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Evolving Systems 10-Q 2012

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2

Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

x      Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended March 31, 2012

 

OR

 

o         Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from               to               

 

Commission File Number: 0-24081

 

EVOLVING SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

84-1010843

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

 

9777 Pyramid Court, Suite 100 Englewood, Colorado

 

80112

(Address of principal executive offices)

 

(Zip Code)

 

(303) 802-1000

(Registrant’s telephone number, including area code)

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

 

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

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting companyx

(Do not check if a 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

 

As of May 3, 2012 there were 11,221,879 shares outstanding of Registrant’s Common Stock (par value $0.001 per share).

 

 

 



EVOLVING SYSTEMS, INC.

Quarterly Report on Form 10-Q

March 31, 2012

Table of Contents

 

PART I — FINANCIAL INFORMATION

Item 1

Financial Statements

 

Condensed Consolidated Balance Sheets as of March 31, 2012 and December 31, 2011 (Unaudited)

 

Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2012 and 2011 (Unaudited)

 

Condensed Consolidated Statements of Other Comprehensive income for the Three Months Ended March 31, 2012 and 2011 (Unaudited)

 

Condensed Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for the Three Months Ended March 31, 2012 (Unaudited)

 

Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2012 and 2011 (Unaudited)

 

Notes to Unaudited Condensed Consolidated Financial Statements

Item 2

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Item 3

Quantitative and Qualitative Disclosures About Market Risk

Item 4

Controls and Procedures

 

PART II — OTHER INFORMATION

Item 1

Legal Proceedings

Item 1A

Risk Factors

Item 2

Unregistered Sales of Equity Securities and Use of Proceeds

Item 3

Defaults upon Senior Securities

Item 5

Other Information

Item 6

Exhibits

 

 

Signature

 

 

2



Table of Contents

 

PART I — FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

EVOLVING SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands except share data)

(unaudited)

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

13,775

 

$

34,290

 

Short-term restricted cash

 

52

 

50

 

Contract receivables, net of allowance for doubtful accounts of $77 and $52 at March 31, 2012 and December 31, 2011, respectively

 

3,114

 

4,540

 

Unbilled work-in-progress

 

1,760

 

1,361

 

Prepaid and other current assets

 

1,048

 

1,259

 

Interest receivable, long-term investments, related parties

 

785

 

357

 

Total current assets

 

20,534

 

41,857

 

Long-term investments, related party

 

17,225

 

16,448

 

Property and equipment, net

 

354

 

369

 

Amortizable intangible assets, net

 

503

 

584

 

Goodwill

 

16,328

 

15,782

 

Long-term restricted cash

 

 

2

 

Total assets

 

$

54,944

 

$

75,042

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current portion of capital lease obligations

 

$

9

 

$

8

 

Accounts payable and accrued liabilities

 

4,085

 

3,657

 

Income taxes payable

 

815

 

848

 

Dividends payable

 

558

 

22,271

 

Unearned revenue

 

2,599

 

3,401

 

Total current liabilities

 

8,066

 

30,185

 

Long-term liabilities:

 

 

 

 

 

Capital lease obligations, net of current portion

 

19

 

 

Deferred income taxes

 

415

 

145

 

Total liabilities

 

8,500

 

30,330

 

 

 

 

 

 

 

Commitments and contingencies (Note 10)

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.001 par value; 2,000,000 shares authorized; no shares issued and outstanding as of March 31, 2012 and December 31, 2011

 

 

 

Common stock, $0.001 par value; 40,000,000 shares authorized; 11,400,423 shares issued and 11,221,534 outstanding as of March 31, 2012 and 11,314,493 shares issued and 11,135,604 outstanding as of December 31, 2011

 

11

 

11

 

Additional paid-in capital

 

90,329

 

90,062

 

Treasury stock 178,889 shares as of March 31, 2012 and December 31, 2011, respectively at cost

 

(1,253

)

(1,253

)

Accumulated other comprehensive loss

 

(3,466

)

(4,247

)

Unrealized losses on investments, related parties, net of tax

 

200

 

(284

)

Accumulated deficit

 

(39,377

)

(39,577

)

Total stockholders’ equity

 

46,444

 

44,712

 

Total liabilities and stockholders’ equity

 

$

54,944

 

$

75,042

 

 

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

 

3



Table of Contents

 

EVOLVING SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands except per share data)

(unaudited)

 

 

 

For the Three Months Ended March 31,

 

 

 

2012

 

2011

 

REVENUE

 

 

 

 

 

License fees and services

 

$

3,784

 

$

3,143

 

Customer support

 

2,124

 

2,249

 

Total revenue

 

5,908

 

5,392

 

 

 

 

 

 

 

COSTS OF REVENUE AND OPERATING EXPENSES

 

 

 

 

 

Costs of license fees and services, excluding depreciation and amortization

 

1,818

 

1,234

 

Costs of customer support, excluding depreciation and amortization

 

360

 

687

 

Sales and marketing

 

1,341

 

1,851

 

General and administrative

 

913

 

1,102

 

Product development

 

729

 

679

 

Depreciation

 

73

 

88

 

Amortization

 

99

 

178

 

Total costs of revenue and operating expenses

 

5,333

 

5,819

 

 

 

 

 

 

 

Income (loss) from operations

 

575

 

(427

)

 

 

 

 

 

 

Other income (expense)

 

 

 

 

 

Interest income

 

21

 

8

 

Interest income, related party

 

432

 

 

Interest expense

 

(0

)

(12

)

Foreign currency exchange gain (loss)

 

(96

)

110

 

Other income (expense), net

 

357

 

106

 

 

 

 

 

 

 

Income (loss) from continuing operations before income taxes

 

932

 

(321

)

Income tax expense (benefit)

 

174

 

(92

)

Income (loss) from continuing operations

 

$

758

 

$

(229

)

Income from discontinued operations, net of tax

 

 

1,162

 

Net income

 

$

758

 

$

933

 

 

 

 

 

 

 

Basic income (loss) per common share - continuing operations

 

$

0.07

 

$

(0.02

)

Diluted income (loss) per common share - continuing operations

 

$

0.07

 

$

(0.02

)

 

 

 

 

 

 

Basic income per common share - discontinued operations

 

$

 

$

0.11

 

Diluted income per common share - discontinued operations

 

$

 

$

0.10

 

 

 

 

 

 

 

Basic income per common share - net income

 

$

0.07

 

$

0.09

 

Diluted income per common share - net income

 

$

0.07

 

$

0.08

 

 

 

 

 

 

 

Cash dividend declared per common share

 

$

0.05

 

$

0.05

 

 

 

 

 

 

 

Weighted average basic shares outstanding

 

11,164

 

10,754

 

Weighted average diluted shares outstanding

 

11,369

 

11,223

 

 

4



Table of Contents

 

EVOLVING SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OTHER COMPREHENSIVE INCOME

(in thousands except per share data)

(unaudited)

 

 

 

For the Three Months Ended March 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Net income

 

$

758

 

$

933

 

 

 

 

 

 

 

Other comprehensive income:

 

 

 

 

 

Foreign currency translation gain (loss)

 

782

 

746

 

Unrealized gains on available-for-sale securities

 

 

 

 

 

Unrealized holding gains arising during period

 

772

 

 

Other comprehensive income, before tax

 

1,554

 

746

 

Income tax expense related to components of other comprehensive income

 

(289

)

 

Other comprehensive income, net of tax

 

1,265

 

746

 

 

 

 

 

 

 

Comprehensive income

 

$

2,023

 

$

1,679

 

 

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

 

5



Table of Contents

 

EVOLVING SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)

(in thousands, except share data)

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

Common

 

 

 

Additional

 

 

 

Other

 

 

 

Total

 

 

 

Stock

 

 

 

Paid-in

 

Treasury

 

Comprehensive

 

Accumulated

 

Stockholders’

 

 

 

Shares

 

Amount

 

Capital

 

Stock

 

Income (Loss)

 

(Deficit)

 

Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2011

 

11,135,604

 

$

11

 

$

90,062

 

$

(1,253

)

$

(4,531

)

$

(39,577

)

$

44,712

 

Stock option exercises

 

87,512

 

0

 

195

 

 

 

 

195

 

Common Stock issued pursuant to the Employee Stock Purchase Plan

 

292

 

0

 

1

 

 

 

 

1

 

Stock-based compensation expense

 

 

 

71

 

 

 

 

71

 

Restricted stock issuance, net of cancellations

 

(1,874

)

(0

)

 

 

 

 

(0

)

Common stock cash dividends

 

 

 

 

 

 

(558

)

(558

)

Comprehensive income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

758

 

 

 

Net unrealized losses on investments, related party, net of tax

 

 

 

 

 

 

 

 

 

483

 

 

 

 

 

Foreign currency translation adjustment

 

 

 

 

 

782

 

 

 

 

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

2,023

 

Balance at March 31, 2012

 

11,221,534

 

$

11

 

$

90,329

 

$

(1,253

)

$

(3,266

)

$

(39,377

)

$

46,444

 

 

6



Table of Contents

 

EVOLVING SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

 

 

For the Three Months Ended March 31,

 

 

 

2012

 

2011

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

758

 

$

933

 

Income from discontinued operations

 

 

1,162

 

Income from continuing operations

 

758

 

(229

)

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation

 

73

 

88

 

Amortization of intangible assets

 

99

 

178

 

Amortization of debt issuance costs

 

 

11

 

Stock based compensation

 

71

 

176

 

Accretion of discount on marketable securities

 

(5

)

 

Unrealized foreign currency transaction (gains) and losses, net

 

96

 

(110

)

Benefit from deferred income taxes

 

(1

)

(380

)

Change in operating assets and liabilities:

 

 

 

 

 

Contract receivables

 

