-----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, SJ5qKvme6GV4Pdq1VmPIRrkbaG5SJbRU5z42SX7LEi6M81lBO9y4WCrY6oJB1YAt Ih+nV/VrNRs7rS6omdhkzQ== 0000912057-99-010174.txt : 19991222 0000912057-99-010174.hdr.sgml : 19991222 ACCESSION NUMBER: 0000912057-99-010174 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19991130 FILED AS OF DATE: 19991221 FILER: COMPANY DATA: COMPANY CONFORMED NAME: INTEGRATED SYSTEMS INC CENTRAL INDEX KEY: 0000775163 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 942658153 STATE OF INCORPORATION: CA FISCAL YEAR END: 0228 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-18268 FILM NUMBER: 99778360 BUSINESS ADDRESS: STREET 1: 201 MOFFETT PARK DIRVE CITY: SUNNYVALE STATE: CA ZIP: 94089 BUSINESS PHONE: 4085421500 MAIL ADDRESS: STREET 1: 201 MOFFETT PARK DRIVE CITY: SUNNYVALE STATE: CA ZIP: 94089 10-Q 1 FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-Q (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934. For the quarterly period ended November 30, 1999 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: 0-18268 ------------------------------ INTEGRATED SYSTEMS, INC. (Exact name of Registrant as specified in its charter) CALIFORNIA 94-2658153 (State or other jurisdiction (I.R.S. employer of incorporation or organization) identification no.) ------------------------------ 201 MOFFETT PARK DRIVE SUNNYVALE, CA 94089 (408) 542-1500 (Address, including zip code, of Registrant's principal executive offices and telephone number, including area code) ------------------------------ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes __X___ No _____ The number of shares outstanding of the Registrant's Common Stock on December 14, 1999 was 24,246,248 shares. Page 1 of 28 pages. - 1 - INTEGRATED SYSTEMS, INC. FORM 10-Q QUARTER ENDED NOVEMBER 30, 1999 INDEX PAGE PART I - FINANCIAL INFORMATION Item 1. Financial Statements 3 Condensed Consolidated Balance Sheets as of November 30, 1999 and February 28, 1999 4 Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the Three Months and Nine Months Ended November 30, 1999 and 1998 5 Condensed Consolidated Statements of Cash Flows for the Nine Months Ended November 30, 1999 and 1998 6 Notes to Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3. Qualitative and Quantitative Disclosures about Market Risks 26 PART II - OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 27 SIGNATURES 28 ----------------------------------------------------------------------- This Form 10-Q contains forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995), including but not limited to statements regarding ISI's expectations, hopes or intentions regarding the future. Actual results and trends could differ materially from those discussed in the forward-looking statements. In addition, past trends should not be perceived as indicators of future performance. Among the factors that could cause actual results to differ from the forward-looking statements are those detailed elsewhere in this Report in Management's Discussion and Analysis of Financial Condition and Results of Operations and in ISI's Securities and Exchange Commission reports. ----------------------------------------------------------------------- - 2 - PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS The condensed consolidated interim financial statements included herein have been prepared by Integrated Systems, Inc. ("ISI"), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Although certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, ISI believes that the disclosures made are adequate to make the information presented not misleading. It is suggested that the condensed consolidated interim financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in ISI's Annual Report on Form 10-K for the year ended February 28, 1999. The February 28, 1999 condensed consolidated balance sheet data was derived from the audited financial statements, but does not include all disclosures required by generally accepted accounting principles. The accompanying condensed consolidated interim financial statements have been prepared in all material respects in conformity with the standards of accounting measurements set forth in Accounting Principles Board Opinion No. 28 and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary to summarize fairly the financial position, results of operations, and cash flows for the periods indicated. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full year. - 3 - INTEGRATED SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands)
NOVEMBER 30, FEBRUARY 28, 1999 1999 ---------------- ---------------- (unaudited) ASSETS Current assets: Cash and cash equivalents $ 18,578 $ 19,079 Marketable securities 1,460 9,554 Accounts receivable, net 39,416 28,431 Deferred income taxes 3,014 2,360 Prepaid expenses and other 6,884 5,255 ---------------- --------------- Total current assets 69,352 64,679 Marketable securities 24,743 49,698 Property and equipment, net 21,008 18,633 Intangible assets, net 35,808 3,503 Deferred income taxes 5,259 5,322 Other assets 2,216 1,200 ---------------- --------------- Total assets $ 158,386 $ 143,035 ================ =============== LIABILITIES Current liabilities: Accounts payable $ 6,119 $ 4,761 Accrued payroll and related expenses 8,578 6,250 Other accrued liabilities 8,162 10,668 Income taxes payable 2,950 2,562 Deferred revenue 21,956 18,003 ---------------- --------------- Total current liabilities 47,765 42,244 Long-term debt 598 -- ---------------- --------------- Total liabilities 48,363 42,244 ---------------- --------------- SHAREHOLDERS' EQUITY Common Stock, no par value, 50,000 shares authorized: 24,216 and 22,686 shares issued and outstanding at November 30, 1999 and February 28, 1999 respectively 74,367 59,848 Accumulated other comprehensive (loss), net (1,569) (759) Retained earnings 37,225 41,702 ---------------- --------------- Total shareholders' equity 110,023 100,791 ---------------- --------------- Total liabilities and shareholders' equity $ 158,386 $ 143,035 ================ ===============
The accompanying notes are an integral part of these condensed consolidated financial statements. - 4 - INTEGRATED SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) (in thousands, except per share data) (unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED NOVEMBER 30, NOVEMBER 30, ------------------- ------------------- 1999 1998 1999 1998 -------- -------- -------- -------- Revenue: Product $ 28,094 $ 20,604 $ 67,808 $ 55,488 Services 15,538 14,358 43,464 42,961 ---------- ---------- --------- --------- Total revenue 43,632 34,962 111,272 98,449 ---------- ---------- --------- --------- Cost and expenses Cost of product revenue 4,061 4,441 12,034 10,449 Cost of services revenue 5,967 6,316 17,848 18,919 Marketing and sales 17,094 12,142 45,508 35,505 Research and development 7,204 4,399 18,650 14,498 General and administrative 3,859 3,129 11,070 9,516 Amortization of intangibles 2,320 108 3,628 416 Acquisition-related and other expenses 1,497 1,117 8,586 2,177 ---------- ---------- --------- --------- Total costs and expenses 42,002 31,652 117,324 91,480 ---------- ---------- --------- --------- Income (loss) from operations 1,630 3,310 (6,052) 6,969 Interest and other income 485 1,354 2,582 3,575 ---------- ---------- --------- --------- Income (loss) before income taxes 2,115 4,664 (3,470) 10,544 Provision (benefit) for income taxes (592) 1,492 1,007 974 ---------- ---------- --------- --------- Net income (loss) $ 2,707 $ 3,172 $ (4,477) $ 9,570 ========== ========== ========= ========= Other comprehensive income (loss), net of tax: Foreign currency translation adjustments (64) 364 (221) 346 ---------- ---------- --------- --------- Unrealized gain (loss) on investments 59 135 (589) 431 ---------- ---------- --------- --------- Other comprehensive income (loss) (5) 499 (810) 777 ---------- ---------- --------- --------- Total comprehensive income (loss) $ 2,702 $ 3,671 $ (5,287) $ 10,347 ========== ========== ========= ========= Earnings (loss) per share - basic $ 0.11 $ 0.14 $ (0.19) $ 0.41 ========== ========== ========= ========= Earnings (loss) per share - diluted $ 0.11 $ 0.14 $ (0.19) $ 0.40 ========== ========== ========= ========= Shares used in per share calculations - basic 23,926 22,969 23,322 23,299 ========== ========== ========= ========= Shares used in per share calculations - diluted 24,933 23,241 23,322 23,984 ========== ========== ========= =========
The accompanying notes are an integral part of these condensed consolidated financial statements. - 5 - INTEGRATED SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)
NINE MONTHS ENDED NOVEMBER 30, 1999 1998 -------- -------- Cash flows from operating activities: Net income (loss) $ (4,477) $ 9,570 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization of capitalized software 6,268 3,893 Amortization of other intangibles 3,628 416 In-process research and development written off 6,300 -- Deferred income taxes (1,610) (1,924) Provision for doubtful accounts receivable (45) (25) Changes in assets and liabilities: Accounts receivable (8,780) 3,760 Prepaid expenses and other (1,190) (108) Accounts payable, accrued payroll and other accrued liabilities (3,261) 1,061 Income taxes payable 388 271 Deferred revenue 3,053 372 Other assets and liabilities (1,249) 241 ---------- ---------- Net cash provided by (used in) operating activities (975) 17,527 ---------- ---------- Cash flows from investing activities: Sales and maturities (purchases) of marketable securities, net 32,067 (5,493) Additions to property and equipment (5,653) (3,104) Capitalized software development costs (1,550) (1,405) Acquisitions, net of cash acquired (24,872) -- ---------- ---------- Net cash (used in) investing activities (8) (10,002) ---------- ---------- Cash flows from financing activities: Repurchase of common stock (6,365) (8,739) Proceeds from exercise of common stock options and purchases under the Employee Stock Purchase Plan 6,943 3,108 ---------- ---------- Net cash provided by (used in) financing activities 578 (5,631) ---------- ---------- Effect of exchange rate fluctuations on cash and cash equivalents (96) 352 Net increase (decrease) in cash and cash equivalents (501) 2,246 Cash and cash equivalents at beginning of period 19,079 14,454 ---------- ---------- Cash and cash equivalents at end of period $ 18,578 $ 16,700 ========== ========== Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $ 187 $ 2,340 Supplemental schedule of noncash investing activities: Unrealized gain (loss) on marketable securities, before tax effect $ (982) $ 718 Issuance of common stock in acquisition $ 13,941 $ --
