10-Q 1 b42899cce10-q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON DC 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the quarterly period ended March 31, 2002. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from ____________ to _____________ COMMISSION FILE NUMBER 0-23067 CONCORD COMMUNICATIONS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) MASSACHUSETTS 04-2710876 (State of incorporation) (IRS Employer Identification Number) 600 NICKERSON ROAD MARLBORO, MASSACHUSETTS 01752 (508) 460-4646 (ADDRESS AND TELEPHONE OF PRINCIPAL EXECUTIVE OFFICES) ---------------- INDICATE BY CHECK MARK WHETHER 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, AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS; YES X NO 16,974,508 SHARES OF THE REGISTRANT'S COMMON STOCK, $0.01 PAR VALUE, WERE OUTSTANDING AS OF APRIL 22, 2002. THIS DOCUMENT CONTAINS 28 PAGES. CONCORD COMMUNICATIONS, INC. FORM 10-Q, MARCH 31, 2002 CONTENTS
Item Number Page PART I: FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements Condensed Consolidated Balance Sheets: March 31, 2002 and December 31, 2001 3 Condensed Consolidated Statements of Operations: Three months ended March 31, 2002 and March 31, 2001 4 Condensed Consolidated Statements of Cash Flows: Three months ended March 31, 2002 and March 31, 2001 5 Notes to Condensed Consolidated Financial Statements 6-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10-24 Item 3. Quantitative and Qualitative Disclosures about Market Risk 25 PART II: OTHER INFORMATION Item 1. Legal Proceedings 26 Item 2. Changes in Securities and Use of Proceeds 26 Item 3. Defaults Upon Senior Securities 26 Item 4. Submission of Matters to a Vote of Security Holders 27 Item 5. Other Information 27 Item 6. Exhibits and Reports on Form 8-K 27 SIGNATURE 28
2 PART I: FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONCORD COMMUNICATIONS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
MARCH 31, DECEMBER 31, 2002 2001 ------------- ------------- ASSETS Current Assets: Cash and cash equivalents ................................ $ 12,481,104 $ 9,010,811 Marketable securities .................................... 58,595,503 59,333,068 Accounts receivable, net of allowance of $1,642,377 and $1,409,835 at March 31, 2002 and December 31, 2001, respectively ............................................ 16,337,725 16,537,131 Prepaid expenses and other current assets ................ 3,405,409 3,057,797 ------------- ------------- Total current assets ................................. 90,819,741 87,938,807 ------------- ------------- Equipment and Improvements, at cost: Equipment ................................................ 20,420,402 19,636,704 Leasehold improvements ................................... 6,017,789 5,956,710 ------------- ------------- 26,438,191 25,593,414 Less-- Accumulated depreciation and amortization.......... 16,313,341 14,798,688 ------------- ------------- 10,124,850 10,794,726 ------------- ------------- Deferred Tax Asset............................................ 3,500,000 3,500,000 Other Long-Term Assets........................................ 268,692 246,655 ------------- ------------- Total long-term assets ............................... 3,768,692 3,746,655 ------------- ------------- $ 104,713,283 $ 102,480,188 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable ......................................... $ 3,511,493 $ 3,553,417 Accrued expenses.......................................... 13,843,588 13,278,825 Deferred revenue.......................................... 23,879,326 22,141,078 ------------- ------------- Total current liabilities ............................ 41,234,407 38,973,320 ------------- ------------- Stockholders' Equity: Common stock, $0.01 par value: Authorized -- 50,000,000 shares Issued and outstanding-- 16,964,743 and 16,901,193 shares at March 31, 2002 and December 31, 2001, respectively............................................. 169,647 169,012 Additional paid-in capital ............................... 96,895,095 96,365,287 Deferred compensation .................................... (173,608) (241,547) Accumulated other comprehensive income ................... 776,616 1,892,264 Accumulated deficit ...................................... (34,188,874) (34,678,148) ------------- ------------- Total stockholders' equity ........................... 63,478,876 63,506,868 ------------- ------------- $ 104,713,283 $ 102,480,188 ============= =============
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 CONCORD COMMUNICATIONS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED ------------------------------- MARCH 31, MARCH 31, 2002 2001 ------------ ------------ Revenues: License revenues .......................................... $ 14,060,607 $ 13,070,834 Service revenues .......................................... 10,176,605 7,364,499 ------------ ------------ Total revenues ....................................... 24,237,212 20,435,333 ------------ ------------ Cost of Revenues: Cost of license revenues .................................. 566,431 696,387 Cost of service revenues .................................. 3,818,658 4,269,040 ------------ ------------ Total cost of revenues ............................... 4,385,089 4,965,427 ------------ ------------ Gross profit .......................................... 19,852,123 15,469,906 ------------ ------------ Operating Expenses: Research and development .................................. 5,741,467 6,404,872 Sales and marketing ....................................... 12,134,553 12,419,248 General and administrative ................................ 2,054,700 2,546,759 Stock-based compensation .................................. 32,665 191,823 ------------ ------------ Total operating expenses .............................. 19,963,385 21,562,702 ------------ ------------ Operating loss .................................. (111,262) (6,092,796) ------------ ------------ Other Income (Expense): Interest income .......................................... 776,042 799,591 Other expense ............................................ (28,449) (6,001) ------------ ------------ Total other income, net ............................. 747,593 793,590 ------------ ------------ Income (loss) before income taxes ................... 636,331 (5,299,206) Provision for income taxes ..................................... 147,057 66,298 ------------ ------------ Net income (loss) .............................................. $ 489,274 $ (5,365,504) ============ ============ Net income (loss) per common and potential common share: Basic ..................................................... $ 0.03 $ (0.32) ============ ============ Diluted ................................................... $ 0.03 $ (0.32) ============ ============ Weighted average common and potential common shares outstanding: Basic ..................................................... 16,931,200 16,560,541 ============ ============ Diluted ................................................... 18,025,665 16,560,541 ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 CONCORD COMMUNICATIONS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
THREE MONTHS ENDED ------------------------------- MARCH 31, MARCH 31, 2002 2001 ------------ ------------ Cash Flows from Operating Activities: Net income (loss) ............................................. $ 489,274 $ (5,365,404) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities- Depreciation and amortization ............................ 1,514,653 1,484,999 Stock-based compensation ................................. 32,665 191,823 Changes in current assets and liabilities: Accounts receivable .................................. 199,406 2,841,267 Prepaid expenses and other currents assets ........... (347,612) (403,788) Accounts payable ..................................... (41,924) (782,533) Accrued expenses ..................................... 47,023 152,508 Deferred revenue ..................................... 1,738,248 1,089,040 ------------ ------------ Net cash provided by (used in) operating activities ........................................ 3,631,733 (792,188) ------------ ------------ Cash Flows from Investing Activities: Purchases of equipment and improvements ....................... (844,777) (1,319,687) Change in other assets ........................................ (22,037) (5,555) Investments in marketable securities .......................... (2,107,607) (3,072,840) Proceeds from sales of marketable securities .................. 2,247,264 2,655,028) ------------ ------------ Net cash used in investing activities ................... (727,157) (1,743,054) ------------ ------------ Cash Flows from Financing Activities: Proceeds from issuance of common stock ........................ 565,717 39,238 ------------ ------------ Net cash provided by financing activities ............... 565,717 39,238 ------------ ------------ Net increase (decrease) in cash and cash equivalents .......... 3,470,293 (2,496,004) Cash and Cash Equivalents, beginning of period ................ 9,010,811 10,725,265 ------------ ------------ Cash and Cash Equivalents, end of period ...................... $ 12,481,104 $ 8,229,261 ============ ============ Supplemental Disclosure of Cash Flow Information: Cash paid for taxes ........................................... $ 97,100 $ 40,500 ============ ============ Supplemental Disclosure of Noncash Transactions: Reversal of deferred compensation related to forfeitures of stock options ............................................ $ (35,274) $ (1,072,709) ============ ============ Unrealized (loss) gain on available-for-sale securities ....... $ (597,905) $ 941,988 ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 5 CONCORD COMMUNICATIONS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) FORM 10-Q, MARCH 31, 2002 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying condensed consolidated financial statements have been presented by Concord Communications, Inc. (the "Company") unaudited (except the balance sheet information as of December 31, 2001 which has been derived from audited financial statements) in accordance with accounting principles generally accepted in the United States for interim financial statements and with the instructions to Form 10-Q and Regulation S-X pertaining to interim financial statements. Accordingly, these interim financial statements do not include all information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The financial statements reflect all adjustments and accruals which management considers necessary for a fair presentation of financial position as of March 31, 2002 and December 31, 2001, and the results of operations for the three months ended March 31, 2002 and 2001. The results for the interim periods presented are not necessarily indicative of results to be expected for any future period. The financial statements should be read in conjunction with the audited financial statements and the notes thereto included in the Company's 2001 Annual Report on Form 10-K filed with the Securities and Exchange Commission in March 2002. (b) Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. (c) Cash, Cash Equivalents and Marketable Securities The Company follows the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The Company has classified its marketable securities as available-for-sale and recorded them at fair value, with the unrealized gains and losses reported as a separate component of stockholders' equity. The Company considers highly liquid investments, purchased with an original maturity of 90 days or less, to be cash equivalents. Cash and cash equivalents were $12,481,104 and $9,010,811, at March 31, 2002 and December 31, 2001, respectively and consisted of money market funds. (d) Revenue Recognition The Company's revenues consist of software license revenues and service revenues. Software license revenues are recognized in accordance with the American Institute of Certified Public Accountants' Statement of Position (SOP) 97-2, Software Revenue Recognition, as modified by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition with respect to Certain Transactions. Under SOP 97-2, software license revenues are recognized upon execution of a contract and delivery of software, provided that the license fee is fixed and determinable, no significant production, modification or customization of the software is required and collection is considered probable by management. Revenues under multiple-element arrangements, which typically include software products, services and maintenance sold together, are allocated to each element using the residual method in accordance with SOP 98-9. Under the residual method, the fair value of the undelivered elements is deferred and subsequently recognized. The Company has established sufficient vendor specific objective evidence for professional services, training and maintenance and customer support services based on the price charged when these elements are sold separately. Accordingly, software license revenue is recognized under the residual method in arrangements in which software is licensed with professional services, training and maintenance and customer support services. Service revenues include professional services, training and maintenance and customer support fees. Professional services are not essential to the functionality of the other elements in an arrangement and are accounted for separately. Service revenues are recognized as the services are performed. 6 Maintenance revenues are derived from customer support agreements generally entered into in connection with initial license sales and subsequent renewals. Maintenance and customer support fees include the right to unspecified upgrades on a when-and-if-available basis and ongoing technical support. Maintenance revenues are recognized ratably over the term of the maintenance period. Payments for maintenance fees are generally made in advance and are included in deferred revenue. As of March 31, 2002 and December 31, 2001, deferred revenue includes approximately $19.7 million and $17.1 million of deferred maintenance revenues. (e) Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, 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. (f) Financial Instruments, Concentration of Credit Risk and Significant Customers The Company has estimated the fair value of financial instruments using available market information and appropriate valuation methodologies. The carrying values of cash, cash equivalents, marketable securities, accounts receivable, and accounts payable approximate fair market value due to the short-term nature of these financial instruments. Financial instruments that potentially subject the Company to concentrations of credit risk are principally cash, cash equivalents, marketable securities and accounts receivable. The Company has no significant off-balance-sheet or concentration of credit risk exposure such as foreign exchange contracts, option contracts or other foreign hedging arrangements. The Company maintains its cash, cash equivalents and marketable securities with established financial institutions. Concentration of credit risk with respect to accounts receivable is limited to certain customers to whom the Company makes substantial sales. To reduce its credit risk, the Company routinely assesses the financial strength of its customers. The Company maintains an allowance for potential credit losses but historically has not experienced any significant losses related to individual customers or groups of customers in any particular industry or geographic area. No individual customer or reseller accounted for more than 10% of revenue for the three months ended March 31, 2002 or March 31, 2001. No one customer accounted for more than 10% of accounts receivable as of March 31, 2002. One customer accounted for 13.4% of accounts receivable at December 31, 2001; a total of 7.2% of the receivables from this customer was included in the Company's deferred revenue at December 31, 2001. (g) Reclassifications Certain amounts in the prior period's financial statements have been reclassified to conform to the current period's presentation. 2. BASIC AND DILUTED INCOME/LOSS PER COMMON SHARE The Company computes earnings per share following the provisions of SFAS No. 128, Earnings per Share. SFAS No. 128 establishes standards for computing and presenting earnings per share and applies to entities with publicly held common stock or potential common stock. Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding for a period. Diluted net income (loss) per share is computed using the weighted-average number of common and dilutive common-equivalent shares outstanding for the period. Diluted net loss per share is the same as basic net loss per share for the three months ended March 31, 2001, as the effects of potential common stock are antidilutive. Dilutive common-equivalent shares primarily consist of employee stock options. The dilutive effect of outstanding stock options is computed using the treasury stock method. For the three months ended March 31, 2002, employee stock options to purchase 1,915,772 shares were outstanding but not included in the diluted weighted-average share calculation as their effects would have been antidilutive. For the three months ended March 31, 2001, employee stock options to purchase 3,542,350 shares were outstanding but not included in the diluted weighted-average share calculation as the effect would have been antidilutive as a result of the Company's reported loss for the period. 7 Calculation of the basic and diluted net income (loss) per share and potential common share are as follows:
THREE MONTHS ENDED ------------------------------- MARCH 31, MARCH 31, 2002 2001 ------------ ------------- Net income (loss) applicable to common stockholders ............. $ 489,274 $ (5,365,504) ------------ ------------ Weighted average common shares outstanding ...................... 16,931,200 16,560,541 Potential common shares pursuant to stock options 1,094,465 -- ------------ ------------ Diluted weighted average shares ................................. 18,025,665 16,560,541 ============ ============ Basic net income (loss) per common share ........................ $ 0.03 $ (0.32) ============ ============ Diluted net income (loss) per common and potential common share . $ 0.03 $ (0.32) ============ ============
3. COMPREHENSIVE LOSS Comprehensive loss for the three months ended March 31, 2002 and 2001 is as follows:
THREE MONTHS ENDED ------------------------------ MARCH 31, MARCH 31, 2002 2001 ----------- ------------ Net income (loss) applicable to common stockholders............ $ 489,274 $(5,365,504) Unrealized (loss) gain on marketable securities ............... (597,908) 941,988 ----------- ----------- Comprehensive loss ............................................ $ (108,634) $(4,423,516) =========== ===========
4. SEGMENT REPORTING AND INTERNATIONAL INFORMATION The Company follows the provisions of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. SFAS No. 131 establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information for those segments to be presented in interim financial reports issued to stockholders. SFAS No. 131 also establishes standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate, discrete financial information is available for evaluation by the chief operating decision maker, or decision making group, in making decisions on how to allocate resources and assess performance. The Company's chief decision making group, as defined under SFAS No. 131, is the Executive Management Committee. The following table presents the approximate revenue by major geographical regions:
THREE MONTHS ENDED ---------------------------- MARCH 31, MARCH 31, 2002 2001 ----------- ----------- United States ................................ $14,696,000 $13,044,000 Europe ....................................... 5,395,000 4,149,000 Rest of the World............................. 4,146,000 3,238,000 ----------- ----------- Total ........................................ $24,237,000 $20,431,000 =========== ===========
