-----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, Au2OYB/1IHNbeaeTF137HblMB8MAX8CvAJc0yDN8pw5jYJQjjNSw/uTFzfxfqnKj BxFDrdu7m9fCdS5b6YOC3A== 0001012870-98-000844.txt : 19980401 0001012870-98-000844.hdr.sgml : 19980401 ACCESSION NUMBER: 0001012870-98-000844 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: MERCURY INTERACTIVE CORPORATION CENTRAL INDEX KEY: 0000867058 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 770224776 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-22350 FILM NUMBER: 98583341 BUSINESS ADDRESS: STREET 1: 470 POTRERO AVE CITY: SUNNYVALE STATE: CA ZIP: 94086 BUSINESS PHONE: 4085239900 MAIL ADDRESS: STREET 1: 470 POTRERO AVE CITY: SUNNYVALE STATE: CA ZIP: 94086 10-K 1 FORM 10-K FOR FISCAL YEAR ENDED 12/31/1997 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 OR [_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 ---------------- COMMISSION FILE NUMBER 0-22350 MERCURY INTERACTIVE CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 77-0337705 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1325 BORREGAS AVENUE, SUNNYVALE, CA 94089 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (408) 822-5200 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) ---------------- Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.002 par value 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) had been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [_] The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $628,580,936 as of February 28, 1998, based upon the closing sale price reported for that date on the Nasdaq National Market. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily conclusive for other purposes. The number of shares of Registrant's Common Stock outstanding as of February 28, 1998 was 17,149,887. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for Registrant's 1998 Annual Meeting of Stockholders to be held May 20, 1998 are incorporated by reference in Part III of this Form 10-K Report. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- TABLE OF CONTENTS
PAGE ---- PART I Item 1. Business....................................................... 3 General........................................................ 3 Products....................................................... 4 Research and Development....................................... 6 Marketing, Sales and Support................................... 6 Competition.................................................... 8 Manufacturing.................................................. 8 Patents, Trademarks and Licenses............................... 8 Personnel...................................................... 9 Operations in Israel........................................... 10 Item 2. Properties..................................................... 10 Item 3. Legal Proceedings.............................................. 10 Item 4. Submission of Matters to a Vote of Security Holders............ 10 PART II Market for the Registrant's Common Equity and Related 11 Item 5. Stockholder Matters............................................ Item 6. Selected Consolidated Financial Data........................... 12 Management's Discussion and Analysis of Financial Condition and 12 Item 7. Results of Operations.......................................... Item 8. Financial Statements and Supplementary Data.................... 20 Changes in and Disagreements with Accountants on Accounting and 20 Item 9. Financial Disclosure........................................... PART III Item 10. Directors and Executive Officers of the Registrant............. 21 Item 11. Executive Compensation......................................... 21 Item 12. Security Ownership of Certain Beneficial Owners and Management. 21 Item 13. Certain Relationships and Related Transactions................. 21 PART IV Exhibits, Financial Statement Schedules and Reports on Form 8- 22 Item 14. K..............................................................
2 PART I ITEM 1. BUSINESS GENERAL Mercury Interactive Corporation and its subsidiaries (hereafter, collectively, "Mercury Interactive" or the "Company") develop, market and support a family of automated client/server and Web-based system (Internet and intranet) tools for testing business-critical enterprise applications. Since 1989, the Company's testing solutions have helped corporate development organizations, systems integrators and independent software developers identify client/server system problems with greater accuracy, speed and efficiency than traditional methods allow. The power, speed and flexibility of distributed computing architectures with PCs running Microsoft Windows, UNIX workstations, network servers, database servers and Web-based systems have prompted many companies to adopt them on an enterprise-wide basis to support business-critical applications. Client/server solutions are designed to be scalable to accommodate rapid growth, in order to allow customers to boost productivity by enhancing information availability and to provide the customer a competitive advantage. However, the very nature of client/server computing creates challenges for businesses that deploy mission-critical applications. As enterprise systems are installed to accommodate traditional business needs, even the simplest application or system changes can adversely impact the delivery and performance of the solution. Thorough testing of critical applications in enterprise-wide, multi- user environments is required so that the solution is reliable and responsive to user needs. Mercury Interactive is committed to continuing research and development in order to achieve its strategy of offering advanced and innovative testing solutions for evolving business needs. The Company's innovative solutions are designed to automate and orchestrate all phases of software and system quality assurance, and to provide a common thread that allows customers to reduce application development time, increase productivity and decrease operating expenses. Today, that common thread makes its way through some of the world's largest business organizations. Allstate Insurance, Citibank, DHL Airways, Gap, Inc., Michelin, Nabisco, and Quebec Hydro among others, all rely on the Company's solutions for testing their client/server applications and systems. 3 PRODUCTS The Company's current testing products are presented in the table below, and described immediately following.
TYPICAL LIST PRODUCT NAME PRODUCT DESCRIPTION STATUS PRICE RANGE* ------------ ------------------------ ------------------------ ------------------------ XRunner Automated application Release 1.0-1991 $60,000 for five users testing for UNIX, X- Release 4.0-July 1996 Windows WinRunner Automated application Release 1.0-June 1993 $2,850-$5,000 per user testing for Windows, Release 4.0-March 1996 Windows NT, Windows 95 LoadRunner Automated multi-user Release 1.0-November $40,000-$50,000 for testing for UNIX, RTE, 1993 package simulating 50 Windows, Windows NT and Release 4.5-May 1997 users Windows 95 TestDirector Automated test Release 1.0-November $8,995 for server plus 5 management 1994 users, additional users system for QA workgroups Release 4.0-June 1997 for $495 each SQLInspector Middleware testing and Release 2.0-May 1995 $495-$895 per user analysis for Windows Integrated into LoadRunner 4.5-May 1997 WebTest World Wide Web Product family released $195-$995 per copy application March 1996 testing Astra SiteManager Visual Web site Release 1.0-October 1996 $495 per copy management tool Astra SiteTest Web site stress testing Release 1.0-December $9,500 per copy 1996 Release 2.0-December 1997
- -------- * Prices vary within the ranges shown according to system configuration and country where purchased. XRunner The Company's Xrunner(R) is an automated GUI regression tool which tests X- Windows applications running under UNIX. XRunner makes test development easier by incorporating simplified test script management, point-and-click selection and interactive debugging. These features boost new testers' productivity while providing a complete testing solution for evolving business needs. XRunner features the RapidTest Script Wizard which automatically learns an application and generates tests for unattended regresssion testing. XRunner was originally released in 1991. WinRunner The Company's WinRunner(R) tests enterprise applications on Windows 3.1, Windows 95, and Windows NT platforms. WinRunner simplifies test automation by providing powerful, productive and cost effective test solutions. WinRunner utilizes Mercury Interactive's point-and-click Visual Testing to help users quickly create test and verification scenarios. WinRunner provides support for leading development environments such as SAP, PeopleSoft, Baan, Oracle Developer/2000, Microsoft Visual Basic and PowerBuilder. WinRunner 2000 is specifically designed to test applications for compliance with Year 2000 requirements. WinRunner was made generally available in 1993. 4 LoadRunner The Company's LoadRunner(R) is an integrated client/server and Web load testing tool. It provides a scalable load testing solution for managing the risk of enterprise systems. LoadRunner uses a minimum of hardware resources to provide consistent, repeatable and measurable load to exercise the system just like real users would. LoadRunner automates both client and server load testing from a single point of control while helping developers get an accurate view of system behavior and performance throughout the application develpoment lifecycle. LoadRunner is available for Windows, Window 95, Windows NT, UNIX and Remote Terminal Emulation (RTE). LoadRunner was made generally available in 1993. TestDirector The Company's TestDirector(R) is a workgroup test management software which directs the quality assurance process for software development. TestDirector helps developers and testers to be more productive by walking them through a full regression test cycle from planning and design, automated test creation, manual and automatic test execution, defect tracking and application quality analysis. TestDirector was first released in November 1994. SQLInspector The Company's SQLInspector(TM) is a powerful, simple tool for viewing application function calls to databases. SQLInspector includes performance data so that developers can analyze their application's database access, and better understand how to tune the application. SQLInspector 2.0 was integrated into Mercury Interactive's product family when the Company acquired Blue Lagoon Software in 1995. SQLInspector's technology was integrated into LoadRunner in 1997. SQLInspector will not be sold separately in the future. WebTest The Company's WebTest(R) is the first technology designed specifically for testing World Wide Web applications. The new technology helps information systems organizations improve the quality and reliability of Web-based systems by allowing developers to measure response time to a browser request, to determine the maximum number of hits the server can support, and to validate the systems' ability to function correctly under varying conditions. WebTest extends Mercury Interactive's GUI testing tools, WinRunner and XRunner, allowing them to interact with Web pages, browsers, HTML links and images. WebTest, together with LoadRunner, tests Web site performance and capacity by emulating Web user HTTP or secure sockets layer (SSL) encrypted traffic between the browser and server. WebTest was released in March 1996. Astra SiteManager The Company's Astra SiteManager(TM) is a comprehensive visual Web site management tool that is designed to meet the challenges faced by Webmasters and business managers of rapidly growing Web sites with changing contents and shape. Astra SiteManager scans an entire Web site highlighting functional areas with color-coded links and URLs--to create a complete visual map of a Web site. It pinpoints broken links or access problems, compares maps as a site changes, identifies key usage patterns for improving Web site effectiveness and validates dynamically generated pages. Astra SiteManager was released in October 1996. Astra SiteTest The Company's Astra SiteTest(TM) is a stress testing tool for Web-based systems-Internet and intranet-that provides consistent, repeatable and measurable load to exercise the systems as real users would. Astra SiteTest helps Webmasters get an accurate view of system behavior and performance throughout the application development lifecycle. Astra SiteTest was first relased in December 1996. 5 RESEARCH AND DEVELOPMENT Since its inception, the Company has made substantial investments in research and product development. The Company believes that its success will depend in large part on its ability to maintain and enhance its current product line, develop new products, maintain technological competitiveness and meet an expanding range of customer requirements, each of which is essential to maintaining the Company's current leadership position in its market. The technologies that drive the Company's products are aimed at providing a consistent and comprehensive solution to software quality issues throughout the software development organization. By enabling reliable automation of testing, these technologies enable the Company's products to provide substantial productivity improvement. The Company believes that it was the first to comprehensively address client/server software quality by combining key enabling technologies such as output synchronization, GUI-based application testing, multi-platform portability, text recognition and multi-user testing. Mercury Interactive's products are designed to be used throughout the development, maintenance and porting processes and are available on a variety of computing platforms and operating environments. In addition to the teams developing software testing products, the Company maintains an advanced research group that is responsible for exploring new directions and applications of core technologies, migrating new technologies into the existing product lines and maintaining research relationships outside the Company both within industry and academia. The research and development group also maintains relationships with third party software vendors and with all major hardware vendors on whose platforms the Company's products operate. Key development engineers are rotated to assignments in customer support positions in the Company's major markets for periods ranging from three months to two years. This improves feedback from current customers and strengthens ties between the Customer Support Organization and the research and development group. The Company's primary research and development group is located near Tel Aviv, Israel. Performing research and development in Israel offers a number of strategic advantages. Israeli engineers typically hold advanced degrees in computer-related disciplines. Operation in Israel allows the Company to enjoy research subsidies from the government of Israel. Geographic proximity to Europe, a strategic market for the Company, offers another key advantage. As of December 31, 1997 the Company's research and development group consisted of 147 employees. During 1997, 1996 and 1995 net research and development costs were $10.9 million, $9.4 million and $6.5 million, respectively. The Company anticipates that it will continue to commit substantial resources to research and development in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." MARKETING, SALES AND SUPPORT Direct Sales The Company markets its products primarily through its direct sales and service organization, which focuses on major accounts. The Company employs technically proficient salespeople and highly skilled field application engineers capable of serving the sophisticated needs of prospective customers' engineering and management staffs. As of December 31, 1997, the Company's direct sales and service force consisted of 152 employees. The Company has 13 sales and support centers throughout the United States. Internationally, the Company's subsidiaries operate eight sales and support offices located in Canada, the United Kingdom, France, Germany, Japan, Australia, Singapore and Israel. The Company also markets its products through distributors in Europe and Pacific Rim countries. 6 International sales represented 36%, 33% and 24% of the Company's total revenues in 1997, 1996 and 1995, respectively. The Company expects that in future periods, international sales will continue to account for a significant portion of the Company's total revenue. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Alternate Channels The Company has established an indirect sales channel of value added resellers and major system integrators, including Andersen Consulting, Deloitte & Touche, EDS, Ernst & Young, Keane and KPMG. The indirect sales channel accounted for 47%, 43% and 23% of total license revenue in the years ended December 31, 1997, 1996 and 1995, respectively. The Company believes that the indirect sales channel will continue to account for a significant portion of the Company's total revenue in future periods. There is no assurance that the Company will be successful in further developing such channels, that such relationships will result in significant additional sales or that any sales through such channels will have the same profitability, if any, of sales obtained through the Company's direct sales force. In addition, the Company expects its direct and indirect sales channels to compete with each other. Successful indirect sales efforts depend on the abilities, resources, reputations, motivations, and strategies of third parties, and the Company has little control over such factors. If the Company's efforts at further developing these indirect sales channels are unsuccessful, if such channels are unproductive or if the Company were to lose one or more of its value added resellers or major system integrators there could be a material adverse effect on the Company's results of operations or financial position. Customer Support Organization The Company believes that strong customer support is crucial to both the initial marketing of its products and maintenance of customer satisfaction, which in turn, enhances the Company's reputation and generates repeat orders. In addition, the Company believes that the customer interaction and feedback involved in its ongoing support functions provide the Company with information on market trends and customer requirements that is critical to future product development efforts. Pre-sales support is provided by sales personnel and post-sales support is provided by the Company's Customer Support Organization ("CSO") pursuant to renewable annual maintenance contracts. As of December 31, 1997, the Company's CSO consisted of 61 employees. The maintenance contracts provide for technical and emergency support as well as software upgrades, on an if and when available basis. When the Company's local sales and support offices are unable to solve a problem, the Company's engineers and product developers in Israel work with the support personnel. By taking advantage of time differences, the Company can provide support around the clock, ensuring prompt resolution of problems. Pricing The Company licenses its software to customers under non-exclusive license agreements that restrict use of the products to internal purposes at a specified site. The Company typically licenses software products to either allow up to a set number of users to access the software on a network at any one time, using any workstation attached to that network, or to allow use of the software on designated computers or workstations. The Company's products are priced to encourage customers to purchase multiple products and licenses because the cost to the Company of supporting a one-user configuration is almost as high as a multiple-user configuration. License fees are dependent on the product licensed, the number of users of the product licensed and the country in which such licenses are sold, as international prices tend to be higher than United States prices. In addition, the Company sells annual maintenance contracts which include on-site customer support and upgrades for approximately 15% of the license purchase price. Sales to the Company's indirect sales channel partners which are intended for resale to end users are made at varying discounts off of the Company's list prices, generally based on the sales volume of the indirect sales channel partner. 