-----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, OkkwGxBxXQcjwCFBRwSTqTO4XG6PXXXJAVYuYepDE9yHKWZ8FhoYn9Y9PGYmsGpe WdbLMUKYnYhUuDieo8bY8g== 0000936392-99-000107.txt : 19990208 0000936392-99-000107.hdr.sgml : 19990208 ACCESSION NUMBER: 0000936392-99-000107 CONFORMED SUBMISSION TYPE: 10-Q/A PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19980930 FILED AS OF DATE: 19990205 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HNC SOFTWARE INC/DE CENTRAL INDEX KEY: 0000945093 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 330248788 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q/A SEC ACT: SEC FILE NUMBER: 000-26146 FILM NUMBER: 99522771 BUSINESS ADDRESS: STREET 1: 5930 CORNERSTONE CT W CITY: SAN DIEGO STATE: CA ZIP: 92121-3728 BUSINESS PHONE: 6195468877 MAIL ADDRESS: STREET 1: 5930 CORNERSTONE CT WEST CITY: SAN DIEGO STATE: CA ZIP: 92121-3728 10-Q/A 1 AMENDMENT NO. 1 TO FORM 10-Q 1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q/A-1 [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998 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 0-26146 - -------------------------------------------------------------------------------- HNC SOFTWARE INC. (Exact name of registrant as specified in its charter) - -------------------------------------------------------------------------------- DELAWARE 33-0248788 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.)
5930 CORNERSTONE COURT WEST SAN DIEGO, CA 92121 (Address of principal executive offices, including zip code) (619) 546-8877 (Registrant's telephone number, including area code) INDICATE BY CHECK MARK WHETHER THE REGISTRANT: (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS: YES [X] NO [ ] AS OF OCTOBER 30, 1998, THERE WERE 25,811,583 SHARES OF REGISTRANT'S COMMON STOCK, $0.001 PAR VALUE, OUTSTANDING. ================================================================================ 2 EXPLANATORY NOTE In October 1998, the SEC issued a letter to the American Institute of Certified Public Accountants indicating suggested practices for determining in process research and development charges related to acquisitions to be accounted for under the purchase method of accounting. Further, the SEC has indicated that this methodology should be adopted for all transactions accounted for by the purchase method. The Company originally recorded Practical Control Systems, Inc. ("PCS"), Financial Technology, Inc. "FIT") and Advanced Telecommunications Abuse Control System ("ATACS") product line during the first and second quarters of 1998 using then current accepted practices and has now recorded this new methodology and its related effects, retroactively to each quarter impacted. This amendment to Form 10-Q for the quarter ended September 30, 1998 is being filed to conform to these practices with respect to the acquisitions of PCS, FTI and ATACS. INDEX LISTING ================================================================================
Page Number ------ PART I FINANCIAL INFORMATION Item 1: FINANCIAL STATEMENTS Consolidated Balance Sheet at September 30, 1998 (unaudited) 3 and December 31, 1997 Consolidated Statement of Income (unaudited) for the three 4 and nine months ended September 30, 1998 and 1997 Consolidated Statement of Cash Flows (unaudited) for 5 the nine months ended September 30, 1998 and 1997 Consolidated Statement of Changes in Stockholders' Equity and 6 Comprehensive Income for the nine months ended September 30, 1998 Notes to Consolidated Financial Statements (unaudited) 7 Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 12 PART II OTHER INFORMATION Item 6: EXHIBITS AND REPORT ON FORM 8-K 27 Signatures 28 Exhibit Index 29
2 3 PART I - FINANCIAL INFORMATION ================================================================================ Item 1: FINANCIAL STATEMENTS HNC SOFTWARE INC. CONSOLIDATED BALANCE SHEET (in thousands, except per share data)
ASSETS SEPTEMBER 30, DECEMBER 31, 1998 1997 --------- --------- (unaudited) Current assets: Cash and cash equivalents $ 40,746 $ 18,068 Investments available for sale 48,725 24,878 Accounts receivable, net 50,391 32,980 Current portion of deferred income taxes 8,873 11,310 Other current assets 4,711 2,802 --------- --------- Total current assets 153,446 90,038 Property and equipment, net 14,597 12,102 Deferred income taxes, less current portion 15,531 15,322 Long-term investments available for sale 61,125 -- Other assets 26,508 2,415 --------- --------- $ 271,207 $ 119,877 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 5,892 $ 5,728 Accrued liabilities 9,638 5,933 Deferred revenue 7,881 3,883 Other current liabilities 104 191 --------- --------- Total current liabilities 23,515 15,735 Convertible Subordinated Notes 100,000 -- Other non-current liabilities 30 239 Minority interest in consolidated subsidiary 157 43 Stockholders' equity: Preferred stock, $0.001 par value - 4,000 shares authorized: No shares issued or outstanding -- -- Common stock, $0.001 par value - 50,000 shares authorized: 25,809 and 24,538 shares issued and outstanding, respectively 26 25 Paid-in capital 131,502 95,919 Retained earnings 16,000 8,029 Accumulated other comprehensive income (loss) (23) (113) --------- --------- Total stockholders' equity 147,505 103,860 --------- ========= $ 271,207 $ 119,877 ========= =========
See accompanying notes to consolidated financial statements. 3 4 HNC SOFTWARE INC. CONSOLIDATED STATEMENT OF INCOME (in thousands, except per share data) (unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------ ------------------------ 1998 1997 1998 1997 --------- --------- --------- --------- Revenues: License and maintenance $ 36,803 $ 23,705 $ 97,480 $ 64,347 Services and other 10,947 6,284 28,492 17,307 --------- --------- --------- --------- Total revenues 47,750 29,989 125,972 81,654 --------- --------- --------- --------- Operating expenses: License and maintenance 8,021 4,957 22,168 13,987 Services and other 8,521 3,813 20,179 10,952 Research and development 9,172 6,015 23,638 15,376 Sales and marketing 8,797 5,691 25,245 15,477 General and administrative 3,843 3,142 10,848 8,369 In-process research and development -- -- 6,090 -- Acquisition related amortization 1,198 -- 2,004 -- --------- --------- --------- --------- Total operating expenses 39,552 23,618 110,172 64,161 --------- --------- --------- --------- Operating income 8,198 6,371 15,800 17,493 Other income, net 2,084 554 4,913 1,511 Interest expense (1,418) (16) (3,205) (63) Minority interest in income of consolidated subsidiary (54) -- (114) -- --------- --------- --------- --------- Total other income, net 612 538 1,594 1,448 Income before income tax provision 8,810 6,909 17,394 18,941 Income tax provision 3,734 1,782 9,423 4,643 --------- --------- --------- --------- Net income $ 5,076 $ 5,127 $ 7,971 $ 14,298 ========= ========= ========= ========= Earnings per share: Basic net income per common share $ 0.20 $ 0.21 $ 0.32 $ 0.59 ========= ========= ========= ========= Diluted net income per common share $ 0.19 $ 0.20 $ 0.30 $ 0.56 ========= ========= ========= ========= Shares used in computing basic net income per common share 25,694 24,359 25,217 24,213 ========= ========= ========= ========= Shares used in computing diluted net income per common share 27,198 25,894 26,620 25,574 ========= ========= ========= =========
See accompanying notes to consolidated financial statements. 4 5 HNC SOFTWARE INC. CONSOLIDATED STATEMENT OF CASH FLOWS (in thousands, except per share data) (unaudited)
NINE MONTHS ENDED SEPTEMBER 30, ------------------------------- 1998 1997 ------------ ------------- Cash flows from operating activities: Net (loss) income $ 7,971 $ 14,298 Adjustments to reconcile net (loss) income to net cash provided by operating activities: Depreciation and amortization 6,984 3,478 Purchased research and development 6,090 -- Tax benefit from stock option transactions 6,100 4,165 Changes in assets and liabilities: Accounts receivable, net (15,252) (8,298) Other assets (1,648) (927) Deferred income taxes 8,022 4,146 Accounts payable (273) 2,325 Accrued liabilities (3,769) (1,956) Deferred revenue (522) (848) Other liabilities (228) (110) --------- --------- Net cash provided by operating activities 13,475 16,273 --------- --------- Cash flows from investing activities: Purchases of investments (126,960) (27,712) Maturities of investments 38,284 12,100 Proceeds from sale of investments 4,000 5,689 Cash purchased in business acquisition 649 -- Acquisitions, net of cash acquired (6,250) -- Acquisitions of property and equipment (6,472) (6,873) --------- --------- Net cash used in investing activities (96,749) (16,796) --------- --------- Cash flows from financing activities: Net proceeds from issuances of common stock 9,671 3,447 Proceeds from issuances of Convertible Subordinated Notes 100,000 -- Debt issuance costs (2,779) -- Repayment of bank line of credit (770) -- Repayment of capital lease obligations (151) (332) Distributions to CompReview Stockholders -- (5,798) --------- --------- Net cash provided by (used in) financing activities 105,971 (2,683) --------- --------- Effect of exchange rate changes on cash (19) (14) --------- --------- Net increase (decrease) in cash and cash equivalents 22,678 (3,220) Cash and cash equivalents at the beginning of the period 18,068 8,121 --------- --------- Cash and cash equivalents at the end of the period $ 40,746 $ 4,901 ========= ========= Significant non-cash investing activities: Assets assumed in acquisitions of PCS, FTI, and ATACS $ 32,711 $ -- ========= ========= Liabilities assumed in acquisitions of PCS, FTI, and ATACS $ 7,297 $ -- ========= =========
See accompanying notes to consolidated financial statements. 5 6 HNC SOFTWARE INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (in thousands) (unaudited)
