Pervasive Software 10-Q 2005
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2004
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission file number 000-23043
PERVASIVE SOFTWARE INC.
(Exact name of registrant as specified in its charter)
12365 Riata Trace Parkway, Bldg. B
Austin, Texas 78727
(Address of principal executive offices)
(Registrants telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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
(1) Yes x No ¨
(2) Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). x Yes ¨ No
As of February 4, 2005 there were 22,293,078 shares of the Registrants common stock outstanding.
Item 1. Financial Statements
CONDENSED CONSOLIDATED BALANCE SHEETS
See accompanying notes.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
See accompanying notes.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004
1. General and Basis of Financial Statements
The unaudited interim condensed consolidated financial statements include the accounts of Pervasive Software Inc. and its majority-owned subsidiaries (collectively, the Company or Pervasive). All material intercompany accounts and transactions have been eliminated in consolidation.
The financial statements included herein reflect all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary to fairly state the Companys financial position, results of operations and cash flows for the periods presented. These financial statements should be read in conjunction with the Companys consolidated financial statements and notes thereto for the year ended June 30, 2004, which are contained in the Companys Annual Report filed on Form 10-K on September 13, 2004 (File No. 000-23043). The results of operations for the three and six month periods ended December 31, 2004 and 2003 are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year.
On December 4, 2003, the Company completed the acquisition of Data Junction Corporation (Data Junction) pursuant to the Agreement and Plan of Merger dated as of August 8, 2003 (Merger Agreement), (see Note 7 Business Combinations). The acquisition has been accounted for under the purchase method of accounting, and accordingly, the results of operations of Data Junction have been included in the Companys unaudited condensed consolidated financial statements since the date of acquisition.
Certain prior period amounts have been reclassified to conform to current period presentation.
2. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
3. Comprehensive Income
The components of comprehensive income are as follows:
4. Stock Compensation
Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, (Statement 123), prescribes accounting and reporting standards for all stock-based compensation plans, including employee stock options. As allowed by Statement 123, the Company has elected to continue to account for its employee stock-based compensation using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The Company has calculated the fair value of options granted in these periods using the Black-Scholes option-pricing model and has determined the pro forma impact on net income.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, this option valuation model requires the input of highly subjective assumptions including the expected stock price volatility. Because the Companys employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in managements opinion, the Black-Scholes model does not necessarily provide a reliable single measure of the fair value of its employee stock options. The Company is presently reviewing alternative option valuation models for possible use in the future. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options vesting periods.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement 123 to stock-based employee compensation (in thousands, except per share data):
5. Recently Issued Accounting Standards
In December 2004, the FASB issued SFAS No. 123R Share-Based Payment which supersedes Accounting Principle Board Opinion (APB) Opinion No. 25, Accounting for Stock Issued to Employees, SFAS No. 123, Accounting for Stock-Based Compensation, and related implementation guidance. The pronouncement is effective for interim and annual periods beginning after June 15, 2005. Under this pronouncement, stock-based compensation to employees is required to be recognized as a charge to the statement of operations and such charge is to be measured according to the fair value of the stock options. In the absence of an observable market price for the stock awards, the fair value of the stock options would be based upon a valuation methodology that takes into consideration various factors, including the exercise price of the option, the expected term of the option, the current price of the underlying shares, the expected volatility of the underlying share price, the expected dividends on the underlying shares and the risk-free interest rate. We will adopt the delayed provisions of SFAS 123R during the first quarter of our fiscal year 2006; however, we have not yet decided which of the allowable transition alternatives we will utilize. Our current policy is to not expense share-based compensation; however, we do disclose the effect of this item as currently required by SFAS 123, see Note 4 Stock Compensation.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
6. Goodwill and Other Intangible Assets
As of December 31, 2004, Pervasive had goodwill in the amount of $39.0 million associated with the acquisition of Data Junction (see Note 7). The Company previously determined, in accordance with Statement of Financial Accounting Standards No. 142 Goodwill and Other Intangible Assets, that it would assess the impairment of goodwill and other intangible assets with indefinite lives annually in the fourth quarter, or more frequently if other indicators of impairment arise. Other intangible assets, classified as Purchased Technology on the balance sheet, amounted to $5.9 million (net of accumulated amortization of $1.6 million) as of December 31, 2004. These intangible assets consist primarily of developed technology, including the value assigned to amortizable intangible assets in connection with the acquisition of Data Junction during the second quarter of fiscal 2004 consisting of $6.3 million of developed technology. The Company is amortizing these assets on a straight-line basis over their estimated useful lives, generally five to ten years. Amortization expense for the three and six months ended December 31, 2004 was $0.3 million and $0.7 million, respectively. Amortization expense for intangible assets for each of the years ended June 30, 2005, 2006, 2007 and 2008 is anticipated to be $1.4 million and for the year ended June 30, 2009 is anticipated to be $0.9 million.
7. Business Combinations
On December 4, 2003, the Company purchased Data Junction for cash of approximately $16.6 million, net of cash acquired of $6.5 million and including acquisition costs of approximately $1.0 million, and 5,000,000 shares of common stock valued at $30.0 million, based on the average market value of the Companys common stock a few days before and after the acquisition was agreed to and announced on August 8, 2003. Accordingly, the results of operations of the acquired business is included in the consolidated financial statements of the Company from the date of acquisition. The Company acquired Data Junction to broaden its data infrastructure capabilities, increase the Companys size and scale, and leverage the increased customer base of the combined companies. The contributing factors to the purchase price paid by the Company consisted primarily of Data Junctions historical earnings and cash flow from operations and perceived market opportunity for future growth. The purchase price was allocated to the acquired assets and liabilities assumed, based upon managements estimate of their fair values as of the acquisition date. A summary of the purchase price for the Data Junction acquisition is as follows (in millions):
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The value of purchased technology was determined by discounting the incremental earnings attributable to all existing technology which had reached technological feasibility, after considering risks relating to: (i) the expected lifecycle of the technology, (ii) the expected annual operating profit related to the technology, and (iii) the future cash flows associated with the technology. Estimates of future revenues and expenses used to determine the value of developed technology was consistent with the historical trends in the industry and expected outlooks. The purchased technology is being amortized over its respective useful life of five years using the straight-line method.
Of the total purchase price, $1.1 million was allocated to in-process research and development (IPR&D) and was expensed upon acquisition. The value of IPR&D was based on an evaluation of all developmental projects using the guidance set forth in FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method. Projects that qualify as IPR&D represent those that have not yet reached technological feasibility and for which no future alternative uses existed. Technological feasibility is defined as being equivalent to a beta-phase working prototype in which there is no remaining risk relating to the development.
The value of the IPR&D was determined by (i) estimating future revenue and operating profits associated with existing development projects, (ii) projecting the future cash flows and costs to complete the underlying technologies and resultant products and (iii) discounting these cash flows to their net present value. Estimates of future revenue and expenses used to determine the value of in-process research and development were consistent with the historical trends in the industry and the expected outlooks. The entire amount of $1.1 million was charged to operations because related technologies had not reached technological feasibility and they had no alternative use.
The following table represents the Companys unaudited pro forma results of operations for the three and six months ended December 31, 2003 as if the acquisition of Data Junction had occurred as of the beginning of the applicable period. The pro forma information excludes IPR&D charges of $1.1 million in the three and six months ended December 31, 2003, since it is a nonrecurring charge resulting from the acquisition. The unaudited pro forma financial information has been prepared for comparative purposes only and there can be no assurance that this presentation reflects the results of operations that would have occurred had Data Junction been consolidated with the Company during the applicable periods.
PERVASIVE SOFTWARE INC.
