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

 
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PHARSIGHT CORP 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. 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, 2007

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: 001-33846

 

 

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, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  ¨   Accelerated filer  ¨   Non-accelerated filer  x   Smaller reporting company  ¨
  (Do not check if a smaller reporting company)

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

The number of shares of Registrant’s Common Stock outstanding as of February 8, 2008: 9,428,782

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page

PART I.

   FINANCIAL INFORMATION   

Item 1.

   Consolidated Financial Statements (Unaudited)    3
   Condensed Consolidated Balance Sheets – December 31, 2007 and March 31, 2007    3
   Condensed Consolidated Statements of Operations – Three and Nine Months Ended December 31, 2007 and 2006    4
   Condensed Consolidated Statements of Cash Flows – Nine Months Ended December 31, 2007 and 2006    5
   Notes to The Condensed Consolidated Financial Statements    6

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    15

Item 3.

   Quantitative and Qualitative Disclosures about Market Risks    28

Item 4.

   Controls and Procedures    29

PART II.

   OTHER INFORMATION   

Item 1.

   Legal Proceedings    30

Item 1A.

   Risk Factors    30

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    38

Item 3.

   Defaults Upon Senior Securities    38

Item 4.

   Submission of Matters to a Vote of Security Holders    38

Item 5.

   Other Information    38

Item 6.

   Exhibits    38
   Signatures    39

 

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PART I. FINANCIAL INFORMATION

 

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Pharsight Corporation

Condensed Consolidated Balance Sheets

(in thousands, except shares and per share amounts)

 

      December 31, 2007     March 31, 2007  
     (Unaudited)        
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 8,663     $ 7,829  

Short-term investments

     6,408       6,836  

Accounts receivable, net of allowances of $20 at December 31, 2007 and March 31, 2007

     4,313       3,087  

Prepaid and other current assets

     424       523  
                

Total current assets

     19,808       18,275  

Property and equipment, net

     1,434       1,674  

Other assets

     46       46  
                

TOTAL ASSETS

   $ 21,288     $ 19,995  
                
LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED
STOCK AND STOCKHOLDERS’ EQUITY
  

Current liabilities:

    

Accounts payable

   $ 641     $ 769  

Accrued expenses

     617       570  

Accrued compensation

     3,017       3,050  

Deferred revenue

     8,087       8,289  

Current portion of notes payable

     —         292  
                

Total current liabilities

     12,362       12,970  

Notes payable, less current portion

     —         100  

Other long term liabilities

     124       179  

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, 2007 and March 31, 2007

    

Issued and outstanding shares - none and 665,359 at December 31, 2007 and March 31, 2007 respectively (none and 604,887 designated as Series A at December 31, 2007 and March 31, 2007, respectively, none and 60,472 designated as Series B at December 31, 2007 and March 31, 2007 respectively)

     —         7,096  

Commitments and contingencies

     —         —    

Stockholders’ equity:

    

Preferred stock, $0.001 par value:

    

Authorized shares - 5,000,000 at December 31, 2007 and March 31, 2007

    

Issued and outstanding shares - none at December 31, 2007 and March 31, 2007

     —         —    

Common stock, $0.001 par value:

    

Authorized shares - 120,000,000 at December 31, 2007 and March 31, 2007

    

Issued and outstanding shares - 9,409,435 and 6,673,384 at December 31, 2007 and March 31, 2007 respectively

     9       20  

Additional paid-in capital

     82,157       74,027  

Accumulated other comprehensive loss

     (100 )     (69 )

Accumulated deficit

     (73,264 )     (74,328 )
                

Total stockholders’ equity

     8,802       (350 )
                

TOTAL LIABILITIES, REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY

   $ 21,288     $ 19,995  
                

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

 

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Pharsight Corporation

Condensed Consolidated Statements of Operations

(Unaudited)

(in thousands, except per share amounts)

 

     Three Months Ended     Nine Months Ended  
     December 31, 2007     December 31, 2006     December 31, 2007     December 31, 2006  

Revenues:

        

License

   $ 1,406     $ 1,237     $ 4,137     $ 3,977  

Renewal

     1,851       1,444       5,332       4,084  

Maintenance

     307       249       926       724  

Services

     3,809       3,191       10,357       9,048  
                                

Total revenues

     7,373       6,121       20,752       17,833  

Cost of revenues:

        

License, renewal and maintenance

     73       69       190       179  

Services

     2,562       1,802       7,156       5,265  
                                

Total cost of revenues

     2,635       1,871       7,346       5,444  

Gross profit

     4,738       4,250       13,406       12,389  

Operating expenses:

        

Research and development

     1,181       1,066       3,548       3,040  

Sales and marketing

     1,702       1,628       4,980       4,581  

General and administrative

     1,416       1,139       4,089       3,971  
                                

Total operating expenses

     4,299       3,833       12,617       11,592  
                                

Income from operations

     439       417       789       797  

Other income (expense):

        

Interest income

     169       149       505       445  

Interest expense

     —         (34 )     (13 )     (111 )

Other expense, net

     (30 )     (17 )     (121 )     (67 )
                                

Total other income (expense)

     139       98       371       267  
                                

Net income before income taxes

     578       515       1,160       1,064  

Provision for income taxes

     (46 )     (12 )     (96 )     (86 )
                                

Net income

     532       503       1,064       978  

Preferred stock dividend

     —         (203 )     (207 )     (566 )

Deemed dividend from preferred stock conversion

     —         —         (6,993 )     —    
                                

Net income (loss) attributable to common stockholders

   $ 532     $ 300     $ (6,136 )   $ 412  
                                

Net income (loss) per share attributable to common stockholders:

        

Basic

   $ 0.06     $ 0.05     $ (0.72 )   $ 0.06  
                                

Diluted

   $ 0.05     $ 0.04     $ (0.72 )   $ 0.06  
                                

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

        

Basic

     9,403       6,595       8,537       6,571  
                                

Diluted

     10,069       7,255       8,537       7,184  
                                

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, 2007     December 31, 2006  

Cash Flows from Operating Activities:

    

Net income

   $ 1,064     $ 978  

Adjustments to reconcile net income to net cash from operating activities:

    

Depreciation

     688       565  

Stock-based compensation expense

     881       620  

Net impact of preferred stock conversion

     41       —    

Changes in operating assets and liabilities:

    

Accounts receivable, net

     (1,226 )     609  

Prepaids and other current assets

     99       (388 )

Accounts payable

     (128 )     (300 )

Accrued expenses

     40       (184 )

Accrued compensation

     (33 )     363  

Deferred revenue

     (202 )     864  
                

Net cash provided by operating activities

     1,224       3,127  
                

Cash Flows from Investing Activities:

    

Purchases of property and equipment

     (447 )     (317 )

Purchases of investments

     (7,823 )     (7,084 )

Proceeds from sale of investments

     8,251       1,000  
                

Net cash used in investing activities

     (19 )     (6,401 )
                

Cash Flows from Financing Activities:

    

Repayments of notes payable

     (392 )     (444 )

Proceeds from sale of common stock

     126       99  

Dividends paid in cash to preferred stockholders

     (73 )     (219 )
                

Net cash used in financing activities

     (339 )     (564 )
                

Effect of change in exchange rates on cash and cash equivalents

     (32 )     (47 )

Net increase (decrease) in cash and cash equivalents

     834       (3,885 )

Cash and cash equivalents, beginning of period

     7,829       10,832  
                

Cash and cash equivalents, end of period

   $ 8,663     $ 6,947  
                

Supplemental disclosures of non cash activities:

    

Issuance of dividend to preferred stockholders in form of stock

     134       347  

Accrued preferred stock dividend

     —         48  

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

 

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PHARSIGHT CORPORATION

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business

Pharsight Corporation (“Pharsight” or the “Company”) develops and markets software and provides strategic consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process, by reducing the costs and time requirements of their drug 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, for the development of in-vivo-in-vitro correlations and the management of related datasets and workflow, for streamlined on-site validation of certain of our products, for the storage, management, and regulatory reporting of derived data and models in data repositories, and for dynamic visualization and communication of model-based product profiles. The Company’s software products and services utilize 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.

