-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, GFr9Omh/syiUvGCy0YlO8nid8C7N5UZQh4BJXuHj0AfOcfJu9AwGhH3zsqa7l2Af 08RpJ9/MiI2LYxExDYzlzA== 0000706015-99-000002.txt : 19990331 0000706015-99-000002.hdr.sgml : 19990331 ACCESSION NUMBER: 0000706015-99-000002 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FILENET CORP CENTRAL INDEX KEY: 0000706015 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER INTEGRATED SYSTEMS DESIGN [7373] IRS NUMBER: 953757924 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-15997 FILM NUMBER: 99579257 BUSINESS ADDRESS: STREET 1: 3565 HARBOR BLVD CITY: COSTA MESA STATE: CA ZIP: 92626 BUSINESS PHONE: 7149663400 MAIL ADDRESS: STREET 1: 3565 HARBOR BLVD CITY: COSTA MESA STATE: CA ZIP: 926261420 10-K 1 FORM 10-K FOR THE FISCAL YEAR ENDED 12/31/98 ================================================================================ FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from -------- to --------. Commission File Number 0-15997 FILENET CORPORATION (Exact name of Registrant as specified in its charter) Delaware 95-3757924 (State or other jurisdiction of (I.R.S. Employer Identification No.) of incorporation or organization) 3565 Harbor Boulevard, Costa Mesa, California 92626 (Address of principal executive office) (Zip code) Registrant's telephone number, including area code: (714) 966-3400 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Title of each class Name of each exchange which registered Common stock, $0.01 par value Nasdaq Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days: Yes [X] No [ ] Indicate by check mark whether the disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [X] Based on the closing sale price of March 22, 1999, the aggregate market value of the 31,623,336 shares of voting stock of the Registrant held by nonaffiliates of the Registrant on such date was $243,183,454. For purposes of such calculation, only executive officers, board members and beneficial owners of more than 10% of the Company's outstanding common stock are deemed to be affiliates. The number of shares outstanding of the Registrant's common stock was 31,934,143 at March 22, 1999. DOCUMENTS INCORPORATED BY REFERENCE Portions of Registrant's definitive proxy statement for its 1999 Annual Meeting are incorporated by reference into Part III as set forth herein. Portions of Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1998 are incorporated by reference into Parts II, III and IV as set forth herein. ================================================================================ FILENET CORPORATION FORM 10-K For the Year Ended December 31, 1998 INDEX Page PART I Item 1. Business...............................................................3 Item 2. Properties.............................................................9 Item 3. Legal Proceedings......................................................9 Item 4. Submission of Matters to a Vote of Security Holders............. .....10 PART II Item 5. Market for the Registrant's Common Stock and Related .................11 Stockholder Matters Item 6. Selected Financial Data...............................................11 Item 7. Management's Discussion and Analysis of Financial Condition ..........12 and Results of Operations Item 8. Financial Statements and Supplementary Data...........................12 Item 9. Changes in and Disagreements with Accountants on Accounting ..........12 and Financial Matters PART III Item 10. Directors and Executive Officers of the Registrant...................12 Item 11. Executive Compensation...............................................12 Item 12. Security Ownership of Certain Beneficial Owners and Management.......12 Item 13. Certain Relationships and Related Transactions.......................12 PART IV Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K......13 Signatures....................................................................18 2 PART I Item 1. Business GENERAL FileNET Corporation (FileNET or the Company) develops, markets and services a family of Integrated Document Management (IDM) software products that provide solutions for managing unstructured information thereby enhancing an enterprise's productivity. The Company also offers professional services relative to the implementation of these products. FileNET's Panagon(TM) software allows users to access, edit, process, organize, secure, store and archive documents in client/server and Web-based environments. Additionally, the Company manufactures and sells a line of 12-inch optical storage and retrieval libraries (OSARs(R)). MARKETS AND APPLICATIONS The Company offers a family of complementary products under the brand name Panagon, which enable users to manage, on an enterprise-wide basis, the storage, processing and workflow of documents and other unstructured information that are part of a centralized or distributed server repository or Web site, including scanned images, faxes, text, spreadsheets, HTML pages, graphics, drawings, photographs, computer output reports, voice, and video. The Company's products provide both client/server-based and Web-centric document management architecture solutions that can be implemented on a modular basis. Organizations can choose one, some, or all of the Company's products to build the solution that most effectively meets their needs. The Company's customers are typically those enterprises that have active paper document files, process significant numbers of electronic documents in their day-to-day operations, or have complex, mission-critical business processes for a variety of applications such as mortgage loan servicing, customer relationship management, enterprise resource planning, insurance claims processing, regulatory compliance, accounts payable and receivable, and Web-based document management. Additionally, the Company's products address ad hoc business processes at the departmental and workgroup levels to improve overall enterprise productivity and integrate with industry-standard productivity applications like Microsoft Office, Lotus Notes, and SAP R/3. The Company markets its products in more than 70 countries through a direct sales force and its ValueNET(R) partner community consisting of systems integrators, value-added resellers and distributors. More than 350 firms, operate as third-party resellers under the Company's ValueNET program and combine FileNET products with vertical market-specific value-added services to provide turnkey solutions and complex systems integration for customers. Other firms such as Law Cypress, and MicroAge Image Choice are distributors of the Company's software products selling to resellers throughout North America. The Company also has OEM agreements with other firms involving the Company's software products. The Company's Customer Support operating segment offers software maintenance service for its products worldwide. The Company's Professional Services operating segment offers implementation and other technical consulting services to both end-users of the Company's products and to resellers. Professional Services are marketed by the Company's direct sales force and its resellers. PRODUCTS Software The following software products are currently being offered by the Company: Integrated Document Management In February 1998, the Company introduced the Panagon family of IDM software. The Panagon family of products includes new desktop and Web services software and a rebranding of then-existing server based products. With Panagon, the Company created a software infrastructure that allows customers to capture any type of document electronically, then access, manage, publish and integrate the information with their existing critical business applications throughout the enterprise. Using Microsoft's Windows Explorer or Netscape, customers can search the enterprise network for information, retrieve documents of all types, work with the information, and then route it as needed for further review, processing, or decision making. The Panagon IDM Desktop products are built around Microsoft's component software architecture (COM) and allow applications to be developed and tailored to meet an organization's business requirements. Panagon IDM Desktop reduces the cost of ownership through the ability to deploy applications on the Web or in a client/server environment. Cost of ownership is also reduced through the use of rapid application development (RAD) techniques and compatibility with industry-standard programming tools such as Visual Basic, PowerBuilder, and Java. As a result, it takes less time to develop customized IDM applications, less time to integrate the software components and deploy across the enterprise, and less time to train users. 3 The Panagon family includes a complete suite of IDM software components that are built to work together, eliminating integration issues competitors have when combining products from different vendors. Panagon products include: Panagon IDM Desktop (Thick Client) and Panagon IDM Web Services (Thin Client) are software applications that offer best-of-class integrated document management for ad hoc query and access, or mission-critical applications. Customers can access all documents stored in enterprise libraries from within an Internet browser interface or via a custom application integrated into line of business systems. Panagon IDM Desktop delivers "out-of-the-box" integration with Microsoft Windows environments and productivity applications such as Microsoft Office, seamlessly managing and viewing more than 200 document formats. Users can create work processes to include others that need to share, distribute, or approve, with the built-in workflow and integrated e-mail features. Panagon IDM Services is a server-based IDM solution incorporating Panagon IDM Image Services and Panagon Document Services technologies. This is the high-performance repository system that integrates with Panagon IDM Desktop and Panagon IDM Web Services for managing all types of documents. Panagon IDM Services can be used as both an imaging and document system together or as separate applications. Panagon Visual WorkFlo(R) is an object-oriented, enterprise-wide, scaleable business process automation solution that can be used to create applications that reflect the way work processes are performed. It allows managers to control and modify work processes to meet the needs of a dynamic business environment, and integrates information flow between software applications within a company's business processes. Panagon Visual WorkFlo supports multiple client, server and applications development environments such as Java and integrates with leading business process reengineering products for reduced implementation time. Panagon Report Manager is a high-performance, client/server computer output to laser disk (COLD) product that eliminates printing and distributing computer-generated reports and statements. It significantly lowers costs and inefficiencies by allowing companies to index, store, retrieve, view, print, fax, and distribute computer-generated output on magnetic or optical disk. Panagon Report Manager is built around industry standards and has an intuitive, graphical user interface with report mining capabilities. Panagon Capture is an enterprise document capture application that has a complete set of highly-configurable components for capturing virtually all document types: scanned paper documents, fax, e-mail, word processing documents, spreadsheets, HTML, audio and video-clips, and images making them immediately available to users. Its modular components can be configured to meet simple capture requirements in distributed environments or enterprise-wide capture requirements for production operations. Panagon Document Warehouse(TM) for SAP software is a document and data archiving application certified by SAP, for use with the popular R/3 Enterprise Resource Planning (ERP) application suite. Panagon Web Publisher simplifies and automates Web publishing operations for Internet, intranet, and extranet Web sites. It eliminates virtually all HTML hand coding, dramatically reducing workloads for Web masters, Information Technology (IT) staff, and Web publishers. It automatically updates entire Web sites and on-line compound documents with no manual intervention, avoids problems with broken links, and virtually eliminates out-of-date Web documents. Web Publisher can be further extended using Microsoft Active Server Pages (ASPs) to deliver customized Web applications. Panagon Web Publisher is an advanced Web publishing solution that leverages FileNET's IDM software. Panagon WorkGroup(TM) software is a midrange document imaging and work management product based on a subset of the Panagon IDM products combined with certain pre-packaged software applications. 4 Watermark(R) software products enable users worldwide to exchange, process and share scanned images, faxes and other electronic documents within departments and workgroups of large enterprises and throughout midsize and small business environments. Watermark documents and folders are integrated into existing line-of-business applications and take advantage of the latest Microsoft operating systems and database technologies. The Panagon family of products is available to new and existing customers. New customers will receive the benefits of integrated document and image management functions as opposed to separate solutions offered by competitors. Existing customers can deploy new IDM applications independently or along-side existing applications that were created with FileNET's legacy software. Existing customers choosing to take advantage of Panagon's broader IDM capabilities for applications already deployed can recreate the existing applications using the IDM development environment. HARDWARE The Company manufactures and markets an OSAR product based on 12-inch optical disk storage technology and also offers optional integration services providing customers the ability to purchase complete solutions. All named products mentioned in this Form 10-K, other than the Company's named products, may reference trademarks or registered trademarks owned by the respective holder. RESEARCH AND DEVELOPMENT The Company's research and development activities are focused on software product development. Research and development expenditures were $50.1 million, $40.9 million and $37.6 million for the years ended December 31, 1998, 1997, and 1996, respectively. The Company believes that its future success depends upon its ability to continue to enhance its existing software products and to develop new software products that satisfactorily meet market needs. Accordingly, the Company intends to continue to make substantial investments in its research and development activities. BACKLOG The Company typically ships its products within a short period of time after acceptance of orders, which is common in the computer software industry. The Company does not consider the level of backlog to be a significant or important indicator of future revenue or earnings. SERVICES, SUPPORT AND MANUFACTURING The Company maintains service and support organizations that provide both pre-sales and post-sales services on a worldwide basis. The Company's Customer Support segment provides software maintenance and technical support services to customers and resellers who have contracted for such services. This service is provided through telephone response centers in Costa Mesa, California; Dublin, Ireland; Sydney, Australia; and Singapore, or through on-site visits to customer sites when necessary. Customer Support will also provide support on a fee-per-service basis for those customers and resellers who have not entered into a maintenance contract with the Company. During 1998, the Company completed the process of transferring hardware maintenance it previously provided to Hewlett-Packard (HP). Customers who require maintenance of hardware products bought from the Company will now contract directly with HP or other service providers for such service. Previously, customers had contracted with the Company, which in turn subcontracted the maintenance work to HP. The Company's Professional Services segment provides consulting services to customers, primarily on a time and material basis. These services range from management of large-scale implementations of the Company's products to pre-packaged standard services such as software installation. Services are provided by consultants employed directly by the Company and through a network of qualified partners. 5 The Company's support facilities in Costa Mesa, California and Dublin, Ireland, conduct software manufacturing, localization, integration, test and quality control. EMPLOYEES As of December 31, 1998, the Company had 1,666 full-time employees of which 387 were employed in research and development; 491 in sales, 76 in marketing, 157 in professional services, 296 in customer support; 95 in operations; and 164 in administration. Employees in the Company's German subsidiary are represented by a labor union. No other employees are represented by labor unions, and the Company has never experienced a work stoppage. The Company believes that it enjoys good employee relations. COMPETITION The market for the Company's products is highly competitive. According to the GartnerGroup, the market for imaging, workflow, and document management is serviced by over 50 software companies. The Company's principal competitors for its various product lines include the following companies: 1) Workflow and document imaging-- Banctec, Inc., IBM, Keyfile, Optika, Unisys Corporation, Mosaix, Eastman Software (a Kodak company), 2) Electronic Document Management--Documentum, IBM, Interleaf, Novasoft, Novell, Open Text, and Hummingbird 3) COLD--Computron, IBM and Microbank. Numerous smaller software vendors also compete in each product area. The Company also experiences competition from systems integrators who configure hardware and software into customized systems. Database vendors such as Oracle, Sybase and Informix and messaging vendors such as Microsoft and IBM may compete with the Company in the future. It is also possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. The Company also expects that competition will increase as a result of software industry consolidations. See "Certain Considerations - Competition" below. PATENTS AND LICENSES The Company holds three patents for its OSAR product which expire August 26, 2003, June 23, 2004 and August 4, 2004, respectively. The Company has also entered into non-exclusive license arrangements with a number of organizations, including IBM and Oracle, which permit the Company and its resellers to grant sublicenses to end users of the Company's systems to use software developed by these third-party vendors. See "Certain Considerations - Intellectual Property and Other Proprietary Rights" below. CERTAIN CONSIDERATIONS This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of 1934, as amended and Section 27A of the Securities Act of 1933, as amended, and is subject to the safe harbors created by those sections. These forward looking statements involve risks and uncertainties, including those discussed in the Company's Annual Report to Stockholders for the year ended December 31, 1998, certain sections of which are incorporated herein by reference as set forth in Items 7 and 8 of this report. The actual results that the Company achieves may differ materially from any forward-looking statements, which reflect management's opinions only as of the date hereof. The Company undertakes no obligation to revise or publicly release the results of any revisions to these forward-looking statements. Readers should carefully review the factors described below and in other documents the Company files from time to time with the Securities and Exchange Commission, including its 1998 Annual Report to Stockholders and the Quarterly Reports on Form 10-Q to be filed by the Company in 1999. Rapid Technological Change; Product Development: The market for the Company's products is characterized by rapid technological developments, evolving industry standards, changes in customer requirements and frequent new product introductions and enhancements. The Company's continued success will be dependent upon its ability to continue to enhance its existing products, develop and introduce, in a timely manner, new products incorporating technological advances and respond to customer requirements, including without limitation enhancements to certain specified Company software products to achieve year 2000 compliance. There can be no assurance that the Company will be successful in developing and marketing new products or enhancements to its existing products on a timely basis or that any new or enhanced products will adequately address the changing needs of the marketplace. If the Company is unable to develop and introduce new products or enhancements to existing products in a timely manner in response to changing market conditions or customer requirements, including without limitation enhancements to certain existing software products to achieve year 2000 compliance, the Company's business and operating results could be adversely affected. From time to time, the Company or its competitors may announce new products, capabilities or technologies that have the potential to replace or shorten the life cycles of the Company's existing products. There can be no assurance that announcements of currently planned or other new products 6 will not cause customers to delay their purchasing decisions in anticipation of such products, which could have a material adverse effect on the Company's business and operating results. Uncertainty of Future Operating Results; Fluctuations in Quarterly Operating Results: Prior growth rates in the Company's revenue and operating results should not necessarily be considered indicative of future growth or operating results. Future operating results will depend upon many factors, including the demand for the Company's products; the effectiveness of the Company's efforts to continue to integrate various products it has developed or acquired and to achieve the desired level of sales from such product integration; the level of product and price competition; the length of the Company's sales cycle; improvements in the productivity of the Company's sales force; seasonality of individual customer buying patterns; the size and timing of individual transactions; the delay or deferral of customer implementations; the budget cycles of the Company's customers; the timing of new product introductions and product enhancements by the Company and its competitors; the mix of sales by products, services and distribution channels; levels of international sales; acquisitions by competitors; changes in foreign currency exchange rates including EURO exchange rates beginning in 1999; the ability of the Company to develop and market new products and control costs; and general domestic and international economic and political conditions. As a result of these factors, revenues and operating results for any quarter are subject to variation and are not predictable with any significant degree of accuracy. Therefore, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Moreover, such factors could cause the Company's operating results in a given quarter to be below the expectations of public market analysts and investors. In either case, the price of the Company's common stock could be materially adversely affected. Competition: The document imaging, workflow, computer output to laser disk and electronic document management software markets are highly competitive, and there are certain competitors of the Company with substantially greater sales, marketing, development and financial resources. The Company believes that the competitive factors affecting the market for its products and services include vendor and product reputation; product quality, performance and price; the availability of products on multiple platforms; product scalability; product integration with other enterprise applications; product functionality and features; product ease of use; and the quality of customer support services and training. The relative importance of each of these factors depends upon the specific customer involved. While the Company believes it competes favorably in each of these areas, there can be no assurance that it will continue to do so. Moreover, the Company's present or future competitors may be able to develop products comparable or superior to those offered by the Company, offer lower price products or adapt more quickly than the Company to new technologies or evolving customer requirements. Competition is expected to intensify. In order to be successful in the future, the Company must respond to technological change, customer requirements and competitors' current products and innovations. There can be no assurance that the Company will be able to continue to compete effectively in its market or that future competition will not have a material adverse effect on its business, financial condition or results of operations. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of the markets served by the Company. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on the Company's business, financial condition or results of operations. Intellectual Property and Other Proprietary Rights: The Company's success depends, in part, on its ability to protect its proprietary rights to the technologies used in its principal products. The Company relies on a combination of copyrights, trademarks, trade secrets, confidentiality procedures and contractual provisions to protect its proprietary rights. There can be no assurance that the Company's existing or future copyrights, trademarks, trade secrets or other intellectual property rights will be of sufficient scope or strength to provide meaningful protection or a commercial advantage to the Company. The Company has no software patents. Also, in selling certain of its products, the Company relies on "shrink wrap" licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the United States. There can be no assurance that such factors would not have a material adverse effect on the Company's business, financial condition or results of operations. In addition, the Company also relies on certain software that it licenses from third parties, including software that is integrated with internally developed software used in the Company's products to perform key functions. There can be no assurance that such third parties will remain in business, that they will continue to support their products, that their products are, or will be, year 2000 compliant, or that their products will otherwise continue to be available to the Company on commercially reasonable terms. The loss or inability to maintain any of these software licenses could result in delays or reductions in product shipments until equivalent software can be developed, identified, licensed and integrated, which could adversely affect the Company's business, financial condition or results of operations. The Company may, from time to time, be notified that it is infringing certain patent or intellectual property rights of others. Combinations of technology acquired through past or future acquisitions and the Company's technology will create new products and technology that may give rise to claims of infringement. While no actions other than those discussed below are currently pending against 7 the Company for infringement of patent or other proprietary rights of third parties, there can be no assurance that third parties will not initiate infringement actions against the Company in the future. Infringement actions can result in substantial cost to, and diversion of, resources of the Company. If the Company were found to infringe upon the rights of others, no assurance can be given that licenses would be obtainable on acceptable terms or at all, that significant damages for past infringement would not be assessed or that further litigation relative to any such licenses or usage would not occur. The failure to successfully defend any claims or obtain necessary licenses or other rights, the ultimate disposition of any claims or the advent of litigation arising out of any claims of infringement, could have a material adverse effect on the Company's business, financial condition or results of operations. In October 1994, Wang Laboratories, Inc. (Wang) filed a complaint in the United States District Court for the District of Massachusetts alleging that the Company is infringing five patents held by Wang (the FileNET Case). On June 23, 1995, Wang amended its complaint to include an additional related patent. On July 2, 1996, Wang filed a complaint in the same court alleging that Watermark Software Inc., formerly a wholly owned subsidiary that was merged into the Company, is infringing three of the same patents asserted in the initial complaint (the Watermark Case). On October 9, 1996, Wang withdrew its claim in the FileNET Case that one of the patents it initially asserted is infringed by certain of the Company's products, which were commercialized before the initial complaint was filed. Wang reserved the right to assert that patent against the Company's products commercialized after that date in a separate lawsuit. In March 1997, Eastman Kodak Company (Kodak) purchased the Wang imaging business unit that has responsibility for this litigation. The patents in the suit have been transferred to a Kodak subsidiary, Kodak Limited of England, which, in turn, has exclusively licensed them to another Kodak subsidiary, Eastman Software, Inc. in the United States (Eastman). On July 30, 1997, the Court permitted Eastman and Kodak Limited of England to be substituted in the litigation in place of Wang. The Company has moved for summary judgement on noninfringement as to each of the five patents in the suit, and for summary judgment of invalidity as to one of the patents. Eastman moved for summary judgment as to the Company's unenforceability defense on one of the patents. In July 1998, the Magistrate Judge assigned to the case, heard oral arguments on the Company's motion for summary judgement that U.S. Patent 4,918,588 is not infringed and is invalid. The Magistrate Judge has not yet decided these motions. The Company believes that after he has ruled on these motions, he will hear oral arguments in the remaining motions in the sequence in which they were filed. A trial date has not been set. If it should be determined that the patents at issue in the litigation are valid and are infringed by any of the Company's products, including Watermark products, the Company will, depending on the product, redesign the infringing products or seek to obtain a license to market the products. There can be no assurance that the Company will be able to obtain such a license on acceptable terms. Based on the Company's analysis of these Eastman patents and their respective file histories, the Company believes that it has meritorious defenses to Eastman's claims; however, the ultimate outcome or any resulting potential loss cannot be determined at this time. Dependence on Certain Relationships: The Company has entered into a number of key relationships with other companies such as Microsoft Corporation, IBM Global Services, SAP AG, Hewlett-Packard Company, and Sun Microsystems, Inc. There can be no assurance that these companies will not reduce or discontinue their relationships with, or support of, the Company and its products. Dependence on Key Management and Technical Personnel: The Company's success depends to a significant degree upon the continued contributions of its key management, marketing, technical and operational personnel. In general, the Company does not utilize employment agreements for its key employees. The loss of the services of one or more key employees could have a material adverse effect on the Company's operating results. The Company also believes its future success will depend in large part upon its ability to attract and retain additional highly skilled management, technical, marketing, product development and operational personnel. Competition for such personnel, particularly engineers and other technical personnel, is intense, and pay scales in the software industry are increasing. There can be no assurance that the Company will be successful in attracting and retaining such personnel. International Sales: Historically, the Company has derived approximately one-third of its total revenues from international sales. International business is subject to certain risks including varying technical standards; tariffs and trade barriers; political and economic instability; reduced protection for intellectual property rights in certain countries; difficulties in staffing and maintaining foreign operations; difficulties in managing foreign distributors; varying requirements for localized products; potentially adverse tax consequences; currency exchange fluctuations including those related to the EURO beginning in 1999; the burden of complying with a wide variety of complex foreign laws, regulations and treaties; and the possibility of difficulties in collecting accounts receivable. In particular, the current economic crisis in the Asia Pacific region and Latin America may limit future growth or cause a decline in international revenues. There can be no assurance that any of these factors will not have a material adverse effect on the Company's business, financial condition or results of operations. 8 Product Liability: Products as complex as those sold by the Company are susceptible to errors or failures, especially when first introduced or when new versions are released. The Company's products are often intended for use in applications that are critical to a customer's business. As a result, the Company's customers may rely on the effective performance of the software to a greater extent than the market for software products generally. The Company conducts extensive product testing to ensure that its products are free of significant errors and defects. In addition, the Company has designed and tested the most current versions of its products to be year 2000 compliant. However, some of the Company's customers are running earlier products that are not year 2000 compliant. Although the Company has been encouraging such customers to migrate to current product versions, no assurance can be given that all of them will do so in a timely fashion, if at all. Moreover, the Company also relies on certain software that it licenses from third parties, including software that is integrated with internally developed software and is used in the Company's products to perform key functions. There can be no assurance that such third-party software will be free of errors and defects or be year 2000 compliant in a timely fashion. Although the Company has not experienced any material product liability claims to date, there can be no assurance that errors or defects, whether associated with year 2000 functions or otherwise, will not result in product liability claims against the Company in the future. The Company's license agreements with customers typically contain provisions designed to limit its exposure to potential product liability claims. However, it is possible that such limitation of liability provisions may not be effective under the laws of certain jurisdictions. Although the Company has not experienced any product liability claims to date, the sale and support of products may entail the risk of such claims, and there can be no assurance that the Company will not be subject to such claims in the future. A successful product liability claim brought against the Company could have a material adverse effect upon the Company's business, operating results and financial condition. Stock Price Volatility: The Company believes that a variety of factors could cause the trading price of its common stock to fluctuate, perhaps substantially, including quarter-to-quarter variations in operating results; announcements of developments related to its business; fluctuations in its order levels; general conditions in the technology sector or the worldwide economy; announcements of technological innovations, new products or product enhancements by the Company or its competitors; key management changes; changes in joint marketing and development programs; developments relating to patents or other intellectual property rights or disputes; and developments in the Company's relationships with its customers, distributors and suppliers. In addition, in recent years the stock market in general, and the market for shares of high-technology stocks in particular, have experienced extreme price fluctuations that have often been unrelated to the operating performance of affected companies. Such fluctuations could adversely affect the trading price of the Company's common stock. Item 2. Properties The Company currently leases 280,000 square feet of office, development and manufacturing space in Costa Mesa, California and 92,000 square feet of office and development space in Kirkland, Washington. The Company also leases sales and support offices in 31 locations in the United States, 17 in Europe, 3 in Australia, 4 in Canada, and 4 in Asia. The Company believes that the Costa Mesa and Kirkland facilities will be adequate for the Company's anticipated needs through 1999. Item 3. Legal Proceedings In October 1994, Wang Laboratories, Inc. (Wang) filed a complaint in the United States District Court for the District of Massachusetts alleging that the Company is infringing five patents held by Wang (the FileNET Case). On June 23, 1995, Wang amended its complaint to include an additional related patent. On July 2, 1996, Wang filed a complaint in the same court alleging that Watermark, formerly a wholly-owned subsidiary that was merged into the Company, is infringing three of the same patents asserted in the initial complaint (the Watermark Case). On October 9, 1996, Wang withdrew its claim in the FileNET Case that one of the patents it initially asserted is infringed by the Company's products that were commercialized before the initial complaint was filed. Wang reserved the right to assert that patent against the Company's products commercialized after that date in a separate lawsuit. In March 1997, Eastman Kodak Company (Kodak) purchased the Wang imaging business unit that has responsibility for this litigation. The patents in the suit have been transferred to a Kodak subsidiary, Kodak Limited of England, which, in turn, has exclusively licensed them to another Kodak subsidiary, Eastman Software, Inc. in the United States (Eastman). On July 30, 1997, the Court permitted Eastman and Kodak Limited of England to be substituted in the litigation in place of Wang. FileNET has moved for summary judgement on noninfringement as to each of the five patents in the suit, and for summary judgment of invalidity as to one of the patents. Eastman moved for summary judgment as to the Company's unenforceability defense on one of the patents. In July 1998, the Magistrate Judge assigned to the case, heard oral arguments on the Company's motion for summary judgement that U.S. Patent 4,918,588 is not infringed and is invalid. 9 The Magistrate Judge has not yet decided these motions. The Company believes that after he has ruled on these motions, he will hear oral arguments in the remaining motions in the sequence in which they were filed. A trial date has not been set. If it should be determined that the patents at issue in the litigation are valid and are infringed by any of the Company's products, including Watermark products, the Company will, depending on the product, redesign the infringing products or seek to obtain a license to market the products. There can be no assurance that the Company will be able to obtain such a license on acceptable terms. Based on the Company's analysis of these Eastman patents and their respective file histories, the Company believes that it has meritorious defenses to Eastman's claims; however, the ultimate outcome or any resulting potential loss cannot be determined at this time. On December 20, 1996, plaintiff Michael I. Goldman filed a class action complaint against the Company and certain of its officers and directors in the Superior Court of California, County of Orange (the Goldman State Action). The action was purportedly filed on behalf of a class of purchasers of the Company's common stock during the period October 19, 1995 through July 2, 1996. The plaintiff alleged that the Company and other defendants violated Cal. Corp. Code ss.ss. 25400 and 25500, Cal. Civ. Code ss.ss. 1709-1710 and Cal. Bus. & Prof. Code ss.ss. 17200 et seq. in connection with various public statements made by the Company and certain of its officers and directors during the putative class period. On September 30, 1998, the Court entered an order dismissing this action in its entirety without prejudice. On April 1, 1997, plaintiff Michael I. Goldman filed another class action complaint against the Company and certain of its officers and directors in the United States District Court for the Central District of California (the Goldman Federal Action). The action purportedly was filed on behalf of the same class of purchasers of the Company's common stock as the Goldman State Action. The allegations contained in the Goldman Federal Action were very similar to the allegations contained in the Goldman State Action, except that the Goldman Federal Action asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5. On September 23, 1998, the Court entered an order dismissing this action in its entirety without prejudice. On October 23, 1998, plaintiff Avram Gart filed a class action complaint against the Company and certain of its officers and directors in the Superior Court of California, County of Orange (the Gart State Action). The action was purportedly filed on behalf of a class of purchasers of the Company's common stock during the period January 13, 1998 through October 7, 1998. The plaintiff alleges that the Company and the other defendants violated Cal. Corp. Code ss.ss. 25400 and 25500 in connection with various public statements made by the Company and certain of its officers and directors during the putative class period. On November 5, 1998, the court entered an order dismissing this action in its entirety without prejudice. On October 27, 1998, plaintiff Thomas P. Nyquist filed a class action complaint against the Company and certain of its officers and directors in the United States District Court for the Central District of California (the Nyquist Federal Action). The action was purportedly filed on behalf of a class of purchasers of the Company's common stock during the period April 16, 1998 through October 7, 1998. The plaintiff alleges claims under Sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5 in connection with various public statements made by the Company and certain of its officers and directors during the putative class period. The complaint seeks unspecified compensatory damages, interest, attorneys' fees, expert witness fees and costs. Plaintiff has filed a motion for the appointment of lead plaintiffs and consolidation of any future related actions. Defendants have not yet responded to the complaint. The Company believes that all of the allegations contained in the Nyquist Federal Action are without merit and intends to defend the actions vigorously. Subsequent to December 31, 1998, the former shareholders of Saros Corporation filed a demand for mandatory arbitration to release approximately 0.2 million shares which were held in escrow pursuant to the Agreement and Plan of Merger dated January 17, 1996 between FileNET Corporation, FileNET Acquisition Corporation and Saros Corporation and for damages. The Company believes that it has meritorious reasons for not releasing the shares and other defenses to the claims; however, the ultimate outcome or any resulting potential loss cannot be presently determined. The Company, in the normal course of business, is subject to various other legal matters. While the results of litigation and claims cannot be predicted with certainty, the Company believes that the final outcome of these other matters will not have a materially adverse effect on the Company's consolidated results of operations or financial condition. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of fiscal 1998. 10 PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters There is hereby incorporated herein by reference the information appearing under the caption "Stock Market and Dividend Information," which appears on page 48 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1998 and is filed herewith as Exhibit 13.1. Item 6. Selected Financial Data The following table summarizes certain selected financial data:
For Fiscal Years Ended ------------------------------------------------------------------------------- Dec. 31, 1998 Dec. 31, 1997 Dec. 31, 1996 Dec. 31, 1995 Jan. 1, 1995 (1998) (1997) (1996) (1995) (1994) ------------------------------------------------------------------------------- (In thousands, except per share amounts) Consolidated statements of operations data: Revenue: Software revenue $171,153 $132,723 $140,659 $116,052 $ 81,102 Service revenue 115,501 89,280 82,118 67,174 60,753 Hardware revenue 23,579 29,422 46,136 46,152 50,480 ---------- --------- --------- --------- ---------- Total revenue 310,233 251,425 268,913 229,378 192,335 Costs and expenses: Cost of software revenue 16,814 13,416 15,389 14,688 12,307 Cost of service revenue 73,786 56,503 53,568 44,277 41,645 Cost of hardware revenue 13,181 20,330 29,633 28,800 30,999 Research and development 50,132 40,927 37,577 25,169 18,439 Selling, general and administrative 156,813 125,122 117,761 96,499 71,267 Merger, restructuring, write-off of purchased in-process research and development and other costs 2,000 6,000 16,011 6,393 0 ---------- --------- ---------- --------- ---------- Total costs and expenses 312,726 262,298 269,939 215,826 174,657 ---------- --------- ---------- --------- ---------- Operating income (loss) (2,493) (10,873) (1,026) 13,552 17,678 Other income, net 3,840 3,160 2,838 2,780 1,821 ---------- --------- ---------- --------- ---------- Income (loss) before income taxes 1,347 (7,713) 1,812 16,332 19,499 Provision (benefit) for income taxes 391 (2,187) 4,456 8,116 5,356 ---------- --------- ---------- --------- ---------- Net income (loss) $ 956 $ (5,526) $ (2,644) $ 8,216 $ 14,143 ========== ========= ========== ========= ========== Basic earnings (loss) per share $ 0.03 $ (0.18) $ (0.09) $ 0.28 $ 0.52 Diluted earnings (loss) per share $ 0.03 $ (0.18) $ (0.09) $ 0.26 $ 0.48 Weighted average shares outstanding - basic 31,083 30,310 30,014 28,860 27,322 Weighted average shares outstanding - diluted 33,367 30,310 30,014 31,712 29,668 Consolidated balance sheet data: Working capital $ 67,722 $ 79,091 $ 85,475 $ 83,797 $ 63,149 Total assets 206,822 179,440 192,274 187,393 152,642 Stockholders' equity 130,320 118,811 132,806 131,158 101,006 Certain reclassifications have been made to the prior years' selected financial data to conform with the current year's presentation.
