Entrust 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2007
COMMISSION FILE NUMBER 000-24733
(Exact name of registrant as specified in its charter)
ONE HANOVER PARK, SUITE 800
16633 DALLAS PARKWAY
ADDISON, TX 75001
(Address of principal executive offices & zip code)
Registrants telephone number, including area code: (972) 713-5800
Securities registered pursuant to Section 12(b) of the Act
Securities registered pursuant to Section 12(g) of the Act
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. ¨ Yes x No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. ¨ Yes x No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). ¨ Yes x No
As of June 30, 2007, there were 60,941,634 of Common Stock, $.01 par value, outstanding. The aggregate market value of the common stock held by non-affiliates of the registrant, computed using the closing sale price of common stock of $4.06 per share on June 29, 2007, as reported on the Nasdaq Global Market, was approximately $163,883,130.
The number of shares outstanding of the registrants common stock as of February 29, 2008 was 61,185,385.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Entrust, Inc.s definitive Proxy Statement for its 2008 Annual Meeting of Stockholders to be held on May 2, 2008 are incorporated by reference into Part III of this Annual Report on Form 10-K.
TABLE OF CONTENTS
This report includes or incorporates by reference forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, many of which, by their nature, are inherently uncertain and outside our control. These statements include among other things, statements regarding Entrust, Inc.s expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this report are based on information available to Entrust up to and including the date of this document, and Entrust expressly disclaims any obligation to update or alter its forward-looking statements, whether as a result of new information, future events or otherwise. Entrusts actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors, including those set forth below under Managements Discussion and Analysis of Financial Condition and Results of OperationsQuarterly Results of Operations, Risk FactorsCertain Factors That May Affect Our Business and elsewhere in this report. Readers should also carefully review the risks outlined in other documents that Entrust files from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q that Entrust files in 2008.
Entrust, Entrust-Ready, Entrust/Entelligence, and getAccess are registered trademarks of Entrust, Inc. or a subsidiary of Entrust, Inc. in certain countries. Entrust Authority, Entrust TruePass, Entrust GetAccess, Entrust Entelligence, Entrust CygnaCom, and ISG are trademarks or service marks of Entrust, Inc. or a subsidiary of Entrust, Inc. in certain countries. All other trademarks and service marks used in this annual report are the property of their respective owners.
The demands on todays enterprises and governments require ever-increasing extension outside their boundaries to interact with suppliers, customers, citizens and employees. Integrated supply chains, e-commerce, e-government and mobile employees are demanding business applications to be open and available to them at all times. Todays extended enterprise and government environments require the ability to efficiently secure digital identities and information, which are continuously targeted by individuals or criminal organizations that thrive on obtaining sensitive data by leveraging data breaches, identity thefts and fraud attacks.
As the information security market continues to mature, 2007 saw organizations move away from a reactionary position to more proactive strategies. Accordingly, the way organizations view security and how to apply it to their businesses is evolving.
The definition of how identities are defined in todays online environment continues to expand. Once the concept of an identity applied only to an individual, and organizations were concerned with determining who was on the other end of a transaction. Now, identities apply not only to individuals but also to the computers, servers, personal digital assistants and applications that they use. Authentication is no longer a one-way proposition; mutual authentication is vital to combating data theft and fraud.
Organizations continue to invest heavily in information security and the number of security projects continues to increase. What has changed is how organizations look at security. Increasingly, organizations are abandoning the security as insurance view of the last few years, and moving toward a more sophisticated layered security strategy that addresses risk. Security is now being applied based on the risk elements related to the data an organization holds and the transactions it conducts. In addition, organizations see a strong, layered security approach as a tool of enablement that promotes efficiency, interoperability and synergy between corporations, client, customers, vendors and suppliers.
Simultaneously, public understanding of the risks to digital identities and information drives organizations toward action. Malware, phishing, pharming, database breaches, laptop theft and man-in-the-middle attacks on
identities and information have created anxiety among consumers and citizens. Organizations are responding to customer fears by working to prevent the brand damage resulting from identity-related fraud and data breaches.
Meanwhile, legislators also have become involved in creating laws and regulations such as California SB1386, Payment Card Industry Data Security Standard (PCI), Gramm-Leach-Bliley, Basel II, UK Faster Payment Initiative, Identity Theft Red Flag Guidelines (Sections 114 and 315 of the Fair and Accurate Credit Transactions Act of 2003) (Red Flag) and the Federal Financial Institutions Examination Councils (FFIEC) guidance on financial institution authentication. These mandates have increased the pressure on organizations to mitigate risk to identities and information. In addition, more than 35 states have passed data breach legislation very similar to CA SB1386, requiring organizations to notify individuals whose personal information may have been compromised as a result of a data breach.
Penalties resulting from brand damage and customer defection in light of a security breach are expensive. When the stakes are so high, organizations have begun taking the security decisions out of the hands of users and building rules and policies designed to automate security. Layering security into applications based on automated rules and policies helps to properly and consistently remediate risks.
Part of a strong, layered security strategy for consumer, enterprise and government environments, Entrust, Inc. is a global provider of security solutions that protect and secure digital identities and information. Entrust software and associated services enable businesses and governments around the world to conduct high-value, highly sensitive transactions, over wired and wireless networks including the Internet, in compliance with todays regulatory guidelines.
More than 1,700 customers have purchased and deployed Entrust solutions that integrate into the broad range of applications organizations use today to leverage Internet and enterprise applications to improve productivity. We have more than 125 patents and patent applications pending that demonstrate our commitment to innovation and addressing the needs of our customers. Entrust has redefined layered securityoutlined in detail belowto help secure information and identities and enable security-conscious enterprises and governments to implement efficient, cost-effective and interoperable solutions that help stimulate revenue, mitigate risk, secure information and protect end-users.
In 2007, Entrust continued to focus on key vertical and geographical markets, product transformation and innovation, customer deployments and service improvements. Entrusts corporate priority in 2008 is to continue the momentum established in 2007 and to focus on delivering growth in revenue, deferred revenue, earnings and cash flow. To achieve this goal, Entrust plans to drive revenue growth by expanding markets for its new solutions, executing on vertical and geographical opportunities, increasing channels to market, keeping a tight hold on costs and remaining focused on customers.
Layered Security Strategies
Entrusts layered security solutions enable enterprises and governments to securely leverage the online channelgenerating revenue, decreasing costs and increasing operational efficiencies while mitigating risk and ensuring regulatory compliance.
Security has moved beyond protecting the border of an organization, which is why Entrust has redefined layered security that has evolved from border protection toward comprehensive strategies that secure identities and information. In turn, Entrust recommends a layered approach that includes SSL, authentication, fraud
detection, secure shared data, e-mail security and management of digital certificates. Entrusts layered security model provides security-conscious organizations a level of synergy, interoperability and cost-effectiveness.
Entrusts layered security model delivers environments that are easy-to-use, increase end-user acceptance and limit help-desk calls. The approach helps enable companies to meet regulatory and industry compliance requirements for security including PCI, FFIEC, UK Faster Payment Initiative, Red Flag, Homeland Security Presidential Directive 12 (HSPD-12), numerous state data breach regulations and others.
In support of this strategic layered approach, Entrust offers three distinct solution platformsAuthentication & Fraud Monitoring, Information Protection and Public Key 2.0that support a range of dynamic, cost-effective products and solutions.
Authentication & Fraud Monitoring Platform
The Entrust Authentication & Fraud Platform Monitoring features the award-winning Entrust IdentityGuard versatile authentication platform, and Entrust TransactionGuard, which secure and protect the digital identities of consumers, citizens, government agents and corporate employees.
With more than 9.2 million licenses in use today, Entrust IdentityGuard 9.0 is an open versatile authentication platform that enables organizations to layer securityaccording to access requirements or the risk of a given transactionacross diverse users and applications. The platforms authentication options include strong username and password enforcement, IP-geolocation, machine/device authentication, questions and answers, out-of-band one-time passcode (delivered via voice, SMS or e-mail), grid cards and a range of one-time-passcode tokens.
Also featured in the Authentication & Fraud Monitoring Platform, Entrust TransactionGuard monitors transactions and seeks fraudulent behavior and access patterns amid the massive volumes of data generated by transactional Web sites. The solution examines this data and identifies potentially suspicious behavior and high-risk activities without impacting the user experience or system performance. It serves as a resource to protect consumers and help organizations defend and manage the risk associated with online services.
To guard against fraud attacks, the Entrust Risk Based Consumer Authentication solution relies on Entrust IdentityGuard and Entrust TransactionGuard to defend against fraud by layering authentication methods in accordance with the risk associated with individual transactions.
In addition, Entrust SSL certificatesstandard SSL, extended validation (EV) SSL and Unified Communication certificatesprovide the first line of defense against information theft, phishing and man-in-the-middle by confirming identities on the Web via trusted vetting processes and proven technology.
Entrust GetAccess, a respected single sign-on (SSO) solution, delivers a single entry and access point to Web portal information and applications. The solution serves as the springboard for Web services and provides authentication and authorization for XML and Web services data. Supporting the broadest range of authentication methods and user devices available today, Entrust GetAccess makes it possible for organizations to personalize services, content and data for the diverse needs of a varied user community.
Information Protection Platform
The Entrust Information Protection Platform, which is designed to protect sensitive data, while in motion or at rest, from unauthorized access and inadvertent disclosure. The platform uses the Entrust Entelligence suite of solutions, which includes Entrust Entelligence Group Share for shared network folder encryption; Entrust Entelligence Messaging Server for e-mail security; and Entrust Entelligence Disk Security for the protection and encryption of files, hard drives and removable media.
Entrust Entelligence Group Share is an innovative network folder encryption solution, which offers never-before-seen capabilities that provide enterprises transparent, persistent (i.e., remains encrypted regardless of where it is stored) and automatic encryption for network files and folders. The offering also includes powerful auditing tools to comply with respective regulations and mandates.
Entrust Entelligence Messaging Server is an e-mail security solution that makes it easier to communicate securely with external business partners and customers. The Messaging Server delivers standards-based e-mail encryption capabilities in a comprehensive platform. The solution is easy to deploy and maintain for organizations that communicate sensitive or regulated informationboth inside and outside their organizationvia e-mail.
The solution supports a wide range of options including OpenPGP, S/MIME and SSL encryption standards, all within the users native e-mail client. EMS also includes support for mobile e-mail clients such as BlackBerry and HTML-enabled, browser-based cell phones. The solution allows external recipients to communicate securely using the encryption standard of their choice, including S/MIME, Open PGP, Web Mail Pull and Web Mail Push.
The solution also employs a multiprotocol content control solution, Vericept Content 360º, which provides deeper visibility into how sensitive content is handled in an organization.
Public Key Platform
The Entrust PKI Platform provides authentication, encryption and digital certificate capabilities to the enterprise and government marketplace. The goal of a public key infrastructureor PKIis to establish and maintain a trustworthy networking environment. This is achieved by providing key and certificate management services that enable encryption and digital signature capabilities across applications in a way that is transparent and easy to use. Once deployed, a PKI can authenticate identities, secure e-mail communication via encryption, authenticate/digitally sign documents or encrypt/decrypt sensitive files and folders.
Modular and fully integrated, the Entrust Authority PKI portfolio is built on the foundation of Entrust Authority Security Manager, the certification authority (CA) responsible for issuing and managing users digital identities. Optional PKI components can easily be integrated to help meet an organizations unique security requirements and transparently automate all security-related processes through a single PKI.
For customers looking to take advantage of the security benefits of PKI without managing the infrastructure themselves, the Entrust Managed Services PKI is a flexible, cost-effective alternative. Entrusts best-of-breed PKI solutions are available in an easy-to-manage, administer-hosted offering. The Entrust Managed Services PKI is hosted in a comprehensive, multilayered secure environment with fully redundant infrastructures in two geographic locations. The Entrust Managed Services PKI enables customers to concentrate on growing their core business securely without the need to develop internal PKI expertise.
The Entrust PKI Managed Service offering is managed and executed by our Professional Services team for both the public and private sectors. The solution was chosen as the PKI provider for the General Services Administration (GSA) HSPD-12 Managed Service Offering in 2007.
Key Portfolio Launches
As an innovator and pioneer in information security, Entrusts market leadership and expertise in delivering award-winning software solutions is demonstrated by several key distinctions Entrust and its products received from leading organizations. These and other 2007 highlights include:
PKI and Digital Certificate Products:
Authentication & Fraud Products:
Information Protection Products:
As of December 31, 2007, Entrust had licensed software to more than 1,700 customers in more than 60 countries. These customers, in turn, have implemented Entrust software to securely deliver information and services to millions of consumer, enterprise and government end-users. Entrusts customers are global 1,500 enterprises, including financial, healthcare, telecommunications and large manufacturing organizations, as well as domestic and foreign government agencies.
Key customer events in 2007 include:
The Entrust Professional Services team has demonstrated its experience worldwide by delivering innovative solutions utilizing both standard and customized Entrust products. Many of the Internet security industrys most highly skilled and experienced engineers, security architects, and security consultants are members of the Entrust team. These experts have assisted the worlds governments and Global 1500 companies in addressing complex security issues with practical solutions. In the process, they have established an outstanding reputation for on-time delivery, exceptional quality and innovative approaches to complex business opportunities globally. In July 2006, Entrust acquired Business Signatures to add fraud detection and monitoring capabilities to its solution set. The Entrust Professional Services team has integrated and added support of these new solutions to its offerings. Each of the categories below (a-f) has added these capabilities.
Entrust CygnaCom has been providing professional information security services and cryptographic solutions to government and business clients since 1994. With a staff of highly qualified engineers, Entrust CygnaCom provides a wide range of consulting services and customized solutions to help clients develop, implement and maintain their information security programs, policies and strategy. Entrusts McLean, Virginia location provides it with a large professional services organization to meet the growing needs of the U.S. Federal government. Entrust CygnaComs facilities were among the first to be accredited by the U.S. Department of Commerce, the National Institute of Standards and Technology, and the National Voluntary Laboratory Accreditation Program for information technology security testing against the federal cryptographic criteria (Common Criteria (ISO/IEC 15408)). In June 2006, Entrust acquired Orion Security Solutions to add additional capabilities to the Entrust CygnaCom team.
Entrust Internet security consulting services empower customers with knowledge by identifying Internet security business drivers related to organizations needs, priorities and return on investment. This knowledge is used to prepare security-requirement analyses and security-policy documents, develop business cases and speed time-to-market by avoiding potential pitfalls associated with enterprise software deployment.
Entrust deployment services provide planning and implementation expertise to assist in the installation and deployment of Entrust enhanced Internet security solutions. For organizations seeking a proven solution aligned with business objectives, Entrust deployment services provide end-to-end project management and execution.
To maximize the return on investment of an Entrust solution, customers can leverage the expertise of Entrusts systems integration team. Common areas of integration include customization of user registration and identification systems, incorporation of entitlements with third-party and legacy applications, improvement of existing legacy and third-party application security, and provision of enhanced user and security management.
With a broad range of expertise and proven experience on multiple platforms, applications and environments, Entrusts system integration team delivers solutions with quantifiable benefits to challenging business opportunities. Key components of success include rapid time-to-market, efficient transfer of knowledge, and the utilization of knowledge gained in hundreds of previous deployments of Entrust products.
Entrusts Managed Services PKI offering is managed and executed by our Professional Services team for both the public and private sectors. The solution was chosen as the PKI provider for the General Services Administration (GSA) HSPD-12 Managed Service Offering in 2007.
For customers looking to take advantage of the security benefits of PKI without managing the infrastructure themselves, the Entrust Managed Services PKI is a flexible, cost-effective alternative. Entrusts best-of-breed PKI solutions are now available in an easy to manage and administer hosted offering, The Entrust Managed Services PKI is hosted in a comprehensive, multilayered secure environment with fully redundant infrastructures in two geographic locations. The Entrust Managed Services PKI enables customers to concentrate on growing their core business securely without the need to develop internal PKI expertise.
Entrust Training serves customers, partners and employees. More than 5,000 customers, partners and employees have attended technical training. In these in-depth, hands-on sessions, attendees learn how to deploy, operate, administer, customize and/or support Entrust software solutions. Entrust also offers video based training for both general security and Entrust specific solutions. These high quality DVDs can be used in corporate training but can also serve as part or the entirety of a structured educational program. Entrust training also produces job aids, such as quick reference guides and video instruction clips, to help user populations adopt Entrust desktop components.
Entrust believes that the highest quality of customer and technical service delivery is crucial to its success, and Entrust service and support programs are key components of its commitment to offer the industrys broadest set of enhanced Internet security services. Entrust is committed to being an industry leader in the area of support as it has become a key customer attribute in selecting a technology partner. Entrust has invested heavily in this area and the investment has paid off in the form of increased customer satisfaction and increased support and maintenance revenue.
Entrusts three-tiered, global support program gives customers the flexibility to choose between proven service and support levels that align with business needs. In addition, customers can access Entrusts Extranet for online self-service technical support.