Beginning fiscal 2008, Pharsight started to operate in three operating segments, which are also its reportable segments: Software Products, Strategic Consulting Services and Reporting and Analysis Services. 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 unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“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 U.S.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, 2007.

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, 2007 are not necessarily indicative of results to be expected for the fiscal year ending March 31, 2008, 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.

Reverse Stock Split:

On October 18, 2007, the Company’s Board of Directors approved a 1-for-3 reverse split of its common stock, following approval by the Company’s stockholders on August 8, 2007. The reverse stock split was effective at 5:00 pm on November 13, 2007. As a result, the Company’s issued and outstanding common stock was reduced from approximately 28.2 million shares to approximately 9.4 million shares. The par value of the common stock was not affected by the reverse stock

 

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split and remains at $0.001 per share. All per share amounts and outstanding shares, including all common stock equivalents (stock options, warrants, preferred stocks, other equity incentive awards and equity compensation plans) have been retroactively adjusted in the Condensed Consolidated Financial Statements and in the Notes to the Condensed Consolidated Financial Statements for all periods presented to reflect the reverse stock split.

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.

Revenue Recognition

Our revenues are derived from four primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support (PCS or maintenance services), (2) services related to scientific and training consulting and software deployment, (3) Strategic Consulting Services and (4) Reporting and Analysis 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 term-based 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, or VSOE of fair value to allocate the fee to the separate elements for these arrangements. 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 or the remaining 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 licenses and PCS. Prior to the second quarter of fiscal 2008, we had not established VSOE of fair value to allocate the fee to the separate elements of the arrangement. We recognized revenue attributable to license and PCS ratably over the remaining period of the PCS term once the product was delivered. For financial statement presentation purposes, revenues from arrangements that included perpetual licenses were 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 were recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses. During the second quarter of fiscal 2008, we established VSOE of fair value of the separate elements of our enterprise software products. For perpetual license arrangements, we allocate revenue to delivered components, normally the license component of the arrangement, using the residual method, based on VSOE of fair value of the undelivered elements (generally the maintenance services components), which is specific to us. We determine the fair value of the undelivered elements based on our current price list and the historical evidence of the Company’s sales of these elements to third parties. The revenue attributable to the delivered components is recognized once the implementation and installation services are completed and accepted by the customer and the revenue attributable to the undelivered components is recognized ratably over the period until the services are completed.

We enter into arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. Prior to the second quarter of fiscal 2008, we had not established VSOE of fair value to allocate the fee to the separate elements of the arrangement. For arrangements involving a significant amount of services related to installation and implementation of our software products, we recognized revenue for the entire arrangement ratably over the remaining period of the PCS term once the implementation and installation services were completed and accepted by the customer. For financial statement presentation purposes, revenues from arrangements that included perpetual and term-based licenses were

 

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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 were recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses. The implementation/installation services revenues were recorded as services revenue in the statement of operations. During the second quarter of fiscal 2008, we established VSOE of fair value of the separate elements of our enterprise software product arrangements. For perpetual license arrangements, we allocate revenue to delivered components, normally the license and installation components of the arrangement, using the residual method, based on VSOE of fair value of the undelivered elements (generally the maintenance services components), which is specific to us. We determine the fair value of the undelivered elements based on our current price list and the historical evidence of the Company’s sales of these elements to third parties. The revenue attributable to the delivered components is recognized once the implementation and installation services are completed and accepted by the customer and the revenue attributable to the undelivered components is recognized ratably over the period until the services are completed.

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 is recognized ratably over the license term when the software is delivered to the distributors and other revenue recognition criteria are met.

Strategic Consulting Services and Reporting and Analysis Services Segments

We enter into arrangements for Strategic Consulting Services contracts and Reporting and Analysis Services contracts, which do not fall under the scope of SOP 97-2. Arrangements for these 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.

 

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The majority of our Pharsight Knowledgebase Server (“PKS”) software arrangements include software deployment services. Prior to the second quarter of fiscal 2008, we deferred revenue for software deployment services, along with the associated license revenue, until the services were completed. If there was significant uncertainty about the project completion or receipt of payment for the professional services, we deferred revenue until the uncertainty was sufficiently resolved. Starting from the second quarter of fiscal 2008, for PKS perpetual licenses, we allocate revenue to delivered components, normally the license component of the arrangement, using the residual method, based on VSOE of fair value of the undelivered elements (generally the maintenance services components), which is specific to us. We determine the fair value of the undelivered elements based on our current price list and the historical evidence of the Company’s sales of these elements to third parties. The revenue attributable to the delivered components is recognized once the implementation and installation services are completed and accepted by the customer and the revenue attributable to the undelivered components is recognized ratably over the period until the services are completed.

Deferred Revenue

Deferred revenue is comprised of deferred license fees (initial and renewal) and maintenance and support, which are recognized ratably over the one-year period of the license. In applying our revenue recognition policy we must determine which portions of our revenue are recognized in the current period and which portions must be deferred. For some of our enterprise software license contracts that required customer acceptance of installation, we will defer the revenue until such criteria is meet. In addition, deferred revenue includes 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.

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

 

     December 31,
2007
   March 31,
2007

License

   $ 2,245    $ 2,800

Renewals

     4,289      4,298

Training

     —        40

Maintenance

     899      650

Services

     654      501
             

Total deferred revenue

   $ 8,087    $ 8,289
             

Earnings per Share

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

Diluted earnings per share attributable to common stockholders is computed by dividing net income or loss attributable to common stockholders for the period by the weighted-average number of shares of vested common stock 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.

On June 27, 2007, the Company converted 604,887 shares of Series A Convertible Preferred Stock and 66,519 shares of Series B Convertible Preferred Stock into common stock as a result of the election to convert all such shares into common stock by our preferred stockholders. The total number of restricted unregistered shares of common stock issued as a result of this conversion was 2,685,628.

On November 13, 2007, a one-for-three reverse stock split became effective. The Company’s common stock began to trade on the OTC Bulletin Board on a split adjusted basis on November 14, 2007, under a new trading symbol “PHRS.OB”.

 

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The trading symbol changed to “PHST” after the Company started to trade on the Nasdaq Capital Market on November 27, 2007. Accordingly, the calculations of basic and diluted net income (loss) per share have been adjusted to reflect this change as follows (in thousands, except per share data):

 

     Three Months Ended     Nine Months Ended  
     December 31,
2007
   December 31,
2006
    December 31,
2007
    December 31,
2006
 

Net income

   $ 532    $ 503     $ 1,064     $ 978  

Preferred stock dividend

     —        (203 )     (207 )     (566 )

Deemed dividend from preferred stock conversion

     —        —         (6,993 )     —    
                               

Net income (loss) attributable to common for basic computation

   $ 532    $ 300     $ (6,136 )   $ 412  
                               

Weighted average common shares outstanding

     9,403      6,595       8,537       6,571  

Diluted effect of:

         

Stock options and stock-based awards in the periods ended

     666      660       —         613  
                               

Dilutive weighted-average common shares outstanding

     10,069      7,255       8,537       7,184  
                               

Net Income (loss) per share attributable to common stockholders

         

Basic

   $ 0.06    $ 0.05     $ (0.72 )   $ 0.06  
                               

Diluted

   $ 0.05    $ 0.04     $ (0.72 )   $ 0.06  
                               

Common equivalent shares have been excluded from the computation of diluted earnings per share for the nine month ended December 31, 2007 as the effect of including such shares would be antidilutive due to a loss recorded in these periods. All common equivalent shares of preferred stock (on an as-if-converted basis), have been excluded from the computation of diluted earnings per share for the same period in fiscal 2007 as the effect of including such shares would be antidilutive.

The following table sets forth, the number of potential common stock shares excluded from the calculation of net income (loss) per share attributable to common stockholders in the nine months ended December 31, 2007 and 2006 due to antidilution (in thousands):

 

     December 31,
     2007    2006

Outstanding options

   413    1,301

Warrants

   252    204

Redeemable convertible preferred stock

   —      2,621
         
   665    4,126
         

Stock-Based Compensation

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.

Effective April 1, 2006, we adopted the fair value recognition provisions under the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, (“SFAS 123R”).We estimate the fair value of options granted using the Black-Scholes option valuation model and the assumptions shown in Note 1, “Stock-Based Compensation,” to the condensed consolidated financial statements. 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 a combination of historical volatilities, 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.