11 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations There is hereby incorporated herein by reference the information appearing under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations," which appears on pages 16 through 26 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1998 and is filed herewith as Exhibit 13.2. Item 8. Financial Statements and Supplementary Data There is hereby incorporated herein by reference the information appearing on pages 27 through 46 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1998 and is filed herewith as Exhibit 13.3. The accompanying Independent Auditors' Report is also incorporated herein by reference and filed herewith as Exhibit 13.3. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Directors and Executive Officers of the Registrant There is hereby incorporated herein by reference the information appearing under the caption "Election of Directors," under the caption "Executive Officers of the Company," and under the caption "Compliance with Securities Laws" of the Registrant's definitive Proxy Statement for its 1999 Annual Meeting to be filed with the Securities and Exchange Commission. Item 11. Executive Compensation There is hereby incorporated herein by reference the information appearing under the caption "Executive Compensation" and under the caption "Election of Directors" of the Registrant's definitive Proxy Statement for its 1999 Annual Meeting to be filed with the Securities and Exchange Commission. Item 12. Security Ownership of Certain Beneficial Owners and Management There is hereby incorporated herein by reference the information appearing under the caption "Voting Securities and Principal Holders Thereof" of the Registrant's definitive Proxy Statement for its 1999 Annual Meeting to be filed with the Securities and Exchange Commission. Item 13. Certain Relationships and Related Transactions There is hereby incorporated herein by reference the information appearing under the caption "Note 13: Related Party Transactions," which appears on page 44 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1998 and is filed herewith as Exhibit 13.4. 12 PART IV Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K (a) Financial statements 1. The list of financial statements contained in the accompanying Index to Consolidated Financial Statements covered by the Independent Auditors' Report is herein incorporated by reference. 2. Financial statement schedule The listed financial statement schedule contained in the accompanying Index to Consolidated Financial Statements covered by the Independent Auditors' Report is herein incorporated by reference. 3. Exhibits The list of exhibits contained in the accompanying Index to Exhibits is herein incorporated by reference. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1998. Index to Consolidated Financial Statements Covered by Independent Auditors' Report Item 14(a) (1) and (2)
Page Reference ----------------------------- 1998 Annual Report to Form 10-K Stockholders The information under the following captions, which is included in the 1998 Annual Report to Stockholders, is incorporated herein by reference: Independent Auditors' Report 46 Consolidated balance sheets at December 31, 1998 and December 31, 1997 27 Consolidated statements of operations for each of the years ended December 31, 1998, 1997 and 1996 28 Consolidated statements of comprehensive income (loss) for each of the years ended December 31, 1998, 1997 and 1996 29 Consolidated statements of stockholders' equity for each of the years ended December 31, 1998, 1997 and 1996 30 Consolidated statements of cash flows for each of the years ended December 31, 1998, 1997 and 1996 31 Notes to consolidated financial statements 32 Independent Auditors' Report on Schedule 14 Schedule for each of the three years ended December 31, 1998, 1997 and 1996 - Schedule II. Valuation and Qualifying Accounts and Reserves 15
13 INDEPENDENT AUDITORS' REPORT ON SCHEDULE To the Stockholders and the Board of Directors FileNET Corporation Costa Mesa, California We have audited the consolidated financial statements of FileNET Corporation and its subsidiaries (the Company) as of December 31, 1998 and 1997 and for each of the three years in the period ended December 31, 1998, and have issued our report thereon dated January 26, 1999 (March 10, 1999 as to Note 8). Such consolidated financial statements and report are included in the Company's 1998 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the financial statement schedule of FileNET Corporation and its subsidiaries, listed in Item 14. The consolidated financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ Deloitte & Touche LLP January 26, 1999 (March 10, 1999 as to Note 8) Costa Mesa, California 14 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS (dollars in thousands)
Balance at Additions Balance at Beginning Charged to End Description of Period Costs & Exp Deductions of Period - -------------------------------------------------------------------------------------------------------- Year ended December 31, 1998: Inventory reserves $ 330 $ 381 $ 310 (1) $ 401 Allowance for doubtful accounts $ 1,690 $ 1,041 $ 668 (2) $ 2,063 Allowance for sales returns $ 2,725 $ 52 $ 458 (3) $ 2,319 Year ended December 31, 1997: Inventory reserves $ 660 $ 380 $ 710 (1) $ 330 Allowance for doubtful accounts $ 2,140 $ 350 $ 800 (2) $ 1,690 Allowance for sales returns $ 3,185 $ 460 (3) $ 2,725 Year ended December 31, 1996: Inventory reserves $ 573 $ 635 $ 548 (1) $ 660 Allowance for doubtful accounts $ 1,540 $ 1,205 $ 605 (2) $ 2,140 Allowance for sales returns $ 3,153 $ 32 $ 3,185 (1) Consists primarily of the write-off of excess/obsolete inventories. (2) Consists primarily of uncollectible invoice amounts. (3) Consists primarily of returned systems.
15 Index to Exhibits Exhibit No. Description - ------- ----------------------------------------------------------------------- 3.1* Restated Certificate of Incorporation, as amended (filed as Exhibit 3.1 to Form S-4 filed on January 26, 1996; Registration No. 333-00676). 3.1.1* Certificate of Amendment of Restated Certificate of Incorporation (filed as Exhibit 3.1.1 to Form S-4 filed on January 26, 1996, Registration No. 333-00676). 3.2* Bylaws (filed as Exhibit 3.2 of the Registrant's registration statement on Form S-1, Registration No. 33-15004 (the "Form S-1")). 4.1* Form of certificate evidencing Common Stock (filed as Exhibit 4.1 to the Form S-1, Registration No. 33-15004). 4.2* Rights Agreement, dated as of November 4, 1988 between FileNET Corporation and the First National Bank of Boston, which includes the form of Rights Certificate as Exhibit A and the Summary of Rights to Purchase Common Shares as Exhibit B (filed as Exhibit 4.2 to Form S-4 filed on January 26, 1996; Registration No. 333-00676). 4.3* Amendment One dated July 31, 1998 and Amendment Two dated November 9, 1998 to Rights Agreements between FileNET Corporation and BANKBOSTON N.A. formerly known as The First National Bank of Boston (filed as Exhibit 4.3 to Form 10-Q for the quarter ended September 30, 1998). 10.1* Second Amended and Restated Credit Agreement (Multicurrency) by and among the Registrant and Bank of America National Trust and Savings Association dated June 25, 1997, effective June 1,1997 (filed as Exhibit 10.1 to Form 10-Q for the quarter ended June 30, 1997). 10.2* Business Alliance Program Agreement between the Registrant and Oracle Corporation dated July 1, 1996, as amended by Amendment One thereto (filed as Exhibit 10.4 to Form 10-QA for the quarter ended June 30, 1996). 10.3* Runtime Sublicense Addendum between the Registrant and Oracle Corporation dated July 1, 1996, as amended by Amendment One thereto (filed as Exhibit 10.4 to Form 10-QA for the quarter ended June 30, 1996). 10.3.1* Runtime Sublicense Addendum between the Registrant and Oracle Corporation dated July 1, 1996; as amended by Amendments Two through Six thereto (filed as Exhibit 10.3.1 to Form 10-Q for the quarter ended September 30, 1998). 10.4* Full Use and Deployment Sublicense Addendum between the Registrant and Oracle Corporation dated July 1, 1996, as amended by Amendment One thereto (filed as Exhibit 10.4 to Form 10-QA for the quarter ended June 30, 1996). 10.5* Lease between the Registrant and C. J. Segerstrom & Sons for the headquarters of the Company, dated April 30, 1987 (filed as Exhibit 10.19 to the Form S-1). 10.6* Third Amendment to the Lease between the Registrant and C. J. Segerstrom & Sons dated April 30, 1987, for additional facilities at the headquarters of the Company, dated October 1, 1992 (filed as exhibit 10.7 to Form 10-K filed on April 4, 1997). 10.7* Fifth Amendment to the Lease between the Registrant and C. J. Segerstrom & Sons dated April 30, 1987, for the extension of the term of the lease, dated March 28, 1997 (filed as exhibit 10.8 to Form 10-Q for the quarter ended March 31, 1997). 10.8* 1989 Stock Option Plan for Non-Employee Directors of FileNET Corporation, as amended by the First Amendment, Second Amendment, Third Amendment thereto (filed as Exhibit 10.9 to Form S-4 filed on January 26, 1996; Registration No. 333-00676). 10.9* Amended and Restated 1995 Stock Option Plan of FileNET (filed as Exhibit 99.1 to Form S-8 filed on November 9, 1998; Registration No. 333-66997). - -------------------------------------------- * Incorporated herein by reference 16 Exhibit No. Description - ------- ----------------------------------------------------------------------- 10.10* Second Amended and Restated Stock Option Plan of FileNET Corporation, together with the forms of Incentive Stock Option Agreement and Non-Qualified Stock Option Agreements (filed as Exhibits 4(a), 4(b) and 4(c), respectively, to the Registrant's Registration Statement on Form S-8, Registration No. 33-48499), and an Amendment thereto (filed as Exhibit 4(d) to the Registrant's Registration Statement on Form S-8, Registration No. 33-69920), and the Second Amendment thereto (filed as Appendix A to the Registrant's Proxy Statement for the Registrant's 1994 Annual Meeting of Stockholders, filed on April 29, 1994). 10.11* Non-Statutory Stock Option Agreement (with Notice of Grant of Stock Option and Special Addendum) between Registrant and Mr. Lee Roberts (filed as exhibit 99.17 to Form S-8 on August 20, 1997). 10.12* Non-Statutory Stock Option Agreement (with Notice of Grant of Stock Option and Special Addendum) between Registrant and Mr. Ron Ercanbrack (filed as exhibit 99.19 to Form S-8 on August 20, 1997). 10.13* Agreement for the Purchase of IBM products dated December 20, 1991 (filed on May 5, 1992 with the Form 8 amending the Company's Form 10-K for the fiscal year ended December 31, 1991). 10.14* Amendment #A1011-941003-01 dated September 30, 1994, to the Agreement for the Purchase of IBM products dated December 20, 1991 (filed as exhibit 10.12 to form 10-K for the fiscal year ended December 31, 1996). 10.15* Development and Initial Supply Agreement between the Registrant and Quintar Company dated August 20, 1992 (filed as Exhibit 10.21 to Form 10-K for the year ended January 3, 1993). 10.16* Amendment dated December 22, 1992 to the Development and Initial Supply Agreement between the Registrant and Quintar Company dated August 20, 1992 (filed as Exhibit 10.22 to Form 10-K for the year ended January 3, 1993). 10.17 Amendment 2 dated December 18, 1998 to the Product License Agreement between the Registrant and Novell, Inc. dated May 16, 1995. 10.18* Agreement and Plan of Merger between the Registrant and Watermark Software Inc. dated July 18, 1995 (filed as Exhibit 10.27 to Form 10-Q for the quarter ended July 2, 1995). 10.19* Agreement and Plan of Merger between the Registrant and Saros Corporation, as amended, dated January 17, 1996 (filed as Exhibits 2.1, 2.2, 2.3, and 2.4 to Form 8-K on March 13, 1996). 10.20* Stock Purchase Agreement by and Among FileNET Corporation, IFS Acquisition Corporation, Jawaid Khan and Juergen Goersch dated January 17, 1996 and Amendment 1 to Stock Purchase Agreement dated January 30, 1996 (filed as Exhibit 10.2 to form 10-K for the year ended December 31, 1995). 10.21* Amended and Restated FileNET Corporation 1998 Employee Stock Purchase Plan (filed as Exhibit 99.15 to Form S-8, filed on November 9, 1998; Registration No. 333-66997). 10.22* FileNET Corporation International Employee Stock Purchase Plan. (filed as Exhibit 99.16 to Form S-8, filed on November 9, 1998; Registration No. 333-66997). 13.1 Market for the Registrant's Common Stock and Related Stockholder Matters incorporated by reference to page 48 of the 1998 Annual Report. 13.2 Management's Discussion and Analysis of Financial Condition and Results of Operations incorporated by reference to pages 16 through 26 of the 1998 Annual Report. 13.3 Financial Statements incorporated by reference to pages 27 through 46 of the 1998 Annual Report. 13.4 Certain Relationships and Related Transactions incorporated by reference to page 44 of the 1998 Annual Report. 21.1 List of subsidiaries of Registrant (filed as FileNET Corporation Subsidiary Information). 23.1 Consent of Deloitte & Touche LLP (filed as Independent Auditors' Consent). 27 Financial Data Schedule. - --------------------------------------------- * Incorporated herein by reference 17 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FILENET CORPORATION Date: March 30, 1999 By: /s/ Lee D. Roberts ------- ------------------------------------ Lee D. Roberts President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date: March 30, 1999 By: /s/ Lee D. Roberts ------- ------------------------------------ Lee D. Roberts President and Chief Executive Officer (Principal Executive Officer) Director Date: March 30, 1999 By: /s/ Mark S. St. Clare ------- ------------------------------------ Mark S. St. Clare Chief Financial Officer and Sr. Vice President, Finance (Principal Financial Officer) Date: March 30, 1999 By: /s/ Brian A. Colbeck ------- ------------------------------------ Brian A. Colbeck Controller and Chief Accounting Officer Date: March 30, 1999 By: /s/ Theodore J. Smith ------- ------------------------------------ Theodore J. Smith Chairman of the Board Date: March 30, 1999 By: /s/ L. George Klaus ------- ------------------------------------ L. George Klaus Director Date: March 30, 1999 By: /s/ William P. Lyons ------- ------------------------------------ William P. Lyons Director Date: March 30, 1999 By: /s/ John C. Savage ------- ------------------------------------ John C. Savage Director Date: March 30, 1999 By: /s/ Roger S. Siboni ------- ------------------------------------ Roger S. Siboni Director Date: March 30, 1999 By: /s/ Carolyn M. Ticknor ------- ------------------------------------- Carolyn M. Ticknor Director 18 EX-13.1 2 MARKET FOR THE REGISTRANT'S COMMON STOCK Stock Market and Dividend Information The Company's common stock is traded in the National Market System (NASDAQ) under the symbol FILE. The following are the high and low closing prices from January 1, 1996 through December 31, 1998, as reported by NASDAQ: High Low 1998 4th Quarter $ 12.50 $ 4.56 3rd Quarter 31.88 14.00 2nd Quarter 29.97 22.81 1st Quarter 24.44 14.89 1997 4th Quarter $ 16.32 $ 8.07 3rd Quarter 10.07 7.75 2nd Quarter 8.32 5.16 1st Quarter 15.88 7.75 1996 4th Quarter $ 18.07 $ 13.00 3rd Quarter 17.50 10.32 2nd Quarter 28.94 16.63 1st Quarter 32.63 20.38 The closing price of the Company's common stock on December 31, 1998 was $11.47. The approximate number of stockholders of record on February 26, 1999, was 860. The closing price of the Company's common stock on that date was $8.03. The Company has not paid any cash dividends on its common stock. The Company currently intends to retain earnings for use in its business and does not anticipate paying cash dividends in the foreseeable future. The Company's ability to pay dividends is limited by the terms of its line of credit agreement. 48 EX-13.2 3 MANAGEMENT'S DISCUSSION AND ANALYSIS MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Results of Operations The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes thereto contained elsewhere in this Annual Report. Revenue
(dollars in millions) - --------------------- Percent Percent December 31, 1998 change 1997 change 1996 Software revenue Domestic $ 107.7 20% $ 89.7 2% $ 87.6 International 63.5 48% 43.0 (19%) 53.1 -------- ------- -------- --------- -------- Total software revenue $ 171.2 29% $132.7 (6%) $ 140.7 Percentage of total revenue 55% 53% 52% Customer support revenue Domestic $ 57.0 31% $ 43.4 25% $ 34.8 International 16.5 50% 11.0 18% 9.3 -------- ------- -------- --------- -------- Total customer support revenue $ 73.5 35% $ 54.4 23% $ 44.1 Percentage of total revenue 24% 22% 16% Professional services revenue Domestic $ 20.4 47% $ 13.9 6% $ 13.1 International 6.0 18% 5.1 (29%) 7.2 -------- ------- -------- --------- -------- Total professional services $ 26.4 39% $ 19.0 (6%) $ 20.3 revenue Percentage of total revenue 8% 7% 8% Hardware revenue Domestic $ 17.1 (16%) $ 20.4 (28%) $ 28.3 International 6.5 (28%) 9.0 (49%) 17.8 -------- ------- -------- --------- -------- Total hardware revenue $ 23.6 (20%) $ 29.4 (36%) $ 46.1 Percentage of total revenue 8% 12% 17% Education and other revenue Domestic $ 10.2 (5%) $ 10.7 (21%) $ 13.5 International 5.3 2% 5.2 24% 4.2 -------- ------- -------- --------- -------- Total other revenue $ 15.5 (3%) $ 15.9 (10%) $ 17.7 Percentage of total revenue 5% 6% 7% Total revenue Domestic $212.4 19% $178.1 0 $ 177.3 International 97.8 33% 73.3 (20%) 91.6 -------- ------- -------- --------- -------- Total revenue $310.2 23% $251.4 (7%) $ 268.9 ======== ======= ======== ========= ========
Software revenue from the licensing of the Company's software products increased 29% in 1998 due to an increase in the volume of shipments both domestically and internationally, including the Company's Panagon product line which was released during the first quarter of 1998. The magnitude of the increase in 1998 software revenue is partially attributable to weakness in orders during the first quarter of 1997 and may not be indicative of future revenue growth. The 6% decrease in software revenue in 1997 was due to a decrease in new domestic orders during the first quarter of 1997 and a decrease in new international orders for the year, offset by increased demand experienced domestically during the third and fourth quarters. Customer support revenue consists of revenue from maintenance contracts and "fee for service" revenues. Customer support revenue increased 35% and 23% in 1998 and 1997, respectively, due to increased maintenance revenue attributable to growth in the Company's installed base. Professional services revenue is generated primarily from consulting and implementation services provided to end users of the Company's software products and technical consulting services provided to the Company's resellers. Such services are primarily performed on a time and material basis. Professional services revenue increased 39% in 1998 over 1997. This increase was attributable 16 to the Company's efforts discussed below to build its professional services capabilities to support its solutions-oriented strategy. Professional services revenue decreased 6% in 1997 from 1996. This decrease was attributable to weakness in the international market for such services. Hardware revenue is now generated primarily from the sale of 12-inch optical storage and retrieval libraries (OSAR) and third-party hardware. Hardware revenue decreased 20% and 36% in 1998 and 1997, respectively, as expected due to customers ordering competitive products. The Company expects hardware revenue to continue to decline in both absolute dollars and as a percentage of total revenue. Other revenue is generated from the sale of spare parts, education services, supplies and "third party" products. Other revenue decreased 3% and 10% in 1998 and 1997, respectively, as expected due to a decrease in demand for spare parts. The decrease in revenue for spare parts was partially offset by an increase in revenue from education services. International revenue represented 32%, 29% and 34% of total revenues in 1998, 1997 and 1996, respectively. The relatively low percentage in 1997 was due to weakness in order levels in the European market and, to a lesser extent, the strengthening of the U.S. dollar against foreign currencies. The Company expects international revenue to continue to represent a significant percentage of total revenue. However, the current economic crises in several parts of the world, particularly Asia and Latin America, is and could continue to adversely affect international sales. In addition, international revenues could be adversely affected if the U.S. dollar strengthens against international currencies. Cost of Revenue