7 Backlog The time between order and delivery of the Company's products is generally quite short. The number of orders, as well as the size of individual orders, can vary substantially from month to month. Because of the short period between order receipt and shipment of products, the Company typically does not have a significant backlog of unfilled orders and believes that backlog is neither significant to an understanding of its business nor representative of potential revenue for any future period. COMPETITION While the Company believes it is the leading provider of automated client/server, E-business and Enterprise Resource Planning ("ERP", such as the packaged applications offered by SAP and Baan) testing tools, several other companies compete in the automated client/server testing market and several potential customers have decided to develop testing utilities internally. The market for automated client/server, E-business and ERP testing tools is relatively young and competing solutions for the problem of software testing productivity are evolving rapidly. The market for software products, in general, is highly competitive. The Company continues to face direct competition from established and emerging companies, both publicly and privately-held. In the past year, a number of the Company's competitors have been consolidated through acquisitions and may have significantly greater resources than the Company. There could be a material adverse effect on the Company's results of operations or financial position if any of the major software manufacturers, which have significantly greater resources than the Company decide to devote substantial resources to entering the software testing market or if there is an increase in developing testing utilities internally by the Company's customers or potential customers. A variety of external and internal factors could adversely affect the Company's ability to compete. These include the relative functionality, price/performance and reliability of the products offered by the Company and its competitors, the timing and success of new product development or enhancement efforts of the Company and its competitors and the effectiveness of the marketing efforts of the Company and its competitors. There can be no assurance that the Company will be able to compete successfully in the future or that competitive pressures will not adversely affect the Company's business. MANUFACTURING The Company's products are principally composed of user manuals and storage media, such as diskettes tapes, and/or CD-ROM, which are produced by the Company in its facility in Israel. Often, the Company's products require multiple user manuals and magnetic media. The Company believes that there is an adequate supply of and source for the raw materials for its products and that there are multiple sources available for storage media duplication and manual printing. The Company performs final quality control tests on its products. Although the Company believes that its quality control activities effectively accomplish the Company's product quality goals, there can be no assurance that the Company's quality control efforts will always be completely successful. Undetected material programming errors, product tampering, and exposure to a computer virus in the product development, duplication, assembly or distribution process, whether performed by the Company, its contractors, distributors, or resellers, could have a material adverse effect on shipments of new and existing products. Assembly and packaging of final products are performed both by the Company and by domestic and overseas subcontractors of the Company. PATENTS, TRADEMARKS AND LICENSES The Company currently relies upon a combination of trademark, copyright, and trade secret laws and contractual provisions to establish and protect proprietary rights in its products. The source code for the Company's products is protected both as a trade secret and as an unpublished copyrighted work. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use the Company's products or technology without authorization, or to develop similar technology independently. In addition, effective copyright and trade secret protection may be unavailable or limited in certain foreign countries. 8 Because the software industry is characterized by rapid technological change, the Company believes that factors such as the technological and creative skills of its personnel, new product developments, frequent product enhancements, name recognition and reliable product maintenance are more important to establishing and maintaining a technology leadership position than the various legal protections of its technology. The Company presently has no registered copyrights. The Company holds three patents for elements contained in certain of its products, and it has filed several other U.S. and foreign patent applications on various elements of its products. There can be no assurance that any of the Company's patent applications will result in an issued patent or that, if issued, such patent would be upheld if challenged. There can be no assurance that the Company's competitors will not independently develop technologies that are substantially equivalent or superior to the Company's technology. Although the Company believes that its products and other proprietary rights do not infringe the proprietary rights of third parties, and although the Company has received no communications from third parties alleging the infringement of the proprietary rights of such parties, there can be no assurance that intellectual property infringement claims will not be asserted against the Company in the future or that any such claims will not require the Company to enter into royalty or cross-license arrangements or result in costly litigation. PERSONNEL As of December 31, 1997, the Company had a total of 437 employees, of which 185 were based in the United States and 252 were based internationally. Of the total, 240 were engaged in marketing, sales and related customer support services, 147 were in research and development, and 50 were in general and administrative functions. The Company's success depends in significant part upon the performance of its senior management and certain key employees and its continuing ability to attract and retain highly qualified sales, technical and managerial personnel. Competition for such personnel is intense and there can be no assurance that the Company can retain its key managerial and technical employees or that it can attract, assimilate or retain other highly qualified technical and managerial personnel in the future. None of the Company's employees are represented by a labor union. The Company has never experienced any work stoppages. The executive officers of the Company as of March 1, 1998, are as follows:
NAME AGE POSITION ---- --- -------- Aryeh Finegold.............. 51 Chairman of the Board of Directors Amnon Landan................ 39 President, Chief Executive Officer and Director Sharlene Abrams............. 40 Vice President of Finance and Administration, Chief Financial Officer and Secretary Kenneth R. Klein............ 38 Vice President of North American Sales Moshe Egert................. 33 Vice President of European Operations
Mr. Aryeh Finegold, a founder of the Company, has served as Chairman of the Board of Directors since the Company's incorporation in July 1989, served as Chief Executive Officer from July 1989 until January 1997 and served as President from July 1989 until October 1995. Previously, Mr. Finegold was President, Chief Executive Officer and Chairman of the Board of Directors of Ready Systems, Inc. He also co-founded Daisy Systems, Inc., serving as its President and Chief Executive Officer. Previously, Mr. Finegold was a product line architect in the micro-processor division at Intel Corporation. Mr. Amnon Landan has served as President and Chief Executive Officer of the Company since February 1997, and has been a director of the Company since February 1996. From October 1995 to January 1997 he served as President, and from March 1995 to September 1995 he served as President of North American Operations. He served as Chief Operating Officer from August 1993 until March 1995. From December 1992 to August 1993, he served as the Company's Vice President of Operations and from June 1991 to December 1992, he served as Vice President of Research and Development. From November 1989 to June 1991, he served in several technical positions with the Company. 9 Ms. Sharlene Abrams has served as Vice President of Finance and Administration and Chief Financial Officer of the Company since November 1993. She has served as Secretary of the Company since February 1996. Prior to joining the Company, Ms. Abrams was employed at Price Waterhouse LLP for more than five years, most recently as a senior manager. Mr. Kenneth R. Klein has served as Vice President of North American Sales of the Company since April 1995. From May 1992 to March 1995, he served as the Company's Western Area Sales Manager. From March 1990 to May 1992, Mr. Klein served as Regional Sales Manager for Interactive Development Environments, a CASE tool company. Mr. Moshe Egert has served as Vice President of European Operations since July 1996. From February 1994 to June 1996, he served as Director of European Marketing. From October 1990 through January 1994, he served in several management and technical positions with the Company. OPERATIONS IN ISRAEL The Company's research and development operations are primarily located in Israel and may be affected by economic, political and military conditions in that country. The Company's business is also dependent on trading relationships between Israel and other countries. Accordingly, the Company's operations could be adversely affected if major hostilities involving Israel should occur or if trade between Israel and its current trading partners were interrupted or curtailed. The Company benefits from various policies of the government of Israel, including reduced taxation and special subsidy programs, designed to stimulate economic activity, particularly the high technology industry in that country. The Company's operations also benefit from the availability of highly skilled and relatively low cost scientific and technical personnel in Israel. As a condition of its receipt of funds for various research and development projects conducted under programs sponsored by the government of Israel, the Company has agreed that products resulting from these projects may not be manufactured, nor may the technology developed in the projects be transferred, outside of Israel without government consent. ITEM 2. PROPERTIES The Company is headquartered in Sunnyvale, California. In August of 1997, the Company purchased a 55,000 square foot building, into which it relocated during the first quarter of 1998. The Company's research and development activities are conducted by the Company's subsidiary in Israel, where that subsidiary leases approximately 23,800 square feet under a lease that expires in December 2000. In addition, in 1995, the Company purchased land in Israel where construction of a new research and development facility is currently underway. The Company's field sales and support operations occupy leased facilities in 13 locations in the United States, one location in Canada, three locations in Europe, and four locations in the Pacific Rim. The Company believes that its existing facilities are adequate for its current needs and that additional space will be available as needed. ITEM 3. LEGAL PROCEEDINGS There are presently pending no legal proceedings, other than routine litigation incidental to the Company's business, to which the Company is a party or to which any of its properties is subject. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 1997 to a vote of the holders of Mercury Interactive Corporation's Common Stock through the solicitation of proxies or otherwise. 10 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET FOR COMMON STOCK Mercury Interactive Corporation Common Stock is traded on the Nasdaq National Market tier of The Nasdaq Stock Market under the symbol MERQ. The following table lists the high and low sales price since January 1, 1996:
HIGH LOW ------ ------ 1997: First quarter ended March 31.................................. $14.75 $ 9.75 Second quarter ended June 30.................................. $17.75 $10.31 Third quarter ended September 30.............................. $23.88 $14.25 Fourth quarter ended December 31.............................. $26.75 $19.50 1996: First quarter ended March 31.................................. $24.00 $14.00 Second quarter ended June 30.................................. $23.75 $11.25 Third quarter ended September 30.............................. $16.00 $11.25 Fourth quarter ended December 31.............................. $19.25 $ 9.75
The trading price of the Company's Common Stock is subject to wide fluctuations in response to quarterly variations in operating results, announcements of technological innovations or new products by the Company or its competitors, as well as other events or factors. In addition, the stock market has from time to time experienced extreme price and volume fluctuations that have particularly affected the market price of many high technology companies and that often have been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. HOLDERS OF RECORD On February 28, 1998, there were approximately 5,500 holders of record of Mercury Interactive Corporation Common Stock. DIVIDENDS The Company paid no dividends during fiscal 1997. The Company intends to retain earnings for use in its business and does not anticipate paying any cash dividends in the foreseeable future. 11 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
YEAR ENDED DECEMBER 31, ------------------------------------------- 1997 1996 1995 1994 1993 -------- -------- -------- ------- ------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Statements of Operations Data: Revenue: License.......................... $ 56,683 $ 43,270 $ 32,765 $20,270 $11,830 Service.......................... 20,017 11,280 6,685 3,180 1,170 -------- -------- -------- ------- ------- Total revenue.................. 76,700 54,550 39,450 23,450 13,000 -------- -------- -------- ------- ------- Cost of revenue: License.......................... 4,351 3,419 2,626 1,594 1,637 Service.......................... 6,225 3,240 1,887 872 364 -------- -------- -------- ------- ------- Total cost of revenue.......... 10,576 6,659 4,513 2,466 2,001 -------- -------- -------- ------- ------- Gross profit....................... 66,124 47,891 34,937 20,984 10,999 -------- -------- -------- ------- ------- Operating expenses: Research and development, net.... 10,933 9,396 6,523 4,285 2,013 Write off of in-process research and development and related expenses........................ 5,500 -- 7,700 -- -- Marketing and selling............ 36,804 29,360 21,361 9,576 6,781 General and administrative....... 6,362 4,113 3,911 2,531 996 Settlement of litigation......... -- 2,600 2,000 -- -- -------- -------- -------- ------- ------- Total operating expenses....... 59,599 45,469 41,495 16,392 9,790 -------- -------- -------- ------- ------- Income (loss) from operations...... 6,525 2,422 (6,558) 4,592 1,209 Other income, net.................. 3,109 3,361 2,277 1,348 209 -------- -------- -------- ------- ------- Income (loss) before provision for income taxes...................... 9,634 5,783 (4,281) 5,940 1,418 Provision for income taxes......... 2,927 1,157 970 891 56 -------- -------- -------- ------- ------- Net income (loss).................. $ 6,707 $ 4,626 $ (5,251) $ 5,049 $ 1,362 Net income (loss) per share (basic)........................... $ 0.41 $ 0.29 $ (0.38) $ 0.40 $ 0.37 Net income (loss) per share (diluted)......................... $ 0.39 $ 0.28 $ (0.38) $ 0.38 $ 0.13 Weighted average common shares (basic)........................... 16,373 15,908 13,947 12,610 3,645 Weighted average common shares (diluted)......................... 17,104 16,563 13,947 13,337 10,130 DECEMBER 31, ------------------------------------------- 1997 1996 1995 1994 1993 -------- -------- -------- ------- ------- Balance Sheet Data: Working capital.................. $ 88,739 $ 78,082 $ 75,475 $33,722 $31,069 Total assets..................... 143,410 117,489 112,820 49,594 41,733 Stockholders' equity............. 112,987 99,039 92,616 39,167 33,003
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations contains descriptions of the Company's expectations regarding future trends affecting its business. These forward looking statements and other forward looking statements made elsewhere in the document are made in reliance upon the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Please read the section below titled "Factors that may affect future results" to review conditions which the Company believes could cause actual results to differ materially from those contemplated by the forward looking statements. Forward looking 12 statements include, but are not limited to, those items identified with a footnote symbol. The Company undertakes no obligation to update the information contained herein. The following table sets forth, as a percentage of revenue, certain consolidated statement of operations data for the periods indicated (after giving effect to rounding). These operating results are not necessarily indicative of the results for any future period.
