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Entrust 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2
Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark one)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number 000-24733

 

 

ENTRUST, INC.

(Exact name of registrant as specified in its charter)

 

 

 

MARYLAND   62-1670648

(State or other jurisdiction of

incorporation or organization)

 

(IRS employer

identification no.)

ONE HANOVER PARK, SUITE 800

16633 DALLAS PARKWAY

ADDISON, TX 75001

(Address of principal executive offices & zip code)

Registrant’s telephone number, including area code: (972) 713-5800

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨    Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):    Yes   ¨    No  x

There were 61,439,449 shares of the registrant’s Common stock, par value $0.01 per share, outstanding as of November 4, 2008.

 

 

 


Table of Contents

ENTRUST, INC.

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

   3

  ITEM 1.

   FINANCIAL STATEMENTS    3
   CONDENSED CONSOLIDATED BALANCE SHEETS    3
   CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS    4
   CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS    5
   NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS    6

  ITEM 2.

   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS    13

  ITEM 3.

   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK    39

  ITEM 4.

   CONTROLS AND PROCEDURES    40

PART II. OTHER INFORMATION

   40

  ITEM 1.

   LEGAL PROCEEDINGS    40

  ITEM 1A.

   RISK FACTORS    41

  ITEM 2.

   UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS    41

  ITEM 3.

   DEFAULTS UPON SENIOR SECURITIES    41

  ITEM 4.

   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS    41

  ITEM 5.

   OTHER INFORMATION    41

  ITEM 6.

   EXHIBITS    41

SIGNATURES

   42

Entrust, Entrust-Ready, 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, 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 quarterly report are the property of their respective owners.

 

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Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

ENTRUST, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

 

(In thousands, except share and per share data)

   September 30,
2008
    December 31,
2007
 

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 23,400     $ 20,485  

Accounts receivable (net of allowance for doubtful accounts of $863 at September 30, 2008 and $2,009 at December 31, 2007)

     15,474       20,773  

Prepaid expenses and other receivables

     3,945       4,079  
                

Total current assets

     42,819       45,337  

Property and equipment, net

     1,451       1,490  

Purchased product rights and other purchased intangible assets, net

     9,999       11,543  

Goodwill

     60,214       60,214  

Long-term strategic and equity investments

     91       91  

Other long-term assets, net

     1,096       3,479  
                

Total assets

   $ 115,670     $ 122,154  
                

Liabilities

    

Current liabilities:

    

Accounts payable

   $ 9,716     $ 10,787  

Accrued liabilities

     4,832       5,543  

Accrued restructuring charges, current portion

     5,488       5,419  

Deferred revenue

     27,418       27,894  
                

Total current liabilities

     47,454       49,643  

Accrued restructuring charges, long-term portion

     9,608       13,847  

Other long-term liabilities

     826       218  
                

Total liabilities

     57,888       63,708  
                

Minority interest in subsidiary

     4       4  
                

Shareholders’ equity

    

Common stock, par value $0.01 per share: 250,000,000 authorized shares: 61,431,458 and 61,098,702 issued and outstanding shares at September 30, 2008 and December 31, 2007, respectively

     614       611  

Additional paid-in-capital

     773,273       771,223  

Accumulated deficit

     (716,364 )     (713,523 )

Accumulated other comprehensive income

     255       131  
                

Total shareholders’ equity

     57,778       58,442  
                

Total liabilities and shareholders’ equity

   $ 115,670     $ 122,154  
                

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

ENTRUST, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

     Three months ended
September 30,
    Nine months ended
September 30,
 

(In thousands, except share and per share data)

   2008     2007     2008     2007  

Revenues:

        

Product

   $ 9,435     $ 8,170     $ 28,078     $ 26,244  

Services and maintenance

     15,021       15,773       46,695       46,755  
                                

Total revenues

     24,456       23,943       74,773       72,999  
                                

Cost of revenues:

        

Product

     2,208       1,815       6,688       5,785  

Services and maintenance

     7,207       7,205       22,110       22,412  

Amortization of purchased product rights

     128       355       788       1,032  
                                

Total cost of revenues

     9,543       9,375       29,586       29,229  
                                

Gross profit

     14,913       14,568       45,187       43,770  
                                

Operating expenses:

        

Sales and marketing

     7,817       8,207       24,326       26,113  

Research and development

     4,271       4,929       13,445       15,590  

General and administrative

     2,606       2,929       8,846       9,447  

Impairment of long-term asset

     1,518       —         1,518       —    
                                

Total operating expenses

     16,212       16,065       48,135       51,150  
                                

Loss from operations

     (1,299 )     (1,497 )     (2,948 )     (7,380 )
                                

Other income (expense):

        

Interest income

     93       188       322       544  

Foreign exchange gain (loss)

     81       (88 )     156       (18 )

Gain on sale of long-term strategic investments

     —         —         18       —    

Loss from equity investments

     —         —         —         (77 )
                                

Total other income (expense)

     174       100       496       449  
                                

Loss before income taxes

     (1,125 )     (1,397 )     (2,452 )     (6,931 )

Provision for income taxes

     114       104       389       228  
                                

Net loss

   $ (1,239 )   $ (1,501 )   $ (2,841 )   $ (7,159 )
                                

Net loss per share:

        

Basic

   $ (0.02 )   $ (0.02 )   $ (0.05 )   $ (0.12 )

Diluted

   $ (0.02 )   $ (0.02 )   $ (0.05 )   $ (0.12 )

Weighted average common shares used in per share computations:

        

Basic

     61,392       60,986       61,283       60,717  

Diluted

     61,392       60,986       61,283       60,717  

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

ENTRUST, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Nine months ended
September 30,
 
     2008     2007  
     (In thousands)  

OPERATING ACTIVITIES:

    

Net loss

   $ (2,841 )   $ (7,159 )

Non-cash items in net loss:

    

Depreciation and amortization

     3,589       3,489  

Non-cash compensation expense

     2,033       4,079  

Loss from equity investments

     —         77  

Provision for doubtful accounts

     (38 )     190  

Gain on sale of long-term strategic investments

     (18 )     —    

Impairment of long-term asset

     1,518       —    

Changes in operating assets and liabilities:

    

Decrease in accounts receivable

     5,507       2,089  

(Increase) decrease in prepaid expenses and other receivables

     503       (1,028 )

Increase (decrease) in accounts payable

     (548 )     2,532  

Decrease in accrued liabilities

     (1,123 )     (7,011 )

Decrease in accrued restructuring charges

     (4,170 )     (3,940 )

Increase (decrease) in deferred revenue

     (219 )     3,795  
                

Net cash provided by (used in) operating activities

     4,193       (2,887 )
                

INVESTING ACTIVITIES:

    

Maturities of marketable investments

     —         2,639  

Purchases of property and equipment

     (873 )     (321 )

Proceeds on disposition of property and equipment

     —         372  

Proceeds on sale of long-term strategic investments

     18       —    

Increase in long-term deposits

     593       —    

Increase in other long-term assets

     (588 )     (353 )
                

Net cash provided by (used in) investing activities

     (850 )     2,337  
                

FINANCING ACTIVITIES:

    

Proceeds from exercise of stock options

     20       1,089  
                

EFFECT OF EXCHANGE RATE CHANGES ON CASH

     (448 )     1,043  
                

NET INCREASE IN CASH AND CASH EQUIVALENTS

     2,915       1,582  

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     20,485       19,888  
                

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 23,400     $ 21,470  
                

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

ENTRUST, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share data, unless indicated otherwise)

NOTE 1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the audited annual consolidated financial statements and, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial position, results of operations and cash flows of Entrust, Inc., a Maryland corporation, and its consolidated subsidiaries (collectively, the “Company”). The results of operations for the nine months ended September 30, 2008 are not necessarily indicative of the results to be expected for the full year. Certain information and footnote disclosures normally contained in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the Consolidated Financial Statements and related Notes contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

NOTE 2. IMPAIRMENT OF LONG-TERM ASSET

During the third quarter of 2008, the Company recorded an impairment of $1,518 in the book value of capitalized software development costs related to its video based training, originally developed for both general security and Entrust specific solutions, for sale to its customers. During the third quarter of 2008, the Company became aware that its lead customer for this product was no longer interested in pursuing an agreement to license the content of the video based training technology. This fact, combined with changes in the management of the video based training program and the decision to discontinue investment in the maintenance of the technology to ensure continuity with the Company’s software releases, indicated to the Company’s management that a degradation in the carrying value of the related capitalized development costs may have occurred. The Company applied an expected present value technique to estimate the fair value of this long-lived asset in determining that the recoverable value had been impaired.

NOTE 3. FAIR VALUE MEASUREMENT

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.