SALES, MARKETING AND BUSINESS DEVELOPMENT
Entrust offers its products, solutions and services through a multichannel sales approach, reflecting the characteristics and buying behavior of the target markets covered. Entrust plans to continue to focus its marketing and sales efforts to capitalize upon the need for secure digital identities and information within the consumer, enterprise and government markets. Entrust plans to utilize a prioritized combination of direct and indirect sales channels around the globe. Entrust believes that its direct sales force, working in conjunction with indirect channels offering complementary products and services, provides Entrust with a competitive advantage in responding to customer needs as they evolve. Entrust intends to deliver revenue growth in 2008 through its sales efforts in the following ways:
See Note 20 to our consolidated financials statements located elsewhere in the Annual Report for more information regarding the geographic distribution of revenues earned.
To support its direct sales force and the TrustedPartner network, Entrust has a marketing team whose goals are to create a consistent, focused communication strategy that increases awareness of Entrusts digital identity and information security solutions and services, and leverages that awareness in the identification of new sales opportunities. The marketing team creates and conducts integrated programs that include advertising, direct mail, trade shows, seminars, Web marketing, public relations and ongoing customer communication.
Entrust intends to invest in targeted marketing programs for existing customers and prospects in key vertical and geographic markets.
Identifying new markets and opportunities in advance of the current competitive landscape has been a consistent theme at Entrust. The breadth of Entrusts security products, solutions and services, key relationships and the number of customers are testimony to Entrusts success.
To identify and develop strategic relationships with targeted industry providers more effectively, Entrust has a business development organization that pursues select business development activities, including the administration and promotion of the Entrust-Ready Program. These activities permit Entrust to strengthen relationships with existing strategic providers and identify and encourage new providers of software, network computing and communications products to make their products interoperable with Entrust. Entrust actively looks for opportunities to continue its leadership position, whether by partnering, internally developing or acquiring the necessary technologies and services to provide a full suite of solutions to its customers.
Certain Entrust products are subject to special export requirements administered by the governments of the United States, Canada and other countries. Entrusts products may also be subject to import restrictions and/or use restrictions imposed by some countries. Consequently, Entrusts ability to export its products to destinations outside the U.S. and Canada is subject to a variety of administrative requirements, government approvals or licensing requirements. Re-exports of the products between countries other than the U.S. and Canada may be subject to the export control laws of those countries in addition to those provisions of the U.S. and/or Canadian export control laws which apply to re-exports. In light of these regulations, depending on the end-user, end-use and country of destination, some of our products may not be sold to certain parties, and some products made available abroad may contain significantly weaker encryption capabilities than those available to customers in the U.S. and Canada. In addition, extra controls which the United States applies to sales to foreign governmental entities, as noted below, can create additional obligations for Entrust in this market sector. All other Entrust products are exempt from U.S. export authorization and they have been marketed accordingly.
In summary, the rules are as follows: U.S. products cannot be exported to certain prohibited persons and entities, to certain embargoed countries, or for certain types of end-uses. No U.S. governmental review is required for some exports, such as products containing limited use encryption, including products that are limited to financial applications, and exports for internal use by foreign subsidiaries of companies based in the U.S. and in certain other countries. For other encryption products, exports are allowed after a one-time 30-day review, except that certain products identified as restricted require separate licenses for export to government end-users in certain countries.
Entrust relies on a combination of patent, copyright, trademark and trade secret laws, nondisclosure agreements and other contractual provisions to establish, maintain and protect Entrusts proprietary rights. Entrust currently has a portfolio of over one hundred and twenty-five (125) patents and pending patent applications. During the past eighteen months Entrust has filed intellectual property lawsuits against Addison Avenue Federal Credit Union (alleged patent infringement), Open Solutions Inc. (alleged patent infringement), and Corel Corporation (alleged copyright infringement). Entrust intends to continue to seek opportunities to monetize its intellectual property assets through licensing and, when necessary, litigation.
Pursuant to patent cross-license agreements, Entrust also licenses some of its patents to other corporations and, in return, receives rights from those corporations in respect to patents owned or licensable by such corporations. Entrust is a licensee under patent cross license agreements with Nortel Networks Limited (Nortel) and Tumbleweed Communications Corp. The license with Nortel was entered into in connection with Entrusts spinout from Nortel. Entrust is also a licensee in respect to certain individual patents that are not part of any cross licensing arrangement.
A very large proportion of Entrusts products incorporate technology that is licensed or purchased from third parties and, as such, a significant percentage of Entrusts revenues depend upon the availability of licensed or purchased technology. Entrust uses a large number of open source software packages in its products. In general, these software packages are licensed to Entrust on a no-charge basis without any representations or warranties as to performance or non-infringement of third-party intellectual property rights. Accordingly, if these open source packages are found to infringe or misappropriate any third-party intellectual property rights, Entrust could potentially be held liable by such third parties and potentially by Entrusts customers pursuant to intellectual property indemnity obligations in Entrusts license agreements with such customers. In such a case, Entrust would not have any recourse against the developer of such infringing or misappropriating open source software. Certain open source packages used by Entrust, and in particular, certain components in the GNU Linux operating system, are licensed pursuant the GNU General Public License (the GPL). In certain instances, the terms of the GPL may require a licensee to make certain of that licensees own proprietary software available under the same terms as the GPL. As such, application of the GPLs viral terms to a licensees own proprietary software could result in that proprietary software become available, at no charge, as open source software. Entrust does not believe that any of its proprietary software is subject to the viral provisions of the GPL, however, the exact scope of these viral provisions has not been definitively established in any court actions and there is significant disagreement within the software industry about the actual scope of these viral provisions.
Some of Entrusts newer products incorporate or are based on hardware products and components that are supplied and assembled by third-party suppliers, and, as such, a portion of Entrusts revenues are based upon the availability of such products and components to Entrust. For example, Entrust now delivers some of its products in an appliance form factor. This means that products that were previously licensed as software only are now delivered on a hardware platform. These hardware platforms are generally commercially available rack-mountable servers. Entrust is also in the process of introducing hardware-based one-time password (OTP) authentication tokens that use electrical devices mounted onto a circuit board. If the pricing of these third-party products, or components thereof, changes or if new suppliers are used, there may be a detrimental or positive impact on the competitiveness and/or availability of these Company products.
The amount and nature of the third-party technology used in Entrusts products varies between products. In general, and except as further discussed below, Entrusts products or other revenue generating activities (i) do not depend to a material extent on any one technology that is only available from a single source, (ii) do not depend to a material extent on any technology that would require a significant engineering effort to replace, or (iii) are not of a type that cannot be supplied by multiple vendors. Furthermore, except as further discussed below, Entrust believes that due to market competitiveness, any change in vendors or in third-party providers of technology will not have a material effect on the pricing or appeal of the affected Company product. To the extent that Entrust uses hardware products or components for its products, Entrust believes that these products and components are relatively standard and are readily available from multiple sources. For example, to the extent that Entrust offers appliance-based products, the rack-mountable servers that it uses for those appliances can be replaced provided that the replacement server has sufficient processing power and memory to support the operation of the GNU Linux operating system and Entrust applications and other applications that are supported by the current server. Given the number of hardware servers that now support GNU Linux and its associated applications, Entrust believes that it would be able to find a satisfactory replacement from a technical perspective. To the extent that Entrust uses various hardware components for the OTP tokens, Entrust believes that the electrical devices being used within these OTP tokens are sufficiently generic that suitable technical substitutes could be obtained within reasonable timeframes.
Entrust maintains internal processes to monitor the terms and renewal dates for various third-party technologies so that Entrust is able to plan in advance for contract renegotiation, extension, or product substitution. Therefore, it is Entrusts belief that, in general, in the case of interruption, non-renewal or expiration of a third-party license, the measures currently in place will allow Entrust to promptly provide for replacement technology. However, some of Entrusts products incorporate technology licensed from third parties that cannot be promptly replaced. An example is certain Java-related technologies that are made available, without a royalty obligation, by Sun Microsystems, Inc. (Sun). Notwithstanding the fact that this technology is only available from a single source, Entrust believes that there is no material risk that such technology will become unavailable to Entrust without significant prior notice. In the case of the Java-related technologies referenced above, Entrust believes there is no material risk that Sun is going to significantly change the terms under which those Java-related technologies are made available to the computer industry and further if Sun were to make any significant changes, it would provide its licensees with alternative choices or a significant period of time to transition to other technologies.
Another example of a technology that could potentially be difficult to replace is the GNU Linux operating system. The GNU Linux operating system is used as the underlying operating system for a number of Entrusts appliance-based products. If the GNU Linux operating system was no longer available to Entrust, or was to become available to Entrust only under terms and conditions that were unacceptable to Entrust, then Entrust would need to seek a replacement operating system for its appliance-based products. The transition to such a replacement operating system could be lengthy and costly because of the need to potentially modify various Company applications that previously ran on the GNU Linux operating system so that they could run on the replacement operating system. Such a transition might also involve incremental royalty costs if the royalties for the replacement operating system exceeded those that Entrust is paying for the variant of GNU Linux that it is currently using. It is also possible that Entrust might have to replace other third-party applications with which Company applications currently interoperate if such third-party applications are not supported on any replacement operating system that might be selected by Entrust. If this were the case, this need to replace these third-party applications could increase the re-engineering effort and might result in the need to license commercial packages with attendant royalty obligations.
In the case of Entrusts Certificate Services business, the commercial viability of that business is dependent on having various browser manufacturers continue to embed Entrusts root key certificate in their browsers. If one or more of these manufacturers were to remove Entrusts root key certificate from their browser, the viability of Entrusts Certificate Services business could be negatively affected. However, because of the rate of turnover of various browser releases, the effect of such a removal would probably be gradual. Additionally, it might also
be possible to address such a removal by entering into a cross certification arrangement with another certification authority whose root key certificate was still embedded in the affected browser. It should be noted that such a potential solution might be expensive or unavailable because any certification authorities that might be in a position to cross certify with Entrust would also probably have competitive offerings to Entrusts Certificate Services business.
Entrust addresses key markets that help mitigate business risk by securing information and securing identities. Entrust solutions protect users and reduce loss from business fraud and protect sensitive data, regardless where it resides, while providing robust controls and audit on those who can access critical systems. Our focus is on 6 emerging growth areas: Consumer Authentication, Enterprise Authentication, Content Control, Email Security, Digital Certificates and Developer Tools. In each of these areas, Entrust encounters some of its traditional competitors, as well as new vendors who are entering the market.
Entrust believes that the principal competitive factors affecting the market for its security solutions include features such as ease of use, quality/reliability of security, scalability, customer service and support and price. Although Entrust believes that its products compete favorably in respect of all these factors, there can be no assurance that Entrust can maintain its competitive position against current or potential competitors.
As of December 31, 2007, Entrust had 455 full-time employees globally. No employees are covered by any collective bargaining agreements, and Entrust believes that its relationship with its employees is good.
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We maintain a website with the address www.entrust.com. We are not including the information contained on our website as part of, or incorporating it by reference into, this Annual Report on Form 10-K. We make
available free of charge through our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. Also posted on our Web site are charters for our Audit Committee, Compensation Committee and Nominations and Corporate Governance Committee and a Code of Business Conduct. In addition, we intend to disclose on our website any amendments to, or waivers from our Code of Business Conduct that are required to be publicly disclosed pursuant to rules of the Securities and Exchange Commission.
CERTAIN FACTORS THAT MAY AFFECT OUR BUSINESS
Our revenues and operating results are subject to significant fluctuations and such fluctuations may lead to a reduced market price for our stock.
Our revenues and operating results have varied in the past and may continue to fluctuate in the future. We believe that period-to-period comparisons of our operating results are not necessarily meaningful, but securities analysts and investors often rely upon these comparisons as indicators of future performance. If our operating results in any future period fall below the expectations of securities analysts and investors, or the guidance that we provide, the market price of our securities would likely decline. Factors that have caused our results to fluctuate in the past and which are likely to affect us in the future include the following:
Estimating future revenues is difficult, and our failure to do so accurately may lead to a reduced market price for our stock and reduced profitability.
Estimating future revenues is difficult because we ship our products soon after an order is received and, as such, we do not have a significant order backlog. Thus, quarterly license revenues depend heavily upon orders received and shipped within the same quarter. Moreover, we historically have recorded 50% to 60% of our total quarterly revenues in the third month of the quarter, with a concentration of revenues in the second half of that month. We expect that this concentration of revenues, which is attributable in part to the tendency of some customers to make significant capital expenditures at the end of a fiscal quarter and to sales patterns within the software industry, will continue.
Our expense levels are based, in significant part, upon our expectations as to future revenues and are largely fixed in the short term. We may be unable to adjust spending in a timely manner to compensate for any unexpected shortfall in revenues. Any significant shortfall in revenues in relation to our expectations could have an immediate and significant effect on our profitability for that quarter and may lead to a reduced market price for our stock.
Because of the lengthy and unpredictable sales cycle associated with our large software transactions, we may not succeed in closing transactions on a timely basis or at all, which would adversely affect our revenues and operating results.
Transactions for our solutions often involve large expenditures, and the sales cycles for these transactions are often lengthy and unpredictable. Factors affecting the sales cycle include:
We may not succeed in closing such large transactions on a timely basis or at all, which could cause significant variability in our revenues and results of operations for any particular period. If our results of operations and cash flows fall below the expectations of securities analysts, or below the targeted guidance range that we have provided, our stock price may decline.
A limited number of customers has accounted for a significant percentage of our revenues, which may decline if we cannot maintain or replace these customer relationships, and for a significant percentage of our accounts receivable.
Historically, a limited number of customers have accounted for a significant percentage of our revenues. In 2007, 2006 and 2005, our three largest customers accounted in the aggregate for 28%, 28% and 31% of revenues, respectively. We anticipate that our results of operations in any given period will continue to depend to a significant extent upon revenues from a small number of large customers. In addition, we anticipate that such customers will continue to vary over time, so that the achievement of our long-term goals will require us to obtain additional significant customers on an ongoing basis. Our failure to enter into a sufficient number of large licensing agreements during a particular period could have a material adverse effect on our revenues, which may be, but not necessarily, mitigated by higher volume of lower dollar transactions.
In addition, our accounts receivable include material balances from a limited number of customers, with five customers accounting in the aggregate for 26% of gross accounts receivable at December 31, 2007, compared to 22% of gross accounts receivable at December 31, 2006. No customer individually accounted for 10% or more of net accounts receivable at December 31, 2007 and 2006. As of December 31, 2007, the total accounts receivable is $20.8 million, net of an allowance for doubtful accounts of $2.0 million. Changes in the financial condition of these customers could result in a different assessment of the existing credit risk of our accounts receivable and thus, a different required allowance, which could have a material impact on our reported earnings.
The U.S. and Canadian Federal Governments account for a significant percentage of our revenues, which may decline or be subject to delays, which would adversely affect our operating results.
The extended government vertical (Governments, including Healthcare) accounted for 44% of our product revenue in 2007 and 39% of product revenue in 2006. The U.S. and Canadian governments represented 15% and 9% of total revenues, respectively, in 2007, which includes revenues sold through resellers to these government end users. Sustaining and growing revenues in the government market will depend, in large part, on the following:
A decline, or delay in the growth of this market could reduce demand for our products, adversely affecting our revenues and results of operations. In addition, changes in Government officials as a result of elections could have an impact on our prospects in the Government market. Our ability to sell to the Government may also be impacted by changes to, or termination of, the supply agreement(s) we have in place with the Government, which from time to time come up for renewal and renegotiation. Finally, failure to properly monitor pricing on government contracts could result in liability for penalties to the government for non-compliance.
We sometimes enter into complex contracts, which require ongoing monitoring and administration. Failure to monitor and administer these contracts properly could result in liability or damages.
We sometimes enter into complex contracts with our Government customers that contain clauses that provide that if a customer who falls within a specific category (known as a Relevant Customer) is offered better terms on Entrusts software products and related services that had been offered to the Government customer, then the Government customer will be able to buy additional quantities of those software products and services for the same length of time, from the same effective date and on the better terms that were offered to the Relevant Customer. Entrust monitors compliance with these contracts on a continuous basis. Entrust also conducts periodic self-assessments to ensure that the contracts are being properly administered and that there are no accruing liabilities for non-compliance. If these contracts are not properly monitored and administered, they may be breached and could result in damages payable by us which, depending on their magnitude, could have a material adverse effect on our business, financial condition and results of operations.
War, the significant threat of war, or a terrorist act could adversely affect our business.
Historically, the economy has been adversely affected by war, the significant threat of war and terrorist acts. Any of these factors could cause one or more of the following to occur:
A decline or delay in economic spending due to war, the significant threat of war or a terrorist act could reduce demand for our products, materially adversely affecting our revenues and results of operations.
A widespread outbreak of an illness or other health issue could negatively affect our business, making it more difficult and expensive to meet our obligations to our customers, and could result in reduced demand from our customers.
A number of countries in the Asia/Pacific region have experienced outbreaks of SARS and/or bird flu in recent years. As a result of such an outbreak, businesses can be shut down temporarily and individuals can become ill or quarantined. Outbreaks of infectious diseases such as these, particularly in North America, Europe
or other locations significant to our operations, could adversely affect general commercial activity, which could have a material adverse effect on our financial condition, results of operations, business or prospects. If our operations are curtailed because of health issues, we may need to seek alternate sources of supply for services and staff and these alternate sources may be more expensive. Alternate sources may not be available or may result in delays in shipments to our customers, each of which would affect our results of operations. In addition, a curtailment of our product design operations could result in delays in the development of new products. Further, if our customers businesses are affected by health issues, they might delay or reduce purchases from us, which could adversely affect our results of operations.
