Quest Software 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the Fiscal Year Ended December 31, 2006
For the Transition Period from ________ to ________.
Commission File No. 000-26937
QUEST SOFTWARE, INC.
(Exact Name of Registrant as Specified in its Charter)
Registrants Telephone Number, Including Area Code: (949) 754-8000
Securities Registered Pursuant to Section 12(b) of the Act:
Securities Registered Pursuant to Section 12(g) of the Act: Common Stock
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act.
Yes ¨ No x
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 ¨ No x
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (check one):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
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 aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $1.1 billion as of June 29, 2007, based upon the closing sale price reported for that date on The Nasdaq Global Select Market.
As of November 15, 2007, 102,154,171 shares of the Registrants common stock were outstanding.
Documents Incorporated by Reference
TABLE OF CONTENTS
Discussions under the captions Business, Risk Factors, and Managements Discussion and Analysis of Financial Condition and Results of Operations include or may include forward-looking statements within the meaning of the federal securities laws. We have based these forward-looking statements on currently available information and our current beliefs, expectations and projections about future events. All forward-looking statements contained herein are subject to numerous risks and uncertainties. Our actual results and the timing of certain events could differ materially from those projected in the forward looking statements due to a number of factors discussed under the heading Risk Factors in this Report and in our other filings with the Securities and Exchange Commission (SEC). Should one or more of these risks or uncertainties materialize, or should the underlying estimates or assumptions prove incorrect, actual results or outcomes may vary significantly from those suggested by forward-looking information. Any forward-looking statements contained in this document are based on information available at the time of filing and we make no undertaking to update any of these forward-looking statements.
This Annual Report on Form 10-K of Quest Software, Inc. for the year ended December 31, 2006 reflects the restatement of our consolidated financial statements for the years ended December 31, 2005 and 2004, and the notes related thereto. This Report also includes the restatement of our selected consolidated financial data as of and for the fiscal years ended December 31, 2005, 2004, 2003 and 2002, which is included in Item 6, and a restatement of our unaudited quarterly financial data for each of the quarters in the fiscal year ended December 31, 2005 and for the quarter ended March 31, 2006 which is included in Item 8. Item 8 of this Report also includes unaudited quarterly financial data for each of the quarters ended June 30, 2006 and September 30, 2006, which data were not previously filed. The Companys decision to restate its accounting for employee stock options was based on the results of a voluntary, independent investigation of its historical stock option granting practices and related accounting that was conducted by a Special Committee of the Companys Board of Directors.
In May 2006, we formed a special committee of the Companys Board of Directors, comprised of two independent directors (the Special Committee), to conduct an investigation into our historic stock option granting practices and related accounting. The investigation was conducted with the assistance of independent outside legal counsel and outside forensic accounting consultants. The background, scope and findings of the investigation are more fully described in Part II, Item 7 of this Report.
As a result of the Special Committees investigation and managements review of its findings, we have determined that the accounting measurement dates for most of the stock option grants we awarded during the period from June 1998 to April 2002 were not determined in accordance with Generally Accepted Accounting Principles (GAAP). Accordingly we have applied revised measurement dates for financial accounting purposes to those option grants and corrected our accounting for such awards.
The Company determined revised accounting measurement dates for options to purchase approximately 21.8 million shares of Common Stock granted in 3,324 awards on 56 grant dates during the period from June 1998 to April 2002. The Company also determined revised accounting measurement dates for options to purchase 778,250 shares of Common Stock granted in 58 individual awards made after April 30, 2002 through December 2005. As a result, the Company recorded $136.9 million in additional stock-based compensation expense on a pre-tax basis for the years 1999 through 2005. The additional stock-based compensation expense is net of forfeitures related to employee terminations. To determine revised measurement dates, management evaluated all of the available evidence. For those grants where the revised measurement date could not be determined with certainty, management applied judgment to determine what it believes to be the most appropriate accounting measurement date in accordance with GAAP, and considered what different amounts of additional compensation expense that would have resulted had different dates been selected. For a discussion of the judgments underlying the revised measurement dates, see Managements Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of this Report.
The stock option accounting errors corrected in the restatement were primarily caused by inadequate procedures and controls for stock option granting activity. For most of the grants requiring measurement date changes, the process of obtaining formal approvals of the Companys Board of Directors or Compensation Committee was generally not completed until after the grant date. For some grants, the Company also had not finalized the recipients and amounts of these options on the originally stated grant date. The Special Committee also concluded that grant dates and exercise prices for many stock options granted during the period from October 1999 to April 2002 were determined retrospectively by means of an
administrative practice initially designed for monthly processing of option grants to new employees whereby the grant date was determined to be the date during the month of the employees hiring when the Companys closing stock price had reached its lowest level during the month. This practice was expanded to include option grants to existing employees and, in some cases, the period was expanded from a monthly determination to a quarterly determination. This practice was discontinued after the April 2002 grants.
From May 2002 through December 2005, the Company made significant changes in its stock option granting practices, processes and controls. These changes included revising the form of the unanimous written consent used to document Compensation Committee actions to include an execution date and a delegation of authority by the Board of Directors to a Secondary Committee, consisting of the Companys Chairman and Chief Executive Officer, to approve option grants subject to certain parameters. Grants to officers and directors and other grants outside of the delegation parameters continued to require Compensation Committee approval but the delegation of authority significantly reduced the number of grants that required Compensation Committee approval. The additional compensation expense resulting from the correction of accounting for options granted after April 2002 was not material to any subsequent interim or annual financial statement period.
The Special Committee made no finding of fraud or intentional misconduct by any current or former employees, officers or directors, and concluded that no further changes in the companys executive officers will be recommended.
We are also recording approximately $5.4 million of pre-tax accounting adjustments for the years 1999 through December 31, 2005 relating to stock option modifications, repricings of stock option grants and other errors in accounting for stock option transactions with our employees and consultants. The Company also determined that additional errors in its historical financial statements require correction as part of the restatement.
The cumulative effect of all restatement adjustments for periods before 2004 is reflected as an adjustment to our accumulated deficit as of January 1, 2004 from $(47.1) million to $(139.4) million. The cumulative after tax impact to net income for all of the periods effected by the restatement was $96.0 million.
For a detailed description of the restatement, see Note 2, Restatement of Previously Issued Financial Statements to the accompanying audited consolidated financial statements and the section entitled Restatement in Managements Discussion and Analysis of Financial Condition and Results of Operations contained in Item 7 of this Report.
Unless otherwise noted, all of the information in this Annual Report on Form 10-K is as of December 31, 2006. This Report does not reflect any events that occurred after December 31, 2006 other than the Special Committee investigation, resulting restatements and related matters, and Note 15 Subsequent Events of our Notes to Consolidated Financial Statements. Our previously filed financial statements for the quarter ended March 31, 2006 will be restated in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2007.
We have not amended and do not intend to amend any of our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods affected by the restatement. For this reason, the consolidated financial statements and related financial information contained in any related previously filed financial reports for periods affected by the restatement, and related opinions of the Companys independent registered public accounting firm, should not be relied upon.
Quest Software, Inc. (Quest, the Company, we, us or our) designs, develops, markets, distributes and supports enterprise systems management software products. Our goal is to provide our customers with products that improve the performance, productivity and reliability of their software applications and associated software infrastructure components such as databases, application servers and operating systems. Quest is an Independent Software Vendor, or ISV, a company whose products are designed to support or to interact or interoperate with other vendors software or hardware platforms. As such, we continually strive to innovate and evolve our product portfolio to support the dynamic nature of our markets as well as those of our customers IT environments. Our success has been predicated on identifying large and growing markets, developing and acquiring new products and technologies and then leveraging our sales organization and installed base to further our growth. While the company began as a provider of tools and solutions for the Oracle database, we continued to expand our offerings into other markets such as Application Performance Management and Windows
Management. Most recently, the success of Virtualization as a platform has created new opportunities for Quest solutions and we entered that market with a key majority investment in late 2005 to serve as the underpinning of the entry into this market-space. We believe that this will bring Quest into a new era of management products where we can leverage our expertise in managing the physical IT assets which have already been deployed over the years while also supporting newer virtualization based solutions that customers are utilizing to support their dynamic environment.
We generate revenues by licensing our software products, principally on a perpetual basis, and by providing support, maintenance and implementation services for these products. As such, our reportable operating segments are Licenses and Services. The Licenses segment develops and markets licenses to use our software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to our software products. We have a large product portfolio of high-value products that include very technically complex solutions focused on improving the management and performance of mission-critical software applications and the underlying component infrastructure. We also have volume products and software tools that enable our customers to reduce capital and operating expenditures or leverage existing investments in personnel and IT systems. An active acquisition program is an important element of our corporate strategy and has served as a key mechanism upon which to broaden our product portfolio and enter new markets. This is evidenced by the entrance into both the Application Management and Windows Management businesses, both through a series of key acquisitions which served to propel the company beyond its Database Management roots. Within the last three fiscal years, we have invested over $290.0 million, in the aggregate, to acquire a number of companies. Our acquisition strategy is directed to broaden our product portfolio and strengthen our competitive position against both direct competitors and the continual improvements made by the platform vendors.
Our primary portfolio of software products includes software solutions grouped into three categories: 1) Application Management, 2) Database Management and 3) Windows Management. Examples of the benefits delivered by our products include:
Application Management is a core competency and is predicated on ensuring performance and availability of mission-critical applications throughout their life cycle. In the last two years we have made significant investments in the form of hiring experienced developers, product managers and others with marketing expertise to improve and broaden our suite of solutions for Application Management. Presently, our products are focused on the monitoring and performance management of customers primary enterprise software applications, whether packaged or custom-developed. These applications are complex in that they traverse every layer of the IT stack including storage, databases, application servers, web servers and the actual network itself all of which adds to the complexity of managing this environment. Historically speaking, the management of these applications was sequestered amongst each physical layer of the stack. As applications themselves became more complex over time and the need for our customers to improve application service levels became a market requirement, we embarked on a comprehensive research and development effort to build new product solutions which would unify a set of existing tools and create new functionality to support the current customer demand profile. Today, customers require a solution which not only manages application service levels, and helps diagnose the root causes of performance problems but also integrates and supports means to provide necessary corrective action. Our success within the market and current strategic focus for building increased capabilities is based upon the fact that packaged and custom-developed applications run within multi-vendor infrastructure environments. This means that customers have a myriad of platforms and investments they have deployed over the years and require tools that manage the breadth and depth of their environments. From a breadth perspective, our products manage custom web-based applications written in Java and .NET as well as packaged applications, such as PeopleSoft, Oracle E-Business Suite and SAP. From a depth perspective, our products cover key databases such as Oracle, DB2 and SQL Server as well as Oracle and BEA application servers and all key web servers in todays market. Quest is in a unique position to provide this solution by leveraging existing products in our other product areas such as Database Management and Windows Management, which in certain cases, can be coupled with new solutions to be delivered in our Application Management product set in 2007.
Database Management is a market where we initially built an industry-leading reputation and today continues to represent a core technical strength for the company. While our revenue growth rate in this area has declined by comparison to our other product areas, our Database Development products have gained wide acceptance in the market and continue to generate a significant amount of cash flow for the company. As databases continue to grow in size, complexity and mission
criticality every year the environments in which they are deployed require higher levels of service and thus more advanced tools and solutions to support their operation. As such, the predominant customer environment is comprised of a heterogeneous mix of database platforms which are fronted by a wide array of application and web servers all of which must be orchestrated to support a business service. This complex environment requires a vendor to offer a broad tool-set in order to be successful in the market. Our products are marketed to database administrators (DBA) and developers and are designed to improve database performance and to increase the level of productivity for those database developers responsible for the efficient and accurate deployment of mission-critical databases. Historically, our products and early success were focused within the Oracle segment of the database market and we are currently recognized as a leading Oracle ISV. However, within the last few years, Oracle has introduced products that compete directly with our Shareplex, Quest Central for Oracle and TOAD products. This in turn has negatively impacted our ability to grow revenues for certain of these products as we have in the past. In order to diversify our database business, enhance our ability to sustain revenue growth, and in direct response to the heterogeneous nature of our customers database profile, we embarked on a strategy to build and acquire products which addressed similar customer needs on other database platforms such as IBMs DB2 and Microsofts SQL Server. More specifically, in 2001, we introduced database management tools offerings for DB2 and in the last few years, we entered the SQL Server market. Within our database management product line those products aligned with SQL Server have been the fastest growing products. To capitalize on this trend and further accelerate our move into the SQL Server market we acquired Imceda Software, Inc. in 2005. Imceda Software expanded our offerings by delivering products for backup, recovery and security auditing solutions for SQL Server.
Our Windows Management product portfolio has been the driver of our revenue growth during the last few years. Our portfolio of products has been built by key acquisitions such as FastLane Technologies, Inc. and Aelita Software Corporation in addition to core development and new product innovation. As we continue to recognize Microsofts ubiquity throughout our customer base, our strategy has been to identify areas within Microsoft Windows Server, Active Directory and Exchange platforms where we can broaden the core functionality a customer receives out of the box. Active Directory is an essential part of Microsofts Windows architecture that acts as the central authority to define and maintain the network infrastructure, perform system administration and control the user experience of a customers Microsoft infrastructure, including Microsoft Exchange, Microsofts widely used email system. When an individual logs onto his or her employers e-mail system, for example, he or she is logging on through Active Directory, which stores and verifies the persons passwords, access rights and system profiles. Active Directory is a powerful system that is gaining wider acceptance as a primary system for controlling and validating user access rights, with Microsofts desktop predominance driving this trend. We believe Microsoft Active Directory will continue to play a strategic role in the enterprise. During 2005, we introduced products to extend Active Directory throughout the heterogeneous enterprise with integration and support for both Linux and UNIX. These products were based upon the products and technologies from Vintela, Inc. which we acquired in July 2005. We also acquired products to assist customers with the migration to the Exchange platform whether they were on earlier versions of a Microsoft product or other messaging systems including Domino/Notes or GroupWise. With our acquisition of AfterMail Limited in January of 2006, we expanded the messaging platforms supported by Quests archive solution from purely Microsoft Exchange to heterogeneous enterprises using IBM Lotus Notes, Novell GroupWise, Sendmail and other SMTP-based systems.
We invest a significant portion of our cash flow into our product development and management capabilities, and just over one-third of our employees work in product development, quality assurance or technical documentation roles. Given that we have a large number of products, many of which must perform across different combinations of existing infrastructure within our customers IT configurations, we spend a significant amount of our R&D efforts to ensure that our products work consistently within heterogeneous IT environments. For example, a particular customer that deploys an Oracle financial application on an Oracle application server with an Oracle database will generally get different performance characteristics than if it was deployed on a BEA application server with a DB2 database. For Quest, that means we need to test, evaluate and build capabilities within our products that help our customers manage these subtle differences which requires an extended effort to capture the potential and associated combinations and permutations of a customers infrastructure. A large proportion of our R&D organization supports and develops existing products lines. As we increasingly seek new product opportunities within emerging markets, we have at times successfully leveraged our expertise from current products. An example of this is our entrance into the Sharepoint market with products that share some technical aspects found in a few of our other products. In other instances where time to market is essential, we have supplemented our own technical efforts with acquisitions of technology and products from acquired companies such as we did with Aftermail Limited which accelerated our move into the messaging market. In building our products, we stress technical innovation and depth, ease of deployment, ease of use and tangible, readily articulated and measurable customer benefits. We sell our products primarily via our direct field sales force and, increasingly, our telesales organization, supplemented by indirect sales through resellers and distributors. We have offices located in 29 countries worldwide.
We are a California corporation incorporated in 1987. Our principal offices are located at 5 Polaris Way, Aliso Viejo, California, 92656. We operate on a calendar fiscal year.
Solutions, Products and Services
Our products, known for achieving operational excellence, are also used to solve some of todays toughest information technology (IT) challenges, such as achieving compliance, managing complex applications and simplifying identity management. We have three go-to-market strategies that are utilized in the sales process; Achieving Compliance, Managing Complex Applications and Simplifying Identity Management.
We market products grouped along three main categories: 1) Application Management, 2) Database Management and 3) Windows Management. Major products in these categories are described as follows.
Our Application Management products are focused on bringing automation to the tasks performed by the IT organization to manage the complexity of the application lifecycle. Our flagship product for Application Management is Foglight while Spotlight, PerformaSure and JProbe products, the latter two focused on J2EE applications, round out the remainder of our offerings. In the last few years we undertook a significant effort to update Foglight. Foglight Version 5.0 was released in mid-2007. The goal was to evolve an architecture which was bred in the era of broad application level monitoring to a dynamic solution designed to help customers manage their Business Services requirements complete with service dependency mapping, customizable policies and process workflows. Our products can be targeted at both pre-production and production environments and as such, we combine these products into suites which pair business-centric views of applications with deep domain expertise to both measure and improve the performance of packaged and custom applications.
