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PHARSIGHT CORP 10-Q 2005
Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

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

 

For the Quarterly Period Ended June 30, 2005

 

or

 

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

 

For the Transition Period from              to             

 

Commission File Number: 000-31253

 


 

PHARSIGHT CORPORATION

(Exact name of Registrant as specified in its charter)

 


 

Delaware   77-0401273

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

 

800 West El Camino Real

Mountain View, CA 94040

(Address of principal executive offices, including zip code)

 

(650) 314-3800

(Registrant’s telephone number, including area code)

 


 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨     No  x

 

The number of shares of Registrant’s Common Stock outstanding as of August 5, 2005: 19,385,200

 



Table of Contents

TABLE OF CONTENTS

 

         Page

PART I.   FINANCIAL INFORMATION     
Item 1.   Financial Statements (Unaudited)    3
    Condensed Consolidated Balance Sheets – June 30, 2005 and March 31, 2005    3
    Condensed Consolidated Statements of Operations – Three Months Ended June 30, 2005 and 2004    4
    Condensed Consolidated Statements of Cash Flows – Three Months Ended June 30, 2005 and 2004    5
    Notes to Condensed Consolidated Financial Statements    6
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations    13
Item 3.   Quantitative and Qualitative Disclosures about Market Risk    33
Item 4.   Controls and Procedures    33
PART II.   OTHER INFORMATION     
Item 1.   Legal Proceedings    34
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds    34
Item 3.   Defaults Upon Senior Securities    34
Item 4.   Submission of Matters to a Vote of Security Holders    34
Item 5.   Other Information    34
Item 6.   Exhibits    34
    Signatures    35

 

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Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

PHARSIGHT CORPORATION

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

 

    

June 30,

2005


   

March 31,

2005*


 
     (Unaudited)        
ASSETS                 

Current assets:

                

Cash and cash equivalents

   $ 9,035     $ 10,579  

Accounts receivable, net of allowance for doubtful accounts of $90 and $94 at June 30, 2005 and March 31, 2005, respectively

     4,723       4,809  

Prepaids and other current assets

     639       594  
    


 


Total current assets

     14,397       15,982  

Property and equipment, net

     1,005       604  

Other assets

     152       236  
    


 


Total assets

   $ 15,554     $ 16,822  
    


 


LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND

STOCKHOLDERS’ DEFICIT

                

Current liabilities:

                

Accounts payable

   $ 729     $ 862  

Accrued expenses

     672       754  

Accrued compensation

     1,477       1,881  

Deferred revenue

     6,652       7,178  

Current portion of notes payable

     1,975       1,975  
    


 


Total current liabilities

     11,505       12,650  

Deferred revenue, long term portion

     108       126  

Notes payable, less current portion

     167       410  

Redeemable convertible preferred stock, $0.001 par value:

                

Authorized shares—3,200,000 (2,000,000 designated as Series A and 1,200,000 designated as Series B) at June 30, 2005 and March 31, 2005

                

Issued and outstanding shares—1,869,085 at June 30, 2005 and March 31, 2005, respectively (1,814,662 designated as Series A at June 30, 2005 and March 31, 2005 and 54,423 designated as Series B at June 30, 2005 and March 31, 2005, respectively)—Aggregate redemption and liquidation value—$7,491

     6,266       6,266  

Commitments and contingencies

                

Stockholders’ deficit:

                

Preferred stock, $0.001 par value:

                

Authorized shares—1,800,000 at June 30, 2005 and March 31, 2005

                

Issued and outstanding shares—none at June 30, 2005 and March 31, 2005

                

Common stock, $0.001 par value:

                

Authorized shares—120,000,000 at June 30, 2005 and March 31, 2005 Issued and outstanding shares—19,361,009 and 19,332,939 at June 30, 2005 and March 31, 2005, respectively

     19       19  

Additional paid-in capital

     74,224       74,360  

Accumulated other comprehensive loss

     (4 )     (24 )

Accumulated deficit

     (76,731 )     (76,985 )
    


 


Total stockholders’ deficit

     (2,492 )     (2,630 )
    


 


Total liabilities, redeemable convertible preferred stock, and stockholders’ deficit

   $ 15,554     $ 16,822  
    


 



* Amounts as of March 31, 2005 are derived from the March 31, 2005 audited financial statements.

 

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

 

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Table of Contents

PHARSIGHT CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

 

    

Three Months Ended

June 30,


 
     2005

    2004

 

Revenues:

                

License

   $ 884     $ 894  

Renewal

     1,160       1,182  

Maintenance

     191       43  

Services

     3,459       2,915  
    


 


Total revenues

     5,694       5,034  

Costs of revenues

                

License, renewal, maintenance

     80       93  

Services

     1,807       1,751  
    


 


Total cost of revenues

     1,887       1,844  
    


 


Gross margin

     3,807       3,190  

Operating expenses:

                

Research and development

     872       710  

Sales and marketing

     1,278       1,092  

General and administrative

     1,370       1,254  
    


 


Total operating expenses

     3,520       3,056  
    


 


Income from operations

     287       134  

Other income (expense):

                

Interest expense

     (37 )     (42 )

Interest income

     44       10  

Other expense

     (19 )     (4 )
    


 


Total other expense

     (12 )     (36 )
    


 


Income before income taxes

     275       98  

Provision for income taxes

     (21 )     (4 )
    


 


Net income

     254       94  

Preferred stock dividends

     (145 )     (175 )
    


 


Net income (loss) attributable to common stockholders

   $ 109     $ (81 )
    


 


Earnings per share attributable to common stockholders:

                

Basic

   $ 0.01     $ (0.00 )
    


 


Diluted

   $ 0.00     $ (0.00 )
    


 


Shares used to compute earnings per share attributable to common stockholders:

                

Basic

     19,345       19,058  
    


 


Diluted

     22,043       19,058  
    


 


 

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

 

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Table of Contents

PHARSIGHT CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 

    

Three Months Ended

June 30,


 
     2005

    2004

 

Cash Flows From Operating Activities:

                

Net Income

   $ 254     $ 94  

Adjustments to reconcile net income to net cash used in operating activities:

                

Depreciation and amortization

     96       125  

Changes in operating assets and liabilities:

                

Accounts receivable, net

     86       (606 )

Unbilled accounts receivable

     —         (5 )

Prepaids and other current assets

     39       127  

Accounts payable

     (133 )     86  

Accrued expenses

     (82 )     (218 )

Accrued compensation

     (404 )     (429 )

Deferred revenue

     (544 )     (418 )
    


 


Net cash used in operating activities

     (688 )     (1,244 )

Cash Flows From Investing Activities:

                

Purchases of property and equipment

     (497 )     (10 )
    


 


Net cash used in investing activities

     (497 )     (10 )

Cash Flows From Financing Activities:

                

Principal payments on notes payable

     (243 )     (219 )

Principal payments on capital lease obligations

     —         (18 )

Proceeds from the sale of common stock

     10       —    

Dividends paid in cash to preferred stockholders

     (145 )     (73 )
    


 


Net cash used in financing activities

     (378 )     (310 )
    


 


Effect of exchange rate changes on cash and cash equivalents

     19       —    
    


 


Net decrease in cash and cash equivalents

     (1,544 )     (1,564 )

Cash and cash equivalents at the beginning of the year

     10,579       10,027  
    


 


Cash and cash equivalents at the end of the year

   $ 9,035     $ 8,463  
    


 


Supplemental disclosures of non cash activities

                

Issuance of dividend to preferred stockholders in form of stock

   $ —       $ 102  
    


 


Accrued preferred stock dividend

   $ 48     $ 48  
    


 


 

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

 

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Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Description of Business

 

Pharsight Corporation (“Pharsight” or the “Company”) develops and markets software and provides strategic consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process, by reducing the costs and time requirements of their drug discovery, development, and commercialization efforts. Pharsight’s products include proprietary software for clinical trial simulation and computer-aided trial design, for the statistical analysis and mathematical modeling of data, and for the storage, management, and regulatory reporting of derived data and models in data repositories. Both the Company’s software products and its services leverage expertise in the sciences of pharmacology, drug and disease modeling, human genetics, biostatistics and strategic decision-making. Pharsight Corporation was incorporated in California in April 1995 and reincorporated in Delaware in June 2000.

 

Basis of Presentation

 

The accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with our financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2005.

 

The interim financial statements are unaudited but reflect all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the results of these periods. The results of operations for the three months ended June 30, 2005 are not necessarily indicative of results to be expected for the fiscal year ending March 31, 2006, or any other period.

 

Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications had no impact on our historical results of operations or financial position.

 

We operate in two reportable business segments: Software Products and Strategic Consulting. See Note 4.

 

Basis of Consolidation

 

The condensed consolidated financial statements include the accounts of Pharsight and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.

 

Use of Estimates

 

Pharsight’s financial statements are prepared in accordance with GAAP. These accounting principles require the Company to make certain estimates, judgments and assumptions. The Company believes that the estimates, judgments and assumptions upon which they rely are reasonable based upon information available to them at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, the Company’s financial statements will be affected.

 

Revenue Recognition

 

Pharsight’s revenues are derived from two primary sources: (1) initial fees for perpetual product licenses and renewal fees for term-based perpetual product licenses, and (2) services related to scientific and training consulting and software deployment.

 

Pharsight’s revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” (or “SOP 97-2”) as amended. For each arrangement, Pharsight determines whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, collection is probable, and no

 

6


Table of Contents

significant post-delivery obligations remain unfulfilled. If any of these criteria are not met, the Company defers revenue recognition until such time as all of the criteria are met. The Company does not currently offer, has not offered in the past, and does not expect to offer in the future, extended payment term arrangements. If the Company does not consider collectability to be probable, it defers recognition of revenue until the fee is collected.

 

Pharsight has contracts for one-year software licenses (initial and renewal fees) bundled with post contract support services, or PCS, from which it receives solely license and renewal fees. The Company does not have vendor specific objective evidence to allocate the fee to the separate elements, as it does not sell PCS separately. The Company, therefore, does not present this PCS revenue separately, and it does not believe other allocation methodologies, namely allocation based on relative costs, provide a meaningful and supportable allocation between license and PCS revenues. The Company recognizes each of the initial and renewal license fees ratably over the one-year period of the license during which the PCS is expected to be provided as required by paragraph 12 of SOP 97-2.

 

For arrangements consisting solely of services, Pharsight recognizes revenue as services are performed. Arrangements for services may be charged at daily rates for different levels of consultants and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee contracts, with payments based on milestones or acceptance criteria, the Company recognizes revenue as such milestones are achieved, or if customer acceptance of the milestone’s completion is required, upon such customer acceptance, which approximates the level of services provided. A number of internal and external factors can affect the Company’s estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

 

Pharsight enters into arrangements consisting of one-year licenses (bundled with PCS), renewal fees and scientific consulting services. The scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, in that they are not essential to the functionality of the delivered software, are described separately in the arrangement and are sold separately. The Company recognizes license revenues, including license revenue from bundled PCS, on a straight line basis over the PCS term. The Company recognizes revenues from scientific consulting services as these services are provided or upon their acceptance, if applicable. The Company has established vendor specific objective evidence for services, therefore they recognize revenue when services are performed or completed. Vendor specific objective evidence of fair value of scientific services for purposes of revenue recognition in these multiple element arrangements is based on daily rates for different levels of consultants and out-of-pocket expenses.

 

Pharsight also has arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. For arrangements involving a significant amount of services related to installation and implementation of the software products, the Company recognizes revenue for the entire arrangement ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. The Company currently does not have vendor specific objective evidence for PCS, however, revenues from maintenance renewals on perpetual licenses are classified as maintenance revenue on the accompanying statements of operations.

