Item 1. Business
Introduction
Quest Software is a leading independent software vendor (“ISV”) for the primary database management systems and packaged and custom applications used by large and medium sized enterprises. We generate revenues by licensing our products, principally on a perpetual basis, and by providing support, maintenance and implementation services for these products. Our products improve, in many cases dramatically, the quality of service of our customers’ key software applications. Many of our products also significantly reduce associated capital and operating expenses by minimizing hardware, software and/or personnel costs. See Note 14 of “Notes to Consolidated Financial Statements” for information regarding our reportable operating segments and geographic information.
Our strategy is to target high value, widely adopted software platforms and build necessary development expertise through internal hiring and acquisitions. From 1996 to 2000, this strategy enabled us to become a market leading ISV for the Oracle database management system. More recently, we have leveraged this database expertise to address IBM’s DB2 and Microsoft’s SQL Server, two other leading database management systems.
Large and medium-sized enterprises have widely implemented packaged and custom applications running on highly sophisticated database management systems. Enterprises use database systems like Oracle, DB2 or SQL Server to store, organize, access and analyze critical information such as financial, customer, employee, inventory and manufacturing data. In many cases our products can significantly improve the performance, reliability and availability of these systems.
We believe we are now a leading ISV as well for packaged applications such as SAP, Siebel, PeopleSoft and Oracle. These applications typically run in multi-vendor environments with key underlying components, such as application servers, web servers, databases and operating systems, coming from different vendors. Our applications performance management products are designed to detect, diagnose and resolve application performance problems by providing a complete view of these heterogeneous systems. We also provide administrative products for the Microsoft 2000, Active Directory and Microsoft Exchange platforms.
In November 2002, we acquired Sitraka, a leading provider of development tools and application performance management products for applications based on the Java 2 Enterprise Edition (J2EE) development platform, a rapidly emerging standard for component based development of multi-tier applications.
We invest heavily in our product engineering capabilities, which we believe provides competitive differentiation and is a key to long-term success. In building our products, we stress ease of deployment, ease of
use and tangible, readily articulated customer benefits. We sell our products primarily via our direct sales channel, supplemented by indirect sales through systems integrators and value added resellers. We operate in North and South America, Europe and Australia.
Quest is a California corporation incorporated in 1987. Our principal offices are located at 8001 Irvine Center Drive, Irvine, California 92618.
Market Overview
Key enterprise applications are highly complex and require substantial investment, personnel and expertise in their development, deployment and management. Enterprises are placing increasing demands on their information technology (“IT”) organizations while their IT budgets tighten. We design our products to enable these IT organizations to meet their service level objectives more cost effectively by extending the benefits of their existing information technology infrastructure.
An application is useless if it is not available to end-users. Internal and external demands on critical applications grow as application use grows. As clients and customers interact directly with organizations’ internal systems, the availability and performance of the application becomes critical. As internal and customer-facing applications are deployed to a wider audience, rapid and unpredictable spikes in the number of users can dramatically increase the likelihood of performance degradation and system failure. Historically, organizations have relied on a combination of manual processes and a heterogeneous assortment of software tools to manage the performance and reliability of their application infrastructure to ensure the distribution of information throughout the enterprise. The requirements of today’s IT systems have, however, stretched the capabilities of these traditional solutions. Further, as multi-tiered application infrastructures are deployed, the complexity of the environment necessitates that tools be used to identify the location of potential performance bottlenecks before they impact the end user community.
Enterprises are also re-focusing their IT projects back to improving the service levels and reliability of their existing core systems. For business critical databases and applications, many of our products are relevant to these efforts. Our products are designed to increase the cost effectiveness of existing investments in software, computer hardware, storage systems and/or IT personnel. Our application performance management solutions such as the Foglight and Spotlight products discussed below enable IT organizations to monitor and manage the application service levels they provide to internal and external end-users.
Enterprises must also contend with the demands of ever increasing data. Much of this data is stored in database management systems such as Oracle, DB2 and Microsoft SQL server. These trends create demand for our database tools that can improve the utilization and reliability of large-scale databases and of the developers and database administrators and other personnel responsible for maintaining reliability and performance.
Products
We currently market over 50 products, which we have grouped into three main categories: Database Products; Application Performance Management Products; and Microsoft Infrastructure Products. Major products in these categories are described as follows.
Database Products
TOAD and SQL Navigator. These tools improve the productivity and capability of application developers working in the Oracle PL/SQL environment. We provide a complete and integrated development environment for coding stored procedures, schemas and SQL scripts from one intuitive graphical user interface. Debugging, SQL tuning, change analysis, and general administration features improve the quality and performance of database applications before they enter production.
Quest Central. Administrating large databases in production involves many tedious, error-prone and repetitive tasks. To simplify these tasks and increase the accuracy and effectiveness of database administrators (“DBAs”), we have developed Quest Central™. Quest Central is an integrated workbench for Oracle and DB2 databases that combines into one suite four functional components: Database Administration, Performance Diagnostics, SQL Tuning, and “live” or traditional Space Management. Quest Central provides a consistent look and feel for the management of Oracle and DB2 databases, reducing cross training costs and enabling DBAs to manage more databases without adding resources.
SharePlex. In many cases, an organization’s data can be its most valuable resource. Ensuring that data remains available during an unplanned outage, disaster, or even planned downtime for maintenance can be imperative to an organization’s success. SharePlex provides real-time replication of Oracle databases for customers who need to ensure a current, secondary copy of their transactional Oracle database is available if the primary database goes down. Many, customers use SharePlex to offload management reporting, so the activity no longer competes with transaction processing. Finally, SharePlex is also frequently used to eliminate end user disruption by providing access to data during the migration of operating systems, hardware platforms and major application releases.
Application Performance Management Products
Our Application Performance Management products include our Foglight and Spotlight products.
Foglight and Spotlight. Foglight is a 24x7 application monitoring solution that provides a holistic view of an entire application and its related components, including application servers, web servers, databases and operating systems. Foglight offers an array of specialized cartridges focused on ERP and CRM applications to provide a complete monitoring solution for a distributed IT environment. Foglight will alert appropriate IT personnel of existing or threatened nonconforming operating conditions so that they can take preventative or corrective actions. Our series of complementary Spotlight diagnostic products allow IT personnel to drill down deeply into the many components of an application, database or other layer of the application stack to identify the root causes of a problem. With these Application Performance Management solutions, administrators can spend less time in reactive mode and more time focusing on improving and managing their IT infrastructures through:
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notification of potential problems before end users are affected;
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monitoring transaction response time;
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immediately resolving problems through real-time diagnostics; and
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maintaining strict service level agreements.
Microsoft Infrastructure Management Solutions
Microsoft applications and platforms are the global standard for desktop productivity applications. Our products enable IT personnel to more effectively migrate to, manage and administer the Microsoft Windows 2000, Exchange and Active Directory environments.
FastLane Suite. The FastLane Suite of products provides the utilities necessary to plan, deploy and manage Microsoft Windows 2000, Exchange 2000 and Active Directory. The suite includes:
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FastLane Reporter. Reporter allows administrators to easily assess their existing Microsoft Windows and Exchange environments and detect conflicts in advance of new Active Directory deployments.
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FastLane Migrator. Migrator streamlines the actual migration process and allows for central management of the project for local and/or distributed networks. With Migrator, customers accelerate the migration, while reducing the possibility of data loss and end user downtime.
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FastLane Consolidator. Most migrations include some level of server consolidation. Consolidator accelerates and simplifies server consolidations, allowing customers to migrate Microsoft Windows data, security and printers without slowing down the network or end users.
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FastLane ActiveRoles. After the migration, ActiveRoles allows Active Directory administrators to work more efficiently without compromising security or control.
Sales, Marketing and Distribution
We market and sell our products and services worldwide primarily through our direct sales organization. At December 31, 2002, we had 350 direct sales representatives, approximately 250 of which were field sales personnel organized into account teams. These account teams consist of a designated account manager and dedicated sales specialists for certain product lines. Our pre-sales systems engineers are assigned to these sales teams, and their role is to provide technical assistance and demonstrations to sales prospects. The remaining 100 sales representatives were telesales personnel, who sell products such as our Oracle development tools that are generally evaluated through internet downloads. We supplement our direct sales organization with indirect sales channels such as value added resellers and systems integrators. We also employ local resellers in certain international territories not covered by our local sales offices.
We have opened sales offices in the major cities of the United States, Europe and Australia to facilitate close contact between current and potential customers and our field sales organization, which includes sales teams as well as pre- and post-sales technical consultants. At December 31, 2002, we had 44 sales offices including our headquarters offices in Irvine, California.
Our sales and marketing approach is designed to help customers understand both the business and technical benefits of our products. Much of our sales activity involves free product trials for a limited period, typically 15 days, during which a customer can experience the benefits of our products. The pre-sales technical consultants assist our sales teams by conducting on-site proofs of concept and providing other in-depth technical services. We facilitate trial use of our products by making trial copies easily available from our website, as well as having Proof of Concept programs that deliver actual value to the prospect. Finally, we allow sales prospects full access to our customer support organization so that they can obtain an accurate view of the Quest customer experience. We believe this practice contributes in many cases to the purchase of our products.