The accompanying notes are an integral part of these condensed consolidated financial statements. - 6 - INTEGRATED SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Information for the three months and nine months ended November 30, 1999 and 1998 is unaudited) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The condensed consolidated financial statements include the accounts of Integrated Systems, Inc. and its wholly owned subsidiaries, after elimination of all significant intercompany accounts and transactions, and should be read in conjunction with ISI's Annual Report on Form 10-K for the year ended February 28, 1999. These condensed consolidated financial statements do not include all disclosures normally required by generally accepted accounting principles. Certain amounts in the fiscal year 1999 condensed consolidated financial statements have been reclassified to conform to the fiscal year 2000 presentation. These reclassifications had no effect on previously reported results of operations or shareholders' equity. 2. WIND RIVER SYSTEMS, INC. MERGER On October 21, 1999, Integrated Systems, Inc. ("ISI"), and Wind River Systems, Inc. ("Wind"), and University Acquisition Corp., a wholly-owned subsidiary of Wind, entered into a definitive Agreement and Plan of Reorganization ("Merger Agreement"). Wind develops, markets, supports and provides consulting services for advanced software operating systems and development tools for customers to create software applications for embedded computers. Pursuant to the Merger Agreement, ISI will become a wholly-owned subsidiary of Wind. At the effective time of the Merger, all outstanding shares of ISI common stock will be exchanged for shares of Wind common stock. Each share of ISI common stock will automatically be converted into 0.92 of a share of Wind common stock. In addition, Wind will assume all outstanding options to purchase ISI common stock on the terms provided in the Merger Agreement. The transaction is intended to be accounted for as a pooling of interests and to qualify as a tax-free reorganization. In connection with the execution of the Merger Agreement, ISI and Wind entered into a Stock Option Agreement ("Option Agreement"), pursuant to which ISI granted to Wind an irrevocable option to purchase newly issued shares of ISI common stock representing up to 10% of ISI common stock outstanding as of October 21, 1999. The purchase price per option share is $18.46. The Merger, which is expected to close in the fourth quarter of fiscal year 2000, is subject to approval of ISI shareholders and Wind stockholders. The directors of ISI and eight of the executive officers of ISI have agreed to vote their ISI shares in favor of the Merger at the ISI shareholders meeting called for that purpose. On December 3, 1999, the waiting period under Hart-Scott-Rodino Antitrust Improvements Act expired. ISI may be required to pay a substantial termination fee if the Merger Agreement is terminated for certain specific reasons. ISI has filed the Merger Agreement with the Securities and Exchange Commission on November 5, 1999 as an exhibit to its report on Form 8-K. 3. ACQUISITION OF SOFTWARE DEVELOPMENT SYSTEMS, INC. On July 21, 1999, Integrated Systems, Inc. acquired Software Development Systems, Inc., ("SDS") a privately held Illinois corporation for approximately $24.3 million in cash and 1,430,037 in ISI's common stock. This transaction was accounted for using the purchase method of accounting. SDS is engaged in the business of developing, marketing, and supporting embedded software tools. ISI's operating results for the three and nine months ended November 30, 1999 include the results of SDS from the date of acquisition. SDS results are included in the Software reportable segment. ISI's consolidated balance sheet, as of November 30, 1999, reflects a preliminary allocation of the purchase price of SDS, which resulted in a change in accounts receivable, deferred tax assets, prepaid and other current assets, fixed assets, goodwill and other intangible assets, current and long-term - 7 - liabilities. Other intangible assets includes completed technology, OEM relationships, non-compete agreement, trade name and workforce. ISI recorded an expense for the in-process research and development, which was charged against earnings for the second quarter of fiscal year 2000. - 8 - The purchase price of $39.9 million is allocated as follows (in thousands):
Completed technology $ 6,500 In-process research and development 6,300 OEM relationships 2,800 Non-compete agreement 1,000 Trade name 1,800 Workforce 2,900 Deferred tax liability (4,800) Assumed net assets 2,617 Goodwill 20,780 ------------ Total $ 39,897
The following unaudited pro forma summary presents the consolidated results of operations as if the acquisition had occurred at the beginning of each of the periods presented and does not purport to be indicative of the results that would have been achieved had the acquisition been made as of those dates nor of the results which may occur in the future.
Three Months Ended Nine Months Ended November 30, November 30, ---------------------- ---------------------- 1999 1998 1999 1998 ---------- --------- --------- ---------- (in thousands, except per share data) Net revenue $ 43,632 $ 38,299 $ 116,091 $ 107,137 ========== ========== ========= ========== Net income (loss) $ 2,707 $ 498 $ (5,448) $ 431 ========== ========== ========= ========== Earnings (loss) per share - basic & diluted $ 0.11 $ 0.02 $ (0.23) $ 0.02 ========== ========== ========= ==========
4. EARNINGS PER SHARE Earnings per share is computed in accordance with the provisions of Financial Accounting Standards Board Statement of Financial Accounting Standards No. 128 ("SFAS 128"), "Earnings Per Share." Basic earnings per share is computed using the weighted average numbers of common shares outstanding during the period. Diluted earnings per share is computed using the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares result from the assumed exercise of outstanding stock options that have a dilutive effect when applying the treasury stock method. - 9 - The following table sets forth the calculations of earnings per share:
Three Months Ended Nine Months Ended November 30, November 30, ---------------------- ---------------------- 1999 1998 1999 1998 ---------- --------- --------- ---------- (in thousands, except per share data) Basic Net income (loss) $ 2,707 $ 3,172 $ (4,477) $ 9,570 ========== ========= ========= ========== Number of shares: Weighted average number of common shares outstanding 23,926 22,969 23,322 23,299 ========== ========= ========= ========== Earning (loss) per share - basic $ 0.11 $ 0.14 $ (0.19) $ 0.41 ========== ========= ========= ========== Diluted Net income (loss) $ 2,707 $ 3,172 $ (4,477) $ 9,570 ========== ========= ========= ========== Number of shares: Weighted average number of common shares outstanding 23,926 22,969 23,322 23,299 Diluted effect of stock options, net 1,007 272 -- 685 ---------- --------- --------- ---------- Weighted average number of common shares and common equivalent shares outstanding 24,933 23,241 23,322 23,984 ========== ========= ========= ========== Earning (loss) per share - diluted $ 0.11 $ 0.14 $ (0.19) $ 0.40 ========== ========= ========= ==========
Certain options to purchase common stock were not included in the above calculation as their exercise prices were greater than the average market price of common stock in each of the respective periods and their inclusion would be anti-dilutive. The number of such options excluded was approximately 1,015,000 and 2,200,000 for the three months ended November 30, 1999 and 1998, respectively, and 757,000 and 900,000 for the nine months ended November 30, 1999 and 1998, respectively. For periods where a net loss is shown, potentially dilutive securities are excluded from the calculation of loss per common share as their inclusion would have an anti-dilutive effect. These securities, stated in equivalent shares of common stock, consisted of 679,000 options to purchase common stock for the nine months ended November 30, 1999. 5. COMPREHENSIVE INCOME (LOSS) The accumulated balances of other comprehensive income (loss), net of taxes, as of November 30, 1999 was as follows (in thousands):
NOVEMBER 30, 1999 --------------------------------- FOREIGN CURRENCY UNREALIZED TRANSLATION GAINS/ TOTAL ADJUSTMENTS LOSSES OTHER ----------- ---------- ----- Beginning balance $ (967) $ 208 $ (759) Current-period change (221) (589) (810) ----------- ----------- --------- Ending balance $ (1,188) $ (381) $ (1,569)
6. DERIVATIVE FINANCIAL INSTRUMENTS ISI enters into foreign currency forward exchange contracts to hedge the value of recorded foreign currency denominated transactions against fluctuations in exchange rates. The purpose of ISI's foreign exchange exposure management policy and practices is to attempt to minimize the impact of exchange rate fluctuations on the value of the foreign currency denominated assets and liabilities being hedged. All foreign currency forward exchange - 10 - contracts entered into by ISI have maturities of 360 days or less. ISI's total contracted foreign currency forward exchange contracts as at November 30, 1999 and February 28, 1999 were as follows (in thousands):
NOVEMBER 30, 1999 FEBRUARY 28, 1999 ---------------------- ---------------------- UNREALIZED UNREALIZED GAINS/ GAINS/ COST (LOSSES) COST (LOSSES) ---------- ----------- --------- ----------- Japanese Yen $ 2,585 $ (26) $ 3,400 $ 112 British Pound 523 9 -- -- French Franc 578 30 -- -- Italian Lira 555 27 -- -- German Mark 279 12 -- -- Swedish Krona 242 9 -- -- ---------- ----------- ---------- ----------- Total $ 4,762 $ 61 $ 3,400 $ 112 ========== =========== ========== ===========
