10-Q 1 b53405sse10vq.txt SCANSOFT, INC. . . . UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-27038 SCANSOFT, INC. (Exact name of registrant as specified in its charter) DELAWARE 94-3156479 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number)
9 CENTENNIAL DRIVE PEABODY, MA 01960 (Address of principal executive office) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 978-977-2000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12-b-2 of the Securities Exchange Act of 1934). Yes [X] No [ ] 106,288,852 shares of the registrant's Common Stock, $0.001 par value, were outstanding as of January 31, 2005. SCANSOFT, INC. FORM 10-Q THREE MONTHS ENDED DECEMBER 31, 2004 INDEX
PAGE ---- PART I: FINANCIAL INFORMATION Item 1. Consolidated Financial Statements a) Consolidated Balance Sheets at December 31, 2004 (unaudited) and September 30, 2004.......................... 2 b) Consolidated Statements of Operations for the three months ended December 31, 2004 and 2003 (unaudited)......... 3 c) Consolidated Statements of Cash Flows for the three months ended December 31, 2004 and 2003 (unaudited)......... 4 d) Notes to Consolidated Financial Statements (unaudited)... 5 Item 2. Management's Discussion and Analysis of Financial Condition 27 and Results of Operations................................... Item 3. Quantitative and Qualitative Disclosures about Market 44 Risk........................................................ Item 4. Controls and Procedures..................................... 45 PART II: OTHER INFORMATION Item 1. Legal Proceedings........................................... 46 Item 2. Unregistered Sales of Equity Securities and Use of 46 Proceeds.................................................... Item 3. Defaults Upon Senior Securities............................. 46 Item 4. Submission of Matters to a Vote of Security Holders......... 46 Item 5. Other Information........................................... 46 Item 6. Exhibits.................................................... 46 Signatures................................................................... 47 Exhibit Index Certifications
1 SCANSOFT, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
DECEMBER 31, SEPTEMBER 30, 2004 2004 ------------ ------------- (UNAUDITED) ASSETS Current assets: Cash and cash equivalents................................. $ 41,276 $ 22,963 Marketable securities..................................... 1,506 7,373 Accounts receivable, less allowances of $20,208 and $11,308, respectively (Note 3)......................... 50,735 36,523 Inventory................................................. 821 373 Prepaid expenses and other current assets................. 6,535 6,256 --------- --------- Total current assets................................... 100,873 73,488 Long-term marketable securities........................... 3,814 17,355 Goodwill.................................................. 253,825 246,424 Other intangible assets, net.............................. 42,137 43,898 Property and equipment, net............................... 8,253 7,985 Other assets.............................................. 4,011 3,503 --------- --------- Total assets........................................... $ 412,913 $ 392,653 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable.......................................... $ 11,532 $ 8,018 Accrued compensation...................................... 10,146 7,407 Accrued expenses (Note 6)................................. 15,613 12,710 Deferred revenue.......................................... 13,785 10,529 Note payable (Note 8)..................................... 337 457 Deferred payment obligation for technology license........ 2,826 2,760 Other current liabilities................................. 5,348 3,667 --------- --------- Total current liabilities.............................. 59,587 45,548 Deferred revenue............................................ 125 147 Long-term notes payable, net of current portion............. 27,609 27,700 Deferred tax liability...................................... 2,936 2,123 Other liabilities........................................... 14,109 15,390 --------- --------- Total liabilities...................................... 104,366 90,908 --------- --------- Commitments and contingencies (Notes 3, 8 and 9) Stockholders' equity: Series B preferred stock, $0.001 par value; 40,000,000 shares authorized; 3,562,238 shares issued and outstanding (liquidation preference $4,631)............ 4,631 4,631 Common stock, $0.001 par value; 280,000,000 shares authorized; 109,026,636 and 108,604,686 shares issued and 106,249,600 and 105,833,179 shares outstanding, respectively........................................... 109 109 Additional paid-in capital................................ 478,258 476,206 Treasury stock, at cost (2,777,032 and 2,771,505 shares, respectively).......................................... (11,094) (11,071) Deferred compensation..................................... (5,047) (5,465) Accumulated other comprehensive income (loss)............. 371 (843) Accumulated deficit....................................... (158,681) (161,822) --------- --------- Total stockholders' equity............................. 308,547 301,745 --------- --------- Total liabilities and stockholders' equity............. $ 412,913 $ 392,653 ========= =========
The accompanying notes are an integral part of these consolidated financial statements. 2 SCANSOFT, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
THREE MONTHS ENDED DECEMBER 31, ------------------- 2004 2003 -------- -------- REVENUES: Product licenses............................................ $ 46,834 $ 36,464 Professional services....................................... 13,744 8,002 Related parties............................................. -- 2,404 -------- -------- Total revenue.......................................... 60,578 46,870 -------- -------- COSTS AND EXPENSES: Cost of revenue: Cost of product licenses(1)............................... 5,516 4,569 Cost of professional services(1).......................... 9,592 5,911 Cost of revenue from amortization of intangible assets.... 2,825 3,035 -------- -------- Total cost of revenue.................................. 17,933 13,515 -------- -------- Gross margin................................................ 42,645 33,355 Operating expenses: Research and development(1)............................... 9,110 8,869 Sales and marketing(1).................................... 18,551 17,484 General and administrative(1)............................. 6,867 4,777 Amortization of other intangible assets................... 669 851 Stock-based compensation expense.......................... 698 175 Restructuring and other charges, net...................... 659 627 -------- -------- Total operating expenses............................... 36,554 32,783 -------- -------- Income from operations...................................... 6,091 572 Other income (expense): Interest income........................................... 117 128 Interest expense.......................................... (90) (354) Other (expense) income, net............................... (917) 242 -------- -------- Income before income taxes.................................. 5,201 588 Provision for (benefit from) income taxes................... 2,060 (742) -------- -------- Net income.................................................. $ 3,141 $ 1,330 ======== ======== Net income per share, basic and diluted..................... $ 0.03 $ 0.01 ======== ======== Weighted average common shares outstanding, basic........... 108,535 103,072 ======== ======== Weighted average common shares outstanding, diluted......... 115,992 114,648 ======== ======== (1) Excludes stock-based compensation expense as follows: Cost of product licenses.................................... 4 -- Cost of professional services............................... 35 -- Research and development.................................... 84 -- Sales and marketing......................................... 211 17 General and administrative.................................. 364 158 -------- -------- $ 698 $ 175 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. 3 SCANSOFT, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