Our marketing efforts are designed to create awareness and generate demand for our products. To achieve these goals, we participate in industry trade shows, technical conferences and seminars, publish technical and educational articles in industry journals and engage in a variety of other marketing activities, including direct mailings and print and Web-based advertising.
Our professional services organization complements our direct sales organization by providing customers with a full range of support services, including implementations, consulting services and training. We believe that professional services are important to customer satisfaction and the development of long-term customer relationships.
Customer Service and Support
A high level of customer service and support is critical to the successful marketing and sale of our products and the development of long-term customer relationships. We have a reputation for providing a high level of customer support and believe this is a competitive differentiator. Enrollment in our support, maintenance and enhancement program is annual and entitles a customer to: (a) problem resolution services, (b) new functional enhancements of a product and (c) ongoing compatibility with new releases of the database, application or other platform supported by the product. Annual maintenance, support and enhancement fees generally range from 20% to 25% of the initial purchase cost, depending on the product and the level of problem resolution support purchased. Customer support is provided domestically through our offices in Irvine and internationally through our offices in Europe and Canada.
Research and Development
We believe that strong research and product development capabilities are essential to enhancing our core technologies and developing additional products. Innovative capabilities, strong product engineering and rich user interfaces are typical Quest attributes. We target ease of implementation and ease of use in designing our products. Our commitment to ongoing product development is reflected in our investments in research and development, which were $39.7 million, $59.5 million and $59.4 million for the years ended December 31, 2000, 2001 and 2002, respectively. We have actively recruited key software engineers and developers with expertise in the areas of Oracle technologies, Java, Microsoft infrastructure technologies, ERP and CRM systems, IBM database technologies and document management. Our engineers include several of the industry’s leading database management authorities. Complementing these individuals, our senior management has extensive background in applications, database management, monitoring, and enterprise and system software industries.
Competition
The market for application management solutions is emerging rapidly, and, as a result, is intensely competitive and characterized by rapidly changing technology and evolving standards. Pricing pressures have increased over the past year, reflecting both competition and IT spending contraction. We expect competition to continue to increase both from existing competitors and new market entrants. We believe that our ability to compete effectively depends on many factors, including:
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the ease of use, performance, features, price and reliability of our products as compared to those of our competitors;
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the value proposition of our products in terms of return on investment and/or reduced cost of ownership;
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the timing and market acceptance of new products and enhancements to existing products developed by us and our competitors;
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the quality of our customer support; and
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the effectiveness of our sales and marketing efforts.
We compete in some cases with the vendors of databases, applications and other systems that we manage; for example, Oracle provides various tools for managing its databases that are competitive with Quest offerings. Competition from Oracle with certain of our Database Products including Shareplex and Quest Central for Oracle has increased over the last 24 months. In some cases these platform vendor-provided tools are bundled with the platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of our products. Moreover, there is substantial risk that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.
We also compete with other vendors of database, application and systems management tools. Public companies with whom we compete include:
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the large, well established systems management vendors-IBM/Tivoli, Computer Associates and BMC Software;
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smaller application and database management vendors such as Mercury Interactive, Embarcadero and Precise;
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providers of Windows NT management and migration tools, such as NetIQ, Aelita and BindView.
Some of our competitors and potential competitors have greater name recognition, a larger installed customer base company-wide and significantly greater financial, technical, marketing, and other resources than we do. Competitors may also be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can.
Because there are relatively low barriers to entry in the software market, we may encounter additional competition as other established and emerging companies enter our field and introduce new products and technologies. Venture capitalists and others have funded numerous application, database and systems management companies over the last five years. Accordingly, it is likely that new competitors or alliances among current and new competitors will emerge and rapidly gain acceptance.
There can be no assurance that we will be able to compete successfully against current and future competitors. Increased competition could result in price reductions, fewer customer orders, reduced gross margins and loss of market share, any of which could materially affect our business, operating results or financial condition.
Proprietary Rights
Our success and ability to compete depend on our ability to develop and maintain the proprietary aspects of our technology. We rely on a combination of trademark, trade secret, copyright law and contractual restrictions to protect the proprietary aspects of our technology. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to signed or shrink-wrap license agreements, which impose restrictions on the licensee’s ability to utilize the software. Finally, we seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements with us and by restricting access to our source code. We currently hold several trademark registrations and have numerous trademark applications in the United States and certain foreign countries.
Employees
As of December 31, 2002, we employed 1,813 full-time employees, including 772 in sales and marketing, 642 in research and development, 187 in customer service and support and 212 in general and administrative. We believe that our future success will depend in large part upon our continuing ability to attract and retain highly skilled managerial, sales, marketing, customer support and research and development personnel. Like other software companies, we face intense competition for such personnel, and we have at times experienced and continue to experience difficulty in recruiting qualified personnel. There can be no assurance that we will be successful in attracting, assimilating and retaining other qualified personnel in the future. We are not subject to any collective bargaining agreement and we believe that our relationships with our employees are good.
Website
Our website is located at www.quest.com. Information contained on our website is not part of this annual report on Form 10-K. We make available, free of charge on or through our website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.
Executive Officers of the Registrant
The names of our executive officers and other information about them are shown below.
Name
Age
Position
Vincent C. Smith
Chief Executive Officer and Chairman of the Board
M. Brinkley Morse
Vice President, Finance and Operations
Eyal M. Aronoff
Chief Technical Officer
Douglas F. Garn
Vice President of Worldwide Sales
Vincent C. Smith has served as our Chief Executive Officer since 1997 and a director since 1995. Mr. Smith became Chairman of the Board in 1998. In 1994, Mr. Smith was Director of Open Systems at BMC Software, where he managed its sales operations. From 1992 to 1994, Mr. Smith co-founded Patrol Software North America and served as its Vice President of Worldwide Sales and Marketing. Patrol Software merged with BMC in 1994. Mr. Smith worked at Oracle Corporation from 1987 to 1992 in a variety of sales management positions.
M. Brinkley Morse is our Vice President, Finance and Operations. Mr. Morse has held this position since January 2001. Before joining Quest, Mr. Morse served as Senior Vice President, Corporate Development and Secretary of BMC Software from September 1998 to August 2000, and he served as General Counsel and Secretary of BMC from November 1988 to September 1998.
Eyal M. Aronoff is our Chief Technical Officer and has held this position since September 2000. From March 1996 to September 2000, Mr. Aronoff was our Vice President of Technology and Engineering. Mr. Aronoff founded R*Tech Systems, a database management company, in 1992 and served as its President from 1992 to 1996, when we acquired this company. Prior to this, Mr. Aronoff worked for John Bryce Ltd., an Oracle distributor in Israel, and served in the Israeli Defense Force.
Douglas F. Garn is our Vice President of Worldwide Sales. Mr. Garn held this position from January 1998 to January 2002 and returned to this position in January 2003 after a medical leave of absence. From March 1996 to January 1998, Mr. Garn was Vice President of North American Sales for Peregrine Systems, Inc. From July 1995 until April 1996, Mr. Garn was Vice President of Sales with Syntax, Inc., a networking software company. From November 1993 until July 1995, Mr. Garn was Regional Sales Manager with BMC.
Item 2.
Item 2. Properties
Our principal administrative, sales, marketing, support and research and development facilities are currently located in approximately 135,100 square feet of space in Irvine, California. One of these facilities is under a six-year lease that includes an option to renew this lease for an additional five-year term. The other facility is under a 3 1/2 year lease.
We also lease sales offices in several major metropolitan areas of the U.S., including Atlanta, Boston, Chicago, Dallas, Houston, New York, San Francisco and Washington, D.C. Our Canadian subsidiaries currently operate from three leased facilities in Toronto, Ontario; Ottawa, Ontario and Halifax, Nova Scotia. Our German subsidiary currently operates from a leased facility in Cologne. Our Australian subsidiary operates from two leased facilities in Melbourne and Sydney, which total approximately 10,000 square feet. Our UK subsidiary leases a 5,300 square-foot office in the London metropolitan area.
Item 3.
Item 3. Legal Proceedings
On July 2, 2002, Computer Associates International, Inc. filed a complaint against the Company and four of its employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in connection with our development of the database administration component of
our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. We will vigorously defend CA’s claims and do not believe that this matter will have a material adverse effect on our results of operations or financial condition.
We are a party to other litigation, which we consider to be routine and incidental to our business. Management does not expect the results of any of these actions to have a material adverse effect on our results of operations or financial condition.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of 2002.
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity and Related Shareholder Matters
Our common stock is listed on the NASDAQ National Market under the symbol “QSFT.” The following table sets forth the high and low sale prices on the NASDAQ National Market for our common stock for the periods indicated.