ACCUMULATED OTHER TOTAL COMMON STOCK PAID-IN COMPREHENSIVE RETAINED STOCKHOLDER'S COMPREHENSIVE SHARES AMOUNT CAPITAL INCOME (LOSS) EARNINGS EQUITY INCOME ------ ------ ------- ------------- -------- ------ ------ BALANCE AT DECEMBER 31, 1997 24,538 $ 25 $ 95,919 $ (113) $ 8,029 $ 103,860 $ Common stock options exercised 663 1 7,737 7,738 Common stock issued under Employee Stock Purchase Plan 68 1,933 1,933 Tax benefit from stock option transactions 6,100 6,100 Common stock issued for acquisition of PCS 143 5,088 5,088 Common stock issued for acquisition of FTI 397 14,725 14,725 Unrealized gain on investments 109 109 109 Foreign currency translation adjustment (19) (19) (19) Net income 7,971 7,971 7,971 -------- --------- --------- --------- --------- --------- --------- BALANCE AT SEPTEMBER 30, 1998 25,809 $ 26 $ 131,502 $ (23) $ 16,000 $ 147,505 $ 8,061 ======== ========= ========= ========= ========= ========= =========
See accompanying notes to consolidated financial statements 6 7 HNC SOFTWARE INC. ================================================================================ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 GENERAL In management's opinion, the accompanying unaudited consolidated financial statements for HNC Software Inc. (the "Company") for the three months and nine months ended September 30, 1998 and 1997 have been prepared in accordance with generally accepted accounting principles for interim financial statements and include all adjustments (consisting only of normal recurring accruals) that the Company considers necessary for a fair presentation of its financial position, results of operations, and cash flows for such periods. However, the accompanying financial statements do not contain all of the information and footnotes required by generally accepted accounting principles for complete financial statements. All such financial statements are unaudited except the December 31, 1997 balance sheet. This Report and the accompanying unaudited and audited financial statements should be read in conjunction with the Company's audited financial statements and notes thereto presented in its Annual Report on Form 10-K/A for the fiscal year ended December 31, 1997 (the "1997 Annual Report"). Footnotes that would substantially duplicate the disclosures in the Company's audited financial statements for the fiscal year ended December 31, 1997 contained in the 1997 Annual Report have been omitted. The interim financial information contained in this Report is not necessarily indicative of the results to be expected for any other interim period or for the full fiscal year ending December 31, 1998. NOTE 2 BASIS OF PRESENTATION The consolidated financial statements and related notes contained in this Report give retroactive effect to the Company's November 28, 1997 acquisition of CompReview, Inc., accounted for as a pooling of interests, for all periods presented. The acquisitions of Practical Control Systems Technologies, Inc. ("PCS") and Financial Technology, Inc. ("FTI") were completed on March 31, 1998 and April 7, 1998, respectively, and accounted for as purchases as of the respective acquisition dates. In addition, the acquisition of the Advanced Telecommunications Abuse Control System ("ATACS") product line of Bedford Associates, Inc., which is a wholly owned subsidiary of British Airways plc, was completed on June 11, 1998 and accounted for as a purchase as of that date. In connection with these acquisitions, acquired in-process research and development in the aggregate amount of $6.1 million was charged to operations at the respective acquisition dates. NOTE 3 ACQUISITIONS In March 1998, the Company acquired PCS, a company that develops, markets and supports fully integrated distribution center management software products that address the distribution needs of the retail, manufacturing and wholesale industries. HNC acquired PCS in exchange for 142,868 shares of HNC common stock, 14,286 of which are subject to an escrow to secure certain indemnification obligations of the former PCS stockholders plus the contingent right, subject to PCS' achievement of certain financial objectives during calendar 1998 and 1999, to receive certain additional shares of HNC common stock. 7 8 In April 1998, the Company acquired FTI, a company that develops and markets profitability measurement and decision support software products and related support services to banks and other similar financial institutions. HNC acquired FTI in exchange for the issuance of 396,617 shares of HNC common stock, 97,390 of which are subject to an escrow to secure certain indemnification obligations of the former FTI stockholders; a cash payment of $1.5 million; and the contingent right, subject to FTI's achievement of certain financial objectives during calendar 1998, to receive certain additional shares of HNC common stock. In June 1998, the Company acquired the ATACS product line. ATACS is a fraud-management software solution for wireline, wireless and Internet telecommunication service providers. HNC acquired the ATACS product line for a cash payment of $4.75 million. NOTE 4 REVENUE RECOGNITION During the first quarter of 1998, the Company adopted Statement of Position No. 97-2 ("SOP 97-2"), "Software Revenue Recognition," as amended by Statement of Position No. 98-4 "Deferral of the Effective Date of a Provision of SOP 97-2, Software Revenue Recognition". SOP 97-2 provides guidance for software revenue recognition. The adoption of SOP 97-2 did not have a significant impact on the Company's financial position or results of operations. NOTE 5 COMPREHENSIVE INCOME During the first quarter of 1998, the Company adopted Statement of Financial Accounting Standards No. 130 "Reporting Comprehensive Income" ("FAS 130"). FAS 130 requires the Company to report in the financial statements, in addition to net income, comprehensive income and its components including foreign currency items and unrealized gains and losses on certain investments in debt and equity securities. Comprehensive income is defined as "the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners." NOTE 6 RECLASSIFICATIONS Certain prior period balances have been reclassified to conform to the current period presentation. 8 9 NOTE 7 RECONCILIATION OF NET INCOME (LOSS) AND SHARES USED IN PER SHARE COMPUTATIONS
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------- --------------------- 1998 1997 1998 1997 ------- ------- ------- ------- NET INCOME USED: Net income used in computing diluted net income per common share $ 5,076 $ 5,127 $ 7,971 $14,298 ======= ======= ======= ======= SHARES USED: Shares used in computing basic net income per common share 25,694 24,359 25,217 24,213 Weighted average options to purchase common stock as determined by application of the treasury stock method 1,488 1,533 1,387 1,359 Purchase Plan common stock equivalents 16 2 16 2 ------- ------- ------- ------- Shares used in computing diluted net income per common share 27,198 25,894 26,620 25,574 ======= ======= ======= =======
The conversion of the Company's 4.75% convertible subordinated notes for the three and nine month periods ended September 30, 1998 of 2,230,000 and 1,700,000 shares, respectively, were not used to calculate diluted net loss per share as their effect would be anti-dilutive. 9 10 NOTE 8 NEW ACCOUNTING PRONOUCEMENTS In June 1997, the FASB issued Statement of Financial accounting Standards No. 131 ("FAS 131"), "Disclosures about Segments of an Enterprise and Related Information," which HNC is required to adopt for its 1998 annual financial statements. This statement establishes standards for reporting information about operating segments in the annual financial statements and requires selected information about operating segments in interim financial reports issued to stockholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Under FAS 131, operating segments are to be determined consistent with the way that management organizes and evaluates financial information internally for making operating decisions and assessing performance. HNC has not determined the impact of the adoption of this new accounting standard on its consolidated financial statement disclosures. In June 1998, the Financial Accounting Standards Board issued Statement of Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133") which the Company will be required to adopt during the first quarter of 2000. This statement establishes a new model for accounting for derivatives and hedging activities. Under FAS 133, all derivatives must be recognized as assets and liabilities and measured at fair value. The Company has not determined the impact of the adoption of this new accounting standard on its financial position or results of operations. NOTE 9 CONVERTIBLE SUBORDINATED NOTES In March 1998, the Company issued $100,000,000 of 4.75% Convertible Subordinated Notes (the "Notes") due 2003. The Notes will be convertible into common stock at any time prior to the close of business on the maturity date, unless previously redeemed or repurchased, at a conversion price of $44.85 per share (equivalent to a conversion rate of approximately 22.30 shares per $1,000 principal amount of Notes), subject to adjustment. NOTE 10 INVESTMENTS At September 30, 1998 and December 31, 1997, the amortized cost and estimated fair value of investments available for sale were as follows (in thousands):
SEPTEMBER 30, 1998 ----------------------------------------------------- AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE -------- -------- -------- -------- U.S. government and federal agencies $ 75,686 $ 75 $ -- $ 75,761 U.S. corporate debt 26,951 60 -- 27,010 Foreign corporate debt 7,043 36 -- 7,079 -------- -------- -------- -------- $109,680 $ 171 $ -- $109,850 ======== ======== ======== ========