If the enterprise information technology budgets and the digital identity security market do not continue to grow, demand for our products and services will be adversely affected.
The market for digital identity and information security solutions is at an early stage of development. Continued growth of the digital identity security market will depend, in large part, on the following:
A decline in the growth of this market could reduce demand for our products, adversely affecting our revenues and results of operations.
A breach of security at one of our customers, whether or not due to our products, could harm our reputation and reduce the demand for our products.
The processes used by computer hackers to access or sabotage networks and intranets are rapidly evolving. A well-publicized actual or perceived breach of network or computer security at one of our customers, regardless of whether such breach is attributable to our products, third-party technology used within our products or any significant advance in techniques for decoding or cracking encrypted information, could adversely affect the markets perception of us and our products, and could have an adverse effect on our reputation and the demand for our products.
In addition, the security level of our products is dependent upon the processes and procedures used to install and operate our products. Failure on the part of our customers to properly install and operate our products, could cause a security breach, which could adversely affect the markets perception of us and our products, and could have an adverse effect on our reputation and the demand for our products.
Sales of our products may decline if some of our products are found to contain bugs or errors.
Our existing testing procedures may not detect errors, failures or bugs in our software products. Such errors may become evident at any time during the life of our products. The discovery of any errors, failures or bugs in any products, including third-party technology incorporated into our products, may result in:
Accordingly, the discovery of any errors, failures or bugs may have a significant adverse effect on the sales of our products and our results of operations.
Our revenues may decline if we cannot compete successfully in an intensely competitive market.
We target our products at the rapidly evolving market for digital identity and information security solutions. Many of our current and potential competitors have longer operating histories, greater name recognition, larger installed bases and significantly greater financial, technical, marketing and sales resources than we do. As a result, they may be able to react more quickly to emerging technologies and changes in customer requirements, or to devote greater resources to the promotion and sale of their products. In addition, certain of our current competitors in particular segments of the security marketplace may in the future broaden or enhance their offerings to provide a more comprehensive solution competing more fully with our functionality.
Increased competition and increased market volatility in our industry could result in lower prices, reduced margins or the failure of our products and services to achieve or maintain market acceptance, any of which could have a serious adverse effect on our business, financial condition and results of operations.
Our business will not be successful if we do not keep up with the rapid changes in our industry.
The emerging market for digital identity and information security products and related services is characterized by rapid technological developments, frequent new product introductions and evolving industry standards. To be competitive, we have to continually improve the performance, features and reliability of our products and services, particularly in response to competitive offerings, and be first to market with new products and services or enhancements to existing products and services. Our failure to develop and introduce new products and services successfully on a timely basis and to achieve market acceptance for such products and services could have a significant adverse effect on our business, financial condition and results of operations.
We may have difficulty managing our operations, which could adversely affect our ability to successfully grow our business.
Our personnel, systems, procedures and controls may not be adequate to support our operations. The geographic dispersal of our operations may make it more difficult to manage our growth.
We depend on our key personnel for the success of our business and the loss of one or more of our key personnel could have an adverse effect on our ability to manage our business or could be negatively perceived in the capital markets.
Our success and our ability to manage our business depend, in large part, upon the efforts and continued service of our senior management team. The loss of one or more of our key personnel could have a material adverse effect on our business and operations. It could be difficult for us to find replacements for our key personnel, as competition for such personnel is intense. Further, such a loss could be negatively perceived in the capital markets, which could reduce the market value of our securities.
If we fail to continue to attract and retain qualified personnel, our business may be harmed.
Our future success depends upon our ability to continue to attract and retain highly qualified scientific, technical, sales and managerial personnel, including key personnel at acquired companies. Competition for such
personnel is intense, particularly in the field of information security, and there can be no assurance that we can retain our key scientific, technical, sales and managerial employees or that we can attract, motivate or retain other highly qualified personnel in the future. These challenges are made more severe by our history of operating losses, the employment reductions from our restructurings, and the fact that the exercise price of a majority of outstanding stock options is below the current market price of our stock. If we cannot retain or are unable to hire such key personnel, our business, financial condition and results of operations could be significantly adversely affected.
We may not be able to protect our intellectual property rights, which could make us less competitive and cause us to lose market share.
Our future success will depend, in part, upon our intellectual property rights and our ability to protect these rights. We rely on a combination of patent, copyright, trademark and trade secret laws, nondisclosure agreements, shrink-wrap licenses and other contractual provisions to establish, maintain and protect our proprietary rights. Despite our efforts to protect our proprietary rights, unauthorized third parties may:
Policing piracy and other unauthorized use of our products is difficult, particularly in international markets and as a result of the growing use of the Internet. In addition, third parties might successfully design around our patents or obtain patents that we would need to license or design around. Finally, the protections we have obtained may not be sufficient because:
We do aggressively defend and/or enforce our intellectual property rights. However, our inability or failure to protect our proprietary rights could have a significant adverse effect on our business, financial condition or results of operations, while actions taken to enforce our intellectual property rights could substantially increase our quarterly expenses.
We have been subject to, and may in the future become subject to, intellectual property infringement claims that could be costly and could result in a diversion of managements attention.
As the number of security products in the industry and the functionality of these products further overlaps, software developers and publishers may increasingly become subject to claims of infringement or misappropriation of the intellectual property or proprietary rights of others. From time to time, we have received notices from third parties either soliciting our interest in obtaining a license under one or more patents owned or licensed by these third parties or suggesting that our products may be infringing one or more patents owned or licensed by these third parties.
From time to time, we have received notices from various customers stating that we may be responsible for indemnifying such customers pursuant to indemnification obligations in product license agreements with such customers for alleged infringement of patents assigned to third parties. To date, we are not aware that any customer has filed an action against us for indemnification. In addition, third parties may assert infringement or
misappropriation claims against us in the future. Defending or enforcing our intellectual property could be costly and could result in a diversion of managements attention, which could have a significant adverse effect on our business, financial condition or results of operations. A successful claim against us could also have a significant adverse effect on our results of operations for the period in which damages are paid. Additionally, as a result of a successful claim, we could potentially be enjoined from using technology that is required for our products to remain competitive, which could in turn have an adverse effect on our results of operations for subsequent periods.
We may lose access to technology that we license from outside vendors, which loss could adversely affect our ability to sell our products.
We rely on outside licensors for patent and/or software license rights in technology that is incorporated into and is necessary for the operation of our products. Our success will depend in part on our continued ability to have access to such technologies that are or may become important to the functionality of our products. Any inability to continue to procure or use such technology could have a significant adverse effect on our ability to sell some of our products.
We rely on partners to integrate our products with their products and to resell our products. Changes in these relationships could adversely affect our ability to sell our products.
We rely on partners to integrate our products with their products or to maintain adherence to industry standards so that our products will be able to work with them to provide enhanced security attributes. For example, our ability to provide digital signatures on Adobe forms is dependent upon Adobe continuing to allow Entrust to have access to their private Application Programming Interfaces in future releases. In addition, we have resale relationships with companies such as Critical Path, Safenet, Pointsec, Corestreet, Vericept and Sun Microsystems/Waveset. Inability to maintain these relationships could have a material adverse effect on our results of operations.
We may lose suppliers whose loss could adversely affect our ability to sell our products.
Some of Entrusts newer products incorporate or are based on hardware products and components that are supplied and assembled by third-party suppliers, and, as such, a portion of Entrusts revenues are based upon the availability of such products and components to Entrust. If the pricing of these third-party products, or components thereof, changes or if new suppliers are used, there may be a detrimental or positive impact on the competitiveness and/or availability of these products.
Current and future acquisitions or investments could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our results of operations.
It is possible, as part of our current and future growth strategies that we will from time-to-time acquire or make investments in companies, technologies, product solutions or professional services offerings. With respect to these acquisitions, we would face the difficulties of assimilating personnel and operations from the acquired businesses and the problems of retaining and motivating key personnel from such businesses. In addition, these acquisitions may disrupt our ongoing operations, divert senior management from day-to-day business, increase our expenses and adversely impact our results of operations. Any future acquisitions would involve certain other risks, including the assumption of additional liabilities, potentially dilutive issuances of equity securities and incurrence of debt. In addition, these types of transactions often result in charges to earnings for such items as amortization of purchased intangibles or in-process research and development expenses.
For example, in June 2006, we completed the acquisition of all of the issued and outstanding shares of the common stock of Orion, based in McLean, Virginia, and in July 2006, we completed the acquisition of all of the
issued and outstanding shares of the capital stock and options of Business Signatures, based in Redwood City, California. While management has largely integrated the newly acquired technology and operations, each of the above risks applies to these acquisitions.
We face risks associated with our international operations, which, if not managed properly, could have a significant adverse effect on our business, financial condition or results of operations.
In the future, we may establish additional foreign operations, hire additional personnel and establish relationships with additional partners internationally. This expansion would require significant management attention and financial resources and could have an adverse effect on our business, financial condition and results of operations. Although our international sales currently are primarily denominated in U.S. dollars, UK pounds sterling and Euro dollars, we may increasingly denominate sales in foreign currencies in the future. In addition, our international business may be subject to the following risks:
Any one of these risks could significantly and adversely affect our business, financial condition or results of operations.
If the laws regarding exports of our products further limit or otherwise restrict our business, we could be prohibited from shipping our products to restricted countries, which would result in a loss of revenues.
Some of our products are subject to export controls under the laws of the United States, Canada and other countries. The list of products and countries for which exports are restricted, and the relevant regulatory policies, are likely to be revised from time to time. If we cannot obtain required government approvals under these regulations, we may not be able to sell products abroad or make products available for sale internationally via computer networks such as the Internet. Furthermore, United States governmental controls on the export of encryption products and technology may in the future restrict our ability to export some of our products.
Our stock price is volatile and may continue to be volatile in the future.
The trading price of our Common stock has been, and is expected to continue to be, highly volatile and may be significantly and adversely affected by factors such as:
Provisions of our charter and bylaws may delay or prevent transactions that are in our shareholders best interests.
Our charter and bylaws contain provisions, including a staggered board of directors that may make it more difficult for a third party to acquire us, or may discourage bids to do so. We think these measures enable us to review offers for our shares of Common stock to determine if they are in the best interests of our shareholders. These provisions could limit the price that investors might be willing to pay for shares of our Common stock and could make it more difficult for a third party to acquire, or could discourage a third party from acquiring, a majority of our outstanding voting stock. Our Board of Directors also has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by the shareholders. The rights of the holders of Common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock could make it more difficult for a third party to acquire, or may discourage a third party from acquiring, a majority of our outstanding voting stock.
There are no material unresolved written comments that were received from the SEC staff 180 days or more before the end of Entrusts fiscal year relating to its periodic or current reports under the Securities Exchange Act of 1934.
Entrusts U.S. headquarters, including executive offices and administrative facilities, is located in Addison, Texas at One Hanover Park, Suite 800, 16633 N Dallas Parkway, where Entrust leases office space. Entrusts Canadian headquarters is located in Ottawa, Ontario, Canada, where Entrust leases office space. Entrust also leases office space in Santa Clara, California, Redwood City, California, McLean, Virginia, Sydney, Australia, Mumbai, India, Beijing, China and Tokyo, Japan. Entrusts Europe, Middle East and Africa operations are headquartered in office space that it leases in Reading, England and Munich, Germany. The Santa Clara property is no longer in use by Entrust.
On July 7, 2000, an action entitled Frankel v. Entrust Technologies Inc., et al., No. 2-00-CV-119, was filed in the U.S. District Court for the Eastern District of Texas. Subsequently, several similar actions were also filed. These actions were consolidated and on January 22, 2001, a consolidated complaint was filed. The consolidated complaint purported to be a class action lawsuit brought on behalf of persons who purchased or otherwise acquired Common stock of Entrust during the period from October 19, 1999 through July 3, 2000. The consolidated complaint alleged that the defendants misrepresented and failed to disclose certain information about Entrusts business and prospects, as required by the Securities Exchange Act of 1934. It did not specify the amount of damages sought.
On September 30, 2002, Judge T. John Ward of the U.S. District Court for the Eastern District of Texas issued an order dismissing this purported securities class action lawsuit pending against Entrust with prejudice; however, the order is subject to the possibility of an appeal. As of the date of the filing of this report, Entrust has not learned of any appeal being filed. If an appeal is granted, an adverse judgment or settlement in this lawsuit could have a significant adverse impact on Entrusts future financial condition or results of operations.
Entrust is subject, from time to time, to various other legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these other legal matters will have a material adverse effect on Entrusts consolidated results of operations or consolidated financial position.
No matter was submitted to a vote of Entrust shareholders during the fourth quarter of 2007.
EXECUTIVE OFFICERS AND DIRECTORS OF THE REGISTRANT
The information provided below is as of March 6, 2008. The executive officers and directors of Entrust are as follows:
F. William Conner, age 48, has served as Entrusts President and Chief Executive Officer since April 2001 and as Chairman of the Board from October 1998 to May 2000 and from January 2002 to the present. He has been on the board of directors since July 1997. He has been credited with leading the corporate turnaround of Entrust. He has been highlighted in such publications as The Wall Street Journal, Washington Post and the Financial Times as a knowledge leader in the fight against cyber crime and identity theft. Mr. Conner has been a leader in the effort to elevate information security to a corporate governance issue and fashion a public-private partnership to protect Americas critical infrastructure. He launched and co-chaired the Business Software Alliance Information Security Governance Task Force, which released a security management framework in April 2003. He also co-chaired the National Cyber Security Partnerships Corporate Governance Task Force, which released its information security governance framework in April 2004. He has been recognized as one of the Federal Computer Weeks Federal 100the top executives from government, industry and academia who had the greatest impact on the government information systems community in 2003. In 2003, Mr. Conner received the Corporate CEO Award as part of the annual Tech Titans Award program.
From November 1999 to April 2001, Mr. Conner served as President, Enterprise Networks and eBusiness Solutions of Nortel Networks, a global Internet and communications company, where he led the turnaround of the Enterprise business while redefining and delivering ebusiness applications. From September 1998 to October 1999, he served as the first Chief Marketing Officer of Nortel Networks, leading the effort to reposition the company as a global leader in building the high-performance Internet and was recognized as Marketer of the Year in High Tech. From 1992 to September 1998, Mr. Conner held a number of key executive leadership positions at Nortel Networks, including President of its first data business, that lead to the acquisition of Bay Networks, Executive Vice President of Nortel Networks Enterprise Networks Business and a variety of other key leadership positions in sales and marketing.
Mr. Conner previously served on the boards of Travelocity, Williams Communications, Joint Forces Advisory Board, Southern Methodist University Tate Board, Dallas Symphony Executive Board and the Metroplex Technology Business Council.
Mr. Conner graduated from Princeton University with a bachelors degree in mechanical engineering. He also earned a masters degree in business administration from the Wharton School of the University of Pennsylvania.
David Wagner, age 43, has been our Senior Vice President and Chief Financial Officer since April 2003. He joined Entrust in 1996 as Controller when he helped guide Entrust through a private placement and on to becoming a public entity. His broad experience at Entrust includes significant involvement in all of the organizations public offerings and cross-functional responsibilities both in finance and operations. Prior to his appointment as Chief Financial Officer he served as Entrusts Vice President, Controller & Treasurer since 1999. Prior to joining Entrust, he held various finance and accounting positions at Nortel Networks from 1991 through 1995 and at Raytheon Systems from 1982 to 1991. Mr. Wagner is a graduate of The Pennsylvania State University where he received an undergraduate degree in accounting and a masters of business administration.
Kevin Simzer, age 41, has been our Senior Vice President and Chief Marketing Officer since June 2003. He has more than 21 years of experience in high technology, has held a variety of roles with the organization and is currently responsible for all aspects of research and development, product management, technical support, training, marketing and business development for Entrust globally. Prior to taking on the role of senior vice president, he was the vice president of research and development at Entrust.
Mr. Simzers professional life has been distinguished by a number of industry firsts, as well as innovative research and development. His career began at Bell Northern Research, Nortels research and development arm, working on product development for large-scale switching and data systems. Key projects included the worlds first telephone switching system supporting Integrated Services Digital Network and a highly scalable distributed system built using Advanced Intelligent Networking technology.
Mr. Simzer completed his undergraduate studies in computer engineering at the University of Ottawa and St. Lawrence College. In addition, Mr. Simzer earned a masters degree in business administration from Queens University in Kingston, Ontario, Canada.
Steve Holton, age 40, has been our Senior Vice President & GM for U.S. Sales and Managed Services since March 2007. Mr. Holton oversees all U.S. based direct and indirect sales, and leads all global sales related to the sale of Entrusts hosted product line, including PKI and SSL.