 

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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 below table summarizes the stock-based expenses recorded during the three and nine months ended December 31, 2007 and 2006 (in thousands):

 

     Three Months Ended    Nine Months Ended
     December 31,
2007
   December 31,
2006
   December 31,
2007
   December 31,
2006

Cost of revenues

   $ 71    $ 39    $  153    $  121

Research and development

     34      19      87      55

Sales and marketing

     132      80      361      236

General and administrative

     109      57      280      208
                           

Total

   $ 346    $ 195    $ 881    $ 620
                           

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,
 
     2007     2006     2007     2006     2007     2006     2007     2006  

Expected life (years)

   0.49     0.50     0.49     0.49     4.89     2.71     4.82     2.69  

Expected stock price volatility

   62.3 %   47.5 %   58.8 %   59.3 %   140.8 %   96.8 %   166.7 %   121.2 %

Risk-free interest rate

   3.45 %   5.09 %   4.16 %   5.08 %   3.52 %   4.74 %   4.89 %   5.03 %

Stock Options

The following is a summary of stock option activity during the three months ended December 31, 2007 (in thousands):

 

     Number of Options
(in thousands)
    Weighted Average
Exercise Price per
Share
   Weighted Average
Remaining Contractual
Term (years)
   Aggregate Intrinsic
Value as of 12/31/07
(in thousands)

Balance at September 30, 2007

   2,002     $ 4.22      

Options granted

   27     $ 5.25      

Options exercised

   (9 )   $ 0.74      

Options canceled

   (11 )   $ 6.59      
                  

Balance at December 31, 2007

   2,009     $ 4.24    7.11    $ 3,626
                        

Options vested and expected to vest at December 31, 2007

   1,714     $ 4.15    6.84    $ 3,354
                        

Options exercisable at December 31, 2007

   1,182     $ 3.84    5.97    $ 2,922
                        

The weighted average remaining amortization period was 2.47 years as of December 31, 2007. The Company had 1,181,940 exercisable options and the unamortized stock compensation was $2.3 million as of December 31, 2007.

 

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Comprehensive Income (Loss)

Statement of FAS No. 130, “Reporting Comprehensive Income” (“SFAS 130”), requires the Company 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. The Company’s comprehensive income (loss) consists of net income (loss) adjusted for the effect of foreign currency translation gains or losses and unrealized gains or losses on available-for-sale investments.

Concentrations of Credit Risk

The Company receives a substantial amount of its revenue from a limited number of customers. For the three and nine months ended December 31, 2007, sales to the Company’s top two customers accounted for 17% and 16% of total revenue, respectively, and sales to its top five customers in the same periods accounted for 33% and 29% of total revenue, respectively. 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 fiscal 2007, 2006 and 2005, sales to our top two customers accounted for 28%, 42% and 45% of total revenue, respectively and sales to our top five customers accounted for 43%, 52% and 62%. Three customers comprised 34% and 41% of total accounts receivable, respectively at December 31, 2007 and 2006.

The following table sets forth, for the fiscal years given, the percentages of sales to each customer accounted for 10% or more of our total revenues:

 

2007

  

2006

  

2005

Pfizer

   17%   

Pfizer

   25%   

Pfizer

   25%

Eli Lilly

   11%   

Eli Lilly

   17%   

Eli Lilly

   20%

For the three months ended December 31, 2007, no single customers accounted for more than 10% of our total revenue during the period. For the nine months ended December 31, 2007, only the sales to Pfizer were approximately 10% of our total revenue during the period.

Recent Accounting Pronouncements

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 recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 in the first quarter of fiscal 2008 which did not have a material effect on its consolidated results of operations and financial condition.

In September 2006, the FASB issued Statement No. 157 “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies only to other accounting pronouncements that require or permit fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The Company is in the process of evaluating the impact of the adoption of this statement on its consolidated financial position or results of operations.

In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact of SFAS 159 on its consolidated financial position and results of operations.

In December 2007, the FASB issued FASB Statements No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”) and No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”). Effective for fiscal years beginning after December 15, 2008, the standards will improve, simplify, and converge internationally the accounting

 

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for business combinations and the reporting of noncontrolling interests in consolidated financial statements. SFAS 141R requires the acquiring entity in a business combination to recognize all the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. SFAS 160 provides guidance for accounting and reporting of noncontrolling interests in consolidated financial statements. The Company is currently assessing the impact of SFAS 141R and SFAS 160 on its consolidated financial statements and future operations.

2. NOTES PAYABLE

The Company has a credit facility with Silicon Valley Bank (the “Bank”), providing for up to $5 million in borrowings, secured by eligible accounts receivable. On June 21, 2007, we entered into the Seventh Amendment to the Loan and Security Agreement (the “Seventh Amendment “) with the Bank. The Seventh Amendment amends in part Section 2.1 of the Loan and Security Agreement to decrease the Quick Ratio from at least 2.00 to 1.00 to at least 1.75 to 1.00 and amends Section 2.2 of the Loan and Security Agreement by increasing the “Committed Revolving Line” from $3 million to $5 million. If our modified quick ratio is equal to 1.75:1 or greater, the Bank may include foreign accounts receivable to determine eligible receivables. However, if the modified quick ratio is less than 1.75:1, all or a portion of foreign accounts may be excluded from eligible account receivables. There was no outstanding borrowing under this facility as of December 31, 2007.

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 was payable over 36 months. In addition, we secured an equipment credit facility through June 2006 for up to $600,000. Each advance was payable over 36 months. On August 9, 2007, we paid off the remaining balances for both loans.

3. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND WARRANTS

On June 27, 2007, all of the holders of preferred stock elected to convert all of their shares of preferred stock into shares of common stock. Each share of preferred stock was convertible into four shares of common stock. As a result of conversion, our outstanding shares of common stock increased by 2,685,628 shares and we recorded a $7.0 million deemed dividend which represented the excess of (1) the fair value of all securities and other consideration transferred in the transaction by the Company to the holders of the convertible preferred stock over (2) the fair value of securities issuable to the stockholders in the calculation of earning per share.

As of December 31, 2007, the total number of the warrants outstanding was 694,438. The exercise prices ranged from $0.75 per share to $21.60 per share. The warrants issued in connection with the 2002 private investment were originally exercisable for a period of five years from issuance. 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 Company’s registration statement covering the resale of the common stock issuable upon exercise of the warrants has not been effective since November 2002. If not exercised after the extended expiration date, the right to purchase the common stock will terminate. The warrants contain a cashless exercise feature. The common stock issuable upon exercise of the warrants is entitled to the benefits and is subject to the terms of a registration right agreement.

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 No. 131, is its chief executive officer. The CODM allocates resources to and assesses the performance of each operating segment using information about their revenue and gross profit. The

 

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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.

The Company operates in three operating segments, which are also its reportable segments: Software Products, Strategic Consulting Services and Reporting and Analysis Services. These segments were determined based on how management and our CODM view and evaluate the Company’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 Services 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.

The Company’s Reporting and Analysis Services segment was launched in the first quarter of fiscal 2008. It addresses the full spectrum of client needs for modeling and simulation in regulatory reports such as those required in Section 5 of the Common Technical Document. These services meet growing customer demands for analysis and reporting of pharmacokinetic/pharmacodynamic data generated in clinical and preclinical studies supporting new drug approvals. These studies include toxicokinetic, single- and multiple-ascending dose, drug-drug interaction, renal and hepatically impaired, fed-fasted, bioequivalence/bioavailability, QT prolongation, and others.

