-----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, BIg5ATbUviZVrY17Qtz4Pk87Oc4VMKG3gJY+jFyE0JZTFl9Pw5VWCnVkOGj9+Ebz uoDbN8YYezftJhZZ2t73CQ== 0000950005-98-000793.txt : 19981015 0000950005-98-000793.hdr.sgml : 19981015 ACCESSION NUMBER: 0000950005-98-000793 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19980831 FILED AS OF DATE: 19981014 SROS: NASD 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: 98725251 BUSINESS ADDRESS: STREET 1: 3260 JAY ST CITY: SANTA CLARA STATE: CA ZIP: 95054-3309 BUSINESS PHONE: 4089801500 MAIL ADDRESS: STREET 1: 3260 JAY STREET CITY: SANTA CLARA STATE: CA ZIP: 95054-3309 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 August 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: 0-18268 ------------------------------ 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 September 30, 1998 was 23,049,497 shares. INTEGRATED SYSTEMS, INC. FORM 10-Q QUARTER ENDED AUGUST 31, 1998 INDEX Page ---- PART I - FINANCIAL INFORMATION Item 1. Financial Statements 3 Condensed Consolidated Balance Sheets as of August 31, 1998 and February 28, 1998 4 Condensed Consolidated Statements of Income for the Three and Six Months Ended August 31, 1998 and 1997 5 Condensed Consolidated Statements of Cash Flows for the Six Months Ended August 31, 1998 and 1997 6 Notes to Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 3. Quantitative and Qualitative Disclosures about Market Risks 18 PART II - OTHER INFORMATION Item 1. Legal Proceedings 19 Item 4. Submission of matters to a vote of Security Holders 19 Item 6. Exhibits and Reports on Form 8-K 19 SIGNATURES 20 ================================================================================ 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 the Company'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 in Management's Discussion and Analysis of Financial Condition and Results of Operations and in the Company's Annual Report on Form 10-K for the year ended February 28, 1998, and other documents filed by the Company with the Securities and Exchange Commission. ================================================================================ -2- PART I - FINANCIAL INFORMATION Item 1. Financial Statements The condensed consolidated interim financial statements included herein have been prepared by Integrated Systems, Inc. ("the Company"), 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, the Company 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 the Company's Annual Report on Form 10-K for the year ended February 28, 1998. The February 28, 1998 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)
August 31, February 28, 1998 1998 --------- --------- (unaudited) ASSETS Current assets: Cash and cash equivalents $ 14,812 $ 14,454 Marketable securities 2,658 6,670 Accounts receivable, net 25,449 29,455 Deferred income taxes 995 1,603 Prepaid expenses and other 5,085 4,548 --------- --------- Total current assets 48,999 56,730 Marketable securities 58,856 46,322 Property and equipment, net 18,796 18,428 Intangible assets, net 2,515 2,867 Deferred income taxes 4,763 2,363 Other assets 1,155 1,410 --------- --------- Total assets $ 135,084 $ 128,120 ========= ========= LIABILITIES Current liabilities: Accounts payable $ 4,285 $ 5,073 Accrued payroll and related expenses 4,671 4,321 Other accrued liabilities 5,378 5,372 Income taxes payable 1,981 2,747 Deferred revenue 16,363 16,181 --------- --------- Total current liabilities 32,678 33,694 SHAREHOLDERS' EQUITY Common Stock, no par value, 50,000 shares authorized: 23,488 and 23,339 shares issued and outstanding at August 31, 1998 and February 28, 1998, respectively 64,951 63,647 Accumulated other comprehensive income, net (1,012) (1,290) Retained earnings 38,467 32,069 --------- --------- Total shareholders' equity 102,406 94,426 --------- --------- Total liabilities and shareholders' equity $ 135,084 $ 128,120 ========= ========= The accompanying notes are an integral part of these condensed consolidated financial statements.
-4- INTEGRATED SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share data) (unaudited)
Three Months Ended Six Months Ended August 31, August 31, ------------------------ ------------------------- 1998 1997 1998 1997 -------- -------- -------- -------- Revenue: Product $ 17,723 $ 15,502 $ 34,884 $ 29,260 Services 14,282 16,668 28,603 27,498 -------- -------- -------- -------- Total revenue 32,005 32,170 63,487 56,758 -------- -------- -------- -------- Costs and expenses: Cost of product revenue 3,479 3,521 7,133 6,250 Cost of services revenue 6,066 9,546 11,478 15,121 Marketing and sales 11,258 10,872 23,363 20,281 Research and development 4,658 4,747 10,099 9,549 General and administrative 4,399 3,057 7,755 5,579 -------- -------- -------- -------- Total costs and expenses 29,860 31,743 59,828 56,780 -------- -------- -------- -------- Income (loss) from operations 2,145 427 3,659 (22) Interest and other income 1,308 979 2,221 1,774 -------- -------- -------- -------- Income before income taxes 3,453 1,406 5,880 1,752 Provision (benefit) for income taxes 1,105 471 (518) 596 -------- -------- -------- -------- Net income $ 2,348 $ 935 $ 6,398 $ 1,156 ======== ======== ======== ======== Earnings per share - basic $ 0.10 $ 0.04 $ 0.27 $ 0.05 ======== ======== ======== ======== Earnings per share - diluted $ 0.10 $ 0.04 $ 0.26 $ 0.05 ======== ======== ======== ======== Shares used in per share calculations - basic 23,501 23,182 23,464 23,151 ======== ======== ======== ======== Shares used in per share calculations - diluted 24,276 23,969 24,356 23,910 ======== ======== ======== ======== 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)
Six Months Ended August 31, --------------------------- 1998 1997 -------- -------- Cash flows from operating activities: Net income $ 6,398 $ 1,156 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,868 2,934 Provision for (release of) doubtful accounts receivable (200) 1,243 Deferred income taxes (1,989) 212 Changes in assets and liabilities: Accounts receivable 4,146 22 Prepaid expenses and other (537) (406) Accounts payable, accrued payroll and other accrued liabilities (432) 3,956 Income taxes payable (766) (704) Deferred revenue 182 880 Other assets and liabilities 213 265 -------- -------- Net cash provided by operating activities 9,883 9,558 -------- -------- Cash flows from investing activities: Purchases of marketable securities, net (8,029) (12,345) Additions to property and equipment (2,312) (2,815) Capitalized software development costs (530) (250) -------- -------- Net cash used in investing activities (10,871) (15,410) -------- -------- Cash flows from financing activities: Repurchase of common stock (1,059) (187) Proceeds from exercise of common stock options and purchases under the Employee Stock Purchase Plan 2,363 1,517 -------- -------- Net cash provided by financing activities 1,304 1,330 -------- -------- Effect of exchange rate fluctuations on cash and cash equivalents 42 (195) Net increase (decrease) in cash and cash equivalents 358 (4,717) Cash and cash equivalents at beginning of period 14,454 25,585 -------- -------- Cash and cash equivalents at end of period $ 14,812 $ 20,868 ======== ======== Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $ 2,040 $ 986 Supplemental schedule of noncash investing and financing activities: Unrealized gain on marketable securities $ 493 $ 198 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 and six months ended August 31, 1998 and 1997 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 the Company's Annual Report on Form 10-K for the year ended February 28, 1998. These condensed consolidated financial statements do not include all disclosures normally required by generally accepted accounting principles. Certain amounts in the fiscal year 1998 condensed consolidated financial statements have been reclassified to conform to the fiscal year 1999 presentation. These reclassifications had no effect on previously reported results of operations or shareholder's equity. 2. 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 number 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. The following table sets forth the calculations of earnings per share:
