10-Q 1 d10q.txt FORM 10-Q DTD 06/30/02 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 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 June 30, 2002 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: 1-11859 PEGASYSTEMS INC. ------------------------------------------------------ (Exact name of Registrant as specified in its charter) Massachusetts 04-2787865 -------------------------------- --------------------------------- (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization ) 101 Main Street Cambridge, MA 02142-1590 ---------------------------------------- ---------- (Address of principal executive offices) (zip code) (617) 374-9600 --------------------------------------------------- (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 X No ------- ------- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. There were 34,136,434 shares of the Registrant's common stock, $.01 par value per share, outstanding on July 18, 2002. PEGASYSTEMS INC. AND SUBSIDIARIES Index to Form 10-Q Page ---- Part I - Financial Information Item 1. Condensed Consolidated Financial Statements Condensed Consolidated Balance Sheets at June 30, 2002 and December 31, 2001 3 Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2002 and 2001 4 Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and 2001 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk 21 Part II - Other Information Item 1. Legal Proceedings 22 Item 2. Changes in Securities and Use of Proceeds 22 Item 3. Defaults upon Senior Securities 22 Item 4. Submission of Matters to a Vote of Security Holders 22 Item 5. Other Information 22 Item 6. Exhibits and Reports on Form 8-K 22 SIGNATURES 23 2 PEGASYSTEMS INC. Condensed Consolidated Balance Sheets (in thousands, except share-related amounts)
June 30, December 31, 2002 2001 -------- -------- ASSETS Current assets: Cash and cash equivalents $ 49,020 $ 33,017 Trade accounts receivable, net of allowance for doubtful accounts of $1,038 in 2002 and $1,034 in 2001 4,790 9,592 Short-term license installments, net 35,733 31,359 Prepaid expenses and other current assets 663 2,286 -------- -------- Total current assets 90,206 76,254 Long-term license installments, net 45,088 43,155 Equipment and improvements, net 2,325 3,053 Acquired technology, net (Note 3) 1,254 -- Purchased software and other assets, net 1,443 2,610 Goodwill (Note 3) 3,167 -- -------- -------- Total assets $143,483 $125,072 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accrued payroll expenses $7,313 $7,940 Accounts payable and accrued other expenses 4,820 4,900 Deferred revenue 9,033 6,176 Current portion of capital lease obligations -- 81 -------- -------- Total current liabilities 21,166 19,097 Commitments and contingencies (Note 5) Deferred income taxes 1,000 1,000 Other long-term liabilities 202 17 -------- -------- Total liabilities 22,368 20,114 Stockholders' equity: Preferred stock, $.01 par value, 1,000,000 shares authorized; no shares issued and outstanding -- -- Common stock, $.01 par value, 45,000,000 shares authorized; 34,135,434 shares and 32,754,648 shares issued and outstanding in 2002 and 2001, respectively 341 328 Additional paid-in capital 108,407 101,318 Stock warrants 3,271 2,897 Retained earnings 8,798 757 Accumulated other comprehensive income (loss) 298 (342) -------- -------- Total stockholders' equity 121,115 104,958 -------- -------- Total liabilities and stockholders' equity $143,483 $125,072 ======== ========
See notes to condensed consolidated financial statements. 3 PEGASYSTEMS INC. Condensed Consolidated Statements of Operations (in thousands, except per share amounts)
Three Months Ended Six Months Ended June 30, June 30, ------------------ ------------------ 2002 2001 2002 2001 ---- ---- ---- ---- Revenue: Software license $19,105 $ 8,653 $35,371 $19,534 Services 7,562 14,862 15,507 27,585 -------- -------- -------- -------- Total revenue 26,667 23,515 50,878 47,119 -------- -------- -------- -------- Cost of revenue: Cost of software license 673 1,231 1,316 1,878 Cost of services 7,601 9,900 14,893 20,144 -------- -------- -------- -------- Total cost of revenue 8,274 11,131 16,209 22,022 -------- -------- -------- -------- Gross Profit 18,393 12,384 34,669 25,097 Operating expenses: Research and development 5,604 4,995 11,354 9,986 Selling and marketing 5,979 4,231 11,708 9,140 General and administrative 3,103 2,106 5,512 5,096 -------- -------- -------- -------- Total operating expenses 14,686 11,332 28,574 24,222 -------- -------- -------- -------- Income from operations 3,707 1,052 6,095 875 Installment receivable interest income 1,258 1,450 2,516 2,900 Other interest income, net 180 234 323 448 Other income (expense), net (292) 141 (443) (2) -------- -------- -------- -------- Income before provision for income taxes 4,853 2,877 8,491 4,221 Provision for income taxes 250 225 450 475 -------- -------- -------- -------- Net income $ 4,603 $ 2,652 $ 8,041 $ 3,746 ======== ======== ======== ======== Earnings per share: Basic $0.14 $0.08 $0.24 $0.11 ===== ===== ===== ===== Diluted $0.13 $0.08 $0.22 $0.11 ===== ===== ===== ===== Weighted average number of common and common equivalent shares outstanding: Basic 33,738 32,655 33,442 32,625 ====== ====== ====== ====== Diluted 36,819 33,379 35,900 33,371 ====== ====== ====== ======
See notes to condensed consolidated financial statements. 4 PEGASYSTEMS INC. Condensed Consolidated Statements of Cash Flows (in thousands)
Six Months Ended June 30, ------------------- 2002 2001 ---- ---- Cash Flows from Operating Activities: Net income $ 8,041 $ 3,746 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,504 3,539 Changes in operating assets and liabilities: Trade and installment accounts receivable (1,208) (3,575) Prepaid expenses and other current assets 1,650 337 Accounts payable and accrued expenses (946) 1,531 Deferred revenue 2,798 1,889 ------- ------- Net cash provided by operating activities 12,839 7,467 ------- ------- Cash Flows from Investing Activities: Acquisition of 1mind (See note 3) (573) -- Purchase of equipment and improvements (291) (252) Other long term assets and liabilities (3) 173 ------- ------- Net cash used in investing activities (867) (79) ------- ------- Cash Flows from Financing Activities: Payments of capital lease obligations (81) (159) Proceeds from sale of stock under employee stock purchase plan 177 164 Exercise of stock options 3,631 49 ------- ------- Net cash provided by financing activities 3,727 54 ------- ------- Effect of exchange rate changes on cash and cash equivalents 304 (192) ------- ------- NET INCREASE IN CASH AND CASH EQUIVALENTS 16,003 7,250 ------- ------- CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 33,017 17,339 ------- ------- CASH AND CASH EQUIVALENTS, END OF PERIOD $49,020 $24,589 ------- -------
See notes to condensed consolidated financial statements. 5 PEGASYSTEMS INC. Notes to Condensed Consolidated Financial Statements June 30, 2002 Note 1 - Basis of Presentation The unaudited condensed consolidated financial statements of Pegasystems Inc. (the "Company") have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three month and six month periods ended June 30, 2002 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2002. We suggest that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2001, included in our 2001 Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC"). Certain amounts in the 2001 consolidated financial statements were reclassified to be consistent with the current presentation. Reimbursements received for out-of-pocket expenses have been reflected as services revenue, in compliance with Emerging Issues Task Force No. 01-14; in prior periods the reimbursements had been reflected as reduction of cost of services.