 

Deferred Revenue

 

Deferred revenue is comprised of license fees (initial and renewal), which are recognized ratably over the one-year period of the license. In addition, deferred revenue includes services and training revenue, which will be recognized as services are performed. Deferred revenue also includes license and service fees for arrangements that include significant implementation services, which have not yet been completed. Long term deferred revenue represents amounts received for maintenance and support services to be provided beginning in periods after one year from the balance sheet date.

 

The principal components of deferred revenue were as follows (in thousands):

 

    

June 30,

2005


  

March 31,

2005


License fees

   $ 2,078    $ 2,625

Renewals

     2,741      2,975

Training

     15      29

Maintenance

     633      524

Services

     1,293      1,151
    

  

Total deferred revenue

   $ 6,760    $ 7,304
    

  

Short term deferred revenue

   $ 6,652    $ 7,178

Long term deferred revenue

     108      126
    

  

Total deferred revenue

   $ 6,760    $ 7,304
    

  

 

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Table of Contents

Net Income (Loss) per Share

 

Basic net income (loss) per share attributable to common stock is computed by dividing net income or loss attributable to common stockholders for the period by the weighted-average number of shares of vested common stock (i.e. not subject to a right of repurchase) outstanding during the period.

 

Diluted net income (loss) per share attributable to common stockholders is computed by dividing net income attributable to common stockholders for the period by the weighted-average number of shares of vested common stock outstanding and, where dilutive, weighted average number of shares of unvested common stock outstanding. Diluted net income (loss) per share attributable to common stockholders also gives effect, as applicable, to the potential dilutive effect of outstanding stock options and warrants to purchase common stock using the treasury stock method, and convertible preferred stock using the as-if-converted method, as of the beginning of the period presented or the original issuance date, if later.

 

The following table presents the calculation of basic and diluted net income (loss) per share (in thousands, except per share data):

 

    

Three Months Ended

June 30,


 
     2005

    2004

 

Net income

   $ 254     $ 94  

Preferred stock dividend

     (145 )     (175 )
    


 


Net income (loss) attributable to common stockholders for basic computation

   $ 109     $ (81 )
    


 


Weighted average common shares outstanding

     19,345       19,058  

Dilutive effect of:

                

Stock options and stock-based awards

     2,698       —    
    


 


Dilutive weighted-average common shares outstanding

     22,043       19,058  
    


 


Net income (loss) per share attributable to common stockholders

                

Basic

   $ 0.01     $ (0.00 )
    


 


Diluted

   $ 0.00     $ (0.00 )
    


 


 

All potential common stock equivalent shares including preferred stock (on an as-if-converted basis), have been excluded from the computation of diluted earnings per share in the period ended June 30, 2004 as the effect of including such shares would be antidilutive due to the net loss recorded in that period.

 

The number of potential common stock shares excluded from the calculation of net income (loss) per share attributable to common stockholders at June 30, 2005 and, 2004 due to antidilution is detailed in the following table (in thousands):

 

     June 30,

     2005

   2004

Outstanding options

   2,794    3,948

Warrants

   123    2,091

Redeemable convertible preferred stock

   7,476    7,476
    
  
     10,393    13,515
    
  

 

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Table of Contents

Stock-Based Compensation

 

The Company generally grants stock options to its employees for a fixed number of shares with an exercise price equal to the fair market value of the stock on the date of grant. As permitted under the Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”) and SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (“FAS 148”), the Company has elected to follow the intrinsic value method of accounting as defined by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations in accounting for stock awards to employees. Accordingly, no compensation expense is recognized in the Company’s financial statements in connection with employee stock awards where the exercise price of the award is equal to the fair market value of the stock at the date of the award. When stock options are granted with an exercise price that is lower than the fair market value of the stock on the date of grant, the difference is recorded as deferred compensation and amortized to expense on a graded basis over the vesting term of the stock options.

 

As required by FAS 148, the following table illustrates the effect on net income (loss) per share if the Company had accounted for its stock option and stock purchase plans under the fair value method of accounting (in thousands, except per share amounts):

 

    

Three Months Ended

June 30,


 
     2005

    2004

 

Net income (loss) attributable to common stockholders, as reported

   $ 109     $ (81 )

Less:

                

Total stock-based employee compensation expense determined under the fair value method for all awards

     (221 )     (137 )
    


 


Pro forma net loss attributable to common stockholders

   $ (112 )   $ (218 )
    


 


Basic net income (loss) per share attributable to common stockholders

                

As reported

   $ 0.01     $ (0.00 )
    


 


Pro forma

   $ (0.01 )   $ (0.01 )
    


 


Diluted net income (loss) per share attributable to common stockholders

                

As reported

   $ 0.00     $ (0.00 )
    


 


Pro forma

   $ (0.01 )   $ (0.01 )
    


 


 

The Company estimates the fair value of its options using the Black-Scholes option value model, which was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. The Company’s employee stock options have characteristics significantly different than those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimates. The fair value of options granted and the option component of the employee purchase plan shares were estimated at the date of grant, assuming no expected dividends, and with the following weighted average assumptions:

 

    

ESPP

Three Months Ended

June 30,


   

Options

Three Months Ended

June 30,


 
     2005

    2004

    2005

    2004

 

Expected life (years)

   0.49     0.49     4.00     4.00  

Expected stock price volatility

   111.7 %   200.0 %   203.8 %   115.0 %

Risk-free interest rate

   3.34 %   1.00 %   3.67 %   3.30 %

 

Comprehensive Income (Loss)

 

SFAS No. 130, “Reporting Comprehensive Income” (“SFAS 130”), requires Pharsight to display comprehensive income (loss) and its components as part of the financial statements. Comprehensive income (loss) includes certain changes in equity that are excluded from net income (loss). Pharsight’s comprehensive income (loss) consists of net income (loss) adjusted for the effect of unrealized foreign exchange gains or losses. The foreign currency translation adjustments for the three months ended June 30, 2005 were $20,000. The accumulated comprehensive loss at June 30, 2005 and March 31, 2005 was $4,000 and $24,000, respectively.

 

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Concentrations of Credit Risk

 

The Company receives a substantial majority of its revenue from a limited number of customers. For the three months ended June 30, 2005 and 2004 sales to the Company’s top two customers accounted for 44% and 48% of total revenue, respectively, and sales to its top five customers in the same periods accounted for 59% and 62% of total revenue, respectively. One customer accounted for 32% and 31% of total revenues for the three months ended June 30, 2005 and 2004, respectively. Another customer accounted for 12% and 17% of total revenues for the three months ended June 30, 2005 and 2004, respectively. For fiscal 2005, 2004 and 2003, sales to our top two customers accounted for 45%, 28% and 28% of total revenue, respectively, and sales to the top five customers in the same periods accounted for 62%, 50% and 50% of total revenue.

 

Two customers comprised 39% and 18% of accounts receivable at June 30, 2005. Three customers comprised 35%, 15% and 10% of accounts receivable at March 31, 2005.

 

Recent Accounting Pronouncements

 

SFAS 123R

 

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share-Based Payment,” or SFAS 123R, which is a revision FAS 123, “Accounting for Stock-Based Compensation”. SFAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends Statement of Accounting Standards No. 95, “Statement of Cash Flows”. SFAS 123R requires all companies to measure compensation expense for all share-based payments (including employee stock options and options issued pursuant to employee stock purchase plans) based upon the fair value of the stock-based awards at the date of grant. SFAS 123R is effective for all public companies for annual periods beginning after June 15, 2005. Retroactive application of the requirements of FASB Statement No. 123 to the beginning of the fiscal year that includes the effective date is permitted, but not required. Early adoption of Statement 123R is encouraged. A component of SFAS 123(R) includes one of the following options: (a) modified-prospective method, (b) the modified-retrospective method, restating all prior periods or (c) the modified-retrospective method, restating only the prior interim periods of 2005. A determination as to which of the three options the Company will adopt will be made at a later date. As permitted by SFAS 123, the Company currently accounts for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123(R)’s fair value method will have a significant impact on the Company’s result of operations, although it will have no impact on its overall financial position. The impact of adoption of Statement 123R for the first quarter of fiscal 2006 would be similar to the pro forma calculation in “Stock Based Compensation” above.

 

2. NOTES PAYABLE

 

The Company has a secured term loan outstanding, payable over 48 months, with monthly payments that commenced in July 2002. The balance on the term loan as of June 30, 2005 was $875,000. In February 2005, the Company secured an additional term loan for the purchase of a new financial system, which was added to the existing term loan. The $300,000 term loan is payable over 36 months. The balance outstanding on the term loan as of June 30, 2005 was $267,000.

 

In June 2005, the Company extended and expanded its credit facilities with Silicon Valley Bank, providing for up to $3.0 million in borrowings, secured against 80% of eligible domestic accounts receivable. The current balance on this credit facility was $1.0 million. In addition, the Company secured an equipment credit facility through June 2006 for up to $600,000. Each advance will be payable over 36 months. As of June 30, 2005, the Company has not drawn down any amounts on the equipment credit facility.

 

The following financial covenants apply to the extended Silicon Valley Bank loan facilities: net loss no greater than $200,000 in the first quarter of fiscal 2006; net income of at least $1.00 in the remaining three quarters of fiscal 2006; and a minimum modified quick ratio (defined as cash and cash equivalents plus accounts receivable, divided by total current liabilities, including all bank debt and not including deferred revenue) of 1.5:1 for the months of April 2004 through July 2004, 1.75:1 for the months of August 2004 through November 2004, and 2:1 for the months of December 2004 and each month thereafter. The Company was in compliance with each of these covenants as of June 30, 2005. Interest on our revolving lines of credit is accrued at 0.5% above prime and is payable monthly from the date of borrowing. Interest on our term loans is accrued at 1.25% above prime and is payable monthly from the date of borrowing. Certain of the Company’s assets, excluding intellectual property, secure both facilities.

 

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3. REDEEMABLE CONVERTIBLE PREFERRED STOCK

 

Series B Redeemable Convertible Preferred Stock

 

On June 1, 2004, (the “Valuation Date”), we issued a dividend in the form of 18,142 shares of Series B Redeemable Convertible Preferred Stock (“Series B Preferred”) to our Series A Preferred shareholders, at the election of the Series A Preferred shareholders. The Series B Preferred has identical rights, preferences and privileges as the Series A Preferred, except that the Series B Preferred is not entitled to the dividend payment right. Due to the nature of the redemption features of the Series B Preferred, we have excluded the Series B Preferred from stockholders’ equity in our financial statements. (Please refer to the discussion of the Preferred Stock Financing in Note 8 – Preferred Stock, in the Notes to Financial Statements contained in Item 8 of our Annual Report on Form 10-K, filed on June 29, 2005.) During the three months ended June 30, 2005, we paid cash dividends of $145,000 to our Series A Preferred shareholders.

 

The amount of the Series B Preferred dividend was determined based on the estimated per share fair value of the Series B Preferred Stock. To record the fair value of the Series B Preferred Stock, we performed a valuation based on our 5-day average stock price leading up to and including the Valuation Date. Various factors including, but not limited to, deemed time to liquidity and form of dividend payment were considered in the valuation of the Series B Preferred Stock. The estimated fair value of the Series B Preferred Stock issued on June 1, 2004 was $102,000 or $5.61 per share of Series B Preferred Stock. The equivalent as-converted common stock per-share value was $1.40, representing a premium of 7.7% over our then-current common stock price of $1.30.