7. SEGMENT REPORTING ISI has two reportable segments, Software and Engineering Services. The Software segment includes design and development tools, real-time operating systems software and components, and provides related maintenance, training and consulting services for the embedded software market. The Engineering Services segment provides design expertise to the embedded software and other markets, and comprises Doctor Design. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. ISI evaluates performance based on profit or loss from operations before income taxes, excluding non-recurring gains and losses, acquisition-related and other costs, and interest and other income. ISI accounts for intersegment sales and transfers as if the sales or transfers were to third parties, that is, at current market prices. Corporate costs, such as those related to ISI's headquarters, are recorded in the Software segment. ISI's reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different technology and marketing strategies. The Engineering Services business was acquired as a unit and the management at the time of the acquisition has been retained. - 11 - The following tables summarize revenue and operating profit before acquisition-related and other costs and before amortization of intangibles for each segment. For the three months ended November 30, 1998 (in thousands):
ENGINEERING SOFTWARE SERVICES TOTAL -------- ----------- -------- Revenue from external customers $ 27,019 $ 7,943 $ 34,962 Intersegment revenue $ -- $ 224 $ 224 Depreciation $ 1,173 $ 268 $ 1,441 Operating profit before amortization of intangibles, acquisition-related and other costs $ 3,101 $ 1,434 $ 4,535 For the three months ended November 30, 1999 (in thousands): ENGINEERING SOFTWARE SERVICES TOTAL -------- ----------- -------- Revenue from external customers $ 35,902 $ 7,730 $ 43,632 Intersegment revenue $ -- $ -- $ -- Depreciation $ 3,049 $ 211 $ 3,260 Operating profit before amortization of intangibles, acquisition-related and other costs $ 4,040 $ 1,407 $ 5,447 For the nine months ended November 30, 1998 (in thousands): ENGINEERING SOFTWARE SERVICES TOTAL -------- ----------- -------- Revenue from external customers $ 78,044 $ 20,405 $ 98,449 Intersegment revenue $ -- $ 1,466 $ 1,466 Depreciation $ 3,579 $ 730 $ 4,309 Operating profit before amortization of intangibles, acquistion-related and other costs $ 5,429 $ 4,133 $ 9,562 For the nine months ended November 30, 1999 (in thousands): ENGINEERING SOFTWARE SERVICES TOTAL -------- ----------- -------- Revenue from external customers $ 90,113 $ 21,159 $111,272 Intersegment revenue $ -- $ -- $ -- Depreciation $ 4,190 $ 630 $ 4,820 Operating profit before amortization of intangibles, acquisition-related and other costs $ 3,909 $ 2,253 $ 6,162
- 12 - The following table summarizes property and equipment and capital expenditures by segment, for the nine months ended November 30, 1998 and 1999 (in thousands):
FOR THE NINE MONTHS ENDED NOVEMBER 30, ------------------------- 1998 1999 ----------- ----------- Software: Property and equipment, net $ 17,006 $ 19,573 Capital expenditures $ 2,263 $ 5,328 Engineering services: Property and equipment, net $ 1,627 $ 1,435 Capital expenditures $ 841 $ 325
Revenue to non-affiliated customers analyzed on a geographical basis for the three and nine months ended November 30, 1998 and 1999 were as follows (in thousands):
FOR THE THREE MONTHS ENDED NOVEMBER 30, -------------------------- 1998 1999 ----------- ----------- North America $ 19,615 $ 25,401 Europe 9,547 12,074 Asia/Pacific 5,800 6,157 ----------- ----------- Total $ 34,962 $ 43,632 =========== =========== FOR THE NINE MONTHS ENDED NOVEMBER 30, ------------------------- 1998 1999 ----------- ----------- North America $ 55,628 $ 64,398 Europe 26,050 30,267 Asia/Pacific 16,771 16,607 ----------- ----------- Total $ 98,449 $ 111,272 =========== ===========
No customer accounted for 10% or more of total revenue in the reported periods. 8. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities", which supercedes and amends a number of existing standards. The statement is effective for ISI's fiscal year 2002, but earlier application is permitted. The impact of the adoption of this statement, if any, on the financial statements of ISI has not yet been determined. - 13 - ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following information should be read in conjunction with the condensed consolidated interim financial statements and the notes thereto included in Item 1 of this Quarterly Report and with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in ISI's Annual Report on Form 10-K for the year ended February 28, 1999, as filed with the Securities and Exchange Commission on May 28, 1999. OVERVIEW Integrated Systems, Inc. provides solutions for embedded software development consisting of real-time operating systems and software components for embedded microprocessors; tools for designing, developing and optimizing embedded applications; networking products for device connectivity and management; and engineering design services for accelerated co-sourced product development. ISI's products help users accelerate the design, development, debugging, implementation and maintenance of embedded software. ISI's products and services are intended to reduce the expense associated with embedded software and system development and enable customers to develop systems featuring greater functionality, enhanced performance, improved reliability and ease-of-use. ISI markets and supports its products and provides services on a worldwide basis to a variety of users in a broad range of industries, including telecommunications, data communications, automotive, consumer electronics, office products and point-of-sale, and aerospace. Founded in 1980, ISI is headquartered in Sunnyvale, California, with a worldwide sales and service presence extending throughout Asia, Europe, and the Americas. Effective July 21, 1999 ISI acquired all the outstanding stock and stock rights of Software Development Systems, Inc. ("SDS") which develops, markets and supports a family of specialized integrated software products used in the embedded-systems industry. The total purchase price of approximately $39.9 million consisted of 1,430,037 shares of ISI's common stock with an estimated fair value of approximately $13.9 million, cash consideration of $24.3 million and acquisition costs of $1.7 million. The acquisition has been accounted for using the purchase method of accounting and accordingly the purchase price has been allocated to the tangible and intangible assets acquired and liabilities assumed on the basis of their respective fair values on the acquisition date. ISI's consolidated balance sheet, as of November 30, 1999, reflects a preliminary allocation of the purchase price of SDS. ISI has combined the businesses of its Diab Data and SDS subsidiaries to form one tools business named Diab-SDS. On October 21, 1999, Integrated Systems, Inc. ("ISI"), and Wind River Systems, Inc. ("Wind"), and University Acquisition Corp., a wholly-owned subsidiary of Wind, entered into a definitive Agreement and Plan of Reorganization ("Merger Agreement"). Wind develops, markets, supports and provides consulting services for advanced software operating systems and development tools for customers to create software applications for embedded computers. Pursuant to the Merger Agreement, ISI will become a wholly-owned subsidiary of Wind. At the effective time of the Merger, all outstanding shares of ISI common stock will be exchanged for shares of Wind common stock. Each share of ISI common stock will automatically be converted into 0.92 of a share of Wind common stock. In addition, Wind will assume all outstanding options to purchase ISI common stock on the terms provided in the Merger Agreement. The transaction is intended to be accounted for as a pooling of interests and to qualify as a tax-free reorganization. In connection with the execution of the Merger Agreement, ISI and Wind entered into a Stock Option Agreement ("Option Agreement"), pursuant to which ISI granted to Wind an irrevocable option to purchase newly issued shares of ISI common stock representing up to 10% of ISI common stock outstanding as of October 21, 1999. The purchase price per option share is $18.46. The Merger, which is expected to close in the fourth quarter of fiscal year 2000, is subject to approval of ISI shareholders and Wind stockholders. The directors of ISI and eight of the executive officers of ISI have agreed to vote their ISI shares in favor of the Merger at the ISI shareholders meeting called for that purpose. On December 3, 1999, the waiting period under Hart-Scott-Rodino Antitrust Improvements Act expired. - 14 - ISI may be required to pay a substantial termination fee if the Merger Agreement is terminated for certain specific reasons. ISI has filed the Merger Agreement with the Securities and Exchange Commission on November 5, 1999 as an exhibit to its report on Form 8-K. FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY Except for the historical information contained in this Quarterly Report, the matters herein contain "forward-looking" statements and information. All forward-looking statements included in this document are based on information available to ISI on the date hereof, and ISI assumes no obligation to update any such forward-looking statements. ISI's actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include, but are not limited to those discussed below, and to other risk factors detailed in ISI's Annual report on Form 10-K for the year ended February 28, 1999, and other documents filed by ISI with the Securities and Exchange Commission. RESULTS OF OPERATIONS The following tables set forth for the periods presented the percentage of total revenue represented by each line item in ISI's condensed consolidated statements of operations and the percentage change in each line item from the prior year period.