1,538

 

1,890

 

Unbilled work-in-progress

 

(352

)

(494

)

Prepaid and other assets

 

(185

)

(131

)

Accounts payable and accrued liabilities

 

294

 

139

 

Unearned revenue

 

(880

)

(507

)

Other long-term obligations

 

 

 

Net cash provided by operating activities of continuing operations

 

1,506

 

631

 

Net cash provided by operating activities of discontinued operations

 

 

5,968

 

Net cash provided by operating activities

 

1,506

 

6,599

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Purchase of property and equipment

 

 

(39

)

Restricted cash

 

 

(3

)

Net cash used in investing activities of continuing operations

 

 

(42

)

Net cash used in investing activities of discontinued operations

 

 

(5

)

Net cash used in investing activities

 

 

(47

)

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Capital lease payments

 

(6

)

(4

)

Common stock cash dividends

 

(22,271

)

(532

)

Proceeds from the issuance of stock

 

196

 

75

 

Net cash used in financing activities of continuing operations

 

(22,081

)

(461

)

Net cash used in financing activities of discontinued operations

 

 

(3

)

Net cash used in financing activities

 

(22,081

)

(464

)

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

60

 

115

 

 

 

 

 

 

 

Net increase in cash and cash equivalents

 

(20,515

)

6,203

 

Cash and cash equivalents at beginning of period

 

34,290

 

10,801

 

Cash and cash equivalents at end of period

 

$

13,775

 

$

17,004

 

 

 

 

 

 

 

Supplemental disclosure of other cash and non-cash financing transactions:

 

 

 

 

 

Interest paid

 

$

 

$

1

 

Income taxes paid

 

220

 

79

 

Common stock dividend declared

 

558

 

538

 

Property and equipment purchased and included in accounts payable

 

29

 

20

 

Unrealized gain on investments, related party

 

320

 

 

 

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Table of Contents

 

EVOLVING SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1 — BASIS OF PRESENTATION

 

Organization We are a provider of software solutions and services to the wireless, wireline and cable markets. We maintain long-standing relationships with many of the largest wireless, wireline and cable companies worldwide. Our customers rely on us to develop, deploy, enhance, maintain and integrate complex, highly reliable software solutions for a range of Operations Support Systems (“OSS”).  We offer software products and solutions focused on activation and provisioning: our service activation solution, TertioTM (“TSA”) used to activate complex bundles of voice, video and data services for traditional and next generation wireless and wireline networks;  our SIM card activation solution, Dynamic SIM Allocation TM (“DSA”) used to dynamically allocate and assign resources to wireless devices that rely on SIM cards, and our connected devices activation solution, Intelligent M2M Controller that support the activation of M2M devices with intermittent or infrequent usage patterns.

 

Interim Consolidated Financial Statements — The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and in conformity with the instructions to Form 10-Q and Article 10 of Regulation S-X and the related rules and regulations of the Securities and Exchange Commission (“SEC”).  Accordingly, certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. However, we believe that the disclosures included in these financial statements are adequate to make the information presented not misleading. The unaudited condensed consolidated financial statements included in this document have been prepared on the same basis as the annual consolidated financial statements, and in our opinion reflect all adjustments, which include normal recurring adjustments necessary for a fair presentation in accordance with GAAP and SEC regulations for interim financial statements. The results for the three months ended March 31, 2012 are not necessarily indicative of the results that we will have for any subsequent period.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes to those statements for the year ended December 31, 2011 included in our Annual Report on Form 10-K.

 

Discontinued Operations - On April 21, 2011, we announced the execution of an Asset Purchase Agreement, dated as of April 21, 2011 (the “Purchase Agreement”), with NeuStar, Inc., a Delaware corporation (the “Buyer”).  Under the terms of the Purchase Agreement, we agreed to sell our Numbering Solutions Business (the “Numbering Business”) to the Buyer for $39.4 million in cash, subject to increase or decrease in accordance with a post-closing working capital adjustment and the assumption of certain liabilities related to the Numbering Business (the “Asset Sale”). The Asset Sale qualified for treatment as discontinued operations during the second quarter of 2011 upon receipt of shareholder approval at a special meeting of shareholders on June 23, 2011. On July 1, 2011, we completed the Asset Sale of the Numbering Business. There was no post-closing working capital adjustment. This divested business is reflected in these consolidated financial statements as discontinued operations and historical information related to the divested business has been reclassified accordingly. Refer to Note 9, Discontinued Operations, for more information regarding the Asset Sale.

 

Revisions and Reclassifications We have changed the classification of revenue totaling approximately $62,000 from continuing operations to discontinued operations and depreciation expense of approximately $22,000 from discontinued operations to continuing operations at March 31, 2011.  Net income for the period remained at $0.9 million.

 

Use of Estimates The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reporting period. We made estimates with respect to revenue recognition for estimated hours to complete projects accounted for using the percentage-of-completion method, allowance for doubtful accounts, income tax valuation allowance, fair values of long-lived assets, valuation of intangible assets and goodwill, useful lives for property, equipment and intangible assets, business combinations, capitalization of internal software development costs and fair value of stock-based compensation amounts.  Actual results could differ from these estimates.

 

Foreign Currency Our functional currency is the U.S. dollar.  The functional currency of our foreign operations is the respective local currency for each foreign subsidiary.  Assets and liabilities of foreign operations denominated in local currencies are translated at the spot rate in effect at the applicable reporting date.  Our consolidated statements of operations are translated at the weighted average rate of exchange during the applicable period.  The resulting unrealized cumulative translation adjustment, net of applicable income taxes, is recorded as a component of accumulated other comprehensive income (loss) in stockholders’ equity.  Realized and unrealized transaction gains and losses generated by transactions denominated in a currency different from the functional currency of the applicable entity are recorded in other income (loss) in the consolidated statements of operations in the period in which they occur.

 

Principles of Consolidation The consolidated financial statements include the accounts of Evolving Systems, Inc. and subsidiaries, all of which are wholly owned.  All significant intercompany transactions and balances have been eliminated in

 

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Table of Contents

 

consolidation.

 

Goodwill Goodwill is the excess of acquisition cost of an acquired entity over the fair value of the identifiable net assets acquired.  Goodwill is not amortized, but tested for impairment annually or whenever indicators of impairment exist. These indicators may include a significant change in the business climate, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business or other factors. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit.

 

We performed our annual goodwill impairment test as of July 31, 2011, when we had $16.9 million of goodwill included the following reporting units, License and Services (“L&S”) — UK of $7.6 million and Customer Support (“CS”) — UK of $9.3 million. The fair value of each reporting unit was estimated using both market and income based approaches. Specifically, we incorporated observed market multiple data from selected guideline public companies and values arrived at through the application of discounted cash flow analyses which in turn were based upon our financial projections as of the valuation date. We believe that a market participant would weigh both possibilities without a bias to one or the other. Consequently, we gave equal consideration to both. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. If the carrying value of a reporting unit were to exceed its fair value, we would then compare the fair value of the reporting unit’s goodwill to its carrying amount, and any excess of the carrying amount over the fair value would be charged to operations as an impairment loss. If the projected future performance of either of our segments as estimated in the income valuation approach is adjusted downward or is lower than expected in the future, we could be required to record a goodwill impairment charge.  As a result of the first step of the 2011 goodwill impairment analysis, the fair value of each reporting unit exceeded its carrying value.  Therefore the second step was not necessary.  A hypothetical 5% decrease in the estimated fair value of our CS-UK reporting unit still result in the estimated fair value exceeding its carrying value.  However, a hypothetical 5% decrease in the estimated fair value of our L&S-UK reporting unit would result in its carrying value exceeding its estimated fair value and therefore require the second step, which could result in impairment for that reporting unit.

 

Intangible Assets Amortizable intangible assets consist primarily of purchased software and licenses, customer contracts and relationships, trademarks and tradenames, and business partnerships acquired in conjunction with our purchase of Tertio Telecoms Ltd. (“Evolving Systems U.K.”).  These assets are amortized using the straight-line method over their estimated lives.

 

We assess the impairment of identifiable intangibles if events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. Factors that we consider significant which could trigger an impairment analysis include the following:

 

·                  Significant under-performance relative to historical or projected future operating results;

 

·                  Significant changes in the manner of use of the acquired assets or the strategy of the overall business;

 

·                  Significant negative industry or economic trends; and/or

 

·                  Significant decline in our stock price for a sustained period.

 

If, as a result of the existence of one or more of the above indicators of impairment, we determine that the carrying value of intangibles and/or long-lived assets may not be recoverable, we compare the estimated undiscounted cash flows expected to result from the use of the asset and its eventual disposition to the asset’s carrying amount. If an amortizable intangible or long-lived asset is not deemed to be recoverable, we recognize an impairment loss representing the excess of the asset’s carrying value over its estimated fair value.

 

Fair Value Measurements Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement:

 

Level 1 — Quoted prices in active markets for identical assets or liabilities.

 

Level 2 — Observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

Level 3 — Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.

 

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The valuation techniques used to measure our marketable debt securities were derived from quoted prices in active markets for identical assets or liabilities.

 

Cash, Cash Equivalents and Marketable Securities - All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. Our marketable debt securities have been classified and accounted for as available-for-sale and are reported at fair value.  Unrealized gains and losses related to changes in the fair value of securities are recognized in the accumulated other comprehensive income, net of tax in our consolidated balance sheets.  Changes in the fair value of available-for-sale securities impact our net income only when such securities are sold or an other-than-temporary impairment is recognized.  Realized gains and losses on the sale of securities are determined by specific identification of each security’s cost basis.  We review our marketable debt securities to determine if the securities are other-than-temporarily impaired, which would require us to record an impairment charge in the period any such determination is made.  In making the judgment, we evaluate, among other things, the duration and extent to which the fair value of the securities are less than its cost, the financial condition of the issuer and any changes thereto, our intent to sell, or whether it is more likely than not it will be required to sell, the securities before recovery of the investment’s amortized cost basis.  Management’s assessment on whether a security is other-than-temporarily impaired could change in the future due to new developments or changes in assumptions related to our security.  Management determines the appropriate classification of its investments at the time of purchase and re-evaluates the available-for-sale designations as of each balance sheet date. We classify our marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Marketable debt securities with maturities of 12 months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term.