No one country, except the United States, accounts for greater than 10% of total revenues. Substantially all of the Company's assets are located in the United States. The Company's reportable segments are determined by customer type: managed service providers/ telecommunications carriers (MSP/TC) and enterprise. The accounting policies of the segments are the same as 8 those described in Note 1. The Executive Management Committee evaluates segment performance based on revenue. Accordingly, all expenses are considered corporate level activities and are not allocated to segments. Also, the Executive Management Committee does not assign assets to these segments. The table presents the approximate revenue by reportable segment:
THREE MONTHS ENDED ------------------------------- MARCH 31, MARCH 31, 2002 2001 ----------- ----------- MSP/TC............................................. $ 9,847,000 $ 8,451,000 Enterprise......................................... 14,390,000 11,980,000 ----------- ----------- Total.............................................. $24,237,000 $20,431,000 =========== ===========
5. RECENT ACCOUNTING PRONOUNCEMENTS In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS No. 144 further refines the requirements of SFAS No. 121, which required that companies (1) recognize an impairment loss only if the carrying amount of a long-lived asset is not recoverable based on its undiscounted future cash flows and (2) measure an impairment loss as the difference between the carrying amount and fair value of the asset. In addition, SFAS No. 144 provides guidance on accounting and disclosure issues surrounding long-lived assets to be disposed of by sale. The Company adopted SFAS No. 144 beginning on January 1, 2002. The adoption did not have any impact on the Company's consolidated financial position, results of operations or cash flows. In November 2001, the Emerging Issues Task Force issued Topic No. D-103 relating to the accounting for reimbursements received for out-of-pocket expenses. In accordance with Topic No. D-103, reimbursements received for out-of-pocket expenses incurred should be characterized as revenue in the statement of operations. The Company has historically accounted for reimbursements received for out-of-pocket expenses incurred as a reduction to cost of service revenues in the statement of operations to offset the costs incurred. The Company adopted Topic No. D-103 on January 1, 2002, and comparative financial statements for prior periods are reclassified to comply with the guidance in Topic No. D-103. During the three month periods ended March 31, 2002 and 2001, reimbursed out-of-pocket expenses totaled $6,200 and $4,000, respectively. There was no impact on the gross profit as a percentage of total revenues or gross margin for the three month periods ended March 31, 2002 or 2001. 9 CONCORD COMMUNICATIONS, INC. FORM 10-Q, MARCH 31, 2002 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Concord develops, markets and supports the eHealthTM Suite of scalable information technology (IT) infrastructure fault and performance management software solutions. eHealthTM integrates fault and performance management of the systems, applications and networks that comprise today's IT infrastructure. Concord's solutions optimize the performance and availability of IT infrastructures on which enterprises, managed service providers and telecommunication carriers depend for their day-to-day business and operational success. Concord's software solutions monitor fault conditions throughout the infrastructure in real time; test availability and responsiveness of critical services; collect, consolidate, normalize and analyze a high volume of data from the IT infrastructure; alert IT personnel to faults and potential outages, maximize uptime of the IT infrastructure and automatically execute corrective action to restore availability, if desired. Concord does not provide forecasts of its future financial performance. From time to time, however, the information provided by Concord or statements made by our employees may contain forward-looking statements. In particular, some statements contained in Concord's Form 10-Q for the three month period ended March 31, 2002, are not historical statements (including, but not limited to, statements concerning the plan and objectives of management, increases in revenue (domestically and internationally), increases in sales and marketing, research and development and general and administrative expenses (domestically and internationally), Concord's ability to use deferred tax assets, Concord's success in competing in international markets, Concord's expected future profitability and Concord's expected liquidity and capital resources). This document contains forward-looking statements. Any statements contained herein that do not describe historical facts are forward-looking statements. The Company makes such forward-looking statements under the provisions of the "safe harbor" section of the Private Securities Litigation Reform Act of 1995. The forward-looking statements contained herein are based on current expectations but are subject to a number of risks and uncertainties. The facts that could cause actual results to differ materially from current expectations include the following: risks of intellectual property rights and litigation, risks in technology development and commercialization, risks in product development and market acceptance of and demand for the Company's products, risks of downturns in economic conditions generally, and in the software, networking and telecommunications industries specifically, risks associated with competition and competitive pricing pressures, risks associated with international sales, risks associated with the Company's recent acquisitions and other risks detailed in this Form 10-Q and in the Company's filings with the Securities and Exchange Commission. 10 RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain financial data as percentages of the Company's total revenue:
UNAUDITED THREE MONTHS ENDED --------------------------------- MARCH 31, MARCH 31, 2002 2001 ------------ ----------- Revenues: License revenues 58.0% 64.0% Service revenues 42.0 36.0 ----- ----- Total revenues 100.0 100.0 Cost of Revenues: Cost of license revenues 2.3 3.4 Cost of service revenues 15.8 20.9 ----- ----- Total cost of revenues 18.1 24.3 ----- ----- Gross profit 81.9 75.7 ----- ----- Operating Expenses: Research and development 23.7 31.3 Sales and marketing 50.1 60.8 General and administrative 8.5 12.5 Stock-based compensation 0.1 0.9 ----- ----- Total operating expenses 82.4 105.5 ----- ----- Loss from operations -0.5 -29.8 Other income, net 3.1 3.9 ----- ----- Income (loss) before taxes 2.6 -25.9 Provision for income taxes 0.6 0.3 ----- ----- Net income (loss) 2.0% -26.2% ===== =====
REVENUES. Concord's revenues consist of software license revenues and service revenues. Software license revenues are recognized in accordance with the American Institute of Certified Public Accountants' Statement of Position (SOP) 97-2, Software Revenue Recognition, as modified by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions. Under SOP 97-2, software license revenues are recognized upon execution of a contract and delivery of software, provided that the license fee is fixed or determinable, no significant production, modification or customization of the software is required and collection is considered probable by management. Revenues under multiple-element arrangements, which typically include software products and maintenance sold together, are allocated to each element using the residual method in accordance with SOP 98-9. Service revenues are recognized as the services are performed. Maintenance revenues are derived from customer support agreements generally entered into in connection with initial license sales and subsequent renewals. Maintenance revenues are recognized ratably over the term of the maintenance period. Payments for maintenance fees are generally made in advance. TOTAL REVENUES. The Company's total revenues increased 18.6% to $24.2 million in the three months ended March 31, 2002 from $20.4 million in the three months ended March 31, 2001. LICENSE REVENUES. Concord's license revenues are derived from the licensing of software products. License revenues increased 7.6% to $14.1 million, or 58.0% of total revenues, in the three months ended March 31, 2002 from $13.1 million, or 64.0% of total revenues, in the three months ended March 31, 2001. The increase in license revenues resulted from sales to existing customers of new products, sales to new customers and increased revenues to international markets. The decrease in license revenues as a percent of total revenues for the three months ended March 31, 2001 and March 31, 2002 was the result of a significant increase in service revenues, consisting mainly of maintenance revenues. 11 SERVICE REVENUES. Concord's service revenues consist of fees for maintenance, training and professional services. Service revenues increased 38.3% to $10.2 million or 42.0% of total revenues, in the three months ended March 31, 2002 from $7.4 million or 36.0% of total revenues in the three months ended March 31, 2001. The increase in service revenues was mainly due to a significant increase in maintenance revenue which is generated from new and renewed maintenance contracts. An increase in the number of customers and the resulting demand for services by these customers further helped drive the increase in service revenue for the period ended March 31, 2002 compared to March 31, 2001. INTERNATIONAL REVENUES. Concord's international revenues increased 29.2% to $9.5 million or 39.4% of total revenues for the three months ended March 31, 2002 from $7.4 million or 36.2% of total revenues for the three months ended March 31, 2001. International revenues are primarily driven by customers based in Europe, as well as the continued expansion of operations outside the United States and the establishment of additional reseller relationships. COST OF REVENUES. Cost of revenues includes expenses associated with royalty costs, production, fulfillment and product documentation, along with personnel costs associated with providing customer support in connection with maintenance, training and professional service contracts. Royalty costs are composed of third party software costs. Cost of revenues decreased 11.6% to $4.4 million, or 18.1% of total revenues, in the three months ended March 31, 2002 from $5.0 million, or 24.3% of total revenues, in the three months ended March 31, 2001, resulting in gross margins of 81.9% and 75.7% respectively. The decrease in cost of revenues as a percent of sales was driven by increased efficiencies and better management of expenses in the customer support organization. We expect to maintain our cost of revenues as a percentage of total revenues; however, this will depend upon our royalty costs and our revenue growth, among other factors. Accordingly, there can be no assurance that we will be successful in maintaining our cost of revenues as a percentage of total revenues. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses consist primarily of personnel costs associated with software development. Research and development expenses decreased 10.4% to $5.7 million, or 23.7% of total revenues, in the three months ended March 31, 2002 from $6.4 million, or 31.3% of total revenues, in the three months ended March 31, 2001. The decrease in research and development expenses was primarily due to a decrease in headcount in research and development from 143 to 131 people as well as a reduction of discretionary expenses for the period ended March 31, 2002 compared to March 31, 2001. We intend to decrease our research and development expenses as a percentage of total revenues. Our ability to decrease these expenses as a percentage of revenue will depend upon our revenue growth, among other factors. Accordingly, there can be no assurance that we will be successful in decreasing our expenses as a percentage of total revenues. SALES AND MARKETING EXPENSES. Sales and marketing expenses consist primarily of salaries, commissions to sales personnel and agents, travel, tradeshow participation, public relations, advertising and other promotional expenses. Sales and marketing expenses decreased 2.3% to $12.1 million, or 50.1% of total revenues, in the three months ended March 31, 2002 from $12.4 million, or 60.8% of total revenues, in the three months ended March 31, 2001. The decrease in sales and marketing expenses was primarily the result of a reduction in marketing and promotional activities as well as a reduction in headcount in sales and marketing from 183 to 178 people from March 31, 2001 to March 31, 2002. We intend to decrease our sales and marketing expenses as a percentage of total revenues. Our ability to decrease these expenses as a percentage of revenue will depend upon our revenue growth, among other factors. Accordingly, there can be no assurance that we will be successful in decreasing our expenses as a percentage of total revenues. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses consist primarily of salaries for financial, accounting, legal, administrative and management personnel. General and administrative expenses decreased 19.3% to $2.1 million, or 8.5% of total revenues, in the three months ended March 31, 2002 from $2.5 million, or 12.5% of total revenues, in the three months ended March 31, 2001. The decrease in general and administrative expenses is due to a decrease in headcount from 41 to 34 people as well as a reduction in discretionary expenses. We expect to decrease these expenses as a percentage of revenue; this will ultimately depend upon our revenue growth, among other factors. Accordingly, there can be no assurance that we will be successful in decreasing our expenses as a percentage of total revenues. 12 STOCK-BASED COMPENSATION. Stock-based compensation relates to the issuance of stock options with exercise prices below the deemed fair value of the Company's common stock at the date of grant. Deferred stock-based compensation is amortized through charges to operations over the vesting period of the options, which is generally four years. For the three months ended March 31, 2002 and 2001, stock-based compensation expense was approximately $33,000 and $192,000, respectively. The Company recorded a reversal of deferred stock based compensation of approximately $35,000 and $1.1 million for the three months ended March 31, 2002 and 2001, respectively, related to forfeitures of stock options by terminated employees. OTHER INCOME. Other income consists of interest earned on funds available for investment, net of foreign currency exchange gains and losses and miscellaneous foreign taxes. The Company had net other income of $748,000 and $794,000 for the three months ended March 31, 2002 and 2001, respectively. PROVISION FOR INCOME TAXES. The Company recorded an income tax provision of approximately $147,000 and $66,000 in the three months ended March 31, 2002 and 2001 respectively. The income tax provision for the three months ended March 31, 2002 and 2001 is mainly related to foreign taxes resulting from the profitability of certain of the Company's foreign operations. In 2002, the Company estimated that it would not need to record a provision for domestic federal and state income taxes as a result of the use of net operating loss carryforwards. LIQUIDITY AND CAPITAL RESOURCES As of March 31, 2002, the Company had cash, cash equivalents and marketable securities of $71.1 million, an increase of $2.8 million from $68.3 million as of December 31, 2001. Concord had working capital of $49.6 million and $48.9 million as of March 31, 2002 and December 31, 2001, respectively. The increase in working capital was primarily attributable to an increase in cash, cash equivalents and marketable securities due to income from continuing operations during the quarter. Net cash provided by operating activities was $3.6 million for the three months ended March 31, 2002 and $792,000 for the three months ended March 31, 2001. Accounts receivable decreased $199,000 due to an increase in the allowance for accounts receivable. Deferred revenue increased $1.7 million mainly due to an increase in new and renewed maintenance contracts. Investing activities have consisted of the acquisition of property and equipment, most notably computer and networking equipment to support the corporate infrastructure and also investments in marketable securities. The Company manages its market risk on its investment securities by selecting investment grade securities with the highest credit ratings of relatively short duration that trade in highly liquid markets. Financing activities consisted primarily of the issuance of common stock from the exercise of stock options during the three months ended March 31, 2002 and 2001. As of March 31, 2002, the Company has future payments under facility and certain equipment lease agreements expiring through June 2007 of $3.6 million, $10.4 million and $4.9 million in one year, one to three years, and thereafter, respectively. The Company has deferred tax assets of approximately $21.9 million, the largest component of which represents NOL carryforwards and research and development credits. The Company has partially reserved for these deferred tax assets by recording a valuation allowance of $18.4 million. The resulting net deferred tax asset is based on the Company's estimate of NOL carryforwards it expects to use in the next two years; all other tax assets have been fully reserved. Pursuant to paragraphs 20 to 25 of SFAS No. 109, the Company considered both positive and negative evidence in assessing the need for a valuation allowance at December 31, 2001. The factors that weighed most heavily on the Company's decision to record a valuation allowance were (i) the substantial restrictions on the use of certain of its existing NOL and credit carryforwards and (ii) the uncertainty of future profitability. In addition, the Company is subject to rapid technological change, competition from substantially larger competitors, a limited family of products and other related risks, as more thoroughly described in the "Risk Factors" section of the Company's Form 10-K for the year ended December 31, 2001. As a result, the Company found the evidence 13 described above to be the most reliable objective evidence available in determining that a valuation allowance against its tax assets would be necessary. Pursuant to the Tax Reform Act of 1986, the utilization of net operating loss (NOL) carryforwards for tax purposes may be subject to an annual limitation if a cumulative change of ownership of more than 50% occurs over a three-year period. At December 31, 2001, the utilization of approximately $2,309,000 of the Company's NOL carryforwards are restricted to $330,000 per year as a result of an ownership change that occurred in 1995. In addition, the utilization of approximately $15,663,000 of NOL carryforwards that were acquired as a result of the FirstSense acquisition is also restricted as a result of a prior ownership change of FirstSense. Utilization of the FirstSense NOL carryforwards is limited to $4.3 million per year. As of December 31, 2001, the Company's NOL deferred tax asset includes approximately $2.3 million pertaining to the benefit associated with the exercise and subsequent disqualifying disposition of incentive stock options by the Company's employees. When and if the Company realizes this asset, the resulting change in the valuation allowance will be credited directly to additional paid-in capital, pursuant to the provisions of SFAS No. 109. As of March 31, 2002, Concord's principal sources of liquidity included cash, cash equivalents, and marketable securities. The Company believes that its current cash, cash equivalents, and marketable securities and cash provided by future operations will be sufficient to meet the working capital and anticipated capital expenditure requirements for at least the next 12 months. Although operating activities may provide cash in certain periods, to the extent Concord experiences growth in the future, its operating and investing activities may require additional cash. Consequently, any such future growth may require Concord to obtain additional equity or debt financing. CRITICAL ACCOUNTING POLICIES In December 2001, the SEC requested that all registrants list their three to five most "critical accounting policies" in the Management Discussion and Analysis section of their Annual Report on Form 10-K. The SEC indicated that a "critical accounting policy" is one which is both important to the portrayal of the company's financial condition and results and requires management's most difficult, subjective or complex judgements, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We believe that the following three accounting policies fit this definition: Revenue Recognition, Accounts Receivable and Accounting for Income Taxes. (a) Revenue Recognition Policy We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed and determinable and collection of the resulting receivable is reasonably assured. Delivery generally occurs when product is delivered to a common carrier and the delivery terms are FOB Concord. All revenues generated from our worldwide operations are approved at our corporate headquarters, located in the United States. At the time of the transaction, we assess whether the fee associated with our revenue transaction is fixed and determinable and whether or not collection is reasonably assured. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of a fee is due after our normal payment terms, which are usually 30 to 60 days from invoice date, we account for the fee as not being fixed and determinable. In these cases, we usually recognize revenue upon receipt of cash. We assess collection based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. We do not request collateral from our customers. If we determine that collection of a fee is not reasonably assured, we defer the fee and usually recognize revenue upon receipt of cash. For all sales, we use either a purchase order or signed license agreement as evidence of an arrangement. Sales through our resellers are usually evidenced by a master agreement governing the relationship together with purchase orders on a transaction-by-transaction basis. 14 For arrangements with multiple obligations (for example, undelivered maintenance and support), we allocate revenue to each component of the arrangement using the residual value method based on the fair value of the undelivered elements. This means that we defer revenue from the fee arrangement equivalent to the fair values of the undelivered elements. We determine fair values for ongoing maintenance and support obligations using our internal pricing policies for maintenance and by referencing the prices at which we have sold separate maintenance contract renewals to our customers. We determine fair values of services, such as training or consulting, by referencing the prices at which we have separately sold comparable services to our customers. Our arrangements do not generally include clauses involving acceptance of our products by our customers. However, if an arrangement includes an acceptance provision, revenue recognition occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period. (b) Accounts Receivable Policy We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history and the customer's current credit worthiness, as determined by our review of their current credit information. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based on a percentage of our accounts receivable, our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and appropriate reserves have been established, we cannot guarantee that we will continue to experience the same credit loss rates that we have experienced in the past. (c) Accounting for Income Taxes Policy As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. To do this, we estimate our actual current tax liabilities, while also assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income. To the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. Significant management judgement is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance of $18.4 million as of March 31, 2002, due to uncertainties related to our ability to utilize some of our deferred tax assets, primarily consisting of the utilization of certain net operating loss carryforwards from prior years. We are unsure whether we will have sufficient future taxable income to allow us to use these net operating losses, before they expire. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods we may need to establish an additional valuation. Establishing new or additional valuation allowances could materially adversely impact our financial position and results of operations. Our net deferred tax assets as of March 31, 2002 were $3.5 million, net of a valuation allowance of $18.4 million. The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management's judgement in their application. There are also areas in which the exercise of management's judgement in selecting an available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto which begin on page F-1 of the Annual Report on Form 10-K for the year ended December, 31, 2001 and which contain accounting policies and other disclosures required by generally accepted accounting principles. 15 FACTORS THAT COULD AFFECT FUTURE RESULTS References in these risk factors to "we," "our," the "Company," and "us" refer to Concord Communications, Inc., a Massachusetts corporation. Any investment in our common stock involves a high degree of risk. If any of the following risks actually occur, our business, results of operations and financial condition would likely suffer. This document contains forward-looking statements. Any statements contained in this document that do not describe historical facts are forward-looking statements. Concord makes such forward-looking statements under the provisions of the "safe harbor" section of the Private Securities Litigation Reform Act of 1995. In particular, statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations, which are not historical facts (including, but not limited to, statements concerning: the plans and objectives of management; increases in sales and marketing, research and development, customer support and service, and general and administrative expenses; expectations regarding increased competition and Concord's ability to compete successfully; sustenance of revenue growth both domestically and internationally; the size, scope and description of Concord's target customer market; future product development, including but not limited to anticipated expense levels to fund product development, acquisitions and the integration of acquired companies; and our expected liquidity and capital resources) constitute forward-looking statements. Forward-looking statements contained herein are based on current expectations, but are subject to a number of risks and uncertainties. Concord's actual future results may differ significantly from those stated in any forward-looking statements. Factors that may cause such differences include, but are not limited to, the factors discussed below. OUR FUTURE OPERATING RESULTS ARE UNCERTAIN. Prior to 2001, we marketed and sold our products primarily in the performance management market. In 2001, our product functionality was expanded to include both fault and performance management features to penetrate the fault management market. Accordingly, we have a limited operating history in this expanded market upon which we can evaluate our business. As currently developed, our product is an integrated fault and performance management tool that manages applications, systems and networks. The integrated fault and performance market is highly competitive and rapidly evolving. Additionally, many of our competitors in this new market have a longer operating history and greater resources. Our limited operating history and the uncertain economic climate makes the prediction of future results of operations difficult or impossible. Our prospects must be considered in light of the risks, costs, and difficulties frequently encountered by emerging companies operating in the highly competitive software industry. THE MARKET FOR INTEGRATED FAULT AND PERFORMANCE MANAGEMENT SOFTWARE IS EMERGING. The market for our integrated fault and performance solution is in an early stage of development. Although the rapid expansion and increasing complexity of computer applications, systems, and networks in recent years has increased the demand for fault and performance management software products, the awareness of, and the need for, an integrated fault and performance solution is a recent development. Because the market for this solution is only beginning to develop, it is difficult to assess: - the size of this market; - the appropriate features and prices for products to address this market; - the optimal distribution strategy; and - the competitive environment that will develop. The development of this market and our growth will depend significantly upon the desire and success of telecommunication carriers, managed services providers, and enterprises to integrate fault and performance management for their applications, systems, and networks. Moreover, it will depend on the willingness of telecommunication carriers, managed service providers, systems integrators, and outsourcers to integrate fault and performance management software into their product and service offerings. The market for integrated fault and performance management software may not grow or we may fail to assess and address the needs of this market. 