THREE MONTHS ENDED DECEMBER 31, ------------------ 2004 2003 -------- ------- CASH FLOWS FROM OPERATING ACTIVITIES Net income.................................................. $ 3,141 $ 1,330 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation........................................... 1,021 894 Amortization of other intangible assets................ 3,494 3,886 Accounts receivable allowances......................... 346 358 Non-cash portion of restructuring charges.............. -- 20 Stock-based compensation............................... 698 175 Foreign exchange loss.................................. (891) (888) Non-cash interest expense.............................. 66 (22) Deferred tax provision................................. 1,076 (177) Changes in operating assets and liabilities, net of effects from acquisitions: Accounts receivable.................................... (12,824) (9,042) Inventory.............................................. (436) 493 Prepaid expenses and other current assets.............. (49) 1,654 Other assets........................................... 117 1,249 Accounts payable....................................... 3,080 921 Accrued expenses....................................... 4,138 (2,976) Other liabilities...................................... (146) 311 Deferred revenue....................................... 2,772 4,025 -------- ------- Net cash provided by operating activities............ 5,603 2,211 -------- ------- CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures for property and equipment........... (829) (1,457) Cash received (paid) for acquisitions, including transaction costs...................................... (6,694) 1,221 Gross sales and maturities of marketable securities....... 19,494 553 -------- ------- Net cash provided by investing activities.............. 11,971 317 -------- ------- CASH FLOWS FROM FINANCING ACTIVITIES Settlement of acquisition related liabilities............. -- (6,940) Payment of note payable and deferred acquisition payments............................................... (227) (301) Purchase of treasury stock................................ (125) (1,062) Payments under deferred payment agreement................. -- (410) Proceeds from issuance of common stock, net of issuance costs.................................................. -- (1,272) Proceeds from issuance of common stock under employee stock-based compensation plans......................... 203 2,381 -------- ------- Net cash used in financing activities................ (149) (7,604) -------- ------- Effects of exchange rate changes on cash and cash equivalents............................................... 888 175 -------- ------- Net (decrease) increase in cash and cash equivalents........ 18,313 (4,901) Cash and cash equivalents at beginning of period............ 22,963 47,485 -------- ------- Cash and cash equivalents at end of period.................. $ 41,276 $42,584 ======== =======
The accompanying notes are an integral part of these consolidated financial statements. 4 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The accompanying consolidated financial statements of ScanSoft, Inc. (the "Company" or "ScanSoft") have been prepared in accordance with accounting principles generally accepted in the United States of America. In the opinion of management, these unaudited interim consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the financial position at December 31, 2004, and the results of operations and cash flows for the three months ended December 31, 2004 and 2003. Although the Company believes that the disclosures in these financial statements are adequate to make the information presented not misleading, certain information normally included in the footnotes prepared in accordance with generally accepted accounting principles in the United States of America has been omitted as permitted by the rules and regulations of the Securities and Exchange Commission. The accompanying financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company's Transition Report on Form 10-K/T for the nine month transition period ended September 30, 2004 filed with the Securities and Exchange Commission on January 6, 2005. The results for the three months ended December 31, 2004 are not necessarily indicative of the results that may be expected for the year ending September 30, 2005, or any future period. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CHANGE IN FISCAL YEAR On October 23, 2004, the Company's Board of Directors approved a change in the Company's fiscal year end from December 31 to September 30, effective beginning September 30, 2004. USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. On an ongoing basis, ScanSoft evaluates its estimates and judgments, including those related to revenue recognition, the costs to complete the development of custom software applications and valuation allowances (specifically sales returns and other allowances); accounting for patent legal defense costs; the valuation of goodwill, other intangible assets and tangible long-lived assets, estimates used in accounting for acquisitions; assumptions used in valuing stock-based compensation instrument, evaluation loss contingencies; and valuation allowances for deferred tax assets. Actual amounts could differ significantly from these estimates. ScanSoft bases its estimates and judgments on historical experience and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the amounts of revenue and expenses that are not readily apparent from other sources. BASIS OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated. FOREIGN CURRENCY TRANSLATION The functional currency of the Company's foreign subsidiaries is the local currency, with the exception of the Company's subsidiary in Budapest, Hungary for which the functional currency is the U.S. dollar. Assets and liabilities of foreign subsidiaries that are denominated in non-functional currencies are revalued into its 5 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) functional currency at exchange rates in effect at the balance sheet date. The Company reported in other income (expense), net foreign currency transaction and other translation losses of $1.0 million for the three months ended December 31, 2004 and a $0.4 million gain for the comparable period in 2003. Assets and liabilities of foreign subsidiaries that are denominated in foreign currencies are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Revenue and expense items are translated using the average exchange rates for the period. Net unrealized gains and losses resulting from foreign currency translation are included in other comprehensive income (loss), which is a separate component of stockholders' equity, except for Budapest for which foreign currency translation adjustments are recorded in other income (expense). Foreign currency transaction gains and losses are included in results of operations. FOREIGN CURRENCY RISK MANAGEMENT In certain circumstances, the Company enters into forward exchange contracts to hedge against foreign currency fluctuations. These contracts are used to reduce the Company's risk associated with exchange rate movements, as the gains or losses on these contracts are intended to offset the exchange rate losses or gains on the underlying exposures. The Company does not engage in foreign currency speculation. Hedges of underlying exposures are designated and documented at the inception of the hedge and are evaluated for effectiveness monthly. Forward exchange contracts representing cash flow hedges qualify for hedge accounting when they are designated as a hedge of the foreign currency exposure and they are effective in minimizing such exposure. Gains and losses on forward exchange contracts that qualify for hedge accounting are recognized as other comprehensive income (loss) in stockholders' equity, along with the associated losses and gains on the hedged item. As the terms of the forward exchange contract and underlying exposure are matched generally at inception, hedging effectiveness is calculated by comparing the change in fair value of the contract to the change in fair value of the underlying exposure. To date the Company has not incurred any significant gains or losses associated with hedge ineffectiveness. REVENUE RECOGNITION The Company recognizes revenue in accordance with Statement of Position ("SOP") 97-2, Software Revenue Recognition, as amended by SOP 98-9, "Modification of SOP 97-2 with Respect to Certain Transactions", SOP 81-1 Accounting for Performance of Construction Type and Certain Performance Type Contracts and the Securities and Exchange Commission's Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial Statements" ("SAB 104") and Emerging Issues Task Force (EITF) Issue No. 01-09, "Accounting for Consideration Given by a Vendor (Including a Reseller of the Vendors Products)" and FASB 48 ("FAS 48"), "Revenue Recognition when Right of Return Exists". In general we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, collectibility is probable, and vendor specific objective evidence ("VSOE") exists for any undelivered elements. We reduce revenue recognized for estimated future returns, price protection and rebates, and certain marketing funds at the time the related revenue is recorded. Certain distributors and value-added resellers have been granted rights of return for as long as the distributors or resellers hold the inventory. The Company has not aggregated and analyzed historical returns from distributor and resellers to form a basis in order to estimate the future sales returns by distributor and resellers. As a result, the Company recognizes revenue from sales to these distributors and resellers when the distributor and reseller have sold products through to retailers and end-users. Title and risk of loss pass to the distributor or reseller upon shipment, at which time the transaction is invoiced and payment is due. Based on reports from distributors and resellers of their inventory balances at the end of each period, the Company records an allowance against accounts receivable for the sales price of all inventories subject to return. 