Annual Reports

 
Quarterly Reports

  • 10-Q (Aug 13, 2008)
  • 10-Q (Feb 14, 2008)
  • 10-Q (Nov 9, 2007)
  • 10-Q (Aug 13, 2007)
  • 10-Q (Feb 12, 2007)
  • 10-Q (Nov 13, 2006)

 
8-K

 
Other

PHARSIGHT CORP 10-Q 2007

Documents found in this filing:

  1. 10-Q
  2. Ex-10.1
  3. Ex-31.1
  4. Ex-31.2
  5. Ex-32.1
  6. Ex-32.1
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 December 31, 2006

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)

321 E. Evelyn Ave., 3rd Floor

Mountain View, CA 94041-1530

(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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer”in Rule 12b-2 of the Exchange Act).

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (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 February 5th, 2007: 19,731,794

 



Table of Contents

TABLE OF CONTENTS

 

           Page

PART I.

  

FINANCIAL INFORMATION

  

Item 1.

  

Financial Statements (Unaudited)

   3
  

Condensed Consolidated Balance Sheets – December 31, 2006 and March 31, 2006

   3
  

Condensed Consolidated Statements of Operations –Three and Nine Months Ended December 31, 2006 and 20055

   4
  

Condensed Consolidated Statements of Cash Flows – Nine Months Ended December 31, 2006 and 2005

   5
  

Notes to Condensed Consolidated Financial Statements

   6

Item 2.

  

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

   17

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

   31

Item 4.

  

Controls and Procedures

   32

PART II.

  

OTHER INFORMATION

  

Item 1.

  

Legal Proceedings

   32

Item 1A.

  

Risk Factors

   32

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   41

Item 3.

  

Defaults Upon Senior Securities

   41

Item 4.

  

Submission of Matters to a Vote of Security Holders

   41

Item 5.

  

Other Information

   41

Item 6.

  

Exhibits

   41
  

Signatures

   42

 

2


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)

 

    

December 31,

2006

   

March 31,

2006*

 
     (Unaudited)        
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 6,947     $ 10,832  

Short-term investments

     6,084       —    

Accounts receivable, net of allowance for doubtful accounts of $20 at December 31, 2006 and March 31, 2006

     3,976       4,585  

Prepaids and other current assets

     687       298  
                

Total current assets

     17,694       15,715  

Property and equipment, net

     1,777       2,025  

Other assets

     45       46  
                

Total assets

   $ 19,516     $ 17,786  
                

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND

STOCKHOLDERS’ DEFICIT

    

Current liabilities:

    

Accounts payable

   $ 494     $ 794  

Accrued expenses

     650       1,035  

Accrued compensation

     2,515       2,152  

Deferred revenue

     8,523       7,605  

Current portion of notes payable

     1,300       1,519  
                

Total current liabilities

     13,482       13,105  

Deferred revenue, long term portion

     —         54  

Notes payable, less current portion

     167       392  

Other long term liabilities

     198       253  

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 December 31, 2006 and March 31, 2006

    

Issued and outstanding shares—1,977,937 at December 31, 2006 and 1,923,511 at March 31, 2006, (1,814,662 designated as Series A at December 31, 2006 and March 31, 2006 and 163,275 and 108,849 designated as Series B at December 31, 2006 and March 31, 2006, respectively)—Aggregate redemption and liquidation value—$7,928

     6,988       6,641  

Commitments and contingencies

     —         —    

Stockholders’ deficit:

    

Preferred stock, $0.001 par value:

    

Authorized shares—1,800,000 at December 31, 2006 and March 31, 2006

    

Issued and outstanding shares—none at December 31, 2006 and March 31, 2006

    

Common stock, $0.001 par value:

    

Authorized shares—120,000,000 at December 31, 2006 and March 31, 2006 issued and outstanding shares—19,714,142 and 19,594,684 at December 31, 2006 and March 31, 2006, respectively

     20       19  

Additional paid-in capital

     73, 944       73,790  

Accumulated other comprehensive loss

     (62 )     (13 )

Accumulated deficit

     (75,221 )     (76,455 )
                

Total stockholders’ deficit

     (1,319 )     (2,659 )
                

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

   $ 19,516     $ 17,786  
                

* Amounts as of March 31, 2006 are derived from the March 31, 2006 audited financial statements.

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

 

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Pharsight Corporation

Condensed Consolidated Statements of Operations

(In thousands, except per share amounts)

(Unaudited)

 

     Three Months Ended
December 31,
    Nine Months Ended
December 31,
 
   2006     2005     2006     2005  

Revenues:

        

License

   $ 1,237     $ 1,672     $ 3,977     $ 3,793  

Renewal

     1,444       1,258       4,084       3,639  

Maintenance

     249       272       724       768  

Services

     3,191       2,555       9,048       9,171  
                                

Total revenues

     6,121       5,757       17,833       17,371  

Costs of revenues

        

License, renewal and maintenance

     69       63       179       221  

Services

     1,802       1,766       5,265       5,549  
                                

Total cost of revenues (1)

     1,871       1,829       5,444       5,770  
                                

Gross profit

     4,250       3,928       12,389       11,601  

Operating expenses:

        

Research and development (1)

     1,066       878       3,040       2,558  

Sales and marketing (1)

     1,628       1,496       4,581       4,216  

General and administrative (1)

     1,139       1,262       3,971       3,967  
                                

Total operating expenses

     3,833       3,636       11,592       10,741  
                                

Income from operations

     417       292       797       860  

Other income (expense):

        

Interest income

     149       64       445       160  

Interest expense

     (34 )     (46 )     (111 )     (124 )

Other expense, net

     (17 )     (11 )     (67 )     (40 )
                                

Total other income (expense)

     98       7       267       (4 )
                                

Income before income taxes

     515       299       1,064       856  

Provision for income taxes

     (12 )     (25 )     (86 )     (65 )
                                

Net income

     503       274       978       791  

Preferred stock dividends

     (203 )     (190 )     (566 )     (549 )
                                

Net income attributable to common stockholders

   $ 300     $ 84     $ 412     $ 242  
                                

Net income per share attributable to common stockholders:

        

Basic

   $ 0.02     $ 0.00     $ 0.02     $ 0.01  
                                

Diluted

   $ 0.01     $ 0.00     $ 0.02     $ 0.01  
                                

Shares used to compute net income per share attributable to common stockholders:

        

Basic

     19,785       19,445       19,714       19,393  
                                

Diluted

     21,765       21,967       21,553       22,120  
                                

(1)    Allocation of stock-based compensation expenses:

 

        

Cost of revenues

   $ 39     $ —       $ 121     $ —    

Research and development

     19       —         55       —    

Sales and marketing

     80       —         236       —    

General and administrative

     57       —         208       —    
                                

Total

   $ 195     $ —       $ 620     $ —    
                                

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

 

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Pharsight Corporation

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

 

     Nine Months Ended
December 31,
 
   2006     2005  

Cash Flows From Operating Activities:

    

Net income

   $ 978     $ 791  

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

    

Depreciation

     565       377  

Stock-based compensation expense

     620       —    

Changes in operating assets and liabilities:

    

Accounts receivable, net

     609       (321 )

Prepaids and other current assets

     (388 )     368  

Accounts payable

     (300 )     (430 )

Accrued expenses

     (184 )     623  

Accrued compensation

     363       168  

Deferred revenue

     864       69  
                

Net cash provided by operating activities

     3,127       1,645  

Cash Flows From Investing Activities:

    

Purchases of property and equipment

     (317 )     (1,856 )

Purchases of short-term investments

     (7,084 )     —    

Sales of short-term investments

     1,000       —    
                

Net cash used in investing activities

     (6,401 )     (1,856 )

Cash Flows From Financing Activities:

    

Proceeds from issuance of notes payable

     —         600  

Principal payments on notes payable

     (444 )     (781 )

Proceeds from the sale of common stock

     99       62  

Dividends paid in cash to preferred stockholders

     (219 )     (291 )
                

Net cash used in financing activities

     (564 )     (410 )
                

Effect of exchange rate changes on cash and cash equivalents

     (47 )     16  
                

Net decrease in cash and cash equivalents

     (3,885 )     (605 )

Cash and cash equivalents at the beginning of the period

     10,832       10,579  
                

Cash and cash equivalents at the end of the period

   $ 6,947     $ 9,974  
                

Supplemental disclosures of non cash activities:

    

Issuance of dividend to preferred stockholders in form of stock

   $ 347     $ 258  
                

Accrued preferred stock dividend at the end of the quarter

   $ 48     $ 48  
                

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

 

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Pharsight Corporation

Notes To 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 meta data for drug modeling, and provides strategic and other 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.

Pharsight operates in two operating segments, which are also its reportable segments: Software Products and Strategic Consulting. These segments were determined based on how management and the Company’s Chief Operating Decision Maker, (“CODM”), who is the Company’s Chief Executive Officer, view and evaluate the business.