(dollars in millions) - --------------------- Percent Percent December 31, 1998 change 1997 change 1996 Cost of software revenue $ 16.8 25% $ 13.4 (13%) $ 15.4 Percentage of software revenue 10% 10% 11% Cost of customer support revenue $ 34.7 29% $ 26.9 13% $ 23.9 Percentage of customer service revenue 47% 49% 54% Cost of professional services revenue $ 22.5 52% $ 14.8 (9%) $ 16.3 Percentage of professional services revenue 85% 78% 80% Cost of hardware revenue $ 13.2 (35%) $ 20.3 (31%) $ 29.6 Percentage of hardware revenue 56% 69% 64% Cost of education and other revenue $ 16.6 12% $ 14.8 10% $ 13.4 Percentage of other revenue 107% 93% 76% ----------------- ----------------------------- Cost of total revenue $103.8 15% $ 90.2 (9%) $ 98.6 ================= =============================
The cost of software revenue includes royalties paid to third parties and the cost of software distribution. The cost of software revenue as a percentage of software revenue was 10% in 1998 and 1997 compared to 11% in 1996. The decrease in 1997 was due to savings related to the consolidation of software distribution activities. The cost of customer support revenue includes customer support personnel, supplies, and the cost of third party hardware maintenance. The cost of customer support revenue as a percentage of customer support revenue decreased to 47% in 1998 from 49% in 1997 and 54% in 1996. The decrease in 1998 was due to the higher proportion of fees for service revenue and the transition of higher cost hardware maintenance services to a third party contractor. The decrease in 1997 is primarily due to the transition of hardware maintenance to a third party contractor, offset by lower margins associated with international maintenance. The cost of professional services revenue consists primarily of professional services personnel and third party contractors. The cost of professional services revenue as a percentage of professional services revenue increased to 85% in 1998 from 78% in 1997. This increase was primarily due to the addition of professional services personnel to support the Company's announced strategy of delivering complete document management solutions to customers, including related consulting services. Most of these personnel were added in the latter 17 half of 1998 and did not become productive prior to the end of the year. The cost of professional services revenue as a percentage of professional services revenue decreased to 78% in 1997 from 80% in 1996. This decrease was attributable to a reduction in the professional services cost structure in response to decreasing international professional services revenue. The Company believes that competition for qualified technical and managerial personnel for its professional services segment is intense and will remain so for the foreseeable future. This may result in higher levels of compensation expense and, hence, higher cost of professional services revenue. Such costs may also be adversely affected if the Company uses outside contractors at greater than anticipated levels to fulfill contracts. The cost of hardware revenue includes the cost of manufacturing OSARs, third-party purchased hardware and the cost of hardware integration personnel. The cost of hardware revenue as a percentage of hardware revenue decreased to 56% in 1998 from 69% in 1997 and 64% in 1996. The decrease in 1998 is attributable to a reduction in fixed manufacturing costs. The increase in 1997 is due to a decrease in hardware revenue without a corresponding decrease in fixed costs related to the Company's hardware manufacturing and integration activities. The cost of education and other revenue includes the costs of spare parts, education services, supplies and third party product. The cost of education and other revenue as a percentage of education and other revenue increased to 107% in 1998 from 93% in 1997. This increase was primarily due to the increased costs of education services. Research and Development and Selling, General and Administrative Expense
(dollars in millions) - ---------------------- Percent Percent December 31, 1998 change 1997 change 1996 Research and development $ 50.1 22% $ 40.9 9% $ 37.6 Percentage of total revenue 16% 16% 14% Selling, general and administrative $ 156.8 25% $ 125.1 6% $ 117.8 Percentage of total revenue 51% 50% 44%
Research and development expenses increased 22% in 1998 primarily due to an increase in salaries and facilities costs and an increase in the use of contract developers necessitated by the intense competitive environment for software engineers. The 9% increase in 1997 was primarily due to a general increase in salaries. As a percentage of total revenue, research and development expenses increased to 16% in 1997 due to the decrease in revenue and the increased level of spending. The Company expects that competition for qualified technical personnel will remain intense for the foreseeable future and may result in higher levels of compensation expense for the Company. The Company believes that research and development expenditures, including compensation of technical personnel, are essential to maintaining its competitive position and expects these costs to continue to constitute a significant percentage of revenue. Selling, general and administrative expenses increased 25% in 1998 and 6% in 1997. The increase in 1998 was due primarily to the expansion of the Company's sales force, an increase in sales training costs, and an increase in commissions and advertising which were in part offset by lower legal expenses. The increase in 1997 was due primarily to the Company's continued international expansion and higher legal costs (see Note 12 of Notes to Consolidated Financial Statements for a description of legal proceedings). Selling, general and administrative expenses as a percentage of total revenue was 51% in 1998, 50% and 44% in 1997 and 1996, respectively. The increase from each year was primarily due to expense levels increasing at a more rapid rate than revenue. Restructuring, Merger, Write-off of Purchased In-process Research and Development and Other Costs: The $2.0 million in restructuring and other costs in 1998 represents the costs of a reduction in headcount associated with the restructuring of the Company's sales and marketing operations, as well as costs of consolidating facilities. The restructuring and other costs include 18 approximately $1.1 million for severance payments for 54 employees, $0.7 million for facility closing costs and $0.2 million of other charges. The $6.0 million in restructuring and other costs in 1997 represented the costs of consolidating the Watermark business unit's Burlington, Massachusetts engineering and marketing functions with those at FileNET's Costa Mesa, California location, as well as a reduction in headcount in certain other areas of the Company. The restructuring and other costs include approximately $2.2 million for severance payments for 111 employees, $2.2 million for the write-off of assets impaired by the decision to restructure, $0.4 million for facility closing costs, $0.4 million for equipment lease cancellations, $0.3 million for cancellation of third party development contracts, $0.2 million related to the withdrawal of certain products from the market and $0.3 million of other charges. The $16.0 million merger, restructuring and write-off of purchased in-process research and development costs in 1996 consisted of $10.0 million for the write-off of purchased in-process research and development costs related to the acquisition of International Financial Systems Ltd. (IFSL), $4.2 million in merger costs related to the Saros acquisition, and $1.8 million in restructuring costs related to the Saros and Watermark acquisitions. The restructuring charges represented the costs of consolidating the various companies' sales and administrative functions and include $1.4 million for severance payments for 30 employees and $0.4 million for the write-off of certain contractual obligations and other costs. At December 31, 1998, accrued restructuring and other costs of $1.7 million were included in other accrued liabilities. The Company anticipates that the remaining restructuring costs will be expended during 1999. Other Income: Other income, net of other expenses, was $3.8 million in 1998, $3.2 million in 1997 and $2.8 million in 1996. The increases in 1998 and 1997 were primarily due to increases in interest income associated with higher balances of cash and marketable securities. Provision for Income Taxes: The provision for income taxes was a charge of $0.4 million in 1998, compared to a benefit of $2.2 million and a charge of $4.5 million recorded in 1997 and 1996, respectively. The effective tax rate was 29% in 1998 and 28% in 1997. The 1996 effective tax rate was 246% as a result of expensing the purchased in-process research and development costs without tax benefit, nondeductible one-time costs and earnings generated in certain low taxed jurisdictions, partially offset by the utilization of tax losses incurred in the United States. Quantitative and Qualitative Disclosures about Market Risk: The Company is exposed to a variety of risks, including changes in interest rates affecting the return on its investments and foreign currency fluctuations. In the normal course of business, the Company employs established policies and procedures to manage its exposure to fluctuations in interest rates and foreign currency values. Interest Rate Risk: The Company's exposure to market rate risk for changes in interest rates relates primarily to the Company's investment portfolio. The Company has not used derivative financial instruments in its investment portfolio. The Company places its investments with high-quality issuers and, by policy, limits the amount of credit exposure to any one issuer. The Company protects and preserves its invested funds by limiting default, market and reinvestment risk. The Company's investments in marketable securities consist primarily of high-grade corporate and 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. The Company classifies all of its 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 stockholders' equity. Foreign Currency: Risk The Company has entered into forward foreign exchange contracts primarily to hedge amounts due from and the net assets of selected subsidiaries denominated in foreign currencies (mainly in Europe and Asia Pacific) against fluctuations in exchange rates. The Company has not entered into forward foreign exchange contracts for speculative or trading purposes. The Company's accounting policies for these contracts are based on the Company's designation of the contracts as hedging transactions. The criteria the Company uses for designating a contract as a hedge include the contract's effectiveness in risk reduction and one-to-one matching of derivative instruments to 19 underlying transactions. Gains and losses on forward foreign exchange contracts are recognized in income in the same period as gains and losses on the underlying transactions. If an underlying hedged transaction is terminated earlier than initially anticipated, the offsetting gain or loss on the related forward foreign exchange contract would be recognized in income in the same period. In addition, since the Company enters into forward contracts only as a hedge, any change in currency rates would not result in any material net gain or loss, as any gain or loss on the underlying foreign currency denominated balance would be offset by the gain or loss on the forward contract. The Company operates in certain countries in Latin America, Eastern Europe and Asia Pacific where there are limited forward currency exchange markets and thus the Company has unhedged transaction exposures in these currencies. The following table summarizes the notional amounts, which are equivalent to the fair market value, of the Company's foreign currency agreements entered into in December 1998 and 1997, all maturing in three months:
(in thousands) - --------------- At December 31, 1998 1997 ---------------------------------- ------------------------------------ Notional Amount Notional Amount Notional Amount Notional Amount Purchased Sold Purchased Sold European currencies $ 11,238 $ (8,488) $ 31,261 $ 35,775 Australian dollar (2,938) (4,299) Asian currencies 929 (698) Canadian dollar (522) (1,014) Total $ 12,167 $(11,948) $ 31,261 $ 29,764
Management believes that inflation has not had a significant impact on the prices of the Company's products, the cost of its materials, or its operating results for the three years ended December 31, 1998. Financial Condition Liquidity and Capital Resources: As of December 31, 1998, combined cash, cash equivalents, and marketable securities (short and long-term) were $82.2 million, an increase of $10.4 million from the $71.8 million at the end of 1997. Cash provided by operating activities in 1998 was $33.3 million and was comprised primarily of additions to net income for depreciation and amortization expense and increases in accounts payable, accrued compensation, and unearned maintenance revenue. Cash used by investing activities totaled $23.7 million, consisting of capital expenditures offset by the net sale and maturity of marketable securities. Cash provided by financing activities was $9.1 million consisting of proceeds of $13.5 million from issuance of common stock in connection with the exercise of employee stock options and the employee stock purchase plan, offset by $4.4 million to repurchase common stock. Cash provided by operating activities in 1997 was $24.7 million. Cash used by the net loss for the year was offset by lower accounts receivable balances associated with a lower average days sales outstanding, lower inventories associated with the Company's decrease in hardware revenue and additions to net income for depreciation and amortization. Cash used by investing activities totaled $11.3 million, consisting of capital expenditures offset by the net sale and maturity of marketable securities. Cash used by financing activities was $2.6 million and was the result of the repurchase of common stock at a cost of $5.6 million, offset by proceeds from the issuance of common stock in connection with the exercise of employee stock options and the employee stock purchase plan. Cash used by operating activities in 1996 was $1.7 million. The balance is primarily due to a net loss and the effect of higher accounts receivable balances associated with higher revenue and higher average days sales outstanding, offset in part by the non-cash additions to net income for write-off of capitalized and purchased in-process research and development costs, depreciation, and amortization of capitalized software. Cash used by investing activities totaled $16.7 million, consisting of capital expenditures and the purchase of IFSL, offset by proceeds from the sale of equipment and the net sale and maturity of marketable securities. Net cash provided by financing 20 activities was $2.6 million and was the result of proceeds from the issuance of common stock and stock option income tax benefits, offset by the repurchase of common stock. The Company's capital expenditures were $32.5 million in 1998, $14.3 million in 1997, and $17.9 million in 1996. The Company's primary capital expenditures are for research and development equipment, demonstration and training equipment, enhancements to its internal network and business systems, leasehold improvements on leased property, and furniture for new offices. The increase in 1998 capital expenditures over the levels of the prior two years was due primarily to large internal information technology infrastructure and systems projects, as well as expenditures incurred for leasehold improvements and furnishings for the Company's office in Kirkland, Washington. The Company anticipates that it will acquire approximately $26.0 million of capital equipment in 1999. During the first quarter of 1998, the Company repurchased $4.4 million of its common stock. The Company repurchased $10.2 million of common stock in 1997 and 1996 for a total of $14.6 million in treasury stock. The Company anticipates that its present cash balances, together with internally generated funds and credit lines, will be sufficient to meet its working capital and capital expenditure needs throughout 1999. Other Matters Year 2000: With the approach of the year 2000, the Company recognized that significant issues could arise in connection with the computer software products it licenses and the internal business systems which are essential to its operations. In 1997, the Company implemented a year 2000 Integrity Program (the Program) to ensure that the Company's computer software products and internal business systems will function properly in the year 2000 and thereafter. The Program, as it relates to the software products licensed to customers, includes year 2000 compliance testing and certification of certain existing software products. All new generations of the Company's software products will be released as year 2000 compliant. Not all current software products of the Company are year 2000 compliant and the Company does not plan to make them so. Upgraded year 2000 compliant versions of such software products are being made available to customers and resellers who will then bear the responsibility for installing the upgraded software product in order to make their systems year 2000 compliant. Some of the Company's customers are running software product versions that are not year 2000 compliant. The Company has been encouraging such customers to migrate to current software product versions. It is possible that the Company may experience increased expenses in addressing migration issues for such customers. The Company's customer support organization initiated a program, Customer Service Profile 2000, to review the status of each Company product currently installed at a customer location and it provided the diagnostics used in this program to its resellers for their use at their customer locations. Customers who have support agreements with the Company have been directly informed as to whether or not the particular software products they have installed are year 2000 compliant. All customers are kept informed of the release of year 2000 compliant updates and upgrades via the Company's Web site. The inability of any of the Company's software products to properly manage and manipulate data in the year 2000 could result in increased warranty costs, customer satisfaction issues, potential lawsuits and other costs and liabilities, as well as customers being unable to run software licensed from the Company and incurring significant costs from the resultant business interruption. The Company has spent an estimated $1.0 million on year 2000 product related projects through December 31, 1998. The 1999 expense for year 2000 product related projects is estimated to be less than $1.0 million. Demand for the Company's software products could be adversely impacted to the extent customers and potential customers are temporarily distracted by their year 2000 remediation efforts, as such products compete for Information Technology (IT) resources that have been diverted for such remedial efforts which may have higher priority than implementing document management systems. The Company has also initiated communications with significant third party vendors of computer software with which the Company's systems interface or upon which the Company's software products depend in order to coordinate efforts to minimize the extent to which the Company's business will be vulnerable to such third parties' failure to remediate their own year 2000 issues. Although the Company's compliance testing utilizes the embedded third-party software as an essential part of its software being tested, the Program does not include certification of customer-developed applications which run on