 

Revenue Recognition — We recognize revenue when an agreement is signed, the fee is fixed or determinable and collectability is reasonably assured. We recognize revenue from two primary sources: license fees and services, and customer support.   The majority of our license fees and services revenue is generated from fixed-price contracts, which provide for licenses to our software products and services to customize such software to meet our customers’ use.   When the customization services are determined to be essential to the functionality of the delivered software, we recognize revenue using the percentage-of-completion method of accounting. In these types of arrangements, we do not typically have Vendor Specific Objective Evidence (“VSOE”) of fair value on the license fee/services portion (services are related to customizing the software) of the arrangement due to the large amount of customization required by our customers; however, we do have VSOE for the warranty/maintenance services based on the renewal rate of the first year of maintenance in the arrangement. The license/services portion is recognized using the percentage-of-completion method of accounting and the warranty/maintenance services are separated based on the renewal rate in the contract and recognized ratably over the warranty or maintenance period. We estimate the percentage-of-completion for each contract based on the ratio of direct labor hours incurred to total estimated direct labor hours and recognize revenue based on the percent complete multiplied by the contract amount allocated to the license fee/services.  Since estimated direct labor hours, and changes thereto, can have a significant impact on revenue recognition, these estimates are critical and we review them regularly. If the arrangement includes a customer acceptance provision, the hours to complete the acceptance testing are included in the total estimated direct labor hours; therefore, the related revenue is recognized as the acceptance testing is performed. Revenue is not recognized in full until the customer has provided proof of acceptance on the arrangement.  Generally, our contracts are accounted for individually. However, when certain criteria are met, it may be necessary to account for two or more contracts as one to reflect the substance of the group of contracts. We record amounts billed in advance of services being performed as unearned revenue. Unbilled work-in-progress represents revenue earned but not yet billable under the terms of the fixed-price contracts. All such amounts are expected to be billed and collected within 12 months.

 

We may encounter budget and schedule overruns on fixed-price contracts caused by increased labor or overhead costs. We make adjustments to cost estimates in the period in which the facts requiring such revisions become known. We record estimated losses, if any, in the period in which current estimates of total contract revenue and contract costs indicate a loss. If revisions to cost estimates are obtained after the balance sheet date but before the issuance of the interim or annual financial statements, we make adjustments to the interim or annual financial statements accordingly.

 

In arrangements where the services are not essential to the functionality of the delivered software, we recognize license revenue when a license agreement has been signed, delivery and acceptance have occurred, the fee is fixed or determinable and collectability is reasonably assured. Where applicable, we unbundle and record as revenue fees from multiple element arrangements as the elements are delivered to the extent that VSOE of fair value of the undelivered elements exist. If VSOE for the undelivered elements does not exist, we defer fees from such arrangements until the earlier of the date that VSOE does exist on the undelivered elements or all of the elements have been delivered.

 

We recognize revenue from fixed-price service contracts using the proportional performance method of accounting, which is similar to the percentage-of-completion method described above. We recognize revenue from professional services provided pursuant to time-and-materials based contracts and training services as the services are performed, as that is when our obligation to our customers under such arrangements is fulfilled.

 

We recognize customer support, including maintenance revenue, ratably over the service contract period. When maintenance is bundled with the original license fee arrangement, its fair value, based upon VSOE, is deferred and recognized during the periods when services are provided.

 

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Stock-based Compensation — We account for stock-based compensation by applying a fair-value-based measurement method to account for share-based payment transactions with employees and directors. We record compensation costs associated with the vesting of unvested options on a straight-line basis over the vesting period.  Stock-based compensation is a non-cash expense because we settle these obligations by issuing shares of our common stock instead of settling such obligations with cash payments.    We use the Black-Scholes model to estimate the fair value of each option grant on the date of grant.  This model requires the use of estimates for expected term of the options and expected volatility of the price of our common stock.

 

Comprehensive Income - Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains, and losses that under GAAP are recorded as an element of shareholders’ equity but are excluded from net income. Other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency and unrealized gains and losses on marketable securities categorized as available-for-sale.

 

Income Taxes — We record deferred tax assets and liabilities for the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in the accompanying condensed consolidated balance sheets, as well as operating loss and tax credit carry-forwards. We measure deferred tax assets and liabilities using enacted tax rates expected to be applied to taxable income in the years in which those temporary differences are expected to be recovered or settled.  We reduce deferred tax assets by a valuation allowance if, based on available evidence, it is more likely than not that these benefits will not be realized.

 

We use a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return.  For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities.

 

Recent Accounting Pronouncements - In June 2011, the Financial Accounting Standards Board issued guidance on presentation of comprehensive income. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. Instead, an entity will be required to present either a continuous statement of net income and other comprehensive income or in two separate but consecutive statements. The new guidance will be effective for us beginning March 31, 2012 and will result in presentation changes only.

 

NOTE 2 — FINANCIAL INSTRUMENTS

 

All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. Marketable debt securities have been classified and accounted for as available-for-sale. Management determines the appropriate classification of its investments at the time of purchase and reevaluates the available-for-sale designations as of each balance sheet date. We classify our marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Marketable debt securities with maturities of 12 months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term.

 

The following tables summarize our available-for-sale securities’ adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category recorded as long-term marketable securities as of March 31, 2012 (in thousands):

 

 

 

March 31, 2012

 

 

 

Adjusted

 

Unrealized

 

Unrealized

 

Fair

 

Long-term

 

 

 

Cost

 

Gains

 

Losses

 

Value

 

Investments

 

Level:2

 

 

 

 

 

 

 

 

 

 

 

Corporate debt securities

 

$

16,905

 

$

320

 

 

$

17,225

 

$

17,225

 

 

The net unrealized gains as of March 31, 2012 are related to long-term corporate debt securities. We may sell certain corporate debt securities prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit deterioration and duration management. We recognized no net realized gains or losses during the three ended March 31, 2012. The maturities of our long-term corporate debt securities range from five to eight years.

 

We consider the declines in market value of our corporate debt securities investment portfolio to be temporary in nature. Our investment policy requires investments to be rated B- or better. Fair values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, we review factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer and any changes thereto, and our intent to sell, or whether it is more likely than not we will be required to sell the investment before recovery of the investment’s amortized cost basis. During the three months ended March 31, 2012, we did not recognize any impairment charges. As of March 31, 2012, we do not consider any of our investments to be other-than-temporarily impaired.

 

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As of March 31, 2012 all of our corporate debt security investments are concentrated within the senior secured notes of a single issuer, which is a related party (see note 13).  The corporate debt securities mature on April 15, 2017 and earn interest at a rate of 10%. The senior notes are secured by a pledge of and first lien security interest in (subject to certain exceptions) substantially all of the assets of the issuer, rank senior in right of payment to existing and future subordinated indebtedness of the issuer and upon the occurrence of certain changes of control (as defined in the senior notes indenture), the issuer must give holders of the senior notes an opportunity to sell their notes to the issuer at a purchase price of 101% of the principal amount, plus accrued and unpaid interest, if any, to the date of purchase. During the three months ended March 31, 2012, we recorded interest income of $0.4 million and have interest receivable of $0.8 million.  These debt securities represent approximately 7% of the issuer’s total series of senior secured notes. Any significant adverse developments in that issuer’s business, industry, operations or financial condition could have a disproportionately adverse impact on the value of our investment, our receipt of interest and principal payments under the notes, or our financial condition and operating results.  As of April 23, 2012 the investments were sold for approximately $17.8 million and we will record the related gain on sale in the second quarter of 2012.

 

NOTE 3 — GOODWILL AND INTANGIBLE ASSETS

 

We recorded goodwill as a result of the acquisition of Evolving Systems U.K. in November 2004.

 

Changes in the carrying amount of goodwill by reporting unit were as follows (in thousands):

 

 

 

License and
Services

 

Customer
Support

 

Total

 

 

 

UK

 

UK

 

Goodwill

 

Balance as of December 31, 2011

 

$

7,059

 

$

8,723

 

$

15,782

 

Effects of changes in foreign currency exchange rates

 

244

 

302

 

546

 

Balance as of March 31, 2012

 

$

7,303

 

$

9,025

 

$

16,328

 

 

We conducted our annual goodwill impairment test as of July 31, 2011, and we determined that goodwill was not impaired as of the test date. From July 31, 2011 through March 31, 2012, no events have occurred that we believe may have impaired goodwill.

 

We amortized identifiable intangible assets on a straight-line basis over estimated lives ranging from one to seven years and include the cumulative effects of foreign currency exchange rates.  As of March 31, 2012 and December 31, 2011, identifiable intangibles were as follows (in thousands):

 

 

 

March 31, 2012

 

December 31, 2011

 

Weighted-

 

 

 

 

 

 

 

Net

 

 

 

 

 

Net

 

Average

 

 

 

(1) Gross

 

Accumulated

 

Carrying

 

(1) Gross

 

Accumulated

 

Carrying

 

Amortization

 

 

 

Amount

 

Amortization

 

Amount

 

Amount

 

Amortization

 

Amount

 

Period

 

Purchased software

 

$

1,424

 

$

1,424

 

$

 

$

1,376

 

$

1,376

 

$

 

4.6 yrs

 

Trademarks and tradenames

 

718

 

590

 

128

 

694

 

545

 

149

 

7.0 yrs

 

Business partnerships

 

117

 

117

 

 

113

 

113

 

 

5.0 yrs

 

Customer relationships

 

2,102

 

1,727

 

375

 

2,031

 

1,596

 

435

 

5.3 yrs

 

 

 

$

4,361

 

$

3,858

 

$

503

 

$

4,214

 

$

3,630

 

$

584

 

5.2 yrs

 

 


(1)  Changes in intangible gross values as of March 31, 2012 compared to December 31, 2011 are the direct result of the changes in foreign currency exchange rates for the periods then ended.