PERCENTAGE OF PERIOD-TO-PERIOD TOTAL REVENUE PERCENTAGE CHANGE ----------------- ------------------ THREE MONTHS ENDED THREE MONTHS ENDED NOVEMBER 30, NOVEMBER 30, 1999 1998 1999 COMPARED TO 1998 -------- -------- --------------------- Revenue: Product 64 % 59 % 36 % Services 36 41 8 ------ ----- Total revenue 100 100 25 ------ ----- Costs and expenses: Cost of product revenue 9 13 (9) Cost of services revenue 14 18 (6) Marketing and sales 39 35 41 Research and development 17 13 64 General and administrative 9 9 23 Amortization of intangibles 5 -- NM Acquisition-related and other expenses 3 3 NM ------ ----- Total costs and expenses 96 91 33 ------ ----- Income from operations 4 9 NM Interest and other income 1 4 (64) ------ ----- Income before income taxes 5 13 NM Provision (benefit) for income taxes (1) 4 NM ------ ----- Net income 6 % 9 % NM ------ -----
NM = Not Meaningful - 15 -
PERCENTAGE OF PERIOD-TO-PERIOD TOTAL REVENUE PERCENTAGE CHANGE ----------------- ------------------ NINE MONTHS ENDED NINE MONTHS ENDED NOVEMBER 30, NOVEMBER 30, 1999 1998 1999 COMPARED TO 1998 -------- -------- --------------------- Revenue: Product 61 % 56 % 22 % Services 39 44 1 ------ ----- Total revenue 100 100 13 ------ ----- Costs and expenses: Cost of product revenue 11 11 15 Cost of services revenue 16 19 (6) Marketing and sales 41 36 28 Research and development 17 15 29 General and administrative 10 10 16 Amortization of intangibles 3 -- NM Acquisition-related and other expenses 7 2 NM ------ ----- Total costs and expenses 105 93 28 ------ ----- Income (loss) from operations (5) 7 NM Interest and other income 2 4 (28) ------ ----- Income (loss) before income taxes (3) 11 NM Provision for income taxes 1 1 NM ------ ----- Net income (loss) (4) % 10 % NM ====== =====
NM = Not Meaningful REVENUE Revenue consists of fees from the licensing of software products ("product revenue") and from the maintenance and support of software products, customer training, and engineering services ("services revenue"). Total revenue was $43.6 million for the three months ended November 30, 1999 and $111.3 million for the nine months ended November 30, 1999, as compared to $35.0 million and $98.4 million in the same periods of fiscal year 1999. Total revenue increased 25% and 13%, for the three and nine months ended November 30, 1999 over the respective prior year periods. ISI operates in two business segments, the Software segment and the Engineering Services segment, each of which contribute product revenue and services revenue. The Software segment includes design and development tools, RTOS software and components, and also provides related maintenance, training and consulting services for the embedded software market. The Engineering Services segment provides design expertise to the embedded software and other markets. This segment is managed separately as ISI's subsidiary, Doctor Design. - 16 - Components of ISI's revenue by segment for the third quarter and first nine months of fiscal years 1999 and 2000 were as follows:
Three Months Ended November 30, 1998: Nine Months Ended November 30, 1998: ENGINEERING ENGINEERING SOFTWARE SERVICES TOTAL SOFTWARE SERVICES TOTAL -------- ----------- ----- -------- ----------- ----- Product.............. $18,657 $ 1,947 $20,604 Product........... $52,409 $ 3,079 $ 55,488 Services............. 8,362 5,996 14,358 Services.......... 25,635 17,326 42,961 ------- ------- ------- ------- ------- -------- Total................ $27,019 $ 7,943 $34,962 Total............. $78,044 $20,405 $ 98,449 ======= ======= ======= ======= ======= ======== Three Months Ended November 30, 1999: Nine Months Ended November 30, 1999: ENGINEERING ENGINEERING SOFTWARE SERVICES TOTAL SOFTWARE SERVICES TOTAL -------- ----------- ----- -------- ----------- ----- Product.............. $26,454 $ 1,640 $28,094 Product........... $62,318 $ 5,490 $ 67,808 Services............. 9,448 6,090 15,538 Services.......... 27,795 15,669 43,464 ------- ------- ------- ------- ------- -------- Total................ $35,902 $ 7,730 $43,632 Total............. $90,113 $21,159 $111,272 ======= ======= ======= ======= ======= ========
Product revenue increased 36% to $28.1 million in the three months ended November 30, 1999, as compared to $20.6 million in the same period of fiscal year 1999. For the first nine months of fiscal year 2000, product revenue increased 22% to $67.8 million, compared with $55.5 million for the same period last year. The percentage of ISI's total revenue attributable to product revenue increased to 64% for the three months ended November 30, 1999, up from 59% in the same quarter last year. For the first nine months of fiscal year 2000, product revenue, as a percentage of total revenue, increased to 61%, as compared to 56% in the same period of fiscal year 1999. The increases in product revenue are primarily due to increased sales of embedded software licenses and associated development tools, which partly resulted from the inclusion of Software Development Systems, Inc. ("SDS") since the date of acquisition. Services revenue increased 8% to $15.5 million for the three months ended November 30, 1999, as compared to $14.4 million for the same period last year. For the first nine months of fiscal year 2000, services revenue increased 1% to $43.5 million, as compared to $43.0 million in the first nine months of fiscal year 1999. At the end of fiscal year 1999, ISI ceased entering into lower margin, fixed-price government contracts. Impacting year-to-date services revenue growth was the absence of this government contract revenue and the reallocation of Doctor Design engineering services activities to the porting of pJAVA and internet appliance work, which ISI believes are strategic to future revenue growth. These two factors, offset be a continued growth in the installed base resulting in higher maintenance and support revenues, contributed to lower services revenue growth rates as compared with product revenues. Price increases were not a material factor in ISI's revenue growth in the periods presented. Revenue from customers located internationally for the three months ended November 30, 1999 was 42% of total revenue, as compared with 44% in the same period last year. For the first nine months of fiscal year 2000, international revenues were 42% of total revenue, as compared to 43% in the first nine months of fiscal year 1999. International revenue for the first nine months of fiscal year 2000 increased $4.1 million from the same period in fiscal year 1999 due primarily to growth in Europe. COSTS AND EXPENSES Cost of product revenue includes third-party royalties, product packaging and documentation costs, amortization of capitalized software development costs, and hardware costs. Cost of product revenue, as a percentage of product revenue, was 14% during the three months ended November 30, 1999, as compared to 22% in the same period of fiscal year 1999. For the first nine months of fiscal year 2000, cost of product revenue was 18% of total revenue, as compared to 19% in the same period last year. The decrease in cost of product revenue, as a percentage of product revenue, in the three and nine months ended November 30, 1999 as compared to same period last year is due primarily to the reduction in royalty expense as a result of the acquisition of SDS. Prior to the acquisition, these expenses were reported as cost of product revenue. For the nine months ended November 30, 1999, the reduction in product revenue margins was partially offset by a large Doctor Design product sale in the first quarter of fiscal year 2000, which had a very low margin. Excluding the effect of this sale, cost of product revenue was 16% of product revenue in the first nine months of fiscal year 2000. Cost of services revenue includes personnel and related direct costs associated with providing training, maintenance, engineering and consulting services to customers and the infrastructure to manage a services organization. Cost of services revenue, as a percentage of services revenue, was 38% in the three months ended November 30, 1999, as compared to 44% in the same period of fiscal year 1999. For the first nine months of fiscal year 2000, cost of service revenue was 41% of services revenue, as compared with 44 % in the same period last year. The decrease in cost of services revenue, as a percentage of services revenue, for the periods presented is due primarily to a shift in revenue mix. An increase in higher margin software maintenance revenue was offset by a decline in lower margin fixed price contract revenue. - 17 - Marketing and sales expenses increased 41% to $17.1 million in the three months ended November 30, 1999, as compared to $12.1 million in the same quarter last year. For the first nine months of fiscal year 2000, marketing and sales expenses increase 28% to $45.5 million, up from $35.5 million in the same period of fiscal year 1999. As a percentage of total revenue, marketing and sales costs increased to 39% in the three months ended November 30, 1999, from 35% in the same period of fiscal year 1999. For the first nine months of fiscal year 2000, marketing and sales costs increased to 41% of total revenue, as compared to 36% for the first nine months of fiscal year 1999. The dollar increases in marketing and sales expenses versus the prior year for the periods presented are primarily due to the continued growth of the domestic and international sales and support infrastructure, and the inclusion of SDS since the date of acquisition. ISI believes that significant investment for product research and development is essential to product and technical leadership. Research and development expenses increased 64% to $7.2 million in the three months ended November 30, 1999, as compared to $4.4 million in the same period last year. For the first nine months of fiscal year 2000, research and development expenses increased 29% to $18.7 million, as compared to $14.5 million in the same period of fiscal year 1999. As a percentage of total revenue, research and development costs increased to 17% for the three months ended November 30, 1999, as compared to 13% in the same quarter last year. For the first nine months of fiscal year 2000, research and development costs increased to 17% of total revenue, as compared with 15% for the same nine months of fiscal year 1999. The dollar increases in research and development expenses in the periods reported were due primarily to costs associated with pJAVA and internet appliance work at Doctor Design