Mr. Holton brings more than 15 years of sales success in early-stage and mature technologies, with extensive experience in start-up, turnaround, IPO and accelerated-growth situations. One of Mr. Holtons most notable successes prior to Entrust was when he served as the VP of North American Sales for RightNow, an on-demand CRM software vendor. Under his five-year direction, RightNows annual revenue grew from $2 million to $65 million with 20 consecutive quarters of revenue growth and the ultimate launch of RightNows IPO in 2004 (NASDAQ:RNOW). Under his leadership, RightNow became a profitable global leader in the industry with offices on four continents and over 1,200 SMB/F500 customers. Mr. Holton honed his sales leadership skills at Pennsylvania-based Sanofi-Pasteur, a vaccine-oriented biotechnology organization. Mr. Holton served as Regional Sales Manager where he earned a number of leadership awards. He was also honored for running the companys best-performing region for three consecutive years.
Mr. Holton earned his International MBA from Duke Universitys Fuqua School of Business, and he received his undergraduate degree in Biology from California State University.
Peter Bello, age 45, is the Senior Vice President of U.S. Federal and CALA (Canadian, Asia, and Latin America) sales. Mr. Bello also has the role of leading the North American and CALA Professional Services teams. He has responsibility for our U.S. Federal Sales team, Government Relations, CALA Sales team, as well as North American Professional Services. Mr. Bello has 22 years in the industry, and is noted for his strong combination of technical and business acumen. Mr. Bello joined Entrust as Director of North American
Professional Services in February of 1998 to help build the professional services practice and organization. He successfully grew the North American Professional Services from a start up to a $6 million business over a 4 year period. Mr. Bello was promoted to Vice President, North American Professional Services with additional responsibilities for Latin America and Asia Pacific. He was President of CygnaCom Solutions from March of 2002 until November of 2007. CygnaCom Solutions has been providing professional information security services and cryptographic solutions to government and business clients since 1994. This business includes US Federal government accredited security test laboratories. Prior to joining Entrust, Mr. Bello held various positions of increased responsibility at Nortel Networks from 1985-1998 in the areas of engineering, technical support, marketing, and order management. He graduated from Rensselaer Polytechnic Institute with BS in Electrical Engineering.
Andrew Pinder, age 60, is the Senior Vice President, EMEA & Global Government Sales Strategy. Prior to joining Entrust as an Executive in October 2006, Mr. Pinder served on the Entrust Board of Directors from July 2004 until October 2006. As the United Kingdoms e-Envoy, Mr. Pinder spearheaded the Prime Ministers directive to bring Internet access to all British citizens and businesses by 2005. He was also responsible for forging stronger information networks in the British government and for enabling the U.K. to be a recognized leading e-Government and a leader in e-Business. Mr. Pinder was awarded the Commander of the Order of the British Empire (CBE) in HM the Queens New Years Honours list for his services to the Cabinet Office. He is also a non executive director of United Utilities PLC and its subsidiary Vertex Data Sciences Ltd., both of the United Kingdom. Before his appointment as e-Envoy in 2001, Mr. Pinder was a partner in a venture capital firm and carried out a number of management consultancy assignments for the British government. Previous executive leadership roles include positions as the head of European Operations and Technology at Citibank, Director of Operations and Technology at Prudential Corporation, and as Director of Information Technology at the Office of Inland Revenue.
Butler C. Derrick, Jr., age 71, has been a Director of Entrust since May 1999. Since February 2004 Mr. Derrick has been the managing partner of Nelson, Mullins, Riley and Scarborough LLP. From August 1998 to February 2004, Mr. Derrick was a Partner at the law firm of Powell, Goldstein, Frazer & Murphy LLP, Washington, D.C. From January 1995 to July 1998, Mr. Derrick was a Partner at the law firm of Williams & Jensen, Washington, D.C. Mr. Derrick served in Congress as a United States Representative from South Carolina from January 1975 to January 1995. While in Congress, Mr. Derrick held numerous posts, including Deputy Majority Whip and Vice Chairman of the House Rules Committee.
Jerry C. Jones, age 52, has served on the Entrust Board of Directors since December 2003. He serves as Acxiom Corporations Business Development and Legal Leader. At Acxiom, he is responsible for the legal team, leads the strategy and execution of mergers and alliances, and assists in other strategic initiatives. Mr. Jones came to Acxiom in March 1999 from the Rose Law Firm in Little Rock, Arkansas, where for 19 years he specialized in problem solving and business litigation. He is the Chairman of the Arkansas Virtual Academy, a statewide public school in Arkansas. He is a 1980 graduate of the University of Arkansas School of Law and holds a bachelors degree in Public Administration from the University of Arkansas.
Michael P. Ressner, age 59, has been a Director of Entrust since May 1999. From January 2001 to December 2002, Mr. Ressner served as Vice President, Nortel Networks. Prior to that time, he served as Vice President of Finance of Nortel Networks Enterprise Solutions group from February 1999 to January 2001. From May 1994 to January 1999, Mr. Ressner served as Vice President of Finance for the Carrier Solutions business unit of Nortel Networks. Prior to these assignments, he held a number of senior finance management posts within various business units of Nortel Networks. Mr. Ressner currently serves on the Board of Directors of Magellan Health Services, Tekelec, and Exide Technologies.
Douglas Schloss, age 49, has served on the Board of Directors of Entrust since July 2001. Since January 1994, he has been the President and Chief Executive Officer of Rexford Management, Inc., a firm that manages an investment partnership specializing in transaction arbitrage. He is also the President of the Board at St. Pauls
School in Concord, New Hampshire. He has served as Chief Executive Officer and Chairman of Marcus Schloss & Co., Inc., a registered broker-dealer and formerly a New York Stock Exchange specialist firm, since March 1993. Prior to these positions, Mr. Schloss managed the equity trading desk and arbitrage investment portfolio of Marcus Schloss & Co.
Ray W. Washburne, age 47, has served on our Board of Directors since June 2006. Since 1990, he has been the chairman and CEO of Charter Holding. He also serves on the board of directors for the M Crowd Restaurant Group, a company he co-founded in 1991. In addition, he is on the advisory board for Colonial Bank Texas and the Dallas Citizens Council. He is a graduate of Southern Methodist University and serves on the schools 21st Century Counsel. He is also an adjunct professor at the universitys Cox School of Business. He is an active member of the Dallas Citizens Counsel, the Dallas Assembly, the Texas Lyceum and the Dallas chapter of the Young Presidents Organization.
Terdema Ussery II, age 48, has served on the Board of Directors since December 2006. Since 1996, he has served as the Dallas Mavericks president and CEO and was a catalyst in the organizations resurgence, including increased corporate sponsorship, ticket sales, television revenues and community impact under his direction. He is also the CEO for HDNet where he spearheaded the launch of the network, one of the worlds first all-high-definition television stations and negotiated the channels first content and distribution agreements. Prior to these two positions he served as president of Nike Sports Management. Prior to his post at Nike, he also served as commissioner of the Continental Basketball Association (CBA). He is a graduate of Princeton and has a masters degree from the John F. Kennedy School of Government at Harvard and a law degree from Cal-Berkeley.
Michael E. McGrath, age 58, has served on the Board of Directors since February 2007. Mr. McGrath is the former president and chief executive officer at Dallas-based i2 Technologies, and currently serves on the companys board of directors. He is also the executive chairman of The Thomas Group. In 1976, Mr. McGrath co-founded Pittiglio Rabin Todd & McGrath (PRTM) and served as its president and CEO until his retirement in July 2004. During the last decade, PRTM grew to be one of the larger and most successful management consulting firms in the world. Mr. McGrath is recognized as an expert in product development and product strategy. Mr. McGrath holds a bachelors degree in computer science and management science from Boston College and a masters degree in business administration from Harvard Business School.
The principal market on which our Common stock is traded is the Nasdaq Global Market, under the symbol ENTU. The following table sets forth, for the periods indicated, the high and low sales prices per share of our common stock as reported on the Nasdaq Global Market.
As of March 6, 2008, we had approximately 897 holders of record of common stock. Because many of these shares are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these holders of record.
We have never declared or paid any cash dividends on our shares of common stock. We intend to retain future earnings, if any, to finance our growth strategy. We do not anticipate paying cash dividends on our common stock in the foreseeable future. Payment of future dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our financial condition, our operating results, our current and anticipated cash needs, restrictions in any future financing agreements and our plans for expansion. See Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources.
Information relating to compensation plans under which equity securities of Entrust, Inc. are authorized for issuance is set forth in Part III, Item 12 of this Annual Report on Form 10-K and such information is incorporated herein by reference.
No purchase was made by or on behalf of Entrust or any affiliated purchaser, (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934)) during the quarter ended December 31, 2007 of shares or other units of any class of Entrusts equity securities that is registered by Entrust pursuant to section 12 of the Exchange Act.
Entrust did not sell any securities during 2006 which were not registered under the Securities Act.
The following graph compares the cumulative 5-year total return of holders of Entrust, Inc.s common stock with the cumulative total returns of the Russell 2000 index and the NASDAQ Computer & Data Processing index. The graph tracks the performance of a $100 investment in our common stock and in each of the indexes (with the reinvestment of all dividends) from December 31, 2002 to December 31, 2007.
The stock price performance included in this graph is not necessarily indicative of future stock price performance.
The data set forth below should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and notes thereto included elsewhere in this Annual Report.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Selected Financial Data and our consolidated financial statements and notes thereto appearing elsewhere in this Annual Report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under Risk FactorsCertain Factors That May Affect Our Business and elsewhere in this Annual Report.
As a trusted security expert, Entrust secures digital identities and information through layered security solutions that help provide confidence for consumers, enterprises and governments, enabling them to do transactions more securely. With more than 125 patents granted or pending, our solutions help enterprises secure channels of communication, which allows information-sharing among stakeholders and enables compliance with information security and government regulations. More than 1,700 customers in 60 different countries across the globe leverage Entrusts world-class solutions.
We conduct business in one operating segment. We develop, market and sell software solutions that secure digital identities and information. We also perform professional services to install, support, and integrate our software solutions with other applications. All of these activities may be fulfilled in conjunction with partners and are managed through our global organization.
As an innovator and pioneer in the Internet security and Public Key Infrastructure (PKI) fields, Entrusts market leadership and expertise in delivering award-winning identity and data protection management software solutions is demonstrated by the diversity of its products, geographic representation, and customer segments. We continue to drive revenue in our key products.
We have three key layered approaches that we take to our customers; our Layered Consumer, Enterprise and Government Security Architectures. These layered approaches to security help give our customers a roadmap for building security across their enterprise and customer facing applications, and for governments, citizens facing applications. The layered approach allows our customers to customize the level of security to the value of the data or transaction. A layered security strategy from a single, trusted vendor affords security-conscious organizations a level of synergy, interoperability and cost-effectiveness unmatched by a collection of third-party products. Further, layered security models foster environments of easy-to-use security solutions that increase end-user acceptance and reduce help-desk calls. Entrust has attractive capabilities in the market to assist our customers with their growing identity and information protection needs.
Our Layered Consumer Architecture approach consists of six layers:
Our Layered Enterprise Architecture approach consists of five layers:
Entrust has three key platforms, Authentication and Transaction Monitoring, Information Protection and Public Key which support our layered security architectures. We have a unique end-to-end platform for securing digital identities and information. This end-to-end software platform is easy to implement, user friendly and cost effective with the ability to evolve over time to grow with our customers needs.
Authentication and Transaction Monitoring, come together in 2007 to provide a new level of assurance for both internal and external parties, through Risk-Based Authentication.
Entrust offers a range of authentication capabilities with its authentication platform so that specific methods can be used with specific users and applications. First steps can be as simple as deploying SSL certificates or user name and password. Entrust has long played a key role in this space through our SSL and single sign-on products. Risk-Based Authentication, however, goes much deeper than SSL and single sign-on. Risk-Based Authentication has the ability to judge each individual transaction on its own merits driven by policy level decisions on the level of risk associated with certain transactions. With Entrusts Risk-Based Authentication solution, transactions can be monitored in real time and then a determination can be made on the level of security required for that transaction. This is done through the combination of Entrust IdentityGuard and Entrust TransactionGuard. This combined offering is a modern architecture for consumer authentication which has a layered approach of non-invasive anomaly detection and selective intervention with minimal impact on the user experience.
Product Category Financial Metrics:
These three categories are how we report our product revenue externally, but do not directly correlate to our three platforms that we use with customers.
We also provide support and maintenance services to our customers. Support and maintenance revenue made of nearly two-thirds of our total services revenues in Q4 of 2007, achieving record high levels. It is important to note that we achieved record renewals in the fourth quarter of 2007, both in terms of customer retention rate and the dollar value of retention. The customer retention rate and the associated dollar value renewals were over 95 percent in 2007. We also provide professional services, including architecture, installation, and integration services related to the products that we sell. Our support and maintenance, and our professional services have shown consistent steady growth and, since Q2 2006, have achieved 7 quarters of sequential quarter-over-quarter revenue growth.
In 2007, deferred revenue increased $3.9 million to $27.9 million from year-end 2006. The increase in deferred revenue was driven by an increase in subscription product bookings (60% of the increase) and support and maintenance renewals. These numbers show the continued strength of our support and maintenance renewals and the growth in our subscription based software growth.
In the fourth quarter of 2007, Entrust achieved a net income of $0.02 per share, which is an improvement of $0.05 per share from a net loss of $0.03 per share in the fourth quarter of 2006. During 2007 we have significantly reduced our total expenses through a combination of managed headcount reductions lowering of contracting expenses and controlling variable operating costs. Those expense reduction initiatives were somewhat offset by the additional costs we are experiencing due to the appreciation of the Canadian dollar from approximately $.85 per US dollar at the beginning of the year to $1.00 per U.S. dollar exchange rate at the end of 2007. This increase in the Canadian dollar to the U.S. dollar cost Entrust nearly $5.0 million in additional expense in 2007.
Entrust sells its solutions globally, with an emphasis on North America, Europe and Asia. These primary areas have demonstrated the most potential for early adoption of the broadest set of Entrust solutions. Entrust extends to other non-core geographies through strategic partner relationships, which increases the leverage of our direct sales channel worldwide. In North America, Entrust is targeting a return to revenue growth in its software business by leveraging Entrusts historical strength in selling to key verticals such as government (Federal, State, Provincial), financial services and global 1000 enterprises. Europe and the Middle East are regions where Entrusts products and solutions continue to experience strong demand and we believe that this market will provide growth, with increased momentum from governments and enterprises leveraging Entrusts solutions to transform their business processes and to leverage the Internet and networking applications.
We market and sell our products and services in both the enterprise and government market space. In Q4, 2007, 40% of our product sales were in our extended government vertical market, which includes healthcare. For the year 45% of product revenue was driven by extended government customers around the world. This revenue has been driven by key global projects that have started to increase product purchases. In the extended government vertical market, we have a strong penetration in the U.S. Federal government, the governments of Canada, Singapore, Denmark, the United Kingdom, Kingdom of Saudi Arabia and across continental Europe. In fact, Entrust now counts 17 of the top 22 e-governments, as set forth in a report of Accenture issued in June 2007, as customers.
A key change in the government space has been the movement from purely internal security solutions that our customers require to more external citizen facing applications. These projects include ePassports, national ID programs, eBorders, physical and logical access programs for government employees, and a growing number of citizen facing applications. Security is at the core of all these projects and our wide product set positions Entrust well in this space. We have already announced six ePassport projects that Entrust has won and we have been selected as the infrastructure for a number of national ID and Ministry of Defense programs. In 2007 we won national PKI infrastructures in the Kingdom of Saudi Arabia, Brunei and Slovenia. Specifically, we had one million dollar transaction in the 3rd quarter for the Saudi Arabia PKI infrastructure and in the fourth quarter their ePortal infrastructure was our largest transaction.
In Q4, 2007, 60% of our product sales were in our extended enterprise vertical market. We continue to see demand from global enterprises as they continue to respond to regulatory and governance compliance demands and extend their internal and external networks to more and more individuals inside and outside their domain. We have experienced a change in the shape of many enterprise deals. Specifically, enterprises are buying for their immediate need and then adding to their purchases as the projects begin roll out.
Our largest vertical within the enterprise market is the financial services vertical. In the fourth quarter of 2007, financial services accounted for 32% of product revenue. Although financial services remain our second largest vertical our revenue from this vertical was impacted by financial institutions exposure to sub prime issues in the second half of 2007. We did have very good success in the financial vertical in Chile, where we won nine banks with our Risk Based Authentication solution in the fourth quarter.
A key driver of our product growth has been the recent spotlight on identity theft due to breaches at companies like Choicepoint, LexisNexis and TJX. These breaches have proven that self-regulation over the past
few years has been insufficient at addressing the underlying issues. Recent legislation has addressed these concerns. California S.B. 1386 has cast more visibility on the issue for citizens, corporations, and the government. The law requires both corporations and the government to notify California residents if their sensitive data has been breached unless encryption technology is deployed. Additionally, more than 35 states have now passed breach notification requirements.
Entrust for years has been a leader in securing digital identities and information. In the fourth quarter of 2004, we introduced IdentityGuard which is our easy-to-use second factor of authentication solution. In Q4, 2007, IdentityGuard product revenue was $1.7 million, its highest level of the year. Entrust IdentityGuard transactions increased to 194 in 2007, up 113%, from 91 in 2006. New customer acquisition was strong in 2007 with 85 of the 194 transactions coming from new customers.
