-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Cw4oZCzr9+j9qm8U+VV95kzX4/NCFXf6XLUj1bDb60YogG7lfEI97C6/nY6cd2TA MMWOoJ5m5knbIN719zIF2Q== 0000950135-99-005287.txt : 19991117 0000950135-99-005287.hdr.sgml : 19991117 ACCESSION NUMBER: 0000950135-99-005287 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990930 FILED AS OF DATE: 19991115 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CONCORD COMMUNICATIONS INC CENTRAL INDEX KEY: 0000915290 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 042710876 STATE OF INCORPORATION: MA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-23067 FILM NUMBER: 99756647 BUSINESS ADDRESS: STREET 1: 600 NICKERSON RD CITY: MARLBORO STATE: MA ZIP: 01752 BUSINESS PHONE: 508-460-4646 MAIL ADDRESS: STREET 1: 600 NICKERSON RD CITY: MARLBORO STATE: MA ZIP: 01752 10-Q 1 CONCORD COMMUNICATIONS INC 9/30/99 1 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 September 30, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ to ______________ COMMISSION FILE NUMBER 0-23067 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 14,351,553 SHARES OF THE REGISTRANT'S COMMON STOCK, $0.01 PAR VALUE, WERE OUTSTANDING AS OF OCTOBER 31, 1999. THIS DOCUMENT CONTAINS 24 PAGES. THE EXHIBIT INDEX IS ON PAGE 23. 2 CONCORD COMMUNICATIONS, INC. FORM 10-Q, SEPTEMBER 30, 1999 CONTENTS Item Number Page PART I: FINANCIAL INFORMATION Item 1. Financial Statements Balance sheets: September 30, 1999 and December 31, 1998 3 Statements of operations: Three and nine months ended September 30, 1999 and September 30, 1998 4 Statements of cash flows: Nine months ended September 30, 1999 and September 30, 1998 5 Notes to financial statements 6-7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8-18 Item 3. Quantitative and Qualitative Disclosures about Market Risk 19 PART II: OTHER INFORMATION Item 1. Legal Proceedings 20 Item 2. Changes in Securities and Use of Proceeds 20 Item 3. Defaults Upon Senior Securities 20 Item 4. Submission of Matters to a Vote of Security Holders 20 Item 5. Other Information 21 Item 6. Exhibits and Reports on Form 8-K 21 SIGNATURE 22 EXHIBIT INDEX 23 2 3 PART I: FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONCORD COMMUNICATIONS, INC. BALANCE SHEETS SEPTEMBER 30, DECEMBER 31, 1999 1998 ------------ ------------ ASSETS Current Assets: Cash and cash equivalents .......................... $ 6,181,221 $11,164,349 Marketable securities .............................. 54,523,521 39,237,680 Accounts receivable, net of allowance of approximately $660,000 and $450,000, respectively . 9,838,566 5,048,879 Prepaid expenses and other current assets .......... 910,159 509,805 ----------- ----------- Total current assets ............................. 71,453,467 55,960,713 ----------- ----------- Equipment and Improvements, at cost: Equipment .......................................... 6,057,544 3,701,266 Leasehold improvements ............................. 2,926,921 385,128 ----------- ----------- 8,984,465 4,086,394 Less-- Accumulated depreciation and amortization .. 2,573,843 1,365,222 ----------- ----------- 6,410,622 2,721,172 ----------- ----------- $77,864,089 $58,681,885 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable.................................... $ 3,437,644 $ 3,553,673 Accrued expenses.................................... 7,231,241 4,086,983 Deferred revenue.................................... 7,520,716 5,296,469 ----------- ----------- Total current liabilities................... 18,189,601 12,937,125 ----------- ----------- Stockholders' Equity: Preferred stock, $.01 par value -- Authorized -- 1,000,000 shares no shares issued or outstanding Common stock, $.01 par value -- -- -- Authorized -- 50,000,000 shares Issued and outstanding -- 13,484,031 and 13,040,374 shares, respectively.................... 134,677 130,405 Additional paid-in capital...................... 76,383,071 69,938,129 Deferred compensation........................... (65,213) (101,189) Accumulated other comprehensive income.......... (875,806) 149,606 Accumulated deficit............................. (15,902,241) (24,372,191) ----------- ----------- Total stockholders' equity ................. 59,674,488 45,744,760 ----------- ----------- $77,864,089 $58,681,885 =========== =========== The accompanying notes are an integral part of these financial statements. 3 4 CONCORD COMMUNICATIONS, INC. STATEMENTS OF OPERATIONS
THREE MONTHS ENDED NINE MONTHS ENDED ---------------------------- ---------------------------- SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 1999 1998 1999 1998 ----------- ----------- ----------- ----------- Revenues: License revenues........... $13,085,991 $ 8,871,444 $35,943,156 $22,076,035 Service revenues........... 3,930,607 1,724,165 9,663,289 4,120,085 ----------- ----------- ----------- ----------- Total revenues............ 17,016,598 10,595,609 45,606,445 26,196,120 Cost of Revenues............ 2,302,878 1,199,744 5,827,347 3,052,002 ----------- ----------- ----------- ----------- Gross profit.............. 14,713,720 9,395,865 39,779,098 23,144,118 ----------- ----------- ----------- ----------- Operating Expenses: Research and development... 2,887,207 1,871,055 7,513,001 5,086,423 Sales and marketing........ 6,332,727 4,647,777 18,239,826 12,093,884 General and administrative. 1,008,919 778,287 2,607,285 1,945,105 ----------- ----------- ----------- ----------- Total operating expenses... 10,228,853 7,297,119 28,360,112 19,125,412 ----------- ----------- ----------- ----------- Operating income.......... 4,484,867 2,098,746 11,418,986 4,018,705 ----------- ----------- ----------- ----------- Other Income (Expense): Interest income............ 802,488 572,814 2,267,940 1,677,628 Interest expense........... -- -- -- (514) Other...................... (11,920) (14,919) (20,975) (54,460) ----------- ----------- ----------- ----------- Total other income........ 790,568 557,895 2,246,964 1,622,654 ----------- ----------- ----------- ----------- Income before income taxes 5,275,435 2,656,641 13,665,590 5,641,359 Provision for income taxes. 2,008,000 213,800 5,196,000 213,800 ----------- ----------- ----------- ----------- Net income................ $ 3,267,435 $ 2,442,841 $ 8,469,950 $ 5,427,559 =========== =========== =========== =========== Net income per common and potential common share: Basic $ 0.24 $ 0.19 $ 0.64 $ 0.43 =========== =========== =========== =========== Diluted $ 0.23 $ 0.17 $ 0.59 $ 0.39 =========== =========== =========== =========== Weighted average common and potential common shares outstanding: Basic 13,458,074 12,790,004 13,320,566 12,526,567 =========== =========== =========== =========== Diluted 14,307,794 14,135,361 14,314,721 14,018,940 =========== =========== =========== ===========
The accompanying notes are an integral part of these financial statements. 4 5 CONCORD COMMUNICATIONS, INC. STATEMENTS OF CASH FLOWS NINE MONTHS ENDED -------------------------- SEPTEMBER 30, SEPTEMBER 30, 1999 1998 ------------ ----------- Cash Flows from Operating Activities: Net income $ 8,469,950 $ 5,427,559 Adjustments to reconcile net income to net cash provided by operations: Depreciation and amortization 219,185 757,354 Changes in current assets and liabilities: Accounts receivable (4,789,687) (1,364,943) Prepaid expenses and other current assets (400,354) (414,332) Accounts payable (116,029) 1,797,488 Accrued expenses 3,144,258 (236,618) Deferred revenue 2,224,247 1,942,600 ------------ ----------- Net cash provided by operating activities 8,751,570 7,909,108 ------------ ----------- Cash Flows from Investing Activities: Purchases of marketable securities (184,753,484) (29,550,566) Sales of marketable securities 169,467,643 21,066,337 Purchases of equipment and improvements (4,898,071) (949,914) ------------ ----------- Net cash used in investing activities (20,183,912) (9,434,143) ------------ ----------- Cash Flows from Financing Activities: Proceeds from exercise of stock options 6,449,214 741,854 ------------ ----------- Net Decrease in Cash and Cash Equivalents (4,983,128) (783,181) Cash and Cash Equivalents, beginning of period 11,164,349 7,858,186 ------------ ----------- Cash and Cash Equivalents, end of period $ 6,181,221 $ 7,075,005 ============ =========== Supplemental Disclosure of Cash Flow Information: Cash paid for taxes $ 226,180 $ -- ============ =========== Supplemental Disclosure of Noncash Transactions: Unrealized (loss) gain on available-for-sale $ (1,025,412) $ 316,317 ============ =========== Tax benefit associated with employee stock options $ 5,000,000 $ -- ============ =========== Retirement of fully depreciated fixed assets $ -- $ 4,330,000 ============ =========== The accompanying notes are an integral part of these financial statements. 