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

 

     Three Months Ended
December 31,
     2007    2006
     Software
Products
   Strategic
Consulting
Services
   Reporting
and
Analysis
Services
   Total    Software
Products
   Strategic
Consulting
Services
   Reporting
and
Analysis
Services
   Total

Revenues:

                       

License, renewal and maintenance

   $ 3,564    $ —      $ —      $ 3,564    $ 2,930    $ —      $ —      $ 2,930

Services

     460      2,980      369      3,809      323      2,868      —        3,191
                                                       

Total revenues

   $ 4,024    $ 2,980    $ 369    $ 7,373    $ 3,253    $ 2,868    $ —      $ 6,121
                                                       

Gross profit

   $ 3,494    $ 1,101    $ 143    $ 4,738    $ 2,991    $ 1,259    $ —      $ 4,250

 

     Nine Months Ended
December 31,
     2007    2006
     Software
Products
   Strategic
Consulting
Services
   Reporting
and
Analysis
Services
   Total    Software
Products
   Strategic
Consulting
Services
   Reporting
and
Analysis
Services
   Total

Revenues:

                       

License, renewal and maintenance

   $ 10,395    $ —      $ —      $ 10,395    $ 8,785    $ —      $ —      $ 8,785

Services

     1,460      8,047      850      10,357      1,067      7,981      —        9,048
                                                       

Total revenues

   $ 11,855    $ 8,047    $ 850    $ 20,752    $ 9,852    $ 7,981    $ —      $ 17,833
                                                       

Gross profit

   $ 10,456    $ 2,770    $ 180    $ 13,406    $ 8,994    $ 3,395    $ —      $ 12,389

 

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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, 2007 and March 31, 2007.

 

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 demand for our products and services, potential revenue growth, 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 and reporting and analysis 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

 

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datasets and workflow; WinNonlin Validation Suite for streamlined on-site validation of WinNonlin; Pharsight Knowledgebase Server (PKS), WinNonlin Autopilot, 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. Our software products and our services utilize expertise in the sciences of pharmacology, drug and disease modeling, biostatistics and strategic decision-making. Our service offerings use this expertise to interpret and improve the design of scientific experiments and clinical trials, and to optimize clinical trial design and portfolio decisions. By integrating scientific, clinical, and business decision criteria into a dynamic model-based methodology, we help our customers 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 three business segments: Software Products, Strategic Consulting Services, and Reporting and Analysis Services. 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 and workflows required to perform, analyze, and report on the clinical tests 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. Reporting and Analysis Services was launched in the beginning of fiscal 2008 to address client needs for modeling and simulation in the production of reports submitted to regulatory authorities to gain marketing authorization. In the production of these analyses and reports, our Reporting and Analysis Services group often makes use of Pharsight software products. 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 Nasdaq Stock Market. In November 2002, our common stock ceased to trade on Nasdaq Stock Market and began to trade on the Over-The-Counter Bulletin Board system. In November 2007, our common stock ceased to trade on the Over-The-Counter Bulletin Board system and began trading on the Nasdaq Stock Market. 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 2008

 

   

Our revenue for the third quarter of fiscal 2008 was $7.4 million, an increase of 20% compared with revenue of $6.1 million in the third quarter of fiscal 2007.

 

   

Our gross profit in the third quarter of fiscal 2008 was $4.7 million compared with a gross profit of $4.3 million for the same quarter of fiscal 2007. Our gross margin percentage for the three months ended December 31, 2007 has decreased to 64% from 69% in the same quarter of fiscal 2007 partially due to the ramp-up of the Reporting and Analysis Services segment launched in the first quarter of fiscal 2008 and partially due to the increased headcount in our Strategic Consulting Services segment.

 

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Our net income for the nine months ended December 31, 2008 was $1.1 million, an increase of 9% compared to the net income of $978,000 in the same period of fiscal 2007.

Challenges and Risks

Our net income was $1.1 million for the nine months ended December 31, 2007. We achieved our first quarter of profitability in the fourth quarter of fiscal 2004 and had annual profitability during fiscal 2005, 2006 and 2007. Prior to that time we had incurred losses since our inception. We currently have an accumulated deficit of approximately $73.3 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.

We have achieved positive annual operating cash flow since fiscal 2005. As of December 31, 2007, we had $15.1 million in cash, cash equivalents and short-term investments and the limit on our line of credit is $5 million. 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 that are outside of our control, such as the state of the overall economy, the demand for our products and services and the length and lack of predictability of our sales cycle. In addition, if we proceed with one or more significant acquisitions in which the consideration includes cash, we could be required to use a substantial portion of our available cash to consummate any such acquisition. Acquisitions may result in the incurrence of debt, material one-time write-offs, or purchase accounting adjustments and restructuring charges. They may also result in recording goodwill and other intangible assets in our financial statements which may be subject to future impairment charges or ongoing amortization costs, thereby reducing future earnings. To the extent that we issue new stock or other rights to purchase stock or to generate additional cash, existing stockholders may be diluted and earnings per share may decrease.

While we expect that the overall long-term revenue trend in our software business will continue to increase in response to customer demand, 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. Many customers are engaged in fixed fee contracts and consequently, Strategic Consulting Services revenue and Reporting and Analysis Services revenue can be impacted by milestones that are not completed as expected during the quarter primarily due to client decisions. We have seen a trend develop where more of our projects have become fixed-fee or milestone based, as a result, the timing of completion on milestones may cause fluctuations in quarterly Strategic Consulting Services and Reporting and Analysis Services revenue.

We generate a significant portion of our revenue from a limited number of customers. 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 customers. 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 customers. The loss of one of our large customers would hurt our business and may prevent us from achieving or sustaining profitability.

Our Strategic Consulting Services 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 customers 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 Services group and Reporting and Analysis Services 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 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 customers 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.

 

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Critical Accounting Policies and Estimates

We prepare our financial statements in accordance with generally accepted accounting principles in the United States of America (“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 these accounting policy are critical to fully understand and evaluate our reported financial results.

Revenue Recognition

Our revenues are derived from four primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support (PCS or maintenance services ), (2) services related to scientific and training consulting and software deployment, (3) Strategic Consulting Services and (4) Reporting and Analysis 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 term-based 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, VSOE of fair value to allocate the fee to the separate elements for these arrangements. 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 or the remaining 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 licenses and PCS. Prior to the second quarter of fiscal 2008, we had not established VSOE of fair value to allocate the fee to the separate elements of the arrangement. We recognized revenue attributable to license and PCS ratably over the remaining period of the PCS term once the product was delivered. For financial statement presentation purposes, revenues from arrangements that included perpetual licenses were 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 were recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses. During the second quarter of fiscal 2008, we established VSOE of fair value of the separate elements of our enterprise software products. For perpetual license arrangements, we allocate revenue to delivered components, normally the license component of the arrangement, using the residual method, based on VSOE of fair value of the undelivered elements (generally the maintenance services components), which is specific to us. We determine the fair value of the undelivered elements based on our current price list and the historical evidence of the Company’s sales of these elements to third parties. The revenue attributable to the delivered components is recognized once the implementation and installation services are completed and accepted by the customer and the revenue attributable to the undelivered components is recognized ratably over the period until the services are completed.

We enter into arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. Prior to the second quarter of fiscal 2008, we had not established VSOE of fair value to allocate the fee to the

 

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separate elements of the arrangement. For arrangements involving a significant amount of services related to installation and implementation of our software products, we recognized revenue for the entire arrangement ratably over the remaining period of the PCS term once the implementation and installation services were completed and accepted by the customer. For financial statement presentation purposes, revenues from arrangements that included perpetual and term-based licenses were 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 were recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses. The implementation/installation services revenues were recorded as services revenue in the statement of operations. During the second quarter of fiscal 2008, we established VSOE of fair value of the separate elements of our enterprise software product arrangements. For perpetual license arrangements, we allocate revenue to delivered components, normally the license and installation components of the arrangement, using the residual method, based on VSOE of fair value of the undelivered elements (generally the maintenance services components), which is specific to us. We determine the fair value of the undelivered elements based on our current price list and the historical evidence of the Company’s sales of these elements to third parties. The revenue attributable to the delivered components is recognized once the implementation and installation services are completed and accepted by the customer and the revenue attributable to the undelivered components is recognized ratably over the period until the services are completed.

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 is recognized ratably over the license term when the software is delivered to the distributors and other revenue recognition criteria are met.

Strategic Consulting Services and Reporting and Analysis Services Segments

We enter into arrangements for Strategic Consulting Services contracts and Reporting and Analysis Services contracts, which do not fall under the scope of SOP 97-2. Arrangements for these 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.