 

4. SEGMENT INFORMATION

 

Segment information is presented in accordance with SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” This standard is based on a management approach, which requires segmentation based upon the Company’s internal organization and reporting of revenue and operating income based upon internal accounting methods. The Company’s financial reporting systems present various data for management to run the business, including internal profit and loss statements prepared on a basis not consistent with accounting principles generally accepted in the United States. Not all assets are allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for the Company to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.

 

The Company’s Chief Operating Decision Maker (“CODM”), as defined by SFAS No. 131, is its Chief Executive Officer. The CODM allocates resources to and assesses the performance of each operating segment using information about their revenue and operating profit before interest and taxes. The Company’s segments are designed to promote better alignment of strategic objectives between development, sales, marketing and services organizations; provide for more timely and rational allocation of development, sales and marketing resources within businesses; and for long-term planning efforts on key objectives and initiatives. The segments are used to allocate resources internally and provide a framework to determine management responsibility. Intersegment sales costs are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

 

The Company operates in two operating segments, which is also its reportable segments: Software Products and Strategic Consulting. These segments were determined based on how management and its CODM view and evaluate Pharsight’s business.

 

The Company’s Software Products segment consists of software products and software deployment and integration services that provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform the clinical testing needed to bring drugs to market. By applying mathematical modeling and simulation to all available information regarding the compound being tested, researchers can clarify and quantify which trial and treatment design factors will influence the success of clinical trials.

 

The Company’s Strategic Consulting segment consists of consulting, training and process redesign conducted by its clinical and decision scientists in the application and implementation of its core decision methodology. The Company’s methodology enables customers to identify which uncertainties are greatest and matter most, and then to design development programs, trial sequences, and individual trials in such a way that those trials systematically reduce the identified uncertainties, in the most rapid and cost-effective manner possible.

 

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Summarized financial information on the Company’s reportable segments is shown in the following table (in thousands):

 

    

Three Months Ended

June 30,


     2005

   2004

    

Software

Products


   

Strategic

Consulting


   Total

  

Software

Products


  

Strategic

Consulting


    Total

Revenues:

                                           

License and renewal

   $ 2,235     $ —      $ 2,235    $ 2,119    $ —       $ 2,119

Services

     255       3,204      3,459      529      2,386       2,915
    


 

  

  

  


 

Total revenues

     2,490       3,204      5,694      2,648      2,386       5,034

Gross margin

     2,095       1,712      3,807      2,241      949       3,190

Income (loss) from operations

   $ (85 )   $ 372    $ 287    $ 214    $ (80 )   $ 134

 

Corporate and reconciling amounts include adjustments to state operating income in accordance with GAAP and corporate level expenses not specifically attributed to a segment. There were no reconciling items to income (loss) from operations in the three months ended June 30, 2005 or 2004. There were no inter-segment revenues for the periods shown above.

 

5. CONTINGENCIES AND GUARANTEES

 

Contingencies

 

From time to time and in the ordinary course of business, the Company may be subject to various claims, charges, and litigation. In the opinion of management, final judgments from such pending claims, charges, and litigation, if any, against the Company, would not have a material adverse effect on the Company’s financial position, result of operations, or cash flows.

 

Guarantees

 

From time to time, the Company enters into certain types of contracts that contingently require it to indemnify parties against third party claims. These obligations relate to certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship. Other obligations relate to certain commercial agreements with its customers, under which the Company may be required to indemnify such parties against liabilities and damages arising out of claims of patent, copyright, trademark or trade secret infringement by its software. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. Because the obligated amounts of these types of agreements often are not explicitly stated, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, the Company has not had to make any payments for these obligations, and no liabilities have been recorded for these obligations on the Company’s balance sheets as of June 30, 2005 and March 31, 2005.

 

6. SUBSEQUENT EVENT

 

In July 2005, Pharsight entered into a lease agreement for approximately 14,000 square feet in Mountain View, CA, which will be the new corporate headquarters. Pharsight’s move-in date will be in September 2005. Please refer to the Contractual Commitments section of Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations, for operating lease commitments.

 

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

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections, including statements regarding the benefits of our products and services, anticipated revenue or operating expenses, anticipated product development, trends in customer demand, expansion opportunities for our products and services, revenue from sales to certain customers and our competitive position. In some cases, these forward-looking statements can be identified by words such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “assume,” “potential,” “continue,” “intend,” “hope,” “can,” or the negative of such terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including without limitation the business risks discussed under the caption “Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Future Results and Market Price of Stock” in this Quarterly Report on Form 10-Q. These forward-looking statements involve risks and uncertainties that could cause our, or our industry’s, actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activities, performance or achievements expressed or implied in such forward-looking statements. These business risks should be considered in evaluating our prospects and future financial performance. Although we believe that expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Our expectations are as of the date we file this Quarterly Report on Form 10-Q, and we do not intend to update any of the forward-looking statements after the date we file this Quarterly Report on Form 10-Q to conform these statements to actual results, unless required by law.

 

Overview

 

Pharsight Corporation develops and markets software and provides strategic consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process, by reducing the costs and time requirements of their drug discovery, development, and commercialization efforts. Our products include proprietary software for clinical trial simulation and computer-aided trial design, for the statistical analysis and mathematical modeling of data, and for the storage, management, and regulatory reporting of derived data and models in data repositories. Both our software products and our services leverage expertise in the sciences of pharmacology, drug and disease modeling, human genetics, biostatistics and strategic decision-making. Our service offerings use this expertise to interpret and improve the design of scientific experiments and clinical trials, and to optimize clinical trial design and portfolio decisions. By integrating scientific, clinical, and business decision criteria into a dynamic model-based methodology, we help our customers to optimize the value of their drug development programs and portfolios from discovery to post-launch marketing and any point in between. We use computer-based drug-disease models, dynamic predictive market models, clinical trial simulation and advanced valuation models to create a continuously evolving view of our customers’ development efforts and product portfolios.

 

The use of our software and methodology is on the leading edge of the traditional drug-development process, which is heavily dependent upon clinical trials and patient testing. Although our methodology does not displace the use of human trials in drug development, we believe our analysis software and our methodology renders human trials more efficient and relevant. The continued growth of our customer base, the increase in the number of contracts with our customers, and the increase in our average contract values over time have shown a trend that we believe demonstrates increased acceptance of our methodology and an increased demand for its use. We believe that these trends, in addition to increasing regulatory requirements from the FDA, demonstrate a potential for increased revenue growth resulting from increased demand for our current products and services, as well as long-term opportunities to expand the breadth and coverage of both our consulting services and software product offerings.

 

For reporting purposes, we operate in two business segments: Software Products and Strategic Consulting. Our Software Products segment consists of software products and software deployment and integration services that provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform clinical testing needed to bring drugs to market. Our Strategic Consulting segment consists of consulting, training and process redesign conducted by our clinical and decision scientists in the application and implementation of our core decision methodology. These segments were determined based on how management and our Chief Operating Decision Maker, or CODM, who is our Chief Executive Officer, view and evaluate Pharsight’s business.

 

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Challenges and Risks

 

We achieved our first quarter of profitability in the fourth quarter of fiscal 2004 and have maintained profitability through the first quarter of fiscal 2006. Prior to that time we had incurred losses since inception. We currently have an accumulated deficit of approximately $76.7 million. To meet increased demand for our products and services, we may be required to invest further in our operations, technology and infrastructure, which may result in our inability to sustain profitability. Although we believe we are currently experiencing increased demand for our consulting services, we may have difficulty expanding our capacity to deliver such services in a profitable manner, if at all.

 

We achieved positive operating cash flow in fiscal 2004 and continued to have positive operating cash flow in fiscal 2005; however, we experienced negative operating cash flow in the first quarter of fiscal 2006. Although we believe that our current cash balances are sufficient to meet our working capital needs for the next twelve months, our ability to generate positive net cash flow and sustain positive operating cash flow on a quarterly and annual basis is based on a number of factors, including some which are outside of our control, such as the state of the overall economy, the demand for our products and the length and lack of predictability of our sales cycle. As a result, we may need to raise additional funds through public or private financings or other sources to fund our operations. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and to incur additional indebtedness.

 

In the three months ended June 30, 2005, we generated 39% of our total revenues, or $2.2 million, from software license and renewal fees, compared to 42% of total revenues, or $2.1 million, in the three months ended June 30, 2004. Software services revenue decreased to $255,000 or 5% of total revenue, compared to $529,000 or 11% of total revenue for the three months ended June 30, 2004. While we expect that the overall long-term revenue trend in our software business will continue to increase in response to customer demand, the revenue in individual quarters may fluctuate significantly, based upon timing of completion of large software installations and related revenue recognition. Unanticipated delays in deployment schedules may have significant impact on the timing of revenue recognition and may have corresponding significant impact on our net income in that quarter.

 

We generate a significant portion of our revenue from a limited number of clients. We expect that a significant portion of our revenue will continue to depend on sales to a small number of clients. In addition, the worldwide pharmaceutical industry has undergone, and may in the future undergo, substantial consolidation, which may reduce the number of our existing and potential clients. The loss of one of our large clients would hurt our business and prevent us from sustaining profitability.

 

Our clients may also expand their internal drug development organizations to include functions and individuals that might perform services similar to those performed by our strategic consulting group. As a result, our consulting business could have difficulty sustaining its current levels of revenues, or increasing its revenues in the future. Unanticipated delays in consulting project schedules may have significant impact to the timing of revenue recognition and may have corresponding significant impact on our net income in that quarter.

 

The pharmaceutical industry in general has recently experienced, and may continue to experience, forced withdrawal of certain drugs from the public market due to unforeseen safety risks. Our clients may, as a result, experience declines in their revenues, which may lead to reductions in their current level of spending on software solutions and strategic consulting services. This could adversely affect our business and prevent us from increasing or sustaining our software and strategic consulting revenues.

 

Critical Accounting Policies and Estimates

 

We prepare our financial statements in accordance with U.S. generally accepted accounting principles, or GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material

 

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differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The primary critical accounting policies that currently affect our financial condition and results of operations are revenue recognition and allowance for doubtful accounts, which impact revenue. We believe that this accounting policy is critical to fully understand and evaluate our reported financial results.

 

Revenue Recognition

 

Our revenues are derived from two primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and (2) services related to scientific and training consulting and software deployment.

 

Our revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” or SOP 97-2 as amended. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, collection is probable, and no significant post-delivery obligations remain unfulfilled. If any of these criteria are not met, we defer revenue recognition until such time as all of the criteria are met. We do not currently offer, have not offered in the past, and do not expect to offer in the future, extended payment term arrangements. If we do not consider collectability to be probable, we defer recognition of revenue until the fee is collected.

 

We have contracts for one-year software licenses (initial and renewal fees) bundled with post-contract support services, or PCS, from which we receive solely license and renewal fees. We do not have vendor specific objective evidence to allocate the fee to the separate elements, as we do not sell PCS separately. We, therefore, do not present PCS revenue separately, and we do not believe other allocation methodologies, namely allocation based on relative costs, provide a meaningful and supportable allocation between license and PCS revenues. We recognize each of the initial and renewal license fees ratably over the one-year period of the license during which the PCS is expected to be provided as required by paragraph 12 of SOP 97-2.

 

For arrangements consisting solely of services, we recognize revenue as services are performed. Arrangements for services may be charged at daily rates for different levels of consultants and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or if customer acceptance of the milestone’s completion is required, upon such customer acceptance, which approximates the level of services provided. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

 

We enter into arrangements consisting of one-year licenses (bundled with PCS), renewal fees and scientific consulting services. The scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, in that they are not essential to the functionality of the delivered software, are described separately in the arrangement and are sold separately. We recognize license revenues, including license revenue from bundled PCS, on a straight line basis over the PCS term. We recognize revenues from scientific consulting services as these services are provided or upon their acceptance, if applicable. We have established vendor specific objective evidence for services, therefore we recognize revenue when services are performed or completed. Vendor specific objective evidence of fair value of scientific services for purposes of revenue recognition in these multiple element arrangements is based on daily rates for different levels of consultants and out-of-pocket expenses.