16 THE MARKET FOR OUR PRODUCTS IS INTENSELY COMPETITIVE. The market for our products is new, intensely competitive, rapidly evolving, and subject to technological change. Our current and future competitors include: - report toolset vendors; - fault management software vendors; - application performance software vendors; - enterprise management software, framework and platform providers; - large, well established management framework companies that have developed network management platforms; - developers of network element management solutions; - probe vendors. We expect competition to persist, increase, and intensify in the future with possible price competition developing in our markets. Many of our current and potential competitors have longer operating histories and significantly greater financial, technical and marketing resources and name recognition than us. We do not believe our market will support a large number of competitors and their products. If we do not provide products that achieve success in our market in the short term, we could suffer an insurmountable loss in market share and brand name acceptance. We cannot ensure that we will compete effectively with current and future competitors. THE MARKET FOR PERFORMANCE AND FAULT MANAGEMENT OF SOFTWARE APPLICATIONS, SYSTEMS AND NETWORKS IS BECOMING INCREASINGLY TARGETED BY LARGER COMPANIES WITH SUBSTANTIALLY GREATER RESOURCES. A considerable portion of our revenue is generated from sales of products that manage both the fault and performance aspects of software applications and systems. This market is very competitive and we are in direct competition with larger companies with substantially greater resources. These larger companies are able to devote considerable resources to the development of competitive products and the creation and maintenance of direct and indirect sales channels. The continued presence of these larger companies in this market may impact our ability to retain or increase our market share. MARKET ACCEPTANCE OF OUR EHEALTH(TM) PRODUCT FAMILY IS CRITICAL TO OUR SUCCESS. We currently derive substantial product revenues from our eHealth(TM) product family, and we expect that revenues from these products will continue to account for almost all of our product revenues in the foreseeable future. Broad market acceptance of these products is critical to our future success. We cannot ensure that market acceptance of our eHealth(TM) Suite of products will increase or even remain at current levels. Factors that may affect the market acceptance of our integrated solution include: - the availability and price of competing solutions, products and technologies; and - the success of our sales efforts and those of our marketing partners. Moreover, if demand for integrated fault and performance management software products increases, we anticipate that our competitors will introduce additional competitive products and new competitors could enter our market and offer alternative products resulting in decreased market acceptance of our products. WE MAY NEED FUTURE CAPITAL FUNDING. We plan to continue to expend substantial funds on the continued development, marketing, and sale of the eHealth(TM) product family. We cannot ensure that our existing capital resources, the proceeds from our initial public offering during October 1997, and any funds that may be generated from future operations together will be sufficient to finance our future operations or that other sources of funding will be available on terms acceptable to us, if at all. 17 In addition, future sales of substantial amounts of our securities in the public market could adversely affect prevailing market prices and could impair our future ability to raise capital through the sale of our securities. WE MUST INTRODUCE PRODUCT ENHANCEMENTS AND NEW PRODUCTS ON A TIMELY BASIS. Because of rapid technological change in the software industry and potential changes in the IT infrastructure, fault and performance management software market, and changes in industry standards, the life cycle of versions of our eHealth(TM) products is difficult to estimate. We cannot ensure that: - we will successfully develop and market enhancements to our eHealth(TM) products or successfully develop new products that respond to technological changes, evolving industry standards or customer requirements; - we will not experience difficulties that could delay or prevent the successful development, introduction and sale of such enhancements or new products; or - such enhancements or new products will adequately address the requirements of the marketplace and achieve market acceptance. THE NEED FOR OUR PRODUCTS MAY DECREASE IF MANUFACTURERS INCORPORATE OUR PRODUCT FEATURES INTO THEIR PRODUCT OFFERINGS. Our products manage the performance of computer applications, systems, and networks. Presently, manufacturers of both hardware and software have not implemented these management functions into their products in any significant manner. These products typically include, but are not limited to, operating systems, workstations, network devices, and software. If manufacturers begin to incorporate these management functions into their products it may decrease the value of our products and have a substantial impact on our business. WE CANNOT ENSURE THAT OUR REVENUES WILL GROW OR THAT WE WILL BE PROFITABLE. As a company, we have expended considerable resources to develop innovative products that have enabled us to penetrate new markets both in the United States and internationally. As a result of these efforts, we achieved revenue growth and profitability for the fiscal years ended 2000, 1999, and 1998. However, as the worldwide economy weakened in 2001, our revenues did not grow at expected levels. We operated at a net loss and we cannot ensure that we can generate revenue growth on a quarterly or annual basis, or that we can achieve or sustain any revenue growth in the future. Our annual revenue in 2002 may be lower than our annual revenue in 2001. In an effort to return to profitability, we have reduced our operating expenses for 2001 and plan to continue to limit operating expenses for 2002. However, competition in the marketplace may require us to increase our operating expenses in the future in order to: - fund higher levels of research and development; - increase our sales and marketing efforts; - develop new distribution channels; - broaden our customer support capabilities; and - expand our administrative resources in anticipation of future growth. To the extent that increases in our expenses precede or are not followed by increased revenue, our profitability will continue to suffer. Our revenue must grow substantially in order for us to become profitable on a quarterly or annual basis. In addition, in view of the rapidly evolving nature of our business and markets and our limited operating history in our current market, we believe that one should not rely on period-to-period comparisons of our financial results as an indication of our future performance. 18 OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE. We are likely to experience significant fluctuations in our quarterly operating results caused by many factors, including, but not limited to: - changes in the demand for our products by customers or group of customers; - the timing, composition, and size of orders from our customers, including the tendency for significant bookings to occur in the last month of each fiscal quarter; - our customers' spending patterns and budgetary resources for fault and performance management software solutions; - the success of our new customer generation activities; - introductions or enhancements of products, or delays in the introductions or enhancements of products, by us or our competitors; - changes in our pricing policies or those of our competitors; - changes in the distribution channels through which products are sold; - our success in anticipating and effectively adapting to developing markets and rapidly changing technologies; - our success in attracting, retaining, and motivating qualified personnel; - changes in the features and functions of products sold by us and our competitors; - the publication of opinions about us and our products, or our competitors and their products, by industry analysts or others; - changes in general economic conditions; and - geopolitical conditions in the world. Though our services revenue has been increasing as a percentage of total revenues, we do not have a significant ongoing revenue stream that may mitigate quarterly fluctuations in operating results, as do other software companies with a longer history of operations. Increases in our revenues will also depend on our successful implementation of our distribution strategy as we attempt to expand our channels of distribution. Due to the buying patterns of certain of our customers and also to our own sales incentive programs focused on annual sales goals, revenues in our fourth quarter could be higher than revenues in our first quarter of the following year. There also may be other factors, such as seasonality and the timing of receipt and delivery of orders within a fiscal quarter, that significantly affect our quarterly results, which are difficult to predict given our limited operating history. Our quarterly sales and operating results depend generally on: - the volume and timing of orders within the quarter; - the tendency of sales to occur late in fiscal quarters; and - our fulfillment of orders received within the quarter. A significant portion of our product sales occur in the final month of each fiscal quarter. Any delay in the shipment of products prior to the end of the quarter may result in decreased revenues for the quarter. Additionally, intense competition and budgetary constraints placed upon our customers typically increase during the final month of a fiscal quarter and may adversely affect the revenues for that quarter. In addition, our expense levels are based in part on our expectations of future orders and sales, which are extremely difficult to predict. A substantial portion of our operating expenses is related to personnel, facilities, and 19 sales and marketing programs. Accordingly, we may not be able to adjust our fixed expenses quickly enough to address any significant shortfall in demand for our products in relation to our expectations. Due to all of the foregoing factors, we believe that our quarterly operating results are likely to vary significantly in the future. Therefore, in some future quarter our results of operations may fall below the expectations of securities analysts and investors. In such event, the trading price of our common stock would likely suffer. THE IMPACT OF THE RECENT TERRORIST ATTACKS AND THE RISK OF FUTURE TERRORIST ATTACKS MAY ADVERSELY IMPACT OUR REVENUE. The tragic events of September 11, 2001 impacted our sales to companies in the New York City area and our sales to the United States government. These markets have not yet recovered from the events of September 11, 2001 and it is impossible to determine when, and if, they will recover. Sales in the New York City area and sales to the United States government are a significant source of revenue for us and our business may be adversely affected as these areas recover. Additionally, recent terrorist warnings, both in the United States and internationally, suggest the possibility of future terrorist attacks. As we sell products both in