DECEMBER 31, 1997 ------------------------------------------------------- AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE -------- -------- -------- --------- U.S. government and federal agencies $ 20,682 $ -- $ (1) $ 20,681 U.S. corporate debt 1,894 -- (1) 1,893 Foreign corporate debt 2,304 -- -- 2,304 -------- -------- -------- -------- $ 24,880 $ -- $ (2) $ 24,878 ======== ======== ======== ========
10 11 At September 30, 1998 and December 31, 1997, all foreign corporate debt investments were denominated in U.S. dollars. The objectives of the Company's investment policy are the safety and preservation of invested funds and liquidity of investments that is sufficient to meet cash flow requirements. The Company's policy is to place its cash, cash equivalents and investments available for sale with high credit quality financial institutions and commercial companies and government agencies in order to limit the amount of credit exposure. It is also the Company's policy to maintain certain concentration limits, to only invest in certain "allowable securities" as determined by the Company's management and must be denominated in U.S. dollars. The Company's investment portfolio shall not have an average portfolio maturity of beyond one year and shall maintain certain liquidity positions. Investments are prohibited in certain industries and speculative activities. NOTE 11 IN PROCESS RESEARCH AND DEVELOPMENT In connection with the acquisitions of PCS, PTI and ATACS, acquired in-process research and development in the aggregate amount of $6.1 million was charged to operations at the respective acquisition dates. Practical Control Solutions, Inc. PCS is a worldwide supplier of fully integrated distribution center management software products that address the distribution needs of the retail, wholesale and manufacturing industries. PCS' products may be classified into two categories: Nautilus, an off-the-shelf warehouse management software system designed with all the tools needed to control the course of warehouse operations and Nautilus CBT, an operational tutorial database which guides the user through Nautilus operations. Certain products were complete in certain areas and under development in others. The classification of the technology as complete or under development was made in accordance with the guidelines of Statement of Financial Accounting Standards No. 86 ("SFAS 86"), Statement of Financial Accounting Standards No. 2 ("SFAS 2") and Financial Accounting Standards Board Interpretation No. 4 ("FIN4"). At the time of acquisition, PCS had a number of new software products under development including Nautilus Versions 6.0 and 7.0 and Nautilus CBT. Nautilus Version 6.0 and Nautilus CBT were both nearly complete but had not reached technological feasibility as of the acquisition date. Financial Technology, Inc. FTI has been a leading provider of management accounting software for financial institutions since 1982. Since 1994, FTI has focused on profitability measurement and other decision support systems. FTI's products are generally classified into six categories: ProfitVision, MarketVision, RiskVision, DataVision, Decision Support Products and Financial Platform Products. FTI had various new products under development in each of these categories, none of which had reached technological feasibility and of the acquisition date. The classification of each new technology as complete or under development was made in accordance with the guidelines of SFAS 86, SFAS 2 and FIN4. ATACS. ATACS is a fraud management software solution for the wireline, wireless and Internet telecommunication service provider industries. The system detects fraudulent traffic thereby avoiding significant financial losses to traditional telecommunication carriers and Internet Service Providers. ATACS' Version 4.2 includes significant enhanced features from its prior version, including new enhancements to Velocity, Message Handlers and a subsystem to support fraud detection of on-line transactions. ATACS Version 4.1 was completed and producing revenues prior to the acquisition date while Version 4.2, which includes new technology that allows the system to function on three interface platforms, was under development and had not yet reached technological feasibility as of the acquisition date. Although Version 4.2 has as its foundation technology from the completed as well as in-process technology, BNC believes that it will have changed significantly so as to be considered new research and development efforts. The classification of each research and development project as complete or under development was made in accordance with the guidelines of SFAS 86, SFAS 2 and FIN4. 11 12 HNC SOFTWARE INC. ================================================================================ Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD LOOKING STATEMENTS: NO ASSURANCES INTENDED This Report (including without limitation the following section regarding Management's Discussion and Analysis of Financial Condition and Results of Operations) contains forward-looking statements (within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934) regarding the Company and its business, financial condition, results of operations and prospects. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," and similar expressions or variations of such words, are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Report. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements. Although forward-looking statements in this Report reflect the good faith judgment of the Company's management, such statements can only be based on facts and factors currently known by the Company. Consequently, forward-looking statements are inherently subject to risks and uncertainties. Accordingly, actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include without limitation those discussed in "Potential Fluctuations in Operating Results" or "Year 2000 Compliance" as well as those discussed elsewhere in this Report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this Report. The Company undertakes no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Report. Readers are urged to carefully review and consider the various disclosures made by the Company in this Report, which attempt to advise interested parties of the risks and factors that may affect the Company's business, financial condition, results of operations and prospects. POTENTIAL FLUCTUATIONS IN OPERATING RESULTS The Company's revenues and operating results have varied significantly in the past and may do so in the future. Factors affecting the Company's revenues and operating results include: the degree of acceptance of the Company's products; the markets and industries served by the Company; the historical tendency of the Company to receive, during a given fiscal period, a small number of relatively large customer orders, such that failure to recognize revenue from any such order in that fiscal period may disproportionately and adversely affect the Company's revenues and operating results for that fiscal period; customer cancellation of long-term contracts that yield recurring revenues; customers' ceasing their use of Company products for which the Company receives recurring, usage-based fees and disputes with customers regarding fees payable to the Company; the lengthy sales cycle of most of the Company's products; the Company's ability to successfully and timely develop, introduce and market new products and product enhancements; the timing of new product announcements and introductions by the 12 13 Company and its competitors; changes in the mix of distribution channels; changes in the level of operating expenses; the Company's ability to achieve progress and fulfill its obligations under percentage-of-completion contracts; the Company's success in completing certain pilot installations within contracted fee budgets; competitive conditions in the industry; domestic and international economic conditions; and market conditions in the Company's targeted markets. In addition, license agreements entered into during a quarter may not meet the Company's revenue recognition criteria, with the result that, even if the Company meets or exceeds its forecast of aggregate licensing and other contracting activity for a given fiscal period, it is possible that the Company's revenues for that fiscal period would not meet expectations. Furthermore, the Company's operating results may be affected by factors unique to certain of its product lines. For example, although in the past a large portion of the Company's revenues were derived from contracts providing for periodic, recurring fees, the Company now derives a substantial and increasing portion of its revenues from products (particularly products for the retail industry) priced as "perpetual" license transactions in which the Company receives a one-time license fee that is recognized upon delivery of the software and acceptance by the customer. Thus, failure to complete a perpetual license transaction during a fiscal quarter would have a disproportionate adverse impact on the Company's operating results for that quarter. The Company expects that fluctuations in its operating results will continue for the foreseeable future. Consequently, the Company believes that period-to-period comparisons of its financial results should not be relied upon as an indication of future performance. Because the Company's expense levels are based in part on its expectations regarding future revenues and are fixed to a large extent in the short term, the Company may be unable to adjust spending in time to compensate for any revenue shortfall. Accordingly, the Company may not be able to maintain profitability on a quarterly or annual basis in the future. Due to some or all of the foregoing