SoftBrands 10-K 2005
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
GENERAL FORM FOR REGISTRATION OF SECURITIES
Pursuant to Section 12(b) or (g) of The Securities Exchange Act of 1934
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code
Securities to be registered pursuant to Section 12(b) of the Act:
Securities to be registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
(Title of class)
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 ý NO o
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 the 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. o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO ý
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES o NO ý
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to
the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last
business day of the registrants most recently completed second fiscal quarter. $72,035,933.
APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or
15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.
YES ý NO o
The number of shares of the registrants common stock outstanding as of October 31, 2005 was 40,036,000.
2005 Annual Report on Form 10-K
Table of Contents
FORWARD LOOKING STATEMENTS
Our Form 10-K contains a number of statements about our future operations. We make statements regarding anticipated product introductions, changes in markets, customers and customer order rates, expenditures in research and development, growth in revenue, taxation levels, the effects of pricing, and the growth in our foreign operations, and others not specifically identified, all of which represent our expectations and beliefs about future events. In some cases, you can identify forward-looking statements by terminology such as may, will, should, could, expect, intend, plan, anticipate, believe, estimate, predict, potential, continue or similar words and expressions. These statements are only predictions and involve known and unknown risks, uncertainties and other factors that may cause our or our industrys actual results, level of activity, performance or achievements to be materially different from those expressed or implied by these forward-looking statements. The factors that may cause our operations to vary materially from those contemplated by our forward-looking statements include:
Economic and market conditions can adversely affect our revenue growth and operating results. Demand for enterprise software and our solutions is affected by general economic conditions, competition, product acceptance and technology lifecycles. A general weakening of the economy and business conditions that affect information technology and the industries we serve could result in delays and decreases of customer purchases, and in decreases in our renewal rates for software maintenance.
Our operating results may be adversely affected by downturns in the industries we serve. Our financial results depend, in significant part, upon economic and market conditions in the manufacturing and hospitality industries. The hospitality industry experienced a significant downturn as a result of 9/11 and the SARS outbreak. Disasters such as the tsunami in the Indian Ocean region, hurricanes Katrinas and Ritas impact in the United States and the avian influenza worry could have similar impact upon both the manufacturing and hospitality markets in the regions directly or indirectly affected. Continued changes in the hospitality and manufacturing markets could impact our ability to sell our software.
The markets for some of our products are mature and we may have difficulty generating significant new software license sales in those markets. The combination of a decline in the level of manufacturing activity in the United States and Western Europe and saturation due to market maturity of Enterprise Resource Planning (ERP) software may limit new license sales growth.
We may become more dependent on products that are not widely accepted and that have limited sales and service revenue history. We are marketing our Fourth Shift Edition for SAP Business One product, for use with SAP Business One to small- to mid-sized manufacturing companies and plants or divisions of multinational enterprises. This product was released in April 2005. We have not sold substantial numbers of these products and cannot be certain that they will ever be widely accepted in the marketplace.
Sales of Fourth Shift Edition are dependent upon continuation of agreements with, and cooperation from, SAP and termination of those agreements and cooperation could render continued sales difficult or impractical. We are devoting significant resources to marketing Fourth Shift Edition for SAP Business One as one of our leading product offerings for small to mid-sized manufacturers. We have developed Fourth Shift Edition in accordance with a development agreement with SAP Business One and distribute Fourth Shift Edition directly with copies of SAP Business One that we sell as a SAP Business One reseller and in part through arrangements with SAP Business One resellers. Termination of our agreements with SAP Business One could end our ability to sell SAP Business One, limit our market for the product to existing SAP Business One users, and terminate many of our distribution channels.
We have substantial international sales which are subject to the many risks of international operations. Our operations are international in scope, with operations in Europe, Middle East, China and Africa. For the year ended September 30, 2005, 47.2% of our revenue was derived from sales outside the United States. These sales are subject to many of the risks of international operations including:
higher operating costs in some regions;
currency controls and fluctuations in currency exchange rates;
changes in local market business requirements and increased cost and development time required to modify and translate our products for local markets;
inability to recruit qualified personnel in a specific country or region;
difficulty in establishing and maintaining relationships with local resellers, systems integrators or other third-party vendors;
differing foreign technical standards;
differing regulatory requirements;
export restrictions and controls, tariffs and other trade barriers;
difficulties in staffing and managing international operations;
reduced protection for intellectual property rights;
changes in political and economic conditions;
seasonal reductions in business activity;
potentially adverse tax assessments; and
terrorism, disease, or other events that may affect local economies and access, and that may particularly affect utilization of hotels and therefore our hospitality business.
The sales cycle for our products makes it difficult to predict our operating results. Our customers often take significant time evaluating our products before licensing the software. The period between initial customer contact and a purchase may vary from one month to more than one year. During the evaluation period, prospective customers may delay purchases, may decide not to purchase and may scale down proposed orders for reasons that we do not control and cannot predict, including:
reduced demand for enterprise software solutions;
introduction of products by our competitors;
lower prices offered by our competitors;
changes in the budgets and purchasing priorities of the customer;
need for education of customer personnel; and
changes in the customers information systems.
We may be unable to retain or attract customers if we do not develop new products and enhance our current products in response to technological changes and competing products. We have been required, and will continue to be required, to adapt our products to rapidly changing standards for operating systems, databases and other technologies. We will be unable to compete effectively if we are unable to:
maintain and enhance our technological capabilities to correspond to these changing environments and standards;
develop and market products and services that meet changing customer needs; and
anticipate or respond to technological changes on a cost-effective and timely basis.
A significant portion of our research and development resources is devoted to product upgrades that address new systems and maintenance requirements or add functionality to our products. The remainder of our research and development resources are devoted to new products that we cannot be certain will be widely accepted.
Our revenue is partly dependent on renewal of maintenance agreements by our customers. We generate substantial recurring revenue from our customer support program and other software maintenance services, most of which renew annually at the customers option. During the year ended September 30, 2005, we generated $43.5 million or approximately 62% of our total revenue from software maintenance services. The level of our maintenance revenue is directly related to the number of our software products that are in active use by customers. If our customers cease using our products, if we are unable to maintain the rate of addition of new customers, or if our customers determine that they cannot afford maintenance, our maintenance revenue can be expected to decline. Revenue generated from customers using legacy products that receive lower rates of development funding represent an increasing risk of cancellation.
We may be required to delay revenue recognition into future periods, which could adversely impact our operating results. We may be required to defer revenue recognition for license fees due to several factors, if:
our license agreements include applications that are under development or have other undelivered elements which may be essential or may not have a vendor specific objective evidence of fair value;
we deliver services which could delay product delivery or acceptance; or
a third-party vendor, whose technology is incorporated into our software products, delays delivery of the final software product to the customer.
We are occasionally unable to negotiate contract terms that permit revenue recognition at the time of delivery or even as work on the project is completed.
We have adopted anti-takeover defenses that could make it difficult for another company to acquire control of SoftBrands. Provisions in our second amended and restated certificate of incorporation and bylaws, our stockholder rights plan and under Delaware law could make it more difficult for other companies to acquire us, even if doing so would benefit our stockholders. Our charter documents contain the following provisions which may inhibit an acquisition:
advance notification procedures for matters to be brought before stockholder meetings;
a limitation on who may call stockholder meetings;
a prohibition on stockholder action by written consent;
a classified or staggered board of directors; and
the ability of our board of directors to issue shares of preferred stock without a stockholder vote.
Further, our stockholder rights plan could delay, deter or prevent any potential bidder from acquiring more than 10% of our voting stock without the agreement of our Board of Directors. Because we are incorporated under Delaware law, a stockholder who acquires more than 15% but less than 85% of our stock may have difficulty acquiring us during the three years after the date of the stock acquisition.
A number of our competitors are well-established software companies that have advantages over us. We face competition from a number of software companies that have advantages over us due to their larger customer bases, greater name recognition, long operating and product development history, greater international presence and substantially greater financial, technical and marketing resources. These competitors include well-established companies such as Microsoft Corporation, Oracle Corporation and SSA, all of which have larger installed customer bases. In addition, we compete with a variety of more specialized software and services vendors, including: Epicor Software Corporation, QAD, Inc., SYSPRO Impact Software, Inc., Infor Global Solutions, IFS, Intentia International AB and Glovia International.
A recently adopted change in the way companies must account for stock options may affect our earnings and cause us to change our compensation practices. Through September 30, 2005 we accounted for the issuance of stock options under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. In December 2004, the Financial Accounting Standards Board (FASB) adopted SFAS No. 123R, Share-Based Payment, (SFAS No. 123R) which is effective for us starting in the first quarter of fiscal 2006. SFAS No. 123R requires us to report in our operating statement, the fair value of awards under our stock plans as a compensation expense affecting both net income (loss) and earnings (loss) per share. Through September 30, 2005, we recorded compensation expense only in connection with option grants that had an exercise price below fair market value. For option grants that had an exercise price at fair market value, until the first quarter of fiscal 2006, we calculated compensation expense and disclosed their impact on net income (loss) and earnings (loss) per share, as well as the impact of all stock-based compensation expense, only in a footnote to our consolidated financial statements. SFAS No. 123R requires us to expense the fair value of stock based benefit awards, stock options, restricted stock and stock appreciation rights, as compensation cost starting with the first quarter in fiscal 2006.
Changes in the terms on which we license technologies from third-party vendors could result in the loss of potential revenues or increased costs or delays in the production and improvement of our products. We license third-party software products that we incorporate into, or resell with, our own software products. For example, we incorporate customer relations software licensed from Pivotal into some of our products, and we rely on the SQL database management system for many of our products and the Oracle database management system for some of our products. We also have reseller relationships with a number of other companies, which allow us to resell their technology with our products. These licenses and other technology licenses are subject to periodic renewal and may include minimum sales requirements. A failure to renew, or early termination of these licenses or other technology licenses could adversely impact our business.
If our products infringe on the intellectual property rights of third parties and we are sued for infringement or cannot obtain licenses to these rights on commercially acceptable terms, our business would suffer. Many participants in the technology industry have an increasing number of patents and patent applications and have demonstrated a readiness to take legal action based on allegations of patent and other intellectual property infringement. As the number and functionality of our products increase, we believe that we may become increasingly subject to the risk of infringement claims. If infringement claims are brought against us, these assertions could distract management and we may have to expend potentially significant funds and resources to defend or settle such claims. If we are found to infringe on the intellectual property rights of others, we could be forced to pay significant license fees or damages for infringement.
We have limited protection of our intellectual property and, if we fail to adequately protect our intellectual property, we may not be able to compete. We rely on a combination of contract, copyright, trademark and trade secret laws to protect this information. Existing copyright laws afford only limited protection. In general, we do not release the source code of our
products, although we may permit customers to obtain access to our source code through a source code escrow arrangement. This access to our source code may increase the likelihood of misappropriation or other misuse of our intellectual property. In addition, the laws of some countries in which our software products are or may be licensed do not protect our software products and intellectual property rights to the same extent as the laws of the United States. Defending our rights could be costly.