Application Assurance Suite for Java & Portals. Custom-developed J2EE (Java 2 Enterprise Edition) applications require a unique set of performance management solutions to assure performance and reliability across the entire application lifecycle. We provide an integrated solution designed to help all the stakeholders of a J2EE application measure, analyze and optimize the performance of their application environments before they are released to staging and production. Our Application Assurance Suite for Java & Portals is a performance diagnostic tool for multi-tiered Java application and enterprise portals running in pre-production and test environments. The suite is composed of several products including:
Performance Management Suite for Java & Portals. Within the production environment, customers can ensure high-quality delivery of applications to end-users across the enterprise while managing the many facets of the dynamic infrastructure. Foglight is an application management solution that monitors every tier in critical application stacks including databases, networks, application servers, web servers and applications alerting administrators to problems before they impact end-users. Foglight offers an array of specialized cartridges focused on ERP and CRM applications to provide a complete monitoring solution for a distributed IT environment. Our series of complementary Spotlight diagnostic products allow IT personnel to visualize the components of an application, database or other layer of the application stack all the way down to the end user. Our User Experience Monitor allows administrators to measure and manage web-based application performance and service levels from the end-users perspective.
Stat® ACM. Stat ACM (Application Change Management) helps IT managers lower their PeopleSoft and Oracle E-Business Suite total cost of ownership by providing end-to-end change management and version control. It helps keep up with change configurations and customizations so that they are updated, approved and deployed to instances throughout the application implementation lifecycle. By tracking version control and versioning capabilities as well as process management, change request tracking, requirements management and distributed development support, Stat ACM adds visibility, hides complexity and automates workflow through an easy-to-use GUI (graphical user interface) environment.
A companys database management systems represent some of the most complex and critical components within its infrastructure. As companies broaden their utilization of databases from multiple platform vendors, database administrators and developers are required to learn to use non-integrated toolsets across their environment to manage the performance and complexity of this tier. Our market leading database management products support the needs of todays database developers and DBAs by providing superior domain capabilities and cross-platform productivity tools within an integrated console to improve database quality and performance.
Database Development. These tools improve the productivity and capability of database developers working in the Oracle Procedural Language (PL)/SQL environment. The primary products in this product family are TOAD® and SQL Navigator.® We provide a complete and integrated development environment for coding stored procedures, schemas and SQL scripts from one intuitive graphical user interface. Debugging, SQL tuning, change analysis, and general administration features improve the quality and performance of database applications before they enter production.
The Quest Central® product family for Oracle, SQL Server, DB2 and Sybase. Administering large heterogeneous database systems in production involves many tedious, error-prone and repetitive tasks. To streamline and automate these tasks and improve the accuracy and effectiveness of database administrators, we have developed the Quest Central product family. Quest Central is a suite of tools that enables the DBA to identify the cause of performance problems without manual trial and error or decentralized tools. These products provide details on historical performance analysis and metrics to provide insight as to how performance issues occur. The Quest Central family of products provides a consistent presentation delineating the performance management of multiple databases enabling DBAs to manage more databases without adding resources. We are currently marketing and selling Quest Central DBA product families for Oracle, Microsoft SQL Server, DB2 and Sybase databases.
SharePlex.® SharePlex provides real-time replication of Oracle databases for customers who need to ensure a current, secondary copy of their transactional Oracle database is available if the primary database is unavailable. Many customers use SharePlex to offload management reporting, so the activity no longer compromises the performance of transaction processing. Further, SharePlex is also frequently used to eliminate end user disruption by providing continuous access to data during the migration of operating systems, hardware platforms and major application releases.
LiteSpeed for SQL Server. LiteSpeed offers significant benefits to the entire organization accountable for managing Microsofts SQL Server databases, including backups, business operations and storage management. Benefits range from time and cost savings for the IT staff on a daily basis and for IT management to support the organizations overall mission. LiteSpeed for SQL Server dramatically reduces storage costs and backup/recovery windows by compressing data in significantly less time than other backup solutions. The LiteSpeed for SQL Server backup engine compresses data up to 95 percent, in half the time required by other backup solutions. LiteSpeed speeds up restore times through its ability to recover individual database objects and encapsulate complete database restores into a single file.
Microsoft applications and their associated infrastructure platform continue to be a global standard. Our products enable IT personnel to simplify, automate and secure their infrastructure with management, migration and integration capabilities for this environment. Our products are focused on key elements of the infrastructure including Microsofts Active Directory, Exchange and Windows Server. Our Windows Management products include:
Quest Management for Active Directory. Microsoft Active Directory is technically complex and requires meticulous management to ensure the accuracy and security of its content across the entire enterprise. Quest Management for Active Directory is a set of products that provide diagnostics, recovery, detailed auditing, group policy management, reporting, self-service, role-based delegation and user provisioning. Our products offer a practical approach to automated user provisioning and provide a comprehensive delegation model, consolidated reporting and auditing and expert advice on problem resolution for teams managing complex Microsoft infrastructures.
Quest Management for Exchange. E-mail growth is leading to increased traffic, storage and support issues, including compliance. Quest Management for Exchange provides a comprehensive set of tools to migrate, store, recover and intelligently manage growth and the related spending for mission-critical Exchange infrastructures. Our products enable mailbox and public folder management, distribution list management, usage analysis, and diagnostics to optimize investment and performance in Exchange environments. This allows administrators and managers to better target investments, enforce corporate policies, enhance customer service, reduce administrative costs and improve troubleshooting efficiency. Additional functionality and integration is available for customers who have chosen Microsoft Operations Manager (MOM) as their unattended monitoring solution.
Quest Migration Suite for Active Directory. The Quest Migration Suite for Active Directory is a ZeroIMPACT solution for planning and executing migration projects to Active Directory from Windows NT or Novell NDS. It supports thorough migration planning and Active Directory pruning and grafting with no interruption to business workflow. Its distributed processing and robust project management features simplify migration processes.
Quest Migration Suite for Exchange. The Quest Migration Suite for Exchange is also a ZeroIMPACT solution that helps plan and execute migration projects to Exchange 2000/2003 from Exchange 5.5 or 2000. In addition this product enables customers to migrate from a Domino/Notes or GroupWise environment to Exchange. It helps to ensure seamless migration processes and provides a centralized place for project management as well as analysis tools and reporting mechanisms.
Quest InTrust. Quest InTrust offers auditing and policy compliance to help systems administrators securely collect, store and report on event data to meet the needs of external regulations, internal policies and best practices.
Vintela Authentication Services. Vintela Authentication Services, (VAS) allows Unix and Linux to take advantage of the access, authentication and authorization within Active Directory. This product functionally extends Active Directorys security, compliance and authentication capabilities into the extended enterprise.
Customer Support Services
A high level of product maintenance and technical support is critical to the successful marketing and sale of our products and the development of long-term customer relationships. We have a reputation for providing a high level of customer support and believe this is a competitive differentiator. Initial enrollment in our customer support program for
one year is bundled with a sale of a software license and entitles a customer to problem resolution services, new functional enhancements of a product, and ongoing compatibility with new releases of the database, application or other platforms supported by the product; annual renewals are offered thereafter. We also offer multi-year support. In 2006 we made infrastructure investments including the implementation of knowledge management software and upgraded our global support system as part of a process to increase our support services capabilities and address the growing list of our products. Customer support is provided domestically through our offices in Aliso Viejo and internationally through our offices in Europe, Canada and Singapore (which was opened in 2006).
Professional Consulting and Training Services
Our professional services include pre- and post-sales consulting, as well as education and training. Our consulting services include a wide range of offerings such as assistance with optimization, migration, simplifying an infrastructure or increasing its responsiveness, and installation and systems integration for the rapid deployment of Quest products. We offer our consulting and training services with the initial deployment of our products as well as on an ongoing basis to address the continuing needs of our customers. Our professional services staff is located throughout North America, Europe and APAC, enabling us to perform installations and respond to customer demands rapidly across our global customer base.
We also have relationships with resellers, professional service organizations and system integrators including Accenture, Avanade, Cap Gemini and others, which include participation in the deployment of our products to customers. These relationships help promote Quest products and provide additional technical expertise to enable us to provide the full range of professional services our customers require to deploy our products.
We offer product education courses to train our business partners and customers on the implementation and use of our products. Product training is provided at our headquarters, on-line and at customer sites as well as other regional and international locations.
Sales, Marketing and Distribution
We market and sell our products and services worldwide primarily through our direct sales organization, our telesales organization and, increasingly, via indirect sales channels with a group of value added resellers (VARs) and distributors. At December 31, 2006, we had approximately 460 full-time direct sales representatives. Approximately 84% of our sales representatives are field sales personnel, who sell all of our products other than those sold by our telesales representatives. The remaining 16% of our sales representatives are telesales employees, who sell products such as our Oracle and J2EE development and certain Microsoft related products that are generally evaluated through Internet downloads rather than on-site technical demonstrations. We have approximately 260 pre-sales systems engineers who work with these field sales teams to provide technical assistance and demonstrations to sales prospects. We have continued to invest in this area to supplement our direct sales organization with indirect sales channels with companies such as Dell and IBM in addition to resellers focused on governmental business. This activity requires broad based programs to recruit, manage and expand our support operations to grow and expand these relationships. We also employ local resellers in certain international territories not covered by our local sales offices.
We have sales offices in many major cities of the United States, Europe, Asia and Australia to facilitate close contact between current and potential customers and our field sales organization. Sales originated outside of the United States are generally denominated in the foreign currency of the country of origin. Our European operation, which has received considerable focus and investment, has been our fastest growing geographic region over the last several years. The APACJ region is our newest region and has seen considerable investment in 2006 including the recent build-out of our technical support center in Singapore and hiring of sales and support personnel for us to build capabilities within the marketplace.
Our marketing efforts are designed to create awareness, generate leads, and assist the worldwide sales organization with converting leads into closed sales. We have three general go to market messages, Achieving Compliance, Managing Complex Applications and Simplifying Identity Management which are supported by key initiatives throughout our sales organization and are utilized by sales teams to get on the radar screen of customers. These initiatives are focused on critical issues facing todays IT buyers and are meant to exemplify how Quest products can be integrated to address customer requirements around these issues. We use a full complement of marketing vehicles including industry trade shows and conferences, user groups and discussion forums, educational white papers and knowledge briefs, electronic and print advertising, webcasts, direct marketing via electronic and postal mailings, and online advertising. Strategic and channel partners often assist us with the development, funding and execution of our marketing programs. Targeted campaigns and sales programs are developed based on objective, audience and product mix and are executed in our regions around the world to maximize revenue opportunities as quickly as possible.
For information regarding our segment revenue and revenue by geographic area, please refer to Note 14 of our Notes to Consolidated Financial Statements.
Research and Development
We believe that strong research and product development capabilities are essential to enhancing our core technologies and developing additional products. Innovative capabilities, strong product engineering and rich user interfaces are typical Quest attributes. We target ease of implementation and ease of use in designing our products. Our commitment to ongoing product development is reflected in our investments in research and development, which were $110.6 million, $89.1 million and $83.6 million for the years ended December 31, 2006, 2005 and 2004, respectively. We have actively recruited key software engineers and developers with expertise in the areas of Oracle technologies, Java, Microsoft infrastructure technologies, ERP and CRM systems. We have also built-up these competencies through small and medium-sized acquisitions and majority owned investments which have provided us with expertise in virtualization management technologies. In addition to the U.S., we have significant product development operations in Canada, Australia, Russia and Israel.
The market for enterprise systems management solutions is intensely competitive and characterized by rapidly changing technology and evolving standards. We expect competition to continue to increase both from existing competitors and new market entrants. We believe that our ability to compete effectively depends on many factors, including:
We compete in some instances with the platform vendors of databases, applications, infrastructure and other systems that our products are designed to support. If these vendors include similar or equivalent functionality relative to our software as standard features of their underlying product, our revenues could be adversely affected. For example, competition with Oracle over the last several years has materially reduced license revenues generated by certain of our Database Management products including SharePlex and Quest Central for Oracle and has negatively impacted the growth rate of license revenues associated with our Oracle Database Development tools. Microsoft has continually upgraded the functionality of its platform offerings, which we believe will increase competitive pressure for our products in the future.
We also compete with other vendors of database, application and windows management tools. Public and private companies with whom we compete include:
Some of our competitors and potential competitors have greater name recognition, a larger installed customer base company-wide and significantly greater financial, technical, marketing, and other resources than we do. Competitors may also be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can.
Because there are relatively low barriers to entry in the software market, we may encounter additional competition as other established and emerging companies enter our field and introduce new products and technologies. Venture capitalists and others have funded numerous database, application and windows management companies. Accordingly, it is likely that new competitors or alliances among current and new competitors will emerge and see their offerings rapidly gain acceptance.
There can be no assurance that we will be able to compete successfully against current and future competitors. Increased competition could result in price reductions, fewer customer orders, reduced gross margins and loss of market share, any of which could materially affect our business, operating results or financial condition.
We have experienced seasonality in our orders and revenue, which has resulted in seasonality in our earnings. We tend to experience a higher volume of transactions and associated revenues in our third and fourth quarters ending September 30 and December 31, respectively, and within the last few weeks of a quarter, as a result of our customers spending patterns and, to a lesser extent, the structure of our sales commission program. As a result of this seasonality for license transactions, we tend to have higher orders and revenues in the fourth quarters of a year than orders and revenues in the first quarter of the following year. We expect this seasonality to continue in the future.
We rely on a combination of patents, copyrights, trademarks, service marks, trade secret laws, and contractual restrictions to establish and protect proprietary rights in our products and services. The source code for our products is protected both as a trade secret and as an unpublished copyrighted work. Despite our precautions, it may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization. In addition, the laws of various countries in which our products may be sold may not protect our products and intellectual property rights to the same extent as the laws of the U.S. Our competitors may independently develop technologies that are substantially equivalent or superior to our technology.
We rely on software that we license from third parties for certain components of our products and services to enhance our products and services and meet evolving customer needs. The failure to license any necessary technology, or to maintain our existing licenses, could result in reduced demand for our products.
Because the software industry is characterized by rapid technological change, we believe that factors such as the technological and creative skills of our personnel, new product developments, frequent product enhancements, name recognition, and reliable product maintenance are more important to establishing and maintaining a technology leadership position than the various legal protections of our technology.
We hold 9 patents issued in the United States and have 29 patent applications (including continuation and divisional applications) and 5 provisional patent applications on file with the United States Patent and Trademark Office for various technologies incorporated into our products. We intend to continue to file patent applications as appropriate in the future. We cannot be sure, however, that any of our pending patent applications will be allowed, that any issued patents will protect our intellectual property or will not be challenged by third parties, or that the patents of others will not seriously harm our ability to do business. In addition, others may independently develop similar or competing technologies or design around any of our patents. We do not believe we are significantly dependent on any of our patents as we do not generally license our patents to other companies and do not receive any revenue as a direct result of our patents.
Although we believe that our products and services and other proprietary rights do not infringe upon the proprietary rights of third parties, third parties may assert intellectual property infringement claims against us in the future. Any such claims may result in costly, time-consuming litigation and may require us to enter into royalty or cross-license arrangements.
As of December 31, 2006, we employed 2,843 full-time employees, including 1,147 in sales and marketing, 83 in professional services, 1,075 in research and development, 216 in customer service and support and 322 in general and administrative, including information services personnel. We believe that our future success will depend in large part upon our continuing ability to attract and retain highly skilled managerial, sales, marketing, customer support, research and development and general and administrative personnel. Like other software companies, we face intense competition for such personnel, and we have at times experienced and continue to experience difficulty in recruiting and retaining qualified personnel. None of our employees are represented by a labor union; we have never experienced any work stoppages and we believe that our relationships with our employees are good.
Our website is located at www.quest.com. We make available, free of charge on or through our website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. Information contained on our website is not part of this annual report on Form 10-K.
An investment in our shares involves risks and uncertainties. You should carefully consider the factors described below before making an investment decision in our securities. The risks described below are the risks that we currently believe are material risks of the business and the industry in which we compete.
Our business, financial condition and results of operations could be adversely affected by any of the following risks. If we are adversely affected by such risks, then the trading price of our common stock could decline, and you could lose part or all of your investment.
