10-Q 1 d10q.txt FORM 10-Q FOR MERCURY INTERACTIVE UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _______ TO _______. Commission File Number: 0-22350 MERCURY INTERACTIVE CORPORATION (Exact name of registrant as specified in its charter) Delaware 77-0224776 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1325 Borregas Avenue, Sunnyvale, California 94089 (Address of principal executive offices) Registrant's telephone number, including area code: (408) 822-5200 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 a shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO The number of shares of Registrant's Common Stock outstanding as of October 31, 2001 was 82,719,860. 1 MERCURY INTERACTIVE CORPORATION INDEX
Page No. ------- PART I. FINANCIAL INFORMATION Item 1. Unaudited Financial Statements: Condensed Consolidated Balance Sheets - September 30, 2001 and December 31, 2000 3 Condensed Consolidated Statements of Operations - Three and nine months ended September 30, 2001 and 2000 4 Condensed Consolidated Statements of Cash Flows - Nine months ended September 30, 2001 and 2000 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk 22 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 23 SIGNATURE 24
2 PART I. FINANCIAL INFORMATION ----------------------------- Item 1. Unaudited Financial Statements MERCURY INTERACTIVE CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited)
September 30, December 31, 2001 2000 ---- ---- ASSETS Current assets: Cash and cash equivalents $ 183,242 $ 226,387 Short-term investments 239,989 402,356 Trade accounts receivable, net 61,036 62,989 Other receivables 12,779 13,233 Prepaid expenses and other assets 23,372 21,316 ----------- ----------- Total current assets 520,418 726,281 Long-term investments 237,613 153,623 Investments in non-consolidated companies 18,944 -- Property and equipment, net 94,128 82,895 Goodwill and other intangible assets, net 130,318 -- Other assets, net 12,010 13,576 ----------- ----------- Total assets $ 1,013,431 $ 976,375 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 9,932 $ 12,931 Accrued liabilities 49,638 58,942 Income taxes payable 34,450 23,797 Deferred revenue 88,703 77,673 ----------- ----------- Total current liabilities 182,723 173,343 Convertible subordinated notes 500,000 500,000 ----------- ----------- Total liabilities 682,723 673,343 ----------- ----------- Stockholders' equity: Common stock 165 162 Capital in excess of par value 226,109 190,232 Treasury stock (16,082) -- Notes receivable from issuance of stock (11,437) (7,528) Unearned stock-based compensation (6,135) -- Accumulated other comprehensive loss (1,868) (1,415) Retained earnings 139,956 121,581 ----------- ----------- Total stockholders' equity 330,708 303,032 ----------- ----------- Total liabilities and stockholders' equity $ 1,013,431 $ 976,375 =========== ===========
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 MERCURY INTERACTIVE CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (unaudited)
Three months ended Nine months ended September 30, September 30, ------------- -------------- 2001 2000 2001 2000 ---- ---- ---- ---- Revenues: License $ 51,200 $ 54,200 $178,500 $144,700 Service 32,800 25,300 92,200 64,800 -------- -------- -------- -------- Total revenues 84,000 79,500 270,700 209,500 -------- -------- -------- -------- Cost of revenues: License 5,930 5,152 17,957 11,788 Service 7,218 6,942 22,934 17,480 -------- -------- -------- -------- Total cost of revenues 13,148 12,094 40,891 29,268 -------- -------- -------- -------- Gross profit 70,852 67,406 229,809 180,232 -------- -------- -------- -------- Operating expenses: Research and development (excluding stock- based compensation of $236, $0, $393 and $0, respectively) 9,255 8,132 28,051 23,692 Marketing and selling (excluding stock- based compensation of $408, $0, $662 and $0, respectively) 45,171 38,995 142,003 106,867 General and administrative (excluding stock- based compensation of $290, $0, $434 and $0, respectively) 5,578 4,766 16,696 12,223 Amortization of stock-based compensation 934 -- 1,489 -- Restructuring, integration and other related charges 4,415 -- 5,361 -- Amortization of goodwill and other intangible assets 12,452 -- 17,783 -- -------- -------- -------- -------- Total operating expenses 77,805 51,893 211,383 142,782 -------- -------- -------- -------- Income (loss) from operations (6,953) 15,513 18,426 37,450 Other income, net 1,418 5,332 9,597 11,168 -------- -------- -------- -------- Income (loss) before provision for income taxes (5,535) 20,845 28,023 48,618 Provision for income taxes 1,570 4,169 9,648 9,724 -------- -------- -------- -------- Net income (loss) ($ 7,105) $ 16,676 $ 18,375 $ 38,894 ======== ======== ======== ======== Net income (loss) per share (basic) ($ 0.09) $ 0.21 $ 0.22 $ 0.49 ======== ======== ======== ======== Net income (loss) per share (diluted) ($ 0.09) $ 0.18 $ 0.20 $ 0.42 ======== ======== ======== ======== Weighted average common shares (basic) 83,266 80,263 82,494 79,571 ======== ======== ======== ======== Weighted average common shares and equivalents (diluted) 83,266 92,533 90,386 91,674 ======== ======== ======== ========
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 MERCURY INTERACTIVE CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)
Nine months ended September 30, ------------- 2001 2000 ---- ----- Cash flows from operating activities: Net income $ 18,375 $ 38,894 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 9,904 6,479 Amortization of goodwill and other intangibles assets 17,783 -- Amortization of stock-based compensation 1,489 -- Changes in assets and liabilities: Trade accounts receivable, net 3,342 (6,730) Other receivables 454 (6,180) Prepaid expenses and other assets 515 (2,285) Accounts payable (3,284) 1,642 Accrued liabilities (10,012) 22,146 Income taxes payable 7,481 8,125 Deferred revenue 7,662 32,813 --------- --------- Net cash provided by operating activities 53,709 94,904 --------- --------- Cash flows from investing activities: Cash paid in conjunction with Freshwater Software acquisition, net (143,961) -- Proceeds from (purchase of) investments, net 78,377 (367,639) Purchases of investments in non-consolidated companies (18,944) -- Acquisition of property and equipment, net (19,289) (18,429) --------- --------- Net cash used in investing activities (103,817) (386,068) --------- --------- Cash flows from financing activities: Issuance of common stock, net of related notes receivable 23,498 23,569 Issuance of convertible subordinated notes, net -- 485,515 Purchase of treasury stock (16,082) -- --------- --------- Net cash provided by financing activities 7,416 509,084 --------- --------- Effect of exchange rate changes on cash (453) 10 --------- --------- Net increase (decrease) in cash and cash equivalents (43,145) 217,930 Cash and cash equivalents at beginning of period 226,387 113,346 --------- --------- Cash and cash equivalents at end of period $ 183,242 $ 331,276 ========= =========
The accompanying notes are an integral part of these condensed consolidated financial statements. 5 MERCURY INTERACTIVE CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) NOTE 1 - BASIS OF PRESENTATION The unaudited financial information furnished herein reflects all adjustments, consisting only of normal recurring adjustments, that in the opinion of management are necessary to fairly state the Company's consolidated financial position, the results of its operations, and its cash flows for the periods presented. This Quarterly Report on Form 10-Q should be read in conjunction with the Company's audited financial statements for the year ended December 31, 2000, included in the 2000 Form 10-K. The condensed consolidated statements of operations for the three and nine months ended September 30, 2001 are not necessarily indicative of results to be expected for the entire fiscal year ended December 31, 2001. NOTE 2 - NET INCOME PER SHARE Earnings per share are calculated in accordance with the provisions of Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"). SFAS 128 requires the reporting of 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 number of common shares outstanding and all dilutive potential common shares outstanding, using the treasury stock method. For the three and nine months ended September 30, 2001 and 2000, dilutive potential common shares outstanding reflects shares issuable under the Company's stock option plans. The following table summarizes the Company's earnings per share computations for the three and nine months ended September 30, 2001 and 2000 (in thousands, except per share amounts):