Our success depends on our ability to continue to retain and attract qualified personnel. We believe that our success depends upon our ability to continue to train, retain, effectively manage and attract highly skilled technical, managerial, sales and marketing personnel. If our efforts in these areas are not successful, our costs may increase, development and sales efforts may be hindered and our customer service may be degraded. There is intense competition for personnel in the software industry. From time to time, we experience difficulties in locating enough highly qualified candidates in desired geographic locations, or with required industry-specific expertise.
If we fail to maintain effective internal control over financial reporting, we may not be able to accurately report our financial results which could have a material adverse effect on our business or operating results. Effective internal control over financial reporting is necessary for us to provide reliable financial reports and is important in helping to prevent financial fraud. If we are unable to achieve and maintain adequate internal control over financial reporting, our business and operating results could be adversely affected. We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement. For example, we discovered during the summer of 2005 a material weakness in our tax reporting compliance that had caused us to incorrectly report the tax benefit from losses from continuing operations as a benefit to discontinued operations, and also discovered a material weakness in disclosure controls that caused errors in our computation of earnings per share and diluted earnings per share. We are implementing procedures to remedy these weaknesses. Any failure to implement new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations. Further, the Sarbanes-Oxley Act of 2002 requires, beginning with our annual report for the 2006 fiscal year, our management to state whether our internal control over financial reporting is effective, and will require our independent registered public accounting firm to attest to managements conclusion. If our management is not able to come to a conclusion that our internal control over financial reporting is effective, or if our independent registered public accounting firm is unable to attest to managements conclusion, investors could lose confidence in our reported financial information.
We may need additional capital to make future acquisitions. We believe our cash balances, together with cash from operations will be sufficient to meet cash requirements through September 30, 2006 and beyond. However, we may need or choose to raise capital for various strategic or operational reasons including acquisitions. If we do so with unregistered securities these securities may be priced at a discount to freely tradable shares as currently reflected on the pink sheets. There can be no assurance we will be able to raise capital and the pricing and terms of any capital could be unfavorable to current stockholders.
SoftBrands, Inc. provides enterprise software and professional services to approximately 4,500 customers in more than 60 countries. We have established a worldwide infrastructure for distribution, development and support of enterprise software. Our integrated software suites provide the tools necessary for small- and mid-sized businesses in the manufacturing and hospitality sectors to improve efficiency, enhance customer satisfaction and improve profitability. Headquartered in Minneapolis, Minnesota, we have more than 570 employees and branch offices in Europe, China, Australia, India and Africa. We operate in two principal business segments: manufacturing software and hospitality software.
Development of Business
Over the past twelve months, we introduced a key new manufacturing software product, expanded our relationship with SAP, grew our reseller network, made key new additions to our management team, significantly strengthened our balance sheet, and made an important acquisition, among other developments.
We completed development of Fourth Shift Edition for SAP Business One, a set of software applications based on our core Fourth Shift product that is integrated with SAP Business One software, in early April 2005. Although the introduction of Fourth Shift Edition was delayed by several months, we sold fourteen Fourth Shift Edition Systems during fiscal year 2005 and currently offer the product suite in the United States, Canada and ASEAN markets.
We continued to increase our distribution capability in fiscal 2005 by adding resellers for both our hospitality and manufacturing software. 24 business partners are now in place to sell Fourth Shift Edition for SAP Business One. In the hospitality business, 14 partners are now in place in the U.S. market to sell Medallion.
As a continuation of the initiative we instituted in 2003 to make our operations more efficient, we took significant steps in fiscal 2005 to develop a customer support center for our hospitality operations in India. Our goal is to systemize and reduce operational costs while maintaining high service levels for customers. We believe we achieved that goal with our manufacturing support operations when we established a support center for manufacturing in Bangalore, India, in 2003. During 2005, we also moved first-line product support for hospitality customers to Bangalore, with support staff in regional offices focusing on second-line technical product support. We believe that support costs for any companies we might acquire can also be significantly reduced by providing support through Bangalore.
In May 2005 we hired Ralf Suerken as senior vice president and general manager of our manufacturing business, and Steven J. VanTassel as senior vice president and general manager of our hospitality business. Mr. Suerken most recently was chief operating officer of PRAGMATEK, which provides management consulting and SAP implementation services for the mid market. Mr. VanTassel most recently was chief operating officer of Agiliti, Inc., a Minneapolis-based provider of managed data center hosting services.
We significantly improved our cash position and balance sheet during 2005. In June 2005, we received $12.6 million in a distribution from the AremisSoft Corporation Liquidating Trust. We maintain a 10% interest in net collections from the AremisSoft Liquidating Trust, and this distribution represents cash collected by the trust from a settlement with a former executive officer of AremisSoft Corporation. In early August 2005 we used some of the proceeds from the trust distribution to repay a portion of our debt with Capital Resource Partners (CRP) and retired $8.0 million of the $20.0 million of debt outstanding. Later in August 2005 we completed the sale of 18,000 shares of our Series C Convertible Preferred Stock and Warrants to purchase 1,200,000 shares of common stock for a purchase price of $18.0 million. ABRY Partners, a private equity firm, purchased $15 million of the preferred stock and warrants, and Capital Resource Partners purchased the balance. John Hunt, a partner at ABRY, joined our board of directors. In connection with this financing, we retired the remainder of our outstanding debt with CRP.
In October 2005 we acquired Infra Business Solutions, GmbH, a privately held German software company that is a reseller and development partner of SAP Business One, for $2.0 million. Through the newly acquired German operation, we intend to introduce Fourth Shift Edition for SAP Business One in the German market in 2006. The acquisition increases our ability to serve small- to medium-sized manufacturers that operate in the SAP environment one of our key strategic goals. We also intend to apply
this acquisition strategy in our hospitality business by acquiring companies that have a substantial base of maintenance-paying customers and/or provide opportunities for migration to Medallion, our leading property management system. Our goal in the hospitality market is to become the property management system leader for independent hotels and then to leverage this position to increase our penetration of larger hotel chains as they upgrade their investment in property management system technology.
Manufacturing Software Operations
Our manufacturing business supports the enterprise information management needs of small- to mid-sized manufacturing companies and small- to mid-sized plants in large enterprise environments. Our manufacturing software business currently generates the majority of our revenue, comprising $50.6 million or 71.5 percent of our consolidated revenue for the year ended September 30, 2005. Currently, we have a customer base of approximately 2,200 worldwide, including the October 2005 acquisition of Infra Business Solutions, GmbH, which added approximately 400 customers.
We offer ERP software, consulting, implementation, installation and ongoing support to manufacturing customers worldwide. Our principal products include Fourth Shift Edition for SAP Business One, Fourth Shift, Demand Stream, and evolution. Fourth Shift Edition for SAP Business One, is a set of software applications, based on our core Fourth Shift product, which is integrated with SAP Business One software. Fourth Shift is designed to work with Microsoft operating systems (Windows NT/XT/2000) and is offered with either a SQL Server database or an mdbs database system. Demand Stream, a platform independent product, extends functionality of our Fourth Shift Product, and other ERP systems, into the market of lean manufacturing. evolution, an ERP system that was developed independent of Fourth Shift by a company acquired by a predecessor, provides functionality and tools specifically suited to converter manufacturers. Our core products for manufacturing include:
Fourth Shift Edition for SAP Business One, our joint-initiative with SAP Business One to address the software applications needs of medium-sized manufacturing companies and plants or divisions of multinational enterprises, was introduced on April 2, 2005. As the largest enterprise application software company in the world, we believe that SAP has significant marketing, distribution and name-recognition resources that will assist us in penetrating these markets. We agreed in 2004 to work with SAP Business One to create a solution for mid-market manufacturing opportunities and devoted development resources during 2004 and early fiscal 2005 to completing that integration. SAP has appointed us as a distributor so that we may sell both Fourth Shift Edition for SAP Business One and complete SAP Business One systems to our customers and potential customers. This product was introduced in the United States in April 2005; Canada in July 2005; and Australia, New Zealand, Singapore and Malaysia in the fourth quarter of fiscal 2005.
Fourth Shift Edition for SAP Business One is designed to be an affordable solution for small- and mid-sized manufacturers. It enables emerging companies to streamline their operational and managerial processes with an SAP-centric solution. Fourth Shift Edition for SAP Business One is built to meet the unique needs of small- and medium-sized businesses and is designed to be implemented quickly. Using Fourth Shift Edition for SAP Business One, customers are able to access real-time information through a single system containing financial, customer relationship management, manufacturing and management control capabilities. The product is based on flexible, open technology to make it possible to change and adapt as a business grows.
Fourth Shift, our core enterprise software solution is designed to improve the quality, efficiency and speed of a customers supply chain, global manufacturing operations, and strategic and tactical business decisions. Fourth Shifts comprehensive ERP suite facilitates critical business functions including manufacturing, operations, financials, workflow, e-business, human resources, and customer and supplier relationship management. Fourth Shift software, which is built on a Microsoft platform, is used by approximately 1,200 customers worldwide and is translated into more than a dozen languages. Since the Fourth Shift software was introduced in 1985, we have shipped more than 4,000 systems. We offer our customers more than 50 Fourth Shift modules that we have developed, as well as 15 companion modules that we distribute on behalf of third parties, which may be licensed individually or in combination. Our typical sale price for an installation of Fourth Shift, including license, training and other up-front services, is approximately $200,000.
Fourth Shift offers an extended enterprise software system to help streamline a manufacturers operations, improve efficiency and maximize profitability across the organization. Included in our Fourth Shift offering are:
Enterprise Resource Planning (ERP): A set of integrated applications that tie together and streamline business processes and information across a companys accounting, engineering, manufacturing, order entry, purchasing and shipping operations. This helps customers reduce overall inventory levels while improving cash collection and on-time order shipments. Our ERP applications comprise more than 50 modules.
Customer Relationship Management (CRM): A fully integrated application that extends the Fourth Shift core ERP system to encompass a companys sales, marketing and customer service groups. Working with a single set of data helps customers provide more timely and accurate answers to their prospects and customers. Our CRM system
helps manage communications, across multiple channels, with all of a companys key constituencies: prospects, customers, partners and suppliers.
E-Business: Fourth Shift includes applications that enable Fourth Shift users to collaborate electronically with their customers and suppliers. This improves a customers efficiency and increases revenue by reducing out-of-stock and backorder situations, improving order accuracy and reducing order generation costs. The applications allow a manufacturers customers and suppliers to do business with them on the Web, any time of the day or night, which ultimately reduces costs while making the company easier to do business with. Benefits include improved customer service and the ability to open new channels and gather valuable market information. The e-business tools are fully integrated with the core Fourth Shift enterprise system.
Workflow: The VisiBar and VisiWatch extensions of our Fourth Shift product help track the movement of components and products through the plant from receiving through production, to the warehouse and final shipping. These applications also enable customers to monitor transactions and automatically take action as specified events occur. This improves efficiency through tighter control over inventory with greater accuracy and less manual intervention.
Human Resources Management System: Applications that automate and streamline a companys human resources functions, including recruitment, hiring, benefits administration, payroll, compliance and employee training. This helps reduce administrative costs, minimize employee turnover, and optimize a manufacturers investment in people through more effective recruitment, retention and training.