On March 21, 2003, the closing price of our common stock on the NASDAQ National Market was $9.65 per share. As of March 21, 2003, there were 259 holders of record of our common stock (not including beneficial holders of shares held in “street name”).
We have not declared or paid any cash dividends on our common stock in the last two fiscal years and do not expect to do so in the foreseeable future. We currently intend to retain all available funds for use in the operation and expansion of our business. Any future determination to pay dividends will be at the discretion of our board of directors and will depend on our results of operations, financial conditions, contractual and legal restrictions and other factors the board deems relevant.
Item 6.
Item 6. Selected Financial Data
(1)
Intangible asset and goodwill amortization includes goodwill amortization of $35.7 million in 2000 and $56.0 million in 2001 of goodwill arising from acquisitions completed in 2000 and 2001. In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. We adopted SFAS No. 142 at the beginning of the first quarter of 2002. As required by SFAS No. 142, we discontinued amortizing the remaining balances of goodwill as of the beginning of fiscal 2002. See Notes 1, 4 and 5 of “Notes to Consolidated Financial Statements.”
(2)
Represents cash dividends paid in 1999 to holders of shares of Series B Redeemable Preferred Stock, all of which were redeemed in connection with our initial public offering in August 1999.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations also should be read in conjunction with the consolidated financial statements and notes to those statements included elsewhere in this Report. Certain statements in this Report, including statements regarding our business strategies, operations, financial conditions and prospects, are forward-looking statements. Use of the words “believe,” “expect,” “anticipate,” “will,” “contemplate,” “would” and similar expressions that contemplate future events may identify forward-looking statements.
Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures made in this report, including those described under “Risk Factors,” and in other filings with the SEC, that attempt to advise interested parties of certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect management’s opinions only as of the date thereof. We do not assume any obligation to revise or update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.
Overview
We provide application management software solutions that maximize the availability, performance and manageability of our customer’s business critical applications and their underlying databases and other associated components. Many of our products also increase the cost effectiveness of a customer’s IT investments, including personnel, software and hardware.
Our revenues consist of software license fees and service fees. Our software-licensing model is primarily based on perpetual license fees, and our licenses are either server-based or, for our SQL development, report management and Microsoft administration tools, user-based. Service revenues primarily represent the ratable recognition of software maintenance contract fees, which entitle a customer to technical support via telephone and the internet and product enhancements. These maintenance contracts all have annual terms. Customers purchase a software maintenance contract for the first year when they license a product and have the option of renewing the maintenance contract annually thereafter. Service revenues also include revenues from consulting and training services.
Acquisition of Sitraka
On November 1, 2002, we acquired all of the outstanding common stock of Sitraka, Inc. (Sitraka), a developer of application-server performance management products, in exchange for cash payments of $53.4 million and up to $3.6 million in additional contingent consideration. The acquisition was accounted for as a purchase and the purchase price was allocated primarily to goodwill totaling $35.9 million and other intangible assets totaling $25.0 million. In connection with the acquisition, we recorded a charge totaling $2.9 million for the fair value of purchased in-process research and development (IPR&D). We recorded this charge because the technological feasibility of products under development at the date of acquisition had not been established and no future alternative uses existed. The charge represented the estimated fair value of the incomplete research and development products based on discounted cash flows. Management is primarily responsible for estimating the fair value of IPR&D, which was determined with the assistance of an independent appraiser.
We identified and valued two IPR&D projects. Both projects were approximately 50% complete at the date of acquisition and the estimated cost to complete the projects was $1.3 million. One project was directed toward the development of improvements to an existing product and the other for a product that was in pre-production.
The IPR&D for the improvements to the existing product represented 55% of the total value of IPR&D acquired, while the product in pre-production represented the balance of 45%. At the date of acquisition both projects were anticipated to be completed in the first quarter of 2003. The projects were completed as anticipated and made generally available for sale in March 2003. See Note 5 of “Notes to Consolidated Financial Statements.”
Results of Operations
Except as otherwise indicated, the following percentages are percentage of total revenues:
Comparison of Fiscal Years Ended December 31, 2002 and 2001
Revenues
Total revenues increased 4.8% to $258.4 million in 2002 from $246.5 million in 2001.
License Revenues-License revenues decreased 7.3% to $161.4 million in 2002 from $174.1 million in 2001. We believe customer efforts to reduce IT spending in response to general economic conditions contributed to the decrease in license revenues in 2002. In addition, we experienced increased competition related to our high availability and production support products for Oracle and our Vista output management products, which also contributed to the decline in license revenues. The decline in license revenues for these products was offset by growth in other product areas, primarily our Microsoft administration products and our monitoring products. License revenues represented 62.5% of total revenues in 2002, compared to 70.6% in 2001. License revenues in North America decreased to $113.1 million in 2002 from $136.1 million in 2001, a decline of 16.9%. The decrease in North American license revenues was offset slightly by the acquisition of Sitraka in the fourth quarter of 2002. License revenues outside of North America increased 26.8% to $48.3 million in 2002 from
$38.1 million in 2001, and accounted for 29.9% of total license revenues, compared to 21.9% in 2001. The increase in license revenues outside of North America is primarily due to strengthening operations in Europe as a result of continued investment in our foreign operations. License revenues attributable to our European operations represented $43.0 million in 2002, compared to $33.1 million in 2001, representing growth of 29.9%.
Service Revenues-Service revenues increased 33.8% to $96.9 million in 2002 from $72.4 in 2001. This increase was derived primarily from higher renewal maintenance fees. Higher renewal maintenance fees derived from growth in the base of installed products and, we believe, from improved support renewal billing processes and improved maintenance renewal rates. To a much lesser extent, support revenues from the acquired base of Sitraka customers also contributed to year-over-year increase in service revenues. Professional services as a percentage of total service revenues represented 9.7% in 2002 and 15.4% in 2001.
Cost of Revenues
Cost of Licenses-Cost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication and amortization of purchased software rights. Cost of licenses decreased to $2.9 million in 2002 from $4.5 million in 2001, representing a decline of $1.6 million or 35.6%. Cost of licenses as a percentage of license revenues was 1.8% for 2002, compared with 2.6% in 2001. The decrease in cost of licenses for 2002 was primarily due to a decrease in third-party royalty obligations associated with our acquisition of RevealNet in the third quarter of 2001, whose products we distributed, and a decrease in amortization expense related to rights in purchased software rights. We expect that cost of licenses as a percentage of license revenues will remain relatively constant in 2003.
Cost of Services-Cost of services primarily consists of personnel, facilities and systems costs used in providing support, consulting and training services. Cost of services decreased to $17.8 million in 2002 from $18.5 million in 2001, representing a decline of $0.7 million. Cost of services as a percentage of service revenues declined to 18.4% for 2002, compared to 25.6% for 2001. The decrease in cost of services for 2002 is primarily attributable to a reduction in the amount of fees paid to outside consultants who provided specialized professional services.
Amortization of Purchased Intangible Assets-Amortization of purchased intangible assets includes amortization of the fair value of acquired technology associated with the acquisitions made during 2000, 2001 and 2002. Amortization of purchased intangible assets decreased to $5.7 million in 2002 from $8.0 million in 2001, representing a decrease of $2.3 million or 28.8%. The decrease is primarily due to the completion of amortization of purchased intangible assets related to certain acquisitions made in 2000, offset slightly by amortization related to acquisitions made in 2002. Intangible assets purchased as part of acquisitions were $3.2 million and $30.6 million in 2001 and 2002, respectively. The useful lives of the technology acquired range from one to seven years, and we expect the amortization of these purchased intangible assets to be approximately $7.2 million in 2003, $4.2 million in 2004 and thereafter $13.8 million. See “Critical Accounting Policies and Estimates” for additional discussion regarding accounting for intangible assets.
Operating Expenses
Sales and Marketing-Sales and marketing expenses consist primarily of compensation and benefit costs, sales commissions, facilities and systems costs, recruiting costs, trade shows, travel and entertainment and marketing communications costs such as advertising and promotion. Sales and marketing expenses increased 4.8% to $127.8 million in 2002 from $121.9 million in 2001. As a percentage of total revenues, sales and marketing remained relatively flat from 2001 to 2002. The increase in sales and marketing expenses in 2002 resulted from increased labor expenses, primarily due to additional headcount from our acquisition of Sitraka, higher sales commission expenses and increased depreciation of sales and marketing information technology assets.
Research and Development-Research and development expenses consist primarily of compensation and benefit costs for software developers, software product managers, quality assurance and technical documentation personnel, facilities and systems costs and payments made to outside software development consultants in connection with our on-going efforts to enhance our core technologies and develop additional products. Research and development expenses were constant at $59.4 million in 2002 compared with $59.5 million in 2001, and declined as a percentage of total revenues to 23.0% in 2002 from 24.2% in 2001. In 2002, we implemented cost-control measures that resulted in decreases in travel expenses and fees paid to outside software development consultants. These savings were offset by increased labor costs primarily attributable to the additional headcount resulting from the Sitraka acquisition.