 

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

The majority of our Pharsight Knowledgebase Server (“PKS”) software arrangements include software deployment services. Prior to the second quarter of fiscal 2008, we deferred revenue for software deployment services, along with the associated license revenue, until the services were completed. If there was significant uncertainty about the project completion or receipt of payment for the professional services, we deferred revenue until the uncertainty was sufficiently resolved. Starting from the second quarter of fiscal 2008, for PKS perpetual licenses, we allocate revenue to delivered components, normally the license component of the arrangement, using the residual method, based on VSOE of fair value of the undelivered elements (generally the maintenance services components), which is specific to us. We determine the fair value of the undelivered elements based on our current price list and the historical evidence of the Company’s sales of these elements to third parties. The revenue attributable to the delivered components is recognized once the implementation and installation services are completed and accepted by the customer and the revenue attributable to the undelivered components is recognized ratably over the period until the services are completed.

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.

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.

Revenues:

 

     Three Months Ended  
(In thousands, except percentages)    December 31, 2007     December 31, 2006     (%)
Change
 
   Amount    % of Total     Amount    % of Total    

Total revenues:

            

License, renewal and maintenance

   $ 3,564    48 %   $ 2,930    48 %   22 %

Services

     3,809    52 %     3,191    52 %   19 %
                    

Total revenues

   $ 7,373    100 %   $ 6,121    100 %   20 %
                    

Software Products segment revenues:

            

License, renewal and maintenance

   $ 3,564    48 %   $ 2,930    48 %   22 %

Services

     460    7 %     323    5 %   42 %
                    

Total Software Products segment revenues

   $ 4,024    55 %   $ 3,253    53 %   24 %
                    

Strategic Consulting Services segment revenues

   $ 2,980    40 %   $ 2,868    47 %   4 %
                    

Reporting and Analysis Services segment revenues

   $ 369    5 %   $ —      0 %   100 %
                    

 

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     Nine Months Ended  
(In thousands, except percentages)    December 31, 2007     December 31, 2006     (%)
Change
 
   Amount    % of Total     Amount    % of Total    

Total revenues:

            

License, renewal and maintenance

   $ 10,395    50 %   $ 8,785    49 %   18 %

Services

     10,357    50 %     9,048    51 %   14 %
                    

Total revenues

   $ 20,752    100 %   $ 17,833    100 %   16 %
                    

Software products segment revenues:

            

License, renewal and maintenance

   $ 10,395    50 %   $ 8,785    49 %   18 %

Services

     1,460    7 %     1,067    6 %   37 %
                    

Total software products segment revenues

   $ 11,855    57 %   $ 9,852    55 %   20 %
                    

Strategic consulting segment revenues

   $ 8,047    39 %   $ 7,981    45 %   1 %
                    

Reporting and Analysis Services segment revenues

   $ 850    4 %   $ —      0 %   100 %
                    

Total revenues

Revenue for the third quarter of fiscal 2008 increased 20% to $7.4 million, compared to $6.1 million in the same quarter of fiscal 2007. This increase was primarily attributable to a $771,000 increase in Software Products revenue and a $481,000 increase in Services revenue.

Revenue for the nine months ended December 31, 2007 increased 16% to $20.8 million, compared to $17.8 million in the same period in fiscal 2007. This increase was primarily attributable to the growth of sales of our software products, including PKS, Autopilot and desktop products as well as an additional $850,000 in revenue derived from our Reporting and Analysis Services group launched at the beginning of fiscal 2008.

Software Products segment revenues

License, renewal and maintenance revenues. For the three and nine months ended December 31, 2007, software product revenues increased to $4.0 million and $11.9 million, respectively, compared to $3.3 million and $9.9 million in the same periods of fiscal 2007, primarily as a result of increased sales of our software products due to the growth of our commercial customers, increased desktop products prices and our renewal rates remain high. In addition, we established VSOE for our enterprise software products during the second quarter of fiscal 2008 which had a positive impact on our revenue and we introduced WinNonlin Autopilot in the first quarter of fiscal 2008.

For the three and nine months ended December 31, 2007, desktop software products revenues increased to $2.2 million and $6.4 million, respectively, compared with $2.0 million and $6.0 million for the same periods in fiscal 2007 which was primarily due to our renewals rates remain high and the growth of our commercial customers.

PKS software products revenues increased to $765,000 and $2.7 million in the three and nine months ended December 31, 2007, respectively, compared to $697,000 and $2.2 million in the same periods in fiscal 2007. The increase in PKS software products revenues is mainly due to an increase of $108,000 and $379,000, respectively, in renewals by our existing customers as a result of a larger customer base and additional sales of new PKS licenses to five existing PKS customers during the first nine months of fiscal 2008. Furthermore, during the second quarter of fiscal 2008, we established VSOE for PKS related products which had a positive impact of $147,000 on our revenue for the nine months ended December 31, 2007; accordingly, our deferred revenue was decreased by the same amount.

DMX software revenues remained relatively constant at $198,000 and $596,000 in the three and nine months ended December 31, 2007, respectively, compared to $193,000 and $599,000 in the same periods of fiscal 2007.

WinNonlin Autopilot or Autopilot was introduced in the first quarter of fiscal 2008. The revenue generated from sales of Autopilot was $363,000 and $697,000 in the three and nine months ended December 31, 2007, respectively.

 

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Services revenues. Software services revenues were $460,000 and $1.5 million in the three and nine months ended December 31, 2007, respectively, compared to $323,000 and $1.1 million in the same periods in fiscal 2007. The increase in software services revenue for the three and nine months ended December 31, 2007 was primarily due to an increase in the training and various deployment and automation projects executed during fiscal 2008 as compared to the same period in fiscal 2007.

Strategic Consulting Services segment revenues

Strategic Consulting Services segment revenues remained relatively constant at $3.0 million and $8.0 million in the three and nine months ended December 31, 2007, respectively, compared to $2.9 million and $8.0 million in the same periods in fiscal 2007.

Reporting and Analysis Services segment revenues

Reporting and Analysis Services segment was launched in the first quarter of fiscal 2008 and the total revenue generated was $369,000 and $850,000 for the three and nine months ended December 31, 2007. This segment showed a 36% growth in the third quarter of fiscal 2008 compared to the second quarter of fiscal 2008.

Cost of Revenues:

 

               %
Change
    % of Revenues  
     Three Months Ended      Three Months Ended  
(In thousands, except percentages)    December 31,
2007
   December 31,
2006
     December 31,
2007
    December 31,
2006
 

Total revenues

   $ 7,373    $ 6,121    20 %    
                    

License, renewal and maintenance

     73      69    6 %   2 %   2 %

Services

     2,562      1,802    42 %   67 %   56 %
                    

Total cost of revenues

   $ 2,635    $ 1,871    41 %   36 %   31 %
                    

Cost of software Products Services segments revenues:

            

License, renewal and maintenance

     73      69    6 %   2 %   2 %

Services

     457      193    137 %   99 %   60 %
                    

Cost of Software Products Services segment

   $ 530    $ 262    102 %   13 %   8 %
                    

Cost of Strategic Consulting Services segment

   $ 1,879    $ 1,609    17 %   63 %   56 %
                    

Cost of Reporting and Analysis Services segment

   $ 226    $ —      100 %   61 %   —    
                    

 

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               %
Change
    % of Revenues  
     Nine Months Ended      Nine Months Ended  
(In thousands, except percentages)    December 31,
2007
   December 31,
2006
     December 31,
2007
    December 31,
2006
 

Total revenues

   $ 20,752    $ 17,833    16 %    
                    

License, renewal and maintenance

     190      179    6 %   2 %   2 %

Services

     7,156      5,265    36 %   69 %   58 %
                    

Total cost of revenues

   $ 7,346    $ 5,444    35 %   35 %   31 %
                    

Cost of Software Products Services segments revenues:

            

License, renewal and maintenance

     190      179    6 %   2 %   2 %

Services

     1,208      679    78 %   83 %   64 %
                    

Cost of Software Products Services segment

   $ 1,398    $ 858    63 %   12 %   9 %
                    

Cost of Strategic Consulting Services segment

   $ 5,278    $ 4,586    15 %   66 %   57 %
                    

Cost of Reporting and Analysis Services segment

   $ 670    $ —      100 %   79 %   —    
                    

Total cost of revenues

Total cost of revenues were $2.6 million and $7.3 million for the three and nine months ended December 31, 2007, respectively, compared to $1.9 million and $5.4 million in the same periods in fiscal 2007. Cost of revenue is comprised mainly of payroll and payroll related expenses plus royalty expenses and shipping costs. The increase in total cost of revenue is primarily associated with increased payroll and consulting related expenses associated with higher department headcount in fiscal 2008 and the additional costs associated with Reporting and Analysis Services group launched in the first quarter of fiscal 2008. Also included is the allocation of $71,000 and $153,000 of stock-based compensation expense in the three and nine months ended December 31, 2007, respectively, compared to $39,000 and $121,000 in the same periods of fiscal 2007.