YEAR ENDED DECEMBER 31, ---------------- 1997 1996 1995 ---- ---- ---- Revenue: License...................................................... 74% 79% 83% Service...................................................... 26 21 17 --- --- --- Total Revenue.............................................. 100 100 100 --- --- --- Cost of revenue: License...................................................... 6 6 7 Service...................................................... 8 6 4 --- --- --- Total cost of revenue...................................... 14 12 11 --- --- --- Gross margin................................................... 86 88 89 --- --- --- Operating expenses: Research and development, net................................ 14 17 17 Write off of in-process research and development and related expenses.................................................... 7 -- 19 Marketing and selling........................................ 48 54 54 General and administrative................................... 8 7 10 Settlement of litigation..................................... -- 5 5 --- --- --- Total operating expenses................................... 77 83 105 --- --- --- Income (loss) from operations.................................. 9 5 (16) Other income, net.............................................. 4 6 5 --- --- --- Income (loss) before provision for income taxes................ 13 11 (11) --- --- --- Provision for income taxes..................................... 4 2 2 --- --- --- Net income (loss).............................................. 9% 9% (13)% --- --- ---
Revenue License revenue increased to $56.7 million in 1997 from $43.3 million in 1996 and $32.8 million in 1995. The Company's growth in license revenue is attributable primarily to growth in license fees from the WinRunner and LoadRunner products, as well as sales of TestDirector. License revenue also benefited from the Company's ongoing expansion into alternate distribution channels, such as referral partners, systems integrators and value added resellers. Revenue generated through alternate channels represented approximately 47% in 1997, 43% in 1996 and 23% in 1995. Service revenue increased to $20.0 million or 24% of total revenue in 1997 from $11.3 million or 21% of total revenue in 1996 and $6.7 million or 17% of total revenue in 1995. This increase in service revenue in 1997 compared to 1996 and 1995 is primarily due to the renewal of maintenance contracts and an increase in training and consulting revenue. The Company expects that service revenues will continue to increase in absolute dollars as long as the Company's customer base continues to grow./1/ - -------- /1/ Forward looking statement 13 International revenue represented 36%, 33% and 24% of total revenue in 1997, 1996 and 1995, respectively. The increase in international revenue, as a percentage of total revenue, resulted primarily from increased marketing and sales efforts in Europe. The Company expects international revenue to continue to increase in absolute dollars, and, to a lesser extent, as a percentage of revenue in the future; however, achievement of these results cannot be assured./1/ Cost of revenue License cost of revenue, as a percentage of license revenue, was 8% in 1997, 1996 and 1995. License cost of revenue includes cost of production personnel, product packaging and amortization of capitalized software development costs. Service cost of revenue, as a percentage of service revenue, increased to 31% in 1997 from 29% in 1996 and 28% in 1995. Service cost of revenue consists primarily of costs of providing customer technical support, training and consulting. The increased cost in 1997 reflects increased outsourcing of training and consulting activities. Research and development For the year ended December 31, 1997, research and development, net expense was $10.9 million, or 14% of total revenue, an increase from $9.4 million, or 17% of total revenue in 1996, and $6.5 million, or 17% of total revenue in 1995. The increase in spending reflects increased personnel costs offset, in 1997, by a foreign currency translation benefit on costs incurred in Israel. In September of 1997, the Company acquired certain technologies from Dixon Software Technology which will be integrated into its future generations of load-testing products. As a result of this purchase in the third quarter of 1997, the Company recorded a one-time charge for write off of in-process research and development and related costs of $5.5 million. In May of 1995, the Company acquired Blue Lagoon Software and, in December of 1995, the Company acquired EBY Semantica, both developers of client/server technologies. (See Note 8 to Notes to Consolidated Financial Statements.) As a result of these acquisitions, during 1995 the Company recorded non-recurring charges totaling $7.7 million, comprised of write off of in-process research and development and obsolete technology totaling approximately $6.3 million and $650,000, respectively, as well as approximately $750,000 of related incentive compensation payments. Research and development expense for each of the three years ended December 31, 1997, 1996 and 1995 is net of research grants received by the Company from the government of Israel, and includes royalty expense for obligations to the government of Israel for sales of products developed under government-funded research. The Company obtained grants from the Office of the Chief Scientist in the Israeli Ministry of Industry and Trade ("the Chief Scientist") in the amounts of $2.0 million, $1.8 million and $1.6 million in 1997, 1996 and 1995, respectively. In 1996, the Company also received a grant in the amount of $391,000 from the Israel-U.S. Binational Industrial Research and Development Foundation ("BIRD-F"). The Company is not obligated to repay these grants; however, it has agreed to pay royalties at rates ranging from 2% to 5% of product sales resulting from the research, up to the amount of the grants obtained and for certain grants up to 150% of the grants obtained. Royalty expense under these agreements amounted to approximately $1.6 million, $1.1 million and $1.4 million for the years ended December 31, 1997, 1996 and 1995, respectively. As of December 31, 1997, the Company is committed to pay, if and when earned, $3.6 million in additional royalties for Chief Scientist grants and $700,000 for the BIRD-F grants. The Company capitalized $500,000, $1.3 million and $885,000 of software development costs during the years ended December 31, 1997, 1996 and 1995, respectively. Amortization charges included in cost of license revenues were $600,000 and $300,000 in 1997 and 1996, respectively. No amortization was recorded by the Company through 1995. In conjunction with the technology acquisition in 1997 and the Blue Lagoon and Semantica acquisitions in 1995, the Company wrote-off approximately $250,000 and $450,000 of capitalized development costs as obsolete in the years ended December 31, 1997 and 1995, respectively. At December 31, 1997 and 1996 the Company had a net balance of capitalized software development costs of $1.2 million and $1.5 million, respectively. - -------- /1/ Forward looking statement 14 The Company intends to continue making significant expenditures on research and development to develop new products and expand the platforms and operating systems on which its products are offered./1/ While the Company believes that these current research and development expenditures will be beneficial in the long term development of its business, there can be no assurances that the development of products will be successful or will not be rendered obsolete by future technology acquisitions or development./1/ Research and development expenditures are incurred substantially in advance of related revenue and in some cases do not result in the generation of revenue. Marketing and selling Marketing and selling expenses were $36.8 million in 1997, compared to $29.4 million in 1996 and $21.4 million in 1995. The 1995 expense included approximately $1.2 million related to the acquisition of Blue Lagoon and Semantica (principally, special incentive payments to management and write-off of fixed assets), and $900,000 for severance payments to employees related to restructuring of the Company's international operations. The increase in expenses in 1997 as compared to 1996 was primarily due to a $3.4 million increase in commission expense attributable to the higher revenue level. Other personnel-related costs, including salaries, benefits and travel, increased $3.7 million, reflecting the growth in sales headcount from 113 to 152. Excluding the non-recurring expenses of 1995, the increase in expenses in 1996 as compared to 1995 includes approximately $7.6 million in additional sales costs, primarily for increased headcount, commissions, facilities and sales infrastructure, as well as $2.9 million in additional marketing costs for advertising, marketing communications, seminars and trade shows. General and administrative General and administrative expense increased to $6.4 million, or 8% of total revenue in 1997, from $4.1 million, or 7% of total revenue in 1996 and $3.9 million, or 10% of total revenue in 1995. The increase in 1997 reflects primarily increased personnel and information systems expense. Other income, net Other income, net consists primarily of interest income and foreign exchange gains and losses. The decrease in other income, net to $3.1 million in 1997 from $3.4 million in 1996 is due primarily to foreign exchange losses. (See Note 2 to Notes to Consolidated Financial Statements) The significant increase in other income, net in 1996 from $2.3 million in 1995 relates to increased interest income which resulted from the investment of the proceeds from the Company's second public offering of Common Stock in August 1995. Provision for income taxes The Company participates in special programs sponsored by the government of Israel relating to taxation, contributing to significantly lower income tax expense than expected based on the U.S. federal income tax rate. Provisions in future years will depend upon the mix of worldwide income and the tax rates in effect for various tax jurisdictions. In the 1997 tax provision, the Company has not fully recognized the tax benefit associated with the write off of purchased in-process technology and related expenses because realization of the future tax benefit is uncertain. The tax provision for 1995 reflected U.S. and foreign taxes after consideration of non-deductible charges related to the Blue Lagoon and Semantica acquisitions. Net income (loss) The Company reported net income of $6.7 million in 1997, compared to net income of $4.6 million in 1996 and a net loss of $5.3 million in 1995. The results of operations were impacted by the $5.5 million purchase of technology and related expenses in 1997, and by the Blue Lagoon and Semantica acquisitions and related non- - -------- /1/ Forward looking statement 15 recurring events in 1995, discussed above. The Company's operating expenses are based in part on its expectations of future revenues, and expenses are generally incurred in advance of revenues. The Company plans to continue to expand and increase its operating expenses to support anticipated revenue growth./1/ If revenues do not materialize in a quarter as expected, the Company's results from operations for that quarter are likely to be materially adversely affected. Results of operations may be disproportionately affected by a reduction in revenues because only a small portion of the Company's expenses varies with its revenues. Inflation Inflation has not had a significant impact on the Company's operating results to date. FACTORS THAT MAY AFFECT FUTURE RESULTS The Company operates in a dynamic and rapidly changing environment that involves numerous risks and uncertainties. The following section lists some, but not all, of those risks and uncertainties which may have a material adverse effect on the Company's business, financial condition or results of operations.This section should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto included in this Annual Report on Form 10-K. The Company has identified certain forward looking statements in the Management's Discussion and Analysis of Financial Condition and Results of Operations with a footnote/1/ symbol. The Company may also make oral forward looking statements from time to time. Actual results may differ materially from those projected in any such forward looking statements due to a number of factors, including those set forth below and elsewhere in this Form 10-K. The market for software products is generally characterized by rapidly changing technology, frequent new product introductions and changes in customer requirements, which can render existing products obsolete or unmarketable. The Company believes that a major factor in its future success will be its ability to continue to develop and introduce in a timely and cost- effective manner enhancements to its existing products and new products that will gain market acceptance. There can be no assurance that the Company will be able to identify, develop, manufacture, market or support new products or enhancements successfully, that any such new products or enhancements will gain market acceptance, or that the Company will be able to respond effectively to technological changes. There can be no assurance that the Company will not encounter technical or other difficulties that could delay introduction of new products in the future. If the Company is unable to introduce new products or enhancements and respond to industry changes on a timely basis, its business could be materially adversely affected. The market for the automated software testing products is relatively new and undeveloped. Marketing and sales techniques in the automated software testing marketplace, as well as the basis for competition, are not well established. There can be no assurance that a significant market for automated software testing products will be developed or that the Company's products will be accepted in any expanded market. Although the Company believes that the current trend toward increased use of automated software testing will continue, a majority of software testing is still carried out manually, and there can be no assurance that the automated software market will enjoy continued growth./1/ The Company's current products and products under development are limited in number and concentrated exclusively in the software testing market. The life cycles of the Company's products are difficult to estimate due, in large measure, to the recent emergence of the Company's market as well as the unknown future effect of product enhancements and competition. Price reductions or declines in demand for the Company's software testing products, whether as a result of competition, technological change or otherwise, would have a material adverse effect on the Company's results of operations or financial position. The Company may from time to time experience significant fluctuation in quarterly operating results due to a variety of factors. Such fluctuations in quarterly operating results may occur in the future due to many factors, some of which are outside of the Company's control. Products are generally shipped as orders are received, and, - -------- /1/ Forward looking statement 16 consequently, quarterly sales and operating results depend primarily on the volume and timing of orders received during the quarter, which are difficult to forecast. In particular, the Company has historically received a substantial portion of its orders at the end of a quarter, up to the last few days of a quarter. If an unanticipated order shortfall occurs at the end of a quarter, the Company's operating results for the quarter could be materially adversely affected. In addition, product orders are affected by the buying patterns of customers. The buying trends of customers are further impacted by internal budgetary considerations relating to Year 2000 remediation efforts. A significant portion of the Company's operating expenses are relatively fixed, and planned expenditures are based on sales forecasts. All of the foregoing may result in unanticipated quarterly earning shortfalls or losses. Accordingly, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. The market for software products, in general, is highly competitive. The Company continues to face direct competition from established and emerging companies, both publicly and privately-held. In the past year, a number of the Company's competitors have been consolidated through acquisitions and may have significantly greater resources than the Company. There could be a material adverse effect on the Company's results of operations or financial position if any of the major software manufacturers, which have significantly greater resources than the Company, decided to devote substantial resources to entering the software testing market or if there is an increase in developing testing utilities internally by the Company's customers or potential customers. A variety of external and internal factors could materially adversely affect the Company's ability to compete. These include the relative functionality, price, performance and reliability of the products offered by the Company and its competitors, the timing and success of new product development or enhancement efforts of the Company and its competitors, and the effectiveness of the marketing efforts of the Company and its competitors. There can be no assurance that the Company will be able to compete successfully in the future or that competitive pressures will not materially adversely affect the Company's business. Sales to customers located outside the United States have historically accounted for a significant percentage of revenue and the Company anticipates that such sales will continue to be a significant percentage of the Company's total revenue./1/ Accordingly, such factors as currency fluctuations, political and economic instability and trade restrictions could have a negative impact on the Company's financial performance. Certain of the Company's sales are made in currencies other than the U.S. Dollar and its financial results are reported in U.S. Dollars. Fluctuations in the rates of exchange between the U.S. Dollar and other currencies may have a material adverse effect on the Company's results of operations and financial position. To date, the Company has not hedged to any significant extent against currency translation risks. As part of its growth strategy, the Company may, from time to time, acquire or invest in complementary businesses, products or technologies. While there are currently no commitments with respect to any particular acquisition or investment, the Company's management frequently evaluates the strategic opportunity available related to complimentary businesses, products or technologies. 