6 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) The Company also makes an estimate of sales returns by retailers or end users directly or through its distributors or resellers based on historical returns experience. The Company has aggregated and analyzed historical returns from retailers and end users which forms the basis of its estimate of future sales returns by retailers or end users. In accordance with FAS 48, the provision for these estimated returns is recorded as a reduction of revenue at the time that the related revenue is recorded. If actual returns differ significantly from its estimates, such differences could have a material impact on the Company's results of operations for the period in which the actual returns become known. Revenue from royalties on sales of the Company's products by OEMs to third parties, where no services are included, is typically recognized upon delivery to the third party when such information is available, or when the Company is notified by the OEM that such royalties are due as a result of a sale, provided that all other revenue recognition criteria are met. When the Company provides professional services considered essential to the functionality of the software, such as custom application development for a fixed fee, it recognizes revenue from the fees for such services and any related software licenses based on the percentage-of-completion method in accordance with SOP 81-1. The Company generally determines the percentage-of-completion by comparing the labor hours incurred to date to the estimated total labor hours required to complete the project. The Company considers labor hours to be the most reliable, available measure of progress on these projects. Adjustments to estimates to complete are made in the periods in which facts resulting in a change become known. When the estimate indicates that a loss will be incurred, such loss is recorded in the period identified. Significant judgments and estimates are involved in determining the percent complete of each contract. Different assumptions could yield materially different results. When the Company provides services on a time and materials basis, it recognizes revenue as it performs the services based on actual time incurred. Other professional services not considered essential to the functionality of the software are limited and primarily include training and feasibility studies, which are recognized as revenue when the related services are performed. When the Company provides software support and maintenance services, it recognizes the revenue ratably over the term of the related contracts, typically one year. The Company may sell, under one contract or related contracts, software licenses, custom software applications and other services considered essential to the functionality of the software and a maintenance and support arrangement. The total contract value is attributed first to the maintenance and support arrangement based on VSOE of its fair value and additionally based upon stated renewal rates. The remainder of the total contract value is then attributed to the software license and related professional services, which are typically recognized as revenue using the percentage-of-completion method. As a result, discounts inherent in the total contract value are attributed to the software license and related professional services. The Company may sell under one contract or related contracts, software licenses, maintenance and support arrangement and professional services not considered essential to the functionality of the software. In those arrangements, the total contract value is attributed first to the undelivered elements of maintenance and support and professional services based on VSOE of their fair values. The remainder of the contract value is attributed to the software licenses, which are typically recognized as revenue upon delivery, provided all other revenue recognition criteria are met. As a result, discounts inherent in the total contract value are attributed to the software licenses. The Company follows the guidance of EITF No. 01-09, in determining whether consideration given to a customer should be recorded as an operating expense or a reduction of revenue recognized from that same 7 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) customer. Consideration given to a customer is recorded as a reduction of revenue unless both of the following conditions are met: - The Company receives an identifiable benefit in exchange for the consideration, and the identified benefit is sufficiently separable from the customer's purchase of the Company's products and services such that the Company could have purchased the products from a third party, and - The Company can reasonably estimate the fair value of the benefit received. Consideration, including that in the form of the Company's equity instruments (if applicable), is recorded as a reduction of revenue, to the extent the Company has recorded cumulative revenue from the customer or reseller. The Company follows the guidance of EITF Issue No. 01-14, Income Statement Characterization of Reimbursements for "Out-of-Pocket" Expenses Incurred, and records reimbursements received for out-of-pocket expenses as revenue, with offsetting costs recorded as cost of revenue. Out-of-pocket expenses generally include, but are not limited to, expenses related to airfare, hotel stays and out-of-town meals. CASH EQUIVALENTS Cash equivalents are short-term, highly liquid instruments with original maturities of 90 days or less at the date of acquisition. The Company invests primarily in commercial paper and money market funds. During the three months ended December 31, 2004, the Company escrowed approximately $0.4 million of cash, with Anglo Irish Bank in connection with the renewal of the 3.5 million euro hedge contract. The Company had previously escrowed approximately $0.5 million of cash as a result of a dispute with one of its vendors. The Company is working to resolve this dispute at which time the escrow will be returned to the Company or released from escrow. As of December 31, 2004, total cash escrowed was approximately $0.9 million and is included in cash and cash equivalents in the accompanying balance sheet. ACCOUNTS RECEIVABLE The Company establishes reserves against its accounts receivable for potential credit losses when it determines receivables are at risk for collection based upon the length of time the receivables are outstanding as well as various other criteria. Receivables are written off against these reserves in the period they are determined to be uncollectible. INVENTORY Inventory consists of finished goods, primarily of software media and user manuals, and is stated at the lower of cost (determined on a first-in, first-out basis) or market value. PROPERTY AND EQUIPMENT Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the term of the related lease or the estimated economic useful life, if shorter. The cost and related accumulated depreciation of sold or retired assets are removed from the accounts and any gain or loss is included in operations. Repairs and maintenance costs are expensed as incurred. 8 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) LONG-LIVED TANGIBLE AND INTANGIBLE ASSETS AND GOODWILL The Company has significant long-lived tangible and intangible assets, including goodwill, which are susceptible to valuation adjustments as a result of changes in various factors or conditions. Long-lived tangible and intangible assets include fixed assets, patents and core technology, completed technology and trademarks which are amortized using the straight-line method over their estimated useful lives. The values of intangible assets, with the exception of goodwill, were initially determined by a risk-adjusted, discounted cash flow approach. The Company assesses the potential impairment of identifiable intangible assets and fixed assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors it considers important, which could trigger an impairment of such assets, include the following: - Significant underperformance relative to historical or projected future operating results; - Significant changes in the manner of or use of the acquired assets or the strategy for the Company's overall business; - Significant negative industry or economic trends; - Significant decline in the Company's stock price for a sustained period; and - A decline in the Company's market capitalization below net book value. Future adverse changes in these or other unforeseeable factors could result in an impairment charge that would impact future results of operations and financial position in the reporting period identified. SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142) requires, among other things, the discontinuance of goodwill amortization. The standard also includes provisions for the assessment of the useful lives of existing recognized intangible assets and the identification of reporting units for purposes of assessing potential future impairments of goodwill. The Company has assessed the useful lives of its existing intangible assets, other than goodwill, and believes that estimated useful lives remain appropriate. In addition, the Company has determined that it operates in one reporting unit. As a result, the fair value of the