Software Products segment

Cost of license, renewal and maintenance revenues. Cost of license, renewal and maintenance revenues primarily consists of royalty expense for third-party software included in our products, and cost of materials for both initial products and product updates provided for in our annual license agreements. Cost of license, renewal and maintenance revenues increased to $73,000 and $190,000 for the three and nine months ended December 31, 2007, respectively, compared to $69,000 and $179,000 in the same periods in fiscal 2007 as a result of higher license, renewal and maintenance revenue.

Cost of services revenues. Cost of services revenues consists of payroll and related costs, travel expenses, facilities and overhead costs associated with our deployment services group. Cost of services revenue was $457,000 and $1.2 million for the three and nine months ended December 31, 2007, respectively, compared to $193,000 and $679,000 in the same periods in fiscal 2007. The increase is primarily due to increased training related events and associated revenue in fiscal 2008, accordingly, cost of services related to training services, deployment and automation projects also increased.

Strategic Consulting Services segment

Cost of services for our Strategic Consulting Services segment consists of payroll and payroll related costs, travel expenses, facilities and overhead costs associated with our strategic consulting personnel. Cost of services for our Strategic Consulting Services segment was $1.9 million and $5.3 million for the three and nine months ended December 31, 2007, respectively, compared to $1.6 million and $4.6 million in the same periods in fiscal 2007. The increase in cost of services

 

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for our Strategic Consulting Services segment for the three months ended December 31, 2007 is primarily due to an increase of $137,000 in payroll due to the increase of department headcount and an $81,000 change in costs associated with the support to Sales and Marketing group. The increase in cost of services for our Strategic Consulting Services segment for the nine months ended December 31, 2007 was primarily due to an increase of $273,000 in payroll and consultant related expenses and a change of $306,000 in costs associated with the support to Sales and Marketing group.

Reporting and Analysis Services segment

Cost of services for our Reporting and Analysis Services segment consists of payroll and payroll related costs, travel expenses, facilities and overhead costs associated with our reporting and analysis personnel. Cost of services for our Reporting and Analysis Services segment was $226,000 and $670,000, respectively for the three and nine months ended December 31, 2007. The headcount for this business unit increased significantly during the nine months ended December 31, 2007 in order to increase our service capacity.

Operating expenses

Research & development

 

                     % of Total Revenues  
     Three Months Ended    %
Change
    Three Months Ended  
(In thousands, except percentages)    December 31,
2007
   December 31,
2006
     December 31,
2007
    December 31,
2006
 

Total revenues

   $ 7,373    $ 6,121    20 %    
                    

Total R&D expenses

   $ 1,181    $ 1,066    11 %   16 %   17 %
                    
                     % of Total Revenues  
     Nine Months Ended    %Change     Nine Months Ended  
(In thousands, except percentages)    December 31,
2007
   December 31,
2006
     December 31,
2007
    December 31,
2006
 

Total revenues

   $ 20,752    $ 17,833    16 %    
                    

Total R&D Expenses

   $ 3,548    $ 3,040    17 %   17 %   17 %
                    

Research and development expenses consist mainly of payroll, payroll related expenses and third-party consulting expenses. Also included is the allocation of $34,000 and $87,000 of stock-based compensation expense in the three and nine months ended December 31, 2007, respectively, compared to $19,000 and $55,000 in the same periods of fiscal 2007.

Research and development expenses were $1.2 million and $3.5 million for the three and nine months ended December 31, 2007, respectively, compared to $1.1 million and $3.0 million for the same periods in fiscal 2007. The percentage of total revenue of research and development expenses remains relatively constant at 17% for the nine months ended December 31, 2007 and 2006, respectively. The increase in research and development expenses for the three months ended December 31, 2007 compared to the same period in fiscal 2007 was primarily due to an increase of $70,000 in costs associated with various R&D projects. The increase in research and development expenses for the nine months ended December 31, 2007, compared to the same period in fiscal 2007 was primarily due to a $312,000 increase in payroll and consulting related expenses due to increased department headcounts and an increase of $123,000 in costs associated with various R&D projects.

Sales and marketing

 

                     % of Total Revenues  
     Three Months Ended    %
Change
    Three Months Ended  
(In thousands, except percentages)    December 31,
2007
   December 31,
2006
     December 31,
2007
    December 31,
2006
 

Total revenues

   $ 7,373    $ 6,121    20 %    
                    

Total sales and marketing

   $ 1,702    $ 1,628    5 %   23 %   27 %
                    
                     % of Total Revenues  
     Nine Months Ended    %
Change
    Nine Months Ended  
(In thousands, except percentages)    December 31,
2007
   December 31,
2006
     December 31,
2007
    December 31,
2006
 

Total revenues

   $ 20,752    $ 17,833    16 %    
                    

Total sales and marketing

   $ 4,980    $ 4,581    9 %   24 %   26 %
                    

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 the allocation of $132,000 and $361,000 of stock-based compensation expense in the three and nine months ended December 31, 2007, respectively, compared to $80,000 and $236,000 in the same periods of fiscal 2007.

 

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Sales and marketing expenses were $1.7 million and $4.9 million for the three and nine months ended December 31, 2007, respectively, compared to $1.6 million and $4.6 million for the same periods in fiscal 2007. The increase in sales and marketing expenses in absolute dollars for the three months ended December 31, 2007 compared to the same period in fiscal 2007 was primarily due to an increase of $122,000 in payroll related expenses due to higher department headcount. The increase in sales and marketing for the nine months ended December 31, 2007, compared to the same period in fiscal 2007 was primarily partially due to an increase of $630,000 in payroll related expenses due to higher department headcount and an increase of $125,000 in stock compensation expenses.

General and administrative

 

                     % of Total Revenues  
     Three Months Ended    %
Change
    Three Months Ended  

(In thousands, except percentages)

   December 31,
2007
   December 31,
2006
     December 31,
2007
    December 31,
2006
 

Total revenues

   $ 7,373    $ 6,121    20 %    
                    

Total general and administrative

   $ 1,416    $ 1,139    24 %   19 %   19 %
                    
                     % of Total Revenues  
     Nine Months Ended    %
Change
    Nine Months Ended  
(In thousands, except percentages)    December 31,
2007
   December 31,
2006
     December 31,
2007
    December 31,
2006
 

Total revenues

   $ 20,752    $ 17,833    16 %    
                    

Total general and administrative

   $ 4,089    $ 3,971    3 %   20 %   22 %
                    

General and administrative expenses consist primarily of personnel costs of executive officers and support personnel, facilities, investor relations, insurance, legal and accounting fees. Also included is the allocation of $109,000 and $280,000 of stock-based compensation expense in the three and nine months ended December 31, 2007, respectively, compared to $57,000 and $208,000 in the same periods of fiscal 2007.

General and administrative expenses were $1.4 million and $4.1 million in the three and nine months ended December 31, 2007, respectively, compared to $1.1 million and $4.0 million in the same periods in fiscal 2007. The increase in general and administrative expense in absolute dollars and as a percentage of revenue in the three months ended December 31, 2007 was primarily as a result of an increase of $94,000 in payroll and payroll related expenses due to increased department headcounts, an $81,000 increase in legal fees, mainly associated with relisting on Nasdaq Stock Market and various increases from miscellaneous items. The general and administrative expenses for the nine months ended December 31, 2007 remained relatively constant at $4.1 million, compared to $4.0 million for the same period ended December 31, 2006.