5 6 CONCORD COMMUNICATIONS, INC. NOTES TO FINANCIAL STATEMENTS FORM 10-Q, SEPTEMBER 30, 1999 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1. INTERIM FINANCIAL STATEMENTS The accompanying financial statements have been presented by Concord Communications, Inc., (the "Company") without audit (except that the balance sheet information as of December 31, 1998 has been derived from audited financial statements) in accordance with generally accepted accounting principles 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 generally accepted accounting principles 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 September 30, 1999 and December 31, 1998, and results of operations for the three and nine months ended September 30, 1999 and 1998. 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 1998 Annual Report on Form 10-K filed with the Securities and Exchange Commission in March 1999. 2. NET INCOME PER SHARE The Company follows the provisions of SFAS No. 128, Earnings Per Share, effective December 15, 1997. 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. The dilutive effect of potential common shares for the nine months ended September 30, 1999 and September 30, 1998, consisting of outstanding stock options, is determined using the treasury method. Calculations of basic and diluted net income per common share and potential common share are as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 1999 1998 1999 1998 ----------- ----------- ----------- ----------- Net income $ 3,267,435 $ 2,442,841 $ 8,469,950 $ 5,427,559 =========== =========== =========== =========== Weighted average common shares outstanding 13,458,074 12,790,004 13,320,566 12,526,567 Potential common shares pursuant to stock options 849,720 1,345,357 994,155 1,492,373 ----------- ----------- ----------- ----------- Diluted weighted average shares 14,307,794 14,135,361 14,314,721 14,018,940 =========== =========== =========== =========== Basic net income per common share $ 0.24 $ 0.19 $ 0.64 $ 0.43 =========== =========== =========== =========== Diluted net income per common and potential common share $ 0.23 $ 0.17 $ 0.59 $ 0.39 =========== =========== =========== ===========
3. COMPREHENSIVE INCOME The Company follows the provisions of SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. The statement is effective for fiscal years beginning after December 15, 1997 and the Company has adopted the statement in its quarter ended March 31, 1998. Comprehensive income for the three and nine months ended September 30, 1999 and 1998 is as follows:
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, 1999 1998 1999 1998 ---------- ---------- ---------- ---------- Net income $3,267,435 $2,442,841 $8,469,950 $5,427,559 Unrealized (loss) gain on marketable securities (142,261) 298,924 (1,025,412) 325,317 ---------- ---------- ---------- ---------- Comprehensive income $3,125,174 $2,741,765 $7,444,538 $5,752,876 ========== ========== ========== ==========
6 7 4. COMMITMENTS In March, 1999 the Company signed a 7 year operating lease for its principal operating facilities. Aggregate rental payments under the lease will be $12.0 million. Following the abandonment of the Company's existing office space, the Company recorded a third quarter charge of $700,000, representing the remaining lease commitment, less expected sublease income. 5. TAX PROVISION The Company has recorded a tax provision of $5.2 million in the nine months ended September 30, 1999, based on its effective tax rate for 1999, computed in accordance with SFAS No. 109, Accounting for Income Taxes. Pursuant to SFAS No. 109, the Company has recorded the tax benefit associated with the exercise and subsequent disqualifying disposition of incentive stock options by the Company's employees (approximately $5.0 million) as a component of additional paid in capital. 6. ACQUISITION OF EMPIRE TECHNOLOGIES On October 19, 1999, Concord Communications, Inc., a Massachusetts corporation ("Concord" or the "Company"), entered into an Agreement and Plan of Reorganization (the "Merger Agreement") providing for the merger (the "Merger") of E Acquisition Corp., a Georgia corporation and wholly-owned subsidiary of the Company ("Merger Sub") with and into Empire Technologies, Inc. ("Empire"). the merger was effected on October 29, 1999 (the "Effective Date") pursuant to a Certificate of Merger filed with the Secretary of State of the State of Georgia on that date. Pursuant to the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of the common stock, no par value per share, of Empire (the "Empire Common Stock") was converted into 815,248 shares (the "Conversion Ratio") of the common stock, $.01 par value per share, of the Company (the "Concord Common Stock"). Since there were 1,000 outstanding shares of Empire Common Stock immediately prior to the effective time of the Merger, Concord issued an aggregate of 815,248 shares of Concord Common Stock to the stockholders of Empire in the Merger in a private placement transaction pursuant to Section 4(2) under the Securities Act of 1933. Empire is a leading provider of solutions for proactive self-management of UNIX and Windows NT systems, as well as mission-critical applications. The merger was accounted for as a pooling of interests. Because the acquisition occurred after September 30, 1999, the financial statements herein do not reflect the restatement of the Company's historical statements. The following table sets forth certain proforma statement of operations data as if the combination had occurred on September 30, 1999:
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, 1999 1998 1999 1998 ----------- ----------- ----------- ----------- Revenue Concord Communications, Inc. $17,016,598 $10,595,609 $45,606,445 $26,196,120 Empire Technologies, Inc. 1,324,877 591,559 2,580,802 1,435,753 ----------- ----------- ----------- ----------- Total $18,341,475 $17,608,157 $48,187,247 $27,631,873 =========== =========== =========== =========== Net Income Concord Communications, Inc. $ 3,400,595 $ 2,442,841 $ 8,603,110 $ 5,427,559 Empire Technologies, Inc. 319,640 149,379 735,197 1,112,006 ----------- ----------- ----------- ----------- Total $ 3,720,235 $ 2,592,220 $ 9,338,307 $ 6,539,565 =========== =========== =========== =========== Net income per common and potential common share: Basic $ 0.26 $ 0.19 $ 0.66 $ 0.49 =========== =========== =========== =========== Diluted $ 0.25 $ 0.17 $ 0.62 $ 0.44 =========== =========== =========== =========== Weighted average common and potential common shares outstanding: Basic 14,273,322 13,605,252 14,135,814 13,341,815 =========== =========== =========== =========== Diluted 15,123,042 14,950,609 15,129,969 14,834,188 =========== =========== =========== ===========
7 8 CONCORD COMMUNICATIONS, INC. FORM 10-Q, SEPTEMBER 30, 1999 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company develops, markets and supports a family of turnkey, automated, scalable, Web-based performance analysis and reporting solutions for the management of computer networks. Substantially all of the Company's revenues are derived from the Network Health product family which began shipping in the first quarter of 1995. The Company does not provide forecasts of its future financial performance. From time to time, however, the information provided by the Company or statements made by its employees may contain forward looking statements. In particular, some statements contained in this Form 10-Q and the Company's Annual Report and Form 10-K, for the fiscal year ended December 31, 1998, are not historical statements (including, but not limited to, statements concerning the plan and objectives of management; increases in sales and marketing, research and development and general and administrative expenses; expenses associated with Year 2000 and the Company'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 and other risks detailed in the Company's filings with the Securities and Exchange Commission. RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain financial data as percentages of the Company's total revenue:
THREE MONTHS ENDED NINE MONTHS ENDED ------------------------------ ------------------------------ SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 1999 1998 1999 1998 Revenues: License revenues 76.9% 83.7% 78.8% 84.3% Service revenues 23.1% 16.3% 21.2% 15.7% ---- ---- ---- ---- Total revenues 100.0% 100.0% 100.0% 100.0% Cost of revenues 13.5% 11.3% 12.8% 11.7% ---- ---- ---- ---- Gross profit 86.5% 88.7% 87.2% 88.3% Operating expenses: Research and development 17.0% 17.7% 16.5% 19.4% Sales and marketing 37.2% 43.9% 40.0% 46.2% General and administrative 5.9% 7.3% 5.7% 7.4% ---- ---- ---- ---- Income from operations 26.4% 19.8% 25.0% 15.3% ---- ---- ---- ---- Other income, net 4.6% 5.3% 5.0% 6.2% ---- ---- ---- ---- Income before income taxes 31.0% 25.1% 30.0% 21.5% ---- ---- ---- ---- Provision for income taxes 11.8% 2.0% 11.4% 0.8% ---- ---- ---- ---- Net income 19.2% 23.1% 18.6% 20.7% ---- ---- ---- ----