 

We also have arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. For arrangements involving a significant amount of services related to installation and implementation of our software products, we recognize revenue for the entire arrangement ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. We currently do not have vendor specific objective evidence for PCS, however revenues from maintenance renewals on perpetual licenses are classified as maintenance revenue on our income statement.

 

Judgments affecting revenue recognition. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter. We recognize revenue in accordance with GAAP rules that have been prescribed for the software industry. The accounting rules related to revenue recognition are complex and are affected by interpretations of the rules and an understanding of industry practices, both of which are subject to change. Consequently, the revenue recognition accounting rules require management to make significant judgments.

 

We do not record revenue on sales to customers whose ability to pay is in doubt at the time of sale. Rather, we recognize revenue from these customers as cash is collected. The determination of a customer’s ability to pay requires significant judgment. In this regard, management considers the international region of the customer and the financial viability of the customer in assessing a customer’s ability to pay.

 

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We generally do not consider revenue arrangements with extended payment terms to be fixed or determinable and, accordingly, we do not generally recognize revenue on these arrangements until the customer payments become due. The determination of whether extended payment terms are fixed or determinable requires management to exercise significant judgment, including assessing such factors as the past payment history with the individual customer and evaluating the risk of concessions over an extended payment period. The determinations that we make can materially impact the timing of recognition of revenues. Our normal payment terms currently range from “net 30 days” to “net 60 days,” which are not considered by us to be extended payment terms.

 

The majority of our PKS software arrangements include software deployment services. We defer revenue for software deployment services, along with the associated license revenue, until the services are completed. If there is significant uncertainty about the project completion or receipt of payment for the professional services, we defer revenue until the uncertainty is sufficiently resolved.

 

Additionally, for fixed fee strategic consulting contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or if customer acceptance is required, upon customer acceptance, which approximates the level of services provided. Management makes a number of estimates related to recognizing revenue for such contracts, as discussed further above. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

 

Allowance for Doubtful Accounts

 

We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than the full payment on our currently outstanding receivables. We make judgments as to our ability to collect receivables and provide allowances for the portion of receivables when collection becomes doubtful. Provisions are made, in part, based upon a specific review of all significant outstanding invoices. A component of the allowance attributable to invoices not specifically reviewed is also recorded based on differing percentage rates based upon the age of the receivable. In determining these percentages, we analyze our historical collection experience and current economic trends.

 

Results of Operations

 

The following table sets forth, for the periods given, selected unaudited consolidated financial data by reportable segment as a percentage of our revenue and the percentage of period-over-period change. The table and the discussion below should be read in connection with the consolidated financial statements and the notes thereto which appear elsewhere in this report. All percentage calculations set forth in this section have been made using figures presented in the consolidated financial statements, and not from the rounded figures referred to in the text of this management discussion and analysis.

 

                    

Percentage of Total

Revenues


 
    

Three Months Ended

June 30,


  

Percentage of

Dollar Change

Year Over Year


   

Three Months Ended

June 30,


 

(In thousands, except percentages)    


   2005

   2004

     2005

    2004

 

Total Revenues

                                

License and renewal

   $ 2,235    $ 2,119    5 %   39 %   42 %

Services

     3,459      2,915    19 %   61 %   58 %
    

  

        

 

Total revenues:

   $ 5,694    $ 5,034    13 %   100 %   100 %
    

  

        

 

Software products segment revenues

                                

License and renewal

   $ 2,235    $ 2,119    5 %   39 %   42 %

Services

     255      529    (52 )%   5 %   11 %
    

  

        

 

Total software products segment revenues:

   $ 2,490    $ 2,648    (6 )%   44 %   53 %
    

  

        

 

Strategic consulting segment revenues:

   $ 3,204    $ 2,386    34 %   56 %   47 %
    

  

        

 

 

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Comparison of Three Months Ended June 30, 2005 and 2004

 

Total revenues

 

Revenue for the first quarter of fiscal 2006 increased approximately 13% to $5.7 million, compared to $5.0 million in the first quarter of fiscal 2005. This increase was primarily attributable to an increase in PKS renewal software license revenues and maintenance renewals and growth in strategic consulting services revenues.

 

Software products segment revenues

 

License and renewal revenues. For the first quarter of fiscal 2006, desktop software products revenues increased to $1.6 million from $1.5 million in the first quarter of fiscal 2005, primarily as a result of an increase in our installed base in the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005, and our ability to maintain a high rate of license renewals during the first quarter of fiscal 2006.

 

PKS software products revenues increased to $495,000 in the first quarter of fiscal 2006, from $450,000 in the first quarter of fiscal 2005. The increase in revenue is mainly attributable to an increase in PKS maintenance renewals of $115,000 and PKS license renewals of approximately $18,000, offset by a decrease of $88,000 in PKS initial licenses.

 

DMX software revenues were $174,000 in the first quarter of fiscal 2006, compared to $175,000 in the first quarter of fiscal 2005.

 

Services revenues. Software services revenues were $255,000 in the first quarter of fiscal 2006, compared to $529,000 in the first quarter of fiscal 2005. Software services revenue in the first quarter of fiscal 2005 was largely driven by increased services revenues associated with our DMX product.

 

Strategic consulting segment revenues

 

Strategic consulting segment revenues were $3.2 million in the first quarter of fiscal 2006, compared to $2.4 million in the first quarter of fiscal 2005. The increase in strategic consulting segment revenues in the first quarter of fiscal 2006 compared to the same period in fiscal 2005 was driven by overall growth in our strategic consulting business and higher utilization of our scientific personnel.

 

                    

Percentage of Total

Revenues


 
    

Three Months Ended

June 30,


  

Percentage of

Dollar Change

Year Over Year


   

Three Months Ended

June 30,


 

(In thousands, except percentages)    


   2005

   2004

     2005

    2004

 

Cost of Revenues

                                

License and renewal

   $ 80    $ 93    (14 )%   1 %   2 %

Services

     1,807      1,751    3 %   32 %   35 %
    

  

        

 

Total cost of revenues:

   $ 1,887    $ 1,844    2 %   33 %   37 %
    

  

        

 

Cost of software products segments revenues

                                

License and renewal

   $ 80    $ 93    (14 )%   1 %   2 %

Services

     315      314    0 %   6 %   6 %
    

  

        

 

Total software products segment

   $ 395    $ 407    (3 )%   7 %   8 %
    

  

        

 

Cost of strategic consulting segment revenues

   $ 1,492    $ 1,437    4 %   26 %   29 %
    

  

        

 

 

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Cost of revenues

 

Total cost of revenues

 

Total cost of revenues were $1.9 million for the first quarter of fiscal 2006, compared to $1.8 million in the first quarter of fiscal 2005. The increase was primarily attributable to an increase in payroll and payroll related expenses. The decrease as a percentage of revenues in the first quarter of fiscal 2006 as compared to the first quarter of fiscal 2005 was related to increased efficiencies in both our software products and strategic consulting segments.

 

Software products segment

 

Cost of license and renewal revenues. Cost of license and renewal revenues primarily consists of royalty expense for third-party software included in our products, and cost of materials for both initial products and product updates provided for in our annual license agreements. Cost of license and renewal revenues was $80,000 for the first quarter of fiscal 2006, compared to $93,000 in the first quarter of fiscal 2005. The decrease in cost of license and renewal revenues in absolute dollars and as a percentage of revenue, in the first quarter of fiscal 2006 is primarily due to a decrease in payroll expenses of $11,000.

 

Cost of services revenues. Cost of service revenues consists of payroll and related costs, travel expenses, and facilities and overhead costs associated with our deployment services group. Cost of services revenue was $315,000 and remained relatively unchanged in absolute dollars and as a percentage of revenue for the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005.

 

Strategic consulting segment

 

Cost of services for our strategic consulting segment consists of payroll and payroll related costs, travel expenses, and facilities and overhead costs associated with our strategic consulting personnel. Cost of services for our strategic consulting segment was $1.5 million for the first quarter in fiscal 2006, compared to $1.4 million in the first quarter of fiscal 2005. The increase in cost of services for our strategic consulting segment in absolute dollars in fiscal 2006 was primarily attributable to increased headcount and payroll-related costs. The decrease as a percentage of revenues in the first quarter of fiscal 2006 was related to increased efficiencies in our strategic consulting organization.

 

Operating expenses

 

Research and development

 

                    

Percentage of Total

Revenues


 
    

Three Months Ended

June 30,


  

Percentage of

Dollar Change

Year Over Year


   

Three Months Ended

June 30,


 

(In thousands, except percentages)    


   2005

   2004

     2005

    2004

 

Software products segment

   $ 872    $ 710    23 %   15 %   14 %

Strategic consulting segment

     —        —      0 %   0 %   0 %
    

  

        

 

Total research and development

   $ 872    $ 710    23 %   15 %   14 %
    

  

        

 

 

Research and development expenses consist mainly of payroll, payroll related expenses and third-party consulting expenses.

 

Software products segment

 

Research and development expenses were $872,000 for the first quarter of fiscal 2006 compared to $710,000 for the first quarter of fiscal 2005. The increase in research and development expenses in absolute dollars, and as a percentage of revenue, for the first quarter of fiscal 2006 compared to the first quarter of fiscal 2005 was primarily due to an increase in third-party consulting expense of $134,000.

 

Strategic consulting segment

 

The strategic consulting segment does not engage in research and development activities, nor is any such expense allocable to the segment, therefore it does not incur research and development related expenses.

 

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Sales and marketing

 

                    

Percentage of Total

Revenues


 
    

Three Months Ended

June 30,


  

Percentage of

Dollar Change

Year Over Year


   

Three Months Ended

June 30,


 

(In thousands, except percentages)    


   2005

   2004

     2005

    2004

 

Software products segment

   $ 729    $ 627    16 %   13 %   13 %

Strategic consulting segment

     549      465    18 %   9 %   9 %
    

  

        

 

Total sales and marketing

   $ 1,278    $ 1,092    17 %   22 %   22 %
    

  

        

 

 

Sales and marketing expenses consist primarily of personnel costs, including salaries, commissions for sales, corporate marketing, facilities related costs and travel related costs.

 

Total sales and marketing expense

 

Sales and marketing expenses were $1.3 million in the first quarter of fiscal 2006, compared to $1.1 million in the first quarter of fiscal 2005. The increase in sales and marketing expense in absolute dollars in the first quarter of fiscal 2006 was primarily the result of an increase in payroll and payroll related expenses of $144,000 due to increased headcount and the resulting increased allocation of facilities related expenses of $36,000. Sales and marketing expense as a percentage of revenue remained relatively consistent in the first quarter of fiscal 2006, compared to the first quarter of fiscal 2005. The software products and strategic consulting segments both have dedicated sales and marketing resources, as well as a shared pool of sales and marketing resources which are allocated to the segments based on each segment’s revenue as a relative percentage of total revenues. Inter-segment sales costs related to the shared pool of resources are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

 

Software products segment

 

Sales and marketing expenses for the software products segment were $729,000 in the first quarter of fiscal 2006, compared to $627,000 in the first quarter of fiscal 2005. The increase in sales and marketing expense in absolute dollars in the first quarter of fiscal 2006, as compared to the same period in fiscal 2005 was primarily the result of approximately $100,000 in payroll and payroll related expenses and $15,000 in the allocation of facilities related expenses, partially offset by a decrease in depreciation expense of $23,000. Sales and marketing expenses as a percentage of revenue during the first quarter of fiscal 2006, as compared to the first quarter in fiscal 2005, remained relatively consistent.