Demand Stream is a lean enterprise automation software system that provides functionality to support the demand-driven factory from the shop floor through the supply chain. Demand Stream works in tandem with a manufacturing customers ERP system and is not dependent on Fourth Shift or any of our other software products. Demand Stream was introduced in 2001 and currently has 27 customer installations worldwide, primarily in the United States and China.
Lean manufacturing principles concentrate on constant manufacturing process monitoring and connectivity to suppliers and customers. It is intended to cause the manufacturing process to provide precisely what customers demand in the way of minimizing interruption because of lack of supply, but at the same time to minimizing raw materials, work in process and finished goods inventory.
The Dynamic Lean Engine platform drives the Demand Stream software and is designed to automate pull and easily integrate lean processes through the enterprise and supply chain. Key capabilities of the dynamic lean engine include: user-driven rules, which easily accommodate lean practices; always-on agent, which is agent-driven and event-based to continuously monitor and signal lean activities; connector toolkit, an open, two-way integration to allow with efficiency of seamless integration to third-party systems, such as ERP systems, and suppliers through internet connectivity and Web-based portals; and AutoCapture, which streamlines collection of data through bar coding, scanning, scales and other means.
evolution is an ERP system that enterprise software serving manufacturing and distribution markets. It is particularly suitable for converter manufacturers, such as manufacturers of metals, paper, and fabric producers, where reels, rolls, coils or bundles of raw materials are converted into finished product. Introduced in 1986, evolution is currently used worldwide in approximately 700 locations.
Built on a services oriented architecture (SOA), and using business process management (BPM) tools to model, design, configure, and implement customers unique functional requirements, evolution allows customers to tailor the application without modifying underlying source code. The evolution application is a platform neutral application, which means that it is available on all common enterprise platforms, including:
Database platform support for Oracle, Informix and Microsoft SQL database engines.
Server platform support for HP-UX, Solaris, IBM AIX and Microsoft 2003 Windows Server.
Interface runs in a zero client mode, meaning any browser enabled device can access and work with the evolution applications.
Sales of new licenses for our manufacturing software products totaled $7.7 million during the year ended September 30, 2005, $7.4 million during the year ended September 30, 2004 and $7.0 million for the twelve months ended Sept. 30, 2003, constituting 15.2%, 15.1% and 14.8%, of our overall manufacturing revenue during those periods.
We generate both transaction revenue from provision of professional services and substantial recurring revenue from software maintenance contracts.
The maintenance we provide through customer support is critical to our customers and we experience high annual retention rates for support services because customers have a strong desire to receive updates and assistance for what are often mission critical systems for them. We also generate revenue through a variety of manufacturing professional services offerings, including remote system administration and hosting, training, implementation and consulting services. Customer support and professional services related to our manufacturing software products totaled $41.3 million during the year ended September 30, 2005, $40.0 million during the year ended September 30, 2004 and $39.3 million for the twelve-month period ended September 30, 2003, constituting 81.6%, 81.4%, and 83.4%, respectively, of our overall manufacturing revenue during those periods. We offer our manufacturing customers the following services:
Support Services. Support Services, our software maintenance service, is our primary service offering for manufacturing software customers. Customers pay an annual fee of 20 percent of the current list price of the software modules they license. Included in this annual maintenance contract are:
New software releases that contain customer requested enhancements and new technology that enables our customers to improve their service and operational efficiencies.
Interim Service Releases that contain updated documentation and code, and customer enhancements.
Unlimited prioritized telephony support with access to industry and product experts on service customer questions or issues.
Technical publications that provide customers information on utilizing the application to streamline their business.
Online, real time WebEx support sessions providing customers instructions on how to resolve technical issues or an answer specific questions related to their data.
Access to a web-enabled knowledge base where customers get answers to commonly asked questions anytime, anywhere; a web-enabled, global customer service system where customers can issue service requests, interact with support consultants, and update information until they have received a solution; a web-enabled message board where customers can collaborate and share knowledge on industry specific use of the mission critical application; and web-enabled monthly seminars on topics such as: new software releases, lean manufacturing practices, or industry adoption of new technologies like RFID.
Approximately 92% of our manufacturing software customers renew their maintenance contracts annually. The number of customers purchasing maintenance contracts has declined in the past several years in the United States due to normal customer attrition and lower sales of new licenses to the Fourth Shift product in recent years. Despite the lower number of customers under support agreements, we have been able to keep support service revenues from manufacturing customers relatively even over the past three years due to incremental revenue from new service offerings and cost of living price increase.
Professional Services. SoftBrands has developed other value-added service offerings for customers, listed below:
Remote System Administration (RSA) and Hosting. RSA and Hosting are service offerings where our personnel remotely manage and monitor the ERP application on a clients network system, or host the server in a secure location. This allows the IT staff of our customers to focus on strategic issues versus routine system maintenance. This service is currently offered in the United States and China.
Remote Upgrade Services. This service offering eliminates the need for onsite upgrades. It provides enhanced service for customers at a lower cost and is one of our high margin offerings. This service is offered in the United States and China.
Web Tutors. This service was developed as a result of analyzing our customers most frequently asked questions on How to Use the application. Even though extensive user documentation exists in our applications and the knowledge base, some customers want the answers right away and would rather view and listen to the answers. Therefore, our support consultants collaborated and built pre-recorded, web based seminars addressing these How to Use questions making them available at the click of a mouse and credit card any time, anywhere.
Database Services. Upon customer request, these services range from providing database reconstruction (where customers databases have been destroyed without sufficient backups) to general ledger reorganization based on new financial reporting requirements.
Support Services continuously reviews the quality of service our customers experience by sending real-time surveys to our customers. Additionally, our customers can request a service manager to call with a click of a button on the quality survey. We consistently get high quality of service ratings from our customers and receive numerous customer quotes on our support consultants.
Our regional support consultants have on average eight years of product experience and an additional eight years of experience working for manufacturing companies. They are domain experts and continually receive training on:
New software releases and interim service releases prior to distribution to our customers.
Customer relationship skills to adapt to our customers behavior style in order to solve the service request efficiently and provide a positive experience to our customer.
Training and Consulting Services. We also provide training services (web-based, classroom, customer onsite and computer-based) and consulting services to manufacturing software customers. We offer a fee-based WebTutor service, which provides online, recorded how-to lessons for customers on more than 30 subject areas.
We conduct annual customer service surveys, host annual user conferences, implement continuous satisfaction snapshots and employ experienced support consultants in order to enhance and differentiate our service offerings.
It is our objective to increase our service revenue by selling newly developed services to existing customers in the Americas, offering existing service programs developed in the United States to customers in Europe and China and providing support services to new customers that purchase Fourth Shift Edition for SAP Business One and Demand Stream software.
We maintain the following principal offices for our manufacturing operations:
We also have customer service hubs for the manufacturing business in Mexico City, Mexico; Blackburn, United Kingdom; Mantua, New Jersey; and Johannesburg, South Africa. Manufacturing sales offices are located in Singapore; Shanghai, Beijing and Guangzhou, China; Johannesburg, South Africa; Dublin, Ireland; and Mexico City, Mexico.
We established a worldwide customer support center for our manufacturing operations in Bangalore in 2003 to complement our existing support staff worldwide. The center in India provides Remote Systems Administration and first-line customer support for English-speaking customers, with remaining hubs providing second-line customer support and additional new service offerings. We believe our worldwide support teams will improve value to our customers, improve our operating margins and improve our customers and employees quality of work life.
Sales and Marketing
We distribute our manufacturing software and services through a combination of direct sales and resellers. We currently employ 42 direct sales personnel in our manufacturing operations worldwide and have contracts with approximately 28 resellers and referral partners. Our goal is to substantially increase the number of channel partners selling our manufacturing software. The following table summarizes the principal means of distribution for our manufacturing products by geography:
We have increased the amount of distribution resources devoted to our newest product offering, Fourth Shift Edition for SAP Business One. We also intend to continue to focus on gaining market share with product replacement sales in mature ERP markets such as the United States and Western Europe, where few new manufacturing plants are being built.
Our manufacturing customers are concentrated in the following industries: life sciences, machinery, chemical and plastics, automotive, consumer products and electronics. We currently have approximately 1,900 manufacturing customers worldwide. No single customer has accounted for more than 10% of our revenue during any of the past three fiscal years. We believe that small- to medium-sized manufacturers that operate in the SAP environment represent a strong growth opportunity for our manufacturing software products in the United States.
In the Europe, Middle East and North Africa markets, we believe that Eastern Europe (primarily Czechoslovakia and Poland) and Russia, represent potential opportunities for growth, particularly with the introduction of Fourth Shift Edition for SAP Business One.
In the Asia-Pacific market, the manufacturing sector in China is growing rapidly, and we believe we are well positioned to capitalize on this growth. SoftBrands has had a presence in China since 1989. Our current manufacturing customers in China are primarily western-based companies with major operations in China. We also believe that introduction of a local language version of Fourth Shift Edition for SAP Business One would allow us to further capitalize on this growing market.
Research and Development
We currently employ a staff of 71 computer engineers and programmers in our manufacturing software development department. Our product development departments for manufacturing are located in the following areas:
Our Fourth Shift development staff focuses on developing new functionality that our customers have indicated they desire and extending the interoperability of Fourth Shift with other software products and new platforms. We are also currently devoting substantial effort to enhancing the functionality of Fourth Shift Edition for SAP Business One. Our evolution development staff is focused on custom programming using the evolution tools to create individualized ERP systems for evolution customers. Our
Demand Stream development staff has created, and continues to create, new software technology that further enhances this new product.
The market for ERP software is intensely competitive worldwide and price sensitive. Our manufacturing software products compete for installations in companies, company subsidiaries or individual plants with less than $1 billion in revenue. SoftBrands manufacturing products compete worldwide based on reputation, quality, reliability and service offerings. The U.S. market for ERP software for small- to mid-sized manufacturing concerns is characterized by a number of smaller companies, none of which has a significant portion of the market. We believe that the functionality of many of the product offerings in this market has become similar and that the U.S. portion of the market has become mature and largely saturated by existing vendors. Competition in the U.S. market has become particularly acute, and the market has shown reduced growth since 2000. EMEA and Asia-Pacific markets are less saturated and stronger growth opportunities exist.
Key competitors for Fourth Shift and Fourth Shift Edition for SAP Business One include Epicor Software Corporation, QAD, Inc., SYSPRO Impact Software, Inc., Microsoft Corporation, Oracle Corporation, and Infor Global Solutions. Key competitors for Demand Stream include QAD, Inc. and Oracle Corporation. SoftBrands evolution product competes with vendors of financial and enterprise management products from a number of suppliers, including QAD, Inc., JD Edwards, Oracle Corporation, IFS, Intentia International AB and Glovia International.
Hospitality Software Operations
Our Hospitality business supports the enterprise information management needs of hotels and resorts. Our hospitality software business generated $20.2 million, or 28.5 percent of our consolidated revenue for the year ended September 30, 2005.