Basis of Presentation

The accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. 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, 2006.

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 and nine months ended December 31, 2006 are not necessarily indicative of results to be expected for the fiscal year ending March 31, 2007, or any other period.

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 U.S. 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.

Cash, Cash Equivalents and Short-term Investments

Cash equivalents consist of highly liquid investments with original maturities from the date of purchase of three months or less. Investments with an original maturity at the time of purchase of over three months are classified as short-term investments regardless of maturity date as all investments are classified as available-for-sale and can be readily liquidated to meet current operational needs. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in interest income.

 

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Revenue Recognition

Our revenues are derived from three primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support (PCS), (2) services related to scientific and training consulting and software deployment, and (3) strategic consulting services.

Our revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“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.

Software Product Segment

We enter into arrangements 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 this PCS separately. Therefore, we do not present PCS revenue separately in connection with these arrangements, 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. Revenues from bundled arrangements are recorded as license revenues in the statement of operations in the initial year and as renewal revenue in subsequent years.

We enter into arrangements consisting of perpetual or term-based licenses and PCS. We do not have vendor specific objective evidence to allocate the fee to the separate elements. We recognize revenue attributable to license and PCS ratably over the remaining period of the PCS term once the product is delivered. For financial statement presentation purposes, revenues from arrangements that include perpetual licenses are allocated among and recorded as license and maintenance revenue based upon management’s estimate of fair value and the Company’s price list. Renewals of related PCS are recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses.

We enter into 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. For financial statement presentation purposes, revenues from arrangements that include perpetual and term-based licenses are allocated among and recorded as license, maintenance, renewal and service revenue based upon management’s estimate of fair value and the Company’s price list. Renewals of related PCS are recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses. The implementation/installation services revenues are recorded as services revenue in the statement of operations.

We enter into arrangements consisting of optional scientific consulting services. The optional scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, as they are not essential to the functionality of the delivered software, are described and priced separately in the arrangement and are sold separately. We recognize fees from optional scientific consulting services (equal to the amounts set forth in the contracts) as revenue as these services are provided or upon their acceptance, as applicable.

For arrangements consisting solely of services, we recognize revenue as consulting services are performed. Arrangements for consulting 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 using the proportional performance method - 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 have two international distributors. There is no right of return or price protection for sales to the international distributors Revenue on sales to these distributors are recognized ratably over the license term when the software is delivered to the distributors and other revenue recognition criteria are met.

 

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Strategic Consulting Segment

We enter into arrangements for strategic consulting contracts, which do not fall under the scope of SOP 97-2. Arrangements for consulting services may be charged at daily rates and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee with payments based on milestones or acceptance criteria, we recognize revenue using the proportional performance method—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 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.

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 U.S. 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.

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 Pharsight Knowledgebase Server (“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.

Deferred Revenue

Deferred revenue is comprised of deferred license fees (initial and renewal), which are recognized ratably over the one-year period of the license. In addition, deferred revenue includes payments for services and training revenue, which will be recognized as services are performed. Deferred revenue also includes deferred 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):

 

    

December 31,

2006

  

March 31,

2006

License

   $ 3,229    $ 3,078

Renewal

     3,257      3,473

Training

     43      4

Maintenance

     915      557

Services

     1,079      547
             

Total deferred revenue

   $ 8,523    $ 7,659
             

Short term deferred revenue

   $ 8,523    $ 7,605

Long term deferred revenue

     —        54
             

Total deferred revenue

   $ 8,523    $ 7,659
             

 

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Earnings per Share

Basic earnings 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 (i.e. not subject to a right of repurchase) outstanding during the period.

Diluted earnings 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 earnings 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 earnings per share (in thousands, except per share data):

 

     Three Months Ended
December 31,
    Nine Months Ended
December 31,
 
   2006     2005     2006     2005  

Net income

   $ 503     $ 274     $ 978     $ 791  

Preferred stock dividend

     (203 )     (190 )     (566 )     (549 )
                                

Net income attributable to common stockholders for basic computation

   $ 300     $ 84     $ 412     $ 242  
                                

Weighted average common shares outstanding

     19,785       19,445       19,714       19,393  

Dilutive effect of:

        

Stock options and stock-based awards and as-if converted preferred stock in the periods ended

     1,980       2,522       1,839       2,727  
                                

Dilutive weighted-average common shares outstanding

     21,765       21,967       21,553       22,120  
                                

Net income per share attributable to common stockholders

        

Basic

   $ 0.02     $ 0.00     $ 0.02     $ 0.01  
                                

Diluted

   $ 0.01     $ 0.00     $ 0.02     $ 0.01  
                                

All potential common shares including preferred stock (on an as-if-converted basis), have been excluded from the computation of diluted earnings per share in the three and nine-month period ended December 31, 2006 as the effect of including such shares would be antidilutive.

The number of potential common stock shares excluded from the calculation of earnings per share attributable to common stockholders in the nine-month period ending December 31, 2006 and, 2005 due to antidilution is detailed in the following table (in thousands):

 

     December 31,
   2006    2005

Outstanding options

   3,903    2,881

Warrants

   613    123

Redeemable convertible preferred stock

   7,863    7,621
         
   12,379    10,625
         

Stock-Based Compensation

Adoption of SFAS 123R

The Company has adopted several stock plans that provide equity instruments to our employees and non-employee directors. Our plans include incentive and non-statutory stock options and restricted stock awards. Stock options generally vest ratably over a four-year period on the anniversary date of the grant, and expire ten years after the grant date. The Company also has employee stock purchase plans that allow qualified employees to purchase Company shares at 85% of the fair market value on specified dates.

Prior to April 1, 2006, we accounted for stock-based employee compensation plans under the measurement and recognition provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related Interpretations, as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).

 

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We generally recorded no stock-based compensation expenses during periods prior to April 1, 2006 as all stock-based grants had exercise prices equal to the fair market value of our common stock on the date of grant. We also recorded no compensation expense in connection with our employee stock purchase plans as they qualified as non-compensatory plans following the guidance provided by APB 25. In accordance with SFAS 123 and SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” we disclosed our net income or loss and net income or loss per share for the three and nine months ended December 31, 2005 as if we had applied the fair value based method in measuring compensation expense for our stock-based compensation programs. Under SFAS 123, we elected to calculate our compensation expense by applying the Black-Scholes valuation model, applying the graded vesting expense attribution method and recognizing forfeited awards in the period that they occurred.

Effective April 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R ”) using the modified prospective transition method. Under that transition method, compensation expense that we recognized for the three and nine months ended December 31, 2006 included: (a) compensation expense for all share-based payments granted prior to but not yet vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based payments granted or modified on or after April 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Compensation expense is recognized only for those awards that are expected to vest, whereas prior to the adoption of SFAS 123R, we recognized forfeitures as they occurred. In addition, we elected the straight-line attribution method as our accounting policy for recognizing stock-based compensation expense for all awards that are granted on or after April 1, 2006. For awards subject to graded vesting that were granted prior to the adoption of SFAS 123R, we use an accelerated expense attribution method. Results in prior periods have not been restated.

We estimate the fair value of options granted using the Black-Scholes option valuation model and the assumptions shown below. We estimate the expected term of options granted based on the history of grants, exercises and post-vesting cancellations in our option database. Contractual term expirations have not been significant. We estimate the volatility of our common stock at the date of grant based on historical prices of our common stock to complete the calculation of expected volatility, consistent with SFAS 123R and SEC Staff Accounting Bulletin No. 107. Prior to the adoption of SFAS 123R, we relied exclusively on the historical prices of our common stock in the calculation of expected volatility. We base the risk-free interest rate that we use in the Black-Scholes option valuation model on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with remaining terms equivalent to the expected term of our option grants. We have never paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. For options granted before April 1, 2006, we estimated the fair value using the multiple option approach and we are amortizing the fair value on a graded vesting basis. For options granted on or after April 1, 2006, we estimate the fair value using a single option approach and amortize the fair value on a straight-line basis. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. We may elect to use different assumptions under the Black-Scholes option valuation model in the future if our current experience indicates that a different measure is preferable, which could materially affect our net income or loss and net income or loss per share.