As of December 31, 2007, we have over 9.0 million licensed users of IdentityGuard and have gone over $11.0 million in total sales of the solution. IdentityGuards low cost point, its simplicity for the mass market, and its effectiveness in countering online theft and phishing, are the key drivers for the increased revenue growth we are experiencing. Along with the revenue growth for second factor authentication, we are also seeing customers increasingly interested in data protection and encryption. With a combination of Entrust IdentityGuard, GetAccess and TruePass, customers can accomplish authentication and role based access control, digital signature, and encryption from one solution provider.
In the first quarter of 2007, Entrust introduced the industrys first $5 one-time-passcode (OTP) security token. In the second quarter, we made the product commercially available and delivered our tokens to our first customers. In addition to the OTP token, Entrust IdentityGuard customers enjoy a range of authentication methods from a single platform. This provides unprecedented flexibility and choice customers currently do not have with existing OTP token vendors.
In April 2006, Entrust introduced a Managed Public Key Infrastructure (PKI) service. This service was launched in response to customer requests for Entrust to offer a hosted service to give them a choice between a service offering for PKI certificates and our traditional PKI software purchase option. Our service offering is designed to help enterprises and government agencies grow and accelerate their core business security, without having to develop PKI expertise internally. In December 2006, the Entrust managed PKI service made the General Services Administration (GSA) list of approved shared service providers. This status enables Entrust to help federal agencies reap the security benefits of PKI without having to maintain the certification authority (CA) themselves. In Q3, 2007, we became the primary supplier for the US Federal Governments General Services Administration HSPD-12 directive.
Our managed service is not our first entrance into the services business. We have been helping our customers for years design, deploy and manage our solutions. We have also been successful in growing our SSL certificate business, which increased over 43% in the fourth quarter over last year and increased 32% for the full year. With the introduction of the new Extended Validation SSL Certificates and Unified Communications Certificates we should be able to grow this business into 2008.
Entrust in the past has relied significantly on large deals, meaning deals of $1 million or more, in each quarter. We have over the past few years reduced this dependence, but they remain a significant portion of our product revenue on a quarterly basis. Our software revenue from our top five customers in Q4, 2007 was approximately 8% of our total revenue in that quarter and we did not have a product deal over $1 million in the quarter. These numbers were slightly outside our historical range, which is generally between 10% and 25% of revenue from the top five customers and zero to four transactions over $1 million. In 2007, nearly 90 percent of our product revenue came from transactions under $500 thousand. This shift in our business model to more, smaller transactions has reduced our dependence on deals over $500 thousand.
We continue to be impacted from time to time on our software revenue by the timing of our customers buying process, which may include proof of concepts, senior management reviews and budget delays that
sometimes results in longer than anticipated sales cycles. We are also impacted by our customers recent buying behavior, which is to buy only for immediate need as opposed to making a larger purchase in order to get a better discount. Any of these factors may impact our revenue on a quarterly basis.
Our management uses the following metrics to measure performance:
During 2007, we continued our strategy of focusing on core vertical and geographic markets. Revenues of $99.7 million represented a 5% increase over 2006, and consisted of 36% product sales and 64% services and maintenance. Services and maintenance revenues increased 6% over 2006, due to increased demand for both consulting services and support and maintenance services, while product revenues increased 2% from 2006, primarily driven by an improved product transaction closure rate, despite a lower average purchase value for product transactions compared to 2006. Net loss in 2007 was $6.2 million, or $0.10 per share, compared to a net loss of $15.4 million, or $0.26 per share in 2006, with total expenses decreasing 2% to $106.6 million in 2007, due in part to a $2.8 million adjustment to our restructuring accrual related to our California facility in 2006. We used $4.5 million in cash flow from operations in 2007, compared to net cash generated in operations of $4.3 million in 2006. Entrust Emerging Growth Products (Entrust IdentityGuard, Boundary Messaging and Fraud Detection) accounted for 23% of product revenue, which is a decrease of 13% from 2006. Entrust PKI Products accounted for 70% of product revenue, which is an increase of 11% from 2006. Entrust SSL Certificate Services revenues, a component of our PKI Product solutions suite, increased 32% over 2006. Entrust Single Sign-On Products accounted for 7% of product revenue, which is a decrease of 16% from 2006. Overall, Extended Government accounted for 44% and Extended Enterprise accounted for 56% of the product revenue in 2007. The financial services vertical accounted for approximately 28% of 2007 product revenues, a decrease of 11% from 2006.
Other highlights from 2007 included:
CRITICAL ACCOUNTING POLICIES
The preparation of our financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We believe our estimates and assumptions are reasonable. However, actual results and the timing of the recognition of such amounts could differ from those estimates.
In 2007, our most complex accounting judgments were made in the areas of software revenue recognition, allowance for doubtful accounts, the provision for income taxes, accounting for uncertain tax positions, valuation of goodwill, purchased intangibles and other long-term assets, and stock-based compensation. These areas are expected to continue to be ongoing elements of our critical accounting processes and judgments.
Software Revenue Recognition
With respect to software revenue recognition, we recognize revenues in accordance with the provisions of the American Institute of Certified Public Accountants Statement of Position No. 97-2, Software Revenue Recognition, Statement of Position No. 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions and related accounting guidance and pronouncements. Due to the complexity of some software license agreements, we routinely apply judgments to the application of software revenue recognition accounting principles to specific agreements and transactions. We analyze various factors, including
a review of the specifics of each transaction, historical experience, credit worthiness of customers and current market and economic conditions. Changes in judgments based upon these factors could impact the timing and amount of revenues and cost recognized. Different judgments and/or different contract structures could lead to different accounting conclusions, which could have a material effect on our reported earnings.
Revenues from perpetual software license agreements are recognized when we have received an executed license agreement or an unconditional order under an existing license agreement, the software has been shipped (if there are no significant remaining vendor obligations), collection of the receivable is reasonably assured, the fees are fixed and determinable and payment is due within twelve months. Revenues from license agreements requiring the delivery of significant unspecified software products in the future are accounted for as subscriptions and, accordingly, are recognized ratably over the term of the agreement from the first instance of product delivery. License revenues are generated both through direct sales to end users as well as through various partners, including system integrators, value-added resellers and distributors. License revenue is recognized when the sale has occurred for an identified end user, provided all other revenue recognition criteria are met. We are notified of a sale by a reseller to the end user customer in the same period that the product is delivered through to the end user customer. We do not offer a right of return on sales of our software products.
We do not generally include acceptance provisions in arrangements with customers. However, if an arrangement includes an acceptance provision, we recognize revenue upon the customers acceptance of the product, which occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.
For all sales, we use a binding contract, purchase order or another form of documented agreement as evidence of an arrangement with the customer. Transactions with our distributors are evidenced by a master agreement governing the relationship, together with binding purchase orders on a transaction-by-transaction basis. We consider delivery to occur when we ship the product, so long as title and risk of loss have passed to the customer. If an arrangement includes undelivered products or services that are essential to the functionality of the delivered product, delivery is not considered to have occurred until these products or services are delivered.
At the time of a transaction, we assess whether the sale amount is fixed or determinable based upon the terms of the documented agreement. If we determine the fee is not fixed or determinable at the outset, we recognize revenue when the fee becomes fixed and determinable. We assess if collection is reasonably assured based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection is not reasonably assured, we do not record revenue until such time as collection becomes probable, which is generally upon the receipt of cash.
We are sometimes subject to fiscal funding clauses in our software licensing transactions with the United States government and its agencies. Such clauses generally provide that the license is cancelable if the legislature or funding authority does not appropriate the funds necessary for the governmental unit to fulfill its obligations under the licensing arrangement. In these circumstances, software licensing arrangements with governmental organizations containing a fiscal funding clause are evaluated to determine whether the uncertainty of a possible license arrangement cancellation is remote. If the likelihood of cancellation is assessed as remote, then the software licensing arrangement is considered non-cancelable and the related software licensing revenue is recognized when all other revenue recognition criteria have been met.
For arrangements involving multiple elements, we allocate revenue to each component based on the vendor-specific objective evidence of the fair value of the various elements. These elements may include two or more of the following: software licenses, maintenance and support, consulting services and training. For arrangements where vendor-specific objective evidence is not available for a delivered element, we first allocate the arrangement fee to the undelivered elements based on the total fair value of those undelivered elements, as indicated by vendor-specific objective evidence. This portion of the arrangement fee is deferred. Then the difference (residual) between the total arrangement fee and the amount deferred for the undelivered elements is
recognized as revenue related to the delivered elements. We attribute the discount offered in a multiple-element arrangement entirely to the delivered elements of the transaction, which are typically software licenses. Fair values for the future maintenance and support services are based upon substantially similar sales of renewals of maintenance and support contracts to other customers. Fair value of future services, training or consulting services is based upon substantially similar sales of these services to other customers. In some instances, a group of contracts or agreements with the same customer may be so closely related that they are, in effect, part of a single multiple-element arrangement, and therefore, we would undertake to allocate the corresponding revenues amongst the various components, as described above.
We also eliminate intercompany profits on revenue transactions with unconsolidated subsidiaries that are accounted for under the equity method to the extent of our ownership interest in that related party, if the product and/or services have not been sold through to an unrelated third party end-user customer.
Our consulting services generally are not essential to the functionality of the software. Our software products are fully functional upon delivery and do not require any significant modification or alteration. Customers purchase these consulting services to facilitate the adoption of our technology and dedicate personnel to participate in the services being performed, but they may also decide to use their own resources or appoint other consulting service organizations to provide these services. When the customization is essential to the functionality of the licensed software, then both the software license and consulting services revenues are recognized under the percentage of completion method, which requires revenue to be recognized based upon the percentage of work effort completed on the project.
Allowance for Doubtful Accounts
We maintain doubtful accounts allowances for estimated losses resulting from the inability of our customers to make required payments. We assess collection based on a number of factors, including previous transactions with the customer and the creditworthiness of the customer. We do not request collateral from our customers.
We base our ongoing estimate of allowance for doubtful accounts primarily on the aging of the balances in the accounts receivable, our historical collection patterns and changes in the creditworthiness of our customers. Based upon the analysis and estimates of the uncollectibility of our accounts receivable, we record an increase in the allowance for doubtful accounts when the prospect of not collecting a specific account receivable becomes probable. The allowance for doubtful accounts is established based on the best information available to us and is re-evaluated and adjusted as additional information is received. We exhaust all avenues and methods of collection, including the use of third party collection agencies, before writing-off a customer balance as uncollectible. While credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Each circumstance in which we conclude that a provision for non-payment by a customer may be required must be carefully considered in order to determine the true factors leading to that potential non-payment to ensure that it is proper for it to be categorized as an allowance for bad debts.
However, a significant change in the financial condition of a major customer, such as the European distributor discussed below, could have a material impact on our estimates regarding the sufficiency of our allowance. Our accounts receivable include material balances from a limited number of customers, with five customers accounting for 26% of gross accounts receivable at December 31, 2007, compared to 22% of gross accounts receivable at December 31, 2006. No customer accounted for 10% or more of net accounts receivable at December 31, 2007. For more information on our customer concentration, see our related discussion in Risk Factors. Therefore, changes in the assumptions underlying this assessment or changes in the financial condition of our customers, resulting in an impairment of their ability to make payments, and the timing of information related to the change in financial condition could result in a different assessment of the existing credit risk of our accounts receivable and thus, a different required allowance, which could have a material impact on our reported earnings.
During 2006, we became aware of financial concerns regarding one of our European distributors and, as a result, we concluded that it was necessary to record an increase to our provision for doubtful accounts of $0.9 million, which accounted for the majority of the $1.0 million increase in this provision for that year. These balances remain outstanding and, as a result, the allowance for doubtful accounts remains substantially unchanged from the end of 2006 for these items, other than to adjust for the effect of changes in foreign exchange rates. However, the allowance for doubtful accounts has increased by approximately $300 thousand in 2007 to provide for miscellaneous accounts that have continued to age from the end of 2006 and the earlier quarters of 2007.
Provision for Income Taxes
The preparation of our consolidated financial statements requires us to assess our income taxes in each of the jurisdictions in which we operate, including those outside the United States. In addition, we have based the calculation of our income taxes in each jurisdiction upon inter-company agreements, which could be challenged by tax authorities in these jurisdictions. The income tax accounting process involves our determining our actual current exposure in each jurisdiction together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue and accrued restructuring charges, for tax and accounting purposes. These differences result in the recognition of deferred tax assets and liabilities. We then record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized.
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. We recorded a valuation allowance of $156.0 million as of December 31, 2007, which offsets deferred income tax assets relating to United States and foreign net operating loss (NOL) and tax credit carry-forwards in the amount of $129.3 million and $26.7 million of deferred tax assets resulting from temporary differences. This valuation allowance represents the full value of our deferred tax assets, due to uncertainties related to our ability to utilize our deferred tax assets as a result of our recent history of financial losses. Therefore, our balance sheet includes no net deferred tax benefits related to these deferred tax assets. Valuation allowances are provided against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and the timing of the temporary differences becoming deductible. We consider, among other available information, historical earnings, scheduled reversals of deferred tax liabilities, projected future taxable income, prudent and feasible tax planning strategies and other matters in making this assessment. Until an appropriate level of profitability is sustained, we expect to continue to record a full valuation allowance and will not record any benefit from the deferred tax assets.
Accounting for Uncertain Tax Positions
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109, (FIN No. 48), which clarifies the accounting for uncertainty in tax positions. FIN No. 48 requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not of not being sustained on audit, based on the technical merits of the position. FIN No. 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. The provisions of FIN No. 48 were effective for us as of the beginning of our 2007 fiscal year.
We adopted the provisions of FIN No. 48 on January 1, 2007. As a result of the implementation of FIN No. 48, we were not required to record a liability for unrecognized tax benefits, resulting in no adjustment to the January 1, 2007 accumulated deficit balance. Correspondingly, the amount of unrecognized tax benefits at January 1, 2007 was zero and, thus, did not impact our effective tax rate. The amount of unrecognized tax benefits did not change as of December 31, 2007.
The implementation of FIN No. 48 required us to use judgment in establishing the tax positions undertaken by us in our tax filings across the world, as well as determining which of these positions are certain or uncertain. In making these determinations, we were required to make interpretations of tax legislation and administrative enforcement of this legislation in multiple jurisdictions, but primarily in the United States and Canada. In addition, we used judgment to assess whether the identified uncertain tax positions were more likely than not of being sustained upon audit examination by the tax authority in the relevant jurisdictions. If applicable, we are also required to make estimates of the value of unrecognized tax benefits and the significance of any change to our results of operations and financial position. Finally, we were required to estimate, if applicable, the financial impact of interest and penalties of any position that would not likely be sustained on audit.
Valuation of Goodwill, Purchased Intangibles and Other Long-term Assets
We have completed several acquisitions in recent years, from which we have acquired goodwill and other purchased intangible assets, in the form of purchased product rights, customer relationships, partner relationships and non-competition agreement assets. We purchased CygnaCom Security Solutions, Inc. and enCommerce, Inc. in 2000, Entrust Japan Co. Limited and certain assets of AmikaNow! Corporation in 2004, and Orion Security Solutions, Inc. and Business Signatures Corporation in 2006.
These acquisitions were accounted for under the purchase method of accounting, and, accordingly, the purchase prices were allocated to the fair value of the tangible and intangible assets and liabilities acquired, with the remainder allocated to goodwill. In determining the fair value of the intangible assets acquired, we are required to make significant assumptions and judgments regarding such things as the estimated future cash flows that we believe will be generated as a result of the acquisition of customer/partner relationships and purchased product rights, and the estimated useful life of these acquired intangible assets. We believe that our assumptions and resulting conclusions are the most appropriate based on existing information and market expectations. However, different assumptions and judgments as to future events could have resulted in different fair values being allocated to the intangible assets acquired.
We will review these assets for impairment in future, in accordance with the guidance in Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Intangible Assets, which require goodwill to be reviewed for impairment at least annually or whenever events indicate that their carrying amount may not be recoverable, and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
Goodwill with a balance of $60.2 million at December 31, 2007 is tested for impairment annually and also in the event of an impairment indicator. To determine any goodwill impairment, we perform a two-step process on an annual basis, or more frequently if necessary, to determine 1) whether the fair value of the relevant business unit exceeds carrying value and 2) the amount of impairment loss, if any. This test requires us to make judgments as to what is the appropriate business unit with which to associate the individual components of goodwill for the purposes of determining whether the carrying value of the goodwill has exceeded the fair value or market value of the relevant business unit. In our judgment, we operate in only one business segment. The assumptions used to test for impairment, including expected revenues, discount rates, and terminal values, are highly subjective. Valuation models are sensitive to changes in assumptions, and therefore changes in these assumptions in the future could result in significant impairment charges or changes to our expected amortization. No impairment was required as a result of the annual impairment test as of December 31, 2007.
