10-Q 1 a72746e10-q.txt FORM 10-Q FOR QUARTER ENDED MARCH 31, 2001 1 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 MARCH 31, 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 Identification No.) incorporation or organization) 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 May 2, 2001 was 87,695,352. 2 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 March 31, 2001 (unaudited)................................................ 3 Consolidated Statements of Operations for the Three Months Ended March 31, 2000 and 2001 (unaudited).............................. 4 Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2000 and 2001 (unaudited)..................................... 5 Consolidated Statements of Comprehensive Operations for the Three Months Ended March 31, 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............................................................................ 11 Item 3. Quantitative and Qualitative Disclosure about Market Risk............................. 23 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K...................................................... 24 Signatures..................................................................................... 25
2 3 PART I FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS QUEST SOFTWARE, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) ASSETS
MARCH 31, DECEMBER 31, 2001 2000 (UNAUDITED) ------------ ----------- Current assets: Cash and cash equivalents $ 25,155 $ 35,169 Short-term marketable securities 8,587 9,873 Accounts receivable, net 38,443 36,347 Prepaid expenses and other current assets 11,390 11,456 Income taxes receivable 1,558 1,582 Deferred income taxes 14,833 14,786 --------- --------- Total current assets 99,966 109,213 Property and equipment, net 46,840 56,816 Long-term marketable securities 118,084 115,717 Goodwill and purchased intangible assets, net 255,858 238,807 Deferred income taxes 3,001 3,001 Other assets 10,423 10,309 --------- --------- Total assets $ 534,172 $ 533,863 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 5,503 $ 5,122 Accrued compensation 9,350 10,111 Other accrued expenses 22,491 18,468 Deferred revenue 32,052 40,299 --------- --------- Total current liabilities 69,396 74,000 Long-term liabilities and other 6,422 6,305 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 87,151 issued and outstanding at December 31, 2000 and March 31, 2001, respectively 500,324 510,353 Accumulated deficit (23,214) (37,996) Accumulated other comprehensive income 132 390 Notes receivable from sale of common stock (18,888) (19,189) --------- --------- Total shareholders' equity 458,354 453,558 --------- --------- Total liabilities and shareholders' equity $ 534,172 $ 533,863 ========= =========
See accompanying notes to the consolidated financial statements. 3 4 QUEST SOFTWARE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
THREE MONTHS ENDED MARCH 31, --------------------- 2000 2001 -------- -------- Revenues: Licenses $ 21,895 $ 48,429 Services 6,830 14,683 -------- -------- Total revenues 28,725 63,112 Cost of revenues: Licenses 635 889 Services 1,870 4,078 Amortization of purchased intangible assets 657 2,035 -------- -------- Total cost of revenues 3,162 7,002 -------- -------- Gross profit 25,563 56,110 Operating expenses: Sales and marketing 13,914 30,860 Research and development 7,366 13,930 General and administrative 3,097 6,353 Other compensation costs and intangible amortization 7,378 15,982 -------- -------- Total operating expenses 31,755 67,125 -------- -------- Loss from operations (6,192) (11,015) Other income, net 979 1,777 -------- -------- Loss before income tax provision (5,213) (9,238) Income tax provision 472 5,543 -------- -------- Net loss $ (5,685) $(14,781) ======== ======== Basic and diluted net loss per share $ (0.07) $ (0.17) ======== ======== Basic and diluted weighted average shares 81,371 87,016
See accompanying notes to the consolidated financial statements. 4 5 QUEST SOFTWARE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
THREE MONTHS ENDED MARCH 31, ---------------------- 2000 2001 --------- -------- Cash flows from operating activities: Net loss $ (5,685) $(14,781) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization 7,291 18,453 Compensation expense associated with stock option grants 764 2,029 Accrued interest receivable from shareholders (49) (301) Provision for bad debts -- 285 Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable 4,163 1,170 Prepaid expenses and other current assets (2,221) 329 Other assets (285) (496) Accounts payable (2,175) (322) Accrued compensation (68) 948 Income taxes payable 244 5,474 Other accrued expenses (4,156) (3,848) Other liabilities -- (226) Deferred revenue 3,170 8,717 --------- -------- Net cash provided by operating activities 993 17,431 Cash flows from investing activities: Purchases of property and equipment (2,114) (12,534) Cash paid for acquisitions, net of cash acquired (15,851) -- Purchases of marketable securities (165,096) (18,939) Sales and maturities of marketable securities 24,235 20,277 --------- -------- Net cash used in investing activities (158,826) (11,196) Cash flows from financing activities: Repayment of notes payable (2,603) -- Repayment