Entrust 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the quarterly period ended March 31, 2008
For the transition period from to
Commission File Number 000-24733
(Exact name of registrant as specified in its charter)
ONE HANOVER PARK, SUITE 800
16633 DALLAS PARKWAY
ADDISON, TX 75001
(Address of principal executive offices & zip code)
Registrants telephone number, including area code: (972) 713-5800
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 61,268,351 shares of the registrants Common stock, par value $0.01 per share, outstanding as of May 5, 2008.
TABLE OF CONTENTS
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.
CONDENSED CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
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 three months ended March 31, 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 Companys Annual Report on Form 10-K for the year ended December 31, 2007.
NOTE 2. 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 non-recurring nonfinancial assets and nonfinancial liabilities. Non-recurring 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, indefinite lived intangible assets measured at fair value for impairment testing, asset retirement obligations initially measured at fair value, and those initially measured at fair value in a business combination.
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 liabilitys 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 SFAS No. 157 will not have a significant impact on the Companys consolidated financial position, results of operations or cash flows. However, 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.
On February 15, 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities: Including an amendment of FASB Statement No. 115, to reduce earnings volatility caused by related assets and liabilities measured differently under GAAP. SFAS No. 159 allows all entities to make an irrevocable instrument-by-instrument election to measure eligible items at fair value in their entirety. In addition, unrealized gains and losses will be reported in earnings at each reporting date. SFAS No. 159 also establishes presentation and disclosure requirements that focus on providing information about the impact of electing the fair value option. SFAS No. 159 is effective as of the beginning of the first fiscal year that begins after November 15, 2007, concurrent with the adoption of SFAS No. 157. The adoption of SFAS No. 159 will not have a significant impact on its consolidated financial position, results of operations or cash flows, as the Company did not elect the fair value option for any financial assets or liabilities.
NOTE 3. STOCK-BASED COMPENSATION
Compensation cost related to stock options, stock appreciation rights (SARs) and restricted stock units (RSUs) recognized in operating results was $1,043 and $1,305 in the three months ended March 31, 2008 and 2007, respectively.
The following table sets forth the related weighted-average assumptions, used to determine compensation cost for stock options and SARs.
Summary of activity for the three months ended March 31, 2008 under the Companys stock option plans is set forth below:
During the three months ended March 31, 2008, the amount of cash received from the exercise of stock options was $1.
At March 31, 2008, there was $2,880 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 months ended March 31, 2008 and 2007 was $751 and $966, respectively.
At March 31, 2008, there was approximately $916 of total unrecognized compensation cost related to non-vested RSUs granted under our stock plans. Compensation expense related to RSUs for the three months ended March 31, 2008 and 2007 was $292 and $339, respectively. During the first three 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 4. 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 three months ended March 31, 2008:
NOTE 5. 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 Companys 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 March 31, 2008:
June 2001 Restructuring Plan
On June 4, 2001, the Company announced a Board-approved restructuring plan to refocus on the Companys 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 Companys 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 to long-term liabilities. However, the current obligations would require the Company to fund $4,000 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 $2,600 in fiscal 2011.
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 March 31, 2008:
As of March 31, 2008, the Company had estimated a total of $8,300 of sublease recoveries in its restructuring accrual, related to the Santa Clara facility, recoverable under an existing sublease agreement.
NOTE 6. 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, under the treasury stock method for the three months ended March 31, 2008 and 2007 was 1,594,728 and 326,281 shares, respectively, which increased the weighted average common shares outstanding used in the computation. In addition, 10,931,003 and 6,564,164 out-of-the-money exercisable options that had exercise prices in excess of the average market price for the three months ended March 31, 2008 and 2007, respectively, were excluded from the computation of diluted net income (loss) per share in accordance with the treasury stock method.
In the three months ended March 31, 2008, the Company issued 131,723 shares of Common stock, related to the exercise of employee stock options and restricted stock units.
NOTE 7. MARKETABLE AND OTHER INVESTMENTS
The Company maintains marketable investments mainly in a strategic cash management account. This account is used to invest primarily in highly rated corporate securities, in securities guaranteed by the U.S. government or its agencies and highly rated municipal bonds, primarily with a remaining maturity of not more than 24 months. All such investments are classified as held to maturity investments, and are stated at amortized cost. The Company did not hold any short term marketable investments as of March 31, 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 this 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 subsidiarys expenses that are denominated in Canadian dollars, in an attempt to reduce earnings volatility that might result from fluctuations in the exchange rate between the Canadian and U.S. dollar. During the first quarter of 2008, the Company engaged in forward contracts to purchase Canadian dollars, covering exposures on approximately $3.0 million of its Canadian subsidiarys expenses denominated in Canadian dollars. None of these contracts extended past March 31, 2008 and no previously purchased foreign exchange contracts had extended past December 31, 2007. Subsequent to March 31, 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 second 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 second 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 Companys 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 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 March 31, 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 March 31, 2008 represented approximately 14% of the voting share capital of Ohana. The carrying value of the Companys investment in Ohana at March 31, 2008 was $91.
The Company also holds an equity interest in Asia Digital Media Limited (Asia Digital Media), which at March 31, 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 Companys investment in Asia Digital Media at March 31, 2008 and 2007. The Company recorded no revenues from Asia Digital Media for the three months ended March 31, 2008 and 2007.
NOTE 8. SEGMENT AND GEOGRAPHIC 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 Companys 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.
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:
NOTE 9. COMPREHENSIVE INCOME (LOSS)
The components of comprehensive income (loss) are as follows:
NOTE 10. 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 Companys 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 11. RECENTLY ISSUED ACCOUNTING STANDARDS
In March 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 161, Disclosures about Derivative Instruments and Hedging Activitiesan 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 entitys 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 Companys 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.
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.
As a trusted security expert, Entrust secures digital identities and information through 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 Entrusts world-class solutions.
We conduct business in one operating segment. We develop, market and sell software solutions that secure digital identities and information. We also perform professional services to 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, Entrusts market leadership and expertise in delivering award-winning identity and data protection management software solutions is demonstrated by the diversity of its products, geographic representation, and customer segments. We continue to drive revenue in our key products.