Purchased product rights, customer relationships, partner relationships and non-competition agreements of key personnel of acquired companies totaling $11.5 million at December 31, 2007 are amortized using the straight-line method over their estimated useful lives, generally four to ten years. These assets are reviewed for impairment whenever events indicate that their carrying amount may not be recoverable. In such reviews, the related expected undiscounted cash flows are compared with their carrying values to determine if a write-down to fair value is required. These reviews required significant judgment and estimation regarding the amount and timing of future revenues and related expenses associated with these acquired assets.
In addition, we have a net balance of $3.5 million from our investment in other long-term assets at December 31, 2007, which consist primarily of capitalized software development costs, which includes costs to develop video based training, for both general security and Entrust specific solutions, for sale to our customers. These capitalized costs are amortized ratably as the underlying revenues are recognized on sales of capitalized software or over a three year period. The economic useful life of these capitalized software development costs is periodically re-assessed.
We are not aware of any impairment events during the year ended December 31, 2007. However, if the demand for the technologies, products and assets acquired and developed materializes slowly, to a minimum extent, or not at all in the relevant market, we could lose all or substantially all of our investment in these assets, which would have a significant impact on our consolidated financial position and results of operations.
Our stock award program is a broad-based, long-term retention program that is intended to contribute to our success by attracting, retaining and motivating talented employees and to align employee interests with the interests of our existing shareholders. Stock based awards may be granted to employees when they first join us, when there is a significant change in an employees responsibilities and, occasionally, to achieve equity within a peer group. Stock based awards may also be granted in specific circumstances for retention or reward purposes. The Compensation Committee of the Board of Directors may, however, grant additional awards to executive officers and key employees for other reasons. Under the stock based award plans, the participants may be granted options to purchase shares of Common stock and substantially all of our employees and directors participate in at least one of our plans. Options issued under these plans generally are granted at fair market value at the date of grant and become exercisable at varying rates, generally over three or four years. Options issued before April 29, 2005 generally expire ten years from the date of grant; awards issued on or after April 29, 2005 generally expire seven years from the date of grant.
In addition, we use restricted stock units (RSUs) and stock appreciation rights (SARs) in incentive compensation plans for employees and members of the Board of Directors, in place of, or in combination with stock options to purchase shares of our stock. RSUs allow the employees to receive our Common stock once the units vest. The RSUs generally vest over two to four years.
Beginning in 2006, the Compensation Committee of the Board of Directors has issued performance stock units to certain key employees. These performance grants are based on the achievement of certain pre-determined criteria such as budgeted level of revenue attainment or target stock price. The associated compensation expense for awards with performance conditions is accrued over the service period when that the performance criteria are reasonably certain to be achieved. Compensation cost for an award with a market condition will be recognized ratably for each vesting tranche over the requisite service period in a similar manner as an award with a service condition.
We recognize that stock options and other stock-based incentive awards dilute existing shareholders and have attempted to control the number granted while remaining competitive with our compensation packages. Accordingly, from 2003 to 2005 we reduced our gross stock option grant rate, which contributed to a low net grant rate under our stock-based incentive plans during that time. In 2006 the gross grant rate increased for a number of reasons including issuing employee equity pursuant to two acquisitions and hiring a key executive. The equity plan overhang also increased as a result of assuming the equity plan of one acquired company. In 2007 we returned to our practice from 2003 to 2005 of reducing our gross stock option grant rate and keeping a low net grant rate. The Compensation Committee of the Board of Directors oversees the granting of all stock-based incentive awards.
SFAS No. 123(R) requires us to measure compensation cost for stock awards at fair value and recognize compensation expense over the service period for awards expected to vest. The estimation of stock awards that
will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating awards expected to vest including type of awards, employee class, and our historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates.
We use the Black-Scholes option pricing model to determine the fair value of our stock options. The determination of the fair value of stock-based awards using an option pricing model is affected by our stock price as well as assumptions regarding a number of subjective variables. Changes in the input assumptions can materially affect the fair value estimate of our stock options. Those assumptions include estimating the expected volatility of the market price of our common stock over the expected term, the expected term of the award, the risk free interest rate expected during the option term and the expected dividends to be paid.
We have reviewed each of these assumptions and determined our best estimate for these variables. Of these assumptions, the expected volatility of our common stock is the most difficult to estimate since it is based on expected performance of our common stock. We use the implied volatility of historical market prices for our common stock on the public stock market to estimate expected volatility. An increase in the expected volatility, expected term, and risk free interest rate, all will cause an increase in compensation expense. The dividend yield on our common stock is assumed to be zero since we do not pay dividends and have no current plans to do so in the future.
In 2007, compensation expense of $5.0 million was recognized for stock options, RSUs and SARs. Total remaining compensation estimated to be recognized over the remaining service periods for these awards is $5.4 million. This compensation cost included estimation of expected forfeitures. Forfeiture estimations are based on analysis of historical forfeiture rates.
Accordingly, stock based compensation will continue to have a significant impact on our results of operations depending on levels of stock-based awards granted in the future. In general, the annual stock-based compensation expense is expected to decline in future years when compared to the expense reported in prior years, since we plan to reduce our gross stock based award grants. This decline is primarily the result of a change in stock-based compensation strategy as determined by management.
RESULTS OF OPERATIONS
The following table sets forth certain statement of operations data expressed as a percentage of total revenues for the periods indicated:
YEARS ENDED DECEMBER 31, 2007, 2006 AND 2005
Total revenues in 2007 were $99.7 million, which represented an increase of 5% from the $95.2 million of total revenues in 2006, which in turn, represented a 3% decrease from the $98.1 million of total revenues in 2005. Total revenues derived from North America of $71.3 million in 2007 represented an increase of 8% from the $66.3 million in 2006, which in turn, represented a 3% increase from the $64.6 million in 2005. Total revenues derived from outside of North America of $28.4 million in 2007 represented a decrease of 2% from the $28.9 million in 2006, which in turn, represented a 14% decrease from the $33.5 million in 2005.
The increase in total revenues during 2007 compared to 2006, was driven primarily by our services revenue which increased by $3.6 million or 6% from 2006. Also, product revenue improved 3% in 2007, mainly due to the resurgence in PKI revenues, which increased 11% from 2006 and represented 70% of total product revenues in 2007. This growth was shared across all major geographic segments in both services and product. Also, the overall increase for 2007 compared to 2006 was in part due to the extended government market. Extended government revenues in the United States were $19.5 million for 2007, representing a 13% increase from $17.2 million in 2006. The level of non-North American revenues has fluctuated from period to period and this trend is expected to continue for the foreseeable future.
The decrease in total revenues during 2006 compared to 2005 was driven primarily by decreased average deal size for product transactions, primarily outside of North America, and a shift in our product mix toward our emerging growth products, which includes IdentityGuard, Boundary Messaging and Fraud Detection. While the higher volume of emerging growth product transactions worked to improve our product revenues in 2006, our overall revenues were impacted as these deals tend to carry less professional services requirements. The overall decline for 2006 compared to 2005 was in part due to the extended government market. For 2006 extended government revenues in the United States were $17.2 million, representing an 11% decrease from $19.4 million in 2005.
The United States government represented 15%, 15% and 17% of total revenues in 2007, 2006 and 2005, respectively, when including revenues sold through resellers to the government end users. However, direct sales to the United States government represented only 10%, 10% and 9% of total revenues in 2007, 2006 and 2005, respectively. The Canadian government represented 9%, 10% and 10% of total revenues in 2007, 2006 and 2005, respectively, when including revenues sold through resellers to the government end users. However, direct sales to the Canadian government represented only 7%, 9% and 6% of total revenues in 2007, 2006 and 2005, respectively. No other individual customer accounted for 10% or more of total revenues in 2007, 2006 and 2005.
We eliminate intercompany profits on revenue transactions with unconsolidated subsidiaries that are accounted for under the equity method to the extent of our ownership interest in that related party, if the product and/or services have not been sold through to an unrelated third party end-user customer. During 2005, we sold product and services to Asia Digital Media with a fair value of $763 thousand, which after intercompany profit eliminations related to our direct and indirect ownership at 2005 of approximately 27%, was recognized as $667 thousand of net revenues. We had no revenues from Asia Digital Media in 2006 and 2007.
Product revenues of $36.4 million in 2007 represented an increase of 3% from the $35.5 million in 2006, which in turn, represented an increase of 4% from the $34.2 million in 2005. These revenues represented 36%, 37% and 35% of total revenues in 2007, 2006 and 2005, respectively.
The increase in product revenues for 2007, when compared to 2006, is due to growth in our PKI product category. In particular, our PKI revenue, which represented 70% of product revenues in 2007, increased 11% over last year. The key drivers of PKI growth have been the growth of our SSL certificate business which was up 32% from 2006, while our core PKI product revenue is up 44% over last year. Global government projects around ePassports, National IDs and government employee credentialing for projects like HSPD-12 helped drive the core PKI growth. Also, growth in SSL came from continued market share growth in the enterprise space, as well as the launch of two new certificate types; EV SSL certificates and Unified Communications Certificates (UCC) SSL certificates for Microsoft Web Outlook. In general, PKI is experiencing a resurgence of interest in digital certificates for authentication and the growing need to encrypt information both at rest and in transit, with strong authentication of secure messaging continuing to be the key revenue drivers. We experienced improved interest in our government solutions in 2007, with $12.4 million of product revenues from Extended Government organizations during 2007, compared to $11.4 million for 2006, an increase of 9%. We believe we are well positioned to address the global government opportunity in digital credentials for ePassports, eBorders, National ID cards, government employee credentials and PKI digital certificates and infrastructure. Our Emerging growth (IdentityGuard, Boundary Messaging and Fraud Detection) products continued to perform well in 2007, representing 23% of product revenues, although revenues from this product category declined 13% compared to 2006, mainly due to the spike in revenues we experienced in second half of 2006 as U.S. financial institutions focused on FFIEC compliance. This factor was the primary driver of the growth of products revenues in 2006 when compared to 2005. IdentityGuard continued to be the largest component of our Emerging Growth products revenues, with the number of transactions increasing to 194 in 2007, representing a 113% increase over 2006.
We had 472 product revenue transactions (a product revenue transaction is defined as an IdentityGuard product sale of any size plus all other product sales in excess of $10 thousand) in 2007, up from 324 in 2006, or a 46% increase, which in turn was up from 292 product revenue transactions in 2005, or an increase of 11%. This included 133 new customers in 2007, which represented a 64% and 66% increase from 2006 and 2005, respectively. However, the average product revenue transaction size decreased from $89 thousand in 2006 to $57 thousand in 2007, or a decrease of 36%, after the average product revenue transaction size decreased from $99 thousand in 2005. This downward trend in transaction size is due to a shift in our product mix toward our lower cost emerging growth products. However, growth in deals under $500 thousand is fueling our overall top line product revenue growth in 2007 and 2006 compared to the respective prior years. Revenue from deals under $500 thousand increased 21% over 2006 and accounted for 89% of product revenues in 2007, which we believe speaks well of the underlying strength of our portfolio and the balance we are starting to see in product revenue performance. We would expect transaction levels to remain high going forward and the trend of lower average deal size to continue in the coming quarters. In general, the top-five average quarterly product revenue transactions as a percentage of total revenues declined from 15% and 14% in 2005 and 2006, respectively to 9% in 2007. This decrease in average product revenue transaction size and the decline in the top-five average product revenue transactions are consistent with our expectations. The combination of customer buying patterns, generally smaller-sized IdentityGuard transactions and increased subscription business gives us a more predictable revenue base. Also, consistent with this trend of lower average product revenue size were the number of deals greater than $1 million, which were down to two in 2007 from three in 2006 and five in 2005. We would expect transaction levels to remain high going forward and the trend of lower average deal size to continue in the coming periods.
Product revenues as a percentage of total revenues decreased in 2007 when compared to 2006, due to a stronger demand for services, relative to the demand for products.
Services and Maintenance Revenues
Services and maintenance revenues of $63.3 million in 2007 represented an increase of 6% from the $59.7 million in 2006, which in turn, represented a decrease of 7% from the $63.9 million in 2005. These revenues represented 64%, 63% and 65% of total revenues in 2007, 2006 and 2005, respectively.
The increase in services and maintenance revenues for 2007 compared to 2006 was due mainly to improved support and maintenance revenues, which now accounts for nearly two-thirds of our services revenue. In addition, our professional services business was strong across the board geographically, while our customers continued to renew their support agreements at a rate of 95% for 2007. Services and maintenance revenues as a percentage of total revenues for 2007 increased slightly in comparison to 2006 primarily because of the overall stronger demand for services and maintenance, despite improved revenues from our product offerings.
The decrease in services and maintenance revenues for 2006 compared to 2005 was due to a shift in demand to our emerging growth products, which require less professional services to implement, deploy and integrate, than our PKI and single sign-on solutions. Also, third party hardware revenues were significantly lower in 2006 compared to 2005, because of a significant hardware order of $1.1 million, which bolstered services revenues in 2005. We had also experienced lower Canadian government professional services revenues in 2006 and a shift in services that has accompanied our growth in U.S. channel partners revenues. Services and maintenance revenues as a percentage of total revenues for 2006 decreased compared to 2005 due to improvement in product revenues combined with a decrease in services and maintenance revenues.
Total expenses consist of costs of revenues associated with products and services and maintenance, amortization of purchased products rights and operating expenses associated with sales and marketing, research and development, general and administrative and restructuring charges and adjustments. Total expenses of $106.6 million in 2007 represented a decrease of 2% from $108.8 million in 2006. This decrease from 2006 to 2007 was due primarily to an overall headcount reduction of 10% combined with lower costs associated with marketing programs, and higher reported expenses in 2006 as a result of a $2.8 million restructuring charge in the first quarter of 2006 related to the sublease on our Santa Clara, California facility, offset by the impact of additional costs associated with employee compensation, primarily in sales and research and development, as a result of the acquisitions completed midway through 2006, increased non-cash expenses for stock based compensation and amortization of purchased intangibles, and an unfavorable shift in the exchange rates between the U.S. dollar and other major currencies of $3.5 million for the year. As of December 31, 2007, we had 455 full-time employees globally, compared to 503 full-time employees at December 31, 2006.
Total expenses of $108.8 million in 2006 represented an increase of 17% from $93.0 million in 2005. This increase from 2005 to 2006 was due primarily to the impact of additional costs associated with stock option compensation, increased headcount primarily due to acquisitions, marketing programs, outside professional services, amortization of purchased intangible assets, an unfavorable shift in foreign exchange between the United States and Canadian dollars, a provision recorded against accounts receivable balances with one of our European distributors, and an adjustment to our restructuring accruals of $2.8 million related to our excess Santa Clara facility, offset by lower facility depreciation costs for leasehold improvements at our Ottawa facility and lower third party hardware expenses. As of December 31, 2006, we had 503 full-time employees globally, compared to 475 full-time employees at December 31, 2005.
Cost of Revenues
Cost of Product Revenues
Cost of product revenues consists primarily of costs associated with our SSL and managed PKI businesses, product media, documentation, packaging and royalties to third-party software vendors. Cost of product revenues was $7.8 million in 2007, $7.6 million in 2006 and $5.2 million in 2005, representing 21%, 21% and 15% of product revenues for the respective years. The increase in the cost of product revenues in absolute dollars of 3% from 2006 to 2007 reflected the net effect of increased investment in additional staffing for our SSL and managed PKI businesses and higher amortization of capitalized software development costs, offset by a shift in overall product sales mix away from products that incorporate third party technologies relative to the prior year. Also, the unfavorable shift in the exchange rates between the U.S. dollar and other major currencies resulted in increased reported expenses of $0.3 million for 2007 when compared to 2006. We expect that these trends will continue in the immediate future.
The increase in the cost of product revenues in absolute dollars of 46% and as a percentage of product revenues from 2005 to 2006 is primarily attributable to several large product revenue transactions that carried third-party software royalties in 2006.
Cost of Services and Maintenance Revenues
Cost of services and maintenance revenues consists primarily of personnel costs associated with customer support, training and consulting services, as well as amounts paid to third-party consulting firms for those services. Cost of services and maintenance revenues was $30.4 million for 2007, which represented a 4% increase from $29.3 million for 2006, which in turn, represented a decrease of 4% from $30.5 million in 2005. Cost of services and maintenance revenues represented 30%, 31% and 31% of total revenues for each of the respective years.
The increase in the cost of services and maintenance revenues in absolute dollars for 2007 when compared to 2006 can be attributed primarily to staff related costs and increased third party hardware expenses. The higher staff related costs for 2007 was due in large part to increased stock based compensation expenses and the
unfavorable shift in the exchange rates between the U.S. dollar and other major currencies, which resulted in higher reported expenses of $0.9 million for 2007 when compared to 2006, the majority of which related to staffing costs. The average number of employees on our services and maintenance teams has been static from 2006 to 2007, despite the resources added as a result of the acquisition of Orion in June 2006 and Business Signatures in July 2006. Services and maintenance expenses as a percentage of total revenues decreased from 2006 and 2007, which was the net result of higher total revenues, which accounted for a two-percentage point decrease, when compared to 2006, offset by increased overall services and maintenance expenses, which resulted in a one-percentage point increase in the services and maintenance expenses as a percentage of total revenues.