8 9 REVENUES. 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. 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. In 1999, software license revenues are recognized in accordance with SOP 97-2, as modified by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition with respect to Certain Transactions. 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. International Revenues. The Company recognized $2.8 million and $2.2 million of revenues from international locations in the three months ended September 30, 1999 and 1998, representing 16.7% and 20.5% of total revenues, respectively. The Company recognized $7.8 million and $4.6 million of revenues from international locations in the nine months ended September 30, 1999 and 1998, representing 17.2% and 17.5% of total revenues, respectively. The Company's revenues from international locations were primarily generated from customers located in Europe. Revenues from customers located in Europe accounted for 13.2% and 14.3% of total revenues in the three months ended September 30, 1999 and 1998, respectively. Revenues from customers located in Europe accounted for 13.6% and 12.6% of total revenues in the nine months ended September 30, 1999 and 1998, respectively. The continued increase in revenues from international locations is primarily the result of the Company's expansion of its operations outside the United States which has included both the hiring of additional personnel as well as the establishment of additional reseller agreements. The Company believes that continued growth and profitability will require further expansion of its sales in international markets. The Company expects to commit additional time and development resources to customizing its products and services for selected international markets. TOTAL REVENUES. The Company's total revenues increased 60.6% to $17.0 million in the three months ended September 30, 1999 from $10.6 million in the three months ended September 30, 1998. The Company's total revenues increased 74.1% to $45.6 million in the nine months ended September 30, 1999 from $26.2 million in the nine months ended September 30, 1998. LICENSE REVENUES. The Company's license revenues are derived from the licensing of software products. License revenues increased 67.8% to $13.1 million, or 76.9% of total revenues, in the three months ended September 30, 1999 from $8.9 million, or 83.7% of total revenues, in the three months ended September 30, 1998. License revenues increased 62.8% to $35.9 million, or 78.8% of total revenues, in the nine months ended September 30, 1999 from $22.1 million, or 84.3% of total revenues, in the nine months ended September 30, 1998. The increase in license revenues resulted from increased sales to new customers and additional sales to existing customers for new products and upgrades of existing licenses. SERVICE REVENUES. The Company's service revenues consist of fees for maintenance, training and professional services. Service revenues increased 128.0% to $3.9 million, or 23.1% of total revenues, in the three months ended September 30, 1999 from $1.7 million, or 16.3% of total revenues, in the three months ended September 30, 1998. Service revenues increased 134.5% to $9.7 million, or 21.2% of total revenues, in the nine months ended September 30, 1999 from $4.1 million, or 15.7% of total revenues, in the nine months ended September 30, 1998. The increase in service revenues was attributed to an increase in revenue from maintenance contracts, training and professional services for new and existing customers. 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 and professional service contracts. Royalty costs are comprised of third party software costs. Cost of revenues increased 91.9% to $2.3 million, or 13.5% of total revenues, in the three months ended September 30, 1999 from $1.2 million, or 11.3% of total revenues, in the three months ended September 30, 1998, resulting in gross margins of 86.5% and 88.7% in each respective period. Cost of revenues increased 90.9% to $5.8 million, or 12.8% of total revenues, in the nine months ended September 30, 1999 from $3.1 million, or 11.7% of total revenues, in the nine months ended September 30, 1998, resulting in gross margins of 87.2% and 88.3% in each respective period. The increase in cost of revenues was primarily the result of increased spending in customer support to be more responsive to a growing customer base. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses consist primarily of personnel costs associated with software development. Research and development expenses increased 54.3% to $2.9 million, or 17.0% of total 9 10 revenues, in the three months ended September 30, 1999 from $1.9 million, or 17.7% of total revenues, in the three months ended September 30, 1998. Research and development expenses increased 47.7% to $7.5 million, or 16.5% of total revenues, in the nine months ended September 30, 1999 from $5.1 million, or 19.4% of total revenues, in the nine months ended September 30, 1998. The increase in absolute dollars was primarily due to the use of outside contractors for consulting and recruiting along with increased headcount in research and development from 48 to 65 for the period from September 30, 1998 to September 30, 1999. The Company's product architecture and higher revenue base have allowed the Company to introduce new products at lower incremental costs thereby reducing research and development expenses as a percentage of revenues. The Company anticipates that it will continue to commit substantial resources to research and development in the future and that product development expenses may increase in absolute dollars in future periods. 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 increased 36.3% to $6.3 million, or 37.2% of total revenues, in the three months ended September 30, 1999 from $4.6 million, or 43.9% of total revenues, in the three months ended September 30, 1998. Sales and marketing expenses increased 50.8% to $18.2 million, or 40.0% of total revenues, in the nine months ended September 30, 1999 from $12.1 million, or 46.2% of total revenues, in the nine months ended September 30, 1998. The increase in absolute dollars was primarily the result of increased headcount to continue to build the direct sales force along with additional marketing and promotional activities to penetrate the market. The decline in sales and marketing expenses as a percentage of total revenues is due to sales productivity improvements resulting from the expansion of the Network Health product family, increased revenues from existing customers, improved lead generation and reduced sales cycles. Headcount in sales and marketing increased from 62 to 103 people from September 30, 1998 to September 30, 1999. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses consist primarily of salaries for financial, administrative and management personnel and related travel expenses, as well as legal and accounting expenses. General and administrative expenses increased 29.6% to $1.0 million, or 5.9% of total revenues, in the three months ended September 30, 1999 from $778,000, or 7.3% of total revenues, in the three months ended September 30, 1998. General and administrative expenses increased 34.0% to $2.6 million, or 5.7% of total revenues, in the nine months ended September 30, 1999 from $1.9 million, or 7.4% of total revenues, in the nine months ended September 30, 1998. The increase in absolute dollars is associated with an increase of costs in general support areas. Headcount in general and administrative functions increased from 13 to 18 people from September 30, 1998 to September 30, 1999. General and administrative expenses declined as a percentage of total revenues during the 1999 period due to a significant increase in revenues during that period. OTHER INCOME. Other income consists of interest earned on funds available for investment. The Company had net other income of $790,000 for the three months ended September 30, 1999 and net other income of $558,000 for the three months ended September 30, 1998. The Company had net other income of $2.2 million for the nine months ended September 30, 1999 and net other income of $1.6 million for the nine months ended September 30, 1998. The increase in net other income is attributed to the investment of cashflows from the Company's operations. LIQUIDITY AND CAPITAL RESOURCES The Company financed its operations, prior to its initial public offering, primarily through the private sale of equity securities and a credit line for equipment purchases. On October 24, 1997, the Company completed its initial public offering of 3,335,000 shares of Common Stock at a price of $14.00 per share. Of these shares, 2,735,000 were issued by the Company and 600,000 were sold by selling shareholders. The Company received net proceeds of approximately $34.7 million. The Company had working capital of $53.3 million at September 30, 1999. Net cash provided by operating activities was $8.8 million and $7.9 million for the nine months ended September 30, 1999 and 1998, respectively. Cash, cash equivalents and marketable securities were $60.7 million and $44.6 million at September 30, 1999 and 