The table below presents net income and basic and diluted net income per share as if compensation cost for the Company’s stock option plans had been determined based on the estimated fair value of awards under those plans on the grant date in accordance with SFAS 123 (in thousands, except per share amounts):

 

    

Three
Months Ended

December 31,

   

Nine
Months Ended
December 31,

 
     2005     2005  

Net income attributable to common stockholders, as reported

   $ 84     $ 242  

Less:

    

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

     (255 )     (721 )
                

Pro forma net income (loss) attributable to common stockholders

   $ (171 )   $ (479 )
                

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

    

As reported

   $ 0.00     $ 0.01  
                

Pro forma

   $ (0.01 )   $ (0.02 )
                

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

    

As reported

   $ 0.00     $ 0.01  
                

Pro forma

   $ (0.01 )   $ (0.02 )
                

 

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Valuation Assumptions for Stock Options and ESPP

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     Options  
   Three Months Ended
December 31,
    Nine Months Ended
December 31,
    Three Months Ended
December 31,
    Nine Months Ended
December 31,
 
   2006     2005     2006     2005     2006     2005     2006     2005  

Expected life (years)

   0.50     0.50     0.49     0.49     2.71     2.51     2.69     3.18  

Expected stock price volatility

   47.5 %   83.9 %   59.3 %   87.4 %   96.8 %   196.6 %   121.2 %   203 %

Risk-free interest rate

   5.09 %   4.37 %   5.08 %   3.88 %   4.74 %   4.37 %   5.03 %   3.77 %

Stock Options

The following is a summary of stock option activity during the three months ended December 31, 2006:

 

    

Numbers of Options
Outstanding

(in thousands)

    Weighted Average
Exercise Price Per
Share
   Weighted Average
Remaining Contractual
Term
  

Aggregate Intrinsic
Value

as of 12/31/06

(in thousands)

Balance at September 30, 2006

   5,270     $ 1.28    7.65    $ 1,829

Options granted

   55       1.40      

Options exercised

   (31 )     0.75      

Options canceled

   (46 )     1.69      
                  

Balance at December 31, 2006

   5,248     $ 1.28    7.43    $ 1,809
                        

Options vested and expected to vest at December 31, 2006

   4,714     $ 1.27    7.25    $ 1,793
                        

Options exercisable at December 31, 2006

   2,898     $ 1.21    6.27    $ 1,653
                        

The weighted average remaining amortization period was 1.32 years as of December 31, 2006. The Company had 2,898,000 exercisable options and the unamortized stock compensation was $1.7 million as of December 31, 2006. Cash received from exercise of stock option for the three and nine months ended December 31, 2006 were $23,000 and $84,000, respectively. No income tax benefit was realized from stock option exercised during the three and nine months ended December 31, 2006.

The weight average fair value per share of options granted during the three and nine months ended December 31, 2006 were $0.88 and $0.98, respectively.

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 and unrealized gains or losses on available-for-sale investments. Comprehensive losses for three and nine months ended December 31, 2006 were $30,000 and $49,000, respectively. The accumulated comprehensive loss at December 31, 2006 and March 31, 2006 was $62,000 and $13,000 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 and nine months ended December 31, 2006, sales to the Company’s top two customers accounted for 35% and 29% of total revenue, respectively, and sales to its top five customers in the same periods accounted for 49% and 46% of total revenue, respectively. For the three and nine months ended December 31, 2005, sales to the Company’s top two customers accounted for 33% and 34% of total revenue, respectively, and sales to its top five customers in the same periods accounted for 57% and 49% of total revenue, respectively. One customer accounted for 21% and 18% of total revenue for the three month and nine months ended December 31, 2006, respectively, compared to 23% and 19% of total revenue, respectively, for the same period in fiscal 2006. Another customer accounted for 14% and 11% of total revenues for the three and nine months ended December 31, 2006 respectively, compared to 10% and 15% of total revenue, respectively, for the same periods in fiscal 2006.

Three customers comprised 41% of accounts receivable at December 31, 2006. Three customers comprised 47% of accounts receivable at March 31, 2006.

Recent Accounting Pronouncements

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. Specifically, SAB 108 articulates the SEC’s position that registrants should quantify the effects of prior period errors using both a balance sheet approach (“iron curtain method”) and an income statement approach (“rollover method”) and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective as of the end of the Company’s 2007 fiscal year, allowing a one-time transitional cumulative effect adjustment to beginning retained earnings as of April 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB 108.

The Company evaluated the impact of the adoption of SAB 108 and recorded a cumulative effect adjustment of $256,000 related to the accounting for accrued expenses. The company was overaccrued on recurring professional services fees included in general and administrative expenses. The error arose as a result of accrual of such services ratably over the year rather than as the service was rendered. Under the rollover method of evaluating misstatements, the effect of the methodology used by the company did not result in a material misstatement of the financial statements.

The Company evaluated the impact of correcting all misstatements, including both carryover and reversing effects of prior years misstatements on the current year financial statements. The Company determined that the effect of the errors on all prior financial statement filings were immaterial, but would be considered material to the financial statements under the methodology prescribed by SAB 108. Therefore, the Company recorded a cumulative effect adjustment to the applicable carrying values of liabilities for these previous errors as of April 1, 2006, with an offsetting adjustment to retained earnings. The amount recorded was a debit of $256,000 to accrued expenses with the offsetting credit of $256,000 to retained earnings. The error was discovered during the three months ended December 2006 and the adjustment was recorded at that time. The understatement of expense was not considered material for any other reported period and those results were therefore not restated.

 

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The table below represents the restated Statement of Equity as a result of the adjustment made related to the adoption of SAB 108:

 

     Redeemable
Convertible
Preferred Stock
   Common Stock    Additional
Paid-In
Capital
    Accumulated
Other
Compre-
hensive
Income (Loss)
    Accumu-
lated
Deficit
    Total  
     Shares    Amount    Shares    Amount         

Balance at March 31, 2006

   1,923    $ 6,641    19,595    $ 19    $ 73,790     $ (13 )   $ (76,455 )   $ (2,659 )
                                                        

Issuance of common stock under employee benefit plans, net of repurchases

   —        —      212      1      100       —         —         101  

Issuance of Series B redeemable convertible preferred stock

   54      347    —        —        (347 )     —         —         (347 )

Accrued dividends on Series A redeemable convertible preferred stock

   —        —      —        —        (219 )     —         —         (219 )

Comprehensive income:

                    

Stock-based compensation expense

   —        —      —        —        620       —         —         620  

Unrealized loss on foreign currency exchange

   —        —      —        —        —         (49 )     —         (49 )

Cumulative effect of accounting change to adopt SAB 108

   —        —      —        —        —         —         256       256  

Net income

   —        —      —        —        —         —         978       978  

Total comprehensive income

                       1,185  
                                                        

Balance at December 31, 2006

   1,977    $ 6,988    19,807    $ 20    $ 73,944     $ (62 )   $ (75,221 )   $ (1,319 )
                                                        

In June 2006, the FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Financial Accounting Standards Board Statement No. 109, or FAS 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Earlier adoption is permitted as of the beginning of an enterprise’s fiscal year, provided the enterprise has not yet issued financial statements, including financial statements for any interim period for that fiscal year. The Company will adopt FIN 48 in the first quarter of fiscal 2008 and currently does not expect that the adoption of FIN 48 will have material effect on its consolidated results of operations and financial condition.

2. Notes Payable

The Company has a credit facility with Silicon Valley Bank (the “Bank”), providing for up to $3.0 million in borrowings, secured against 80% of eligible accounts receivable. If the Company’s modified quick ratio (defined as cash and cash equivalents and investments plus accounts receivable, divided by total current liabilities, including all bank debt but excluding deferred revenue) is equal to 2.5:1 or greater, the Bank may include foreign accounts receivable to determine eligible receivables. However, if the modified quick ratio is less than 2.5:1, all or a portion of the foreign accounts may be excluded from eligible account receivables. The borrowed balance under this credit facility was $1.0 million at December 31, 2006.

The Company had a secured term loan with Silicon Valley Bank, payable over 48 months, with monthly payments that commenced in July 2002. The balance was paid off as of June 30, 2006. 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 this term loan as of December 31, 2006 was $117,000. 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 December 31, 2006, the borrowed balance on this equipment credit facility was $350,000.

 

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On January 2, 2007, the Company and the Bank entered into the Sixth Amendment (the “Loan Amendment”) to the Loan and Security Agreement, effective as of May 24, 2004 by and between Silicon Valley Bank and the Company, as amended (the “Loan and Security Agreement”). The Loan Amendment amends in part Section 2.4 of the Loan and Security Agreement to lower the interest rate payable at a per annum rate of 0.375% above the prime rate on the advances, term 2 loan and equipment advances and amends Section 13.1 of the Loan and Security Agreement by changing the “Revolving Maturity Date” to May 24, 2008. In addition, the Loan Amendment amends in part Section 6.7 of the Loan and Security Agreement by deleting section 6.7(iii), “Tangible Net Worth” in its entirety. Furthermore, the Loan Amendment also provides for additional representation and warranties by the Company.

The Company must maintain a minimum modified quick ratio of 2:1. Certain of the Company’s assets, excluding intellectual property, secure both facilities. The Company was in compliance with all financial covenants as of December 31, 2006.