Stock-Based Compensation

The below table summarizes the stock-based expenses recorded during the three and nine months ended December 31, 2007 and 2006 (in thousands):

 

     Three Months Ended    Nine Months Ended
     December 31,
2007
   December 31,
2006
   December 31,
2007
   December 31,
2006

Cost of revenues

   $ 71    $ 39    $ 153    $ 121

Research and Development

     34      19      87      55

Sales and marketing

     132      80      361      236

General and administrative

     109      57      280      208
                           

Total

   $ 346    $ 195    $ 881    $ 620
                           

The Compensation Committee of the Board of Directors reviews and approves the organization-wide stock option grants. The stock-based compensation expenses were $346,000 and $881,000 for the three and nine months ended December 31, 2007, respectively, compared to $195,000 and $620,000 for the same periods in fiscal 2007. The increases in stock-based compensation expenses in fiscal 2008 were primarily due to increased company-wide headcount, changes of expected life and volatility of stock options and fluctuation of our forfeiture rates.

 

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Provision for Income Taxes

Year over year comparison for the three and nine months ended December 31, 2007 and 2006 (in thousands):

 

     Three Months Ended     Nine Months Ended  
     December 31,
2007
    December 31,
2006
    (%) Change     December 31,
2007
     December 31,
2006
     (%) Change  

Provision for income taxes

   $ (46 )   $ (12 )   283 %   $ (96 )    $ (86 )    12 %

Provisions for income taxes for the three months ended December 31, 2007 and 2006 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.

Reverse Stock Split

On October 18, 2007, the Company’s Board of Directors approved a 1-for-3 reverse split of its common stock, following approval by the Company’s stockholders on August 8, 2007. The reverse stock split was effective at 5:00 pm on November 13, 2007. As a result, the Company’s issued and outstanding common stock was reduced from approximately 28.2 million to approximately 9.4 million shares. The par value of the common stock was not affected by the reverse stock split and remains at $0.001 per share. All per share amounts and outstanding shares, including all common stock equivalents (stock options, warrants, preferred stocks, other equity incentive awards and equity compensation plans) have been restated in the Condensed Consolidated Financial Statements, Notes to the Condensed Consolidated Financial Statements and this Item 2 for all periods presented to reflect the reverse stock split.

Liquidity and Capital Resources

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

 

     December 31
2007
    March 31
2007
    $ Change     % Change  

Cash and cash equivalents

   $ 8,663     $ 7,829     $ 834     11 %
                    

Short-term investments

   $ 6,408     $ 6,836     $ (428 )   (6 %)
                    

Working capital

   $ 7,446     $ 5,305     $ 2,141     40 %
                    
     Nine Months Ended  
     December 31  
     2007     2006     $ Change     % Change  

Net cash used in operating activities

   $ 1,224     $ 3,127     $ (1,903 )   (61 %)
                    

Net cash used in investing activities

   $ (19 )   $ (6,401 )   $ 6,382     (100 %)
                    

Net cash used in financing activities

   $ (339 )   $ (564 )   $ 225     (40 %)
                    

Cash, Cash Equivalents and Short-Term Investments. As of December 31, 2007, 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 and cash equivalents during the nine months ended December 31, 2007, compared to March 31, 2007 was attributable to income generated during the period, partially offset by an increase of $1.2 million in account receivable driven by the timing of the revenue generated and cash collections. At December 31, 2007, our current working capital, defined as current assets less current liabilities, increased to $7.4 million. Included as a reduction to working capital is deferred revenue of $8.1 million, which will not require cash to settle, but will be recognized as revenue in the future. We believe that our existing cash balances will be sufficient to meet our working capital requirements for at least

 

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the next 12 months. However, if we proceed with one or more significant acquisitions in which the consideration includes cash, we could be required to use a substantial portion of our available cash to consummate any such acquisition. Acquisitions may result in the incurrence of debt, material one-time write-offs, or purchase accounting adjustments and restructuring charges. They may also result in recording goodwill and other intangible assets in our financial statements which may be subject to future impairment charges or ongoing amortization costs, thereby reducing future earnings. To the extent that we issue new stock or other rights to purchase stock or to generate additional cash, existing stockholders may be diluted and earnings per share may decrease.

Cash Flows for Operating Activities. Cash flows provided by operating activities decreased in the first nine months of fiscal 2008 compared to the same period of fiscal 2007 primarily due to an increase in accounts receivable of $1.2 million driven by the timing of the revenue generated and cash collections during the period, a decrease in deferred revenue of $202,000, partially offset by an increase of non-cash items of $425,000. Such items include depreciation, amortization, preferred stock conversion and stock-based compensation expenses. Our accounts receivable and deferred revenue balances fluctuate from period to period and are primarily dependent on the timing of the closure of our license agreements, the related invoicing and payment provisions and collections.

Cash Flows for Investing Activities. Cash used in investing activities during the first nine months of fiscal 2008 was primarily related to the purchases and sales of short-term investments and miscellaneous asset purchases of capital equipment necessary for our ongoing operations. Cash used in investing activities decreased in the nine months of fiscal 2008 compared to the same period of fiscal 2007 primarily due to the proceeds from sales of short term investments.

Cash Flows for Financing Activities. Cash used in financing activities the first nine months of fiscal 2008 decreased to $339,000 compared to $564,000 for the same period of fiscal 2007. Cash used in financing activities in the first nine months of fiscal 2008 was primarily the result of a $392,000 payment against our outstanding loan facilities with Silicon Valley Bank and a $73,000 payment of dividends to our preferred stockholders, offset by the receipt of $126,000 in proceeds from sales of common stock.

Credit Facilities and Loans. We have a credit facility with Silicon Valley Bank (the “Bank”), providing for up to $5 million in borrowings, secured by eligible accounts receivable. On June 21, 2007, we entered into the Seventh Amendment to the Loan and Security Agreement (the “Seventh Amendment “) with the Bank. The Seventh Amendment amends in part Section 2.1 of the Loan and Security Agreement to decrease the Quick Ratio from at least 2.00 to 1.00 to at least 1.75 to 1.00 and amends Section 2.2 of the Loan and Security Agreement by increasing the “Committed Revolving Line” from $3 million to $5 million. If our modified quick ratio is equal to 1.75:1 or greater, the Bank may include foreign accounts receivable to determine eligible receivables. However, if the modified quick ratio is less than 1.75:1, all or a portion of foreign accounts may be excluded from eligible account receivables. There was no outstanding borrowing under this facility as of December 31, 2007.

We 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, we secured an additional term loan for the purchase of a new financial system, which was added to the existing term loan. The $300,000 additional term loan was payable over 36 months. In addition, we secured an equipment credit facility through June 2006 for up to $600,000. Each advance was payable over 36 months. On August 9, 2007, we paid off the remaining balances for both loans.

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.

On June 27, 2007, all of the holders of preferred stock elected to convert all of their shares of preferred stock into shares of common stock. Each share of preferred stock was convertible into four shares of common stock. As a result of conversion, our outstanding shares of common stock increased by 2,685,628 shares and we recorded a $7 million deemed dividend which represented the excess of (1) the fair value of all securities and other consideration transferred in the transaction by the Company to the holders of the convertible preferred stock over (2) the fair value of securities issuable pursuant to the shareholders in the calculation of earning per shares.

 

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As of December 31, 2007, the total number of shares underlying the outstanding warrants was 694,438 on a post reverse stock split basis. The exercise prices ranged from $0.75 per share to $21.60 per share. The warrants issued in connection with the 2002 private investment were originally exercisable for a period of five years from issuance. 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 Company’s registration statement covering the resale of the common stock issuable upon exercise of the warrants has not been effective since November 2002. If not exercised after the extended expiration date, the right to purchase the common stock will terminate. The warrants contain a cashless exercise feature. The common stock issuable upon exercise of the warrants is entitled to the benefits and is subject to the terms of a registration right agreement.

Contractual Commitments. As of December 31, 2007, we have operating leases of our facilities that expire at various times through fiscal years 2010 and 2011. These arrangements allow us to obtain the use of the equipment and facilities without purchasing them. If we were to acquire these assets, we would be required to obtain financing and record a liability related to the financing of these assets or we would need to utilize upfront cash flow to purchase them. During the three and nine months ended December 31, 2007, we recorded rent expense of $123,000 and $326,000, respectively.