Matters relating to or arising from our stock option investigation, including regulatory proceedings, litigation matters and potential additional expenses, may adversely affect our business and results of operations
As described in the Explanatory Note to this Report, Part II, Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations and in Note 2 of our Notes to Consolidated Financial Statements included in this Report, we are restating our consolidated financial statements for periods through March 31, 2006 to reflect the findings of a voluntary, independent investigation of our stock option granting practices and related accounting. This investigation was conducted by A Special Committee of the Board of Directors with the assistance of independent outside legal counsel and outside forensic accounting consultants. To date, we have incurred significant expenses related to legal, accounting, tax and other professional services in connection with the investigation, the related restatements and related regulatory inquiries or proceedings and litigation matters, and may incur significant expenses in the future with respect to such matters. These events, even if resolved favorably, may be time-consuming, expensive and disruptive to normal business operations, and the outcomes of regulatory proceedings or litigation matters are difficult to predict and could have a material adverse effect on our business, results of operations and financial condition.
Although we believe we have made appropriate judgments in determining the financial and tax impacts of our historical stock option granting practices, we cannot provide assurance that the Securities and Exchange Commission (SEC) or the Internal Revenue Service (IRS) will agree with the manner in which we have accounted for and reported, or not reported, the financial and tax impacts. For a discussion of the judgments underlying the revised measurement dates, see Managements Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of this Report. If the SEC or the IRS disagrees with our financial or tax adjustments or related disclosures and such disagreement results in material changes to our historical financial statements, we may be required to further restate our prior financial statements, amend prior filings with the SEC or take other action that is not currently contemplated.
In June 2006 we received an informal request for information from the Securities and Exchange Commission regarding our stock option practices. In January 2007 we were informed that the SEC issued a formal order of investigation in the matter. We have also been informally contacted by the U.S. Attorneys Office for the Central District of California and have been asked to voluntarily produce documents relating to our stock option granting practices. We are cooperating with the SEC and the U.S. Attorneys Office in connection with these matters, but can not predict if, when or how they will be resolved or what, if any, actions we may be required to take as part of any resolution of these matters. Any action by the SEC, the U.S. Attorneys Office or other governmental agency could result in civil or criminal sanctions against us and/or certain of our current and former officers, directors and employees.
Additionally, as discussed in Note 13 of Notes to Consolidated Financial Statements, included in Item 15 of this Report, we currently are engaged in civil litigation with parties that have alleged a variety of claims against Quest and certain of our current and former officers and directors relating to our stock option grant practices and related accounting. Although we and the other defendants intend to defend these claims vigorously, there are many uncertainties associated with any litigation, and we cannot assure you that these actions will be resolved without substantial costs and/or settlement charges. We have entered into indemnification agreements with each of our present and former directors and executive officers under which Quest is required to indemnify each such directors or executive officers against expenses, including attorneys fees, judgments, fines and settlements, paid by such individual in connection with the pending litigation (other than indemnified liabilities arising from willful misconduct or conduct that is knowingly fraudulent or deliberately dishonest).
The resolution of the pending investigations by the SEC and U.S. Attorneys Office, the defense of our pending civil litigation and any additional litigation relating to our past stock option grant practices or related restatement of our financial statements could result in significant costs and diversion of the attention of management and other key employees.
If we do not maintain compliance with Nasdaq listing requirements, our common stock could be delisted, which could, negatively impact the trading market for our securities and impact our ability to maintain equity-based stock incentive programs for our employees
As a result of the stock option investigation and the restatement of our consolidated financial statements we could not timely file certain of our periodic reports with the SEC and, accordingly, our Common Stock has remained subject to delisting from the Nasdaq Global Select Market. We still have not yet filed our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2007, June 30, 2007 and September 30, 2007 and will not have achieved full compliance with SEC reporting requirements until these reports are filed, as well as any other periodic reports which may hereafter become due. In November 2007, the Nasdaq Board of Directors advised the Company that we will be required to comply with the Nasdaq filing requirements by January 9, 2008. In addition, we were unable to solicit proxies for an annual meeting of shareholders in 2006 because we could not provide an annual report to shareholders, and have not been in compliance with the Nasdaq requirement to hold an annual meeting of shareholders. We have also not held a 2007 annual meeting of shareholders. Our intention is to hold an annual meeting of shareholders as soon as practicable following the filing of all of our delinquent periodic reports.
Our common stock could be delisted if we do not file our remaining delinquent reports with the SEC, if we are required to further restate or amend our filings or if we otherwise do not maintain compliance with applicable listing requirements. If our securities are delisted from the Nasdaq Global Select Market, they would subsequently be transferred to the National Quotation Service Bureau, or Pink Sheets. The trading of our common stock through the Pink Sheets might reduce the price of our common stock and the levels of liquidity available to our stockholders. In addition, the trading of our common stock through the Pink Sheets could materially and adversely affect our access to the capital markets and our ability to raise capital through alternative financing sources on terms acceptable to us, or to raise capital at all. Securities that trade through the Pink Sheets are no longer eligible for margin loans, and a company trading through the Pink Sheets cannot avail itself of federal preemption of state securities or blue sky laws, which adds substantial compliance costs to securities issuances, including pursuant to employee option plans, stock purchase plans and private or public offerings of securities. Increased compliance burdens can also be expected to impact our ability to maintain and administer stock option programs and other forms of equity incentives for our employees, which could also impair our ability to recruit and retain key employees. If we are delisted in the future from the Nasdaq Global Select Market and transferred to the Pink Sheets, we could also be subject to other negative implications, including the potential loss of confidence by suppliers, customers and employees and the loss of institutional investor interest in our securities. Any or all of the foregoing consequences of delisting could adversely affect our business and results of operations.
We had material weaknesses in internal control over financial reporting and cannot assure you that material weaknesses will not be identified in the future. If our internal control over financial reporting or disclosure controls and procedures are not effective, there may be errors in our financial statements that could require a restatement or our filings may not be timely and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price
Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year, and to include a management report assessing the effectiveness of our internal control over financial reporting in each Annual Report on Form 10-K. Section 404 also requires our independent registered public accounting firm to attest to, and report on, managements assessment of our internal controls over financial reporting. In assessing the findings of the Special Committees review and the restatement set forth in this Report, our management concluded that there were material weaknesses, as defined in the Public Company Accounting Oversight Boards Auditing Standard No. 2, in our internal controls over financial reporting as of December 31, 2006. See the discussion included in Part II, Item 9A of this Report for additional information regarding our internal control over financial reporting.
Our management does not expect that our internal control over financial reporting will prevent all error or all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control systems objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
We cannot assure you that all significant deficiencies and material weaknesses identified in this Report will be adequately remedied or will be fully remedied by any specific date, although we believe that our material weakness in internal controls relating to revenue recognition has been remedied as of the date of filing this Report. In addition, we can provide no assurances that significant deficiencies or material weaknesses in our internal control over financial reporting will not be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder. The existence of a material weakness could result in errors in our financial statements that could result in a restatement of financial statements, cause us to fail to timely meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to a decline in our stock price.
We may incur additional expenses in order to assist our employees with potential federal and state income tax liabilities which may arise under Section 409A of the Internal Revenue Code
As a result of our stock option investigation, we have determined that many of our outstanding stock option awards are deemed to have been granted at an exercise price below the fair market value of our stock on the actual accounting measurement date. The primary adverse tax consequences are: (1) that the re-measured options vesting after December 31, 2004 are potentially subject to option holder excise tax under Section 409A of the Internal Revenue Code (and, as applicable, similar excise taxes under state law); and (2) certain incentive stock options previously granted, could be deemed granted at below market value producing incremental payroll tax liabilities. We have recorded approximately $0.6 million of expenses in the year ended December 31, 2006 relating to the anticipated settlement by the Company of federal and applicable state income taxes on behalf of the Companys employees for tainted options that were exercised during 2006. Employees of the Company who continue to hold tainted options may be subject to additional taxes, penalties and interest under Section 409A if no action is taken to cure the options from exposure under Section 409A before December 31, 2008.
Regarding potential future liabilities associated with Section 409A, we have yet to determine whether we will either implement a plan to assist the affected employees for the amount of this tax, adjust the terms of the original option grant, or adjust the terms of the original option grant and pay the affected employees an amount to compensate such employees for this lost benefit. As such, no additional expense has been recorded in the consolidated financial statements.
Our future success may be impaired and our operating results will suffer if we cannot respond to rapid market, competitive and technological conditions in the software industry
The market for our software products and services is characterized by:
To maintain our competitive position, we must continue to enhance our existing products and develop new products and services, functionality, and technology that address the increasingly sophisticated and varied needs of our customers and prospective customers, which requires significant investment in research and development resources and capabilities, involves significant technical and business risks and requires substantial lead-time and significant investments in product development. If we fail to anticipate new technology developments, customer requirements, industry standards, or if we are unable to develop new products and services that adequately address these new developments, requirements, and standards in a timely manner, or if we are incapable of timely bringing new or enhanced products to market, our products and services may become obsolete, we may not generate suitable returns from our research and development investments, and our ability to compete may be impaired, our revenue could decline, and our operating results may suffer.
During the past three years, a large portion of our revenue growth has been attributable to the growth of our Microsoft Systems Management products and services, and we have relied upon sustained revenue and cash flow generation from our database management products in order to fund sales, marketing and research and development initiatives associated with our other product areas. We cannot provide any assurance that the revenues we derive from these product areas will continue to grow. In addition, over the last few years we have committed significant resources to development of new and enhanced application management products and have expanded our sales and services organizations to address anticipated business opportunities presented by our expanding application management product and services lines. We cannot provide any assurance that this strategy will be successful or that the release of our enhanced application management products or other new products or services will increase our revenue growth rate.
Our quarterly operating results may fluctuate in future periods and, as a result, we may fail to meet expectations of investors and analysts, causing our stock price to fluctuate or decline
Our revenues and operating results may vary significantly from quarter-to-quarter due to a number of factors. These factors include the following:
In addition, the timing of our software product revenues is difficult to predict and can vary substantially from product-to-product and customer-to-customer. We budget our operating expenses on our expectations regarding future revenue levels. The timing of larger orders and customer buying patterns are difficult to forecast. Therefore, we may not learn of shortfalls in revenue or earnings or other failures to meet our expectations until late in a particular quarter. As a result, if total revenues for a particular quarter are below our expectations, we would not be able to proportionately reduce operating expenses for that quarter.
We have experienced seasonality in our orders and revenues, which may result in seasonality in our earnings. The fourth quarter of the year typically has the highest orders and revenues for the year and higher orders and revenues than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers being typically higher in the third and fourth quarters and, to a lesser extent, from the structure of our sales commission program. In addition, the tendency of some of our customers to wait until the end of a fiscal quarter to finalize orders has resulted in higher order volumes towards the end of the quarter. We expect this seasonality to continue in the future.
Due to these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Fluctuations in our results of operations are also likely to affect the market price of our common stock, if our operating results differ from expectations of investors or securities analysts, and may not be related to or indicative of our long-term performance.
Variations in the size and timing of our customer orders and differing nature of our products and services could expose us to revenue fluctuations and higher operating costs
Our license revenues in any quarter are substantially dependent on orders booked and delivered in that quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license transactions or if the contract terms were to prevent us from recognizing revenue during that quarter. The sales cycles for certain of our software products can last from three to nine months, or longer, and often require pre-purchase evaluation periods and customer education, which can affect timing of orders. Further, we have often booked a large amount of our sales in the last month, weeks or days of each quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each quarter is recognized from previously deferred revenue, our quarterly performance will depend primarily upon current order volumes to generate revenues for that quarter. These factors may cause significant periodic variation in our license revenues. In addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet expectations until the end of that quarter.
Our product portfolio is engineered for a broad variety of operating system, database and application platforms, and having a diverse set of functions and features. Some products, such as our database management products and other component products, are directed at database administrators and are generally sold at lower price points, and we strive to generate demand for these products through our telesales organization and marketing programs designed to maximize lead generation and website traffic. Sales of other, enterprise-wide products, primarily SharePlex and Foglight, require substantial time and effort from our sales and support staff as well as involvement by our professional services organizations and, to an increasing degree, our systems integrator partners. Large individual sales, or even small delays in customer orders, can cause significant variation in our revenues and adversely affect our results of operations for a particular period. Historically, we have not placed significant reliance on large sales transactions in any given quarter, with a substantial volume of our revenues being driven from smaller transactions. However, if we encounter difficulty sustaining our component product volumes, and cannot generate a sufficient number of large customer orders, or if customers delay or cancel such orders in a particular quarter, our revenues and operating results may be adversely affected. For these reasons, we face increasing complexity in building and sustaining the optimum combination of field and inside sales personnel to address the various and changing sales and distribution characteristics of our products, which in turn impacts our ability to manage and minimize our sales and marketing costs.
We rely heavily on our direct sales activities for license and services revenues, including renewals of annual maintenance contracts. We have in the past restructured or made other adjustments to our sales force in response to management changes, product changes, performance issues and other internal considerations. We recently made some adjustments to our coverage model to increase focus on global and other major accounts. Weve also recently increased headcount in our telesales and sales associate groups. These changes can result in a temporary lack of focus and reduced productivity, which could have temporary negative effects on our license or services revenues.
Accordingly, if our revenue growth rates slow or our revenues decline, or if we fail to efficiently correlate our sales and marketing resources to our various products and their differing sales and distribution strategies, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or quickly changed.
Many of our products are vulnerable to direct competition from Oracle and other platform vendors
We compete with Oracle in the market for database management solutions and the competitive pressure continues to increase. We expect that Oracles commitment to and presence in the database management product market will increase in the future and therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its server software offerings and expand their development products possibly at no additional cost to its users. Competition from Oracle with certain of our Database Management products including SharePlex and Quest Central for Oracle has increased over the last two years and has continued to increase with Oracles introduction of the next version of its database, known as Oracle 11g. Oracle 11g has enhanced capabilities in the functions competitive with SharePlex, Quest Central for Oracle and with the Oracle monitoring capabilities of Foglight including monitoring capabilities from the entire application stack. We believe increased competition from Oracle has materially depressed our SharePlex and Quest Central for Oracle revenues over the last four years. Oracle recently released SQL Developer which competes with TOAD, our market leading Database Development product for Oracle databases which contributes significantly to our revenues and net income.
In addition to the increasing competitive pressure from Oracle, Microsoft has continually upgraded the functionality of its platform offerings, which we also believe will increase competitive pressure for our Microsoft products in the future.
In some cases these types of platform vendor-provided tools are bundled with the platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of purchasing our products. Moreover, there is substantial risk that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.
Our migration products for Microsofts Active Directory and Exchange are vulnerable to fluctuations in the rate at which customers migrate to these products
Our products for the migration, administration and management of Microsofts Active Directory and Exchange products currently contribute approximately one-quarter of our Windows platform revenue, but migration license sales declined slightly in 2006. Our ability to sell licenses for our Active Directory and Exchange migration products depends in part on the rate at which customers migrate to newer versions of Microsofts Active Directory or to newer versions of Microsoft Exchange, and from other messaging platforms to Exchange. If these migration rates were to materially decrease, our license revenues from these migration products would likely decline.
Many of our products are dependent on database or application technologies of others; if these technologies lose market share or become incompatible with our products, or if these vendors introduce competitive products or acquire or form strategic relationships with our competitors, the demand for our products could suffer
We believe that our success has depended in part, and will continue to depend in part for the foreseeable future, upon our relationships with providers of major database and enterprise software programs, including Oracle, IBM, Microsoft and SAP. Our competitive advantage consists in substantial part on the integration between our products and products provided by these major software providers, and our extensive knowledge of their products and technologies. If these companies for any reason decide to promote technologies and standards that are not compatible with our technologies, or if they lose market share for their database or application products, our business, operating results and financial condition would be materially adversely affected. Furthermore, these major software vendors could attempt to increase their presence in the markets we serve by either introducing products that compete with our products or acquiring or forming strategic alliances with our competitors. These companies have longer operating histories, larger installed bases of customers and substantially greater financial, distribution, marketing and technical resources than we do, as well as well-established relationships with many of our present and potential customers, and may be in better position to withstand and respond to the current factors impacting this industry. As a result, we may not be able to compete effectively with these companies in the future, which could materially adversely affect our business, operating results and financial condition.
If we fail to manage our operations and grow revenue or fail to continue to effectively control expenses, our future operating results could be adversely affected
Historically, the scope of our operations, the number of our employees and the geographic area of our operations and our revenue have grown rapidly. In addition, we have acquired both domestic and international companies. This growth and the assimilation of acquired operations and their employees could continue to place a significant strain on our managerial, operational and financial resources. To manage our current growth and any future growth effectively, we need to continue to implement and improve additional management and financial systems and controls. We may not be able to manage the current scope of our operations or future growth effectively and still exploit market opportunities for our products and services in a timely and cost-effective way.