1998, respectively. Deferred revenues increased for the nine months ended September 30, 1999 by $2.2 million due to an increase in overall sales activity; the increase consisted of $2.5 million from deferred maintenance contracts and a decrease of $318,000 from service and software license sales with remaining contingencies such as completion of services, product acceptance and credit worthiness. Investing activities have consisted of the acquisition of property and equipment, most notably computer and networking equipment to support the growing employee base and 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 10 11 relatively short duration that trade in highly liquid markets. Financing activities consisted primarily of the issuance of common stock and exercise of options during the nine months ended September 30, 1999 and 1998. Pursuant to the Tax Reform Act of 1986, the utilization of net operating loss 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. As a result of the Company's 1995 preferred stock financings, such a change in ownership has occurred. As a result of this ownership change, the use of the net operating loss carryforwards is limited. The Company has determined that its initial public offering did not cause another ownership change. The Company has deferred tax assets of approximately $17.3 million composed primarily of net operating loss carryforwards and research and development credits. The Company has fully reserved for these deferred tax assets by recording a valuation allowance of $17.3 million, as the Company believes that it is more likely than not that it will not be able to realize this asset. Pursuant to paragraphs 20 to 25 of Statement of Financial Accounting Standards (SFAS) No. 109, the Company considered both positive and negative evidence in assessing the need for a valuation allowance at December 31, 1997 and 1998. The factors that weighed most heavily on the Company's decision to record a full valuation allowance were (i) the Company's history of losses, (ii) the substantial restrictions on the use of its existing net operation loss (NOL) carryforwards and (iii) the uncertainty of future profitability. As a result of the ownership change described above, the future use of approximately $16.6 million of the Company's NOL carryforwards are limited to only $330,000 per year; the substantial majority of such NOL carryforwards will expire before they can be used. Pursuant to the provisions of SFAS No. 109, the Company used all of its remaining unrestricted NOL and credit carryforwards in computing the 1998 tax provision. The Company is also subject to rapid technology 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 fiscal year ended December 31, 1998. The Company's dependence on a single product family in an emerging market makes the prediction of future results difficult, if not impossible, especially in the highly competitive software industry. As a result, the Company found the evidence described above to be the most reliable objective evidence available in determining that a full valuation allowance against its tax assets would be necessary. The Company's net operating loss deferred tax asset includes approximately $8.9 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. The Company received a tax benefit of approximately $5.0 million pursuant to the exercise of employee stock options. The Company recorded this benefit as a component of additional paid in capital for the period ended September 30, 1999. 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. As of September 30, 1999, the Company's principal sources of liquidity included cash and marketable securities. The Company believes that its current cash and market securities and cash provided by future operations will be sufficient to meet its working capital and anticipated capital expenditure requirements for the next 12 months. Although operating activities may provide cash in certain periods, to the extent the Company experiences growth in the future, its operating and investing activities may require significant cash. Consequently, any such future growth may require the Company to obtain additional equity or debt financing. YEAR 2000 COMPLIANCE / YEAR 2000 READINESS DISCLOSURE STATEMENT The company is aware of the issues associated with the programming code in existing computer systems and software products as the millennium (Year 2000) approaches. The Company has set up a task force, which consists of the Director of Information Technology (IT) and Operations, the Manager of System Applications and representative personnel from each functional area. This task force is addressing the Year 2000 issue in the following categories: the Network Health product; internal business computer systems and software applications; internal systems other than computer hardware and software; and systems of the Company's external suppliers and service providers. The Company is also assessing its Year 2000 associated costs, risks and potential contingency plans. Despite the Company's efforts with respect to the Year 2000 issue, there can be no assurance that the Company's business, results of operations or financial condition would not be materially adversely affected by the failure of the Company's 11 12 products, its internal systems and applications or the systems of its third party suppliers and service providers to properly operate or manage data beyond 1999. NETWORK HEALTH PRODUCT. In 1997, the Company initiated the necessary development to ensure Year 2000 compliance in the Network Health family of applications and believes it has achieved Year 2000 compliance in Network Health 4.1, which was released in August 1998. The Company's existing customers can receive this release and future releases, at no charge, through their annual software maintenance contract. The Company requires its customers to purchase software maintenance in order to receive product support. Specifically, the Company defines Year 2000 Compliance as the following: no value for current date will cause any interruption in operation; date-based functionality must behave consistently for dates prior to, during, and after Year 2000; in all interfaces and data storage, the century in any date must be specified either explicitly or by unambiguous algorithms or inferencing rules; Year 2000 must be recognized as a leap year. The Company's definition of Year 2000 Compliance is adopted from the British Standard Institute's Definition of Year 2000 Conformity Requirements (PD2000-1). A copy of the standard is available for review on the Company's website. The Company makes no guarantee of, claims no responsibility for and disclaims any liability to its customers, with respect to Year 2000 compliance of operating platforms, hardware, software or other products not developed by the Company, including equipment monitored by the Network Health product. INTERNAL BUSINESS COMPUTER SYSTEMS AND SOFTWARE APPLICATIONS. In 1998, the Company commenced a Year 2000 date conversion project to address all internal existing computer systems, software applications and related computer equipment (e.g. printers) used in conjunction with its internal operations. The Company plans to identify, modify, upgrade and/or replace any systems that have been identified as non-Year 2000 compliant to minimize the possibility of a material disruption to it business. The Company has finished assessing all existing internal systems and expects to complete the compliance process on these systems before the end of 1999. INTERNAL SYSTEMS OTHER THAN COMPUTER HARDWARE AND SOFTWARE. The operation of office and facilities equipment such as fax machines, photocopiers, telephone switches, security systems, elevators, and other common devices may also be affected by the Year 2000 issue. The Company has identified and assessed its options to remediate, the Year 2000 issue on its office and facilities equipment. The Company expects to complete any needed modifications and upgrades on its office and facilities equipment before the end of 1999. SYSTEMS OF EXTERNAL SUPPLIERS AND SERVICE PROVIDERS. The Company has initiated communications with third party suppliers of the computers, software and other equipment used, operated or maintained by the Company to identify and, to the extent possible, to resolve any issues regarding the Year 2000 issue. The Company has also initiated communications with facilities service providers upon which the Company relies for daily operations. All external suppliers and service providers have been asked to provide a written assurance that they are also preparing to be Year 2000 compliant in a timely manner, and that their products/services will be available to the Company up to and beyond the Year 2000, without interruption. A response has been received from 100% of these suppliers and service providers. However, there can be no assurance that the systems operated by other companies upon which the Company relies will be Year 2000 compliant on a