We have three key layered approaches that we take to our customers; our Layered Consumer, Enterprise and Government Security Architectures. These layered approaches to security help give our customers a roadmap for building security across their enterprise and customer facing applications, and for governments, citizens facing applications. The layered approach allows our customers to customize the level of security to the value of the data or transaction. A layered security strategy from a single, trusted vendor affords security-conscious organizations a level of synergy, interoperability and cost-effectiveness unmatched by a collection of third-party products. Further, layered security models foster environments of easy-to-use security solutions that increase end-user acceptance and reduce help-desk calls. Entrust has attractive capabilities in the market to assist our customers with their growing identity and information protection needs.
Our Layered Consumer Architecture approach consists of six layers:
Our Layered Enterprise Architecture approach consists of five layers:
Entrust has three key platforms, Authentication and Transaction Monitoring, Information Protection and Public Key which support our layered security architectures. We have a unique end-to-end platform for securing digital identities and information. This end-to-end software platform is easy to implement, user friendly and cost effective with the ability to evolve over time to grow with our customers needs.
Authentication and Transaction Monitoring, 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 its authentication platform so that specific methods can be used with specific users and applications. First steps can be as simple as deploying SSL certificates or user name and password. Entrust has long played a key role in this space through our SSL and single sign-on products. Risk-Based Authentication, however, goes much deeper than SSL and single sign-on. Risk-Based Authentication has the ability to judge each individual transaction on its own merits driven by policy level decisions on the level of risk associated with certain transactions. With Entrusts Risk-Based Authentication solution, transactions can be monitored in real time and then a determination can be made on the level of security required for that transaction. This is done through the combination of Entrust IdentityGuard and Entrust TransactionGuard. This combined offering is a modern architecture for consumer authentication which has a layered approach of non-invasive anomaly detection and selective intervention with minimal impact on the user experience.
Product Category Financial Metrics:
These three categories are how we report our product revenue externally, but do not directly correlate to our three platforms that we use with customers.
We also provide support and maintenance services to our customers. Support and maintenance revenue made up nearly two-thirds of our total services revenues in Q1 of 2008, achieving record Q1 levels. It is important to note that we achieved record renewals in the first quarter of 2008 of over 96% in terms of customer retention rate. The customer retention rate and the associated dollar value renewals were over 96 percent in the quarter. We also provide professional services, including architecture, installation, and integration services related to the products that we sell. Our support and maintenance revenues have shown consistent steady growth increasing 13% over Q1 last year.
In Q1, 2008 deferred revenue increased $1.0 million, to $28.9 million from $27.9 million at year-end 2007. The increase in deferred revenue was driven by an increase in subscription product bookings and support and maintenance renewals. These numbers show the continued strength of our support and maintenance renewals and the growth in our subscription based software bookings.
In the first quarter of 2008, Entrust achieved an improvement of $0.02 per share from first quarter of 2007. During 2007, we 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 Q1 2008. This unfavorable shift in exchange rates has cost Entrust $3.5 million in additional reported expense in 2007 and an additional $2.3 million in Q1 of this year.
Entrust sells its solutions globally, with an emphasis on North America, Europe and Asia. These primary areas have demonstrated the most potential for early adoption of the broadest set of Entrust solutions. Entrust extends to other non-core geographies through strategic partner relationships, which increases the leverage of our direct sales channel worldwide. In North America, Entrust is targeting a return to revenue growth in its software business by leveraging Entrusts historical strength in selling to key verticals such as government (Federal, State, Provincial), financial services and global 1000 enterprises. Europe and the Middle East are regions where Entrusts products and solutions continue to experience strong demand and we believe that this market will provide growth, with increased momentum from governments and enterprises leveraging Entrusts solutions to transform their business processes and to leverage the Internet and networking applications.
We market and sell our products and services in both the enterprise and government market space. In Q1, 2008, 53% of our product sales were in our extended government vertical market, which includes healthcare. This revenue has been driven by key global projects that have started to increase product purchases. In the extended government vertical market, we have a strong penetration in the U.S. Federal government, the governments of Canada, Singapore, Denmark, the United Kingdom, Kingdom of Saudi Arabia and across continental Europe. In fact, Entrust now counts 17 of the top 22 e-governments, as set forth in a report of Accenture issued in June 2007, as customers.
A key change in the government space has been the movement from purely internal security solutions that our customers require to more external citizen facing applications. These projects include ePassports, national ID programs, eBorders, physical and logical access programs for government employees, and a growing number of citizen facing applications. Security is at the core of all these projects and our wide product set positions Entrust well in this space. We have already announced six ePassport projects that Entrust has won and we have been selected as the infrastructure for a number of national ID and Ministry of Defense programs. In 2007, we won national PKI infrastructures in the Kingdom of Saudi Arabia, Brunei
and Slovenia. Specifically, we had a one million dollar transaction in the 3rd 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.
In Q1, 2008, 47% of our product sales were in our extended enterprise vertical market. We continue to see demand from global enterprises as they continue to respond to regulatory and governance compliance demands and extend their internal and external networks to more and more individuals inside and outside their domain. We have experienced a change in the shape of many enterprise deals. Specifically, enterprises are buying for their immediate need and then adding to their purchases as the projects begin roll out.
Our largest vertical within the enterprise market is the financial services vertical. In the first quarter of 2008, financial services accounted for 34% of product revenue. In this quarter, we had very good success in the financial vertical with our Risk Based Authentication solutions where we delivered for two top global financial institutions.
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 Q1, 2008, Risk Based Authentication product revenue was $2.2 million. The key driver for our Risk Based Authentication platform is Entrust IdentityGuard. In the first quarter, Entrust IdentityGuard transactions increased to 56, up 65%, from 34 in Q1, 2007. New customer acquisition was also strong in Q1with 27 of the 56 transactions coming from new customers.