 

Strategic consulting segment

 

Sales and marketing expenses for the strategic consulting segment were $549,000 in the first quarter of fiscal 2006, compared to $465,000 in the first quarter of fiscal 2005. The increase in expense in absolute dollars was primarily the result of an increase of $44,000 in payroll and payroll related expenses due to increased headcount and $21,000 in facilities related costs.

 

General and administrative

 

                    

Percentage of Total

Revenues


 
    

Three Months Ended

June 30,


  

Percentage of

Dollar Change

Year Over Year


   

Three Months Ended

June 30,


 

(In thousands, except percentages)    


   2005

   2004

     2005

    2004

 

Software products segment

   $ 579    $ 654    (11 )%   10 %   13 %

Strategic consulting segment

     791      600    32 %   14 %   12 %
    

  

        

 

Total sales and marketing

   $ 1,370    $ 1,254    9 %   24 %   25 %
    

  

        

 

 

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General and administrative expenses consist primarily of personnel costs of executive officers and support personnel, facilities, investor relations, legal and accounting fees.

 

Total general and administrative expense

 

General and administrative expenses were $1.4 million in the first quarter of fiscal 2006 compared to $1.3 million in the first quarter of fiscal 2005. The increase in absolute dollars in the first quarter of fiscal 2006 as compared to the first quarter of fiscal 2005, was primarily the result of an increase of approximately $85,000 in payroll and payroll related expenses and approximately $80,000 from the allocation of facility related expenses, offset by a decrease of approximately $38,000 in legal expenses. The decrease in general and administrative expenses as a percentage of revenues for the first quarter of fiscal 2006, compared to the same period in fiscal 2005, was related to ongoing cost containment efforts while revenues have increased.

 

Software products segment

 

General and administrative expenses for the software products segment were $579,000 in the first quarter of fiscal 2006 compared to $654,000 in the first quarter of fiscal 2005. The decrease in general and administrative expense in absolute dollars in the first quarter of fiscal 2006 was primarily the result of a decrease in professional service fees of $50,000 and other general business expenses of approximately $43,000, offset by an increase in the allocation of facility related expenses of $28,000. General and administrative costs for the software product segment also decreased as the result of a lower relative percentage of software product segment revenues to total revenues. The decrease in general and administrative expenses as a percentage of revenue for the first quarter of fiscal 2006 was related to ongoing cost containment efforts while revenues have increased.

 

Strategic consulting segment

 

General and administrative expenses for the strategic consulting segment were $791,000 in the first quarter of fiscal 2006 compared to $600,000 in the first quarter of fiscal 2005. The increase in general and administrative expense in absolute dollars and as a percentage of revenue for the first quarter of fiscal 2006 compared to the same period in fiscal 2005 was primarily the result of an increase in the allocation of general and administrative costs to the strategic consulting segment as the result of a higher relative percentage of strategic consulting segment revenues to total revenues.

 

Provision for Income Taxes

 

Year over year comparison for the three months ended June 30, 2005 (in thousands):

 

    

Three Months Ended

June 30,


     2005

   2004

Provision for income taxes

   $ 21    $ 4
    

  

 

Provisions for income taxes were recorded for the three months ended June 30, 2005 and 2004. These provisions were attributable to federal and state alternative minimum taxes, other state taxes and foreign income tax. The amounts provided were at rates less than the combined U.S. federal and state statutory rates due to the utilization of federal and state net operating loss carry forwards.

 

Liquidity and Capital Resources

 

From our inception through the initial public offering of our common stock, we funded operations through the private sale of preferred stock, with net proceeds of approximately $38 million, limited borrowings and equipment leases. In August 2000, we completed our initial public offering of 3,000,000 shares of common stock, at a price of $10.00 per share, all of which were issued and sold by us for net proceeds of $26.4 million, net of underwriting discounts and commissions of $2.1 million and expenses of $1.5 million. We paid $6.1 million to holders of our Series C preferred stock at the closing of the offering as required by the terms of the Series C preferred stock. After this payment, our net proceeds were $20.3 million. In June and September of fiscal 2003, we completed a private placement of preferred stock to several of our investors, raising additional net proceeds of $7.2 million, as further described below.

 

 

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Summarized cash, working capital and cash flow information is as follows (dollars in thousands):

 

    

June 30,

2005


    % Change

   

March 31,

2004


 

Cash and cash equivalents

   $ 9,035     (15 )%   $ 10,579  
    


       


Working capital

   $ 2,892     (13 )%   $ 3,332  
    


       


    

Three Months Ended

June 30,


 
     2005

    % Change

    2004

 

Cash flows from operating activities

   $ (688 )   (45 )%   $ (1,244 )
    


       


Cash flows from investing activities

   $ (497 )   49 %   $ (10 )
    


       


Cash flows from financing activities

   $ (378 )   22 %   $ (310 )
    


       


 

Cash and Cash Equivalents. As of June 30, 2005, our cash and cash equivalents consisted primarily of demand deposits and money market funds. The decrease in our cash and cash equivalents in the three months ended June 30, 2005 was primarily due to $497,000 used in investing activities for property and equipment and $388,000 of cash used in financing activities in the pay down of notes payable and cash payment for dividends. The largest use of cash from operating activities was due to a decrease in accounts payable and accrued expenses due to the timing of payments and a decrease in deferred revenue.

 

Cash Flows From Operating Activities. Cash flows used in operating activities decreased in the first three months of fiscal 2006 as compared to the first three months of fiscal 2005 primarily due to net income, a decrease in accounts receivables from our cash collection efforts, and decreases in accounts payable, accrued expenses, and deferred revenue.

 

Cash Flows From Investing Activities. Cash flows used in investing activities during the first three months of fiscal 2006 primarily related to the investment in a new financial system that we began implementing during the fourth quarter of fiscal 2005. Cash flows used in investing activities in the first three months of fiscal 2005 related to purchases of capital equipment necessary for our ongoing operations.

 

Cash Flows From Financing Activities. Cash flows used in financing activities in the first three months of fiscal 2006 were primarily a result of payments against our outstanding loan facilities with Silicon Valley Bank and payments of dividends to our preferred stockholders. Cash flows used in financing activities in the first three months of fiscal 2005 were primarily a result of payments against our outstanding loan facilities with Silicon Valley Bank and payments of dividends to our preferred stockholders.

 

Credit Facilities. We have a secured term loan outstanding, payable over 48 months, with monthly payments having commenced in July 2002. The balance on the term loan as of June 30, 2005 was $875,000. In February 2005, we secured an additional term loan for the purchase of a new financial system, which was added to the existing term loan. The $300,000 term loan is payable over 36 months. The balance outstanding on the term loan as of June 30, 2005 was $267,000.

 

In June 2005, we extended and expanded our credit facilities with Silicon Valley Bank, providing for up to $3.0 million in borrowings, secured against 80% of eligible domestic accounts receivable. The current balance on this credit facility was $1.0 million. In addition, we secured an equipment credit facility through June 2006 for up to $600,000. Each advance will be payable over 36 months. As of June 30, 2005, we have not drawn down any amounts on the equipment credit facility.

 

The following financial covenants apply to the extended Silicon Valley Bank loan facilities: net loss no greater than $200,000 in the first quarter of fiscal 2006; net income of at least $1.00 in the remaining three quarters of fiscal 2006; and a minimum modified quick ratio (defined as cash and cash equivalents plus accounts receivable, divided by total current liabilities, including all bank debt and not including deferred revenue) of 1.5:1 for the months of April 2004 through July 2004, 1.75:1 for the months of August 2004 through November 2004, and 2:1 for the months of December 2004 and each month thereafter. We were in compliance with each of these covenants as of June 30, 2005. Interest on our revolving lines of credit is accrued at 0.5% above prime and is payable monthly from the date of borrowing. Interest on our term loans is accrued at 1.25% above prime and is payable monthly from the date of borrowing. Certain of our assets, excluding intellectual property, secure both facilities.

 

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Preferred Stock Financing. On June 26, 2002 and September 11, 2002, we completed private placements of our securities to certain entities affiliated with Alloy Ventures, Inc. and the Sprout Group, both of which were existing stockholders, pursuant to a Preferred Stock and Warrant Purchase Agreement (the “Purchase Agreement”). Pursuant to the Purchase Agreement, we sold an aggregate of 1,814,662 units (each a “Unit,” and collectively the “Units”). Each Unit consisted of one share of our Series A redeemable convertible preferred stock (the “Series A Preferred”) and a warrant to purchase one share of our common stock. The purchase price for each Unit was $4.133, which is the sum of $4.008 (four times the underlying average closing price for our common stock over the five trading days prior to the initial closing (i.e., $1.002)) and $0.125 for each share of Series A Preferred and warrant, respectively. The second closing, which occurred on September 11, 2002, was subject to stockholder approval, which was obtained on September 6, 2002.

 

The Series A Preferred is redeemable at any time after five years from the date of issuance upon the affirmative vote of at least 75% of the holders of Series A Preferred, at a price of $4.008 per share plus any unpaid dividends. Each share of Series A Preferred is convertible into four shares of our common stock at the election of the holder or upon the occurrence of certain other events. The holders of Series A Preferred are entitled to receive, but only out of legally available funds, quarterly cumulative dividends at the rate of 8% per year commencing in September 2002, which are payable in cash or shares of Series B redeemable convertible preferred stock (the “Series B Preferred” and, together with the Series A Preferred, the “Preferred Stock”), at the election of the holder. The terms of the Series B Preferred are identical to the Series A Preferred, except that the Series B Preferred is not entitled to receive the 8% dividends. In the event of any liquidation or winding up of the company, the holders of the Series A Preferred and Series B Preferred shall be entitled to receive in preference to the holders of the common stock a per share amount equal to the greater of (a) the original issue price, plus any accrued but unpaid dividends and (b) the amount that such shares would receive if converted to common stock immediately prior thereto (the “Liquidation Preference”). After the payment of the Liquidation Preference to the holders of Preferred Stock, the remaining assets shall be distributed ratably to the holders of the common stock. A merger, acquisition, sale of voting control of the company in which our stockholders do not own a majority of the outstanding shares of the surviving corporation, or a sale of all or substantially all of our assets, shall be deemed to be a liquidation.

 

The holders of Series A Preferred and Series B Preferred are entitled to vote together with the common stock. Each share of Preferred Stock has a number of votes equal to the number of shares of common stock then issuable upon conversion of such share of Preferred Stock. In addition, consent of the holders of at least 75% of the then outstanding Preferred Stock is required for certain actions, including any action that amends our charter documents so as to adversely affect the Preferred Stock.

 

The warrants are exercisable for a period of five years from issuance with an exercise price of $1.15 per share.

 

The Series A Preferred Stock is entitled to receive an annual dividend of 8% payable quarterly in cash or shares of Series B Preferred Stock, at the election of the holder of the Series A Preferred Stock. The Series B Preferred Stock has identical rights, preferences and privileges to the Series A Preferred Stock except that the Series B Preferred Stock is not entitled to 8% dividends. These quarterly dividends commenced in September 2002. During the first quarter of fiscal 2006, we paid $145,000 in cash dividends to the Series A Preferred stockholders and we recorded an additional $48,000 in accrued dividends payable as of June 30, 2005. On June 1, 2004 (the “Valuation Date”), at the election of a Series A Preferred stockholder, instead of cash we issued a dividend in the form of 18,142 shares of Series B Preferred Stock to a Series A Preferred stockholder.