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The statements contained in this Report on Form 10-Q that are not purely historical statements are forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, including statements regarding the Companys expectations, beliefs, hopes, intentions or strategies regarding the future. These forward-looking statements involve risks and uncertainties. Actual results may differ materially from those indicated in such forward-looking statements. We are under no duty to update any forward-looking statements after the date of this filing on Form 10-Q to conform these statements with actual results. See Risk Factors that May Affect Future Results, and the factors and risks discussed in the Companys Annual Report on Form 10-K filed on September 13, 2004 (File No. 000-23043) and other reports filed from time to time with the Securities and Exchange Commission.
Pervasive Software is a global value leader in data infrastructure software. Thousands of businesses worldwide rely on our solutions to help manage, integrate, analyze and secure their critical data. Our data management and integration product lines are designed specifically for small to mid-sized businesses and departments of large enterprises where high performance, flexibility, rapid deployment and low total cost of ownership (TCO) are paramount. In addition, significant portions of our product line are embeddable into commercial applications for sale predominantly to small to mid-size enterprises (SMEs) through a well-developed channel of independent software vendors (ISVs), value-added resellers (VARs) and systems integrators.
Our data management solutions combine high performance and low TCO to provide superior value for ISVs, VARs, our distributors and departments within larger enterprises. More than 6 million server seats of our Pervasive.SQL database have been licensed since inception in 1994. The full data management product line also includes specific solutions for data movement and synchronization and addresses security challenges related to data integrity, accountability, continuity and availability throughout the data life cycle. The product line is designed for integration by ISVs into client/server, Web and mobile applications and is predominantly sold to SMEs, which typically have environments with little to no information technology (IT) infrastructure and require self-tuning, low-administration products.
Our data and application integration solutions feature a comprehensive set of visual design tools to rapidly build and test integration processes, regardless of size and complexity, across hundreds of data formats and applications within and outside of the enterprise. The Pervasive Integration product line is designed to grow and scale for the diverse data and application integration needs of mid-sized businesses and departments of large enterprises. Our focus on rapid implementation and ease of use helps reduce the complexity, costs and risks associated with traditional labor-intensive integration methods.
From a strategic perspective, we continue to take important steps to compete in a software market defined by increasing levels of maturation and commoditization. Linux is achieving mainstream adoption as an open source operating system, and we believe open source database software will also become widely adopted. In January 2005, we announced our entry into the mainstream corporate database market with Pervasive Postgres, based on the freely available open source database, PostgreSQL. We believe Pervasive is well positioned among existing public database companies to leverage many years of data management expertise and promote open source adoption in the mainstream corporate database market. We intend to generate revenue from Pervasive Postgres in the form of support subscriptions and professional services. The addition of Pervasive Postgres to our data infrastructure software family now gives us a broad spectrum of database offerings that meets the needs of customers both large and small.
Our strength is evidenced by the size and diversity of our customer base, serving tens of thousands of customers
in virtually every industry and market around the world. We sell products worldwide in more than 150 countries through direct sales and channel distribution. Our customer base of more than 35,000 customers includes a distribution channel of more than 10,000 ISVs, developers, VARs, systems integrators and partners who have built or deployed applications on top of our data management platform. We also have a customer base of more than 25,000 end users for our integration products and services. Founded in 1994, Pervasive is headquartered in Austin, Texas, with international offices in Brussels; Frankfurt; London; Paris; Milan; Warsaw and Bangalore; and a joint venture in Japan.
On December 4, 2003 we completed the acquisition of Data Junction Corporation (Data Junction). The acquisition was made pursuant to an Agreement and Plan of Merger, dated as of August 8, 2003, by and among us, Ramal Acquisition Corp., our wholly owned Delaware subsidiary and Data Junction. The aggregate cash plus share purchase price for all of the common stock of Data Junction was approximately $46.6 million, net of cash acquired from Data Junction (See Note 7 of Notes to the Condensed Consolidated Financial Statements). The results of operations of Data Junction from December 4, 2003 to December 31, 2004 are included in our consolidated results of operations.
The acquisition of Data Junction brought important data integration and transformation technologies and products, which are highly complementary to our existing data management products, expertise and customer base. The acquisition significantly advances our strategy to be the global value leader in data infrastructure software, enabling more than 25,000 businesses, such as major corporations, systems integrators and software vendors, to capitalize on their data investments. Winner of more than 20 major industry awards, Data Junction is a market leader in innovative integration technology, helping customers quickly and cost-effectively connect disparate data sources. Primary integration products include a comprehensive set of visual design tools for rapidly building and testing data integration processes that work with hundreds of data formats and applications. This enables design with total control over all aspects of the integration project from creating integration maps to managing complex, event-driven flow of inter-application messages and EDI processes. Data Junction virtually created the category known as ETL (extract, transform and load) in 1986 with Data Junction v1.0, one of the worlds first hub-and-spoke approaches to data conversion and translation, and today is charting new ground in the development of business and application integration technologies.
In July 2001, we formed a new business venture with AG-TECH Corporation, a company developing, selling and importing packaged software, to sell and support our products in Japan. AG-TECH has been engaged in the sales and support of Btrieve (predecessor to Pervasive.SQL) and Pervasive.SQL products since 1986. In conjunction with the joint venture, AG-TECH launched a new operating division staffed with specialists experienced in selling and supporting Pervasive.SQL to assume responsibility for OEM sales, packaged software sales, technical support and localization and translation of our products into Japanese. The new business venture has resulted in improved profitability on sales in Japan as the arrangement allowed us to significantly reduce our costs in Japan. In connection with the new business venture, we obtained a less than 20% ownership interest in AG-TECH and the ability to elect one director to the AG-TECH Board of Directors. Pervasives revenues from Japan were $3.0 million and $2.9 million for the six-month periods ended December 31, 2003 and 2004, respectively. In June 2004, we amended our distribution agreement with AG-TECH for an extended three-year period ending June 30, 2007.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and assumptions are reviewed periodically. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following represent our critical accounting policies:
Revenue Recognition - We license our software through OEM license agreements with software developers, or ISVs, and through shrink-wrap software licenses, sold through ISVs, value-added resellers, or VARs, systems integrators and distributors, or direct to end users. Revenues are recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, no significant Company obligations with regard to implementation remain, the fee is fixed or determinable and collectibility is probable. Revenues related to OEM license agreements involving nonrefundable fixed minimum license fees are recognized upon delivery of the product master or first copy if no significant vendor obligations remain. Per copy royalties related to OEM license agreements in excess of a fixed minimum amount are recognized as revenue when such amounts are reported to us. Revenue from post contract support and the right to receive unspecified upgrades is recognized ratably over the contract term. We generally provide telephone support to customers and end users in the 30 days immediately following the sale at no additional charge and at a minimal cost per call. We accrue the cost of providing this support. Revenue from consulting services and training is recognized when the related services are performed. We enter into agreements with certain distributors that provide for certain stock rotation and price protection rights. These rights allow the distributor to return products in a non-cash exchange for other products or for credits against future purchases. Revenue from shipping and handling is recognized at the shipping date. Shipping and handling costs are included in costs of product license revenues in the Condensed Consolidated Statements of Operations.
Sales Returns and Bad Debt Reserves - We reserve for the cost of estimated sales returns, stock rotation and price protection rights as well as uncollectible accounts based on experience.
Goodwill and Other Intangible Assets We assess whether goodwill and indefinite-lived intangibles are impaired on an annual basis. Upon determining the existence of goodwill and/or indefinite-lived intangibles impairment, we measure that impairment based on the amount by which the book value of goodwill and/or indefinite-lived intangibles exceeds its fair value. The implied fair value of goodwill is determined by deducting the fair value of a reporting units identifiable assets and liabilities from the fair value of the reporting unit as a whole, as if that reporting unit had just been acquired and the purchase price were being initially allocated. Additional impairment assessments may be performed on an interim basis if we encounter events or changes in circumstance that would indicate that, more likely than not, the book value of goodwill and/or indefinite-lived intangibles has been impaired.
Results of Operations
The following table sets forth for the periods indicated the percentage of revenues represented by certain lines in our Consolidated Statements of Operations.