of capital lease obligations (697) (146) Proceeds from exercise of stock options 677 905 Proceeds from employee stock purchase plan 1,417 2,992 Proceeds from issuance of common stock, net 253,469 -- --------- -------- Net cash provided by financing activities 252,263 3,751 Effect of exchange rate changes on cash and cash equivalents 42 28 --------- -------- Net increase in cash and cash equivalents 94,472 10,014 Cash and cash equivalents, beginning of period 39,643 25,155 --------- -------- Cash and cash equivalents, end of period $ 134,115 $ 35,169 ========= ======== Supplemental disclosures of consolidated cash flow information: Cash paid for: Interest $ 118 $ 36 ========= ======== Income taxes $ 346 $ 66 ========= ======== Supplemental schedule of noncash investing and financing activities: Unrealized (loss) gain from available-for-sale securities $ (455) $ 258 ========= ======== Tax benefit related to stock option exercises $ 336 $ 5,523 ========= ========
See accompanying notes to the consolidated financial statements. 5 6 QUEST SOFTWARE, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS (IN THOUSANDS) (UNAUDITED)
THREE MONTHS ENDED MARCH 31, --------------------- 2000 2001 ------- -------- Net loss $(5,685) $(14,781) Other comprehensive (loss) gain: Unrealized (loss) gain on available-for-sale securities (455) 258 ------- -------- Comprehensive loss $(6,140) $(14,523) ======= ========
See accompanying notes to the consolidated financial statements. 6 7 QUEST SOFTWARE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The accompanying unaudited interim consolidated financial statements of Quest Software, Inc., a California corporation (the "Company" or "Quest"), as of March 31, 2001 and for the three months ended March 31, 2000 and 2001 reflect all adjustments (consisting of normal recurring accruals) which, 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 generally accepted accounting principles of 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 months ended March 31, 2001 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2001. 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. 2. ACQUISITIONS Operations of the companies acquired throughout fiscal 2000 are included in the consolidated financial statements from the dates of acquisition. The first quarter of 2001 includes actual results of these acquisitions. The pro forma results of operations data for the first quarter 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):
First Quarter Ended March 31, --------------------------------- 2000 2001 -------- -------- (pro forma) (as reported) Revenues $ 32,450 $ 63,112 Net loss (18,125) (14,781) Net loss per share - basic and diluted (0.22) (0.17)
7 8 3. OTHER COMPENSATION COSTS The Company records compensation expense for options to purchase the Company's common stock granted at 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, which is 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):
ALLOCATION OF OTHER COMPENSATION AS REPORTED EXPENSE PRO FORMA ----------- ------------------ --------- First quarter ended March 31, 2000 Cost of services revenues $ 1,870 $ -- $ 1,870 Sales and marketing 13,914 688 14,602 Research and development 7,366 42 7,408 General and administrative 3,097 34 3,131 First quarter ended March 31, 2001 Cost of services revenues $ 4,078 $ 126 $ 4,204 Sales and marketing 30,860 725 31,585 Research and development 13,930 1,025 14,955 General and administrative 6,353 153 6,506
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 dilutive. The table below sets forth the reconciliation of the denominator of the earnings per share calculations (in thousands):
THREE MONTHS ENDED MARCH 31, ------------------ 2000 2001 ------ ------ Shares used in computing basic net income (loss) per share 81,371 87,016 Dilutive effect of stock options --(1) --(1) ------ ------ Shares used in computing diluted net income (loss) per share 81,371 87,016 ====== ======
(1) Effect would have been anti-dilutive, accordingly, the amount is excluded from shares used in computing diluted net loss per share. The dilutive effect of stock options would have been 6,169 and 3,985 for the three months ended March 31, 2000 and 2001, respectively. 8 9 5. ACCUMULATED OTHER COMPREHENSIVE INCOME Accumulated other comprehensive operations as of March 31, 2001 is comprised of the following (in thousands): UNREALIZED GAIN ON AVAILABLE-FOR-SALE SECURITIES ------------------ Balance, December 31, 2000.......... $132 Current period changes 258 --- Balance, March 31, 2001............. $390 === 6. SHAREHOLDERS' EQUITY In January 2001, approximately 94,000 shares of common stock were issued under the Company's Employee Stock Purchase Plan at a price of $31.82 per share. 7. STOCK OPTION PLANS The following table summarizes information about stock options outstanding as of March 31, 2001 (in thousands, except for per share data):
Number of Options Number of Exercisable as of Shares Price per Share March 31, 2001 --------- --------------- ----------------- Balance at December 31, 2000 10,641 $ 0.50 - $53.63 Granted 3,457 15.13 - 23.69 Exercised (351) 0.50 - 25.38 Canceled (510) 0.59 - 53.63 ------ Balance at March 31, 2001 13,237 $ 0.50 - $53.63 2,104 ======
