-----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, DhNYp1jjUCIqUfvGYoMY7YsfoxVDcktuIZU26qe4O/SQ9llatLZfrs0Zg2+6ZMQF l8yy9+JKDre0mgv7xHI/EA== 0001047469-99-039030.txt : 19991018 0001047469-99-039030.hdr.sgml : 19991018 ACCESSION NUMBER: 0001047469-99-039030 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990831 FILED AS OF DATE: 19991015 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: 99729383 BUSINESS ADDRESS: STREET 1: 201 MOFFETT PARK DIRVE CITY: SUNNYVALE STATE: CA ZIP: 95054-3309 BUSINESS PHONE: 4085421500 MAIL ADDRESS: STREET 1: 201 MOFFETT PARK DRIVE CITY: SUNNYVALE STATE: CA ZIP: 94089 10-Q 1 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, 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 September 30, 1999 was 23,712,924 shares. Page 1 of 26 pages INTEGRATED SYSTEMS, INC. FORM 10-Q QUARTER ENDED AUGUST 31, 1999 INDEX
Page ---- PART I - FINANCIAL INFORMATION - ------------------------------ Item 1. Financial Statements 3 Condensed Consolidated Balance Sheets as of August 31, 1999 and February 28, 1999 4 Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the Three Months and Six Months Ended August 31, 1999 and 1998 5 Condensed Consolidated Statements of Cash Flows for the Six Months Ended August 31, 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 13 PART II - OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds 24 Item 4. Submission of Matters to a Vote of Security Holders 24 Item 6. Exhibits and Reports on Form 8-K 25 SIGNATURES 26
--------------------------------------------------------------------------- --------------------------------------------------------------------------- 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)
AUGUST 31, FEBRUARY 28, 1999 1999 --------------- --------------- (unaudited) ASSETS Current assets: Cash and cash equivalents $ 15,941 $ 19,079 Marketable securities 1,992 9,554 Accounts receivable, net 28,525 28,431 Deferred income taxes 2,197 2,360 Prepaid expenses and other 5,338 5,255 --------------- --------------- Total current assets 53,993 64,679 Marketable securities 24,644 49,698 Property and equipment, net 20,520 18,633 Intangible assets, net 37,493 3,503 Deferred income taxes 5,259 5,322 Other assets 2,053 1,200 --------------- --------------- Total assets $ 143,962 $ 143,035 --------------- --------------- --------------- --------------- LIABILITIES Current liabilities: Accounts payable $ 4,933 $ 4,761 Accrued payroll and related expenses 6,773 6,250 Other accrued liabilities 7,100 10,668 Income taxes payable 3,413 2,562 Deferred revenue 19,031 18,003 --------------- --------------- Total current liabilities 41,250 42,244 Long-term debt 816 - --------------- --------------- Total liabilities 42,066 42,244 --------------- --------------- SHAREHOLDERS' EQUITY Common Stock, no par value, 50,000 shares authorized: 23,695 and 22,686 shares issued and outstanding at August 31, 1999 and February 28, 1999, respectively 68,942 59,848 Accumulated other comprehensive (loss), net (1,564) (759) Retained earnings 34,518 41,702 --------------- --------------- Total shareholders' equity 101,896 100,791 --------------- --------------- Total liabilities and shareholders' equity $ 143,962 $ 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 SIX MONTHS ENDED AUGUST 31, AUGUST 31, ------------------------------- -------------------------------- 1999 1998 1999 1998 --------------- --------------- --------------- --------------- Revenue: Product $ 20,765 $ 17,723 $ 39,714 $ 34,884 Services 14,283 14,282 27,926 28,603 --------------- --------------- --------------- --------------- Total revenue 35,048 32,005 67,640 63,487 --------------- --------------- --------------- --------------- Costs and expenses: Cost of product revenue 3,064 2,875 7,973 6,008 Cost of services revenue 5,888 6,670 11,882 12,603 Marketing and sales 14,388 11,258 28,413 23,363 Research and development 6,137 4,658 11,446 10,099 General and administrative 3,708 3,203 7,211 6,387 Amortization of intangibles 1,308 136 1,308 308 Acquisition-related and other expenses 7,089 1,060 7,089 1,060 --------------- --------------- --------------- --------------- Total costs and expenses 41,582 29,860 75,322 59,828 --------------- --------------- --------------- --------------- Income (loss) from operations (6,534) 2,145 (7,682) 3,659 Interest and other income 697 1,308 2,097 2,221 --------------- --------------- --------------- --------------- Income (loss) before income taxes (5,837) 3,453 (5,585) 5,880 Provision (benefit) for income taxes 1,518 1,105 1,599 (518) --------------- --------------- --------------- --------------- Net income (loss) $ (7,355) $ 2,348 $ (7,184) $ 6,398 --------------- --------------- --------------- --------------- --------------- --------------- --------------- --------------- Other comprehensive income (loss), net of tax: Foreign currency translation adjustments 244 79 (157) (18) Unrealized gain (loss) on investments (247) 335 (648) 296 --------------- --------------- --------------- --------------- --------------- --------------- --------------- --------------- Other comprehensive income (loss) (3) 414 (805) 278 --------------- --------------- --------------- --------------- Total comprehensive income (loss) $ (7,358) $ 2,762 $ (7,989) $ 6,676 --------------- --------------- --------------- --------------- --------------- --------------- --------------- --------------- Earnings (loss) per share - basic $ (0.32) $ 0.10 $ (0.31) $ 0.27 --------------- --------------- --------------- --------------- --------------- --------------- --------------- --------------- Earnings (loss) per share - diluted $ (0.32) $ 0.10 $ (0.31) $ 0.26 --------------- --------------- --------------- --------------- --------------- --------------- --------------- --------------- Shares used in per share calculations - basic 23,266 23,501 23,021 23,464 --------------- --------------- --------------- --------------- --------------- --------------- --------------- --------------- Shares used in per share calculations - diluted 23,266 24,276 23,021 24,356 --------------- --------------- --------------- --------------- --------------- --------------- --------------- ---------------
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, ------------------------------ 1999 1998 ---------------- ------------- Cash flows from operating activities: Net income (loss) $ (7,184) $ 6,398 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization of capitalized software 4,400 2,560 Amortization of other intangibles 1,308 308 In-process research & development written off 6,300 - Deferred income taxes (754) (1,989) Provisions for doubtful accounts receivable (51) (200) Changes in assets and liabilities: Accounts receivable 2,123 4,146 Prepaid expenses and other 356 (537) Accounts payable, accrued payroll and other accrued liabilities (7,622) (432) Income taxes payable 851 (766) Deferred revenue 1,028 182 Other assets and liabilities (846) 213 ---------------- ------------- Net cash provided by (used in) operating activities (91) 9,883 ---------------- ------------- Cash flows from investing activities: Sales (purchases) of marketable securities, net 31,536 (8,029) Additions to property and equipment, net (3,776) (2,312) Capitalized software development costs (1,050) (530) Acquisitions, net of cash acquired (24,872) - ---------------- ------------- Net cash provided by (used in) investing activities 1,838 (10,871) ---------------- ------------- Cash flows from financing activities: Repurchase of common stock (6,365) (1,059) Proceeds from exercise of common stock options and purchases under the Employee Stock Purchase Plan 1,518 2,363 ---------------- ------------- Net cash provided by (used in) financing activities (4,847) 1,304 ---------------- ------------- Effect of exchange rate fluctuations on cash and cash equivalents (38) 42 Net increase (decrease) in cash and cash equivalents (3,138) 358 Cash and cash equivalents at beginning of period 19,079 14,454 ---------------- ------------- Cash and cash equivalents at end of period $ 15,941 $ 14,812 ---------------- ------------- ---------------- ------------- Supplemental disclosure of cash flow information: Cash paid during the period for income taxes $ 748 $ 2,040 Supplemental schedule of noncash investing activities: Unrealized gain (loss) on marketable securities $ (1,080) $ 493 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 six months ended August 31, 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. ACQUISITION OF SOFTWARE DEVELOPMENT SYSTEMS, INC. On July 21, 1999, Integrated Systems, Inc. ("ISI") 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 months ended and six months ended August 31, 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 August 31, 1999, reflects a preliminary allocation of the purchase price of SDS, which resulted in an increase in accounts receivable, deferred tax assets, prepaid and other current assets, fixed assets, goodwill and other intangible assets, current and long-term 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. The purchase price of $39.2 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 20,118 -------------- Total $ 39,235 -------------- --------------