Relative to SFAS No. 157, the FASB issued FASB Staff Positions (“FSP”) No. 157-1 and 157-2. FSP No. 157-1 amends SFAS No. 157 to exclude SFAS No. 13, “Accounting for Leases,” and its related interpretive accounting pronouncements that address leasing transactions, while FSP No. 157-2 delays the effective date of the application of SFAS No. 157 to fiscal years beginning after November 15, 2008 for all nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis.

The Company adopted SFAS No. 157 as of January 1, 2008, with the exception of the application of the statement to nonfinancial assets and nonfinancial liabilities. Nonfinancial assets and nonfinancial liabilities for which the Company has not applied the provisions of SFAS No. 157 include those measured at fair value in goodwill impairment testing and indefinite lived intangible assets measured at fair value for impairment testing.

 

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Table of Contents

SFAS No. 157 establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

The Company utilizes the market approach to measure fair value for its financial assets and liabilities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.

The adoption of FSP No. 157-2 will not have a significant impact on the Company’s consolidated financial position, results of operations or cash flows. The Company will use fair value measurement under SFAS No. 157 in future evaluations of impairment under SFAS No. 142, “Goodwill and Other Intangibles” in fiscal years beginning after November 15, 2008.

NOTE 4. STOCK-BASED COMPENSATION

Compensation cost related to stock options, stock appreciation rights (“SARs”) and restricted stock units (“RSUs”) recognized in operating results was $524 and $1,346 in the three months ended September 30, 2008 and 2007, respectively, and $2,033 and $4,079 in the nine months ended September 30, 2008 and 2007, respectively.

The following table sets forth the related weighted-average assumptions, used to determine compensation cost for stock options and SARs.

 

     Three Months Ended,
September 30, 2008
    Three Months Ended,
September 30, 2007
 

Weighted average assumptions:

    

Expected volatility

   39 %   55 %

Risk free rate of return

   4.43 %   4.50 %

Expected option term (years)

   4.75     4.58  

Summary of activity for the three months ended September 30, 2008 under the Company’s stock compensation plans is set forth below:

 

     Shares
Available
    Awards
Outstanding
    Weighted
Average
Exercise
Price
   Aggregate
Intrinsic
Value
(000’s)
   Weighted
Average
Remaining
Contractual
Life in
Years

Balance at June 30, 2008

   2,673,693     14,867,406     5.06    1,122    4.46

Exercisable

     11,673,397     5.68    569    4.09

Terminated under Prior Plans

   (46,000 )          

Shares issued

   (6,268 )          

Stock options:

            

Granted

   (30,000 )   30,000     2.11    —     

Forfeited

   293,872     (378,096 )   4.43    21   

Vested

   —       (55,769 )   8.82    2   

Unvested

   —       (322,327 )   3.31    19   

Expired

   23,060     (107,567 )   7.56    —     

 

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Exercised

   —       (46,087 )   0.23    96   

Restricted stock units:

            

Granted

   (110,000 )   55,000     —      21   

Forfeited

   11,000     (8,566 )   —      20   

Unvested

   —       (8,566 )   —      20   

Matured

   —       (33,437 )   2.37    79   

Stock appreciation rights:

            

Forfeited

   —       (8,776 )   3.64    —     

Unvested

   —       (8,776 )   3.64    —     
                    

Balance at September 30, 2008

   2,809,357     14,369,877     5.20    597    4.70

Exercisable

     11,746,482     5.62    324    4.26

During the three and nine months ended September 30, 2008, the amount of cash received from the exercise of stock options was $11 and $20, respectively.

At September 30, 2008, there was $1,630 of total unrecognized compensation cost related to non-vested stock option and SARs awards. Compensation expense related to stock options and SARs for the three and nine months ended September 30, 2008 was $360 and $1,340, respectively, and was $1,033 and $3,093 for the three and nine months ended September 30, 2007, respectively.

At September 30, 2008, there was $685 of total unrecognized compensation cost related to non-vested RSUs granted under our stock plans. Compensation expense related to RSUs for the three and nine months ended September 30, 2008 was $164 and $693, respectively, and was $313 and $986 for the three and nine months ended September 30, 2007, respectively. During the first nine months of 2008, the Company granted 50,000 RSUs, the vesting of which is based upon the achievement of market conditions. Compensation cost for an RSU award with a market condition are recognized ratably for each vesting tranche over the requisite service period in a similar manner as an award with a service condition, based on the grant date fair value of the award. However, unlike awards with a service or performance condition, the compensation cost for an award with a market condition will not be reversed solely because the market condition is not satisfied.

NOTE 5. ALLOWANCE FOR DOUBTFUL ACCOUNTS

The Company performs ongoing credit evaluations of its customers and, generally, does not require collateral from its customers to support accounts receivable. The Company maintains an allowance for doubtful accounts due to credit risk to provide adequate protection against estimated losses resulting from the inability of customers to make required payments. The Company bases its ongoing estimate of allowance for doubtful accounts primarily on the aging of balances in its accounts receivable, historical collection patterns and changes in the creditworthiness of its customers. Based upon this analysis, the Company records an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. The allowance for doubtful accounts is established based on the best information available to the Company and is re-evaluated and adjusted as additional information is received. The following table summarizes the changes in the allowance for doubtful accounts for the nine months ended September 30, 2008 and 2007:

 

     Nine Months Ended
September 30,
     2008     2007

Allowance for doubtful accounts, beginning of period

   $ 2,009     $ 1,470

Provision for doubtful accounts, net

     (38 )     190

Amounts written-off, net of recoveries

     (1,108 )     246
              

Allowance for doubtful accounts, end of period

   $ 863     $ 1,906
              

 

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NOTE 6. ACCRUED RESTRUCTURING CHARGES

May 2003 Restructuring Plan

On May 27, 2003, the Company announced a restructuring plan aimed at lowering costs and better aligning its resources to customer needs. The plan allowed the Company to have tighter integration between customer touch functions, which better positions the Company to take advantage of the market opportunities for its new products, and solutions. The restructuring plan included eliminating positions to lower operating costs, closing under-utilized office capacity, primarily from the excess space in the Company’s Santa Clara, California and Addison, Texas facilities, and re-assessing the useful life of related excess long-lived assets. The workforce portion of the restructuring plan had been significantly completed by December 31, 2003, while the facilities plan was executed by September 30, 2003. The Company also announced non-cash charges related to the impairment of a long-term strategic investment and the impairment of purchased product rights acquired through the enCommerce acquisition of June 2000.

The balance of the accrued restructuring charges for the May 2003 restructuring are payable within the next 12 months.

Summary of Accrued Restructuring Charges for May 2003 Restructuring

The following table is a summary of the accrued restructuring charges related to the May 2003 plan at September 30, 2008:

 

(in millions)    Total Charges
Accrued at
Beginning of
Year
   Cash
Payments
   Accrued
Restructuring
Charges at
September 30,
2008

Consolidation of excess facilities

   $ 0.2    0.2    $ —  
                  

June 2001 Restructuring Plan

On June 4, 2001, the Company announced a Board-approved restructuring plan to refocus on the Company’s most significant market opportunities and to reduce operating costs due to the macroeconomic factors that were negatively affecting technology investment in the market. The restructuring plan included a workforce reduction, consolidation of excess facilities, and discontinuance of non-core products and programs.

The consolidation of excess facilities included the closure of eight offices throughout the world, but the majority of the costs related to the Company’s facility in Santa Clara, California. These costs are payable contractually over the remaining term of the Santa Clara facility lease, which runs through 2011, reduced by estimated sublease recoveries. During 2006, the Company made further adjustments to the restructuring charges that had previously been recorded related to the June 2001 restructuring plan with respect to our Santa Clara, California facility, resulting from the conclusion of an extension agreement with the current sublessee to sublease the California facility through March 31, 2011, which represents substantially all of the remaining lease period on the building. As a result of the conclusion of the final sublease arrangement during 2006, the Company adjusted its accrual related to the June 2001 restructuring by $2,765 to reflect the known sublet lease recoveries under the extension agreement.

The Company has evaluated and pursued all reasonable possibilities to settle the lease obligations associated with the June 2001 restructuring, but has been unable to find an acceptable outcome. Therefore, the Company has concluded that it is appropriate to classify the portion of the outstanding liabilities that is not payable within the next 12 months as long-term liabilities. However, the current obligations would require the Company to fund $1,400 of its accrued restructuring charges for the June 2001 restructuring during the remainder of fiscal 2008, with the remaining accrued restructuring charges for the June 2001 restructuring to be paid as follows: $5,500 in fiscal 2009, $5,700 in fiscal 2010 and $2,500 in fiscal 2011.

 

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Summary of Accrued Restructuring Charges for June 2001 Restructuring

The following table is a summary of the accrued restructuring charges net of sublease recoveries related to the June 2001 plan at September 30, 2008:

 

(in millions)    Total Charges
Accrued at
Beginning of
Year
   Cash
Payments
   Accrued
Restructuring
Charges at
September 30,
2008

Consolidation of excess facilities

   $ 19.1    $ 4.0    $ 15.1
                    

As of September 30, 2008, the Company had estimated a total of $7,000 of sublease recoveries in its restructuring accrual, related to the Santa Clara facility, recoverable under an existing sublease agreement.