Revenue from our embedded database product, Pervasive.SQL decreased in the current quarter relative to the comparable period in the prior fiscal year. We believe this decrease was due to a variety of factors, including but not limited to, the length of time since the last major version release of our database product (December 2002), increasing competition and what we believe to be the increasingly negative impact of general economic conditions on our ISV customers who build applications utilizing our database software and reduced demand for the ISVs software applications themselves. Revenue from recently introduced add-on products for our database products, namely AuditMaster and Data Exchange, continued to generate database related revenue in the three months ended December 31, 2004 as we continue to market these add-on products to our large base of database customers. In addition, we believe the integration products we acquired in fiscal year 2004 represent an excellent growth opportunity as we invest in revenue synergies and opportunities presented by the acquired business, combined with our historical database business and channels. A continued reduction in our embedded database business, or our inability to grow our integration products business, could have a material adverse effect on our business, operating results and financial condition.
Our revenues were $11.6 million in the three months ended December 31, 2004, an increase of 1% over the $11.5 million reported for the comparable period in the prior fiscal year. Our revenues for the six-month period ending December 31, 2004 increased 12% to $23.4 million as compared to $20.9 million for the comparable period in the prior fiscal year. License and service revenues for the three and six month periods ended December 31, 2004 were the result of a decrease in our embedded database product revenue, offset by the inclusion of Data Junction revenues for the entire three and six month periods ended December 31, 2004.
Our product license revenues were $8.9 million in the three months ended December 31, 2004, a decrease of 10% over the $9.9 million for the comparable period in the prior fiscal year. Our product license revenues for the six-month period ending December 31, 2004 decreased 2% to $17.8 million as compared to $18.2 million for the comparable period in the prior fiscal year. The decrease in product license revenue was primarily due to decreases in our embedded database product revenue, offset partially by the inclusion of license revenue from Data Junction products for the entire three and six month periods ended December 31, 2004.
Licenses of our embedded database software operating on Windows NT or other Microsoft operating systems continue to represent approximately 90% of our database product license revenues. We expect that the percentages of our revenues attributable to licenses of our software operating on particular platforms will continue to change from time to time. We cannot be certain that our revenues attributable to licenses of our software operating on Windows NT, or any other operating system platform, will increase or decrease in the future.
Our service and other revenues were $2.7 million in the three months ended December 31, 2004, an increase of 65% over the $1.7 million for the comparable period in the prior fiscal year. Our service and other revenues for the six-month period ending December 31, 2004 increased 102% to $5.5 million as compared to $2.7 million for the comparable period in the prior fiscal year. The increase in service and other revenue was primarily due to the inclusion of service and other revenue from Data Junction for the entire three and six month periods ended December 31, 2004.
International revenues, consisting of all revenues from customers located outside of North America, were $4.3 million and $4.2 million in the three months ended December 31, 2003 and 2004, representing 37% and 37% of total
revenues, respectively. International revenues were $8.3 million and $9.1 million in the six months ended December 31, 2003 and 2004, representing 40% and 39% of total revenues, respectively. We attribute the increase in international revenue during the first half of fiscal 2005 as compared to the first half of fiscal 2004 primarily to increased database product revenue in Europe during the first half of fiscal 2005. We expect that international revenues will continue to account for a significant portion of our revenues in the future.
Costs and Expenses
Cost of Product License Revenues. Cost of product license revenues consists primarily of the cost to manufacture and fulfill orders for our shrink-wrap software products, payment of license fees for third-party technologies embedded in our products and amortization of purchased technology. Cost of product license revenues was $0.4 million and $0.6 million in the three months ended December 31, 2003 and 2004, representing 3% and 5% of total revenues, respectively. Cost of product license revenues was $0.6 million and $1.1 million for the six-month period ending December 31, 2003 and 2004, representing 3% and 5% of total revenues, respectively. The increase in cost of product license revenues is principally the result of amortization related to the $6.3 million value assigned to developed technology acquired through the Data Junction acquisition. The Data Junction acquisition occurred on December 4, 2003, and accordingly, we began to recognize amortization expense after the acquisition date. We anticipate that cost of product license revenues in the near term will be consistent with costs incurred during the three months ended December 31, 2004.
Cost of Service and Other Revenues. Cost of service and other revenues consists primarily of the cost to provide technical support, primarily telephone support, which is typically provided within 30 days of purchase and the costs to deliver professional services and training services to others. Cost of service and other revenues was $1.2 million and $1.1 million in the three months ended December 31, 2003 and 2004, representing 11% and 10% of total revenues, respectively. Cost of service and other revenues was $2.3 million and $2.5 million for the six-month period ending December 31, 2003 and 2004, representing 11% and 11% of total revenues, respectively. Cost of service and other revenues increased in dollar amount for the six month period ended December 31, 2004 primarily as a result of the inclusion of technical support and consulting personnel and related operating costs associated with the Data Junction operations for the entire six month period ended December 31, 2004, offset by a reduction in total technical support personnel in the first year following the acquisition. We anticipate that cost of service and other revenues in the near term will be consistent with the costs incurred during the three months ended December 31, 2004.
Sales and Marketing. Sales and marketing expenses consist primarily of salaries, commissions and bonuses earned by sales and marketing personnel, foreign sales office expenses, marketing programs and promotional expenses, and travel and entertainment. Sales and marketing expenses were $3.9 million and $5.5 million in the three months ended December 31, 2003 and 2004, representing 34% and 47% of total revenues, respectively. Sales and marketing expenses were $7.3 million and $10.9 million for the six months ending December 31, 2003 and 2004, representing 35% and 47% of total revenues, respectively. The increase in sales and marketing expenses is due primarily to the inclusion of operating costs associated with the Data Junction operations for the entire three and six month periods ended December 31, 2004. We expect sales and marketing expenses in the near term may increase from costs incurred during the three months ended December 31, 2004, as we continue to increase investments in sales and marketing personnel and marketing programs related to the data integration product line acquired in the Data Junction acquisition, market the next version of our embedded database product, Pervasive.SQL V.9, and invest in demand creation activities related to our open source database initiative, Pervasive Postgres.
Research and Development. Research and development expenses consist primarily of personnel and related costs. Research and development expenses were $2.3 million and $2.8 million in the three months ended December 31, 2003 and 2004, representing 20% and 24% of total revenues, respectively. Research and development expenses were $4.4 million and $5.4 million for the six months ended December 31, 2003 and 2004, representing 21% and 23% of total revenues, respectively. Research and development expenses increased primarily as a result of costs relating to the inclusion of Data Junction operations for the entire three and six month periods ended December 31, 2004. We anticipate that research and development expenses in the near term may decrease from costs incurred during the three months ended December 31, 2004, as we continue to leverage investments in our offshore development center located in Bangalore, India.
General and Administrative. General and administrative expenses consist primarily of the personnel and other costs associated with our finance, human resources, information systems and administrative departments. General and administrative expenses were $1.6 million and $1.1 million in the three months ended December 31, 2003 and 2004, representing 14% and 10% of total revenues, respectively. General and administrative expenses were $2.7 million and $2.2 million for the six months ended December 31, 2003 and 2004, representing 13% and 9% of total revenues, respectively. General and administrative expenses decreased primarily as a result of a non-recurring charge of $0.3 million for the write-off of related party notes receivable in the second quarter of fiscal 2004. We anticipate that our general and administrative expenses in the near term will be consistent with costs incurred during the three months ended December 31, 2004.
The write-off of related party notes receivable in the second quarter of fiscal 2004 totaled approximately $0.3 million and was included in general and administrative expenses. These notes receivable, dated July 2001 and March 2002, were written off in accordance with the original terms of the note agreements with our former Chairman of the Board and Chief Executive Officer Ron Harris. The terms of the original notes required the forgiveness of the balance of the notes in the event Mr. Harris service to the Company ended under certain conditions. With the expiration and non-renewal of Mr. Harris term as a Director of the Company at the 2003 Annual Shareholders Meeting on December 3, 2003, and with the absence of any other agreement calling for the continued service of Mr. Harris to the Company, the conditions for forgiveness of the notes were met.