factors, or other factors, it is possible that in some future quarter the Company's operating results will be below the expectations of public market analysts and investors. In that event, the price of the Company's common stock and, in turn, the price of the Company's 4.75% convertible subordinated notes due 2003 (the "Notes"), would likely be materially adversely affected. YEAR 2000 COMPLIANCE GENERAL It is generally anticipated that many organizations will experience operational difficulties at the beginning of the Year 2000 as a result of the fact that many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. Significant uncertainty exists in the software and other industries concerning the scope and magnitude of problems associated with the century change. As early as 1997, the Company had begun the process of planning and updating, in some cases, its earlier versions of existing software products. More recent versions of these same products as well as new products were developed with Year 2000 date processing in mind. To track performance of completing any remaining compliance work as well as to assess the Year 2000 issue more broadly, the Company developed a Year 2000 project plan. PROJECT The Company initiated a company-wide Year 2000 Project (Y2k Project) during 1998 to more formally monitor compliance of its year 2000 exposure for each major business unit and has divided the project into three major sections that address its critical date sensitive 13 14 components: software products, information technology ("IT") infrastructure, and non-IT systems. The Y2k Project consists of (1) assessing the current state of readiness for all critical components, (2) developing project plans that track the status of work performed toward completing planned solutions and (3) developing contingency plans. In August 1998, IT directors of all significant business units were asked to inventory all major components and provide the current state of readiness as well as an indication as to when readiness would otherwise be expected. In addition, each major business unit was asked to provide project plan status reports that indicate how compliance would be achieved, as well as to quantify the extent and timing of the effort and to identify when testing of the solution would be completed. Finally, each major business unit was asked to consider various scenarios that might impact successful implementation of their Year 2000 solutions and to develop alternative or back-up plans to mitigate the risk of not being ready on time. CURRENT STATUS The Company has completed the initial stage of its Y2k Project by taking inventory of its more major software products, identifying the state of readiness for each and developing project plans for completing and implementing designed solutions. Based on the Company's assessment of its major software products to date, the Company believes that the current version of each is Year 2000 compliant. However, there can be no assurance that all of the Company's customers will install the Year 2000 compliant version of the Company's products in a timely manner, which could lead to failure of customer systems and product liability claims against the Company. The Company is also expected to complete its review of the remaining major components of its IT infrastructure, such as its applications developed in-house or purchased from a supplier, by the end of 1998. The Company is reviewing its major non-IT system components for Year 2000 compliance and intends to take appropriate action based on the results of such review. Non-IT systems include hardware and other electronic systems, excluding application systems, used in operations of the Company's business. The assessment and project plans of non-IT Year 2000 solutions are currently expected to be available by the end of 1998. The Company's plan for the Year 2000 calls for compliance verification of third parties supplying software and information systems to the Company for both IT and non-IT systems and communication with significant suppliers to determine the readiness of third parties' remediation of their own Year 2000 issues. As part of its assessment, the Company is evaluating the level of validation it will require of third parties to ensure their Year 2000 readiness. To date, the Company has not encountered any material Year 2000 issues concerning its computer systems. Potential worst case Year 2000 scenarios currently being considered by HNC address issues arising from non-compliance by its customers, suppliers or internal operating systems. Although the Company's Y2k Project will strive to uncover significant non-compliance issues, in the worst case not all Y2k problems may be uncovered by the year 2000, which could have a material adverse effect on the Company's business. However, the Company believes that its most probable worst case scenario is more likely to arise from its customers' and vendors' inability to become Year 2000 compliant than from the Company's failure to bring its own products into 14 15 compliance. As a result, the Company's supply chain and revenues could be adversely impacted. As discussed below, the Company generates a significant portion of its revenues from usage-based license fees which would be at risk if its customers are unable to operate their computer systems due to Year 2000 problems caused by software developed internally by the customer or purchased from a third party vendor. Some considerations include quantifying the impact that usage-based fees may have on the Company's business and understanding the compliance programs and contingency plans, if any, the Company's vendors and customers have developed. COSTS All costs associated with carrying out the Company's plan for the Year 2000 compliance are being expensed as incurred. The total cost associated with preparation for the Year 2000 has not been, and is not expected to be, material to the Company's business, financial condition or results of operations. Nevertheless, the Company may not timely identify and remediate all significant Year 2000 problems and remedial efforts may involve significant time and expense. Failure to identify such problems could, for example, impair the Company's internal product development efforts and internal management systems. There can be no assurance that any Year 2000 compliance problems of the Company or its customers or suppliers will not have a material adverse effect on the Company's business, financial condition and results of operations. RISKS The inability of the Company to complete its assessment and any necessary modifications to recently acquired products could have a material adverse effect on the Company's business, financial condition and results of operations. Even if the Company's products are Year 2000 compliant, the Company may in the future be subject to claims based on Year 2000 issues in the products of other companies, or issues arising from the integration of multiple products within a system. The costs of defending and resolving Year 2000-related disputes, and any liability of the Company for Year 2000 related damages, including consequential damages, could have a material adverse effect on the Company's business, financial condition and results of operations. Further, the Company's products are generally used with enterprise systems involving complex software products developed by other vendors, which may not be Year 2000 compliant. In particular, many of the Company's customers are financial institutions, insurance companies and other companies with insurance and financial services businesses, all of which use legacy computer systems that are expected to be particularly susceptible to Year 2000 compliance issues. If the Company's customers are unable to use their information systems because of the failure of such non-compliant systems or software or for any other reason, there would be a decrease in the volume of transactions that the Company's customers process using the Company's products. As a result, the Company's recurring revenue in the form of usage-based transactional fees from customers in the insurance and financial solutions markets would decline, which would have a material adverse effect on the Company's business, financial condition and results of operations. Such failure could also affect the perceived performance of the Company's products, which could have a negative effect on the Company's competitive position. In addition, the Company believes that the purchasing patterns of customers and potential customers may be affected by Year 2000 issues as companies expend significant resources to correct or patch their current software systems for Year 2000 compliance. These expenditures may result in reduced funds available to purchase software products such as those offered by the Company, which could result in a material adverse effect on the Company's business, financial condition and results of operations. 