The decrease in the cost of services and maintenance revenues in absolute dollars for 2006 when compared to 2005, can be attributed primarily to the reduced facilities related costs due to lower depreciation on our Ottawa facility, reduced third party hardware expenses and reduced other outside service costs. The third party hardware costs were much higher in 2005 because of a significant hardware order from a customer during that year. The increased staff related costs from 2005 to 2006 are primarily related to stock option compensation expenses and increased compensation costs associated with existing resources. The average number of employees on our services and maintenance teams decreased by 2% overall, from 2005 to 2006 in response to the decline in demand for consulting and integration services, despite the increased resources added as a result of the acquisition of Orion in June 2006 and Business Signatures in July 2006. Services and maintenance expenses as a percentage of total revenues were consistent between 2006 and 2005, which was the net result of lower overall services and maintenance expenses accounting for a one-percentage point decrease in the services and maintenance expenses as a percentage of total revenues, while the lower total revenues in 2006 resulted in a one-percentage point increase, compared to 2005.
Services and maintenance gross profit as a percentage of services and maintenance revenues was 52% for 2007, 51% for 2006 and 52% for 2005. The improvement in services and maintenance gross profit as a percentage of services and maintenance revenues in 2007, compared to 2006, was primarily due to higher support and maintenance margins of 2%, offset by a slight decline in overall professional services margins.
The decrease in services and maintenance gross profit as a percentage of services and maintenance revenues in 2006, compared to 2005, was primarily attributable to lower professional services revenues, particularly in Canada, which accounted for the two-percentage point decrease, partly offset by a one-percentage point increase due to improved support and maintenance margins in 2006 compared to 2005.
We plan to continue to optimize the utilization of existing professional services resources, while addressing incremental customer opportunities that may arise with the help of partners and other sub-contractors, until an investment in additional full-time resources is justifiable. This plan may have an adverse impact on the gross profit for services and maintenance, as the gross profit realized by using partners and sub-contractors is generally lower. The mix and volume of services and maintenance revenues may vary from period to period and from transaction to transaction, which will also affect our gross margins and results of operations.
Operating ExpensesSales and Marketing
Sales and marketing expenses increased 1% to $34.4 million in 2007 from $33.9 million in 2006, which in turn, represented a 19% increase from $28.5 million in 2005. These expenses represented 35%, 36% and 29% of total revenues in the respective years.
The increase in sales and marketing expenses for 2007 when compared to 2006 was primarily due to higher staff related costs and purchased intangibles amortization associated with the Business Signatures acquisition and investments made to grow the sales force to ensure we can handle the increased transaction load going forward. Sales and marketing headcount increased 6% on average year-over-year when compared to the previous year, resulting in increased salaries and benefits expense, including sales commissions, and increased facilities costs. Offsetting these increases were reductions in bad debt expense and marketing programs spending for 2007. In addition, we have experienced an unfavorable shift in the exchange rates between the U.S. dollar and other major currencies, which resulted in higher reported sales and marketing expenses of $1.2 million in 2007 when compared to 2006. The decrease in sales and marketing expenses as a percentage of total revenues for 2007, compared to 2006, was the net result of higher overall expenses, resulting in a one-percentage point increase for 2007, offset by a two-percentage point decrease in sales and marketing expenses as a percentage of total revenues due to higher total revenues when compared to 2006.
The sales and marketing expense increase for 2006 when compared to 2005 was primarily due to higher staff related costs, purchased intangibles amortization associated with the Business Signatures acquisition and increased spending on marketing programs due to higher advertising expenses, focused on generating awareness of our brand and FFIEC solutions. In addition, we recorded increases in our bad debt provision of $1.0 million in 2006, against accounts receivable balances, primarily related to one of our European distributors, compared to $0.4 million of net bad debt recoveries in 2005. Sales and marketing headcount increased 30% when compared to the prior year, increasing related salaries and benefits expense by $2.8 million for 2006 when compared to 2005. These increases were partially offset by lower facility related costs, because the leasehold improvements associated with our Ottawa facility reached the point of being fully depreciated late in 2005. The increase in sales and marketing expenses as a percentage of total revenues for 2006 compared to 2005 reflected the higher expenses in 2006, which resulted in a five-percentage point increase in 2006. This effect was magnified for 2006, by a two-percentage point increase in sales and marketing expenses as a percentage of total revenues due to lower total revenues when compared to 2005.
We intend to continue to focus on improving the productivity of the sales and marketing teams. As planned, we added additional sales coverage, which should allow us to better execute on the opportunities we are seeing in both in the United States and abroad. We will continue to focus on our channels, with a view to providing the executive team time to focus on strategically growing the business. However, we believe it is necessary for us to continue to make significant investments in sales and marketing to support the launch of new products, services and marketing programs by maintaining our strategy of (a) investing in hiring and training our sales force in anticipation of future market growth, and (b) investing in marketing efforts in support of new product launches. We believe it is necessary to invest in marketing programs that will improve the awareness and understanding of information security governance, and we will continue to invest in marketing toward that goal. Failure to make such investments could have a significant adverse effect on our operations. While we are focused on marketing programs and revenue-generating opportunities to increase software revenues, there can be no assurances that these initiatives will be successful.
During 2007, the provision for doubtful accounts increased approximately $500 thousand to $2.0 million, of which $200 thousand related to changes in the exchange rates, with the remainder of the increase due to the aging of customer accounts. During 2006, the provision for doubtful accounts increased by $1.0 million due primarily to a provision recorded related to accounts receivable balances with one of our European distributors. During 2005, the allowance for doubtful accounts decreased from $1.0 million to $0.5 million primarily as a result of a reduction in the allowance because of the improvement in our accounts receivable aging in 2005, principally due to collection of a long outstanding receivable, which had been fully provided for in fiscal 2003. Generally, we experienced effective cash collections throughout 2007, 2006 and 2005.
Operating ExpensesResearch and Development
Research and development expenses increased 2% to $20.2 million in 2007 from $19.9 million in 2006, which in turn, increased 21% from $16.4 million in 2005. These expenses represented 20%, 21% and 17% of total revenues in the respective years.
The increase in research and development expenses for 2007 when compared to 2006 was primarily due to higher staff related costs as a result of the unfavorable shift in the exchange rates between Canada and the U.S. that resulted in higher reported costs of $0.8 million for 2007 when compared to 2006, since the majority of these research and development expenses are denominated in Canadian dollars, as well as increased stock based compensation expense. However, these increases were partly offset by reductions in research and development headcount of 6% on average year-over-year compared to 2006. The decrease in research and development expenses as a percentage of total revenues for 2007, compared to 2006, reflects the higher revenues in 2007, which resulted in the one-percentage point decrease in 2007 compared to the prior year.
The increase in research and development expenses for 2006 when compared to 2005 was primarily due to higher staff related costs and increased spending on outside professional contractors, as a result of the Business Signatures acquisition. Also, the unfavorable shift in the exchange rates between Canada and the U.S. resulted in increased costs of $1.0 million for 2006 when compared to 2005, since the majority of these research and development expenses are denominated in Canadian dollars. In addition, staff-related costs were higher due to the recognition of stock option expenses in 2006. These increases were partially offset by lower depreciation costs associated with our Ottawa facility. The increase in research and development expenses as a percentage of total revenues for 2006, compared to 2005, reflected the higher expenses in 2006, which resulted in a three-percentage point increase in 2006. This effect was magnified by a one-percentage point increase in research and development expenses as a percentage of total revenues due to lower total revenues for 2006 when compared to 2005.
We believe that we must continue to maintain our investment in research and development in order to protect our technological leadership position, software quality and security assurance leadership. We therefore expect that research and development expenses may have to increase in the future.
Operating ExpensesGeneral and Administrative
General and administrative expenses decreased 13% to $12.5 million in 2007 from $14.3 million in 2006, which in turn, increased 24% from $11.5 million in 2005. These expenses represented 13%, 15% and 12% of total revenues in the respective years.
The decrease in general and administrative expenses in absolute dollars in 2007 compared to 2006 was due to the effect of continued management discipline in this area, with net savings of $1.8 million, primarily as a result of headcount reductions, which declined 19% on average year-over-year, and reduced use of outside professional firms. These decreases were partly offset by the unfavorable shift we have experienced in the exchange rates between the U.S. dollar and other major currencies, which resulted in higher reported general and administrative expenses of $0.2 million in 2007 when compared to 2006. General and administrative expenses as a percentage of total revenues decreased for 2007 compared to 2006, due mainly to the decrease in recorded expenses, which accounted for a one-percentage point decrease. This effect was magnified by a one-percentage point decrease in general and administrative expenses as a percentage of total revenues due to higher total revenues in 2007 when compared to 2006.
The increase in staff-related costs in absolute dollars in 2006 compared to 2005 was primarily due to deferred compensation plan costs and stock-based compensation expenses, as well as incremental reported costs resulting from the unfavorable shift in the exchange rates between Canada and the U.S. Also, additional legal expenses were incurred in connection with a patent infringement claim initiated by us early in 2006, which was the primary cause of the increase in outside professional services in 2006. General and administrative expenses as a percentage of total revenues increased for 2006 compared to 2005, due mainly to the increase in recorded expenses, which accounted for a two-percentage point increase. This effect was magnified by a one-percentage point increase in general and administrative expenses as a percentage of total revenues due to lower total revenues in 2006 when compared to 2005.
We continue to explore opportunities to gain additional efficiencies in our administrative processes and to contain expenses in these functional areas.
Amortization of Purchased Product Rights and Other Purchased Intangibles
Amortization of purchased product rights was $1.4 million for 2007, compared to $1.1 million and $802 thousand for 2006 and 2005, respectively. These costs are related to the developed technology purchased in connection with the acquisitions of Business Signatures in 2006, as well as the acquisition of certain business assets from AmikaNow! during 2004. This expense was recorded as a component of cost of revenues.
Amortization of other purchased intangibles totaled $1.0 million in 2007, compared to $569 thousand for 2006 and $75 thousand for 2005. These costs are related to the customer/partner relationships and non-competition agreement assets purchased in connection with the acquisitions of Orion and Business Signatures in 2006, as well as the acquisition of certain business assets from AmikaNow! during 2004. Of this expense, $877 thousand, $479 thousand and $75 thousand was recorded as a component of sales and marketing expenses for 2007, 2006 and 2005, respectively, while $153 thousand and $90 thousand was recorded as a component of cost of services and maintenance revenues for 2007 and 2006, respectively.
Restructuring Charges and Adjustments
During 2006, we made adjustments to increase the restructuring charges that we had previously recorded related to the June 2001 restructuring plan with respect to our Santa Clara, California facility. The previous sublease with our subtenant was scheduled to end in December 2006. Although we had been monitoring the sublet market on an on-going basis, we had received an extension offer and had begun preparations for placing the facility on the market. These events caused us to revisit our estimated sublease recoveries at that time. We concluded that we needed to increase the restructuring charges that we had previously recorded related to our June 2001 restructuring plan by a further $2.9 million in the first quarter of fiscal 2006 to reflect a change in our projected sublet lease recoveries as evidenced by the market for leased facilities in that region. Subsequently, in the second quarter of 2006, we made a further adjustment to decrease the restructuring charges that we had previously recorded related to the June 2001 restructuring plan with respect to our Santa Clara, California facility by $130 thousand, to reflect the fact that the building sublease was extended with the current subtenant to March 31, 2011 and the corresponding expected sublet lease recoveries. These adjustments were charged to the restructuring charges line in the condensed consolidated statement of operations in 2006.
Write-down of Long-term Strategic and Equity Investments
We recorded non-cash charges in the first quarter of 2006 related to the impairment of long-term investments in Asia Digital Media and Ohana of $2.4 million and $659 thousand, respectively, as we concluded that these investments had suffered an other than temporary decline in fair value.
Interest income was $688 thousand in 2007, compared to $2.2 million and $2.4 million in 2006 and 2005, respectively, representing 1%, 2% and 2% of total revenues in the respective years. The decrease in investment income for 2007 compared to 2006 and 2005 was primarily due to the funds invested in the acquisition of Orion, Business Signatures and stock repurchases in 2006. In addition, the reduced balance of funds invested was a result of amounts drawn down to fund cash flow from operations and to acquire long-lived assets during 2006 and 2007. The funds invested decreased to $20.5 million at December 31, 2007 from $22.5 million at December 31, 2006 and $82.5 million at December 31, 2005. However, the rate of return on our marketable investments improved to approximately 5% for 2007 compared to approximately 5% for 2006 and 3% for 2005.
Gain on Sale of Strategic Long-term Investments
We recorded a gain on the sale of certain strategic long-term investments, in which we had a less than 10% ownership, during 2007 in the amount of $793 thousand. This type of sale is not expected to be a recurring event.
Loss from Equity Investments
We recorded $77 thousand, $445 thousand and $760 thousand of losses, net of intercompany profit eliminations, related to our investments in Asia Digital Media in 2007, 2006 and 2005, respectively. We began accounting for this investment under the equity method of accounting in the fourth quarter of 2004, since we had the potential to significantly influence its operations and management.
Provision for Income Taxes
We recorded an income tax provision of $308 thousand in 2007, compared to $284 thousand in 2006 and $532 thousand in 2005. These provisions represent primarily the taxes payable in certain foreign jurisdictions. The effective income tax rates differed from statutory rates primarily due to the impairment of long-term strategic investments, stock option expenses, purchased product rights, restructuring charges, foreign research and development tax credits, as well as an adjustment of the valuation allowance that has offset the tax benefits from the significant net operating loss and tax credit carry-forwards available.
QUARTERLY RESULTS OF OPERATIONS
Our quarterly operating results have varied substantially in the past and are likely to vary substantially from quarter to quarter in the future due to a variety of factors. In particular, our period-to-period operating results are significantly dependent upon the completion date of large license agreements. In this regard, the purchase of our products often requires a significant capital investment, which customers may view as a discretionary cost and, therefore, a purchase that can be deferred or canceled due to budgetary or other business reasons. Estimating future revenues is also difficult because we ship our products soon after an order is received and, therefore, we do not have a significant backlog. Thus, quarterly license revenues are heavily dependent upon orders received and shipped within the same quarter. Moreover, we have generally recorded a significant portion of our total quarterly revenues in the third month of a quarter, with a concentration of these revenues in the last half of that third month. This concentration of revenues is influenced by customer tendencies to make significant capital expenditures at the end of a fiscal quarter. We expect these revenue patterns to continue for the foreseeable future. In addition, quarterly license revenues are dependent on the timing of revenue recognition, which can be affected by many factors, including the timing of customer installations and acceptance. In these regards, we have from time to time experienced delays in recognizing revenues with respect to certain orders. In any period a significant portion of our revenue may be derived from large sales to a limited number of customers. Despite the uncertainties in our revenue patterns, our operating expenses are based upon anticipated revenue levels and such expenses are incurred on an approximately ratable basis throughout the quarter. As a result, if expected revenues are delayed or otherwise not realized in a quarter for any reason, our business, operating results and financial condition would be adversely affected in a significant way.
The following tables set forth certain unaudited consolidated quarterly statement of operations data for the eight quarters in the two-year period ended December 31, 2007, as well as such data expressed as a percentage of our total revenues for the periods indicated. These data have been derived from unaudited consolidated financial statements that, in our opinion, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of such information when read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Annual Report.
As a result of the adjustment to our restructuring accrual related to our California facility and the impairment of our investment in Asia Digital Media and Ohana recorded in the first quarter of 2006, our operating expenses and net loss were higher in that quarter than in the subsequent quarters of 2006 and 2007. The operating results for any quarter are not necessarily indicative of results for any future period.
The following table sets forth certain statement of operations data expressed as a percentage of total revenues for the periods indicated:
LIQUIDITY AND CAPITAL RESOURCES
We used $4.5 million of cash in operating activities during 2007. This cash outflow was primarily a result of an increase in accounts receivable of $0.5 million, a decrease in accounts payable and accrued liabilities of $4.4 million, a decrease in accrued restructuring charges of $5.2 million and an increase in prepaid expenses and other receivables of $1.3 million, partially offset by cash inflows resulting from a net income after adjusting for non-cash charges of $3.3 million, and an increase in deferred revenue of $3.6 million. Our average days sales outstanding at December 31, 2007 was 70 days, which represents a slight worsening from the 68 days that we reported at December 31, 2006. The overall increase in days sales outstanding from December 31, 2006 was mainly due to lower in-quarter collections due to poorer sales linearity compared to the fourth quarter of 2006, partly offset by an increase in the allowance for doubtful accounts from the previous year. For purposes of calculating average days sales outstanding, we divide ending accounts receivable by the applicable quarters revenues and multiply this amount by 90 days. The level of accounts receivable at each quarter end is affected by the concentration of revenues in the final weeks of each quarter and may be negatively affected by expanded international revenues in relation to total revenues as licenses to international customers often have longer payment terms.
Any increase or decrease in our accounts receivable balance and days sales outstanding will affect our cash flow from operations and liquidity. Our accounts receivable and days sales outstanding may increase due to changes in factors such as the timing of when sales are invoiced and the length of customers payment cycle. Generally, international and indirect customers pay at a slower rate than domestic and direct customers, so that an increase in revenue generated from international and indirect customers may increase our days sales outstanding and accounts receivable balance. We have observed an increase in the length of our customers payment cycles, which may result in higher accounts receivable balances, and could expose us to greater general credit risks with our customers and increased bad debt expense.