Three months ended Nine months ended September 30, September 30, ------------- ------------- 2001 2000 2001 2000 ---- ---- ---- ---- Numerator: Net income (loss) ($7,105) $16,676 $18,375 $38,894 ======== ======= ======= ======= Denominator: Denominator for basic net income per share - weighted average shares 83,266 80,263 82,494 79,571 Incremental common shares attributable to shares issuable under employee stock plans -- 12,270 7,892 12,103 -------- ------- ------- ------- Denominator for diluted net income per share - weighted average shares 83,266 92,533 90,386 91,674 ======== ======= ======= ======= Net income per share (basic) ($0.09) $ 0.21 $ 0.22 $ 0.49 ======== ======= ======= ======= Net income per share (diluted) ($0.09) $ 0.18 $ 0.20 $ 0.42 ======== ======= ======= =======
For the three and nine months ended September 30, 2001, options to purchase 9,800,735 and 6,104,260 shares of common stock with a weighted average price of $55.99 and $65.20, respectively, were considered anti-dilutive because the options' exercise price was greater than the average fair market value of the Company's common stock for the period then ended. For the three and nine months ended September 30, 2000, options to purchase 324,250 and 32,000 shares of common stock with a weighted average price of $107.39 and $125.44, respectively, were considered anti-dilutive. The 4,494,400 shares of common stock reserved for issuance upon conversion of the outstanding convertible subordinated notes issued in 2000 were not included in diluted earnings per share because the conversion would be anti-dilutive. 6 NOTE 3 - RESTRUCTURING AND RELATED CHARGES During the third quarter of 2001, in connection with management's plan to reduce costs and improve operating efficiencies, the Company recorded restructuring charges of $4.4 million, consisting of $2.9 million for headcount reductions, $1.1 million for the cancellation of a marketing event, and $400,000 for professional services and consolidation of facilities. Headcount reductions consisted of a reduction in force of approximately 140 employees, or approximately 8% of the Company's worldwide workforce. Total cash outlays associated with the restructuring are expected to be $4.2 million. The remaining $0.2 million of restructuring costs consists of non-cash charges for asset write-offs. During the third quarter of 2001, cash used for restructuring costs was $ 2.8 million. The majority of the remaining cash outlays of $1.4 million, which include severance costs and fees associated with the cancellation of a marketing event, are expected to occur in the fourth quarter of 2001. NOTE 4 - ACQUISITION OF FRESHWATER SOFTWARE On May 21, 2001, the Company acquired all of the outstanding securities of Freshwater Software, Inc. ("Freshwater"), a provider of eBusiness monitoring and management solutions. The Company acquired Freshwater for cash consideration of $146.1 million. The purchase price was allocated to tangible assets of $6.9 million and assumed liabilities of $4.5 million. The purchase price included $849,000 for the fair value of 13,000 assumed Freshwater vested stock options, as well as direct acquisition costs of $529,000. The allocation of the purchase price resulted in an excess of purchase price over net tangible assets acquired of $148.1 million. This was allocated $7.6 million to workforce and purchased technology and $140.5 million to goodwill, including $3.0 million of goodwill for deferred tax benefits associated with the workforce and purchased technology. The goodwill and other intangible assets are presently being amortized on a straight-line basis over 3 years. Amortization expense for the three and nine months ended September 30, 2001 was $12.5 million and $17.8 million, respectively. The Company expects to amortize approximately $12.0 million in the fourth quarter of 2001. The transaction was accounted for as a purchase and, accordingly, the operating results of Freshwater have been included in the accompanying consolidated financial statements of the Company from the date of acquisition. If the purchase had occurred at the beginning of each period, net revenues attributable to the Company and Freshwater would have been $84.0 million, $275.1 million, $82.0 million and $215.9 million for the three and nine months ended September 30, 2001 and 2000, respectively; net income (loss) would have been ($7.1) million, ($6.4) million, $1.6 million and $(6.2) million for the three and nine months ended September 30, 2001 and 2000, respectively; and earnings (loss) per share would have been $(0.09), ($0.08), $0.16 and $0.54 for the three and nine months ended September 30, 2001 and 2000, respectively. In conjunction with the acquisition of Freshwater, the Company recorded a charge for certain nonrecurring restructuring and integration costs of $946,000 during the second quarter of 2001. The charge included costs for consolidation of facilities, employee severance, fixed asset write-offs and systems and process integration. The Company expects all costs associated with the charge to be paid by the end of the fourth quarter of 2001. 7 NOTE 5 - COMPREHENSIVE INCOME The Company reports components of comprehensive income in its annual consolidated statements of shareholders' equity. Comprehensive income consists of net income and foreign currency translation adjustments. The Company's total comprehensive income for the three and nine months ended September 30, 2001 and 2000 was as follows (in thousands): Three months ended Nine months ended September 30, September 30, ------------- ------------- 2001 2000 2001 2000 ---- ---- ---- ---- Net income (loss) ($7,105) $16,676 $18,375 $38,894 Currency translation gain (loss) (872) 128 (453) 10 ------- ------- ------- ------- Comprehensive income (loss) ($7,977) $16,804 $17,922 $38,904 ======= ======= ======= ======= NOTE 6 - INCOME TAXES The effective tax rate for the three and nine months ended September 30, 2001 differs from statutory tax rates principally because of the non-deductibility of charges for amortization of goodwill and other intangible assets and stock-based compensation, and special reduced taxation programs by the government of Israel. NOTE 7 - INVESTMENTS IN NON-CONSOLIDATED COMPANIES The Company makes venture capital investments in private companies and private equity funds for business and strategic purposes. These investments are accounted for under the cost method, as the Company does not have the ability to exercise significant influence over these companies' operations. The Company monitors its investments for impairment and will record reductions in carrying values if and when necessary. NOTE 8 - STOCK-BASED COMPENSATION The Company accounts for stock-based compensation using the intrinsic value method presented in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and related interpretations, and complies with the disclosure provisions of Statement of Financial Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). Under APB 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of the Company's stock and the exercise price. The Company has not issued stock options to non-employees. The Company amortizes stock-based compensation using the straight-line approach over the remaining vesting periods of the related options. In connection with the acquisition of Freshwater, the Company recorded unearned stock-based compensation totaling $10.4 million associated with 140,000 unvested stock options assumed. The Company reduced unearned compensation recorded of $3.1 million due to the termination of certain employees in conjunction with the third quarter restructuring. Amortization of unearned stock-based compensation for the three and nine months ended September 30, 2001 was $934,000 and $1.5 million, respectively. The Company expects to amortize approximately $600,000 per quarter over the remaining vesting periods of the related options. NOTE 9 - STOCK REPURCHASE PROGRAM During the third quarter of 2001, the Board of Directors authorized the repurchased 783,500 shares of the Company's common stock in the open market, subject to normal trading restrictions, at an average price of $20.40. 