15 16 HNC is also reviewing its major internal corporate systems for Year 2000 compliance and intends to take appropriate action based on the results of such review. HNC's plan for the Year 2000 calls for compliance verification of external vendors supplying software and information systems to HNC and communication with significant suppliers to determine the readiness of third parties' remediation of their own Year 2000 issues. As part of its assessment, HNC is evaluating the level of validation it will require of third parties to ensure their Year 2000 readiness. To date, HNC has not encountered any material Year 2000 issues concerning its computer systems. HNC plans to complete its Year 2000 research and testing and create any necessary contingency plans by the end of the first quarter of 1999. All costs associated with carrying out HNC's plan for Year 2000 compliance are being expenses as incurred. The total cost associated with preparation for the Year 2000 has not been, and is not expected to be, material to HNC's business, financial condition or results of operations. Nevertheless, HNC may not timely identify and remediate all significant Year 2000 problems and remedial efforts may involve significant time and expense. Failure to identify such problems could, for example, impair HNC's internal product development efforts and internal management systems. There can be no assurance that any Year 2000 compliance problems of HNC or its customers or suppliers will not have a material adverse effect on HNC's business, financial condition and results of operations. RESULTS OF OPERATIONS HNC develops, markets and supports predictive software solutions for leading service industries. These predictive software solutions employ, variously, proprietary neural-network predictive decision engines, profiles, traditional statistical modeling, business models, expert rules and context vectors to convert existing data and business experiences into meaningful recommendations and actions. HNC has developed a growing family of predictive software products that provide specific solutions for each of the healthcare/insurance, financial solutions and retail markets. The Company's healthcare/insurance products, which are developed and marketed by its HNC Insurance Solutions subsidiary, emphasize the workmen's compensation field and provide a variety of solutions to insurers, parties who administer insurance claims and health care administrators. HNC's products for the financial solutions market include products targeted at bank and private label payment card issuers and payment processors and products that allow lenders to automate the loan approval decision process. For the retail industry, HNC has developed a group of products that address inventory control, merchandise management and financial control management. For the nine months ended September 30, 1998, approximately 7% of the Company's sales were denominated in currencies other than the Company's functional currency, which is the US dollar. These foreign currencies are primarily those of Western Europe, Canada and Australia. The Company's revenues are comprised of license and maintenance revenues, installation and implementation revenues, contracts and other revenues and service bureau revenues. The Company's revenues for the three months ended September 30, 1998 were $47.8 million, an increase of 59% over revenues of $30.0 million for the same period in the prior year. The Company's revenues for the nine months ended September 30, 1998 were $126.0 million, an increase of 54% over revenues of $81.7 million for the same period in the prior year. 16 17 During the first quarter of 1998, the Company adopted Statement of Position No. 97-2 ("SOP 97-2"), "Software Revenue Recognition" and as amended by Statement of Position No. 98-4 "Deferral of the Effective Date of a Provision of SOP 97-2, Software Revenue Recognition". SOP 97-2 provides guidance for software revenue recognition. The adoption of SOP 97-2 did not have a significant impact on the Company's financial position or results of operations. REVENUES LICENSE AND MAINTENANCE REVENUES. The Company's license and maintenance revenues are derived from annual license fees, monthly license fees, perpetual license fees and annual maintenance fees. License and maintenance revenues were $36.8 million for the quarter ended September 30, 1998, an increase of 55% from $23.7 million for the comparable quarter in 1997. The increase in license and maintenance revenues was due primarily to the growth of license fee revenues from the financial solutions segment of approximately $5.3 million and the retail solutions segment of approximately $3.4 million. The increase in the financial solutions industry revenue during the quarter ended September 30, 1998 compared to the quarter ended September 30, 1997, is attributable to an increase in sales of the Falcon and AREAS product lines and sales generated by the recently acquired company, FTI. On September 30, 1998, the Company entered into a two year service agreement and a three year sale/license agreement for its AREAS, Data Mining Workstation, DeployNet/API and SIMD Numerical Array Processor products with Transamerica Intellitech. The increase in license and maintenance revenues in the retail solutions segment in the quarter ended September 30, 1998 compared to the quarter ended September 30, 1997, was primarily attributable to an increase in sales of the Retek suite of products. Products of the recently acquired company, PCS, were added to the Retek suite of products during the first quarter of 1998. Contributing to the increase in license and maintenance revenues in the quarter ended September 30, 1998 compared to the quarter ended September 30, 1997, were increases in the insurance solutions segment of approximately $2.7 million due primarily to an increase in the customer base and in the telecommunications solutions segment of approximately $1.6 million due to the recently acquired ATACS product line. License and maintenance revenues were $97.5 million for the nine months ended September 30, 1998, an increase of 51% from $64.3 million for the comparable period in 1997. The increase in license and maintenance revenues was due primarily to the growth of license fee revenues from the financial solutions segment of approximately $14.3 million and the retail solutions segment of approximately $11.9 million. The increase in the financial solutions industry revenue during the nine months ended September 30, 1998 compared to the nine months ended September 30, 1997, is attributable primarily to an increase in sales of the Falcon, FTI (the recently acquired company), AREAS and ProfitMax. The increase in license and maintenance revenues in the retail solutions segment in the nine months ended September 30, 1998 compared to the nine months ended September 30, 1997, was primarily due to an increase in sales of the Retek suite of products. Contributing to the increase in license and maintenance revenues were increases in the insurance solutions segment of approximately $4.2 million and license and maintenance revenues in the telecommunications solutions segment from the recently acquired ATACS product line of approximately $2.2 million. 17 18 SERVICES AND OTHER REVENUES. Services and other revenues are comprised of installation and implementation revenues, service bureau operations revenues and revenues which are derived from consulting contracts, new product development contracts with commercial customers and, to a lesser extent, research and development contracts with the United States Government. Revenues from installation and implementation services and contract services are generally recognized as the services are performed using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion. Service bureau revenues are derived from the Company's service bureau operations, which provide CRLink's functionality to customers that do not wish to obtain a license, that use this service until they can implement their own internal CRLink operation or that use this service when their volumes peak to high levels. Service bureau customers typically subscribe for services under month-to-month agreements and service bureau fees are recognized as revenue when the processing services are performed. Services and other revenues for the quarter ended September 30, 1998 were $10.9 million, an increase of 74% from $6.3 million for the quarter ended September 30, 1997. Additionally, services and other revenues for the nine months ended September 30, 1998 were $28.5 million, an increase of 65% from $17.3 million for the nine months ended September 30, 1997. The retail solutions segment accounted for approximately $3.0 million and $8.0 million of the increase during the quarter and nine months ended September 30, 1998, respectively. These increases were attributable to increases in consulting contracts with commercial customers in the retail industry. The insurance solutions segment accounted for approximately $600,000 and $2.5 million of the increase during the quarter and nine months ended September 30, 1998 compared to the quarter and nine months ended September 30, 1997, respectively. These increases were attributable to an increase in the number of customers utilizing the Company's service bureau operations. The financial solutions segment accounted for approximately $600,000 and $1.2 million of the increase during the quarter and nine months ended September 30, 1998, respectively. This increase was primarily due to new installations of the Capstone product line during the third quarter of 1998, and the Capstone, Falcon and ProfitMax product lines for the nine months ended September 30, 1998. EXPENSES LICENSE AND MAINTENANCE EXPENSES. License and maintenance expenses primarily consist of the Company's expenses for personnel engaged in customer support activities, costs of travel to customer sites and the costs of documentation materials. License and maintenance expenses for the third quarter of 1998 were $8.0 million and constituted 22% of license and maintenance revenues for the quarter, whereas such expenses were $5.0 million and represented 21% of license and maintenance revenues in the third quarter of 1997. Additionally, license and maintenance expenses for the nine months ended September 30, 1998 were $22.2 million and represented 23% of license and maintenance revenues for that nine-month period, whereas such expenses were $14.0 million and represented 22% of license and maintenance revenues for the nine months ended September 30, 1997. The financial solutions segment accounted for approximately $1.0 million and $3.6 million of the increase