As of March 31, 2008, we have gone well over 10.0 million licensed users of IdentityGuard and have gone over $13.0 million in total sales of the solution. IdentityGuards low cost point, its simplicity for the mass market, and its effectiveness in countering online theft and phishing, are the key drivers for the increased revenue growth we are experiencing. Along with the revenue growth for second factor authentication, we are also seeing customers increasingly interested in data protection and encryption. With a combination of Entrust IdentityGuard, GetAccess and TruePass, customers can accomplish authentication and role based access control, digital signature, and encryption from one solution provider.
In the first quarter of 2007, Entrust introduced the industrys first $5 one-time-passcode (OTP) security token. In the second quarter 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. In this quarter, we received customer commitment on our largest IdentityGuard token deal, which is for 500,000 tokens over the next three years.
In April 2006, Entrust introduced a Managed Public Key Infrastructure (PKI) service. This service was launched in response to customer requests for Entrust to offer a hosted service to give them a choice between a service offering for PKI certificates and our traditional PKI software purchase option. Our service offering is designed to help enterprises and government agencies grow and accelerate their core business security, without having to develop PKI expertise internally. In December 2006, the Entrust managed PKI service made the General Services Administration (GSA) list of approved shared service providers. This status enables Entrust to help federal agencies reap the security benefits of PKI without having to maintain the certification authority (CA) themselves. In Q3, 2007, we became the primary supplier for the US Federal Governments General Services Administration HSPD-12 directive. In Q1 of 2008, we achieved record bookings of over $1.0 million and captured two Fortune 200 accounts.
Our managed service is not our first entrance into the services business. We have been helping our customers for years design, deploy and manage our solutions. We have also been successful in growing our
SSL certificate business, which increased 41% in the first quarter over last year and achieved record order bookings. With the introduction of the new Extended Validation SSL Certificates and Unified Communications Certificates we should be able to grow this business into 2008.
Entrust in the past has relied significantly on large deals, meaning deals of $1 million or more, in each quarter. We have over the past few years reduced this dependence, but they remain a significant portion of our product revenue on a quarterly basis. Our software revenue from our top five customers in Q1, 2008 was approximately 11% of our total revenue in the quarter and we did not have a product deal over $1 million in the quarter. 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, over 90 percent of our product revenue came from transactions under $500 thousand. This shift in our business model to more, smaller transactions has reduced our dependence on deals over $500 thousand.
We continue to be impacted from time to time on our software revenue by the timing of our customers buying process, which may include proof of concepts, senior management reviews and budget delays that sometimes results in longer than anticipated sales cycles. We are also impacted by our customers recent buying behavior, which is to buy only for immediate need as opposed to making a larger purchase in order to get a better discount. Any of these factors may impact our revenue on a quarterly basis.
Our management uses the following metrics to measure performance:
During the first quarter of 2008, we continued our strategy of focusing on core vertical and geographic markets. Revenues of $25.8 million represented a 5% increase from the first quarter of 2007, and consisted of 37% product sales and 63% services and maintenance. Services and maintenance revenues increased 5% from the first quarter of 2007, due to increased demand for both consulting services and support and maintenance services, while product revenues also increased 5% from the first quarter of 2007, driven by an improved product transaction closure rate, despite a lower average purchase value, compared to the same quarter of 2007. Net loss for the first quarter of 2008 was $1.2 million, or $0.02 per share, compared to net loss of $2.4 million, or $0.04 per share for the same period of 2007, with total expenses decreasing 1% to $27.1 million. We generated $2.5 million in cash flow from operations in the first quarter of 2008, compared to net cash used in operations of $2.5 million in the same quarter of 2007. Entrust Emerging Growth Products (Entrust IdentityGuard, Boundary Messaging and Fraud Detection) accounted for 27% of product revenue, which is an increase of 13% from Q1, 2007 and 5% from Q4, 2007. Entrust PKI Products accounted for 70% of product revenue, which is an increase of 6% from Q1, 2007 and 1% from Q4, 2007. Entrust Certificate Services revenues, a component of our PKI Product solutions suite, increased 41% over Q1, 2007 and 4% over Q4, 2007. Entrust Single Sign-On Products accounted for 3% of product revenue, which is a decrease of 41% from Q1, 2007 and 71% from Q4, 2007. Extended Government accounted for 53% and Extended Enterprise accounted for 47% of the product revenue in the quarter. The financial vertical accounted for approximately 34% of first quarter 2008 product revenues, an increase of 84% over Q1, 2007 and a decrease of 6% from Q4, 2007.
Other highlights from the first quarter of 2008 included:
CRITICAL ACCOUNTING POLICIES
The preparation of our financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We believe our estimates and assumptions are reasonable. However, actual results and the timing of the recognition of such amounts could differ from those estimates.
In the first 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 shipped (if there are no significant remaining vendor obligations), collection of the receivable is reasonably assured, the fees are fixed and determinable and payment is due within twelve months. Revenues from license agreements requiring the delivery of significant unspecified software products in the future are accounted for as subscriptions and, accordingly, are recognized ratably over the term of the agreement from the first instance of product delivery. License revenues are generated both through direct sales to end users as well as through various partners, including system integrators, value-added resellers and distributors. License revenue is recognized when the sale has occurred for an identified end user, provided all other revenue recognition criteria are met. We are notified of a sale by a reseller to the end user customer in the same period that the product is delivered through to the end user customer. We do not offer a right of return on sales of our software products.
We do not generally include acceptance provisions in arrangements with customers. However, if an arrangement includes an acceptance provision, we recognize revenue upon the customers acceptance of the product, which occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.
For all sales, we use a binding contract, purchase order or another form of documented agreement as evidence of an arrangement with the customer. Transactions with our distributors are evidenced by a master
agreement governing the relationship, together with binding purchase orders on a transaction-by-transaction basis. We consider delivery to occur when we ship the product, so long as title and risk of loss have passed to the customer. If an arrangement includes undelivered products or services that are essential to the functionality of the delivered product, delivery is not considered to have occurred until these products or services are delivered.