We provide property management systems and leisure management systems to hotels, resorts, spas and health clubs. We have two primary property management systems, Medallion and PORTfolio. Our primary leisure management system is RIO. None of these three products are designed to operate together and each is sold as a separate product to separate markets. Although PORTfolio and Medallion are both property management systems that could compete with each other, we acquired them at separate times and they have features that appeal to different geographic and hotel markets. Medallion is more widely used in small- to mid-sized hotel chains. PORTfolio has centralized reservation functionality and is used in the United Kingdom and in English speaking countries for larger hotels and hotel chains. RIO is designed specifically to serve sites that accommodate the multiple leisure activities of full service resorts, such as fitness centers, spas, golfing, tennis courts and dining.
Medallion is a Windows-based property management system designed primarily for medium service independent hotels and hotel chains worldwide. It features an easy to use single-screen approach to property management backed by a high number of features. Medallion is a fully translated product that can accommodate both single- and double-byte languages, and therefore can be sold in all global markets. A key feature of Medallion is its look and book function that lets a user drag and drop bookings using a graphical representation of their property. Medallion is designed for hotel staff that has little time for lengthy or sophisticated training. We believe that Medallion contains the functionality needed to meet the needs of our market, including: reservations; rate management; guest accounting; city ledger; conferencing and banqueting; group handling; travel agent allocations; guest and company history; integrated rate management; credit card processing; sales and marketing tools; and employee e-mail and task manager. As we continue to increase the functionality of Medallion, we believe it will offer customers of legacy systems an attractive replacement product. Medallion is sold both by our direct sales force and a network of business partners. There are currently more than 800 installations of Medallion worldwide.
PORTfolio is a comprehensive client/server hotel system that offers a wide range of functions for both the front- and back-office operations in single-site and multi-property hotels. With PORTfolios centralized management system, hotel chains can take advantage of a central reservation system, along with centralized guest and company history, data warehousing and sales ledger. PORTfolio has many customizable features allowing hotel staff to keep operations flowing from one shift to the next. Staff can easily track reservations, client history, room availability, rate levels, and day-to-day communications with graphically rich screens and easy-to-read menus. Other key features include diary, end-of-day processing, housekeeping, maintenance, accounts receivable and full management reporting. There are currently approximately 250 installations of PORTfolio, primarily in the United Kingdom.
RIO supports the activities of spas, health clubs and resorts. RIO is an integrated system that has particular strength in high-end accommodation resorts and spas. We have offered the RIO product for approximately four years. There are currently approximately 150 installations of RIO worldwide. The RIO system has seven software modules that are designed to
operate independently as stand-alone applications, or collectively in any combination to provide an integrated solution that shares the same client historical database. The heart of the system is the Client Profile Manager, which allows a resort or spa to capture all aspects of client preferences and activities. RIO can tie together all areas of a resort property, including spa, restaurant, gift shop, classes, special events, tennis and fitness center, through specific modules such as RIO Spa, RIO Retail and RIO Dining.
A large portion of hospitality revenue is derived from maintenance of legacy software systems, primarily IGS Hotel and LANmark. IGS Hotel operates in a multitasking DOS environment and offers a wide range of functions for both the front- and back-office operations in a hotel. LANmark is a property management product which operates in multitasking DOS environments and offers many of the same features as IGS Hotel.
SoftBrands provides customer support for hospitality customers on a geographic basis from locations in the United States, India, United Kingdom, Ireland, China, South Africa and Australia. We have developed a worldwide customer support center in Bangalore, India that is providing first-line customer support for hospitality clients on an around-the-clock basis. Customer support and professional services related to our hospitality software products totaled $12.8 million during the year ended September 30, 2005. We offer a standardized customer support program for all hospitality products. This is a comprehensive, fee-based program designed to help customers obtain the maximum benefit from their business management software; customers pay an annual fee of 15 to 30 percent of the current list price of the modules licensed. We also offer the following services:
Installation Services. In order to make getting started with our products as easy as possible for our customers SoftBrands provides project organization and definition, system installation, customer training, go-live support and post-installation reviews, all provided by our certified engineers (or certified partners).
Education and Consulting. Our business consultants provide customized educational experiences to our hospitality customers, delivered by our business consultants, based on the unique configuration requirements of each client. We also offer several education options, including online and on-site classes.
System Optimization and Consulting. Our consultants work with installed customers to optimize their installations to meet changing needs, including procedural reviews, system tuning, interface development and certification, version upgrades and report customization.
We maintain the following principal offices for our hospitality operations:
We also have sales offices in Beijing, China; Dublin, Ireland; and Johannesburg and Cape Town, South Africa, as well as distributors worldwide.
Sales and Marketing
We distribute our hospitality products both through a worldwide direct sales organization and a growing reseller channel. We currently employ approximately 15 direct sales personnel in our hospitality operations worldwide, and have contracts with approximately 15 resellers. Our goal is to significantly increase the number of business partners selling our Medallion product, particularly in the U.S. and EMEA markets.
Currently, we have a hospitality customer base of approximately 2,200 worldwide. We believe organic growth in hospitality will come from replacing legacy systems with new products such as Medallion, and winning new-name accounts.
Research and Development
We currently employ a staff of 34 computer engineers and programmers in our hospitality software development department and we utilize the services of RekSoft, a St. Petersburg, Russia-based company for primary development services for Medallion. The focus of our current development efforts is on increasing the functionality of Medallion. We have a multi-year development contract with Reksoft which is up for renewal in 2006. We have also made a long-term commitment to software development and coding in India, with the creation of a worldwide development center in Bangalore. Seventeen of the hospitality development staff are located at the Bangalore operation with responsibility for testing, quality assurance and product development.
The enterprise software market for the hotel and resort category is highly competitive and highly fragmented. SoftBrands hospitality products compete with a wide range of competitors, including: MICROS Systems, Inc., HIS, Brilliant, Protel Hotelsoftware GmbH, MSI and Springer-Miller Systems, Inc.
We have registered a total of 35 trademarks for software services and products with the United States Patent and Trademark Office and with the equivalent offices of most foreign countries in which we do business. We have also registered the copyright on previous versions of our Fourth Shift software products and may register future versions.
We regard our software as proprietary and retain title to and ownership of the software we develop. We attempt to protect our rights in the software primarily through trade secrets. We have not published the source code of most of our software products and require employees and other third-parties who have access to the source code, and other trade secret information, to sign confidentiality and nondisclosure agreements acknowledging our ownership and the nature of these materials as our trade secrets.
Despite these precautions, it may be possible for unauthorized parties to copy or reverse-engineer portions of our products. While our competitive position could be threatened by disclosure or reverse engineering of our proprietary information, we believe that copyright and trademark protection are less important than other factors such as the knowledge, ability and experience of our personnel, name recognition and ongoing product development and support.
Our software products are licensed to end users under a perpetual, nontransferable, nonexclusive license that stipulates which modules can be used and how many concurrent users may use them. We rely primarily on shrink wrap or click through licenses for the protection of our products. These license agreements are either printed in the packaging of our software or appear in an installation screen for our software and must be reviewed and acknowledged before the software is used. These forms of licenses typically are not signed by the licensee and may be more difficult to enforce than signed agreements in some jurisdictions.
Although our products have never been the subject of an infringement claim, we cannot assure that third parties will not assert infringement claims against us in the future or that any such assertion will not require us to enter into royalty arrangements or result in costly litigation.
We have 574 employees and have contracts with 87 consultants who devote a substantial amount of time to our affairs. Our manufacturing business employs approximately 316 people worldwide, with 119 employees in the Americas; 56 in EMEA; 90 in Asia-Pacific; and 51 in India. Our hospitality business employs 151 people worldwide, with 46 employees in the Americas; 46 in EMEA; 12 in Asia-Pacific; and 47 in India. We also employ 107 people in general and administrative positions that are not directly assigned to any one of the two operating groups. None of our employees are represented by a labor union and we believe our employee relations are good.
We make available, free of charge, through our website (www.softbrands.com) our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we have electronically filed or furnished such materials to the Securities and Exchange Commission. The information available on our website is not incorporated into this Annual Report on Form 10-K.
We do not own any real property. We lease office space and some equipment. The following table sets forth the terms of leases for our largest offices:
We also maintain administrative offices in Dallas, Texas. We lease additional facilities and offices for international sales operations in Johannesburg and Cape Town, South Africa, and Singapore. We believe that we currently have adequate leased space to accommodate current operations and that facilities for administrative personnel are adequate for expansion plans. We also believe that expansion space is readily available in virtually all the markets in which we operate.
ITEM 3. LEGAL PROCEEDINGS
We are periodically engaged in litigation in the ordinary course of business and do not believe that any of such litigation is material to our ongoing operations.
We held our annual meeting of stockholders at 1:00 p.m. on Monday, August 8, 2005. Stockholders holding 38,181,861 shares, or approximately 86.07% of the outstanding stock entitled to vote, were represented at the meeting by proxy or in person. Three matters were submitted for consideration by stockholders at the meeting: (1) the election of two Class III directors to hold office until the annual meeting in 2008; (2) a proposal to amend our amended and restated certificate of incorporation to effect a reverse stock split in one of three ratios; and (3) a proposal to amend the SoftBrands, Inc. 2001 Stock Incentive Plan to increase the number of shares of common stock reserved for issuance under the plan by 1,000,000 shares.
1. Election of Class III Directors. The following nominees were elected as members of the Board of Directors as Class III Directors until the annual meeting of shareholders in 2008 or until such time as a successor may be elected:
2. Amendment to effect Reverse Stock Split. Our stockholders approved an amendment which provides the Board of Directors authority, at any time prior to March 31, 2006 to effect a reverse stock split in a ratio of 1 for 3, 1 for 4, or 1 for 5, by a vote of 36,781,304 shares in favor, 1,373,011 shares against, 27,546 shares abstaining, and no broker non-votes. Our Board of Directors has not determined whether it will effect such an amendment, or if it does, at what ratio. If the currently pending application for listing with AMEX is approved without the split, we do not expect to affect any split.
3. Amendment to Increase Shares under 2001 Incentive Stock Plan. Our stockholders approved an amendment to our 2001 Stock Incentive Plan to increase the number of shares of common stock available for issuance under that plan by a vote of 18,840,328 shares in favor, 1,739,479 shares against, 2,421,089 shares abstaining, and 15,180,965 broker non-votes.
Until March 15, 2005, our common stock was not registered under the Securities Exchange Act of 1934, and had not traded on any exchange. Our shares are traded between stockholders and third parties on an individual transaction basis and trading prices
are published in the pink sheets, a quotation service that displays sale prices, and volume information for transactions with market makers in over-the-counter (OTC) equity securities. All such quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions.
Until class representatives distributed shares they held to class action claimants in April 2004, although trading occurred in our shares, the NASD had imposed a when-issued status that rendered settlement of the trades difficult. During this period, there was not an active trading market in our shares of common stock and on many days, no trades, or virtually no trades, occurred. Because class representatives of the plaintiffs in In re AremisSoft Securities Litigation delivered shares of our common stock they held to individual class claimants in April 2004, trading after that time represented substantially higher volumes.
Based on information obtained from the pink sheets, the high and low bid quotations for the common stock for each of the quarters of our fiscal years ended September 30, 2004 and 2005,are set forth in the table below:
As of October 31, 2005, we had 2,948 record holders of our common stock, and we estimate that we have approximately 4,900 beneficial holders. Prior to the April 2004 distribution of shares by class representatives to class members, we had fewer than 300 record holders of our common stock.