Three Months Ended Six Months Ended August 31, August 31, ----------------- ----------------- (in thousands, except per share data) 1998 1997 1998 1997 ------- ------- ------- ------- Basic: Net income $ 2,348 $ 935 $ 6,398 $ 1,156 ======= ======= ======= ======= Number of shares: Weighted average number of common shares outstanding 23,501 23,182 23,464 23,151 ======= ======= ======= ======= Earnings per share - basic $ 0.10 $ 0.04 $ 0.27 $ 0.05 ======= ======= ======= ======= Diluted: Net income $ 2,348 $ 935 $ 6,398 $ 1,156 ======= ======= ======= ======= Number of shares: Weighted average number of common shares outstanding 23,501 23,182 23,464 23,151 Dilutive effect of stock options, net 775 787 892 759 ------- ------- ------- ------- Weighted average number of common and common equivalent shares outstanding 24,276 23,969 24,356 23,910 ======= ======= ======= ======= Earnings per share - diluted $ 0.10 $ 0.04 $ 0.26 $ 0.05 ======= ======= ======= =======
3. Comprehensive Income In March 1998, the Company adopted Financial Accounting Standards Board Statement of Financial Accounting Standards No. 130 ("FAS 130"), "Reporting Comprehensive Income." Comprehensive income is defined as the change in equity from transactions and other events and circumstances excluding transactions resulting from investments by owners and distributions to owners. For the Company, the primary difference between net income and comprehensive income results from foreign currency translation adjustments and unrealized gains and losses on available-for-sale marketable securities. Comprehensive income for the three and six months ended August 31, 1998 and 1997 is as follows:
Three Months Ended Six Months Ended August 31, August 31, ----------------------- ------------------------ (In thousands) 1998 1997 1998 1997 ------- ------- ------- ------- Net income $ 2,348 $ 935 $ 6,398 $ 1,156 Other comprehensive income, net of tax: Foreign currency translation adjustments 79 (610) (18) (353) Unrealized gain on marketable securities 335 180 296 119 ------- ------- ------- ------- Other comprehensive income (loss) 414 (430) 278 (234) ------- ------- ------- ------- Total comprehensive income $ 2,762 $ 505 $ 6,676 $ 922 ======= ======= ======= =======
-7- The accumulated balances of other comprehensive income as of August 31, 1998 and 1997 are as follows: (in thousands)
August 31, 1998 August 31, 1997 ----------------------------------------- ---------------------------------------- Foreign Foreign Currency Unrealized Currency Unrealized Translation Gains/ Total Translation Gains/ Total Adjustments Losses Other Adjustments Losses Other ----------- ---------- ------- ----------- ---------- ------- Beginning balance $(1,438) $ 148 $(1,290) $(1,130) $ 148 $ (982) Current-period change (18) 296 278 (353) 119 (234) ------- ------- ------- ------- ------- ------- Ending balance $(1,456) $ 444 $(1,012) $(1,483) $ 267 $(1,216) ======= ======= ======= ======= ======= =======
4. Derivative Financial Instruments The Company enters into foreign currency forward exchange contracts to reduce the impact of currency exchange rate fluctuations on monetary assets and liability positions. The objective of these contracts is to minimize the impact of exchange rate fluctuations on the Company'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 the Company have maturities of less than one year. At August 31, 1998, the Company had approximately $2.5 million of foreign currency forward exchange contracts outstanding, $2.2 million in Japanese yen and $0.3 million in Swedish Krona. There were no foreign currency forward exchange contracts at February 28, 1998. Unrealized gains on foreign currency forward exchange contracts at August 31, 1998 were approximately $19,000. Other than the use of foreign currency forward exchange contracts discussed above, the Company does not currently invest in or hold any other derivative financial instruments. 5. Income Taxes In May 1998, the Company made an election with the Internal Revenue Service to treat the Company's Austrian subsidiary, Takefive Software GmbH, as a foreign branch of the Company in the United States tax return. For financial statement purposes, this election resulted in a one-time benefit of $2.4 million in the first quarter of fiscal year 1999. 6. Contingencies In October 1997, Greenhills Software, Inc. ("Greenhills"), a supplier, filed a demand for arbitration against the Company, alleging among other things, breach of contract, fraud, negligent misrepresentation and misappropriation of trade name. In December 1997, the Company responded to the arbitration demand, and filed a counter-claim against Greenhills. The Company believes it has meritorious defenses to all claims against the Company and intends to defend the claims vigorously. No accrual has been made in the accompanying consolidated financial statements related to this dispute, as the ultimate outcome is presently not determinable. The dispute, however, is subject to inherent uncertainties and thus, there can be no assurance that it will be resolved favorably to the Company or that it will not have a material adverse effect on the Company's consolidated financial position or results of operations. The Company is subject to various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While management does not believe that the outcome of any of the legal matters will have a material adverse effect on the Company's consolidated financial position, legal matters are subject to inherent uncertainties and thus, there can be no assurance that these matters will be resolved favorably to the Company. 