3. Redeemable Convertible Preferred Stock

Series B Redeemable Convertible Preferred Stock

The holders of our Series A redeemable convertible preferred stock (the “Series A Preferred”) are entitled to receive cumulative dividends in preference to any dividend on the common stock, payable quarterly at the rate of 8% per annum, either in cash or in shares of Series B redeemable convertible preferred stock (the “Series B Preferred”) at the election of the holder. 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 7 – Preferred Stock, in the Notes to Financial Statements contained in our Annual Report on Form 10-K for the year ended March 31, 2006, filed with SEC on June 26, 2006.) During the three and nine months ended December 31, 2006, we paid cash dividends of $73,000 and $219,000 to our Series A Preferred stockholders and issued dividends of 18,142 and 54,426 shares of Series B Preferred Stock to Series A Preferred stockholders with estimated fair values of $130,000 and $347,000, respectively.

Beginning on June 26, 2007, the holders of the preferred stock may elect to have us redeem all or a portion of their shares of preferred stock at any time, or the Company may elect to redeem all of the outstanding shares of preferred stock. If the holders do not elect to have their shares of preferred stock redeemed, or we do not elect to redeem the preferred stock, then we are obligated to continue to pay dividends in the aggregate amount of approximately $582,000 per year. However, the terms of the preferred stock provide that the preferred stock will automatically convert to common stock in the event of a public offering meeting certain minimum conditions or that the holders of the preferred stock may convert their preferred shares into common stock, and our obligation to pay dividends or redeem the preferred stock would cease at that time. Any of these outcomes is beyond our control until June 26, 2007, at which time the Company can force redemption of the preferred stock. The probability of any of these outcomes is highly subjective. If we were required or if we elected to redeem all of the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $7.9 million.

The following table depicts activities for Series B Preferred Stock for the two years ended March 31, 2006 and the quarter ended December 31, 2006:

 

     Number of shares of Series B

Balance at March 31, 2004

   36,281

Preferred Series B issued June 1, 2004

   18,142
    

Balance at March 31, 2005

   54,423

Preferred Series B issued September 1, 2005

   18,142

Preferred Series B issued December 1, 2005

   18,142

Preferred Series B issued March 1, 2006

   18,142
    

Balance at March 31, 2006

   108,849

Preferred Series B issued June 1, 2006

   18,142

Preferred Series B issued September 1, 2006

   18,142

Preferred Series B issued December 1, 2006

   18,142
    

Balance at December 31, 2006

   163,275
    

 

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The amount of the Series B Preferred dividend was determined based on the estimated per share fair value of the Series B Preferred. To record the fair value of the Series B Preferred, the Company performed a valuation based on its 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.

The following table depicts the estimated fair value of Series B Preferred Stock issued in each quarterly period beginning in the quarter ended March 31, 2004:

 

Date of Stock Issued

   Numbers of Shares
of Series B
   Price per Share    Total Estimated Fair
Value

March 31, 2004

   36,281    $ 6.00    $ 217,686

June 1, 2004

   18,142      5.61      101,777

September 1, 2005

   18,142      7.80      141,508

December 1, 2005

   18,142      6.47      117,379

March 1, 2006

   18,142      6.38      115,746

June 1, 2006

   18,142      6.12      111,029

September 1, 2006

   18,142      5.87      106,494

December 1, 2006

   18,142      7.20      130,622
              
   163,275       $ 1,042,241
              

4. Segment Information

Segment information is presented in accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS 131”). 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 U.S. GAAP. Assets are not 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 CODM, as defined by SFAS 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 are 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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Table of Contents

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

 

     Three Months Ended December 31,
   2006    2005
   Software
Products
   Strategic
Consulting
   Corporate
&
Reconciling
Amounts
   Total    Software
Products
   Strategic
Consulting
    Corporate
&
Reconciling
Amounts
    Total

Revenues:

                     

License, renewal and maintenance

   $ 2,930    $ —      $ —      $ 2,930    $ 3,202    $ —       $ —       $ 3,202

Services

     323      2,868      —        3,191      868      1,687       —         2,555
                                                         

Total revenues

     3,253      2,868      —        6,121      4,070      1,687       —         5,757

Gross profit

     2,991      1,259      —        4,250      3,593      335       —         3,928

Income (loss) from operations

     404      13      —        417      894      (599 )     (3 )     292

 

     Nine Months Ended December 31,
   2006    2005
   Software
Products
   Strategic
Consulting
    Corporate
&
Reconciling
Amounts
   Total    Software
Products
   Strategic
Consulting
    Corporate
&
Reconciling
Amounts
    Total

Revenues:

                    

License, renewal and maintenance

   $ 8,785    $ —       $ —      $ 8,785    $ 8,200    $ —       $ —       $ 8,200

Services

     1,067      7,981       —        9,048      2,365      6,806       —         9,171
                                                          

Total revenues

     9,852      7,981       —        17,833      10,565      6,806       —         17,371

Gross profit

     8,994      3,395       —        12,389      9,029      2,572       —         11,601

Income (loss) from operations

     1,137      (340 )     —        797      1,619      (755 )     (4 )     860

Corporate and reconciling amounts include adjustments to present operating income in accordance with GAAP and corporate level expenses not specifically attributed to a segment. There were $3,000 and $4,000 in reconciling items to income from operations in the three and nine months ended December 31, 2005. There were no inter-segment revenues for the periods shown above.

The below table summarized the allocation of stock-based compensation expenses on the Company’s reportable segments:

 

     Three Months Ending
December 31,
   Nine Months Ending
December 31,
   2006    2005    2006    2005

Software Products

   $ 98    $ —      $ 332    $ —  

Strategic Consulting

     97      —        288      —  
                           

Total

   $ 195    $ —      $ 620    $ —  
                           

 

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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 condensed consolidated balance sheets as of December 31, 2006 and March 31, 2006.

 

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 in Part II – Item 1A – “Risk Factors” 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. Pharsight's proprietary software products include Trial Simulator™ for clinical trial simulation and computer-aided trial design; WinNonlin® and WinNonMix® for the statistical analysis and mathematical modeling of PK/PD data; IVIVC Toolkit™ for WinNonlin® for the development of in vivo-in vitro correlations and the management of related datasets and workflow; WinNonlin® Validation Suite™ for streamlined on-site validation of WinNonlin; Pharsight Knowledgebase Server™ (PKS™), PKS Reporter™ and PK Automation™ for the storage, management, analysis, and regulatory reporting of derived data and models in data repositories; PKS™ Validation Suite™ for streamlined on-site validation of PKS; and Drug Model Explorer® for dynamic visualization and communication of model-based product profiles. Both our software products and our services utilize expertise in the sciences of pharmacology, drug and disease modeling, biostatistics and strategic decision-making.

 

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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 optimize the value of their drug development programs and portfolios from discovery to post-launch marketing.

We believe the use of our software and methodology is reaching the mainstream of the drug development process, as evidenced by the FDA’s call for modeling discussions in Phase IIa meetings with sponsors, the use of modeling and simulation by the FDA to support decisions on program designs or labeling in 25% of recent new drug application reviews, and the establishment of modeling and simulation groups in most of the top pharmaceutical and biotechnology companies. Although our methodology does not displace the use of human trials in drug development, we believe our 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 and the FDA’s emphasis on modeling and simulation found in the Critical Path Initiative and in our Cooperative Research and Development Agreement (CRADA) with the FDA announced in June 2006, 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 our business.

We were incorporated in California in April 1995, and we reincorporated in Delaware in June 2000. In August 2000, we completed our initial public offering and our common stock began trading on the Nasdaq National Market. In November 2002, our common stock ceased to trade on the Nasdaq National Market and it is currently traded on the Over-The-Counter Bulletin Board system. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge through our website at http://www.pharsight.com as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission or SEC. Copies of our annual report will be made available, free of charge, upon written request to the Chief Financial Officer, c/o Pharsight Corporation, 321 E. Evelyn Ave., 3 rd Floor, Mountain View, CA 94041-1530.

Financial Highlights for Fiscal Third Quarter 2007

 

   

Our revenue for the third quarter of fiscal 2007 was $6.1 million, an increase of 6% compared with revenue of $5.8 million in the third quarter of fiscal 2006. Revenue for the first nine months of fiscal 2007 was $17.8 million an increase of 3% compared with revenue of $17.4 million the same period in fiscal 2006.

 

   

Our gross margin in the third quarter of fiscal 2007 was 69% compared with a gross margin of 68% for the third quarter of fiscal 2006. Gross margin for the first nine months of fiscal 2007 improved to 69% compared with a gross margin of 67% for the first nine months of fiscal 2006.

 

   

Net income for the third quarter grew 84% year-over-year. Net income for the first nine months grew 24% year-over-year.

 

   

We achieved operating cash flow of $3.1 million for the nine months ended December 31, 2006 compared with $1.6 million for the same period in fiscal 2006.

Challenges and Risks

We achieved our first quarter of profitability in the fourth quarter of fiscal 2004 and had annual profitability during fiscal 2005 and 2006. Prior to that time we had incurred losses since inception. We currently have an accumulated deficit of approximately $75.2 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.

