portion of our revenue and expenses are derived from international operations which are primarily conducted in foreign currencies. As a result, changes in the value of foreign currencies relative to the U.S. dollar have impacted our results of operations and may impact our future results of operations. At October 31, 2016, we employed approximately 1,720 full time employees worldwide, of which 620 employees were based in North America, 540 employees in EMEA, 480 employees in Asia Pacific and 80 employees in Latin America.

  

 
16

 

 

Our customer base and our target markets are primarily global manufacturing companies; therefore, our results are heavily influenced by the state of the manufacturing economy on a global basis. As a result, our management team monitors several economic indicators, with particular attention to the Global and Country Purchasing Managers’ Indexes (“PMI”). The PMI is a survey conducted on a monthly basis by polling businesses that represent the makeup of respective sectors. Since most of our customers are manufacturers, our revenue has historically correlated with fluctuations in the manufacturing PMI. Global macro economic trends and manufacturing spending are important barometers for our business, and the health of the U.S., Western European and Asian economies have a meaningful impact on our financial results.

 

We are transitioning our business model from traditional perpetual licensing to cloud based subscription (Software as a Service) and we have seen an acceleration of customer preference for the cloud. During the third quarter of fiscal 2017 we closed most of our new deals in the cloud in addition to converting several of our existing customers. Recurring revenue, which we define as subscription revenue plus maintenance revenue, accounted for 66% of total revenue for the first nine months of fiscal 2017, up from 62% one year ago. By reducing our customers’ up-front costs and providing more flexibility in how customers gain access to and pay for our products we expect our cloud business model will be more attractive to our customers than perpetual licenses. We anticipate this will increase our long-term revenue growth rate by increasing total subscriptions and customer value over time. As a result of our increased sales in the cloud, our license revenue is declining as a percentage of total revenue in comparison to prior years, a trend that we believe will continue. We expect this will put adverse pressure on short-term profitability as we invest to support growth of our cloud business and our sales and operational expenses are recognized ahead of revenue.

  

OVERVIEW OF THE FIRST NINE MONTHS OF FISCAL 2017

 

A significant portion of our business is conducted in currencies other than the U.S. dollar, particularly the euro.  We operate in several geographical regions as described in Note 13 “Business Segment Information” within the Notes to Condensed Consolidated Financial Statements. In the first nine months of fiscal 2017, approximately 53% of our total revenue was generated outside of North America and we expect to continue generating a significant portion of our revenue outside the U.S. Weakening of the value of the U.S. dollar compared to foreign currency exchange rates generally has the effect of increasing our revenues but also increasing our expenses denominated in currencies other than the U.S. dollar. Similarly, strengthening of the U.S. dollar compared to foreign currency exchange rates generally has the effect of reducing our revenues but also reducing our expenses denominated in currencies other than the U.S. dollar. We plan our business accordingly by deploying additional resources to areas of expansion, while continuing to monitor our overall expenditures given the economic uncertainties of our target markets. In order to provide a framework for assessing how our underlying businesses performed excluding the effect of foreign currency fluctuations, we compare the changes in results from one period to another period using constant currency. In order to calculate our constant currency results, we apply the current foreign currency exchange rates to the prior period results. In the table below, we present the change based on actual results in reported currency and in constant currency.

 

   

Three

Months

Ended

October 31, 2016

   

Three

Months

Ended

October 31, 2015

   

Change in

Constant

Currency

   

Change due

to Currency

Fluctuations

   

Total

Change as

Reported

 

(in thousands)

                                       

Total revenue

  $ 69,534     $ 68,037     $ 2,047     $ (550

)

  $ 1,497  

Cost of revenue

    33,057       31,005       (2,227

)

    175       (2,052

)

Gross profit

    36,477       37,032       (180

)

    (375

)

    (555

)

Operating expenses

    34,218       33,565       (973

)

    320       (653

)

Income from operations

  $ 2,259     $ 3,467     $ (1,153

)

  $ (55

)

  $ (1,208

)

 

   

Nine

Months

Ended

October 31, 2016

   

Nine

Months

Ended

October 31, 2015

   

Change in

Constant

Currency

   

Change due

to Currency

Fluctuations

   

Total

Change as

Reported

 

(in thousands)

                                       

Total revenue

  $ 204,709     $ 208,593     $ (707

)

  $ (3,177

)

  $ (3,884

)

Cost of revenue

    97,999       95,731       (3,341

)

    1,073       (2,268

)

Gross profit

    106,710       112,862       (4,048

)

    (2,104

)

    (6,152

)

Operating expenses

    107,482       106,312       (2,398

)

    1,228       (1,170

)

(Loss) income from operations

  $ (772

)

  $ 6,550     $ (6,446

)

  $ (876

)

  $ (7,322

)

 

 
17

 

 

Total revenue for the first nine months of fiscal 2017 decreased by 2%, to $204.7 million, when compared to the same period last year. Currency had an adverse impact on total revenue of $3.2 million. On a constant currency basis total revenue decreased by $0.7 million. The decline in revenue was driven by lower license and professional services revenue partially offset by growth in subscription revenue from our cloud offering. We expect license revenue to decline as we transition existing and new customers to the cloud. During the third quarter of fiscal 2017 professional services backlog increased. In future quarters we expect this will contribute to higher professional services revenue and improved margins due to higher utilization.