7. Subsequent Events In September 1998, the Company's Board of Directors authorized the Company to repurchase 1,000,000 shares of common stock for cash from time-to-time at market prices. These shares are in addition to the 1,000,000 shares previously authorized in April 1997. As of September 30, 1998, the Company had repurchased 825,000 shares of common stock in open market transactions for $7.2 million under this stock repurchase program. In September 1998, the Company's Board of Directors adopted a shareholder rights plan declaring a dividend of one preferred share purchase right for each share of the Company's common stock outstanding on October 15, 1998 (the "Record Date") and further directing the issuance of one such right with respect to each share of the Company's common stock that is issued after the Record Date, except in certain circumstances. The rights will expire on September 30, 2008. -8- The rights are initially attached to the Company's common stock and will not trade separately. If a person or a group acquires 20 percent or more of the Company's common stock (an "Acquiring Person"), or announces an intention to make a tender offer for the Company's common stock, the consummation of which would result in a person or group acquiring 20 percent or more of the Company's common stock, then the rights will be distributed and will thereafter trade separately from the common stock. In the event rights are distributed, each right may be exercised for 1/200th of a share of a newly designated Series A Junior Participating Preferred Stock at an exercise price of $55.00. The preferred stock has been structured so that the value of 1/200th of a share of such preferred stock will approximate the value of one share of common stock. Upon a person or group becoming an Acquiring Person, holders of the rights (other than the Acquiring Person) will have the right to acquire shares of the Company's common stock at a substantially discounted price. Additionally, if a person or group becomes an Acquiring Person and the Company is acquired in a merger or other business combination, or 50 percent or more of its assets are sold in a transaction with an Acquiring Person, the holders of rights (other than the Acquiring Person) will have the right to receive shares of common stock of the acquiring corporation at a substantially discounted price. Subsequent to a person or group becoming an Acquiring Person, the Company's Board of Directors may, at its option, require the exchange of outstanding rights (other than those held by the Acquiring Person) for common stock at an exchange ratio of one share of the Company's common stock per right. The Board may redeem outstanding rights at any time prior to a person or group becoming an Acquiring Person at a price of $0.001 per right. Prior to such time, the terms of the rights may be amended by the Board. 8. Recent Accounting Pronouncements In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosure About Segments of an Enterprise and Related Information," which specifies disclosure requirements for segment reporting. The statement supersedes SFAS 14 and SFAS 18, is effective for fiscal years beginning after December 15, 1997, and requires earlier periods to be restated if practicable. The impact of the adoption of this statement, if any, on the Financial Statements of the Company has not yet been determined. In April 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." SOP 98-1 provides guidance for determining whether computer software is internal-use software and on accounting for the proceeds of computer software originally developed or obtained for internal use and then subsequently sold to the public. It also provides guidance on capitalization of the costs incurred for computer software developed or obtained for internal use. The Company has not yet determined the impact, if any, of adopting this statement. The disclosure prescribed by SOP 98-1 will be effective for the Company's fiscal year ending February 28, 2000. In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities", which supercedes and amends a number of existing standards. The statement is effective for fiscal years beginning after June 15, 1999, but earlier application is permitted. The impact of the adoption of this statement, if any, on the Financial Statements of the Company has not yet been determined. -9- 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 the Company's Annual Report on Form 10-K for the year ended February 28, 1998, as filed with the Securities and Exchange Commission on May 29, 1998. Overview Integrated Systems, Inc. ("the Company") provides comprehensive solutions of software products and engineering services for the development of embedded microprocessor-based applications for the real-time embedded computer market. 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 the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements. The Company'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 the Company's Annual Report on Form 10-K for the year ended February 28, 1998, and other documents filed by the Company with the Securities and Exchange Commission. Results of Operations The following table sets forth for the periods presented the percentage of total revenue represented by each line item in the Company's condensed consolidated statements of income 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 August 31, August 31, 1998 1997 1998 compared to 1997 ---------- ---------- ----------------------------- Revenue: Product 55 % 48 % 14 % Services 45 52 (14) ---------- ---------- Total revenue 100 100 (1) ---------- ---------- Costs and expenses: Cost of product revenue 11 11 (1) Cost of services revenue 19 30 (36) Marketing and sales 35 34 4 Research and development 14 15 (2) General and administrative 14 9 44 ---------- ---------- Total costs and expenses 93 99 (6) ---------- ---------- Income from operations 7 1 402 Interest and other income 4 3 34 ---------- ---------- Income before income taxes 11 4 146 Provision for income taxes 4 1 135 ---------- ---------- Net income 7 % 3 % 151 % ========== ==========
-10-
Percentage of Period-to-Period Total Revenue Percentage Change ------------------------ ---------------------------- Six Months Ended Six Months Ended August 31, August 31, 1998 1997 1998 compared to 1997 ---------- ---------- ---------------------------- Revenue: Product 55 % 52 % 19 % Services 45 48 4 ---------- ---------- Total revenue 100 100 12 ---------- ---------- Costs and expenses: Cost of product revenue 11 11 14 Cost of services revenue 18 26 (24) Marketing and sales 37 36 15 Research and development 16 17 6 General and administrative 12 10 39 ---------- ---------- Total costs and expenses 94 100 5 ---------- ---------- Income from operations 6 0 N/M Interest and other income 3 3 25 ---------- ---------- Income before income taxes 9 3 236 (Benefit)/provision for income taxes (1) 1 N/M ---------- ---------- Net income 10 % 2 % 453 % ========== ========== N/M = Not Meaningful
Revenue Revenue consists of fees from the licensing and sale of software products and providing related maintenance and support, customer training and engineering and consulting services. Total revenue decreased by 1% from $32.2 million in the second quarter of fiscal year 1998 to $32.0 million in the second quarter of fiscal year 1999, and increased by 12% from $56.8 million in the first six months of fiscal year 1998 to $63.5 million in the first six months of fiscal year 1999. Product revenue increased 14% from $15.5 million in the second quarter of fiscal year 1998 to $17.7 million in the second quarter of fiscal year 1999, and by 19% from $29.3 million in the first six months of fiscal year 1998 to $34.9 million in the first six months of fiscal year 1999. The increases in product revenue were primarily due to increases in the number of licenses of the Company's pRISM+(TM) product, which was released in the second quarter of fiscal year 1998, as well as from increased licensing of the Company's Diab Data compilers and SNiFF+(TM) products. Services revenue decreased 14% from $16.7 million in the second