8. 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, gross profit and income (loss) from operations, as this information and the geographic information described below are the only information provided to the chief operating decision maker on a segment basis. 9 10 Operating segment data for the three months ended March 31, 2000 and 2001 were as follows (in thousands):
LICENSES SERVICES TOTAL -------- -------- ------- First quarter ended March 31, 2000 Revenues $21,895 $ 6,830 $28,725 Cost of revenues 1,292 1,870 3,162 ------- ------- ------- Gross profit $20,603 $ 4,960 $25,563 ======= ======= ======= First quarter ended March 31, 2001 Revenues $48,429 $14,683 $63,112 Cost of revenues 2,924 4,078 7,002 ------- ------- ------- Gross profit $45,505 $10,605 $56,110 ======= ======= =======
Revenues are attributed to geographic areas based on the location of the entity from which the products or services were sold. Revenues, gross profit, income (loss) from operations and long-lived assets concerning principal geographic areas in which the Company operates as of and for the three months ended March 31, 2000 and 2001, respectively, were as follows (in thousands):
NORTH OTHER AMERICA(1) EUROPE INTERNATIONAL TOTAL ---------- ------- ------------- --------- First quarter ended March 31, 2000 Revenues $ 23,717 $ 4,463 $ 545 $ 28,725 Gross profit 23,161 2,302 100 25,563 Income (loss) from operations (6,368) 336 (160) (6,192) Long-lived assets 134,556 564 947 136,067 First quarter ended March 31, 2001 Revenues $ 52,112 9,272 1,728 $ 63,112 Gross profit 50,839 5,099 172 56,110 Income (loss) from operations (1,765) (2,366) (6,884) (11,015) Long-lived assets 292,703 1,611 1,309 295,623
(1) Principally represents operations in the United States. 10 11 ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in this report, including statements regarding the Company's strategy, financial performance and revenue sources, are forward-looking statements. These forward-looking statements are based on current expectations and entail various risks and uncertainties that could cause actual results to differ materially from those expressed in such forward-looking statements. The Company's actual results could differ materially from the results anticipated in these forward-looking statements as a result of certain factors set forth under "Risk Factors" and elsewhere in this report. Readers are urged to carefully review and consider the various disclosures made by the Company in this report and in the Company's other reports filed with the SEC, including the Company's Annual Report on Form 10-K for the year ended December 31, 2000, that attempt to advise interested parties of certain risks and factors that may affect the Company's business. Readers are cautioned not to place undue reliance on these forward-looking statements to reflect events or circumstances occurring after the date hereof. The following discussion should be read in conjunction with the Company's consolidated financial statements and notes thereto. OVERVIEW We provide application management software solutions that enhance our customers' return on IT investment dollars by maximizing availability, improving performance, maximizing the effectiveness of IT personnel and improving the quality of business critical applications. Our product families are designed to meet the availability and performance requirements of our customers' most critical applications. Each product family 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 can include ERP (enterprise resource planning) systems, CRM (customer relationship management) systems, B2B (business to business) e-commerce systems, corporate messaging and Internet and web-based 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 derive our revenues primarily from the sale of software licenses and related annual maintenance fees. Pricing of our software licenses is based on the number of servers, workstations and/or users of our products. 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. International revenues from licenses and services sold to customers outside of North America were $15.3 million in 1999 and $28.7 million in 2000, and were $5.0 and $11.0 for the three months ended March 31, 2000 and 2001, respectively. We intend to expand our international sales activities as part of our business strategy. All of our current international revenues are derived from the operations of our wholly owned international subsidiaries, which consist of both direct sales and sales through distributors. Our international subsidiaries conduct business in the currency of the country in which they operate (with the exception of Mexico and Brazil where the U.S. Dollar is used), exposing us to currency fluctuations and currency transaction losses or gains which are outside of our control. Historically, fluctuations in foreign currency exchange rates have not had a material effect on our business. We have not, to date, conducted any hedging transactions to reduce our risk to currency fluctuations. 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. 11 12 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 March 31, ------------------- 2000 2001 ------ ------ Revenues: Licenses 76.2% 76.7% Services 23.8 23.3 ------ ------ Total revenues 100.0 100.0 Cost of revenues: Licenses 2.2 1.4 Services 6.5 6.5 Amortization of purchased intangible assets 2.3 3.2 ------ ------ Total cost of revenues 11.0 11.1 ------ ------ Gross profit 89.0 88.9 Operating expenses: Sales and marketing 48.4 48.9 Research and development 25.6 22.1 General and administrative 10.8 10.1 Other compensation costs and intangible amortization 25.7 25.3 ------ ------ Total operating expenses 110.5 106.4 ------ ------ Loss from operations (21.5) (17.5) Other income, net 3.4 2.8 ------ ------ Loss before income tax provision (18.1) (14.7) Income tax provision 1.6 8.8 ------ ------ Net Loss (19.7)% (23.5)% ====== ====== As a Percentage of Related Revenues: Cost of licenses 2.9% 1.8% Cost of services 27.4 27.8