8 NOTE 10 - GEOGRAPHIC REPORTING The Company has three reportable operating segments: the Americas, Europe, and the Rest of the World. These segments are organized, managed and analyzed geographically and operate in one industry segment: the development, marketing, and selling of integrated performance management solutions. The Company evaluates operating segment performance based primarily on net revenues and certain operating expenses. Financial information for the Company's operating segments is summarized below for the three and nine months ended September 30, 2001 and 2000 (in thousands): Three months ended Nine months ended September 30, September 30, ------------- ------------- 2001 2000 2001 2000 ---- ---- ---- ---- Net revenues to third parties: Americas $53,300 $54,100 $176,800 $142,600 Europe 23,700 18,100 71,800 49,000 Rest of the World 7,000 7,300 22,100 17,900 ------- ------- -------- -------- Consolidated $84,000 $79,500 $270,700 $209,500 ======= ======= ======== ======== September 30, December 31, 2001 2000 ---- ---- Identifiable assets: Americas $ 802,538 $808,583 Europe 43,632 21,538 Rest of the World 167,261 146,254 ---------- -------- Consolidated $1,013,431 $976,375 ========== ======== The subsidiary located in the United Kingdom accounted for 11% of the consolidated net revenue to unaffiliated customers for the nine months ended September 30, 2001 and less than 10% for both the three months ended September 30, 2001 and 2000 and nine months ended September 30, 2000, respectively. Operations located in Israel accounted for 16% and 13% of the consolidated identifiable assets at September 30, 2001 and December 31, 2000, respectively. No other subsidiary represented 10% or more of the related consolidated amounts for the periods presented. NOTE 11 - DERIVATIVE FINANCIAL INSTRUMENTS The Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") as amended by SFAS 137 and SFAS 138, in the first fiscal quarter of 2001. SFAS 133 establishes new standards of accounting and reporting for derivative instruments and hedging activities, and requires that all derivatives, including foreign currency exchange contracts, be recognized on the balance sheet at fair value. Changes in the fair value of derivatives that do not qualify for hedge treatment must be recognized currently in earnings. All of the Company's derivative financial instruments are recorded at their fair value in other current assets. The transition adjustment upon adoption of SFAS 133 was not material. The Company enters into forward foreign exchange contracts ("forward contracts") to hedge foreign currency denominated receivables due from certain European and Pacific Rim subsidiaries against fluctuations in exchange rates. The Company does not enter into forward contracts for speculative or trading purposes. The criteria used for designating a forward contract as a hedge considers its effectiveness in reducing risk by matching hedging instruments to underlying transactions. Gains and losses on forward contracts are recognized in other income in the same period as gains and losses on the underlying transactions. The Company had outstanding forward contracts with nominal amounts totaling $11.0 million and $13.0 million at September 30, 2001 and December 31, 2000, respectively. The open forward contracts at September 30, 2001 mature at various dates through June 2002 and are hedges of certain foreign currency transaction exposures in the Australian Dollar, French Franc, Euro, Norwegian 9 Kroner, Japanese Yen, Swiss Franc and Swedish Krona. The unrealized net gain on the Company's forward contracts at September 30, 2001 and December 31, 2000 was $344,000 and $282,000, respectively. NOTE 12 - RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board released Statements of Financial Accounting Standards No. 141, "Business Combinations" ("SFAS 141"), and No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). FAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, establishes specific criteria for the recognition of intangible assets separately from goodwill, and requires unallocated negative goodwill to be written off immediately as an extraordinary gain. Under SFAS 142, goodwill and indefinite lived intangible assets will no longer be amortized, goodwill and intangible assets deemed to have an indefinite life will be tested for impairment at least annually, and the amortization period of intangible assets with finite lives will no longer be limited to forty years. SFAS 142 is effective for fiscal years beginning after March 15, 2001. The Company will adopt SFAS 142 during its fiscal year ended December 31, 2002. In August 2001, the FASB issued SFAS No. 143 ("SFAS 143"), "Accounting for Asset Retirement Obligations." This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This Statement applies to all entities. It applies to legal obligations associated with the retirement of long-loved assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset, except for certain obligations or lessees. SFAS 143 is effective for financial statements issued for fiscal years beginning after June 25, 2002. The Company expects that the initial application of SFAS 143 will not have an impact on its financial statements. In October 2001, the FASB issued SFAS No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-lived Assets." The objectives of SFAS 144 are to address significant issues relating to the implementation of FASB Statement 121 ("SFAS 121"), "Accounting for the Impairment of Long-lived assets to be Disposed of," and to develop a single accounting model, based on the framework established by SFAS 121, for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. Although SFAS 144 supercedes SFAS 121, it retains some fundamental provisions of SFAS 121. SFAS 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. The Company expects that the initial application of SFAS 144 will not have a material impact on its financial statements. 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as "believes," "anticipates," "expects," "intends," "plans," "will," "may" and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in "Risk Factors." Our business may have changed since the date hereof, and we undertake no obligation to update the forward-looking statements in this Quarterly Report on Form 10-Q. Results of Operations Revenue ------- License revenue decreased 6% to $51.2 million for the three months ended September 30, 2001 from $54.2 million for the three months ended September 30, 2000. The decrease in license revenue for the three months ended September 30, 2001 was primarily attributable to a decrease in license fees from testing products due to the worldwide economic slow down and the adverse impact on business of the terrorist activities of September 11, 2001. License revenue increased 23% to $178.5 million for the nine months ended September 30, 2001 from $144.7 million for the nine months ended September 30, 2000. Our growth in license revenue was attributable primarily to growth in license fees from testing products as well as revenue from our APM/MSP offerings. Service revenue increased 30% to $32.8 million for the three months ended September 30, 2001 from $25.3 million for the three months ended September 30, 2000. Service revenue increased 42% to $92.2 million for the nine months ended September 30, 2001 from $64.8 million for the nine months ended September 30, 2000. The increase in service revenue was a result of renewals of existing maintenance contracts. We expect that service revenue will continue to increase in absolute dollars as long as our customer base continues to grow. Cost of revenue --------------- License cost of revenue includes cost of materials, product packaging, equipment depreciation, production personnel and costs associated with our MSP business. License cost of revenue increased to $5.9 million and $18.0 million for the three and nine months ended September 30, 2001, respectively, compared to $5.2 million and $11.8 million for the three and nine months ended September 30, 2000. License cost of revenue, as a percentage of license revenue, increased to 12% and 10% for the three and nine months ended September 30, 2001, respectively, from 10% and 8% for the three and nine months ended September 30, 2000, respectively. The increase was primarily due to additional headcount and personnel-related costs and Internet service fees for our MSP business. Service cost of revenue consists primarily of costs of providing customer technical support, training and consulting. Service cost of revenue increased to $7.2 million and $22.9 million for the three and nine months ended September 30, 2001, respectively, compared to $6.9 million and $17.5 million for the three and nine months ended September 30, 2000. Service cost of revenue, as a percentage of service revenue, decreased to 22% and 25% for the three months ended September 30, 2001 and 2000, respectively. Service cost of revenue, as a percentage of service revenue was 27% for both the nine months ended September 30, 2001 and 2000, respectively. The absolute dollar increase in service cost of revenue was primarily due to an increase in personnel-related costs reflecting growth in customer support headcount partially offset by a decrease in training and