 

All U.S. intangible assets were sold as part of the Asset Sale. Amortization expense of identifiable intangible assets was $0.1 million and $0.2 million for the three months ended March 31, 2012 and 2011, respectively.  As Evolving Systems U.K. uses the British Pound Sterling as its functional currency, the amount of future amortization actually recorded will be based upon exchange rates in effect at that time. Expected future amortization expense related to identifiable intangibles based on our carrying amount as of March 31, 2012 was as follows (in thousands):

 

Three Months Ending March 31:

 

 

 

2012

 

$

302

 

2013

 

201

 

 

 

$

503

 

 

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NOTE 4 — EARNINGS PER COMMON SHARE

 

We compute basic earnings per share (“EPS”) by dividing net income or loss available to common stockholders by the weighted average number of shares outstanding during the period, including common stock issuable under participating securities. We compute diluted EPS using the weighted average number of shares outstanding, including participating securities, plus all potentially dilutive common stock equivalents. Common stock equivalents consist of stock options.

 

Our policy is to treat unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents, whether paid or unpaid, as participating securities, included in the computation of both basic and diluted earnings per share.

 

The following is the reconciliation of the denominator of the basic and diluted EPS computations (in thousands, except per share data):

 

 

 

Three Months Ended March 31,

 

 

 

2012

 

2011

 

Basic income (loss) per share:

 

 

 

 

 

Income (loss) from continuing operations

 

$

758

 

$

(229

)

Income from discontinued operations, net of tax

 

$

 

$

1,162

 

Net income

 

$

758

 

$

933

 

 

 

 

 

 

 

Basic weighted average shares outstanding

 

11,164

 

10,754

 

 

 

 

 

 

 

Basic income (loss) per share:

 

 

 

 

 

Continuing operations

 

$

0.07

 

$

(0.02

)

Discontinued operations

 

$

0.00

 

$

0.11

 

Net Income

 

$

0.07

 

$

0.09

 

 

 

 

 

 

 

Diluted income (loss) per share:

 

 

 

 

 

Income (loss) from continuing operations

 

$

758

 

$

(229

)

Income from discontinued operations, net of tax

 

$

 

$

1,162

 

Net income

 

$

758

 

$

933

 

 

 

 

 

 

 

Weighted average shares outstanding

 

11,164

 

10,754

 

Effect of dilutive securities - options

 

205

 

469

 

Diluted weighted average shares outstanding

 

11,369

 

11,223

 

 

 

 

 

 

 

Diluted income (loss) per share:

 

 

 

 

 

Continuing operations

 

$

0.07

 

$

(0.02

)

Discontinued operations

 

$

 

$

0.10

 

Net Income

 

$

0.07

 

$

0.08

 

 

For the three months ended March 31, 2012 and 2011, 0.3 million and 0.4 million shares, respectively, of common stock were excluded from the dilutive stock calculation because their exercise prices were greater than the average fair value of our common stock for the period.

 

NOTE 5 — SHARE-BASED COMPENSATION

 

We account for stock-based compensation by applying a fair-value-based measurement method to account for share-based payment transactions with employees and directors, and record compensation cost for all stock awards granted after January 1, 2006 and awards modified, repurchased, or cancelled after that date, using the modified prospective method. We record compensation costs associated with the vesting of unvested options on a straight-line basis over the vesting period. We recognized $0.1 million and $0.2 million of compensation expense in the consolidated statements of operations, with respect to our stock-based compensation plans for

 

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the three months ended March 31, 2012 and 2011, respectively.  The following table summarizes stock-based compensation expenses recorded in the consolidated statement of operations (in thousands):

 

 

 

For the Three Months
Ended March 31,

 

 

 

2012

 

2011

 

Cost of license fees and services, excluding depreciation and amortization

 

$

5

 

$

11

 

Cost of customer support, excluding depreciation and amortization

 

1

 

1

 

Sales and marketing

 

6

 

24

 

General and administrative

 

53

 

115

 

Product development

 

6

 

25

 

Share based compensation - continuing operations

 

71

 

176

 

Discontinued operations

 

 

11

 

Total share based compensation

 

$

71

 

$

187

 

 

Stock Incentive Plans

 

In January 1996, our stockholders approved an Amended and Restated Stock Option Plan (the “Option Plan”).  Under the Option Plan, as amended, 4,175,000 shares were reserved for issuance.  Options issued under the Option Plan were at the discretion of the Board of Directors, including the vesting provisions of each stock option granted. Options were granted with an exercise price equal to the closing price of our common stock on the date of grant, generally vest over four years and expire no more than ten years from the date of grant. The Option Plan terminated on January 18, 2006; options granted before that date were not affected by the plan termination.  At March 31, 2012 and December 31, 2011, 0.4 million options remained outstanding under the Option Plan, respectively.

 

In March 2007, upon the hiring of our Vice President of World Wide Sales and Marketing, in accordance with then-NASDAQ Marketplace Rule 4350(i)(1)(a)(iv) (now Rule 5635(c)(iv)), the Board of Directors approved an inducement award under a stand-alone equity incentive plan.  We granted 50,000 non-qualified options to purchase shares of our common stock at an exercise price equal to the closing price of our common stock on the date of grant.  The options vested over four years and expired ten years from the date of grant. At March 31, 2012 and December 31, 2011, 0 and 50,000 options remained outstanding under this plan, respectively.

 

In June 2007, our stockholders approved the 2007 Stock Incentive Plan (the “2007 Stock Plan”) with a maximum of 1,000,000 shares reserved for issuance. In June 2010, our stockholders approved an amendment to the 2007 Stock Plan which increased the maximum shares that may be awarded under the plan to 1,250,000. Awards permitted under the 2007 Stock Plan include:  Stock Options, Stock Appreciation Rights, Restricted Stock, Restricted Stock Units, Performance Awards and Other Stock-Based Awards.  Awards issued under the 2007 Stock Plan are at the discretion of the Board of Directors.  As applicable, awards are granted with an exercise price equal to the closing price of our common stock on the date of grant, generally vest over four years for employees and one year for directors and expire no more than ten years from the date of grant.  At March 31, 2012, there were approximately 0.2 million shares available for grant under the 2007 Stock Plan, as amended, as well as an increase of 45,749 authorized shares as a result of the antidilution modification in connection with the special dividend (see details below).  At March 31, 2012 and December 31, 2011, 0.4 million options were issued and outstanding under the 2007 Stock Plan as amended, respectively.

 

During the three months ended March 31, 2012 and 2011, we awarded a total of 0 and 10,000 shares of restricted stock, respectively to members of our Board of Directors and senior management.  During the three months ended March 31, 2012 and 2011, 2,000 and 9,000 shares of restricted stock vested, respectively.  During the three months ended March 31, 2012 and 2011 1,875 and 625 shares of restricted stock were forfeited, respectively. The fair market value of restricted shares for share-based compensation expensing is equal to the closing price of our common stock on the date of grant. Stock-based compensation expense includes $9,000 and $45,000 for the three months ended March 31, 2012 and 2011, respectively, of expense related to restricted stock grants. The restrictions on the stock awards are released quarterly, generally over four years for senior management and over one year for board members.

 

As described above, on November 10, 2011, we declared a special cash dividend of $2.00 per share on all of the issued and outstanding common stock, or an aggregate of approximately $22.3 million, which was paid on January 3, 2012. In connection with the special dividend, the Compensation Committee of the Board of Directors of the Company approved anti-dilution adjustments to outstanding stock option awards pursuant to the Company’s equity-based compensation plans to take into account the payment of the special cash dividend. Outstanding stock option awards were adjusted on January 3, 2012 (the ex-dividend date), by reducing the exercise price and increasing the number of shares issuable upon the exercise of each option, in accordance with safe harbor provisions of Section 409A of the Internal Revenue Code, such that the aggregate difference between the market price and exercise price times the number of shares issuable upon exercise was substantially the same immediately before and after the payment of the

 

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special dividend. The antidilution modification made with respect to such options resulted in a decrease in the weighted average exercise price from $7.46 to $5.80 and an increase in the aggregate number of shares issuable upon exercise of such options by 45,749.  Since our Stock Plan permits, but does not require, antidilution modifications, FAS 123R requires a comparison of the fair value of each award immediately prior to and after the date of modification, assuming the value immediately prior to modification contains no antidilution protection, and the value immediately after modification contains full antidilution protection. This comparison resulted in no aggregate difference or additional compensation expense in the three months ended March 31, 2012.