the Company's 21 software products or third party software which is incorporated in the Company's software products. Customers and third party vendors will remain directly responsible for year 2000 compliance testing of their software. The Company requires that contingency plans be developed and validated in the event that any of its products cannot be updated and certified year 2000 compliant before its scheduled release date. The Company expects to have its contingency plans in place by October 31, 1999. In addition, the Company is forming a rapid response team as part of its Customer Services and IT groups that will respond to any problems during the year 2000 date change period. The Program also includes a review of all internal IT systems for year 2000 compliance. This year 2000 compliance effort for IT systems is divided into three categories: 1) applications development and support; 2) IT production services and operations; and 3) business communications (data, voice and video). The program methodology consists of four phases: I) assessment; II) potential impact analysis; III) compliance integration; and IV) update, assessment, and contingency plan. The Company's significant business systems (financial, operational, marketing, customer support, etc.) have been reviewed and are either currently year 2000 compliant or will be upgraded and/or replaced so as to be year 2000 tested and compliant during 1999. All of the hardware and software deployed in the Company's technical infrastructure is either fully year 2000 tested and compliant or is scheduled to be replaced with year 2000 compliant components by October 31, 1999. The Company is also evaluating IT related environmental systems (heating, air conditioning, security, etc.) and intends to make all such systems year 2000 compliant by October 31, 1999. To the extent possible, the Company will develop and execute contingency plans designed to allow continued operation in the event of failure of the Company's or third parties' systems by October 31, 1999. For those business, infrastructure and environmental systems that are to be upgraded in order to achieve year 2000 compliance, the majority were already scheduled for upgrade for other business reasons. The Company's cost to fund such year 2000 compliance projects has been $0.2 million through December 31, 1998. The 1999 expense for year 2000 compliance projects is estimated to be less than $0.6 million. Although the Company is not aware of any material operational issues or costs associated with preparing its software products and internal systems for the year 2000, there can be no assurance that there will not be a delay in, or increased costs associated with, the implementation of the necessary systems and changes to address the year 2000 issue. The Company's inability to implement such systems and changes could have an adverse effect on future results of operations. The costs of the Company's year 2000 project and the date on which the Company believes it will be completed are based on management's best estimates and include assumptions regarding third party modification plans. However, in particular due to the potential impact of third party modification plans, there can be no assurance that these estimates will be achieved and actual results could differ materially from those anticipated. The foregoing statements are based upon management's best estimates at the present time, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources, third party modification plans and other factors. There can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the nature and amount of programming required to upgrade or replace each of the affected programs, and the success of the Company's external customers, resellers, and vendors and suppliers in addressing the year 2000 issue. The EURO Conversion: On January 1, 1999, eleven of the fifteen-member countries of the European Union established fixed conversion rates between their existing sovereign currencies and the EURO. These countries have agreed to adopt the EURO as their common legal currency from that date. The EURO will trade on currency exchanges and be available for non-cash transactions. These countries will issue sovereign debt exclusively in EURO and will redenominate outstanding sovereign debt. Effective on January 1, 1999, these countries no longer control their own monetary policies by directing independent interest rates for the legacy currencies. Instead, the authority to direct monetary policy, including money supply and official interest rates for the EURO, is exercised by the new European Central Bank. The legacy currencies are scheduled to remain legal tender in these countries as a denomination of the EURO between January 1, 1999 and January 1, 2002 (the "transition period"). During the transition period, public and private parties may pay for goods and services using either the EURO or the country's legacy currency on a "no compulsion, no prohibition" basis. However, conversion rates 22 will no longer be computed directly from one legacy currency to another. Instead, a "triangulation" process will be applied whereby an amount denominated in one legacy currency first will be converted into an amount denominated in EURO, and the resultant EURO-denominated amount is converted into the second legacy currency. The Company has made the necessary changes to its internal business systems to support transactions denominated in the EURO, including establishing EURO price lists for affected countries. The Company is in the process of evaluating the impact that the conversion to the EURO will have on its financial condition and results of operations. Based on this evaluation to date, the Company currently does not believe that there will be a material adverse impact on its financial condition or results of operations as a result of the EURO conversion. Recent Accounting Pronouncements: In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities." which is effective for fiscal year 2000, but earlier adoption is permitted. SFAS 133 will require the Company to record all derivatives on the balance sheet at fair value. For derivatives that are hedges, changes in the fair value of derivatives will be offset by the changes in the fair value of the hedged assets, liabilities or firm commitments. The Company believes the impact of adopting this standard will not be material to its results of operations or equity. Environmental Matters: The Company is not aware of any issues related to environmental matters that have, or are expected to have, a material affect on its business. Facts That May Affect Future Results This Annual Report may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 21e of the Securities Exchange Act of 1934, as amended and Section 27a of the Securities Act of 1933, as amended, and is subject to the safe harbors created by those sections. These forward looking statements involve risks and uncertainties, including those discussed below and in the Notes to Consolidated Financial Statements. The actual results that the Company achieves may differ materially from any forward-looking statements, which reflect management's opinions only as of the date hereof. The Company undertakes no obligation to revise or publicly release the results of any revisions to these forward-looking statements. Readers should carefully review the factors described below and in other documents the Company files from time to time with the Securities and Exchange Commission, including its Annual Report on Form 10-k for 1998 and the Quarterly Reports on Form 10-q to be filed by the Company in 1999. The Company's business, financial condition, operating results and prospects can be impacted by a number of factors, including but not limited to those set forth below and elsewhere in this report, any one of which could cause the Company's actual results to differ materially from historical results or from the Company's anticipated future results. Factors that may affect the Company's business, financial condition and results of operations include: Rapid Technological Change; Product Development: The market for the Company's products is characterized by rapid technological developments, evolving industry standards, changes in customer requirements and frequent new product introductions and enhancements. The Company's continued success will be dependent upon its ability to continue to enhance its existing products, develop and introduce, in a timely manner, new products incorporating technological advances and respond to customer requirements, including without limitation enhancements to certain specified Company software products to achieve year 2000 compliance. There can be no assurance that the Company will be successful in developing and marketing new products or enhancements to its existing products on a timely basis or that any new or enhanced products will adequately address the changing needs of the marketplace. If the Company is unable to develop and introduce new products or enhancements to existing products in a timely manner in response to changing market conditions or customer requirements, including without limitation enhancements to certain existing software products to achieve year 2000 compliance, the Company's business and operating results could be adversely affected. From time to time, the Company or its competitors may announce new products, capabilities or technologies that have the potential to replace or shorten the life cycles of the Company's existing products. There can be no assurance that announcements of currently planned or other new products will not cause customers to delay their purchasing decisions in anticipation of such products, which could have a material adverse effect on the Company's business and operating results. 23 Uncertainty of Future Operating Results; Fluctuations in Quarterly Operating Results Prior growth rates in the Company's revenue and operating results should not necessarily be considered indicative of future growth or operating results. Future operating results will depend upon many factors, including the demand for the Company's products; the effectiveness of the Company's efforts to continue to integrate various products it has developed or acquired and to achieve the desired level of sales from such product integration; the level of product and price competition; the length of the Company's sales cycle; improvements in the productivity of the Company's sales force; seasonality of individual customer buying patterns; the size and timing of individual transactions; the delay or deferral of customer implementations; the budget cycles of the Company's customers; the timing of new product introductions and product enhancements by the Company and its competitors; the mix of sales by products, services and distribution channels; levels of international sales; acquisitions by competitors; changes in foreign currency exchange rates including EURO exchange rates beginning in 1999; the ability of the Company to develop and market new products and control costs; and general domestic and international economic and political conditions. As a result of these factors, revenues and operating results for any quarter are subject to variation and are not predictable with any significant degree of accuracy. Therefore, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Moreover, such factors could cause the Company's operating results in a given quarter to be below the expectations of public market analysts and investors. In either case, the price of the Company's common stock could be materially adversely affected. Competition: The document imaging, workflow, computer output to laser disk and electronic document management software markets are highly competitive, and there are certain competitors of the Company with substantially greater sales, marketing, development and financial resources. The Company believes that the competitive factors affecting the market for its products and services include vendor and product reputation; product quality, performance and price; the availability of products on multiple platforms; product scalability; product integration with other enterprise applications; product functionality and features; product ease of use; and the quality of customer support services and training. The relative importance of each of these factors depends upon the specific customer involved. While the Company believes it competes favorably in each of these areas, there can be no assurance that it will continue to do so. Moreover, the Company's present or future competitors may be able to develop products comparable or superior to those offered by the Company, offer lower price products or adapt more quickly than the Company to new technologies or evolving customer requirements. Competition is expected to intensify. In order to be successful in the future, the Company must respond to technological change, customer requirements and competitors' current products and innovations. There can be no assurance that the Company will be able to continue to compete effectively in its market or that future competition will not have a material adverse effect on its business, financial condition or results of operations. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of the markets served by the Company. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on the Company's business, financial condition or results of operations. Intellectual Property and Other Proprietary Rights: The Company's success depends, in part, on its ability to protect its proprietary rights to the technologies used in its principal products. The Company relies on a combination of copyrights, trademarks, trade secrets, confidentiality procedures and contractual provisions to protect its proprietary rights. There can be no assurance that the Company's existing or future copyrights, trademarks, trade secrets or other intellectual property rights will be of sufficient scope or strength to provide meaningful protection or a commercial advantage to the Company. The Company has no software patents. Also, in selling certain of its products, the Company relies on "shrink wrap" licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the United States. There can be no assurance that such factors would not have a material adverse effect on the Company's business, financial condition or results of operations. In addition, the Company also relies on certain software that it licenses from third parties, including software that is integrated with 24 internally developed software used in the Company's products to perform key functions. There can be no assurance that such third parties will remain in business, that they will continue to support their products, that their products are, or will be, year 2000 compliant, or that their products will otherwise continue to be available to the Company on commercially reasonable terms. The loss or inability to maintain any of theses software licenses could result in delays or reductions in product shipments until equivalent software can be developed, identified, licensed and integrated, which could adversely affect the Company's business, financial condition or results of operations. The Company may, from time to time, be notified that it is infringing certain patent or intellectual property rights of others. Combinations of technology acquired through past or future acquisitions and the Company's technology will create new products and technology that may give rise to claims of infringement. While no actions other than those discussed below are currently pending against the Company for infringement of patent or other proprietary rights of third parties, there can be no assurance that third parties will not initiate infringement actions against the Company in the future. Infringement actions can result in substantial cost to, and diversion of, resources of the Company. If the Company were found to infringe upon the rights of others, no assurance can be given that licenses would be obtainable on acceptable terms or at all, that significant damages for past infringement would not be assessed or that further litigation relative to any such licenses or usage would not occur. The failure to successfully defend any claims or obtain necessary licenses or other rights, the ultimate disposition of any claims or the advent of litigation arising out of any claims of infringement, could have a material adverse effect on the Company's business, financial condition or results of operations. In October 1994, Wang Laboratories, Inc. (Wang) filed a complaint in the United States District Court for the District of Massachusetts alleging that the Company is infringing five patents held by Wang (the FileNET Case). On June 23, 1995, Wang amended its complaint to include an additional related patent. On July 2, 1996, Wang filed a complaint in the same court alleging that Watermark Software Inc., formerly a wholly owned subsidiary that was merged into the Company, is infringing three of the same patents asserted in the initial complaint (the Watermark Case). On October 9, 1996, Wang withdrew its claim in the FileNET Case that one of the patents it initially asserted is infringed by certain of the Company's products, which were commercialized before the initial complaint was filed. Wang reserved the right to assert that patent against the Company's products commercialized after that date in a separate lawsuit. In March 1997, Eastman Kodak Company (Kodak) purchased the Wang imaging business unit that has responsibility for this litigation. The patents in the suit have been transferred to a Kodak subsidiary, Kodak Limited of England, which, in turn, has exclusively licensed them to another Kodak subsidiary, Eastman Software, Inc. in the United States (Eastman). On July 30, 1997, the Court permitted Eastman and Kodak Limited of England to be substituted in the litigation in place of Wang. The Company has moved for summary judgement on noninfringement as to each of the five patents in the suit, and for summary judgment of invalidity as to one of the patents. Eastman moved for summary judgment as to the Company's unenforceability defense on one of the patents. In July 1998, the Magistrate Judge assigned to the case, heard oral arguments on the Company's motion for summary judgement that U.S. Patent 4,918,588 is not infringed and is invalid. The Magistrate Judge has not yet decided these motions. The Company believes that after he has ruled on these motions, he will hear oral arguments in the remaining motions in the sequence in which they were filed. A trial date has not been set. If it should be determined that the patents at issue in the litigation are valid and are infringed by any of the Company's products, including Watermark products, the Company will, depending on the product, redesign the infringing products or seek to obtain a license to market the products. There can be no assurance that the Company will be able to obtain such a license on acceptable terms. Based on the Company's analysis of these Eastman patents and their respective file histories, the Company believes that it has meritorious defenses to Eastman's claims; however, the ultimate outcome or any resulting potential loss cannot be determined at this time. Dependence on Certain Relationships: The Company has entered into a number of key relationships with other companies such as Microsoft Corporation, IBM Global Services, SAP AG, Hewlett-Packard Company, and Sun Microsystems, Inc. There can be no assurance that these companies will not reduce or discontinue their relationships with, or support of, the Company and its products 25 Dependence on Key Management and Technical Personnel: The Company's success depends to a significant degree upon the continued contributions of its key management, marketing, technical and operational personnel. In general, the Company does not utilize employment agreements for its key employees. The loss of the services of one or more key employees could have a material adverse effect on the Company's operating results. The Company also believes its future success will depend in large part upon its ability to attract and retain additional highly skilled management, technical, marketing, product development and operational personnel. Competition for such personnel, particularly