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 any acquisition or investment will be realized. Future acquisitions or investments by the Company could result in potentially dilutive issuances of equity securities, the incurrence of debt and contingent liabilities, amortization expenses related to goodwill and other intangible assets, any of which could materially adversely affect the Company's operating results and financial condition. During the year ended December 31, 1997, the Company acquired certain technologies which will be integrated into its next version of load-testing products. As a result of this purchase, the Company's results of operations for the year ended December 31, 1997 included a write-off of in-process research and development expense and related charges of $5.5 million. There can be no assurance that the Company will be successful in its efforts to integrate the acquired technologies or will not incur additional charges in subsequent quarters to - -------- /1/ Forward looking statement 17 reflect costs associated with the acquisition. Although the Company believes the acquisition of technology described above is in the best interest of the Company and its stockholders, there are significant risks involved with this transaction, including, but not limited to, difficulties or delays in achieving product and technology integration benefits and difficulties in maintaining revenue levels during the transition to new products. Since its inception, the Company has obtained royalty-bearing grants from various Israeli government agencies, and the Company expects to receive additional grants in the future./1/ Forward looking statement Any such grants will likely decline as a percentage of gross research and development spending and there can be no assurance that the Company will receive any such grants. Termination or substantial reduction of such grants or changes in revenue classification could have a material adverse effect on the Company. The terms of certain grants prohibit the manufacture of products developed under these grants outside of Israel and the transfer of technology developed pursuant to the terms of these grants to any person, without the prior written consent of the government of Israel. As a result, if the Company is unable to obtain the consent of the government of Israel, the Company may not be able to take advantage of strategic manufacturing and other opportunities outside of Israel. Since 1991, the Company has experienced significant annual increases in revenue. This growth has placed, and if it continues will place, a significant strain on the Company's management, resources and operations. To accommodate its recent growth, the Company is implementing a variety of new or expanded business and financial systems, procedures and controls, including the improvement of its accounting and other internal management systems. There can be no assurance that the implementation of such systems, procedures and controls can be completed successfully, or without disruption of the Company's operations. If the Company's growth continues, the Company will be required to hire and integrate substantial numbers of new employees. The market has become increasingly competitive both in the United States and Israel and may require the Company to pay higher salaries. The Company's failure to manage growth effectively could have a material adverse effect on the Company's results of operations or financial position. The Company's success depends to a significant extent on the performance of its senior management and certain key employees. Competition for highly skilled employees, including sales, technical and management personnel, is intense in the computer industry. The Company's failure to attract additional qualified employees or to retain the services of key personnel could materially adversely affect the Company's business. The Company currently relies on a combination of trademark, copyright and trade secret laws and contractual provisions to protect its proprietary rights in its products. The Company presently has no registered copyrights. The Company holds three patents for elements contained in certain of its products, and it has filed several other U.S. and foreign patent applications on various elements of its products. There can be no assurance that any of the Company's patent applications will result in an issued patent or that, if issued, such patent would be upheld if challenged. There can be no assurance that the Company's competitors will not independently develop technologies that are substantially equivalent or superior to the Company's technology. There can also be no assurance that the measures taken by the Company to protect its propriety rights will be adequate to prevent misappropriation of the technology or independent development by others of similar technology. In addition, the laws of various countries in which the Company's products may be sold may not protect the Company's products and intellectual property rights to the same extent as the laws of the United States. There can be no assurance that third parties will not assert intellectual property infringement claims against the Company or that any such claims will not require the Company to enter into royalty or cross-license arrangements or result in costly litigation. In selling its products, the Company frequently relies on "shrink wrap" licenses that are not signed by licensees. The provisions in such licenses limiting the Company's exposure to potential product liability claims may therefore be unenforceable under the laws of certain jurisdictions. Although, the Company carries errors and omissions insurance against such claims, there can be no assurance that such insurance will continue to be available on acceptable terms, if at all, or that such insurance will provide the Company with adequate protection - -------- /1/ Forward looking statement 18 against any such claims. Although the Company has not experienced any product liability claims to date, the sale and support of products by the Company may entail the risk of such claims. A significant product liability claim against the Company could have a material adverse effect upon the Company's business, financial condition and results of operations. The Company's stock price, has been and will continue to be, subject to significant volatility. Past financial performance should not be considered a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. If revenues or earnings in any quarter fail to meet expectations of the investment community, there could be an immediate and significant impact on the Company's stock price. In addition, the Company's stock price may be affected by broader market trends that may be unrelated to the Company's performance. The approach of Year 2000 presents significant issues for many computer systems, since much of the software in use today may not accurately process data beyond 1999. The Company has recently implemented new information systems and accordingly does not anticipate any internal Year 2000 issues from its own information systems, databases or programs./1/ However, the Company could be adversely impacted by Year 2000 issues faced by major distributors, suppliers, customers, vendors and financial service organizations with which the Company interacts. The Company is currently taking steps to address the impact, if any, of the Year 2000 issue on the operations of the Company. There can be no assurances that the Company will be able to detect all potential failures of the Company's and/or third parties' computer systems. A significant failure of the Company's or a third party's computer system could have a material adverse effect on the Company's business, financial condition and result of operations. 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, disclosure of those assets and liabilities at the date of the financial statements and the recorded amounts of 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. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1997, the Company's principle source of liquidity consisted of $92.3 million of cash and investments as compared with $80.0 million and $85.7 million at December 31, 1996 and 1995, respectively. The December 31, 1997 balance included $75.5 million short term and $3.8 million long-term investments in high quality government and corporate securities. During 1997, the Company generated $17.1 million net cash from operating activities, compared with cash used for operating activities of $1.6 million in 1996 and net cash provided by operating activities of $2.1 million in 1995. The increase in 1997 was primarily due to an increase in net income, excluding the write off of in-process research and development and an increase in deferred revenue, partially offset by an increase in accounts receivable. The decrease in 1996 compared with 1995 was due primarily to payment of litigation, acquisition and restructuring costs accrued during 1996. The Company's primary investing activities were purchases of property and equipment and capitalization of software development costs, which totaled to $12.3 million, $5.9 million and $7.8 million in 1997, 1996 and 1995, respectively. Purchases of property and equipment in 1997 included $7.3 million for the Company's new headquarters building in Sunnyvale, California, and $1.8 million to begin construction of a new facility in Israel. During the first quarter of 1998, the Company spent approximately $1.5 million to complete renovation of the building. The Company expects to spend an additional $8.0 million to complete construction of the Israel facility and will relocate its Israel subsidiary in 1999. The Company's primary financing activity consisted of issuances of common stock under the Employee Stock Option and Stock Purchase Plans and, in 1995, completion of the Company's secondary public offering of - -------- /1/ Forward looking statement 19 Common Stock. Proceeds from issuance of stock under the Employee Stock Option and Purchase Plans amounted to $5.9 million, $1.9 million and $2.8 million in 1997, 1996 and 1995 respectively. Net proceeds from the secondary public offering of Common Stock amounted to $53.7 million. Assuming there is no significant change in the Company's business, the Company believes that its current cash and investment balances and cash flow from operations, will be sufficient to fund the Company's cash needs for at least the next twelve months./1/ ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial statements required pursuant to this Item are presented beginning on page F-1 of this report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE During the twenty-four month period preceding December 31, 1997, the Company neither changed accountants nor had disagreements with its accountants on any matter of accounting principles or practices, financial statement disclosure or auditing scope and procedures. - -------- /1/ Forward looking statement 20 PART III Certain information required by Part III is omitted from this Annual Report on Form 10-K because the Company will file a definitive proxy statement within 120 days after the end of its fiscal year pursuant to Regulation 14A (the "Proxy Statement") for its Annual Meeting of Stockholders, currently scheduled for May 20, 1998, and the information included in the Proxy Statement is incorporated herein by reference. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information concerning the Company's officers required by this Item is incorporated by reference to the section of Part I of this Annual Report entitled "Item 1. Business--Personnel." The information concerning the Company's directors required by this Item is incorporated by reference to the information under the heading "Election of Directors--Nominees" in the Company's Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to the Company's Proxy Statement under the heading "Executive Compensation." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference to the Company's Proxy Statement under the heading "Security Ownership of Certain Beneficial Owners and Management." ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference to the Company's Proxy Statement under the heading "Certain Transactions." 21 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: 1. Financial Statements. The following financial statements of Mercury Interactive Corporation are filed as a part of this report:
PAGE ---- Report of Independent Accountants...................................... F-1 Consolidated Balance Sheets at December 31, 1997 and 1996.............. F-2 Consolidated Statements of Operations for the years ended December 31 1997, 1996 and 1995................................................... F-3 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1997, 1996 and 1995...................................... F-4 Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995................................................... F-5 Notes to Consolidated Financial Statements............................. F-6
2. Schedules The following financial statement schedule is filed as part of this Form 10- K: Schedule II--Valuation and Qualifying Accounts for the Three Years Ended December 31, 1997 Financial statement schedules not listed above have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 3. Exhibits 2.1(6) Agreement and Plan of Reorganization by and among the Company, Blue Lagoon Software and David L. Cherin dated April 25, 1995. 2.2(10) Share Purchase Agreement between the Company and EBY-Semantica, executed December 12, 1995. 3.3(1) Certificate of Incorporation of Registrant, as amended and restated to date. 3.4(1) By-laws of Registrant, as amended to date. 10.1(1,2) 1989 Stock Option Plan and forms of Incentive Stock Option Agreement and Nonstatutory Stock Option Agreement. 10.2(1) Form of Directors' and Officers' Indemnification Agreement. 10.3(1) Registration and Information Rights Agreement made as of March 13, 1992. 10.4(7) Lease Agreement dated August 19, 1994 between the Registrant, and Microtec Research, Inc., covering the property at 470 Potrero Avenue, Sunnyvale, California. 10.5(1) Lease Agreement dated August 30, 1990 between the Registrant and Reuven Down covering the property at 4 Hayotzrim Street, Or Yehudah, a suburb of Tel Aviv, Israel (translated from original Hebrew). 10.7(1) Consulting Agreement by and between the Registrant and Aryeh Finegold, dated March 1, 1992. 10.8(1) Agreement by and between Mercury Interactive (Israel) Limited, a wholly-owned subsidiary of the Registrant ("Mercury Israel"), and the Office of the Chief Scientist in the Ministry of Industry and Trade dated February 11, 1991 (translation from original Hebrew). 10.9(1) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated February 10, 1992 (translation from original Hebrew). 10.10(1) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated December 13, 1992 (translation from original Hebrew).