 

While the impact of currency changes negatively affected our revenue, it also reduced our expenses. Total cost of revenue for the first nine months of fiscal 2017 increased by $2.3 million, or 2%, when compared to the same period last year, but on a constant currency basis, total cost of revenue increased by $3.3 million, or 3%. Similarly, operating expenses for the first nine months of fiscal 2017 increased by $1.2 million, or 1%, compared to the same period last year, but on a constant currency basis, operating expenses increased by $2.4 million or 2%. The net unfavorable impact of currency fluctuations on our income from operations was $0.9 million for the first nine months of fiscal 2017.

  

License Revenue. License revenue is derived from software license fees that customers pay for our core product, QAD Enterprise Applications, and any add-on modules they purchase. On a constant currency basis license revenue decreased by $6.7 million, or 31%, in the first nine months of fiscal 2017 compared to the same period last year. During the first nine months of fiscal 2017 the number and size of license orders were lower when compared to the same period last year. Our revenue mix has continued to shift significantly from license to subscription revenue as a result of our business model transition. We expect cloud revenue will continue to increase and license revenue to decline.

 

At times, our license revenue is impacted by deferrals. When we enter into a multi-element transaction with fixed fee services or when we sell licenses for additional users under a pricing model that does not satisfy vendor specific objective evidence (“VSOE”) requirements, we may be required to recognize license revenue ratably over the longer of the maintenance period or expected services implementation timeframe rather than recognizing license revenue at the time of sale. Additionally, if at the time of the license sale we have not finalized the services agreement, we will defer the entire arrangement until the services agreement is signed.

 

We expect new customers are more likely to subscribe to our products in the cloud rather than purchasing perpetual licenses. As a result, we expect a majority of our license revenue will be generated from existing customers and their affiliates. We believe global economic volatility will continue to shape customers’ buying decisions, making it difficult to forecast sales cycles for our products and the timing of software license sales. In addition, we expect license revenue to decrease as our cloud business continues to grow and existing customers elect to subscribe to QAD products in the cloud instead of purchasing licenses.

 

Subscription Revenue. Subscription revenue consists of recurring fees from customers to access our products via the cloud and other subscription offerings. Our cloud offerings typically include access to QAD software, hosting, support and product updates, if and when available. Included in subscription revenue are the fees for transition services such as set up, configuration, database conversion and migration. Sales of QAD Cloud ERP represented approximately 85% of our total subscription revenue in the first nine months of fiscal 2017 and 2016. Our subscription revenue represented approximately 18% and 14% of our total revenue in the first nine months of fiscal 2017 and 2016, respectively. Our cloud customer retention rate is in excess of 90%. We track our retention rate by calculating the annualized revenue of customer sites with contracts scheduled to renew during the period compared to the annualized revenue associated with the customer sites that have canceled during the period. The percentage of revenue not canceled is our retention rate.

  

On a constant currency basis, subscription revenue increased by $9.9 million, or 36%, in the first nine months of fiscal 2017 when compared to the same period last year. Subscription margin was 46%, or unchanged from last year. Given the acceleration of our cloud business, we have made additional investments in infrastructure in order to support additional environments for our new customers. The revenue associated with these environments lags behind the cost, and as a result we experience margin pressure during periods of high growth. Subscription margins should improve over time, but these quarterly fluctuations should be expected as we invest to support cloud growth. Growing our cloud solution and offering our products as SaaS continues to be a key strategic initiative for us.

 

 
18

 

 

Our cloud customers include a mix of existing customers who have converted from our on-premise model and new customer implementations of our cloud solution. New customers typically generate less revenue up front as compared to customers who are converting to cloud. New customers tend to increase the number of users as their sites go live over time. Existing customers are already using our product at the time of conversion to the cloud; therefore, sites and users generally go live from the conversion date. Subscription revenue is billed on a quarterly or annual basis and recognized ratably over the term of the agreement, typically 12 to 60 months. We expect cloud revenue in fiscal 2017 will continue to grow between 30% and 40%.