The following is a summary of our contractual commitments associated with our debt and lease obligations as of December 31, 2007 (in thousands):

 

Contractual Obligations

   Total    Less Than 1
Year
   1-3 Years    4-5 Years

Operating leases

   $ 1,447    $ 479    $ 888    $ 80
                           

Total commitments

   $ 1,447    $ 479    $ 888    $ 80
                           

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 fiscal 2007, fiscal 2006 and 2005. However, there is no assurance that we can continue to maintain positive cash flow quarterly or annually, we experienced negative operating cash flow in some quarters due to timing of normal payments during the quarter. 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 for the next twelve months.

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. 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. 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

We had cash, cash equivalents and short-term investments totaling $15.1 million at December 31, 2007. 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.

 

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ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

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 our 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 Exchange Act 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 SEC 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, 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

We are in the process of reviewing and analyzing our system of internal controls as we prepare for our first management report on the effectiveness of internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002 for fiscal 2008. Beginning with our annual report for fiscal 2009, we must comply with the auditor attestation requirement of Section 404 of the Sarbanes – Oxley Act of 2002 as the initial attestation report from our external auditor on our internal controls will be required.

 

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PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

From time to time, Pharsight may become involved in claims, legal proceedings, or state or federal government agency proceedings that arise in the ordinary course of its business. We are not currently a party to any material litigation and are currently not aware of any pending or threatened litigation that could have any material adverse effect upon our business, operating results or financial condition.

 

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.

Risks That Affect Our Future Operations

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 quarter until attaining profitability in the fourth quarter of fiscal 2004. While we have maintained annual profitability for fiscal 2005, 2006 and 2007, as of December 31, 2007, we had an accumulated deficit of $73.3 million. We may incur losses again as we continue to develop our business. Our ability to sustain profitability is based on a number of assumptions, including some outside of our control, including the state of the overall economy and the demand for our products. If these assumptions do not prove to be accurate then we may not be able to generate sufficient revenues to sustain profitability. Furthermore, even if we do sustain profitability and positive operating cash flow, we may not be able to increase profitability or positive operating cash flow on a quarterly or annual basis. If our profitability does not meet the expectations of investors, the price of our common stock may decline.

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

We believe we have adequate cash to sustain operations through the next 12 months, and we are managing the business to achieve positive cash flow utilizing existing assets. However, even if we sustain profitability, we may not be able to generate sufficient profits to grow our business. As a result, we may need to raise additional funds through public or private financings or other sources to fund our operations. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and incur additional indebtedness. If we proceed with one or more significant acquisitions in which the consideration includes cash, we could be required to use a substantial portion of our available cash to consummate any such acquisition. Acquisitions may result in the incurrence of debt, material one-time write-offs, or purchase accounting adjustments and restructuring charges. They may also result in recording goodwill and other intangible assets in our financial statements which may be subject to future impairment charges or ongoing amortization costs, thereby reducing future earnings. To the extent that we issue new stock or other rights to purchase stock or to generate additional cash, existing stockholders may be diluted and earnings per share may decrease.

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;

 

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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;

 

   

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

 

   

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

 

   

Unanticipated changes in the capacity of our services organization;

 

   

Delays or deferrals of customer implementations of our software products;

 

   

Delays or deferrals of client drug development processes;

 

   

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

 

   

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

 

   

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

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

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

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

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

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

 

   

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

 

   

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

 

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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. 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 services revenue as a percentage of total revenue, or a decrease in software license revenue as a percentage of total revenue, may decrease our overall margins.

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

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

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

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

We receive a substantial majority of our revenue from a limited number of customers. For fiscal 2007, 2006 and 2005, sales to our top two customers accounted for 28%, 42% and 45% of total revenue, respectively and sales to our top five customers accounted for 43%, 52% and 62% of total revenue, respectively. In fiscal 2007, Pfizer, our largest customer, accounted for 17% of our total revenue, and Eli Lilly accounted for 11% of our total revenue. In fiscal 2006, Pfizer accounted for 25% of our total revenue and Eli Lilly accounted for 17% of our total revenue. In fiscal 2005, Pfizer accounted for 25% and Eli Lilly accounted for 20% of our total revenue. During the nine months ended December 31, 2007, sales to Pfizer and Lily were 13% of our total revenue. Our top two customers changed to Pfizer and Daiichi Sankyo Inc, or Daiichi and the sales to these two customers were 10% and 6% of our total revenue, respectively. The totals sales to the top two customers accounted for 16% of our total revenue during the nine months ended December 31, 2007, decreased from 29% of the same period of fiscal 2007. We are dependent on Pfizer, Eli Lilly or Daiichi for a substantial portion of our revenues, and if we were to lose Pfizer, Eli Lilly or Daiichi as a customer, it would have a material adverse effect on our revenues and business. We expect that a significant portion of our revenue will continue to depend on sales to a small number of customers. In addition, the worldwide pharmaceutical industry has undergone, and may in the future undergo, substantial consolidation, which may further reduce the number of our existing and potential customers. If we do not generate as much revenue from these major customers as we expect to, if revenue from such customers is delayed, or if we lose any of them as customers, our total revenue may be significantly reduced.

 

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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.

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

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

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

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

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

 

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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.

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 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.

 

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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 revenue for fiscal 2007, 2006 and 2005 were approximately 34%, 24% and 22%, respectively. International sales of our products and services as a percentage of our total revenue for the three and nine months ended December 31, 2007 was 32% and 33%, respectively. We have a total of 22 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.

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.

 

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While we believe we currently have adequate internal control over financial reporting, we will be required, as of March 31, 2008, to evaluate and report on the effectiveness of our internal control under Section 404 of the Sarbanes-Oxley Act of 2002 and any adverse results from the evaluation and reporting 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.

While we currently believe our internal control over financial reporting is effective, we are in the process of system and process documentation and evaluation needed to comply with Section 404, which is both costly and challenging. During this process, if our management identifies one or more material weaknesses in our internal control over financial reporting, and those weaknesses are not appropriately remediated prior to March 31, 2008, we will be unable to assert such internal control is effective. If we are unable to assert that our internal control over financial reporting is effective as of March 31, 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.

In July 2007, the Securities and Exchange Commission approved the Public Company Accounting Oversight Board, or PCAOB, Auditing Standard No. 5, “An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements”. Auditing Standard No. 5 (“AS 5”) replaces the PCAOB’s previous internal control auditing standard, Auditing Standard No. 2. The new standard applies to audits of all companies required by SEC rules to obtain an audit of internal control. AS 5 is a principles-based framework that focuses the internal control audit on the most important matters and eliminates procedures that are unnecessary to achieve the intended benefits. It 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. Beginning with our annual report for the fiscal year ended March 31, 2009, we must comply with the auditor attestation requirements of Section 404.

While we currently anticipate being able to satisfy the requirements of Section 404 in a timely fashion, we cannot be certain as to the timing of completion of our evaluation, testing and any required remediation due in large part to the fact that there is no precedent available by which to measure compliance with new Auditing Standard No. 5. If we are not able to comply with the requirements of Section 404 in a timely manner or if our independent registered public accounting firm is not able to complete the procedures required by Audit Standard No. 5 to support their attestation report, we would likely 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 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 United States Food and Drug Administration or comparable international agencies do not directly regulate the majority our products and services, 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. In addition, our Reporting and Analysis Services are subject to various regulatory requirements designed to ensure the quality and integrity of the data or products of these services. These regulations are governed primarily by good laboratory practice, or GLP, and good clinical practice, or GCP, guidelines mandated by the FDA. 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

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 management; and

 

   

changes in the conditions and trends in the pharmaceutical market.

For instance, before our reverse stock split on November 13, 2007, the trading price of our common stock closed as low as $1.21 and as high as $1.85 per share during fiscal 2007. 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.

 

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Our principal stockholders will have a controlling influence over our business affairs and may make business decisions with which you disagree and which may adversely affect the value of your investment.

Our executive officers, directors, major stockholders and their affiliates beneficially own or control, indirectly or directly, a substantial number of shares of our common stock. As a result, if some of these persons or entities act together, they will have the ability to control matters submitted to our stockholders for approval, including the election and removal of directors, amendments to our certificate of incorporation and bylaws, and the approval of any business combination. These actions may be taken even if they are opposed by other stockholders. This concentration of ownership may also have the effect of delaying or preventing a change of control of our company or discouraging others from making tender offers for our shares, which could prevent our stockholders from receiving a premium for their shares.

 

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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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: February 12, 2008

 

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

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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