(in thousands, except per share data) Three Months Six Months Ended June 30, Ended June 30, 2001 2001 -------------- -------------- Services revenue as reported previously $14,203 $26,138 Add: Reimbursements for out-of-pocket expenses 659 1,447 ------- ------- Services revenue, reclassified $14,862 $27,585 ======= ======= Cost of services as reported previously $ 9,241 $18,697 Add: Reimbursements for out-of-pocket expenses 659 1,447 ------- ------- Cost of services, reclassified $ 9,900 $20,144 ======= =======
Note 2 - Significant Accounting Policies (a) Business We develop, market, license and support software that enables transaction intensive-organizations to manage a broad array of customer interactions. We also offer consulting, training, maintenance and support services to facilitate the installation and use of our products. (b) Management Estimates and Reporting 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 periods presented. Actual results could differ from those estimates. Significant assets and liabilities with reported amounts based on estimates include trade and installment accounts receivable, long term license installments and deferred revenue. 6 (c) Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Pegasystems Limited (a United Kingdom company), Pegasystems Company (a Canadian company), Pegasystems Worldwide Inc. (a United States corporation), Pegasystems Pty. Ltd. (an Australian company), Pegasystems Investment Inc. (a United States corporation), and Pegasystems Private Limited (a Singapore company). All intercompany accounts and transactions have been eliminated in consolidation. (d) Foreign Currency Translation The translation of assets and liabilities of our foreign subsidiaries is made at period-end exchange rates, while equity accounts are translated at historic exchange rates, and revenue and expense accounts are translated at the average exchange rates during the period transactions occurred. The resulting translation adjustments are reflected as a separate component of accumulated other comprehensive income (loss). Realized and unrealized exchange gains or losses from transactions and adjustments are reflected in other income (expense), net, in the accompanying consolidated statements of operations. (e) Revenue Recognition Our revenue is derived from two primary sources: software license fees and service fees. We offer both perpetual and term software licenses. Perpetual license fees are generally payable at the time the software is delivered, and are generally recognized as revenue upon customer acceptance. Term software license fees are generally payable on a monthly basis under license agreements that generally have a five-year term and may be renewed for additional years at the customer's option. The present value of future license payments is generally recognized as revenue upon customer acceptance and commitment to the contractual payment stream. A portion of the fee from each arrangement is initially deferred and recognized as installment receivable interest income over the license term. In addition, many of our license agreements provide for license fee increases based on inflation. The present value of such increases is recognized when the increases become known. For purposes of the present value calculations, the discount rates used are estimates of customers' borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.5% and 8.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements can be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized upon customer commitment to the new license terms. Our service revenue is comprised of fees for software implementation, consulting, maintenance, and training services. Our software implementation and consulting agreements typically require us to provide a specified level of implementation services for a specified fee, with additional consulting services available at an hourly rate. Revenues for time and material projects are recognized as fees are billed. Revenues for fixed price projects are recognized as services are delivered once the fair value of services and any other elements to be delivered under the arrangement can be determined. All costs of services are expensed as incurred. Historically, we have had difficulty accurately estimating the time and resources needed to complete fixed price projects. As a result, determination of the fair value of the elements of the contract has generally occurred later in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. Prior to the point at which the fair value of the elements of a contract can be determined, revenue recognition for fixed price projects is limited to amounts equal to costs incurred, resulting in no gross profit. Once the fair values of the elements of a contract are apparent, profit associated with the fixed price services elements will begin to be recognized. Software license customers are offered the option to enter into a maintenance contract, which requires the customer to pay a monthly maintenance fee over the term of the maintenance agreement, typically renewable annually. Prepaid maintenance fees are deferred and are recognized evenly over the term of the maintenance agreement. We generally recognize training fees revenue as the services are provided. 7 We reduce revenue for estimates of the fair value of potential concessions when revenue is initially recorded. These estimated amounts are deferred or reserved until the related elements of the agreement are completed and provided to the customer. (f) Concentration of Credit Risk Financial instruments that potentially subject us to a concentration of credit risk consist of short-term cash investments, trade accounts receivable, and long-term license installments receivable. We record long-term license installments in accordance with our revenue recognition policy, which results in receivables from customers due in periods exceeding one year from the reporting date, primarily from large organizations with strong credit ratings. We grant credit to customers who are located throughout the world. We perform credit evaluations of customers and generally do not request collateral from customers. Amounts due under long-term license installments are expected to be received as follows: License Installments Years ended December 31, (in thousands) Remainder of 2002 $ 20,000 2003 26,375 2004 18,585 2005 14,574 2006 9,995 2007 2,594 2008 974 --------- 93,097 Deferred license interest income (12,276) --------- Total license installments receivable $ 80,821 ========= (g) Cash and Cash Equivalents We consider all highly liquid investments with remaining maturities of three months or less at the date of purchase to be cash equivalents. (h) Equipment and Improvements Equipment and improvements are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which are three years for equipment and five years for furniture and fixtures. Leasehold improvements and equipment under capital leases are amortized over the term of the lease or the useful life of the asset, whichever is less. Repairs and maintenance costs are expensed as incurred. (i) Impairment of Long-Lived Assets We evaluate our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the fair value of the asset. (j) Research and Development and Software Costs Research and development costs, other than certain software related costs, are expensed as incurred. Capitalization of software costs begins upon the establishment of technical feasibility, generally demonstrated by a working model or an operative version of the computer software product that is completed in the same 8 language and is capable of running on all of the platforms as the product to be ultimately marketed. Such costs have not been material to date, and as a result, no internal costs were capitalized during the three and six months ended June 30, 2002 and 2001. Software costs are included in cost of software license revenue. No amortization expense for internally developed capitalized software costs was charged to cost of software license revenue during the three and six months ended June 30, 2002 and 2001. (k) Net Earnings Per Share Basic earnings per share are computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share includes, to the extent inclusion of such shares would be dilutive to earnings per share, the effect of outstanding options and warrants, computed using the treasury stock method.