-7- 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 SIX MONTHS ENDED AUGUST 31, AUGUST 31, 1999 1998 1999 1998 ------------- ------------ ------------- ------------ (in thousands, except per share data) Pro forma net revenue $ 36,498 $ 34,578 $ 72,459 $ 68,838 ------------- ------------ ------------- ------------ ------------- ------------ ------------- ------------ Pro forma net income (loss) $ (4,698) $ (143) $ (6,937) $ (67) ------------- ------------ ------------- ------------ ------------- ------------ ------------- ------------ Pro forma earnings (loss) per share - basic & diluted $ (0.20) $ (0.01) $ (0.30) $ - ------------- ------------ ------------- ------------ ------------- ------------ ------------- ------------
3. 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. 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) 1999 1998 1999 1998 ------------ -------------- ------------ -------------- Basic Net income (loss) $ (7,355) $ 2,348 $ (7,184) $ 6,398 ------------ -------------- ------------ -------------- ------------ -------------- ------------ -------------- Number of shares: Weighted average number of common shares outstanding 23,266 23,501 23,021 23,464 ------------ -------------- ------------ -------------- ------------ -------------- ------------ -------------- Earning (loss) per share - basic $ (0.32) $ 0.10 $ (0.31) $ 0.27 ------------ -------------- ------------ -------------- ------------ -------------- ------------ -------------- Diluted Net income (loss) $ (7,355) $ 2,348 $ (7,184) $ 6,398 ------------ -------------- ------------ -------------- ------------ -------------- ------------ -------------- Number of shares: Weighted average number of common shares outstanding 23,266 23,501 23,021 23,464 Diluted effect of stock options, net - 775 - 892 Weighted average number of common shares ------------ -------------- ------------ -------------- and comon equivalent shares outstanding 23,266 24,276 23,021 24,356 ------------ -------------- ------------ -------------- ------------ -------------- ------------ -------------- Earning (loss) per share - diluted $ (0.32) $ 0.10 $ (0.31) $ 0.26 ------------ -------------- ------------ -------------- ------------ -------------- ------------ --------------
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 2,472,000 for the three months ended August 31, 1999, and 1,363,000 for the six months ended August 31,1999. For periods where a net loss is shown, potentially dilutive stock options are excluded from the calculation of loss per common share as their inclusion would have an anti-dilutive effect. These stock options, stated in equivalent shares of common stock, consisted of 332,000 and 514,000 options to purchase common stock for the three months ended and the six months ended August 31, 1999, respectively. -8- 4. COMPREHENSIVE INCOME (LOSS) The accumulated balances of other comprehensive income (loss), net of taxes, as of August 31, 1999 and 1998 were as follows (in thousands):
AUGUST 31, 1999 AUGUST 31, 1998 ------------------------------------------ ---------------------------------------- FOREIGN FOREIGN CURRENCY UNREALIZED CURRENCY UNREALIZED TRANSLATION GAINS/ TOTAL TRANSLATION GAINS/ TOTAL ADJUSTMENTS LOSSES OTHER ADJUSTMENTS LOSSES OTHER --------------- ------------ ------------- -------------- ------------ ------------ Beginning balance $ (967) $ 208 $ (759) $ (1,438) $ 148 $ (1,290) Current-period change (157) (648) (805) (18) 296 278 --------------- ------------ ------------- -------------- ------------ ------------ Ending balance $ (1,124) $ (440) $ (1,564) $ (1,456) $ 444 $ (1,012) --------------- ------------ ------------- -------------- ------------ ------------ --------------- ------------ ------------- -------------- ------------ ------------
5. 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 contracts entered into by ISI have maturities of 360 days or less. ISI's total contracted foreign currency forward exchange contracts as at August 31, 1999 and February 28, 1999 were as follows (in thousands):
AUGUST 31, 1999 FEBRUARY 28, 1999 ---------------------------- -------------------------- UNREALIZED UNREALIZED GAINS/ GAINS/ COST (LOSSES) COST (LOSSES) --------------- ------------ ------------- ------------ Japanese Yen $ 1,847 $ (189) $ 3,400 $ 112 British Pound 590 (4) - - French Franc 400 (2) - - Italian Lira 150 (5) - - German Mark 250 (6) - - Swedish Krona 288 (16) - - --------------- ------------ ------------- ------------ Total $ 3,525 $ (222) $ 3,400 $ 112 --------------- ------------ ------------- ------------ --------------- ------------ ------------- ------------