22 10.11(1,2) Form of 1993 Employee Stock Purchase Plan and form of Agreements. 10.12(1) 401(k) Plan. 10.14(1) Microsoft Solutions Channel Alliance Agreement dated March 5, 1993 between Registrant and Microsoft Corporation. 10.15(2,4) 1994 Directors' Stock Option Plan and form of Agreements. 10.16(3) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated May 5, 1993 (translation from original Hebrew). 10.17(3) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated June 21, 1993 (translation from original Hebrew). 10.18(3) Agreement by and between Mercury Israel and the Fund for the Encouragement of Marketing Abroad in the Ministry of Industry and Trade dated February 15, 1993 (translation from original Hebrew). 10.19(5) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated November 13, 1994 (translation from original Hebrew). 10.20(5) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated November 13, 1994 (translation from original Hebrew). 10.21(7) Agreement by and between Mercury Israel and the Fund for the Encouragement of Marketing Abroad in the Ministry of Industry and Trade dated January 1, 1996 (translation from original Hebrew). 10.22(7) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated September 30, 1995 (translation from original Hebrew). 10.23(7) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated September 30, 1995 (translation from original Hebrew). 10.24(8) Preferred Share Purchase Rights Agreement. 10.25(9) 1996 Supplemental Stock Plan. 10.26(11) Purchase Agreement between Mercury Interactive Corporation and Dixon Software Technology dated September 30, 1997. 10.27(11) Purchase and Sale Agreement and Joint Escrow Instructions by and between Mercury Interactive Corporation and M. C. Securities, LLC dated July 1, 1997. 21.1 Subsidiaries of Registrant. 23.1 Consent of Independent Accountants. 24.1 Power of Attorney (see page 25). 27.1 Financial Data Schedule
- -------- (1) Incorporated by reference to identically numbered exhibits filed in response to Item 16(a), "Exhibits," of the Registrant's Registration Statement on Form S-1, as amended (File No. 33-68554), which was declared effective on October 29, 1993. (2) Designates management contract or compensatory plan arrangements required to be filed as an exhibit of this Annual Report on Form 10-K. (3) Exhibits 10.16, 10.17 and 10.18 are incorporated by reference to Exhibits 10.1, 10.2 and 10.3, respectively, filed with the Form 10-Q for the three month period ended March 31, 1994. (4) Incorporated by reference to identically numbered exhibits filed with the Form 10-Q for the three month period ended September 30, 1994. (5) Incorporated by reference to identically numbered exhibits filed with the Form 10-K for the year ended December 31, 1994. (6) Incorporated by reference to the identically numbered exhibit to the Company's Registration Statement on Form S-3, No. 33-95066, filed with the Securities and Exchange Commission on July 27, 1995. (7) Incorporated by reference to the identically numbered exhibit filed with the Form 10-K for the year ended December 31, 1995. (8) Incorporated by reference to the Exhibit 1 to the Company's Form 8-A, filed with the Securities and Exchange Commission on July 9, 1996. 23 (9) Incorporated by reference to Exhibit 4.2 to the Company's Registrations Statement of Form S-8, No. 333-09913, filed with the Securities and Exchange Commission on August 9, 1996. (10) Incorporated by reference to Exhibit 2.2, filed with the Company's Form 10-K for the year ended December 31, 1996. (11) Exhibits 10.26 and 10.27 are incorporated by reference to Exhibits 10.1 and 10.2, respectively, filed with the Form 10-Q for the three month period ended September 30, 1997. (b) Reports on Form 8-K No report on Form 8-K was filed during the fourth quarter of the year ended December 31, 1997. 24 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT, MERCURY INTERACTIVE CORPORATION, A CORPORATION ORGANIZED AND EXISTING UNDER THE LAWS OF THE STATE OF DELAWARE, HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. Mercury Interactive Corporation Dated: March 20, 1998 /s/ Sharlene Abrams By___________________________________ SHARLENE ABRAMS, VICE PRESIDENT OF FINANCE AND ADMINISTRATION, CHIEF FINANCIAL OFFICER AND SECRETARY POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints jointly and severally, Aryeh Finegold and/or Sharlene Abrams and each one of them, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. SIGNATURES TITLE DATE /s/ Aryeh Finegold Chairman of the March 20, 1998 - ------------------------------------- Board of Directors ARYEH FINEGOLD /s/ Amnon Landan President, Chief March 20, 1998 - ------------------------------------- Executive Officer AMNON LANDAN and Director (Principal Executive Officer) /s/ Sharlene Abrams Vice President of March 20, 1998 - ------------------------------------- Finance and SHARLENE ABRAMS Administration, Chief Financial Officer (Principal Financial and Accounting Officer) and Secretary /s/ Igal Kohavi Director March 20, 1998 - ------------------------------------- IGAL KOHAVI /s/ Yair Shamir Director March 20, 1998 - ------------------------------------- YAIR SHAMIR /s/ Giora Yaron Director March 20, 1998 - ------------------------------------- GIORA YARON 25 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Mercury Interactive Corporation In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) present fairly, in all material respects, the financial position of Mercury Interactive Corporation and its subsidiaries at December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE LLP San Jose, California February 4, 1998 F-1 MERCURY INTERACTIVE CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
DECEMBER 31, ------------------ 1997 1996 -------- -------- ASSETS Current assets: Cash and cash equivalents................................ $ 57,211 $ 44,337 Short-term investments................................... 31,357 26,686 Trade accounts receivable (net of allowance for doubtful accounts and sales returns of $1,878 and $1,136)........ 23,782 18,503 Government grant and other receivables................... 3,606 3,139 Inventories.............................................. 252 560 Prepaid expenses and other current assets................ 2,954 3,307 -------- -------- Total current assets................................... 119,162 96,532 Long-term investments...................................... 3,771 8,954 Property and equipment, net................................ 19,292 10,413 Deposits and other assets.................................. 1,185 1,590 -------- -------- $143,410 $117,489 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable......................................... $ 4,045 $ 1,859 Accrued liabilities...................................... 15,411 8,782 Deferred revenue......................................... 10,967 7,809 -------- -------- Total current liabilities.............................. 30,423 18,450 -------- -------- Commitments and contingencies (Note 5) Stockholders' equity: Common Stock, par value $.002 per share, 25,000 shares authorized; 16,738 and 16,056 shares issued and outstanding............................................. 33 32 Capital in excess of par value........................... 107,800 100,235 Cumulative translation adjustment........................ (424) (99) Retained earnings (accumulated deficit).................. 5,578 (1,129) -------- -------- Total stockholders' equity............................. 112,987 99,039 -------- -------- $143,410 $117,489 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-2 MERCURY INTERACTIVE CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEAR ENDED DECEMBER 31, ----------------------- 1997 1996 1995 ------- ------- ------- Revenue: License............................................. $56,683 $43,270 $32,765 Service............................................. 20,017 11,280 6,685 ------- ------- ------- Total revenue..................................... 76,700 54,550 39,450 ------- ------- ------- Cost of revenue: License............................................. 4,351 3,419 2,626 Service............................................. 6,225 3,240 1,887 ------- ------- ------- Total cost of revenue............................. 10,576 6,659 4,513 ------- ------- ------- Gross profit.......................................... 66,124 47,891 34,937 ------- ------- ------- Operating expenses: Research and development, net....................... 10,933 9,396 6,523 Write off of in-process research and development and related expenses................................... 5,500 -- 7,700 Marketing and selling............................... 36,804 29,360 21,361 General and administrative.......................... 6,362 4,113 3,911 Settlement of litigation............................ -- 2,600 2,000 ------- ------- ------- Total operating expenses.......................... 59,599 45,469 41,495 ------- ------- ------- Income (loss) from operations......................... 6,525 2,422 (6,558) Other income, net..................................... 3,109 3,361 2,277 ------- ------- ------- Income (loss) before provision for income taxes....... 9,634 5,783 (4,281) Provision for income taxes............................ 2,927 1,157 970 ------- ------- ------- Net income (loss)..................................... $ 6,707 $ 4,626 $(5,251) ======= ======= ======= Net income (loss) per share (basic)................... $ 0.41 $ 0.29 $ (0.38) ======= ======= ======= Net income (loss) per share (diluted)................. $ 0.39 $ 0.28 $ (0.38) ======= ======= ======= Weighted average common shares (basic)................ 16,373 15,908 13,947 ======= ======= ======= Weighted average common shares (diluted).............. 17,104 16,563 13,947 ======= ======= =======
The accompanying notes are an integral part of these consolidated financial statements. F-3 MERCURY INTERACTIVE CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS)
RETAINED COMMON STOCK CAPITAL IN STOCKHOLDER CUMULATIVE EARNINGS/ ------------- EXCESS OF LOANS TRANSLATION ACCUMULATED SHARES AMOUNT PAR VALUE RECEIVABLE ADJUSTMENT DEFICIT TOTAL ------ ------ ---------- ----------- ----------- ----------- -------- Balance at December 31, 1994................... 12,776 $26 $ 39,830 $(35) $(150) $ (504) $ 39,167 Stock issued in exchange for Blue Lagoon Software............... 66 -- 1,431 -- -- -- 1,431 Issuance of Common Stock in secondary public offering, net of issuance costs of $483 2,408 4 53,714 -- -- -- 53,718 Stock issued under stock option and employee stock purchase plans 478 1 2,766 35 -- -- 2,802 Tax benefit related to stock options.......... -- -- 568 -- -- -- 568 Currency translation adjustment............. -- -- -- -- 181 -- 181 Net loss................ -- -- -- -- -- (5,251) (5,251) ------ --- -------- ---- ----- ------ -------- Balance at December 31, 1995................... 15,728 31 98,309 -- 31 (5,755) 92,616 Stock issued under stock option and employee stock purchase plans... 328 1 1,887 -- -- -- 1,888 Tax benefit related to stock options.......... -- -- 39 -- -- -- 39 Currency translation adjustment............. -- -- -- -- (130) -- (130) Net income.............. -- -- -- -- -- 4,626 4,626 ------ --- -------- ---- ----- ------ -------- Balance at December 31, 1996................... 16,056 32 100,235 -- (99) (1,129) 99,039 Stock issued under stock option and employee stock purchase plans... 682 1 5,866 -- -- -- 5,867 Tax benefit related to stock options.......... -- -- 1,699 -- -- -- 1,699 Currency translation adjustment............. -- -- -- -- (325) -- (325) Net income.............. -- -- -- -- -- 6,707 6,707 ------ --- -------- ---- ----- ------ -------- Balance at December 31, 1997................... 16,738 $33 $107,800 $-- $(424) $5,578 $112,987 ====== === ======== ==== ===== ====== ========
The accompanying notes are an integral part of these consolidated financial statements. F-4 MERCURY INTERACTIVE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
YEAR ENDED DECEMBER 31, --------------------------- 1997 1996 1995 -------- ------- -------- Cash flows from operating activities: Net income (loss)............................... $ 6,707 $ 4,626 $ (5,251) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization................. 3,741 3,263 2,156 Deferred income taxes......................... 270 674 (719) Non-cash acquisition and other non-recurring charges...................................... -- -- 2,255 Changes in assets and liabilities: Trade accounts receivable................... (7,214) (6,527) (4,562) Government grant and other receivables...... (730) (564) (790) Inventories................................. 345 (44) 125 Other assets................................ 513 (1,084) (830) Accounts payable............................ 1,800 591 (282) Accrued liabilities......................... 6,756 (5,087) 10,689 Deferred revenue............................ 4,936 2,594 (705) -------- ------- -------- Net cash provided by (used in) operating activities............................... 17,124 (1,558) 2,086 -------- ------- -------- Cash flows from investing activities: Investment proceeds net......................... 512 4,149 (15,990) Acquisition of property and equipment........... (11,799) (4,596) (6,958) Capitalization of software development costs.... (500) (1,340) (885) -------- ------- -------- Net cash used in investing activities..... (11,787) (1,787) (23,833) -------- ------- -------- Cash flows from financing activities: Proceeds from issuance of Common Stock, net..... 5,866 1,888 56,520 Tax benefit associated with exercise of stock options........................................ 1,699 39 568 -------- ------- -------- Net cash provided by financing activitiesNet cash provided by financing activities............................... 7,565 1,927 57,088 -------- ------- -------- Effect of exchange rate changes on cash........... (28) (95) 44 -------- ------- -------- Net increase (decrease) in cash................... 12,874 (1,513) 35,385 Cash and cash equivalents at beginning of period.. 44,337 45,850 10,465 -------- ------- -------- Cash and cash equivalents at end of period........ $ 57,211 $44,337 $ 45,850 ======== ======= ======== SUPPLEMENTAL DISCLOSURE: Cash paid during the period for income taxes...... $ 2,083 $ 1,182 $ 838