We believe significant expenditures in research and development are required to remain competitive, and expect that research and development expenses will continue to represent approximately 20-25% of total revenues for the foreseeable future.
General and Administrative-General and administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, administrative and information services personnel, professional fees, and facilities and systems costs. General and administrative expenses increased to $24.9 million in 2002 from $24.0 million in 2001, representing an increase of $0.9 million or 3.8%. The increase in 2002 is primarily attributable to increased legal expenses and premiums for directors’ and officers’ liability insurance coverage. General and administrative expenses as a percentage of total revenues remained relatively flat from 2001 to 2002.
Intangible Asset and Goodwill Amortization-Intangible asset and goodwill amortization includes the amortization of intangible assets. These costs decreased to $2.0 million in 2002 from $56.7 million in 2001, principally resulting from our adoption of SFAS No. 142. All remaining and future acquired goodwill will be subject to impairment tests annually, or earlier if indicators of potential impairment exist, using a fair-value-based approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144. Previously recognized workforce-in-place intangible assets were reclassified to goodwill effective January 1, 2002. See Note 1 of “Notes to Consolidated Financial Statements” for a reconciliation of previously reported net income (loss) and earnings (loss) per share to the amounts adjusted for the exclusion of goodwill amortization had we adopted the non-amortization provisions of SFAS No. 142 as of January 1, 2001.
Other Compensation Costs-Other compensation costs is comprised primarily of compensation expense associated with the issuance of stock options with exercise prices below fair market value. These costs decreased to $2.0 million in 2002 from $7.0 million in 2001.
Other Income, Net-Other income, net consists primarily of interest income and expense and gain (loss) on equity investments. Other income, net increased to $6.2 million in 2002 from $3.8 million in 2001. The increase is primarily due to a $0.3 million net gain recognized in 2002 on equity investments, partially offset by lower yields on investments as a function of the decreasing interest rate environment and a loss recognized on the disposal of an aircraft. The net gain on equity investments in 2002 was attributable to a $1.9 million gain on the sale of an equity investment, largely offset by a non-cash charge of $1.6 million reflecting an adjustment for other than temporary impairment of an equity investment. These investments are in privately held information technology companies, many of which are in the start-up or development stage. These investments are carried at cost, subject to adjustment for other than temporary impairment. The average interest rates of our investments are summarized under “Item 7a:
Item 7a. Quantitative and Qualitative Disclosures About Market Risks
We transact business in a number of different foreign countries around the world. In most instances, revenues are collected and operating expenses are paid in the local currency of the country in which we are transacting. Accordingly, we are exposed to incremental volatility in sales and earnings within these countries due to fluctuations in foreign exchange rates.
Our exposure to foreign exchange risk is directly proportional to the magnitude of foreign net profits and losses denominated in currencies other than the U.S. dollar, as well as our net foreign investment in non-U.S. dollar assets. These exposures have the potential to produce either gains or losses. Our cumulative currency gains or losses in any given period are typically lessened by the economic benefits of diversification and low correlation between different currencies, but there can be no assurance that this pattern will continue to be true in future periods.
The foreign currencies to which we currently have the most significant exposure are the Canadian dollar, the British pound, the Euro and the Australian dollar. Based on our overall currency rate exposure at December 31, 2002, a ten percent change in currency rates would not have a material effect on our consolidated financial position, results of operations or cash flows.
To date, we have not used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for speculative trading purposes. We regularly monitor the potential cost benefit of hedging foreign exchange exposures with derivatives and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.
Interest Rate Risk
Our exposure to market interest-rate risk relates primarily to our investment portfolio. We have not used derivative financial instruments to hedge the market risks of our investments. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer other than the
United States government and its agencies. Our investments in marketable securities consist primarily of investment-grade bonds and United States government and agency securities. Investments purchased with an original maturity of three months or less are considered to be cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders’ equity.
Information about our investment portfolio is presented in the table below, which states the amortized book value and related weighted-average interest rates by year of maturity (in thousands):
We maintain a level of cash and cash equivalents such that we have generally been able to hold our investments to maturity. Accordingly, changes in the market interest rate would not have a material effect on the fair value of such investments.
Item 8.
Item 8. Financial Statements and Supplementary Data
The financial statements required by this item are included in Part IV, Item 15 of this Form 10-K and are presented beginning on page.
The following table sets forth selected unaudited consolidated quarterly financial data for the eight quarters ended December 31, 2002:
Item 9.
Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure.
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Information regarding our directors will be included in our definitive proxy statement, to be delivered to shareholders in connection with our 2003 annual meeting. Such information is incorporated herein by reference.
Information with respect to our executive officers may be found in Part I, Item 1, under the heading “Executive Officers of the Registrant.”
Item 11.
Item 11. Executive Compensation
Information regarding compensation of certain named executive officers will be included in the section captioned “Executive Compensation” appearing in our definitive proxy statement, to be delivered to shareholders in connection with our 2003 annual meeting of shareholders. Such information is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information required by this item will be included in the section captioned “Security Ownership of Certain Beneficial Owners and Management” appearing in our definitive proxy statement, to be delivered to shareholders in connection with our 2003 annual meeting of shareholders. The information regarding securities authorized for issuance under equity compensation plans will be included in the section captioned “Equity Compensation Plan Information” appearing in our definitive proxy statement, to be delivered to shareholders in connection with our 2003 annual meeting of shareholders. Such information is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
Information required by this item will be included in the section captioned “Related Party Transactions” appearing in our definitive proxy statement, to be delivered to shareholders in connection with our 2003 annual meeting of shareholders. Such information is incorporated herein by reference.
Item 14.
Item 14. Controls and Procedures
a) Evaluation of disclosure controls and procedures:
Within the ninety days prior to the date of this annual report and with the participation of the Company’s management, including the Company’s chief executive officer and principal financial officer, the Company performed an evaluation of its disclosure controls and procedures. Based on such evaluation, the Company’s chief executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures were effective and sufficient to ensure that information required to be disclosed by the Company in the reports that it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to the Company’s management as appropriate to allow timely decisions regarding required disclosure.
b) Changes in internal controls:
There have been no significant changes in the Company’s internal controls, or in other factors that could significantly affect these internal controls, subsequent to the date the Company completed its evaluation.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules And Reports On Form 8-K
(a) The following documents are filed as part of this Form 10-K.
1.
Financial Statements
Page
Independent Auditors’ Report
Consolidated Balance Sheets as of December 31, 2001 and 2002
Consolidated Statements of Operations for the Years Ended December 31, 2000, 2001 and
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2000, 2001 and
Consolidated Statements of Cash Flows for the Years Ended December 31, 2000, 2001 and
Notes to Consolidated Financial Statements
2.
Financial Statement Schedules
The following financial statement schedule should be read in conjunction with the consolidated financial statements of Quest Software, Inc. filed as part of this Report:
•
Schedule II - Valuation and Qualifying Accounts
Schedules other than that listed above have been omitted since they are either not required or not applicable or because the information required is included in the consolidated financial statements included elsewhere herein or the notes thereto.
3.
Exhibits
Exhibit Number
Exhibit Title
3.1
Second Amended and Restated Articles of Incorporation.(1)
3.2
Second Amended and Restated Bylaws, as amended.(2)
3.3
Certificate of Amendment of Second Amended and Restated Articles of Incorporation.(3)
3.4
Certificate of Amendment of Bylaws(4)
4.1
Form of Registrant’s Specimen Common Stock Certificate.(1)
10.1++
Registrant’s 1998 Stock Option/Stock Issuance Plan.(1)
10.2++
Registrant’s 1999 Stock Incentive Plan.(1)
10.3++
Registrant’s 1999 Employee Stock Purchase Plan.(1)
10.4
Form of Directors’ and Officers’ Indemnification Agreement.(1)
10.5
Office Space Lease dated as of June 17, 1999 between The Irvine Company and Quest Software, Inc.(1)
10.6
Office Lease between The Northwestern Mutual Life Insurance Company (Landlord) and Quest Software, Inc. (Tenant) dated as of September 30, 1999.(2)
10.7
Office lease, dated June 2000, between Fund VIII and Fund IX Associates and Quest Software, Inc.(5)
10.8++
Registrant’s 2001 Stock Incentive Plan(6)
10.9
First Amendment to Lease dated as of January 2, 2003 between The Irvine Company and Quest Software, Inc.
Exhibit Number
Exhibit Title
21.1
Subsidiaries of the Company.
23.1
Consent of Deloitte & Touche LLP.
99.1
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2
Certification of Vice President, Finance and Operations pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(1)
Incorporated herein by reference to the Company’s Registration Statement on Form S-1 and all amendments thereto (File No. 333-80543).
(2)
Incorporated herein by reference to the Company’s Registration Statement on Form S-1 and all amendments thereto (File No. 333-30816).
(3)
Incorporated herein by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2000.