quarter of fiscal year 1998 to $14.3 million in the second quarter of fiscal year 1999, and increased by 4% from $27.5 million in the first six months of fiscal year 1998 to $28.6 million in the first six months of fiscal year 1999. The decrease quarter over quarter is due to the impact in the second quarter of fiscal year 1998 of an engineering services contract which required the procurement of approximately $2.6 million of materials resulting in unusually high services revenue and cost of services revenue in the second quarter of fiscal year 1998. The increase between the two six-month periods is due primarily to continued growth of the installed customer base and the renewal of maintenance and support contracts, and from growth in consulting and engineering services, offset, in part, by the impact of the contract discussed above. Price increases were not a material factor in the Company's revenue growth in the periods presented. The percentage of the Company's total revenue from customers located internationally was 42% and 31% in the second quarters of fiscal years 1999 and 1998, respectively, and 43% and 31% in the first six months of fiscal years 1999 and 1998, respectively. In Europe and Japan, revenues and expenses are primarily denominated in local currencies. In the second quarter of fiscal year 1999 and for the six months ended August 31, 1998 the U.S. dollar strengthened against many foreign currencies as compared to the second quarter and first six months of fiscal year 1998. This resulted in relatively lower revenues and expenses when translated into U.S. dollars for the second quarter and first six months of fiscal year 1999, compared to the comparative periods of fiscal year 1998. The Company's operating and pricing strategies take into account changes in exchange rates over time, however, the Company's results of operations may be significantly affected in the short term by fluctuations in foreign currency exchange rates. In addition, in recent months the currencies of many countries in the Asia Pacific region have lost significant value against the dollar. As a result, sales in this region could be adversely affected throughout fiscal year 1999. -11- Costs and Expenses Cost of product revenue includes third-party royalties, costs of product packaging, documentation, amortization of capitalized software development costs, and the costs related to equipment hardware. The Company's cost of product revenue as a percentage of product revenue was 23% and 20% in the second quarters of fiscal years 1998 and 1999, respectively, and 21% and 20% in the first six months of fiscal years 1998 and 1999, respectively. Costs 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 can fluctuate due to shifts in the services revenue mix between higher margin maintenance and support revenues and lower margin engineering and consulting services revenues. In addition, the cost of services revenue as a percentage of services revenue can fluctuate due to shifts in the proportion of fixed price versus time and material engineering and consulting contracts. The Company's cost of services revenue as a percentage of services revenue decreased from 57% in the second quarter of fiscal year 1998 to 42% in the second quarter of fiscal year 1999, and from 55% in the first six months of fiscal year 1998 to 40% in the first six months of fiscal year 1999. These percentage decreases were due mainly to a decrease in lower margin fixed price contracts. In particular, as discussed above, during the second quarter of fiscal year 1998, the Company was required to procure a significant amount of materials with no associated gross margin, under the terms of a large engineering services contract. Excluding this anomaly, cost of services revenue as a percentage of services revenue was 50% for the second quarter and the first six months of fiscal year 1998. Marketing and sales expenses were $11.3 million and $10.9 million in the second quarters of fiscal years 1999 and 1998, respectively, representing 35% and 34% of total revenue, respectively, and $23.4 million and $20.3 million in the first six months of fiscal years 1999 and 1998, respectively, representing 37% and 36% of total revenue ,respectively. The dollar increases for all periods presented were primarily due to the Company's continued investment in its domestic and international sales and support infrastructure. The Company believes that significant investment for product research and development is essential to product and technical leadership. Research and development expenses were $4.7 million in the second quarters of fiscal years 1999 and 1998, representing 14% and 15%, respectively, of total revenue, and $10.1 million and $9.5 million in the first six months of fiscal years 1999 and 1998, respectively, representing 16% and 17% of total revenue, respectively. General and administrative expenses were $4.4 million and $3.1 million in the second quarters of fiscal years 1999 and 1998, respectively, representing 14% and 9% of total revenue, respectively, and $7.8 million and $5.6 million in the first six months of fiscal years 1999 and 1998, respectively, representing 12% and 10% of total revenue, respectively. The dollar increases for all periods presented were primarily the result of CEO termination and recruitment costs, higher legal costs and other outside service costs. Interest and other income was $1.3 million in the second quarter of fiscal 1999 compared to $1.0 million in the second quarter of fiscal year 1998. The increase is primarily due to higher interest earned from increased holdings of cash and marketable securities in fiscal year 1999. Interest and other income was $2.2 million in the first six months of fiscal year 1999 compared to $1.8 million in the first six months of fiscal year 1998. Recent Accounting Pronouncements In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131 ("SFAS 131"), "Disclosure About Segments of an Enterprise and Related Information," which specifies disclosure requirements for segment reporting. The statement supersedes SFAS 14 and SFAS 18, is effective for fiscal years beginning after December 15, 1997, and requires earlier periods to be restated if practicable. The impact of the adoption of this statement, if any, on the Financial Statements of the Company has not yet been determined. In April 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-1 ("SOP 98-1") "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". SOP 98-1 provides guidance for determining whether computer software is internal-use software and on accounting for the proceeds of computer software originally developed or obtained for internal use and then subsequently sold to the public. It also provides guidance on capitalization of the costs incurred for computer software developed or obtained for internal use. The Company has not yet determined the impact, if any, of adopting this statement. The disclosure prescribed by SOP 98-1 will be effective for the Company's fiscal year ending February 28, 2000. In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting Derivative Instruments and Hedging Activities", which supercedes and amends a number of existing standards. The statement is effective for fiscal years beginning after June 15, 1999, but earlier application is permitted. The impact