We cannot assure you that our operating expenses will be lower than our estimated or actual revenues in any given quarter. If we experience a shortfall in revenue in any given quarter, we likely will not be able to further reduce operating expenses quickly in response. Any significant shortfall in revenue could immediately and adversely affect our results of operations for that quarter. Also, due to the fixed nature of many of our expenses and our current expectation for revenue growth, our income from operations and cash flows from operating and investing activities could be lower than in recent years.
Failure to develop and sustain additional distribution channels in the future may adversely affect our ability to grow revenues
We intend to direct additional efforts to drive domestic and international revenue growth through sales of our products and services through indirect distribution channels, such as global hardware and software vendors, systems integrators, or value-added resellers. Our ability to increase future revenues depends on our ability to expand our indirect distribution channels. If we fail in our efforts to maintain, expand and diversify our indirect distribution channels, our business, results of operations and financial condition could be adversely affected. Increasing activity in indirect distribution channels will present a number of additional risks, including:
Intense competition in the markets for our products could adversely affect our results of operations
The markets for our products are highly competitive. As a result, our future success will be affected by our ability to, among other things, outperform our competitors in meeting the needs of current and prospective customers and identifying and addressing new technological and market opportunities. Our competitors may develop more advanced technology, adopt more aggressive pricing policies and undertake more effective sales and marketing campaigns and may be able to leverage more extensive financial, technical or partner resources. If we are unable to maintain our competitive position, our revenues may decline and our operating results may be adversely affected.
Our operating results may be negatively impacted by fluctuations in foreign currency exchange rates
Our international operations are generally conducted through our international subsidiaries, with the associated revenues and related expenses, and balance sheets, denominated in the currency of the country in which the international subsidiaries operate. As a result, our operating results may be harmed by fluctuations in exchange rates between the U.S. Dollar and other foreign currencies. The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our exposure to fluctuations in foreign currency exchange rates.
Our international operations and our planned expansion of our international operations expose us to certain risks
We maintain research and development operations primarily in Canada, Australia, Russia and Israel, and continue to expand our international sales activities, with particular focus in Asia Pacific (including Japan), as part of our business strategy. As a percentage of total revenues, revenues outside of North America were 35%, 33% and 31% for the years ended December 31, 2006, 2005 and 2004, respectively. As a result, we face increasing risks from our international operations, including, among others:
Operating in international markets also requires significant management attention and financial resources and will place additional burdens on our management, administrative, operational and financial infrastructure. We cannot be certain that investment and additional resources required in establishing facilities in other countries will produce desired levels of revenue or profitability. In addition, we have limited experience in developing localized versions of our products and marketing and distributing them internationally.
Acquisitions of companies or technologies may result in disruptions to our business and diversion of management attention
We have in the past made and we expect to continue to make acquisitions of complementary companies, products or technologies. Acquisitions require us to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may subject us to liabilities and risks that are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert managements attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. We may have to use cash, incur debt or issue equity securities to pay for any future acquisitions. Use of cash or debt may affect our liquidity and use of cash would reduce our cash reserves and reduce our
financial flexibility. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for intangible assets with indefinite useful lives. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of an acquisition.
Accounting for equity investments in companies may affect our operating results
We have made equity investments in other software companies and a private equity fund. We regularly consider opportunities to make equity investments in other companies focused on software development or marketing activities, and expect from time to time to complete additional investments. These investments are risky because the market for the products and technologies being developed by these companies are typically in the early stages and may never materialize. In addition, we have made at least one investment in a private software company that has required us to consolidate the results of operations of this company into ours and we may determine in the future to invest in additional companies at similar levels. Estimating the fair value of our equity investments is inherently subjective and may contribute to volatility in our reported results of operations. We have recognized accounting charges due to the impairment of the value of our investments in the past and may need to do so again in the future if we cannot substantiate the fair value of our strategic equity investments. If we are required to consolidate the operating results of these companies, use the equity method of accounting, or write down the value of our cost-method investments, our operating results may be adversely affected.
We face risks associated with governmental contracting
We derive a portion of our revenues from contracts with the United States government and its agencies and from contracts with state and local governments or agencies. Demand and payment for our products and services are impacted by public sector budgetary cycles and funding availability, with funding reductions or delays adversely impacting public sector demand for our products and services. Public sector customers may also change the way they procure new contracts and may adopt new rules or regulations governing contract procurement, including required competitive bidding or use of open source products, where available. These factors may limit the growth of or reduce the amount of revenues we derive from the public sector, which could negatively affect our results of operations.
We may not generate increased business from our current customers, which could slow our revenue growth in the future
Most of our customers initially make a purchase of our products for a single department or location. Many of these customers may choose not to expand their use of our products. If we fail to generate expanded business from our current customers, our business, operating results and financial condition could be materially adversely affected. In addition, as we deploy new modules and features for our existing products or introduce new products, our current customers may choose not to purchase this new functionality or these new products. Moreover, if customers elect not to renew their maintenance agreements, our service revenues would be materially adversely affected.
Failure to develop or leverage strategic relationships could harm our business by denying us selling opportunities and other benefits
Our development, marketing, and distribution strategies rely increasingly on our ability to form strategic relationships with software and other technology companies. These business relationships often consist of cooperative marketing programs, joint customer seminars, lead referrals, and cooperation in product development. Many of these relationships are not contractual and depend on the continued voluntary cooperation of each party with us. Divergence in strategy or change in focus by, or competitive product offerings by, any of these companies may interfere with our ability to develop, market, sell, or support our products, which in turn could harm our business. Further, if these companies enter into strategic alliances with other companies or are acquired, they could reduce their support of our products. Our existing relationships may be jeopardized if we enter into alliances with competitors of our strategic partners. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products.
Failure to adequately protect our intellectual property rights could harm our competitive position
Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology. We generally rely on a combination of trademark, trade secret, patent, copyright law and contractual restrictions to establish and protect our proprietary rights in our products and services.
Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any such resulting litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management and financial resources, which could harm our business.
Our means of protecting our proprietary rights may prove to be inadequate and competitors may independently develop similar or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services.
Third parties may claim that our software products or services infringe on their intellectual property rights, exposing us to litigation that, regardless of merit, may be costly to defend
Our success and ability to compete are also dependent upon our ability to operate without infringing upon the proprietary rights of others. Third parties may claim that our current or future products infringe their intellectual property rights. Any such claim, with or without merit, could have a significant effect on our business and financial results. Any future third party claim could be time consuming, divert managements attention from our business operations and result in substantial litigation costs, including any monetary damages and customer indemnification obligations, which may result from such claims. In addition, parties making these claims may be able to obtain injunctive or other equitable relief affecting our ability to license the products that incorporate the challenged intellectual property. As a result of such claims, we may be required to obtain licenses from third parties, develop alternative technology or redesign our products. We cannot be sure that such licenses would be available on terms acceptable to us, if at all. If a successful claim is made against us and we are unable to develop or license alternative technology, our business and financial results and position could be materially adversely affected.
Our business may be adversely affected if our software contains errors or security flaws
The software products we offer are inherently complex. Despite testing and quality control, we cannot be certain that errors or security flaws will not be found in current versions, new versions or enhancements of our products after commencement of commercial shipments. Significant technical challenges also arise with our products because our customers purchase and deploy our products across a variety of computer platforms and integrate them with a number of third-party software applications and databases. If new or existing customers have difficulty deploying our products or require significant amounts of customer support, our operating margins could be harmed. Moreover, we could face possible claims and higher development costs if our software contains undetected errors or security flaws or if we fail to meet our customers expectations. As a result of the foregoing, we could experience:
The detection and correction of any security flaws can be time consuming and costly. In addition, a product liability claim, whether or not successful, could harm our business by increasing our costs and distracting our management.
We incorporate software licensed from third parties into some of our products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for, or prevent the shipping of, our products
Certain of our software products contain components developed and maintained by third-party software vendors. We expect that we may have to incorporate software from third-party vendors in our future products. We may not be able to replace the functionality provided by the third-party software currently offered with our products if that software becomes obsolete, defective or incompatible with future versions of our products or is not adequately maintained or updated. Any significant interruption in the availability of these third-party software products or defects in these products could harm our sales unless and until we can secure an alternative source. Although we believe there are adequate alternate sources for the technology licensed to us, such alternate sources may not provide us with the same functionality as that currently provided to us.
Natural disasters or power outages could disrupt our business
A substantial portion of our operations is located in California, and we are subject to risks of damage and business disruptions resulting from earthquakes, floods, wildfires and similar events, as well as from power outages. We have in the past experienced limited and temporary power outages in our California facilities due to power shortages, and we expect in the future to experience additional power losses. While the impact to our business and operating results has not been material, we cannot assure you that natural disasters or power outages will not adversely affect our business in the future. Since we do not have sufficient redundancy in our networking infrastructure, a natural disaster or other unanticipated problem could have an adverse effect on our business, including both our internal operations and our ability to communicate with our customers or sell and deliver our products.
Failure to attract and retain personnel may negatively impact our business
Our success and ability to compete depends largely on the continued contributions of our key management, sales, engineering, marketing, support, professional services and finance personnel. We have recently had moderate turnover in our sales and research and development organizations, significant turnover in the management of our accounting and finance department, and many key positions are held by people who are new to the Company or to their roles. If these people are unable to quickly become familiar with the issues they face in their roles or are not well suited to their new roles, then this could result in the Company having problems in executing its strategy or in reporting its financial results. We are uniquely dependent upon the talents, relationships and contributions of a few executives and have no guarantee of their retention. We have been targeted by recruitment agencies seeking to hire our key management, finance, engineering, sales and marketing and professional services personnel.
We historically have used stock options as a significant component of our employee compensation program in order to align employees interests with the interests of our shareholders, encourage employee retention and provide competitive compensation packages. During the pendency of our stock option investigation and related restatement, we were unable to continue granting stock options to new and existing employees and did not permit exercises of outstanding stock options. These actions have impacted our overall competitive posture with respect to employee compensation and retention of qualified personnel. If we are unable to hire or retain qualified personnel, or if newly hired personnel fail to develop the necessary skills or fail to reach expected levels of productivity, our ability to develop and market our products will be weakened.
Our corporate and administrative headquarters and certain research and development, sales and marketing and support personnel are located at two buildings that comprise our 170,000 square foot facility that we own in Aliso Viejo, California. We also lease properties throughout the United States and foreign countries to house additional research and development, sales and marketing, general and administrative and support personnel. Our largest leased facilities include:
We believe that our properties are in good condition, adequately maintained and suitable for the conduct of our business. Certain of our lease agreements provide options to extend the lease for additional specified periods. For additional information regarding our obligations under leases, see Note 13 of our Notes to Consolidated Financial Statements.
The information set forth under Note 13 of our Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this Report, is incorporated herein by reference. For an additional discussion of certain risks associated with legal proceedings, see the section entitled Risk Factors in Item 1A of this Report.
No matters were submitted to a vote of security holders during the fourth quarter of 2006.
Our common stock is listed on The Nasdaq Global Select Market (formerly the NASDAQ National Market) under the symbol QSFT. Due to the Special Committee investigation of our historical stock option practices and the related restatements of our historical consolidated financial statements and ongoing impact of the resulting compensation expense adjustments, (see Note 2 of our Notes to Consolidated Financial Statements), we did not timely file our quarterly reports for the quarterly periods ended June 30, 2006, September 30, 2006, March 31, 2007, June 30, 2007 and September 30, 2007 or this Report, as required by the continued listing requirements of The Nasdaq Global Select Market. Therefore, the Companys stock remains subject to delisting from The Nasdaq Global Select Market.
The following table sets forth the high and low sale prices on The Nasdaq Global Select Market for our common stock for the periods indicated.
On November 15, 2007, the closing sale price of our common stock on The Nasdaq Global Select Market was $16.65 per share. As of November 15, 2007, there were 178 holders of record of our common stock (not including beneficial holders of shares held in street name).
We have never declared or paid any cash dividends on our common stock and do not expect to do so in the foreseeable future. We currently intend to retain all available funds for use in the operation and expansion of our business. Any future determination to pay dividends will be at the discretion of our board of directors and will depend on our results of operations, financial condition, contractual and legal restrictions and other factors the board deems relevant.
The following graph shows a comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for Quest Software, the NASDAQ Composite Index (the NASDAQ Index), and the S&P Systems Software Index (the Industry Index). The graph assumes $100 was invested in each of the Common Stock of Quest Software, the NASDAQ Index and the Industry Index on December 31, 2001. Note that historic stock price performance is not necessarily indicative of future stock price performance.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Quest Software, Inc., The NASDAQ Composite Index
And The S & P Systems Software Index
The following selected consolidated financial data is qualified by reference to and should be read in conjunction with the consolidated financial statements and the related notes and Managements Discussion and Analysis of Financial Condition and Results of Operations. The income statement data for the years ended December 31, 2006, 2005 and 2004, and the balance sheet data as of December 31, 2006 and 2005, were derived from the audited consolidated financial statements included in this Report.
The consolidated balance sheets as of December 31, 2005, 2004, 2003 and 2002 and the consolidated statements of income for the years then ended have been restated as set forth in this Report. The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and related notes thereto included in this Report to fully understand factors that may affect the comparability of the information presented below. The restatement of the Companys financial statements is more fully described in the Explanatory Note immediately preceding Part I, Item 1; Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations; and in Note 2, Restatement of Previously Issued Financial Statements in our Notes to Consolidated Financial Statements. The as restated amounts reflect the required retrospective adoption of a change in accounting for planned major maintenance activities on our corporate aircraft, which was sold in November 2006. See Note 1 of our Notes to Consolidated Financial Statements.
The Company has not amended its previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods affected by this restatement. The financial information that was presented in previous filings or otherwise reported for these periods is amended by the information in this Annual Report on Form 10-K and with respect to the quarter ended March 31, 2006, in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2007. The financial statements and related financial information contained in such previously filed reports should no longer be relied upon.
The following discussion of our financial condition and results of operations (MD&A) should be read in conjunction with the consolidated financial statements and notes to those statements included elsewhere in this Report, and gives effect to the restatement discussed below and in Note 2 of our Notes to Condensed Consolidated Financial Statements. Certain statements in this Report, including statements regarding our business strategies, operations, financial condition and prospects are forward-looking statements. Use of the words believe, expect, anticipate, will, contemplate, would and similar expressions that contemplate future events may identify forward-looking statements.
Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures made in this Report, including those described under Risk Factors, and in other filings with the SEC that attempt to advise interested parties of certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect managements opinions only as of the date thereof. We do not assume any obligation to revise or update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.
Subsequent to the issuance of the Companys 2005 consolidated financial statements, the Companys management determined that incorrect measurement dates were used for financial accounting purposes for certain stock option grants made in prior periods and that other stock option and non-stock option related errors in its historical financial statements require correction, as described in more detail below. As a result, the consolidated financial statements as of December 31, 2005 and for the years ended December 31, 2005 and 2004 have been restated from the amounts previously reported to correct these errors. The after tax effect to net income of all adjustments amounted to $(1.3) million, $9.6 million and $(4.9) million for the years ended December 31, 2006, 2005 and 2004, respectively.
Background and Scope of the Investigation
On May 17, 2006, a financial analyst at Deutsche Bank published a report entitled Infrastructure SW Update: Analyzing potential for backdated stock options. The report analyzed the likelihood of various software companies having historically back dated equity awards. Quest Software was identified in this report as one company with characteristics similar to other companies which had previously announced stock option investigations. After reviewing the Deutsche Bank report, our General Counsel and then Chief Financial Officer initiated an internal review of the facts and circumstances of our historical stock option granting practices and related documentation. On May 22, 2006, the Board of Directors was briefed on the existence of the Deutsche Bank report and preliminary results of the internal review.
On May 26, 2006, our Board formed a Special Committee of independent directors to conduct an investigation of our historical stock option granting practices and related accounting. The Special Committee was initially comprised of Kevin M. Klausmeyer and Augustine L. Nieto II, both members of the Audit Committee, with the understanding that Mr. Nieto would serve temporarily until another independent, disinterested member was appointed. On June 8, 2006, H. John Dirks joined our Board and was appointed to the Audit Committee and the Special Committee, replacing Mr. Nieto as a member of the Special Committee. The Special Committee retained outside legal counsel, Duane Morris LLP, and Duane Morris retained forensic accounting consultants, Navigant Consulting, Inc., to assist in the investigation.