(4)
Incorporated herein by reference to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2001
(5)
Incorporated herein by reference to the Company’s Annual Report on Form 10-K for the year ended December 30, 2000
(6)
Incorporated herein by reference to the Company’s Registration Statement on Form S-8 (File No. 333-82784) filed on February 14, 2002
++
Indicates a management contract or compensatory arrangement.
(b) Reports on Form 8-K
No reports on Form 8-K were filed by Quest Software, Inc. during the quarter ended December 31, 2002.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Pursuant to the requirements of the Securities Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/S/ VINCENT C. SMITH
Vincent C. Smith
Chief Executive Officer
(principal executive officer)
and Chairman of the Board
March 31, 2003
/S/ DAVID M. DOYLE
David M. Doyle
Director
March 31, 2003
/S/ M. BRINKLEY MORSE
M. Brinkley Morse
Vice President, Finance and Operations
(principal financial officer)
March 31, 2003
/S/ KEVIN E. BROOKS
Kevin E. Brooks
Corporate Controller
(principal accounting officer)
March 31, 2003
/S/ DORAN G. MACHIN
Doran G. Machin
Director
March 31, 2003
/S/ JERRY MURDOCK, JR.
Jerry Murdock, Jr.
Director
March 31, 2003
/S/ RAYMOND J. LANE
Raymond J. Lane
Director
March 31, 2003
/S/ AUGUSTINE L. NIETO II
Augustine L. Nieto II
Director
March 31, 2003
CERTIFICATIONS
I, Vincent C. Smith, certify that:
1. I have reviewed this annual report on Form 10-K of Quest Software, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date:
March 31, 2003
/S/ VINCENT C. SMITH
Vincent C. Smith,
Chief Executive Officer
CERTIFICATIONS
I, M. Brinkley Morse, certify that:
1. I have reviewed this annual report on Form 10-K of Quest Software, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6. The registrant’s other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date:
March 31, 2003
/s/ M. BRINKLEY MORSE
M. Brinkley Morse,
Vice President, Finance and Operation
INDEPENDENT AUDITORS’ REPORT
The Shareholders and Board of Directors
Quest Software, Inc.
We have audited the accompanying consolidated balance sheets of Quest Software, Inc. and subsidiaries (the Company) as of December 31, 2001 and 2002, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Quest Software, Inc. and subsidiaries at December 31, 2001 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the financial statements, the Company changed its method of accounting for goodwill and other intangible assets during 2002 as a result of adopting Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”
/s/ DELOITTE & TOUCHE LLP
Costa Mesa, California
January 29, 2003
QUEST SOFTWARE, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)
See accompanying notes to consolidated financial statements.
QUEST SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
QUEST SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)
(in thousands)
See accompanying notes to consolidated financial statements.
QUEST SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
QUEST SOFTWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
See Note 5 for details of assets acquired and liabilities assumed in purchase transactions.
See accompanying notes to consolidated financial statements.
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Description of Business and Summary of Significant Accounting Policies
Nature of Operations and Basis of Presentation - Quest Software, Inc., was incorporated in California in 1987 and is a leading developer and vendor of application and database management software products. We also provide consulting, training, and support services to our customers. We have wholly-owned research and development subsidiaries in Israel and Canada and sales subsidiaries in Canada, Europe, Australia, and Latin America for marketing, distribution, and support of our products and services. The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and include our accounts and those of our wholly owned subsidiaries. All inter-company transactions and balances have been eliminated in consolidation.
Foreign Currency Translation - In accordance with Statement of Financial Accounting Standards (SFAS) No. 52, Foreign Currency Translation, the United States dollar is considered to be the functional currency for our foreign subsidiaries, as such subsidiaries act primarily as an extension of our parent company’s operations. Assets and liabilities in these subsidiaries are re-measured at current exchange rates, except for property and equipment, depreciation and investments, which are translated at historical exchange rates. Revenues and expenses are translated at weighted average exchange rates in effect during the year, except for costs related to those balance sheet items, which are translated at historical rates. Foreign currency translation gains and losses are included in the consolidated statements of operations. Translation adjustments were not material for the years ended December 31, 2000, 2001 and 2002.
Fair Value of Financial Instruments - The carrying amounts of our financial instruments including cash and cash equivalents, marketable securities, accounts receivable, investments, accounts payable and accrued liabilities approximates their respective fair values because of the relatively short period of time between origination of the instruments and their expected realization, or because they are carried at fair value.
Cash and Cash Equivalents - We consider all highly liquid investments purchased with original maturities of three months or less to be cash equivalents.
Concentration of Credit Risk - Financial instruments that potentially subject us to credit risk include cash and cash equivalents, marketable securities and accounts receivable. Trade receivables potentially subject us to concentrations of credit risk. We believe that credit risks related to our investment portfolio are moderated by limitations we place on our exposure to any one issuer and credit risks on trade accounts receivable are moderated by the diversity of our products, customers and geographic sales areas. We closely monitor extensions of credit and have not experienced significant credit losses in the past. We maintain reserves for estimated credit losses and sales returns, and such losses and returns have historically been within management’s expectations. No single customer accounted for 10% or more of our total revenues or accounts receivable for the years ended December 31, 2000, 2001 or 2002.
Marketable Securities - We have classified all debt securities with original maturities of greater than three months as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income. The cost basis for realized gains and losses on available-for-sale securities is determined on a specific identification basis. We have classified available-for-sale securities as current or long-term based primarily on the maturity date of the related securities.
Investments in Non-consolidated Companies - We have made venture capital investments in early stage private companies and a private equity fund for business and strategic purposes, and may make additional
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
investments of this nature in the future. These investments are accounted for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. We periodically monitor our investments for impairment and will record reductions in carrying values if and when necessary. The evaluation process is based on information that we request from these privately-held companies. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings and revenue outlook, operational performance, management or ownership changes, and competition. If we determine that the carrying value of our investment in a company is at an amount below fair value, we write down the investment and record a loss in the consolidated statements of operations. Estimating the fair value of non-marketable equity investments in early-stage technology companies is inherently subjective and may contribute to volatility in our reported results of operations. Investments in non-consolidated companies are included in other assets on our consolidated balance sheet at December 31, 2001 and 2002.
Long-Lived Assets - We account for the impairment and disposition of long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. In accordance with SFAS No. 144, long-lived assets to be held are reviewed for events or changes in circumstances, which indicate that their carrying value may not be recoverable. We periodically review the carrying value of long-lived assets to determine whether or not impairment to such value has occurred. At December 31, 2001 and 2002, there was no impairment of long-lived assets based on our most recent analysis.
Property and Equipment - Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over the estimated useful lives ranging from three to seven years. Leasehold improvements are amortized over the shorter of the estimated useful lives of the improvements or the term of the related lease. Repair and maintenance costs associated with property, equipment and leasehold improvements are expensed as incurred. Software licenses are recorded at cost and are amortized over the shorter of the estimated useful lives of the related products or the term of the license, generally three years.
Goodwill and Amortizing Intangible Assets - Goodwill arising from acquisitions (Notes 4 and 5) is recorded as the excess of the purchase price over the fair value of assets acquired and was amortized prior to 2002 over a useful life of five years. Accumulated goodwill amortization was $89.5 million in 2001. Purchased intangible assets are recorded at the appraised value of technology, customer lists, trademarks and non-compete agreements acquired and amortized using the straight-line method over estimated useful lives of one to seven years. Accumulated amortization of purchased intangible assets was $5.9 million, $16.4 million and $23.9 million at December 31, 2000, 2001 and 2002, respectively. The net carrying amount of purchased intangible assets was considered recoverable at December 31, 2002, based on the undiscounted future cash flows expected to be realized from continued sales of the related software products. The carrying amount of goodwill was considered recoverable at December 31, 2002. As a result of adopting SFAS No. 142 in 2002, goodwill is no longer amortized but is evaluated for impairment at least annually. See “New Accounting Pronouncements.”
Other Assets - Other assets include prepaid royalties, lease security deposits, employee receivables and cost basis investments, which are accounted for on the cost basis as we do not have the ability to exercise significant influence. Cost basis investments are adjusted only for other-than-temporary impairments, additional investments or the sale of an investment.
Revenue Recognition - We record revenue in accordance with the American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition, and SOP 98-9,
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions. The AICPA and its Software Revenue Recognition Task Force continue to issue interpretations and guidance for applying the relevant standards to a wide range of sales contract terms and business arrangements that are prevalent in the software industry. Also, the Securities and Exchange Commission (SEC) has issued Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements, which provides guidance related to revenue recognition based on interpretations and practices followed by the SEC.