Write-off of Acquired In-Process Research and Development. In connection with the Data Junction acquisition in December 2003, we recorded a charge of $1.1 million, or approximately 2% of the total purchase price, for IPRD. The value allocated to the projects identified as IPRD was charged to operations during the three months ended December 31, 2003.
At the acquisition date, Data Junctions in-process project was Release 9.0 of the Data Junction integration software product. At the date of the acquisition, IPRD was approximately 70% complete, based upon costs expended to date and estimated costs to complete the project. Release 9.0 will include significant new code that will result in the creation of an improved architecture designed to solve the high performance integration needs of larger companies and will be much better suited to tackle more complex data and application integration projects.
As of the Data Junction acquisition date, this technology had not yet reached technological feasibility and had no alternative uses. The technological feasibility of an in-process product is established when the enterprise has completed all planning, designing, coding and testing activities necessary to establish that the product can be produced to meet its design specifications. The value of IPRD was determined using an income approach. This approach takes into consideration earnings remaining after deducting from cash flows related to the in-process technology the market rates of return on contributory assets, including assembled workforce, customer accounts and existing technology. The cash flows are then discounted to present value at an appropriate rate. Discount rates are determined by an analysis of the risks associated with each of the identified intangible assets. Given the riskier nature of the cash flows related to the IPRD, a higher discount was warranted, and is based on the cost of equity plus 1000 basis points. The resulting cash flows attributable to the IPRD were discounted at a discount rate of 25.4%. The resulting net cash flows to which this discount rate was applied are based on managements estimates of revenues, operating expenses, and income taxes from such acquired technology. It is anticipated that, barring unforeseen circumstances, substantially all of the features of Release 9.0 of the Data Junction integration software project are expected to be completed in the third quarter of fiscal year 2005. Some of the risks and uncertainties inherent in the estimated costs to complete the project and the attainment of completion, include, but are not limited to, the difficulty of predicting the duration of product development and the risks that changes in the product requirements will result in unexpected redesign activity.
Provision for Income Taxes. Provision for income taxes was approximately $0.2 million and $0.1 million in the three months ended December 31, 2003 and 2004, respectively. Provision for income taxes was approximately $0.4 million and $0.1 million for the six months ended December 31, 2003 and 2004, respectively. The provision for income taxes consists primarily of income taxes related to foreign operations and decreased from the comparable period in the prior fiscal year due to a reduction in withholding requirements associated with license revenues generated in Japan. Income from U.S. operations has been offset by net operating losses carried forward from previous years.
Based on a number of factors, we believe that it is more likely than not, that a substantial amount of our deferred tax assets may not be realized. Accordingly, we have recorded a valuation allowance equal to the net deferred tax asset due to uncertainties regarding the realization of deferred tax assets based on the lack of significant earnings history and risks associated with business combinations. We expect to continue to incur foreign taxes associated with our international operations while our domestic income taxes will remain minimal as we utilize substantial net operating losses and foreign tax credits carried forward from previous years.
Liquidity and Capital Resources
Cash provided by continuing operations was $1.1 million and $3.7 million for the six months ended December 31, 2004 and 2003, respectively. Cash provided by continuing operations for the six months ended December 31, 2004 decreased primarily due to decreased net income, before non-cash acquisition related charges, and the payment of a lease termination fee of $2.3 million in the quarter ended September 30, 2004.
In December 2003, we used $16.6 million, net of $6.5 million of cash held by Data Junction at the time of the closing of the transaction, and issued 5 million shares of Pervasive common stock to acquire the outstanding shares of Data Junction, including certain acquisition-related costs.
During the first six months of fiscal 2005, we received net proceeds of $6.2 million from the sale or maturity of marketable securities, consisting of various taxable and tax advantaged securities. We received proceeds of $0.4 million, net, in marketable securities during the first six months of fiscal 2004. In addition, we purchased property and equipment totaling approximately $0.4 million and $0.4 million in the six months ended December 31, 2004 and 2003, respectively. This property consisted primarily of computer hardware and software. We expect that our capital expenditures may increase during the current fiscal year as compared to the prior year as a result of possible capital projects to upgrade certain front and back office systems.
In July 2003, we announced the authorization of a new $5.0 million stock repurchase plan which became effective upon expiration of the previous plan on July 21, 2003. During the six months ended December 31, 2004, we repurchased 306,600 shares of common stock at a cost of approximately $1.6 million.
We are exploring new opportunities to build, license or acquire products and services for introduction to and through our expansive worldwide channel. Any such transactions could cause us to issue dilutive equity securities, reduce our cash and marketable securities, or incur debt or contingent liabilities.
On December 31, 2004, we had $32.1 million in working capital, including $34.7 million in cash, cash equivalents and marketable securities.
Recently Issued Accounting Standards
In December 2004, the FASB issued SFAS No. 123R Share-Based Payment which supersedes Accounting Principle Board Opinion (APB) Opinion No. 25, Accounting for Stock Issued to Employees, SFAS No. 123, Accounting for Stock-Based Compensation, and related implementation guidance. The pronouncement is effective for interim and annual periods beginning after June 15, 2005. Under this pronouncement, stock-based compensation to employees is required to be recognized as a charge to the statement of operations and such charge is to be measured according to the fair value of the stock options. In the absence of an observable market price for the stock awards, the fair value of the stock options would be based upon a valuation methodology that takes into consideration various factors, including the exercise price of the option, the expected term of the option, the current price of the underlying shares, the expected volatility of the underlying share price, the expected dividends on the underlying shares and the risk-free interest rate. We will adopt the delayed provisions of SFAS 123R during the first quarter of our fiscal year 2006; however, we have not yet decided which of the allowable transition alternatives we will utilize. Our current policy is to not expense share-based compensation; however, we do disclose the effect of this item as currently required by SFAS 123, see Note 4 Stock Compensation, in our Notes to Condensed Consolidated Financial Statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The majority of our operations are based in the United States and, accordingly, the majority of our transactions are denominated in U.S. Dollars. However, we do have foreign-based operations where transactions are denominated in foreign currencies and are subject to market risk with respect to fluctuations in the relative value of currencies. Currently, we have operations in Japan, Belgium, Germany, France, England, Italy and India and conduct transactions in the local currency of each location. We monitor our foreign currency exposure and, from time to time will attempt to reduce our exposure through hedging. The impact of fluctuations in the relative value of other foreign currencies was not material for the six months ended December 31, 2004. Quantitative and qualitative information about market risk was addressed in Item 7A of our Form 10-K for the fiscal year ended June 30, 2004.
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
You should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only ones we face. Any of the following risks could harm our business, financial condition or results of operations. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment.
Our Financial Results May Vary Significantly from Quarter to Quarter
Our operating results have varied significantly from quarter to quarter at times in the past and may continue to vary significantly from quarter to quarter in the future due to a variety of factors. Many of these factors are outside of our control. These factors include:
We derive a significant portion of our revenues from relatively large transactions. The sales cycles for these transactions tend to be longer than the sales cycles on smaller orders. This longer sales cycle for large transactions makes it difficult to predict the quarter in which these sales will occur. Accordingly, our operating results may fluctuate from quarter to quarter based on the existence and timing of larger transactions. A reduction in large transactions during any quarter could materially impact our revenues.
Our revenue growth and profitability depend on the overall demand for our products and services, which in turn depends on general economic and business conditions. The nature and extent of the effect of the current economic climate on our ability to sell our products and services is uncertain. A softening of demand for our products and services caused by weakening of the economy may result in decreased revenues or lower growth rates. There can be no assurance that we will be able to effectively promote revenue growth rates in all economic conditions.