 

The fair value of each option grant is estimated on the date of grant using the Black-Scholes model.  The Black-Scholes model uses four assumptions to calculate the fair value of each option grant.  The expected term of share options granted is derived using the simplified method, which we adopted in January 2008. The risk-free interest rate is based upon the rate currently available on zero-coupon U.S. Treasury instruments with a remaining term equal to the expected term of the stock options.  The expected volatility is based upon historical volatility of our common stock over a period equal to the expected term of the stock options.  The expected dividend yield is based upon historical and anticipated payment of dividends.  The weighted-average assumptions used in the fair value calculations are as follows:

 

 

 

For the Three Months Ended March 31,

 

 

 

2012

 

2011

 

Expected term (years)

 

5.8

 

*

 

Risk-free interest rate

 

0.86

%

*

 

Expected volatility

 

65.5

%

*

 

Expected dividend yield

 

3.5

%

*

 

 


* - None granted

 

 

 

 

 

 

The following is a summary of stock option activity under the plans for the three months ended March 31, 2012:

 

 

 

 

 

 

 

Weighted-

 

 

 

 

 

 

 

 

 

Average

 

 

 

 

 

(1)

 

Weighted-

 

Remaining

 

Aggregate

 

 

 

Number of

 

Average

 

Contractual

 

Intrinsic

 

 

 

Shares

 

Exercise

 

Term

 

Value

 

 

 

(in thousands)

 

Price

 

(Years)

 

(in thousands)

 

Options outstanding at December 31, 2011

 

862

 

$

5.80

 

5.06

 

$

1,635

 

Options granted

 

53

 

$

5.76

 

 

 

 

 

Less options forfeited

 

(18

)

$

6.73

 

 

 

 

 

Less options exercised

 

(88

)

$

2.22

 

 

 

 

 

Options outstanding at March 31, 2012

 

809

 

$

6.17

 

5.18

 

$

1,211

 

 

 

 

 

 

 

 

 

 

 

Options exercisable at March 31, 2012

 

675

 

$

6.53

 

4.54

 

$

1,039

 

 


(1)         Beginning balance of options outstanding as of December 31, 2011, was adjusted by 45,749 options due to the aforementioned anti-dilution adjustments to outstanding stock option awards.

 

There were 52,800 stock options granted during the three months ended March 31, 2012.  No stock options were granted during the three months ended March 31, 2011. The weighted-average grant-date fair value of stock options granted during the three months ended March 31, 2012 was $2.60.

 

As of March 31, 2012, there was approximately $0.3 million of total unrecognized compensation costs related to unvested stock options.  These costs are expected to be recognized over a weighted average period of 2.0 years.

 

The total fair value of stock options vested during the three months ended March 31, 2012 and 2011 was $0.1 million and $0.2 million, respectively. The deferred income tax benefits from stock option expense related to Evolving Systems U.K. totaled approximately $4,000 and $14,000 for the three months ended March 31, 2012 and 2011, respectively.

 

Cash received from stock option exercises for the three months ended March 31, 2012 and 2011 was $0.2 million and $69,000, respectively.

 

During the three months ended March 31, 2011, we had net settlement exercises of stock options, whereby the optionee did not pay cash for the options but instead received the number of shares equal to the difference between the exercise price and the market price on the date of exercise. Net settlement exercises during the three months ended March 31, 2011, resulted in approximately 91,000 shares

 

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issued and 120,000 options cancelled in settlement of shares issued.  There were no net settlement exercises during the three months ended March 31, 2012.

 

Employee Stock Purchase Plan

 

Under the Employee Stock Purchase Plan (“ESPP”), we  are authorized to issue up to 550,000 shares under the ESPP. Under the terms of the ESPP, employees may elect to have up to 15% of their gross compensation withheld through payroll deduction to purchase our common stock, capped at $25,000 annually and no more than 10,000 shares per offering period. The purchase price of the stock is 85% of the lower of the market price at the beginning or end of each three-month participation period. As of March 31, 2012, there were approximately 74,000 shares available for purchase.  For the three months ended March 31, 2012 and 2011, we recorded compensation expense of $300 and $3,000, respectively, associated with grants under the ESPP which includes the fair value of the look-back feature of each grant as well as the 15% discount on the purchase price.  This expense fluctuates each period primarily based on the level of employee participation.

 

The fair value of each purchase made under our ESPP is estimated on the date of purchase using the Black-Scholes model.  The Black-Scholes model uses four assumptions to calculate the fair value of each purchase.  The expected term of each purchase is based upon the three-month participation period of each offering.  The risk-free interest rate is based upon the rate currently available on zero-coupon U.S. Treasury instruments with a remaining term equal to the expected term of each offering.  The expected volatility is based upon historical volatility of our common stock.  The expected dividend yield is based upon historical and anticipated payment of dividends.  The weighted average assumptions used in the fair value calculations are as follows:

 

 

 

Three Months Ended March 31,

 

 

 

2012

 

2011

 

Expected term (years)

 

0.25

 

0.25

 

Risk-free interest rate

 

0.1

%

0.1

%

Expected volatility

 

35.22

%

44.6

%

Expected dividend yield

 

3.58

%

2.8

%

 

Cash received from employee stock plan purchases for the three months ended March 31, 2012 and 2011 was $2,000 and $6,000, respectively.

 

We issued shares related to the ESPP of approximately 300 and 1,000 for the three months ended March 31, 2012 and 2011.

 

NOTE 6 — CONCENTRATION OF CREDIT RISK

 

For the three months ended March 31, 2012 and 2011, one significant customer (defined as contributing at least 10%) accounted for 24% and 11%, respectively, of revenue from continuing operations.  The significant customer for the three months ended March 31, 2012 is a large telecommunications operator in Europe.  The significant customer for the three months ended March 31, 2011 is a large telecommunications operator in Asia.

 

As of March 31, 2012, one significant customer accounted for approximately 11% of contract receivables and unbilled work-in-progress.  This customer is a large telecommunications operator in Central America.  At December 31, 2011, three significant customers accounted for approximately 32% (12%, 10% and 10%) of contract receivables and unbilled work-in-progress.  These customers are two large telecommunications operators in Europe and one in Africa.

 

As of March 31, 2012 all of our corporate debt security investments were concentrated within one issuer. These debt securities are senior secured and our holdings were approximately 7% of the issuer’s total debt offering.  These debt securities have been sold as of April 23, 2012.

 

NOTE 7 — INCOME TAXES

 

We recorded net income tax expense (benefit) of $0.2 million and ($0.1) million for the three months ended March 31, 2012 and 2011, respectively.  The net expense during the three months ended March 31, 2012 consisted of current income tax expense of $0.2 million and a deferred tax benefit of ($30,000). The current tax expense consists primarily of Alternative Minimum Tax (“AMT”), state tax and unrecoverable foreign withholding tax in the U.S., income tax from our U.K.-based operations and income taxes related to our operations in India. The majority of the U.K. income tax expense is related to unrecoverable foreign withholding taxes. The foreign withholding taxes are typically used to offset our income tax liability, but we do not believe we will have enough taxable income to utilize the foreign withholding taxes during the year. The deferred tax expense was net of a tax benefit primarily related to intangible assets from our U.K.-based operations. The net benefit during the three months ended March 31, 2011 consisted of current income tax expense of $0.3 million and a deferred tax benefit of $0.4 million. The current tax expense consists of income tax from our U.K.-based operations, Alternative Minimum Tax (“AMT”), state income taxes and unrecoverable foreign withholding tax in the U.S. The deferred tax benefit was related to the release of our valuation allowance on our tax asset from our Indian

 

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operations as we will begin to utilize Minimum Alternative Tax (“MAT”) payments made during our tax holiday, which can be applied toward future taxes payable since the tax holiday expired on March 31, 2011. We also had a tax benefit related to intangible assets from our U.K.-based operations.

 

In conjunction with the acquisition of Evolving Systems U.K., we recorded certain identifiable intangible assets.  Since the amortization of these identifiable intangibles is not deductible for income tax purposes, we established a long-term deferred tax liability of $4.6 million at the acquisition date for the expected difference between what would be expensed for financial reporting purposes and what would be deductible for income tax purposes. As of March 31, 2012 and December 31, 2011, this component of the deferred tax liability was $0.1 million, respectively.  This deferred tax liability relates to Evolving Systems U.K., and has no impact on our ability to recover U.S.-based deferred tax assets.  This deferred tax liability will be recognized as a reduction of deferred income tax expense as the identifiable intangibles are amortized.

 

As of March 31, 2012 and December 31, 2011 we continued to maintain a valuation allowance on portions of our domestic net deferred tax asset as we have determined it is more likely than not that we will not realize these deferred tax assets.  Such assets primarily consist of certain net operating loss carryforwards and other tax credits.  We assessed the realizability of our domestic deferred tax assets using all available evidence.  In particular, we considered both historical results and projections of profitability for the reasonably foreseeable future periods.  We are required to reassess our conclusions regarding the realization of our deferred tax assets at each financial reporting date. A future evaluation could result in a conclusion that all or a portion of the valuation allowance is no longer necessary, which could have a material impact on our results of operations and financial position.  The $0.4 million of deferred tax liabilities as of March 31, 2012, were comprised of the following:

 

 

 

March 31, 2012

 

Deferred tax assets:

 

 

 

Net operating loss carryforwards

 

$

4,441

 

Research & Development Credits

 

303

 

AMT/MAT credit

 

942

 

Stock Compensation

 

628

 

Depreciable assets

 

97

 

Accrued liabilities and reserves

 

209

 

Total deferred tax assets

 

6,620

 

 

 

 

 

Deferred tax liabilities

 

 

 

Undistributed Foreign Earnings

 

$

(1,476

)

Intangibles

 

(141

)

Unrealized gains on investments

 

(120

)

Total deferred tax liability

 

(1,737

)

 

 

 

 

Net deferred tax assets, before valuation allowance

 

$

4,883

 

Valuation allowance

 

(5,298

)

Net deferred tax liabilities

 

$

(415

)

 

As of March 31, 2012 and December 31, 2011 we had no liability for unrecognized tax benefits.  We do not believe there will be any material changes in our unrecognized tax positions over the next twelve months.