Software Licenses, Services, and Post-Contract Customer Support - We market our software licenses through our direct sales force and indirectly through resellers. Revenues from sales of software licenses, which generally do not contain multiple elements, are recognized when: (1) we enter into a legally binding arrangement with a customer; (2) we deliver the products; (3) customer payment is deemed fixed or determinable and free of contingencies or significant uncertainties; and (4) collection is probable. If all the requirements of revenue recognition have not been met, revenue recognition is deferred until such items are known or resolved. Revenue from post-sale customer support is deferred and recognized ratably over the term of the support contract. Revenue from consulting and training services is recognized as the services are performed. We provide a limited warranty on all sales of software licenses, which states that for a period of 30 days from delivery the media on which the software is recorded will be free from material defects in materials and workmanship under normal use, and that the operation of our software will substantially conform to the applicable product documentation. We do not maintain a warranty reserve as costs incurred in association with the warranty are not material.
For arrangements with multiple elements, we allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor-specific objective evidence.” Vendor-specific objective evidence of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately. If we cannot objectively determine the fair value of any undelivered element included in bundled software and service arrangements, we defer revenue until all elements are delivered, services have been performed or until fair value can objectively be determined.
Software Development Costs - Costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. After technological feasibility is established, any additional costs are capitalized in accordance with SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed. Because we believe that our current process for developing software is essentially completed concurrently with the establishment of technical feasibility, no software development costs have been capitalized as of December 31, 2001 and 2002.
Other Compensation Costs - We record compensation expense for options granted to purchase common stock if the related exercise price of the option is below fair market value. The expense equals the difference between the fair market value of our common stock on the grant or assumption date and the exercise price of the stock options. We assumed certain stock options in connection with various acquisitions. The expense is recognized ratably over the vesting period of the stock options, currently four to five years. We recorded unearned stock-based compensation of $6.9 million in September 2000 associated with unvested stock options to purchase approximately 192,055 shares of our common stock that were assumed in connection with our acquisition of FastLane Technologies Inc. The options assumed were valued using the fair market value of our common stock on the date of acquisition, which was $53.625 per share. Through December 31, 2002, we reduced unearned stock-based compensation by $2.8 million due to the termination of certain FastLane Technologies employees for awards that had not vested. We also record compensation costs from additional payroll taxes incurred when employees exercise stock options based on the difference between the exercise price and the market price on the date of exercise.
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The following table shows the allocation to Cost of Services Revenues, Sales and Marketing, Research and Development, and General and Administrative expenses of such costs based on the related headcount (in thousands):
Amortization expense for other compensation costs was $5.1 million, $7.0 million and $2.1 million in 2000, 2001 and 2002, respectively. We expect to amortize at least $0.5 million in the first quarter of 2003, $0.3 million per remaining quarters of 2003, and insignificant amounts through 2004, which corresponds to the remaining vesting periods of the related options.
Advertising Expenses - We expense all advertising costs as incurred, and such costs were $1.8 million, $2.8 million, and $3.4 million for the years ended December 31, 2000, 2001 and 2002, respectively.
Income Taxes - We account for income taxes under the provisions of SFAS No. 109, Accounting for Income Taxes. Deferred taxes on income result from temporary differences between the reporting of income for financial statements and tax reporting purposes. Measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and tax bases of our assets and liabilities result in a deferred tax asset, SFAS No. 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized.
Stock-Based Compensation - We account for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, we have chosen to continue to account for our stock-based compensation plans under APB Opinion No. 25 and provide the expanded disclosures specified in SFAS No. 123. Had compensation cost been determined using the provisions of SFAS No. 123, our net income (loss) available to common shareholders would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data):
For purposes of estimating the compensation cost of our option grants in accordance with SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. Weighted-average assumptions used for 2000, 2001 and 2002 were as follows:
Net Income (Loss) Per Share - We compute net income (loss) per share in accordance with SFAS No. 128, Earnings per Share. Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings (loss) per share reflects the potential dilution of securities by including other common stock equivalents, including stock options, in the weighted-average number of common shares outstanding for a period, if dilutive. For the years ended December 31, 2000 and 2001, all potential common stock equivalents have been excluded from the computation of diluted net loss per share because the effect would be antidilutive.
The table below sets forth the reconciliation of the denominator of the earnings (loss) per share calculation (in thousands):
(1)
Effect would have been anti-dilutive, accordingly, the amount is excluded from shares used in computing diluted net loss per share. The dilutive effect of stock options would have been 5,764 and 4,316 for 2000 and 2001, respectively. There were no anti-dilutive shares in 2002.
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Comprehensive Income (Loss) - The difference between net income (loss) and comprehensive net income (loss) was an unrealized gain on available-for-sale securities of $0.2 million, $0.4 million and $0.8 million for the years ended December 31, 2000, 2001 and 2002, respectively.
Use of Estimates - The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Risks and Uncertainties - We are subject to risks and uncertainties in the normal course of business, including customer acceptance of its products, rapid technological changes, delays in introducing and market acceptance of new products, competition, e-business developments, international expansion, ability to attract and retain qualified personnel, ability to protect its intellectual property, and other matters inherent in the software industry.
Reclassifications - Certain reclassifications have been made to the prior-years’ balances to conform to the current year’s presentation, which includes the adoption of Emerging Issues Task Force (“EITF”) 01-14, Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred. The result of this adoption was an increase in total service revenues with a corresponding increase in cost of service revenues of $1.2 million in 2001. The impact for the current year is higher service revenues and cost of service revenues of $0.9 million. These amounts were previously offset against cost of service revenues. No reclassifications were made for the year ended December 31, 2000 as amounts were not material.
New Accounting Pronouncements:
In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. We adopted SFAS No. 142 at the beginning of the first quarter of 2002. As required by SFAS No. 142, we discontinued amortizing the remaining balances of goodwill as of the beginning of fiscal year 2002. All remaining and future acquired goodwill will be subject to impairment tests annually, or earlier if indicators of potential impairment exist, using a fair-value-based approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Previously recognized workforce-in-place intangible assets were reclassified to goodwill effective January 1, 2002.
Under SFAS No. 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. Our reporting units are generally consistent with the operating segments underlying the reportable segments identified in Note 14-Geographic and Segment Information. We performed our impairment review as of January 1, 2002 and October 31, 2002 and as a result determined that the carrying value of our reporting units was less than their estimated fair value. In calculating the fair value of the reporting units, the market and income approaches, specifically the market multiple, comparable transaction, allocation of market capitalization and discounted cash flow methodologies were deemed the most reliable and used for impairment analysis. We will perform subsequent annual impairment reviews during the fourth quarter of each year, or earlier if indicators of potential impairment exist. Future impairment reviews may result in charges against earnings to write down the value of goodwill.
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
A reconciliation of previously reported net income (loss) and earnings (loss) per share to the amounts adjusted for the exclusion of goodwill and workforce-in-place amortization, net of the related income tax effect, had we adopted the non-amortization provisions of SFAS No. 142 as of January 2000 is as follows for the years ended December 31 (in thousands, except per share amounts):
Effective January 1, 2002, we adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. This new statement also supersedes certain aspects of Accounting Principles Board (“APB”) 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual, and Infrequently Occurring Events and Transactions, with regard to reporting the effects of a disposal of a segment of a business and will require expected future operating losses from discontinued operations to be reported in discontinued operations in the period incurred (rather than as of the measurement date as presently required by APB 30). In addition, more dispositions may qualify for discontinued operations treatment. The adoption of SFAS No. 144 did not have a significant impact on our financial position, results of operations, or cash flows.
In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes EITF Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs incurred in a Restructuring). SFAS No. 146 requires that costs associated with exit or disposal activities be recognized when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. We will apply the requirements of SFAS No. 146 to exit activities initiated after December 31, 2002, as required.
In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others. FIN 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002; while the provisions of the disclosure requirements are effective for
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
financial statements of interim or annual reports ending after December 15, 2002. We adopted the disclosure provisions of FIN 45 during the fourth quarter of fiscal 2002 and such adoption did not have a material impact on our consolidated financial statements. We are currently evaluating the recognition provisions of FIN 45 but expect that they will not have a material adverse impact on our consolidated results of operations or financial position upon adoption.
In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (“SFAS 148”). SFAS 148 amends Statement No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), to provide alternative methods for voluntary transition to SFAS 123’s fair value method of accounting for stock-based employee compensation. SFAS 148 also requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income (loss) and earnings (loss) per share in annual and interim financials statements. The provisions of SFAS 148 are effective in fiscal years ending after December 15, 2002. We are currently evaluating the provisions of SFAS 148 but expect that they will not have a material adverse impact on our consolidated financial statements upon adoption since we have not adopted the fair value method.
In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. Since we currently have no variable interest entities, we expect that the adoption of the provisions of FIN 46 will not have a material adverse impact on our consolidated results of operations or financial position.
2. Marketable Securities
The following table summarizes our portfolio of marketable securities (in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Interest income, included in other income (expense), net in the accompanying consolidated statements of operations, was, $13.5 million, $10.8 million and $9.3 million for the years ended December 31, 2000, 2001 and 2002, respectively.