6. 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, -9- 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. The following tables summarize revenue and operating profit before acquisition-related and other costs and before interest and other income for each segment. For the three months ended August 31, 1998 (in thousands):
Engineering Software Services Total ---------------- --------------- ------------ Revenue from external customers $ 24,622 $ 7,383 $ 32,005 Intersegment revenue $ - $ - $ - Depreciation $ 1,151 $ 303 $ 1,454 Operating profit before amortization of intangibles, acquisition-related and other costs $ 2,052 $ 1,289 $ 3,341
For the three months ended August 31, 1999 (in thousands):
Engineering Software Services Total ---------------- --------------- ------------ Revenue from external customers $ 29,020 $ 6,028 $ 35,048 Intersegment revenue $ - $ - $ - Depreciation $ 1,560 $ 213 $ 1,773 Operating profit before amortization of intangibles, acquisition-related and other costs $ 1,298 $ 565 $ 1,863
For the six months ended August 31, 1998 (in thousands):
Engineering Software Services Total ---------------- --------------- ------------ Revenue from external customers $ 49,783 $ 13,704 $ 63,487 Intersegment revenue $ - $ - $ - Depreciation $ 2,098 $ 462 $ 2,560 Operating profit before amortization of intangibles, acquisition-related and other costs $ 2,328 $ 2,699 $ 5,027
-10- For the six months ended August 31, 1999 (in thousands):
Engineering Software Services Total ---------------- --------------- ------------ Revenue from external customers $ 54,211 $ 13,429 $ 67,640 Intersegment revenue $ - Depreciation $ 3,012 $ 419 $ 3,431 Operating profit (loss) before amortization of intangibles, acquisition-related and other costs $ (131) $ 846 $ 715
The following table summarizes property and equipment and capital expenditures by segment, for the six months ended August 31, 1998 and 1999 (in thousands):
For the Six Months Ended August 31, -------------------------------- 1998 1999 ---------------- --------------- Software: Property and equipment, net $ 17,178 $ 19,226 Capital Expenditures $ 1,869 $ 3,515 Engineering Services: Property and equipment, net $ 1,618 $ 1,294 Capital Expenditures $ 443 $ 261
Revenue to non-affiliated customers analyzed on a geographical basis for the three and six months ended August 31, 1998 and 1999 were as follows (in thousands):
For the Three Months Ended August 31, -------------------------------- 1998 1999 ---------------- --------------- North America $ 18,584 $ 20,046 Europe 8,549 9,434 Asia/Pacific 4,872 5,568 ---------------- --------------- Total $ 32,005 $ 35,048 ---------------- --------------- ---------------- --------------- For the Six Months Ended August 31, -------------------------------- 1998 1999 ---------------- --------------- North America $ 36,013 $ 38,997 Europe 16,503 18,193 Asia/Pacific 10,971 10,450 ---------------- --------------- Total $ 63,487 $ 67,640 ---------------- --------------- ---------------- ---------------
-11- No customer accounted for 10% or more of total revenue in the reported periods. 7. 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. -12- 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 $39.2 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 $1.0 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 August 31, 1999, reflects a preliminary allocation of the purchase price of SDS. 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. -13- RESULTS OF OPERATIONS The following table sets forth for the periods presented the percentage of total revenue represented by each line item in ISI'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, 1999 1998 1999 COMPARED TO 1998 --------- --------- ------------------------ Revenue: Product 59 % 55 % 17 % Services 41 45 0 --------- -------- Total revenue 100 100 10 --------- -------- Costs and expenses: Cost of product revenue 9 9 7 Cost of services revenue 17 21 (12) Marketing and sales 41 35 28 Research and development 18 14 32 General and administrative 10 10 16 Amortization of intangibles 4 1 NM Acquisition-related and other expenses 20 3 NM --------- -------- Total costs and expenses 119 93 39 --------- -------- Income (loss) from operations (19) 7 NM Interest and other income 2 4 (47) --------- -------- Income (loss) before income taxes (17) 11 NM Provision for income taxes 4 4 37 --------- -------- Net income (loss) (21) % 7 % (414) % --------- -------- --------- --------