timely basis. ASSOCIATED COSTS. To date, the Company has not incurred any material costs related to the assessment of, and efforts to upgrade or replace existing systems identified as non-Year 2000 compliant. Management is continuing to assess the total Year 2000 compliance expense, but based on a review to date, does not expect the amounts required to be expensed over the balance of 1999 to have an adverse material effect on its business, results of operations or financial condition. There can be no assurance, however, that further assessment of the Company's internal systems and applications will not indicate that additional Company efforts to assure Year 2000 compliance are necessary, and that such efforts may be costly. ASSOCIATED RISKS. The Company expects to identify and resolve all Year 2000 issues that could materially adversely affect its business, financial condition or results of operations. However, management realizes it may not be possible to determine with complete certainty that all Year 2000 problems affecting the Company will be identified or corrected in a timely manner. As a result, the Company could be at risk of experiencing a significant number of operational inconveniences and inefficiencies that may divert management's time and attention from its ordinary business activities and at risk of experiencing a lesser number of serious system or product failures that may require significant efforts by the Company to prevent or alleviate material business disruptions. CONTINGENCY PLANS. The Company recognizes the importance of readiness for potential worst case scenarios. As a result, the Company is working to identify scenarios with significant risks, which would require contingency plans. The Company has begun to develop and expects to complete any needed contingency plans no later than the fall of 1999. 12 13 CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS The Company does not provide forecasts of the future financial performance of the Company. From time to time, however, the information provided by the Company or statements made by its employees may contain forward looking statements. 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. 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 and general and administrative expenses; expenses associated with Year 2000 and the Company's expected liquidity and capital resources) constitute forward-looking statements. The Company'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, and the other risks discussed in the Company's 1998 Annual Report on Form 10-K filed with the Securities and Exchange Commission in March 1999. LIMITED OPERATING HISTORY; UNCERTAINTY OF FUTURE OPERATING RESULTS The Company changed its focus to network management software in 1991 and commercially introduced its first Network Health product in 1995. Accordingly, the Company has only a limited operating history in the network performance analysis and reporting market upon which an evaluation of its business and prospects can be based. The Company has incurred significant net losses in each of the last five fiscal years preceding fiscal year 1997. As of September 30, 1999, the Company had accumulated net losses of $14.0 million. The limited operating history of the Company and its dependence on a single product family in an emerging market makes the prediction of future results of operations difficult or impossible, and the Company and its prospects must be considered in light of the risks, costs and difficulties frequently encountered by emerging companies, particularly companies in the competitive software industry. Although the Company has achieved recent revenue growth, and profitability for the fiscal years ended 1998 and 1997, there can be no assurance that the Company can generate substantial additional revenue growth on a quarterly or annual basis, or that any revenue growth that is achieved can be sustained. Revenue growth that the Company has achieved or may achieve may not be indicative of future operating results. In addition, the Company has increased, and plans to increase further, its operating expenses in order to fund higher levels of research and development, increase its sales and marketing efforts, develop new distribution channels, broaden its customer support capabilities and expand its administrative resources in anticipation of future growth. To the extent that increases in such expenses precede or are not subsequently followed by increased revenues, the Company's business, results of operations and financial condition would be materially adversely affected. There can be no assurance that the Company will sustain profitability on a quarterly or annual basis. The Company must achieve substantial revenue growth in order to sustain profitability. In addition, in view of recent revenue growth, the rapidly evolving nature of its business and markets and its limited operating history in its current market, the Company believes that period-to-period comparisons of financial results are not necessarily meaningful and should not be relied upon as an indication of future performance. In light of the Company's strong performance to date in 1999, the Company recorded a tax provision of $5.2 million in the nine months ended September 30, 1999. POTENTIAL FLUCTUATIONS IN QUARTERLY OPERATING RESULTS The Company is likely to experience significant fluctuations in quarterly operating results caused by many factors, including, but not limited to: (i) changes in the demand for the Company's products; (ii) the timing, composition and size of orders from the Company's customers, including the tendency for significant bookings to occur in the last month of each fiscal quarter; (iii) spending patterns and budgetary resources of its customers on network management software solutions; (iv) the success of the Company's new customer generation activities; (v) introductions or enhancements of products, or delays in the introductions or enhancements of products, by the Company or its competitors; (vi) changes in the Company's pricing policies or those of its competitors; (vii) changes in the distribution channels through which products are sold; (viii) the Company's ability to anticipate and effectively adapt to developing markets and rapidly changing technologies; (ix) changes in networking or communications technologies; (x) the Company's ability to attract, retain and motivate qualified personnel; (xi) changes in the mix of products sold; (xii) the publication of opinions about the Company and its products, or its competitors and their products, by industry analysts or others; and (xiii) changes in general economic conditions. Unlike other software companies with a longer history of operations, the Company does not derive a significant portion of its revenues from maintenance contracts, and therefore does not have a significant ongoing revenue stream that may tend to mitigate quarterly fluctuations in operating results. Furthermore, the Company is attempting to expand its channels of distribution, and increases in the Company's revenues will be dependent on its ability to implement successfully its distribution strategy. Due to the buying patterns of certain of the Company's customers and also to the Company's own sales incentive programs 13 14 focused on annual sales goals, revenues in the Company's fourth quarter could be higher than revenues in the first quarter of the succeeding year. There also may be other factors that significantly affect the Company's quarterly results which are difficult to predict given the Company's limited operating history, such as seasonality and the timing of receipt and delivery of orders within a fiscal quarter. Consistent with software industry practice, the Company expects to operate with a limited amount of backlog. As a result, 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 the ability of the Company to fill orders received within the quarter, all of which are difficult to forecast and manage. The Company's expense levels are based in part on its expectations of future orders and sales, which, given the Company's limited operating history, are extremely difficult to predict. A substantial portion of the Company's operating expenses are related to personnel, facilities, and sales and marketing programs. This level of spending for such expenses cannot be adjusted quickly and is, therefore, relatively fixed in the short term. Accordingly, any significant shortfall in demand for the Company's products in relation to the Company's expectations would have an immediate and material adverse effect on the Company's business, results of operations and financial condition. Due to all of the foregoing factors, the Company believes that its quarterly operating results are likely to vary significantly in the future. Therefore, in some future quarter the Company's results of operations may fall below the expectations of securities analysts and investors. In such event, the trading price of the Company's