during the quarter and nine months ended September 30, 1998 compared to the quarter and nine months ended September 30, 1997, respectively. The insurance solutions 18 19 segment accounted for approximately $1.2 million and $2.4 million of the increase during the quarter and nine months ended September 30, 1998, respectively. The retail solutions segment accounted for approximately $700,000 and $2.0 million of the increase during the quarter and nine months ended September 30, 1998, respectively. The primary reason for the increase in these expenses across all industry segments in the three and nine month periods ended September 30, 1998 over the comparable periods in 1997 (both in absolute dollars and as a percent of revenues), was increased staffing and associated costs in client services to support an increased volume of business. SERVICES AND OTHER EXPENSES. Services and other expenses consist of personnel and other expenses associated with providing installation and implementation services, the Company's performance of development, consulting, and research and development contracts and the costs associated with the service bureau operations. Service and other expenses for the third quarter of 1998 were $8.5 million and 78% of services and other revenues, whereas such expenses were $3.8 million and 61% of service and other revenues during the third quarter of 1997. Services and other expenses for the first nine months of 1998 were $20.2 million and 71% of service and other revenues, whereas such expenses were $11.0 million and 63% of services and other revenues during the first nine months of 1997. The retail solutions segment accounted for approximately $3.0 million and $6.1 million of the increase during the quarter and nine months ended September 30, 1998 compared to the quarter and nine months ended September 30, 1997, respectively. These increases are attributable to an increase in consulting contracts with commercial customers in the retail industry. Due to the increase in demand for retail consulting services, the retail solutions segment utilized a significant amount of contract labor, which in turn caused a decrease in gross margins. The financial solutions segment accounted for approximately $900,000 and $1.9 million of the increase during the quarter and nine months ended September 30, 1998, respectively. This increase (and the associated decrease in gross margins) was a result of a shift in the mix of implementations within the financial solutions segment due primarily to an increase in Capstone implementations, which have substantially lower margins than implementations of the Falcon line of products. The insurance solutions segment accounted for approximately $500,000 and $1.2 million of the increase during the quarter and nine months ended September 30, 1998, respectively. The associated increases in gross margins were the result of increased volume of service bureau customers combined with relatively fixed costs. RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses consist primarily of salaries and other personnel-related expenses and subcontracted development services. Research and development expenses in the third quarter of 1998 were $9.2 million or 19% of total revenues compared to $6.0 million or 20% of total revenues in the third quarter of the prior year. Research and development expenses for the first nine months of 1998 were $23.6 million or 19% of total revenues compared to $15.4 million or 19% of total revenues for the first nine months of the prior year. The insurance solutions segment accounted for approximately $2.0 million and $4.4 million of the increase during the quarter and nine months ended September 30, 1998 compared to the quarter and nine months ended September 30, 1997, respectively. The retail solutions segment accounted for approximately $400,000 and $2.6 million of the increase during the quarter and nine months ended September 30, 1998, respectively. The financial solutions 19 20 segment accounted for approximately $600,000 and $1.6 million of the increase during the quarter and nine months ended September 30, 1998, respectively. The increase in these expenses in absolute dollars was due primarily to increases in staffing and related costs to support increased product development activities, primarily related to enhancements to the insurance solutions and retail solutions products and, to a lesser extent, the financial solutions products. Research and development expenses also increased in absolute dollars due to increased efforts required to support the research and development functions of businesses acquired by the Company in late fiscal 1997 and in fiscal 1998. SALES AND MARKETING EXPENSES. Sales and marketing expenses consist primarily of salaries and benefits, commissions, travel, entertainment and promotional expenses. Sales and marketing expenses were $8.8 million or 18% of total revenues in the third quarter of 1998 compared to $5.7 million or 19% of total revenues in the third quarter of 1997. Sales and marketing expenses were $25.2 million or 20% of total revenues in the first nine months of 1998 compared to $15.5 million or 19% of total revenues in the first nine months of 1997. The retail solutions segment accounted for approximately $1.0 million and $4.8 million of the increase during the quarter and nine months ended September 30, 1998 compared to the quarter and nine months ended September 30, 1997, respectively. The financial solutions segment accounted for approximately $1.4 million and $3.6 million of the increase during the quarter and nine months ended September 30, 1998, respectively. The insurance solutions segment accounted for approximately $200,000 and $800,000 of the increase during the quarter and nine months ended September 30, 1998, respectively. The increases in sales and marketing expenses were due primarily to increases in staffing related to the Company's expansion of its direct sales and marketing staff, including opening sales offices in Canada, Germany, South Africa, France and Japan. Contributing to the increases were increased expenses for trade shows, advertising, corporate marketing programs and other expenses to support the recently acquired businesses. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses were $3.8 million or 8% of total revenues in the third quarter of 1998, compared to $3.0 million or 10% of total revenues in the third quarter of the prior year. General and administrative expenses were $10.8 million or 9% of total revenues in the first nine months of 1998, compared to $8.4 million or 10% of total revenues in the first nine months of the prior year. Included in general and administrative expenses were acquisition related costs of $123,000 for the three month period ended September 30, 1997. These costs were related to the acquisition of CompReview in November 1997. Acquisition related costs of $673,000 and $123,000 were included in general and administrative expenses in the first nine months of 1998 and in the first nine months of 1997, respectively. These costs related to the acquisition of CompReview in November 1997 and the acquisition of PCS in first quarter of 1998 and the acquisitions of FTI and ATACS in the second quarter of 1998. Excluding acquisition costs, the retail solutions segment accounted for approximately $60,000 and $900,000 of the increase during the quarter and nine months ended September 30, 1998 compared to the quarter and nine months ended September 30, 1997, respectively. Excluding acquisition costs, the financial solutions segment accounted for approximately $300,000 and $600,000 of the increase during the quarter and nine months ended September 30, 1998, respectively. The increase in absolute dollars was due primarily to increased staffing and 20 21 related expenses, including recruiting costs, to support higher levels of sales and development activity across the Company resulting in part from the Company's recent acquisitions. The decrease of general and administrative expenses as a percentage of total revenues was the result of general and administrative expenses increasing at a lower rate than revenues in the same fiscal periods. IN-PROCESS RESEARCH AND DEVELOPMENT EXPENSES. In-process research and development expenses were $6.1 million for the nine month period ended September 30, 1998. These one-time write-offs were related to the acquisitions of PCS, $1.8 million, and FTI, $3.0 million, and the asset purchase of ATACS, $1.3 million, during the first nine months of 1998. Practical Control Solutions, Inc. PCS is a worldwide supplier of fully integrated distribution center management software products that address the distribution needs of the retail, wholesale and manufacturing industries. PCS' products may be classified into two categories: Nautilus, an off-the-shelf warehouse management software system designed with all the tools needed to control the course of warehouse operations and Nautilus CBT, an operational tutorial database which guides the user through Nautilus operations. Certain products were complete in certain areas and under development in others. The classification of the technology as complete or under development was made in accordance with the guidelines of Statement of Financial Accounting Standards No. 86 ("SFAS 86"), Statement of Financial Accounting Standards No. 2 ("SFAS 2") and Financial Accounting Standards Board Interpretation No. 4 ("FIN4"). At the time of acquisition, PCS had a number of new software products under development, including Nautilus Versions 6.0 and 7.0 and Nautilus CBT. Nautilus Version 6.0 and Nautilus CBT were both nearly complete but had not reached technological feasibility as of the acquisition date and approximately $280,000 of development costs were assumed to be incurred through to their scheduled