NM = Not Meaningful -14-
PERCENTAGE OF PERIOD-TO-PERIOD TOTAL REVENUE PERCENTAGE CHANGE --------------------- ------------------------ SIX MONTHS ENDED SIX MONTHS ENDED AUGUST 31, AUGUST 31, 1999 1998 1999 COMPARED TO 1998 --------- --------- ------------------------ Revenue: Product 59 % 55 % 14 % Services 41 45 (2) --------- -------- Total revenue 100 100 7 --------- -------- Costs and expenses: Cost of product revenue 12 9 33 Cost of services revenue 17 20 (6) Marketing and sales 42 37 22 Research and development 17 16 13 General and administrative 11 10 13 Amortization of intangibles 2 - NM Acquisition-related and other expenses 10 2 NM --------- -------- Total costs and expenses 111 94 13 --------- -------- Income (loss) from operations (11) 6 NM Interest and other income 3 3 (6) --------- -------- Income (loss) before income taxes (8) 9 NM Provision for income taxes 3 (1) NM --------- -------- Net Income (loss) (11) % 10 % (212) % --------- -------- --------- --------
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 increased by 10% from $32.0 million in the second quarter of fiscal year 1999 to $35.0 million in the second quarter of fiscal year 2000 and increased 7% from $63.5 million in the first six months of fiscal year 1999 to $67.6 million in the first six months in fiscal year 2000. 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. -15- Components of ISI's revenue by segment for the second quarter and first six months of fiscal years 1999 and 2000 were as follows:
Three Months Ended August 31, 1998: Six Months Ended August 31, 1998: Engineering Engineering Software Services Total Software Services Total ------------ --------------- ------------- ------------- ------------ ------------ Product................ $ 16,960 $ 763 $ 17,723 Product.......... $ 33,752 $ 1,132 $ 34,884 Services............... 7,662 6,620 14,282 Services......... 16,031 12,572 28,603 ------------ --------------- ------------- ------------- ------------ ------------ Total.................. $ 24,622 $ 7,383 $ 32,005 Total............ $ 49,783 $ 13,704 $ 63,487 ------------ --------------- ------------- ------------- ------------ ------------ ------------ --------------- ------------- ------------- ------------ ------------ Three Months Ended August 31, 1999: Six Months Ended August 31, 1999: Engineering Engineering Software Services Total Software Services Total ------------ --------------- ------------- ------------- ------------ ------------ Product................ $ 19,434 $ 1,331 $ 20,765 Product.......... $ 35,864 $ 3,850 $ 39,714 Services............... 9,586 4,697 14,283 Services......... 18,347 9,579 27,926 ------------ --------------- ------------- ------------- ------------ ------------ Total.................. $ 29,020 $ 6,028 $ 35,048 Total............ $ 54,211 $ 13,429 $ 67,640 ------------ --------------- ------------- ------------- ------------ ------------ ------------ --------------- ------------- ------------- ------------ ------------
Product revenue increased 17% from $17.7 million in the second quarter of fiscal year 1999 to $20.8 million in the second quarter of fiscal year 2000 and increased 14% from $34.9 million in the first six months of fiscal year 1999 to $39.7 million in the first six months of fiscal year 2000. The percentage of ISI's total revenue attributable to Product Revenue increased from 55% in the second quarter and first six months of fiscal year 1999 to 59% in the second quarter and first six months of fiscal year 2000. The increase in product revenue was due primarily to increased sales of embedded software licenses and the inclusion of Product Revenue attributable to SDS, since the date of acquisition, plus an increase in Product Revenue at Doctor Design. Services revenue remained approximately the same, $14.3 million in the second quarter of fiscal year 1999 and fiscal year 2000, and decreased 2% from $28.6 million for the first six months of fiscal year 1999 to $27.9 million for the first six months of fiscal year 2000. The decrease was due primarily to ISI's decision to shift away from lower margin, fixed-price government contracts, which contributed $2.2 million in the first six months of fiscal year 1999, offset by continued growth of the installed customer base and the renewal of maintenance and support contracts. Price increases were not a material factor in ISI's revenue growth in the periods presented. The percentage of ISI's total revenue from customers located internationally was 43% in the second quarters of fiscal years 2000 and 1999, and 42% and 43% in the first six months of the fiscal years 2000 and 1999, respectively. International revenue, as a percentage of total revenue, in the first six months of fiscal year 2000, showed growth of $1.7 million in the European region which was partially offset the a slight decline in revenue in the Asia/Pacific region of $0.5 million. 