Common Stock would likely be materially adversely affected. EMERGING NETWORK MANAGEMENT SOFTWARE MARKET The market for the Company's products is in an early stage of development. Although the rapid expansion and increasing complexity of computer networks in recent years has increased the demand for network management software products, the awareness of and the need for such products is a recent development. Because the market for these products 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 the Company's growth will be significantly dependent on the willingness of network service providers, including telecommunications carriers, internet service providers, systems integrators and outsourcers, to integrate network performance analysis and reporting software into their product and service offerings. Failure of the network performance analysis and reporting market to grow or failure of the Company to properly assess and address such market would have a material adverse effect on the Company's business, results of operations and financial condition. DEPENDENCE ON TELECOMMUNICATIONS CARRIERS A significant portion of the Company's revenues are, and are expected to continue to be, attributable to sales of products to telecommunications carriers. The Company's future performance is significantly dependent upon telecommunications carriers' increased incorporation of the Company's solutions as part of their package of product and service offerings to end users. The failure of the Company's products to perform favorably in and become an accepted component of the telecommunications carriers' product and service offerings, or a slower than expected increase or a decrease in the volume of sales of the Company's products and services to telecommunications carriers, could have a material adverse effect on the Company's business, results of operations and financial condition. CONCENTRATED PRODUCT FAMILY The Company currently derives substantially all of its revenues from its Network Health product family, and the Company expects that revenues from these products will continue to account for substantially all of the Company's revenues for the foreseeable future. Broad market acceptance of these products is, therefore, critical to the Company's future success, and any factor adversely affecting sales or pricing levels of these products could have a material adverse effect on the Company's business, results of operations and financial condition. There can be no assurance that market acceptance of Network Health will increase or even remain at current levels. Factors that may affect the market acceptance of the Company's products include the availability and price of competing products and technologies and the success of the sales efforts of the Company and its marketing partners. Moreover, the Company anticipates that its competitors will introduce additional competitive products, particularly if demand for network management software products increases, which may reduce future market acceptance of the Company's products. In addition, new competitors could enter the Company's market and offer alternative products, which may impact the market acceptance of the Company's products. The Company's future performance will also depend in part on the successful development, introduction and market acceptance of new and enhanced products. There can be no assurance that any such new or enhanced products will be successfully developed, 14 15 introduced and marketed, and failure to do so would have a material adverse effect on the Company's business, results of operations and financial condition. RAPID TECHNOLOGICAL CHANGE; DEPENDENCE ON STANDARD PROTOCOLS The software industry is characterized by rapid technological change, frequent introductions of new products, 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 obsolete and unmarketable. Network Health's ability to analyze and generate reports, as well as the quality of the reports, is dependent on Network Health's utilization of the industry-standard SNMP protocol and the data resident in conventional 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 Network Health with these devices which, in turn, could affect Network Health's ability to analyze and generate comprehensive reports or the quality of the reports. Furthermore, although the Company's products currently run 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, the Company's products. Any of the foregoing developments could have a material adverse effect on the Company's business, results of operations and financial condition. PRODUCT ENHANCEMENTS AND NEW PRODUCTS Because of rapid technological change in the software industry and potential changes in the network management software market and industry standards, the life cycle of versions of Network Health is difficult to estimate. The Company's future success will depend upon its ability to address the increasingly sophisticated needs of its customers by developing and introducing enhancements to Network Health on a timely basis that keep pace with technological developments, emerging industry standards and customer requirements. There can be no assurance that the Company will be successful in developing and marketing enhancements to Network Health or in developing new products that respond to technological changes, evolving industry standards or customer requirements, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and sale of such enhancements or new products, or that such enhancements or new products will adequately address the requirements of the marketplace and achieve any significant degree of market acceptance. COMPETITION; NEW ENTRANTS The market for the Company's products is new, intensely competitive, rapidly evolving and subject to technological change. Competitive and alternative offerings are available from the major product categories of remote monitoring (RMON) probe vendors, element management software, and other performance analysis and reporting offerings. Another area of competition comes from a number of companies offering network performance reporting services; including International Network Services (INS). In addition, the Company expects the large network management platform vendors to begin to offer products directly competitive with the Company's products. These companies may bundle their products with other hardware and software in a manner that may discourage users from purchasing products offered by the Company. This strategy may be particularly effective for companies with leading market shares in the network hardware and software market, including Hewlett-Packard Company, Lucent Technologies, International Business Machines Corporation and Cabletron Systems, Inc.. Developers of network element management solutions such as Cisco Systems, Inc., 3Com Corporation and Nortel Networks, Inc. may also compete with the Company in the future. The Company expects competition to persist, increase and intensify in the future with possible price competition developing in the Company's markets. Many of the Company's current and potential competitors have longer operating histories and significantly greater financial, technical and marketing resources and name recognition than the Company. The Company does not believe its market will support a large number of competitors and their products. In the past, a number of software markets have become dominated by one or a small number of suppliers, and a small number of suppliers or even a single supplier may dominate the Company's market. If the Company does not provide products that achieve success in its market in the short term, the Company could suffer an insurmountable loss in market share and brand name acceptance, which would result in a material adverse effect on the Company's business, results of operations and financial condition. There can be no assurance that the Company will be able to compete effectively with current and future competitors. UNCERTAIN PROTECTION OF INTELLECTUAL PROPERTY RIGHTS The Company's success depends significantly upon its proprietary technology. The Company relies on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements and other contractual provisions to establish, maintain and protect its proprietary rights, all of which afford only limited protection. The Company has four issued U.S. patents, three pending U.S. patent applications, and various foreign counterparts. There can be no assurance that patents will issue from these pending 15 16 applications or from any future applications or that, if issued, any claims allowed will be sufficiently broad to protect the Company's technology. In addition, there can be no assurance that any patents that have been or may be issued will not be challenged, invalidated or circumvented, or that any rights granted thereunder would provide protection of the Company's proprietary rights. Failure of any patents to protect the Company's technology may make it easier for the Company's competitors to offer equivalent or superior technology. The Company has registered or applied for registration for certain trademarks, and will continue to evaluate the registration of additional trademarks as appropriate. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or services or to obtain and use information that the Company regards as proprietary. Third parties may also independently develop similar technology without breach of the Company's 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, the Company's products are licensed under shrink wrap license agreements that are not signed by licensees and therefore may not be binding under the laws of certain jurisdictions. Certain technologies used by the Company's products are licensed from third parties, generally on a non-exclusive basis. 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 the Company's ability to ship certain of its products while it seeks 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 the Company's products or relating to current or future technologies, there can be no assurance that the Company will be able to do so on commercially reasonable terms or at all. Although the Company does not believe that it is infringing the intellectual property rights of others, claims of infringement are becoming increasingly common as the software industry develops and legal protections, including patents, are applied to software products. Litigation may be necessary to protect the Company's proprietary technology, and third parties may assert infringement claims against the Company with respect to their proprietary rights. Any claims or litigation can be time-consuming and expensive regardless of their merit. Infringement claims against the Company can cause product release delays, require the Company to redesign its products or require the Company to enter into royalty or license agreements, which agreements may not be available on terms acceptable to the Company or at all. RISK OF PRODUCT DEFECTS; PRODUCT LIABILITY As a result of their complexity, software products may contain undetected errors or failures when first introduced or as new versions are released. There can be no assurance that, despite testing by the Company and testing and use by current and potential customers, errors will not be found in new products after commencement of commercial shipments or, if discovered, that the Company will be able to successfully correct such errors in a timely manner or at all. The occurrence of errors and failures in the Company's products could result in loss of or delay in market acceptance of the Company's products, and alleviating such errors and failures could require significant expenditure of capital and other resources by the Company. The consequences of such errors and failures could have a material adverse effect on the Company's business, results of operations and financial condition. Since the Company's products are used by its customers to predict future network problems and avoid failures of the network to support critical business functions, design defects, software errors, misuse of the Company's products, incorrect data from network elements or other potential problems within or out of the Company's control that may arise from the use of the Company's products could result in financial or other damages to the Company's customers. The Company does not maintain product liability insurance. Although the Company's license agreements with its customers typically contain provisions designed to limit the Company's exposure to potential claims as well as any liabilities arising from such claims, such provisions may not effectively protect the Company against such claims and the liability and costs associated therewith. Accordingly, any such claim could have a material adverse effect upon the Company's business, results of operations and financial condition. The Company provides warranties for its products for a period of time (currently three months) after the software is purchased. The Company's license agreements generally do not permit product returns by the customer, and product returns and warranty expense for fiscal 1998, 1997 and 1996 represented less than 1.0% of total revenues during each of such periods. However, no assurance can be given that product returns will not increase as a percentage of total revenues in future periods. RELIANCE ON STRATEGIC PARTNERS AND OTHER EVOLVING DISTRIBUTION CHANNELS The Company's distribution strategy is to develop multiple distribution channels, including sales through strategic marketing partners and value added resellers, such as Newbridge Networks Corporation; telecommunications carriers, such as MCI 16 17 Communications Corporation; OEMs, such as Cabletron Systems, Inc.; and independent software vendors, as well as international distributors (collectively "channel partners"). The Company has developed a number of these relationships and intends to continue to develop new channel partner relationships. Accordingly, the success of the Company will be dependent in large part on its ability to develop these additional distribution relationships and on the performance and success of these third parties, particularly telecommunications carriers and other network service providers. The Company's channel partner relationships have been established recently, and the Company cannot predict the extent to which its channel partners will be successful in marketing the Company's products. The Company generally expects that its agreements with its channel partners will be terminable by either party without cause. None of the Company's channel partners are required to purchase minimum quantities of the Company's products and none of these agreements contain exclusive distribution arrangements. The Company's inability to attract important and effective channel partners, or their inability to penetrate their respective market segments, or the loss of any of the Company's channel partners, as a result of competitive products offered by other companies or products developed internally by these channel partners or otherwise, could materially adversely affect the Company's business, results of operations and financial condition. MANAGEMENT OF POTENTIAL GROWTH The Company recently has experienced significant growth in its sales and operations and in the complexity of its products and product distribution channels. The Company has recently increased and is continuing to increase the size of its sales force and coverage territories. Furthermore, the Company has recently established and is continuing to establish additional distribution channels through third party relationships. The Company's growth, coupled with the rapid evolution of the Company's markets, has placed, and is likely to continue to place, significant strains on its administrative, operational and financial resources and increase demands on its internal systems, procedures and controls. If the Company is unable to manage future growth effectively, the Company's business, results of operations and financial condition could be materially adversely affected. DEPENDENCE ON KEY PERSONNEL The Company's performance is substantially dependent on the performance of its key technical and senior management personnel, none of whom is bound by an employment agreement. The loss of the services of any of such personnel could have a material adverse effect on the business, results of operations and financial condition of the Company. The Company does not maintain key person life insurance policies on any of its employees. The Company's success is highly dependent on its continuing ability to identify, hire, train, motivate and retain highly qualified management, technical, and sales and marketing personnel, including recently hired officers and other employees. Competition for such personnel is intense, and there can be no assurance that the Company will be able to attract, assimilate or retain highly qualified technical and managerial personnel in the future. The inability to attract and retain the necessary management, technical, and sales and marketing personnel could have a material adverse effect on the Company's business, results of operations and financial condition. EXPANSION INTO INTERNATIONAL MARKETS The Company intends to expand its operations outside of the United States and enter additional international markets, primarily through the establishment of additional reseller arrangements. The Company expects to commit additional time and development resources to customizing its products and services for selected international markets and to developing international sales and support channels. There can be no assurance that such efforts will be successful. In addition to the uncertainty as to the Company's ability to establish an international presence, there are certain difficulties and risks inherent in doing business internationally, including, but not limited to: (i) costs of customizing products and services for international markets; (ii) dependence on independent resellers; (iii) multiple and conflicting regulations; (iv) exchange controls; (v) longer payment cycles; (vi) unexpected changes in regulatory requirements; (vii) import and export restrictions and tariffs; (viii) difficulties in staffing and managing international operations; (ix) greater difficulty or delay in accounts receivable collection; (x) potentially adverse tax consequences; (xi) the burden of complying with a variety of laws outside the United States; (xii) the impact of possible recessionary environments in economies outside the United States; and (xiii) political and economic instability. In addition, the Company's ability to expand its business in certain countries will require modification of its products, particularly national language support. The Company's current export sales are denominated in United States dollars and the Company currently expects to continue this practice as it expands its international operations. To the extent that international sales continue to be denominated in U.S. 