Significant portions of our expenses are not variable in the short term and cannot be quickly reduced to respond to decreases in revenues. Therefore, if our revenues are below our expectations, our operating results are likely to be adversely and disproportionately affected. In addition, we may change our prices, modify our distribution strategy and policies, accelerate our investment in research and development, sales or marketing efforts in response to competitive pressures or pursue new market opportunities. Any one of these activities may further limit our ability to adjust spending in response to revenue fluctuations.
Seasonality May Contribute to Fluctuations in Our Quarterly Operating Results
Our business has, on occasion, experienced seasonal customer buying patterns. In recent years, we have generally experienced relatively weaker demand in the quarters ending March 31 and September 30. We believe that this pattern may continue. In addition, we anticipate that demand for our products in Europe and Japan will decline in the summer months because of reduced corporate buying patterns during the vacation season.
We Currently Operate Without a Backlog
We generally operate with virtually no order backlog because our software products are shipped and revenue is recognized shortly after orders are received. This lack of backlog makes product revenues in any quarter substantially dependent on orders booked and shipped throughout that quarter.
Our Performance Depends on Market Acceptance of Pervasive.SQL
We derive a substantial portion of our revenues from the license of our Pervasive.SQL products. Continued market acceptance of Pervasive.SQL may be influenced heavily by factors outside of our control such as new product offerings or promotions by competitors, mergers and acquisitions of customers and competitors, the product development and deployment cycles of developers and resellers who embed or bundle our products into packaged software applications and demand for applications of the type built on our products. Market acceptance of Pervasive.SQL V8 and future upgrades also may be influenced by factors in our control such as product quality, relative demand for feature and functionality upgrades and any future product announcements or price changes.
Revenue from our embedded database product, Pervasive.SQL decreased in the current quarter relative to the comparable period in the prior fiscal year. We believe this decrease was due to a variety of factors, including but not limited to, the length of time since the last major version release of our database product (December 2002), increasing competition and what we believe to be the increasingly negative impact of general economic conditions
on our ISV customers who build applications utilizing our database software and reduced demand for the ISVs software applications themselves. Revenue from recently introduced add-on products for our database products, namely AuditMaster and Data Exchange, continued to generate database related revenue in the three months ended December 31, 2004 as we continue to market these add-on products to our large base of database customers. In addition, we believe the integration products we acquired in fiscal year 2004 represent an excellent growth opportunity as we invest in revenue synergies and opportunities presented by the acquired business, combined with our historical database business and channels. A continued reduction in our embedded database business, or our inability to grow our integration products business, could have a material adverse effect on our business, operating results and financial condition.
Our Efforts to Develop and Maintain Brand Awareness of Our Products May Not be Successful
Brand awareness is important given competition in the market for data infrastructure software products. We are aware of other companies that use the word Pervasive either in their marks alone or in combination with other words. We expect that it may be difficult or impossible to prevent third-party usage of the Pervasive name and variations of this name for competing goods and services. Competitors or others who use marks similar to our brand name may cause confusion among actual and potential customers, which could prevent us from achieving significant brand recognition. If we fail to promote and maintain our brand or incur significant related expenses, our business, operating results and financial condition could be materially adversely affected.
We May Face Problems with Our Recent Acquisition of Data Junction Corporation
On December 8, 2003, we announced the completion of our acquisition of privately held Data Junction Corporation, a pioneering data and application integration company based in Austin, Texas, for approximately $16.6 million in cash, net of $6.5 million of cash held by Data Junction at the time of the closing of the transaction, and 5 million shares of our common stock. We cannot be certain that the acquisition of Data Junction will be successful or that we will realize the anticipated benefits of the acquisition. In particular, we may not realize the strategic and operational benefits and objectives we had anticipated, including, greater revenue and market opportunities, maintaining industry leadership and consistent profitability. In addition, the demand for our combined product offerings may fluctuate and we may face increased competition in the markets for our products. Any of these factors may have a material adverse effect on our business, operating results and financial condition.
We Must Succeed in the Data Management Infrastructure Software Market as well as the Data Integration Software Market if we are to Realize the Expected Benefits of the Merger
Our long-term strategic plan depends upon the successful development and introduction of products and solutions that address the needs of the data management infrastructure software market as well as the data integration software market. In order for us to succeed in these markets, we must align strategies and objectives and focus a significant portion of our resources towards serving these markets.
The challenges involved include the following:
In addition, our success in these markets will depend on several factors, many of which are outside our control including:
If we are unable to succeed in this market our business may be harmed and we may be prevented from realizing the anticipated benefits of the merger.
We Must Overcome Significant Challenges in Integrating Business Operations and Product Offerings in order to Realize the Benefits of the Acquisition of Data Junction
The merger will not achieve its anticipated benefits unless we successfully combine our operations with those of Data Junction and integrate the two companies business operations and products in a timely manner. Fully integrating Pervasive and Data Junction is a complex, time-consuming and expensive process and may result in revenue disruption and operational difficulties if not completed in a timely and efficient manner. Prior to the merger, each company operated independently, each with its own business, business culture, markets, clients, employees and systems. Following the merger, we must operate as a combined organization utilizing common (1) information communication systems, (2) operating procedures, (3) financial controls and (4) human resource practices, including benefits, training and professional development programs. There may be substantial difficulties, costs and delays involved in the integration. These difficulties, costs and delays may include:
We may not succeed in addressing these risks or any other problems encountered in connection with the merger. If the benefits of the merger do not exceed the costs associated with the merger, including any dilution to our stockholders resulting from the issuance of shares in connection with the merger, our financial results could be harmed.
The Market Price of Our Common Stock May Decline as a Result of the Merger
The market price of our common stock could decline as a result of the merger, based on the occurrence of a number of events, including:
There May be Sales of Substantial Amounts of Pervasive Common Stock after the Merger, which could cause Our Stock Price to Fall
A substantially large number of shares of our common stock may be sold into the public market within a short period of time following the closing of the merger. As a result, our stock price could fall. Of the approximately 5,000,000 shares of our common stock issued in connection with this merger, approximately 203,000 shares were immediately available for resale by the former shareholders of Data Junction and approximately 4,797,000 shares of our common stock are subject to lock-up agreements that restrict the timing of the resale of these shares. Under the lock-up agreements, the shares were released and available for sale in the public market 270 days after the closing date of the merger. However, approximately 4,652,000 of the 4,797,000 shares of our common stock subject to lock-up agreements may only be sold in compliance with the time, manner and volume limitations of Rule 144 for a period of two years from such holders last day of employment with Pervasive or five years from the closing, whichever is later. A sale of a large number of newly released shares of our common stock could therefore result in a sharp decline in our stock price. In addition, the sale of these shares could impair our ability to raise capital through the sale of additional stock.
We May Face Problems in Connection With Past Acquisitions, Joint Ventures or Licensing Arrangements Other than the Recent Acquisition of Data Junction
In January 2005, we entered into an offshore development, support and services agreement with Aztec Software and Technologies Limited, an outsourcing company based in Bangalore, India. Pursuant to the agreement, Aztec will provide certain enhancements to Pervasive Postgres and certain levels of support to our customers who have entered into support agreements with us related to Pervasive Postgres. We cannot be certain that we will be successful in the promotion of Pervasive Postgres or that end users will purchase our annual subscriptions for support. It is possible that our efforts to promote and support Pervasive Postgres may divert the attention of management away from our other products and that we may not realize the strategic and operational benefits and objectives we had anticipated, including, greater revenue and market opportunities. Any of these factors may have a material adverse effect on our business, operating results and financial condition.
In July 2003, we licensed technology from ABACUS Research A.G., a software development company based in St. Gallen, Switzerland. The licensed technology enables users to perform advanced searches into application and Web portal data, providing sub-second responses across large databases. We licensed the technology for $600,000. Following a productization and integration effort, availability of this technology is planned for fiscal year 2005. We cannot be certain that the productization and integration effort will be successful.