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. Cost of product revenue as a percentage of Product Revenue was 15% and 16% in the second quarter of fiscal years 2000 and 1999, respectively, and 20% and 17% in the first six months of fiscal years 2000 and 1999, respectively. The decrease in cost of product revenue as a percentage of Product Revenue in the second quarter of fiscal year 2000 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. The increase in cost of product revenue as a percentage of Product Revenue in the first six months of fiscal year 2000 as compared to the first six months of fiscal year 1999 is due primarily to 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 six 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. ISI's cost of services revenue as a percentage of Services Revenue was 41% and 47% in the second quarter of fiscal years 2000 and 1999, respectively and 43% and 44% in the first six months of fiscal years 2000 and -16- 1999, respectively. The decrease in cost of service revenue as a percentage of Service Revenue is due primarily to a shift in revenue mix in both business segments. Higher margin software maintenance revenue increased in the software segment, while lower margin engineering services revenue at Doctor Design decreased in the second quarter of fiscal year 2000 as compared to the second quarter of fiscal year 1999. In addition, in the first six months of fiscal year 1999 there was a higher proportion of fixed price engineering and consulting services contracts than in the first six months of fiscal year 2000. Fixed-price contracts are typically lower margin than time and materials contracts. Marketing and sales expenses increased by 28% from $11.3 million in the second quarter of fiscal year 1999 to $14.4 million in the second quarter of fiscal year 2000 and represented 41% and 35% of total revenue in the second quarter of fiscal years 2000 and 1999, respectively. Marketing and sales expenses increased 22% from $23.4 million in the first six months of fiscal year 1999 to $28.4 million in the first six months of fiscal year 2000 and represented 42% and 37% of total revenue in the first six months of fiscal years 2000 and 1999, respectively. The dollar increases in marketing and sales expenses in the periods presented was 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 32% from $4.7 million in the second quarter of fiscal year 1999 to $6.1 million in the second quarter of fiscal year 2000, and increased as a percentage of total revenue from 14% in the second quarter of fiscal year 1999 to 18% in the second quarter of fiscal year 2000. Research and development expenses increased 13% from $10.1 million in the first six months of fiscal year 1999 to $11.4 million in the first six months of fiscal year 2000, and increased as a percentage of total revenue from 16% in the first six months of fiscal year 1999 to 17% in the first six months of fiscal year 2000. The dollar increases in research and development expenses in the periods reported were due primarily to costs associated with new product initiatives 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 were $3.7 million in the second quarter of fiscal year 2000 compared to $3.2 million in the second quarter of fiscal year 1999 and represented 10% of total revenue in both periods. General and administrative expenses were $7.2 million and $6.4 million in the first six months of fiscal years 2000 and 1999, respectively, and represented 11% and 10% of total revenue, respectively. 