consulting outsourcing expense. Service cost of revenue as a percentage of service revenue may vary based on the degree of outsourcing of training and consulting and the profitability of individual consulting engagements. Research and development ------------------------ Research and development expense consists primarily of costs associated with the development of new products, enhancements of existing products and quality assurance procedures, and is comprised primarily of 11 employee salaries and related costs, consulting costs, equipment depreciation and facilities expenses. Research and development expense was $9.3 million and $28.1 million, or 11% and 10% of total revenue for the three and nine months ended September 30, 2001, respectively, compared to $8.1 million and $23.7 million, or 10% and 11% of total revenue for the three and nine months ended September 30, 2000, respectively. The increase in absolute dollars of research and development spending in the three and nine months ended September 30, 2001 reflected an increase in spending due to growth in research and development headcount resulting in increased personnel-related costs. Marketing and selling --------------------- Marketing and selling expense consists primarily of employee salaries and related costs, sales commissions, facilities expenses and marketing programs. Marketing and selling expense was $45.2 million and $142.0 million or 54% and 52% of total revenue for the three and nine months ended September 30, 2001, compared to $39.0 million and $106.9 million, or 49% and 51% of total revenue for the three and nine months ended September 30, 2001 and 2000, respectively. The absolute dollar increase in marketing and selling expenses was primarily due to an increase in personnel-related costs reflecting growth in sales and marketing headcount, including the increase in sales headcount related to our cybersales organization and APM business, and increased spending on facilities and marketing programs. The increase in selling and marketing expenses as a percentage of revenue reflected lower than expected revenues due to the worldwide economic slow down and the adverse impact on business of the terrorist activities on September 11, 2001. Commission expenses for the three months ended September 30, 2001 decreased due to lower revenue levels as compared to the three months ended September 30, 2000. We expect marketing and selling expenses to increase in absolute dollars if total revenue increases, but these expenses may vary as a percentage of revenue. General and administrative -------------------------- General and administrative expense consists primarily of employee salaries and costs related to executive and finance personnel. General and administrative expense was $5.6 million and $16.7 million or 7% and 6% of total revenue for the three and nine months ended September 30, 2001, compared to $4.8 million and $12.2 million, or 6% of total revenue for both the three and nine months ended September 30, 2001 and 2000, respectively. The increase in absolute dollar spending reflected increased staffing and associated costs necessary to manage and support our operations. Amortization of stock-based compensation ---------------------------------------- In connection with the acquisition of Freshwater, we recorded unearned stock-based compensation totaling $10.4 million associated with 140,000 unvested stock options assumed. We reduced unearned compensation of $3.1 million due to the termination of certain employees in conjunction with the third quarter restructuring. Amortization of unearned stock-based compensation for the three and nine months ended September 30, 2001 was $934,000 and $1.5 million, respectively. We expect to amortize approximately $600,000 per quarter over the remaining vesting periods of the related options. Restructuring, integration and other related charges ---------------------------------------------------- During the third quarter of 2001, in connection with management's plan to reduce costs and improve operating efficiencies, we recorded restructuring charges of $4.4 million, consisting of $2.9 million for headcount reductions, $1.1 million for the cancellation of a marketing event, and $400,000 for professional services and consolidation of facilities. Headcount reductions consisted of a reduction in force of approximately 140 employees, or approximately 8% of our worldwide workforce. Total cash outlays associated with the restructuring are expected to be $4.2 million. The remaining $0.2 million of restructuring costs consists of non-cash charges for asset write-offs. During the third quarter of 2001, cash outlays used for restructuring costs were $2.8 million. The majority of the remaining cash outlays of $1.4 million, which include severance costs and fees associated with the cancellation of a marketing event, are expected to occur in the fourth quarter of 2001. In conjunction with the acquisition of Freshwater, we recorded a charge for certain nonrecurring restructuring 12 and integration costs of $946,000 during the second quarter of 2001. The charge included costs for consolidation of facilities, employee severance, fixed asset write-offs and systems and process integration. We expect all costs associated with the charge to be paid by the end of the fourth quarter of 2001. Amortization of goodwill and other intangible assets ----------------------------------------------------- On May 21, 2001, we acquired all of the outstanding securities of Freshwater Software, Inc. ("Freshwater"), a provider of eBusiness monitoring and management solutions. We acquired Freshwater for cash consideration of $146.1 million. The purchase price was allocated to tangible assets of $6.9 million and assumed liabilities of $4.5 million. The purchase price included $849,000 for the fair value of 13,000 assumed Freshwater vested stock options, as well as direct acquisition costs of $529,000. The allocation of the purchase price resulted in an excess of purchase price over net tangible assets acquired of $148.1 million. This was allocated $7.6 million to workforce and purchased technology and $140.5 million to goodwill, including $3.0 million of goodwill for deferred tax benefits associated with the workforce and purchased technology. The goodwill and other intangible assets are being presently amortized on a straight-line basis over 3 years. Amortization expense for the three and nine months ended September 30, 2001 was $12.5 million and $17.8 million, respectively. We expect to amortize approximately $12.0 million in the fourth quarter of 2001. The transaction was accounted for as a purchase and, accordingly, the operating results of Freshwater have been included in our accompanying consolidated financial statements from the date of acquisition. If the purchase had occurred at the beginning of each period, our consolidated net revenues would have been $84.0 million, $275.1 million, $82.0 million and $215.9 million for the three and nine months ended September 30, 2001 and 2000, respectively; net income (loss) would have been ($7.1) million, ($6.4) million, $1.6 million and $(6.2) million for the three and nine months ended September 30, 2001 and 2000, respectively; and earnings (loss) per share would have been $(0.09), ($0.08), $0.16 and $0.54 for the three and nine months ended September 30, 2001 and 2000, respectively. Other income, net ----------------- Other income, net consists primarily of interest income, interest expense related to our convertible subordinated notes, and foreign exchange gains and losses. The decrease in other income, net to $1.4 million from $5.3 million and $9.6 million from $11.2 million for the three and nine months ended September 30, 2001 and 2000, respectively, reflected primarily lower interest rates. Provision for income taxes -------------------------- We have structured our operations in a manner designed to maximize income in Israel where tax rate incentives have been extended to encourage foreign investments. The tax holidays and rate reductions which we will be able to realize under programs currently in effect expire at various dates through 2012. Future provisions for taxes will depend upon the mix of worldwide income and the tax rates in effect for various tax jurisdictions. The effective tax rate for the three and nine months ended September 30, 2001 differs from statutory tax rates principally because of the non-deductibility of charges for amortization of goodwill and other intangible assets and stock-based compensation, and special reduced taxation programs by the government of Israel. Liquidity and Capital Resources At September 30, 2001, our principal source of liquidity