The accompanying notes are an integral part of these consolidated financial statements. F-5 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1--THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES Mercury Interactive Corporation (the "Company"), incorporated in Delaware in July 1989, develops, markets and supports a family of automated client/server and Web-based system tools for testing business-critical enterprise applications. The Company operates in one industry segment. See Note 7 for geographic reporting. No customer accounted for more than 10% of the Company's sales in 1997, 1996 or 1995. Basis of presentation The Company has a wholly-owned research and development subsidiary incorporated in Israel and sales subsidiaries in Canada, Europe and the Pacific Rim for marketing, distribution and support of products. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Foreign currency translation The functional currency of the Company's subsidiary in Israel is the U.S. dollar. Assets and liabilities in Israel are translated at year-end exchange rates, except for property and equipment, which is translated at historical rates. Revenues and expenses are translated at average exchange rates in effect during the year, except for costs related to those balance sheet items which are translated at historical rates. Foreign currency translation gains and losses, which have not been material to date for this subsidiary, are included in the statement of operations. The functional currency of all other subsidiaries are the local currencies. Accordingly, all assets and liabilities of these subsidiaries are translated at the current exchange rate at the end of the period and revenues and costs at average exchange rates in effect during the period. The gains and losses from translation of these subsidiaries' financial statements are recorded directly into a separate component of stockholders' equity. Net gains and losses resulting from foreign exchange transactions were not significant during any of the periods presented. Cash and cash equivalents The Company considers all highly liquid debt instruments purchased with a maturity of three months or less at the date of purchase to be cash equivalents. Short-term and long-term investments The Company considers all investments with maturities of less than one year as of December 31, 1997 to be short-term investments and all investments with maturities greater than one year to be long-term investments. In accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the Company has categorized its marketable securities as "available for sale" securities. The investments, which all have contractual maturities of less than two years, are carried at cost plus accrued interest, which approximated market value for the entire fiscal year. Realized gains or losses are determined on the specific identification method and are reflected in other income. F-6 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The portfolio of short and long-term investments (including cash and cash equivalents) consisted of the following:
DECEMBER 31, --------------- INVESTMENT TYPE 1997 1996 --------------- ------- ------- Cash...................................................... $13,087 $10,287 Debt (state or political subdivision)..................... 71,396 57,355 Money market preferred stock.............................. 7,856 12,335 ------- ------- Total................................................... $92,339 $79,977 ======= =======
Revenue recognition The Company's product revenues are derived from product licensing fees, and the Company's service revenues are derived from maintenance support services, training and consulting. Revenue from product licensing fees is recognized upon shipment and resolution of any material vendor obligations. Products shipped, for which material vendor obligations exist, are recorded as deferred revenue. Service revenue from customer maintenance fees for ongoing customer support and product updates is recognized ratably over the period of the contract. Payments for maintenance fees are generally made in advance, are nonrefundable and are classified as deferred revenue. Revenues for training and consulting services are recognized as the services are provided. Inventories Inventories are stated at the lower of standard cost, which approximates actual cost, using the first-in, first-out method, or market. Property and equipment Property and equipment are stated at cost. Depreciation and amortization are provided using the straight-line method over the estimated economic lives of assets, which are three to ten years for office furniture and equipment, three to five years for computers and related equipment, four to ten years for leasehold improvements, or the term of the lease, whichever is shorter, and thirty years for the building. Research and development In accordance with Statement of Financial Accounting Standards No. 86, "Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed," all costs incurred to establish the technological feasibility of a computer product to be sold, leased or otherwise marketed are expensed as research and development costs. Costs incurred subsequent to the establishment of technological feasibility, and prior to the general release of the product to the public are capitalized. Amortization of capitalized software development costs is provided on a product-by-product basis using the straight-line method over the estimated economic life of the products of two years. The Company capitalized $500,000, $1.3 million and $885,000 of software development costs during the years ended December 31, 1997, 1996 and 1995, respectively. Amortization charges included in cost of license revenues were $600,000 and $300,000 in 1997 and 1996, respectively. No amortization was recorded by the Company through 1995. In conjunction with the technology acquisition in 1997 and the Blue Lagoon and Semantica acquisitions in 1995, the Company wrote-off approximately $250,000 and $450,000 of capitalized F-7 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) development costs as obsolete in the years ended December 31, 1997 and 1995, respectively. At December 31, 1997 and 1996 the Company had a net balance of capitalized software development costs of $1.2 million and $1.5 million, respectively. Research and development expense for each of the three years ended December 31, 1997, 1996 and 1995 is net of research grants received by the Company from the government of Israel, and includes royalty expense for obligations to the government of Israel for sales of products resulting from government-funded research. The Company obtained grants from the Office of the Chief Scientist in the Israeli Ministry of Industry and Trade ("the Chief Scientist") in the amounts of $2.0 million, $2.2 million and $1.6 million in 1997, 1996 and 1995, respectively. In 1996, the Company also received a grant in the amount of $391,000 from the Israel-U.S. Binational Industrial Research and Development Foundation ("BIRD-F"). The Company is not obligated to repay these grants; however, it has agreed to pay royalties at rates ranging from 2% to 5% of product sales resulting from the research, up to the amount of the grants obtained and, for certain grants, up to 150% of the grants obtained. Royalty expense under these agreements amounted to approximately $1.6 million, $1.1 million and $1.4 million for the years ended December 31, 1997, 1996 and 1995, respectively. As of December 31, 1997, the Company is committed to pay, if and when earned, $3.6 million in additional royalties for Chief Scientist grants and $700,000 for the BIRD-F grants. Stock-based compensation The Company accounts for stock-based compensation using the intrinsic value method presented in Accounting Principles Board Opinion (APB) No. 25, " Accounting for Stock Issued to Employees" and related interpretations. The Company's policy is to grant options with an exercise price equal to the quoted market price of the Company' stock on the grant date. Accordingly, no compensation cost has been recognized in the Company's statements of operations. The Company provides additional pro forma disclosure as required under Statement of Financial Accounting Standard No. 123 (SFAS 123), "Accounting for Stock-based Compensation." See Note 3. Concentration of risks Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash equivalents, investments and accounts receivable. The Company invests primarily in money market accounts and marketable securities and places its investments with high quality financial, government or corporate institutions. The Company's accounts receivable are derived from sales to customers located primarily in the U.S., Canada, Europe, Pacific Rim and Israel. The Company performs ongoing credit evaluations of its customers and to date has not experienced any material losses. Net income (loss) per share Earnings per share are calculated in accordance with the provisions of Statement of Accounting Standards No. 128, "Earnings per Share," (SFAS 128), effective for 1997. SFAS 128 requires the Company to report both basic earnings per share, which is the weighted-average number of common shares outstanding, and diluted earnings per share, which includes the weighted- average common shares outstanding and all dilutive potential common shares outstanding. All periods presented herein have been restated to reflect the adoption of SFAS 128. For the years ended December 31, 1997 and 1996, dilutive potential common shares outstanding reflects shares issuable under the Company's stock option plans. For the year ended December 31, 1995, potential common F-8 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) shares have been excluded because their effect was anti-dilutive. The following table summarizes the Company's earnings per share computations for the years ended December 31, 1995, 1996 and 1997.
NET INCOME AVERAGE EARNINGS (LOSS) (LOSS) SHARES PER SHARE ---------- ------- --------------- December 31, 1995: Basic earnings per share................ $(5,251) 13,947 $(0.38) Dilutive adjustments.................... -- ------- ------ Diluted earnings per share.............. $(5,251) 13,947 (0.38) ------- ------ December 31, 1996: Basic earnings per share................ $ 4,626 15,908 $ 0.29 Dilutive adjustments.................... 655 ------- ------ Diluted earnings per share.............. $ 4,626 16,563 0.28 ------- ------ December 31, 1997: Basic earnings per share................ $ 6,707 16,373 $ 0.41 Dilutive adjustments.................... 731 ------- ------ Diluted earnings per share.............. $ 6,707 17,104 0.39 ------- ------
At December 31, 1997 and 1996, options to purchase a total of 235,273 shares of common stock with an average exercise price of $19.30 and 251,471 shares of common stock with an average exercise price of $18.05, respectively, are considered anti-dilutive because the options' exercise price was greater than the average fair market value of the Company's common stock for the years then ended. Management Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Reclassifications Certain previously reported amounts have been reclassified to conform to the 1997 consolidated financial statement presentation. New Accounting Pronouncements In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements for the periods beginning after December 15, 1997. Comprehensive income, as defined, includes all changes in equity (net assets) during a period from nonowner sources including unrealized gains and losses on available-for-sale securities. Reclassification of financial statements for earlier periods for comparative purposes is required. The Company will adopt SFAS No. 130 beginning in 1998 and does not expect such adoption to have a material effect on the consolidated financial statements. In June 1997, the FASB issued SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information." This statement establishes standards for the way companies report information about operating F-9 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) segments in annual financial statements for periods beginning after December 15, 1997. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. It is not expected that adoption of SFAS No. 131 will have an impact to the Company's consolidated financial statements. In November 1997, the American Institute of Certified Public Accountants issued a Statement of Position 97-2, "Software Revenue Recognition" (the SoP). The SoP is effective for transactions entered into in fiscal years beginning after December 15, 1997. Retroactive application of the provisions of this SoP is prohibited. The Company has reviewed the SoP and believes that, based on its current policies, the application of this SoP will not have a material impact on the recording of future revenue. NOTE 2--FINANCIAL STATEMENT COMPONENTS
DECEMBER 31, ----------------- 1997 1996 -------- ------- (IN THOUSANDS) Government grant and other receivables: Government grant receivables........................... $ 977 $ 1,484 Employee receivables................................... 277 529 Other receivables...................................... 2,352 1,126 -------- ------- $ 3,606 $ 3,139 ======== ======= Property and equipment: Land................................................... $ 5,128 $ 2,878 Building............................................... 6,712 -- Computers and equipment................................ 13,722 10,151 Office furniture and equipment......................... 2,186 2,306 Leasehold improvements................................. 2,154 2,148 -------- ------- 29,902 17,483 Less: accumulated depreciation and amortization........ (10,610) (7,070) -------- ------- $ 19,292 $10,413 ======== ======= Accrued liabilities: Payroll and accrued commissions (including payroll taxes)................................................ $ 5,397 $ 2,738 Vacation and severance................................. 1,945 1,538 Acquisition of technologies and related cost........... 2,316 -- Royalties.............................................. 1,357 1,062 Income taxes........................................... 939 636 Other.................................................. 3,457 2,808 -------- ------- $ 15,411 $ 8,782 ======== =======
YEAR ENDED DECEMBER 31, ------------------------ 1997 1996 1995 ------- ------- ------- (IN THOUSANDS) Other income, net: Interest income.................................. $ 3,547 $ 3,148 $ 1,987 Foreign exchange gains (losses) and other........ (438) 213 290 ------- ------- ------- $ 3,109 $ 3,361 $ 2,277 ======= ======= =======
F-10 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3--COMMON STOCK In August 1989, the Company adopted a stock option plan (the "Plan"). Options granted under the Plan are for periods not to exceed ten years. For holders of 10% or more of the total combined voting power of all classes of the Company's stock, options may not be granted at less than 110% of the fair value of the Common Stock at the date of grant and the option term may not exceed 5 years. Incentive stock option grants under the Plan must be at exercise prices no less than 100% of the fair market value and non-statutory stock option grants under the Plan must be at exercise prices no less than 85% of the fair market value of the stock on the date of grant. Options are immediately exercisable but all shares purchased upon exercise of options are subject to repurchase by the Company until vested. Options generally vest over a period of four years. In May 1996, the Company adopted a stock option plan solely for grants to employees of the Company and its subsidiaries located outside the United States (the "Supplemental Plan"). The Company reserved 500,000 shares of Common Stock for issuance upon exercise of stock options to be granted under this plan. The provisions of the Supplemental Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the Plan. The following table presents the combined activity of the Plan and the Supplemental Plan for the years ended December 31, 1995, 1996 and 1997 (shares in thousands):