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 $1.3 million in the second quarter of fiscal year 2000 compared to $0.1 million in the second quarter of fiscal year 1999. Amortization of intangibles was $1.4 million and $0.3 million in the first six months of fiscal years 2000 and 1999, respectively. The increases for all periods presented were due primarily to amortization of goodwill and other intangibles associated with the acquisition of SDS in the second quarter of fiscal year 2000. Acquisition-related and other expenses were $7.1 million and $1.1 million in the second quarter of fiscal years 2000 and 1999, respectively. The $7.1 million in the second quarter of fiscal year 2000 was due primarily to costs incurred in the transition of SDS, including a $6.3 million charge relating to the write-off of in-process research and development costs. The $1.1million in the second quarter of fiscal year 1999 was primarily a result of CEO recruitment and 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 affected 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. -17- 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. Interest and other income decreased from $1.3 million in the second quarter of fiscal year 1999 to $0.7 million in the second quarter of fiscal year 2000 and from $2.2 million to $2.1 million in the first six months of fiscal years 1999 and 2000, respectively, due primarily to a decrease in the amount of interest-bearing cash equivalents and marketable securities, used in the acquisition of SDS, and to the absence of rental income from the sub-lease of part of ISI's Sunnyvale headquarters in the second quarter of fiscal year 2000 as compared to the second quarter of fiscal year 1999. Net income in the second quarter of fiscal year 2000 was negatively impacted by $8.4 million in acquisition related charges, including $6.3 million for in-process research and development and $1.3 million in amortization of goodwill and other intangibles. Despite a net loss in the second quarter of fiscal year 2000, a tax provision resulted due to the exclusion of amortization of goodwill and other intangibles, 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 and other intangibles, the effective tax rate for the second quarter of fiscal year 2000 was 30%. The effective tax rate for the second quarter 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 80% towards being fully compliant and expects to be in full compliance before the Year 2000. Accordingly, ISI has not developed formal contingency plans and feels there is minimal risk that the systems will not be compliant before Year 2000. All financial, order processing and manufacturing software is fully Year 2000 Compliant. With respect to internal non-financial software and embedded chip technology, ISI is currently gathering data to assess the impact of the Year 2000 on systems such as security equipment and telephones, with Year 2000 Compliance scheduled for late 1999. Assessment and implementation plans are already being executed in approximately 75% of these areas. If ISI is unable to achieve Year 2000 Compliance for its major non-financial systems, the year 2000 could have a material impact on the operations of ISI. It is estimated that ISI is 75% towards being in full 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 is in 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. It is expected that full identification will be completed by late 1999. To the extent that responses to Year 2000 readiness are unsatisfactory, ISI intends to change suppliers, service providers or contractors to those who have demonstrated Year 2000 readiness but cannot -18- be assured that it will be successful in finding such alternative suppliers, service providers and contractors. ISI currently has formal information concerning the Year 2000 Compliance status of about 70% of its suppliers including most of its critical suppliers. 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 August 31, 1999 it is estimated that costs associated with preparation for the Year 2000 were approximately $1.4 million and that a further $250,000 will be incurred to complete the above plans. Of these amounts, approximately $500,000 is to cover new/replacement technologies, and $1.2 million is of a repair or upgrade nature. LIQUIDITY AND CAPITAL RESOURCES ISI had funded its operations to date principally through cash flows from operations. As of August 31, 1999, ISI had $42.6 million of cash, cash equivalents and marketable securities. This represents a decrease of $35.8 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 $0.1 million during the first six months of fiscal year 2000. This represents a decrease of $10.0 million from the amount generated in the first six months of fiscal year 1999. Net cash from operating activities decreased in the first six 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. Net cash provided by investing activities was $1.9 million in the first six months of fiscal year 2000. This compares to net cash used in investing activities of $10.9 million in the first six months of fiscal year 1999. The difference between the two comparative periods is due primarily to the sales of marketable securities to fund