 

Contractual Commitments. As of June 30, 2005, we had operating leases of our facilities and certain property and equipment that expire at various times through fiscal years 2005 and 2011. These arrangements allow us to obtain the use of the equipment and facilities without purchasing them. If we were to acquire these assets, we would be required to obtain financing and record a liability related to the financing of these assets or we would need to utilize upfront cash flow to purchase them. During the three months ended June 30, 2005, we recorded rent expense related to these arrangements of $148,000.

 

The following is a summary of our contractual commitments associated with our debt and lease obligations as of June 30, 2005, including our new lease commitment described in the Notes to Financial Statements contained in Note 6 – Subsequent Event (in thousands):

 

     Payments Due by Period

Contractual Obligations


   Total

  

Less Than 1

Year


   1-3 Years

   3-5 Years

  

More Than 5

Years


Redeemable convertible preferred stock (1)

   $ 1,164    $ 582    $ 582    $ —      $ —  

Notes payable

     2,142      1,975      167      —        —  

Operating leases

     2,157      332      543      573      709
    

  

  

  

  

Total commitments

   $ 5,463    $ 2,889    $ 1,292    $ 573    $ 709
    

  

  

  

  


(1) The holders of the preferred stock may elect to have us redeem the preferred stock immediately after it becomes redeemable in June 2007. However, if this does not occur then we will continue to pay dividends in the aggregate amount of approximately $582,000 per year. Further, the terms of the preferred stock provide that it will automatically convert to common stock in the event of a public offering meeting certain minimum conditions, and if this were to occur, our obligation to pay dividends or redeem the preferred stock would cease at that time. Any of these outcomes is beyond our control and the probability of any of these outcomes is highly subjective. The amounts presented in the table above reflect only our contractual obligations related to dividend payments to the holders of the preferred stock up to June 2007, at which point the stock may or may not redeem.

 

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Short Term and Long Term Liquidity. We believe that the combination of our cash and cash equivalents and currently anticipated cash flow from operations should be adequate to sustain operations through the next 12 months. We are managing the business to achieve positive cash flow utilizing existing assets. We have maintained relatively unchanged operating expenses through cost containment efforts over the past several fiscal years and although we generated positive operating cash flow for fiscal 2005 and 2004, there is no assurance that we can continue to do so. We are committed to the successful execution of our operating plan and we will take continued actions as necessary to ensure our cash resources are sufficient to fund our working capital requirements at least through fiscal 2006.

 

Our long-term liquidity and capital requirements will depend on numerous factors including our future revenues and expenses, growth or contraction of operations and general economic pressures. We may not be able to maintain our current market share, or continue to expand our business, without investing in our operations, technology, or product and service offerings. In order to do so, we may need to raise additional funds through public or private financings or other sources to fund our operations. However, our common stock is not listed on an exchange or the Nasdaq National Market, and until it is listed it will be difficult for us to make sales of our equity stock. In addition, the terms of our preferred stock may prevent us from issuing additional shares of preferred stock on terms that investors would require in order to invest in our preferred stock. The necessity of raising additional funds could require us to incur debt on terms that could restrict our ability to make capital expenditures and incur additional indebtedness. As a result, we may not be able to obtain additional funds on commercially reasonable terms, or at all. In addition, beginning in June 2007, the holders of our preferred stock can force us to redeem the shares of our preferred stock, and if we were required to redeem all of the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $7.5 million.

 

Recent Accounting Pronouncements

 

SFAS 123R

 

On December 16, 2004, the Financial Accounting Standards Board, or FASB issued Statement of Accounting Standards No. 123R, “Share-Based Payment”, or SFAS 123R, which is a revision of Statement of Accounting Standards No. 123, “Accounting for Stock-Based Compensation”. SFAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends Statement of Accounting Standards No. 95, “Statement of Cash Flows”. SFAS 123R requires all companies to measure compensation expense for all share-based payments (including employee stock options and options issued pursuant to employee stock purchase plans) based upon the fair value of the stock-based awards at the date of grant. SFAS 123R is effective for all public companies for annual periods beginning after June 15, 2005. Retroactive application of the requirements of FASB Statement No. 123 to the beginning of the fiscal year that includes the effective date is permitted, but not required. Early adoption of SFAS 123R is encouraged. A component of SFAS 123R includes one of the following options: (a) modified-prospective method, (b) the modified-retrospective method, restating all prior periods or (c) the modified-retrospective method, restating only the prior interim periods of 2005. A determination as to which of the three options we will adopt will be made at a later date. As permitted by SFAS 123, we currently account for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognizes no compensation

 

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Table of Contents

cost for employee stock options. Accordingly, the adoption of SFAS 123R’s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123R for the first quarter of fiscal 2006 would be similar to the pro forma calculation in the Notes to Financial Statements contained in Note 1 – Organization and Summary of Significant Accounting Policies – Stock-Based Compensation.

 

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FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK

 

We operate in a rapidly changing economic and technological environment that presents numerous risks. Many of these risks are beyond our control and are driven by factors that we cannot predict. The following discussion, as well as our discussion above of critical accounting policies and estimates, highlights some of these risks. You should carefully consider the risks and uncertainties described below and the other information in this report before deciding whether to invest in shares of our common stock. If any of the following risks actually occur, our business, financial condition or operating results could be materially adversely affected. This could cause the trading price of our common stock to decline, and you may lose part or all of your investment.

 

Items That Affect Our Future Operations

 

We have had a history of losses, have only recently achieved profitability, and we may not be able to generate sufficient revenues to sustain profitability.

 

We commenced our operations in April 1995 and incurred net losses for every fiscal year until attaining profitability in fiscal 2005. We achieved profitability in the fourth quarter of fiscal 2004 and have maintained profitability through the first quarter of fiscal 2006. As of June 30, 2005, we had an accumulated deficit of $76.7 million. We may incur losses again as we continue to develop our business. Our ability to sustain profitability is based on a number of assumptions, including some outside of our control, including the state of the overall economy and the demand for our products, and if these assumptions do not prove to be accurate then we may not be able to generate sufficient revenues to sustain profitability. Furthermore, even if we do sustain profitability and positive operating cash flow, we may not be able to increase profitability or positive operating cash flow on a quarterly or annual basis. If our profitability does not meet the expectations of investors, the price of our common stock may decline.

 

We have a limited amount of capital resources and we may not be able to sustain or grow our business if we cannot sustain profitability or raise additional funds on a timely basis.

 

We believe we have adequate cash to sustain operations through the next 12 months, and we are managing the business to achieve positive cash flow utilizing existing assets. However, even if we sustain profitability, we may not be able to generate sufficient profits to grow our business. As a result, we may need to raise additional funds through public or private financings or other sources to fund our operations. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and incur additional indebtedness.

 

The terms of our credit facilities contain covenants that limit our flexibility and prevent us from taking certain actions.

 

The terms governing our credit facilities with Silicon Valley Bank include a number of significant restrictive covenants. These covenants could adversely affect us by limiting our ability to plan for or react to market conditions, meet our capital needs and execute our business strategy. These covenants will, among other things, limit our ability to:

 

    incur additional debt;

 

    make certain investments;

 

    create liens; or

 

    sell certain assets.

 

These covenants may significantly limit our operating and financial flexibility and limit our ability to respond to changes in our business or competitive activities. Our failure to comply with these covenants could result in an event of default, which, if not cured or waived, could result in our being required to repay these borrowings before their scheduled due date. In addition, Silicon Valley Bank could foreclose on our assets.

 

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Table of Contents

Our quarterly operating results may fluctuate significantly and may not be predictive of future financial results.

 

Our quarterly operating results may fluctuate in the future, and may vary from investors’ expectations, depending on a number of factors, including:

 

    Variances in demand for our products and services and the relative mix of such demand;

 

    Timing of the introduction of new products or services and enhancements of existing products or services;

 

    Our ability to complete fixed-price service contracts without committing additional unplanned resources;

 

    Unanticipated changes in the capacity of our services organization;

 

    Delays or deferrals of customer implementations of our software products;

 

    Delays or deferrals of client drug development processes;

 

    The tendency of some of our customers to wait until the end of a fiscal quarter or fiscal year in the hope of obtaining more favorable terms;

 

    Changes in industry conditions affecting our customers, including industry consolidation; and

 

    Our ability to realize operating efficiencies through restructuring or other actions.

 

As a result, quarterly comparisons may not indicate reliable trends of future performance.

 

We manage our expense levels in part based upon our expectations concerning future revenue, and these expense levels are relatively fixed in the short term. If we have lower revenue than expected, we may not be able to reduce our spending in the short term in response. Any shortfall in revenue would have a direct impact on our results of operations.

 

In the past we have taken actions intended to reduce our expenses on an annualized basis. Our cost reduction measures have left us with less excess capacity to deliver our products and services. If there is a significant increase in demand from what we estimate, it will take us longer to address this demand, which would limit our ability to grow our business and sustain profitability.

 

We may be required to defer recognition of software license revenue for a significant period of time after entering into an agreement, which could negatively impact our results of operations.

 

We may have to delay recognizing license revenue for a significant period of time for a variety of types of transactions, including:

 

    Transactions that include both currently deliverable software products and software products that are under development or contain other currently undeliverable elements;

 

    Transactions where the customer demands services that include significant modifications, customizations or complex interfaces that could delay product delivery or acceptance;

 

    Transactions that involve non-standard acceptance criteria or identified product-related performance issues; and

 

    Transactions that include contingency-based payment terms or fees.

 

These factors and other specific accounting requirements for software revenue recognition require that we have very precise terms in our license agreements to allow us to recognize revenue when we initially deliver software or perform services. Although we have a standard form of license agreement that we believe meets the criteria for current revenue recognition on delivered elements, we negotiate and revise these terms and conditions in some transactions. Therefore, it is possible that from time to time we may license our software or provide service with terms and conditions that do not permit revenue recognition at the time of delivery or even as work on the project is completed. In the three months ended June 30, 2005 and 2004, software license revenue accounted for 39% and 42% of our total revenues, respectively. The majority of our large PKS software transactions include services pertaining to modification and customization of the core PKS software product, which may result in delayed revenue recognition for a significant period of time.

 

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An increase in service revenue as a percentage of total revenues, or a decrease in software license revenue as a percentage of total revenues, may decrease our overall margins.

 

We realize lower margins on services than on license revenues. In addition, we may contract with certain third parties to supplement the services we provide to customers, which generally yields lower gross margins than our deployment organization or internal scientific staff. As a result, if service revenue increases as a percentage of total revenue or if we increase our use of third parties to provide such services, our gross margins would be lower and our operating results may be adversely affected.

 

Because our sales and implementation cycles are long and unpredictable, our revenues are difficult to predict and may not meet our expectations or those of our investors.

 

The lengths of our sales and implementation cycles are difficult to predict and depend on a number of factors, including the type of product or services being provided, the nature and size of the potential customer and the extent of the commitment being made by the potential customer. Our sales cycle is unpredictable and may take six months or more. Our implementation cycle is also difficult to predict and can be longer than one year. Each of these can result in delayed revenues, increased selling expenses and difficulty in matching revenues with expenses, which may contribute to fluctuations in our results of operations. A key element of our strategy is to market our product and service offerings to large organizations. These organizations can have particularly lengthy decision-making processes and may require evaluation periods, which could extend the sales and implementation cycle. Moreover, we often must provide a significant level of education to our prospective customers regarding the use and benefit of our product and service offerings, which may cause additional delays during the evaluation and acceptance process. We therefore have difficulty forecasting the timing and recognition of revenues from sales of our product and service offerings.

 

Our revenue is concentrated in a few customers, and if we lose any of these customers our revenue may decrease substantially.