consisted of $660.8 million of cash and investments compared to $782.4 million at December 31, 2000. The September 30, 2001 balance included $240.0 million of short-term and $237.6 million of long-term investments in high quality financial, government, and corporate securities. During the nine months ended September 30, 2001, we generated approximately $53.7 million cash from operations, primarily from our net income. For the nine months ended September 30, 2001, our investing activities consisted of net cash paid in conjunction with the Freshwater acquisition of $144.0 million, investments made in non-consolidated companies of $18.9 million and purchases of property and equipment of $19.3 million offset by proceeds from investments of $78.4 million. We have committed to make additional capital contributions to a private equity fund totaling $12.0 million. Our purchases of property and equipment 13 included $2.3 million for the renovation of headquarters buildings in Sunnyvale, as well as, $3.1 million for the construction of research and development facilities in Israel. We expect to spend an additional $5.0 million to complete the renovation of our buildings in Sunnyvale and expect to spend an additional $5.5 million to complete the construction of the Israel facilities. Our primary financing activity consisted of issuances of common stock under our employee stock option and stock purchase plans, net of notes receivable collected from issuance of common stock of $23.5 million. Our financing activities also consisted of the purchase of treasury stock of $16.1 million. In July 2000, we raised $485.4 million from the issuance of convertible subordinated notes with an aggregate principal amount of $500.0 million. The notes mature on July 1, 2007 and bear interest at a rate of 4.75% per annum, payable semiannually on January 1 and July 1 of each year. The notes are subordinated in right of payment to all of our future senior debt. The notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. We may redeem our notes, in whole or in part, at any time on or after July 1, 2003. Assuming there is no significant change in our business, we believe that our current cash and investment balances and cash flow from operations will be sufficient to fund our cash needs for at least the next twelve months. Recent Accounting Pronouncements In June 2001, the Financial Accounting Standards Board released Statements of Financial Accounting Standards No. 141, "Business Combinations" ("SFAS 141"), and No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). FAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, establishes specific criteria for the recognition of intangible assets separately from goodwill, and requires unallocated negative goodwill to be written off immediately as an extraordinary gain. SFAS 142 requires that goodwill and indefinite lived intangible assets will no longer be amortized, goodwill and intangible assets deemed to have an indefinite life will be tested for impairment at least annually, and the amortization period of intangible assets with finite lives will no longer be limited to forty years. SFAS 142 is effective for fiscal years beginning after March 15, 2001. We will adopt SFAS 142 during its fiscal year ended December 31, 2002. The impact of the implementation of SFAS 142 will require us to reclassify our balance sheet to show the composition of the Freshwater goodwill and other intangible assets that were acquired in May 2001. The implementation will also require us to discontinue amortization of our goodwill and other intangibles after December 31, 2001 and to evaluate the intangibles for impairment on an annual basis. In August 2001, the FASB issued SFAS No. 143 ("SFAS 143"), "Accounting for Asset Retirement Obligations." This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This Statement applies to all entities. It applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset, except for certain obligations or lessees. SFAS 143 is effective for financial statements issued for fiscal years beginning after June 25, 2002. We expect that the initial application of SFAS 143 will not have an impact on our financial statements. In October 2001, the FASB issued SFAS No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-lived Assets." The objectives of SFAS 144 are to address significant issues relating to the implementation of FASB Statement 121 ("SFAS 121"), "Accounting for the Impairment of Long-lived assets to be Disposed of," and to develop a single accounting model, based on the framework established by SFAS 121, for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. Although SFAS 144 supercedes SFAS 121, it retains some fundamental provisions of SFAS 121. SFAS 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. We expect that the initial application of SFAS 144 will not have a material impact on our financial statements. Risk Factors In addition to the other information included in this Quarterly Report on Form 10-Q, the following risk factors should be considered carefully in evaluating us and our business. 14 Our future success depends on our ability to respond to rapid market and technological changes by introducing new products and services and continually improving the performance, features and reliability of our existing products and services and responding to competitive offerings. Our business will suffer if we do not successfully respond to rapid technological changes. The market for our software products and services is characterized by: . rapidly changing technology; . frequent introduction of new products and services and enhancements to existing products and services by our competitors; . increasing complexity and interdependence of Web-related applications; . changes in industry standards and practices; and . changes in customer requirements and demands. To maintain our competitive position, we must continue to enhance our existing software testing and application performance management products and services and to develop new products and services, functionality and technology that address the increasingly sophisticated and varied needs of our prospective customers. The development of new products and services, and enhancement of existing products and services, entail significant technical and business risks and require substantial lead-time and significant investments in product development. If we fail to anticipate new technology developments, customer requirements or industry standards, or if we are unable to develop new products and services that adequately address these new developments, requirements and standards in a timely manner, our products may become obsolete, our ability to compete may be impaired and our revenues could decline. We expect our quarterly revenues and operating results to fluctuate, and it is difficult to predict our future revenues and operating results. Our revenues and operating results have varied in the past and are likely to vary significantly from quarter to quarter in the future. These fluctuations are due to a number of factors, many of which are outside of our control, including: . fluctuations in demand for and sales of our products and services; . our success in developing and introducing new products and services and the timing of new product and service introductions; . our ability to introduce enhancements to our existing products and services in a timely manner; . changes in the mix of products or services sold in a quarter; . the introduction of new or enhanced products and services by our competitors and changes in the pricing policies of these competitors; . the discretionary nature of our customers' purchase and budget cycles and changes in their budgets for software and Web-related purchases; . changes in economic conditions affecting our customers or our industry; . the amount and timing of operating costs and capital expenditures relating to the expansion of our business; . deferrals by our customers of orders in anticipation of new products or services or product enhancements; and 15 . the mix of our domestic and international sales, together with fluctuations in foreign currency exchange rates. In addition, the timing of our license revenues is difficult to predict because our sales cycles are typically short and can vary substantially from product to product and customer to customer. We base our operating expenses on our expectations regarding future revenue levels. As a result, if total revenues for a particular quarter are below our expectations, we could not proportionately reduce operating expenses for that quarter. We have experienced seasonality in our revenues and earnings, with the fourth