NOTE 7. NET INCOME (LOSS) PER SHARE AND SHARES OUTSTANDING

Basic net income (loss) per share is computed by dividing the net income (loss) by the weighted average number of shares of Common stock of all classes outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) by the weighted average number of shares of Common stock and potential Common stock outstanding, and when dilutive, options to purchase Common stock (including stock options, restricted stock units and stock appreciation rights) using the treasury stock method. The options to purchase Common stock are excluded from the computation of diluted net income (loss) per share if their effect is antidilutive.

The antidilutive effect excluded from the diluted net loss per share computation related to options to purchase Common stock or Common stock to be issued under stock award agreements for the three and nine months ended September 30, 2008 was 1,216,389 and 1,335,368 shares, respectively, compared to a dilutive effect of 1,969,169 and 506,825 shares for the three and nine months ended September 30, 2007, respectively, which increased the weighted average common shares outstanding used in the computation. In addition, 11,551,264 and 10,812,046 out-of-the-money exercisable options that had exercise prices in excess of the average market price for the three months ended September 30, 2008 and 2007, respectively, were excluded from the computation of diluted net income (loss) per share.

In the three and nine months ended September 30, 2008, the Company issued 79,368 and 332,756 shares of Common stock, respectively, related to the exercise of employee stock options and restricted stock units.

NOTE 8. MARKETABLE AND OTHER INVESTMENTS

The Company did not hold any short term marketable investments as of September 30, 2008 and December 31, 2007.

Historically, the Company has not engaged in formal hedging activities, but the Company does periodically review the potential impact of foreign exchange risk to ensure that the risk of significant potential losses is minimized. In the past, when advantageous, the Company has engaged in forward contracts to purchase Canadian dollars to cover exposures on the Canadian subsidiary’s 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. The Company did not engage in any forward contracts to purchase Canadian dollars to cover exposures on expenses denominated in Canadian dollars in the third quarter of 2008. No previously purchased foreign exchange contracts had extended past June 30, 2008. Subsequent to September 30, 2008, the Company has engaged in forward contracts to purchase Canadian dollars covering exposures on approximately $3.0 million of expenses denominated in Canadian dollars in the fourth quarter of 2008. The Company currently has not engaged in any forward contracts to purchase Canadian dollars to cover exposures on expenses denominated in Canadian dollars in future periods beyond the fourth quarter of 2008.

The Company holds equity securities stated at cost, which represent long-term investments in private companies made in 2000 and 2001 for business and strategic alliance purposes. The Company’s ownership share in these companies ranges from 1% to 10% of the outstanding voting share capital. The Company monitors and assesses the ongoing operating performance of the underlying companies for evidence of

 

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impairment. Since 2001, the Company has recorded impairments totaling $14,007, net of recoveries, with respect to these investments as a result of other than temporary declines in fair value. The strategic investments made in 2000 and 2001 had no net remaining carrying value at September 30, 2008. In addition, the Company holds an investment recorded at cost in ADML Holdings, Ltd., and its affiliate, Ohana Wireless, Inc. (collectively, “Ohana”), which at September 30, 2008 represented approximately 14% of the voting share capital of Ohana. The carrying value of the Company’s investment in Ohana at September 30, 2008 was $91.

The Company also holds an equity interest in Asia Digital Media Limited (“Asia Digital Media”), which at September 30, 2008 represented approximately 44% of the voting share capital of this company. This investment is accounted for by the Company using the equity method of accounting for investments in common stock.

There was no remaining carrying value of the Company’s investment in Asia Digital Media at September 30, 2008 and 2007.

NOTE 9. SEGMENT AND GEOGRAPHIC INFORMATION

Segment information

The Company conducts business in one operating segment: namely, the design, production and sale of software products and related services for securing digital identities and information. The nature of the Company’s different products and services is similar and, in general, the type of customers for those products and services is not distinguishable. The Company does, however, prepare information for internal use by the Chairman, President and Chief Executive Officer on a geographic basis. Accordingly, the Company has included a summary of the financial information, on a geographic basis, as reported to the Chairman, President and Chief Executive Officer.

Geographic information

Revenues are attributed to specific geographical areas based on where the sales orders originated. Income (loss) before income taxes is presented based on the allocation of earnings amongst statutory jurisdictions, and is not necessarily indicative of the geographic distribution of revenues. Company assets are identified with operations in the respective geographic areas.

The Company operates in three main geographic areas as follows:

 

     Three months ended
September 30,
    Nine months ended
September 30,
 

(In thousands)

   2008     2007     2008     2007  

Revenues:

        

United States

   $ 10,015     $ 12,090     $ 34,121     $ 35,854  

Canada

     5,207       4,474       14,884       15,734  

Europe, Asia and Other

     9,234       7,379       25,768       21,411  
                                

Total revenues

   $ 24,456     $ 23,943     $ 74,773     $ 72,999  
                                

Income (loss) before income taxes:

        

United States

   $ (1,812 )   $ (435 )   $ (2,116 )   $ (813 )

Canada

     629       (863 )     (222 )     (5,852 )

Europe, Asia and Other

     58       (97 )     (114 )     (266 )
                                

Total income (loss) before income taxes

   $ (1,125 )   $ (1,395 )   $ (2,452 )   $ (6,931 )
                                

 

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     September 30,
2008
   December 31,
2007

Total assets:

     

United States

   $ 89,440    $ 95,988

Canada

     18,983      22,146

Europe, Asia and Other

     7,247      4,020
             

Total

   $ 115,670    $ 122,154
             

NOTE 10. COMPREHENSIVE INCOME (LOSS)

The components of comprehensive income (loss) are as follows:

 

     Three months ended
September 30,
    Nine months ended
September 30,
 

(In thousands)

   2008     2007     2008     2007  

Net loss

   $ (1,239 )   $ (1,501 )   $ (2,841 )   $ (7,159 )

Foreign currency translation adjustments

     (7 )     (174 )     124       (745 )
                                

Comprehensive loss

   $ (1,246 )   $ (1,675 )   $ (2,717 )   $ (7,904 )
                                

NOTE 11. LEGAL PROCEEDINGS

The Company is subject, from time to time, to various 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 legal matters will have a material adverse effect on the Company’s consolidated results of operations or consolidated financial position. Certain legal proceedings in which we are involved are discussed in Part 1. Item 3. of our Annual Report on Form 10-K for the year ended December 31, 2007. Unless otherwise indicated, all proceedings in that earlier Report remain outstanding with no change in status.

NOTE 12. 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 the Company’s 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 parent’s 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 the Company’s financial position, results of operations or cash flows.

In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133”. SFAS No. 161 requires entities that utilize derivative instruments to provide qualitative disclosures about their objectives and strategies for using such instruments, as well as any details of credit-risk-related contingent features contained within derivatives. SFAS No. 161 also requires entities to disclose additional information about the amounts and

 

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location of derivatives located within the financial statements, how the provisions of SFAS 133 have been applied, and the impact that hedges have on an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. The Company currently does not anticipate the adoption of SFAS No. 161 will have a material impact on the disclosures already provided.

From time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company’s management believes that the impact of recently issued standards that are not yet effective will not have a material impact on its consolidated financial statements upon adoption.

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This report contains forward-looking statements that involve risks and uncertainties. The statements contained in this report that are not purely historical are 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, including without limitation statements regarding our expectations, beliefs, intentions or strategies regarding the future. You can find many of these statements by looking for words such as “approximates,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “would,” “may” or similar expressions in this quarterly report on Form 10-Q. These forward-looking statements are subject to numerous assumptions, risks and uncertainties. All forward-looking statements included in this report are based on information available to us, up to and including, the date of this document, and we assume no obligation to update any such forward-looking statements. Our 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 “Overview” and “Risk Factors” and elsewhere in this report. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and notes thereto appearing elsewhere in this report.

EXECUTIVE OVERVIEW

As a trusted security expert, Entrust secures digital identities and information through a layered security approach 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 secure 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 Entrust’s 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 architect, 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 software and Public Key Infrastructure (“PKI”) fields, Entrust’s market leadership and expertise in delivering award-winning identity and data protection management software solutions is demonstrated by the diversity of our 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.

 

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Our Layered Consumer Architecture approach consists of six layers:

 

  1. Extended Validation (“EV”) SSL Certificates

 

  2. Versatile Authentication & Single Sign-On (“SSO”)

 

  3. Fraud Detection & Risk-based Authentication

 

  4. Transaction Signing & Encryption

 

  5. Secure Web & E-mail

 

  6. Open Fraud Intelligence Network

Our Layered Enterprise Architecture approach consists of five layers:

 

  1. Workstation & Network Authentication

 

  2. SSL, Unified Communications Certificates

 

  3. Remote Access Authentication

 

  4. Secure Shared Folders

 

  5. Secure Boundary & End-to-End Messaging

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 came 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 our 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 Entrust’s 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:

 

   

Entrust Emerging Growth Products accounted for 38% ($3.6 million) of product revenues for Q3, 2008.