and research and development expenses attributable to SDS, since the date of acquisition. ISI anticipates that it will continue to devote substantial resources to product research and development throughout fiscal year 2000. General and administrative expenses increased 23% to $3.9 million in the third quarter of fiscal year 2000, as compared to $3.1 million in the same quarter of fiscal year 1999. For the first nine months of fiscal year 2000, general and administrative expenses increased 16% to $11.1 million, as compared to $9.5 million in the same period last year. General and administrative costs remained at 9% of total revenues for the three months ended November 30, 1999, as compared to the same percentage in the same quarter last year. For the first nine months of fiscal year 2000, general and administrative expenses remained at 10% of total revenue, as compared to the same percentage in the first nine months of fiscal year 1999. The dollar increase in the periods reported was due primarily to an increase in administrative infrastructure at Doctor Design and general and administrative expenses attributable to SDS, since the date of acquisition. Amortization of intangibles was $2.3 million in the three months ended November 30, 1999, as compared to $0.1 million in the same period of fiscal year 1999. For the nine months ended November 30, 1999, amortization of intangibles increased to $3.6 million, as compared to $0.4 million in the same period last year. The increase for all periods presented is due to amortization of intangible assets relating to ISI's acquisition of SDS in the second quarter of fiscal year 2000. Acquisition-related and other expenses were $1.5 million in the three months ended November 30, 1999, as compared to $1.1 million in the same quarter of fiscal year 1999. For the nine months ended November 30, 1999, acquisition-related and other expenses were $8.6 million, as compared to $2.2 million in the same period last year. For fiscal year 2000, acquisition-related and other expenses are comprised of a $6.3 million charge relating to the write-off of in-process research and development costs, discussed below, and $2.3 million of other expenses related to the acquisition of SDS. During fiscal year 1999, acquisition-related and other expenses consisted of CEO termination and recruitment costs and one-time legal costs. ISI recognized an in-process research and development charge of $6.3 million relating to the SDS acquisition, during the second quarter of fiscal year 2000. The amount allocated to in-process technology represents purchased in-process technology for a project that has not yet reached technological feasibility and has no alternative future use. The value of in-process project research and development was determined by estimating the net cash flows resulting from the completion of the project reduced to the percentage of completion of the project. Net cash flows were tax effected using estimated income taxes consistent with ISI's anticipated tax rate for the foreseeable future and then discounted back to their present value at a discount rate based on ISI's required risk adjusted weighted average rate of return. ISI estimated revenues, margins and operating costs based upon historical information about similar product developments combined with projections of future revenue and cost patterns, including projections used when initially evaluating the acquisition of SDS. ISI cannot guarantee that it will realize revenue from this in-process project in the amounts estimated or that the costs incurred will be materially consistent with estimates made. The nature of the efforts to develop all purchased in-process technology into commercially viable products principally relates to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the resulting products can meet their design specification, including function, features and technical performance requirements. - 18 - Due to the fact that the project is in-process there is uncertainty whether it can be successfully finished and result in the net cash flows that were originally estimated at acquisition. It is reasonably possible that the development of this technology could fail because of either prohibitive cost, the ISI's inability to perform the required completion efforts or other factors outside ISI's control such as a change in the market for the resulting developed products. If the development of the technology is unsuccessful, the technology may be abandoned during the development phase. Should ISI's development efforts fail or encounter significant delay then ISI's future returns may be significantly reduced. In such case, ISI may be unable to recover its investment in this project, may be less well positioned to benefit from new product markets in these areas and ISI's future operating results could be adversely affected. OTHER INCOME AND EXPENSES Interest and other income decreased to $0.5 million in the three months ended November 30, 1999, as compared to $1.4 million in the same quarter of fiscal year 1999. For the nine months ended November 30, 1999, interest and other income decreased to $2.6 million from $3.6 million in the same period last year. The decrease in fiscal year 2000 is due to a decline in the amount of interest-bearing cash equivalents and marketable securities, used in the acquisition of SDS, and the absence of rental income from the sub-lease of a portion of ISI's Sunnyvale headquarters during parts of fiscal year 2000. PROVISION FOR INCOME TAXES Net income was negatively impacted by $12.2 million of SDS acquisition-related charges in the nine months ended November 30, 1999, including $6.3 million of in-process research and development, $3.6 million of amortization of goodwill and other intangibles, and $2.3 million of other acquisition-related costs. Despite a net loss for the nine months ended November 30, 1999, a tax provision resulted due to the exclusion of amortization of goodwill and exclusion of in-process research and development, which are non-deductible for income tax purposes. Excluding non-deductible acquisition-related expenses and amortization of goodwill, the effective tax rate for the first nine months of fiscal year 2000 is 30%. The effective tax rate for the same period of fiscal year 1999 was 32%. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities", which supercedes and amends a number of existing standards. The statement is effective for ISI's fiscal year 2002, but earlier application is permitted. The impact of the adoption of this statement, if any, on the financial statements of ISI has not yet been determined. "YEAR 2000" ISSUES ISI believes that all of its most current product releases will not cease to perform nor generate incorrect or ambiguous data or results solely due to a change in date to or after January 1, 2000, and will calculate any information dependent on such dates in the same manner, and with the same functionality, data integrity, and performance, as such products do on or before December 31, 1999 (collectively, "Year 2000 Compliance"). However, there can be no assurance that all of ISI's customers will implement the Year 2000 compliant release of ISI's products in a timely manner, which could lead to failure of customer systems and product liability claims against ISI. Even if ISI's products are Year 2000 compliant, ISI may, in the future, be subject to claims based on Year 2000 issues in the products of other companies or issues arising from the integration of multiple products within a system. The costs of defending and resolving Year 2000-related disputes, and any liability of ISI for Year 2000-related damages, including consequential damages, could have a material adverse effect on ISI's business, financial condition and results of operations. Such failure could also affect the perceived performance of ISI's products, which could have a negative effect on ISI's competitive position. In reviewing its operations for Year 2000 Compliance, ISI has identified three categories of risk: internal business software, internal non-financial software and embedded chip technology, and external noncompliance by suppliers. With respect to internal business software, ISI is in full compliance for all its mission-critical systems. - 19 - Accordingly, ISI has not developed formal contingency plans. All financial, order processing and manufacturing software is fully Year 2000 Compliant. With respect to internal non-financial software and embedded chip technology, ISI recently achieved full Year 2000 compliance. ISI does not currently have a contingency plan in place for its internal non-financial software and embedded chip technology. With respect to external noncompliance by suppliers, ISI has completed the process of identifying and contacting its critical suppliers, service providers and contractors to determine the extent to which ISI's interface systems are vulnerable to those third parties' failure to remedy their own Year 2000 issues. To the extent that responses to Year 2000 readiness have been unsatisfactory, ISI intends to change suppliers, service providers or contractors to those who have demonstrated Year 2000 readiness. In the event that any of ISI's critical suppliers do not successfully and timely achieve Year 2000 Compliance, and ISI is unable to replace them with new or alternate suppliers, ISI's business or operations could be adversely affected. All costs associated with carrying out ISI's plan for the Year 2000 Compliance are being expensed as incurred, and are being funded from cash provided from operations. As of November 30, 1999 it is estimated that costs associated with preparation for the Year 2000 were approximately $1.6 million to complete the above plans. Of these amounts, approximately $600,000 was to cover new/replacement technologies, and $1.0 million was of a repair or upgrade nature. LIQUIDITY AND CAPITAL RESOURCES ISI has funded its operations to date principally through cash flows from operations. As of November 30, 1999, ISI had $44.8 million of cash, cash equivalents and marketable securities. This represents a decrease of $33.6 million from February 28, 1999, primarily as a result of the acquisition of SDS and from the repurchases of common stock. Net cash used in operating activities was $1.0 million during the first nine months of fiscal year 2000. This represents a decrease of $18.5 million from the amount generated in the first nine months of fiscal year 1999. Net cash from operating activities decreased in the first nine