The Special Committees investigation covered facts, circumstances and timing of stock option grants made by the Company from June 1998 to December 2005. The Special Committee and its advisors reviewed voluminous electronic and hard copy documents, including files of the Companys current and former employees, officers and directors involved in the administration and approval of, as well as in the accounting for, stock option grants made under the Companys stock option programs. In addition to the documents reviewed, the Special Committees lawyers conducted interviews with more than 20 individuals that had knowledge of our stock option granting practices, including current and former employees, officers and directors.
Historical Stock Option Granting Practices
Prior to January 1, 2006, we accounted for our stock option grants under Accounting Principles Board Opinion No. 25 (APB No. 25) and had provided the required disclosures pursuant to the provisions of Statement of Financial Accounting Standards, or SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123). On January 1, 2006, we adopted
SFAS No. 123R, Share-Based Payment (SFAS 123R), under the modified prospective method. For the accounting measurement date revisions made, we revised the historical pro forma footnote disclosures made in accordance with SFAS 123. Additionally, we restated our consolidated financial statements for the three months ended March 31, 2006 to reflect the impact of revised accounting measurement dates on compensation expense recognized in accordance with SFAS 123R.
As permitted by the terms of our stock incentive plans, the Board of Directors was vested with the authority to administer and grant stock options under the plans, and the Board of Directors had delegated general authority for stock option plan administration to the Compensation Committee of the Board. Until August 2003, all employee stock option grants were required to be approved by the Board of Directors or the Compensation Committee. Beginning in August 2003 and as permitted by the terms of our stock incentive plans, the Board of Directors delegated authority, subject to specific parameters, to our Chief Executive Officer as a Secondary Committee to approve stock option awards to employees other than officers or directors of the Company. Option grants to officers and directors and other grants outside of the parameters discussed below continued to require Compensation Committee approval in order to complete the required granting actions.
From June 1998 through December 2005, the exercise price for all stock option grants was typically set at the closing sale price of our Common Stock on the original stated grant date, as reported by Nasdaq. During this period, we made the following types of grants of stock options to employees, including officers, and members of our Board of Directors:
For our stock option grants dated from June 1998 through early 2001, we generally sought approval of the entire Board of Directors, including all new hire, merit and annual grants. Prior to September 1999, we did not have a defined process for determining the date on which we made grants, and no regular granting pattern could be established from our review of the facts and circumstances of those granting actions. Accordingly, the Special Committee concluded that required granting actions for stock option grants during the pre-IPO period between June 1998 and June 1999 were not completed with the required specificity and finality until June 9, 1999. On this date, we adopted our 1999 Stock Incentive Plan in contemplation of our IPO, which was completed in August 1999.
Beginning in late 1999, we changed our stock option granting practices by implementing a practice where we typically dated new hire and merit grants to employees on a monthly basis, where the grant date for any given new hire would be based on the month during which the new hire signed an employment offer letter or started employment with the Company. When option grants were granted to existing employees as merit grants, they were approved using the same practice and included in the monthly new-hire grant procedure. Option grants for these grants for a given month were dated as of the trading date during that month on which the closing price for our Common Stock reported by Nasdaq was determined to be the lowest monthly closing price, and the exercise price established for those option grants was the closing sale price of the Common Stock on such date. We made annual or broad-based, company-wide grants in 2000, 2001 and 2002 to executive and non-executive employees as of grant dates determined on the same basis as new hire or merit grants. The Special Committee also determined that approvals for certain option grants made in connection with acquisitions were obtained in connection with new hire or merit grants during this period, and that the period within which new hire and merit grant dates were determined was expanded from monthly to quarterly on a few occasions.
All discretionary employee grants required approval by the Board of Directors or the Compensation Committee to complete the required granting actions. For most grants we did not obtain approval from the Board of Directors or Compensation Committee (most often by means of a form of unanimous written consent that reflected an as of approval date), until after the end of the period (the particular month or quarter) within which the original grant date was intended.
Beginning with our April 2001 granting action, we sought Compensation Committee approval for all discretionary stock option grants to employees and other eligible participants, including consultants. In May 2002, we changed our stock option granting practices by determining grant dates and exercise prices as of the date when the required granting actions were actually completed. As a result, our April 2002 monthly new hire and merit grant was the last monthly grant for which the originally stated grant date was determined using the methodology of determining a grant price on a monthly or quarterly basis.
In August 2003, the Board of Directors established a Secondary Committee under the terms of our 1999 Stock Incentive Plan and 2001 Stock Incentive Plan, consisting of Vincent C. Smith, our Chairman of the Board and Chief Executive Officer, and delegated authority to the Secondary Committee to approve awards of stock options to employees within specific parameters. The delegation provided authority to grant up to 50,000 options to any employee in connection with his or her hiring into the Company, and up to 20,000 options to existing employees; provided, however, than no authority was delegated with respect to option grants to officers or directors of the Company. Compensation Committee approval continued to be a required granting action for all stock option grants outside of the parameters of the delegated authority. For grants outside the scope of delegated authority, the Compensation Committee approved such grants at a meeting or by unanimous written consent form.
Prior to the restatement discussed below, we used the originally stated grant dates as set forth above as the measurement date for financial accounting purposes. Accordingly, in each case the exercise price was determined to be equal to the closing stock price of our Common Stock as reported by Nasdaq on that date. In the restatement, we revised the accounting measurement dates for many grants and recorded stock-based compensation expense when the revised measurement date resulted in intrinsic value.
Findings of the Investigation and Measurement Date Determinations
The Special Committee performed a detailed review of all stock option grants awarded from August 13, 1999 (the date of the Companys initial public offering) through June 30, 2003 and all annual grants from July 1, 2003 through December 2005, covering grants to purchase 30,739,235 shares of Common Stock made in 7,287 awards on 39 granting dates. The Special Committee also performed limited testing on a sample of stock option grants made prior to the initial public offering covering grants to purchase 10,632,744 shares of Common Stock made in 762 awards on 38 granting dates. The Special Committee also performed limited testing on a sampling of new hire and merit stock option grants awarded after June 30, 2003 covering grants to purchase 5,082,350 shares of Common Stock representing 61% of all new hire and merit options granted during this period.
We classified option grants subject to the investigation into three time periods: (1) June 1998 through August 1999 (the Pre-IPO Period); (2) September 1999 through April 30, 2002; and (3) May 1, 2002 through December 2005. Because annual, broad-based grants were made in a process substantially similar to new hire and merit grants, we did not separately classify option grants by the nature of their granting process. Based on the facts obtained as a result of the Special Committee investigation, we identified grants for which we used an incorrect measurement date for financial accounting purposes, as defined under Generally Accepted Accounting Principles in the United States, or GAAP. To determine the correct accounting measurement dates for these grants we followed the guidance in APB No. 25, which deems the measurement date to be the first date on which all of the following are known with finality: (1) the identity of the individual employee who is entitled to receive the option grant; (2) the number of options that the individual employee is entitled to receive; and (3) the options exercise price.
The Special Committee performed a grant date by grant date analysis of approximately 38 option grant dates during the Pre-IPO Period, 36 option grant dates between the IPO and June 30, 2003 and all 3 annual grants from July 1, 2003 through December 2005 for compliance with APB No. 25. Where we determined that we did not complete the required granting actions by the original grant date, we used judgment to determine corrected accounting measurement dates for all awards included within the granting action on each grant date consistent with what the evidence suggested was our practice or process. If the revised measurement date was not the same date we used previously, we made accounting adjustments as required, which resulted in stock-based compensation and related tax effects when an option had intrinsic value on the revised accounting measurement date.
The Special Committee reviewed a variety of documents and information in connection with its investigation including but not limited to the following:
A total of 3,382 awards covering grants to purchase 22,553,293 shares of Common Stock required measurement date changes, of which options to purchase 3,604,950 shares of Common Stock were granted to employees who were executive officers of the Company at the time of their respective grant dates. None of our non-employee directors received stock option grants requiring measurement date corrections.
The Special Committee determined that both current and former senior management contributed to the Companys lack of controls and inappropriate grant practices. Specifically, the Special Committee determined that two former Chief Financial Officers and a former Corporate Controller, failed to perform the responsibilities of their positions and contributed to the Companys lack of controls and inappropriate grant practices. One former Chief Financial Officer resigned from the Company for unrelated reasons in January 2001. The other Chief Financial Officer resigned from the Company on November 18, 2006, after declining to be interviewed by the Special Committee. The Corporate Controller was reassigned from his accounting management role in October 2006.
The Special Committee made no finding of fraud or intentional misconduct by any current or former employees, officers or directors, and concluded that no further changes in the companys executive officers will be recommended.
The following table summarizes certain information with respect to option awards requiring accounting measurement date changes:
A summary of incremental pre-tax stock-based compensation expense related to options awarded in each time period covering the period from June 1998 through December 31, 2005 (restatement period) resulting from a change in the accounting measurement date (in thousands), is as follows:
Pre-IPO Period Grants
During the course of the investigation, information and documentation relating to stock option grants made prior to the Companys initial public offering was evaluated. The Special Committee determined that accounting measurement dates for most of the stock option grants during the period from June 23, 1998 through August 11, 1999 were incorrectly determined. These instances involved an aggregate of 757 stock option grants awarded to employees covering 10,519,744 shares of Common Stock. Specifically, the Special Committee discovered evidence that required details of 588 awards covering 9,373,344 shares covered by all grants between June 1998 and June 9, 1999 did not have the required level of finality or were not supported by sufficient documentation until June 9, 1999, the date on which the Companys 1999 Stock Incentive Plan was adopted by the Company and approved by its shareholders.
For the stock option grants awarded between June 10, 1999 through August 11, 1999, the Company was unable to locate evidence of completion of required granting actions (specifically, approval of the stock option grants by the Companys Board of Directors or Compensation Committee). These instances involved an aggregate of 169 stock option grants to employees to purchase an aggregate of 1,146,400 shares of the Companys Common Stock. None of these stock options were granted to executive officers or senior officers who participated in the stock option granting processes associated with these grants. The Company has been honoring these stock options awards and settling them with stock and intends to continue doing so. Measurement date determinations for these option grants were made on the basis of all available relevant information and reflect the Companys reasonable conclusion as to the most likely option granting actions that occurred and related facts and circumstances. Specifically, we used evidence of the dates on which the Notices of Grant were executed on behalf of the Company as the best evidence of the granting actions actually completed, and used those dates as the revised measurement dates for financial reporting purposes.
Corrections to the accounting measurement dates for option grants during the Pre-IPO Period resulted in the recording of additional pre-tax stock-based compensation of $23.3 million.
Post IPO Grants - September 1999 through April 2002
In the fourth quarter of 1999, the Company initiated a practice of processing option grants to newly-hired employees and merit or promotion grants to existing employees on a monthly basis, starting with the grants dated September 1999, and to determine a single grant date for stock options granted within each of those particular months. The Special Committee found evidence demonstrating that stock option grants made in any given month were routinely made as of the trading date associated with the lowest closing sale price reported by Nasdaq for our Common Stock from September 1999 through April 2002, with only a few grants during such period made on other dates. The Special Committee also found evidence that the option grant dating practice expanded to quarterly, rather than monthly, grant date determinations.
For stock option grants during this time period, the Special Committee determined that:
For each of the 21 discretionary grants affected by the Special Committees findings during this period, the Special Committee determined an accounting measurement date based on information and documentation evidencing the date as of which the related action by unanimous written consent (UWC) had been signed by all of the directors or, in the case of Compensation Committee action, members of the Compensation Committee. However, in many cases, the Company was unable to locate definitive and complete documentation evidencing the date on which the last required approval of a UWC was signed by certain directors and received by the Company. For these stock option grants, the Companys measurement date determinations were made on the basis of all available relevant information and reflect the Companys reasonable conclusion as to the most likely option granting actions that occurred based on related facts and circumstances. For grants where there was insufficient evidence to determine when all required written consents were actually obtained, but there was evidence of the dates of receipt of individual written consents (such as contemporaneous electronic messages to or from individuals involved in the granting activities or facsimile header dates on signed unanimous written consent forms), we used this information as evidence of when the Compensation Committee approval was obtained, and used that date as the revised measurement date for financial reporting purposes. In other cases where we could not locate evidence of the date or dates on which required granting approvals were obtained, we used evidence of the dates on which the Notices of Grant were executed on behalf of the Company as the best evidence of the granting actions actually completed, and used those dates as the revised measurement dates for financial reporting purposes. We believe that these grants were communicated to employees in a timely manner. In some cases, we awarded option grants that were different in amount than that approved by the required granting actions or to employees whose awards were not included in lists approved by the Board of Directors or Compensation Committee. In each of these circumstances, we evaluated the existing information related to each individual grant and we established a new accounting measurement date when we determined that the terms of the award were fixed with finality, which was generally the date on which the related Notice of Grant was signed on behalf of the Company.
Section 16 Insiders received stock options covering an aggregate of 2,904,950 shares of Common Stock in these grant events, which collectively resulted in $24.0 million of additional compensation expense over the restatement period. See the discussion under the heading Remedial Actions below with respect to actions taken by the Company with respect to option awards to Section 16 Insiders. Employees other than Section 16 Insiders received options to purchase an aggregate of 8,350,349 shares in these grant events. Corrections to the measurement dates for all of the misdated grants during the period from September 1999 through April 2002 resulted in the recording of additional stock-based compensation expense of $113.3 million.
Revised measurement dates for certain grants awarded during the period from September 1999 to September 2000 could not be determined with certainty. We therefore made judgments to establish the revised dates. These awards were made on six dates and covered options to purchase approximately 467,000 shares of Common Stock, or approximately one-half of the total number of shares covered by stock options granted during this period. For these grants, we have recorded pre-tax compensation expense adjustments of approximately $8.4 million. We determined the revised measurement dates for these awards based upon the dates upon which the Company signed the Notices of Grant which was deemed for measurement date purposes, to be the dates on which the grants were completed. Had we used different judgments regarding the timing of the revised measurement dates, the stock-based compensation expense charges we recorded in the restatement would have been different.
We prepared a sensitivity analysis to determine the hypothetical minimum and maximum compensation expense charge that we might have recorded for these grants if we had used different judgments to determine the revised measurement dates. We applied our sensitivity methodology on a grant date by grant date basis to examine the largest hypothetical variations in stock-based compensation expense within a range of possible measurement dates for each grant event, which ranged from the originally recorded grant date to the revised measurement date. While we believe the evidence and methodology used to determine the revised measurement dates to be the most appropriate, we also believe that illustrating the differences in stock-based compensation expense using these alternative date ranges provides incremental insight into the extent to which hypothetical stock-based compensation expense would have fluctuated if we chose other measurement dates.
After developing the range for each grant event included in our sensitivity analysis, we selected the highest and lowest closing sale price of our Common Stock within the date range to determine the range of potential compensation expense adjustments for the grants. We then compared these aggregated amounts to the stock-based compensation expense that we recorded for the stock option grants analyzed. If we had used the highest closing sale price of our Common Stock within the date range for these grant events, our stock-based compensation expense adjustment relating to these grants would have increased by approximately $4.3 million, from $8.4 million to $12.7 million. Conversely, had we used the lowest closing sale price of our Common Stock within the date range for the grants analyzed,, we would not have recorded a stock-based compensation expense adjustment for these specific grants, as the fair market value of our common stock on those dates would have been at or below the actual exercise price of the options awarded.
Post IPO Grants - May 1, 2002 through December 2005
The Special Committee performed a detailed review of all stock option grants awarded between May 1, 2002 and June 30, 2003 and all annual grants awarded between May 1, 2002 and December 2005. Measurement date exceptions were noted for 45 grants covering options to purchase 294,750 shares, for which an additional stock-based compensation expense of approximately $278,000 has been recorded in the restated financial statements included in this Report. Based on the significant improvements in the Companys stock option granting practices during this period, the Special Committee determined to conduct limited sampling and testing of new hire and merit stock option grants awarded after June 30, 2003. The Special Committee sampled 88 new hire and merit grants, covering 5,082,350 shares of Common Stock (61% of all shares covered
by new hire and merit option grants). The remaining new hire and merit stock option grants occurring during the period from July 1, 2003 through December 31, 2005 were not individually reviewed and did not appear to have any unusual pricing or other characteristics indicating a need for full individual review. Sampling and other analysis indicated that these remaining grants consisted of new hire and merit grants to non-officer employees. Various tests were performed to determine whether these remaining grants had any unique pricing or other characteristics. None were identified, although measurement date exceptions were noted for 13 grants covering options to purchase 483,500 shares, for which an additional stock-based compensation expense of approximately $41,000 has been recorded in the restated financial statements included in this Report. Given the immaterial number of shares and limited income statement impact, along with the absence of unique pricing or other characteristics, additional review procedures were not deemed necessary for these remaining grants occurring after June 30, 2003 and were therefore not applied.