 

   

Entrust PKI Products accounted for 58% ($5.5 million) of product revenues for Q3, 2008.

 

   

Entrust Single Sign-On Products accounted for 4% ($376 thousand) of product revenues for Q3, 2008.

These three categories are how we report our product revenues 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 revenues increased 7% for the first three quarters of 2008 and now accounts for over $10.0 million of quarterly revenue. It is important to note that we achieved record renewals in the first three quarters of 2008 of over 95% in terms of customer retention rate. We also provide professional services, including architecture, installation, and integration services related to the products that we sell.

 

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In Q3, 2008, deferred revenues were of $27.4 million, a decrease of $734 thousand from Q3, 2007. The decrease in deferred revenue was due primarily to the impact of the Canadian dollar on the deferred revenue balance. These numbers show the continued strength of our support and maintenance renewals and the growth in our subscription based software bookings.

In the first three quarters of 2008, Entrust increased our profitability by $4.3 million or $0.07 per share. During 2007 and the first three quarters of 2008, 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 experienced due an unfavorable shift in the exchange rates between the U.S dollar and other major currencies in 2007 and the first three quarters of 2008. This unfavorable shift in exchange rates had cost Entrust $3.5 million in additional reported expense in 2007 and an additional $3.4 million in the first nine months of 2008.

Entrust sells 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 our software business by leveraging Entrust’s 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 Entrust’s 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 Entrust’s 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 the first three quarters of 2008, the extended Government vertical made up 46% of product revenues, which is virtually flat versus the same period of 2007. 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, the 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 the national PKI infrastructures in the Kingdom of Saudi Arabia, Brunei and Slovenia. Specifically, we had a one million dollar transaction in the third quarter of 2007 for the Saudi Arabia PKI infrastructure, while in the fourth quarter of 2007 their ePortal infrastructure was our largest transaction. Further, in the first quarter of 2008, our largest transaction was for an eBorders project in Europe, while in the second and third quarters, we won our first two Extended Access Control passport deals from European Union countries.

In Q3, 2008, 64% 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 Q3, 2008 the financial services vertical accounted for approximately 49% of product revenues and was up 40% over the first three

 

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quarters of 2007. In this quarter of 2008, we had very good success in the financial vertical with our Risk-Based Authentication solutions, where we delivered our largest transaction with a Canadian bank selecting Entrust IdentityGuard and TransactionGuard. Overall, four of our top five product transactions were with financial institutions outside of the U.S. and Great Britain.

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. Entrust has built on that heritage to become a leader in the Risk-Based Authentication market. In Q3, 2008, Risk-Based Authentication accounted for 28% of product revenues, up 80% from a year ago. The key drivers for our Risk-Based Authentication platform is Entrust IdentityGuard and our On-line Fraud detection solution, Entrust TransactionGuard. In the third quarter, Entrust IdentityGuard continued to have positive momentum, making up 63 of our 130 transactions.

As of September 30, 2008, we have gone well over 10.0 million licensed users of IdentityGuard and have nearly $16.0 million in total sales of the solution. IdentityGuard’s 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 industry’s first $5 one-time-passcode (OTP) security token. In the second quarter of 2007, 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. We have received a customer commitment on our largest IdentityGuard token deal, which is for 500,000 tokens over the next three years, and this quarter we delivered our first large token shipment.

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. Our core PKI, government opportunity and Managed Services offerings have us positioned to continue our leadership position.

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 was up 36% for the first three quarters of the year. Year-to-year comparison showed an increase of 34% for the third quarter of 2008, accounting for $2.5 million of PKI product revenues in Q3, 2008. We are also seeing increased momentum with business development partners and channels to market these offerings.

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, with no product transactions over $1 million in Q3, 2008. The top five product transactions accounted for 10% of Q3, 2008 revenues. These numbers were at the low end of our historical range, which is generally between 10% and 25% of revenue from the top five customers and zero to two transactions over $1 million. In the quarter, the average purchase size was $50,000, a slight decrease from $51, 000 in Q3, 2007. Total transactions in Q3, 2008 reached 130. Forty-four transactions or 34% of the total transactions were from new customers.

 

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We may be impacted from time to time on our software revenue by the length and timing of our customers’ buying process, which may include proof of concepts, senior management reviews and customer budget delays that sometimes results in longer than anticipated sales cycles. We are also impacted by our customers’ buying behavior, which in recent times has been 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:

 

   

Number and average size of product revenue transactions;

 

   

Number of revenue transactions over $1 million and < $500 thousand;

 

   

Top-five product revenue transactions as a percentage of total revenues;

 

   

Product revenue split between extended enterprise and extended government verticals;

 

   

Product revenue split between three key product areas: Emerging Growth Products, Public Key Infrastructure and Single Sign-on;

 

   

Geographic revenue split;

 

   

Product and services revenues as a percentage of total revenues;

 

   

Gross profit as a percentage of services and maintenance revenues; and

 

   

Deferred revenue, cash and cash equivalents, and accounts receivable.

BUSINESS OVERVIEW

During the third quarter of 2008, we continued our strategy of focusing on core vertical and geographic markets. Revenues of $24.5 million represented a 2% increase from the third quarter of 2007, and consisted of 39% product sales and 61% services and maintenance. Services and maintenance revenues decreased 5% from the third quarter of 2007, due to decreased demand for consulting services, while product revenues increased 15% from the third quarter of 2007, driven by improved subscription-based product revenues and improved closure rate for product transactions, despite a lower average purchase value, compared to the same quarter of 2007. Net loss for the third quarter of 2008 was $1.2 million, or $0.02 per share, compared to net loss of $1.5 million, or $0.02 per share for the same period of 2007, with total expenses increasing 1% to $25.8 million, including a $1.5 million write-down of a long-term asset. We used $1.0 million in cash flow from operations in the third quarter of 2008, compared to net cash flow used in operations of $3.0 million in the same quarter of 2007. Entrust Emerging Growth Products (Entrust IdentityGuard, Boundary Messaging and Fraud Detection) accounted for 38% of product revenue, which is an increase of 88% from Q3, 2007 and 38% from Q2, 2008. Entrust PKI Products accounted for 58% of product revenue, which is a decrease of 12% from Q3, 2007 and 11% from Q2, 2008. Entrust Certificate Services revenues, a component of our PKI Product solutions suite, increased 34% over Q3, 2007 and 5% over Q2, 2008. Entrust Single Sign-On Products accounted for 4% of product revenue, which is an increase of 570% from Q3, 2007 and 47% from Q2, 2008. Extended Government accounted for 36% and Extended Enterprise accounted for 64% of the product revenue in the quarter. The financial vertical accounted for approximately 49% of third quarter 2008 product revenues, an increase of 92% from Q3, 2007 and 81% from Q2, 2008.

Other highlights from the third quarter of 2008 included:

 

   

The top five product transactions accounted for 10% of Q3, 2008 revenues. The average purchase size this quarter was $50,000, down from $51,000 in Q3, 2007 and $58,000 in Q2, 2008. Total transactions in Q3, 2008 were 130, which is up from 115 in Q3, 2007, and 103 in Q2, 2008. Forty-four (or 34%) of the transactions were from new customers, an increase of 16% from Q3, 2007.

 

   

Revenue from subscription based product and services accounted for 56% of total revenue for Q3, 2008, an increase of 6% from Q3, 2007 and consistent with Q2 2008.

 

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Deferred revenue was $27.4 million, which is a decrease of 3% from Q3, 2007 and 6% from Q2, 2008.

 

   

We ended Q3, 2008 with $23.4 million in cash and cash equivalents, which is up from $21.5 million at the end of Q3, 2007 and down from $25.4 million at the end of Q2, 2008, and no debt.

 

   

We had no product transactions over $1 million in Q3, 2008, compared to one such transaction in Q3, 2007. Revenue from transactions under $500 thousand increased 23% from Q3, 2007, continuing to drive our strategy to be less reliant on large deals. Transactions under $500 thousand accounted for 93% of product revenue in Q3, 2008, compared to 88% in Q3, 2007.

 

   

Entrust and 3M announced a partnership to provide an integrated end-to-end secure ePassport solution, which provides the necessary components to implement Basic Access Control (BAC) and EAC ePassport security, while also securing the surrounding data and communications infrastructures.

 

   

DnB NOR, the largest financial institution in Norway, aligned its comprehensive security strategy with Entrust, Inc. and the zero-touch fraud detection component of the Entrust Risk-based Authentication Solution. With total assets of more than $308 billion (USD), DnB NOR serves more than 2.5 million customers worldwide. The bank will leverage the Entrust solution — for more than 1.7 million users — to protect private-, corporate- and consumer-banking customers online.