quarter of the year typically having the highest revenue and earnings for the year and higher revenue and earnings than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers and from the structure of our sales commission program. We expect this seasonality to continue in the future. In addition, our customers' decisions to purchase our products and services are discretionary and subject to their internal budgets and purchasing processes. We believe that the slowdown in the economy, the terrorist activity on September 11, 2001, and the ensuing declaration of the war on terrorism has caused and may continue to cause customers to reassess their immediate technology needs and to defer purchasing decisions, and accordingly has reduced and could reduce demand in the future for our products and services. Due to these and other factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. If our operating results are below the expectations of investors or securities analysts, the trading prices of our securities could decline. We expect to face increasing competition in the future, which could cause reduced sales levels and result in price reductions, reduced gross margins or loss of market share. The market for our testing and application performance management products and services is extremely competitive, dynamic and subject to frequent technological changes. There are few substantial barriers of entry in our market. In addition, the use of the Internet for a growing range of Web applications is a recent and emerging phenomenon. The Internet lowers the barriers of entry, allowing other companies to compete with us in the testing and application performance management markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities. In the market for solutions for testing of applications, our principal competitors include Compuware, Empirix, Radview, Rational Software, and Segue Software. In the new and rapidly changing market for application performance management solutions, our competitors include providers of hosted services such as BMC Software, Keynote Systems and Service Metrics (a division of Exodus Communications), and emerging companies. In addition, we face potential competition in this market from existing providers of testing solutions such as Segue Software and Compuware. Finally, in both the markets for testing solutions and for application performance management solutions, we face competition from established providers of systems and network management software such as Computer Associates and Tivoli, a division of IBM. The software industry is increasingly experiencing consolidation and this could increase the resources available to our competitors and the scope of their product offerings. Our competitors and potential competitors may undertake more extensive marketing campaigns, adopt more aggressive pricing policies or make more attractive offers to distribution partners and to employees. If we fail to maintain our existing distribution channels and develop additional channels in the future, our revenues will decline. We derive a substantial portion of our revenues from sales of our products through distribution channels such as systems integrators, value-added resellers, ASPs, ISPs or ISVs. We expect that sales of our products through these channels will continue to account for a substantial portion of our revenues for the foreseeable future. We have also entered into private labeling arrangements with ASPs who incorporate our products and services into theirs. We may not experience increased revenues from these new channels, which could harm our business. 16 The loss of one or more of our systems integrators, value-added resellers, ASPs, ISPs or ISVs, or any reduction or delay in their sales of our products and services could result in reductions in our revenue in future periods. In addition, our ability to increase our revenue in the future depends on our ability to expand our indirect distribution channels. Our dependence on indirect distribution channels presents a number of risks, including: . each of our systems integrators, value-added resellers, ASPs, ISPs or ISVs can cease marketing our products and services with limited or no notice and with little or no penalty; . our existing systems integrators, value-added resellers, ASPs, ISPs or ISVs may not be able to effectively sell any new products and services that we may introduce; . we may not be able to replace existing or recruit additional systems integrators, value-added resellers, ASPs, ISPs or ISVs if we lose any of our existing ones; . our systems integrators, value-added resellers, ASPs, ISPs or ISVs may also offer competitive products and services from third parties; . we may face conflicts between the activities of our indirect channels and our direct sales and marketing activities; and . our systems integrators, value-added resellers, ASPs, ISPs or ISVs may not give priority to the marketing of our products and services as compared to our competitors' products. We depend on strategic relationships and business alliances for continued growth of our business. Our development, marketing and distribution strategies rely increasingly on our ability to form strategic relationships with software and other technology companies. These business relationships often consist of cooperative marketing programs, joint customer seminars, lead referrals and cooperation in product development. Many of these relationships are not contractual and depend on the continued voluntary cooperation of each party with us. Divergence in strategy or change in focus by, or competitive product offerings by, any of these companies may interfere with our ability to develop, market, sell or support our products, which in turn could harm our business. Further, if these companies enter into strategic alliances with other companies or are acquired, they could reduce their support of our products. Our existing relationships may be jeopardized if we enter into alliances with competitors of our strategic partners. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products. If we are unable to manage repaid changes in our business, our business may be harmed. Since 1991 and 2000, we have experienced significant annual increases in revenue, employees and number of product and service offerings. This growth has placed and, if it continues, will place a significant strain on our management and our financial, operational, marketing and sales systems. Recently we reduced our headcount, if we cannot manage rapid changes in our business environment effectively, our business, competitive position, operating results and financial condition could suffer. Although we are implementing a variety of new or expanded business and financial systems, procedures and controls, including the improvement of our sales and customer support systems, the implementation of these systems, procedures and controls may not be completed successfully, or may disrupt our operations. Any failure by us to properly manage these transitions could impair our ability to attract and service customers and could cause us to incur higher operating costs and experience delays in the execution of our business plan. Conversely, if we fail to reduce staffing levels when necessary, our costs would be excessive and our business and operating results could be adversely affected. The success of our business depends on the efforts and abilities of our senior management and other key personnel. We depend on the continued services and performance of our senior management and other key personnel. We do not have long term employment agreements with any of our key personnel. The loss of any of our executive officers or other key employees could hurt our business. The loss of senior personnel can result in significant disruption to our ongoing operations, and new senior personnel must spend a significant amount of time 17 learning our business and our systems in addition to performing their regular duties. For example, in November 2001, we announced that Douglas Smith had been appointed as our new Executive Vice President and Chief Financial Officer, replacing Sharlene Abrams. If we cannot hire qualified personnel, our ability to manage our business, develop new products and increase our revenues will suffer. We believe that our ability to attract and retain qualified personnel at all levels in our organization is essential to the successful management of our growth. In particular, our ability to achieve revenue growth in the future will depend in large part on our success in expanding our direct sales force and in maintaining a high level of technical consulting, training and customer support. There is substantial