reporting unit was determined using the Company's market capitalization as of July 1, 2004. As the fair value of the reporting unit as of this date was in excess of the carrying amount of the net assets, the Company concluded that its goodwill was not impaired. No further analysis was required under SFAS 142. The Company uses the market value approach on an enterprise level basis to determine fair value in the initial step of its goodwill impairment test. Based on this, the Company performed the annual assessment during the last quarter of fiscal 2004 and determined that these intangible assets were not impaired. The Company completes goodwill impairment analyses at least annually, or more frequently when events and circumstances occur indicating that the recorded goodwill might be impaired. Significant judgments and estimates are involved in determining the useful lives of intangible assets, determining what reporting units exist and assessing when events or circumstances would require an interim impairment analysis of goodwill or other long-lived assets to be performed. Changes in the organization or the Company's management reporting structure, as well as other events and circumstances, including but not limited to technological advances, increased competition and changing economic or market conditions, could result in (a) shorter estimated useful lives, (b) additional reporting units, which may require alternative methods of estimating fair values or greater disaggregation or aggregation in our analysis by reporting unit, and/or (c) other changes in previous assumptions or estimates. In turn, this could have a significant impact on the consolidated financial statements through accelerated amortization and/or impairment charges. 9 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) RESEARCH AND DEVELOPMENT COSTS Costs incurred in the research and development of new software products and enhancements to existing products, other than certain software development costs that qualify for capitalization, are expensed as incurred. Software development costs incurred subsequent to the establishment of technological feasibility, but prior to the general release of the product, are capitalized and amortized to cost of revenue over the estimated useful life of the related products. In the three months ended December 31, 2004 and 2003, costs eligible for capitalization were not material. LEGAL EXPENSES INCURRED TO DEFEND PATENTS The Company capitalizes external legal costs incurred in the defense of its patents if the Company believes that the future economic benefit of the patent will be increased. The Company monitors the legal costs incurred and the anticipated outcome of the legal action and, if changes in the anticipated outcome occur, writes off capitalized costs, if any, in the period the change is determined. As of December 31, 2004 and September 30, 2004, capitalized patent defense costs totaled $0.8 million and $0.5 million, respectively. CAPITALIZATION OF INTERNAL USE SOFTWARE COSTS The Company capitalizes development costs of software for internal use pursuant to Statement of Position No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. As of December 31, 2004, the Company had capitalized costs of $0.4 million related to internal financial systems of which a portion of the cost for modules not yet deployed have been included in construction in process. INCOME TAXES Deferred tax assets and liabilities are determined based on differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. A valuation allowance against deferred tax assets is recorded if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The Company does not provide for U.S. income taxes on the undistributed earnings of its foreign subsidiaries, which the Company considers to be permanent investments. The Company monitors the realization of its deferred tax assets based on changes in circumstances, for example, recurring periods of income for tax purposes following historical periods of cumulative losses or changes in tax laws or regulations. The Company's income tax provisions and its assessment of the realizability of its deferred tax assets involve significant judgments and estimates. If the Company continued to generate taxable income through profitable operations in future years it may be required to recognize these deferred tax assets through the reduction of the valuation allowance which would result in a material benefit to its results of operations in the period in which the benefit is determined, excluding the recognition of the portion of the valuation allowance which relates to net deferred tax assets acquired in a business combination and stock compensation. COMPREHENSIVE INCOME Total comprehensive income, net of taxes, was $4.4 million and $1.1 million for the three months ended December 31, 2004 and 2003, respectively. Comprehensive income for the three months ended December 31, 2004 consists of net income of $3.1 million, foreign currency translation gains of $1.2 million and unrealized gains on marketable securities of $0.1 million. For the purposes of comprehensive income disclosures, the 10 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) Company does not record tax provisions or benefits for the net changes in the foreign currency translation adjustment, as the Company intends to permanently reinvest undistributed earnings in its foreign subsidiaries. CONCENTRATION OF RISK Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, cash equivalents, marketable securities and accounts receivable. The Company places its cash and cash equivalents with financial institutions with high credit ratings. The Company performs ongoing credit evaluations of its customers' financial condition and does not require collateral, since management does not anticipate nonperformance of payment. The Company also maintains reserves for potential credit losses and such losses have been within management's expectations. At December 31, 2004 one customer represented 12% of the Company's net accounts receivable balance. At September 30, 2004, no customer represented greater than 10% of the Company's net accounts receivable balance. FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS Financial instruments include cash equivalents, marketable securities, accounts receivable, and notes payable and are carried in the financial statements at amounts that approximate their fair value as of December 31, 2004 and September 30, 2004. MARKETABLE SECURITIES The Company accounts for its marketable equity securities in accordance with SFAS 115 "Accounting for Certain Investments in Debt and Equity Securities." Beginning in April 2004, the Company began investing in short and long-term marketable securities to improve the yield on its investment portfolio. At December 31, 2004, the stated maturities of the Company's investments are $1.5 million within one year and $3.8 million within one to five years. These investments are classified as available-for-sale and are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income, net of tax. Realized gains and losses on sales of short-term and long-term investments have not been material. During the three month period ended December 31, 2004, no short-term or long-term marketable securities were purchased. All short-term and long-term marketable securities have been classified as available-for-sale securities as follows:
NET UNREALIZED ESTIMATED COST LOSSES FAIR VALUE ------ ---------- ---------- (IN THOUSANDS) BALANCE AT DECEMBER 31, 2004 Classified as current assets: U.S. government agencies............................. $ 529 $ (1) $ 528 Corporate notes...................................... 982 (4) 978 ------ ---- ------ Short-term marketable securities.................. 1,511 (5) 1,506 ------ ---- ------ Classified as long-term assets: Corporate bonds...................................... 3,865 (51) 3,814 ------ ---- ------ Long-term marketable securities................... 3,865 (51) 3,814 ------ ---- ------ Total.................................................. $5,376 $(56) $5,320 ====== ==== ======
11 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED)
NET UNREALIZED ESTIMATED COST LOSSES FAIR VALUE ------- ---------- ---------- (IN THOUSANDS) BALANCE AT SEPTEMBER 30, 2004 Classified as current assets: U.S. government agencies............................ $ 4,419 $ (4) $ 4,415 Corporate notes..................................... 2,967 (9) 2,958 ------- ----- ------- Short-term marketable securities................. 7,386 (13) 7,373 ------- ----- ------- Classified as long-term assets: U.S. government agencies............................ 2,055 (15) 2,040 Corporate bonds..................................... 15,427 (112) 15,315 ------- ----- ------- Long-term marketable securities.................. 17,482 (127) 17,355 ------- ----- ------- Total................................................. $24,868 $(140) $24,728 ======= ===== =======