 

   

Slovenia selected Entrust to facilitate its government’s migration to a second-generation ePassport solution based on the EAC standard. Slovenia’s second-generation ePassport capabilities, integrated by technology partner S&T, represent one of the core components of the country’s citizen-centric e-government.

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 the third quarter of 2008, 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

 

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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 customer’s 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.

 

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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 24% of gross accounts receivable at September 30, 2008, compared to 25% of gross accounts receivable at September 30, 2007. One customer accounted for 10% or more of net accounts receivable at September 30, 2008. 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, which accounted for approximately $1.0 million of the $1.9 million balance of allowance for doubtful accounts at June 30, 2008. These receivable balances were written off during the third quarter of 2008 and, as a result, the allowance for doubtful accounts decreased $1.0 million to a balance of $0.9 million at September 30, 2008.

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

 

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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 September 30, 2008.

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,

 

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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 September 30, 2008 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 and no events have indicated that their carrying amount may not be recoverable.

Purchased product rights, customer relationships, partner relationships and non-competition agreements of key personnel of acquired companies totaling $10.0 million at September 30, 2008 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 require significant judgment and estimation regarding the amount and timing of future revenues and related expenses associated with these acquired assets.

In addition, subsequent to the impairment discussed below, we have a net balance of $1.1 million from our investment in other long-term assets at September 30, 2008, which consist primarily of capitalized software development costs, related to Entrust products offered 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. During the third quarter of 2008, we recorded an impairment of $1.5 million in the book value of capitalized software development costs related to our video based training, originally developed for both general security and Entrust specific solutions, for sale to our customers. During the third quarter of 2008, we became aware that our lead customer for this product was no longer interested in pursuing an agreement to license the content of the video based training technology. This fact, combined with changes in the management of the video based training program and the decision to discontinue investment in the maintenance of the technology to ensure continuity with our software releases, indicated to our management that a degradation in the carrying value of the related capitalized development costs may have occurred. We applied an expected present value technique to estimate the fair value of this long-lived asset in determining that the recoverable value had been impaired.

We are not aware of any further impairment events during the three months ended September 30, 2008. 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 remaining investment in these assets, which would have a significant impact on our consolidated financial position and results of operations.

 

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Stock-Based Compensation

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 employee’s 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

 

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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.

For the three and nine months ended September 30, 2008 compensation expense of $0.5 million and $2.0 million, respectively, was recognized for stock options, RSUs and SARs. Total remaining compensation estimated to be recognized over the remaining service periods for these awards is $2.3 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.

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 parent’s 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 March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133”. SFAS No. 161 requires entities that utilize derivative instruments to provide qualitative disclosures about their objectives and strategies for using such instruments, as well as any details of credit-risk-related contingent features contained within derivatives. SFAS No. 161 also requires entities to disclose additional information about the amounts and location of derivatives located within the financial statements, how the provisions of SFAS 133 have been applied, and the impact that hedges have on an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. We currently do not anticipate the adoption of SFAS No. 161 will have a material impact on the disclosures already provided.

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.

 

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RESULTS OF OPERATIONS

The following table sets forth certain condensed consolidated statement of operations data expressed as a percentage of total revenues for the periods indicated:

 

     Three months ended
September 30,
    Nine months ended
September 30,
 
     2008     2007     2008     2007  

Revenues:

        

Product

   38.6 %   34.1 %   37.6 %   36.0 %

Services and maintenance

   61.4     65.9     62.4     64.0  
                        

Total revenues

   100.0     100.0     100.0     100.0  
                        

Cost of revenues:

        

Product

   9.0     7.6     8.9     7.9  

Services and maintenance

   29.5     30.1     29.6     30.7  

Amortization of purchased product rights

   0.5     1.5     1.1     1.4  
                        

Total cost of revenues

   39.0     39.2     39.6     40.0  
                        

Gross profit

   61.0     60.8     60.4     60.0  
                        

Operating expenses:

        

Sales and marketing

   32.0     34.3     32.5     35.8  

Research and development

   17.5     20.6     18.0     21.4  

General and administrative

   10.6     12.2     11.8     12.9  

Impairment of long-term asset

   6.2     —       2.0     —    
                        

Total operating expenses

   66.3     67.1     64.3     70.1  
                        

Loss from operations

   (5.3 )   (6.3 )   (3.9 )   (10.1 )
                        

Other income (expense):

        

Interest income

   0.4     0.8     0.4     0.7  

Foreign exchange gain (loss)

   0.3     (0.4 )   0.2     —    

Gain on sale of long-term strategic investments

   —       —       —       —    

Loss from equity investments

   —       —       —       (0.1 )
                        

Total other income (expense)

   0.7     0.4     0.6     0.6  
                        

Loss before income taxes

   (4.6 )   (5.9 )   (3.3 )   (9.5 )

Provision for income taxes

   0.5     0.4     0.5     0.3  
                        

Net loss

   (5.1 )%   (6.3 )%   (3.8 )%   (9.8 )%
                        

REVENUES

Total Revenues

 

(millions)    Three months ended
September 30,
   Nine months ended
September 30,
   Percentage change  
   2008    2007    2008    2007    Three months ended
September 30
    Nine months ended
September 30
 

North America

   15.3    16.5    49.1    51.6    -7 %   -5 %

Outside North America

   9.2    7.4    25.7    21.4    24 %   20 %
                                

Total

   24.5    23.9    74.8    73.0    3 %   2 %
                                

 

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Our total revenues were $24.5 million for the three months ended September 30, 2008, which represented an increase of 3% from the $23.9 million for the three months ended September 30, 2007. Total revenues were $74.8 million for the nine months ended September 30, 2008, which represented an increase of 2% from the $73.0 million of total revenues for the nine months ended September 30, 2007. Total revenues derived from North America of $15.3 million and $49.1 million in the third quarter and first nine months of 2008, respectively, represented a decrease of 7% and 5% from the $16.5 million and $51.6 million in the same periods of 2007. Total revenues derived from outside of North America of $9.2 million and $25.7 million for the third quarter and first nine months of 2008, respectively, represented an increase of 24% and 20% from the $7.4 million and $21.4 million in the same periods of 2007.

The overall increase in total revenues during the three and nine months ended September 30, 2008, when compared to the same periods in 2007, was driven by year over year increases in product revenues, which was up 15% in the third quarter and 7% for the first nine months, when compared to the same periods of 2007, primarily from our Risk Based Authentication solutions and our subscription based businesses. However, extended government revenues in the United States were $4.4 million and $13.5 million for the three and nine months ended September 30, 2008, respectively, compared to $4.7 million and $14.8 million for the same periods in 2007, representing a 6% and 9% decrease, respectively. Our subscription based product and services revenues has grown in 2008, accounting for 56% and 54% of total revenues for the third quarter and first nine months of 2008, respectively, including support & maintenance revenues, up from 54% and 50% in the same periods of 2007, an increase of 10% for the first nine months of the year. The United States and Canadian governments represented 16% and 8% of total revenues in the third quarter of 2008, respectively, when including revenues sold through resellers to the government end users. However, direct sales to the United States and Canadian governments represented 9% and 4% of total revenues in the third quarter of 2008, respectively. Overall, the United States and Canadian governments represented 14% and 9% of total revenues in the first nine months of 2008, when including revenues sold through resellers to the government end users. However, direct sales to the United States and Canadian governments represented 8% and 5% of total revenues in the first nine months of 2008. No individual customer accounted for 10% or more of total revenues in the three and nine months ended September 30, 2008.

The level of non-North American revenues has fluctuated from period to period and this trend is expected to continue for the foreseeable future. We believe the improved revenues for the first nine months of 2008, compared to the same period in 2007, reflects the strength of our evolving product portfolio, distribution network, strong customer relationships and the quality of our support and services.

 

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Product Revenues

 

(millions)    Three months ended
September 30,
    Nine months ended
September 30,
    Percentage change  
   2008     2007     2008     2007     Three months ended
September 30
    Nine months ended
September 30
 

North America

   5.2     5.0     16.8     17.6     4 %   -5 %

Outside North America

   4.2     3.2     11.3     8.6     31 %   31 %
                                    

Total

   9.4     8.2     28.1     26.2     15 %   7 %
                                    

Percentage of total revenues

   39 %   34 %   38 %   36 %    

Product revenues of $9.4 million for the three months ended September 30, 2008 represented an increase of 15% from the $8.2 million for the three months ended September 30, 2007, representing 39% and 34% of total revenues in the respective periods. Product revenues of $28.1 million for the nine months ended September 30, 2008 represented an increase of 7% from the $26.2 million for the nine months ended September 30, 2007, representing 38% and 36% of total revenues in each of the respective periods.