Other Stock Option Related Adjustments
In addition to adjustments to our reported stock-based compensation expenses resulting from corrections to accounting measurement dates, the restatement also reflects stock-option related adjustments arising from a variety of other issues discovered during our investigation:
All but $0.7 million of the foregoing adjustments were recorded in periods preceding 2004. As a result, most of the impact of these adjustments is reflected in the adjustment of our opening accumulated deficit balance at January 1, 2004 in the consolidated financial statements included in this Report.
We may also incur additional expenses as a result of certain federal and state income tax consequences of the findings of our stock option investigation. We have determined that many of our outstanding stock option awards are deemed to have been granted at an exercise price below the fair market value of our stock on the actual accounting measurement date. The primary adverse tax consequence is that the re-measured options vesting after December 31, 2004 are potentially subject to option holder excise tax under Section 409A of the Internal Revenue Code (and, as applicable, similar excise taxes under state law). We have recorded approximately $0.6 million of expenses in the year ended December 31, 2006 relating to the anticipated settlement by the Company of federal and applicable state income taxes on behalf of the Companys employees for tainted options that were exercised during 2006. Employees of the Company who continue to hold tainted options that
vested after December 31, 2004 or are still unvested may be subject to additional taxes, penalties and interest under Section 409A if no action is taken to cure the options from exposure under Section 409A before December 31, 2008. The Company has yet to determine whether it will either implement a plan to assist the affected employees for the amount of this tax, adjust the terms of the original option grant, or adjust the terms of the original option grant and pay the affected employees an amount to compensate such employees for this lost benefit with respect to the unexercised options that vested after December 31, 2004.
The following remedial steps were directed or recommended by the Special Committee in December 2006:
The increase to the exercise prices of such options held by Messrs. Smith, Garn, Morse, and Brooks also had the effect of eliminating potential tax consequences to them under Section 409A of the Internal Revenue Code and comparable provisions of applicable state tax law.
Non-Stock Option Related Adjustments
The Company has determined that additional errors in its historical financials statements require correction in this restatement. Many of these errors were identified by the Company or its auditors in connection with the restatement related procedures. Other adjustments include items identified in prior periods, but deemed them not to be material to the Companys results of operations, and are included in this restatement. A summary of the impact of these adjustments to pre-tax income for the years ended December 31, 2005 and 2004 (in thousands), is as follows:
Based upon a review of more than 100,000 software license and services transactions over the restatement period, the Company identified several instances where previously reported revenues were required to be corrected and recognized across various and appropriate reporting periods. There were several categories of revenue adjustments, but most were attributable to the following three categories of errors:
First, a programming error made at the time of our financial systems initial implementation in 2000, resulted in a systematic miscalculation of the timing of revenue recognition across certain of the Companys orders that contained a post-contract technical support services (referred to as PCS) line item. The error was identified and corrected in 2005 however we failed to evaluate the impact of the programming error and its effect on previously reported revenues. This error caused a shift in the timing of revenue recognition for all affected orders across numerous quarters and years, resulting in periodic quarterly over- and understatements of revenue.
Second, incorrect interpretations with respect to the timing of revenue recognition for certain complex orders resulted in an overstatement of license and/or PCS revenue either early in the contract or around the time of initial customer purchase and an understatement of the corresponding revenue either later in the contract or over a ratable period designated in the contract.
Third, inconsistent application of the Companys revenue recognition policies in geographies outside North America resulted in an overstatement of license and PCS revenue at and around the time of initial customer purchase and an understatement of the corresponding revenue at the time of cash collection.
Operating Expenses and Other Income (Expense), Net Adjustments
The Company also identified several instances where previously reported operating expenses or other income (expense), net items were required to be corrected and recognized across various reporting periods.
The first item related to an incorrect application of SFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets, where we performed our impairment analysis of acquired technology at the acquisition level as opposed to a product-by-product level approach, which resulted in an understatement of intangibles amortization expense related to acquired assets in the period that the impairment occurred and a corresponding overstatement of the related expense over that assets remaining estimated useful life.
The second item related to the incorrect revaluation of monetary assets and liabilities in foreign subsidiaries as required by SFAS No. 52, Foreign Currency Translation, which resulted in the periodic misstatement (both over and under) of the other income (expense), net line item on the income statement with the corresponding offsetting impact to monetary asset and liability accounts on the balance sheet (primarily cash and accounts receivable).
In addition to the revenue, operating expenses and other income (expense), net items covered specifically above, there were several additional adjustments also included in these restatement items that were grouped into the other categories given their minimal individual impact. Many of these adjustments include certain errors that were not previously recorded because in each case, and in the aggregate, the underlying errors were not considered by management to be material to our consolidated financial statements.
All the items identified above generally affect the timing pattern of revenue, expense and income recognition. As such, they do not generally change the cumulative revenues, expenses, pre-tax operating income, liquidity or cash flow of the Company.
Impact of Errors on Previously Issued Consolidated Financial Statements
As a result of the findings of the Special Committees investigation with respect to employee stock options and the other adjustments described in this Report, our consolidated financial statements for the years ended December 31, 2005 and 2004 have been restated. The restated consolidated financial statements include unaudited financial information for interim periods of 2005 and 2006 consistent with Article 10-01 of Regulation S-X. We recorded additional stock-based compensation expense and other accounting adjustments, and related tax adjustments, affecting our previously-reported financial statements for 1999 through 2003, the effects of which are summarized in cumulative adjustments to our common stock (additional paid-in capital), unearned compensation, accumulated deficit and note receivable from sale of common stock accounts as of January 1, 2004, in the amounts of $80.6 million, $48.2 million, $92.5 million and $17.2 million, respectively. See the Consolidated Statements of Shareholders Equity, included in Part IV, Item 15 of this Report.
The financial information presented in this Item 7 has been adjusted to reflect the incremental impact resulting from the restatement adjustments discussed above, as follows (in thousands):
Summary of Impact of Restatement Adjustments
Our Company and Business Model
Quest Software, Inc. delivers innovative products that help IT organizations get more performance from their computing environment. Our product areas are Application Management, Database Management and Windows Management. The focus of our products is based upon generating higher levels of performance, manageability and productivity throughout our customers IT infrastructure and with products and services that enable them to manage the investments they have made within their IT environment.
Our initial core competency as a database management company was built upon deep expertise within the Oracle database platform where we assembled a portfolio of products to manage and speed the development on the platform. As customers required heterogeneous database management tools, we broadened our product portfolio to deliver complementary solutions and expanded our offerings to address other database platforms, including DB2 and SQL Server. Today, most of our database management revenue is derived from products focused on the Oracle platform. In the last several years however, Oracle has increased the functionality of their database products creating a stronger competitive offering which has impaired our license growth for certain products. This has negatively impacted our database management product growth. On the other hand, our database development product group led by TOAD, continues to be the most significant revenue contributor of our Oracle database products. In early 2006 Oracle introduced SQL Developer, a free tool which competes with TOAD. While TOAD distinguishes itself as a feature-rich heterogeneous database platform tool, we invested in sales and marketing resources to broaden our customer footprint with TOAD and strengthen our feature set of this key product. While doing this we simultaneously sought to stimulate our broader database-driven product revenues by placing more emphasis on the SQL Server Database, a Microsoft product. Given the rapid growth of SQL Server within the market, our strategy has been to foster continued development on this platform and to build increased management capabilities into our offerings in support of the platform. While databases typically front large application deployments, they logically interact with other elements of the application infrastructure. This logical linkage and reliance on the database led Quest into its next product focal point known as application management.
From our acquisition of Foglight Software in January 2000 and then Sitraka in October 2002, to our current offerings for application management, we have made significant investments in developing and supporting products for this market. Foglight remains our flagship product and largest revenue component of our application management offerings. As our customers face the need to manage more complex applications with service oriented architectures, our products for identifying application outages and performance have become important tools. Much of 2006 was an investment year for our application management products. Our R&D team was focused on developing the next version of Foglight by reconstructing the product, integrating the previously acquired Sitraka technology and other end-user aspects into an integrated solution which was brought to market during 2007.
After establishing a market presence in both the database and application management markets, we sought to broaden our portfolio further into the Windows management tools market in early 2000 with our acquisition of Fastlane Technologies. In 2004, we acquired Aelita Software. Our acquisition of Aelita, combined with internally developed products, solidified our position as one of Microsofts leading ISVs. We market and support management tools for three key Microsoft platforms Active Directory, Exchange and SQL Server, and our products address both migration and management of the Windows platform. Our migration business comprises a set of products which support migration from other competitive platforms to its comparable Microsoft platform, as well as migrations from earlier to the most current version of Microsoft platforms. In addition, we offer products which complement the core platform tools which are natively used by customers to manage these platforms once they are in a production environment.
As our Windows products emerged and continued to grow in market popularity, the composition of our overall revenue profile changed from being primarily derived from the Oracle database platform tools to a more balanced profile with our Windows products. During 2006, as most large scale migrations were completed earlier, the primary driver of our revenue growth shifted from our migration products to the management group of products in our Windows portfolio. The management portfolio was bolstered in 2005 with products acquired through Vintela and Imceda which covered SQL Server and Active Directory.
We derive revenues from three primary sources: (1) software licenses, (2) post-contract technical support services (referred to as PCS) and (3) professional consulting and training services (referred to as PSO). Our software licensing model is primarily based on perpetual license fees, and our license fees are typically calculated either on a per-server basis or a per-seat basis.
PCS contracts entitle a customer to telephone or internet support and unspecified maintenance releases, updates and enhancements. First-year PCS contracts are typically sold with the related perpetual software license and renewed on an annual basis thereafter at the customers option. Annual PCS renewal fees are priced as a percentage of the net initial customer purchase price (which includes both the fee for a perpetual license and first year PCS). Revenue is allocated to first year PCS based on vendor-specific objective evidence (VSOE) of fair value and amortized over the term of the maintenance contract, typically 12 months although at times we sell PCS with terms of greater than 12 months.
Over the last few years revenues generated by our PCS offerings have become a larger contributor to the total revenue base of the company. As our PCS customer base grows, the PCS renewal rate has a larger influence on the PCS revenue growth rate and the amount of new software license revenues has a diminishing effect. Therefore, the growth rate of total revenues does not necessarily correlate directly to the growth rate of new software license revenues in a given period. The primary determinant of changes in our PCS revenue profile is the rate at which our customers renew their annual maintenance and support agreements. If our PCS renewal rates were to decline materially, our PCS revenues and total revenues would likely decline materially as well. Although we do not currently expect our PCS renewal rates to deteriorate, there can be no assurance they will not.
We also provide PSO services which relate to installation of our products and do not include significant customization to or development of the underlying software code. Revenue is allocated to PSO services based on VSOE of fair value and recognized as the services are performed. Such revenues represent 13.5%, 13.4% and 12.1% of total services revenues for the twelve months ended December 31, 2006, 2005 and 2004, respectively.
Our primary expenses are our personnel costs, which include compensation, benefits and payroll related taxes, which are a function of our world-wide headcount. We estimate that these personnel related costs represented approximately 67% of total expenses in 2006. Our headcount at the end of fiscal 2006 was approximately 2,850 compared to approximately 2,750 at the end of fiscal 2005. Total stock-based compensation expense increased from $12.4 million in 2005 to $27.0 million in 2006, representing a 118% year-over-year increase, primarily because of our adoption of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (SFAS 123R).
We invest heavily in research and development in order to design, develop and enhance a wide variety of products and technologies. We have also maintained an approach of using acquisitions as a strategy to obtain incremental products and technology that will be attractive to our customers. In addition, we are primarily a direct-sales driven organization that expends significant selling costs in order to secure new customer license sales and the follow-on PCS revenue stream that can continue forward beyond the initial license sale.
Our foreign currency gains or losses are predominantly attributable to translation gains or losses on our net balances of monetary assets and liabilities in our foreign subsidiaries, including accounts receivable and cash, which were primarily denominated in the Euro, and to a lesser extent, the British Pound and Canadian Dollar. The foreign currency translation adjustments to these balance sheet items are calculated by comparing the currency spot rates at the end of a quarter to the spot rates at the end of the previous quarter. On this basis, we recorded, in other income (expense), net, a net gain of $4.4 million in 2006 and a net loss of $5.6 million in 2005, representing a year-over-year change of 179%. While currency fluctuations between 2005 and 2006 significantly impacted our other income (expense), net, foreign currency exchange rates did not materially affect our income from operations in 2006. The impact of currency rate changes was less than 1% on our income from operations, meaning the strengthening foreign currencies increased revenues and expenses by less than 1% each in 2006.
Our 2006 Results
As discussed in more detail throughout our MD&A:
Recently Issued Accounting Pronouncements
See Note 1 of our Notes to Consolidated Financial Statements for information regarding recently issued accounting pronouncements.
Critical Accounting Policies and Estimates
Our consolidated financial statements are based on the selection and application of generally accepted accounting principles, which require us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates and any such differences may be material to our financial statements. We believe that the policies set forth below may involve a higher degree of judgment and complexity in their application than our other accounting policies and represent the critical accounting policies and estimates used in the preparation of our financial statements. If different assumptions or conditions were to prevail, the results could be materially different from our reported results. Historically, our assumptions, judgments and estimates relative to our critical accounting policies and estimates have not differed materially from actual results. Our significant accounting policies are presented within Note 1 of our Notes to Consolidated Financial Statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the related disclosures.
Our revenue recognition policy is one of our critical accounting policies because revenue is a key component of our results of operations and is based on complex rules that require us to make significant judgments and estimates. In applying our revenue recognition policy we must determine which portions of our revenue are recognized currently (generally perpetual software licenses) and which portions must be deferred (generally PCS and PSO). In addition, we analyze various factors including our pricing policies, the credit-worthiness of our customers, accounts receivable aging data and contractual terms and conditions in helping us make judgments about revenue recognition. Changes in judgments on any of these factors could materially impact the timing and amount of revenue and costs recognized.
We recognize revenue pursuant to the requirements of Statement of Position 97-2, Software Revenue Recognition (SOP 97-2), issued by the American Institute of Certified Public Accountants (AICPA), as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions and the related Technical Practice Aids of the AICPA. In accordance with SOP 97-2, we recognize revenue when all of the following criteria are met: (1) there is persuasive evidence of an arrangement; (2) we deliver the products; (3) fees are fixed or determinable and license agreement terms are free of contingencies or uncertainties that may alter the agreement such that they may not be complete and final; and (4) collection is probable.
We initially capture value for our products by selling a perpetual software license to end customers. The fee for the first year of PCS is included in, or bundled with, the perpetual software license at the time of initial sale. As such, the combination at initial sale of a perpetual software license and one year of PCS represents a multiple-element arrangement for revenue recognition purposes.
When all four of our revenue recognition criteria are met the multiple-element aspect of our arrangements means the only revenue recognized upfront, at the time of initial sale, is the residual revenue allocated to the perpetual software license. The revenue associated with the fair value of the undelivered PCS and/or PSO included in the initial sale is deferred and is subsequently recorded to revenue ratably over the support term and as such services are performed, respectively. The fair value of the undelivered elements is determined based on VSOE of fair value.
Revenue for our standalone sale of annual PCS renewals in years two, three and beyond is recognized ratably over the support term. Sales of PCS for multiple annual periods are treated similarly.
Revenue from our PSO is generally recognized as professional services are performed in accordance with the underlying service contracts.
Our PCS VSOE of fair value is determined by reference to the prices our end customers pay for this support when it is sold separately; that is, when we enter into an arms length, annual renewal transaction with end customers where the only offering sold is PCS. These standalone PCS renewal transactions are typically for one year in duration and are priced as a targeted percentage of the initial, discounted purchase price which includes both the upfront license fee and the first year of PCS. We bill these PCS renewal transactions in advance of the services provided. We also offer end customers the right to purchase PCS for multiple annual periods at discounted prices beyond the first year as they will be paying cash upfront, well in advance of the multi-year services performed.
Our PSO VSOE of fair value is determined by reference to our established pricing and discounting practices for these services when sold separately. Our PSO are typically sold as time-and-materials based contracts that range from five to fifteen days in duration. We sell PSO both standalone and as part of multiple-element arrangements.