At the time of a transaction, we assess whether the sale amount is fixed or determinable based upon the terms of the documented agreement. If we determine the fee is not fixed or determinable at the outset, we recognize revenue when the fee becomes fixed and determinable. We assess if collection is reasonably assured based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection is not reasonably assured, we do not record revenue until such time as collection becomes probable, which is generally upon the receipt of cash.
We are sometimes subject to fiscal funding clauses in our software licensing transactions with the United States government and its agencies. Such clauses generally provide that the license is cancelable if the legislature or funding authority does not appropriate the funds necessary for the governmental unit to fulfill its obligations under the licensing arrangement. In these circumstances, software licensing arrangements with governmental organizations containing a fiscal funding clause are evaluated to determine whether the uncertainty of a possible license arrangement cancellation is remote. If the likelihood of cancellation is assessed as remote, then the software licensing arrangement is considered non-cancelable and the related software licensing revenue is recognized when all other revenue recognition criteria have been met.
For arrangements involving multiple elements, we allocate revenue to each component based on the vendor-specific objective evidence of the fair value of the various elements. These elements may include two or more of the following: software licenses, maintenance and support, consulting services and training. For arrangements where vendor-specific objective evidence is not available for a delivered element, we first allocate the arrangement fee to the undelivered elements based on the total fair value of those undelivered elements, as indicated by vendor-specific objective evidence. This portion of the arrangement fee is deferred. Then the difference (residual) between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements. We attribute the discount offered in a multiple-element arrangement entirely to the delivered elements of the transaction, which are typically software licenses. Fair values for the future maintenance and support services are based upon substantially similar sales of renewals of maintenance and support contracts to other customers. Fair value of future services, training or consulting services is based upon substantially similar sales of these services to other customers. In some instances, a group of contracts or agreements with the same customer may be so closely related that they are, in effect, part of a single multiple-element arrangement, and therefore, we would undertake to allocate the corresponding revenues amongst the various components, as described above.
We also eliminate intercompany profits on revenue transactions with unconsolidated subsidiaries that are accounted for under the equity method to the extent of our ownership interest in that related party, if the product and/or services have not been sold through to an unrelated third party end-user customer.
Our consulting services generally are not essential to the functionality of the software. Our software products are fully functional upon delivery and do not require any significant modification or alteration. Customers purchase these consulting services to facilitate the adoption of our technology and dedicate personnel to participate in the services being performed, but they may also decide to use their own resources or appoint other consulting service organizations to provide these services. When the customization is essential to the functionality of the licensed software, then both the software license and consulting services revenues are recognized under the percentage of completion method, which requires revenue to be recognized based upon the percentage of work effort completed on the project.
Allowance for Doubtful Accounts
We maintain doubtful accounts allowances for estimated losses resulting from the inability of our customers to make required payments. We assess collection based on a number of factors, including previous transactions with the customer and the creditworthiness of the customer. We do not request collateral from our customers.
We base our ongoing estimate of allowance for doubtful accounts primarily on the aging of the balances in the accounts receivable, our historical collection patterns and changes in the creditworthiness of our customers. Based upon the analysis and estimates of the uncollectibility of our accounts receivable, we record an increase in the allowance for doubtful accounts when the prospect of not collecting a specific account receivable becomes probable. The allowance for doubtful accounts is established based on the best information available to us and is re-evaluated and adjusted as additional information is received. We exhaust all avenues and methods of collection, including the use of third party collection agencies, before writing-off a customer balance as uncollectible. While credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Each circumstance in which we conclude that a provision for non-payment by a customer may be required must be carefully considered in order to determine the true factors leading to that potential non-payment to ensure that it is proper for it to be categorized as an allowance for bad debts.
However, a significant change in the financial condition of a major customer, such as the European distributor discussed below, could have a material impact on our estimates regarding the sufficiency of our allowance. Our accounts receivable include material balances from a limited number of customers, with five customers accounting for 25% of gross accounts receivable at March 31, 2008, compared to 27% of gross accounts receivable at March 31, 2007. No customer accounted for 10% or more of net accounts receivable at March 31, 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 of $0.9 million, which accounted for the majority of the $1.0 million increase in this provision for that year. These balances remain outstanding and, as a result, the allowance for doubtful accounts remains substantially unchanged from the end of 2006 for these items, other than to adjust for the effect of changes in foreign exchange rates. However, the allowance for doubtful accounts did increase by approximately $300 thousand in 2007 to provide for miscellaneous accounts that have continued to age from the end of 2006 and the earlier quarters of 2007. The allowance for doubtful accounts remains substantially unchanged from the end of 2007.
Provision for Income Taxes
The preparation of our consolidated financial statements requires us to assess our income taxes in each of the jurisdictions in which we operate, including those outside the United States. In addition, we have based the calculation of our income taxes in each jurisdiction upon inter-company agreements, which could be challenged by tax authorities in these jurisdictions. The income tax accounting process involves our determining our actual current exposure in each jurisdiction together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue and accrued restructuring charges, for tax and accounting purposes. These differences result in the recognition of deferred tax assets and liabilities. We then record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized.
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. We recorded a valuation allowance of $156.0 million as of December 31, 2007, which offsets deferred income tax assets relating to United States and foreign net operating loss (NOL) and tax credit carry-forwards in the amount of $129.3 million and $26.7 million of deferred tax assets resulting from temporary differences. This valuation allowance represents the full value of our deferred tax assets, due to uncertainties related to
our ability to utilize our deferred tax assets as a result of our recent history of financial losses. Therefore, our balance sheet includes no net deferred tax benefits related to these deferred tax assets. Valuation allowances are provided against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and the timing of the temporary differences becoming deductible. We consider, among other available information, historical earnings, scheduled reversals of deferred tax liabilities, projected future taxable income, prudent and feasible tax planning strategies and other matters in making this assessment. Until an appropriate level of profitability is sustained, we expect to continue to record a full valuation allowance and will not record any benefit from the deferred tax assets.