of the adoption of this statement, if any, on the Financial Statements of the Company has not yet been determined. -12- "Year 2000" Issues The Company believes that all its most current releases of its products 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 the Company's customers will implement the Year 2000 compliant release of the Company's products in a timely manner, which could lead to failure of customer systems and product liability claims against the Company. Even if the Company's products are Year 2000 compliant, the Company 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 the Company for Year 2000-related damages, including consequential damages, could have a material adverse effect on the Company's business, financial condition and results of operations. Such failure could also affect the perceived performance of the Company's products, which could have a negative effect on the Company's competitive position. The Company is reviewing its major internal corporate systems for Year 2000 Compliance and intends to take appropriate action based on the results of such review. The Company's plan for the Year 2000 calls for compliance verification of external vendors supplying software and information systems to the Company and communication with significant suppliers to determine the readiness of third parties' remediation of their own Year 2000 issues. As part of its assessment, the Company is evaluating the level of validation it will require of third parties to ensure their Year 2000 readiness. To date, the Company has not encountered any material Year 2000 issues concerning its computer systems. All costs associated with carrying out the Company's plan for the Year 2000 Compliance are being expensed as incurred. The total costs associated with preparation for the Year 2000 has not been, and is not expected to be, material to the Company's business, financial condition or results of operation. Nevertheless, the Company may not timely identify and remediate all significant Year 2000 problems and remedial efforts may involve significant time and expense. There can be no assurance that any Year 2000 Compliance problems of the Company or its customers or suppliers will not have a material adverse effect on the Company's business, financial condition and results of operations. "Euro" Issues The Economic and Monetary Union ("EMU") and the introduction of a new currency (the "Euro"), will begin in Europe on January 1, 1999. The new currency enables the European Union ("EU") to blend the economies of EU's member states into one large market with unrestricted and unencumbered trade and commerce across borders. Eleven European countries are expected to participate in the first membership wave of EMU, including the Netherlands, Belgium, Luxembourg, Germany, France, Ireland, Finland, Austria, Italy, Spain and Portugal. Other member states are expected to join in the years to come. The Company has not evaluated the impact of the introduction of the new currency and has not determined the impact, if any, on the Company's financial position, results of operations or cash flows. Liquidity and Capital Resources The Company funds its operations principally through cash flows from operations. As of August 31, 1998, the Company had $76.3 million of cash, cash equivalents and marketable securities. This represents an increase of $8.9 million from February 28, 1998. In April 1997, the Company announced that the Board of Directors had authorized a common stock repurchase program allowing the Company to repurchase up to 1,000,000 shares of common stock for cash, from time-to-time at market prices. No time limit was set for the completion of the program. In September 1998, the Board of Directors authorized a further 1,000,000 shares of common stock to be repurchased under this program. As of September 30, 1998 the Company had repurchased 825,000 shares of common stock for $7.2 million under this program. Net cash provided by operating activities during the first six months of fiscal year 1999 totaled $9.9 million, as compared to $9.6 million in the first six months of fiscal year 1998. Net cash provided by operating activities increased, due to an increase in net income and changes in accounts receivable, off set by changes in accounts payable, accrued payroll and other accrued liabilities, and income taxes payable. Net cash used in investing activities totaled $10.9 million in the first six months of fiscal year 1999 compared to $15.4 million in fiscal year 1998. Net cash used in investing activities was higher in the first six months of fiscal year 1998 due primarily to higher purchases of marketable securities. Net cash provided by financing activities totaled $1.3 million in the first six months of fiscal years 1999 and 1998. Net cash provided by financing activities is the result of proceeds from the exercise of common stock options and purchases under the Employee Stock Purchase plan, offset by repurchases of the Company's common stock. The Company believes that cash flows from operations, together with existing cash balances, will be adequate to meet the Company's cash requirements for working capital, stock repurchase and capital expenditures for the next 12 months and the foreseeable future. -13- Risk Factors that May Affect Future Results of Operations Fluctuations in Quarterly Results The Company's quarterly operating results can vary significantly depending on a number of factors, including the volume and timing of orders received during the quarter, the mix of and changes in customers to whom the Company's products are sold, the timing and acceptance of new products and product enhancements by the Company or its competitors, changes in pricing, buyouts of run-time licenses, product life cycles, the level of the Company'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 the Company'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 the foregoing factors are difficult to forecast. The future operating results of the Company may fluctuate as a result of these and other factors, including the Company's ability to continue to develop innovative and competitive products. The Company historically has operated with an immaterial 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, the Company generally recognizes a substantial portion of its total revenue from sales orders received and shipped in the last two weeks of the quarter. As such, the magnitude of quarterly fluctuations may not become evident until very late in, or after the end of, a particular quarter. In addition, an increasing amount of the Company's sales orders involve products and services which yield revenue over multiple quarters or upon completion of performance. Because the Company's staffing and operating expenses are based on anticipated total revenue levels, and a high percentage of the Company'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 the Company's operating results from quarter to quarter. The procurement process of the Company'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 the Company's products increasingly becomes a more strategic decision made at higher management levels, there can be no assurance that sales cycles for the Company's products will not lengthen. In addition, a portion of the Company'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 