(in thousands, except per share data) Three Months Ended Six Months Ended June 30, June 30, ---------------------- -------------------- 2002 2001 2002 2001 ---- ---- ---- ---- Basic ----- Net income $ 4,603 $ 2,652 $8,041 $ 3,746 ======= ======= ====== ======= Weighted average common shares outstanding 33,738 32,655 33,442 32,625 ======= ======= ====== ======= Basic earnings per share $0.14 $0.08 $0.24 $0.11 ======= ======= ====== ======= Diluted ------- Net income $ 4,603 $ 2,652 $8,041 $ 3,746 ======= ======= ====== ======= Weighted average common shares outstanding 33,738 32,655 33,442 32,625 Effect of assumed exercise of stock options 3,081 724 2,458 746 ------- ------- ------- ------- Weighted average common shares Outstanding, assuming dilution 36,819 33,379 35,900 33,371 ======= ======= ====== ======= Diluted earnings per share $0.13 $0.08 $0.22 $0.11 ======= ======= ====== ======= Outstanding options and warrant excluded as impact would be anti-dilutive 2,025 8,007 4,128 7,530 ======= ======= ====== =======
(l) Segment Reporting We currently operate in one operating segment, customer service software. We derive substantially all of our operating revenue from the sale and support of one group of similar products and services. Substantially all of our assets are located within the United States. For the three and six months ending June 30, 2002 and 2001, we derived our operating revenue from the following countries, principally through export from the United States of America: 9
Three Months Ended Six Months Ended June 30, June 30, -------- -------- (in $ thousands) 2002 2001 2002 2001 ---- ---- ---- ---- United States $21,224 80% $17,494 74% $ 40,582 80% $34,815 74% United Kingdom 4,232 16% 3,589 15% 7,878 15% 6,928 15% Europe 258 1% 1,173 5% 1,156 2% 3,738 8% Other 953 3% 1,259 6% 1,262 3% 1,638 3% ------- ------- -------- ------- $26,667 100% $23,515 100% $ 50,878 100% $47,119 100%
During the three months ended June 30, 2002 and 2001, one customer accounted for approximately 23% and 16% of our total revenue, respectively. During the six months ended June 30, 2002 and 2001, one customer accounted for approximately 31% and 10% of our total revenue, respectively. At June 30, 2002, one customer represented 10% of outstanding accounts receivable and one customer represented 13% of long and short-term license installments. (m) Stock Options We periodically grant stock options for a fixed number of shares to employees and directors with an exercise price equal to the fair market value of the shares at the date of the grant. We account for such stock option grants using the intrinsic value method in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees", and intend to continue to do so. Stock options granted to non-employee contractors are accounted for using the fair value method in accordance with Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation". We have adopted the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," relative to the impact of the fair value method. (n) Fair Value of Financial Instruments The principal financial instruments held consist of cash and equivalents, accounts receivable and payable, capital lease obligations, and license installment receivables arising from license transactions. The carrying values of cash and equivalents, accounts receivable, accounts payable, and capital lease obligations approximates their fair value due to the short-term nature of the accounts. Using current market rates, the fair value of license installment receivables approximates carrying value at June 30, 2002 and 2001. (o) Legal Costs We expense litigation costs as incurred. (p) New Accounting Standards We have adopted the Financial Accounting Standards Board ("FASB") SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." These pronouncements provide guidance on how to account for the acquisition of businesses and intangible assets, including goodwill, which arise from such activities. SFAS No.141 affirms that only one method of accounting may be applied to a business combination, the purchase method. SFAS No. 141 also provides guidance on the allocation of purchase price to the assets acquired. SFAS No. 142 provides that goodwill resulting from business combinations no longer be amortized to expense, but rather requires an annual assessment of impairment and, if necessary, adjustments to the carrying value of goodwill. 10 We have adopted SFAS No. 143, "Accounting for Obligations Associated with the Retirement of Long-Lived Assets and SFAS No. 144 "Accounting for the Impairment of Disposal of Long-Lived Assets. SFAS No.143 establishes accounting standards for the recognition and measurement of an asset retirement obligation and its associated asset retirement cost. It also provides guidance for legal obligations associated with the retirement of tangible long-lived assets. SFAS No. 144 establishes a single accounting model for the impairment or disposal of long-lived assets, including discontinued operations. Adoption of these pronouncements is not expected to have a significant effect on our consolidated financial statements. Note 3 - Acquisition On February 6, 2002, we acquired substantially all of the assets of 1mind Corporation ("1mind") for initial consideration value of $3.7 million. Depending upon the achievement of specified milestones by the acquired business in 2002 and validation of the negotiated value of 1mind, we may pay up to approximately $6 million in additional consideration substantially in the form of shares of our common stock. We believe that the acquisition will help increase our penetration of the healthcare and insurance markets, strengthen our management and delivery teams and deepen our product offerings. The acquisition of 1mind has been accounted for as purchase and the operations of 1mind have been included in our consolidated financial statements from the date of acquisition. Results of operations would not have changed materially for 2001 or the current year if 1mind had been acquired on January 1, 2001 and 2002, respectively. The cash flow impact of $573 thousand from this acquisition was transaction costs of $614 thousand less cash acquired of $41 thousand. We have not yet completed the process of appraising the fair values of 1mind assets, and therefore, the allocation of the purchase price in the condensed consolidated financial statements is based on estimates, and is subject to change.