We have applied for listing privileges for our common stock on the American Stock Exchange, but cannot be certain those privileges will be available. Because our common stock is not traded on a national exchange and has been trading at a price of less than $5.00, trading in our common stock is subject to the penny stock rules of the Securities Exchange Commission. The penny stock rules require a broker-dealer, prior to a transaction in a penny stock to deliver a standardized risk disclosure document, which: (a) contains a description of the nature and level of risk in the market for penny stocks in both public offerings and secondary trading; (b) contains a description of the brokers or dealers duties to the customer and of the rights and remedies available to the customer with respect to a violation to such duties or other requirements of securities laws; (c) contains a brief, clear, narrative description of a dealer market, including bid and ask prices for penny stocks and significance of the spread between the bid and ask price; (d) contains a toll-free telephone number for inquiries on disciplinary actions; (e) defines significant terms in the disclosure document or in the conduct of trading in penny stocks; and (f) contains such other information and is in such form as the Commission shall require by rule or regulation. The broker-dealer also must provide, prior to effecting any transaction in a penny stock, the customer: (a) with bid and offer quotations for the penny stock; (b) the compensation of the broker-dealer and its salesperson in the transaction; (c) the number of shares to which such bid and ask prices apply, or other comparable information relating to the depth and liquidity of the market for such stock; and (d) monthly account statements showing the market value of each penny stock held in the customers account. In addition, the penny stock rules require that prior to a transaction in a penny stock not otherwise exempt from those rules; the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchasers written acknowledgment of the receipt of a risk disclosure statement, a written agreement to transactions involving penny stocks, and a signed and dated copy of a written suitably statement. These disclosure requirements may have the effect of reducing the trading activity in the secondary market for our stock and, as a result, stockholders may have difficulty selling those securities.
Equity Compensation Plan Information
The following table describes shares of our common stock that are available for purchase under outstanding options or warrants or other rights, or reserved for issuance under options, warrants or other rights that may be granted in the future, under our equity compensation plans.
(1) In addition to options, we may issue restricted stock awards, performance awards and other stock-based awards.
Subject to restrictions under Delaware law and the rights and preferences of our two classes of outstanding preferred stock, dividends on our common stock must be determined and declared by our Board of Directors. We have never declared or paid a dividend on our common stock and we intend to retain earnings, if any, to support our growth for the foreseeable future. We are obligated to pay dividends at a rate of 6% to holders of Series C Convertible Preferred Stock. Dividends are paid in semi-annual installments, commencing December 31, 2005.
The following selected consolidated financial data should be read together with Managements Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and related notes included elsewhere in this Form 10-K. The selected consolidated balance sheet data as of September 30, 2005, 2004 and 2003 and the selected consolidated statements of operations data for the years ended September 30, 2005 and 2004, and for the nine-month period ended September 30, 2003, and the for year ended December 31, 2002 have been derived from our audited consolidated financial statements. Audited consolidated financial statements as of and for the years ended September 30, 2005 and 2004 and for the nine-month period ended September 30, 2003, are included under Item 8 of this Form 10-K. The unaudited financial statement data for 2001 is presented on a carve-out basis reflecting the operations of SoftBrands as a subsidiary of AremisSoft Corporation, and as with the data for 2005, 2004, 2003 and 2002 below, does not include the accounts of those AremisSoft subsidiaries operated apart from the continuing business. Historical results are not necessarily indicative of the results to be expected in the future.
(1) The 2001 loss from continuing operations includes impairment charges to goodwill of $22,300,000 and other intangible assets of $1,165,000.
(2) Loss from continuing operations per share for 2002 and 2001 is presented on a carve-out basis; therefore, the weighted average shares outstanding reflect the number of shares issued upon the formation of SoftBrands, Inc., which was 40,000,000.
(3) The 2001 loss from continuing operations would have been $35.7 million and basic and diluted loss per share would have been $0.89, had we adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, and excluded goodwill amortization.
The following discussion of our financial condition and results of operations should be read together with the financial statements and related notes, which are included elsewhere in this Form 10-K. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in more detail at the beginning of this Form 10-K. We undertake no obligation to update any information in our forward-looking statements.
Results of Operations
We changed our fiscal year end to September during the 2003 calendar year in order to more closely align our fiscal periods to the point in time we separated from AremisSoft. Fiscal 2003 is a nine-month period from January 1 to September 30, 2003.
During the nine months ended September 30, 2003, we devoted substantial resources to a custom software development contract with a large hospitality customer, expanded marketing and development for our hospitality products and devoted development resources in manufacturing to our Demand Stream product. The customer development contract was initially expected to result in significant revenue and our next-generation hospitality software offering, but we began experiencing technical issues and delays in its completion during late 2002 that continued into 2003. The negative impact of this contract, on which we recorded $1.9 million of costs but only $400,000 of revenue during the fiscal period, combined with the negative effects of the SARS epidemic on the hospitality software market and internal challenges with multiple products, required more resources than we had available. At the end of the September 30, 2003 fiscal period we restructured our operations, particularly in our hospitality business, in order to return to positive cash flow. We reduced personnel, office locations and commitments in September 2003 and took a $2.0 million restructuring charge as a result, as well as impairment charges on the carrying value of some hospitality intangible assets.
In the fiscal year ended September 30, 2004, we capitalized on various strategic steps taken during 2003 to renew growth in new license sales of the Fourth Shift and other core manufacturing products, agreed to a significant joint initiative to develop software for medium-sized manufacturing concerns as part of the SAP Business One product suite, and continued development of the market for our new Demand Stream lean manufacturing product. In our hospitality operations, following the restructuring announced on September 30, 2003, we completed new versions of our leading software products and obtained renewed support and confidence from major customers. We focused our development efforts in both our manufacturing and hospitality segments on software products aimed at small to medium sized business and plants or divisions of multinational enterprises. In our manufacturing segment, we concentrated on completing the integration of Fourth Shift to create Fourth Shift Edition for SAP Business One and began focusing our US marketing and sales efforts on this product. In hospitality, we focused on Medallion, our property management system for medium service independent hotels and chains.
We released Fourth Shift Edition for SAP Business One at the beginning of our third quarter in fiscal 2005 and sold 14 Fourth Shift Edition systems in the third and fourth quarters of 2005. Although this was below our expectations, we anticipate improved sales in fiscal year 2006 as we integrate additional functionality into the product as well as capitalize on reseller relationships we are forming with SAP Business One resellers. We also continued to generate sales of our leading Fourth Shift product in Asia and some renewed interest in the United States. Because we maintained low attrition in the Fourth Shift customer base, we continued to produce strong manufacturing maintenance revenue in fiscal year 2005. In our hospitality business, we sold 194 Medallion systems in fiscal 2005, compared to 112 systems in fiscal 2004, increasing the installed customer base to more than 800 sites. During fiscal year 2006, we intend to continue to invest in Medallion sales and marketing activities in North America, the EMEA region and China to increase sales to new accounts and to develop interfaces to the Medallion product to make it attractive to larger hotel chains.
We significantly improved our cash position and balance sheet during 2005. In June 2005, we received $12.6 million in a distribution from the AremisSoft Corporation Liquidating Trust. We maintain a 10% interest in net collections from the AremisSoft Liquidating Trust, and this distribution represents cash collected by the trust from a settlement with a former executive officer of AremisSoft Corporation. In early August 2005 we used some of the proceeds from the trust distribution to repay our debt with Capital Resource Partners (CRP) and retired $8.0 million of the $20.0 million of debt outstanding. Later in August 2005 we completed the sale of 18,000 shares of our Series C Convertible Preferred Stock and Warrants to purchase 1,200,000 shares of common stock for a purchase price of $18.0 million. ABRY Partners, a private equity firm, purchased $15.0 million of the preferred stock and warrants, and CRP purchased the balance. John Hunt, a partner at ABRY, joined our board of directors. In connection with this financing, we retired the remainder of our outstanding debt with CRP.
Critical Accounting Policies and Estimates
We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America. We are required to make estimates and judgments in preparing the financial statements that affect the reported amounts of our assets, liabilities, revenue and expenses. We base our estimates on our historical experience and on various other assumptions that we believe are reasonable under the circumstances. If our assumptions prove inaccurate or if our future results are not consistent with our historical experience, we may be required to make adjustments in our policies that affect our reported results. Our most critical accounting policies and estimates include: (a) the manner and basis upon which we record revenue, (b) the valuation of our deferred tax assets, (c) the valuation of accounts receivable, (d) the valuation of goodwill and intangibles and (e) restructuring charges. We also have other key accounting policies that are less subjective and, therefore, their application would not have a material impact on our reported results of operations. The following is a discussion of our most critical policies, as well as the estimates and judgments involved.
Revenue Recognition. Revenue recognition rules for software companies are very complex. We follow specific and detailed guidelines in determining the proper amount of revenue to be recorded; however, certain judgments affect the application of our revenue recognition policy. Revenue results can be difficult to predict and any shortfall of revenue or delay in recognizing revenue could cause our quarterly operating results to vary significantly. Our revenue recognition policy is more fully described in Note 2 of our Notes to Consolidated Financial Statements, while the summary below describes the more judgmental areas of our revenue recognition.
We generate revenue primarily from sale of licenses to our software under perpetual license agreements, from sale of software maintenance or customer support for that software, from sale of services related to the software, and in some instances from sale of related hardware. In many cases in which we sell a software license, we also sell customer support services, implementation services and hardware. We generally recognize software license revenue when we ship product to a customer. In order to do so, we must make a determination that the software license fees are fixed or determinable, that the shipment is not contingent on customer acceptance or on the delivery of any other element of services or products we provide, and that it is probable that we will collect the license fees. We must also charge separately for each element of the sales price that is not delivered with the license and these elements can not be essential to the performance of the software in order for license revenue to be recognized up-front. We document our sales with contracts or purchase orders that attempt to make clear that the purchase of the software license is not contingent or conditioned on the delivery of another element, such as customer support. Nevertheless, if we fail to properly document our sales, or if the objective evidence of the value of the other elements contained in a multi-element contract change, we might be required to defer license revenue, or recognize less license revenue upon shipment.
Where the services we provide are essential to the functionality of the software or another element of a contract, such as where we conduct custom software development as part of a software license sale, we recognize all related revenue based on the percentage-of-completion of the contracted servicesnormally measured based on the number of total hours of services performed compared to an estimate of the total hours to be incurred. Significant judgments and estimates related to the use of percentage-of-completion accounting include whether the services being provided are essential to the functionality of the software or another element of a contract and whether we have the ability to estimate the total service hours to be performed.