completion in mid-1998. Nautilus 7.0 was in an early stage of development as of the acquisition date. HNC assumed that it would incur approximately $974,000 of additional development costs through to technological feasibility, which was assumed to be in early 1999. All in-process research and development (R&D) projects continue to progress, in all material respects, consistently with the assumptions that HNC provided to the independent appraiser for use in the valuation of the in-process R&D. The inability of HNC to complete this technology within the expected timeframes could materially impact future revenues and earnings, which could have a material adverse effect on HNC's business, financial condition and results of operations. Financial Technology, Inc. FTI has been a leading provider of management accounting software for financial institutions since 1982. Since 1994, FTI has focused on profitability measurement and other decision support systems. FTI's products are generally classified into six categories: ProfitVision, MarketVision, RiskVision, DataVision, Decision Support Products and Financial Platform Products. FTI had various new products under development in each of these categories, none of which had reached technological feasibility as of the acquisition date. The classification of each new technology as complete or under development was made in accordance with the guidelines of SFAS 86, SFAS 2 and FIN4. Each new product under development has varying release dates for completion ranging from July 1998 through December 1999. The valuation was based on the assumption that the estimated cost to complete all products under development, measured as of the acquisition date, is approximately $2.1 million, of which $1.2 million would be incurred through December 1998 and an additional $900,000 would be incurred 21 22 during 1999. The valuation approach also assumed that these products would generate revenues through the year 2002. These statements regarding revenues and expenses are forward-looking statements, which are subject to risks and uncertainties. Actual results may differ materially from those anticipated. The important factors that could cause actual results to differ include those discussed in "Potential Fluctuations in Operating Results" and elsewhere in this Report. The inability of HNC to complete this technology within the expected timeframes could materially impact future revenues and earnings, which could have a material adverse effect on HNC's business, financial condition and results of operations. In-process research and development projects continue to progress, in all material respects, consistently with management's original assumptions that were provided to the independent appraiser and used to value the in-process R&D. ATACS. ATACS is a fraud management software solution for the wireline, wireless and Internet telecommunication service provider industries. The system detects fraudulent traffic thereby avoiding significant financial losses to traditional telecommunication carriers and Internet Service Providers. ATACS' Version 4.2 includes significant enhanced features from its prior version, including new enhancements to Velocity, Message Handlers and a subsystem to support fraud detection of on-line transactions. ATACS Version 4.1 was completed and producing revenues prior to the acquisition date while Version 4.2, which includes new technology that allows the system to function on three interface platforms, was under development and had not yet reached technological feasibility as of the acquisition date. Although Version 4.2 has as its foundation technology from the completed as well as in-process technology, HNC believes that it will have changed significantly so as to be considered new research and development efforts. The classification of each research and development project as complete or under development was made in accordance with the guidelines of SFAS 86, SFAS 2 and FIN4. The valuation approach assumed that the cost to reach technological feasibility would be approximately $250,000 and the release would be completed by July 1998. In-process research and development projects continue to progress, in all material respects, consistently with HNC's original assumptions that were provided to the independent appraiser and used to value the in-process R&D. Valuation Approach. HNC used an independent appraisal firm to assist it with its valuation of the fair market value of the purchased assets of PCS, FTI and ATACS. Fair market value is defined as the estimated amount at which an asset might be expected to be exchanged between a willing buyer and willing seller assuming the buyer continues to use the assets in their current operations. HNC provided assumptions by product line of revenue, cost of goods sold and operating expense to the appraiser to assist in the valuation. The appraisal considered three traditional approaches to valuation: the cost approach, the market approach and the income approach. Practical Control Solutions, Inc. With respect to the forecasted earnings provided to the appraiser, PCS is forecasting slightly higher revenue growth rates as long as it can continue to meet market demands with new releases each year. These higher growth rates reflect PCS' expectation of greater market acceptance with the release of its ORACLE-based platform, as well as new improvements, that will be found in Nautilus versions 6 and 7. PCS' gross margins are forecasted to remain consistent relative to prior years. PCS is also expecting its current operating expense levels to only moderately increase in absolute dollars and, as a result, earnings before interest and taxes is expected to increase in later years. Management believes these growth expectations are reasonable if the new product versions are offered according to the schedules 22 23 reflected in the financial statements. The statements regarding expectations for PCS are forward-looking statements, which are subject to risks and uncertainties. Actual results may differ materially from those anticipated. The important factors that could cause actual results to differ include those discussed in "Potential Fluctuations in Operating Results" and elsewhere in this Report. Financial Technology Inc. Prior to 1997, FTI primarily sold financial reporting general ledger software to mid-sized banks. During 1997, FTI began to derive a significant amount of its revenue from ProfitVision, a customer profitability system for the same financial institutions. With respect to the forecasted earnings provided to the appraiser, FTI is forecasting significant revenue growth from a full line of new software measurement tools. The financial forecasts reflected in the appraiser's report reflect management's expectation of significant revenue growth from a number of new product offerings. Operating margins (before interest and taxes) are currently expected to increase from historical trends. Management currently believes that these projected increases are reasonable in light of the number of new product offerings and increased gross profit obtained from these new software measurement tools which is in contrast to those obtained from its financial reporting packages historically sold by FTI. The statements regarding expectations for FTI are forward-looking statements, which are subject to risks and uncertainties. Actual results may differ materially from those anticipated. The important factors that could cause actual results to differ include those discussed in "Potential Fluctuations in Operating Results" and elsewhere in this Report. ATACS. ATACS represented a product line within Bedford Associates, Inc. since 1995. Management was provided with limited historical information but, in conjunction with the acquisitions, reviewed contracts that supported revenue and identified and ultimately hired the development and support team that represents the underling costs of revenue as well as development costs. Under Bedford, ATACS was not an aggressively marketed product and, as a result, sales growth slowed and margins slightly dropped. The product becomes more widely marketable with the offering of Version 4.2, which expands the functionality to three new operating environments. With respect to the forecasted earnings provided to the appraiser, the forecasts reflected higher growth rates than prior years' ranges, reflecting the new product offering and several years of prior marketing of the product now generating sales opportunities. Gross margins are also forecasted to increase rather significantly reflecting higher revenue levels and economies of scale in the production and support cost areas. The statements regarding expectations for ATACS are forward-looking statements, which are subject to risks and uncertainties. Actual results may differ materially from those anticipated. The important factors that could cause actual results to differ include those discussed in "Potential Fluctuations in Operating Results" and elsewhere in this Report. With respect to the discount rates used in the valuation approach, the incomplete technology represents a mix of near and mid-term prospects for the business and imparts a level of uncertainty to its prospects. It is the nature of the business to be constantly developing new software for future product releases. A reasonable expectation of return on the incomplete technology would be higher than that of completed technology due to these inherent risks. As a result, the earnings associated with incomplete technology were discounted at a rate of 40.0%, 27.0% and 22.5% for PCS, FTI and ATACS, respectively, based upon the following methodologies: 23 24 Practical Control Solutions, Inc. Because PCS did not have short-term or long term debt as of the date of acquisition, the Moody's seasoned