During 2007, we generated $3.0 million of our cash related to investing activities. Cash provided by reductions in our marketable investments in the amount of $2.6 million, proceeds from disposition of property and equipment of $0.4 million and proceeds from the sale of strategic long-term investments of $0.8 million was partially offset by the investment of $0.4 million in property and equipment, primarily for computer hardware upgrades throughout our organization, and $0.4 million in other long-term assets related to capitalized software development costs.
We generated cash of $1.1 million in financing activities during 2007 as a result of cash provided by the issuance of Common stock related to the exercise of employee stock options.
As of December 31, 2007, our cash and cash equivalents in the amount of $20.5 million provided our principal sources of liquidity. Overall, we used $2.0 million in cash, cash equivalents and marketable investments during 2007. Although we continue to target operating profitability, based on sustainable revenue and operating expense structures, we estimate that we may continue to use cash in fiscal 2008 to satisfy the obligations provided for under our restructuring program.
However, if operating losses continue to occur, then cash, cash equivalents and marketable investments will be negatively affected.
While there can be no assurance as to the extent of usage of liquid resources in future periods, we believe that our cash flows from operations and existing cash and cash equivalents will be sufficient to meet our needs for at least the next twelve months.
In terms of long-term liquidity requirements, we will need to fund the $19.3 million of accrued restructuring charges at December 31, 2007 through fiscal 2011, as detailed below. This amount is net of expected sublet recoveries on restructured facilities of $9.0 million. The lease obligations included in these accrued restructuring
charges are disclosed in the table of contractual commitments below. In addition, we expect to spend approximately $2.0 million per year on capital expenditures, primarily for computer equipment needed to replace existing equipment that is coming to the end of its useful life, a significant portion of which are expected to be procured under operating leases.
We believe that our existing cash and cash equivalents as well as future operating cash flows, will be sufficient to fund these long-term requirements.
We have commitments that will expire at various times through 2015. We lease administrative and sales offices and certain property and equipment under non-cancelable operating leases that will expire at various dates to 2015. A summary of our contractual commitments at December 31, 2007 is as follows:
In addition to the lease commitments included above, we have provided letters of credit totaling $3.3 million as security deposits in connection with certain office leases.
The 2005 Entrust Deferred Incentive and Retention Bonus Plan (the 2005 Deferred Plan) was adopted by the Compensation Committee of the Board of Directors on November 7, 2005. The primary objective of the 2005 Deferred Plan is to attract and retain valued employees by remunerating selected executives and other key employees with cash awards based on the contribution of the individual employee. During the first quarter of 2006, we granted awards to employees under the plan that potentially could result in payments of $1.6 million over the subsequent two years, assuming that all employees receiving the awards remain employed with us for the entire two year vesting period of the awards. Of this amount, it was estimated that, as of December 31, 2007, $175 thousand was remaining to be paid out under this plan.
Other commitments include financing arrangements entered into for the purpose of funding annual insurance premiums, with a remaining balance as of December 31, 2007 of $605 thousand, to be paid during fiscal 2008.
Subsequent to the end of fiscal year, the 2008 Entrust Deferred Retention Bonus Plan (the 2008 Deferred Plan) was adopted by the Compensation Committee of the Board of Directors on February 19, 2008. The primary objective of the 2008 Deferred Plan is to attract and retain valued employees by remunerating selected executives and other key employees with cash awards based on the contribution of the individual employee. The Compensation Committee, in its sole discretion, shall determine which employees are eligible to receive awards under the plan and shall grant awards in such amounts and on such terms as it shall determine. Subject to limited exceptions, an employees award under the plan shall vest in one-seventh of the amount of the award over the seven calendar quarters commencing on January 1, 2008, provided that the employee continues to be employed by us on each of such dates. During the first quarter of 2008, we granted awards to employees under the plan that potentially could result in payments of $1.5 million over the subsequent seven quarters, assuming that all employees receiving the awards remain employed with us for the entire seven quarter vesting period of the awards.
In the ordinary course of business, we enter into standard indemnification agreements with our business partners and customers. Pursuant to these agreements, we agree to modify, repair or replace the product, pay royalties for a right to use, defend and reimburse the indemnified party for actual damages awarded by a court against the indemnified party for an intellectual property infringement claim by a third party with respect to our products and services, and indemnify for property damage that may be caused in connection with consulting services performed at a customer site by our employees or our subcontractors. The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have general and umbrella insurance policies that generally enable us to recover a portion of any amounts paid. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of December 31, 2006.
We generally warrant for ninety days from delivery to a customer that our products will perform free from material errors that prevent performance in accordance with user documentation. Additionally, we warrant that our consulting services will be performed consistent with generally accepted industry standards including other warranties. We have only incurred nominal expense under our product or service warranties. As a result, we believe the estimated fair value of our obligations under these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of December 31, 2007.
We have entered into employment and executive retention agreements with certain employees and executive officers, which, among other things, include certain severance and change of control provisions. We have also entered into agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity.
RECENTLY ISSUED ACCOUNTING STANDARDS
In December 2007, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141 (revised 2007), Business Combinations, which replaces SFAS No 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. SFAS No. 141(R) is effective for financial statements issued for fiscal years beginning after December 15, 2008 and will apply prospectively to business combinations completed on or after that date. The impact of the adoption of SFAS No. 141(R) on our financial position, results of operations and cash flows will depend on the terms and timing of future acquisitions, if any.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51, which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parents equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in earnings. SFAS No. 160 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and will apply prospectively, except for the presentation and disclosure requirements, which will apply retroactively. The adoption of SFAS No. 160 will not have a significant impact on our financial position, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which establishes a framework for measuring fair value under other accounting pronouncements that require fair value measurements
and expands disclosures about such measurements. SFAS No. 157 does not require any new fair value measurements, but rather it creates a consistent method for calculating fair value measurements to address non-comparability of financial statements containing fair value measurements utilizing different definitions of fair value. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 157 will not have a significant impact on our consolidated financial position, results of operations or cash flows. However, we will use fair value measurement under SFAS No. 157 in future evaluations of impairment, if any, as required under SFAS No. 142, Goodwill and Other Intangibles.
On February 15, 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities: Including an amendment of FASB Statement No. 115, to reduce earnings volatility caused by related assets and liabilities measured differently under GAAP. SFAS No. 159 allows all entities to make an irrevocable instrument-by-instrument election to measure eligible items at fair value in their entirety. In addition, unrealized gains and losses will be reported in earnings at each reporting date. SFAS No. 159 also establishes presentation and disclosure requirements that focus on providing information about the impact of electing the fair value option. SFAS No. 159 is effective as of the beginning of the first fiscal year that begins after November 15, 2007, concurrent with the adoption of SFAS No. 157. The adoption of SFAS No. 159 will not have a significant impact on our consolidated financial position, results of operations or cash flows, as we did not elect the fair value option for any financial assets or liabilities.
From time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by us as of the specified effective date. Unless otherwise discussed, our management believes that the impact of recently issued standards that are not yet effective will not have a material impact on our consolidated financial statements upon adoption.
Risk Associated with Interest Rates
Our investment policy states that we will invest our cash reserves, including cash, cash equivalents and marketable investments, in investments that are designed to preserve principal, maintain liquidity and maximize return. We actively manage our investments in accordance with these objectives. Some of these investments are subject to interest rate risk, whereby a change in market interest rates will cause the principal amount of the underlying investment to fluctuate. Therefore, depreciation in principal value of an investment is possible in situations where the investment is made at a fixed interest rate and the market interest rate then subsequently increases.
The following table presents the cash, cash equivalents and marketable investments, entered into for purposes other than trading purposes, that we held at December 31, 2007 and 2006 that would have been subject to interest rate risk, and the related ranges of maturities as of those dates:
We try to manage this risk by maintaining our cash, cash equivalents and marketable investments with high quality financial institutions and investment managers. As a result, we believe that our exposure to market risk related to interest rates is minimal. Our financial instrument holdings at year-end were analyzed to determine their sensitivity to interest rate changes. The fair values of these instruments were determined by net present values. In this sensitivity analysis, we used the same change in interest rate for all maturities. All other factors were held constant. If there were an adverse change in interest rates of 10%, the expected effect on net income related to our financial instruments would be less than $50 thousand.
Risk Associated with Exchange Rates
We are subject to foreign exchange risk as a result of exposures to changes in currency exchange rates, specifically between the United States and Canada, the United Kingdom, the European Union and Japan. This exposure is not considered to be material with respect to the United Kingdom, European and Japanese operations due to the fact that these operations are not significant. However, because a disproportionate amount of our expenses are denominated in Canadian dollars, through our Canadian operations, while our Canadian denominated revenue streams are cyclical, we are exposed to exchange rate fluctuations in the Canadian dollar, and in particular, fluctuations between the U.S. and Canadian dollar. Therefore, a favorable change in the exchange rate for the Canadian subsidiary would result in higher revenues when translated into U.S. dollars, but would also mean expenses would be higher in a corresponding fashion and to a greater degree.
Historically, we have not engaged in formal hedging activities, but we do periodically review the potential impact of this foreign exchange risk to ensure that the risk of significant potential losses is minimized. However, as a significant portion of our expenses are incurred in Canadian dollars, our reported expense base increased by $3.5 million in 2007, when compared to 2006, due to fluctuations in the exchange rate between the United States
and Canadian dollars. Taking into account the effect of exchange rate fluctuations on reported Canadian revenues, the net effect on reported earnings was $0.4 million for 2007, when compared to 2006.
In the past, when perceived by management to be advantageous, we have engaged in forward contracts to purchase Canadian dollars, to cover exposures on Canadian subsidiarys expenses that are denominated in Canadian dollars, in an attempt to reduce earnings volatility that might result from fluctuations in the exchange rate between the Canadian and U.S. dollar. During the fourth quarter of 2007, we engaged in forward contracts to purchase Canadian dollars, covering exposures on approximately $5.0 million of our Canadian subsidiarys expenses denominated in Canadian dollars. None of these contracts extended past December 31, 2007 and no previously purchased foreign exchange contracts had extended past September 30, 2007. Subsequent to year end, we have engaged in forward contracts to purchase Canadian dollars covering exposures on approximately $3.0 million of expenses denominated in Canadian dollars in the first quarter of 2008. We currently have not engaged in any forward contracts to purchase Canadian dollars to cover exposures on expenses denominated in Canadian dollars in future periods beyond the first quarter of 2008.
Risk Associated with Long-term Strategic Investments
We hold an investment in Ohana, with a net carrying value at December 31, 2007 of $91 thousand, representing approximately 14.3% of the issued common shares of Ohana. During 2006, we were informed of an Ohana re-financing, which coupled with the changes in the business outlook, led us to conclude that the expectations for Ohana had not materialized and an impairment charge was required to adjust the net carrying value of our equity ownership. As a result, we recorded in 2006 an impairment of our investment in Ohana of $659 thousand. This investment is now accounted for under the cost method. Ohana is in the start-up or development stage, and may lack the financial resources, licenses, technology and governmental approvals necessary to import, develop or offer for sale any commercial product or service. If the demand for Ohanas products and services materializes slowly, to a minimum extent, or not at all in the relevant market, we could lose all or substantially all of our remaining investment.
Entrust does not enter into market-risk sensitive instruments for trading purposes.
Our consolidated financial statements together with the related notes and the report of Grant Thornton LLP, an independent registered public accounting firm, are set forth in the Index to Consolidated Financial Statements at Item 15 and incorporated herein by this reference.
Our Quarterly Results of Operations set forth in Item 7 is incorporated herein by reference.
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934), as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting,
on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There have not been any changes in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) during the fourth quarter of the fiscal year to which this report relates, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Managements Report on Internal Control over Financial Reporting and the Report of Independent Registered Public Accounting Firm thereon are set forth in Item 15 of this Annual Report on Form 10-K and incorporated herein by this reference.
Certain information required by Part III is omitted from this Annual Report as we intend to file our definitive Proxy Statement for our Annual Meeting of Stockholders to be held on May 2, 2008, pursuant to Regulation 14A of the Securities Exchange Act of 1934, not later than 120 days after the end of the fiscal year covered by this Report, and certain information included in the Proxy Statement is incorporated herein by reference.
(a) Executive Officers and Directors. The information in the section entitled Executive Officers and Directors of the Registrant in Part I hereof is incorporated herein by reference.
(b) Directors. The information in the section entitled Directors and Nominees for Directors in the Proxy Statement is incorporated herein by reference.
The disclosure required by Item 405 of Regulation S-K is incorporated herein by reference to the section entitled Section 16(a) Beneficial Ownership Reporting Compliance in the Proxy Statement.
The disclosure required by Item 406 of Regulation S-K, relating to our Code of Business Conduct, is included under Item 1BusinessCorporate Information of this Annual Report and such information is incorporated herein by reference.
Information relating to our audit committee and audit committee financial experts will be in the Proxy Statement referred to above and is incorporated herein by reference.
The information in the sections entitled Compensation of Executive Officers, Non-Employee Director Compensation, Compensation Committee Report and Board and Committee MeetingsCompensation Committee Interlocks and Insider Participation in the Proxy Statement is incorporated herein by reference.
The information in the sections entitled Compensation of Executive OfficersPotential Payments on Termination or Change in Control and Board and Committee Meetings in the Proxy Statement is incorporated herein by reference.
Securities Authorized For Issuance Under Equity Compensation Plans
The following table provides information about the securities authorized for issuance under Entrusts equity compensation plans as of December 31, 2007:
On August 1, 2003 the Companys 1998 Employee Stock Purchase Plan was discontinued. Prior to such termination 173,891 shares were issued under such plan in 2003.
On March 15, 2006, the Board of Directors adopted resolutions, subject to stockholder approval, to approve entry into the Entrust, Inc. 2006 Stock Incentive Plan (the 2006 Plan). The 2006 Plan was approved by the stockholders of the Company on May 5, 2006, resulting in the termination of the Amended and Restated 1996 Stock Incentive Plan, the enCommerce, Inc. 1997 Stock Option Plan, as amended and restated, and the 1999 Non-Officer Employee Stock Incentive Plan, as amended (together, the Prior Plans), with no further grants being permitted under the Prior Plans, provided that, this termination of the Prior Plans will not affect awards that are outstanding under the Prior Plans.
As part of the acquisition of Business Signatures, the Company assumed the obligations of Business Signatures under its 2002 Stock Plan (BSC 2002 Plan). Under this plan, the Company assumed options to purchase 1,792,092 shares of Business Signature common stock in exchange for options to purchase 1,150,590 shares of the Companys common stock. Subject to the exceptions described below, these options will generally expire ten years from the date of grant. Under the BSC 2002 Plan, incentive options may only be granted to employees at an exercise price of no less than the fair value of our common stock on the date of grant. Non-statutory options may be granted at an exercise price of no less than 85% of the fair value of our common stock on the date of grant. For owners of more than 10% of the common stock, incentive options may only be granted for an exercise price of no less than 110% of the fair value of our common stock and these options generally expire five years from date of grant. Options generally vest and become exercisable at a rate of 25% on the one-year anniversary of the vesting commencing date, which may precede the grant date, and 1/48th per month thereafter.
The information in the sections entitled Employment, Non-Competition, Retention and Separation Agreements and Certain Transactions in the Proxy Statement is incorporated herein by reference.
The information regarding principal accounting fees and services in the section entitled Ratification of the Appointment of Independent Public Accountants in the Proxy Statement is incorporated herein by reference.
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.
Date: March 6, 2008
Pursuant to the requirements of the Securities Exchange 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.
Managements Report on Internal Control over Financial Reporting
Management of Entrust, Inc., together with its consolidated subsidiaries (the Company), is responsible for establishing and maintaining adequate internal control over financial reporting. The Companys internal control over financial reporting is a process designed under the supervision of the Companys principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Companys financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
As of the end of the Companys 2007 fiscal year, management conducted an assessment of the effectiveness of the Companys internal control over financial reporting based on the framework established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has determined that the Companys internal control over financial reporting as of December 31, 2007 is effective.
Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Companys assets that could have a material effect on our financial statements.
The Companys internal control over financial reporting as of December 31, 2007 has been audited by Grant Thornton LLP, an independent registered public accounting firm, as stated in their report appearing on page F-2.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and
Shareholders Entrust, Inc.
We have audited Entrust, Inc.s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Entrust, Inc.s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Managements Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Entrusts internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Entrust, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal ControlIntegrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Entrust, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2007, and our report dated March 5, 2008, expressed an unqualified opinion on those financial statements.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and
Shareholders Entrust, Inc.
We have audited the accompanying consolidated balance sheets of Entrust, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Entrust, Inc. and subsidiaries as of December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America.
Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Entrust, Inc. and subsidiaries internal control over financial reporting as of December 31, 2007, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 5, 2008 expressed an unqualified opinion.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
The accompanying notes are an integral part of these financial statements
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
The accompanying notes are an integral part of these financial statements
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY AND COMPREHENSIVE INCOME
for the years ended December 31, 2007, 2006 and 2005
(in thousands, except share data)