THREE MONTHS ENDED MARCH 31, 2000 AND 2001 REVENUES Total revenues for the three months ended March 31, 2001 were $63.1 million, an increase of 120% from the comparable period of 2000. Revenues outside of North America for the three months ended March 31, 2001 were $11.0 million, an increase of 120% from the comparable period of 2000. We believe that the percentage increase in total revenues achieved during this period are not necessarily indicative of future results but we expect revenues to continue to grow in the foreseeable future. LICENSES Licenses for the three months ended March 31, 2001 were $48.4 million, an increase of 121% from the comparable period of 2000. Licenses represented 76.7% of total revenues for the three months ended March 31, 2001, compared to 76.2% for the same period of 2000. Licenses outside of North America accounted for 19.1% and 18.3% of total licenses for the three months ended March 31, 2000 and 2001, respectively. The increases in licenses during the first quarter of 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 first quarter of 2000. 12 13 SERVICES Services for the three months ended March 31, 2001 were $14.7 million, an increase of 115% from the comparable period of 2000. Services revenues represented 23.3% and 23.8% of total revenues for the three months ended March 31, 2000 and 2001, respectively. Services revenues outside of North America accounted for 12.0% and 14.4% of total services for the three months ended March 31, 2000 and 2001, respectively. The increases in services during the first quarter of 2001 reflect an increase in the number of software licenses sold with maintenance agreements and renewals of maintenance agreements on existing licenses relative to the first quarter of 2000, as well as 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 royalties. Cost of licenses were $0.9 million for the three months ended March 31, 2001, versus $0.6 million in the comparable period of 2000, representing an increase of 40%. Cost of licenses as a percentage of license revenues was 2.9% and 1.8% for the three months ended March 31, 2000 and 2001, respectively. The 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 months ended March 31, 2001 were $4.1 million versus $1.9 million for the comparable period of 2000, representing an increase of 118%. Cost of services as a percentage of services revenues were 27.4% and 27.8% for the three months ended March 31, 2000 and 2001, respectively. The 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. 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. We expect the cost of services to increase in absolute dollars for the foreseeable future as additional customer support and consulting personnel are hired. AMORTIZATION OF PURCHASED INTANGIBLE ASSETS Amortization of purchased intangible assets was $2.0 million during the three months ended March 31, 2001 versus $0.7 million in the same period of 2000, representing an increase of 210%. This increase was due entirely to amortization of technology purchased as part of the acquisitions made during the second and third quarters of 2000. The useful lives of the technology acquired ranges from one to three years, and we expect the amortization to be at least $1.0 million over the next eight quarters. OPERATING EXPENSES SALES AND MARKETING Sales and marketing expenses consist primarily of salaries, commissions earned by sales personnel, recruiting costs, trade shows, travel and entertainment, and other marketing communications costs such as advertising and promotion. Sales and marketing expenses were $30.9 million for the three months ended March 31, 2001 versus $13.9 million for the comparable period of 2000, representing an increase of 122%. Sales and marketing expenses as a percentage of total revenues were 48.4% and 48.9% for the three months ended March 31, 2000 and 2001, respectively. The increases reflect our increasing investment in our sales and marketing organization. In particular, salaries and related costs increased $10.7 million, and trade show, advertising and promotional costs increased $1.8 million over the first quarter of 2000. We intend to continue to expand our sales and marketing infrastructure during 2001 and, as a result, expect sales and marketing expenses to increase in absolute dollars. 