Deferred Tax Assets. We currently have worldwide net deferred tax assets of $20.3 million consisting of net operating loss carry forwards, tax credit carry forwards and temporary differences between taxable income on our tax returns and income before income taxes under U.S. generally accepted accounting principles. A deferred tax asset generally represents future tax benefits to be received when these carry forwards can be applied against future taxable income or when expenses previously reported in our financial statements become deductible for income tax purposes. We have, however, recorded a valuation allowance against the full amount of our net deferred tax assets. Our decision to record this valuation allowance was based on our cumulative losses incurred. We will continue to assess the realizability of our deferred tax assets and the need for this valuation allowance based on SFAS No. 109, Accounting for Income Taxes. We expect to continue to provide a full valuation allowance until, or unless, we can sustain a level of profitability that demonstrates our ability to utilize these assets. At that time, the valuation allowance will be reassessed and could be reduced in part or in total. As more fully described in our Managements Discussion and Analysis on income taxes, $12.0 million of our net deferred tax assets were fully reserved when acquired and as such, when realized, will result in tax expense even if there is a corresponding valuation allowance.
Valuation of Accounts Receivable. We maintain an allowance for doubtful accounts, which covers receivables that might not be collectible in an amount we estimate is sufficient to provide adequate protection against losses resulting from extending credit to our customers. In determining the size of the allowance, we consider the need for specific customer reserves and then compute a general reserve based on applying a percentage to the aging of our receivables. The identification of specific customer reserves and the determination of the appropriate percentage to apply to our receivables involve a number of factors, including our historical bad debt experience and the general economic environment. A considerable amount of judgment is required in assessing these factors. If the factors used in determining the allowance do not reflect future performance, then a change in the allowance for doubtful accounts would be necessary. To the extent we conclude the allowance is not adequate, we take a provision, which is included in our general and administrative expense during the quarter we make the determination.
Valuation of Goodwill and Intangibles. We had a balance of goodwill of $22.9 million and net intangible assets of $3.8 million at September 30, 2005. These balances could be reduced by up to $12.0 million if the deferred tax valuation allowance related to net deferred tax assets from the acquisition of Fourth Shift is reversed. The recording of this adjustment is subject to judgment and managements determination of the use or realizability of loss carry forwards obtained in the Fourth Shift acquisition.
In addition, we are required to reduce the carrying value of identifiable intangibles and related goodwill to the extent it may not be recoverable. We assess the potential for impairment of goodwill annually and the impairment of identifiable intangibles and related goodwill whenever events or changes in circumstances indicate the carrying value may not be recoverable. Factors we consider important that could trigger an impairment assessment include the following:
significant under-performance relative to expected historical or projected future operating results;
significant changes in the manner of use of the acquired assets or our overall business strategy;
significant negative industry or economic trends; and
significant decline in our stock price for a sustained period and our market capitalization relative to net book value.
The evaluation of asset impairments requires us to make assumptions about future cash flows over the lives of the reporting units or assets being evaluated, such as the appropriate discount rate and terminal value. These assumptions require significant judgment and actual results may differ from assumed and estimated amounts. For example, we changed the manner in which we used our hospitality assets when we restructured our operations in September 2003, because we made the strategic decision to discontinue certain product development projects and deemphasize the sale of certain of our existing hospitality products. As a result we assessed the capitalized intangible assets related to these projects and products and recorded a total impairment charge of $2.5 million.
If we were to determine that the carrying value of intangibles and goodwill might not be recoverable, we would reduce the carrying value to its fair value. The reduction, if any, could significantly impact our results of operations during the period in which the impairments occur.
Restructuring related charges. When we close or restructure a substantial part of our operations we accrue the fair value of the one-time termination benefits we expect to incur in reducing employee headcount in the period in which the plan is communicated and the other criteria of SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, are met. Costs related to excess leased office space from which we are no longer deriving economic benefit are recognized at fair value at the time we cease using the leased space. Other contract termination costs are recognized at fair value when we actually terminate the contract in accordance with its terms. Other costs associated with exit activities are accrued as of the date the liability is incurred. We estimate the amounts of these costs based on our expectations at the time the charges are taken, and we reevaluate the remaining accruals at each reporting date based on current facts and circumstances. If our estimates or expectations change because we are subjected to contractual obligations or negotiations we did not anticipate, we choose to further restructure our operations, or there are other costs we did not foresee, we adjust the restructuring accruals in the period that our estimates change. Such changes are recorded as increases or decreases to the restructuring related charges in our statements of operations. For example, during 2004, we made changes to how we were utilizing certain leased facilities, including leased space that was vacated and accrued under previous restructurings. These changes resulted in the reversal of $991,000 of previously recorded restructuring charges during the year ended September 30, 2004. At September 30, 2005, we have an accrued restructuring liability remaining of $203,000 for remaining severance obligations.
Period Comparisons 2005 Compared to 2004
The following table summarizes revenue and operating income in our manufacturing software operations and our hospitality software operations, our two principal operating segments during the past two fiscal years, as well as general unallocated corporate expenses during those periods.
Our total revenue increased 2.3% during the year ended September 30, 2005, over the year ended September 30, 2004. Our manufacturing revenue increased 3.0% while our hospitality revenue increased 0.7%. Operating income from our manufacturing operation increased 29.7% during the year ended September 30, 2005 as compared to the previous year and operating income from our hospitality operations increased 60.3%. The increase in manufacturing operating income includes a nominal increase in gross profit margin for the year, combined with an overall reduction in expenses. The hospitality improvement is due to a minor increase in gross profit margin on the year, a decrease in restructuring expenses, including $261,000 of restructuring reversals in the second quarter of fiscal 2005, and a reduction in operating expenses. As part of the restructuring of our hospitality operations announced in September 2003, we consolidated some of the operational and strategic management of our two reportable segments. Corporate expense increased over 26% during the year, as we incurred approximately $1.3 million of outside costs associated with our Sarbanes-Oxley internal control compliance project during 2005, completed registration of our common stock under the Securities Exchange Act of 1934 and became a public reporting company and increased general corporate marketing. Further discussion on major components of our Corporate costs and changes between periods follows.
Total Revenue. The following table summarizes revenue by reportable segment, revenue type and geography for the fiscal years ended September 30, 2005 and 2004.
In the year ended September 30, 2005 we experienced an overall increase of 3.0% in manufacturing revenue over the fiscal year ended September 30, 2004. The release of our new product, Fourth Shift Edition for SAP Business One, along with a new remote system management service were key sources of new revenue in 2005.
License Revenue. Software license revenue represents fees paid by our customers for the right to use our software under perpetual licenses. Our license revenue from manufacturing software increased by 3.2% during the year ended September 30, 2005, compared to the same reporting period last year. The increase was due to a number of factors, including the release and sales of our new Fourth Shift Edition for SAP Business One product in fiscal 2005, and an increase of 2.2% in license revenue from our Fourth Shift product, offset by a 32.5% decrease in revenue from our evolution product and a decrease of 3.7% in DemandStream license revenue. The decrease in revenue from evolution was due in part to the loss of a sales representative and lower revenue from some of our distributors in EMEA. The decrease in DemandStream reflects reallocation of marketing resources to Fourth Shift Edition and our decision to market this product primarily to the installed base of Fourth Shift and Fourth Shift Edition. We anticipate increased sales of Fourth Shift Edition in fiscal 2006, as we increase the functionality and sales channels for the product, and as the maintenance base grows. We also expect modest growth in both Fourth Shift and DemandStream in 2006.
As mentioned above, the biggest boost for our license revenue in fiscal 2005 over fiscal 2004 was the release of Fourth Shift Edition for SAP Business One in April of 2005. We had deferred all revenue for this product until after its general release. Consistent with this release and shipment of the product, we had recognized over $340,000 in license revenue in the third quarter, and added one customer in the fourth quarter, providing for additional revenue not available in fiscal 2004.
Maintenance Revenue. We receive maintenance revenue from our customers for the right to receive both web-based and phone-based customer support, the right to access web based training tools and for the right to receive periodic software upgrades from us on a when and if available basis. Maintenance revenue also includes revenue generated from other services provided by our customer service organization such as our remote management service. Our customers generally enter into annual contracts with us to receive such support. Periodically, we offer multi-year support programs. Our maintenance revenue for manufacturing products increased by 3.2% over the previous fiscal year. The growth in manufacturing maintenance revenue resulted from low attrition rates, an increase in new software sales, and customer adoption of new services in our Americas region such as our remote system management service that were not available in the prior year.
Professional Services Revenue. Our professional services revenue includes fees for training, consulting, installation and project management. Nearly all of our professional services are provided to customers of our software products. Overall, our professional services revenue increased 3.3% over last year. The release of Fourth Shift Edition for SAP Business One, along with the implementation and consulting resources related to that product account for the increase in the professional services revenue for the year.
Typically there is a correlation between professional services revenue and software licenses. Although there are fluctuations in timing and range of follow-on services, we historically experienced significant professional services revenue in the three- to nine-month period following delivery of software.
Third-Party Software and Hardware Revenue. We derive third-party software and hardware revenue primarily from the resale of third-party software licenses (often software applications that are complementary to our products) and hardware. These complementary applications have been integrated to function with our software and extend the functionality of our software offerings, while third-party hardware allows us to offer our customers a turnkey solution. Sales of third-party software and hardware are often made simultaneously with the licensing of our own software. Third party software and hardware revenue decreased over the year by 3.8%. This decrease is due in part to two specific hardware orders received in fiscal 2004 that did not recur in fiscal 2005. Since the sales of third party hardware and software are generally done as a courtesy to provide full solutions to our customers, it is a more volatile stream of revenue, and will fluctuate based on mix and customer demand.
Revenue by Geography. Our overall manufacturing revenue increased in fiscal 2005 as compared to fiscal 2004 in each of the three principal regions of our operations, with a 1.9% increase in revenue in the Americas region, a 2.8% increase in revenue in the Europe, Middle East & Africa (EMEA) region, and an 8.5% increase in revenue in the Asia Pacific (APAC) region. Although license revenue in fiscal 2005 decreased 0.6% in the Americas region, we were able to offset that reduction with an increase in maintenance revenue of 1.3% and professional services revenue of 6.6%. Both our license revenue and our maintenance revenue increased in the EMEA region in fiscal 2005 over fiscal 2004, with an increase of 5.3% in license revenue and 8.3% in maintenance revenue, offset by a reduction in professional services of 7.8% and third-party revenue of 5.9%. The decrease in professional services and third party revenue was due in large part to several large contracts recorded in 2004, but not renewed in 2005. The APAC region is still experiencing the most consistent growth, with a license revenue increase of 11.6%, a maintenance revenue increase by 4.2%
and professional services revenue increase of 15.6% in fiscal 2005 over fiscal 2004. We expect that this trend will continue as the Chinese economy continues to expand and strengthen.
We experienced relatively small growth in our hospitality segment in fiscal 2005 over fiscal 2004. Several factors that aided in this increase were the release of previously deferred revenue on a large project, along with the stabilization of our PORTfolio product, and the release of Medallion 6.0.
License Revenue. Total hospitality license revenue in 2005 increased by 67.6% over the previous year. The increase is due in part to the recognition of $275,000 of license revenue in the third quarter of fiscal 2005 that had been previously deferred due to the acceptance provisions of an agreement with a customer, along with a large custom project related to our PORTfolio product. Overall, license revenue from our PORTfolio product increased by 95.9%, primarily due to the recognition of two items mentioned above, and license revenue from our Medallion product increased of 50.5% from 2004 to 2005. The majority of the Medallion increase occurred in EMEA due to the introduction and marketing of the newest 6.0 version and expansion of our reseller channel. The RIO product also showed a modest increase in a year-over-year comparison.