(in thousands) Shares issued (a) $ 3,295 Warrants issued (b) 374 ------- Total purchase price $ 3,669 ======= Current assets, including cash of $41 $ 339 Equipment and improvements 143 Acquired existing technology (c) 1,400 Goodwill and other intangibles (d) 3,167 Current liabilities (571) Long term liabilities (195) Transaction costs (614) ------- $ 3,669 =======
(a) 569,949 common shares of Pegasystems Inc. valued at approximately $5.78 per share, the average of closing prices as reported by Nasdaq for the three days before and after January 29, 2002, the date of agreement. (b) Warrants to purchase, for nominal consideration, 83,092 common shares of Pegasystems Inc., valued at approximately $4.50 per warrant using a Black-Scholes model. (c) Acquired existing technology results from a preliminary appraisal report of 1mind intangible assets. (d) Any additional consideration paid will be recorded as goodwill. 11 Note 4 - Comprehensive Income The components of comprehensive income are as follows:
(in thousands) Three Months Ended Six Months Ended June 30, June 30, ---------------------- --------------------- 2002 2001 2002 2001 ---- ---- ---- ---- Net income $4,603 $2,652 $8,041 $3,746 Foreign currency translation adjustments, net of income taxes 652 (15) 640 (107) ------ ------ ------ ------ Comprehensive income $5,255 $2,637 $8,681 $3,639 ====== ====== ====== ======
Note 5 - Commitments and Contingencies Company Litigation Qwest Arbitration. On January 17, 2002, we filed a demand for arbitration with the American Arbitration Association in Denver, Colorado against Qwest Corporation, successor in interest to US West Business Resources, Inc. ("Qwest"). We are seeking monetary damages in the arbitration relating to Qwest's termination of a software license and service agreement with us. On February 8, 2002, Qwest filed a counterclaim against us seeking unspecified monetary damages for alleged breach by us of that agreement and software royalties in an unspecified amount. An arbitration hearing is currently scheduled for August, 2002. Ernst and Young Arbitration. On June 9, 2000, the Company and two of its officers filed a complaint against Ernst & Young LLP and Alan B. Levine (a former partner of Ernst & Young) in Massachusetts state court. The Complaint alleges that the defendants committed professional malpractice, breached contractual and fiduciary duties owed to the Company, and issued false and misleading public statements, in connection with advice that Ernst & Young rendered to the Company to record $5 million in revenue in its financial statements for the second fiscal quarter ended June 30, 1997 pursuant to a series of contracts between the Company and First Data Resources, Inc. The complaint sought compensatory damages, including contribution for losses and other costs incurred in connection with certain class action securities litigation, which has been settled. On April 5, 2001, the Court dismissed the Complaint, finding that it was subject to the dispute resolution procedures set forth in an engagement letter between the Company and Ernst & Young. The parties agreed to submit this dispute to arbitration, the evidence phase of which concluded in June, 2002. Post-hearing argument is currently scheduled for August 6, 2002. Acquisition Under the agreement for acquisition of 1mind, depending upon the achievement of specified milestones by the acquired business in 2002 and validation of the negotiated value of 1mind, we may pay up to approximately $6 million in additional consideration, substantially in the form of shares of our common stock. 12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies In connection with the discussion that follows, you are encouraged to read Notes 2 and 3 of the notes to our condensed consolidated financial statements included elsewhere in this report. Our revenue is derived from two primary sources: software license fees and service fees. We offer both perpetual and term software licenses. Perpetual license fees are generally payable at the time the software is delivered, and are generally recognized as revenue upon customer acceptance. Term software license fees are generally payable on a monthly basis under license agreements that generally have a five-year term and may be renewed for additional years at the customer's option. The present value of future license payments is generally recognized as revenue upon customer acceptance and commitment to the contractual payment stream. A portion of the fee from each arrangement is initially deferred and recognized as installment receivable interest income over the license term. In addition, many of our license agreements provide for license fee increases based on inflation. The present value of such increases is recognized when the increases become known. For purposes of the present value calculations, the discount rates used are estimates of customers' borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.5% and 8.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements can be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized upon customer commitment to the new license terms. Our service revenue is comprised of fees for software implementation, consulting, maintenance, and training services. Our software implementation and consulting agreements typically require us to provide a specified level of implementation services for a specified fee, with additional consulting services available at an hourly rate. Revenues for time and material projects are recognized as fees are billed. Revenues for fixed price projects are recognized as services are delivered once the fair value of services and any other elements to be delivered under the arrangement can be determined. All costs of services are expensed as incurred. Historically, we have had difficulty accurately estimating the time and resources needed to complete fixed price projects. As a result, determination of the fair value of the elements of the contract has generally occurred later in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. Prior to the point at which the fair value of the elements of a contract can be determined, revenue recognition for fixed price projects is limited to amounts equal to costs incurred, resulting in no gross profit. Once the fair values of the elements of a contract are apparent, profit associated with the fixed price services elements will begin to be recognized. Software license customers are offered the option to enter into a maintenance contract, which requires the customer to pay a monthly maintenance fee over the term of the maintenance agreement, typically renewable annually. Prepaid maintenance fees are deferred and are recognized evenly over the term of the maintenance agreement. We generally recognize training fees revenue as the services are provided. We reduce revenue for estimates of the fair value of potential concessions when revenue is initially recorded. These estimated amounts are deferred or reserved until the related elements of the agreement are completed and provided to the customer. Three and Six Months Ended June 30, 2002 Compared to Three and Six Months Ended June 30, 2001 Revenue Our total revenue for the three-month period ended June 30, 2002 ("the second quarter of 2002") increased 13% to $26.7 million from $23.5 million for the three month period ended June 30, 2001 ("the second quarter 13 of 2001"). The increase was due to a $10.5 million increase in software license revenue partially offset by a $7.3 million decrease in services revenue. Total revenue for the six months ended June 30, 2002 ("first half of 2002) increased 8% to $50.9 million from $47.1 million in the six months ended June 30, 2001 ("first half of 2001"). The following table summarizes our revenue composition:
(in millions) Three Months Ended Six Months Ended June 30, June 30, ------------------ ----------------- 2002 2001 2002 2001 ---- ---- ---- ---- License revenue --------------- Term license renewals, extensions and additions $ 11.8 $ 6.9 $ 16.5 $ 14.4 Perpetual and subscription licenses 7.3 1.7 18.9 5.1 ------ ------ ------ ------ Total license revenue 19.1 8.6 35.4 19.5 Services Revenue ---------------- Consulting services 5.4 12.9 11.1 23.7 Maintenance 2.2 2.0 4.4 3.9 ------ ------ ------ ------ Total services revenue 7.6 14.9 15.5 27.6 ------ ------ ------ ------ Total revenue $ 26.7 $ 23.5 $ 50.9 $ 47.1 ====== ====== ====== ======