engineers and other technical personnel, is intense, and pay scales in the software industry are increasing. There can be no assurance that the Company will be successful in attracting and retaining such personnel. International Sales: Historically, the Company has derived approximately one-third of its total revenues from international sales. International business is subject to certain risks including varying technical standards; tariffs and trade barriers; political and economic instability; reduced protection for intellectual property rights in certain countries; difficulties in staffing and maintaining foreign operations; difficulties in managing foreign distributors; varying requirements for localized products; potentially adverse tax consequences; currency exchange fluctuations including those related to the EURO beginning in 1999; the burden of complying with a wide variety of complex foreign laws, regulations and treaties; and the possibility of difficulties in collecting accounts receivable. In particular, the current economic crisis in the Asia Pacific region and Latin America may limit future growth or cause a decline in international revenues. There can be no assurance that any of these factors will not have a material adverse effect on the Company's business, financial condition or results of operations. Product Liability: Products as complex as those sold by the Company are susceptible to errors or failures, especially when first introduced or when new versions are released. The Company's products are often intended for use in applications that are critical to a customer's business. As a result, the Company's customers may rely on the effective performance of the software to a greater extent than the market for software products generally. The Company conducts extensive product testing to ensure that its products are free of significant errors and defects. In addition, the Company has designed and tested the most current versions of its products to be year 2000 compliant. However, some of the Company's customers are running earlier products that are not year 2000 compliant. Although the Company has been encouraging such customers to migrate to current product versions, no assurance can be given that all of them will do so in a timely fashion, if at all. Moreover, the Company also relies on certain software that it licenses from third parties, including software that is integrated with internally developed software and is used in the Company's products to perform key functions. There can be no assurance that such third-party software will be free of errors and defects or be year 2000 compliant in a timely fashion. Although the Company has not experienced any material product liability claims to date, there can be no assurance that errors or defects, whether associated with year 2000 functions or otherwise, will not result in product liability claims against the Company in the future. The Company's license agreements with customers typically contain provisions designed to limit its exposure to potential product liability claims. However, it is possible that such limitation of liability provisions may not be effective under the laws of certain jurisdictions. Although the Company has not experienced any product liability claims to date, the sale and support of products may entail the risk of such claims, and there can be no assurance that the Company will not be subject to such claims in the future. A successful product liability claim brought against the Company could have a material adverse effect upon the Company's business, operating results and financial condition. Stock Price Volatility: The Company believes that a variety of factors could cause the trading price of its common stock to fluctuate, perhaps substantially, including quarter-to-quarter variations in operating results; announcements of developments related to its business; fluctuations in its order levels; general conditions in the technology sector or the worldwide economy; announcements of technological innovations, new products or product enhancements by the Company or its competitors; key management changes; changes in joint marketing and development programs; developments relating to patents or other intellectual property rights or disputes; and developments in the Company's relationships with its customers, distributors and suppliers. In addition, in recent years the stock market in general, and the market for shares of high-technology stocks in particular, have experienced extreme price fluctuations that have often been unrelated to the operating performance of affected companies. Such fluctuations could adversely affect the trading price of the Company's common stock. 26 EX-13.3 4 FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEET (dollars in thousands except share amounts) December 31, 1998 1997 - -------------------------------------------------------------------------------- Assets Current assets: Cash and cash equivalents $ 55,820 $ 37,344 Short-term marketable securities 15,484 26,600 Accounts receivable, net of allowances for doubtful accounts and sales returns of $4,382 and $4,415 at December 31, 1998 and 1997, respectively 61,636 61,283 Inventories, net 2,419 3,541 Prepaid expenses and other current assets 8,865 8,309 Deferred income taxes 0 2,643 --------- ---------- Total current assets 144,224 139,720 Property, net 44,177 27,587 Long-term marketable securities 10,885 7,826 Deferred income taxes 6,385 3,366 Other assets 1,151 941 ---------- ---------- Total assets $ 206,822 $ 179,440 ========== ========== Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 21,022 $ 15,003 Accrued compensation and benefits 22,165 17,159 Unearned maintenance revenue 11,238 8,848 Accrued royalties 1,459 2,743 Deferred income taxes 942 0 Other accrued liabilities 19,676 16,876 ---------- ---------- Total current liabilities 76,502 60,629 Stockholders' equity: Preferred stock--$.10 par value, 7,000,000 shares authorized; none issued and outstanding 0 0 Common stock--$.01 par value, 100,000,000 shares authorized; 32,924,950 and 31,121,676 shares issued and outstanding at December 31, 1998 and 1997, respectively 144,242 130,741 Retained earnings 3,304 2,348 Accumulated other comprehensive operations (2,659) (4,146) 144,887 128,943 Treasury stock at cost; 1,098,000 and 820,000 shares at December 31, 1998 and 1997, respectively (14,567) (10,132) ---------- ---------- Total stockholders' equity 130,320 118,811 ---------- ---------- Total liabilities and stockholders' equity $ 206,822 $ 179,440 ========== ========== See accompanying Notes to Consolidated Financial Statements. 27 CONSOLIDATED STATEMENTS OF OPERATIONS (dollars in thousands except share amounts) Year Ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Revenue: Software $ 171,153 $ 132,723 $ 140,659 Service 115,501 89,280 82,118 Hardware 23,579 29,422 46,136 --------- ---------- ---------- Total revenue 310,233 251,425 268,913 --------- ---------- ---------- Costs and expenses: Cost of software revenue 16,814 13,416 15,389 Cost of service revenue 73,786 56,503 53,568 Cost of hardware revenue 13,181 20,330 29,633 Research and development 50,132 40,927 37,577 Selling, general and administrative 156,813 125,122 117,761 Restructuring, merger, write-off of purchased in-process research and development and other costs 2,000 6,000 16,011 --------- ---------- ---------- Total costs and expenses 312,726 262,298 269,939 --------- ---------- ---------- Operating loss (2,493) (10,873) (1,026) Other income, net 3,840 3,160 2,838 Incom (loss) before income taxes 1,347 (7,713) 1,812 Provision (benefit) for income taxes 391 (2,187) 4,456 --------- ---------- --------- Net income (loss) $ 956 $ (5,526) $ (2,644) ========= ========== ========= Earnings (loss) per share: Basic $ 0.03 $ (0.18) $ (0.09) Diluted $ 0.03 $ (0.18) $ (0.09) Weighted average shares outstanding--basic 31,083 30,310 30,014 --------- ---------- ---------- Weighted average shares outstanding--diluted 33,367 30,310 30,014 ========= ========== ========== See accompanying Notes to Consolidated Financial Statements. 28 CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS (dollars in thousands) Year Ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Net income (loss) $ 956 $ (5,526) $ (2,644) Other comprehensive income (loss): Foreign currency translation adjustments, net of tax 1,455 (5,809) 1,671 Unrealized holding gains (losses) on available for sale securities, net of tax 32 (24) (26) -------- ---------------------- Other comprehensive income (loss) 1,487 (5,833) 1,645 -------- ---------------------- Comprehensive income (loss) $ 2,443 $ (11,359) $ (999) ======== ====================== See accompaniying Notes to Consolidated Financial Statements. 29 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (dollars in thousands except per share amounts)
Convertible Accumulated Preferred Stock Common Stock Retained Other Comp Treasury Stock --------------- --------------- Earnings Operations ---------------- Total Shares Amount Shares Amount Shares Amount Balances at January 1, 1996 3,064 $ 19,879 26,508 $100,719 $ 10,518 $ 42 0 $ 0 $131,158 Stock options exercised 796 3,330 3,330 Stock option income tax benefits 2,606 2,606 Common stock issued under the Employee Qualified Stock Purchase Plan 76 1,028 1,028 Exercise of Saros warrants 18 251 251 Conversion of Saros convertible preferred stock to FileNET common stock (3,064) (19,879) 3,064 19,879 Repurchase of treasury shares at cost (400) (4,568) (4,568) Foreign currency translation adjustment 1,671 1,671 Net loss (2,644) (2,644) Other (26) (26) ------------------------------------------------------------------------------------------------ Balances at December 31, 1996 30,462 127,813 7,874 1,687 (400) (4,568) 132,806 Stock options exercised 484 1,721 1,721 Common stock issued under the Employee Qualified Stock Purchase Plan 176 1,207 1,207 Repurchase of treasury shares at cost (420) (5,564) (5,564) Foreign currency translation adjustment (5,809) (5,809) Net loss (5,526) (5,526) Other (24) (24) ------------------------------------------------------------------------------------------------ Balances at December 31, 1997 31,122 130,741 2,348 (4,146) (820) (10,132) 118,811 Stock options exercised 1,642 12,078 12,078 Common stock issued under the Employee Qualified Stock Purchase Plan 161 1,423 1,423 Repurchase of treasury shares at cost (278) (4,435) (4,435) Foreign currency translation adjustment 1,455 1,455 Net income 956 956 Other 32 32 ------------------------------------------------------------------------------------------------ Balances at December 31, 1998 32,925 $144,242 $ 3,304 $(2,659) (1,098) $(14,567) $130,320 ================================================================================================ See accompanying Notes to Consolidated Financial Statements.
30 CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands) Year Ended December 31, 1998 1997 1996 Cash flows from operating activities: Net income (loss) $ 956 $ (5,526) $ (2,644) Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities: Write-off of capitalized and purchased in-process research and development costs 0 0 10,011 Depreciation and amortization 15,360 13,193 13,136 Provision for doubtful accounts 1,041 350 1,205 Deferred income taxes 566 (3,773) (790) Changes in operating assets and liabilities, net of effect of business acquisition: Accounts receivable (573) 9,365 (21,921) Inventories 1,121 5,368 (2,161) Prepaid expenses and other current assets (609) (539) (1,764) Accounts payable 5,905 (1,273) 639 Accrued compensation and benefits 4,820 4,721 688 Unearned maintenance revenue 2,408 3,327 (207) Accrued royalties (1,284) (1,788) 959 Other 3,547 1,240 1,141 --------- ------------------------- Net cash provided by (used for) operating activities 33,258 24,665 (1,708) --------- ------------------------- Cash flows from investing activities: Capital expenditures (32,474) (14,266) (17,866) Proceeds from sale of property 478 264 3,304 Payment for purchase of IFSL, net of assets acquired 0 0 (10,011) Purchases of marketable securities (34,536) (30,274) (32,092) Proceeds from sales and maturities of marketable securities 42,843 32,946 39,990 ---------- ------------------------- Net cash used for investing activities (23,689) (11,330) (16,675) ---------- ------------------------- Cash flows from financing activities: Proceeds from issuance of common stock 13,501 2,928 4,609 Common stock repurchased (4,435) (5,564) (4,568) Stock option income tax benefits 0 0 2,606 ---------- ------------------------- Net cash provided by (used for) financing activities 9,066 (2,636) 2,647 ---------- ------------------------- Effect of exchange rate changes on cash and cash equivalents (159) (1,885) 888 ---------- ------------------------- Net increase (decrease) in cash and cash equivalents 18,476 8,814 (14,848) Cash and cash equivalents, beginning of year 37,344 28,530 43,378 ---------- ------------------------- Cash and cash equivalents, end of year $ 55,820 $ 37,344 $ 28,530 ========== ========================= Supplemental cash flow information: Interest paid $ 25 $ 201 $ 443 Income taxes paid (refunded) $ (2,119) $ 3,050 $ 3,236 See accompanying Notes to Consolidated Financial Statements.
31 Note 1. Summary of Significant Accounting Policies Nature of Operations: FileNET Corporation ("FileNET" or "the Company") develops, markets and services an open, integrated, client/server-based family of document management software products designed for managing information and enhancing enterprise productivity. Additionally, the Company manufactures and sells a line of 12-inch optical storage and retrieval libraries (OSARs). The Company markets its products to a broad range of industries in more than 70 countries through a global sales, services and support organization, including its ValueNET partner program of resellers, system integrators and application developers. Principles of Consolidation: The consolidated financial statements include the accounts of FileNET and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated. Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Investments: The Company's investments in marketable securities consist primarily of high-grade corporate and 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. The Company classifies all of its investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in other comprehensive operations. Other Financial Instruments: The Company enters into forward foreign exchange contracts as a hedge against the effects of fluctuating currency exchange rates on monetary assets and liabilities denominated in currencies other than the functional currency of the relevant entity. The Company is exposed to market risk on the forward exchange contracts as a result of changes in foreign exchange rates; however, the market risk should be offset by changes in the valuation of the underlying exposures. Gains and losses on these contracts, which equal the difference between the forward contract rate and the prevailing market spot rate at the time of valuation, are recognized in the consolidated statements of operations. The counterparties to these contracts are major financial institutions. The Company uses commercial rating agencies to evaluate the credit quality of the counterparties. The Company does not anticipate a loss resulting from credit risk related to any of these institutions (see Note 14). Fair Value of Financial Instruments: The recorded amounts of financial assets and liabilities at December 31, 1998 and 1997 approximate fair value due to the relatively short period of time between origination of the instruments and their expected realization. Inventories: Inventories are stated at the lower of first-in, first-out cost or market (see Note 6). The Company regularly monitors inventories for excess or obsolete items and makes any necessary adjustments at each balance sheet date. Foreign Currency: Translation The Company measures the financial statements of the Company's foreign subsidiaries using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate on the balance sheet date. Revenues, costs and expenses are translated at the rates of exchange prevailing during the year. Translation adjustments resulting from this process are included in other comprehensive operations, net of tax. Gains and losses from foreign currency transactions are included in other income. Property Property: is stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, generally three to five years. Leasehold improvements are amortized over the shorter of the estimated useful lives of the improvements or the term of the related lease (see Note 7). Research and Development: The Company expenses research and development costs as incurred. SFAS No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed" does not materially affect the Company. The Company did capitalize certain software development costs up to and including the second quarter of 1995. The Company amortized the remaining capitalized software development costs during 1996. Amortization expense was $1.2 million for the year ended December 31, 1996. 32 Revenue Recognition: Software revenue is recognized in accordance with the American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, "Software Revenue Recognition." Pursuant to SOP 97-2, software revenue is recognized on sales contracts when all of the following conditions are met: a signed contract is obtained, delivery has occurred, the total sales price is fixed and determinable, collectibility is probable, and any uncertainties with regard to customer acceptance are insignificant. For those contracts that include a combination of software, hardware and/or services, revenue is allocated among the different elements based on Company-specific evidence of fair value of each element. Revenue allocated to software and hardware is recognized as the above criteria are met. Revenue allocated to services is recognized as services are performed and accepted by the customer or, for maintenance agreements, ratably over the life of the related contract. Product Warranty: The Company provides a 90-day warranty for its products against defects in materials and workmanship. A provision for estimated warranty costs is recorded at the time of sale and periodically adjusted to reflect actual experience. Income Taxes: The provision for income taxes is determined in accordance with SFAS No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities arise from temporary differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years (see Note 10). Earnings (Loss) Per Share: Basic earnings (loss) per share is computed using the weighted average number of common shares outstanding during the reporting period. Diluted earnings (loss) per share is computed using the weighted average number of common shares outstanding and the dilutive effect of potential common shares outstanding (see Note 4). Supplier Concentrations: Certain components for the Company's proprietary 12-inch OSARs are available only from a single source. Any inability to obtain components in the amounts needed on a timely basis could result in delays in product shipments which could have a material adverse effect on the Company's operating results. The Company has qualified and is selling 51/4-inch optical storage and retrieval devices from an alternative source which could be utilized by the Company's customers in the event of any interruptions in the delivery of components for the Company's own OSAR product. Stock-based Compensation: The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees" (see Note 9). Long-Lived Assets: The Company accounts for the impairment and disposition of long-lived assets in accordance with SFAS No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of." In accordance with SFAS No. 121, long-lived assets to be held are reviewed for events or changes in circumstances that indicate that their carrying value may not be recoverable. The Company periodically reviews the carrying value of long-lived assets to determine whether or not an impairment to such value has occurred by assessing their net realizable values based on estimated undiscounted cash flows over their remaining useful lives. Based on its most recent analysis, the Company believes that no impairment exists at December 31, 1998. Recent Accounting Pronouncements: In June 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which is effective for fiscal year 2000, but earlier adoption is permitted. SFAS 133 will require the Company to record all derivatives on the balance sheet at fair value. For derivatives that are hedges, changes in the fair value of derivatives will be offset by the changes in the fair value of the hedged assets, liabilities or firm commitments. The Company believes the impact of adopting this standard will not be material to its results of operations or equity. Stock Split: In June 1998, the Company effected a two-for-one stock split of its common stock. All references in the consolidated financial statements and notes thereto to number of shares, number of stock options and per share amounts have been restated to reflect the split. Reclassifications: Certain reclassifications have been made to prior-years' balances to conform to the current year's presentation. 