NET INCOME PER SHARE Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed based on (i) the weighted average number of common shares outstanding, (ii) the assumed conversion of the Series B Preferred Stock, and (iii) the effect, when dilutive, of outstanding stock options, the convertible debenture, warrants, and unvested shares of restricted stock using the treasury stock method. For the three months ended December 31, 2004 and 2003, 12,240,046 and 11,627,399 potentially dilutive common shares were excluded from the computation of net income per share, respectively, because they are antidilutive. 12 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) Below is a required detailed computation of net income for earning per share. As noted in Note 9, the Series B Preferred stock is a participating security, accordingly, the Company has applied EITF Issue No. 03-06 "Participating Securities and the Two-Class Method under FASB Statement No. 128" in computing net income per share for the three months ended December 31, 2004 and 2003, respectively (in thousands, except per share data):
THREE MONTHS ENDED DECEMBER 31, ------------------- 2004 2003 -------- -------- Basic: Net income.................................................. $ 3,141 $ 1,330 Assumed distributions on 3,562 shares of participating convertible preferred stock............................... (146) (89) -------- -------- Net income applicable to common shareholders, basic......... $ 2,995 $ 1,241 -------- -------- Weighted average common shares, basic....................... 104,973 99,510 Net income per share, basic................................. $ 0.03 $ 0.01 ======== ======== Diluted: Net income.................................................. $ 3,141 $ 1,330 Assumed distributions on 3,562 shares of participating convertible preferred stock............................... (140) (84) -------- -------- Net income applicable to common shareholders, diluted....... $ 3,001 $ 1,246 -------- -------- Weighted average common shares, diluted..................... 104,973 99,510 Effect of dilutive securities: Stock options............................................. 2,321 6,218 Convertible debentures, zero interest rate................ 4,587 4,587 Warrants.................................................. 443 509 Unvested restricted stock................................. 106 262 -------- -------- Weighted average common shares, diluted..................... 112,430 111,086 -------- -------- Net income per share, diluted............................... $ 0.03 $ 0.01 ======== ========
ACCOUNTING FOR STOCK-BASED COMPENSATION The Company accounts for stock-based awards to employees using the intrinsic value method as prescribed in Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations. The Company follows the disclosure provisions of Statement of Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation". Deferred compensation is recorded for restricted stock granted to employees based on the fair value of the Company's common stock at the date of grant and is amortized over the period in which the restrictions lapse. All stock-based awards to non-employees are accounted for at their fair value in accordance with SFAS No. 123 and related interpretations. 13 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) Had compensation expense for the Company's stock-based compensation plans been determined based on fair market value at the grant dates, as prescribed by SFAS No. 123, the Company's net income (loss) and pro forma net income (loss) per share would have been as follows (in thousands, except per share amounts):
THREE MONTHS ENDED DECEMBER 31, ---------------------- 2004 2003 --------- ---------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Net income -- as reported................................... $3,141 $ 1,330 Add back: Stock-based compensation included in net income, as reported............................................... 698 175 Deduct: Stock-based employee compensation expense determined under the fair value-based-method......................... (2,794) (2,904) ------ ------- Net income (loss) -- pro forma.............................. $1,045 $(1,399) ====== ======= Net income per share -- as reported: basic and diluted...... $ 0.3 $ 0.1 Net income (loss) per share -- pro forma: basic and diluted................................................... $ 0.1 $ (0.1)
RECLASSIFICATIONS Certain prior year financial statement amounts have been reclassified to conform with current year presentation. RECENT ACCOUNTING PRONOUNCEMENTS In May 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 was originally effective for financial instruments entered into or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning after June 15, 2003, however certain elements of SFAS No. 150 have been deferred. The adoption of the provisions of SFAS No. 150, not deferred, did not have a material impact on the Company's financial position or results of operations and the Company does not expect the adoption of the deferred elements of SFAS No. 150 to have a material impact on the Company's financial position or results of operations. In December 2004, the FASB issued FASB SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The new standard will be effective for the Company in the quarter beginning July 1, 2005. The Company has not yet completed its evaluation but expects the adoption to have a material effect on its consolidated financial statements. 14 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) 3. ACCOUNTS RECEIVABLE Accounts receivable consist of the following:
DECEMBER 31, SEPTEMBER 30, 2004 2004 ------------ ------------- (IN THOUSANDS) Accounts receivable......................................... $57,375 $38,265 Unbilled accounts receivable................................ 13,568 9,566 ------- ------- 70,943 47,831 Less -- allowances.......................................... (20,208) (11,308) ------- ------- $50,735 $36,523 ======= =======
Unbilled accounts receivable relate primarily to revenues earned under royalty-based arrangements for which billing occurs in the month following receipt of the royalty report and to revenues earned under customer contracts accounted for under the percentage-of-completion method that have not yet been billed based on the terms of the specific arrangement. 4. ACQUISITIONS ACQUISITION OF RHETORICAL SYSTEMS LTD. (RHETORICAL) On December 6, 2004, the Company acquired all of the outstanding shares of Rhetorical Systems, Ltd., a supplier of innovative text-to-speech solutions and tools based in Edinburgh, Scotland. With the acquisition of Rhetorical Systems, ScanSoft solidified its position as a leading provider of speech synthesis or text-to-speech (TTS) solutions for a variety of speech-based applications. The Rhetorical acquisition will further differentiate ScanSoft's solutions with a number of techniques, tools and services that enhance the ability to deliver custom, dynamic voices. The results of operations of the acquired business have been included in the financial statements of the Company since the date of acquisition. The consideration consisted of cash payments equal to 2,758,000 Pounds Sterling in cash ($5,360,000) and 449,437 shares of ScanSoft common stock (valued at approximately $1,672,000 in accordance with EITF Issue No. 99-12, "Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination"). The total initial purchase price of approximately $8,477,000 also includes estimated transaction costs of $1,445,000. The merger is a taxable event and has been accounted for as a purchase of a business. 15 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) The preliminary purchase price allocation is as follows (in thousands): Total purchase consideration: Cash...................................................... $ 5,360 Stock issued.............................................. 1,672 Transaction costs......................................... 1,445 ------- Total purchase consideration........................... $ 8,477 ======= Preliminary allocation of the purchase consideration: Current assets............................................ $ 824 Property and equipment.................................... 303 Identifiable intangible assets............................ 1,310 Goodwill.................................................. 7,654 ------- Total assets acquired.................................. 10,091 ------- Current liabilities assumed............................... (1,614) ------- $ 8,477 =======
Current assets acquired primarily relate to cash and accounts receivable and a facility lease deposit. Current liabilities assumed primarily relate to accrued expenses. The following are the identifiable intangible assets acquired and the respective periods over which the assets will be amortized on a straight-line basis:
AMOUNT LIFE --------------- ---------- (IN THOUSANDS) (IN YEARS) Core and completed technology............................... $ 490 10 Customer relationships...................................... 690 4 License professional services contract...................... 100 .25 Non-compete agreements...................................... 30 2-3 ------ $1,310 ======