months of fiscal year 2000, due primarily to lower net income and a large decrease in accrued liabilities related to the Green Hills legal settlement. Additionally, there was an increase of $8.8 million in accounts receivable due to revenue growth in the first nine months of fiscal year 2000, particularly in the third quarter. Net cash used in investing activities decreased by $10.0 million during the first nine months of fiscal year 2000. Net cash used in investing activities in the first nine months of fiscal year 2000 was due primarily to the sale of marketable securities to fund the acquisition of SDS, offset primarily by approximately $24.3 million used in the acquisition of SDS. Net cash provided by financing activities totaled $0.6 million in the first nine months of fiscal year 2000 compared to net cash used of $5.6 million in the first nine months of fiscal year 1999. The difference was due primarily to the repurchase of approximately 641,000 shares of common stock in the first six months of fiscal year 2000, which was offset by an increase in the proceeds from the exercise of options to purchase common stock and purchases under the Employee Stock Purchase Plan. ISI believes that cash flows from operations, together with existing cash and investment balances, will be adequate to meet ISI's cash requirements for working capital and capital expenditures for the next 12 months. RISK FACTORS THIS SECTION ON "RISK FACTORS" INCLUDES FORWARD-LOOKING STATEMENTS THAT REFLECT ISI'S CURRENT VIEWS WITH RESPECT TO FUTURE MATTERS. THE FOLLOWING DISCUSSION ALSO CONTAINS CAUTIONARY STATEMENTS THAT IDENTIFY IMPORTANT FACTORS, INCLUDING CERTAIN RISKS AND UNCERTAINTIES, THAT MAY CAUSE ACTUAL RESULTS OR OUTCOMES TO DIFFER MATERIALLY FROM THOSE IN THE FORWARD-LOOKING STATEMENTS. - 20 - FLUCTUATIONS IN QUARTERLY RESULTS MAKE PERIOD-TO-PERIOD COMPARISONS DIFFICULT. ISI's quarterly operating results can vary significantly depending on a number of factors. These factors include: - - the volume and timing of orders received during the quarter; - - the mix of and changes in customers to whom ISI's products are sold; - - the timing and acceptance of new products and product enhancements by ISI or its competitors; - - changes in pricing; - - buyouts of run-time licenses; - - product life cycles; - - the level of ISI's sales of third party products; - - purchasing patterns of customers; - - competitive conditions in the industry; - - foreign currency exchange rate fluctuations; - - business cycles affecting the markets in which ISI's products are sold; - - extraordinary events, such as litigation or acquisitions, including related charges; and - - economic conditions generally or in various geographic areas. All of these factors are difficult to forecast. The future operating results of ISI may fluctuate as a result of these and other factors, including ISI's ability to continue to develop innovative and competitive products. ISI historically has operated with insignificant product backlog because its products are generally shipped as orders are received. As a result, product revenue in any quarter depends on the volume and timing of orders received in that quarter. In addition, ISI generally recognizes a substantial portion of its total quarterly revenue from sales orders received and shipped in the last two weeks of the quarter. Thus, the magnitude of quarterly fluctuations may not become evident until very late in, or after the end of, a particular quarter. In addition, a significant amount of ISI's sales orders involve products and services that yield revenue over multiple quarters or upon completion of performance. If license agreements entered into during a quarter do not meet ISI's revenue recognition criteria, even if ISI meets or exceeds its forecast of aggregate licensing and other contracting activity, it is possible that ISI's revenues would not meet expectations. Because ISI's staffing and operating expenses are based on anticipated total revenue levels, and a high percentage of ISI's costs are fixed in the short term and do not vary with revenue, small variations between anticipated orders and actual orders, as well as non-recurring or large orders, can cause disproportionate variations in ISI's operating results from quarter to quarter. The procurement process of ISI's customers typically ranges from a few weeks to several months or longer from initial inquiry to order, making the timing of sales and license fees difficult to predict. Moreover, as licensing of ISI's products increasingly becomes a more strategic decision made at higher management levels, ISI believes that sales cycles for ISI's products will lengthen. In addition, a portion of ISI's revenues from services are earned pursuant to fixed price contracts. Variances in costs associated with those contracts could have a material adverse effect on ISI's business and results of operations. ISI's results of operations may also be affected by seasonal trends. While ISI's revenues are not generally seasonal in nature, ISI's total revenue and net income during the first fiscal quarter have historically been lower than the previous fourth fiscal quarter for a variety of reasons, including customer purchase cycles related to expiration of budgetary authorizations. Due to all of the foregoing factors, ISI believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as an indication of future performance. During previous fiscal years, ISI has experienced actual performance that did not meet financial market expectations. It is possible that, in some future quarters, ISI's operating results will again be below the expectations of stock market analysts and investors. ISI'S ABILITY TO REMAIN COMPETITIVE DEPENDS ON ITS ABILITY TO INTRODUCE PRODUCT ENHANCEMENTS AND NEW PRODUCTS QUICKLY THAT MEET CUSTOMER DEMANDS. The market for embedded applications is fragmented and is characterized by ongoing technological developments, evolving industry standards and rapid changes in customer requirements. ISI's success depends upon its ability to continue to develop and introduce in a timely manner new products that take advantage of technological developments, to continue to enhance its existing product lines, to offer its products across a spectrum of microprocessor families used in the embedded systems market and to respond promptly to customers' requirements and preferences. ISI must continuously update its existing products to keep them current - 21 - with changing technology and must develop new products to take advantage of new technologies that could render ISI's existing products obsolete. Development delays are commonplace in the software industry. ISI has experienced delays in the development of new products and the enhancement of existing products in the past and is likely to experience delays in the future. If the results of product development efforts are inadequate or delayed, ISI's business, financial condition and results of operations would be materially adversely affected. ISI may not be successful in developing and marketing, on a timely basis or at all, competitive products, product enhancements and new products that respond to technological change, changes in customer requirements and emerging industry standards. In addition, ISI's enhanced or new products may not adequately address the changing needs of the marketplace. The inability of ISI, due to resource constraints or technological or other reasons, to develop and introduce new products or product enhancements in a timely manner could have a material adverse effect on ISI's business, financial condition or results of operations. From time to time, ISI or its competitors may announce new products, capabilities or technologies that have the potential to replace or shorten the life cycles of ISI's existing products. Announcements of currently planned or other new products may cause customers to defer purchasing existing ISI products. Any failure by ISI to anticipate or respond adequately to changing market conditions, or any significant delays in product development or introduction, would have a material adverse effect on ISI's business, financial condition and results of operations. COMPETITION CAN LEAD TO PRICING PRESSURES. The market for commercially available software tools and embedded operating systems is fragmented, highly competitive and is characterized by pressures to incorporate new features and accelerate the release of new product versions. As the industry continues to develop, ISI expects competition to increase in the future from existing competitors and from other companies that may enter ISI's existing or future markets with similar or substitute solutions that may be less costly or provide better performance or functionality than ISI's products. Some of ISI's existing and many of its potential competitors have substantially greater financial, technical, marketing and sales resources than ISI and ISI might not be able to compete successfully against these companies. In the event that price competition increases significantly, competitive pressures could cause ISI to reduce the prices of its products, which would result in reduced profit margins and could negatively affect the ability of ISI to provide adequate service to its customers. Prolonged price competition would have a material adverse effect on ISI's business, financial condition and results of operations. Also, run-time licenses, which provide for per-unit royalty payments for each embedded system that incorporates ISI's real-time operating systems, may be subject to significant pricing pressures, including buy-out arrangements. A variety of other potential actions by ISI's competitors, including increased promotion and accelerated introduction of new or enhanced products, could have a material adverse effect on ISI's business, financial condition and results of operations. In addition, ISI's pricing model for software licenses may be subject to market pressure. The pricing model for ISI's embedded software products is based on a range of mid-priced development license packages, combined with low-priced per-unit production (run-time) licenses. In the future, the market may demand alternative pricing models. This may result in a material adverse effect on ISI's business, financial condition and results of operations. ISI MUST EFFECTIVELY INTEGRATE ACQUIRED BUSINESSES. ISI has completed a number of acquisitions in recent years and may complete additional acquisitions in the future. The process of integrating an acquired company's business, most recently the acquisition of SDS in July 1999, into ISI's operations may result in unforeseen operating difficulties and expenditures and may absorb significant management attention that would otherwise be available for the ongoing development of ISI's business. Moreover, the anticipated benefits of an acquisition might not be realized. Future acquisitions by ISI could result in potentially dilutive issuances of equity securities, debt-obligations and contingent liabilities, the use of cash reserves, and amortization expenses related to goodwill and other intangible assets, which could have a material adverse effect on ISI's business, financial condition and results of operations. In addition, acquisitions involve numerous risks, including difficulties in the assimilation of the operations, technologies and products of the acquired companies, difficulties in managing diverse geographic sales and research and development operations, the diversion of management attention from other business concerns, risks of entering markets in which ISI has no or limited direct prior experience and the potential loss of key employees of the acquired company. ISI IS SUBJECT TO THE BUSINESS AND ECONOMIC RISKS OF INTERNATIONAL OPERATIONS. In fiscal year 1999 and the first nine months of fiscal year 2000, ISI derived approximately 42% of its total revenue from sales outside of North America. ISI expects that international sales will continue to generate a significant percentage of its total revenue in the foreseeable future. International operations are subject to a number of special risks. These risks include: - - foreign government regulation; - - reduced protection of intellectual property rights in some countries where ISI does business; - 22 - - - longer receivable collection periods and greater difficulty in accounts receivable collection; - - unexpected changes in, or imposition of, regulatory requirements, tariffs, import and export restrictions and other barriers and restrictions; - - potentially adverse tax consequences; - - the burdens of complying with a variety of foreign laws and staffing and managing foreign operations; - - exchange rate fluctuations; - - general geopolitical risks, such as political and economic instability, hostilities with neighboring countries and changes in diplomatic and trade relationships; and - - possible recessionary environments in economies outside the United States. ISI generally denominates sales to and by foreign subsidiaries in local currency. An increase in the relative value of the dollar against local currencies would reduce ISI's revenue in dollar terms or make ISI's products more expensive and, therefore, potentially less competitive in foreign markets. For example, revenue from sales in Japan during fiscal years 1998 and 1997 was adversely affected by the weakness of the yen against the dollar. Similarly, the currencies of many other countries in the Asia Pacific region have recently lost significant value against the dollar, notably the currencies of Korea and Taiwan. ISI's future results of operations could be adversely affected by currency fluctuations. More generally, recent instability in Asian currency and stock market economies could adversely affect the economic health of the entire region and could have an adverse effect on ISI's results of operations. For example, in many countries in the Asia Pacific region, during fiscal years 1998 and 1999 there was little or no growth in investment in product development infrastructure by manufacturing companies. ISI relies on distributors and representatives for sales of its products in some foreign countries and, accordingly, depends on their ability to promote and support ISI's products and, in some cases, to translate them into foreign languages. ISI's international distributors and representatives generally offer products of several different companies, including in some cases products that are competitive with ISI's products, and these distributors and representatives are not subject to any minimum purchase or resale requirements. ISI's international distributors and representatives may not continue to purchase ISI's products or provide them with adequate levels of support. PRODUCT DEFECTS CAN BE EXPENSIVE TO FIX AND CAN CAUSE ISI TO LOSE CUSTOMERS. As a result of their complexity, software products may contain undetected errors or compatibility issues, particularly when first introduced or as new versions are released. Despite testing by ISI and testing and use by current and potential customers, errors might be found in new products after commencement of commercial shipments. The occurrence of errors could result in loss of or delay in market acceptance of ISI's products, which could have a material adverse effect on ISI's business, financial condition and results of operations. The increasing use of ISI's products for applications in systems that interact directly with the general public, particularly applications in transportation, medical systems and other markets where the failure of the embedded system could cause substantial property damage or personal injury, could expose ISI to significant product liability claims. In addition, ISI's products are used for applications in business systems where the failure of the embedded system could be linked to substantial economic loss. ISI's license and other agreements with its customers typically contain provisions designed to limit ISI's exposure to potential product liability and other claims. It is likely, however, that the limitation of liability provisions contained in ISI's agreements are not effective in all circumstances and in all jurisdictions. ISI does not have insurance against product liability risks and insurance may not be available to ISI on commercially reasonable terms. ISI has errors and omissions insurance; however, this insurance may not be adequate to cover claims. A product liability claim or claim for economic loss brought against ISI, or a product recall involving ISI's software, could have a material adverse effect on ISI's business, financial condition and results of operations. ISI's operations depend on its ability to protect its computer equipment and the information stored in its databases against damage by fire, natural disaster, power loss, telecommunications failure, unauthorized intrusion and other catastrophic events. ISI believes it has taken prudent measures to reduce the risk of interruption in its operations. However, these measures might not be sufficient. Any damage or failure that causes interruption in ISI's operations could have a material adverse effect on its business, financial condition, and results of operations. ISI FACES INTENSE COMPETITION FOR QUALIFIED EMPLOYEES. ISI's future performance depends to a significant degree upon the continued contributions of its key management, product development, sales, marketing and operations personnel. In addition, ISI believes its future success will also depend in large part upon its ability to attract and retain highly skilled managerial, engineering, sales, marketing and operations personnel, many of whom are in great demand. Competition for qualified personnel is intense in Santa Clara County, California, where ISI is headquartered, and there can be no assurance that ISI will be successful in attracting and retaining personnel. The - 23 - failure of ISI to attract, assimilate and retain the necessary personnel could have a material adverse effect on ISI's business, financial condition and results of operations. ISI DEPENDS ON ITS INTELLECTUAL PROPERTY RIGHTS, AND IS SUBJECT TO THE RISKS OF INFRINGEMENT. ISI depends on its proprietary technology. Despite ISI's efforts to protect its proprietary rights, it may be possible for unauthorized third parties to copy ISI's products or to reverse engineer or obtain and use information that ISI regards as proprietary. Policing unauthorized use of ISI's products is difficult, and while ISI is unable to determine the extent to which software piracy of its products exists, software piracy can be expected to be a persistent problem. In addition, effective protection of intellectual property rights may be unavailable or limited in foreign countries. The status of United States patent protection in the software industry is not well defined and will evolve as the United States Patent and Trademark Office grants additional patents. Patents have been granted on fundamental technologies in software, and patents may be issued that relate to fundamental technologies incorporated into ISI's products. As the number of patents, copyrights, trademarks and other intellectual property rights in ISI's industry increases, products based on its technology may increasingly become the subject of infringement claims. Third parties could assert infringement claims against ISI in the future. Infringement claims with or without merit could be time consuming, result in costly litigation, cause product shipment delays or require ISI to enter into royalty or licensing agreements. Royalty or licensing agreements, if required, might not be available on terms acceptable to ISI, or at all, which could have a material adverse affect on ISI's business, financial condition and results of operations. In addition, ISI may initiate claims or litigation against third parties for infringement of ISI's proprietary rights or to establish the validity of ISI's proprietary rights. Litigation to determine the validity of any claims, whether or not the litigation is resolved in favor of ISI, could result in significant expense to ISI and divert the efforts of ISI's technical and management personnel from productive tasks. In the event of an adverse ruling in any litigation, ISI might be required to pay substantial damages, discontinue the use and sale of infringing products and expend significant resources to develop non-infringing technology or obtain licenses to infringing technology. The failure of ISI to develop or license a substitute technology could have a material adverse affect on ISI's business, financial condition and results of operations. ISI RELIES ON THIRD-PARTY LICENSES FOR SOME OF ITS PRODUCTS. ISI licenses software development tool products from other companies to distribute with its own products. The inability of these third parties to provide competitive products with adequate features and high quality on a timely basis or to provide sales and marketing cooperation could have a material adverse effect on ISI's business, financial condition and results of operations. In addition, ISI's products compete with products produced by some of ISI's licensors. When these licenses terminate or expire, continued license rights might not be available to ISI on reasonable terms. In addition, ISI might not be able to obtain similar products to substitute into the tool suites. The inability to license these products could have a material adverse effect on ISI's business, financial condition and results of operations. THE MARKET PRICE OF ISI'S STOCK HAS BEEN VOLATILE. The prices for ISI's common stock have fluctuated widely in the past. During the 9 months ended November 30, 1999, the closing price of a share of ISI common stock ranged from a high of $30.13 to a low of $8.44. The management of ISI believes that stock price fluctuations may have been caused by actual or anticipated variations in ISI's operating results, announcements of technical innovations or new products or services by ISI or its competitors, changes in earnings estimates by securities analysts and other factors, including changes in conditions of the software and other technology industries in general. Stock markets have experienced extreme price volatility in recent years. This volatility has had a substantial effect on the market prices of securities issued by ISI and other high technology companies, often for reasons unrelated to the operating performance of the specific companies. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against ISI. Litigation, if instituted, could result in substantial costs and a diversion of management attention and resources, which would have a material adverse effect on ISI's business, financial condition and results of operations even if ISI is successful in any suits. These market fluctuations, as well as general economic, political and market conditions such as recessions, may adversely affect the market price of the common stock. FINANCIAL STATEMENTS ARE BASED ON ESTIMATES AND ASSUMPTIONS. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the recorded amounts of assets and liabilities at the date of the financial statements and the recorded amounts of revenues and expenses during the reporting period. A change in the facts and circumstances surrounding these estimates could result in a change to the estimates and impact future operating results. RISKS RELATING TO THE MERGER. FAILURE TO REALIZE THE BENEFITS OF INTEGRATING THE OPERATIONS OF ISI AND WIND, PRODUCTS AND DEVELOPMENT ORGANIZATIONS COULD DIMINISH THE BENEFITS OF THE MERGER. Achieving the benefits of the merger will depend in part on the integration of Wind's and ISI's operations, products and personnel in a timely and efficient manner. In order - 24 - for the combined companies to provide enhanced and more valuable products to its customers after the merger, it will need to integrate the product lines and development organizations of ISI and Wind. This will be difficult and unpredictable because their products are highly complex, have been developed independently and were designed without regard to such integration. Successful integration of product lines also requires coordination of different development and engineering teams This, too, will be difficult and unpredictable because of possible cultural conflicts and different opinions on technical decisions and product roadmaps. The diversion of management attention and any difficulties encountered in the transition and integration process could have a material adverse effect on the combined company's business, financial condition and operating results. Wind expects to incur costs from integrating ISI's operations, products and personnel. These costs may be substantial and may include costs for: - employee redeployment, relocation or severance; - conversion of information systems; - combining research and development teams and processes; - reorganization or closures of facilities; and - relocation or disposition of excess equipment. There can be no assurance that Wind will be successful in these integration efforts or that Wind will realize the expected benefits of the merger. FAILURE TO RETAIN KEY EMPLOYEES COULD DIMINISH THE BENEFITS OF THE MERGER. The successful combination of Wind and ISI will depend in part on the retention of key personnel. There can be no assurance that Wind will be able to retain ISI's key management, technical, sales and customer support personnel, or that Wind will realize the anticipated benefits of the merger. SALES COULD DECLINE IF CUSTOMER RELATIONSHIPS ARE DISRUPTED BY THE MERGER. ISI's or Wind's customers may not continue their current buying patterns during the pendency of, and following, the merger. Any significant delay or reduction in orders for Wind's or ISI's products could have a material adverse effect on the combined company's business, financial condition and results of operations. Customers may defer purchasing decisions as they evaluate the likelihood of successful integration of Wind's and ISI's products and the combined company's future product strategy. Customers may also consider purchasing products of competitors. In addition, by increasing the breadth of Wind's and ISI's business, the merger may make it more difficult for the combined company to enter into relationships, including customer relationships, with strategic partners, some of whom may view the combined company as a more direct competitor than either Wind or ISI as an independent company. ISI SHAREHOLDERS WILL RECEIVE A FIXED NUMBER OF SHARES OF WIND COMMON STOCK IN THE MERGER, NOT A FIXED VALUE. Upon completion of the merger, each share of ISI common stock will be converted into 0.92 of a share of Wind common stock. Since the exchange ratio is fixed, the number of shares that ISI shareholders will receive in the merger will not change, even if the market price of Wind common stock changes. There will be no adjustment of the exchange ratio or termination of the merger based solely on fluctuations in the price of Wind common stock. In recent years, and particularly in recent months, the stock market, in general, and the securities of technology companies, in particular, have experienced extreme price and volume fluctuations. These market fluctuations may adversely affect the market price of Wind common stock. The market price of Wind common stock upon and after completion of the merger could be lower than the market price on the date of the merger agreement or the current market price. - 25 - ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS ISI enters into foreign currency forward exchange contracts to reduce the impact of currency exchange rate fluctuations on monetary asset and liability positions. The objective of these contracts is to minimize the impact of exchange rate fluctuations on ISI's operating results. Gains and losses associated with exchange rate fluctuations on foreign currency forward exchange contracts are recorded in income as they offset corresponding gains and losses on the foreign currency denominated assets and liabilities being hedged. The costs of the foreign currency forward exchange contracts are also recorded in income. All foreign currency forward exchange contracts entered into by ISI have maturities of less than one year. At November 30, 1999, ISI had approximately $4.8 million of foreign currency forward exchange contracts outstanding, in Japanese yen and numerous European currencies. At February 28, 1999, ISI had approximately $3.4 million of foreign currency forward exchange contracts outstanding, all in Japanese yen. Unrealized gains on foreign currency forward exchange contracts at November 30, 1999 and February 28, 1999 were approximately $ 61,000 and $112,000, respectively. ISI believes that the fair market value of its portfolio of marketable securities or related income would not be significantly impacted by increases or decreases in interest rates due mainly to the short-term nature of the portfolio. However, an increase in interest rates could have a material adverse effect on the fair value of the portfolio. Conversely, declines in interest rates could harm interest income from the portfolio. - 26 - PART II - OTHER INFORMATION --------------------------- ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (A) EXHIBITS 2.1 Agreement and Plan of Merger and Reorganization, dated as of October 21, 1999 by and among Wind River Systems, Inc., University Acquisition Corp. and Integrated Systems, Inc. (Incorporated by reference to Exhibit 2.1 to Form S-4, File No. 333-91545, filed by Wind River Systems, Inc. on November 23, 1999.) 2.2 Option Agreement, dated as of October 21, 1999, between Integrated Systems, Inc. and Wind River Systems, Inc. (Incorporated by reference to Exhibit 2.2 to Form S-4, File No. 333-91545, filed by Wind River Systems, Inc. on November 23, 1999.) 4.1 Form of Voting Agreement, dated as of October 21, 1999 (Incorporated by reference to Exhibit 2.3 to Form S-4, File No. 333-91545, filed by Wind River Systems, Inc. on November 23, 1999.) 27.1 Financial Data Schedule (B) REPORTS ON FORM 8-K. The following reports on Form 8-K were filed during the quarter ended November 30, 1999: On October 4, 1999, the company filed a Form 8-K/A under Item 7 which amended the company's current report on Form 8-K originally filed on August 5, 1999. On November 2, 1999, the company filed a Form 8-K/A, Amended No. 2 under Item 7 which amended the company's current report on Form 8-K/A filed on October 4, 1999 and Form 8-K originally filed on August 5, 1999. On November 5, 1999, the company filed a Form 8-K under Item 1 reporting that it had entered into a definitive Agreement and Plan of Merger and Reorganization with Wind River Systems, Inc. and University Acquisition Corporation. - 27 - 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. Dated: December 21, 1999 INTEGRATED SYSTEMS, INC. (Registrant) /s/ CHARLES M. BOESENBERG ---------------------------- CHARLES M. BOESENBERG President and Chief Executive Officer /s/ WILLIAM C. SMITH ---------------------------- WILLIAM C. SMITH Vice President, Finance and Chief Financial Officer - 28 - EX-27.1 2 EXHIBIT 27.1
5 THE SCHEDULE CONTAINS FINANCIAL INFORMATION FROM Q3 FY00 FORM 10-Q AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE FINANCIAL STATEMENTS. 1,000 9-MOS FEB-29-2000 MAR-01-1999 NOV-30-1999 18,578 1,460 39,416 0 0 69,352 21,008 0 158,386 47,765 0 0 0 74,367 35,656 110,023 67,808 111,272 12,034 29,882 87,442 0 0 (3,470) 1,007 (4,477) 0 0 0 (4,477) (0.19) (0.19)
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