Software license revenue for the second quarter of 2002 increased 121% to $19.1 million from $8.6 million for the second quarter of 2001. The $5.6 million increase in perpetual and subscription licenses was due to a $4.3 million increase in net license revenue from First Data Resources ("FDR"), and a $1.3 million increase in other subscription revenue. Term software license renewals, extensions, and additions increased by $4.9 million. Discount rates used to recognize term license revenue vary directly with overall interest rate levels. The discount rates used to recognize term license revenue in the second quarter of 2002 averaged 4.26%. Of the increase in license revenue for the second quarter versus prior year, approximately $0.6 million was due to reduced discount rates on term license revenue. Software license revenue for the first half of 2002 increased 81% to $35.4 million from $19.5 million in the first half of 2001, due primarily to increased revenue from perpetual licenses. Of the increase in license revenue for the first half versus prior year, approximately $0.9 million was due to reduced discount rates on term license revenue. Of the increase in revenue from perpetual licenses in the first half of 2002, $12.8 million was due to the sale to First Data Resources ("FDR") of a perpetual license that replaced the prior term license subscription which was due to expire in December 2002. Software license revenue recognized under the FDR agreements was $8.6 million in Q1 of 2002, and $5.85 million in Q2 of 2002. Under the terms of the FDR perpetual license agreement, FDR is required to make monthly payments through December 2003. These payments total $5.85 million in each of the third and fourth quarters of 2002 and $3.54 million in each of the four quarters of 2003. We recognize revenue three months in advance of payments per the cancellation provisions of the agreement. We expect to recognize as revenue from the FDR perpetual license $5.85 million in the third quarter of 2002, and $3.54 million in the fourth quarter of 2002 and each of the first three quarters of 2003. In the future, we expect to enter into more perpetual license transactions, the effect of which may be to increase our license revenue and cash flow in the short term and to decrease the amount of revenue and cash flow from the renewal of term software license agreements. Historically, a significant portion of our license revenue has been from renewals of term software license agreements. License transactions with new customers have slowed significantly since the latter part of 2001. Services revenue for the second quarter of 2002 decreased 49% to $7.6 million from $14.9 million for the second quarter 2001. Services revenue for the first half of 2002 decreased 44% to $15.5 million from $27.6 million in the first half of 2001. The decreases were due primarily to delayed customer spending and a decrease in new customer license transactions, which we believe were caused by the current generally weak economic conditions. Typically, we derive substantial revenue from services provided in connection with the implementation of software licensed by new customers. 14 Deferred revenue at June 30, 2002 consisted primarily of billed fees from arrangements for which acceptance of the software license or service milestone had not occurred, the unearned portion of services revenue and advance payment of maintenance fees. Deferred revenue balances increased to $9.0 million as of June 30, 2002 from $6.2 million as of December 31, 2001, due to advance payment of maintenance fees and software licenses, and an increase in the unearned portion of services revenue due to service milestones. International revenues were 20% of total consolidated revenues for the first half of 2002 and 26% for the first half of 2001. Our international revenues may fluctuate in the future because such revenues generally result from a small number of product acceptances during a given period. Historically, most of our contracts have been denominated in U.S. dollars. However, more of our contracts in the future may be denominated in foreign currencies, thereby exposing us to increased currency exchange risk. Cost of revenue Costs of software license includes the amortization associated with a stock purchase warrant we issued in September 1997 under an agreement with First Data Resources and the amortization of the intellectual property we purchased from 1mind. Cost of software license revenue for the second quarter of 2002 decreased 45% to $0.7 million from $1.2 million for the second quarter of 2001. As a percentage of software license revenue, cost of software license revenue decreased to 4% for the second quarter of 2002 from 14% for the second quarter of 2001. Cost of software licenses for the first half of 2002 decreased 30% to $1.3 million from $1.9 million for the first half of 2001. As a percentage of software license revenue, cost of software license revenue decreased to 4% for the first half of 2002 from 10% for the first half of 2001. Such decreases were attributable to a $0.6 million charge taken in the second quarter of 2001 and the increase in software license revenue. The charge was for software acquired by the Company in the fourth quarter of 2000 which, after initially being amortized, was expensed in-full in the second quarter of 2001 because the productive use of this software was no longer anticipated. Cost of services consists primarily of the costs of providing implementation, consulting, maintenance, and training services. Cost of services for the second quarter of 2002 decreased 23% to $7.6 million from $9.9 million for the second quarter of 2001, primarily due to reduced staff costs and lower contractor costs. Cost of services as a percentage of service revenue increased to 101% for the second quarter of 2002 from 67% for the second quarter of 2001. Cost of services for the first half of 2002 decreased 26% to $14.9 million from $20.1 million for the first half of 2001. Cost of services as a percentage of services revenue increased to 96% for the first half of 2002 from 73% for the first half of 2001. The percentage increase was primarily due to the reduction in services revenue, which was only partially offset by reduced staff costs. Service gross margin was negative $39 thousand for the second quarter of 2002. We will continue to review resource requirements to ensure appropriate alignment with revenue expectations. Operating expenses Research and development expenses for the second quarter of 2002 increased 12% to $5.6 million from $5.0 million for 2001. As a percentage of total revenue, research and development expenses remained approximately flat at 21% for the second quarter of 2002 compared to the second quarter of 2001. Research and development expenses for the first half of 2002 increased 14% to $11.4 million from $10.0 million for the first half of 2001. As a percentage of total revenue, research and development expenses increased to 22% for the first half of 2002 from 21% for the first half of 2001.This increase was the result of growth in staffing costs including compensation and benefits, travel, and increased use of third party consultants to support investment in PegaRULES technology as well as other product developments and enhancements. Selling and marketing expenses for the second quarter of 2002 increased 41% to $6.0 million from $4.2 million for the second quarter of 2001. As a percentage of total revenue, selling and marketing expenses increased to 22% for the second quarter of 2002 from 18% for the second quarter of 2001. Selling and marketing expenses for the first half of 2002 increased 28% to $11.7 million from $9.1 million for the first half of 2001. As a percentage of total revenue, selling and marketing expenses increased to 23% for the first half of 2002 from 19% for the first half of 2001. These increases were due to increased staff and marketing programs spending in our application business and investment in the emerging PegaRULES business. 