 

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We achieved positive operating cash flow in fiscal 2004 and continued to have positive operating cash flow in fiscal 2005 and 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. In addition, beginning on June 26, 2007, the holders of our preferred stock may elect to have us redeem all or a portion of their shares of preferred stock at any time, or we may elect to redeem all the outstanding shares of preferred stock. If we were required or if we elected to redeem all the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $7.9 million. As a result, we may need to raise additional funds or secure additional credit facilities through public or private financings or other sources. 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.

While we expect that the overall long-term revenue trend in our software business will continue to increase in response to customer demand, the software revenue in individual quarters may fluctuate significantly, based upon timing of completion of large software installations and related revenue recognition. Unanticipated delays in software project 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. Although we have been diversifying our customer base, a significant portion of our revenue may 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 achieving or sustaining profitability.

Our strategic consulting customers range in size from the largest pharmaceutical companies to small biopharmaceutical companies, and the focus of our work differs depending upon the size and maturity of the customer. In our smaller and medium-sized customers, we tend to engage in discrete projects often with challenging analytic and design problems, where modeling and simulation can be particularly valuable. This kind of work may or may not lead to subsequent engagements. By contrast, at our largest customers, we tend to have ongoing relationships which are more strategic in nature, and we focus on helping improve the process by which they develop drugs, broadening and deepening the application of modeling and simulation over time, with the intent of achieving systematic, lasting performance improvement.

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, more and more time-consuming safety and efficacy testing requirements in drug development, and patent expiries on significant portions of their marketed drugs. Our clients may, as a result, experience 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 U.S. 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 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 and operating expenses. We believe that this accounting policy is critical to fully understand and evaluate our reported financial results.

 

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Revenue Recognition

Our revenues are derived from three primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support (PCS), (2) services related to scientific and training consulting and software deployment, and (3) strategic consulting services.

Our revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“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.

Software Product Segment

We enter into arrangements 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 this PCS separately. Therefore, we do not present PCS revenue separately in connection with these arrangements, 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. Revenues from bundled arrangements are recorded as license revenues in the statement of operations in the initial year and as renewal revenue in subsequent years.

We enter into arrangements consisting of perpetual or term-based licenses and PCS. We do not have vendor specific objective evidence to allocate the fee to the separate elements. We recognize revenue attributable to license and PCS ratably over the remaining period of the PCS term once the product is delivered. For financial statement presentation purposes, revenues from arrangements that include perpetual licenses are allocated among and recorded as license and maintenance revenue based upon management’s estimate of fair value and the Company’s price list. Renewals of related PCS are recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses.

We enter into 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. For financial statement presentation purposes, revenues from arrangements that include perpetual and term-based licenses are allocated among and recorded as license, maintenance, renewal and service revenue based upon management’s estimate of fair value and the Company’s price list. Renewals of related PCS are recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses. The implementation/installation services revenues are recorded as services revenue in the statement of operations.

We enter into arrangements consisting of optional scientific consulting services. The optional scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, as they are not essential to the functionality of the delivered software, are described and priced separately in the arrangement and are sold separately. We recognize fees from optional scientific consulting services (equal to the amounts set forth in the contracts) as revenue as these services are provided or upon their acceptance, as applicable.

For arrangements consisting solely of services, we recognize revenue as consulting services are performed. Arrangements for consulting 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 using the proportional performance method - 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 have two international distributors. There is no right of return or price protection for sales to the international distributors Revenue on sales to these distributors are recognized ratably over the license term when the software is delivered to the distributors and other revenue recognition criteria are met.

 

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Strategic Consulting Segment

We enter into arrangements for strategic consulting contracts, which do not fall under the scope of SOP 97-2. Arrangements for consulting services may be charged at daily rates and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee with payments based on milestones or acceptance criteria, we recognize revenue using the proportional performance method - 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 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.

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 U.S. 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.

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 Pharsight Knowledgebase Server (“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.

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 based upon a specific review of all significant outstanding invoices and evaluation of historical trends of write-offs of accounts we deem uncollectible.

Stock-Based Compensation

Effective April 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” or SFAS 123R, using the modified prospective transition method. Under that transition method, compensation expense that we recognized for the three and nine months ended December 31, 2006 included: (i) compensation expense for all share-based payments granted prior to but not yet vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” or SFAS 123, and (ii) compensation expense for all share-based payments granted or modified on or after April 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Compensation expense is recognized only for those awards that are expected to vest, whereas prior to the adoption of SFAS 123R, we recognized forfeitures as they occurred. We elected to calculate our compensation expenses by applying the Black-Scholes valuation model, applying the graded vesting expense attribution method and recognizing forfeited awards in the period that they occurred. In addition, we elected the straight-line attribution method as our accounting policy for recognizing stock-based compensation expense for all awards that are granted on or after April 1, 2006. For awards subject to graded vesting that were granted prior to the adoption of SFAS 123R, we use an accelerated expense attribution method. Results in prior periods have not been restated.

 

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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
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Three Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Total Revenues

            

License, renewal and maintenance

   $ 2,930    $ 3,202    (8 )%   48 %   56 %

Services

     3,191      2,555    25 %   52 %   44 %
                            

Total revenues:

   $ 6,121    $ 5,757    6 %   100 %   100 %
                            

Software products segment revenues

            

License, renewal and maintenance

   $ 2,930    $ 3,202    (8 )%   48 %   56 %

Services

     323      868    (63 )%   5 %   15 %
                            

Total software products segment revenues:

   $ 3,253    $ 4,070    (20 )%   53 %   71 %
                            

Strategic consulting segment revenues:

   $ 2,868    $ 1,687    70 %   47 %   29 %
                            

 

           Percentage of Total
Revenues
 
   Nine Months Ended
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Nine Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Total Revenues

            

License, renewal and maintenance

   $ 8,785    $ 8,200    7 %   49 %   47 %

Services

     9,048      9,171    (1 )%   51 %   53 %
                            

Total revenues:

   $ 17,833    $ 17,371    3 %   100 %   100 %
                            

Software products segment revenues

            

License, renewal and maintenance

   $ 8,785    $ 8,200    7 %   49 %   47 %

Services

     1,067      2,365    (55 )%   6 %   14 %
                            

Total software products segment revenues:

   $ 9,852    $ 10,565    (7 )%   55 %   61 %
                            

Strategic consulting segment revenues:

   $ 7,981    $ 6,806    17 %   45 %   39 %
                            

Comparison of Three and Nine Months Ended December 31, 2006 and 2005

Total revenues

Revenue for the three months ended December 31, 2006 increased approximately 6% to $6.1 million, compared to $5.8 million in the same period in fiscal 2006. The increase was primarily attributable to a 70% increase in strategic consulting services revenue, offset by a 20% decrease in our software product segment.

Revenue for the nine months ended December 31, 2006 increased approximately 3% to $17.8 million, compared to $17.4 million in the same period in fiscal 2006. This increase was primarily attributable to an increase of 17% in strategic consulting services revenue.

 

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Software products segment revenues

License, renewal and maintenance revenues: For the three months ended December 31, 2006, desktop software products revenues remained constant at $2.0 million compared with the same period in fiscal 2006. For the nine months ended December 31, 2006, desktop software product revenue increased by 18% to $6.0 million, compared to $5.1 million in the same period in fiscal 2006. The increase is primarily attributable to the introduction of two new products, WNL and PKS Validation Suites, in the third quarter of fiscal 2006. Revenues from sales of these two new products for the three and nine months ended December 31, 2006 were $143,000 and $405,000, respectively.

PKS software products revenues increased to $697,000 and $2.2 million for the three and nine months ended December 31, 2006, respectively, from $527,000 and $1.5 million in the same periods in fiscal 2006. The increase in revenue for the three and nine months ended December 31, 2006 is mainly attributable to installation of new PKS projects and additional licenses purchased by an existing customer. Revenues from the completion of new projects and from sales of additional licenses for the three and nine months ended December 31, 2006 were $248,000 and $731,000, respectively.

DMX software revenues decreased to $193,000 and $599,000 in the three and nine months ended December 31, 2006, respectively, from $682,000 and $1.6 million in the same periods in fiscal 2006. The decrease in revenue for the three and nine months ended December 31, 2006 is mainly due to complete recognition of a $1 million DMX project in fiscal 2006.

Services revenues. Software services revenues decreased to $323,000 and $1.1 million in the three and nine months ended December 31, 2006, respectively, from $868,000 and $2.4 million in the same periods in fiscal 2006. The decreases in software services revenue in the three and nine months ended December 31, 2006 were due to completion of smaller PKS deployment and automation contracts, compared with the same period in fiscal 2006 when large PKS projects were completed totaling $602,000 and $1.5 million, respectively.