Accounting for Uncertain Tax Positions
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109, (FIN No. 48), which clarifies the accounting for uncertainty in tax positions. FIN No. 48 requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not of not being sustained on audit, based on the technical merits of the position. FIN No. 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. The provisions of FIN No. 48 were effective for us as of the beginning of our 2007 fiscal year.
We adopted the provisions of FIN No. 48 on January 1, 2007. As a result of the implementation of FIN No. 48, we were not required to record a liability for unrecognized tax benefits, resulting in no adjustment to the January 1, 2007 accumulated deficit balance. Correspondingly, the amount of unrecognized tax benefits at January 1, 2007 was zero and, thus, did not impact our effective tax rate. The amount of unrecognized tax benefits did not change as of March 31, 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, 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 March 31, 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.
Purchased product rights, customer relationships, partner relationships and non-competition agreements of key personnel of acquired companies totaling $10.9 million at March 31, 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 required significant judgment and estimation regarding the amount and timing of future revenues and related expenses associated with these acquired assets.
In addition, we have a net balance of $3.7 million from our investment in other long-term assets at March 31, 2008, which consist primarily of capitalized software development costs, which includes costs to develop video based training, for both general security and Entrust specific solutions, for sale to our customers. These capitalized costs are amortized ratably as the underlying revenues are recognized on sales of capitalized software or over a three year period. The economic useful life of these capitalized software development costs is periodically re-assessed.
We are not aware of any impairment events during the three months ended March 31, 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 investment in these assets, which would have a significant impact on our consolidated financial position and results of operations.
Our stock award program is a broad-based, long-term retention program that is intended to contribute to our success by attracting, retaining and motivating talented employees and to align employee interests with the interests of our existing shareholders. Stock based awards may be granted to employees when they first join us, when there is a significant change in an employees responsibilities and, occasionally, to achieve equity within a peer group. Stock based awards may also be granted in specific circumstances for retention or reward purposes. The Compensation Committee of the Board of Directors may, however, grant additional awards to executive officers and key employees for other reasons. Under the stock based award plans, the participants may be granted options to purchase shares of Common stock and substantially all of our employees and directors participate in at least one of our plans. Options issued under these plans generally are granted at fair market value at the date of grant and become exercisable at varying rates, generally over three or four years. Options issued before April 29, 2005 generally expire ten years from the date of grant; awards issued on or after April 29, 2005 generally expire seven years from the date of grant.
In addition, we use restricted stock units (RSUs) and stock appreciation rights (SARs) in incentive compensation plans for employees and members of the Board of Directors, in place of, or in combination with stock options to purchase shares of our stock. RSUs allow the employees to receive our Common stock once the units vest. The RSUs generally vest over two to four years.
Beginning in 2006, the Compensation Committee of the Board of Directors has issued performance stock units to certain key employees. These performance grants are based on the achievement of certain pre-determined criteria such as budgeted level of revenue attainment or target stock price. The associated compensation expense for awards with performance conditions is accrued over the service period when that the performance criteria are reasonably certain to be achieved. Compensation cost for an award with a market condition will be recognized ratably for each vesting tranche over the requisite service period in a similar manner as an award with a service condition.
We recognize that stock options and other stock-based incentive awards dilute existing shareholders and have attempted to control the number granted while remaining competitive with our compensation packages. Accordingly, from 2003 to 2005 we reduced our gross stock option grant rate, which contributed to a low net grant rate under our stock-based incentive plans during that time. In 2006 the gross grant rate increased for a number of reasons including issuing employee equity pursuant to two acquisitions and hiring a key executive. The equity plan overhang also increased as a result of assuming the equity plan of one acquired company. In 2007 we returned to our practice from 2003 to 2005 of reducing our gross stock option grant rate and keeping a low net grant rate. The Compensation Committee of the Board of Directors oversees the granting of all stock-based incentive awards.
SFAS No. 123(R) requires us to measure compensation cost for stock awards at fair value and recognize compensation expense over the service period for awards expected to vest. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating awards expected to vest including type of awards, employee class, and our historical experience. Actual results, and future changes in estimates, may differ substantially from our current estimates.
We use the Black-Scholes option pricing model to determine the fair value of our stock options. The determination of the fair value of stock-based awards using an option pricing model is affected by our stock price as well as assumptions regarding a number of subjective variables. Changes in the input assumptions can materially affect the fair value estimate of our stock options. Those assumptions include estimating the expected volatility of the market price of our common stock over the expected term, the expected term of the award, the risk free interest rate expected during the option term and the expected dividends to be paid.
We have reviewed each of these assumptions and determined our best estimate for these variables. Of these assumptions, the expected volatility of our common stock is the most difficult to estimate since it is based on expected performance of our common stock. We use the implied volatility of historical market prices for our common stock on the public stock market to estimate expected volatility. An increase in the expected volatility, expected term, and risk free interest rate, all will cause an increase in compensation expense. The dividend yield on our common stock is assumed to be zero since we do not pay dividends and have no current plans to do so in the future.
For the three months ended March 31, 2008 compensation expense of $1.0 million was recognized for stock options, RSUs and SARs. Total remaining compensation estimated to be recognized over the remaining service periods for these awards is $3.6 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 March 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 161, Disclosures about Derivative Instruments and Hedging Activitiesan 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 entitys 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.
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:
Total revenues for the three months ended March 31, 2008 were $25.8 million, which represented an increase of 5% from the $24.6 million of total revenues for the same period in 2007. Total revenues derived from North America of $17.2 million in the first quarter of 2008 represented a decrease of 4% from the $17.9 million in the first quarter of 2007. Total revenues derived from outside of North America of $8.6 million for the first quarter of 2008 represented an increase of 28% from the $6.7 million for the first quarter of 2007.