The amount assigned to identifiable intangible assets acquired was based on their respective fair values determined as of the acquisition date. The excess of the purchase price over the tangible and identifiable assets was recorded as goodwill and amounted to approximately $7.7 million. In accordance with current accounting standards, the goodwill is not being amortized and will be tested for impairment as required by SFAS No. 142. ACQUISITION OF BRAND & GROEBER COMMUNICATIONS GBR ("B&G") On September 16, 2004, the Company acquired B&G, including all the intellectual property relating to embedded speech synthesis technology. The consideration consists of cash payments of approximately $0.2 million and four contingent payments of up to approximately E 5.8 million through 2007 to be paid, if at all, based upon the achievement of certain performance targets, as defined in the acquisition agreement. The total initial purchase price of approximately $0.3 million, includes cash consideration of $0.2 million and estimated transaction costs of $0.1 million. The acquisition has been accounted for as a purchase of a business. 16 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) The following are the identifiable intangible assets acquired and the respective periods over which the assets will be amortized on a straight-line basis:
AMOUNT LIFE -------------- ---------- (IN THOUSANDS) (IN YEARS) Completed technology........................................ $ 80 5 Customer relationships...................................... 180 4 Trade names and trademarks.................................. 20 8 ---- $280 ====
Any excess purchase price over the identified assets will be treated as goodwill. The results of operations of the acquired business's have been included in the financial statements of the Company since the date of acquisition. 5. OTHER INTANGIBLE ASSETS Other intangible assets consist of the following (in thousands):
GROSS CARRYING ACCUMULATED NET CARRYING USEFUL AMOUNT AMORTIZATION AMOUNT LIVES -------------- ------------ ------------ ---------- (IN YEARS) December 31, 2004 Patents and core technology.......... $54,555 $34,751 $19,804 1-9 Completed technology................. 13,528 4,648 8,880 1-4 Tradenames and trademarks............ 5,892 2,585 3,307 1-10 Non-competition agreement............ 4,088 4,058 30 1-6 Acquired favorable lease............. 553 553 -- Customer relationships............... 13,432 3,316 10,116 Other................................ 200 200 -- ------- ------- ------- $92,248 $50,111 $42,137 ======= ======= ======= September 30, 2004 Patents and core technology.......... $53,998 $32,753 $21,245 Completed technology................. 13,511 3,966 9,545 Tradenames and trademarks............ 5,871 2,407 3,464 Non-competition agreement............ 4,058 4,058 -- Acquired favorable lease............. 553 553 -- Customer relationships............... 12,324 2,680 9,644 Other................................ 200 200 -- ------- ------- ------- $90,515 $46,617 $43,898 ======= ======= =======
On March 31, 2003, the Company entered into an agreement that granted an exclusive license to the Company to resell, in certain geographies worldwide, certain productivity applications. The period of exclusivity expires after seven years, unless terminated earlier as permitted under the agreement. Total consideration to be paid by the Company for the license was $13.0 million. On June 30, 2003, the terms and conditions of the agreement were amended, resulting in a $1.2 million reduction in the license fee. The initial payment of $6.4 million due on or before June 30, 2003 was paid in accordance with the terms of the license 17 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) agreement and the first installment payment of $2.8 million due March 31, 2004 was paid on that date. The remaining payment of $2.8 million including interest of $0.2 million will be paid on March 31, 2005. Based on the net present value of the deferred payments due in 2004 and 2005, using an interest rate of 7.0%, the Company recorded $11.4 million as completed technology. That amount is being amortized to cost of revenue based on the greater of (a) the ratio of current gross revenue to total current and expected future revenues for the products or (b) the straight-line basis over the period of expected use, five years. The $0.6 million difference between the stated payment amounts and the net present value of the payments is being charged to interest expense over the payment period. As of December 31, 2004, the payment due on or before March 31, 2005 has been classified as a current liability, deferred payment obligation for technology license. Aggregate amortization expense was $3.5 million and $3.9 million for the three months ended December 31, 2004 and 2003, respectively. Of this amount, $2.8 million and $3.0 million was included in cost of revenue, respectively and $0.7 million and $0.9 million was recorded in operating expenses, respectively. Estimated amortization expense for each of the five succeeding fiscal years as of December 31, 2004 is as follows (in thousands):
SELLING, COST OF GENERAL AND YEAR ENDING SEPTEMBER 30, REVENUE ADMINISTRATIVE TOTAL ------------------------- ------- -------------- ------- 2005 (January 1 - September 30, 2005)................ $ 5,129 $ 2,087 $ 7,216 2006................................................. 5,474 2,425 7,899 2007................................................. 5,435 2,284 7,719 2008................................................. 4,223 2,012 6,235 2009................................................. 2,686 1,655 4,341 Thereafter........................................... 6,390 2,337 8,727 ------- ------- ------- Total................................................ $29,337 $12,800 $42,137 ======= ======= =======
6. ACCRUED EXPENSES Accrued expenses consist of the following (in thousands):
DECEMBER 31, SEPTEMBER 30, 2004 2004 ------------ ------------- Accrued sales and marketing incentives...................... $ 3,200 $ 3,533 Accrued restructuring and other charges..................... 580 574 Accrued royalties........................................... 550 513 Accrued professional fees................................... 2,591 2,673 Accrued acquisition liabilities............................. 32 32 Accrued transaction costs................................... 2,844 362 Accrued other............................................... 5,816 5,023 ------- ------- $15,613 $12,710 ======= =======
18 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) 7. RESTRUCTURING AND OTHER CHARGES During the three months ended December 31, 2004, a charge of approximately $0.7 million was taken in connection with the termination of 10 existing ScanSoft employees. At December 31, 2004, the remaining restructuring accrual from current and prior restructuring activities amounted to $0.6 million. This amount is composed of $0.2 million of lease exit costs and $0.4 million of employee-related severance costs, of which $0.1 million is for severance to the former Caere President and CEO. The severance due to the former Caere President and CEO will be paid through March 2005. Certain other severance costs related to restructuring actions undertaken during 2003 will be paid through March 2009. The following table sets forth the fiscal year 2005 and 2004 restructuring and other charges accrual activity (in thousands):
LEASE EMPLOYEE EXIT RESTRUCTURING AND OTHER CHARGES ACCRUAL RELATED COSTS TOTAL --------------------------------------- -------- ----- ------- Balance at December 31, 2003.............................. 1,552 309 1,861 Restructuring and other charges........................... 801 -- 801 Non-cash write-off........................................ (348) -- (348) Cash Payments............................................. (1,599) (141) (1,740) ------- ----- ------- Balance at September 30, 2004............................. $ 406 $ 168 $ 574 Restructuring and other charges........................... 659 -- 659 Cash Payments............................................. (632) (21) (653) ------- ----- ------- Balance at December 31, 2004.............................. $ 433 $ 147 $ 580 ======= ===== =======
8. DEBT AND CREDIT FACILITIES AND COMMITMENTS AND CONTINGENCIES CREDIT FACILITY On October 31, 2002, the Company entered into a two year Loan and Security Agreement (as amended, the "Loan Agreement") with Silicon Valley Bank (the "Bank") that consisted of a $10.0 million revolving loan (the "Credit Facility"). The Company amended this Loan and Security Agreement, as of March 31, 2004, extending the term to March 31, 2006. Under this amendment, the Company must comply with both a minimum adjusted quick ratio and minimum tangible net worth calculation, as defined in the Loan Agreement. Depending on the Company's adjusted quick ratio, borrowings under the Credit Facility bear interest at the Bank's prime rate plus 0.0% or 0.75%, (5.25% at December 31, 2004), as defined in the Loan Agreement. The maximum aggregate amount of borrowings outstanding at any one time was amended to the lesser of $20.0 million or a borrowing base equal to the aggregate amounts un-drawn on outstanding letters of credit, minus either 80% or 70% of eligible accounts receivable, as defined in the Loan Agreement, based on the Company's adjusted quick ratio. Borrowings under the Loan Agreement cannot exceed the borrowing base and must be repaid in the event they exceed the calculated borrowing base or upon expiration of the two-year loan term. Borrowings under the Loan Agreement are collateralized by substantially all of the Company's personal property, predominantly its