 

We conduct business globally and, as a result, Evolving Systems, Inc. or one or more of our subsidiaries file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions.  In the normal course of business, we are subject to examination by taxing authorities throughout the world, namely the United Kingdom, Germany and India.

 

NOTE 8 — RESTRUCTURING

 

During the second and fourth quarter of 2011, we undertook a reduction in workforce involving the termination of employees resulting in an expense of $1.1 million primarily related to severance for the affected employees. The reduction in workforce was related to the Asset Sale and was completed by December 31, 2011. There were no additional restructuring expenses during the three months ended March 31, 2012.

 

As of March 31, 2012, $0.4 million remains as an accrued liability which will be fully paid by the fourth quarter of 2012.

 

NOTE 9 — DISCONTINUED OPERATIONS

 

On July 1, 2011, we completed the Asset Sale related to our Numbering Business. The Asset Sale qualified for treatment as discontinued operations during the second quarter of 2011 upon receipt of stockholder approval at a special meeting of stockholders on June 23, 2011. Summary results of operations of the Numbering Business for the three months ended March 31, 2011 and

 

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components of the net gain on the transaction were as follows (in thousands):

 

 

 

Three Months
Ended March 31,

 

 

 

2011

 

Revenues

 

$

3,169

 

 

 

 

 

Income before income tax

 

$

993

 

Income tax expense

 

(169

)

Gain on sale of discontinued operations, net of income tax

 

 

Income from discontinued operations, net of income tax

 

$

1,162

 

 

There have been no allocations of corporate interest or general and administrative expenses to discontinued operations.

 

NOTE 10 — STOCKHOLDERS’ EQUITY

 

Common Stock Dividend

 

Our Board of Directors declared a first quarter cash dividend of $.05 per share, payable April 13, 2012, to stockholders of record March 19, 2012. The dividend was accrued as of March 31, 2012 for $0.5 million and paid on April 13, 2012.

 

Any determination to declare a future quarterly dividend, as well as the amount of any cash dividend which may be declared, will be based on our financial position, earnings, earnings outlook and other relevant factors at that time.

 

Treasury Stock

 

Beginning on May 20, 2011, and continuing through December 31, 2012, we intend to make re-purchases of our common stock at prevailing market prices either in the open market or through privately negotiated transactions up to $5.0 million.  The size and timing of such purchases, if any, will be based on market and business conditions as well as other factors.  The Company is not obligated to purchase any shares.  Purchases under the program can be discontinued at any time the Company determines additional purchases are not warranted.

 

From the inception of the plan through March 31, 2012, we purchased 178,889 shares of our common stock for $1.3 million or an average price of $6.97 per share. These shares are currently being held in treasury.

 

Certain Anti-Takeover Provisions/Agreements with Stockholders

 

Our restated certificate of incorporation allows the board of directors to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by our stockholders. The rights of the holders of our common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. Issuance of preferred stock, while providing desired flexibility in connection with possible acquisitions and other corporate purposes, could make it more difficult for a third party to acquire a majority of our outstanding voting stock. As of March 31, 2012 and December 31, 2011, no shares of preferred stock were outstanding.

 

On February 11, 2011, our Board of Directors agreed to amend the stockholder rights plan effectively terminating the plan as of March 1, 2011.

 

In addition, we are subject to the anti-takeover provisions of Section 203 of Delaware General Corporation Law which prohibit us from engaging in a “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in the prescribed manner. The application of Section 203 may have the effect of delaying or preventing changes in control of our management, which could adversely affect the market price of our common stock by discouraging or preventing takeover attempts that might result in the payment of a premium price to our stockholders.

 

NOTE 11 — SEGMENT INFORMATION

 

We define operating segments as components of our enterprise for which separate financial information is reviewed regularly by the chief operating decision-makers to evaluate performance and to make operating decisions. We have identified our Chief Executive Officer and Vice President of Finance as our chief operating decision-makers (“CODM”). These chief operating decision makers review revenues by segment and review overall results of operations.

 

We currently operate our business as two operating segments based on revenue type:  license fees and services revenue, and customer support revenue (as shown on the consolidated statements of operations).  License fees and services (“L&S”) revenue

 

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represents the fees received from the license of software products and those services directly related to the delivery of the licensed products, such as fees for custom development and integration services.  Customer support (“CS”) revenue includes annual support fees, recurring maintenance fees, fees for maintenance upgrades and warranty services.  Warranty services that are similar to software maintenance services are typically bundled with a license sale. Total assets by segment have not been disclosed as the information is not available to the chief operating decision-makers.

 

Segment information is as follows (in thousands):

 

 

 

For the Three Months
Ended March 31,

 

 

 

2012

 

2011

 

Revenue

 

 

 

 

 

License fees and services

 

$

3,784

 

$

3,143

 

Customer support

 

2,124

 

2,249

 

Total revenue

 

5,908

 

5,392

 

 

 

 

 

 

 

Revenue less costs of revenue, excluding depreciation and amortization

 

 

 

 

 

License fees and services

 

1,966

 

1,909

 

Customer support

 

1,764

 

1,562

 

 

 

3,730

 

3,471

 

Unallocated Costs

 

 

 

 

 

Other operating expenses

 

2,983

 

3,633

 

Depreciation and amortization

 

172

 

266

 

Interest income

 

(21

)

(9

)

Interest income, related party

 

(432

)

 

Interest expense

 

0

 

12

 

Foreign currency exchange (gain) loss

 

96

 

(110

)

 

 

 

 

 

 

 

 

Income (loss) from continuing operations before income taxes

 

$

932

 

$

(321

)

 

Geographic Regions

 

We are headquartered in Englewood, a suburb of Denver, Colorado. We use customer locations as the basis for attributing revenues to individual countries. We provide products and services on a global basis through our headquarters and our London-based Evolving Systems U.K. subsidiary. Additionally, personnel in Bangalore, India provide software development services to our global operations. Financial information relating to operations by geographic region is as follows (in thousands):

 

 

 

Three Months Ended March 31,

 

 

 

2012

 

2011

 

 

 

L&S

 

CS

 

Total

 

L&S

 

CS

 

Total

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

Russia

 

$

1,411

 

$

 

$

1,411

 

$

 

$

 

$

 

United Kingdom

 

377

 

503

 

880

 

282

 

546

 

828

 

Malaysia

 

402

 

47

 

449

 

 

43

 

43

 

Other

 

1,594

 

1,574

 

3,168

 

2,861

 

1,660

 

4,521

 

Total revenues

 

$

3,784

 

$

2,124

 

$

5,908

 

$

3,143

 

$

2,249

 

$

5,392

 

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

Long-lived assets, net

 

 

 

 

 

United States

 

$

85

 

$

84

 

United Kingdom

 

17,041

 

16,566

 

Other

 

59

 

85

 

 

 

$

17,185

 

$

16,735

 

 

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NOTE 12 — COMMITMENTS AND CONTINGENCIES

 

(a)          Other Commitments

 

As permitted under Delaware law, we have agreements with officers and directors under which we agree to indemnify them for certain events or occurrences while the officer or director is, or was, serving at our request in this capacity. The term of the indemnification period is indefinite. There is no limit on the amount of future payments we could be required to make under these indemnification agreements; however, we maintain Director and Officer insurance policies, as well as an Employment Practices Liability Insurance Policy, that may enable us to recover a portion of any amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. Accordingly, there were no liabilities recorded for these agreements as of March 31, 2012 or December 31, 2011.

 

We enter into standard indemnification terms with customers and suppliers, in the ordinary course of business, for third party claims arising under our contracts. In addition, as we may subcontract the development of deliverables under customer contracts, we could be required to indemnify customers for work performed by subcontractors. Depending upon the nature of the indemnification, the potential amount of future payments we could be required to make under these indemnification agreements may be unlimited. We may be able to recover damages from a subcontractor or other supplier if the indemnification results from the subcontractor’s or supplier’s failure to perform. To the extent we are unable to recover damages from a subcontractor or other supplier, we could be required to reimburse the indemnified party for the full amount. We have never incurred costs to defend lawsuits or settle claims relating to an indemnification. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, there were no liabilities recorded for these agreements as of March 31, 2012 or December 31, 2011.

 

Our standard license agreements contain product warranties that the software will be free of material defects and will operate in accordance with the stated requirements for a limited period of time.  The product warranty provisions require us to cure any defects through any reasonable means.  We believe the estimated fair value of the product warranty provisions in the license agreements in place with our customers is minimal.  Accordingly, there were no liabilities recorded for these product warranty provisions as of March 31, 2012 or December 31, 2011.

 

Our software arrangements generally include a product indemnification provision whereby we will indemnify and defend a customer in actions brought against the customer for claims that our products infringe upon a copyright, trade secret, or valid patent of a third party. We have not historically incurred any significant costs related to product indemnification claims. Accordingly, there were no liabilities recorded for these indemnification provisions as of March 31, 2012 or December 31, 2011.

 

(b)         Litigation

 

We are involved in various legal matters arising in the normal course of business.  Losses, including estimated costs to defend, are recorded for these matters to the extent they are probable of loss and the amount of loss can be reasonably estimated.

 

NOTE 13 — RELATED PARTY TRANSACTIONS

 

Effective October 15, 2009, George A. Hallenbeck resigned from our Board of Directors and we entered into a consulting agreement with him to provide consulting services. Mr. Hallenbeck is one of the founders of the Company. Under the consulting agreement, we will pay Mr. Hallenbeck an annual fee of $10,000 for his services through May 31, 2012. We had current obligations in the consolidated balance sheets under the agreement of $2,500 and $2,500 as of March 31, 2012 and December 31, 2011, respectively. We recorded $2,500 of general and administrative expense in the consolidated statements of operations, related to this agreement, for the three months ended March 31, 2012, and 2011, respectively.