Our VSOE of fair value is impacted by estimates and judgments that, if significantly different, could materially impact the timing and amount of revenue recognized in current and future periods. These estimates and judgments include, among other items:
Historically, we have been able to establish VSOE of fair value for PCS and PSO but we may modify our pricing and discounting practices in the future. This could result in changes to our VSOE of fair value for these undelivered elements. If this were to occur, our future revenue recognition for multiple-element arrangements would differ significantly from our historical results. If we were unable to support at all through VSOE the fair value of our PCS or PSO, the entire amount of revenue from our initial, upfront sale of both a perpetual software license bundled with one year of PCS and any PSO would be deferred and recognized ratably over the life of the contract.
If we cannot objectively determine the fair value of any undelivered element (hardware, software, specific upgrade rights, etc.) in a bundled software and services arrangement, we defer revenue until all elements are delivered and services are performed, or until fair value can be objectively determined for any remaining undelivered elements.
In addition to perpetual software licenses, we sell a small amount of time-based software licenses (or term licenses) each year wherein customers pay a single fee for the right to use the software and receive PCS for a defined period of time. Approximately 2% of 2006 license revenue was generated by these time-based software licenses. All license and support revenues on these term licenses are deferred and recognized ratably over the license term.
We license our products primarily through our direct sales force, our telesales force and, increasingly, indirect channels including value added resellers and distributors. For our direct sales, we utilize written contracts as the means to establish the terms and conditions upon which our products and services are sold to our end customers. For our indirect sales, we accept orders from our resellers and distributors when we are informed that they have existing orders from an end customer. We utilize written contracts coupled with purchase orders as the means to establish the terms and conditions of these indirect sales transactions.
Indirect sales through resellers, which are a growing proportion of our transaction volume, are generally handled via processes and policies that are similar to an end customer sale. Our practice until January 1, 2007 was to defer revenue recognition on indirect sales transactions of significant size until receipt of payment (assuming all other revenue recognition criteria had been satisfied) as collectability was not reasonably assured. Because of a change in circumstances involving improved cash collection histories with certain resellers we modified our revenue recognition practices to recognize revenue upon delivery of the software when all other revenue recognition criteria are satisfied. The modified practice, which now allows for the earlier recognition on most of our reseller transactions, has been implemented effective January 1, 2007.
Substantially all of our software license arrangements do not include acceptance provisions. Since such acceptance provisions are not contained in our software license arrangements as standard provisions and the incidence of returns in accordance with such acceptance provisions cannot be reasonably estimated, if a contract does include such a provision we recognize revenue upon the earlier of receipt of written customer acceptance or expiration of the acceptance period.
We evaluate arrangements with governmental entities containing fiscal funding or termination for convenience provisions, when such provisions are required by law, to determine the probability of possible cancellation. We consider multiple factors, including the history with the customer in similar transactions, and the planning, budgeting and approval processes undertaken by the governmental entity. If we determine upon execution of these arrangements that cancellation is not likely, we then recognize revenue once all of the criteria described above have been met. If such a determination cannot be made, revenue is recognized upon the earlier of cash receipt or approval of the applicable funding provision by the governmental entity.
We assess whether fees are fixed or determinable at the time of sale and recognize revenue if all other requirements have been met. Our standard payment terms are 30 days but may vary based on the country in which the agreement is executed. We generally deem payments that are due within 6 months to be fixed and determinable based on collections history and thereby satisfy the required revenue recognition criteria.
For additional information regarding our revenue recognition accounting policies see Note 1 of our Notes to Consolidated Financial Statements.
Asset valuation includes assessing the recorded value of certain assets, including accounts receivable, goodwill and other intangible assets. We use a variety of factors to assess valuation, depending upon the asset.
We make estimates of fair value based upon assumptions believed to be reasonable. These estimates are based on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from license sales, maintenance agreements, consulting contracts, customer contracts and acquired developed technologies and patents; expected costs to develop the in-process research and development into commercially viable products and estimated cash flows from the projects when completed; the acquired companys brand and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined companys product portfolio; acquired company key personnels willingness and ability to compete; and discount rates. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.
The net carrying amount of amortizing intangible assets was considered recoverable at December 31, 2006. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, these intangible assets are reviewed for events or changes in circumstances, which indicate that their carrying value may not be recoverable. We periodically review the carrying value of these assets to determine whether or not impairment to such value has occurred. In the event that in the future it is determined that the other intangible assets value has been impaired, an adjustment will be made in that corresponding period resulting in a charge against earnings for the write-down.
Accounting for Income Taxes
As part of the process of preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process requires a significant amount of judgment, estimation and uncertainty and our estimate of income taxes can be highly sensitive to shifts between such tax jurisdictions. Additionally, our U.S. and foreign tax returns are subject to routine compliance reviews by the various tax authorities. Although we believe we have appropriate support for the positions taken on our tax returns, our income tax expense includes amounts intended to satisfy income tax assessments that could result from the examination of our tax returns. Determining the income tax expense for such contingencies requires a significant amount of judgment and estimation. We evaluate such tax contingencies in accordance with the requirements of SFAS No. 5, Accounting for Contingencies, and have accrued for income tax contingencies that meet both the probable and estimable criteria of SFAS No. 5. These estimates are updated over time as more definitive information becomes available from taxing authorities, completion of tax audits, expiration of statutes of limitation, or upon occurrence of other events. The amounts ultimately paid upon resolution of such contingencies could be materially different from the amounts previously included in our income tax expense and therefore could have a material impact on our consolidated results of operations. The tax contingency accrual is recorded as a component of our net income taxes payable/receivable balance.
We recognize deferred income tax assets and liabilities based upon the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Such deferred income taxes primarily relate to the timing of the recognition of certain revenue items and the timing of the deductibility of certain reserves and accruals for income tax purposes. We regularly review the deferred tax assets for recoverability and establish a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time periods within which the underlying timing differences become taxable or deductible, we could be required to establish an additional valuation allowance against the deferred tax assets, which could result in a substantial increase in our effective tax rate and have a materially adverse impact on our operating results. U.S. income taxes were not provided for on undistributed earnings from certain non-U.S. subsidiaries. Those earnings are considered permanently reinvested.
Accounting for Stock-Based Compensation
Prior to January 1, 2006, we accounted for stock option grants in accordance with APB No. 25 and related Interpretations, as permitted by SFAS 123. Accordingly, we recognized compensation expense for stock option grants where the exercise price was lower than the fair market value of our common stock on the grant date. In accordance with SFAS 123 and SFAS 148, Accounting for Stock-Based Compensation Transition and Disclosure, we provided pro forma net income or loss and net income or loss per share disclosures for each period prior to the adoption of SFAS 123R, as if we had applied the fair value-based method in measuring compensation expense for our stock-based compensation plans.
Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123R utilizing the modified prospective transition method. As required by SFAS 123R, we estimate forfeitures of employee stock options and recognize compensation cost only for those awards expected to vest. Forfeiture rates are determined based on historical experience. Estimated forfeitures are adjusted to actual forfeiture experience as needed. Under the modified prospective approach, compensation expense recognized during the twelve months ended December 31, 2006 includes: (a) compensation expense for all stock-based awards granted prior to, but not yet vested, as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all stock-based awards granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the recognition provisions of SFAS 123R. In accordance with the modified prospective transition method, our audited consolidated financial statements for the twelve months ended December 31, 2005 have not been restated to reflect, and do not include, the impact of SFAS 123R.
SFAS 123R requires us to calculate the pool of excess tax benefits (the APIC Pool), available as of January 1, 2006, to absorb tax deficiencies recognized in subsequent periods, assuming we had applied the provisions of the standard in prior periods. We applied the provisions of SFAS 123R in calculating the APIC Pool, which was calculated using the long-haul method.
We estimate the fair value of options granted using the Black-Scholes option valuation model and the assumptions shown in Note 1 of our Notes to Consolidated Financial Statements. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating the expected term, expected volatility, risk-free interest rate and dividend yield. We may use different assumptions under the Black-Scholes option valuation model in the future, which could materially affect our net income or loss and net income or loss per share.
See also Restatement of Previously Issued Financial Statements above and Note 2 of our Notes to Consolidated Financial Statements for the discussion of the restatement related to our stock option grants.
Determining Functional Currencies for the Purpose of Consolidation
In preparing our consolidated financial statements, we are required to re-measure the financial statements of the foreign subsidiaries from their local currency into United States dollars. This process results in foreign currency re-measurement gains and losses included in other income (expense), net in the consolidated income statements.
Under the relevant accounting guidance, the treatment of these re-measurement gains or losses is dependent upon our determination of the functional currency of each subsidiary. The functional currency is determined based on the judgment of management and involves consideration of all relevant economic facts and circumstances affecting the subsidiary. The currency in which the subsidiary transacts a majority of its transactions (including transfer pricing arrangements, billings, financing, payroll and other expenditures) is one consideration of determining the functional currency; however, any dependency upon the parent and the nature of the subsidiarys operations are also considered.
Other income (expense), net includes any gain or loss associated with the re-measurement of a subsidiarys financial statements when the functional currency of a subsidiary is the United States dollar. However, if the functional currency is deemed to be the local currency, any gain or loss associated with the translation of these financial statements into the United States dollar would be included within accumulated other comprehensive income (loss) on our consolidated balance sheets. If we determine that there has been a change in the functional currency of a subsidiary to the local currency, any translation gains or losses arising after the date of change would be included within shareholders equity as a component of accumulated other comprehensive income (loss).
Based on our assessment of the factors discussed above, we consider the United States dollar to be the functional currency for each of our international subsidiaries. As a result of this determination, assets and liabilities in these subsidiaries are re-measured at current exchange rates, except for property and equipment and deferred revenue, which are re-measured at historical exchange rates. Revenues and expenses are re-measured at weighted average exchange rates in effect during the
year except for revenue and costs related to the above mentioned balance sheet items which are re-measured at historical exchange rates. Accordingly, we had a net foreign currency re-measurement gain of $4.4 million, a net loss of $5.6 million and a net gain of $3.4 million for the years ended December 31, 2006, 2005 and 2004, respectively, recorded to other income (expense), net in the respective periods. Had we determined that the functional currency of our subsidiaries was the local currency, these translation gains and losses would have been included in our statement of shareholders equity as a component of comprehensive income for each of the years presented.
The magnitude of these gains or losses is dependent upon movements in the exchange rates of the foreign currencies in which we transact business against the United States dollar and the significance of the assets, liabilities, revenues and expenses denominated in foreign currencies. The company operates in a number of currencies worldwide, most notably in the Euro, the United Kingdom Pound Sterling, Canadian Dollar, Australian Dollar and Russian Ruble. Any future re-measurement gains or losses could differ significantly from those we have experienced in recent years. In addition, if we determine that a change in the functional currency of one of our subsidiaries has occurred at any point in time, we would be required to include any translation gains or losses from the date of change in accumulated other comprehensive income (loss) on our consolidated balance sheets.
Results of Operations
Except as otherwise indicated, the following are percentage of total revenues:
Comparison of Fiscal Years Ended December 31, 2006 and 2005
Total revenues and year-over-year changes are as follows (in thousands, except for percentages):
Licenses Revenues Licenses revenues from sales of our Windows Management products, including those products with technology acquired from Vintela in July 2005 and Aftermail in January 2006 were significant drivers of our licenses revenues growth in both North America and Rest of World. Sales of our Imceda and Vizioncore products also contributed to growth in license revenues. Licenses revenues growth in these product areas was offset slightly by reduced licenses revenues from sales of our Application Management products and our Oracle Database Management products.
Services Revenues The largest component of services revenues is PCS revenue. Services revenues also include fees for PSO. Our Windows Management product line and our Oracle Database Development products primarily drove growth in services revenues. PCS revenues from renewals of annual maintenance agreements have continued to grow. Revenues from PSO increased $7.6 million or 26.1%. PSO as a percentage of total service revenues represented approximately 13.5% in the twelve months ended December 31, 2006 and 2005.
Cost of Revenues
Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages):
Cost of Licenses Cost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, delivery and personnel costs. Cost of licenses as a percentage of license revenues was 1.9% and 2.0% for the twelve months ended December 31, 2006 and 2005, respectively. The absolute dollar increase is primarily the result of increased license sales of royalty-bearing products.
Cost of Services Cost of services primarily consists of personnel, outside consultants, facilities and systems costs used in providing PCS and PSO. Cost of services does not include development costs related to bug fixes and upgrades which are classified in research and development and which are not separately determinable. Personnel related costs increased by approximately $4.4 million, primarily due to significant growth in technical support headcount (average headcount in 2006 increased by 90% over the prior year) and from a $0.7 million increase in stock-based compensation expense. Fees paid to outside professional services consultants in connection with new system implementation support increased by $4.7 million in the twelve months ended December 31, 2006 over the comparable period in 2005 as the demand for our professional services exceeded our ability to provide these services. Cost of services as a percentage of service revenues were 18.3% and 17.8% in the twelve months ended December 31, 2006 and 2005, respectively.
Amortization of Purchased Technology Amortization of purchased technology includes amortization of the fair value of purchased technology associated with acquisitions made since 2002. The 38.8% increase in amortization of purchased technology is primarily due to our acquisitions of AfterMail and Charonware in 2006 and by a $2.3 million impairment charge recorded in the fourth quarter of 2006 for a portion of purchased technology acquired in 2002. We expect amortization of purchased technology within the cost of revenues arising from acquisitions completed prior to December 31, 2006 to be approximately $12.0 million in the year ending December 31, 2007.
Year-over-year changes in the principal components of our operating expenses are as follows (in thousands, except for percentages):
Sales and Marketing Sales and marketing expenses consist primarily of compensation and benefit costs for sales and marketing personnel, sales commissions, related facilities and information systems (IS) costs, and costs of trade shows, travel and entertainment and various discretionary marketing programs. Sales and marketing expense increased $43.6 million during the twelve months ended December 31, 2006 as compared to the same period in 2005. Personnel related costs increased approximately $32.7 million, of which $3.2 million is due to higher stock-based compensation expense. The increase in personnel related costs was primarily due to significant growth in headcount within our direct sales, system engineering, telesales groups and product marketing and commissions on the increased amount of sales in 2006 compared to 2005. Average headcount in sales and marketing increased 19% in 2006 over the prior year.
Research and Development Research and development expenses consist primarily of compensation and benefit costs for software developers who develop new products, bug fixes and upgrades to existing products and at times provide engineering support for PCS services, software product managers, quality assurance and technical documentation personnel, associated facilities and IS costs and payments made to outside software development consultants in connection with our ongoing efforts to enhance our core technologies and develop additional products. Research and development expense increased $21.5 million during the twelve months ended December 31, 2006 as compared to the same period in 2005. Personnel related costs increased approximately $17.9 million, of which $6.6 million related to higher stock-based compensation expense. The increase in personnel related costs was also due to significant growth in headcount within our quality assurance and product development areas.
General and Administrative General and administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, human resources, administrative and IS personnel, and professional fees for audit, tax and legal services, associated facilities and IS costs. General and administrative expense increased $17.3 million during the twelve months ended December 31, 2006 as compared to the same period in 2005. Personnel related costs increased approximately $11.5 million, of which $4.1 million related to higher stock-based compensation expense. The increase in personnel related costs was primarily due to additional headcount hired to support the companys growth.
Fees associated with the investigation of our historical stock option grant practices and related accounting being conducted by the special committee of independent directors, contributed $6.6 million to the overall increase in general and administrative expenses. We also recorded $1.5 million in incremental stock-based compensation expense resulting from modifications to certain former employee stock option grants, as discussed in more detail in Note 11 of our Notes to Consolidated Financial Statements. Restatement related costs recorded in general and administrative expenses were $6.9 million through the nine months ended September 30, 2007.
The increase to personnel costs and fees related to the stock option investigation were offset slightly by a reduction to bad debt expense of approximately $0.9 million.
Amortization of Other Purchased Intangible Assets Amortization of other purchased intangible assets includes the amortization of customer lists, trademarks, non-compete agreements and maintenance contracts associated with acquisitions. The decrease in amortization expense from 2005 to 2006 was due to certain other purchased intangible assets related to our acquisition of Aelita Software in 2004 that were fully amortized by the end of the first quarter of 2006. We expect amortization of other purchased intangible assets reflected on our December 31, 2006 balance sheet to be approximately $6.1 million for the year ending December 31, 2007.
In-Process Research and Development In-process research and development (IPR&D) expenses related to in-process technology acquired from AfterMail and Charonware in 2006 and Wingra Technologies, LLC and Vintela in 2005, respectively. These costs were charged to operations as the technologies had not reached technological feasibility and did not have alternative future uses at the date of acquisition.