The increase in total revenues for the three months ended March 31, 2008, compared to the same period in 2007, was driven equally by product and services revenue, which both increased by 5%. The increase in product revenue from a year ago is primarily due to the strong product revenue contribution from our Risk Based Authentication solutions and our subscription based PKI businesses, especially with global governments and financial institutions, which represented 53% and 34% of our product revenues, respectively. Subscription based product and services revenues accounted for 51% of total revenues for the first quarter of 2008, an increase of 15% from the first quarter of 2007. However, the extended government market in the US decreased to $4.4 million for the three months ended March 31, 2008 from $4.7 million for the same period in 2007, representing a 6% decrease. The United States and Canadian governments each represented 11% of total revenues for the first three 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 7% and 10% of total revenues in the first quarter of 2008, respectively. No other individual customer accounted for 10% or more of total revenues in the three months ended March 31, 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 three 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.
Product revenues of $9.6 million for the three months ended March 31, 2008, represented an increase of 5% from the $9.1 million for the three months ended March 31, 2007. These revenues represent 37% of total revenues in each of the three months ended March 31, 2008 and 2007. The increase in the first quarter of 2008 when compared to the same period in 2007 was driven by the need of global governments for strong authentication and PKI based solutions and financial institutions demand for risk based authentication. The growth is due in large part to our emerging growth products; namely IdentityGuard, Boundary Messaging and Fraud Detection, which accounted for $2.6 million, or 27% of product revenue, up 13% from the first quarter of 2007. Entrust IdentityGuard continued to show strength, achieving its highest quarterly revenue and number of transactions, which increased to 57 this quarter, up from 34 in the first three months of 2007. In addition, our revenue from PKI products in the first quarter of 2008 increased to $6.8 million or 70% of product revenues, up 6% over the same period of last year. The growth in PKI was driven primarily by Entrust certificate services (SSL certificates) which increased 41% to $2.2 million of revenue in the first quarter of 2008, compared to the same quarter of 2007.
Our 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) grew to 136 for the three months ended March 31, 2008, up from 113 for the same period in 2007, or a 20% increase, with 31% of the transactions in the first quarter of 2008 being from new customers. However, the average product revenue transaction size decreased from $61 thousand in the first quarter of 2007 to $50 thousand for the same period in 2008, or a decrease of 18%. 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 quarter of 2008 compared to the same quarter last year. Revenue from deals under $500 thousand increased 13% from the same quarter a year ago, and is continuing to drive our strategy of being less reliant on large deals. These transactions accounted for 90% of product revenue in the first quarter of 2008. Further, there were no product deals greater than $1 million in the first quarter of 2008, compared to one 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 three months ended March 31, 2008 equaled the same period in 2007 at 11%. 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.
Product revenues as a percentage of total revenues for the three months ended March 31, 2008 remained consistent compared to the same period in 2007.
Services and Maintenance Revenues
Services and maintenance revenues of $16.2 million for the three months ended March 31, 2008 represented an increase of 5% from the $15.5 million for the same period in 2007, representing 63% total revenues in each of the respective periods. The increase in services and maintenance revenues for the first quarter in 2008 compared to the same quarter in 2007 is due to our continued strength in our subscription based support and maintenance revenues, despite a decline in our professional services revenues over the same period. Our customers continued to renew their support agreements at a rate of over 95% in the first quarter of 2008, increasing support and maintenance revenues by 13% when compared to the same quarter in 2007. Services and maintenance revenues as a percentage of total revenues for the three months ended March 31, 2008 remained consistent compared to the same period in 2007.
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 and general and administrative. Total expenses of $27.1 million for the three months ended March 31, 2008 represented a decrease of 1% from $27.3 million for the same period of 2007. The slight decrease in total expenses year over year from the first quarter of 2007 was the net effect of a 10% decrease in our overall headcount, as we continue to manage our headcount resources carefully, offset by 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 $2.3 million for the three months ended March 31, 2008. As of March 31, 2008 we had 452 full-time employees globally, compared to 500 full-time employees at March 31, 2007 and 455 employees at December 31, 2007.
COST OF REVENUES
Cost of Product Revenues
Cost of product revenues consists primarily of costs associated with our SSL and managed PKI businesses, product media, documentation, packaging and royalties to third-party software vendors. Cost of product revenues increased 33% to $2.4 million for the three months ended March 31, 2008, compared to $1.8 million for the three months ended March 31, 2007, representing 25% and 20% of product revenues for their respective periods. The increase in the cost of product revenues in absolute dollars and as a percentage of total product revenues from the first quarter of 2007 to the same quarter of 2008 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 unfavorable shift in the exchange rates between the U.S. and other major currencies resulted in increased reported expenses of $0.2 million for three months ended March 31, 2008 when compared to the same period in 2007.
Cost of Services and Maintenance Revenues
Cost of services and maintenance revenues consists primarily of personnel costs associated with customer support, training and consulting services, as well as amounts paid to third-party consulting firms for those services. Cost of services and maintenance revenues was $7.8 million for the three months ended March 31, 2008, which represented a 6% increase from $7.4 million for the three months ended March 31, 2007, representing 30% of total revenues for each of their respective periods.
The increase in cost of services and maintenance revenues in absolute dollars for the three months ended March 31, 2008, when compared to the same period in 2007, can be attributed primarily to the increased hardware and related support costs. The staff related costs remained fairly static despite a 6% decline in headcount for the first quarter of 2008 when compared to the same quarter of 2007. The effect of reduced headcount was largely 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 $0.6 million, the majority of which related to staffing costs. Services and maintenance expenses as a percentage of total revenues remained flat between the first quarter of 2008 and 2007 and was the net result of higher services and maintenance expenses for the three months ended March 31, 2008, which accounted for a two-percentage point increase, when compared to the same period in 2007, offset by higher total revenues, which resulted in a two-percentage point decrease in the services and maintenance expenses as a percentage of total revenues.
Services and maintenance gross profit as a percentage of services and maintenance revenues was 52% for each of the three months ended March 31, 2008 and 2007. This result was the net effect of an increase in services and maintenance gross profit as a percentage of services and maintenance revenues as a result of support and maintenance margins of 2%, offset by a corresponding 2% decline in professional services gross profit.
We plan to continue to optimize the utilization of existing professional services resources, while addressing incremental customer opportunities that may arise with the help of partners and other sub-contractors, until an investment in additional full-time resources is justifiable. This plan may have an adverse impact on the gross profit for services and maintenance, as the gross profit realized by using partners and sub-contractors is generally lower. The mix and volume of services and maintenance revenues may vary from period to period and from transaction to transaction, which will also affect our gross margins and results of operations.