OPTIONS OUTSTANDING ----------------------- WEIGHTED OPTIONS AVERAGE AVAILABLE NUMBER OF EXERCISE FOR GRANT SHARES PRICE --------- ---------- ---------- Balance outstanding at December 31, 1994................................... 48 1,624 $ 7.12 Additional shares authorized.......... 800 -- -- Options granted....................... (824) 824 15.98 Options canceled...................... 136 (136) 9.09 Options exercised..................... -- (308) 4.23 ------ --------- ---------- Balance outstanding at December 31, 1995................................... 160 2,004 10.70 Additional shares authorized.......... 1,209 -- -- Options granted....................... (1,878) 1,878 12.08 Options canceled...................... 523 (523) 14.45 Options exercised..................... -- (234) 7.34 ------ --------- ---------- Balance outstanding at December 31, 1996................................... 14 3,125 11.28 Additional shares authorized.......... 748 -- -- Options granted....................... (1,067) 1,067 11.85 Options canceled...................... 313 (313) 11.98 Options exercised..................... -- (531) 9.61 ------ --------- ---------- Balance outstanding at December 31, 1997................................... 8 3,348 $ 11.67 ====== ========= ==========
In May of 1996, the Board of Directors authorized the Company to offer all employees with outstanding options at exercise price in excess of $16.00 per share the opportunity to exchange such options for new options. Each new option was issued under the same terms as the surrendered options. As a result, options covering 271,083 shares ranging in price from $16.75 to $19.00 were canceled and options for an equal number of shares were granted at the exercise price of $12.75. F-11 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table presents weighted average price and remaining contractual life information about significant option groups outstanding under the Plan and the Supplemental Plan at December 31, 1997 (shares in thousands):
OPTIONS OUTSTANDING OPTIONS EXERCISABLE -------------------------------- -------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED REMAINING AVERAGE NUMBER AVERAGE RANGE OF NUMBER CONTRACTUAL EXERCISE EXERCISABLE EXERCISE EXERCISE PRICES OUTSTANDING LIFE (YR.) PRICE AT 12/31/97 PRICE --------------- ----------- ----------- -------- ----------- -------- $ 0.30-- 9.75............. 1,125 8.02 $ 8.67 372 $ 6.57 $10.00--12.38............. 674 4.75 10.98 295 11.48 $12.75--12.75............. 1,055 7.98 12.75 406 12.75 $13.50--21.13............. 494 8.87 17.11 109 18.38 ----- ---- ------ ----- ------ 3,348 7.47 $11.67 1,182 $11.01 ===== ==== ====== ===== ======
Directors' Stock Option Plan On August 3, 1994, the Board of Directors of the Company adopted the 1994 Directors' Stock Option Plan (the "Directors' Plan"). The Company reserved 500,000 shares of Common Stock for issuance upon exercise of stock options to be granted during the ten year term of the Directors' Plan. Only outside directors may be granted options under the Directors' Plan. The Plan provided for an initial option grant to outside directors of the Company as of August 3, 1994 or upon initial election to the Board of Directors after August 3, 1994. In addition, the plan provides for automatic annual grants of 5,000 shares upon reelection of the individual to the Board of Directors. The option term shall be ten years, and options shall be exercisable while such person remains a director. The exercise price shall be 100% of fair market value on the date of grant. These options will vest as to 5,000 shares annually for each director on the date of each Annual Meeting of Stockholders of the Company after the date of grant of such option. The annual option grant shall vest in full on the fifth anniversary following each individual's re-election to the Board of Directors. The following table presents the activity for the Directors' Plan for the years ended December 31, 1995, 1996 and 1997 (shares in thousands):
OPTIONS OUTSTANDING OPTIONS ----------------------- AVAILABLE NUMBER OF WEIGHTED FOR GRANT SHARES AVERAGE PRICE --------- --------- ------------- Balance outstanding at December 31, 1994........ 400 100 $ 9.13 Options granted......... (20) 20 21.13 Options canceled........ -- -- 9.09 Options exercised....... -- (10) 9.13 --- --- ------ Balance outstanding at December 31, 1995........ 380 110 11.31 Options granted......... (45) 45 14.75 Options canceled........ 45 (45) 12.28 Options exercised....... -- (20) 9.13 --- --- ------ Balance outstanding at December 31, 1996........ 380 90 13.03 Options granted......... (15) 15 12.25 Options canceled........ -- -- -- Options exercised....... -- (10) 9.13 --- --- ------ Balance outstanding at December 31, 1997........ 365 95 $13.32 === === ======
F-12 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table presents weighted average price and remaining contractual life information about significant option groups outstanding under the Director's Plan at December 31, 1997 (shares in thousands):
OPTIONS OUTSTANDING OPTIONS EXERCISABLE -------------------------------- -------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED REMAINING AVERAGE NUMBER AVERAGE RANGE OF NUMBER CONTRACTUAL EXERCISE EXERCISABLE EXERCISE EXERCISE PRICES OUTSTANDING LIFE (YR.) PRICE AT 12/31/97 PRICE --------------- ----------- ----------- -------- ----------- -------- $ 9.13.................... 30 6.32 $ 9.13 10 $ 9.13 $12.25 $13.50............. 30 8.83 12.88 0 -- $15.75 $21.13............. 35 7.90 17.31 5 15.75 --- ---- ------ --- ------ 95 7.70 $13.32 15 $11.33 === ==== ====== === ======
1993 Employee Stock Purchase Plan In October 1993, the Board of Directors and stockholders adopted the Employee Stock Purchase Plan (the "ESPP") and reserved 500,000 shares for issuance. Under the plan, employees are granted the right to purchase shares of Common Stock at a price per share that is the lesser of: (i) 85% of the fair market value of the shares at the participant's entry date into the two- year offering period, or (ii) the fair market value at the end of each six- month segment within such offering period. During 1997, 1996 and 1995, approximately 140,000, 94,000 and 160,000 shares, respectively, were purchased under the Employee Stock Purchase Plan. Pro Forma Disclosure The Company has adopted the disclosure provisions only of SFAS No. 123 and will continue to account for its stock option plans in accordance with the provisions of APB 25. Accordingly, no compensation cost had been recognized for the stock option plans of the ESPP. Pursuant to the requirements of SFAS 123, the following are pro forma net income (loss) and net income (loss) per share for 1997, 1996 and 1995, as if the compensation costs for the option plans and the ESPP had been determined based on the fair value at the grant date for grants in 1997, 1996 and 1995, consistent with the provisions of SFAS 123:
1997 1996 1995 ---- ----- ------- Pro forma net income (loss) (in thousands)............. $596 $(437) $(7,459) Pro forma net income (loss) per share (diluted)........ 0.04 (0.03) (0.53) Pro forma net income (loss) per share (basic).......... 0.03 (0.03) (0.53)
The fair value of options and shares issued pursuant to the option plans and the ESPP at the grant date were estimated using the Black-Scholes model with the following weighted average assumptions:
OPTION PLANS ESPP ---------------- ---------------- 1997 1996 1995 1997 1996 1995 ---- ---- ---- ---- ---- ---- Expected life (years).................... 5.00 4.45 4.90 0.50 0.50 0.50 Risk-free interest rate.................. 6.10% 6.20% 6.85% 5.36% 5.13% 5.92% Volatility............................... 86% 94% 90% 86% 94% 90% Dividend yield........................... None None None None None None
The weighted fair value per share of options granted under the Plan and Supplemental Plan during the years ended December 31, 1997, 1996 and 1995 were $8.47, $8.18 and $11.66, respectively. The weighted fair value F-13 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) per share of options granted under the Directors Plan during the years ended December 31, 1997, 1996 and 1995 were $8.72, $11.36, and $15.57, respectively. NOTE 4--INCOME TAXES Income (loss) before income taxes consists of the following (in thousands):
YEAR ENDED DECEMBER 31, ------------------------- 1997 1996 1995 ------- ------- -------- Domestic.......................................... $ 16 $ (933) $ (204) Foreign........................................... 9,618 6,716 (4,077) ------- ------- -------- $ 9,634 $ 5,783 $ (4,281) ======= ======= ========
The provision for income taxes is comprised of the following (in thousands):
YEAR ENDED DECEMBER 31, ------------------------ 1997 1996 1995 ------- ------- ------- Current: Federal.......................................... $ 1,222 $ (110) $ 1,250 State............................................ 355 65 390 Foreign.......................................... 1,080 528 49 ------- ------- ------- Total.......................................... 2,657 483 1,689 ------- ------- ------- Deferred: Federal.......................................... 193 597 (507) State............................................ 77 77 (212) Foreign.......................................... -- -- -- ------- ------- ------- Total.......................................... 270 674 (719) ------- ------- ------- Total.............................................. $ 2,927 $ 1,157 $ 970 ======= ======= =======
Deferred tax assets consist of the following (in thousands):
DECEMBER 31, ---------------- 1997 1996 ------- ------- Net operating loss carryforwards........................... $ -- $ 2,021 Tax credits................................................ 860 -- Capitalized research and development costs................. -- 26 Accruals and reserves...................................... 972 244 Depreciation and other..................................... 357 -- ------- ------- 2,189 2,291 Valuation allowance........................................ (2,189) (2,021) ------- ------- $ -- $ 270 ======= =======
The Company has provided a valuation allowance of $2.2 million at December 31, 1997 for deferred tax assets for which realization of future benefit is uncertain. F-14 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The provision for income taxes differs from the amount obtained by applying the statutory federal income tax rate to income before taxes as follows (in thousands):
DECEMBER 31, ------------------------- 1997 1996 1995 ------- ------- ------- Statutory federal tax (benefit).................. $ 3,276 $ 2,024 $(1,498) State tax, net of federal benefit................ 549 58 257 Utilization of net operating loss carryforwards.. -- -- (192) Foreign rate differentials from U.S. statutory rate............................................ (2,739) (2,194) 1,449 Non-deductible expenses.......................... 51 68 1,510 Non-utilized net operating losses................ 2,390 1,746 -- Tax-exempt interest.............................. (756) (779) (482) Other............................................ 156 234 (74) ------- ------- ------- $ 2,927 $ 1,157 $ 970 ======= ======= =======
Income taxes are not provided for the undistributed earnings of the Company's foreign subsidiaries because it is management's intention to reinvest such earnings in its foreign operations. The Company's Israeli facilities have been granted the status of an "Approved Enterprise" under the Israeli law for the Encouragement of Capital Investments, 1959, as amended. An Approved Enterprise is eligible for significant tax rate reductions for several years following the first year in which the Company has Israeli taxable income (after consideration of tax losses carried forward). The Company realized tax savings of approximately $4.2 million, $2.2 million and $300,000 in 1997, 1996 and 1995, respectively, as a result of this tax holiday. Because the Israeli Company currently has four overlapping Approved Enterprise plans, the tax holidays and rate reductions which the Company will be able to realize in future years are expected to extend until 2005. NOTE 5--COMMITMENTS AND CONTINGENCIES Royalty Commitments During 1994 and 1995, the Company obtained marketing grants from the Israeli Government, through the Fund for the Encouragement of Marketing Activities, for participation in marketing expenses incurred to increase export sales from Israel. The grants are received from the government of Israel for approved programs for marketing activities and are recognized on the cost reduction basis as a reduction of marketing expenses as such expenses are incurred. During the years ended December 31, 1995 and 1994, the Company received $350,000 and $821,000, respectively, of marketing grant participation. Under the terms of the marketing grant, if and when export sales from Israel to certain countries exceed a predetermined base of historical export sales from Israel, a royalty of 3% of the increase in export sales from Israel must generally be paid, up to the amount of the grant obtained. Royalty expense under this agreement amounted to $542,000, $420,000 and $181,000 for the years ended December 31, 1997, 1996 and 1995, respectively. At December 31, 1997, the Company is committed to pay, if and when earned, $8,000 in additional royalties. Lease commitments The Company leases facilities for sales offices in the U.S. and foreign locations under non-cancelable operating leases that expire from 1998 through 2002. Certain of these leases contain renewal options. The Company also leases certain equipment and vehicles under various leases with lease terms ranging from month- F-15 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) to-month up to one year. Future minimum payments under the facilities and equipment leases with non-cancelable terms in excess of one year are as follows as of December 31, 1997 (in thousands): 1998.................................. $1,210 1999.................................. 826 2000.................................. 563 2001.................................. 104 2002.................................. 6 ------ Total............................... $2,709 ======
Total rent expense under operating leases amounted to $1.5 million, $1.0 million and $813,000 for the years ended December 31, 1997, 1996 and 1995, respectively. NOTE 6--RELATED PARTIES During May 1994, the Company acquired an approximately 33% interest in Qronus Interactive, Ltd. (Qronus), a newly created company, in exchange for granting to Qronus the right to use the Company's hardware products development environment. Such rights had no book value at the date of exchange. The Company accounts for this investment using the equity method. The net carrying value of the investment at inception and at December 31, 1997 is zero. Qronus has been capitalized by approximately $7.9 million in cash from outside investors, which created an approximately $2.4 million difference between the carrying value of the investment and the Company's underlying equity in the net assets of Qronus. The Company's current interest in Qronus is 28%. The unrealized gain of approximately $2.4 million resulting from this transaction is being amortized into results of operations over a five year period. The Company's share of losses of Qronus of $826,000, $627,000 and $284,000 for the years ended December 31, 1997, 1996 and 1995, respectively, offset amortization of the unrealized gain by the Company. The Company expects Qronus to generate operating losses in the foreseeable future. The Company expects its portion of such losses to substantially offset the unrealized gain that is being amortized. Losses in excess of the total unrealized gain, if any, will not be recorded by the Company as it has no obligation to fund such losses. F-16 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7--GEOGRAPHIC REPORTING