accounts receivable, but not its intellectual property. As of December 31, 2004, the Company was in compliance with all covenants. As of December 31, 2004, no amounts were outstanding under the Credit Facility and $18.4 million was available for borrowing in addition to approximately $1.6 million committed under this line of credit for 19 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) outstanding Letters of Credit. The Company can make no guarantees as to its ability to satisfy its future financial covenant calculations. EQUIPMENT LINE OF CREDIT In connection with the acquisition of SpeechWorks, the Company assumed $1.5 million of principal amounts outstanding under a one-year equipment line-of-credit with a bank which expired on June 30, 2003. As of December 31, 2004, a balance of $0.3 million remains outstanding. Borrowings under this line are collateralized by the fixed assets purchased and bear interest at the bank's prime rate (5.25% at December 31, 2004), which is payable in equal monthly payments over a period of 36 months. In accordance with the terms of the equipment line of credit, as of December 31, 2004, principal payments of $0.2 million are due during the year ending September 30, 2005; and $0.1 million are due during the year ending September 30, 2006. Under the financing agreement, the Company is obligated to comply with certain financial covenants related to total tangible net assets and was in compliance as of December 31, 2004. CONVERTIBLE DEBENTURE On January 30, 2003, the Company issued a $27.5 million three-year, zero-interest convertible subordinated debenture due January 2006 (the "Convertible Note") to Philips in connection with the Philips acquisition. The Convertible Note is convertible into shares of the Company's common stock at $6.00 per share at any time until maturity at Philips' option. The conversion rate may be subject to adjustments from time to time as provided in the Convertible Note. The Convertible Note contains a provision in which all amounts unpaid at maturity will bear interest at a rate of 3% per quarter until paid. The Convertible Note contains covenants that place restrictions on the declaration or payment of dividends or distributions (other than distributions of equity securities of the Company) on, or the redemption or purchase of, any shares of the Company's capital stock while the Convertible Note is outstanding. This restriction terminates when one-half or more of the principal amount of the Convertible Note is converted by Philips into common stock. The Convertible Note contains a provision which provides Philips the right to require the Company to redeem the Convertible Note or any remaining portion of the principal amount, on the date a "Change in Control" occurs. The Convertible Note provides that a "Change in Control" is deemed to have occurred when any person or entity acquires beneficial ownership of shares of capital stock of the Company entitling such person or entity to exercise 40% or more of the total voting power of all shares of capital stock of the Company, or the Company sells all or substantially all of its assets, subject to certain exceptions. The Company's acquisition of SpeechWorks did not result in a Change in Control. LITIGATION AND OTHER CLAIMS Like many companies in the software industry, the Company has from time to time been notified of claims that it may be infringing certain intellectual property rights of others. These claims have been referred to counsel, and they are in various stages of evaluation and negotiation. If it appears necessary or desirable, the Company may seek licenses for these intellectual property rights. There is no assurance that licenses will be offered by all claimants, that the terms of any offered licenses will be acceptable to the Company or that in all cases the dispute will be resolved without litigation, which may be time consuming and expensive, and may result in injunctive relief or the payment of damages by the Company. From time to time, the Company receives information concerning possible infringement by third parties of the Company's intellectual property rights, whether developed, purchased or licensed by the Company. In response to any such circumstance, the Company has counsel investigate the matter thoroughly and the Company takes all appropriate action to defend its rights in these matters. 20 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) On September 9, 2004, BIS Advanced Software Systems, Ltd. ("BIS") filed an action against the Company in the United States District Court for the District of Massachusetts claiming patent infringement. Damages are sought in an unspecified amount. In the lawsuit, BIS alleges that the Company is infringing United States Patent No. 6,401,239 entitled "System and Method for Quick Downloading of Electronic files." The Company filed an Answer and Counterclaims on December 22, 2004. The Company believes this claim has no merit, and it intends to defend the action vigorously. On August 5, 2004, Compression Labs Inc. filed an action against the Company in the United States District Court for the Eastern District of Texas claiming patent infringement. Damages are sought in an unspecified amount. In the lawsuit, Compression Labs alleges that the Company is infringing United States Patent No. 4,698,672 entitled "Coding System for Reducing Redundancy." The Company believes this claim has no merit, and intends to defend the action vigorously. On April 23, 2004, Millennium L.P. filed an action against the Company in the United States in the United Sates District Court for the Southern District of New York claiming patent infringement. Damages are sought in an unspecified amount. In the lawsuit, Millennium alleges that the Company is infringing United Sates Patent No. 5,258,855 entitled "Information Processing Methodology"; No. 5,369,508 entitled "Information Processing Methodology"; No. 5,625,465 entitled "Information Processing Methodology"; No. 5,678,416 entitled "Information processing Methodology; and No. 6,094,505 entitled "Information Processing Methodology." The Company filed an Answer on June 17, 2004. The Company believes this claim has no merit, and it intends to defend the action vigorously. On July 15, 2003, Elliott Davis ("Davis") filed an action against SpeechWorks in the United States District Court for the Western District for New York (Buffalo) claiming patent infringement. Damages are sought in an unspecified amount. In the lawsuit, Davis alleges that SpeechWorks is infringing United States Patent No. 4,802,231 entitled "Pattern Recognition Error Reduction System" (the "'231 Patent"). The '231 Patent generally discloses techniques for a pattern recognition system and method wherein errors are reduced by creating independent error templates that correspond to patterns that tend to be erroneously matched and linked error templates that are linked to specified reference templates that are stored for comparison. In addition, on November 26, 2003, Davis filed an action against the Company in the United States District Court for the Western District for New York (Buffalo) claiming that the Company infringed the '231 Patent. Damages are sought in an unspecified amount. Although ScanSoft has, both prior to and as a result of the SpeechWorks acquisition, several products in the speech recognition technology field, ScanSoft believes that the products do not infringe the '231 Patent because neither the Company nor SpeechWorks use the claimed techniques. SpeechWorks filed an Answer and Counterclaim to Davis's Complaint in its case on August 25, 2003 and the Company filed an Answer and Counterclaim to Davis's Complaint in its case on December 22, 2003. The Company believes Davis's claims have no merit and intends to defend the actions vigorously. On November 27, 2002, AllVoice Computing plc filed an action against the Company in the United States District Court for the Southern District of Texas claiming patent infringement. In the lawsuit, AllVoice alleges that the Company is infringing United States Patent No. 5,799,273 entitled "Automated Proofreading Using Interface Linking Recognized Words to Their Audio Data While Text Is Being Changed" (the "'273 Patent"). The '273 Patent generally discloses techniques for manipulating audio data associated with text generated by a speech recognition engine. Although the Company has several products in the speech recognition technology field, the Company believes that its products do not infringe the '273 Patent because, in addition to other defenses, they do not use the claimed techniques. Damages are sought in an unspecified amount. The Company filed an Answer on December 23, 2002. The Company believes this claim has no merit and intends to defend the action vigorously. The Company believes that the final outcome of the current litigation matters described above will not have a significant adverse effect on its financial position or results of operations. However, even if the 21 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) Company's defense is successful, the litigation could require significant management time and will be costly. Should the Company not prevail in these litigation matters, its operating results, financial position and cash