In April 2003, we purchased a database transaction intelligence technology from ThinkNet Inc., a software development company based in Toronto, Ontario. The acquired technology provides a continuous, comprehensive
and auditable view of an applications database operations, such as who did what when, where and how. It consists of a Pervasive.SQL logging plug-in, a query and analysis module, and a sophisticated business rules engine. It also alerts administrators to events according to predefined business rules and reports activity efficiently for analysis. We acquired the technology for $550,000 in cash. Following a productization and integration effort, a new product, Pervasive Audit Master, was launched in the second quarter of fiscal 2004. We cannot be certain that the market acceptance or demand for this new product will meet our expectations.
In July 2001, we formed a new business venture with AG-TECH Corporation, a company developing, selling and importing packaged software, to sell and support our products in Japan. AG-TECH has been engaged in the sales and support of Btrieve (predecessor to Pervasive.SQL) and Pervasive.SQL products since 1986. In conjunction with the joint venture, AG-TECH launched a new operating division staffed with specialists experienced in selling and supporting Pervasive.SQL to assume responsibility for OEM sales, packaged software sales, technical support and localization and translation of our products into Japanese. In connection with the new business venture, we obtained a less than 20% ownership interest in AG-TECH and the ability to elect one director to the AG-TECH Board of Directors. While this venture has been successful to date, we cannot be certain that this venture will continue to be successful, which could result in our inability to successfully operate in Japan. In addition, as a part of our venture, we executed a three year master distributor agreement with AG-TECH, the initial term of which expired June 30, 2004. This agreement has been renewed for an additional three-year term which expires June 30, 2007. We cannot be certain that we will continue to be able to renew our agreement with AG-TECH on terms and conditions at least as favorable to Pervasive as those contained in our present agreement. Further, we may be unable to maintain or increase Japanese market demand for our products.
We May Face Problems in Connection With Future Acquisitions, Joint Ventures or Licensing Arrangements
In the future, we may acquire additional businesses, products and technologies, or enter into joint venture or licensing arrangements, that could complement, modify or expand our business. Our negotiations of potential acquisitions or joint ventures and our integration of acquired businesses, products or technologies could divert management time and resources. Any future acquisitions could require us to issue dilutive equity securities, reduce our cash and marketable securities, incur debt or contingent liabilities, amortize intangibles, or write-off purchased research and development and other acquisition-related expenses. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of acquisitions. In addition, market reactions to acquisitions are difficult to predict and if we do announce any future acquisitions, such market reactions may cause our stock price to fluctuate.
We May Face Problems in Connection With Product Line Expansion
In the future, we may acquire, license or develop additional products. Future product line expansion may require us to modify or expand our business. If we are unable to fully integrate new products with our existing operations, we may not receive the intended benefits of such product line expansion.
A Small Number of Distributors and Sales Related to Accounting Software Applications Account For a Significant Percentage of Our Revenues
The loss of a major distributor, changes in a distributors payment practices, changes in the financial stability of a major distributor or any reduction in orders by such distributor, including reductions due to market or competitive conditions combined with the potential inability to replace the distributor on a timely basis, or any modifications to our pricing or distribution channel strategy could materially adversely affect our business, operating results and financial condition. Many of our ISVs, VARs and end users place their orders through distributors. A relatively small number of distributors have accounted for a significant percentage of our revenues. In the six months ended December 31, 2004, two distributors combined accounted for an aggregate of approximately 17% of our revenues, as compared to the six months ended December 31, 2003, when two distributors accounted for an aggregate of approximately 19% of our revenues. Additionally, we estimate that approximately 20% of our revenues in the fiscal year ended June 30, 2004 were from sales related to accounting software applications. Furthermore, there is currently consolidation taking place among our ISVs that could narrow the number of customers who sell our
products. For example, one of our ISVs, The Sage Group plc, has acquired Timberline Software Corporation, Softline Limited, and ACCPAC International Inc., three of our ISVs. These four ISVs together represented approximately 10% of our revenues in fiscal 2004. Accordingly, our sales to The Sage Group plc could constitute 10% or more of our revenues in the future. As a result, we expect we will continue to depend on a limited number of distributors, certain of our ISV customers and sales related to accounting software applications for a significant portion of our revenues in future periods and the loss of a significant distributor or ISV customer could materially adversely affect our business, operating results and financial condition. Moreover, we expect that such distributors and sales related to accounting software applications will vary from period to period. Our distributors have not agreed to any minimum order requirements. Although we forecast demand and plan accordingly, if a distributor purchases excess product, we may be obligated to accept the return of some products.
We Depend on Our Indirect Sales Channel
Our failure to grow our indirect sales channel or the loss of a significant number of members of our indirect channel partners would have a material adverse effect on our business, financial condition and operating results. We derive a substantial portion of our revenues from indirect sales through a channel consisting of independent software vendors, value-added resellers, systems integrators, consultants and distributors. Our sales channel could be adversely affected by a number of factors including:
We cannot be certain we will be able to continue to attract additional indirect channel partners or retain our current partners. In addition, we cannot be certain our competitors will not attempt to recruit certain of our current or future partners. For example, in December 2000, Microsoft (a competitor) acquired Great Plains Software (an OEM that embeds our product into certain of its products and also a channel partner). This may have had, and any similar transactions may have, an adverse effect on our ability to attract and retain partners.
We May Not Be Able to Develop Strategic Relationships
Our current collaborative relationships may not prove to be beneficial to us, and they may not be sustained. We may not be able to enter into successful new strategic relationships in the future, which could have a material adverse effect on our business, operating results and financial condition. From time to time, we have collaborated with other companies in areas such as product development, marketing, distribution and implementation. However, many of our current and potential strategic partners are either actual or potential competitors with us. In addition, many of our current relationships are informal or, if written, terminable with little or no notice.
We Depend on Third-Party Technology in Our Products
We rely upon certain software that we license from third parties, including software integrated with our internally developed software and used in our products to perform key functions. These third-party software licenses
may not continue to be available to us on commercially reasonable terms. The loss of, or inability to maintain or obtain any of these software licenses, could result in shipment delays or reductions until we develop, identify, license and integrate equivalent software. Any delay in product development or shipment could damage our business, operating results and financial condition.
We May be Unable to Protect Our Intellectual Property and Proprietary Rights
Our success depends to a significant degree upon our ability to protect our software and other proprietary technology. We rely primarily on a combination of copyright, trademark and trade secret laws, confidentiality procedures and contractual provisions to protect our proprietary rights. However, these measures afford us only limited protection. Furthermore, we use third-party service providers in India for some of our development and the laws of India do not protect proprietary rights to the same extent as the laws of the United States. In addition, we rely in part on shrink wrap and click wrap licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. Therefore, our efforts to protect our intellectual property may not be adequate. We cannot be certain that others will not develop technologies that are similar or superior to our technology or design around the copyrights and trade secrets owned by us. Unauthorized parties may attempt to copy aspects of our products or to obtain and use information we regard as proprietary. Although we believe software piracy may be a problem, we are unable to determine the extent to which piracy of our software products occurs. In addition, portions of our source code are developed in foreign countries with laws that do not protect our proprietary rights to the same extent as the laws of the United States.
We may be subjected to claims of intellectual property infringement by third parties as the number of products and competitors in our industry segment continues to grow and the functionality of products in different industry segments increasingly overlaps. Any infringement claims, with or without merit, could be time-consuming, result in costly litigation, divert management attention and resources, cause product shipment delays or the loss or deferral of sales or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us, if at all. In the event of a successful claim of intellectual property infringement against us, should we fail or be unable to either license the technology or similar technology or develop alternative technology on a timely basis, our business, operating results and financial condition could be materially adversely affected.