33 Note 2. Acquisitions Acquisition of Saros: Corporation In March 1996, the Company acquired Saros by issuing approximately 1.9 million shares of FileNET common stock and approximately 337,000 options to purchase FileNET common stock in exchange for all outstanding Saros stock and options. The transaction was accounted for as a pooling-of-interests for financial reporting purposes. Fees and expenses aggregating $4.2 million were expensed in the first quarter of 1996. Subsequent to December 31, 1998, the former shareholders have filed a demand for mandatory arbitration to release approximately 0.2 million shares which were held in escrow pursuant to the Agreement and Plan of Merger and for damages. The Company believes that it has meritorious reasons for not releasing the shares and other defenses to the claims; however, the ultimate outcome or any resulting potential loss cannot be presently determined. Acquisition of International Financial Systems Ltd.: In January 1996, the Company purchased for cash all of the outstanding shares of IFSL, the developer of a computer output to laser disk (COLD) software product for archiving documents. The acquisition was accounted for as a purchase for financial reporting purposes. The purchase price was allocated to net assets of $1.7 million and purchased in-process research and development costs of $10.0 million. The purchased in-process research and development costs were written off at the time of acquisition. Note 3. Restructuring and Other Costs The $2.0 million in restructuring and other costs in 1998 represents the costs of a reduction in headcount related to a restructuring of the Company's sales and marketing organization, as well as costs of consolidating facilities. The restructuring and other costs are comprised of approximately $1.1 million for severance payments for 54 employees, $0.7 million for facility closing costs and $0.2 million of other charges. The $6.0 million in restructuring and other charges in 1997 represents the costs of consolidating the Watermark business unit's Burlington, Massachusetts engineering and marketing functions with those at FileNET's Costa Mesa, California location, as well as a reduction in headcount in certain other areas of the Company. The restructuring and other charges include approximately $2.2 million for severance payments for 111 employees, $2.2 million for the write-off of assets impaired by the decision to restructure, $0.4 million for facility closing costs, $0.4 million for equipment lease cancellations, $0.3 million for cancellation of third party development contracts, $0.2 million related to the withdrawal of certain products from the market and $0.3 million of other charges. The $16.0 million merger, restructuring and write-off of purchase in-process research and development costs in 1996 consisted of $10.0 million for the write-off of purchased in-process research and development costs related to the acquisition of International Financial Systems Ltd. (IFSL), $4.2 million in merger costs related to the Saros acquisition, and $1.8 million in restructuring costs related to the Saros and Watermark acquisitions. The restructuring charges represented the costs of consolidating the various companies' sales and administrative functions and include $1.4 million for severance payments for 30 employees and $0.4 million for the write-off of certain contractual obligations and other costs. At December 31, 1998, accrued restructuring and other charges of $1.7 million are included in other accrued liabilities. The Company anticipates that the remaining restructuring costs will be paid during 1999. 34 Note 4. Earnings (Loss) Per Share The following table is a reconciliation of the earnings and share amounts used in the calculation of basic earnings (loss) per share and diluted earnings (loss) per share. Such calculations include the effect of the conversion of Saros' convertible preferred stock into FileNET common stock, which occurred upon completion of the related acquisition (see Notes 2 and 9): (dollars in thousands, except per share amounts) Net Income Per Share (Loss) Shares Amount Year ended December 31, 1996 Basic (loss) per share $ (2,644) 30,014 $ (0.09) Effect of dilutive stock options 0 0 -------------------------------------------- Diluted (loss) per share $ (2,644) 30,014 $ (0.09) ============================================ Year ended December 31, 1997 Basic (loss) per share $ (5,526) 30,310 $ (0.18) Effect of dilutive stock options 0 0 -------------------------------------------- Diluted (loss) per share $ (5,526) 30,310 $ (0.18) ============================================ Year ended December 31, 1998 Basic earnings per share $ 956 31,083 $ 0.03 Effect of dilutive stock options 2,284 0 -------------------------------------------- Diluted earnings per share $ 956 33,367 $ 0.03 ============================================ Options to purchase shares of common stock in 1997 and 1996 were outstanding during the year but were not included in the computation of diluted loss per share as their effect was antidilutive (see Note 9). Note 5. Other Comprehensive Operations Accumulated other comprehensive operations for each of the three years in the period ended December 31, 1998 is comprised of the following: (dollars in thousands) Foreign Accumulated Currency Unrealized Other Translation Holding Comprehensive Adjustment Gains (Losses) Operations Balance, January 1, 1996 $ 3 $ 39 $ 42 Current period changes (Net of tax of $1,114 and $(17) prospectively) 1,671 (26) 1,645 ---------------------------------------------- Balance, December 31, 1996 1,674 13 1,687 Current period changes (Net of tax of $(3,873) and $(16) prospectively) (5,809) (24) (5,833) ---------------------------------------------- Balance, December 31, 1997 (4,135) (11) (4,146) Current period changes (Net of tax of $970 and $21 prospectively) 1,455 32 1,487 ---------------------------------------------- Balance, December 31, 1998 $ (2,680) $ 21 $ (2,659) ============================================== 35 Note 6. Inventories Inventories, net of reserve for slow moving and obsolete inventory, consisted of the following at December 31: (dollars in thousands) 1998 1997 Raw materials $ 1,676 $ 1,831 Work-in-process 580 950 Finished goods 163 760 ---------- ----------- Inventories, net $ 2,419 $ 3,541 ========== =========== Note 7. Property and Leases Property consisted of the following at December 31: (dollars in thousands) 1998 1997 Machinery, equipment and software $ 95,793 $ 74,981 Furniture and fixtures 12,376 8,808 Leasehold improvements 11,796 5,238 ----------- ------------ 119,965 89,027 Less accumulated depreciation and amortization (75,788) (61,440) ------------ ------------ Property, net $ 44,177 $ 27,587 ============ ============ The Company leases its corporate offices, sales offices, manufacturing facilities, and other equipment under noncancelable operating leases, some of which have renewal options and generally provide for escalation of the annual rental amount. Expenses related to operating leases were $11.3 million, $10.8 million, and $9.6 million for the years ended December 31, 1998, 1997 and 1996, respectively. The following table summarizes future minimum lease payments required under operating leases: (dollars in thousands) 1999 $ 13,245 2000 10,601 2001 8,992 2002 7,613 2003 5,314 Thereafter 6,461 ----------- $ 52,226 =========== Note 8. Borrowing Arrangements The Company has a $20 million commercial line of credit that expires in May 1999. Borrowings under the arrangement are unsecured and bear interest at the bank's prime rate. The Company is restricted from paying dividends during the term of the arrangement and, under the arrangement, must comply with certain covenants, including quarterly and annual profitability covenants. The Company was in compliance with such covenants as of December 31, 1998 after consideration of waivers received related to the purchase of capital assets and 36 consecutive quarterly losses. There were no borrowings outstanding at December 31, 1998 and 1997. The Company expects that it will be able to renew its line of credit with comparable terms. Interest expense was $119,000, $263,000 and $443,000 for the years ended December 31, 1998, 1997 and 1996, respectively. Note 9. Stockholder' Equity Shareholder Rights Plan: In October 1988, FileNET declared a dividend of one common stock purchase right for each outstanding share of common stock. As amended in July and November of 1998, a right may be exercised under certain circumstances to purchase one share of common stock at an exercise price of $87.50, subject to certain antidilution adjustments. The rights become exercisable if and when a person (or group of affiliated or associated persons) acquires 15% or more of FileNET's outstanding common stock, or announces an offer that would result in such person acquiring 15% or more of FileNET's common stock. After the rights become exercisable, each right will entitle its holder to buy a number of shares of FileNET's common stock having a market value of twice the exercise price of the rights. After the rights become exercisable, if FileNET is a party to certain merger or business combination transactions or transfers 50% or more of its assets or earnings power (as defined), each right will entitle its holder to buy a number of shares of common stock of the acquiring or surviving entity having a market value of twice the exercise price of the right. The rights expire November 17, 2008 and may be redeemed by FileNET at one cent per right at any time up to ten days after a person has announced that they have acquired 15% or more of FileNET's common stock. Treasury Stock: In 1997, the Board of Directors authorized, subject to certain business and market conditions, the purchase of up to $10 million of the Company's outstanding common stock. During the year ended December 31, 1997, the number of shares purchased under this authorization was 420,000 shares at an aggregate cost of $5.6 million. During the first quarter of 1998, the Company repurchased 278,000 shares of its common stock at an aggregate cost of $4.4 million, thereby completing the stock repurchase program. In 1996, the Board of Directors authorized, subject to certain business and market conditions, the purchase of up to 400,000 shares of the Company's common stock. The purchases under this authorization were completed during 1996 at an aggregate cost of $4.6 million. Employee Stock Purchase Plans: In May 1998, FileNET adopted the 1998 Employee Stock Purchase Plan and the International Employee Stock Purchase Plan (the Purchase Plans). A total of 300,000 shares were authorized to be added to the remaining share reserve under the predecessor 1988 Employee Qualified Stock Purchase Plan so that the total share reserve for the Purchase Plans would be no more than 400,000 shares. Under the terms of the Purchase Plans, common stock may be offered in successive six-month offering periods to eligible employees of the Company at 85% of the market price of the common stock at the beginning or end of the offering period, whichever is lower. The Purchase Plans cover substantially all employees of the Company. Eligible employees may elect to have a portion of their salary withheld for the purpose of making purchases under the Purchase Plans. Each participant is limited in any plan year to the acquisition of that number of shares that have an aggregate fair market value of not more than $25,000. There are no charges or credits to income in connection with the Purchase Plans. At December 31, 1998, $1,394,000 had been withheld from employees' salaries pursuant to the Purchase Plans for the current offering period, which expires on April 30, 1999. At December 31, 1998, approximately 392,278 shares remained available for future issuance. Stock Option Plans: In April 1986, the Company adopted the 1986 Stock Option Plan (the 1986 Plan). Under the amended terms of the 1986 Plan, options to purchase 6,500,000 shares of the Company's common stock were reserved for issuance to employees, officers and directors. Options to purchase 463,422 and 1,082,830 common shares were exercisable under the 1986 Plan at December 31, 1998 and 1997, respectively. In May 1995, the 1986 Plan was terminated and the remaining reserve of 140,098 shares was transferred into the 1995 Stock Option Plan. No common shares remain available for future grants under the 1986 Plan. Options granted were either incentive stock options or nonqualified stock options. Options granted become exercisable in 20% annual installments beginning one year after the date of grant, as determined by the Board of Directors, and expire no later than ten years plus one day from the date of grant. The exercise price of 37 the incentive stock options and nonqualified options were not to be less than 100% and 85%, respectively, of the fair market value of the Company's common stock at the date of grant. In May 1995, the Company adopted the 1995 Stock Option Plan (the 1995 Plan). Under the amended terms of the 1995 Plan, options to purchase 4,400,000 shares of the Company's common stock were reserved for issuance to employees, officers and directors. This reserve was added to the 140,098 shares of common stock transferred from the 1986 Plan. Outstanding options under the 1986 Plan will continue to be governed by the provisions of the agreements evidencing those grants. To the extent any of those outstanding options terminate or expire prior to exercise, the shares subject to those unexercised options will be available for subsequent option grant pursuant to the provisions of the 1995 Plan. Through December 31, 1998, 1,942,152 options of the 1986 Plan had been terminated and were made available under the 1995 Plan. Options granted under the 1995 Plan's Discretionary Option Grant Program for employees and the Automatic Option Grant Program for directors have an exercise price per share of 100% of the fair market value per share on the grant date and become exercisable in 25% annual installments beginning one year from the date of grant. As of December 31, 1998, 1,160,997 options were exercisable under the 1995 Plan. Prior to their merger into FileNET, Saros and Watermark had adopted stock option plans. These plans were assumed by the Company and outstanding options were converted into options to purchase an aggregate of 975,976 shares of FileNET common stock. Outstanding options under the plans will continue to be governed by the provisions of the agreements evidencing those grants. To the extent any of those outstanding options terminate or expire prior to exercise, the shares subject to those unexercised options will not be available for subsequent option grant. At December 31, 1998, a total of 50,400 options were outstanding and 41,312 were exercisable under these plans. In December 1989, the Company adopted the 1989 Stock Option Plan for Non-Employee Directors (the Directors' Plan). Under the terms of the Directors' Plan, as amended, each FileNET director who was not an employee was automatically granted an initial option to purchase 10,000 shares of FileNET's common stock at its fair market value on the date of grant and was granted an additional option to purchase 3,500 shares every year following the initial grant, provided such person continued to be a director at such time. Options granted under the plan vested at the rate of 20% per year from the grant date. Options to purchase an aggregate of 140,000 shares at prices ranging from $5.75 to $16.35 per share were granted from December 18, 1989 to May 24, 1995. At December 31, 1998, options to purchase 23,600 shares of common stock were exercisable. This plan was terminated in May 1995 with respect to future option grants. Future grants to non-employee directors are to be granted under the provisions of the 1995 Plan. In August 1997, the Company registered a Non-Statutory Stock Option Grant of 600,000 shares, dated May 22, 1997, to the Company's current President and Chief Executive Officer and a Non-Statutory Stock Option Grant of 160,000 shares, dated June 18, 1997, to the Company's Senior Vice President, Worldwide Sales. Such grants were in accordance with employment agreements entered into by the Company and the grantees. Options granted have an exercise price per share of 100% of the fair market value per share on the date of grant and become exercisable in 25% installments beginning one year from the date of grant and will expire no later than ten years from the date of grant. As of December 31, 1998, 40,000 options were exercisable related to these Non-Statutory Stock Option Grants and 150,000 had been exercised to date. On July 11, 1997, the Company approved a stock option cancellation/regrant program which allowed employees, but not non-employee directors, to exchange outstanding options with an exercise price greater than $9.00 for new options. Outstanding options to purchase 3,105,050 shares were canceled and regranted at $9.00 per share, the current market value on July 11, 1997. Under the stock option cancellation/regrant program, the regranted options are considered granted on July 11, 1997. The regranted options retained the exercisable status of the canceled options with the following exceptions. The exercise date for the regranted options related to canceled options that would have been exercisable as of July 11, 1997 was extended six months to January 11, 1998. For the 38 reporting officers as defined in Section 16 of the Securities Exchange Act of 1934, as amended (the Act), the exercise date of regranted options related to canceled options which would have been exercisable on July 11, 1997 was extended twelve months to July 11, 1998. The prospective exercise dates for the remaining regranted options related to canceled options that were not exercisable as of July 11, 1997, were extended six months from the original exercise date. On August 8, 1996, the Company approved a stock option cancellation/regrant program which allowed employees, excluding all directors and reporting officers as defined in Section 16 of the Act, to exchange options with an exercise price greater than $13.00 for new options. Outstanding options to purchase 1,061,142 shares were canceled and regranted at $13.00 per share, the current market value on August 8, 1996. Under the stock option cancellation/regrant program, the regranted options were considered granted on August 8, 1996 and are exercisable prospectively in accordance with the provisions of the agreements evidencing those grants. Information regarding the stock option plans, after giving retroactive effect to the conversions of the Watermark and Saros stock options on their original grant dates, is as follows: Number of Weighted Average Options Exercise Price ----------- ---------------- Balances, January 1, 1996 5,406,218 $ 9.84 Granted (weighted average fair value of $7.48) 2,724,836 $ 18.32 Exercised (796,082) $ 4.19 Canceled (1,733,206) $ 21.67 ----------- ------------- Balances, December 31, 1996 5,601,766 $ 11.11 Granted (weighted average fair value of $4.13) 5,602,098 $ 9.33 Exercised (483,408) $ 3.56 Canceled (3,930,238) $ 13.48 ----------- ------------- Balances December 31, 1997 6,790,218 $ 8.81 Granted (weighted average fair value of $7.41) 2,166,520 $ 13.43 Exercised (1,641,758) $ 7.51 Canceled (597,838) $ 10.86 ------------ ------------- Balances, December 31, 1998 6,717,142 $ 10.47 ============ ============= The following table summarizes information concerning currently outstanding and exercisable options: Options Outstanding Options Exercisable --------------------------------- ------------------------- Weighted Average Range of Number Remaining Weighted Number Weighted Exercise Price Outstanding Contractual Average Exercisable Average Exercise Price Life $ 0.71-$ 6.53 740,891 7.37 $ 5.42 299,109 $ 5.23 $ 6.81-$ 8.94 1,692,664 8.49 $ 7.33 253,184 $ 7.61 $ 9.00 2,216,027 8.52 $ 9.00 858,652 $ 9.00 $ 9.17-$16.35 1,493,399 8.75 $ 12.53 307,725 $ 12.39 $23.88-$29.00 574,161 9.35 $ 26.60 10,661 $ 26.73 --------- --------- $0.71-$29.00 6,717,142 8.51 $ 10.47 1,729,331 $ 8.86 ========= ========= 39 The Company accounts for its stock-based compensation plans in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations. No compensation expense has been recognized for its stock-based compensation plans. The following table summarizes the Company's net income (loss) and net income (loss) per share on a pro forma basis had compensation cost for the Company's stock-based compensation plans been determined based on the provisions of SFAS 123, "Accounting for Stock-Based Compensation": (dollars In thousands, except per share amounts) 1998 1997 1996 --------------------------------------------- Net income (loss)--as reported $ 956 $ (5,526) $ (2,644) Net income (loss)--proforma (6,915) (12,497) (7,320) Diluted earnings (loss) per share--as reported 0.03 (0.18) (0.09) Diluted earnings (loss) per share--proforma (0.21) (0.41) (0.24) The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 1998, 1997 and 1996; expected volatility of 75% for 1998 and 60% for 1997 and 1996; risk-free interest rates of 5.4% to 5.5% for 1998 and 5.3% to 5.6% for 1997 and 5.8% to 6.9% for 1996; and an expected life of 1 year from vest date. Pro forma compensation cost of shares issued under the Employee Qualified Stock Purchase Plans is measured based on the discount from market value. Note 10. Income Taxes The provision (benefit) for income taxes consists of the following: (dollars in thousands) - ------------------------ Years ended December 31, 1998 1997 1996 --------------------------------------------- Current: Federal $ (405) $ 785 $ 2,930 State 32 (40) 75 Foreign 198 841 2,241 Deferred: Federal (20) (1,963) (772) State 40 (1,168) (18) Foreign 546 (642) 0 --------- ------- --------- Total provision $ 391 (2,187) $ 4,456 ========= ======= ========= The valuation allowance increased by $9.9 million, $1.4 million, and $9,000 in the years ended December 31, 1998, 1997 and 1996, respectively. A reconciliation of the Company's effective tax rate (benefit) compared to the statutory Federal tax rate is as follows: Years ended December 31, 1998 1997 1996 ----------------------------- Income taxes (benefit) at statutory Federal rate 35% (35%) 35% State taxes (benefit), net of Federal benefit 5 (6) 4 Unbenefited/utilized domestic losses 153 0 42 Foreign tax rate differential/unbenefited losses (163) 11 (130) Non-deductible acquisition costs 0 0 291 Other (1) 2 4 ----- ------ ------ Total 29% (28%) 246% ===== ====== ====== 40 The Company provides deferred income taxes for temporary differences between assets and liabilities recognized for financial reporting and income tax purposes. The income tax effects of these temporary differences representing significant portions of the deferred taxes at December 31, 1998, and December 31, 1997 are as follows: (dollars in thousands) - ------------------------ December 31, 1998 1997 ---------------------------------- Deferred taxes: Foreign loss carryforwards $ 1,768 $ 2,788 Domestic loss carryforwards 22,540 11,928 Tax credit carryforwards 6,934 3,159 Accrued expenses 1,874 2,954 Sales returns and allowance reserves 982 1,111 Capitalized software (319) (272) Depreciable assets 1,070 857 Residual U.S. tax on foreign earnings (4,504) (4,027) Other (528) 1,963 ---------- ----------- Total 29,817 20,461 Valuation allowance (24,374) (14,452) ---------- ----------- Net deferred tax asset $ 5,443 $ 6,009 ========== =========== The Company has $66.3 million in domestic net operating loss carryforwards which can be utilized to reduce future taxable income. Any unutilized net operating loss carryforward will begin expiring in 2004. The Company has a $6.9 million tax credit carryforward which will expire beginning in 2002. Utilization of $14.9 million of the loss carryforward will be recorded to stockholders' equity when utilized. At December 31, 1998, the Company had Dutch, French and German subsidiary tax loss carryforwards relating to its foreign subsidiary operations of $0.6 million, $1.9 million and $2.5 million, respectively. The Dutch and German tax loss carryforwards have no expiration. French losses of $61,000 will expire in 2000. The Company has not provided any residual U.S. tax on approximately $16.4 million of a portion of the Company's foreign subsidiaries undistributed earnings as the Company intends to indefinitely reinvest such earnings. Note 11. Operating Segment and Geographic Information 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 Company's chief operating decision maker is its Chief Executive Officer. 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 Software, Hardware, Customer Support, and Professional Services. The Software operating segment develops and markets the Company's line of integrated document management software. The Hardware operating segment manufactures and markets the Company's line of OSAR libraries. The Customer Support segment provides after-sale support for both software and hardware products as well as providing software upgrades under the Company's upgrade assurance program. The Professional Services segment provides fee-based implementation and technical services related to the Company's products. The accounting policies of the Company's operating segments are the same as those described in Note 1--Summary of Significant Accounting Policies--except that the disaggregated financial results of the segments reflect allocation of certain functional expense categories consistent with its internal reporting. The Company evaluates performance based on stand-alone segment operating income. Because the Company does not evaluate performance based on return on assets at the operating segment level, certain Company assets are not tracked internally by segment. Therefore, segment asset information is not presented. 41 Operating segment data for each of the three years in the period ending December 31, 1998 was as follows:
(in thousands) Customer Professional Education - --------------- Software Hardware Support Services and Other Consolidated Year Ended December 31, 1998 Revenue $171,153 $ 23,579 $ 73,524 $ 26,383 $ 15,594 $310,233 Depreciation and amortization 9,061 652 3,906 1,047 694 15,360 Operating income (loss) before other income (17,023) 1,807 12,023 (649) 1,349 (2,493) Assets 206,822 Capital expenditures 19,383 1,118 8,341 2,510 1,122 32,474 Year Ended December 31, 1997 Revenue $132,723 $ 29,422 $ 54,417 $ 18,996 $ 15,867 $251,425 Depreciation and amortization 7,582 971 2,926 898 816 13,193 Operating income (loss) before other income (19,779) 107 7,035 22 1,742 (10,873) Assets 179,440 Capital expenditures 8,462 864 3,155 1,063 722 14,266 Year Ended December 31, 1996 Revenue $140,659 $ 46,136 $ 44,136 $ 20,317 $ 17,665 $268,913 Depreciation and amortization 7,939 1,194 2,791 509 703 13,136 Operating income (loss) before other income (7,917) (1,651) 5,335 (308) 3,515 (1,026) Assets 192,274 Capital expenditures 11,771 1,750 2,840 781 724 17,866
Revenue is attributed to geographic areas based on the location of the entity to which the products or services were sold. The operation in Ireland functions as a manufacturing and service center for non-United States customers. An allocation of its assets among the geographic segments is not prepared for management reporting. Information concerning principal geographic areas in which the Company operates was as follows:
(in thousands) - ----------------------- Year ended December 31, 1998 1997 1996 ------------------ ------------------ ------------------ Revenue Assets Revenue Assets Revenue Assets North America: United States $205,797 $142,471 $170,116 $123,681 $173,436 $128,375 Canada 6,669 1,869 8,027 2,263 3,889 2,491 ------------------- ------------------- ------------------- Total North America 212,466 144,340 178,143 125,944 177,325 130,866 Europe: France 7,516 5,562 6,961 2,481 5,616 3,049 Germany 30,675 14,450 21,665 9,100 35,431 10,991 United Kingdom 20,882 9,800 16,838 8,007 19,437 9,242 Ireland 0 23,551 0 29,411 0 32,349 Other Europe 19,373 4,172 9,358 961 10,507 1,736 ------------------- ------------------- ------------------- Total Europe 78,446 57,535 54,822 49,960 70,991 57,367 Asia Pacific 10,058 4,782 13,892 3,494 14,642 4,055 All other international 9,263 165 4,568 42 5,955 (14) ------------------- ------------------- ------------------- Totals $310,233 $206,822 $251,425 $179,440 $268,913 $192,274 =================== =================== ===================
Note 12. Contingencies In October 1994, Wang Laboratories, Inc. (Wang) filed a complaint in the United States District Court for the District of Massachusetts alleging that the Company is infringing five patents held by Wang (the FileNET Case). On June 23, 1995, Wang amended its complaint to include an additional related patent. On 42 July 2, 1996, Wang filed a complaint in the same court alleging that Watermark, formerly a wholly-owned subsidiary that was merged into the Company, is infringing three of the same patents asserted in the initial complaint (the Watermark Case). On October 9, 1996, Wang withdrew its claim in the FileNET Case that one of the patents it initially asserted is infringed by the Company's products that were commercialized before the initial complaint was filed. Wang reserved the right to assert that patent against the Company's products commercialized after that date in a separate lawsuit. In March 1997, Eastman Kodak Company (Kodak) purchased the Wang imaging business unit that has responsibility for this litigation. The patents in the suit have been transferred to a Kodak subsidiary, Kodak Limited of England, which, in turn, has exclusively licensed them to another Kodak subsidiary, Eastman Software, Inc. in the United States (Eastman). On July 30, 1997, the Court permitted Eastman and Kodak Limited of England to be substituted in the litigation in place of Wang. The Company has moved for summary judgement on noninfringement as to each of the five patents in the suit, and for summary judgment of invalidity as to one of the patents. Eastman moved for summary judgment as to the Company's unenforceability defense on one of the patents. In July 1998, the Magistrate Judge assigned to the case, heard oral arguments on the Company's motion for summary judgement that U.S. Patent 4,918,588 is not infringed and is invalid. The Magistrate Judge has not yet decided these motions. The Company believes that after he has ruled on these motions, he will hear oral arguments in the remaining motions in the sequence in which they were filed. A trial date has not been set. If it should be determined that the patents at issue in the litigation are valid and are infringed by any of the Company's products, including Watermark products, the Company will, depending on the product, redesign the infringing products or seek to obtain a license to market the products. There can be no assurance that the Company will be able to obtain such a license on acceptable terms. Based on the Company's analysis of these Eastman patents and their respective file histories, the Company believes that it has meritorious defenses to Eastman's claims; however, the ultimate outcome or any resulting potential loss cannot be determined at this time. On December 20, 1996, plaintiff Michael I. Goldman filed a class action complaint against the Company and certain of its officers and directors in the Superior Court of California, County of Orange (the Goldman State Action). The action was purportedly filed on behalf of a class of purchasers of the Company's common stock during the period October 19, 1995 through July 2, 1996. The plaintiff alleged that the Company and other defendants violated Cal. Corp. Code ss.ss. 25400 and 25500, Cal. Civ. Code ss.ss. 1709-1710 and Cal. Bus. & Prof. Code ss.ss. 17200 et seq. in connection with various public statements made by the Company and certain of its officers and directors during the putative class period. On September 30, 1998, the Court entered an order dismissing this action in its entirety without prejudice. On April 1, 1997, plaintiff Michael I. Goldman filed another class action complaint against the Company and certain of its officers and directors in the United States District Court for the Central District of California (the Goldman Federal Action). The action purportedly was filed on behalf of the same class of purchasers of the Company's common stock as the Goldman State Action. The allegations contained in the Goldman Federal Action were very similar to the allegations contained in the Goldman State Action, except that the Goldman Federal Action asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5. On September 23, 1998, the Court entered an order dismissing this action in its entirety without prejudice. On October 23, 1998, plaintiff Avram Gart filed a class action complaint against the Company and certain of its officers and directors in the Superior Court of California, County of Orange (the Gart State Action). The action was purportedly filed on behalf of a class of purchasers of the Company's common stock during the period January 13, 1998 through October 7, 1998. The plaintiff alleges that the Company and the other defendants violated Cal. Corp. Code ss.ss. 25400 and 25500 in connection with various public statements made by the Company and certain of its officers and directors during the putative class period. On November 5, 1998, the court entered an order dismissing this action in its entirety without prejudice. On October 27, 1998, plaintiff Thomas P. Nyquist filed a class action complaint against the Company and certain of its officers and directors in the United 43 States District Court for the Central District of California (the Nyquist Federal Action). The action was purportedly filed on behalf of a class of purchasers of the Company's common stock during the period April 16, 1998 through October 7, 1998. The plaintiff alleges claims under Sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5 in connection with various public statements made by the Company and certain of its officers and directors during the putative class period. The complaint seeks unspecified compensatory damages, interest, attorneys' fees, expert witness fees and costs. Plaintiff has filed a motion for the appointment of lead plaintiffs and consolidation of any future related actions. Defendants have not yet responded to the complaint. The Company believes that all of the allegations contained in the Nyquist Federal Action are without merit and intends to defend the actions vigorously. The Company, in the normal course of business, is subject to various other legal matters. While the results of litigation and claims cannot be predicted with certainty, the Company believes that the final outcome of these other matters will not have a materially adverse effect on the Company's consolidated results of operations or financial condition. Note 13. Related Party Transactions The Company entered into a two-year agreement on May 20, 1997, to employ its current President and Chief Executive Officer. Under the terms of the agreement, the Company agreed to reimburse the officer for legal costs in defending a lawsuit from the officer's former employer. The case was settled and the cost to the Company was charged to compensation expense in 1997. Note 14. Other Financial Instruments The following table summarizes the notional amounts, which are equivalent to the fair market value, of the Company's foreign currency agreements entered into on December 31, 1998 and 1997, all maturing in three months:
At December 31, 1998 1997 --------------------------------- ---------------------------------- Notional Amount Notional Amount Notional Amount Notional Amount (in thousands) Purchased Sold Purchased Sold --------------------------------- ---------------------------------- European currencies $ 11,238 $ (8,488) $ 31,261 $ 35,775 Australian dollar (2,938) (4,299) Asian currencies 929 (698) Canadian dollar (522) (1,014) ---------------------------------- ---------------------------------- Total $ 12,167 $ (11,948) $ 31,261 $ 29,764 ================================== ==================================
44 Note 15. Quarterly Financial Information (Unaudited)
(Dollars in thousands, except per share amounts) - -------------------------------------------------- First Second Third Fourth Fiscal Quarter Quarter Quarter Quarter Year Year ended December 31, 1998 Revenue $ 73,609 $ 80,372 $ 71,152 $ 85,100 $ 310,233 Income (loss) before income taxes 3,555 6,528 (8,143) (593)* 1,347 Net income (loss) 2,524 4,635 (5,779) (424) 956 Basic earnings (loss) per share 0.08 0.15 (0.18) (0.01) 0.03 Diluted earnings (loss) per share 0.08 0.14 (0.18) (0.01) 0.03 Year ended December 31, 1997 Revenue $ 47,562 $ 62,450 $ 65,011 $ 76,402 $ 251,425 Income (loss) before income taxes (13,082) (5,353)* 2,627 8,095 (7,713) Net income (loss) (9,420) (3,854) 1,891 5,857 (5,526) Basic earnings (loss) per share (0.31) (0.13) 0.06 0.19 (0.18) Diluted earnings (loss) per share (0.31) (0.13) 0.06 0.18 (0.18) *Includes pre-tax charges of $2.0 million in the fourth quarter of 1998 and $6.0 million in the second quarter of 1997 for restructuring and other costs.
45 To the Stockholders and the Board of Directors FileNET Corporation We have audited the accompanying consolidated balance sheets of FileNET Corporation and its subsidiaries (the Company) as of December 31, 1998 and 1997, and the related consolidated statements of operations, comprehensive operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurances about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of FileNET Corporation and its subsidiaries as of December 31, 1998 and 1997 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. /s/ Deloitte & Touche LLP January 26, 1999 (March 10, 1999 as to Note 8) Costa Mesa, California 46 EX-13.4 5 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Note 13. Related Party Transactions The Company entered into a two-year agreement on May 20, 1997, to employ its current President and Chief Executive Officer. Under the terms of the agreement, the Company agreed to reimburse the officer for legal costs in defending a lawsuit from the officer's former employer. The case was settled and the cost to the Company was charged to compensation expense in 1997. EX-21.1 6 LIST OF SUBSIDIARIES OF REGISTRANT FileNET Asia Pacific, Pte. Ltd. (Singapore) FileNET BV (The Netherlands) FileNET Canada, Inc. (Canada) FileNET Company Limited (Ireland) FileNET France (France) FileNET Corporation Europe, EURL (France) FileNET Corporation, Pty. Ltd (Australia) FileNET GmbH (Germany) FileNET Hong Kong Limited (Hong Kong) FileNET Iberia, S.L. (Spain) FileNET International Corporation (U.S. Virgin Isalnds) FileNET Limited (England) FileNET Italy, S.R.L. (Italy) FileNET Sweden AB (Sweden) Hankook FileNET Corporation (Korea) Nihon FileNET K.K. (Japan) Panagon Document Management Software Handels GmbH (Austria) EX-23.1 7 AUDITORS' CONSENT INDEPENDENT AUDITOR'S CONSENT We consent to incorporation by reference in Registration Statements No. 33-90454, 33-96076, 33-80899, 333-02194, 333-09075, 333-34031 and 333-66997 of FileNET Corporation on Form S-8 of our report dated January 26, 1999 (March 10, 1999 as to Note 8) appearing in and incorporated by reference in the Annual Report on Form 10-K of FileNET Corporation for the fiscal year ended December 31, 1998. /s/ Deloitte & Touche LLP Costa Mesa, California March 30, 1999 EX-27 8 FINANCIAL DATA SCHEDULE
5 1000 12-MOS Dec-31-1998 Dec-31-1998 55,820 15,484 61,636 0 2,419 144,224 119,965 (75,788) 206,822 76,502 0 0 0 129,675 645 206,822 194,732 310,233 29,995 103,781 208,945 0 0 1,347 391 956 0 0 0 956 .03 .03
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