 

Maintenance Revenue. We offer support services 24 hours a day, seven days a week in addition to providing software upgrades, which include additional or improved functionality, when and if available. On a constant currency basis, maintenance revenue in the first nine months of fiscal 2017 decreased by $0.3 million to $98.3 million.

 

Maintenance revenue fluctuations are influenced by: (1) new license revenue growth; (2) annual renewal of support contracts; (3) fluctuations in currency rates; (4) adjustments to revenue as a result of revenue recognition rules; and (5) customer conversions to QAD Cloud ERP. The vast majority of our customers renew their annual support contracts. Our annual retention rate of customers subscribing to maintenance is in excess of 90%. We track our retention rate by calculating the annualized revenue of customer sites with contracts scheduled to renew during the period compared to the annualized revenue associated with the customer sites that have canceled during the period. The percentage of revenue not canceled is our retention rate. Conversions to cloud are excluded from the calculation. Maintenance revenue is generally billed on an annual basis and recognized ratably over the term of the agreement, typically twelve months. As we convert more of our existing customers to the cloud we will experience a corresponding negative effect on maintenance revenue. When customers convert to QAD Cloud ERP they no longer pay separately for maintenance as those support services are included as a component of the subscription offering.

 

Professional Services Revenue. Our professional services business includes technical and application consulting, training, implementations, migrations and upgrades related to our solutions. On a constant currency basis professional services revenue decreased by $3.2 million, or 6%, in the first nine months of fiscal 2017 when compared to the same period last year. Professional services projects are discretionary in nature and are affected by general economic conditions in the manufacturing industry and our customers' businesses. During the third quarter of fiscal 2017 professional services backlog increased. In future quarters we expect this will contribute to higher professional services revenue and improved margins due to higher utilization. We manage our partners and subcontractors to supplement our internal resources, which provides us with flexibility to address fluctuations in demand.

  

Our professional services organization provides our customers with expertise and assistance in planning and implementing our solutions whether in the cloud or on-premise. Consultants typically assist customers with the initial installation of a system, the conversion and transfer of the customer’s historical data into our software, and ongoing training, education, and system upgrades. We believe our professional services help customers implement our software more efficiently, support a customer’s success with our solution, strengthen our customer relationships, and add to our industry-specific knowledge base for use in future implementations and product innovations. Our professional services margins tend to range from about breakeven to 10%. We believe we offer competitive rates and view our professional services organization as a department supporting the implementation and deployment of our products and improving the overall customer experience. Professional services margins lower our overall operating margin as professional services margins are inherently lower than margins for our license, maintenance and subscription revenues. Professional services revenue may be impacted by currency fluctuations; however, since we generally use local resources our costs are also impacted by similar currency fluctuations, providing a natural hedge. As a result, our margins have not been significantly impacted by currency fluctuations. 

 

Although our professional services are optional, many of our customers use these services for some of their planning, implementation, or related needs. Professional services are typically rendered under time and materials-based contracts with services typically billed on an hourly basis. Professional services are sometimes rendered under fixed-fee based contracts with payments due on specific dates or milestones.

 

Professional services revenue growth is contingent upon license and subscription revenue growth and customer upgrade cycles, which are influenced by the strength of general economic and business conditions and the competitive position of our software products. Our professional services business has competitive exposure to offshore providers which could create the risk of pricing pressure, fewer customer orders and reduced gross margins.

 

 
19

 

 

Cash Flow and Financial Condition. In the first nine months of fiscal 2017, we generated cash flow from operating activities of $5.5 million. Our cash and equivalents at October 31, 2016 totaled $135.7 million, with the only debt on our balance sheet of $14.3 million related to the mortgage of our headquarters. Our primary uses of cash have been funding investment in research and development and funding operations to drive revenue and earnings growth. In addition, we use cash for acquisitions, dividend payments, share repurchase programs and other equity-related transactions.

 

In fiscal 2017, we anticipate that our priorities for use of cash will be developing sales and services resources, continued investment in the growth of our cloud business and research and development to drive and support long-term strategies. We will continue to evaluate acquisition opportunities that are complementary to our product footprint, solutions delivery and technology direction. We will also continue to assess share repurchases and dividend payments. We do not anticipate additional borrowing requirements in fiscal 2017.

 

 

 

 

 

 RESULTS OF OPERATIONS

 

Revenue

 

   

Three

Months

Ended

October

31, 2016

   

Three

Months

Ended

October

31, 2015

   

Change in

Constant

Currency

   

Change due

to Currency

Fluctuations

   

Total

Change

as

Reported

$

   

%

 

(in thousands)

                                               

Revenue

                                               

License fees

  $ 4,323     $ 6,350     $ (2,060

)

  $ 33     $ (2,027

)

    -32

%

Percentage of total revenue

    6

%

    9

%