the acquisition of SDS, partially offset by approximately $24.3 million used in the acquisition of SDS. Net cash used in financing activities totaled $4.8 million in the first six months of fiscal year 2000 compared to net cash provided of $1.3 million in the first six months of fiscal year 1999. The difference was due primarily to the repurchase of approximately 641,000 shares of common stock, combined with a decrease in the proceeds from the exercise of options to purchase common stock and purchases under the Employee Stock Purchase Plan. ISI believes that the cash flows from operations, together with existing cash and investment balances, will be adequate to meet ISI's cash requirements for working capital, capital expenditures and stock repurchases 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. 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; -19- - 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 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 -20- 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 six 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; - 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 -21- 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 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 -22- 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 6 months ended August 31, 1999, the closing price of a share of ISI common stock ranged from a high of $17.69 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. -23- PART II - OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS During the fiscal quarter, ISI issued an aggregate of 1,430,037 shares of unregistered common stock and $13.9 million in cash to the shareholders of Software Development Systems, Inc. for all of the outstanding common stock of Software Development Systems, Inc. As a result Software Development Systems, Inc is a wholly owned subsidiary of Integrated Systems, Inc. The shares were issued pursuant to an exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Annual Meeting of Shareholders held August 31, 1999, the following matters were submitted to a vote of the security holders: (1) To elect the following to serve as directors of ISI: NAME FOR WITHHELD Charles M. Boesenberg 19,515,433 22,661 John C. Bolger 19,507,733 30,361 Michael A. Brochu 19,504,984 33,110 Narendra K. Gupta 19,498,782 39,312 Vinita Gupta 19,492,932 45,162 Thomas Kailath 19,452,697 85,697 Richard C. Murphy 19,452,592 85,502 (2) To approve an amendment to ISI's 1998 Equity Incentive Plan to increase the shares of common stock available under such Plan by 1,000,000 shares: Votes for 10,133,313 Votes against 4,099,475 Votes abstaining 21,728 Broker non-votes 5,283,578 (3) To approve the adoption of ISI's 1999 Employee Stock Purchase Plan: Votes for 13,969,992 Votes against 278,527 Votes abstaining 26,926 Broker non-votes 5,262,649 (4) To approve an amendment to the Corporations' Bylaws to change the number of authorized Board Directors to a range of 5 to 9 members: Votes for 13,969,992 Votes against 278,527 Votes abstaining 26,926 (5) To ratify the selection of PricewaterhouseCoopers LLP as independent accountants ISI for the fiscal year ending February 29, 2000: Votes for 19,521,932 Votes against 5,000 Votes abstaining 11,162 -24- ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS. The following exhibits are filed as part of the Report: Exhibit Number Title -------- ------ 3.02 Certificate of Amendment of Bylaws (Incorporated by reference to Exhibit 4.05 of the Company's Registration Statement on Form S-8, File No. 333-87959) 10.19 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. 333-87959) 10.20 Registrant's 1999 Employee Stock Purchase Plan (Incorporated by reference to Exhibit 4.03 of the Company's Registration Statement on Form S-8, File No. 333-87959) 27.01 Financial Data Schedule (b) REPORTS ON FORM 8-K. During the fiscal quarter ended August 31, 1999, the Company filed a report on 8-K dated July 21, 1999 relating to the acquisition of Software Development Systems, Inc. -25- 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 14, 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 -26- EX-27.01 2 EXHIBIT 27.01
5 THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM Q2 FY00 FORM 10-Q FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 3-MOS FEB-29-2000 MAR-01-1999 AUG-31-1999 15,941 1,992 28,525 0 0 53,993 20,520 0 143,962 41,250 0 0 0 68,942 32,954 143,962 39,714 67,640 7,973 19,855 55,467 0 0 (5,585) 1,599 (7,184) 0 0 0 (7,184) (0.31) (0.31)
-----END PRIVACY-ENHANCED MESSAGE-----