We Must Adapt to Rapid Technological Change
Our future success will depend upon our ability to continue to enhance our current products and to develop and introduce new products on a timely basis that keep pace with technological developments and new industry standards and satisfy increasingly sophisticated customer requirements. Rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and evolving industry standards characterize the market for our products. The introduction of products embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable. As a result of the complexities inherent in client/server and Web computing environments and in data and application integration solutions, and the performance demanded by customers for data infrastructure software products, new products and product enhancements can require long development and testing periods. As a result, significant delays in the general availability of such new releases or significant problems in the installation or implementation of such new releases could have a material adverse effect on our business, operating results and financial condition. We have experienced delays in the past in the release of new products and new product enhancements. We may not be successful in:
Our Software May Contain Errors or Defects
Errors or defects in our products may result in loss of revenues or delay in market acceptance, and could materially adversely affect our business, operating results and financial condition. Software products such as ours may contain errors, sometimes called bugs, particularly when first introduced or when new versions or enhancements are released. From time to time, we discover software errors in certain of our new products after their introduction. Despite our testing, current versions, new versions or enhancements of our products may still have errors after commencement of commercial shipments. Product errors can put us at a competitive disadvantage and can be costly and time-consuming to correct.
We May Become Subject to Product or Professional Services Liability Claims
A product or professional services liability claim, whether or not successful, could damage our reputation and our business, operating results and financial condition. Our license and service agreements with our customers typically contain provisions designed to limit our exposure to potential product or service liability claims. However, these contract provisions may not preclude all potential claims. Product or professional services liability claims could require us to spend significant time and money in litigation or to pay significant damages.
We Compete with Microsoft while Simultaneously Supporting Microsoft Technologies
We currently compete with Microsoft in the market for data management products while simultaneously maintaining a working relationship with Microsoft. Microsoft has a longer operating history, a larger installed base of customers and substantially greater financial, distribution, marketing and technical resources than Pervasive. As a result, we may not be able to compete effectively with Microsoft now or in the future, and our business, operating results and financial condition may be materially adversely affected.
We expect that Microsofts commitment to and presence in the data management products market will substantially increase competitive pressures. We believe that Microsoft will continue to incorporate SQL Server database technology into its operating system software and certain of its server software offerings, possibly at no additional cost to its users. We believe that Microsoft will also continue to enhance its SQL Server database technology and that Microsoft will continue to invest in various sales and marketing programs involving certain of our channel partners.
Further, in December 2000, Microsoft acquired Great Plains Software, a channel partner of Pervasive. This may have had, and any similar transactions may have, an adverse effect on our ability to compete effectively.
We believe we must maintain a working relationship with Microsoft to achieve success. Many of our customers use Microsoft-based operating platforms. Thus it is critical to our success that our products be closely integrated with Microsoft technologies. Notwithstanding our historical and current support of Microsoft platforms, Microsoft may in the future promote technologies and standards more directly competitive with or not compatible with our technology.
We Face Significant Competition From Other Companies
We encounter competition for our embedded database products primarily from large, public companies, including Microsoft, Oracle, Sybase, IBM and Progress. In particular, Sybases small memory footprint database software product, Adaptive Server Anywhere, and Microsofts product, SQL Server, directly compete with our products. Further, our recently announced Pervasive Postgres initiative competes directly with corporate database solutions sold by the companies listed above. And, because there are relatively low barriers to entry in the software market, we may encounter additional competition from other established or emerging companies providing database products based on existing, new or open-source technologies.
Open-source software, which is an emerging trend in the software marketplace, may impact our business as interest, demand and use increases in the database segment and poses a challenge to our business model, including recent efforts by proponents of open-source software to convince governments worldwide to mandate the use of open-source software in their purchase and deployments of software products. Firms adopting the open-source software model typically provide customers software produced by loosely associated groups of unpaid programmers and made available for license to end users at nominal cost, and earn revenue on complementary services and products, without having to bear the full costs of research and development for the open-source software. Because the present demand for open-source database software is largely concentrated in major corporations, our embedded database business has not been adversely affected to date. However, it is likely that increased adoption of Linux will drive heightened interest in other more mature software categories such as database and certain business applications. Our recently announced open-source software initiative, Pervasive Postgres, is our response to the emerging trend in open source software in the corporate database market. To the extent competing open-source software products gain increasing market acceptance, sales of our products may decline, we may have to reduce prices we charge for our products, and our revenue and operating margins may decline. Mass adoption of open source databases in the SME market could have a material adverse impact on our database business.
Application service providers (ASPs) may enter our market and could cause a change in revenue models from licensing of client/server and Web-based applications to renting applications. Our competitors may be more successful than we are in adopting these revenue models and capturing related market share.
The market for our integration products is highly competitive and subject to rapidly changing technology. We principally compete against ETL (extract, transform and load) software vendors and data warehousing and application integration software providers. Such competitors include Ascential, Business Objects, Embarcadero, Informatica, and Information Builders. In addition, we compete or may compete against database vendors that currently offer, or may develop, products with functionalities that compete with our solutions. These products typically operate specifically with these competitors proprietary databases. Such competitors include IBM, Microsoft and Oracle. Competition also comes in the form of custom code, where potential customers have sufficient internal technical resources to develop solutions in-house without the aid of our products or those of our competitors.
Most of our competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers. In addition, some competitors have demonstrated a willingness to, or may willingly in the future, incur substantial losses as a result of deeply discounted product offerings or aggressive marketing campaigns. As a result, our competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, promotion and sale of competitive products, than we can. There is also a substantial risk that changes in licensing models or announcements of competing products by competitors such as Microsoft, Oracle, Sybase, IBM, Progress, Ascential, Business Objects, Embarcadero, Informatica, Information Builders or others could result in the cancellation of customer orders in anticipation of the introduction of such new licensing models or products. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address customer needs which may limit our ability to sell our products through particular partners. Accordingly, new competitors or alliances among, or consolidations of, current and new competitors may emerge and rapidly gain significant market share in our current or anticipated markets. We also expect that competition will increase as a result of software industry consolidation. Increased competition is likely to result in price reductions, fewer customer orders, reduced margins and loss of market share, any of which could materially adversely affect our business. We cannot be certain we will be able to compete successfully against current and future competitors or that the competitive pressures we face will not materially adversely affect our business, operating results and financial condition.
We Are Susceptible to a Shift in the Market for Client/Server Applications Toward Web-Based Applications
We have derived substantially all of our historical embedded database product revenues from the use of our products in client/server applications. We expect to rely on continued market demand for client/server applications
indefinitely. However, we believe market demand may shift from client/server applications to Web-based applications. If so, this shift could occur before our product line has achieved market acceptance for use in Web-based applications. In addition, we cannot be certain that our existing client/server developers will migrate to Web-based applications and continue to use our products or that other developers of Web-based applications would select our data management products. Further, this shift could result in a change in revenue models from licensing of client/server and Web-based applications to renting of applications from application service providers. A decrease in client/server application sales coupled with an inability to derive revenues from the Web-based application market could have a material adverse effect on our business, operating results and financial condition.
We Depend on International Sales and Operations
We anticipate that for the foreseeable future we will derive a significant portion of our revenues from sources outside North America. In the three months ended December 31, 2004, we derived 37% of our revenues outside North America. Our international operations are generally subject to a number of risks. These risks include:
We may expand or modify our operations internationally. Despite our efforts, we may not be able to expand or modify our operations internationally in a timely and cost-effective manner. Such an outcome would limit or eliminate any sales growth internationally, which in turn would materially adversely affect our business, operating results and financial condition. Even if we successfully expand or modify our international operations, we may be unable to maintain or increase international market demand for our products.
We expect our international operations will continue to place financial and administrative demands on us, including operational complexity associated with international facilities, administrative burdens associated with managing relationships with foreign partners, and treasury functions to manage foreign currency risks and collections. In particular, we have begun to develop products in our new Bangalore, India facility. In order to capitalize on the economic opportunity afforded by developing products in this facility, we must successfully execute new business processes and retain key technical personnel in Austin and India. It is also likely that the company will run parallel processes in many areas of its technical operations in order to assure high quality development and a high standard of customer care. While the long term economic impact created by the India operation is expected to be favorable, these parallel processes could increase our costs in the short term.