the Company's business and results of operations. The Company's results of operations may also be affected by seasonal trends. While the Company's revenues are not generally seasonal in nature, the Company'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, the Company 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, the Company has experienced actual performance that did not meet financial market expectations. It is likely that, in some future quarters, the Company's operating results will again be below the expectations of stock market analysts and investors. Rapid Technological Change; Dependence on New Products The market for embedded applications is fragmented and is characterized by ongoing technological developments, evolving industry standards and rapid changes in customer requirements. The Company's success depends upon its ability to continue to develop and introduce in a timely manner new products that take advantage of technological advances, 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. The Company must continuously update its existing products to keep them current with changing technology and must develop new products to take advantage of new technologies that could render the Company's existing products obsolete. The Company has experienced delays in the development of new products and the enhancement of existing products. Such delays are commonplace in the software industry and are likely to be experienced by the Company in the future. The Company's future prospects depend upon the Company's ability to increase the functionality of existing products in a timely manner and to develop new products that address new technologies and achieve market acceptance. New products and enhancements must keep pace with competitive offerings, adapt to evolving industry standards and provide additional functionality. The inability of the Company, due to resource constraints or technological or other reasons, to develop and introduce new products or product enhancements in a timely manner or the failure of such new products or product enhancements to achieve market acceptance could have a material adverse effect on the Company's business, financial condition or results of operations. 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 defer purchasing existing Company products. Any failure by the Company 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 the Company's business, financial condition and results of operations. -14- Risks Associated with New or Emerging Markets From time to time, the Company embarks on product development for new or emerging markets. Currently, the Company is continuing to expend substantial time and financial resources to develop product lines for applications that use Internet technology with embedded microprocessors. The Company has introduced both embedded operating software and development tools for Internet applications. The commercial Internet market has only recently begun to develop, is rapidly changing and is characterized by an increasing number of new entrants with competitive products. It is difficult to predict with any assurance whether the Internet will prove to be a viable commercial marketplace, or whether demand for Internet related products and services will increase in the future. If the Internet market, or any other new market targeted by the Company in the future, fails to develop or develops more slowly than anticipated or becomes saturated with competitors, or if the Company's products and services do not achieve or sustain market acceptance, the Company's business, financial condition and results of operations would be materially adversely affected. Competition. 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. The Company's products compete with software developed internally by embedded systems manufacturers and software offered by other third parties. Many organizations that internally develop and maintain real-time operating systems have substantial programming resources and can develop specific products for their needs. Many of these companies have significant investments in their existing software and there can be no assurance that the Company will be able to persuade existing and potential customers to replace or augment their internally developed real-time operating systems with the Company's products. The Company's principal competitors for third-party embedded software and related tools are Wind River Systems, Inc., Microsoft Corporation and Sun Microsystems, Inc. The MATRIXx product family competes with products offered by Mathworks Incorporated and a number of other companies that provide design and analysis, modeling and simulation, and code generation products. The Company also competes with a number of other vendors that address one or more segments of the system design process, including vendors that have modified general purpose software engineering products for real-time and control design applications. As the industry continues to develop, the Company expects competition to increase in the future from existing competitors and from other companies that may enter the Company's existing or future markets with similar or substitute solutions that may be less costly or provide better performance or functionality than the Company's products. Some of the Company's existing and many of its potential competitors have substantially greater financial, technical, marketing and sales resources than the Company and there can be no assurance that the Company will be able to compete successfully against these companies. In the event that price competition increases significantly, competitive pressures could cause the Company to reduce the prices of its products, which would result in reduced profit margins. Prolonged price competition would have a material adverse effect on the Company'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 the Company's real-time operating systems, may be subject to significant pricing pressures. A variety of other potential actions by the Company's competitors, including increased promotion and accelerated introduction of new or enhanced products, could have a material adverse effect on the Company's business, financial condition and results of operations. Acquisition-Related Risks The Company completed a number of acquisitions in fiscal year 1996 and one in fiscal year 1997 and may complete additional acquisitions in the future. The process of integrating an acquired company's business into the Company'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 the Company's business. Moreover, there can be no assurance that the anticipated benefits of an acquisition will be realized. Future acquisitions by the Company could result in potentially dilutive issuances of equity securities, the incurrence of debt and contingent liabilities and amortization expenses related to goodwill and other intangible assets, which could have a material adverse effect on the Company'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 the Company has no or limited direct prior experience and the potential loss of key employees of the acquired company. From time to time, the Company evaluates potential acquisitions of businesses, products or technologies. The Company has no present understandings, commitments or agreements