Other Income (Expense), Net
Other income (expense), net includes interest income on our investment portfolio, gains and losses from foreign exchange fluctuations and gains or losses on other financial assets as well as a variety of other non-operating expenses, such as costs incurred with operating and maintaining our corporate aircraft which was sold in the fourth quarter of 2006 and the minority interest in Vizioncore. Other income (expense), net increased to a $13.0 million gain in 2006 from a $1.0 million loss in 2005. Interest income was $11.2 million and $6.8 million in the twelve months ended December 31, 2006 and 2005, respectively. We had a $4.4 million foreign currency gain in 2006 compared to a $5.6 million foreign currency loss in 2005. Our foreign currency gains or losses are predominantly attributable to translation gains or losses on net monetary assets, including accounts receivable and cash, which were primarily denominated in the Euro, and to a lesser extent, the British Pound and Canadian Dollar.
Income Tax Provision
During the twelve months ended December 31, 2006, the provision for income taxes decreased to $16.7 million from $27.3 million in the comparable period of 2005, representing a decrease of $10.6 million. The effective income tax rate decreased to 22.0% in 2006, compared to 45.6% in 2005. In 2006, the Company realized an overall foreign tax benefit from losses in certain higher-tax jurisdiction, and a shift of profitability to lower tax jurisdictions. Included in income tax expense for the twelve months ended December 31, 2005, is a tax provision of approximately $2.3 million related to our repatriation of approximately $43.5 million of qualified earnings under the applicable provisions of the American Jobs Creation Act of 2004, and approximately $2.4 million of additional expense related to a non-deductible IPR&D charge of $6.8 million.
Comparison of Fiscal Years Ended December 31, 2005 and 2004
Total revenues and year-over-year changes are as follows (in thousands, except for percentages):
Licenses Revenues Growth in license revenues is primarily a result of increased software license sales within our Windows Management and Database Management product lines, which increased by approximately 35% and 11%, respectively, from the twelve months of 2004 to the comparable period in 2005. Approximately 57%, or $17.3 million, of the 2004 to 2005 license revenue growth derived from products acquired in 2005.
Services Revenues Our Windows Management product line and our Database Development products primarily drove the growth in services revenues. PCS revenues from renewals of annual maintenance agreements have continued to grow and revenues from PSO increased $9.1 million or 45.6%. PSO as a percentage of total service revenues represented approximately 13% and 12% in the twelve months ended December 31, 2005 and 2004, respectively. Our North American operating results for the first three quarters of 2004 included approximately $7.3 million in services revenues from our Vista Plus output management product line, which we sold in September 2004. Excluding the Vista Plus service revenues from our 2004 results, our North American service revenues increased by approximately 34%.
Cost of Revenues
Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages):
Cost of Licenses Cost of licenses as a percentage of license revenues were 2.0% and 1.8% for the twelve months ended December 31, 2005 and 2004, respectively. Cost of licenses as a percent of total revenues was approximately 1% in both the twelve months ended December 31, 2005 and 2004. The absolute dollar increase is primarily the result of increased license sales of royalty-bearing products.
Cost of Services The 25.7% increase in cost of services was primarily due to an increase of $4.6 million in personnel related costs as a result of significant growth in headcount (average headcount in 2005 increased by 21% over the prior year) and an increase of $1.6 million in fees paid to outside professional services consultants in connection with new system implementation support as the demand for our professional services exceeded our ability to provide these services, offset partially by a $0.6 million reduction in stock-based compensation in the twelve months ended December 31, 2005 over the comparable period in 2004. Cost of services as a percentage of service revenues were 17.8% and 18.5% in the twelve months ended December 31, 2005 and 2004, respectively.
Amortization of Purchased Technology Amortization of purchased technology includes amortization of the fair value of purchased technology associated with acquisitions made from 2001 through the end of 2005. The amount amortized during the twelve months ended December 31, 2005 increased primarily as a result of our acquisitions of Imceda and Vintela. We also recorded impairment charges of $0.6 million and $0.8 million in 2005 and 2004, respectively.
Year-over-year changes in the principal components of our operating expenses are as follows (in thousands, except for percentages):
Sales and Marketing The 18.4% increase in sales and marketing expense was primarily due to an increase of $24.9 million in personnel related costs, such as labor, commissions, bonuses, vacation, reward programs and payroll taxes, of which $2.6 million is due to higher stock-based compensation expense. This increase in personnel related expense was attributable to significant growth in headcount, including the additional headcount from the acquisitions of Imceda and Vintela, and to increased commissions on the increased amount of sales. Average headcount in sales and marketing increased 25% in 2005 over the prior year. Marketing communications, programs, conferences, and road/trade show expenses increased by approximately $2.1 million. A portion of the overall increase was offset by a reduction of approximately $1.8 million in depreciation expense related to our sales force automation system, implemented during 2001 and fully depreciated by the end of the third quarter in 2004. Sales and marketing expenses as a percentage of total revenues were 43.2% and 44.2% in 2005 and 2004, respectively.
Research and Development The 6.5% increase in research and development expense was primarily due to an increase of $2.6 million in personnel related costs. The increase in labor cost was partially offset by a reduction of $3.0 million to stock-based compensation expense. This increase in personnel related expenses was attributable to an increase in the number of employees engaged in research and development activities in 2005, resulting from both direct hiring and acquisitions, including the acquisitions of Imceda and Vintela, as well as increased compensation levels. Research and development expenses as a percentage of total revenues were 18.9% and 21.5% for the twelve months ended December 31, 2005 and 2004, respectively.
General and Administrative The 17.8% increase in general and administrative expense was primarily due to an increase of $4.8 million in personnel related costs. The increase in labor cost was partially offset by a reduction of $1.1 million to stock-based compensation expense. This increase in personnel related expenses was attributable to an increase in the number of employees engaged in general and administrative activities in 2005, resulting primarily from direct hiring, as well as increased cash compensation levels. Average headcount in general and administrative increased 25% in 2005 over the prior year. Higher accounting and tax fees related to our ongoing SOX 404 compliance efforts also contributed approximately $0.9 million, or 12.3% of the increase in general and administrative expenses. Other consulting fees for matters unrelated to SOX 404 increased by approximately $0.9 million. Legal costs decreased by approximately $1.5 million as a result of the settlement or dismissal of material litigation matters in the first quarter of 2005. General and administrative expenses as a percentage of total revenues were 10.3% and 10.6% for the twelve months ended December 31, 2005 and 2004, respectively.
Amortization of Other Purchased Intangible Assets The 37.7% increase in amortization of other purchased intangible assets during 2005 was primarily due to our acquisitions of Imceda and Vintela.
In-Process Research and Development In-process research and development expenses relate to in-process technology acquired from Wingra Technologies, LLC in January 2005, our acquisition of Vintela in July 2005 and our acquisitions of Aelita and Lecco in March and April of 2004, respectively. These costs were charged to operations as the technologies had not reached technological feasibility and did not have alternative future uses at the date of acquisition.
Litigation Loss Provision Litigation loss provision relates to a litigation settlement fully accrued for in 2004 and paid in March 2005.
Other Income (Expense), Net
Other income (expense), net decreased from a $9.3 million gain in 2004 to a $1.0 million loss in 2005. Interest income was $6.8 million and $7.3 million in the twelve months ended December 31, 2005 and 2004, respectively. We had a foreign currency loss of $5.6 million in 2005 compared to a foreign currency gain of $3.4 million in 2004. Our foreign currency losses were predominantly attributable to translation losses on net monetary assets, including accounts receivable and cash, which were primarily denominated in the Euro, and to a lesser extent, the British Pound. On this basis the U.S. Dollar strengthened against the Euro and the British Pound during 2005. Other income (expense), net includes several other components, of which the majority relates to costs incurred with operating and maintaining our corporate aircraft, which was sold in the fourth quarter of 2006.
Income Tax Provision
During the twelve months ended December 31, 2005, the provision for income taxes increased to $27.3 million from $7.9 million in the comparable period of 2004, representing an increase of $19.4 million. The effective income tax rate increased to 45.6% in 2005, compared to 13.1% in 2004. Included in income tax expense for the twelve months ended December 31, 2005, is a tax provision of approximately $2.3 million related to our repatriation of approximately $43.5 million of qualified earnings under the applicable provisions of the American Jobs Creation Act of 2004. Additional increases are largely a result of: (1) a shift in the profitability from entities located in lower tax jurisdictions to entities located in higher tax jurisdictions; and (2) the release of U.S. jurisdiction valuation allowances for the year ended December 31, 2004.
Inflation has not had a significant effect on our results of operations or financial position for the years ended December 31, 2006, 2005 and 2004.
Liquidity and Capital Resources
Cash and cash equivalents and marketable securities were approximately $390.2 million and $243.0 million as of December 31, 2006 and 2005, respectively. Cash and cash equivalents consisted of cash and highly liquid investments purchased with original maturities of three months or less. Marketable securities consisted primarily of short-term investment-grade bonds and United States government and agency securities with original maturities of greater than three months. Our investment objectives were to preserve principal and provide liquidity, while at the same time maximizing market return without significantly increasing risk. We generally hold investments in marketable securities until maturity.
Summarized annual cash flow information is as follows (in thousands):
Our primary source of operating cash flows was the collection of accounts receivable from our customers. Our primary use of cash from operating activities was for compensation and personnel-related expenditures. We intend to continue to fund our operating expenses through cash flows from operations.
The analyses of the changes in our operating assets and liabilities are as follows:
Our primary source of investing cash flows was proceeds from the sale of marketable securities, typically at maturity. Our primary uses of cash from investing activities were for purchases of marketable securities, cash payments for acquisitions and capital expenditures.
Capital expenditures in 2006 included $3.8 million for leasehold improvements and furniture and fixtures for the lease of our new EMEA headquarters office in Maidenhead, United Kingdom. We completed the sale of our corporate aircraft to a third party in 2006 for $15.6 million in cash, net of $0.3 million in transaction fees. Capital expenditures during the twelve months ended December 31, 2005 and 2004 included $29.9 million and $23.3 million, respectively, in cash to complete the purchase of our buildings in Aliso Viejo, California and related infrastructure improvements. We did not have such expenditures in 2006.
In 2006 we used $21.3 million in cash to acquire two companies and to make minority cost-method investments in three early stage private companies. In 2005 we used $120.6 million in cash related to five acquisitions. In 2004 we used $96.7 million in cash related to three acquisitions offset by $22.5 million in cash provided by the sale of our Vista Plus product suite. These acquisitions and disposition are more fully described in Note 5 of our Notes to Consolidated Financial Statements.
We will continue to purchase property and equipment needed in the normal course of our business. We also plan to use cash generated from operations and/or proceeds from investments in marketable securities to fund other strategic investment and acquisition opportunities that we continue to evaluate. We plan to use excess cash generated from operations to invest in short and long-term marketable securities consistent with past investment practices.
Our primary source of financing cash flows has historically been from the issuance of our common stock under our employee stock option plans, excess tax benefits related to stock-based compensation and proceeds from a repurchase agreement. We have also financed acquisitions and capital expenditures with net borrowings under a repurchase agreement in prior periods.
Excess tax benefits related to stock-based compensation were historically reported under net cash provided by operating activities but, under SFAS 123R going forward these amounts are required to be classified as a cash flow from financing activity. Excess tax benefits in years prior to adoption of SFAS 123R were presented in the operating activities section of the consolidated statements of cash flows and were $7.8 million and $4.8 million in 2005 and 2004, respectively. During the years ended December 31, 2005 and 2004, cash flows from financing activities were affected by proceeds from and repayment of our repurchase agreement as more fully described in Note 9 of our Notes to Consolidated Financial Statements.
Because we announced our determination to restate our previously issued financial statements and have become delinquent in our periodic reporting obligations under the Securities Exchange Act of 1934, as amended, we determined that we could no longer rely upon the Registration Statements on Form S-8 previously filed with the U.S. Securities Exchange Commission to register the shares of our common stock issuable upon exercise of stock options granted under our various stock option plans. Accordingly, we took action in the third quarter of 2006 to block exercises of all stock options based on our determination that doing so was necessary to prevent violations of applicable securities law and as a result, we do not expect to receive proceeds from the exercise of stock options until after all of our delinquent reports are filed with the SEC.
We completed our repatriation activity under the American Jobs Creation Act (AJCA) during 2005. This effort resulted in the tax efficient, one time return of $43.5 million cash for funding acquisitions, purchase of real property, funding for research and development related activities and infrastructure and capital investments.
Based on our current operating plan, we believe that our existing cash, cash equivalents, investment balances and cash flows from operations will be sufficient to finance our operational cash needs through at least the next 12 to 24 months. Our ability to generate cash from operations is subject to substantial risks described under the caption Risk Factors. One of these risks is that our future business does not stay at a level that is similar to, or better than, our recent past. Should a general economic downturn or similar event occur, or should the companys products become uncompetitive or less attractive to end customers, we may be unable to generate or sustain positive cash flow from operating activities. We would then be required to use existing cash, cash equivalents and investment balances to support our working capital and other cash requirements. Also, acquisitions are an important part of our business model. As such, significant amounts of cash could and will likely be used in the future for additional acquisitions or strategic investments. If additional funds are required to support our working capital requirements, acquisitions or other purposes, we may seek to raise funds through public or private equity or debt financing or from other sources. We can provide no assurance that additional financing will be available at all or, if available, that we would be able to obtain additional financing on terms favorable to us.
Contractual Obligations and Off-Balance Sheet Arrangements
As of December 31, 2006, our contractual obligations or commercial commitments include our facility lease commitments and operating leases for office facilities and certain items of equipment. In addition, we are committed to pay additional capital contributions to a private equity fund totaling $0.4 million as capital calls are made. We do not have any other off-balance sheet arrangements that could reduce our liquidity.
The following table summarizes our obligations as of December 31, 2006 and the effect we expect such obligations to have on our liquidity and cash flows in future periods (in thousands):
In addition to the cash commitments above, we have certain rights and obligations in the form of call and put options, the amount and likelihood of which are not currently determinable, to acquire the remaining equity interest in two entities for a purchase price to be determined by a formula that is based on multiples of revenue. We also entered into earn-out agreements with the shareholders of companies we acquired during the year ended December 31, 2006. The earn-out payments are based on the acquired companys products total revenue growth over a specified period after the acquisition date. No earn-out payments were required to be paid in 2006 and the amount or likelihood of future payments based on future results is not determinable.
Foreign Exchange Risk
We are a U.S. Dollar functional company and transact business in a number of different foreign countries around the world. In most instances, revenues are collected and operating expenses are paid in the local currency of the country in which we are transacting. Accordingly, we are exposed to both transaction and translation risk relating to changes in foreign exchange rates.
Our exposure to foreign exchange risk is composed of the combination of our foreign net profits and losses denominated in currencies other than the U.S. Dollar, as well as our net balances of monetary assets and liabilities in our foreign subsidiaries. These exposures have the potential to produce either gains or losses depending on the directional movement of the foreign currencies versus the U.S. Dollar and our operational profile in foreign subsidiaries. Our cumulative currency gains or losses in any given period may be lessened by the economic benefits of diversification and low correlation between different currencies, but there can be no assurance that this pattern will continue to be true in future periods. During 2006, we had a $4.4 million foreign currency gain compared to a $5.6 million foreign currency loss in 2005.
The foreign currencies to which we currently have the most significant exposure are the Euro, the Canadian Dollar, the British Pound and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for speculative trading purposes. We regularly monitor the potential cost and benefits of hedging foreign exchange exposures with derivatives and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.
Interest Rate Risk
Our exposure to market interest-rate risk relates primarily to our investment portfolio. We have not used derivative financial instruments to hedge the market risks of our investments. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer other than the United States government and its agencies. Our investments in marketable securities consist primarily of investment-grade bonds and United States government and agency securities. Investments purchased with an original maturity of three months or less are considered to be cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders equity.
We presently do not intend to liquidate our short and long-term investments prior to their scheduled maturity dates. However, in the event that we did liquidate these investments prior to their scheduled maturities and there were no changes in market interest rates, we could be required to recognize a realized loss on those investments when we liquidate. At December 31, 2006, we have an unrealized loss of $0.8 million on our investments in debt securities compared to $1.7 million at December 31, 2005. Our remaining investment positions and duration of the portfolio would not be materially affected by a 100 basis point shift in interest rates.
Information about our investment portfolio is presented in the table below, which states the amortized book value and related weighted-average interest rates by year of maturity (in thousands):
The financial statements required by this item are included in Part IV, Item 15 of this Form 10-K and are presented beginning on page F-1.
The following tables set forth selected unaudited consolidated quarterly financial data for the eight quarters ended December 31, 2006 (in thousands, except per share amounts):
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED INCOME STATEMENTS
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED INCOME STATEMENTS