We Use Third-Party Service Providers in India and If We Are Unable to Use Such Providers Our Business Could Be Temporarily Adversely Affected
We are actively supplementing the capabilities of our organization by contracting with third-party service providers located in India. As other software companies have done and are continuing to do, we may continue to allocate more development and IT resources to Indian third parties, and we may expand our own operational capabilities in India, with the expectation of achieving significant efficiencies, including reducing operational costs and permitting an around-the-clock development cycle. To date, the dispute between India and Pakistan involving the Kashmir region and the incidents of terrorism in India have not adversely affected our operations in India. Should we be unable to conduct operations in India in the future, we believe that our business could be temporarily adversely affected.
Fluctuations in the Relative Value of Foreign Currencies Can Affect Our Business
To date, the majority of our transactions have been denominated in U.S. dollars. The majority of our international operating expenses and substantially all of our sales in Japan have been denominated in currencies other than the U.S. dollar. Therefore, our operating results may be adversely affected by changes in the value of the U.S. dollar. Certain of our international sales are denominated in U.S. dollars, especially in Europe. Any strengthening of the U.S. dollar against the currencies of countries where we sell products denominated in U.S. dollars will increase the relative cost of our products and could negatively impact our sales in those countries. To the extent our international operations expand or are modified, our exposure to exchange rate fluctuations may increase. We have, on occasion, entered into limited hedging transactions to mitigate our exposure to currency fluctuations. Despite these hedging transactions, exchange rate fluctuations have caused, and will continue to cause, currency transaction gains and losses. Although these transactions have not resulted in material gains and losses to date, similar transactions could have a damaging effect on our business, results of operations or financial condition in future periods.
We Must Continue to Hire and Retain Skilled Personnel
Our success depends in large part on our ability to attract, motivate and retain highly skilled employees on a timely basis, particularly executive management, sales and marketing personnel, software engineers and other senior personnel. Our efforts to attract and retain highly skilled employees could be harmed by our past or any future workforce reductions. Our failure to attract and retain the highly trained technical personnel who are essential to our product development, marketing, service and support teams may limit the rate at which we can generate revenue and develop new products or product enhancements. This could have a material adverse effect on our business, operating results and financial condition.
We Have Anti-Takeover Provisions
Our Restated Certificate of Incorporation and Bylaws contain certain provisions that may have the effect of discouraging, delaying or preventing a change in control or unsolicited acquisition proposals that a stockholder might consider favorable. It includes provisions to authorize the issuance of blank check preferred stock; establish advance notice requirements for stockholder nominations for elections to the Board of Directors or for proposing matters that can be acted upon at stockholders meetings; eliminate the ability of stockholders to act by written consent; require super-majority voting to approve certain amendments to the Restated Certificate of Incorporation; limit the persons who may call special meetings of stockholders; and provide for a Board of Directors with staggered, three-year terms. In addition, certain provisions of Delaware law and 1997 Stock Incentive Plan (the 1997 Plan) may also have the effect of discouraging, delaying or preventing a change in control or unsolicited acquisition proposals.
Further, in October 2000, our Board of Directors approved the adoption of a shareholder rights plan whereby
one preferred share purchase right was distributed for each outstanding share of our common stock. The rights are designed to assure that all of our stockholders receive fair and equal treatment in the event of any proposed takeover and to guard against partial tender offers, open market accumulations and other tactics designed to gain control without paying all stockholders a fair price. The rights were not being distributed in response to any specific effort to acquire us.
The rights become exercisable if a person or group hereafter acquires 15% or more of our common stock or announces a tender offer for 15% or more of our common stock. Such events, or if we are acquired in a merger or other business combination transaction after a person acquires 15% or more of our common stock, would entitle the right holder to purchase, at an exercise price of $18.00, a number of shares of common stock having a market value at that time of twice the rights exercise price. Rights held by the acquiring person would become void. The Board of Directors can choose to redeem the rights at one cent per right at any time before an acquiring person hereafter acquires 15% or more of the outstanding common stock. The Rights Plan may have the effect of discouraging, delaying or preventing a change in control or unsolicited acquisition proposals.
We May Elect to Raise Additional Capital Which Might Not Be Available or Which, if Available, May Be on Terms That Are Not Favorable to Us
We may elect to raise additional funds, and we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. If we issue equity securities, the ownership percentage of our stockholders would be reduced, and the new equity securities may have rights, preferences or privileges senior to those of existing holders of our common stock. If we borrow money, we may incur significant interest charges, which could harm our profitability. Holders of debt would also have rights, preferences or privileges senior to those of existing holders of our common stock. If we cannot raise funds on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, which could seriously harm our business, operating results and financial condition.
The Price of Our Stock Has Been Volatile and Could Continue to Fluctuate Substantially
Our common stock is traded in the NASDAQ National Market. The market price of our common stock has been volatile and could fluctuate substantially based on a variety of factors outside of our control, in addition to our financial performance. Furthermore, stock prices for many companies, including our own, fluctuate widely for reasons that may be unrelated to operating results.
While we believe we currently have adequate internal control over financial reporting, we are required to evaluate our internal control under Section 404 of the Sarbanes-Oxley Act of 2002 and any adverse results from such evaluation could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our annual report on Form 10-K for the fiscal year ended June 30, 2005, we will be required to furnish a report by our management on our internal control over financial reporting. Such report will contain among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. Such report must also contain a statement that our auditors have issued an attestation report on managements assessment of such internal controls. Public Company Oversight Board Auditing Standard No. 2 provides the professional standards and related performance guidance for auditors to attest to, and report on, managements assessment of the effectiveness of internal control over financial reporting under Section 404.
While we currently believe our internal control over financial reporting is effective, we are still performing the system and process documentation and evaluation needed to comply with Section 404, which is both costly and challenging. During this process, if our management identifies one or more material weaknesses in our internal control over financial reporting, we will be unable to assert such internal control is effective. If we are unable to assert that our internal control over financial reporting is effective as of June 30, 2005 (or if our auditors are unable
to attest that our managements report is fairly stated or they are unable to express an opinion on the effectiveness of our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price.
ITEM 4. CONTROLS AND PROCEDURES
Our management, with the participation of the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of the design and the operation of the Companys disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based upon this evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the disclosure controls and procedures were effective to ensure that information required to be disclosed in the Companys Exchange Act reports is recorded, processed, summarized and reported in a timely manner.
There have been no significant changes in the Companys internal controls or in other factors which could significantly affect internal controls subsequent to the date the Company carried out its evaluation.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Some of the statements in this Report on Form 10-Q under Managements Discussion and Analysis of Financial Condition and Results of Operations, Risk Factors, and elsewhere in this Report constitute forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934. Forward-looking statements include statements regarding the Companys expectations, beliefs, hopes, intentions or strategies regarding the future. These statements involve known and unknown risks, uncertainties, and other factors that may cause our or our industrys actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by such forward-looking statements. Such factors include, among other things, those listed under Risk Factors and elsewhere in this Report on Form 10-Q.
In some cases, you can identify forward-looking statements by terminology such as may, will, should, expects, plans, anticipates, believes, estimates, predicts, potential, or continue or the negative of such terms or other comparable terminology.
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of such statements. We are under no duty to update any of the forward-looking statements after the date of this Report to conform such statements to actual results.
ITEM 2. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS
In July 2003, we announced the authorization of a new $5.0 million stock repurchase plan which became effective upon expiration of the previous plan on July 21, 2003. During the second quarter of fiscal 2005, we repurchased 97,000 shares under this announced plan. The transactions occurred in open market purchases. The repurchase program may be suspended or discontinued at any time without prior notice.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.