13 14 RESEARCH AND DEVELOPMENT Research and development expenses consist primarily of salaries and benefits for software developers, software product managers, quality assurance personnel, and payments made to outside software development contractors. Research and development expenses were $13.9 million for the three months ended March 31, 2001 versus $7.4 million in the same period of 2000, representing an increase of 89%. These expenses as a percentage of total revenues were 25.6% and 22.1% for the three months ended March 31, 2000 and 2001, respectively. The increase in research and development expenses was due to continued investments in research and development efforts, including the increase in the number of software developers and quality assurance personnel. As a result, salaries and related expenses increased $4.9 million over the first quarter of 2000. The decrease in these expenses as a percentage of total revenues is due to the higher revenues over a relatively smaller growth in these expenses. We believe significant expenditures in research and development are required to remain competitive, and expect these expenses to continue to increase in absolute dollars in 2001. 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 $6.4 million for the three months ended March 31, 2001 versus $3.1 million in the same period of 2000, representing an increase of 105%. These expenses as a percentage of total revenues were 10.8% and 10.1% for the three months ended March 31, 2000 and 2001, respectively. The increase in general and administrative expenses was primarily due to the increase in headcount to support our growing infrastructure and expanding operations. As a result, salaries and related costs increased $1.8 million over the first quarter of 2000. The decrease in these expenses as a percentage of total revenues was due to higher revenues over a relatively smaller growth in these expenses. We expect that general and administrative expenses will continue to increase in absolute dollars as we continue to enhance our infrastructure and support expansion of our operations. 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 $16.0 million for the three months ended March 31, 2001 compared to $7.4 million in the same period of 2000, representing an increase of 117%. These expenses as a percentage of total revenues were 25.7% and 25.3% for the three months ended March 31, 2000 and 2001, respectively. The increase in these costs was due to the acquisitions made during the second and third quarters of 2000. The goodwill and other intangibles are being amortized over their useful lives, and we expect these costs to be at least approximately $15.0 million per quarter through the second quarter of 2003. OTHER INCOME, NET Other income, net was $1.8 million for the three months ended March 31, 2001 compared to $1.0 million for the same period of 2000, representing an increase of 82%. The increase is due to the fact that the first quarter of 2001 had the benefit of a full quarter's interest on proceeds from our secondary public offering, which took place near the end of the first quarter of 2000. PROVISION FOR INCOME TAXES Provision for income taxes was $5.5 million for the three months ended March 31, 2001 compared with $0.5 million for the comparable period of 2000, representing effective rates for these periods of (8.4)% and (60.0%), respectively. Excluding non-deductible amortization of intangible assets and other compensation costs, our effective income tax rate was 40% for both the three months ended March 31, 2000 and 2001. INFLATION Inflation has not had a significant effect on our results of operations or financial position for the three months ended March 31, 2001 or the comparable period of 2000. 14 15 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 March 31, 2001 consisted principally of cash and cash equivalents of $35.2 million and $115.7 million in both short- and long-term high grade corporate and government marketable securities. Net cash provided by operating activities was $0.9 million and $17.4 million for the three months ended March 31, 2000 and 2001, respectively. The increase in 2001 was primarily due to higher non-cash depreciation and amortization expenses and increases in deferred revenue and income taxes payable, offset by net losses and the decrease in other accrued expenses. Investing activities used $158.8 million and $11.2 million during the three months ended March 31, 2000 and 2001, respectively. The decrease in 2001 is due to the decrease in purchases of marketable securities as a result of our secondary public offering in March 2000, as well as acquisitions made during the first quarter of 2000. Offset by this decrease is an increase in capital expenditures made during 2001, which primarily consisted of computer hardware and software to enhance our infrastructure and support our continued expansion. Financing activities provided $252.3 million and $3.8 million for the three months ended March 31, 2000 and 2001, respectively. The decrease is the primarily due to the 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. 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. 