Baa rate for March 31, 1998 was utilized as the cost of debt. The Capital Asset Pricing Model was used to determine the cost of equity. It combines a risk free rate of return with an equity risk premium multiplied by a factor, referred to as Beta, which is based on the performance of common stock prices of similar publicly traded companies. Employing these data, the discount rate attributable to the business was 30%, which was used for valuing completed technology. Since incomplete technology represents a mix of near- and mid-term prospects for the business and imparts a certain level of uncertainty and would require a higher return than completed technology, the valuation report prepared by the Company's Appraiser suggests that a rate of 40% be ascribed to the excess earnings of incomplete technology. Financial Technology Inc. The cash flows attributable to FTI's technology were discounted based on a weighted average cost of capital ("WACC") analysis attributable to the business. In determining an appropriate discount rate utilizing the WACC analysis, an analysis was made of short-term interest rates, the yields of long-term corporate and government bonds, and other alternative investment instruments, as well as the typical capital structure of companies in the industry. Employing this formula, the discount rate attributed to the business was 17% , which was used to discount the completed technology. Incomplete technology represents a mix of near- and mid-term prospects for the business and imparts a certain level of uncertainty. The valuation report prepared by the Company's appraiser suggests that a rate of 27% be ascribed to the excess earnings of incomplete technology. ATACS. Because ATACS did not have short-term or long term debt as of the date of acquisition, the Moody's seasoned Baa rate for May 19, 1998 was utilized as the cost of debt. The Capital Asset Pricing Model was used to determine the cost of equity. It combines a risk free rate of return with an equity risk premium multiplied by a factor, referred to as Beta, which is based on the performance of common stock prices of similar publicly traded companies. Employing these data, the discount rate attributable to the business was 17.5%, which was used for valuing completed technology. Since incomplete technology represents a mix of near- and mid-term prospects for the business and imparts a certain level of uncertainty and would require a higher return than completed technology, the valuation report prepared by the Company's appraiser suggests that a rate of 22.5% be ascribed to the excess earnings of incomplete technology. ACQUISITION RELATED AMORTIZATION EXPENSES. Acquisition related amortization expenses were $1.2 million or 3% of total revenues in the third quarter of 1998 and $2.0 million or 2% of total revenues in the first nine months of 1998. These expenses represent the amortization of intangible assets purchased in conjunction with the Company's acquisitions of PCS and FTI and the asset purchase of ATACS during the first nine months of 1998. TOTAL OTHER INCOME, NET. Other income for the third quarter of 1998 was $612,000 compared to $538,000 in the third quarter of the prior year. Other income for the first nine months of 1998 was $1.6 million compared to $1.4 million in the first nine months of the prior year. Other income is comprised primarily of interest income earned on cash and investment balances, net of interest expense related to the 4.75% convertible subordinated notes due 2003. The increase in the quarter ended September 30, 1998 compared to the quarter ended September 24 25 30, 1997, is the result of increased interest income related to the increase in investments, partially offset by the interest expense related to the notes. INCOME TAX PROVISION. The income tax provisions of $3.7 million and $1.8 million in the third quarters of 1998 and 1997, respectively, and the income tax provisions of $9.4 million and $4.6 million during the first nine months of 1998 and 1997, respectively, are based on management's estimates of the effective tax rates to be incurred by the Company during those respective full fiscal years. The 1998 income tax provisions include the tax effects of non-deductible, one-time write-offs of in-process research and development and/or amortization expense related to the purchases of PCS and FTI. The income tax provision of $1.8 million in the third quarter of 1997 and $4.6 million during the first nine months of 1997 was lower than 1997 taxes at statutory rates primarily as a result of CompReview's subchapter S corporation status prior to the acquisition, which resulted in CompReview's tax liability being borne by its former stockholders rather than by CompReview. As of the date of the acquisition, CompReview's tax status was changed to C corporation. In the future, the Company expects that the effective tax rate will be reflective of the tax rate of other California-based companies. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities during the first nine months of 1998 was $13.5 million, which primarily represented net income before non-cash charges for purchased research and development and depreciation and amortization of approximately $21.0 million, offset in part by an increase in accounts receivable. Net cash used in investing activities was $96.7 million during the first nine months of 1998, primarily due to net purchases of investments of $127.0 million. Net cash provided by financing activities of $106.0 million during the first nine months of 1998 was primarily related to proceeds from the issuance of the Company's 4.75% Convertible Subordinated Notes (the "Notes") due 2003 of $100.0 million issued in conjunction with the Company's debt offering in March 1998 and net proceeds of $9.7 million from the issuance of common stock. This was partially offset by costs of approximately $2.8 million related to the issuance of the above-mentioned Notes. At September 30, 1998, the Company had $150.6 million in cash, cash equivalents and investments available for sale. The Company believes that its current cash, cash equivalents and investments available for sale balances, borrowings under its credit facility and net cash provided by operating activities, will be sufficient to meet its working capital and capital expenditure requirements for at least the next 12 months. The Company expects to invest approximately $2.0 million in capital assets, including computer equipment and building improvements throughout the remainder of 1998. Management intends to invest the Company's cash in excess of current operating requirements in short-term, interest-bearing, investment-grade securities. A portion of the Company's cash could also be used to acquire or invest in complementary businesses or products or otherwise to obtain the right to use complementary technologies or data. The proceeds from the Notes will be used for general corporate purposes, including working capital or to acquire complementary businesses, products or technologies. From time to time, in the ordinary course of business, the Company evaluates potential acquisitions of such businesses, products, technologies or data. 25 26 The objectives of the Company's investment policy are the safety and preservation of invested funds and liquidity of investments that is sufficient to meet cash flow requirements. The Company's policy is to place its cash, cash equivalents and investments available for sale with high credit quality financial institutions and commercial companies and government agencies in order to limit the amount of credit exposure. It is also the Company's policy to maintain certain concentration limits, to only invest in certain "allowable securities" as determined by the Company's management and must be denominated in U.S. dollars. The Company's investment portfolio shall not have an average portfolio maturity of beyond one year and shall maintain certain liquidity positions. Investments are prohibited in certain industries and speculative activities. 26 27 Item 6: EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 2.01 Agreement and Plan of Reorganization dated as of September 16, 1998 among the Registrant, Open Solutions, Inc. and Oahu Transaction Corp., a wholly-owned subsidiary of the Registrant (incorporated by reference to Appendix A to the Proxy Statement/Prospectus included in the Company's Registration Statement on Form S-4 Registration No. 333-64527.). 27.01 Financial Data Schedule. 27.02 Restated Financial Data Schedule.*
(b) Reports on Form 8-K None - ---------------- *Filed herewith. 27 28 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this amendment to report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized. HNC SOFTWARE INC. Date: February 5, 1999 By: /s/ RAYMOND V. THOMAS ------------------------------------------- Raymond V. Thomas Vice President, Finance & Administration and Chief Financial Officer (for Registrant as duly authorized officer and as Principal Financial Officer) 28 29 EXHIBIT INDEX
Exhibits -------- 2.02 Agreement and Plan of Reorganization dated as of September 16, 1998 among the Registrant, Open Solutions, Inc. and Oahu Transaction Corp., a wholly-owned subsidiary of the Registrant (incorporated by reference to Appendix A to the Proxy Statement/Prospectus included in the Company's Registration Statement on Form S-4 Registration No. 333-64527.). 27.01 Financial Data Schedule. 27.02 Restated Financial Data Schedule.*
- ---------------- *Filed herewith. 29 EX-27.02 2 EXHIBIT 27.02
5 1,000 3-MOS DEC-31-1998 JUL-01-1998 SEP-30-1998 40,746 109,850 54,832 (4,441) 326 153,446 28,039 (13,442) 271,207 23,515 100,000 0 0 26 147,502 271,207 47,750 47,750 16,542 16,542 23,010 0 (1,418) 8,810 3,734 5,076 0 0 0 5,076 0.20 0.19
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