3. Cost Basis Investments
At December 31, 2002, we valued our cost basis investments in private companies at $0.6 million. In addition, we have committed to make additional capital contributions to a private equity fund totaling $2.2 million. If the companies in which we have made direct or indirect investments do not complete initial public offerings or are not acquired by publicly traded companies or for cash, we may not be able to sell these investments. In addition, even if we are able to sell these investments we cannot assure that we will be able to sell them at a gain or even recover our investment. For the years ended December 31, 2001 and 2002, we recorded losses in other income, net, of $4.4 million and $1.6 million, respectively, associated with the other-than-temporary impairment and realized a gain of $1.9 million in 2002 on the sale of one of our investments in an early stage private company.
4. Goodwill and Amortizable Intangible Assets
Amortizing intangible assets as of December 31, 2001 and 2002, respectively, are comprised of the following:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Amortization expense for amortizing intangible assets was $6.3 million, $9.6 million and $8.1 million for years ended December 31, 2000, 2001 and 2002, respectively. Estimated annual amortization expense by fiscal year is as follows: 2003-$10.7 million; 2004-$5.7 million; 2005-$4.0 million; 2006-$3.7 million; 2007-$3.0 million; thereafter-$4.0 million. All intangible assets currently recorded will be fully amortized by the end of 2009.
The changes in the carrying amount of goodwill by reportable operating segment for the period ended December 31, 2002 is as follows (in thousands):
(1)
Includes $1,174 of previously recognized assembled workforce intangible assets, which were subsumed into goodwill effective January 1, 2002 and have been reclassified for comparative presentation.
5. Acquisitions
In September 2001, we acquired the outstanding shares of RevealNet, Inc., the industry leader in knowledge- based solutions for Oracle and DB2. This acquisition was made to significantly enhance our database development and management solutions, providing even more and unique value to our large and growing base of Oracle and DB2 Developers and Database Administrators (DBAs). In November 2001, we acquired substantially all of the assets of Laminar Software, Inc. in November 2001 for aggregate purchase prices of $10.1 million and $2.2 million, respectively. The purchase price for RevealNet included shares of our common stock valued at $10 million and direct acquisition costs of $106,000. The purchase price for Laminar Software included shares of our common stock valued at $1.7 million, cash of $152,000, forgiveness of previous cash advances of $252,000, and direct acquisition costs of $40,000.
We acquired the outstanding shares of BB4 Technologies, Inc., a provider of systems availability monitoring solutions in February 2002 and Sitraka, Inc. (Sitraka) a leading developer of application server performance management products in November 2002. The acquisition of Sitraka was made to broaden our application management portfolio of products to enable customers to detect, diagnose and resolve application bottlenecks within multi-tiered Java application environments. The purchase price for BB4 Technologies was $6.6 million, consisting of $4.2 million cash, direct acquisition costs of $0.2 million and future payments of $2.2 million related to non-compete agreements with certain key employees who are former shareholders.
We acquired Sitraka in exchange for cash payments of $53.4 million, up to $3.6 million in additional contingent consideration and direct acquisition costs of $1.1 million. Of the cash paid, $5.2 million was deposited to an escrow account to secure certain indemnification obligations of the selling shareholders. The obligation to pay the contingent consideration is dependent upon receipt of certain tax credits due to Sitraka. Of the contingent consideration obligation of $3.6 million, $2.3 million and $1.3 million expire in April 2004 and October 2005, respectively. As of December 31, 2002 $0.7 million of the contingent consideration had been paid.
In connection with the Sitraka acquisition, we identified and valued two In-Process Research and Development (IPR&D) projects. Both projects were approximately 50% complete at the date of acquisition and
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
the estimated cost to complete the projects was $1.3 million. One project was directed toward the development of improvements to an existing product and the other for a product that was in pre-production. The IPR&D for the improvements to the existing product represented 55% of the total value of the IPR&D acquired while the product in pre-production represented the balance of 45%. At the date of acquisition both projects were anticipated to be completed in the fourth quarter of 2002. The projects were completed as anticipated and made generally available for sale in March 2003.
Related to these IPR&D projects, in connection with the Sitraka acquisition, $2.9 million was allocated to IPR&D and expensed immediately upon completion of the acquisition (as a charge not deductible for tax purposes), because the technological feasibility of products under development had not been established and no future alternative uses existed. The fair value of the IPR&D for this acquisition was determined using the income approach. Under the income approach, expected future after-tax cash flows from each of the projects or product families (projects) under development are estimated and discounted to their net present value at an appropriate risk-adjusted rate of return. Each project was analyzed to determine the technological innovations included in the project; the existence and utilization of core technology; the complexity, cost and time to complete the remaining development efforts; the existence of any alternative future use or current technological feasibility; and the stage of completion in development. Future cash flows for each project were estimated based on forecasted revenues and costs, taking into account the expected life cycles of the products and the underlying technology, relevant market sizes and industry trends. Future cash flows from the significant acquired projects were expected to commence at various dates within three to six months of acquisition.
The projects were then classified as developed technology or IPR&D. The estimated future cash flows for each were discounted to approximate fair value. Discount rates, ranging from 25% to 35% for developed technology and IPR&D, were derived from a weighted average cost of capital analysis, adjusted upward to reflect additional risks inherent in the development process, including the probability of achieving technological success and market acceptance. The IPR&D charge includes the fair value of the portion of IPR&D completed as of the date of acquisition. We are responsible for the amounts determined for IPR&D, as well as developed technology, and believe the amounts are representative of fair values.
The acquisitions were all accounted for as purchase business combinations, and the results of each acquisition’s operations are included in our consolidated statements of operations from the respective dates of acquisition. With the exception of Laminar Software, all goodwill related to these acquisitions is not deductible for tax purposes. The purchase prices of these acquisitions were allocated as follows (in thousands):
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Goodwill by reportable segment, related to acquisitions in 2001 and 2002, is as follows:
Our financial results for the years ended December 31, 2001 and 2002 include actual results of these acquisitions for the period following the dates on which the acquisitions were completed. The pro forma results of operations data for 2001 and 2002 presented below assume that the acquisitions had been made at the beginning of each fiscal year and include amortization of identified intangibles from that date. The pro forma data is presented for informational purposes only and is not necessarily indicative of the results of future operations nor of the actual results that would have been achieved had the acquisitions taken place at the beginning of the fiscal year (in thousands):
6. Property and Equipment
Net property and equipment consist of the following at December 31 (in thousands):
7. Related-Party Transactions
During 1998, we received a note receivable from an officer of Quest for the purchase of 1.9 million shares of our common stock, at a purchase price of $0.39 per share. The note receivable, plus interest accruing at the rate of 5.7% per annum, was due April 2003. In September 2002, the officer repaid the note receivable, plus interest, in full.
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
In April 1999, we repurchased and canceled 29.6 million shares of common stock from a shareholder who, at the time, was one of our executive officers, at a price of $1.18 per share. We also entered into a severance agreement with the former officer whereby he received payments of $200,000 per year through April 2002 and was entitled to use of a company car and related expenses and medical benefits. We recorded approximately $700,000 of expense related to this severance agreement in April 1999. As of December 31, 2002, no additional amounts were owed under the terms of the severance agreement.
In August 2000, we received a note receivable from one of our executive officers, for the purchase of 339,000 shares of our common stock at a purchase price of $46.50 per share. The former officer remains employed by us. The note receivable, plus accrued interest, is due August 2007, bears interest at 6.33% per annum, and is secured by the common stock. The note receivable is deemed to be a non-recourse obligation of the former officer for financial reporting purposes.
A related party provides us with investment advisory services and receives no compensation.
8. Long-Term Debt
In conjunction with an acquisition in 2000, we assumed a $4.4 million zero-interest loan related to a research and development funding arrangement with the Province of Nova Scotia. We have imputed interest on the loan of $1.2 million, which is being amortized to interest expense over the term of the loan. The repayments have been fixed at $1.2 million each July of 2001, 2002 and 2003, with the balance repayable in 2004.
9. Income Taxes
The provision for income taxes consists of the following for the years ended December 31 (in thousands):
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The reconciliation of the U.S. federal statutory rate to the effective income tax rate for the years ended December 31, 2000, 2001 and 2002, is as follows:
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred taxes as of December 31, 2001 and 2002 are as follows (in thousands):
At December 31, 2002, we had recorded a valuation allowance of $19.0 million on our deferred tax assets. Based on the weight of available evidence, we believe that it is more likely than not that these deferred tax assets will not be realized. Approximately $4.3 million of the valuation allowance relates to net operating losses from stock option exercises. If these deferred tax assets are realized in the future, the tax benefit will be credited to shareholders’ equity.
At December 31, 2002, we had federal, state, and foreign net operating loss carryforwards of $22.5 million, $48.0 million and $39.1 million, respectively, which begin to expire in 2018, 2005 and 2003, respectively.
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Approximately $8.9 million of the federal and $12.8 million of the state net operating loss carryforwards relate to acquired companies and are subject to limitations on their utilization.
At December 31, 2002 we had federal and state tax credit carryforwards of $8.2 million and $5.9 million, respectively, which begin to expire in 2018.