Operating ExpensesSales and Marketing
Sales and marketing expenses decreased 4% to $8.7 million for the three months ended March 31, 2008 from $9.1 million for the three months ended March 31, 2007, representing 34% and 37% of total revenues in their respective periods.
The decrease in sales and marketing expenses for the three months ending March 31, 2008 when compared to the comparable period in 2007 was primarily due to lower staff related costs. Sales and marketing headcount decreased 9% overall when compared to one year ago, resulting in decreased compensation expenses for the first quarter of 2008, when compared to the same quarter of 2007. These decreased costs were 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 $0.5 million, the majority of which related to staffing costs. The decrease in sales and marketing expenses as a percentage of total revenues for the three months ended March 31, 2008 compared to the same period in 2007, reflects the lower expenses for the first quarter of 2008, which resulted in a one-percentage point decrease, combined with a two-percentage point decrease in sales and marketing expenses as a percentage of total revenues due to higher total revenues when compared to the same period 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 in the United States and abroad. We will continue to focus on our channels, with a view to providing the executive team time to focus on strategically growing the business. However, 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 quarter of 2008, the provision for doubtful accounts dropped a moderate $0.1 million to $1.9 million, due foreign exchange fluctuation.
Operating ExpensesResearch and Development
Research and development expenses were $4.7 million for the three months ended March 31, 2008 compared to $5.3 million for the same period in 2007, representing 18% and 22% of total revenues in the respective periods.
The decrease in research and development expenses for the three months ended March 31, 2008 when compared to the same quarter 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, significantly reducing our outside professional services expenses for the three months ended March 31, 2008, when compared to the same period in 2007. In addition, our internal research and development headcount decreased 14% year over year from the same quarter of last year. Offsetting these savings, we experienced a shift in exchange rates between Canada and the U.S. that resulted in higher reported costs of $0.7 million for the three months ended March 31, 2008, compared to the same quarter of 2007. The decrease in research and development expenses as a percentage of total revenues for the three months ended March 31, 2008, compared to the same period in 2007, primarily reflects the lower expenses in the first three months of 2008, which resulted in a three-percentage point decrease in research and development expenses as a percentage of total revenues. This effect was magnified by a one-percentage point decrease in research and development expenses as a percentage of total revenues due to higher total revenues for the three months ended March 31, 2008 when compared to the same period of 2007.
We believe that we must continue to maintain our investment in research and development in order to protect our technological leadership position, software quality and security assurance leadership. We therefore expect that research and development expenses may have to increase in the future.
Operating ExpensesGeneral and Administrative
General and administrative expenses were $3.1 million for the three months ended March 31, 2008 compared to $3.3 million for the same period in 2007, representing 12% and 13% of total revenues in the respective periods.
The decline in general and administrative expenses in absolute dollars for the three months ended March 31, 2008 compared to the same period in 2007 was due to the effect of continued management discipline in this area, with net savings of $0.2 million, primarily as a result of a 11% decline in headcount. Offsetting this decrease was an unfavorable shift in the exchange rates between the U.S. dollar and other major currencies resulting in higher reported expenses of $0.4 million, the majority of which related to staffing costs. General and administrative expenses as a percentage of total revenues decreased for the first quarter of 2008 compared to the same quarter of 2007, due to a one-percentage point decrease in general and administrative expenses as a percentage of total revenues because of the lower spending in this area combined with higher total revenues for the first three months of 2008 when compared to the same period in 2007.
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 $345 thousand for the three months ended March 31, 2008, compared to $332 thousand for the same period 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 $249 thousand for the first three months of 2008, compared to $266 thousand for the same period 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 $228 thousand was recorded as a component of sales and marketing expenses for the first three months of 2008 and 2007, respectively, while $38 thousand was recorded as a component of cost of services and maintenance revenues for each of the first three months of 2008 and 2007, respectively.
Interest income was $131 thousand for the three months ended March 31, 2008, compared to $180 thousand for the same period of 2007, representing 1% of total revenues for each of the respective periods. The decrease in investment income for the first quarter of 2008 compared to the same period 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 quarter of 2008 decreased compared to the same quarter of 2007, despite the fact that the funds available increased to $22.8 million at March 31, 2008 from $20.8 million at March 31, 2007.
Loss from Equity Investments
We recorded $77 thousand, net of intercompany profit eliminations, related to our investments in Asia Digital Media for the three months ended March 31, 2007. 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.
Gain on Sale of Strategic Long-term Investments
We recorded a gain on the sale of certain strategic long-term investments, in which we had a less than 10% ownership, during the first quarter of 2008, in the amount of $18, as a result of the adjustment of the proceeds of a sale consummated in 2007. This type of sale is not expected to be a recurring event.
Provision for Income Taxes
We recorded an income tax provision of $64 thousand for the three months ended March 31, 2008, compared to $52 thousand for the same period of 2007. These provisions represented primarily the taxes payable in certain foreign jurisdictions for which no U.S. benefit is expected. The effective income tax rates differed from statutory rates primarily due to the impairment of long-term strategic investments, stock option expenses, purchased product rights, restructuring charges, foreign research and development tax credits, as well as an adjustment of the valuation allowance that has offset the tax benefits from the significant net operating loss and tax credit carry-forwards available.
LIQUIDITY AND CAPITAL RESOURCES
We generated cash of $2.5 million in operating activities during the three months ended March 31, 2008. This cash inflow was primarily a result of a net income after adjusting for non-cash charges of $1.1 million, a decrease in accounts receivable of $1.7 million, an increase in deferred revenue of $1.2 million, and a decrease in prepaid expenses and other receivables of $0.7 million, partially offset by cash outflows resulting from a decrease in accounts payable and accrued liabilities of $0.8 million, and a decrease in accrued restructuring charges of $1.4 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 March 31, 2008 was 67 days, which represents a decrease from the 70 days that we reported at December 31, 2007. The overall decrease in days sales outstanding from December 31, 2007 was mainly due to higher in-quarter collections due to improved sales linearity compared to the fourth quarter of 2007. For purposes of calculating average days sales outstanding, we divide ending accounts receivable by the applicable quarters revenues and multiply this amount by 90 days. The level of accounts receivable at each quarter end is affected by the concentration of revenues in the final weeks of each quarter and may be negatively affected by expanded international revenues in relation to total revenues as licenses to international customers often have longer payment terms.