We stopped actively promoting the hospitality products in all but the EMEA region during fiscal 2004, and instead turned our focus to stabilizing the segment and also to readying the Medallion product for the U.S. market. In 2005, we renewed our sales efforts in the hospitality market and completed a major new release of the Medallion product in the third quarter. We expect this renewed focus, along with the completion of the PORTfolio project and the new Medallion release to generate improved revenue in fiscal 2006.
Maintenance Revenue. Hospitality maintenance revenue decreased 10.2% in fiscal 2005 from fiscal 2004. The majority of our hospitality maintenance revenue is from older products that are no longer sold, and we expect maintenance revenue from these products to decrease over time, but also anticipate increasing maintenance revenue from new sales of Medallion and PORTfolio. The decline in hospitality maintenance revenue in 2005 can also be attributed to normal attrition rates primarily from our legacy LANmark and IGS Hotel customers.
Professional Services. Our hospitality professional services revenue increased 5.3% in fiscal 2005 compared with fiscal 2004. The hospitality group professional services revenue has been influenced by large custom development contracts entered into prior to September 30, 2003. One of these was completed in 2004, generating revenue in the U.S. and two projects in EMEA were recognized in 2005. Professional services revenue is anticipated to grow as we add customers and expand our consulting service offerings.
Revenue by Geography. Geographically, the hospitality revenue changes in the Americas and EMEA were driven by the large projects in those regions. Revenue in APAC decreased due to customer attrition in Australia resulting in part from our decision to de-emphasize efforts there. In 2005 there was a renewed focus on the hospitality market in EMEA and the Americas with the stabilization of the PORTfolio product and the release of the new Medallion 6.0 product that we expect will lead to increased revenue in the 2006 fiscal year in the Americas and EMEA. While APAC may see limited growth in China, we expect continued erosion of maintenance revenue from Australia which historically has been the source of most revenue in the region. The EMEA region grew due to the continued sales success, along with the recognition of revenue from the large, previously deferred project, the realization of added revenue from continued migration of existing customers to PORTfolio 3.1, and growth in the number of business partners in central Europe.
Gross Margin. The following table summarizes gross margin percentages by reportable segment and revenue type for the fiscal years ended September 30, 2005 and 2004:
For the year ended September 30, 2005, we were successful in increasing overall gross margin percentages in manufacturing and maintaining overall hospitality gross margin percentages.
Our manufacturing software license margin improved in fiscal 2005 to 54.1% from 49.9% due to revenue growth and, to a larger extent, a reduction in cost. Our cost of license revenue includes the amortization of acquired software, the amortization of capitalized costs for internally developed software, and the cost of third-party software that is embedded into some of our products. A key factor in the improved margin in fiscal 2005 was a reduction in amortization expense as we approach complete amortization of some of our older software intangibles. This is partially offset by increased royalty expenses, such as royalties due to SAP for the Fourth Shift Edition product, as well as royalties to third-parties. We expect reduced license gross margin percentage as Fourth Shift Edition for SAP Business One increases as a percentage of total manufacturing license revenue and, depending on mix, as sales transition to our reseller channel. We sell Fourth Shift Edition for SAP Business One subject to royalties to SAP Business One for the proprietary code that is incorporated into the product and through direct and through a reseller channel. The royalties, which vary as a percentage of sales price based on discounts and volume, generally reduce margins on this product below typical margins on Fourth Shift sales. Gross margin on license revenue is higher on direct sales and indirect sales of Fourth Shift Edition where we are primarily responsible for providing the software consulting and implementation to the end user. In these situations the end user price is recorded as revenue. Revenue from sales through implementation partners are recorded net of the resellers share of the transaction and therefore the revenue and related margins recognized are lower.
Manufacturing maintenance gross margin increased 2.6% in fiscal 2005 over fiscal 2004, in large part due to the continued development of the manufacturing support center in Bangalore, India. The Bangalore maintenance center for manufacturing became fully operational in late 2004, and continued to grow in size and capability in 2005, providing support to many regions, and helping to manage maintenance costs. At September 30, 2005, we had a manufacturing support staff of 36 in Bangalore India compared to 12 at September 30, 2004. Professional services margin increased to 23.0% in 2005 from 16.2% in 2004, in part because of unusually low professional services revenue and margins in fiscal 2004. Our third-party service revenue, which is associated with hardware and software sold as a courtesy to our customers, and related gross margins continue to be highly variable based on the pricing and the third party products chosen by customers.
Hospitality software license gross margin for fiscal 2005 was 64.8%, a significant improvement over the 16.5% in fiscal 2004. This is due in part to a significant increase in PORTfolio license revenue, as well as a reduction in amortization expense as some older software products reached complete amortization. In 2004 we experienced an unusually low margin level due to lower revenue levels combined with the continued fixed amortization charges.
Hospitality maintenance gross margin showed a decrease in fiscal 2005 from fiscal 2004, with the 2005 margin at 45.2% and the 2004 margin at 51.2%. This is a result of decreasing maintenance revenues, expenses associated with the divestiture of our support operation in Brussels, Belgium and start-up expenses associated with our Bangalore, India hospitality customer support center. Although we expect improvements in hospitality maintenance gross margin percentages as our Bangalore hospitality support center becomes fully operational, these savings will be offset at least in part by continued erosion of maintenance revenues from our legacy products. As we experienced with our manufacturing support center in Bangalore, we anticipated higher costs as the hospitality center
is ramped up as there are significant costs related to hiring and training. As of September 30, 2005 we have a staff of 30 in our hospitality support center compared to five as of September 30, 2004.
Hospitality professional service margins were 16.6% in fiscal 2005, a decrease from 18.5% in fiscal 2004. The professional service margins were lower in 2005 as the hospitality professional services organization recognized revenue on some very low margin projects during the year. Overall the margins are still low due to the recognition of consulting revenue on a large project in the third quarter of 2005 at no margin. We had deferred an amount of revenue on this contract that matched the amount of costs deferred until final acceptance and delivery requirements were met. Our EMEA region professional services margin was also adversely impacted by the need to utilize external consulting resources in central Europe. We expect to see an improvement in the professional services gross margin percentage in the hospitality sector as we improve utilization as the need for installation and training services increase. Although gross margins were relatively flat, our third-party service revenue, which is associated with hardware and software sold as a courtesy to our customers, and related gross margins can be highly variable based on the pricing and the third-party products chosen by customers.
Our corporate function represents an expense center which has a role of overall management of SoftBrands providing strategy, financing, accounting, legal, human resources, information technology, directors and officers insurance, marketing, public company compliance and other overhead costs. Its efforts are not directly attributable to one of our reporting segments. Also included in our fiscal 2005 costs are costs to prepare for compliance with Section 404 of Sarbanes Oxley. Our Corporate costs increased to $15.3 million in 2005 from $12.2 million in 2004, or 26% due to the following major factors: Sarbanes Oxley compliance, professional fees associated with renewed public filings and expanded marketing programs.
Operating Expenses. The following table summarizes operating expenses for the fiscal years ended September 30, 2005 and 2004:
NM: Percentage not meaningful.
Our operating expenses increased in dollars and as a percentage of revenue in the fiscal 2005 over fiscal 2004. The year-over year increase is due to several key factors, including the extensive external professional fees associated with the Sarbanes-Oxley Section 404 compliance project started early in fiscal 2005, the expanded selling and marketing efforts that went into the manufacturing segments new Fourth Shift Edition for SAP Business One product line, the sales and marketing efforts associated with the new hospitality Medallion 6.0 product line, and all the efforts in our corporate re-branding efforts that took place in the first part of fiscal 2005. External costs associated with the Sarbanes-Oxley Section 404 internal control project amounted to $1.3 million for fiscal 2005 compared to no such costs in fiscal 2004. Marketing expenses increased $1.2 million in fiscal 2005 over fiscal 2004.
General and administrative expense includes the salaries, incentive compensation, employee benefits and related overhead costs of finance, human resources, and administrative employees, as well as legal and accounting expenses, consulting fees and bad debt expense. We anticipate a decrease in spending levels in general and administrative expense as we shift more resources to selling roles and reduce costs of Sarbanes-Oxley compliance. Selling and marketing includes all salaries and incentive compensation, employee benefits, travel and overhead costs of sales and marketing personnel, as well as trade show activities and other costs associated with our marketing. As we address new markets and our attention shifts to revenue growth, we anticipate continued increases in selling and marketing expenses.
On March 2, 2005, the SEC deferred the implementation of Sarbanes-Oxley internal control certification and external attestation requirements for non-accelerated filers. Due to the deferral, we were able to postpone some of the work and related expenses that we had originally anticipated incurring in the third and fourth quarters of fiscal 2005. Although we continue to work on completing the implementation, we are taking advantage of the extension by performing the remaining work at a more controlled pace, and we are utilizing internal resources to a greater extent. Some of the costs for testing and attestation services that were originally anticipated in the second half of fiscal year 2005 have been deferred to fiscal 2006. We expect to increase selling and marketing expenses to promote Fourth Shift Edition for SAP Business One and Medallion in fiscal 2006.
Research and product development expenses consist primarily of salaries, employee benefits, related overhead costs and consulting fees associated with product development, enhancements, upgrades, testing, quality assurance and documentation. Research and development expenses in fiscal 2005 decreased slightly over fiscal 2004. Research and development expenses for manufacturing as a percentage of manufacturing revenue were 11.5% during fiscal 2005 and 11.8% during fiscal 2004. Research and development expenses for hospitality as a percentage of hospitality revenue were 12.9% during fiscal 2005 and 13.8% during fiscal 2004. Research and development in the early part of fiscal 2004 included intensive efforts to improve certain hospitality products. Efforts in late fiscal 2004 and in 2005 focused on the release of the new manufacturing and hospitality products. Research and development expenses are anticipated to remain approximately 12% of revenue for 2006.
The net restructuring charge of $950,000 in 2004 reflects the $1.9 million of charges during the year, including $302,000 related to employee severance and termination costs, $1.5 million of lease commitments, and $188,000 related to contract terminations and exit costs less a benefit from reversing previously recorded charges. During the year ended September 30, 2004, management made the decision to utilize two leased spaces that we previously vacated in connection with a restructuring. The remaining restructuring accrual of $991,000 related to these spaces was eliminated and a restructuring benefit was recorded.
In March 2005, we also successfully negotiated an early termination of our lease in Woking, UK. In exchange for all future obligations on this lease, we made a final payment of approximately $500,000. Following this payment, we reversed the remaining liability from our accounts, which resulted in a $180,000 credit to restructuring expense. In addition, during the year we also reversed $81,000 of severance-related restructuring accrual due to lower than expected severance costs.
Cash payments of $182,000 were made during fiscal 2005 related to employee severance and $568,000 related to lease commitments, including the closing of a South Africa office late in 2005. We had a balance of $203,000 of accrued restructuring charges as of September 30, 2005. Severance payments will continue through the first part of fiscal 2006, with the exception of $170,000 of retirement benefits for two former employees that will take effect when the two individuals and their spouses turn 65, and will then be reduced over a period of 25 years or until the accrual runs out, whichever comes first.