with respect to any material acquisition of other businesses, products or technologies, and no material acquisition is currently being pursued actively. In the event that such an acquisition were to occur, however, there can be no assurance that the Company's business, operating results and financial condition would not be materially adversely affected. -15- Risks Associated with International Operations In fiscal years 1996, 1997 and 1998, the Company derived approximately 34%, 38%, and 41%, respectively, of its total revenue from sales outside of North America. In the second quarter and first six months of fiscal year 1999 the Company generated 42% and 43%, respectively, of its total revenue from sales outside of North America. The Company 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, including foreign government regulation, reduced protection of intellectual property rights, 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, staffing and managing foreign operations, general geopolitical risks, such as political and economic instability, hostilities with neighboring countries and changes in diplomatic and trade relationships, possible recessionary environments in economies outside the United States and other factors beyond the control of the Company. The Company generally denominates sales to and by foreign subsidiaries in local currency, and an increase in the relative value of the dollar against such currencies, as has recently occurred, would reduce the Company's revenue in dollar terms or make the Company's products more expensive and, therefore, potentially less competitive in foreign markets. In particular, revenue from sales in Japan during fiscal years 1997, 1998 and in the first six months of fiscal year 1999 was adversely affected by the weakness of the yen against the dollar. Continued weakness of the yen may affect revenue from Japan during fiscal year 1999. The Company has little experience in hedging its foreign currency sales, but has done so on a limited basis. There can be no assurance that the Company's future results of operations will not be adversely affected by currency fluctuations. In recent months, the currencies of many countries in the Asia Pacific region have lost significant value against the dollar, notably the currencies of Korea and Taiwan. As a result, the Company's sales in these countries could be adversely affected. The Company relies on distributors and representatives for sales of its products in certain foreign countries and, accordingly, is dependent on their ability to promote and support the Company's products and, in some cases, to translate them into foreign languages. The Company's international distributors and representatives generally offer products of several different companies, including in some cases products that are competitive with the Company's products, and such distributors and representatives are not subject to any minimum purchase or resale requirements. There can be no assurance that the Company's international distributors and representatives will continue to purchase the Company's products or provide them with adequate levels of support. Risks of Product Defects; Product and Other Liability; Year 2000 Compliance 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. There can be no assurance that, despite testing by the Company and testing and use by current and potential customers, errors will not be found in new products after commencement of commercial shipments. The occurrence of such errors could result in loss of or delay in market acceptance of the Company's products, which could have a material adverse effect on the Company's business, financial condition and results of operations. The increasing use of the Company'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 the Company to significant product liability claims. In addition, the Company's products are used for applications in mission-critical business systems where the failure of the embedded system could be linked to substantial economic loss. The Company believes that all of its most current releases of its products 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"). Year 2000 Compliance issues may arise with respect to any modifications made to the Company's products by a party other than the Company or from the combination or use of the Company's products with any other software programs or hardware devices not provided by the Company, and therefore may result in unforeseen Year 2000 Compliance problems for some of the Company's customers, which may have a material adverse effect on the Company's business, financial condition and results of operations. The Company's license and other agreements with its customers typically contain provisions designed to limit the Company's exposure to potential product liability and other claims. It is likely, however, that the limitation of liability provisions contained in the Company's agreements are not effective in all circumstances and in all jurisdictions. The Company currently does not have insurance against product liability risks or errors or omissions coverage and there can be no assurance that such insurance will be available to the Company on commercially reasonable terms or at all. A product liability claim or claim for economic loss brought against the Company, or a product recall involving the Company's software, could have a material adverse effect on the Company's business, financial condition and results of operations. Additionally, as with any company with a computing infrastructure and utilizing business-application software programs written over many years, the Company's internal operations may be subject to Year 2000 Compliance issues. The Company's operations are dependent 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. The Company believes it has taken prudent measure to reduce the risk of interruption in its operations. However, there can be no assurance that these measures are sufficient. Any damage or failure that causes interruption in the Company's operations could have a material adverse effect on its business, financial condition, and results of operations. -16- Dependence on Key Personnel; Need for Additional Personnel The Company's future performance depends to a significant degree upon the continued contributions of its key management, product development, sales, marketing and operations personnel. The Company does not have employment agreements with any of its key personnel and does not maintain any key person life insurance policies. In addition, the Company 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 such personnel is intense in Santa Clara County, California, where the Company is headquartered, and there can be no assurance that the Company will be successful in attracting and retaining such personnel. In particular, the Company is currently searching for a new President and Chief Executive Officer, and has appointed an interim CEO from within the Company during this transition. The failure of the Company to attract, assimilate and retain the necessary personnel could have a material adverse effect on the Company's business, financial condition and results of operations. Limited Protection of Proprietary Technology The Company's success is heavily dependent upon its proprietary technology. To