15 General and administrative expenses for the second quarter of 2002 increased 47% to $3.1 million from $2.1 million for the second quarter of 2001. As a percentage of total revenue, general and administrative expenses increased to 12% for the second quarter of 2002 from 9% for the second quarter of 2001. General and administrative expenses for the first half of 2002 increased 8% to $5.5 million from $5.1 million for the first half of 2001. As a percentage of total revenue, general and administrative expenses remained approximately flat at 11% for the first half of 2002 compared to the first half of 2001. These increases were due to legal and professional services fees related to the Qwest and Ernst & Young arbitrations. Installment receivable interest income Installment receivable interest income, which consists of the portion of all term license fees under software license agreements that is attributable to the time value of money, decreased in the second quarter of 2002 to $1.3 million from $1.5 million for the second quarter of 2001. Installment receivable interest income for the first half of 2002 decreased to $2.5 million from $2.9 million for the first half of 2001. The decrease was due to a lower average discount rate for our portfolio of term software licenses. A portion of the fee from each term license arrangement is initially deferred and recognized as installment receivable interest income over the remaining term of the license. For purposes of the present value calculations, the discount rates used are estimates of customers' borrowing rates, typically below prime rate, and have varied between 3.5% and 8.0% during the past few years. Other interest income, net Other interest income, net decreased 23% to $0.18 million for the second quarter of 2002 from $0.23 million for the second quarter of 2001. Other interest income, net, decreased to $0.32 million for the first half of 2002 from $0.45 million for the second half of 2001. The decreases were due to lower interest rates, partially offset by larger invested cash balances. Other income (expense), net Other income (expense), net, which consists primarily of currency exchange losses and reseller development funds received from third-party vendors of computer hardware products, was ($0.3) million for the second quarter of 2002 versus $0.1 million for the second quarter of 2001. Other income (expense), net was ($0.4) million for the first half of 2002 compared to two thousand dollars for the first half of 2001. The decreases were due to lower partner commissions and greater currency exchange losses. Income before provision for income taxes Income before provision for income taxes increased to $4.9 million for the second quarter of 2002 from $2.9 million for the second quarter of 2001. This $2.0 million improvement was due primarily to a $11.0 million improvement in software license gross margin from increased revenues, partially offset by a $5.0 million reduction in services gross margin due to lower services revenues, increased operating expenses of $3.4 million, reduction in installment receivable interest income, and greater currency losses. Provision for income taxes The provision for the second quarter of 2002 consists of current taxes provided on foreign subsidiary income. The tax provision for the first half of 2002 and the first half of 2001 was $0.5 million. Provisions have not been recorded for U.S. federal and state taxes due to the availability of loss carryforwards, the recognition of which would offset any tax provision recorded. 16 Liquidity and Capital Resources We have funded our operations primarily from cash flow from operations and the proceeds of our public stock offerings. At June 30, 2002, we had cash and cash equivalents of $49.0 million and working capital of $69.0 million. Net cash provided by operations for the first half of 2002 was $12.8 million compared with $7.5 million for the first half of 2001. The increase was due to a $4.3 million improvement in profitability and a $2.4 million improvement in the collections of accounts receivable, primarily from perpetual licenses. These improvements were partially offset by net changes in accrued expenses, prepaid expenses, other current assets, and deferred revenues. Net cash used in investing activities for the first half of 2002 was $0.9 million compared with $0.1 million for the first half of 2001. The increased use of cash was primarily due to transaction costs associated with the 1mind acquisition. On February 6, 2002, we acquired substantially all of the assets of 1mind for initial consideration valued at $3.7 million, consisting of 569,949 shares of our common stock and warrants to purchase for nominal consideration 83,092 shares of our common stock. Depending upon the achievement of specified milestones by the acquired business in 2002 and validation of the negotiated value of 1mind, we may pay up to approximately $6 million in additional consideration substantially in the form of shares of our common stock. (See Note 3 of notes to condensed consolidated financial statements.) Net cash provided by financing activities for the first half of 2002 was $3.7 million compared with $0.1 million in the first half of 2001. The increase was primarily due to proceeds from employee stock option exercises. We believe that current cash, cash equivalents, and cash flow from ongoing operations will be sufficient to fund our operations for the coming year. Material risks to additional cash flow from operations include a further decline in services revenue and delayed or reduced cash payments accompanying sales of new licenses. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected expenditures. In addition, there can be no assurance that additional capital if needed will be available on reasonable terms, if at all, at such time as we require. Inflation Inflation has not had a significant impact on our operating results to date, and we do not expect it to have a significant impact in the future. Our agreements with customers typically provide for annual increases in term license and maintenance fees based on recognized inflation indexes. Forward-looking statements This Report contains certain forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, the words "believes", "anticipates", "plans", "expects", and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause our actual results to differ materially from those indicated by forward-looking statements made in this report and presented elsewhere by management from time to time. Some of the important risks and uncertainties that may cause our operating results to differ materially or adversely are discussed below. Our stock price has been volatile. Quarterly results have fluctuated and are likely to continue to fluctuate significantly. The market price of our common stock has been and may continue to be highly volatile. Factors that are difficult to predict, such as quarterly revenues and operating results, statements and ratings by financial analysts, and overall market performance, will have a significant effect on the price for shares of our common 17 stock. Revenues and operating results have varied considerably in the past from period to period and are likely to vary considerably in the future. We plan product development and other expenses based on anticipated future revenue. If revenue falls below expectations, financial performance is likely to be adversely affected because only small portions of expenses vary with revenue. As a result, period-to-period comparisons of operating results are not necessarily meaningful and should not be relied upon to predict future performance. The timing of license revenues is related to the completion of implementation services and product acceptance by the customer, the timing of which has been difficult to predict accurately. There can be no assurance that we will be profitable on an annual or quarterly basis or that earnings or revenues will meet analysts' expectations. Fluctuations may be particularly pronounced because a significant portion of revenues in any quarter is attributable to product acceptance or license renewal by a relatively small number of customers. Fluctuations also reflect a policy of recognizing revenue upon product acceptance or license renewal in an amount equal to the present value of the total committed payments due during the term. Customers generally do not accept products until the end of a lengthy sales cycle and an implementation period, typically ranging from one to six months but in some cases significantly longer. In addition, we are more focused on closing larger but fewer license transactions than in the past. This may increase the volatility in our quarterly operating results. Risks over which we have little or no control, including customers' budgets, staffing allocation, and internal authorization reviews, can significantly affect the sales and acceptance cycles. Changes dictated by customers may delay product implementation and revenue recognition. If existing customers do not renew their term licenses, our financial results may suffer. A significant portion of total revenue has been attributable to term license renewals. While historically a majority of customers have renewed their term licenses, there can be no assurance that a majority of customers will continue to renew expiring term licenses. A decrease in term license renewals absent offsetting revenue from other sources would have a material adverse effect on future financial performance. In addition, transition to prepaid perpetual licenses may have a material adverse impact on the amount of term license renewal revenues in future periods. We will need to develop new products, evolve existing ones, and adapt to technology change. Technical developments, customer requirements, programming languages and industry standards change frequently in our markets. As a result, success in current markets and new markets will depend upon our ability to enhance current products, to develop and introduce new products that meet customer needs, keep pace with technology changes, respond to competitive products, and achieve market acceptance. Product development requires substantial investments for research, refinement and testing. There can be no assurance that we will have sufficient resources to make necessary product development investments. We may experience difficulties that will delay or prevent the successful development, introduction or implementation of new or enhanced products. Inability to introduce or implement new or enhanced products in a timely manner would adversely affect future financial performance. Our products are complex and may contain errors. Errors in products will require us to ship corrected products to customers. Errors in products could cause the loss of or delay in market acceptance or sales and revenue, the diversion of development resources, injury to our reputation, or increased service and warranty costs which would have an adverse effect on financial performance. We have historically sold to the financial services market. This market is consolidating rapidly, and faces uncertainty due to many other factors. We have historically derived a significant portion of our revenue from customers in the financial services market, and our future growth depends, in part, upon increased sales to this market. Competitive pressures, industry consolidation, decreasing operating margins within this industry, currency fluctuations, geographic expansion and deregulation affect the financial condition of our customers and their willingness to pay. In addition, customers' purchasing patterns are somewhat discretionary. As a result, some or all of the factors listed above may adversely affect the demand by customers. The financial services market is undergoing intense domestic and international consolidation. In recent years, several customers have been merged or consolidated. Future mergers or consolidations may cause a decline in revenues and adversely affect our future financial performance. 18 We depend on certain key personnel, and must be able to attract and retain qualified personnel in the future. The business is dependent on a number of key, highly skilled technical, managerial, consulting, sales, and marketing personnel, including Mr. Trefler, our Chief Executive Officer. The loss of key personnel could adversely affect financial performance. We do not have any significant key-man life insurance on any officers or employees and do not plan to obtain any. Our success will depend in large part on the ability to hire and retain qualified personnel. The number of potential employees who have the extensive knowledge of computer hardware and operating systems needed to develop, sell and maintain our products is limited, and competition for their services is intense, and there can be no assurance that we will be able to attract and retain such personnel. If we are unable to do so, our business, operating results, and financial condition could be materially adversely affected. The market for our offerings is increasingly and intensely competitive, rapidly changing, and highly fragmented. The market for customer relationship management software and related implementation, consulting and training services is intensely competitive and highly fragmented. We currently encounter significant competition from internal information systems departments of potential or existing customers that develop custom software. We also compete with companies that target the customer interaction and workflow markets and professional service organizations that develop custom software in conjunction with rendering consulting services. Competition for market share and pressure to reduce prices and make sales concessions are likely to increase. Many competitors have far greater resources and may be able to respond more quickly and efficiently to new or emerging technologies, programming languages or standards or to changes in customer requirements or preferences. Competitors may also be able to devote greater managerial and financial resources to develop, promote and distribute products and provide related consulting and training services. There can be no assurance that we will be able to compete successfully against current or future competitors or that the competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition. We must manage increased business complexity and growth effectively. Our business has grown in size, geographic scope and complexity and we have expanded our product offerings and customer base. This growth and expansion has placed, and is expected to continue to place, a significant strain on management, operations and capital needs. Continued growth will require us to hire, train and retrain many employees in the United States and abroad, particularly additional sales and financial personnel. We will also need to enhance our financial and managerial controls and reporting systems. We cannot assure that we will attract and retain the personnel necessary to meet our business challenges. Failure to manage growth effectively may materially adversely affect future financial performance. We rely on certain third-party relationships. We have a number of relationships with third parties that are significant to sales, marketing and support activities, and product development efforts. We rely on relational database management system applications and development tool vendors, software and hardware vendors, and consultants to provide marketing and sales opportunities for the direct sales force and to strengthen our products through the use of industry-standard tools and utilities. We also have relationships with third parties that distribute our products. In particular, we rely on our relationship with First Data Resources for the distribution of products to the credit card market and with PFPC Inc. for distribution of products to the mutual fund market. There can be no assurance that these companies, most of which have significantly greater financial and marketing resources, will not develop or market products that compete with ours in the future or will not otherwise end their relationships with or support of us. We may face product liability and warranty claims. Our license agreements typically contain provisions intended to limit the nature and extent of our risk of product liability and warranty claims. There is a risk that a court might interpret these terms in a limited way or could hold part or all of these terms to be unenforceable. Also, there is a risk that these contract terms might not bind a party other than the direct customer. Furthermore, some of our licenses with our customers are governed by non-U.S. law, and there is a risk that 19 foreign law might give us less or different protection. Although we have not experienced any material product liability claims to date, a product liability suit or action claiming a breach of warranty, whether or not meritorious, could result in substantial costs and a diversion of management's attention and our resources. We face risks from operations and customers based outside of the U.S. Sales to customers headquartered outside of the United States represented approximately 23%, 26% and 21% of our total revenue in 2001, 2000 and 1999, respectively. We, in part through our wholly-owned subsidiaries based in the United Kingdom, Singapore, Canada, and Australia, market products and render consulting and training services to customers based in Canada, the United Kingdom, France, Germany, the Netherlands, Belgium, Switzerland, Austria, Ireland, Sweden, South Africa, Mexico, Australia, Hong Kong, and Singapore. We have established offices in continental Europe, Australia, and Asia. We believe that our continued growth will necessitate expanded international operations requiring a diversion of managerial attention and financial resources. We anticipate hiring additional personnel to accommodate international growth, and we may also enter into agreements with local distributors, representatives, or resellers. If we are unable to do one or more of these things in a timely manner, our growth, if any, in our foreign operations will be restricted, and our business, operating results, and financial condition could be materially and adversely affected. In addition, there can be no assurance that we will be able to maintain or increase international market demand for our products. Most of our international sales are denominated in U.S. dollars. Accordingly, any appreciation of the value of the U.S. dollar relative to the currencies of those countries in which we distribute our products may place us at a competitive disadvantage by effectively making our products more expensive as compared to those of our competitors. Additional risks inherent in our international business activities generally include unexpected changes in regulatory requirements, increased tariffs and other trade barriers, the costs of localizing products for local markets and complying with local business customs, longer accounts receivable patterns and difficulties in collecting foreign accounts receivable, difficulties in enforcing contractual and intellectual property rights, heightened risks of political and economic instability, the possibility of nationalization or expropriation of industries or properties, difficulties in managing international operations, potentially adverse tax consequences (including restrictions on repatriating earnings and the threat of "double taxation"), enhanced accounting and internal control expenses, and the burden of complying with a wide variety of foreign laws. There can be no assurance that one or more of these factors will not have a material adverse effect on our foreign operations, and, consequentially, our business, operating results, and financial condition. We face risks related to intellectual property claims or appropriation of our intellectual property rights. We rely primarily on a combination of copyright, trademark and trade secrets laws, as well as confidentiality agreements to protect our proprietary rights. In October 1998, we were granted a patent by the United States Patent and Trademark Office relating to the architecture of our systems. We cannot assure that such patent will not be invalidated or circumvented or that rights granted there under or the description contained therein will provide competitive advantages to our competitors or others. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain the use of information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology. We are not aware that any of our products infringe the proprietary rights of third parties. There can be no assurance, however, that third parties will not claim infringement by us with respect to current or future products. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays, or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results, and financial condition. 20 We face risks related to the acquisition of 1mind. On February 6, 2002, we acquired substantially all of the assets and specified liabilities of 1mind Corporation and its wholly owned subsidiary (collectively, "1mind"). Following the acquisition of 1mind, we intend to intensify our focus on marketing and selling our products and services within the healthcare market. We face risks in connection with integrating 1mind's technology and personnel into the combined company. Additionally, we face risks involved with integrating and retaining key former 1mind personnel. Managing these risks may result in undue cost or delay and may require us to divert management time and attention from our primary business operations. The result could adversely affect our financial results. Item 3. Quantitative and Qualitative Disclosures about Market Risk Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. Our market risk exposure is primarily fluctuations in foreign exchange rates and interest rates. We have not entered into derivative or hedging transactions to manage risk in connection with such fluctuations. We derived approximately 20% of our total revenue in the first half of 2002 from sales to customers based outside of the United States. Certain of our international sales are denominated in foreign currencies. The price in dollars of products sold outside the United States in foreign currencies will vary as the value of the dollar fluctuates against such foreign currencies. Although our sales denominated in foreign currencies in the first half of 2002 were not material, there can be no assurance that such sales will not be material in the future and that there will not be increases in the value of the dollar against such currencies that will reduce the dollar return to us on the sale of our products in such foreign currencies. We believe that at current market interest rates, the fair value of license installments receivable approximates carrying value as reported on our balance sheets. However, there can be no assurance that the fair value will approximate the carrying value in the future. Factors such as increasing interest rates can reduce the fair value of the license installments receivable. The carrying value reflects a weighted average of historic discount rates. The average rate changes with market rates as new license installment receivables are added to the portfolio, which mitigates exposure to market interest rate risk. 21 Part II - Other Information: Item 1. Legal Proceedings Company Litigation Qwest Arbitration. On January 17, 2002, we filed a demand for arbitration with the American Arbitration Association in Denver, Colorado against Qwest Corporation, successor in interest to US West Business Resources, Inc. ("Qwest"). We are seeking monetary damages in the arbitration relating to Qwest's termination of a software license and service agreement with us. On February 8, 2002, Qwest filed a counterclaim against us seeking unspecified monetary damages for alleged breach by us of that agreement and software royalties in an unspecified amount. An arbitration hearing is currently scheduled for August, 2002. Ernst & Young Arbitration. On June 9, 2000, the Company and two of its officers filed a complaint against Ernst & Young LLP and Alan B. Levine (a former partner of Ernst & Young) in Massachusetts state court. The Complaint alleges that the defendants committed professional malpractice, breached contractual and fiduciary duties owed to the Company, and issued false and misleading public statements, in connection with advice that Ernst & Young rendered to the Company to record $5 million in revenue in its financial statements for the second fiscal quarter ended June 30, 1997 pursuant to a series of contracts between the Company and First Data Resources, Inc. The complaint sought compensatory damages, including contribution for losses and other costs incurred in connection with certain class action securities litigation, which has been settled. On April 5, 2001, the Court dismissed the Complaint, finding that it was subject to the dispute resolution procedures set forth in an engagement letter between the Company and Ernst & Young. The parties agreed to submit this dispute to arbitration, the evidence phase of which concluded in June, 2002. Post-hearing argument is currently scheduled for August 6, 2002. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults upon Senior Securities Not applicable. Item 4. Submission of Matters to a Vote of Security Holders The annual meeting of shareholders was held on June 4, 2002. The following matters were voted upon: 1. Edward Roberts, James O'Halloran, and Richard Jones were elected to serve as Directors of the Company until the 2005 Annual Meeting of Stockholders and until their successors are duly elected and qualified. Mr. Roberts was elected with 32,531,496 votes "FOR" and 20,990 votes "ABSTAINING." Mr. O'Halloran was elected with 32,514,528 votes "FOR" and 37,958 votes "ABSTAINING." Mr. Jones was elected with 32,498,455 votes "FOR" and 54,031 votes "ABSTAINING." 2. The stockholders ratified the appointment by the Board of Directors of Deloitte & Touche, LLP, independent public accountants, to audit the financial statements of the Company for the fiscal year ending December 31, 2002 with 32,284,826 votes "FOR" and 9,420 votes "ABSTAINING." Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K On April 9, 2002, we filed a report with on Form 8-K with the Securities and Exchange Commission reporting the termination by the Commission of its investigation of the Company and certain individuals. 22 Signatures 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. Pegasystems Inc. Date: July 24, 2002 /s/ Alan Trefler ----------------------------------- Chairman and Chief Executive Officer /s/ Christopher Sullivan -------------------------------------- Treasurer and Chief Financial Officer (principal financial officer and chief accounting officer) 23