The growth of product revenues in the third quarter and first nine months of 2008 when compared to the same periods in 2007 was primarily driven by demand for our emerging growth products, which grew 88% in the third quarter and 50% in the first nine months of 2008, representing 31% of product revenues in the first nine months of 2008, compared to 22% for the same period in 2007, and our SSL certificate business. In particular, demand for our fraud and risk based authentication offerings was the strongest, with combined increase in revenues of 100% year to date compared to last year. However, revenue from our PKI products, representing 66% of product revenues in the first nine months of 2008, compared to 72% for the same period of last year, has seen some weakness, with revenues decreasing 12% in the third quarter and 3% in the first nine months of 2008 compared to the same periods of 2007. While our Entrust certificate services (SSL certificates) portion of our PKI business increased 36% to $7.1 million of revenue in the first nine months of 2008, compared to the same period in 2007, this growth was more than offset by the planned decrease in reliance on sales of the full disk products that we resell from Checkpoint; the shift from perpetual license purchases to our subscription based managed service offering; and lower government customer purchases.

We had 130 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 the third quarter of 2008, up 13% from 115 in the same quarter of 2007. Overall, we had 369 product revenue transactions in the first nine months of 2008, up from 334 in the first nine months of 2007, or a 10% increase, with 32% of the

 

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transactions in the first nine months of 2008 being from new customers. The average product revenue transaction size decreased 2% to $50 thousand for the third quarter of 2008 from $51 thousand for the same quarter of 2007, while the average product transaction size decreased 9% to $53 thousand for the first nine months of 2008 from $58 thousand for the same period in 2007. 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 the first nine months of 2008 compared to the same period last year. Revenue from deals under $500 thousand increased 13% from the same period in 2007, and is continuing to drive our strategy of being less reliant on large deals. These transactions accounted for 93% and 92% of product revenue in the third quarter and first nine months of 2008, respectively, compared with 88% and 87% for the respective periods of last year. Further, there were no product deals greater than $1 million in the first nine months of 2008, compared to two for the same period in 2007. 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 for the first nine months of 2008 increased to 10%, up moderately from 9% for the same period in 2007. The combination of customer buying patterns, generally smaller-sized IdentityGuard transactions and increased subscription business gives us a more predictable revenue base. This is consistent with our expectations, due to the increased volume of product transactions and lower reliance on deals greater than $1 million.

Services and Maintenance Revenues

 

(millions)    Three months ended
September 30,
    Nine months ended
September 30,
    Percentage change  
   2008     2007     2008     2007     Three months ended
September 30
    Nine months ended
September 30
 

North America

   10.0     11.6     32.3     33.9     -14 %   -5 %

Outside North America

   5.0     4.2     14.4     12.9     19 %   12 %
                                    

Total

   15.0     15.8     46.7     46.8     -5 %   0 %
                                    

Percentage of total revenues

   61 %   66 %   62 %   64 %    

Services and maintenance revenues of $15.0 million for the three months ended September 30, 2008 represented a decrease of 5% from the $15.8 million for the three months ended September 30, 2007, representing 61% and 66% of total revenues in the respective periods. Services and maintenance revenues of $46.7 million for the nine months ended September 30, 2008, decreased moderately from $46.8 million for the nine months ended September 30, 2007, representing 62% and 64% of total revenues in the respective periods.

The decrease in services and maintenance revenues for the third quarter of 2008, compared to the same period of 2007, is due to lower professional services revenues, primarily in the North American market as a

 

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result of customers’ budget constraints, despite strong subscription-based support and maintenance revenues in the quarter and year to date. However, overall services and maintenance revenues for the first nine months of 2008 have remained roughly flat when compared to the last year. Our customers continued to renew their support agreements at a rate of over 96% for the first nine months of 2008, increasing support and maintenance revenues by 7% when compared to the same period in 2007. Services and maintenance revenues as a percentage of total revenues for the third quarter of 2008 and the first nine months of 2008 decreased due to the combined effect of lower services and maintenance revenues and higher demand for our product offerings compared to the same periods of last year.

EXPENSES

Total Expenses

 

(millions)    Three months ended
September 30,
    Nine months ended
September 30,
    Percentage change  
   2008     2007     2008     2007     Three months ended
September 30
    Nine months ended
September 30
 

Total expenses

   25.8     25.4     77.7     80.4     2 %   -3 %
                                    

Percentage of total revenues

   105 %   106 %   104 %   110 %    

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 impairment of long-term asset. Total expenses of $25.8 million and $77.7 million for the three and nine months ended September 30, 2008, respectively, represented an increase of 2% and a decrease of 3% in each of the respective periods, from $25.4 million and $80.4 million for the same periods of 2007, respectively. The overall decrease in spending for the first nine months of 2008, when compared to the same period in 2007, was primarily due to the effect of an 8% decrease in our overall headcount year over year, as we continue to manage our headcount resources and discretionary spending carefully. This expense decrease was offset by an impairment of a long-term asset recorded during the third quarter of 2008, higher third party royalty costs and an unfavorable shift in the exchange rates between the U.S. dollar and other major currencies that increased our reported expenses by $0.1 million and $3.4 million for the three and nine months ended September 30, 2008, respectively, when compared to the same periods in 2007. As of September 30, 2008 we had 423 full-time employees globally, compared to 459 full-time employees at September 30, 2007 and 455 full-time employees at December 31, 2007.

 

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COST OF REVENUES

Cost of Product Revenues

 

(millions)    Three months ended
September 30,
    Nine months ended
September 30,
    Percentage change  
   2008     2007     2008     2007     Three months ended
September 30
    Nine months ended
September 30
 

Cost of product revenues

   2.2     1.8     6.7     5.8     22 %   16 %
                                    

Percentage of product revenues

   23 %   22 %   24 %   22 %    

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 $2.2 million for the three months ended September 30, 2008, which represented a 22% increase from $1.8 million for the three months ended September 30, 2007, representing 23% and 22% of product revenues in each of the respective periods. Cost of product revenues of $6.7 million for the nine months ended September 30, 2008 represented a 16% increase from $5.8 million for the nine months ended September 30, 2007, which represented 24% and 22% of product revenues in their respective periods The increase in the cost of product revenues in absolute dollars and as a percentage of total product revenues for the third quarter and first nine months of 2008 compared to the same periods of 2007 is primarily attributable to higher third-party software royalties and costs associated with sales of our IdentityGuard token product that was introduced subsequent to the first quarter of 2007. The mix of third-party products and the relative gross margins achieved with respect to these products may vary from period to period and from transaction to transaction and, consequently, our gross margins and results of operations could be adversely affected. Also, the shift in the exchange rates between the U.S. and other major currencies had no significant impact for the three months ended September 30, 2008, when compared to the same period in 2007, but resulted in increased reported expenses of $0.3 million for the nine months ended September 30, 2008, when compared to the same period in 2007.

Cost of Services and Maintenance Revenues

 

(millions)    Three months ended
September 30,
    Nine months ended
September 30,
    Percentage change  
   2008     2007     2008     2007     Three months ended
September 30
    Nine months ended
September 30
 

Cost of services and maintenance revenues

   7.2     7.2     22.1     22.4     0 %   -1 %
                                    

Percentage of services and maintenance revenues

   48 %   46 %   47 %   48 %    

 

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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 $7.2 million for each of the three months ended September 30, 2008 and 2007, respectively, representing 29% and 30% of total revenues for each of the respective periods. Cost of services and maintenance revenues was $22.1 million for the nine months ended September 30, 2008, which represented a 1% decrease from $22.4 million for the nine months ended September 30, 2007, representing 30% and 31% of total revenues for the respective periods.

 

(millions)    Year over year change 2007 to 2008
   Three months ended
September 30
   Nine months ended
September 30

Staff related costs

   0.2    -0.4

Outside professional services

   -0.2    -0.4

Third party hardware and support

   —      0.5
         
   —      -0.3
         

The decrease in the cost of services and maintenance revenues in the first nine months of 2008, compared to the same period in 2007, was mainly attributable to decreased staff related costs and outside professional services contractors. Outside professional services purchased externally decreased as we made a concerted effort to rebalance the work performed by our staff and work performed by subcontractors, improving utilization of internal resources. These savings were partly offset by higher hardware and related support costs and the shift in the exchange rates between the U.S. dollar and other major currencies, which resulted in increased reported expenses of $0.9 million for the nine months ended September 30, 2008, when compared to the same period in 2007, the majority of which related to staffing costs. The decrease in services and maintenance expenses as a percentage of total revenues for the three months ended September 30, 2008 was the result of higher total revenues, which accounted for the one-percentage point decrease, when compared to the same period in 2007. The decrease for the nine months ended September 30, 2008 in services and maintenance expenses as a percentage of total revenues, compared to the prior year, was primarily the result of higher total revenues, which, when combined with lower overall spending, accounted for a one-percentage point decrease in the services and maintenance expenses as a percentage of total revenues.