Strategic consulting segment revenues

Strategic consulting segment revenues increased to $2.9 million and $8.0 million in the three and nine months ended December 31, 2006, respectively, from $1.7 million and $6.8 million in the same periods in fiscal 2006. The increase in strategic consulting revenue for the three and nine months ended December 31, 2006 compared to the same periods in the prior year is primarily due to increases in spending on consulting services by our top two customers. Revenues from our top two customers, Pfizer and Eli Lilly, increased by 92% during the third quarter of fiscal 2007, compared to the same period in fiscal 2006. The increase in strategic consulting revenue for the nine months ended December 31, 2006 compared with the same period in the prior year is also due to increase in revenue from customers other than our top two customers and revenue from new customers engaged throughout fiscal 2007. Revenue from these new customers for the first nine months of fiscal 2007 was $851,000.

Cost of revenues and operating expenses

 

           Percentage of Total
Revenues
 
   Three Months Ended
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Three Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Cost of Revenues

            

License and renewal

   $ 69    $ 63    10 %   1 %   1 %

Services

     1,802      1,766    2 %   29 %   31 %
                            

Total cost of revenues:

   $ 1,871    $ 1,829    2 %   30 %   32 %
                            

Cost of software products segments revenues

            

License and renewal

   $ 69    $ 63    10 %   1 %   1 %

Services

     193      414    (53 )%   3 %   7 %
                            

Total software products segment

   $ 262    $ 477    (45 )%   4 %   8 %
                            

Cost of strategic consulting segment revenues

   $ 1,609    $ 1,352    19 %   26 %   23 %
                            

 

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           Percentage of Total
Revenues
 
   Nine Months Ended
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Nine Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Cost of Revenues

            

License, renewal and maintenance

   $ 179    $ 221    (19 )%   1 %   1 %

Services

     5,265      5,549    (5 )%   30 %   32 %
                            

Total cost of revenues:

   $ 5,444    $ 5,770    (6 )%   31 %   33 %
                            

Cost of software products segments revenues

            

License, renewal and maintenance

   $ 179    $ 221    (19 )%   1 %   1 %

Services

     679      1,315    (48 )%   4 %   8 %
                            

Total software products segment

   $ 858    $ 1,536    (44 )%   5 %   9 %
                            

Cost of strategic consulting segment revenues

   $ 4,586    $ 4,234    8 %   26 %   24 %
                            

Cost of revenues

Total cost of revenues

Total cost of revenues was $1.9 million and $5.4 million for the three and nine months ended December 31, 2006, respectively, compared to $1.8 million and $5.8 million in the same periods in fiscal 2006. Cost of revenue is comprised mainly of payroll and payroll related expenses, royalty expenses and shipping cost. Also included in cost of revenues is $39,000 and $121,000 of stock-based compensation expense related to the adoption of SFAS 123R in the three and nine months ended December 31, 2006, respectively. The increase in total cost of revenues for the three months ended December 31, 2006 was primarily due to the $39,000 of stock-based compensation expense related to the adoption of SFAS 123R. The decrease in total cost of revenues for the nine months ended December 31, 2006 was primarily due to the timing of recognition of expenses related to deferred costs associated with PKS contracts. In fiscal 2006, we recognized $563,000 in deferred costs associated with the completion of several large PKS projects, whereas in fiscal 2007 we recognized $137,000 in deferred costs due to completion of smaller PKS deployment contracts.

Software products segment

Cost of license, renewal and maintenance revenues. Cost of license, renewal and maintenance revenues primarily consists of payroll and payroll related expense for technical support personnel, royalty expense for third-party software included in our products, and cost of materials for both initial products and product updates provided in our annual license agreements. Cost of license and renewal revenues was $69,000 and $179,000 for the three and nine months ended December 31, 2006, respectively, compared to $63,000 and $221,000 in the same period in fiscal 2006. The increase in cost of license, renewal and maintenance revenues in the three months ended December 31, 2006 is primarily due to increased in royalty expense for third-party software. The decrease in cost of license, renewal and maintenance revenues in the nine months ended December 31, 2006 is primarily due to decreases in royalty expenses in the first half of fiscal 2007 and the timing of our purchase of disks and manuals.

Cost of services revenues. Cost of services 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 $193,000 and $679,000 for the three and nine months ended December 31, 2006, respectively, compared to $414,000 and $1.3 million in the same period in fiscal 2006. Cost of services revenues decreased in absolute dollars and as a percentage of total revenue in the three and nine months ended December 31, 2006 as compared with the same period in fiscal 2006. The decrease was due to the timing of recognition of expenses related to deferred costs associated with PKS contracts. In fiscal 2006, we recognized $563,000 in deferred costs associated with the completion of several large PKS projects, whereas in fiscal 2007, we recognized $138,000 in deferred costs due to the completion of smaller PKS deployment contracts.

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 $1.6 million and $4.6 million for the three and nine months ended December 31, 2006, respectively, compared to $1.4 million and $4.2 million in the same periods in fiscal 2006. The increase in cost of services for our strategic consulting segment for the three and nine months ended December 31, 2006 was due to increase in payroll and payroll related costs of $194,000 and $244,000, and stock-based compensation expenses related to the adoption of SFAS 123R of $35,000 and $108,000, respectively.

 

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Operating expenses

Research and development

 

           Percentage of Total
Revenues
 
   Three Months Ended
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Three Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Software products segment

   $ 1,066    $ 878    21 %   17 %   15 %

Strategic consulting segment

     —        —      —       —       —    
                            

Total research and development

   $ 1,066    $ 878    21 %   17 %   15 %
                            

 

           Percentage of Total
Revenues
 
   Nine Months Ended
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Nine Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Software products segment

   $ 3,040    $ 2,558    19 %   17 %   15 %

Strategic consulting segment

     —        —      —       —       —    
                            

Total research and development

   $ 3,040    $ 2,558    19 %   17 %   15 %
                            

Research and development expenses consist mainly of payroll, payroll related expenses and third-party consulting expenses. Also included is $19,000 and $55,000 of stock-based compensation expense related to the adoption of SFAS 123R in the three and nine months ended December 31, 2006.

Software products segment

Research and development expenses were $1.1 million and $3.0 million for the three and nine months ended December 31, 2006, respectively, compared to $878,000 and $2.6 million for the same periods in fiscal 2006. The increase in research and development expenses in absolute dollars and as a percentage of total revenue for the three months ended December 31, 2006 compared to the same periods in fiscal 2006 was due to an increase in third party consulting expense of $150,000, the allocation of stock-based compensation expense of $19,000 and allocation of payroll and payroll related expenses of $11,000 from employees who were assigned to work on development projects from the deployment department. The increase for the nine months ended December 31, 2006 was due to an increase in third party consulting expenses, and the allocation of payroll and payroll related expenses from employees who were assigned to work on development projects from other departments.

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.

Sales and marketing

 

           Percentage of Total
Revenues
 
   Three Months Ended
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Three Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Software products segment

   $ 904    $ 953    (5 )%   15 %   17 %

Strategic consulting segment

     724      543    33 %   12 %   9 %
                            

Total sales and marketing

   $ 1,628    $ 1,496    9 %   27 %   26 %
                            

 

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           Percentage of Total
Revenues
 
   Nine Months Ended
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Nine Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Software products segment

   $ 2,631    $ 2,532    4 %   15 %   15 %

Strategic consulting segment

     1,950      1,684    16 %   11 %   10 %
                            

Total sales and marketing

   $ 4,581    $ 4,216    9 %   26 %   25 %
                            

Sales and marketing expenses consist primarily of personnel costs, including salaries, commissions for sales, corporate marketing, facilities related costs and travel related costs. Also included is $80,000 and $236,000 of stock-based compensation expense related to the adoption of SFAS 123R for the three and nine months ended December 31, 2006, respectively.

Total sales and marketing expense

Sales and marketing expenses were $1.6 million and $4.6 million in the three and nine months ended December 31, 2006, respectively, compared to $1.5 million and $4.2 million in the same periods in fiscal 2006. The increase in sales and marketing expense in absolute dollars and as a percentage of revenue in the third quarter of fiscal 2007 was due to $80,000 of stock-based compensation related to the adoption of SFAS 123R.

The increase in sales and marketing expense for the nine month ended December 31, 2006 was primarily due to increase of $284,000 in payroll and payroll related expenses due to the hiring of new executives near the end of first quarter of fiscal 2006. Payroll and payroll expenses for the first nine months of fiscal 2007 reflect the full year of expenses for the new executives, while in fiscal 2006, only partial year expenses were reflected. In addition, the increase in sales and marketing expenses for the nine months was affected by the increase in stock-based compensation expense of $236,000, offset by a decrease in employment fees of $143,000.

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 $904,000 and $2.6 million in the three and nine months ended December 31, 2006, respectively, compared to $953,000 and $2.5 million in the same periods in fiscal 2006. The decrease in absolute dollars and as a percentage of revenue in the three months ended December 31, 2006 was primarily due to a decrease in the allocation of sales and marketing expenses to the software product segment as a result of lower relative percentage of software product revenue to total revenue compared to the allocation in the same period in fiscal 2006. The increase in sales and marketing expense in absolute dollars for the nine months ended December 31, 2006 was primarily due to allocation of the increase in payroll and payroll related costs associated with the hiring of new executives and the allocation of stock-based compensation expenses related to the adoption of SFAS 123R in fiscal 2007.