YEAR ENDED DECEMBER 31, ---------------------------- 1997 1996 1995 -------- -------- -------- (IN THOUSANDS) Net revenue to third parties: North America.................................. $ 49,339 $ 36,446 $ 29,853 Europe......................................... 21,278 12,995 7,955 Israel and Rest of the World................... 33,967 21,412 12,313 Eliminations................................... (27,884) (16,303) (10,671) -------- -------- -------- Consolidated................................. $ 76,700 $ 54,550 $ 39,450 ======== ======== ======== Operating income (loss): North America.................................. $ (2,397) $ (3,844) $ (2,546) Europe......................................... 2,750 2,413 (871) Israel and Rest of the World................... 7,096 3,961 (2,837) Eliminations................................... (924) (108) (304) -------- -------- -------- Consolidated................................. $ 6,525 $ 2,422 $ (6,558) ======== ======== ======== Identifiable assets: North America.................................. $111,396 $ 94,748 $ 96,894 Europe......................................... 11,656 6,960 4,986 Israel and Rest of the World................... 20,358 15,781 10,940 -------- -------- -------- Consolidated................................. $143,410 $117,489 $112,820 ======== ======== ========
No individual subsidiary had sales to unaffiliated customers or has identifiable assets of 10 percent or more of the related consolidated amounts. Transfers between geographic regions represent intercompany license and service revenue accounted for at prices representative of unaffiliated party transactions. NOTE 8--ACQUISITIONS On May 12, 1995, the Company acquired Blue Lagoon Software ("Blue Lagoon"), a developer of client/server debugging technology, in exchange for 66,000 shares of the Company's Common Stock and assumption of liabilities of Blue Lagoon. The acquisition was accounted for as a purchase. The purchase price, acquisition costs and net liabilities assumed aggregated approximate $2.3 million, of which $2.2 million was allocated to in-process research and development and taken as a one-time charge to operating expenses based on an independent appraisal obtained by the Company. The remaining amount was allocated to intangibles, including technology of the existing product line. The Company has integrated the acquired technology into its existing products. On December 15, 1995, the Company acquired EBY Semantica ("Semantica"), a developer of client/server technology, for $3.0 million in cash. In addition, in December, the Company acquired certain other related technology from a U.S. university for $425,000. The acquisitions were accounted for using the purchase method of accounting. The purchase price and acquisition costs aggregated approximately $4.1 million, and were allocated to in-process research and development expense based on an independent appraisal obtained by the Company. In conjunction with the integration of Blue Lagoon's and Semantica's operations and technology, the Company assessed the impact on its ongoing operations and product development strategy. As a result, during F-17 MERCURY INTERACTIVE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 1995, the Company recorded non-recurring charges primarily related to the write-off of obsolete technology and fixed assets totaling approximately $900,000 ( $450,000 related to Blue Lagoon and $450,000 related to Semantica), and incurred approximately $2.5 million in special incentive compensation for management, customer support, research and development and marketing, selling and general and administrative personnel ($800,000 related to Blue Lagoon and $1.7 million related to Semantica). On September 30, 1997, the Company acquired certain in-process technologies from Dixon Software Technology, an unrelated company, for $4.5 million and related acquisition costs of $1.0 million. As a result of this purchase, the Company recorded a one-time charge of $5.5 million during the year ended December 31, 1997. NOTE 9--LEGAL MATTERS During 1994 and 1995, the Company and its Chairman had been engaged in the defense of certain lawsuits brought by a former employee. As a result of settlement negotiations, the matters were settled for $2.0 million which the Company recorded during the fourth quarter of 1995. During 1995, the Company was engaged in the defense of a lawsuit which alleged that an employee of the Company attempted to copy a software program without authorization. The matter was settled on March 7, 1996 and, as a result, the Company recorded a charge of $2.6 million during the quarter ending March 31, 1996 reflecting settlement costs and related legal fees. F-18 MERCURY INTERACTIVE CORPORATION UNAUDITED QUARTERLY FINANCIAL DATA
QUARTER ENDED --------------------------------------------------------------------------- DEC. 31, SEPT. 30, JUNE 30, MARCH 31, DEC. 31, SEPT. 30, JUNE 30, MARCH 31, 1997 1997 1997 1997 1996 1996 1996 1996 -------- --------- -------- --------- -------- --------- -------- --------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Revenue: License................ $18,800 $14,300 $12,300 $11,283 $13,920 $11,400 $ 9,350 $ 8,600 Service................ 5,400 5,300 5,200 4,117 3,330 2,800 2,750 2,400 ------- ------- ------- ------- ------- ------- ------- ------- Total revenue.......... 24,200 19,600 17,500 15,400 17,250 14,200 12,100 11,000 ------- ------- ------- ------- ------- ------- ------- ------- Cost of revenue: License................ 1,382 1,073 992 904 1,172 1,042 709 496 Service................ 1,879 1,520 1,612 1,214 998 824 786 632 ------- ------- ------- ------- ------- ------- ------- ------- Total cost of revenue.. 3,261 2,593 2,604 2,118 2,170 1,866 1,495 1,128 ------- ------- ------- ------- ------- ------- ------- ------- Gross profit............ 20,939 17,007 14,896 13,282 15,080 12,334 10,605 9,872 ------- ------- ------- ------- ------- ------- ------- ------- Operating expenses: Research and development, net...... 2,479 2,970 2,928 2,556 2,504 2,756 2,373 1,763 Write off of in-process research and development and related expenses...... -- 5,500 -- -- -- -- -- -- Marketing and selling.. 11,302 9,154 8,574 7,774 8,477 7,547 6,976 6,360 General and administrative........ 1,583 1,786 1,563 1,430 1,159 1,093 1,054 807 Settlement of litigation............ -- -- -- -- -- -- -- 2,600 ------- ------- ------- ------- ------- ------- ------- ------- Total operating expenses.............. 15,364 19,410 13,065 11,760 12,140 11,396 10,403 11,530 ------- ------- ------- ------- ------- ------- ------- ------- Income (loss) from operations............. 5,575 (2,403) 1,831 1,522 2,940 938 202 (1,658) Other income, net....... 738 816 846 709 884 856 776 845 ------- ------- ------- ------- ------- ------- ------- ------- Income (loss) before provision for income taxes.................. 6,313 (1,587) 2,677 2,231 3,824 1,794 978 (813) Provision for income taxes.................. 1,263 683 535 446 763 359 198 (163) ------- ------- ------- ------- ------- ------- ------- ------- Net income (loss)....... $ 5,050 $(2,270) $ 2,142 $ 1,785 $ 3,061 $ 1,435 $ 780 $ (650) ======= ======= ======= ======= ======= ======= ======= ======= Net income (loss) per share (basic).......... $ 0.30 $ (0.14) $ 0.13 $ 0.11 $ 0.19 $ 0.09 $ 0.05 $ (0.04) ======= ======= ======= ======= ======= ======= ======= ======= Net income (loss) per share (diluted)........ $ 0.28 $ (0.14) $ 0.13 $ 0.11 $ 0.19 $ 0.09 $ 0.05 $ (0.04) ======= ======= ======= ======= ======= ======= ======= ======= Weighted average common shares (basic)......... 16,653 16,433 16,267 16,137 16,028 15,990 15,837 15,759 ======= ======= ======= ======= ======= ======= ======= ======= Weighted average common shares (diluted)....... 18,339 16,433 17,001 16,644 16,502 16,614 16,564 15,759 ======= ======= ======= ======= ======= ======= ======= =======
F-19 SCHEDULE II MERCURY INTERACTIVE CORPORATION VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1997 (IN THOUSANDS)
ADDITIONS BALANCE AT CHARGED TO DEDUCTIONS BALANCE AT BEGINNING COSTS AND BAD DEBTS END OF DESCRIPTION OF PERIOD EXPENSES CHARGED OFF PERIOD ----------- ---------- ---------- ----------- ---------- Reserve for sales returns and doubtful accounts receivable: December 31, 1997.............. $1,136 $1,927 $1,185 $1,878 December 31, 1996.............. $ 705 $2,831 $2,400 $1,136 December 31, 1995.............. $ 115 $ 990 $ 400 $ 705
EXHIBIT INDEX 2.1(6) Agreement and Plan of Reorganization by and among the Company, Blue Lagoon Software and David L. Cherin dated April 25, 1995. 2.2(10) Share Purchase Agreement between the Company and EBY-Semantica, executed December 12, 1995. 3.3(1) Certificate of Incorporation of Registrant, as amended and restated to date. 3.4(1) By-laws of Registrant, as amended to date. 10.1(1,2) 1989 Stock Option Plan and forms of Incentive Stock Option Agreement and Nonstatutory Stock Option Agreement. 10.2(1) Form of Directors' and Officers' Indemnification Agreement. 10.3(1) Registration and Information Rights Agreement made as of March 13, 1992. 10.4(7) Lease Agreement dated August 19, 1994 between the Registrant, and Microtec Research, Inc., covering the property at 470 Potrero Avenue, Sunnyvale, California. 10.5(1) Lease Agreement dated August 30, 1990 between the Registrant and Reuven Down covering the property at 4 Hayotzrim Street, Or Yehudah, a suburb of Tel Aviv, Israel (translated from original Hebrew). 10.7(1) Consulting Agreement by and between the Registrant and Aryeh Finegold, dated March 1, 1992. 10.8(1) Agreement by and between Mercury Interactive (Israel) Limited, a wholly-owned subsidiary of the Registrant ("Mercury Israel"), and the Office of the Chief Scientist in the Ministry of Industry and Trade dated February 11, 1991 (translation from original Hebrew). 10.9(1) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated February 10, 1992 (translation from original Hebrew). 10.10(1) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated December 13, 1992 (translation from original Hebrew). 10.11(1,2) Form of 1993 Employee Stock Purchase Plan and form of Agreements. 10.12(1) 401(k) Plan. 10.14(1) Microsoft Solutions Channel Alliance Agreement dated March 5, 1993 between Registrant and Microsoft Corporation. 10.15(2,4) 1994 Directors' Stock Option Plan and form of Agreements. 10.16(3) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated May 5, 1993 (translation from original Hebrew). 10.17(3) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated June 21, 1993 (translation from original Hebrew). 10.18(3) Agreement by and between Mercury Israel and the Fund for the Encouragement of Marketing Abroad in the Ministry of Industry and Trade dated February 15, 1993 (translation from original Hebrew). 10.19(5) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated November 13, 1994 (translation from original Hebrew). 10.20(5) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated November 13, 1994 (translation from original Hebrew).
10.21(7) Agreement by and between Mercury Israel and the Fund for the Encouragement of Marketing Abroad in the Ministry of Industry and Trade dated January 1, 1996 (translation from original Hebrew). 10.22(7) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated September 30, 1995 (translation from original Hebrew). 10.23(7) Agreement by and between Mercury Israel and the Office of the Chief Scientist in the Ministry of Industry and Trade dated September 30, 1995 (translation from original Hebrew). 10.24(8) Preferred Share Purchase Rights Agreement. 10.25(9) 1996 Supplemental Stock Plan. 10.26(11) Purchase Agreement between Mercury Interactive Corporation and Dixon Software Technology dated September 30, 1997. 10.27(11) Purchase and Sale Agreement and Joint Escrow Instructions by and between Mercury Interactive Corporation and M. C. Securities, LLC dated July 1, 1997. 21.1 Subsidiaries of Registrant. 23.1 Consent of Independent Accountants. 24.1 Power of Attorney (see page 25). 27.1 Financial Data Schedule
- -------- (1) Incorporated by reference to identically numbered exhibits filed in response to Item 16(a), "Exhibits," of the Registrant's Registration Statement on Form S-1, as amended (File No. 33-68554), which was declared effective on October 29, 1993. (2) Designates management contract or compensatory plan arrangements required to be filed as an exhibit of this Annual Report on Form 10-K. (3) Exhibits 10.16, 10.17 and 10.18 are incorporated by reference to Exhibits 10.1, 10.2 and 10.3, respectively, filed with the Form 10-Q for the three month period ended March 31, 1994. (4) Incorporated by reference to identically numbered exhibits filed with the Form 10-Q for the three month period ended September 30, 1994. (5) Incorporated by reference to identically numbered exhibits filed with the Form 10-K for the year ended December 31, 1994. (6) Incorporated by reference to the identically numbered exhibit to the Company's Registration Statement on Form S-3, No. 33-95066, filed with the Securities and Exchange Commission on July 27, 1995. (7) Incorporated by reference to the identically numbered exhibit filed with the Form 10-K for the year ended December 31, 1995. (8) Incorporated by reference to the Exhibit 1 to the Company's Form 8-A, filed with the Securities and Exchange Commission on July 9, 1996. (9) Incorporated by reference to Exhibit 4.2 to the Company's Registrations Statement of Form S-8, No. 333-09913, filed with the Securities and Exchange Commission on August 9, 1996. (10) Incorporated by reference to Exhibit 2.2, filed with the Company's Form 10-K for the year ended December 31, 1996. (11) Exhibits 10.26 and 10.27 are incorporated by reference to Exhibits 10.1 and 10.2, respectively, filed with the Form 10-Q for the three month period ended September 30, 1997. EX-21.1 2 LIST OF SUBSIDIARIES EXHIBIT 21.1 SUBSIDIARIES OF REGISTRANT Mercury Interactive (Israel) Limited, incorporated under the laws of Israel Mercury Interactive (UK) LTD., incorporated under the laws of the United Kingdom Mercury Interactive France SARL, incorporated under the laws of France Mercury Interactive GmbH, incorporated under the laws of Germany Mercury Interactive (Europe) BV, incorporated under the laws of The Netherlands Mercury Interactive (Canada) Inc., incorporated under the laws of Canada Mercury Interactive Japan K.K., incorporated under the laws of Japan Mercury Interactive (Australia) Pty ltd., incorporated under laws of Australia Mercury Interactive (Singapore) LTD., incorporated under the laws of Singapore EX-23.1 3 CONSENT OF INDEPENDENT ACCOUNTANTS EXHIBIT 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 33-71018, 33-74728, 33-95178, 333-09913, and 333- 27951) of Mercury Interactive Corporation of our report dated February 4, 1998 appearing on page F-1 of this Form 10-K. PRICE WATERHOUSE LLP San Jose, California March 27, 1998 EX-27.1 4 FINANCIAL DATA SCHEDULE
5 YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 13,087,000 79,252,000 25,660,000 1,878,000 252,000 119,162,000 29,902,000 (10,610,000) 143,410,000 30,423,000 0 0 0 33,000 107,376,000 143,410,000 0 76,700,000 10,576,000 59,599,000 0 1,878,000 3,109,000 9,634,000 2,927,000 6,707,000 0 0 0 6,707,000 0.41 0.39
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