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. To the extent that future international sales are denominated in foreign currency, the Company's operating results will be subject to risks associated with foreign currency fluctuation and the Company would consider entering into forward exchange contracts or otherwise engaging in hedging activities. To 17 18 date, as all export sales are denominated in U.S. dollars, the Company has not entered into any such contracts or engaged in any such activities. As the Company increases its international sales, its total revenue may also be affected to a greater extent by seasonal fluctuations resulting from lower sales that typically occur during the summer months in Europe and other parts of the world. POSSIBLE VOLATILITY OF STOCK PRICE The Company completed an initial public offering of its common stock during October of 1997. The market price of the shares of 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 the Company or its 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 the Company's operating results in a particular quarter to meet market expectations may adversely affect the market price of the shares of Common Stock. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against such a company. Such litigation could result in substantial costs and a diversion of management's attention and resources, which would have a material adverse effect on the Company's business, results of operations and financial condition. FUTURE CAPITAL FUNDING The Company plans to continue to expend substantial funds on the continued development, sales and marketing of the Network Health product family. There can be no assurance that the Company's existing capital resources, the proceeds from the Company's initial public offering during October of 1997 and any funds that may be generated from future operations together will be sufficient to finance the Company's future operations or that other sources of funding will be available on terms acceptable to the Company, if at all. In addition, future sales of substantial amounts of the Company's securities in the public market could adversely affect prevailing market prices and could impair the Company's future ability to raise capital through the sale of its securities. The failure to obtain such funding, if required, could have a material adverse effect on the Company's business, results of operations and financial condition. RISK ASSOCIATED WITH RECENT ACQUISITION AND POSSIBLE ACQUISITIONS The Company has recently completed the acquisition of Empire Technologies, Inc. Acquisitions involve a number of special risks, including diversion of management's attention, failure to successfully integrate acquired personnel, information systems and operations of the acquired business, failure to retain key acquired personnel, unanticipated events or circumstances, legal liabilities and amortization of acquired intangible assets, some or all of which could have a material adverse effect on the Company's business, results of operations and financial condition. There can be no assurance that the Company will not encounter difficulties in integrating the operations and products of any acquisition or that the benefits from any integration (including the Empire acquisition) will be realized. In addition, the Company may in the future engage in selective acquisitions of other businesses that are complementary to those of the Company. There can be no assurance that the Company will be able to identify additional suitable acquisition candidates available for sale at reasonable prices, consummate any acquisition or successfully integrate any acquired business into the Company's operations. If the Company were to proceed with one or more significant future acquisitions in which the consideration consisted of cash, a substantial portion of the Company's available cash could be used to consummate the acquisitions. If the Company were to consummate one or more significant acquisitions in which the consideration consisted of stock, stockholders of the Company could suffer dilution of their interests in the Company. Most business acquisitions must be accounted for using the purchase method of accounting. Most of the businesses that might become attractive acquisition candidates for the Company are likely to have significant intangible assets, and acquisition of these businesses, if accounted for as a purchase, would typically result in substantial intangible asset amortization charges to the Company, reducing future earnings or increasing future losses. In addition, such acquisitions could involve acquisition-related charges, such as one-time acquired research and development charges. The magnitude and timing of these charges will affect the Company's business, results of operations and financial condition. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments. The Company does not invest in derivative financial instruments, other financial instruments or derivative commodity instruments for which fair value disclosure would be required under SFAS No. 107. 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 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. 18 19 CONCORD COMMUNICATIONS, INC. FORM 10-Q, SEPTEMBER 30, 1999 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 (c) Issuance in Securities On October 19, 1999, Concord Communications, Inc., a Massachusetts corporation ("Concord" or the "Company"), entered into an Agreement and Plan of Reorganization (the "Merger Agreement") providing for the merger (the "Merger") of E Acquisition Corp., a Georgia corporation and wholly-owned subsidiary of the Company ("Merger Sub") with and into Empire Technologies, Inc. ("Empire"). The Merger was effected on October 29, 1999 (the "Effective Date") pursuant to a Certificate of Merger filed with the Secretary of State of the State of Georgia on that date. Pursuant to the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of the common stock, no par value per share, of Empire (the "Empire Common Stock") was converted into 815,248 shares (the "Conversion Ratio") of the common stock, $.01 par value per share, of the Company (the "Concord Common Stock"). Since there were 1,000 outstanding shares of Empire Common Stock immediately prior to the effective time of the Merger, Concord issued an aggregate of 815,248 shares of Concord Common Stock to the stockholders of Empire in the Merger in a private placement transaction pursuant to Section 4(2) under the Securities Act of 1933. Empire is a leading provider of solutions for proactive self-management of UNIX and Windows NT systems, as well as mission-critical applications. The merger was accounted for as a pooling of interest. (d) 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 stockholders 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 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 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 The exhibits listed in the accompanying Exhibit Index on page 20 are filed or incorporated by reference as part of this Report. (b) Reports on Form 8-K Form 8-k was filed on October 29, 1999 for disclosure of the merger with Empire Technologies, Inc. 19 20 CONCORD COMMUNICATIONS, INC. FORM 10-Q, SEPTEMBER 30, 1999 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/ Gary E. Haroian --------------------- Date: November 15, 1999 Name: Gary E. Haroian Title: Vice President of Finance and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) 20 21 CONCORD COMMUNICATIONS, INC. FORM 10-Q, SEPTEMBER 30, 1999 EXHIBIT INDEX EXHIBIT NO. DESCRIPTION 27.01 Financial Data Schedule 21 EX-27.01 2 FINANCIAL DATA SCHEDULE
5 U.S. DOLLARS 9-MOS DEC-31-1999 JAN-01-1999 SEP-30-1999 1 6,181 54,524 10,498 660 0 910 8,984 2,573 77,864 18,190 0 0 0 76,517 (16,843) 77,864 35,943 45,606 1,788 5,827 28,360 0 2,247 13,666 5,196 8,470 0 0 0 8,470 .59 .59
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