Strategic consulting segment

Sales and marketing expenses for the strategic consulting segment were $724,000 and $2.0 million in the three and nine months ended December 31, 2006, respectively, compared to $542,000 and $1.7 million in the same periods in fiscal 2006. The increase in absolute dollars and as a percentage of revenue for three months ended December 31, 2006 was primarily due to a increase in the allocation of sales and marketing to the strategic consulting segment as a result of higher relative percentage of strategic consulting revenue to total revenue compared to the allocation in the same period in fiscal 2006. The increase in sales and marketing expense in absolute dollars for the nine months ended December 31, 2006 was primarily due to allocation of the increase in payroll and payroll related costs associated with the hiring of new executives and the allocation of stock-based compensation expenses related to the adoption of SFAS 123R in fiscal 2007.

 

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General and administrative

 

           Percentage of Total
Revenues
 
   Three Months Ended
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Three Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Software products segment

   $ 612    $ 867    (29 )%   10 %   15 %

Strategic consulting segment

     527      392    34 %   9 %   7 %

Unallocated G&A

     —        3    (100 )%   0 %   0 %
                            

Total general and administrative

   $ 1,139    $ 1,262    (10 )%   19 %   22 %
                            

 

           Percentage of Total
Revenues
 
   Nine Months Ended
December 31,
  

Percentage of

Dollar Change

Year Over Year

    Nine Months Ended
December 31,
 

(In thousands, except percentages)

   2006    2005      2006     2005  

Software products segment

   $ 2,181    $ 2,319    (6 )%   12 %   13 %

Strategic consulting segment

     1,790      1,642    9 %   10 %   9 %

Unallocated G&A

     —        4    (100 )%   0 %   0 %
                            

Total general and administrative

   $ 3,971    $ 3,965    —   %   22 %   22 %
                            

General and administrative expenses consist primarily of personnel costs of executive officers and support personnel, facilities, investor relations, insurance, legal and accounting and auditing fees. Also included is $57,000 and $208,000 of stock-based compensation expense related to the adoption of SFAS 123R for the three and nine months ended December 31, 2006, respectively. In addition, the Company evaluated the impact of the adoption of SAB 108 and recorded a cumulative effect adjustment of $256,000 related to the accounting for accrued expenses. The company was overaccrued on recurring professional services fees included in general and administrative expenses. The error arose as a result of accrual of such services ratably over the year rather than as the service was rendered. Under the rollover method of evaluating misstatements, the effect of the methodology used by the company did not result in a material misstatement of the financial statements.

The Company evaluated the impact of correcting all misstatements, including both carryover and reversing effects of prior years misstatements on the current year financial statements. The Company determined that the effect of the errors on all prior financial statement filings were immaterial, but would be considered material to the financial statements under the methodology prescribed by SAB 108. Therefore, the Company recorded a cumulative effect adjustment to the applicable carrying values of liabilities for these previous errors as of April 1, 2006, with an offsetting adjustment to retained earnings. The amount recorded was a debit of $256,000 to accrued expenses with the offsetting credit of $256,000 to retained earnings. The error was discovered during the three months ended December 2006 and the adjustment was recorded at that time. The understatement of expense was not considered material for any other reported period and those results were therefore not restated.

Total general and administrative expense

General and administrative expenses were $1.1 million and $3.9 million in the three and nine months ended December 31, 2006, respectively, compared to $1.3 million and $4.0 million in the same periods in fiscal 2006. The decrease in absolute dollars and as a percentage of revenue for three months ended December 31, 2006 as compared to the same period in fiscal 2006 was primarily due to lower than expected audit fees for fiscal 2007 compared to fiscal 2006 and the reversal of prior accruals for these fees, offset by stock-based compensation expense of $57,000.

The software products and strategic consulting segments have as a shared pool of general and administrative resources which are allocated to the segments based on each segment’s revenue as a relative percentage of total revenues. Inter-segment 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 for segment reporting purposes, which may result in changes to segment allocations in future periods.

 

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Software products segment

 

General and administrative expenses for the software products segment were $612,000 and $2.2 million in the three and nine months ended December 31, 2006, respectively, compared to $867,000 and $2.3 million in the same periods in fiscal 2006. The decrease in general and administrative expense in absolute dollars and as a percentage of revenue for both the third quarter of fiscal 2007 and in the first nine months of fiscal 2007 was primarily the result of a decrease in audit and tax fees due to lower than expected audit fees for fiscal 2007. In addition, 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.

Strategic consulting segment

General and administrative expenses for the strategic consulting segment were $527,000 and $1.8 million in the three and nine months ended December 31, 2006, respectively, compared to $392,000 and $1.6 million in the same periods in fiscal 2006. The general and administrative expense in absolute dollars and as a percentage of revenue for the three and nine month ended December 31, 2006 increased compared with the same periods in fiscal 2006. The increase in absolute dollars and as a percentage of revenue for three and nine months ended December 31, 2006 was primarily due to a increase in the allocation of general and administrative expenses to the strategic consulting segment as a result of higher relative percentage of strategic consulting revenue to total revenue compared to the allocation in the same period in fiscal 2006.

Provision for Income Taxes

Year over year comparison for the three and nine months ended December 31, 2006 (in thousands):

 

     Three Months Ended
December 31,
   Nine Months Ended
December 31,
   2006    2005    2006    2005

Provision for income taxes

   $ 12    $ 25    $ 86    $ 65
                           

Provisions for income taxes were recorded for the three and nine months ended December 31, 2006 and 2005. 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

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

 

    

December 31,

2006

   % Change    

March 31,

2006

Cash and cash equivalents

   $ 6,947    (36 )%   $ 10,832

Short-term investments

     6,084    100 %     —  
               

Cash, cash equivalents and short-term investments

   $ 13,031    20 %   $ 10,832
               

Working capital

   $ 4,212    61 %   $ 2,610
               

 

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Table of Contents
     Nine Months Ended  
    

December 31,

2006

    % Change    

March 31,

2006

 
     2006     % Change     2005  

Cash flows from operating activities

   $ 3,127     90 %   $ 1,645  
                  

Cash flows from investing activities

   $ (6,401 )   (245 )%   $ (1,856 )
                  

Cash flows from financing activities

   $ (564 )   (38 )%   $ (410 )
                  

Cash, Cash Equivalents and Short-term Investments. As of December 31, 2006, our cash and cash equivalents consisted primarily of demand deposits and money market funds. Our short-term investments consisted primarily of corporate notes and bonds, government securities and other debt securities with an original maturity at the time of purchase of over three months. The increase in our cash, cash equivalents and short-term investments in the nine months ended December 31, 2006 was primarily due to $3.1 million provided by operating activities, offset by $317,000 used in investing activities for property and equipment purchases and $564,000 of cash used in financing activities in cash payment of dividends and payments of term loans. The largest amount of cash provided from operating activities was due to a decrease in accounts receivable associated with cash collection and an increase in deferred revenue. The largest cash usage from operating activities was due to an increase in other current assets mainly prepaid expenses and a decrease in accounts payable and accrued expenses associated with the timing of payments.

Cash Flows From Operating Activities. Cash flows provided by operating activities increased in the first nine months of fiscal 2007 as compared to the first nine months of fiscal 2006 is primarily due to an increase in net income, a decrease in accounts receivables, an increase in deferred revenue, offset by an increase in prepaid and other assets and a decrease in accrued expenses and deferred revenue.

Cash Flows From Investing Activities. Cash flows used in investing activities during the first nine months of fiscal 2007 primarily related to the purchase of short-term investments of $7.1 million and miscellaneous asset purchases of $317,000 for capital equipment necessary for our ongoing operations offset by sales of short-term investments of $1 million. Cash flows used in investing activities in the first nine months of fiscal 2006 were related to purchases of capital equipment necessary for our ongoing operations, including computers, computer server equipments, and furniture related to the relocation of the Cary, North Carolina office in the first quarter of fiscal 2006 and the relocation of the Mountain View, California headquarters in the second quarter of fiscal 2006. There was also additional data storage purchased for both the Mountain View headquarters and the Cary office in the third quarter of fiscal 2006.

Cash Flows From Financing Activities. Cash flows used in financing activities in the first nine months of fiscal 2007 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 nine months of fiscal 2006 were primarily a result of loan proceeds of $600,000 received in the second quarter of fiscal 2006, offset by the payments against our outstanding loan facilities with Silicon Valley Bank and payments of dividends to our preferred stockholders.

Credit Facilities. The Company has a credit facility with Silicon Valley Bank (the “Bank”), providing for up to $3.0 million in borrowings, secured against 80% of eligible accounts receivable. If the Company’s modified quick ratio (defined as cash and cash equivalents and investments plus accounts receivable, divided by total current liabilities, including all bank debt but excluding deferred revenue) is equal to 2.5:1 or greater, the Bank may include foreign accounts receivable to determine eligible receivables. However, if the modified quick ratio is less than 2.5:1, all or a portion of foreign accounts may be excluded from eligible account receivables. The borrowed balance under this credit facility was $1.0 million at December 31, 2006.

The Company had a secured term loan payable over 48 months, with monthly payments that commenced in July 2002. The balance was paid off as of June 30, 2006. 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 additional term loan is payable over 36 months. The balance outstanding on the additional term loan as of September 30, 2006 was $117,000. 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 September 30, 2006, the balance on this equipment credit facility was $350,000.

On January 2, 2007, the Company and the Bankentered into the Sixth Amendment (the “Loan Amendment”) to the Loan and Security Agreement, effective as of May 24, 2004 by and between Silicon Valley Bank and the Company, as amended (the “Loan and Security Agreement”). The Loan Amendment amends in part Section 2.4 of the Loan and Security Agreement to lower the interest rate payable at a per annum rate of 0.375% above the prime rate on the advances, term 2 loan and equipment advances and amends Section 13.1 of the Loan and Security Agreement by changing the “Revolving Maturity Date” to May 24, 2008. In addition, the Loan Amendment amends in part Section 6.7 of the Loan and Security Agreement by deleting section 6.7(iii), “Tangible Net Worth” in its entirety. Furthermore, the Loan Amendment also provides for additional representation and warranties by the Company.

 

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The Company must maintain a minimum modified quick ratio of 2:1. Certain of our assets, excluding intellectual property, secure both facilities. We were in compliance with all financial covenants as of December 31, 2006.

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 beginning on June 26, 2007 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.

The warrants are generally exercisable for a period of five years from issuance at an exercise price of $1.15 per share. However, the expiration date of the warrants is extended by one day for each day that a registration statement covering the resale of the shares of common stock issuable upon exercise of the warrants is not effective or otherwise suspended.

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 third quarter of fiscal 2007, we paid $73,000 in cash dividends to the Series A Preferred stockholders and we recorded an additional $48,000 in accrued dividends payable as of December 31, 2006.

Contractual Commitments. As of December 31, 2006, we had operating leases for our facilities that expire at various dates through fiscal years 2010 and 2011. During the three and nine months ended December 31, 2006, we recorded rent expense related to these arrangements of $85,000 and $265,000, respectively.

 

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The following is a summary of our contractual commitments associated with our debt and lease obligations as of December 31, 2006, (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)

   $ 339    $ 339    $ —      $ —      $ —  

Notes payable

     1,467      1,300      167      —        —  

Operating leases

     1,855      433      935      487      —  
                                  

Total commitments

   $ 3,661    $ 2,072    $ 1,102    $ 487    $ —  
                                  

(1) Beginning on June 26, 2007, the holders of the preferred stock may elect to redeem all or a portion of their shares of preferred stock or we can elect to redeem all of the outstanding preferred shares. If all of the outstanding shares of preferred stock are not redeemed, then we will continue to be obligated to pay dividends in the aggregate amount of approximately $582,000 per year. However, at any time prior to redemption, the holders of the preferred stock can elect to convert their preferred shares into common stock. Any of these outcomes is beyond our control and the probability of any of these outcomes is highly subjective. If we were required to redeem all of the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $7.9 million.

Short Term and Long Term Liquidity. We believe that the combination of our cash, cash equivalents and short-term investments, and currently anticipated cash flow from operations should be adequate to sustain operations through the next twelve months. We are managing the business to achieve positive cash flow utilizing existing assets. Although operating expenses have increased, which is consistent with the growth of the company over the past several fiscal years, we generated positive annual operating cash flow for the first nine months of fiscal 2007, fiscal 2006, 2005 and 2004. There is no assurance that we can continue to maintain positive cash flow quarterly or annually. 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 2007.

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 addition, beginning on June 26, 2007, the holders of our preferred stock can require us to redeem all or a portion of their shares of 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 $7.9 million. As a result, we may need to raise additional funds or secure additional credit facilities 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. Our common stock is not listed on a national securities exchange, and until it is listed it will be difficult for us to make sales of our equity securities. In addition, the terms of our existing 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.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

Interest rate sensitivity

We had cash, cash equivalents and short-term investments totaling $13.0 million at December 31, 2006. These amounts were invested primarily in money market funds and instruments, corporate notes and bonds, government securities and other debt securities with strong credit ratings. The cash, cash equivalents and short-term investments are held for working capital purposes. We do not enter into investments for trading or speculative purposes.

Our fixed-income portfolio is subject to interest rate risk. Fluctuations in the value of our investment securities caused by a change in interest rates (gains or losses on the carrying value) are recorded in other comprehensive income, and are realized only if we sell the underlying securities.

At March 31, 2006, we had cash and cash equivalents totaling $10.8 million.

 

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ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures.

Subject to the limitations described below, our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission 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 December 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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, 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 December 31, 2006, 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 1A. RISK FACTORS

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 had annual profitability through the third quarter of fiscal 2005, fiscal 2006 and year-to-date fiscal 2007. As of December 31, 2006, we had an accumulated deficit of $75.2 million. We may incur losses again as we continue to develop our business.

 

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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 twelve 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. In addition, the holders of our preferred stock may elect to have us redeem all or a portion of their shares of preferred stock at any time, or we may elect to redeem all the outstanding shares of preferred stock, beginning on June 26, 2007. If we were required or if we elected to redeem all the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $7.9 million. 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.

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

 

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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 December 31, 2006 and 2005, software license revenue accounted for 48% and 56% of our total revenues, respectively. In the nine months ended December 31, 2006 and 2005, software license revenue accounted for 49% and 47% 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.

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.

 

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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 and nine months ended December 31, 2006, sales to our top two customers accounted for 35% and 29% of total revenue, respectively, and sales to our top five customers in the same periods accounted for 49% and 46% of total revenue, respectively. For the three and nine months ended December 31, 2005, sales to our top two customers accounted for 33% and 35% of total revenue, respectively, and sales to our top five customers in the same periods accounted for 57% and 49% of total revenue, respectively. For fiscal 2006, 2005 and 2004 sales to our top two customers accounted for 42%, 45% and 28% of total revenue, respectively, and sales to our top five customers in the same periods accounted for 52%, 62% 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.

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.

 

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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 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.

 

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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 and nine months ended December 31, 2006 and fiscal 2006, 2005, and 2004 were approximately 32%, 34%, 24%, 22% and 29%, respectively. We have a total of 11 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;

 

   

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.

 

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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 will be required in future years 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, 2008, 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. In such a case, we would assess our internal control as ineffective. In addition, beginning with our Annual Report on Form 10-K for the fiscal year ending March 31, 2009, we will be required to include an attestation report by our independent registered public accounting firm 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.

If we are unable to assert that our internal control over financial reporting is effective as of March 31, 2008 (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 as of March 31, 2009), 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.

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 some of 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.

 

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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.

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, the predecessor to the NASDAQ Global 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 no 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 Global 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.

 

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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.

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 December 31, 2006. 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.

The redemption of our preferred stock, or the election by the preferred stockholders to receive their dividend payments in shares instead of cash, may negatively affect our financial condition.

Beginning on June 26, 2007, the holders of our preferred stock may elect to have us redeem all or a portion of their shares of preferred stock at any time, or we may elect to redeem all of the outstanding shares of preferred stock. If we were required, or if we elected, to redeem all the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $7.9 million. As a result, we may need to obtain additional funds or secure additional credit facilities. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise additional funds could harm our business and financial condition. In addition, 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 affect 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.

We face risks related to changes in accounting standards for stock option plans.

Beginning in the first fiscal quarter of 2007, we adopted SFAS 123R, which requires us to recognize compensation expense in our statement of operations for the fair value of stock options granted to our employees over the related vesting periods of the stock options. The requirement to expense stock options granted to employees reduces their attractiveness as a compensation vehicle because the expense associated with these grants results in compensation charges.

 

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In addition, the expenses recorded may not accurately reflect the value of our stock options because the option pricing models commonly used under SFAS 123R were not developed for use in valuing employee stock options and are based on highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Alternative compensation arrangements that can replace stock option programs may also negatively impact profitability. Stock options remain an important employee recruitment and retention tool, and we may not be able to attract and retain key personnel if we reduce the scope of our employee stock option programs. Our employees are critical to our ability to develop and design systems that advance our productivity and technology goals, increase our sales goals and provide support to customers. Accordingly, as a result of the requirements of SFAS 123R, our profitability can be expected to be reduced compared to periods prior to adoption of the new standard.

 

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

None.

 

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: February 9, 2007

 

PHARSIGHT CORPORATION
By:  

/s/ William Frederick

 

William Frederick

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

 

Sixth Amendment to Loan and Security Agreement effective as of January 2, 2007 between Pharsight Corporation and Silicon Valley Bank.

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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