15 16 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; - the possibility that our customers may cancel or defer purchases as a result of reduced IT budgets or in anticipation of new products or product updates by us or by our competitors; - the possibility of an economic slowdown generally; - the amount and timing of expenditures related to expansion of our operations; - our ability to attain market acceptance of new products and services and enhancements to our existing products; - lack of order backlog; - changes in our pricing policies or the pricing policies of our competitors; - the relative growth rates of the Windows NT and UNIX markets, as well as the rate of adoption of Microsoft's release of Windows 2000 by users; - 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. 16 17 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 In any given quarter, sales of some of our products have involved large financial commitments from a relatively small number of customers, and cancellation or deferral of these large contracts would reduce our revenues. In addition, 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. These relatively long sales cycles may cause significant periodic variation in our license revenues. 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. 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 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. 17 18 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. 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. WE EXPECT TO INCUR SIGNIFICANT INCREASES IN OUR OPERATING EXPENSES IN THE FORESEEABLE FUTURE, WHICH MAY AFFECT OUR FUTURE PROFITABILITY We intend to substantially increase our operating expenses for the foreseeable future as we continue to: - increase our sales and marketing activities, including expanding our direct sales and telesales forces; - increase our research and development activities; 18 19 - expand our general and administrative activities; and - expand our customer support organizations. Accordingly, we will be required to significantly increase our revenues in order to maintain profitability. These expenses will be incurred before we generate any revenues by this increased spending. If we do not significantly increase revenues from these efforts, our business and operating results would be negatively impacted. OUR INTERNATIONAL OPERATIONS AND OUR PLANNED EXPANSION OF OUR INTERNATIONAL OPERATIONS EXPOSES US TO CERTAIN RISKS Substantially all of our current international revenues are derived from the operations of three of our wholly-owned subsidiaries in Australia, the United Kingdom and Germany. Revenues from licenses and services to customers outside of North America were $15.3 million in 1999 (representing 21.6% of total revenues), $28.7 million in 2000 (representing 17.3% of total revenues), and $5.0 and $11.0 in the three month periods ended March 31, 2000 and 2001, respectively (representing 17.4% of total revenues in both periods). 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 conduct business in the currency of the country in which they operate, we are subject to currency fluctuations and currency transaction losses or gains which are outside of our control. We plan to expand our international operations as part of our business strategy. The expansion of our existing international operations and entry into additional international markets will require 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. As our international operations expand, our exposure to exchange rate fluctuations will increase as we use an increasing number of foreign currencies. We have not yet entered into any hedging transactions to date to mitigate our expense to currency fluctuations. OUR RECENTLY-IMPLEMENTED STRATEGY OF 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 19 20 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-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: 20 21 - 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 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 21 22 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 our President and Chief Technical Officer. We intend to hire a significant number of additional sales, support, marketing, administrative and research and development personnel over at least the next 12 months. 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. 22 23 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. Our investments in marketable securities consist primarily of high-grade corporate and government securities with maturities of less than two 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 March 31, 2001, the net gain on available-for-sale securities of $0.4 million comprised 46 positions, all of which carry unrealized gains. The following table provides information about our investment portfolio at March 31, 2001:
MARCH 31, 2001 -------------- (dollars in thousands) Cash and cash equivalents $ 35,169 Average interest rate 4.92% Short-term marketable securities $ 9,873 Average interest rate 3.81% Long-term marketable securities $115,717 Average interest rate 7.69% Total portfolio $160,759 Average interest rate 6.85%
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. 23 24 PART II OTHER INFORMATION ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS None. (b) REPORTS ON FORM 8-K None. 24 25 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. May 15, 2001 /s/ M. Brinkley Morse -------------------------------- M. Brinkley Morse Vice President, Finance and Operations 25