Any increase or decrease in our accounts receivable balance and days sales outstanding will affect our cash flow from operations and liquidity. Our accounts receivable and days sales outstanding may increase due to changes in factors such as the timing of when sales are invoiced and the length of customers payment cycle. Generally, international and indirect customers pay at a slower rate than domestic and direct customers, so that an increase in revenue generated from international and indirect customers may increase our days sales outstanding and accounts receivable balance. We have observed an increase in the length of our customers payment cycles, which may result in higher accounts receivable balances, and could expose us to greater general credit risks with our customers and increased bad debt expense.
During the first three months of 2008, we used $0.7 million of cash related to investing activities, primarily related the investment of $0.2 million in property and equipment, primarily for computer hardware upgrades throughout our organization and $0.5 million in other long-term assets related to capitalized costs associated with subletting space in our Canadian facility.
We generated cash of $0.6 million in financing activities during the three months ended March 31, 2008 primarily as a result of cash provided by long-term deposits received from our subtenant in our Canadian facility.
As of March 31, 2008, our cash and cash equivalents in the amount of $22.8 million provided our principal sources of liquidity. Overall, we generated $2.3 million in cash and cash equivalents during the first quarter of 2008. Although we continue to target operating profitability, based on sustainable revenue and operating expense structures, we estimate that we may continue to use cash in fiscal 2008 to satisfy the obligations provided for under our restructuring program.
However, if operating losses continue to occur, then cash, cash equivalents and marketable investments will be negatively affected.
While there can be no assurance as to the extent of usage of liquid resources in future periods, we believe that our cash flows from operations and existing cash and cash equivalents will be sufficient to meet our needs for at least the next twelve months.
In terms of long-term liquidity requirements, we will need to fund the $17.9 million of accrued restructuring charges at March 31, 2008 through fiscal 2011, as detailed below. This amount is net of expected sublet recoveries on restructured facilities of $8.3 million. The lease obligations included in these accrued restructuring charges are disclosed in the table of contractual commitments below. In addition, we expect to spend approximately $2.0 million per year on capital expenditures, primarily for computer equipment needed to replace existing equipment that is coming to the end of its useful life, a significant portion of which are expected to be procured under operating leases.
We believe that our existing cash and cash equivalents as well as future operating cash flows, will be sufficient to fund these long-term requirements.
We have commitments that will expire at various times through 2015. We lease administrative and sales offices and certain property and equipment under non-cancelable operating leases that will expire at various dates to 2015. A summary of our contractual commitments at March 31, 2008 is as follows:
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 March 31, 2008 of $322 thousand, to be paid during fiscal 2008.
The 2008 Entrust Deferred Retention Bonus Plan (the 2008 Deferred Plan) was adopted by the Compensation Committee of the Board of Directors on February 19, 2008. The primary objective of the 2008 Deferred Plan is to attract and retain valued employees by remunerating selected executives and other key employees with cash awards based on the contribution of the individual employee. The Compensation Committee, in its sole discretion, shall determine which employees are eligible to receive awards under the plan and shall grant awards in such amounts and on such terms as it shall determine. Subject to limited exceptions, an employees award under the plan shall vest in one-seventh of the amount of the award over the seven calendar quarters commencing on January 1, 2008, provided that the employee continues to be employed by us on each of such dates. During the first quarter of 2008, we granted awards to employees under the plan that potentially could result in payments of $1.5 million over the subsequent seven quarters, assuming that all employees receiving the awards remain employed with us for the entire seven quarter vesting period of the awards. Of this amount, it was estimated that, as of March 31, 2008, $1.3 million was remaining to be paid out under this plan.
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 March 31, 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 March 31, 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.
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 March 31, 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 these operations are not significant. However, because a disproportionate amount of our expenses are denominated in Canadian dollars, through our Canadian operations, while our Canadian denominated revenue streams are cyclical, we are exposed to exchange rate fluctuations in the Canadian dollar, and in particular, fluctuations between the U.S. and Canadian dollar. Therefore, a favorable change in the exchange rate for the Canadian subsidiary would result in higher revenues when translated into U.S. dollars, but would also mean expenses would be higher in a corresponding fashion and to a greater degree.
Historically, we have not engaged in formal hedging activities, but we do periodically review the potential impact of this foreign exchange risk to ensure that the risk of significant potential losses is minimized. However, as a significant portion of our expenses are incurred in Canadian dollars, our reported expense base increased by $2.3 million in the first quarter of 2008, when compared to the same quarter of 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 $0.3 million for the first quarter of 2008, when compared to same quarter of 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 subsidiarys expenses that are denominated in Canadian dollars, in an attempt to reduce earnings volatility that might result from fluctuations in the exchange rate between the Canadian and U.S. dollar. During the first quarter of 2008, we engaged in forward contracts to purchase Canadian dollars, covering exposures on approximately $3.0 million of our Canadian subsidiarys expenses denominated in Canadian dollars. None of these contracts extended past
March 31, 2008 and no previously purchased foreign exchange contracts had extended past December 31, 2007. Subsequent to year end, we have engaged in forward contracts to purchase Canadian dollars covering exposures on approximately $3.0 million of expenses denominated in Canadian dollars in the second quarter of 2008. We currently have not engaged in any forward contracts to purchase Canadian dollars to cover exposures on expenses denominated in Canadian dollars in future periods beyond the second quarter of 2008.
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
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 Companys 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.
There were no material changes to the Risk Factors disclosed in our annual report on Form 10-K for the year ended December 31, 2007.
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.