 

We receive a substantial majority of our revenue from a limited number of customers. For the three months ended June 30, 2005 and 2004, sales to our top two customers accounted for 44% and 48% of total revenue, respectively, and sales to our top five customers in the same periods accounted for 59% and 62% of total revenue, respectively. For fiscal 2005, 2004 and 2003 sales to our top two customers accounted for 45%, 28% and 28% of total revenue, respectively, and sales to our top five customers in the same periods accounted for 62%, 50% and 50% of total revenue, respectively. We expect that a significant portion of our revenue will continue to depend on sales to a small number of customers. If we do not generate as much revenue from these major customers as we expect to, or if revenue from such customers is delayed, or if we lose any of them as customers, our total revenue may be significantly reduced.

 

We may need to change our pricing models to compete successfully.

 

The markets in which we compete can put pressure on us to reduce our prices. If our competitors offer deep discounts on certain products in an effort to recapture or gain market share, we may then need to lower prices or offer other favorable terms in order to compete successfully. Any such changes would be likely to reduce margins and could adversely affect operating results. We have periodically changed our pricing model and any broadly based changes to our prices and pricing policies could cause service and license revenues to decline or be delayed as our sales force implements and our customers adjust to the new pricing policies. If we do not adapt our pricing models to reflect changes in customer use of our products, our revenues could decrease.

 

If we are unable to generate additional sales from existing customers and/or generate sales to new customers, we may not be able to realize sufficient revenues to sustain or increase our profitability.

 

Our success depends on our ability to develop our existing customer relationships and establish relationships with additional pharmaceutical and biotechnology companies. If we lose any significant relationships with existing customers or fail to establish additional relationships, we may not be able to execute our business plan and our business will suffer. Developing customer relationships with pharmaceutical companies can be difficult for a number of reasons. These companies are often very large organizations with complex decision-making processes that are difficult to affect. In addition, because our products and services relate to the core technologies of these companies, these organizations are generally cautious about working with outside companies. Some potential customers may also resist working with us until our products and services have achieved more widespread market acceptance. Our existing customers could also reassess their commitment to us, not renew existing agreements or choose not to expand the scope of their relationship with us.

 

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Our revenues and results of operations would be adversely affected if a customer cancels a contract for services or software deployment with us.

 

Many of our services agreements can be canceled upon prior notice by our customers. Additionally, due to the nature of our services and deployment engagements, customers sometimes delay projects because of timing of the clinical trials and the need for data and information that prevent us from proceeding with our projects. These delays and contract cancellations cannot be predicted with accuracy and we cannot assure you that we will be able to replace any delayed or canceled contracts with the customer or other customers. If we are unable to replace those contracts, our revenues and results of operations would be adversely affected.

 

We may lose existing customers or be unable to attract new customers if we do not develop new products and services or if our offerings do not keep pace with technological changes.

 

The successful growth of our business depends on our ability to develop new products and services and incorporate new capabilities, including the expansion of our product and services offerings to address a broader set of customer needs related to clinical development of drugs and thereby expand the number of our prospective users, on a timely basis. If we cannot adapt to changing technologies, emerging and evolving industry standards, new scientific developments and increasingly sophisticated customer needs, we may not achieve revenue growth and our products and services may become obsolete, and our business could suffer. We have suffered product delays in the past, resulting in lost product revenues. In addition, early releases of software often contain errors or defects. We cannot assure you that, despite our extensive testing, errors will not be found in our products before or after commercial release, which could result in product redevelopment costs and loss of, or delay in, market acceptance. Furthermore, a failure by us to introduce new products or services on schedule could harm our business prospects. Any delay or problems in the installation or implementation of new products or services may cause customers to forego purchases from us. We may need to accelerate product introductions and shorten product life cycles, which will require high levels of expenditures of research and development that could adversely affect our operating results. A failure by us to introduce new services on a timely and cost-effective basis to meet evolving customer requirements, or to integrate new services with existing services, could harm our business prospects.

 

If the security or confidentiality of our customers’ data is compromised or breached, we could be liable for damages and our reputation could be harmed.

 

As part of implementing our products and services, we inherently gain access to certain highly confidential proprietary customer information. It is critical that our facilities and infrastructure remain secure and are perceived by the marketplace to be secure. Despite our implementation of a number of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. We do not have insurance to cover us for losses incurred in many of these events. If we fail to meet our customers’ security expectations, we could be liable for damages and our reputation could suffer.

 

If we are unable to complete a project due to scientific limitations or otherwise meet our customers’ expectations, our reputation may be adversely affected and we may not be able to generate new business.

 

Because our projects may contain scientific risks, which are difficult to foresee, we cannot guarantee that we will always be able to complete them. Any failure to meet our customers’ expectations could harm our reputation and ability to generate new business. On a few occasions, we have encountered scientific limitations and been unable to complete a project. In each of these cases, we have been able to successfully renegotiate the terms of the project with the particular customer. We cannot assure you that we will be able to renegotiate our customer agreements if such circumstances occur in the future. Moreover, even if we complete a project, we may not meet our customers’ expectations regarding the quality of our products and services or the timeliness of our services.

 

Our future success depends on our ability to continue to retain and attract qualified employees.

 

We believe that our future success depends upon our ability to continue to train, retain, effectively manage and attract highly skilled technical, scientific, managerial, sales and marketing personnel. We currently have limited personnel and other resources to staff and complete consulting and software deployment projects. In addition, as we grow our business, we expect an increase in the number of complex projects and large deployments of our products and services, which require a significant amount of personnel for extended periods of time. In particular, there is a limited supply of modeling and simulation personnel worldwide, and competition for these personnel from numerous companies and academic institutions may limit our ability to hire these persons on commercially reasonable terms. From time to time, we experience difficulties in locating enough highly qualified candidates in desired geographic locations, or with required scientific or industry-specific expertise. Staffing projects and

 

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deploying our products and services will become more difficult as our operations and customers become more geographically diverse. If we are not able to adequately staff and complete our projects, we may lose customers and our reputation may be harmed. Any difficulties we may have in completing customer projects may impair our ability to grow our business.

 

If we lose key members of our management, scientific or development staff, or our scientific advisors, our reputation may be harmed and we may lose business.

 

We are highly dependent on the principal members of our management, scientific and development staff. Our reputation is also based in part on our association with key scientific advisors. The loss of any of these personnel might adversely impact our reputation in the market and harm our business. Failure to attract and retain key management, scientific and technical personnel could prevent us from achieving our strategy and developing our products and services. In addition, our management team has experienced significant personnel changes over the past years and may continue to experience changes in the future. If our management team continues to experience attrition, high turnover, or does not work effectively together, it could harm our business. Additionally, we do not currently hold key-man life insurance policies on our CEO, CFO or other key contributors. The demise of any of these individuals could adversely impact our business.

 

Our business depends on our intellectual property rights, and if we are unable to adequately protect them, our competitive position will suffer.

 

Our intellectual property is important to our competitive position. We protect our proprietary information and technology through a combination of patent, trademark, trade secret and copyright law, confidentiality agreements and technical measures. We have filed nine patent applications, of which two patents have issued. We cannot assure you that the steps we have taken will prevent misappropriation of our proprietary information and technology, nor can we guarantee that we will be successful in obtaining any patents or that the rights granted under such patents will provide a competitive advantage. Misappropriation of our intellectual property could harm our competitive position. We may also need to engage in litigation in the future to enforce or protect our intellectual property rights or to defend against claims of invalidity, and we may incur substantial costs as a result. In addition, the laws of some foreign countries provide less protection of intellectual property rights than the laws of the United States and Europe. As a result, we may have an increasingly difficult time adequately protecting our intellectual property rights as our sales in foreign countries grow.

 

If we become subject to infringement claims by third parties, we could incur unanticipated expense and be prevented from providing our products and services.

 

We cannot assure you that infringement claims by third parties will not be asserted against us or, if asserted, will be unsuccessful. These claims, whether or not meritorious, could be expensive and divert management resources from operating our company. Furthermore, a party making a claim against us could secure a judgment awarding substantial damages, as well as injunctive or other equitable relief that could block our ability to provide products or services, unless we obtain a license to such technology. In addition, we cannot assure you that licenses for any intellectual property of third parties that might be required for our products or services will be available on commercially reasonable terms, or at all.

 

International sales of our product account for a significant portion of our revenue, which exposes us to risks inherent in international operations.

 

We market and sell our products and services in the United States and internationally. International sales of our products and services as a percentage of our total revenues for the three months ended June 30, 2005 and fiscal 2005, 2004, and 2003 were approximately 14%, 22%, 29% and 23%, respectively. We have a total of 13 employees based outside the United States who deploy our software, perform consulting services and perform research in Europe and Australia. We cannot be certain that we have fully complied with all rules and regulations in every applicable jurisdiction outside of the United States with respect to our current and previous operations outside of the United States. The failure to comply with such rules and regulations could result in penalties, monetary or otherwise, against us. Our existing marketing efforts into international markets may require significant management attention and financial resources. We cannot be certain that our existing international operations will produce desired levels of revenue. We currently have limited experience in developing localized versions of our products and services and marketing and distributing our products internationally. Our international operations also expose us to the following general risks associated with international operations:

 

    Disruptions to commercial activities or damage to our facilities as a result of political unrest, war, terrorism, labor strikes and work stoppages;

 

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    Difficulties and costs of staffing and managing foreign operations;

 

    The impact of recessions or inflation in economies outside the United States;

 

    Greater difficulty in accounts receivable collection and longer collection periods;

 

    Reduced protection for intellectual property rights in some countries;

 

    Potential adverse tax consequences, including higher tax rates generally in Europe;

 

    Tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries;

 

    Unexpected changes in regulatory requirements of foreign countries, especially those with respect to software, pharmaceutical and biotechnology companies; and

 

    Fluctuations in the value of currencies.

 

To the extent that such disruptions and costs interfere with our commercial activities, our results of operations could be harmed.

 

Changes in government regulation could decrease the need for the products and services we provide.

 

Governmental agencies throughout the world, but particularly in the United States, highly regulate the drug development and approval process. A large part of our software and services business involves helping pharmaceutical and biotechnology companies through the regulatory drug approval process. Any relaxation in regulatory approval standards could eliminate or substantially reduce the need for our services, and, as a result, our business, results of operations and financial condition could be materially adversely affected. Potential regulatory changes under consideration in the United States and elsewhere include mandatory substitution of generic drugs for patented drugs, relaxation in the scope of regulatory requirements or the introduction of simplified drug approval procedures. These and other changes in regulation could have an impact on the business opportunities available to us.

 

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 ending March 31, 2007, 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 independent registered public accounting firm have issued an attestation report on management’s assessment of such internal control. PCAOB Auditing Standard No. 2 provides the professional standards and related performance guidance for independent registered public accounting firms to attest to, and report on, management’s 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 in the process of 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, and those weaknesses are not appropriately remediated prior to March 31, 2007, 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 March 31, 2007 (or if our independent registered public accounting firm is unable to attest that our management’s report is fairly stated or they are unable to express an opinion on our management’s evaluation or on the effectiveness of the internal control), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price, and our business and operating results could be harmed.

 

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Risks Related To Our Industry

 

Our market may not develop as quickly as expected, and companies may enter our market, thereby increasing the amount of competition and impairing our business prospects.

 

Because our products and services are new and still evolving, there is significant uncertainty and risk as to the demand for, and market acceptance of, these products and services. As a result, we are not able to predict the size and growth rate of our market with any certainty. In addition, other companies, including potential strategic partners, may enter our market. Our existing customers may also elect to terminate our services and internally develop products and services similar to ours. If our market fails to develop, grows more slowly than expected, or becomes saturated with competitors, our business prospects will be impaired.