competition for experienced personnel in the software and technology industry. If we are unable to retain our existing key personnel or attract and retain additional qualified individuals, we may from time to time experience inadequate levels of staffing to perform services for our customers. As a result, our growth could be limited due to our lack of capacity to develop and market our products to our customers. We depend on our international operations for a substantial portion of our revenues. Sales to customers located outside the United States have historically accounted for a significant percentage of our revenue and we anticipate that such sales will continue to be a significant percentage of our revenue. As a percentage of our total revenues, sales to customers outside the United States were 37% and 35% for the three and nine months ended September 30, 2001 and 32% for both the three and nine months ended September 30, 2000, respectively. In addition, we have substantial research and development operations in Israel. We face risks associated with our international operations, including: . changes in taxes and regulatory requirements; . difficulties in staffing and managing foreign operations; . reduced protection for intellectual property rights in some countries; . the need to localize products for sale in international markets; . longer payment cycles to collect accounts receivable in some countries; . seasonal reductions in business activity in other parts of the world in which we operate; . political and economic instability; and . economic downturns in international markets. Any of these risks could harm our international operations and cause lower international sales. For example, some European countries already have laws and regulations related to technologies used on the Internet that are more strict than those currently in force in the United States. Any or all of these factors could cause our business to be harmed. Because our research and development operations are primarily located in Israel, we may be affected by volatile economic, political and military conditions in that country and by restrictions imposed by that country on the transfer of technology. Our operations depend on the availability of highly skilled scientific and technical personnel in Israel. Our business also depends on trading relationships between Israel and other countries. In addition to the risks associated with international sales and operations generally, our 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. These risks are compounded due to the restrictions on our ability to manufacture or transfer outside of Israel any technology developed under research and development grants from the government of Israel, without the prior written consent of the government of Israel. If we are unable to obtain the consent of the government of Israel, we may not be able to take advantage of strategic manufacturing and other opportunities outside of Israel. We have, in 18 the past, obtained royalty-bearing grants from various Israeli government agencies. In addition, we participate in special Israeli government programs that provide significant tax advantages. The loss of, or any material decrease in, these tax benefits could negatively affect our financial results. We are subject to the risk of increased taxes. We have structured our operations in a manner designed to maximize income in Israel where tax rate incentives have been extended to encourage foreign investment. Our taxes could increase if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased. Tax authorities could challenge the manner in which profits are allocated among us and our subsidiaries, and we may not prevail in any such challenge. If the profits recognized by our subsidiaries in jurisdictions where taxes are lower became subject to income taxes in other jurisdictions, our worldwide effective tax rate would increase. Our financial results may be negatively impacted by foreign currency fluctuations. Our foreign operations are generally transacted through our international sales subsidiaries. As a result, these sales and related expenses are denominated in currencies other than the U.S. Dollar. Because our financial results are reported in U.S. Dollars, our results of operations may be harmed by fluctuations in the rates of exchange between the U.S. Dollar and other currencies, including: . a decrease in the value of Pacific Rim or European currencies relative to the U.S. Dollar, which would decrease our reported U.S. Dollar revenue, as we generate revenues in these local currencies and report the related revenues in U.S. Dollars; and . an increase in the value of Pacific Rim, European or Israeli currencies relative to the U.S. Dollar, which would increase our sales and marketing costs in these countries and would increase research and development costs in Israel. We attempt to limit foreign exchange exposure through operational strategies and by using forward contracts to offset the effects of exchange rate changes on intercompany trade balances. This requires us to estimate the volume of transactions in various currencies. We may not be successful in making these estimates. If these estimates are overstated or understated during periods of currency volatility, we could experience material currency gains or losses. Our ability to successfully implement our business strategy depends on the continued growth of the Internet. In order for our business to be successful, the Internet must continue to grow as a medium for conducting business. However, as the Internet continues to experience significant growth in the number of users and the complexity of Web-based applications, the Internet infrastructure may not be able to support the demands placed on it or the performance or reliability of the Internet might be adversely affected. Security and privacy concerns may also slow the growth of the Internet. Because our revenues ultimately depend upon the Internet generally, our business may suffer as a result of limited or reduced growth. Acquisitions may be difficult to integrate, disrupt our business, dilute stockholder value or divert the attention of our management. We may acquire or make investments in other companies and technologies. In the event of any future acquisitions or investments, we could: . issue stock that would dilute the ownership of our then-existing stockholders; . incur debt; . assume liabilities; . incur expenses for the impairment of the value of investments or acquired assets; . incur amortization expense related to intangible assets; or . incur large write-offs. 19 If we fail to achieve the financial and strategic benefits of past and future acquisitions or investments, our operating results will suffer. Acquisitions and investments involve numerous other risks, including: . difficulties integrating the acquired operations, technologies or products with ours; . failure to achieve targeted synergies; . unanticipated costs and liabilities; . diversion of management's attention from our core business; . adverse effects on our existing business relationships with suppliers and customers or those of the acquired organization; . difficulties entering markets in which we have no or limited prior experience; and . potential loss of key employees, particularly those of the acquired organizations. The price of our common stock may fluctuate significantly, which may result in losses for investors and possible lawsuits. The market price for our common stock has been and may continue to be volatile. For example, during the 52-week period ended October 31, 2001, the closing prices of our common stock as reported on the Nasdaq National Market ranged from a high of $134.13 to a low of $18.71. We expect our stock price to be subject to fluctuations as a result of a variety of factors, including factors beyond our control. These factors include: . actual or anticipated variations in our quarterly operating results; . announcements of technological innovations or new products or services by us or our competitors; . announcements relating to strategic relationships, acquisitions or investments; . changes in financial estimates or other statements by securities analysts; . changes in general economic conditions; . terrorist attacks, bio-terrorism and the war on terrorism; . conditions or trends affecting the software industry and the Internet; and . changes in the economic performance and/or market valuations of other software and high-technology companies. Because of this volatility, we may fail to meet the expectations of our stockholders or of securities analysts at some time in the future, and the trading prices of our securities could decline as a result. In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many high-technology companies. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. Any negative change in the public's perception of software or Internet software companies could depress our stock price regardless of our operating results. If we fail to adequately protect our proprietary rights and intellectual property, we may lose a valuable asset, experience reduced revenues and incur costly litigation to protect our rights. We rely on a combination of patents, copyrights, trademarks, service marks and trade secret laws and contractual restrictions to establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our products and use information that we regard as proprietary to create products that compete with ours. Some license provisions protecting against 20 unauthorized use, copying, transfer and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the United States. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase. In many cases, we enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products. Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversions of our management resources, either of which could seriously harm our business. Third parties could assert that our products and services infringe their intellectual property rights, which could expose us to litigation that, with or without merit, could be costly to defend. We may from time to time be subject to claims of infringement of other parties' proprietary rights. We could incur substantial costs in defending ourselves and our customers against these claims. Parties making these claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the United States and abroad and could result in an award of substantial damages against us. In the event of a claim of infringement, we may be required to obtain licenses from third parties, develop alternative technology or to alter our products or processes or cease activities that infringe the intellectual property rights of third parties. If we are required to obtain licenses, we cannot be sure that we will be able to do so at a commercially reasonable cost, or at all. Defense of any lawsuit or failure to obtain required licenses could delay shipment of our products and increase our costs. In addition, any such lawsuit could result in our incurring significant costs or the diversion of the attention of our management. Defects in our products may subject us to product liability claims and make it more difficult for us to achieve market acceptance for these products, which could harm our operating results. Our products may contain errors or "bugs" that may be detected at any point in the life of the product. Any future product defects discovered after shipment of our products could result in loss of revenues and a delay in the market acceptance of these products that could adversely impact our future operating results. In selling our products, we frequently rely on "shrink wrap" or "click wrap" licenses that are not signed by licensees. Under the laws of various jurisdictions, the provisions in these licenses limiting our exposure to potential product liability claims may be unenforceable. We currently carry errors and omissions insurance against such claims, however, we cannot assure you that this insurance will continue to be available on commercially reasonable terms, or at all, or that this insurance will provide us with adequate protection against product liability and other claims. In the event of a product liability claim, we may be found liable and required to pay damages which would seriously harm our business. We have adopted anti-takeover defenses that could delay or prevent an acquisition of our company, including an acquisition that would be beneficial to our stockholders. Our Board of Directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present plans to issue shares of preferred stock. Furthermore, certain provisions of our Certificate of Incorporation and of Delaware law may have the effect of delaying or preventing changes in our control or management, which could adversely affect the market price of our common stock. Leverage and debt service obligations may adversely affect our cash flow. In July 2000, we completed an offering of convertible subordinated notes with a principal amount of $500.0 million. We now have a substantial amount of outstanding indebtedness, primarily the convertible subordinated notes. There is the possibility that we may be unable to generate cash sufficient to pay the principal of, interest on and other amounts due in respect of our 21 indebtedness when due. Our leverage could have significant negative consequences, including: . increasing our vulnerability to general adverse economic and industry conditions; . requiring the dedication of a substantial portion of our expected cash flow from operations to service our indebtedness, thereby reducing the amount of our expected cash flow available for other purposes, including capital expenditures; and . limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete. Item 3. Quantitative and Qualitative Disclosures About Market Risk Our exposure to market rate risk for changes in interest rates is limited to our investment portfolio. Derivative financial instruments are not a part of our investment policy. We place our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer or issue. In addition, we have classified all of our investments as "held to maturity." This classification does not expose the consolidated statements of income or balance sheets to fluctuation in interest rates. At September 30, 2001, $183.2 million, or 28%, of our cash, cash equivalents and investment portfolio carried a maturity of less than 90 days, and an additional $240.0 million, or 36%, carried a maturity of less than one year. All investments mature, by policy, in less than three years. The fair value of the convertible subordinated debentures fluctuates based upon changes in the price of our common stock, changes in interest rates, and our credit worthiness. A portion of our business is conducted in currencies other than the U.S. Dollar. Our operating expenses in each of these countries are in the local currencies, which mitigates a significant portion of the exposure related to local currency revenues. We have entered into forward foreign exchange contracts ("forward contracts") to hedge foreign currency denominated receivables due from certain European and Pacific Rim subsidiaries against fluctuations in exchange rates. We have not entered into forward contracts for speculative or trading purposes. Our accounting policies for these contracts are based on our designation of the contracts as hedging transactions. The criteria we use for designating a forward contract as a hedge considers its effectiveness in reducing risk by matching hedging instruments to underlying transactions. Gains and losses on forward contracts are recognized in other income in the same period as gains and losses on the underlying transactions. The effect of an immediate 10% change in exchange rates would not have a material impact on our operating results or cash flows. From time to time, we make investments in private companies and venture capital funds. As of September 30, 2001, we had invested $18.9 million in private companies. In addition, we have committed to make capital contributions to a venture capital fund totaling $12.0 million and we expect to pay approximately $3.0 million through March 31, 2002 as capital calls are made. If the companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies or for cash, we may not be able to sell these investments. In addition, even if we are able to sell these investments we cannot assure that we will be able to sell them at a gain or even recover our investment. The recent general decline in the Nasdaq Stock Market and the market prices of publicly traded technology companies, as well as any additional declines in the future, will adversely affect our ability to realize gains or a return of our capital on many of these investments. 22 PART II. OTHER INFORMATION -------------------------- Item 6. Exhibits and Reports on Form 8-K (a) No reports on Form 8-K were filed during the three months ended September 30, 2001. 23 SIGNATURE --------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. MERCURY INTERACTIVE CORPORATION (Registrant) Dated: November 14, 2001 By: /s/ Douglas P. Smith -------------------- Douglas P. Smith, Executive Vice President & Chief Financial Officer Principal Financial Officer By: /s/ David A. Kempski -------------------- David A. Kempski, Vice President, Finance Principal Accounting Officer 24