protect its proprietary rights, the Company relies on a combination of copyright, trade secret, patent and trademark laws, nondisclosure and other contractual restrictions on copying and distribution and technical measures. Despite the Company's efforts to protect its proprietary rights, it may be possible for unauthorized third parties to copy the Company's products or to reverse engineer or obtain and use information that the Company regards as proprietary. Policing unauthorized use of the Company's products is difficult, and while the Company 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 certain 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 issue that relate to fundamental technologies incorporated into the Company's products. As the number of patents, copyrights, trademarks and other intellectual property rights in the Company's industry increases, products based on its technology may increasingly become the subject of infringement claims. There can be no assurance that third parties will not assert infringement claims against the Company in the future. Any such claims with or without merit could be time consuming, result in costly litigation, cause product shipment delays or require the Company to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, might not be available on terms acceptable to the Company, or at all, which could have a material adverse affect on the Company's business, financial condition and results of operations. In addition, the Company may initiate claims or litigation against third parties for infringement of the Company's proprietary rights or to establish the validity of the Company's proprietary rights. Litigation to determine the validity of any claims, whether or not such litigation is determined in favor of the Company, could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel from productive tasks. In the event of an adverse ruling in any such litigation, the Company may be required to pay substantial damages, discontinue the use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses to infringing technology. The failure of the Company to develop or license a substitute technology could have a material adverse affect on the Company's business, financial condition and results of operations. Dependence on Licenses from Third Parties The Company licenses certain software development tool products from other companies to distribute with its own products. The inability of such 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 the Company's business, financial condition and results of operations. In addition, the Company's products compete with products produced by certain of the Company's licensors. There can be no assurance that, upon the termination or expiration of these licenses, such licenses will be available on reasonable terms or at all, or that similar products could be obtained to substitute into the tool suites. The inability to license such products could have a material adverse effect on the Company's business, financial condition and results of operations. Volatility of Stock Price The prices for the Company's common stock have fluctuated widely in the past. The management of the Company believes that such fluctuations may have been caused by actual or anticipated variations in the Company's operating results, announcements of technical innovations or new products or services by the Company 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 the Company 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 such a company. Such litigation, if instituted, could result in substantial costs and a diversion of management attention and resources, which would have a material adverse effect on the Company's business, financial condition and results of operations even if the Company is successful in such 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. -17- 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. Item 3. Quantitative and Qualitative Disclosures about Market Risks Foreign Currency Risk. The Company enters into foreign currency forward exchange contracts to reduce the impact of currency exchange rate fluctuations on monetary assets and liability positions. The objective of these contracts is to minimize the impact of exchange rate fluctuations on the Company'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 the Company have maturities of less than one year. At August 31, 1998, the Company had approximately $2.5 million of foreign currency forward exchange contracts outstanding, $2.2 million in Japanese yen and $0.3 million in Swedish Krona. There were no foreign currency forward exchange contracts at February 28, 1998. Unrealized gains on foreign currency forward exchange contracts at August 31, 1998 were approximately $19,000. -18- PART II - OTHER INFORMATION Item 1. Legal Proceedings Information with respect to this item is incorporated by reference to Note 6 of Notes to Condensed Consolidated Financial Statements included herein on Page 8 of this Form 10-Q. Item 4. Submission of Matters to a Vote of Security Holders At the Annual Meeting of Shareholders held July 15, 1998, the following matters were submitted to a vote of the security holders: (1) To elect the following to serve as directors of the Company: Name For Withheld John C. Bolger 19,960,987 27,577 Michael A. Brochu 19,961,489 27,075 Narendra K. Gupta 19,951,172 37,392 Vinita Gupta 19,715,498 273,066 Thomas Kailath 19,724,489 264,075 Richard C. Murphy 19,725,262 263,302 David P. St. Charles 19,581,017 407,547 (2) To approve the adoption of the Company's 1998 Equity Incentive Plan: Votes for 9,674,261 Votes against 4,867,189 Votes abstaining 93,864 (3) To approve an amendment to the 1994 Directors Stock Option Plan to eliminate the provision which limits the maximum number of shares that may be issued to any one director to 40,000 shares: Votes for 13,315,176 Votes against 1,225,171 Votes abstaining 94,967 (4) To ratify the selection of PricewaterhouseCoopers L.L.P. as independent accountants for the Company for the fiscal year ending February 28, 1999: Votes for 19,959,564 Votes against 13,400 Votes abstaining 15,510 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits. The following exhibits are filed as part of the Report: Exhibit Number Title 10.14 Registrant's 1998 Equity Incentive Plan (Incorporated by reference to Exhibit 4.04 of the Company's Registration Statement on Form S-8, File No. 333-64673) 27.01 Financial Data Schedule (b) Reports on Form 8-K. No reports on Form 8-K were filed by Registrant during the three months ended August 31, 1998. -19- 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: October 9, 1998 INTEGRATED SYSTEMS, INC. (Registrant) /S/ JOSEPH ADDIEGO ------------------------------------ JOSEPH ADDIEGO Interim Chief Executive Officer /S/WILLIAM C. SMITH ------------------------------------ WILLIAM C. SMITH Vice President, Finance and Chief Financial Officer -20- EX-27 2 FDS --
5 THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM Q2 FY99 FORM 10-Q FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 6-MOS FEB-28-1999 MAR-01-1998 AUG-31-1998 14,812 2,658 25,449 0 0 48,999 18,796 0 135,084 32,678 0 0 0 64,951 37,455 135,084 34,884 63,487 7,133 18,611 41,217 0 0 5,880 (518) 6,398 0 0 0 6,398 0.27 0.26
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