 

In connection with the restructuring of our business after the sale of the Numbering Business, we eliminated the position of Sr. Vice President and General Counsel held by Anita T. Moseley, effective July 1, 2011. We entered into a consulting agreement with Ms. Moseley to provide consulting services to the Company through December 31, 2011, and was extended through June 30, 2012 on an as-needed basis.  We had obligations in the consolidated balance sheets of approximately $4,000 as of March 31, 2012 and $125 as of December 31, 2011 related to this agreement.  We recorded approximately $5,000 of general and administrative expense in the consolidated statements of operations, related to this agreement, for the three months ended March 31, 2012. No general and administrative expense was recorded in the consolidated statements of operations, related to this agreement, for the three months ended March 31, 2011.

 

In connection with the restructuring of our business after the sale of the Numbering Business, we eliminated the position of Executive Vice President and Chief Financial Officer held by Brian R. Ervine, effective November 30, 2011. We entered into a consulting agreement with Mr. Ervine to provide consulting services to the Company through December 31, 2012, on an as-needed basis. We had obligations in the consolidated balance sheets of $750 as of March 31, 2012 and approximately $8,000 as of December 31, 2011 related to this agreement.  We recorded approximately $10,000 of general and administrative expense in the consolidated statements of operations, related to this agreement, for the three months ended March 31, 2012.  No general and

 

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administrative expense was recorded in the consolidated statements of operations, related to this agreement, for the three months ended March 31, 2011.

 

During the year ended December 31, 2011, we purchased $16.9 million of Primus Telecommunications Group, Inc. (“PTGI”) senior secured notes, net of purchase discounts, on the open market through a registered broker dealer. The Singer Family Trust, our largest shareholder, owns approximately 22% of our outstanding common shares and approximately 14% of the outstanding shares of PTGI.  Richard Ramlall, Senior Vice President of Corporate Development and Chief Communications Officer of PTGI, serves on our board of directors but is not on our Investment Committee of the Board and as such is not involved in any of our investment decisions, nor is Mr. Ramlall involved with any oversight of the financial operations of PTGI.

 

During the three months ended March 31, 2012, we recorded interest income of $0.4 million in our Consolidated Statements of Operations related to the PTGI senior secured notes.  As of March 31, 2012 the PTGI notes were held as a long-term investment on our Consolidated Balance Sheets at $17.2 million.  Additionally, we had interest receivable of $0.8 million from interest earned not yet due and other comprehensive income included unrealized gains of $0.2 million, net of tax, both of which are related to the senior secured notes. The senior notes mature on April 15, 2017 and earn interest at a rate of 10% per year.  As of April 23, 2012 the investments were sold for approximately $17.8 million and we will record the related gain on sale in the second quarter of 2012.

 

NOTE 14 — SUBSEQUENT EVENTS

 

On May 8, 2012, our Board of Directors declared a special cash dividend of $1.70 per share, payable May 29, 2012, to stockholders of record May 18, 2012.

 

From April 1, 2012 through April 23, 2012, we sold all of our long-term investments which were held on our Condensed Consolidated Balance Sheets as of March 31, 2012 at approximately $17.2 million. The investments were sold for approximately $17.8 million and we will record the related gain on sale in the second quarter of 2012.

 

We evaluated our March 31, 2012 financial statements for subsequent events. We are not aware of any additional subsequent events which would require recognition or disclosure in the interim consolidated financial statements.

 

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

 

SPECIAL NOTE ABOUT FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are based on current expectations, estimates, and projections about Evolving Systems’ industry, management’s beliefs, and certain assumptions made by management.  Forward-looking statements include our expectations regarding product, services, and maintenance revenue, annual savings associated with the organizational changes effected in prior years, and short- and long-term cash needs.  In some cases, words such as “anticipates”, “expects”, “intends”, “plans”, “believes”, “estimates”, variations of these words, and similar expressions are intended to identify forward-looking statements.  The statements are not guarantees of future performance and are subject to certain risks, uncertainties, and assumptions that are difficult to predict; therefore, actual results may differ materially from those expressed or forecasted in any forward-looking statements.  Risks and uncertainties of our business include those set forth in our Annual Report on Form 10-K for the year ended December 31, 2011 under “Item 1A. Risk Factors” as well as additional risks described in this Form 10-Q.  Unless required by law, we undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or otherwise.  However, readers should carefully review the risk factors set forth in other reports or documents we file from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

 

OVERVIEW

 

We are a provider of software solutions and services to the wireless, wireline and cable markets. We maintain long-standing relationships with many of the largest wireless, wireline and cable companies worldwide. Our customers rely on us to develop, deploy, enhance, maintain and integrate complex, highly reliable software solutions for a range of OSS.  We offer software products and solutions focused on activation and provisioning: our service activation solution, TSA used to activate complex bundles of voice, video and data services for traditional and next generation wireless and wireline networks;  our SIM card activation solution, DSA used to dynamically allocate and assign resources to wireless devices that rely on SIM cards, and our connected devices activation solution, Intelligent M2M Controller that supports the activation of M2M devices with intermittent or infrequent usage patterns.

 

We recognize revenue in accordance with the prescribed accounting standards for software revenue recognition under generally accepted accounting principles.  Our license fees and services revenues fluctuate from period to period as a result of the timing of revenue recognition on existing projects.

 

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RECENT DEVELOPMENTS

 

During the third quarter of 2011, we completed the Asset Sale of the Numbering Business to NeuStar, Inc. The Numbering Business is reflected in these interim consolidated financial statements as discontinued operations and historical information related to the divested business has been reclassified accordingly. Refer to Note 9, Discontinued Operations, for more information regarding the Asset Sale.

 

Consolidated revenue increased to $5.9 million from $5.4 million for three months ended March 31, 2012 and 2011, respectively.  The increase in revenue is due to higher license and services revenue primarily from DSA, partially offset by lower customer support revenue.

 

Our twelve month backlog increased to $12.5 million as of March 31, 2012, compared to $7.6 million as of March 31, 2011.

 

We have operations in foreign countries where the local currency is used to prepare the financial statements which are translated into our reporting currency, U.S. Dollars. Changes in the exchange rates between these currencies and our reporting currency are partially responsible for some of the changes from period to period in our financial statement amounts. The chart below summarizes how our revenue and expenses would change had they been reported on a constant currency basis. The constant currency basis assumes that the exchange rate was constant for the periods presented (in thousands).

 

 

 

Three Months Ended
March 31,

 

 

 

2012 vs. 2011

 

Revenue

 

$

(59

)

Costs of revenue and operating expenses

 

(149

)

Operating income

 

$

90

 

 

The net effect of our foreign currency translations for the three months ended March 31, 2012 was a $0.1 million decrease in revenue and a $0.2 million decrease in operating expenses versus the three months ended March 31, 2011.

 

RESULTS OF OPERATIONS

 

The following table presents the unaudited consolidated statements of operations reflected as a percentage of total revenue.

 

 

 

 

For the Three Months Ended March 31,

 

 

 

2012

 

2011

 

REVENUE

 

 

 

 

 

License fees and services

 

64

%

58

%

Customer support

 

36

%

42

%

Total revenue

 

100

%

100

%

 

 

 

 

 

 

COSTS OF REVENUE AND OPERATING EXPENSES

 

 

 

 

 

Costs of license fees and services, excluding depreciation and amortization

 

31

%

23

%

Costs of customer support, excluding depreciation and amortization

 

6

%

13

%

Sales and marketing

 

23

%

34

%

General and administrative

 

15

%

20

%

Product development

 

12

%

13

%

Depreciation

 

1

%

2

%

Amortization

 

2

%

3

%

Total costs of revenue and operating expenses

 

90

%

108

%

 

 

 

 

 

 

Income (loss) from operations

 

10

%

(8

)%

 

 

 

 

 

 

Other income (expense)

 

 

 

 

 

Interest income

 

0

%

0

%

Interest income, related party

 

7

%

 

Interest expense

 

(0

)%

(0

)%

Foreign currency exchange gain (loss)

 

(1

)%

2

%

Other income (expense), net

 

6

%

2

%

 

 

 

 

 

 

Income (loss) from continuing operations before income taxes

 

16

%

(6

)%

Income tax expense (benefit)

 

3

%

(2

)%

Income (loss) from continuing operations

 

13

%

(4

)%

Income from discontinued operations, net of tax

 

 

21

%

Net income

 

13

%

17

%

 

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Table of Contents

 

Revenue

 

Revenue is comprised of license fees/services and customer support.  License fees and services revenue represent the fees we receive from the licensing of our software products and those services directly related to the delivery of the licensed product as well as integration and consulting services.  Customer support revenue includes annual support, recurring maintenance, maintenance upgrades and warranty services.  Warranty services consist of maintenance services and are typically bundled with a license sale and the related revenue, based on Vendor-Specific Objective Evidence (“VSOE”), is deferred and recognized ratably over the warranty period.

 

Revenue for the three months ended March 31, 2012 and 2011 was $5.9 million and $5.4 million, respectively.  Increased revenue is primarily due to increased license and services revenue from our DSA product partially offset by decreased customer support revenue.

 

License Fees and Services

 

License fees and services revenue increased $0.6 million, or 20%, to $3.8 million for the three months ended March 31, 2012 from $3.2 million for the three months ended March 31, 2011.  The increase in revenue is primarily related to higher revenue from DSA.

 

Customer Support

 

Customer support revenue decreased $0.1 million, or 6%, to $2.1 million for the three months ended March 31, 2012 from $2.2 million for the three months ended March 31, 2011. The decline in customer support revenue is due to lower revenue from DSA and TSA.