 

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Services and maintenance gross profit as a percentage of services and maintenance revenues was 52% for the three months ended September 30, 2008 compared to 54% for the same quarter of 2007, while services and maintenance gross profit as a percentage of services and maintenance revenues was 53% for the nine months ended September 30, 2008 compared to 52% for the same period of 2007. The decrease in the gross profit percentage for the third quarter was primarily the result of a decline in professional services margins, which accounted for a 4% drop in the gross profit percentage, partially offset by a 2% improvement in the gross profit percentage due to higher support and maintenance margins. The increase in this gross profit percentage for the nine months ended September 30, 2008 was primarily as a result of improved support and maintenance margins, which accounted for a 3% increase in the gross profit percentage point, while a decline in professional services margins partially offset the gross profit percentage increase in the first nine months by 2%.

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 EXPENSES

Operating Expenses—Sales and Marketing

 

(millions)    Three months ended
September 30,
    Nine months ended
September 30,
    Percentage change  
   2008     2007     2008     2007     Three months ended
September 30
    Nine months ended
September 30
 

Total sales and marketing expenses

   7.8     8.2     24.3     26.1     -5 %   -7 %
                                    

Percentage of total revenues

   32 %   34 %   33 %   36 %    

Sales and marketing expenses decreased 5% to $7.8 million for the three months ended September 30, 2008 from $8.2 million for the comparable period in 2007. For the nine months ended September 30, 2008, sales and marketing expenses decreased 7% to $24.3 million from $26.1 million for the comparable period in 2007. Sales and marketing expenses represented 32% and 33% of total revenues for the three and nine months ended September 30, 2008, respectively, compared to 34% and 36%, respectively, for each of the three and nine months ended September 30, 2007.

 

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(millions)    Year over year change 2007 to 2008
   Three months ended
September 30
   Nine months ended
September 30

Staff related costs (includes travel expenses)

   -0.2    -1.4

Marketing programs

   —      -0.4

Outside professional services

   0.1    0.4

Facilities related costs

   -0.1    -0.3

Bad debt expense

   -0.2    -0.1
         
   -0.4    -1.8
         

The decrease in sales and marketing expenses for the three and nine months ended September 30, 2008, compared to the same periods of 2007, was primarily due to lower staff related costs as a result of lower headcount and reduced spending on outside marketing programs in 2008. Sales and marketing headcount decreased 11% overall when compared to the prior year, resulting in decreased compensation expenses for the first nine months of 2008, when compared to the same period in 2007. Also, bad debt expense was lower in the three and nine months ended September 30, 2008, compared to the same periods of 2007. These decreased costs were partly offset by an unfavorable shift in the exchange rates between the U.S. dollar and other major currencies, which resulted in higher reported expenses of $0.1 million and $0.7 million for the three and nine months ended September 30, 2008, respectively, the majority of which was related to staffing costs. The decrease in sales and marketing expenses as a percentage of total revenues for the three and nine months ended September 30, 2008 compared to the same periods in 2007, reflects the lower spending in this area during the first nine months of 2008, which resulted in a one- and two- percentage point decrease in sales and marketing expenses as a percentage of total revenues for the three and nine months ended September 30, 2008, respectively, combined with a one-percentage point decrease in sales and marketing expenses as a percentage of total revenues due to higher total revenues for each of the three and nine months ended September 30, 2008, respectively, when compared to the same periods of 2007.

We intend to continue to focus on improving the productivity of the sales and marketing teams. As required, we will add additional sales coverage, which should allow us to better execute on any opportunities we see in both 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, when necessary we will make significant investments in sales and marketing to support the launch of any 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 the first nine months of 2008, the provision for doubtful accounts dropped $1.1 million to $0.9 million, primarily due to the write-off of a large customer balance in Europe.

 

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Operating Expenses—Research and Development

 

(millions)    Three months ended
September 30,
    Nine months ended
September 30,
    Percentage change  
   2008     2007     2008     2007     Three months ended
September 30
    Nine months ended
September 30
 

Total research and development expenses

   4.3     4.9     13.4     15.6     -12 %   -14 %
                                    

Percentage of total revenues

   18 %   21 %   18 %   21 %    

Research and development expenses decreased 12% to $4.3 million for the third quarter of 2008, compared to $4.9 million for the same period in 2007, while these expenses decreased 14% to $13.4 million for the nine months ended September 30, 2008, compared to $15.6 million for the nine months ended September 30, 2007. Research and development expenses represented 18% of total revenues for each of the three and nine months ended September 30, 2008, respectively, compared to 21% for each of the comparable periods in 2007.

 

(millions)    Year over year change 2007 to 2008
   Three months ended
September 30
   Nine months ended
September 30

Staff related costs

   -0.3    -1.2

Outside professional services

   -0.1    -0.7

Facilities related costs

   -0.2    -0.3
         
   -0.6    -2.2
         

The decrease in research and development expenses for the three and nine months ended September 30, 2008 when compared to the same periods in 2007 was primarily due to lower outside professional services and staff related costs. We have successfully reduced external research and development contractor resources associated with the Business Signatures acquisition, reducing our outside professional services expenses for the three and nine months ended September 30, 2008, when compared to the same periods in 2007. In addition, our internal research and development headcount decreased 12% year over year from the prior year. Offsetting these savings, we experienced a shift in exchange rates between Canada and the U.S. that resulted in higher reported costs of $0.9 million for the nine months ended September 30, 2008, compared to the same period in 2007, the majority of which was related to staffing costs. The decrease in research and development expenses as a percentage of total revenues for the three and nine months ended September 30, 2008, compared to the same periods in 2007, primarily reflects the lower spending, which resulted in a three-percentage point decrease in the third quarter and first nine months of 2008.

 

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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 Expenses—General and Administrative

 

(millions)    Three months ended
September 30,
    Nine months ended
September 30,
    Percentage change  
   2008     2007     2008     2007     Three months ended
September 30
    Nine months ended
September 30
 

Total general and administrative expenses

   2.6     2.9     8.8     9.4     -10 %   -6 %
                                    

Percentage of total revenues

   11 %   12 %   12 %   13 %    

General and administrative expenses decreased to $2.6 million and $8.8 million for the three and nine months ended September 30, 2008, respectively, from $2.9 million and $9.4 million for the comparable periods in 2007. General and administrative expenses represented 11% and 12% of total revenues for the three and nine months ended September 30, 2008, respectively, compared to 12% and 13% for the comparable periods in 2007.

 

(millions)    Year over year change 2007 to 2008
   Three months ended
September 30
   Nine months ended
September 30

Staff related costs

   -0.5    -1.5

Outside professional services

   0.1    0.9

Facilities related costs

   0.1    —  
         
   -0.3    -0.6
         

The decrease in staff-related costs in absolute dollars in the third quarter and first nine months of 2008 compared to the same periods of 2007 was due to the effect of continued management discipline in this area, with net savings of $0.3 million and $0.6 million, respectively, primarily the result of an 9% decline in headcount compared to the prior year. Offsetting this decrease in staff related spending was increased spending on outside professional services in the first nine months of 2008, when compared to the same period in 2007. Also, an unfavorable shift in the exchange rates between the U.S. dollar and other major

 

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currencies resulted in higher reported expenses of $0.5 million for the nine months ended September 30, 2008, when compared to the same period in 2007, the majority of which related to staffing costs. We believe that the increases in outside professional services expenses were non-recurring in nature and expect that these costs will reduce to historical levels for the remainder of the year. General and administrative expenses as a percentage of total revenues decreased for the three and nine months ended September 30, 2008 compared to the same periods in 2007, due primarily to lower spending in this area, which accounted for a one-percentage point decrease in each of the reported periods.

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 $128 thousand and $788 thousand for the three and nine months ended September 30, 2008, respectively, compared to $355 thousand and $1.0 million for the same periods in 2007. 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 $250 thousand and $748 thousand for the three and nine months ended September 30, 2008, respectively, compared to $247 thousand and $780 thousand for the same periods of 2007. 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, $211 thousand and $633 thousand was recorded as a component of sales and marketing expenses for the three and nine months ended September 30, 2008, respectively, compared to $209 thousand and $655 thousand for the same periods of 2007, while $38 thousand and $115 thousand was recorded as a component of cost of services and maintenance revenues for each of the three and nine months ended September 30, 2008 and 2007, respectively.

Impairment of Long-term Asset

During the third quarter of 2008, we recorded an impairment of $1.5 million in the book value of capitalized software development costs related to our video based training, originally developed for both general security and Entrust specific solutions, for sale to our customers.