the United States and internationally, the occurrence of future terrorist attacks may adversely affect our business. OUR SUCCESS IS DEPENDENT UPON SALES TO TELECOMMUNICATION CARRIERS, SERVICE PROVIDERS, AND ENTERPRISE CUSTOMERS. We derive and likely will continue to derive a significant portion of our revenues from the sales of our products to telecommunication carriers, service providers, and enterprise customers. These markets worldwide have suffered from a turbulent economy during 2000 and 2001, turbulence that has been exacerbated by the tragic events of September 11, 2001 and their aftermath. Concord has been negatively affected by the downturn in capital spending within this market. The volume of sales of our products and services to telecommunication carriers, service providers, and enterprise customers may increase slower than we expect or may decrease. OUR COMMON STOCK PRICE COULD EXPERIENCE SIGNIFICANT VOLATILITY. The market price of our common stock may be highly volatile and could be subject to wide fluctuations in response to: - variations in results of operations; - announcements of technological innovations or new products by us or our competitors; - changes in financial estimates by securities analysts; or - other events or factors. In addition, the financial markets have experienced significant price and volume fluctuations that have particularly affected the market prices of equity securities of many high technology companies and that often have been unrelated to the operating performance of such companies or have resulted from the failure of the operating results of such companies to meet market expectations in a particular quarter. Broad market fluctuations or any failure of our operating results in a particular quarter to meet market expectations may adversely affect the market price of our common stock leading to an increased risk of securities class action litigation. Such litigation could result in substantial costs and a diversion of our attention and resources. OUR INDUSTRY IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE. OUR SUCCESS DEPENDS UPON MAINTENANCE OF STANDARD PROTOCOLS. The software industry is characterized by: - rapid technological change; - frequent introductions of new products; 20 - changes in customer demands; and - evolving industry standards. The introduction of products embodying new technologies and the emergence of new industry standards can render existing products and integrated solutions obsolete and unmarketable. Our eHealth(TM) - Network product's analysis and reporting, as well as the quality of its reports, depends upon its utilization of the industry-standard Simple Network Management Protocol (SNMP) and the data resident in conventional Management Information Bases (MIBs). Any change in these industry standards, the development of vendor-specific proprietary MIB technology, or the emergence of new network technologies could affect the compatibility of our eHealth(TM) - Network products with these devices, which in turn could affect its analysis and generation of comprehensive reports or the quality of the reports. Similarly, our Live Health(TM) - Fault Manager product receives only SNMP traps from failing devices, systems, and applications. Any change in these industry standards could hinder the effectiveness of this product. Furthermore, although our eHealth(TM) Suite of products currently runs on industry-standard UNIX operating systems and Windows NT, any significant change in industry-standard operating systems could affect the demand for, or the pricing of, our products and solutions. WE RELY ON STRATEGIC PARTNERS AND OTHER EVOLVING DISTRIBUTION CHANNELS. Our distribution strategy is to develop multiple distribution channels, including sales through: - strategic marketing partners; - value added resellers; - system integrators; - telecommunication carriers; - original equipment manufacturers ("OEMs"); and - independent software vendors and international distributors. We have developed a number of these relationships and intend to continue to develop new "channel partner" relationships. Our success will depend in large part on our development of these additional distribution relationships and on the performance and success of these third parties, particularly telecommunication carriers and other network service providers. We sell our products in the United States through both direct sales to customers and indirect sales to customers through our channel partners. Internationally, we sell our products almost exclusively through indirect sales via our channel partners. Our international channel partners are located in Europe, the Middle East, Africa, Asia, and North and South America and are subject to local laws, regulations, and customs that may make it difficult to accurately assess the potential revenue that can be generated from a certain market. Our success depends upon our ability to attract and retain valuable channel partners and to accurately assess the size and vitality of the markets in which our products are sold. While we have implemented policies and procedures to achieve this, we cannot predict the extent to which we are able to attract and retain valuable channel partners. Additionally, our channel partners may not be successful in marketing and selling our products. We may: - fail to attract important and effective channel partners; - fail to penetrate our targeted market segments through the use of channel partners; or - lose any of our channel partners, as a result of competitive products offered by other companies, or products developed internally by these channel partners or otherwise. WE MAY FAIL TO MANAGE SUCCESSFULLY OUR GROWTH. We have experienced significant growth in our sales and operations personnel; our products have become increasingly complex; and our product distribution channels are being developed and expanded. Our growth, coupled with the rapid evolution of our markets, has placed, and is likely to continue to place, significant strains on 21 our administrative, operational, and financial resources and increase demands on our internal systems, procedures, and controls that may affect the overall profitability of the company. OUR SUCCESS DEPENDS ON OUR RETENTION OF KEY PERSONNEL. Our performance depends substantially on the performance of our key technical and senior management personnel. We may lose the services of any of such persons. We do not maintain key person life insurance policies on any of our employees. Our success depends on our continuing ability to identify, hire, train, motivate, and retain highly qualified management, technical, and sales and marketing personnel. We experience intense competition for such personnel and are constantly exploring new avenues for attracting and retaining key personnel. However, we cannot ensure that we will successfully attract, assimilate, or retain highly qualified technical, managerial or sales and marketing personnel in the future. OUR FAILURE TO EXPAND INTO INTERNATIONAL MARKETS COULD HARM OUR BUSINESS. We intend to continue to expand our operations outside of the United States and enter additional international markets, primarily through the establishment of channel partner arrangements. We expect to commit additional time and development resources to customizing our products and services for selected international markets and to developing international sales and support channels. We cannot ensure that such efforts will be successful. We face certain difficulties and risks inherent in doing business internationally, including, but not limited to: - costs of customizing products and services for international markets; - dependence on independent resellers; - multiple and conflicting regulations; - exchange controls; - longer payment cycles; - unexpected changes in regulatory requirements; - import and export restrictions and tariffs; - difficulties in staffing and managing international operations; - greater difficulty or delay in accounts receivable collection; - potentially adverse tax consequences; - the burden of complying with a variety of laws outside the United States; - the impact of possible recessionary environments in economies outside the United States; - political and economic instability; and - exposure to foreign currency fluctuations. Our successful expansion into certain countries will require additional modification of our products, particularly national language support. Presently, virtually all of our current export sales are denominated in United States dollars. To the extent that international sales do continue to be denominated in U.S. dollars, an increase in the value of the United States dollar relative to other currencies could make our products and services more expensive and, therefore, potentially less competitive in international markets. In certain European Union countries, however, we have introduced pricing in Euros in 2002. To the extent that future international sales are denominated in foreign currency, our operating results will be subject to risks associated with foreign currency fluctuation. Additionally, as we increase our international sales, seasonal fluctuations in revenue generation resulting from lower sales that typically occur during the summer months in Europe and other parts of the world may affect our total revenues. 22 OUR FAILURE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS MAY HARM OUR COMPETITIVE POSITION. Our success depends significantly upon our proprietary technology. We rely on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements, and other contractual provisions to establish, maintain, and protect our proprietary rights. These means afford only limited protection. We have ten issued and seven pending U.S. patents, and various foreign counterparts. We cannot ensure that patents will issue from our pending applications or from any future applications or that, if issued, any claims allowed will be sufficiently broad to protect our technology. In addition, we cannot ensure that any patents that have been or may be issued will not be challenged, invalidated or circumvented, or that any rights granted by those patents would protect our proprietary rights. Failure of any patents to protect our technology may make it easier for our competitors to offer equivalent or superior technology. We have sought also to protect our intellectual property through the use of copyright, trademark, and trade secret laws. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or services, or to obtain and use information that we regard as proprietary. Third parties may also independently develop similar technology without breach of our proprietary rights. In addition, the laws of some foreign countries do not protect proprietary rights to as great an extent as do the laws of the United States. In addition, many of our products are licensed under end user license agreements (also known as "shrinkwrap" licenses) that are not signed by licensees. The law governing the enforceability of shrinkwrap license agreements is not settled in most jurisdictions. There can be no guarantee that we would achieve success in enforcing one or more shrinkwrap license agreements if we sought to do so in a court of law. WE LICENSE CERTAIN TECHNOLOGIES FROM THIRD PARTIES. We license from third parties, generally on a non-exclusive basis, certain technologies used in our products. The termination of any such licenses, or the failure of the third-party licensors to adequately maintain or update their products, could result in delay in our shipment of certain of our products while we seek to implement technology offered by alternative sources, and any required replacement licenses could prove costly. While it may be necessary or desirable in the future to obtain other licenses relating to one or more of our products or relating to current or future technologies, we cannot ensure that we will be successful in doing so on commercially reasonable terms or at all. INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS WOULD HARM OUR BUSINESS. Although we do not believe that we are infringing upon the intellectual property rights of others, claims of infringement are becoming increasingly common as the software industry develops legal protections for software products. Litigation may be necessary to protect our proprietary technology, and third parties may assert infringement claims against us with respect to their proprietary rights. Any claims or litigation can be time-consuming and expensive regardless of their merit. Infringement claims against us can cause product release delays, require us to redesign our products, or require us to enter into royalty or license agreements, which agreements may not be available on terms acceptable to us or at all. PRODUCT DEFECTS COULD RESULT IN THE LOSS OF OR DELAY IN MARKET ACCEPTANCE OF OUR PRODUCTS. As a result of their complexity, software products may contain undetected errors or failures when first introduced or as new versions are released. We cannot ensure that, despite testing by us and testing and use by current and potential customers, errors will not be found in new products we ship or, if discovered, that we will successfully correct such errors in a timely manner or at all. The occurrence of errors and failures in our products could result in loss of, or delay in, market acceptance of our products, and alleviating such errors and failures could require significant expenditure of capital and other resources by us. 23 WE MAY NOT HAVE SUFFICIENT PROTECTION AGAINST PRODUCT LIABILITY CLAIMS. Because our products are used by our customers to identify and predict current and future application, system, and network problems and to avoid failures of the network to support critical business functions, design defects, software errors, misuse of our products, incorrect data from network elements, or other potential problems, within or out of our control, may arise from the use of our products and could result in financial or other damages to our customers. While we do not maintain product liability insurance, our license agreements with our customers typically contain provisions designed to limit our exposure to potential claims as well as any liabilities arising from such claims. As a matter of practice, our license agreements limit our liability in regards to product liability claims, and in many agreements, our maximum liability for product liability claims is limited to the equivalent of the cost of the products licensed under that agreement. However, any litigation or similar procedure related to a product liability claim may require considerable resources to be expended that could adversely affect the business and decrease future revenue. 24 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK DERIVATIVE FINANCIAL INSTRUMENTS, OTHER FINANCIAL INSTRUMENTS AND DERIVATIVE COMMODITY INSTRUMENTS. The Company does not have any derivative financial instruments, other financial instruments or derivative commodity instruments for which fair value disclosure would be required. All of the Company's investments are in investment grade securities with high credit ratings of relatively short duration that trade in highly liquid markets and are carried at fair value on the Company's books. Accordingly, the Company has no quantitative information concerning the market risk of participating in such investments. PRIMARY MARKET RISK EXPOSURES. The Company's primary market risk exposure is in the area of interest rate risk. The Company's investment portfolio of cash equivalents and marketable securities is subject to interest rate fluctuations, but the Company believes this risk is immaterial due to the short-term nature of these investments. Substantially all of the Company's business outside the United States is conducted in U.S. dollar-denominated transactions, whereas the Company's operating expenses in its international branches are denominated in local currency. The Company has no foreign exchange contracts, option contracts or other foreign hedging arrangements. The Company believes that the operating expenses of its foreign operations are immaterial, and therefore any associated market risk is unlikely to have a material adverse effect on the Company's business, results of operations or financial condition. The Company's current export sales are denominated in United States dollars. To the extent that international sales continue to be denominated in United States dollars, an increase in the value of the United States dollar relative to other currencies could make the Company's products and services more expensive and, therefore, potentially less competitive in international markets. 25 CONCORD COMMUNICATIONS, INC. FORM 10-Q, MARCH 31, 2002 PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is not a party to any litigation that it believes could have a material adverse effect on the business, results of operations and financial condition of the Company. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (a) Issuance of Securities On February 4, 2000, the Company completed a merger with FirstSense Software, Inc. The Company has reserved for issuance in connection with the merger, 1,940,000 shares of Concord Common Stock. The Company issued the shares in a private placement transaction pursuant to Section 4(2) under the Securities Act of 1933. The merger was accounted for as a pooling of interests. The Company has filed a Form S-3 Registration Statement to cover the resale of the securities issued in the merger. (b) Use of Proceeds On October 16, 1997, the Company commenced an initial public offering ("IPO") of 2,900,000 shares of common stock, par value $.01 per share (the "Common Stock"), of the Company pursuant to the Company's final prospectus dated October 15, 1997 (the "Prospectus"). The Prospectus was contained in the Company's Registration Statement on Form S-1, which was declared effective by the Securities and Exchange Commission (SEC File No. 333-33227) on October 15, 1997. Of the 2,900,000 shares of Common Stock offered, 2,300,000 shares were offered and sold by the Company and 600,000 shares were offered and sold by certain shareholders of the Company. As part of the IPO, the Company granted the several underwriters an overallotment option to purchase up to an additional 435,000 shares of Common Stock (the "Underwriters' Option"). The IPO closed on October 21, 1997 upon the sale of 2,900,000 shares of Common Stock to the underwriters. On October 24, 1997, the Representatives, on behalf of the several underwriters, exercised the Underwriters' Option, purchasing 435,000 additional shares of Common Stock from the Company. The aggregate offering price of the shares of Common stock in the IPO to the public was $40,600,000 (exclusive of the Underwriters' Option), with proceeds to the Company and selling shareholders, after deduction of the underwriting discount, of $29,946,000 (before deducting offering expenses payable by the Company) and $7,812,000 respectively. The aggregate offering price of the Underwriters' Option exercised was $6,090,000, with proceeds to the Company, after deduction of the underwriting discount, of $5,663,700 (before deducting offering expenses payable by the Company). The aggregate amount of expenses incurred by the Company in connection with the issuance and distribution of the shares of Common Stock offered and sold in the IPO were approximately $3.6 million, including $2.7 million in underwriting discounts and commissions and $950,000 in other offering expenses. The net proceeds to the Company from the IPO, after deducting underwriting discounts and commissions and other offering expenses were approximately $34.7 million. To date, the Company has not utilized any of the net proceeds from the IPO. The Company has invested all such net proceeds primarily in US treasury obligations and other interest bearing investment grade securities. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable 26 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable ITEM 5. OTHER INFORMATION Not Applicable ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits - None 27 CONCORD COMMUNICATIONS, INC. FORM 10-Q, MARCH 31, 2002 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. Concord Communications, Inc. /s/ Melissa H. Cruz ------------------------------------------ April 23, 2002 Name: Melissa H. Cruz Title: Executive Vice President of Business Services and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) 28