 

Costs of Revenue, Excluding Depreciation and Amortization

 

Costs of revenue, excluding depreciation and amortization, consist primarily of personnel costs and other direct costs associated with these personnel, facilities costs, costs of third-party software and partner commissions.  Costs of revenue, excluding depreciation and amortization, were $2.2 million and $1.9 million for the three months ended March 31, 2012 and 2011, respectively.

 

Costs of License Fees and Services, Excluding Depreciation and Amortization

 

Costs of license fees and services, excluding depreciation and amortization, increased $0.6 million, or 47%, to $1.8 million for the three months ended March 31, 2012 from $1.2 million for the three months ended March 31, 2011. The increase in costs is primarily the result of third party software and partner commissions for our DSA product and increased effort to support higher revenue during the period. As a percentage of license fees and services revenue, costs of license fees and services, excluding depreciation and amortization, increased to 48% for the three months ended March 31, 2011 from 39% for the three months ended March 31, 2011.  The increase as a percentage of revenue is primarily due to the aforementioned increase in costs during the period.

 

Costs of Customer Support, Excluding Depreciation and Amortization

 

Costs of customer support, excluding depreciation and amortization, decreased $0.3 million, or 48%, to $0.4 million for the three months ended March 31, 2012 from $0.7 million for the three months ended March 31, 2011.  The decrease in costs is related to fewer hours spent on support projects during the quarter. As a percentage of customer support revenue, costs of customer support revenue, excluding depreciation and amortization, decreased to 17% for the three months ended March 31, 2012 from 31% for the three months ended March 31, 2011.  The decrease in costs as a percentage of revenue is due primarily to the aforementioned decrease in hours spent on support projects during the period.

 

Sales and Marketing

 

Sales and marketing expenses primarily consist of compensation costs, including incentive compensation and commissions, travel expenses, advertising, marketing and facilities expenses. Sales and marketing expenses decreased $0.6 million, or 28%, to $1.3 million for the three months ended March 31, 2012 from $1.9 million for the three months ended March 31, 2011.  The decrease in costs is related primarily lower headcount, travel and entertainment and marketing expense. As a percentage of total revenue, sales and marketing expenses decreased to 23% for the three months ended March 31, 2012 from 34% for the three months ended March 31, 2011. The decrease in sales and marketing costs as a percentage of revenue is primarily due to increased revenue and to the aforementioned decrease in costs during the period.

 

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General and Administrative

 

General and administrative expenses consist principally of employee related costs and professional fees for the following departments: facilities, finance, legal, human resources, and certain executive management.  General and administrative expenses decreased $0.2 million, or 17%, to $0.9 million from $1.1 million for the three months ended March 31, 2012 and 2011, respectively.  The decrease in costs is primarily due to lower headcount and equity compensation. As a percentage of revenue, general and administrative expenses decreased to 15% for the three months ended March 31, 2012 from 20% for the three months ended March 31, 2011. The decrease in general and administrative costs as a percentage of revenue is primarily due to increased revenue and to the aforementioned decrease in costs during the period.

 

Product Development

 

Product development expenses consist primarily of employee related costs and subcontractor expenses.  Product development remained at $0.7 million for the three months ended March 31, 2012 and 2011, respectively.  As a percentage of revenue, product development expenses for the three months ended March 31, 2012 and 2011, decreased to 12% from 13%, respectively.  The decrease as a percentage of revenue is primarily due to the increase in revenue.

 

Depreciation

 

Depreciation expense consists of depreciation of long-lived property and equipment.  Depreciation expense remained at $0.1 million for the three months ended March 31, 2012 and 2011. As a percentage of total revenue, depreciation expense for the three months ended March 31, 2012 and 2011 was 1% and 2%, respectively.  The decrease as a percentage of revenue is primarily due to increased revenue.

 

Amortization

 

Amortization expense consists of amortization of identifiable intangible assets acquired through our acquisition of Evolving Systems U.K.  Amortization expense decreased $0.1 million, or 44%, to $0.1 million from $0.2 million for the three months ended March 31, 2012 and 2011, respectively. As a percentage of total revenue, amortization expense for the three months ended March 31, 2012 and 2011, decreased to 2% from 3%, respectively. The decrease in amortization expense and as a percentage of revenue is due to some intangible assets becoming fully amortized during the second quarter of 2011.

 

Restructuring

 

There were no restructuring expenses during the three months ended March 31, 2012 or 2011.

 

Interest Income

 

Interest income includes interest income earned on cash, cash equivalents and long-term investments.  Interest income increased $0.4 million or 5563%, to $0.5 million for the three months ended March 31, 2012 from $8,000 for the three months ended March 31, 2011. The increase was due primarily to interest from long-term investments.

 

Interest Expense

 

Interest expense includes interest expense from our capital lease obligations.  Interest expense was $0 and $12,000 for the three months ended March 31, 2012 and 2011, respectively. The decrease of $12,000 is primarily due to the expiration of our capital lease obligations in the first quarter of 2012.

 

Foreign Currency Exchange Gain (Loss)

 

Foreign currency transaction gains (losses) resulted from transactions denominated in a currency other than the functional currency of the respective subsidiary and were ($0.1) million and $0.1 million for the three months ended March 31, 2012 and 2011, respectively.  The gains (losses) were generated primarily through the re-measurement of certain non-functional currency denominated financial assets and liabilities of our Evolving Systems U.K. and India subsidiaries.

 

Accumulated Other Comprehensive Income (Loss)

 

Accumulated other comprehensive income (loss) refers to revenue, expenses, gains, and losses that under GAAP are recorded as an element of shareholders’ equity but are excluded from net income. Accumulated other comprehensive income (loss) consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency and unrealized gains and losses on marketable securities categorized as available-for-sale. Accumulated other comprehensive income increased to $1.3 million as of March 31, 2012 compared to $0.7 million as of March 31, 2011. The increase is related primarily stronger subsidiaries’ functional currencies and net unrealized gains related to long-term corporate debt securities.

 

Income Taxes

 

We recorded net income tax expense (benefit) of $0.2 million and ($0.1) million for the three months ended March 31, 2012 and 2011, respectively.  The net expense during the three months ended March 31, 2012 consisted of current income tax expense of $0.2 million and a deferred tax benefit of ($30,000). The current tax expense consists primarily of Alternative Minimum Tax (“AMT”), state tax and unrecoverable foreign withholding tax in the U.S., income tax from our U.K.-based operations and income taxes related to our operations in India. The majority of the U.K. income tax expense is related to unrecoverable foreign withholding

 

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taxes. The foreign withholding taxes are typically used to offset our income tax liability, but we do not believe we will have enough taxable income to utilize the foreign withholding taxes during the year. The deferred tax expense was net of a tax benefit primarily related to intangible assets from our U.K.-based operations. The net benefit during the three months ended March 31, 2011 consisted of current income tax expense of $0.3 million and a deferred tax benefit of ($0.4) million. The current tax expense consists of income tax from our U.K.-based operations, Alternative Minimum Tax (“AMT”), state income taxes and unrecoverable foreign withholding tax in the U.S. The deferred tax benefit was related to the release of our valuation allowance on our tax asset from our Indian operations as we will begin to utilize Minimum Alternative Tax (“MAT”) payments made during our tax holiday, which can be applied toward future taxes payable since the tax holiday expired on March 31, 2011. We also had a tax benefit related to intangible assets from our U.K.-based operations.

 

Our effective tax rate of 19% for the three months ended March 31, 2012 was decreased from an effective tax rate of 29% for the three months ended March 31, 2011.  This decrease in our effective tax rate relates principally to the adjustment of the allocation of tax expense between continuing and discontinued operations and the release of our valuation allowance on our MAT tax asset from our Indian operations.

 

In conjunction with the acquisition of Evolving Systems U.K., we recorded certain identifiable intangible assets.  Since the amortization of these identifiable intangibles is not deductible for income tax purposes, we established a long-term deferred tax liability of $4.6 million at the acquisition date for the expected difference between what would be expensed for financial reporting purposes and what would be deductible for income tax purposes. As of March 31, 2012 and December 31, 2011, this component of the deferred tax liability was $0.1 million, respectively.  This deferred tax liability relates to Evolving Systems U.K., and has no impact on our ability to recover U.S.-based deferred tax assets.  This deferred tax liability will be recognized as a reduction of deferred income tax expense as the identifiable intangibles are amortized.

 

As of March 31, 2012 and December 31, 2011 we continued to maintain a valuation allowance on the domestic net deferred tax asset as we have determined it is more likely than not that we will not realize our domestic deferred tax assets.  Such assets primarily consist of certain net operating loss carryforwards.  We assessed the realizability of our domestic deferred tax assets using all available evidence.  In particular, we considered both historical results and projections of profitability for the reasonably foreseeable future periods.  We are required to reassess our conclusions regarding the realization of our deferred tax assets at each financial reporting date. A future evaluation could result in a conclusion that all or a portion of the valuation allowance is no longer necessary, which could have a material impact on our results of operations and financial position. The $0.4 million of deferred tax liability as of March 31, 2012, were comprised of the following:

 

 

 

March 31, 2012

 

Deferred tax assets:

 

 

 

Net operating loss carryforwards

 

$

4,441

 

Research & Development Credits

 

303

 

AMT/MAT credit

 

942

 

Stock Compensation

 

628

 

Depreciable assets

 

97

 

Accrued liabilities and reserves

 

209

 

Total deferred tax assets

 

6,620

 

 

 

 

 

Deferred tax liabilities

 

 

 

Undistributed Foreign Earnings

 

$

(1,476

)

Unrealized gains on investments

 

(141

)

Intangibles

 

(120

)

Total deferred tax liability

 

(1,737

)

 

 

 

 

Net deferred tax assets, before valuation allowance

 

$

4,883

 

Valuation allowance

 

(5,298

)

Net deferred tax liabilities

 

$

(415