Interest Income

Interest income was $93 thousand and $322 thousand for the three and nine months ended September 30, 2008, respectively, compared to $188 thousand and $544 thousand for the same periods of 2007, representing less than 1% of total revenues for each of the respective periods. The decrease in investment income for the third quarter and first nine months of 2008, compared to the same periods of 2007, was primarily due to the reduced rate of return on our funds invested in cash equivalents, as the interest rates available in the first three quarters of 2008 decreased compared to the same period in 2007, despite the fact that the funds available increased to $23.4 million at September 30, 2008 from $21.5 million at September 30, 2007.

Loss from Equity Investments

We recorded $77 thousand, net of intercompany profit eliminations, related to our investments in Asia Digital Media for the nine months ended September 30, 2007. The carrying value of this investment was zero as at December 31, 2007, and therefore, no further losses were recorded in 2008. 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.

 

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Provision for Income Taxes

We recorded an income tax provision of $114 thousand and $389 thousand for the three and nine months ended September 30, 2008, respectively, compared to $104 thousand and $228 thousand for the same periods of 2007. These provisions represented primarily the taxes payable in certain foreign jurisdictions for which no U.S. benefit is expected. The increase in the first three quarters of 2008 over the same period of the prior year was due in large part to an ongoing examination of a subsidiary’s income tax filings in the United Kingdom. The effective income tax rates differed from statutory rates primarily due to the impairment of long-term strategic investments and long-term assets, 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.

LIQUIDITY AND CAPITAL RESOURCES

We generated cash of $4.2 million in operating activities during the nine months ended September 30, 2008. This cash inflow was primarily a result of a net income after adjusting for non-cash charges of $4.2 million, a decrease in accounts receivable of $5.5 million, and a decrease in prepaid expenses and other receivables of $0.5 million, partially offset by cash outflows resulting from a decrease in accounts payable and accrued liabilities of $1.6 million, a decrease in deferred revenue of $0.2 million, and a decrease in accrued restructuring charges of $4.2 million. The reduction in accounts payable and accrued liabilities was the result of the pay down of accruals related to third party royalties, as well as the timing of accruals related to employee compensation. Our average days sales outstanding at September 30, 2008 was 57 days, which represents a decrease from the 62 days that we reported at June 30, 2008. The overall decrease in days sales outstanding from June 30, 2008 was mainly due to higher in-quarter collections due to improved sales linearity compared to the second quarter of 2008. For purposes of calculating average days sales outstanding, we divide ending accounts receivable by the applicable quarter’s 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 customer’s 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 the first nine months of 2008, we used $0.9 million of cash related to investing activities, primarily related the investment of $0.9 million in property and equipment, largely for computer hardware upgrades throughout our organization and $0.6 million in other long-term assets related to capitalized costs associated with subletting space in our Canadian facility, partially offset by $0.6 million of cash provided by long-term deposits received from our subtenant in our Canadian facility.

As of September 30, 2008, our cash and cash equivalents in the amount of $23.4 million provided our principal sources of liquidity. Overall, we used $2.0 million in cash and cash equivalents during the third quarter of 2008, while generating $2.9 million in the first nine months of 2008, despite the expenditure of $1.4 million and $4.2 million, respectively, to satisfy obligations under our restructuring accruals during those periods. 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.

 

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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 $15.1 million of accrued restructuring charges at September 30, 2008 through fiscal 2011. This amount is net of expected sublet recoveries on restructured facilities of $2.9 million. The gross operating lease obligations for these restructured facilities are detailed 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 September 30, 2008 is as follows:

 

     Payment Due by Period
     Total    Less than
1 Year
   1-3
Years
   3-5
Years
   More than
5 Years
     (in thousands)

Operating lease obligations—currently utilized facilities and equipment

   $ 19,655    $ 4,218    $ 5,216    $ 4,906    $ 5,315

Operating lease obligations—restructured facilities

     18,034      6,664      11,370      —        —  

2008 Entrust Deferred Retention Bonus Plan

     1,492      1,120      372      —        —  

Other commitments

     303      303      —        —        —  
                                  

Total

   $ 39,484    $ 12,305    $ 16,958    $ 4,906    $ 5,315
                                  

In addition to the lease commitments included above, we have provided letters of credit totaling $1.8 million as security deposits in connection with certain office leases.

Other commitments include financing arrangements entered into for the purpose of funding annual insurance premiums, with a remaining balance as of September 30, 2008 of $303 thousand, to be paid during fiscal 2008 and 2009.

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 employee’s 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. Further, the Compensation Committee approved additional awards under this plan, which were granted in November 2008. These awards could potentially result in additional payments totaling $548 thousand over the five subsequent quarters, assuming that all employees receiving awards remain employed with us for the entire vesting period of the awards. Of these amounts, it was estimated that, as of November 6, 2008, $1.3 million was remaining to be paid out under this plan.

 

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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 September 30, 2008.

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 September 30, 2008.

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.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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 fair value of investments, classified as cash equivalents, entered into for purposes other than trading purposes, of $4.8 million, that would have been subject to interest rate risk, approximated amortized cost at September 30, 2008.

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 period-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 the net earnings of these operations, denominated in local currencies, 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,

 

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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 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 $3.4 million in the first nine months of 2008, when compared to the same period in 2007, 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 $0.5 million for the first nine months of 2008, when compared to same period in 2007.

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 subsidiary’s 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. We did not engage in any forward contracts to purchase Canadian dollars to cover exposures on expenses denominated in Canadian dollars in the third quarter of 2008. No previously purchased foreign exchange contracts had extended past June 30, 2008. Subsequent to September 30, 2008, we have engaged in forward contracts to purchase Canadian dollars covering exposures on approximately $3.0 million of our Canadian subsidiary’s expenses denominated in Canadian dollars in the fourth quarter of 2008. The Company currently has not engaged in any forward contracts to purchase Canadian dollars to cover exposures on expenses denominated in Canadian dollars in future periods beyond the fourth quarter of 2008.

 

ITEM 4. CONTROLS AND PROCEDURES

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 most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

The Company is subject, from time to time, to various 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 legal matters will have a material adverse effect on the Company’s consolidated results of operations or consolidated financial position. Certain legal proceedings in which we are involved are discussed in Part 1. Item 3. of our Annual Report on Form 10-K for the year ended December 31, 2007. Unless otherwise indicated, all proceedings in that earlier Report remain outstanding.

 

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ITEM 1A. RISK FACTORS

Information concerning certain risks and uncertainties appears in Part I, Item 1A “Risk Factors” of the Company’s 2007 Form 10-K. You should carefully consider these risks and uncertainties before making an investment decision with respect to shares of our Common stock. Such risks and uncertainties could materially adversely affect our business, financial condition or operating results.

There have been no material changes to the Risk Factors disclosed in our annual report on Form 10-K for the year ended December 31, 2007, except for the risk factor “Continued disruption in U.S. and international economic conditions and credit markets may adversely affect our business, financial condition and results of operation”, which has been added as follows:

Continued disruption in U.S. and international economic conditions and credit markets may adversely affect our business, financial condition and results of operation.

The global economy is currently experiencing a significant contraction, with an almost unprecedented lack of availability of business and consumer credit. This current decrease and any future decrease in economic activity in the United States, United Kingdom or in other regions of the world in which we do business could significantly and adversely affect our results of operations and financial condition in a number of ways. Any decline in economic conditions may reduce the demand for our products and services, thereby reducing our revenues and earnings. Our customers may also experience insolvencies, bankruptcies or similar events which may cause us to incur bad debt expenses at levels higher than historically experienced. Our suppliers may also experience insolvencies, bankruptcies or similar events which may cause us to lose access to support for third party software and hardware that is included in our products. In addition, the increased currency volatility could significantly and adversely affect our results of operations and financial condition. It could cause our prices to be more expensive in foreign markets, which could reduce the demand for our products and services. It could also result in higher reported costs, which might affect our profitability and, ultimately, our liquidity. Also, any of the above factors could adversely affect our ability to access credit or raise capital.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

 

ITEM 5. OTHER INFORMATION

Not applicable.

 

ITEM 6. EXHIBITS

 

Exhibit
Number

 

Description

31.1   Rule 13a-14(a) Certification of Chief Executive Officer.
31.2   Rule 13a-14(a) Certification of Chief Financial Officer.
32.1   Section 1350 Certification of Chief Executive Officer.
32.2   Section 1350 Certification of Chief Financial Officer.

 

* Management contract or compensatory agreement.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

  ENTRUST, INC.
  (Registrant)
Dated: November 6, 2008  

/s/ David J. Wagner

  David J. Wagner
  Chief Financial Officer and Senior Vice President
  (Principal Financial and Accounting Officer)

EXHIBIT INDEX

 

Exhibit
Number

 

Description

31.1   Rule 13a-14(a) Certification of Chief Executive Officer.
31.2   Rule 13a-14(a) Certification of Chief Financial Officer.
32.1   Section 1350 Certification of Chief Executive Officer.
32.2   Section 1350 Certification of Chief Financial Officer.

 

* Management contract or compensatory agreement.

 

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