 

Government regulation of the pharmaceutical industry may restrict our operations or the operations of our customers and, therefore, adversely affect our business.

 

The pharmaceutical industry is regulated by a number of federal, state, local and international governmental entities. Although our products and services are not directly regulated by the United States Food and Drug Administration or comparable international agencies, the use of some of our analytical software products by our customers may be regulated. We currently provide assistance to our customers in achieving compliance with these regulations. The regulatory agencies could enact new regulations or amend existing regulations with regard to these or other products that could restrict the use of our products or the business of our customers, which could harm our business.

 

Consolidation in the pharmaceutical industry could cause disruptions of our customer relationships, interfere with our ability to enter into new customer relationships and have a negative impact on our revenues.

 

In recent years, the worldwide pharmaceutical industry has undergone substantial consolidation. If any of our customers consolidate with another business, they may delay or cancel projects, lay off personnel or reduce spending, any of which could cause our revenues to decrease. In addition, our ability to complete sales or implementation cycles may be impaired as these organizations undergo internal restructuring.

 

Reductions in the IT and/or research and development budgets of our customers may affect our sales.

 

Our customers include researchers at pharmaceutical and biotechnology companies, academic institutions and government and private laboratories. Fluctuations in the IT and research and development budgets of these researchers and their organizations could have a significant effect on the demand for our products. Research and development and IT budgets fluctuate due to changes in available resources, spending priorities, internal budgetary policies and the availability of grants from government agencies. Our business could be harmed by any significant decrease in research and development or IT expenditures by pharmaceutical and biotechnology companies, academic institutions or government and private laboratories.

 

Recent or continued withdrawals of drugs from the public market could affect pharmaceutical spending, reduce the demand for our products and have a negative impact on our revenues.

 

Recently, the pharmaceutical industry has experienced, and may continue to experience, forced withdrawal of certain drugs from the public market due to safety risks. Recent or future drug withdrawals could affect our ability to market and sell our products and services to companies faced with withdrawals. For example, withdrawals of drugs from the public market by our customers or potential customers may result in the reduction of current levels of spending on software solutions and strategic consulting services by these companies to minimize the impact of a potential decline in revenues. In addition, we may provide products or services to customers with drugs in the same class as the drugs withdrawn from the market. If the demand for drugs within the class of drugs faced with recent withdrawals decreases, we may experience a decrease in demand for our products or services in that class of drugs. A decrease in demand for our products, or a decrease in IT or research and development spending by pharmaceutical companies, could prevent us from increasing or sustaining our software and strategic consulting revenues and adversely affect our revenues and results of operations.

 

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Risks Related to Our Stock

 

Our common stock only trades on the Over-the-Counter Bulletin Board system, and has experienced reduced trading volumes and stock price since it began to be traded there.

 

On November 8, 2002 our stock was removed from trading on the Nasdaq National Market as a result of failure to meet the continuing listing requirements, and our common stock is now quoted on the Over-the-Counter Bulletin Board system. Our common stock does not experience large trading volumes. In addition, our delisting from the Nasdaq National Market has caused the loss of our exemption from the provisions of Section 2115 of the California Corporations Code that imposes particular aspects of California corporate law on certain non-California corporations operating within California. As a result, (i) our Board of Directors is no longer classified and our stockholders elect all of our directors at each annual meeting, (ii) our stockholders are entitled to cumulative voting, and (iii) we are subject to more stringent stockholder approval requirements and more stockholder-favorable dissenters’ rights in connection with certain strategic transactions. Some of these changes may impact any possible transaction involving a change of control of Pharsight, which could negatively impact your investment. Other consequences include a reduction in analyst coverage, a lower share price as a result of lower trading volumes, and the loss of certain state securities law exemptions available to us while our securities were traded on the Nasdaq National Market, which may impact our ability to provide for future issuances of our securities, among other consequences.

 

Should we decide to relist our common stock on the Nasdaq National Market, the criteria for relistment may be difficult for us to achieve.

 

The market price of our common stock has been lower than the required minimum bid price for relistment on Nasdaq, and the reduced trading volumes that we currently experience may prevent our stock from reaching the required minimum bid price for Nasdaq relistment. Additionally, our current stockholder’s deficit balance and our history of net losses may make it difficult for us to relist on Nasdaq at any point in the near future, if at all. We may be required to restructure our capital or debt structure, including our redeemable convertible preferred stock, in order to relist on Nasdaq. There is no guarantee that we would be able to effect such restructuring under terms as favorable as our current equity and debt, if at all.

 

The public market for our common stock may be volatile.

 

The market price of our common stock has been, and we expect it to continue to be, highly volatile and to fluctuate significantly in response to various factors, including:

 

    Actual or anticipated variations in our quarterly operating results or those of our competitors;

 

    Announcements of technological innovations or new services or products by us or our competitors;

 

    Timeliness of our introductions of new products;

 

    Changes in financial estimates by securities analysts;

 

    Changes in management; and

 

    Changes in the conditions and trends in the pharmaceutical market.

 

For instance, during fiscal 2005 the price of our common stock closed as low as $0.75 and as high as $2.03 per share. We have experienced very low trading volume in our stock, and thus small purchases and sales can have a significant effect on our stock price. In addition, the stock markets have experienced extreme price and volume fluctuations, particularly in the past year, that have affected the market prices of equity securities of many technology companies. These fluctuations have often been unrelated or disproportionate to operating performance. These broad market factors may materially affect the trading price of our common stock. General economic, political and market conditions, such as recessions and interest rate fluctuations, may also have an adverse effect on the market price of our common stock.

 

Insiders continue to hold a majority of our stock, which may negatively affect your investment.

 

Entities affiliated with two of our directors beneficially own or control a majority of the outstanding common stock, calculated on an as-if-converted basis, as of June 30, 2005. If these parties choose to act or vote together, they will have the power to control all matters requiring the approval of our stockholders, including the election of directors and the approval of significant corporate transactions. This ability may have the effect of delaying or otherwise influencing a possible change in control transaction, which may or may not be favored by our other stockholders. In addition, without the consent of these parties, we would likely be prevented from entering into transactions that could result in our stockholders receiving a premium for their stock.

 

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Our preferred stockholders may elect to receive their dividend payments in the form of shares instead of cash, which may negatively impact our profitability.

 

Our preferred stockholders have elected in the past, and may continue to elect, to receive their quarterly dividend payments in the form of Series B Preferred shares instead of cash. We record the value of these dividend payments in the form of shares at fair market value as of the dividend payment date on our statement of operations. The fair market value is defined as the amount at which the capital stock would change hands between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither being under any compulsion to act, with equity to both. Because there is no market for such Series B Preferred shares, we perform a valuation of the fair market value of these shares. This valuation is impacted by numerous factors, including but not limited to our operations, financial conditions, future prospects and projected operations and performance of the company, as well as historical market prices and trading volume for our publicly traded securities. As such, the valuation of these dividend payments may fluctuate widely, may be greater or lesser than the stated value of the Series B Preferred shares, and may impact our ability to sustain or increase our profitability. We are unable to project with any accuracy the impact of fair market value of the Series B Preferred shares on our statement of operations.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

 

Our exposure to market risk has not changed materially from our exposure at March 31, 2005.

 

ITEM 4. CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures.

 

Subject to the limitations described below, our management, with the participation of our Chief Executive Officer, Shawn O’Connor, and our Chief Financial Officer, Cynthia Stephens, evaluated the effectiveness of Pharsight’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by Pharsight in reports filed or submitted under the Securities Exchange Act of 1934 is properly recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

 

Changes in Internal Control Over Financial Reporting.

 

There was no change in our internal control over financial reporting during the quarter ended June 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. We are making enhancements to our systems and processes for customer purchase order entry and fulfillment of customer order processing.

 

We are in the process of reviewing and analyzing our system of internal controls as we prepare for our first management report on internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002, which we currently expect to adopt in the fiscal year ending March 31, 2007. In this process we have identified areas of our internal controls requiring improvement, and are in the process of designing and documenting enhanced processes and controls to address these matters. Areas for improvement include customer purchase order entry and fulfillment of customer order processing, and we are also expecting to implement improved financial information systems during the first half of fiscal year 2006.

 

Limitations on the Effectiveness of Disclosure Controls and Procedures.

 

Our management, including our Chief Executive Officer and our Chief Financial Officer, does not expect that our disclosure controls and procedures will necessarily prevent all error and all fraud. A control system, no matter how well conceived and operated, can only provide reasonable, not absolute, assurance that the objectives of the control system are met. Any control system will reflect inevitable limitations, such as resource constraints, a cost-benefit analysis based on the level of benefit of additional controls relative to their costs, assumptions about the likelihood of future events and human error. Because of the inherent limitations in a cost-effective control system,

 

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misstatements due to error or fraud may occur and may not be detected. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the objectives of our disclosure control system are met and, as set forth above, our Chief Executive Officer and our Chief Financial Officer have concluded, based on their evaluation as of June 30, 2005, that our disclosure controls and procedures were effective to provide reasonable assurance that the objectives of our disclosure controls and procedures were met.

 

PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

We are subject from time to time to legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

 

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

 

None.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

None.

 

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

 

None.

 

ITEM 5. OTHER INFORMATION

 

On July 18, 2005, we entered into a lease agreement with SFERS Real Estate Corp., U, for approximately 14,000 square feet of office space in Mountain View, CA. This office space will serve as our new corporate headquarters. The lease term will begin on September 1, 2005 and end on August 31, 2010. We have an option to extend the lease term for an additional three years. The annual rental expense during the initial lease term ranges from approximately $205,000 to approximately $256,000. Our move-in date will be in September 2005. The lease agreement is filed herewith as Exhibit 10.6.

 

ITEM 6. EXHIBITS

 

We have filed, or incorporated into this Quarterly Report on Form 10-Q by reference, the exhibits listed on the accompanying Exhibit Index immediately following the signature page of this Quarterly Report on Form 10-Q.

 

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SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

Date: August 9, 2005

 

PHARSIGHT CORPORATION
By:  

/S/ CYNTHIA STEPHENS


   

Cynthia Stephens

Senior Vice President and Chief Financial Officer

(Principal Financial and Accounting Officer)

 

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INDEX TO EXHIBITS

 

Exhibit
Number


 

Description Of Document


10.1   Offer letter dated April 15, 2005 between Pharsight Corporation and James Hayden (which is incorporated herein by reference to Exhibit 10.25 to the Registrant’s Annual Report on Form 10-K filed on June 29, 2005).
10.2   Offer Letter dated April 26, 2005 between Pharsight Corporation and Mark Hovde (which is incorporated herein by reference to Exhibit 10.26 to the Registrant’s Annual Report on Form 10-K filed June 29, 2005).
10.3   Loan Modification Agreement dated May 26, 2005 between Pharsight Corporation and Silicon Valley Bank (which is incorporated herein by reference to Exhibit 10.14 to the Registrant’s Annual Report on Form 10-K filed on June 29, 2005).
10.4   Loan Modification Agreement effective as of June 20, 2005 between Pharsight Corporation and Silicon Valley Bank (which is incorporated herein by reference to Exhibit 99.1 to the Registrant’s Current Report on Form 8-K filed on July 6, 2005).
10.5   Fourth Amendment to Loan and Security Agreement effective as of July 14, 2005 between Pharsight Corporation and Silicon Valley Bank (which is incorporated herein by reference to the Registrant’s Current Report on Form 8-K filed on July 19, 2005).
10.6   Lease at 321 East Evelyn Avenue, Mountain View, California, by and among Pharsight and SFERS Real Estate Corporation, U, dated as of July 18, 2005.
31.1   Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.
31.2   Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.
32.1   Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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