Tax benefits associated with the exercise of stock options of $10.3 million and $17.8 million in 2001 and 2002, respectively, were credited to shareholders’ equity.
Income (loss) before income taxes consists of the following components (in thousands):
Undistributed earnings of our foreign subsidiaries were immaterial as of December 31, 2002. Those earnings are considered to be permanently reinvested. Accordingly, no provision for U.S. federal or state income tax has been provided thereon.
10. Shareholders’ Equity
In March 2000, we completed a secondary offering of 8.4 million shares of our common stock, of which we sold 3.8 million shares and 4.6 million shares were sold by selling shareholders. We received net proceeds of $253.5 million, after underwriting and offering expenses, for the shares we sold. We did not receive any proceeds from the shares sold by selling shareholders.
In December 2000, our Board of Directors authorized a stock repurchase program under which we may repurchase up to 2.0 million shares of our common stock. In October 2001, our Board of Directors increased the total number of shares authorized for repurchase under this program to 5.0 million shares. Under the repurchase program, we may repurchase shares from time to time at varying prices in open market or private transactions. We did not set any timeline within which repurchases would be made and have not committed to repurchase any specific amount of shares. As of December 31, 2000, we had repurchased 1.7 million shares for approximately $57.4 million under this program. No additional shares were repurchased under this program in 2001 and 2002. During 2000, we also repurchased approximately 1,000 shares issued to former shareholders of an acquisition for approximately $600,000. All shares repurchased have been cancelled and returned to the status of authorized and un-issued.
11. Employee Benefit Plans
Stock Option Plans
Our stock option plans provide for the issuance of stock options to our employees, directors and consultants. The options are generally granted with exercise prices equal to the fair market value of our common stock as of the grant date, expire ten years from the date of grant, and ratably vest over a four- to five-year period. As of December 31, 2002, we have authorized 27.8 million shares for issuance under the plans, of which 2.7 million shares are available for future grant.
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
A summary of the status of our stock option plans as of December 31, 2000, 2001 and 2002 and changes during the years ending on those dates is presented below (in thousands, except per share data):
During 2000, options to purchase an aggregate of 594,000 shares, with a weighted-average exercise price of $26.84 per share, were granted with below market exercise prices. No options were granted during 2001 and 2002 with below market exercise prices. Included in compensation and other costs in the accompanying consolidated financial statements is $3.4 million, $4.5 million and $1.5 million of expense recorded during the years ended December 31, 2000, 2001 and 2002, respectively, associated with such option grants. The expense equals the difference between the fair market value of our common stock on the grant date and the exercise price of the stock options and is recognized ratably over the vesting period of the stock options, currently four to five years.
The following tables summarizes information about stock options outstanding at December 31, 2002 (numbers of shares in thousands):
Employee Stock Purchase Plan
Under our 1999 Employee Stock Purchase Plan, we are authorized to issue up to 1.2 million shares of our common stock to eligible employees and the employees of participating subsidiaries. Individuals who are scheduled to work more than 20 hours per week for more than five calendar months per year are eligible to participate in the plan. A participant may contribute up to 15% of their cash earnings, and the accumulated
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
payroll deductions will be applied to the purchase of shares on semi-annual purchase dates. The purchase price per share will be equal to 85% of the lower of the fair market value of the common stock on the start date of the purchase period or the fair market value of the common stock on the semi-annual purchase date. Semi-annual purchase dates will occur on the last business day of January and July each year.
At December 31, 2002, 346,461 shares of common stock were reserved for issuance under this plan. In January 2002, 124,000 shares of common stock were purchased under this plan at a price of $20.26 per share. In July 2002, approximately 238,000 shares of common stock were purchased under this plan at a price of $8.23 per share. At December 31, 2002, $2.2 million was recorded in accrued liabilities that employees had deposited for purchases of common stock under the plan for the current offering period, which expired on January 31, 2003.
Employee 401(k) Plan
We sponsor the Quest Software, Inc. 401(k) Plan (the Plan) covering substantially all of our employees. As allowed under Section 401(k) of the Internal Revenue Code, the Plan provides tax-deferred salary deductions for eligible employees. Employees may contribute from 1% to 15% of their annual compensation to the Plan, limited to a maximum annual amount as set periodically by the Internal Revenue Service. The Plan provides for discretionary contributions, as determined by the Board of Directors. Such contributions to the Plan are allocated among eligible participants in the proportion of their salaries to the total salaries of all participants. Participant contributions vest immediately, while discretionary contributions we make vest over a three-year period. Our discretionary contributions to the Plan totaled $1.0 million for each of the years ended December 31, 2000, 2001 and 2002.
12. Sale of Aircraft
In August 2002, we sold our interest in an aircraft and received proceeds of approximately $1.9 million. The sale resulted in a loss of $0.8 million.
13. Commitments and Contingencies
We lease office facilities and certain equipment under various operating leases. A majority of these leases are non-cancelable and obligate us to pay costs of maintenance, utilities, and applicable taxes. The leases on most of the office facilities contain escalation clauses and renewal options. Total rent expense was $6.5 million, $12.2 million and $12.9 million for the years ended December 31, 2000, 2001 and 2002, respectively.
Minimum lease commitments under non-cancelable operating leases as of December 31, 2002 are as follows (in thousands):
On July 2, 2002, Computer Associates International, Inc. filed a complaint against us and four of our employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and
QUEST SOFTWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
trade secret misappropriation in connection with the development of the database administration component of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. We will vigorously defend CA’s claims and do not believe that this matter will have a material adverse effect on our results of operations or financial condition.
We are a party to other litigation, which we consider to be routine and incidental to our business. Management does not expect the results of any of these actions to have a material adverse effect on our results of operations or financial condition.
In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, and (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in the accompanying consolidated balance sheets.
14. Geographic and Segment Information
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by our chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our operating segments are managed separately because each segment represents a strategic business unit that offers different products or services.
Our reportable operating segments are Licenses and Services. The Licenses segment develops and markets licenses to use our software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to our software products.
We do not separately allocate operating expenses to these segments, nor do we allocate specific assets to these segments. Therefore, segment information reported includes only revenues, cost of revenues, and gross profit, as this information and the geographic information described below are the only information provided to the chief operating decision maker on a segment basis.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Reportable segment data for the three years in the period ended December 31, 2002, is as follows (in thousands):
Revenues are attributed to geographic areas based on the location of the entity to which the products or services were sold. Revenues, gross profit, income (loss) from operations and long-lived assets concerning principal geographic areas in which we operate are as follows (in thousands):
(1)
Principally represents operations in the United States
QUEST SOFTWARE INC.
FINANCIAL STATEMENT SCHEDULE
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNT
S-1
EXHIBIT INDEX
Exhibit Number
Exhibit Title
3.1
Second Amended and Restated Articles of Incorporation.(1)
3.2
Second Amended and Restated Bylaws, as amended.(2)
3.3
Certificate of Amendment of Second Amended and Restated Articles of Incorporation.(3)
3.4
Certificate of Amendment of Bylaws(4)
4.1
Form of Registrant’s Specimen Common Stock Certificate.(1)
10.1++
Registrant’s 1998 Stock Option/Stock Issuance Plan.(1)
10.2++
Registrant’s 1999 Stock Incentive Plan.(1)
10.3++
Registrant’s 1999 Employee Stock Purchase Plan.(1)
10.4
Form of Directors’ and Officers’ Indemnification Agreement.(1)
10.5
Office Space Lease dated as of June 17, 1999 between The Irvine Company and Quest Software, Inc.(1)
10.6
Office Lease between The Northwestern Mutual Life Insurance Company (Landlord) and Quest Software, Inc. (Tenant) dated as of September 30, 1999.(2)
10.7
Office lease, dated June 2000, between Fund VIII and Fund IX Associates and Quest Software, Inc.(5)
10.8++
Registrant’s 2001 Stock Incentive Plan(6)
10.9
First Amendment to Lease dated as of January 2, 2003 between The Irvine Company and Quest Software, Inc.
21.1
Subsidiaries of the Company.
23.1
Consent of Deloitte & Touche LLP.
99.1
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2
Certification of Vice President, Finance and Operations pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(1)
Incorporated herein by reference to our Registration Statement on Form S-1 and all amendments thereto (File No. 333-80543).
(2)
Incorporated herein by reference to our Registration Statement on Form S-1 and all amendments thereto (File No. 333-30816).
(3)
Incorporated herein by reference to our Quarterly Report on Form 10-Q for the period ended June 30, 2000.
(4)
Incorporated herein by reference to our Quarterly Report on Form 10-Q for the period ended June 30, 2001.
(5)
Incorporated herein by reference to our Annual Report on Form 10-K for the year ended December 30, 2000.
(6)
Incorporated herein by reference to our Registration Statement on Form S-8 (File No. 333-82784) filed on February 14, 2002.
++
Indicates a management contract or compensatory arrangement.