The following table presents a summary of our restructuring activities during the years ended September 30, 2005 and 2004 and the nine months ended September 30, 2003 (in thousands):
(1) The impact of foreign currency translation, which is not significant for any period presented, is included with cash payments.
Non-Operating Income and Expenses. The following table summarizes non-operating income and expenses for the fiscal years ended September 30, 2005 and 2004:
Interest Expense. Interest expense was $7.1 million for the year ended September 30, 2005 compared to $4.1 million for the year ended September 30, 2004. Interest expense was primarily related to our long-term institutional debt incurred in November 2002. This debt was paid off in August 2005, resulting in the accelerated amortization of related capitalized financing costs, as well as other accelerated provisions, fees and accretion. Interest expense in fiscal 2005 included $3.3 million of cash interest expense on the institutional debt, $1.1 million of amortization of capitalized financing costs, (including $316,000 of regular monthly amortization over the fiscal year and $809,000 of accelerated amortization costs) and $2.6 million of debt accretion, (including $721,000 of annualized monthly accretion and $1.9 million of accelerated accretion due to the payoff of this debt). In addition, we had $50,000 of other interest expense on other borrowings and capital lease obligations. Interest expense during the year ended September 30, 2004 included $2.8 million of cash interest expense on the institutional debt, $416,000 of amortization of capitalized financing costs, $786,000 of debt accretion due to the recording of an original issue discount at the time the debt was incurred. Unless new debt financing is required, interest expense will be insignificant in 2006.
Change in Value of Mandatorily Redeemable Common Stock Warrant and Loss on Exchange. Our statements of operations for the year ended September 30, 2004 includes a $4.9 million charge for the change in value of the mandatorily redeemable common stock warrant we issued as part of the long-term institutional debt financing in November 2002. At August 18, 2004, just prior to its exchange for Series B Convertible Preferred Stock and a new common stock warrant, the put warrant had appreciated to $7.2 million, resulting in the recognition of $3.1 million of additional non-operating expense. Additionally, in connection with the exchange, a final non-operating charge of $1.8 million was recorded, which reflected the difference between the net carrying value of the put warrant including the remaining unamortized offering costs, and the estimated fair value of the Series B Convertible Preferred Stock and the new warrant issued.
With the exchange and cancellation of the put warrant in August 2004, there was no income or expense related to the put warrant in fiscal year 2005.
Other Income, Net. Other income, net is composed principally of interest income, the effect of foreign currency transaction gains and losses and other miscellaneous non-operating items. Other income, net was $602,000 for the year ended September 30, 2005 compared with $181,000 for the year ended September 30, 2004. Other income, net in 2005 includes approximately $230,000 gain from the sale of two foreign subsidiaries including a non-cash gain of $126,000 from realization of accumulated translation adjustments, $234,000 of interest income and $287,000 of foreign exchange gains. The foreign exchange gains consist primarily of the effect of changes in foreign exchange rates on intercompany payables denominated in U.S. dollars. In 2005 we also recognized $71,000 of foreign exchange gain on Renminbi (RMB) due to the change in currency policy in China. We had RMB 28.3 million in China at September 30, 2005 and we maintain our financial statements in China using the USD as functional currency. Therefore the monthly revaluation of cash in local currency to USD will result in foreign exchange gains or losses.
A significant portion of our foreign exchange gain is the direct result of the change in exchange rates between the British Pound and the U.S. Dollar. We do not currently utilize any derivative security instruments or engage in any hedging activities.
Benefit from Income Taxes. We recorded a benefit from income taxes for continuing operations of $2.2 million for the year ended September 30, 2005, and we recorded a benefit from income taxes of $754,000 during the year ended September 30, 2004. Benefits are stated net of our estimated domestic federal and state liabilities and international tax liabilities. For the year ended September 30, 2005 we recorded $2.8 million of income tax expense as part of discontinued operations and for the year ended September 30, 2004 we recorded $984,000 of income tax expense as part of discontinued operations. This tax expense in discontinued operations is offset as a tax benefit in continuing operations.
Based upon available evidence, there has been sufficient uncertainty regarding the ability to realize our deferred tax assets to warrant a full valuation allowance in our consolidated financial statements. Based on our estimates for 2006 and beyond, we believe the uncertainty regarding the ability to realize our deferred tax assets may diminish to the point where the recognition of our deferred tax assets may be warranted in the future. If we determine that it is more likely than not that we will be able to realize our deferred tax assets in the future, an adjustment to the deferred tax asset valuation allowance would be recorded in the period when such determination is made.
Net deferred tax assets of the Fourth Shift acquisition in 2001 were approximately $12.0 million, all of which were fully reserved through a valuation allowance, thereby increasing the portion of the total purchase price allocated to goodwill. Any subsequent recognition by us of a pre-acquisition tax benefit will be recorded as a reduction to goodwill as opposed to an income tax benefit in our statement of operations. As a result, future income tax expense will not be impacted by reductions of the valuation allowance related to the pre-acquisition deferred tax assets. Any such adjustments would instead be recorded as reductions to goodwill. In addition, prior to any changes in our overall assessment in the realizability of our deferred tax assets, if we generate taxable income in the U.S. or certain other international jurisdictions and utilize pre-acquisition net operating loss carryforwards to offset this income, we will recognize income tax expense at the applicable statutory rate in our statement of operations.
Discontinued Operations. In accordance with the bankruptcy and reorganization plan of AremisSoft Corporation, our former parent, we retained a 10% interest in net collections by the Liquidating Trust established to pursue litigation claims and collection of assets remaining in AremisSoft after bankruptcy. In December 2003 we received a cash distribution of $2.9 million from the Liquidating Trust, which was recorded as income from discontinued operations. In addition, we recorded a net charge of $456,000, from an additional charge of $619,000 offset by a benefit of $163,000 during the 2004 fiscal year. These amounts were recorded net of an income tax expense of $1.1 million. In June 2005, the Liquidating Trust reached a settlement with one of the former officers of AremisSoft, resulting in a cash distribution of $12.6 million to SoftBrands. Additionally, previous estimates of obligations related to the discontinued operations were revised resulting in additional gain on discontinued operations of $502,000. These gains are reported net of an income tax provision of $2.8 million. At September 30, 2005, we have a lease accrual of $662,000 related to these discontinued operations remaining. The landlord and an unrelated tenant are negotiating terms of a new lease that would result in our reversal of this remaining accrual through discontinued operations. As a result, we anticipate reporting this as a gain, net of transaction costs we incur and income taxes from discontinued operations in fiscal 2006. Because neither we
nor any of our executives have any affiliation with the trust other than our 10% interest in net collections, we cannot predict if there will be any future distributions.
Period Comparisons 2004 Compared to 2003
Our fiscal year ended September 30, 2003, which was a transition year after we changed our fiscal year end from December 30, was a nine month period. All comparisons of operating results for the fiscal year ended September 30, 2004 to the nine-month period ended September 30, 2003 are affected by the difference in the number of months in each period. For sake of discussion in our MD&A, we are providing our analysis for these periods of differing lengths by discussing the amounts as a percentage of total revenues or gross margin, as applicable, to make the comparisons more meaningful. Unaudited financial data for the twelve month period ended September 30, 2003 was used for year-over-year change analysis.
The following table presents the results for the fiscal year ended September 30, 2004, the comparable year ended September 30, 2003, and the nine-month period ended September 30, 2003, with percentages of total revenue shown where meaningful:
The following table summarizes revenue and operating income in our manufacturing software operations and our hospitality software operations, our two principal operating segments during the fiscal year ended September 20, 2004 and during the comparable twelve month period ended September 30, 2003, as well as general unallocated corporate expenses during those periods:
Our total revenue decreased 5.0% during the fiscal year ended September 30, 2004 from the comparable twelve-month period ended September 30, 2003. There was a 4.2% overall increase in manufacturing revenue offset by a 21.8% decrease in hospitality revenue. Our operating income in 2004 improved substantially compared to the twelve months in 2003 due primarily to operational shortcomings and large restructuring charges in hospitality in 2003.
Total Revenue. The following table summarizes revenue by reportable segment and revenue type for the fiscal year ended September 30, 2004, and the twelve-month period ended September 30, 2003:
Software License Revenue. In our manufacturing segment, license revenue was $7.4 million during the year ended September 30, 2004, compared to $7.0 million for the twelve months ended September 30, 2003, resulting in a $479,000, or 6.9%, increase. We continued to generate growth in our manufacturing software license revenue in the emerging manufacturing centers of China, where our Fourth Shift product is a well established ERP solution, and made incremental progress in the United States and other geographies both with Fourth Shift and evolution license sales and with newly introduced Demand Stream sales.
Maintenance Revenue. Maintenance revenue was relatively constant from the twelve months ended September 30, 2003 to the twelve months ended September 30, 2004. The consistent maintenance revenue results are consistent with the increase achieved in software license revenue and reflect the continued high renewal rates from our customer base.
Professional Services Revenue. In the manufacturing segment, professional services revenue decreased of $491,000, or 4.6% during the year ended September 30, 2004, from $10.8 million for the twelve months ended September 30, 2003. The decrease in 2004 was the result of a mid-2003 reframe of the business to improve bottom line profitability. This reframe resulted in reduced sales efforts on new sites and the related implementation services. Typically there is a correlation between professional services revenue and software licenses.
Third-Party Software and Hardware Revenue. We had unusually high third-party revenue in the year ended September 30, 2004 resulting in an increase over third-party revenue during the twelve months ended September 30, 2003. The increase during fiscal 2004 was due in large part to customer preference on several large projects.
Software License Revenue. In our hospitality segment, license revenue was $1.7 million during the year ended September 30, 2004, compared to $3.1 million for the twelve months ended September 30, 2003, resulting in a $1.4 million, or 46.2%, decrease. This decrease was caused by our decision in September 2003 to decrease the emphasis of our sales efforts on the sale of licenses to new customers and to increase our efforts to serve existing customers as we worked to stabilize the software code we were providing.
Maintenance Revenue. Maintenance revenue for the hospitality business decreased $1.0 million, or 6.8% during the year ended September 30, 2004 as compared to the previous twelve month period. Following the restructuring and reorganization announced in September 2003, overall revenues for hospitality decreased significantly as we made the decision to focus on serving existing customers. This meant fewer new customers to offset the normal attrition of our hospitality maintenance base.
Professional Services Revenue. For the hospitality segment, professional services revenue decreased $2.4 million, or 48.2% during the year ended September 30, 2004, from $5.0 million during the twelve months ended September 30, 2003. This significant decrease is also due in large part to a sharp drop in software license revenue during fiscal 2004. In addition, the large, one-time custom development project discussed in the Overview section above resulted in $400,000 of professional services revenue in the 2003 period and no revenue in fiscal 2004.
Third-Party Software and Hardware Revenue. In the hospitality segment, third-party software and hardware revenue decreased $730,000 or 32.6% during fiscal 2004 from the twelve months ended September 30, 2003. The hospitality revenue decrease is a result of reduced efforts to obtain new customers while focusing attention on existing customers.
Gross Margin. The following table summarizes gross margin percentages by reportable segment and revenue type for the year ended September 30, 2004, and the twelve-months ended September 30, 2003: