10-Q 1 a77143e10-q.txt QUEST SOFTWARE FORM 10-Q PERIOD ENDED 9/30/01 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- FORM 10-Q ---------------- [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001 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 NO. 000-26937 QUEST SOFTWARE, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) CALIFORNIA 33-0231678 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 8001 IRVINE CENTER DRIVE IRVINE, CALIFORNIA 92618 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (949) 754-8000 Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares outstanding of the Registrant's Common Stock, no par value, as of November 2, 2001 was 89,271,842. ================================================================================ QUEST SOFTWARE, INC. FORM 10-Q INDEX
PAGE NUMBER ------ PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets as of December 31, 2000 and September 30, 2001 (unaudited).............................................................. 3 Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2000 and 2001 (unaudited)....................................... 4 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2000 and 2001 (unaudited)....................................... 5 Consolidated Statements of Comprehensive Operations for the Three and Nine Months Ended September 30, 2000 and 2001 (unaudited)..................... 6 Notes to Consolidated Financial Statements (unaudited)........................... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................................................... 13 Item 3. Quantitative and Qualitative Disclosures about Market Risk....................... 27 PART II. OTHER INFORMATION Item 4. Exhibits and Reports on Form 8-K................................................. 28 Signatures.................................................................................. 29
2 PART I FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS QUEST SOFTWARE, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) ASSETS
DECEMBER 31, SEPTEMBER 30, 2000 2001 ------------ ------------- (UNAUDITED) Current assets: Cash and cash equivalents $ 25,155 $ 59,924 Short-term marketable securities available for sale 8,587 15,659 Accounts receivable, net 38,443 32,297 Prepaid expenses and other current assets 11,390 10,944 Income taxes receivable 1,558 -- Deferred income taxes 14,833 14,354 --------- --------- Total current assets 99,966 133,178 Property and equipment, net 46,840 58,154 Long-term marketable securities available for sale 118,084 118,291 Goodwill and purchased intangible assets, net 255,858 217,394 Deferred income taxes 3,001 3,001 Other assets 10,423 9,568 --------- --------- Total assets $ 534,172 $ 539,586 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 5,503 $ 5,274 Accrued compensation 9,350 13,028 Other accrued expenses 22,491 18,698 Income taxes payable -- 2,348 Deferred revenue 32,052 46,137 --------- --------- Total current liabilities 69,396 85,485 Long-term liabilities and other 6,422 5,358 Shareholders' equity: Preferred stock, no par value, 10,000 shares authorized; no shares issued or outstanding -- -- Common stock, no par value, 150,000 shares authorized; 86,710 and 88,782 issued and outstanding at December 31, 2000 and September 30, 2001, respectively 500,324 528,961 Accumulated deficit (23,214) (61,787) Accumulated other comprehensive income 132 1,371 Notes receivable from sale of common stock (18,888) (19,802) --------- --------- Total shareholders' equity 458,354 448,743 --------- --------- Total liabilities and shareholders' equity $ 534,172 $ 539,586 ========= =========
See accompanying notes to the consolidated financial statements. 3 QUEST SOFTWARE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------------- ------------------------- 2000 2001 2000 2001 ---------- ---------- --------- --------- Revenues: Licenses $ 34,036 $ 37,584 $ 84,459 $ 135,171 Services 10,086 18,755 25,043 51,142 --------- --------- --------- --------- Total revenues 44,122 56,339 109,502 186,313 Cost of revenues: Licenses 874 948 2,379 2,961 Services 2,911 4,616 7,034 13,105 Amortization of purchased intangible assets 1,244 1,894 3,002 5,834 --------- --------- --------- --------- Total cost of revenues 5,029 7,458 12,415 21,900 --------- --------- --------- --------- Gross profit 39,093 48,881 97,087 164,413 Operating expenses: Sales and marketing 20,581 29,593 51,457 91,675 Research and development 11,118 15,262 27,820 44,649 General and administrative 5,052 5,809 11,777 18,248 Other compensation costs and intangible amortization 10,456 16,418 25,865 47,869 --------- --------- --------- --------- Total operating expenses 47,207 67,082 116,919 202,441 --------- --------- --------- --------- Loss from operations (8,114) (18,201) (19,832) (38,028) Other income, net 3,680 2,654 8,317 6,143 Losses on equity investments - - - (1,465) --------- --------- --------- --------- Loss before income taxes (4,434) (15,547) (11,515) (33,350) Income tax provision (benefit) 1,825 (4,706) 4,838 5,223 --------- --------- --------- --------- Net loss $ (6,259) $ (10,841) $ (16,353) $ (38,573) ========= ========= ========= ========= Net loss per share: Basic and Diluted $ (0.07) $ (0.12) $ (0.19) $ (0.44) ========= ========= ========= ========= Weighted average shares: Basic and Diluted 86,536 88,299 84,420 87,613
See accompanying notes to the consolidated financial statements. 4 QUEST SOFTWARE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, ------------------------- 2000 2001 --------- --------- Cash flows from operating activities: Net loss $ (16,353) $ (38,573) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization 28,020 55,996 Compensation expense associated with stock option grants 2,778 4,029 Accrued interest receivable from shareholders (313) (914) Provision for bad debts - 345 Loss on equity investments - (1,465) Changes in operating assets and liabilities, net of effects of acquisitions: Accounts receivable (3,514) 6,367 Prepaid expenses and other current assets (4,293) 540 Deferred taxes 29 - Other assets (2,516) 2,779 Accounts payable 2,673 (270) Accrued compensation 2,740 3,691 Income taxes payable 3,032 8,811 Other accrued expenses (2,833) (4,099) Other liabilities - 603 Deferred revenue 6,106 13,902 --------- --------- Net cash provided by operating activities 15,556 51,742 Cash flows from investing activities: Purchases of property and equipment (35,489) (19,435) Purchases of software licenses (1,265) (1,150) Cash paid for acquisitions, net of cash acquired (78,502) 114 Purchases of marketable securities (291,895) (136,807) Sales and maturities of marketable securities 128,532 130,766 --------- --------- Net cash used by investing activities (278,619) (26,512) Cash flows from financing activities: Repayment of notes payable (1,910) (1,171) Repurchase of common stock (33) - Repayment of capital lease obligations (390) (188) Proceeds from exercise of stock options 3,449 5,432 Proceeds from employee stock purchase plan 3,438 5,593 Proceeds from issuance of common stock, net 253,469 - --------- --------- Net cash provided by financing activities 258,023 9,666 Effect of exchange rate changes on cash and cash equivalents 72 (127) --------- --------- Net (decrease) increase in cash and cash equivalents (4,968) 34,769 Cash and cash equivalents, beginning of period 39,643 25,155 --------- --------- Cash and cash equivalents, end of period $ 34,675 $ 59,924 ========= ========= Supplemental disclosures of consolidated cash flow information: Cash paid for (received): Interest $ 137 $ 81 ========= ========= Income taxes, net of refunds $ 1,709 $ (4,093) ========= ========= Supplemental schedule of noncash investing and financing activities: Unrealized (loss) gain on available-for-sale securities $ (103) $ 1,239 ========= ========= Tax benefit related to stock option exercises $ 4,547 $ 4,965 ========= =========
See accompanying notes to the consolidated financial statements. 5 QUEST SOFTWARE, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS (IN THOUSANDS) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------- ----------------------- 2000 2001 2000 2001 -------- -------- -------- -------- Net loss $ (6,259) $(10,841) $(16,353) $(38,573) Accumulated other comprehensive income (loss): Unrealized gain (loss) on available- for-sale securities 412 1,280 (103) 1,239 -------- -------- -------- -------- Comprehensive loss $ (5,847) $ (9,561) $(16,456) $(37,334) ======== ======== ======== ========
See accompanying notes to the consolidated financial statements. 6 QUEST SOFTWARE, INC. NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying unaudited interim consolidated financial statements of Quest Software, Inc., a California corporation (the "Company" or "Quest"), as of September 30, 2001 and for the three and nine months ended September 30, 2000 and 2001 reflect all adjustments (consisting of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These financial statements should be read in conjunction with the audited financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2000. Operating results for the three and nine months ended September 30, 2001 are not necessarily indicative of the results that may be expected for the quarter or full year ending December 31, 2001 or any other future period. NEW ACCOUNTING PRONOUNCEMENTS: In September 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS No. 133"). SFAS No. 133, as amended, is effective for all fiscal years beginning after June 15, 2000, and establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. Under SFAS No. 133, certain contracts that were not formerly considered derivatives may now meet the definition of a derivative which would be required to be reported as assets or liabilities and carried at fair value. The Company adopted SFAS No. 133 effective January 1, 2001. The adoption of SFAS No. 133 did not have a significant impact on the financial position, results of operations, or cash flows of the Company. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), Business Combinations. SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interest method. SFAS 141 also requires reclassification of certain other identifiable assets to a separate financial statement line to the extent they meet certain criteria. The Company does not believe that the adoption of SFAS 141 will have a significant impact on its financial statements. In July 2001, the FASB issued Statement of Financial Accounting Standard No. 142 ("SFAS 142"), Goodwill and Other Intangible Assets, which is effective for the Company in January of 2002. SFAS No. 142 requires that goodwill and other intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually. The Company will continue to assess its recorded goodwill and other intangible assets under current generally accepted accounting principles at each reporting period until the standard is adopted. The adoption of SFAS No. 142 in January of 2002 will substantially reduce charges to operations for goodwill amortization and change the method for determining impairment. The effect on the financial statements has not been determined. Currently, the Company's amortization of goodwill and other intangible assets is approximately $14.0 million per quarter. In August 2001, the FASB issued Statement of Financial Accounting Standard No. 143 ("SFAS 143"), Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 is required to be adopted for fiscal years beginning after June 15, 2002. The Company has not yet determined what effect this statement will have on its financial statements. Also in August 2001, the FASB issued Statement of Financial Accounting Standard No. 144 ("SFAS 144"), Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes FASB Statement No. 121, 7 QUEST SOFTWARE, INC. NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued) Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. This new statement also supersedes certain aspects of Accounting Principles Board ("APB") 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, with regard to reporting the effects of a disposal of a segment of a business and will require expected future operating losses from discontinued operations to be reported in discontinued operations in the period incurred (rather than as of the measurement date as presently required by APB 30). In addition, more dispositions may qualify for discontinued operations treatment. The provisions of this statement are required to be applied for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The Company has not yet determined what effect this statement will have on its financial statements. 2. ACQUISITIONS Actual results of operations of the companies acquired throughout fiscal 2000 and the company, RevealNet, Inc., acquired in fiscal 2001 are included in the consolidated financial statements from the dates of acquisition. The Company's financial results for the nine months ended September 30, 2001 include actual results of these acquisitions for the full period. The pro forma results of operations data for the same period of 2000 presented below assume that the acquisitions had been made at the beginning of fiscal 2000, and include amortization of goodwill and identified intangibles from that date. The pro forma data is presented for informational purposes only and is not necessarily indicative of the results of future operations nor of the actual results that would have been achieved had the acquisitions taken place at the beginning of fiscal 2000 (in thousands):
NINE MONTHS ENDED SEPTEMBER 30, ------------------------------- 2000 2001 -------------- -------------- (PRO FORMA) (PRO FORMA) Revenues $120,894 $187,751 Net loss (48,888) (38,809) Net loss per share - basic and diluted $ (0.58) $ (0.44)
3. OTHER COMPENSATION COSTS The Company records compensation expense for options to purchase the Company's common stock granted with an exercise price below fair market value. The expense equals the difference between the fair market value of the Company's common stock on the grant date and the exercise price of the stock options and is recognized ratably over the vesting period of the stock options, currently four to five years. The following table shows the allocation to Cost of Services Revenues, Sales and Marketing, Research and Development and General and Administrative expenses of such costs based on the related headcount (in thousands): 8 QUEST SOFTWARE, INC. NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued)
AS REPORTED ALLOCATION PRO FORMA ----------- ---------- --------- Three months ended September 30, 2000 Cost of services revenues $ 2,911 $ 72 $ 2,983 Sales and marketing 20,581 456 21,037 Research and development 11,118 600 11,718 General and administrative 5,052 72 5,124 Three months ended September 30, 2001 Cost of services revenues $ 4,616 $ 59 $ 4,675 Sales and marketing 29,593 439 30,032 Research and development 15,262 381 15,643 General and administrative 5,809 98 5,907 Nine months ended September 30, 2000 Cost of services revenues $ 7,034 $ 167 $ 7,201 Sales and marketing 51,457 1,000 52,457 Research and development 27,820 1,417 29,237 General and administrative 11,777 195 11,972 Nine months ended September 30, 2001 Cost of services revenues $13,105 $ 161 $13,266 Sales and marketing 91,675 1,249 92,924 Research and development 44,649 1,209 45,858 General and administrative 18,248 1,410 19,658
4. NET LOSS PER SHARE The Company computes net loss per share in accordance with SFAS No. 128, Earnings per Share. Basic earnings per share is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities by including other common stock equivalents, including stock options, in the weighted average number of common shares outstanding for a period if the effect of such inclusion would be dilutive. 9 QUEST SOFTWARE, INC. NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued) During the three and nine months ended September 30, 2000 and 2001, there is no difference between basic and diluted earnings per share as inclusion of common stock equivalents (stock options) would have been anti-dilutive. The dilutive effect of stock options would have been 3,859 and 4,211 shares for the three and nine months ended September 30, 2001, respectively, compared to 5,784 and 5,875 shares for the same periods of 2000. 5. SHAREHOLDERS' EQUITY Under the Company's Employee Stock Purchase Plan approximately 94,000 shares of common stock were issued in January 2001 at a price of $31.82 per share and approximately 109,000 shares of common stock were issued in July 2001 at a price of $23.86 per share. In December 2000, the Board of Directors authorized a share repurchase program under which the Company may repurchase up to 2.0 million shares from time to time in open market or private transactions. As of September 30, 2001, the Company had repurchased 1.7 million shares for approximately $57.4 million. In October 2001, the Board of Directors increased the total number of shares authorized for repurchase under this program to 5.0 million. 6. STOCK OPTION PLANS The following table summarizes information about stock options outstanding as of September 30, 2001 (in thousands, except for per share data):
NUMBER OF OPTIONS NUMBER OF WEIGHTED AVERAGE EXERCISABLE AS OF SHARES EXERCISE PRICE SEPTEMBER 30, 2001 --------- ---------------- ------------------ Balance at December 31, 2000 10,641 $ 12.72 Granted 5,398 16.09 Exercised (1,372) 4.33 Canceled (1,817) 19.19 ------- Balance at September 30, 2001 12,850 $ 14.12 2,664 =======
7. OPERATING SEGMENT DATA Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the Company's chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The operating segments of the Company are managed separately because each segment represents a strategic business unit that offers different products or services. The Company's reportable operating segments include Licenses and Services. The Licenses segment develops and markets the Company's software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to the Company's products. The Company does not separately allocate operating expenses to these segments, nor does it allocate specific assets to these segments. Therefore, segment information reported includes only revenues, cost of revenues and gross profit, as this information and the geographic information described below are the only information provided to the chief operating decision maker on a segment basis. 10 QUEST SOFTWARE, INC. NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued) Operating segment data for the three and nine months ended September 30, 2000 and 2001 were as follows (in thousands):
LICENSES SERVICES TOTAL -------- -------- --------- Three months ended September 30, 2000 Revenues $ 34,036 $ 10,086 $ 44,122 Cost of Revenues 2,118 2,911 5,029 -------- -------- -------- Gross profit $ 31,918 $ 7,175 $ 39,093 ======== ======== ======== Three months ended September 30, 2001 Revenues $ 37,584 $ 18,755 $ 56,339 Cost of Revenues 2,842 4,616 7,458 -------- -------- -------- Gross profit $ 34,742 $ 14,139 $ 48,881 ======== ======== ======== Nine months ended September 30, 2000 Revenues $ 84,459 $ 25,043 $109,502 Cost of Revenues 5,381 7,034 12,415 -------- -------- -------- Gross profit $ 79,078 $ 18,009 $ 97,087 ======== ======== ======== Nine months ended September 30, 2001 Revenues $135,171 $ 51,142 $186,313 Cost of Revenues 8,795 13,105 21,900 -------- -------- -------- Gross profit $126,376 $ 38,037 $164,413 ======== ======== ========
Revenues are attributed to geographic areas based on the location of the entity from which the products or services were sold. Revenues, gross profit, loss from operations and long-lived assets concerning principal geographic areas in which the Company operates for the three and nine months ended September 30, 2000 and 2001, respectively, were as follows (in thousands): 11 QUEST SOFTWARE, INC. NOTES TO (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NORTH OTHER AMERICA(1) EUROPE INTERNATIONAL TOTAL ----------- ------- ------------- --------- Three months ended September 30, 2000 Revenues $ 37,043 $ 6,543 $ 536 $ 44,122 Gross profit 34,981 3,822 290 39,093 Loss from operations (5,983) (197) (1,934) (8,114) Long-lived assets 300,876 1,138 3,079 305,093 Three months ended September 30, 2001 Revenues $ 44,042 $10,869 $ 1,428 $ 56,339 Gross profit 39,627 8,330 924 48,881 Loss from operations (14,949) (159) (3,093) (18,201) Long-lived assets 270,756 2,604 2,917 276,277 Nine months ended September 30, 2000 Revenues $ 91,417 $16,222 $ 1,863 $109,502 Gross profit 87,514 8,813 760 97,087 Loss from operations (14,651) (256) (4,925) (19,832) Long-lived assets 300,876 1,138 3,079 305,093 Nine months ended September 30, 2001 Revenues $150,395 $31,775 $ 4,143 $186,313 Gross profit 142,148 20,085 2,180 164,413 Loss from operations (24,240) (4,033) (9,755) (38,028) Long-lived assets 270,756 2,604 2,917 276,277
(1) Principally represents operations in the United States. 8. INVESTMENTS The Company has classified all debt securities with original maturities of greater than three months as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders' equity net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income. The cost basis for realized gains and losses on available-for-sale securities is determined on a specific identification basis. The Company has classified available-for-sale securities as current or long-term based primarily on the maturity date of the related securities. The Company has certain other minority equity investments in non-publicly traded companies. These investments are included in other assets on the Company's consolidated balance sheet at September 30, 2001 and are carried at cost. The Company monitors these investments for impairment and as a result recorded a write-down of $1.5 million in June 2001. The Company does not believe that any further impairment exists for the three months ended September 30, 2001 and has not recorded any additional impairment charges. 12 ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in this report, including statements regarding our business strategies, operations, financial conditions and prospects, are forward-looking statements. Use of the words "believe," "expect," "anticipate," "will," "contemplate," "would" and similar expressions that contemplate future events may identify forward-looking statements. Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures made in this report, including those described under "Risk Factors," and in our Annual Report on Form 10-K for the year ended December 31, 2000 and other filings with the SEC, that attempt to advise interested parties of certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect management's opinions only as of the date thereof. We do not assume any obligation to revise or update forward-looking statements. OVERVIEW We provide application management software solutions that enhance our customers' return on IT investment dollars by maximizing the availability, performance and manageability of business critical applications and their underlying components and by improving the cost effectiveness of a customers information technology investments, including personnel, software and hardware. Each of our product families consists of an integrated suite of software tools that enable personnel to manage and administer complex database systems and business applications, both packaged and custom developed. These applications include ERP (enterprise resource planning) systems, CRM (customer relationship management) systems, B2B (business to business) e-commerce systems, corporate messaging and Internet applications. We enable organizations to leverage IT infrastructure investments by maximizing the performance and availability of enterprise applications with solutions for High Availability, Application Monitoring, Database Management, SQL Development, and Report Management. We also have an integrated product suite directed at managing Microsoft 2000 and Exchange environments. We derive our revenues primarily from the sale of software licenses and related annual maintenance fees. Pricing of our software licenses is generally either server-based or, for our SQL development and report management tools, user-based. Services consist primarily of annual maintenance contracts for technical support and product enhancements, and consulting services. We recognize software license revenues when a non-cancelable license agreement has been signed with a customer, delivery of the software has occurred, the fees are fixed and determinable, no significant post-delivery vendor obligations remain and collection is deemed probable. Maintenance revenues are recognized ratably over the contract term, which is typically one year. Revenues for consulting services are recognized as such services are performed. 13 RESULTS OF OPERATIONS The following table sets forth certain consolidated statements of operations data as a percentage of total revenues, except as indicated:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ----------------- 2000 2001 2000 2001 ----- ----- ------ ------ Revenues: Licenses 77.1% 66.7% 77.1% 72.6% Services 22.9 33.3 22.9 27.4 ----- ----- ----- ----- Total revenues 100.0 100.0 100.0 100.0 Cost of revenues: Licenses 2.0 1.7 2.2 1.6 Services 6.6 8.2 6.4 7.0 Amortization of purchased intangible assets 2.8 3.4 2.7 3.1 ----- ----- ----- ----- Total cost of revenues 11.4 13.3 11.3 11.7 ----- ----- ----- ----- Gross profit 88.6 86.7 88.7 88.3 Operating expenses: Sales and marketing 46.6 52.5 47.0 49.2 Research and development 25.2 27.1 25.4 24.0 General and administrative 11.5 10.3 10.8 9.8 Other compensation costs and intangible amortization 23.7 29.1 23.6 25.7 ----- ----- ----- ----- Total operating expenses 107.0 119.0 106.8 108.7 ----- ----- ----- ----- Loss from operations (18.4) (32.3) (18.1) (20.4) Other income, net 8.3 4.7 7.6 3.3 Losses on equity investments - - - (0.8) ----- ----- ----- ----- Loss before income taxes (10.1) (27.6) (10.5) (17.9) Income tax provision (benefit) 4.1 (8.4) 4.4 2.8 ----- ----- ----- ----- Net loss (14.2)% (19.2)% (14.9)% (20.7)% ===== ===== ===== ===== As a percentage of related revenues: Cost of licenses 2.6% 2.5% 2.9% 2.2% Cost of services 28.9% 24.6% 27.9% 25.5%
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2000 AND 2001 REVENUES Total revenues for the three and nine months ended September 30, 2001 were $56.3 million and $186.3 million, respectively, an increase of 27.7% and 70.1% from the comparable periods of 2000. Revenues outside of North America for the three and nine months ended September 30, 2001 were $12.3 million and $35.9 million, respectively, an increase of 73.7% and 98.6% from the comparable periods of 2000. Licenses License revenues for the three and nine months ended September 30, 2001 were $37.6 million and $135.2 million, respectively, an increase of 10.4% and 60.0% from the comparable periods of 2000. License revenues represented 66.7% and 14 2.6% of total revenues for the three and nine months ended September 30, 2001, respectively, compared to 77.1% of total revenues for the same periods of 2000. Licenses outside of North America accounted for 25.3% and 21.1% of total licenses for the three and nine months ended September 30, 2001, respectively, compared to 16.6% and 17.4% for the same periods in 2000. The increases in licenses during the three and nine month periods ended September 30, 2001 were due to expansion of our worldwide sales force, as well as increased market acceptance of our software products and availability of new products relative to the comparable periods of 2000. New products include Quest Central for DB2 and a variety of products for the Microsoft Windows, as well as the LiveReorg and SQLab Vision products for Oracle. Our license revenues for the three months ended September 30, 2001 were less than originally anticipated by market analysts, in large part due to reluctance by certain customers to complete large license transactions in the wake of business uncertainty following the September 11, 2001 terrorist attacks. We cannot predict what continuing effects these events, in conjunction with a weakening economic environment, may have on our revenues in future quarters. Services Services for the three and nine months ended September 30, 2001 were $18.8 million and $51.1 million, respectively, an increase of 86.0% and 104.2% from the comparable periods of 2000. Services revenues represented 33.3% and 27.4% of total revenues for the three and nine months ended September 30, 2001, respectively, compared to 22.9% for the same periods of 2000. Services revenues outside of North America accounted for 14.9% and 14.5% of total services for the three and nine months ended September 30, 2001, respectively, compared to 14.0% and 13.7% for the same periods in 2000. The increases in services during the three and nine month periods ended September 30, 2001 reflect an increase in the number of software licenses sold with maintenance agreements and renewals of maintenance agreements on an expanding installed base of products, and, to a significantly lesser extent, the increase in consulting and training services performed for customers. COST OF REVENUES Cost of Licenses Cost of licenses includes amortization of software licenses, product media, printing and duplication costs and product royalties. Cost of licenses was $0.9 million and $3.0 million for the three and nine months ended September 30, 2001, respectively, versus $0.9 million and $2.4 million in the comparable periods of 2000. Cost of licenses as a percentage of license revenues were 2.5% and 2.2% for the three and nine months ended September 30, 2001, respectively, compared to 2.6% and 2.9% for the same periods in 2000. The dollar cost increase in cost of licenses was principally the result of increases in royalties resulting from the growth in sales of related products, partially offset by a decrease in printing and duplication costs. The improvement in gross margin resulted from increased license revenues without a corresponding increase in amortization of acquired software licenses, which does not vary by the number of licenses sold. Cost of Services Cost of services includes salaries and related costs for customer support and consulting personnel. Cost of services for the three and nine months ended September 30, 2001 was $4.6 million and $13.1 million, respectively, versus $2.9 million and $7.0 million for the comparable periods of 2000. Cost of services as a percentage of services revenues was 24.6% and 25.5% for the three and nine months ended September 30, 2001, respectively, compared to 28.9% and 27.9% for the same periods in 2000. The dollar cost increase in cost of services is primarily due to the increase in the number of technical support personnel required to manage and support our growing customer base as well as increased product offerings. The improvement in gross margin resulted from a larger installed base of customers and renewable maintenance, without an associated increase in head count to facilitate expanded operations. Our gross margin on services revenues could fluctuate on a quarterly basis in the future, reflecting the timing differences between increasing our organizational investments and the corresponding revenue growth that we expect as a result. Amortization of Purchased Intangible Assets Amortization of purchased intangible assets was $1.9 million and $5.8 million during the three and nine months ended September 30, 2001, respectively, versus $1.2 million and $3.0 million in the same periods of 2000. This increase was due entirely to amortization of technology purchased as part of the acquisitions made during the third quarter of 2000. The useful lives of the technology acquired range from one to three years, and we expect the amortization to be at least $1.0 million over the next eight quarters. 15 OPERATING EXPENSES Sales and Marketing Sales and marketing expenses consist primarily of salaries, sales commissions benefits, recruiting costs, trade shows, travel and entertainment and other marketing communications costs such as advertising and promotion. Sales and marketing expenses were $29.6 million and $91.7 million for the three and nine months ended September 30, 2001, respectively, versus $20.6 million and $51.5 million for the comparable periods of 2000, representing increases of 43.8% and 78.2%, respectively. Sales and marketing expenses as a percentage of total revenues were 52.5% and 49.2% for the three and nine months ended September 30, 2001, respectively, compared to 46.6% and 47.0% in the same periods of 2000. The increases reflect our investment in our sales and marketing organization. In particular, sales and marketing employees increased from 509 as of September 30, 2000 to 718 as of September 30, 2001, an increase of 41.1%. The increase in expenses as a percentage of total revenue for the three months ended September 30, 2001 compared to the same period in 2000 is due to sequentially lower license revenues in the quarter. Research and Development Research and development expenses consist primarily of salaries and benefits for software developers, software product managers, quality assurance and technical documentation personnel, and of payments made to outside software development contractors. Research and development expenses were $15.3 million and $44.6 million for the three and nine months ended September 30, 2001, respectively, versus $11.1 million and $27.8 million in the same periods of 2000, representing increases of 37.3% and 60.5%, respectively. These expenses as a percentage of total revenues were 27.1% and 24.0% for the three and nine months ended September 30, 2001, respectively, compared to 25.2% and 25.4% in the same periods of 2000. The increase in research and development expenses was primarily due to increases in the number of software developers, technical documentation and quality assurance personnel. Research and development headcount increased from 470 as of September 30, 2000 to 617 as of September 30, 2001, an increase of 31.3%. The increase in expenses as a percentage of total revenue for the three months ended September 30, 2001 compared to the same period in 2000 is due to sequentially decreased license revenues. We believe significant expenditures in research and development are required to remain competitive, and expect that research and development expenses will continue to represent 20-25% of total revenues. In the development of new products and enhancements of existing products, the technological feasibility of the software is not established until substantially all product development is complete. Historically, our software development costs eligible for capitalization have been insignificant, and all costs related to internal research and development have been expensed as incurred. General and Administrative General and administrative expenses consist primarily of salaries, benefits and related costs for our executive, finance, administrative and information services personnel. General and administrative expenses were $5.8 million and $18.2 million for the three and nine months ended September 30, 2001, respectively, versus $5.1 million and $11.8 million in the same periods of 2000, representing increases of 15.0% and 54.9%, respectively. These expenses as a percentage of total revenues were 10.3% and 9.8% for the three and nine months ended September 30, 2001, respectively, compared to 11.5% and 10.8% in the same periods of 2000. The increase in general and administrative expenses was primarily due to the increase in headcount to support our growing infrastructure and expanding operations. General and administrative expenses are decreasing as a percentage of revenues, primarily because associated headcount is growing more slowly than revenues. Other Compensation Costs and Intangible Amortization Other compensation costs and intangible amortization include compensation expense associated with the issuance (primarily in 1999) of stock options below fair market value and the amortization of goodwill and other intangible assets associated with acquisitions. These costs totaled $16.4 million and $47.9 million for the three and nine months ended September 30, 2001, respectively, compared to $10.5 million and $25.9 million in the same 16 periods of 2000. These expenses as a percentage of total revenues were 29.1% and 25.7% for the three and nine months ended September 30, 2001, respectively, compared to 23.7% and 23.6% in the same periods of 2000. The increase in these costs was due to the acquisitions made during the third quarter of 2000 and 2001. The adoption of SFAS No. 142 in January of 2002 will substantially reduce charges to operations for goodwill amortization and change the method for determining impairment. The effect on the financial statements has not been determined. Currently, the Company's amortization of goodwill and other intangible assets is approximately $14.0 million per quarter. The Company will continue to monitor goodwill for impairment through the end of the fiscal year. OTHER INCOME, NET Other income, net was $2.7 million and $6.1 million for the three and nine months ended September 30, 2001, respectively, compared to $3.7 million and $8.3 million for the same periods of 2000, representing a decrease of 27.9% and 26.1%, respectively. The decrease is due primarily to less interest income earned in the three months ended September 30, 2001 versus the same period in 2000. The decrease in interest earned is a result of declining interest rates and reductions in cash balances by cash used in acquisitions and the stock repurchases made in December 2000. The average interest rates of our investments are summarized under "Item 3: Quantitative and Qualitative Disclosures About Market Risks -- Interest Rate Risk" below. We expect these average interest rates to come down significantly given the current historically low interest rate environment. Other income, net in the September quarter included a foreign currency benefit of $0.5 million. LOSSES ON EQUITY INVESTMENTS During the second quarter of 2001 we wrote down the carrying value of certain equity investments by $1.5 million to reflect their estimated fair value. Based on the Company's most recent analysis, no additional impairment exists as of September 30, 2001. INCOME TAXES Income tax provision (benefit) for the three and nine months ended September 30, 2001 was $(4.7) million and $5.2 million, respectively, compared with $1.8 million and $4.8 million for the same periods of 2000, representing effective rates of 30.3% and (15.7)%, for the three and nine months ended September 30, 2001, respectively, compared to (41.1)% and (42.0)% in the same periods of 2000. The estimated annual effective rate for 2001 decreased from 55.8% in the second quarter to 15.7% in the third quarter resulting in a tax (benefit) in the third quarter. The decrease in the estimated annual effective rate is due primarily to lower operating income. INFLATION Inflation has not had a significant effect on our results of operations or financial position for the three and nine months ended September 30, 2001 or the comparable periods of 2000. LIQUIDITY AND CAPITAL RESOURCES We have funded our business, to date, primarily from cash generated by our operations, net proceeds of $64.9 million from our initial public offering in August 1999, and net proceeds of $253.5 million from our secondary offering in March 2000. Our sources of liquidity as of September 30, 2001 consisted principally of cash and cash equivalents of $59.9 million and $134.0 million in short- and long-term high grade corporate and government marketable securities. Net cash provided by operating activities was $15.6 million and $51.7 million for the nine months ended September 30, 2000 and 2001, respectively. The increase in 2001 is primarily due to higher net income and higher non-cash depreciation and amortization expenses as a result of increased amortization of goodwill and other intangible assets, which increased by $28.0 million, or 97.5%, over the comparable period of 2000. A tax refund of $4.6 million, increases in deferred revenue, accounts receivable and income taxes payable, offset by net losses also contributed to the increase in 2001. Investing activities used $278.6 million and $26.5 million during the nine months ended September 30, 2000 and 2001, respectively. The decrease in 2001 is due to purchases of marketable securities made in March of 2000 as a result of our secondary public offering as well as acquisitions made during the first and second quarter of 2000 with dissimilar activity in 2001. 17 Financing activities provided $258.0 million and $9.7 million for the nine months ended September 30, 2000 and 2001, respectively. The decrease is primarily due to proceeds of $253.5 million received from the secondary public offering in March 2000. Offsetting this decrease were increases in proceeds from the exercise of stock options and our employee stock purchase plan during 2001. We believe that our existing cash, cash equivalents and investment balances and cash flows from operations will be sufficient to finance our working capital and capital expenditure requirements through at least the next 12 months. We may require additional funds to support our working capital requirements or for other purposes, and may seek to raise additional funds through public or private equity or debt financing, or from other sources. If additional financing is needed, we cannot assure you that such financing will be available to us at commercially reasonable terms or at all. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In September 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS No. 133"). SFAS No. 133, as amended, is effective for all fiscal years beginning after June 15, 2000, and establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. Under SFAS 133, certain contracts that were not formerly considered derivatives may now meet the definition of a derivative which would be required to be reported as assets or liabilities and carried at fair value. The Company adopted SFAS 133 effective January 1, 2001. The adoption of SFAS No. 133 did not have a significant impact on the financial position, results of operations, or cash flows of the Company. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations." SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of- interests method. SFAS 141 also requires reclassification of certain other identifiable assets to a separate financial statement line to the extent they meet certain criteria. The Company does not believe that the adoption of SFAS 141 will have a significant impact on its financial statements. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which is effective for the Company in January of 2002. SFAS No. 142 requires that goodwill and other intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually. The Company will continue to assess its recorded goodwill and other intangible assets under current generally accepted accounting principles at each reporting period until the standard is adopted. The adoption of SFAS No. 142 in January of 2002 will substantially reduce charges to operations for goodwill amortization and change the method for determining impairment. The effect on the financial statements has not been determined. Currently, the Company's amortization of goodwill and other intangible assets is approximately $14.0 million per quarter. In August 2001, the FASB issued Statement of Financial Accounting Standard No. 143 ("SFAS 143"), Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 is required to be adopted for fiscal years beginning after June 15, 2002. The Company has not yet determined what effect this statement will have on its financial statements. Also in August 2001, the FASB issued Statement of Financial Accounting Standard No. 144 ("SFAS 144"), Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. This new statement also supersedes certain aspects of Accounting Principles Board ("APB") 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, with regard to reporting the effects of a disposal of a segment of a business and will require expected future operating losses from discontinued operations to be reported in discontinued operations in the period incurred (rather than as of the measurement date as presently required by APB 30). In addition, more dispositions may qualify for discontinued operations treatment. The provisions of this 18 statement are required to be applied for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The Company has not yet determined what effect his statement will have on its financial statements. 19 RISK FACTORS An investment in our shares involves risks and uncertainties. You should carefully consider the factors described below before making an investment decision in our securities. The risks described below are the risks that we currently believe are material risks of business and the industry in which we compete. Our business, financial condition and results of operations could be adversely affected by any of the following risks. If we are adversely affected by such risks, then the trading price of our common stock could decline, and you could lose all or part of your investment. RISKS RELATED TO OUR BUSINESS OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE IN FUTURE PERIODS AND, AS A RESULT, WE MAY FAIL TO MEET EXPECTATIONS OF INVESTORS AND ANALYSTS, CAUSING OUR STOCK PRICE TO FLUCTUATE OR DECLINE Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors. These factors include the following: - the size and timing of customer orders. See "-- The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in our revenues." - the unpredictability of the timing and level of sales through our indirect sales channel; - the timing of revenue recognition for sales of software products and services; - the extent to which our customers renew their maintenance contracts with us; - exposure to general economic conditions and reductions in corporate IT spending; - changes in our level of operating expenses and our ability to control costs; - our ability to attain market acceptance of new products and services and enhancements to our existing products; - changes in our pricing policies or the pricing policies of our competitors; - the relative growth rates of competing operating system, database and application platforms; - costs related to acquisitions of technologies or businesses, including amortization of goodwill and other intangible assets; and - the timing of releases of new versions of third-party software products that our products support. 20 Fluctuations in our results of operations are likely to affect the market price of our common stock that may not be related to our long-term performance. THE SIZE AND TIMING OF OUR CUSTOMER ORDERS MAY VARY SIGNIFICANTLY FROM QUARTER TO QUARTER WHICH COULD CAUSE FLUCTUATIONS IN OUR REVENUES AND OPERATING RESULTS Our license revenues in any quarter are substantially dependent on orders booked and shipped in that quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, or if the contract terms were to prevent us from recognizing revenue during that quarter. The sales cycles for certain of our software products, such as Vista Plus and SharePlex, can last from three to nine months and often require pre-purchase evaluation periods and customer education. Also, we have often booked a large amount of our sales in the last month or weeks of each quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each quarter is recognized from previously deferred revenue, our quarterly performance will depend primarily upon entering into new contracts to generate revenues for that quarter. These factors may cause significant periodic variation in our license revenues. In addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet expectations until the end of that quarter. Accordingly, if our revenue growth rates slow or our revenues decline, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or quickly changed. GENERAL ECONOMIC CONDITIONS AND REDUCTIONS IN CORPORATE IT SPENDING MAY CONTINUE TO AFFECT REVENUE GROWTH RATES AND IMPACT OUR BUSINESS Our business and operating results are subject to the effects of changes in general economic conditions. Recent unfavorable economic conditions have resulted in reduced corporate IT spending in the industries that we serve and a softening of demand for computer software, not only in the database and application market segments we support but also in the product segment in which we compete. In addition, recent terrorist attacks upon the United States have added or exacerbated economic, political and other uncertainties. If these economic conditions do not improve, or we experience continued deterioration in general economic conditions or reduced corporate IT spending, our business and operating results could be adversely impacted. MANY OF OUR PRODUCTS ARE DEPENDENT ON ORACLE'S TECHNOLOGIES; IF ORACLE'S TECHNOLOGIES LOSE MARKET SHARE OR BECOME INCOMPATIBLE WITH OUR PRODUCTS, THE DEMAND FOR OUR PRODUCTS COULD SUFFER We believe that our success has depended in part, and will continue to depend in part for the foreseeable future, upon our relationship with Oracle and our status as a complementary software provider for Oracle's database and application products. Many versions of our products, including SharePlex, SQLab Vision, and SQL Navigator, are specifically designed to be used with Oracle databases. Although a number of our products work with other environments, our competitive advantage consists in substantial part on the integration between our products and Oracle's products, and our extensive knowledge of Oracle's technology. Currently, a significant portion of our total revenues are derived from products that specifically support Oracle-based products. If Oracle for any reason decides to promote technologies and standards that are not compatible with our technology, or if Oracle loses market share for its database products, our business, operating results and financial condition would be materially adversely affected. MANY OF OUR PRODUCTS ARE VULNERABLE TO DIRECT COMPETITION FROM ORACLE We currently compete with Oracle in the market for database management solutions. We expect that Oracle's commitment to and presence in the database management product market will increase in the future and therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its server software offerings, possibly at no additional cost to its users. We believe that Oracle will also continue to enhance its database management technology. Furthermore, Oracle could attempt to increase its presence in this market by acquiring or forming strategic alliances with our competitors, and Oracle may be in better position to withstand and respond to the current factors impacting this industry. Oracle has a longer operating history, a larger installed base of customers and substantially greater financial, distribution, marketing and 21 technical resources than we do. In addition, Oracle has well-established relationships with many of our present and potential customers. As a result, we may not be able to compete effectively with Oracle in the future, which could materially adversely affect our business, operating results and financial condition. OUR SUCCESS DEPENDS ON OUR ABILITY TO DEVELOP NEW AND ENHANCED PRODUCTS THAT ACHIEVE WIDESPREAD MARKET ACCEPTANCE Our future success depends on our ability to address the rapidly changing needs of our customers by developing and introducing new products, product updates and services on a timely basis, by extending the operation of our products on new platforms and by keeping pace with technological developments and emerging industry standards. In order to grow our business, we are committing substantial resources to developing software products and services for the applications management market. If this market does not continue to develop as anticipated, or demand for our products in this market does not materialize or occurs more slowly than we expect, or if our development efforts are delayed or unsuccessful, we will have expended substantial resources and capital without realizing sufficient revenues, and our business and operating results could be adversely affected. ACQUISITIONS OF COMPANIES OR TECHNOLOGIES MAY RESULT IN DISRUPTIONS TO OUR BUSINESS AND DIVERSION OF MANAGEMENT ATTENTION We have in the past made and we expect to continue to make acquisitions of complementary companies, products or technologies. If we make any additional acquisitions, we will be required to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may subject us to liabilities and risks that are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert management's attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. We may have to incur debt or issue equity securities to pay for any future acquisitions. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for acquired goodwill and other intangible assets. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of acquisition. OUR ABILITY TO INCREASE OUR REVENUES DEPENDS ON OUR ABILITY TO EXPAND OUR INDIRECT SALES CHANNELS We intend to aggressively pursue expansion of our indirect sales channels through arrangements with resellers, systems integrators and distributors. In certain domestic and international markets we may miss sales opportunities if we are unable to enter into successful relationships with locally based resellers. We may become more dependent on these type of relationships. There can be no assurance that we will successfully develop these relationships or that the expansion of indirect sales distribution methods will increase revenues. OUR PAST AND FUTURE GROWTH MAY STRAIN OUR MANAGEMENT, ADMINISTRATIVE, OPERATIONAL AND FINANCIAL INFRASTRUCTURE We have recently experienced a period of rapid growth in our operations that has placed and will continue to place a strain on our management, administrative, operational and financial infrastructure. During this period, we have experienced an increase in the number of our employees, increasing demands on our operating and financial systems and personnel, and an expansion in the geographic coverage of our operations. Our ability to manage our operations and growth requires us to continue to improve our operational, financial and management controls, and reporting systems and procedures. We may need to expand our facilities or relocate some or all of our employees or operations from time to time to support growth. These relocations could result in temporary disruptions of our operations or a diversion of management's attention and resources. In addition, we will be required to hire additional management, financial and sales and marketing personnel to manage our expanding operations. If we are unable to manage this growth effectively, our business, operating results and financial condition may be materially adversely affected. 22 WE MAY NOT GENERATE INCREASED BUSINESS FROM OUR CURRENT CUSTOMERS, WHICH COULD SLOW OUR REVENUE GROWTH IN THE FUTURE Most of our customers initially make a purchase of our products for a single department or location. Many of these customers may choose not to expand their use of our products. If we fail to generate expanded business from our current customers, our business, operating results and financial condition could be materially adversely affected. In addition, as we deploy new modules and features for our existing products or introduce new products, our current customers may choose not to purchase this new functionality or these new products. Moreover, if customers elect not to renew their maintenance agreements, our service revenues would be materially adversely affected. OUR INTERNATIONAL OPERATIONS AND OUR PLANNED EXPANSION OF OUR INTERNATIONAL OPERATIONS EXPOSES US TO CERTAIN RISKS We intend to expand our international sales activities as part of our business strategy. As a result, we face increasing risks from doing business on an international basis, including, among others: - difficulties in staffing and managing foreign operations; - longer payment cycles; - seasonal reductions in business activity in Europe; - increased financial accounting and reporting burdens and complexities; - potentially adverse tax consequences; - potential loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection; - delays in localizing our products; - compliance with a wide variety of complex foreign laws and treaties; and - licenses, tariffs and other trade barriers. In addition, because our international subsidiaries generally conduct business in the currency of the country in which they operate, our exposure to exchange rate fluctuations, which are outside of our control, will increase as our international operations expand. We have not yet entered into any hedging transactions to mitigate exposure to foreign currency fluctuations. Operating in international markets also requires significant management attention and financial resources and will place additional burdens on our management, administrative, operational and financial infrastructure. We cannot be certain that our investments in establishing facilities in other countries will produce desired levels of revenue or profitability. In addition, we have sold our products internationally for only a few years and we have limited experience in developing localized versions of our products and marketing and distributing them internationally. 23 INVESTING IN DEVELOPMENT-STAGE COMPANIES INVOLVES A NUMBER OF RISKS AND UNCERTAINTIES We have and may continue to make investments in development-stage companies that we believe provide strategic opportunities for Quest. Each of these investments involves a number of risks and uncertainties, including diversion of management attention, inability to identify strategic opportunities, inability to value investments appropriately, inability to manage investments effectively and loss of cash invested. We intend that these investments will complement our own research and development efforts, provide access to new technologies and emerging markets, and create opportunities for additional sales of our products and services. However, we cannot assure you that this initiative will have the above mentioned desired results, or even that we will not lose all or any part of these investments. FAILURE TO DEVELOP STRATEGIC RELATIONSHIPS COULD HARM OUR BUSINESS BY DENYING US SELLING OPPORTUNITIES AND OTHER BENEFITS Our current collaborative relationships may not prove to be beneficial to us, and they may not be sustained. We also may not be able to enter into successful new strategic relationships in the future, which could have a material adverse effect on our business, operating results and financial condition. From time to time, we have collaborated with other companies, including Hewlett-Packard and Oracle and certain of the national accounting firms that provide system integration services, in areas such as product development, marketing, distribution and implementation. We could lose sales opportunities if we fail to work effectively with these parties. Moreover, we expect that maintaining and enhancing these and other relationships will become a more meaningful part of our business strategy in the future. However, many of our current partners are either actual or potential competitors with us. In addition, many of these third parties also work with competing software companies and we may not be able to maintain these existing relationships, due to the fact that these relationships are informal or, if written, are terminable with little or no notice. OUR PROPRIETARY RIGHTS MAY BE INADEQUATELY PROTECTED, AND THERE IS RISK OF INFRINGEMENT CLAIMS OR INDEPENDENT DEVELOPMENT OF COMPETING TECHNOLOGY THAT COULD HARM OUR COMPETITIVE POSITION Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology. We rely on a combination of trademark, trade secret, copyright law and contractual restrictions to protect the proprietary aspects of our technology. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any such resulting litigation could result in substantial costs and diversion of resources. Our means of protecting our proprietary rights may prove to be inadequate and competitors may independently develop similar or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services. Our success and ability to compete are also dependent on our ability to operate without infringing upon the proprietary rights of others. Third parties may claim infringement by us of their intellectual property rights. In the event of a successful claim of product infringement against us and our failure or inability to either license the infringed or similar technology or develop alternative technology on a timely basis, we may incur substantial licensing fees, be liable for infringement damage, or be unable to market our products. OUR BUSINESS WILL SUFFER IF OUR SOFTWARE CONTAINS ERRORS The software products we offer are inherently complex. Despite testing and quality control, we cannot be certain that errors will not be found in current versions, new versions or enhancements of our products after commencement of commercial shipments. Significant technical challenges also arise with our products because our customers purchase and deploy our products across a variety of computer platforms and integrate it with a number of third- 24 party software applications and databases. If new or existing customers have difficulty deploying our products or require significant amounts of customer support, our operating margins could be harmed. Moreover, we could face possible claims and higher development costs if our software contains undetected errors or if we fail to meet our customers' expectations. As a result of the foregoing, we could experience: - loss of or delay in revenues and loss of market share; - loss of customers; - damage to our reputation; - failure to achieve market acceptance; - diversion of development resources; - increased service and warranty costs; - legal actions by customers against us which could, whether or not successful, increase costs and distract our management; and - increased insurance costs. In addition, a product liability claim, whether or not successful, could harm our business by increasing our costs and distracting our management. WE INCORPORATE SOFTWARE LICENSED FROM THIRD PARTIES INTO SOME OF OUR PRODUCTS AND ANY SIGNIFICANT INTERRUPTION IN THE AVAILABILITY OF THESE THIRD-PARTY SOFTWARE PRODUCTS OR DEFECTS IN THESE PRODUCTS COULD REDUCE THE DEMAND FOR, OR PREVENT THE SHIPPING OF, OUR PRODUCTS Certain of our software products contain components developed and maintained by third-party software vendors. We expect that we may have to incorporate software from third-party vendors in our future products. We may not be able to replace the functionality provided by the third-party software currently offered with our products if that software becomes obsolete, defective or incompatible with future versions of our products or is not adequately maintained or updated. Any significant interruption in the availability of these third-party software products or defects in these products could harm our sales unless and until we can secure an alternative source. Although we believe there are adequate alternate sources for the technology licensed to us, such alternate sources may not provide us with the same functionality as that currently provided to us. NATURAL DISASTERS OR POWER OUTAGES COULD DISRUPT OUR BUSINESS A substantial portion of our operations are located in California, and we are subject to risks of damage and business disruptions resulting from earthquakes, floods and similar events, as well as from power outages. We have recently experienced limited and temporary power losses in our California facilities due to power shortages, and we expect in the future to experience additional power losses. While the impact to our business and operating results has not been material, we cannot assure you that power losses will not adversely affect our business in the future, or that the cost of acquiring sufficient power to run our business will not increase significantly. Since we do not have sufficient redundancy in our networking infrastructure, a natural disaster or other unanticipated problem could have an adverse effect on our business, including both our internal operations and our ability to communicate with our customers or sell and deliver our products. RISKS RELATED TO OUR INDUSTRY THE DEMAND FOR OUR PRODUCTS WILL DEPEND ON OUR ABILITY TO ADAPT TO RAPID TECHNOLOGICAL CHANGE Our future success will depend on our ability to continue to enhance our current products and to develop and introduce new products on a timely basis that keep pace with technological developments and satisfy increasingly 25 sophisticated customer requirements. Rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and evolving industry standards characterize the market for our products. The introduction of products embodying new technologies and the emergence of new industry standards can render our existing products obsolete and unmarketable. As a result of the complexities inherent in today's computing environments and the performance demanded by customers for embedded databases and Web-based products, new products and product enhancements can require long development and testing periods. As a result, significant delays in the general availability of such new releases or significant problems in the installation or implementation of such new releases could have a material adverse effect on our business, operating results and financial condition. We may not be successful in: - developing and marketing, on a timely and cost-effective basis, new products or new product enhancements that respond to technological change, evolving industry standards or customer requirements; - avoiding difficulties that could delay or prevent the successful development, introduction or marketing of these products; or - achieving market acceptance for our new products and product enhancements. WE MAY NOT BE ABLE TO ATTRACT AND RETAIN PERSONNEL Our future success depends on the continued service of our executive officers and other key administrative, sales and marketing and support personnel, many of whom have recently joined our company. In addition, the success of our business is substantially dependent on the services of our Chief Executive Officer and other executive officers. There has in the past been and there may in the future be a shortage of personnel that possess the technical background necessary to sell, support and develop our products effectively. Competition for skilled personnel is intense, and we may not be able to attract, assimilate or retain highly qualified personnel in the future. Our business may not be able to grow if we cannot attract qualified personnel. Hiring qualified sales, marketing, administrative, research and development and customer support personnel is very competitive in our industry, particularly in Southern California where Quest is headquartered. 26 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS FOREIGN CURRENCY HEDGING INSTRUMENTS We transact business in various foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to revenues and operating expenses in Canada, the United Kingdom, Germany, and Australia denominated in the respective local currency. To date, we have not used hedging contracts to hedge our foreign-currency fluctuation risks. We will assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis. We also do not use derivative financial instruments for speculative trading purposes. INTEREST RATE RISK Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We have not used derivative financial instruments in our investment portfolio. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer other than the United States government and its agencies. Our investments in marketable securities consist primarily of high-grade government securities with maturities of less than three years. Investments purchased with an original maturity of three months or less are considered to be cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders' equity. At September 30, 2001, the net gain on available-for-sale securities of $1.4 million comprised 30 positions, of which all 30 carry unrealized gains. The following table provides information about our investment portfolio at September 30, 2001 (dollars in thousands):
BALANCE AVERAGE RATE ------- ------------ Cash and cash equivalents 35,726 4.32% Short-term marketable securities, available for sale 15,659 6.69% Long-term marketable securities, available for sale 118,291 5.15% Total portfolio 169,676 5.12%
We consider the carrying value of our investment securities to approximate their fair value due to the relatively short period of time between origination of the investments and their expected realization. We also maintain a level of cash and cash equivalents such that we have generally been able to hold our investments to maturity. Accordingly, changes in the market interest rate would not have a material effect on the fair value of such investments. 27 PART II OTHER INFORMATION ITEM 4: EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS None (b) REPORTS ON FORM 8-K None. 28 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. QUEST SOFTWARE, INC. November 14, 2001 /s/ M. BRINKLEY MORSE -------------------------------------- M. Brinkley Morse Vice President, Finance and Operations /s/ KEVIN E. BROOKS -------------------------------------- Kevin E. Brooks Principal Accounting Officer 29