flows could be adversely impacted. GUARANTEES AND OTHER The Company currently includes indemnification provisions in the contracts it enters with its customers and business partners. Generally, these provisions require the Company to defend claims arising out of its products' infringement of third-party intellectual property rights, breach of contractual obligations and/or unlawful or otherwise culpable conduct on its part. The indemnity obligations imposed by these provisions generally cover damages, costs and attorneys' fees arising out of such claims. In most, but not all, cases, the Company's total liability under such provisions is limited to either the value of the contract or a specified, agreed upon, amount. In some cases its total liability under such provisions is unlimited. In many, but not all, cases, the term of the indemnity provision is perpetual. While the maximum potential amount of future payments the Company could be required to make under all the indemnification provisions in its contracts with customers and business partners is unlimited, it believes that the estimated fair value of these provisions is minimal due to the low frequency with which these provisions have been triggered. The Company has entered into agreements to indemnify its directors and officers to the fullest extent authorized or permitted under applicable law. These agreements, among other things, provide for the indemnification of its directors and officers for expenses, judgments, fines, penalties and settlement amounts incurred by any such person in his or her capacity as a director or officer of the company, whether or not such person is acting or serving in any such capacity at the time any liability or expense is incurred for which indemnification can be provided under the agreements. In accordance with the terms of the SpeechWorks merger agreement, the Company is required to indemnify the former members of the SpeechWorks board of directors, on similar terms as described above, for a period of five years from the acquisition date. As a result, the Company recorded a liability related to the fair value of the obligation of $1.0 million in connection with the purchase accounting for the acquisition. Additionally in accordance with the terms of the merger agreement, the Company purchased a director and officer insurance policy related to this obligation for a period of three years from the date of acquisition. In accordance with the provisions of FASB Interpretation No. 45 ("FIN 45"), Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, the following table represents the deferred revenue activity related to the Company's obligations under maintenance and support contracts for the three month period ended December 31, 2004 (in thousands): Beginning balance as of September 30, 2004.................. $ 4,130 Additions due to new billings during fiscal 2005............ 2,827 Maintenance revenue recognized during fiscal 2005........... (2,229) ------- Ending balance as of December 31, 2004...................... $ 4,728 =======
9. STOCKHOLDERS' EQUITY PREFERRED STOCK The Company is authorized to issue up to 40,000,000 shares of preferred stock, par value $0.001 per share. The Company has designated 100,000 shares as Series A Preferred Stock and 15,000,000 as Series B Preferred Stock. In connection with the acquisition of ScanSoft, the Company issued 3,562,238 shares of Series B Preferred Stock to Xerox Corporation ("Xerox"). On March 19, 2004, the Company announced that Warburg Pincus, a global private equity firm, had agreed to purchase all outstanding shares of the Company's 22 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) stock held by Xerox Corporation for approximately $80 million, including the 3,562,238 shares of Series B preferred stock. The Series B Preferred Stock is convertible into shares of common stock on a one-for-one basis. The Series B Preferred Stock has a liquidation preference of $1.30 per share plus all declared but unpaid dividends. The Series B Preferred Stock holders are entitled to non-cumulative dividends at the rate of $0.05 per annum per share, payable when, as and if declared by the Board of Directors. In addition, after payment of such dividends, any additional dividends or distributions shall be distributed among all holders of Common Stock and all holders of Series B Preferred Stock in proportion to the number of shares of Common Stock which would be held by each such holder if all shares of Series B Preferred Stock were converted to Common Stock. To date no dividends have been declared by the Board of Directors. Holders of Series B Preferred Stock have no voting rights, except those rights provided under Delaware law. The undesignated shares of preferred stock will have rights, preferences, privileges and restrictions, including voting rights, dividend rights, conversion rights, redemption privileges and liquidation preferences, as shall be determined by the Board of Directors upon issuance of the preferred stock. The Company has reserved 3,562,238 shares of its common stock for issuance upon conversion of the Series B Preferred Stock. COMMON STOCK WARRANTS On November 15, 2004, in connection with the acquisition of Phonetics Systems, Ltd., the Company issued unvested warrants to purchase 750,000 shares of ScanSoft common stock at an exercise price of $4.46 per share that will vest, if at all, upon the achievement of certain performance targets. The initial valuation of the warrants will occur upon closing of the acquisition and will be treated as purchase consideration in accordance with EITF Issue No. 97-8 "Accounting for Contingent Consideration Issued in a Purchase Business Combination". Future changes in the value of the warrant will be accounted for in accordance with EITF Issue No. 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock". See Note 14 for further discussion on the acquisition of Phonetic Systems, Ltd. The Company issued Xerox a ten-year warrant with an exercise price for each warrant share of $0.61. Pursuant to the terms of this warrant, it is exercisable for the purchase of 525,732 shares of the Company's common stock. On March 19, 2004, the Company announced that Warburg Pincus, a global private equity firm had agreed to purchase all outstanding shares of the Company's stock held by Xerox Corporation, including the warrant referenced above, for approximately $80 million. In connection with this transaction, Warburg Pincus acquired warrants to purchase 2.5 million additional shares of the Company's common stock for total consideration of $0.6 million. The warrants have a six year life and an exercise price of $4.94. The Company received this payment of $0.6 million during the quarter ended June 30, 2004. In connection with the March 31, 2003 acquisition of the certain intellectual property assets related to multimodal speech technology, the Company issued a warrant, expiring October 31, 2005, for the purchase of 78,000 shares of ScanSoft common stock at an exercise price of $8.10 per share. The warrant was immediately exercisable and was valued at $0.1 million based upon the Black-Scholes option pricing model with the following assumptions: expected volatility of 80%, a risk-free rate of 1.87%, an expected term of 2.5 years, no dividends and a stock price of $4.57 based on the Company's stock price at the time of issuance. In connection with the SpeechWorks acquisition, the Company issued a warrant to its investment banker, expiring on August 11, 2009, for the purchase of 150,000 shares of ScanSoft common stock at an exercise price of $3.98 per share. The warrant does not become exercisable until August 11, 2005 and was valued at $0.2 million based upon the Black-Scholes option pricing model with the following assumptions: expected volatility of 60%, a risk-free interest rate of 4.03%, an expected term of 8 years, no dividends and a stock price of $3.92 based on the Company's stock price at the time of issuance. 23 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) In connection with the acquisition of SpeechWorks, the Company assumed the remaining outstanding warrants issued by SpeechWorks to America Online ("AOL") to purchase up to 219,421 shares, as converted, of common stock in connection with a long-term marketing arrangement. The warrant is currently exercisable at a price of $14.49 per share and expires on June 30, 2007. The value of the warrant was insignificant. On December 17, 2003, pursuant to a letter agreement, dated October 17, 2003, the Company issued a warrant to a former employee of SpeechWorks, which expired on December 17, 2004, for the purchase of 11,180 shares of its common stock at an exercise price of $7.70 per share, and 2,552 shares of its common stock at an exercise price of $5.64 per share. The warrant was valued at approximately $18,000 based upon the Black-Scholes option pricing model with the following assumptions: expected volatility of 80%, a risk-free interest rate of 1.63%, an expected term of 1 year, no dividends and a stock price of $5.62 based on the Company's stock price at the time of issuance. STOCK REPURCHASE On August 6, 2003, the Company's board of directors authorized the repurchase of up to $25 million of the Company's common stock over the following 12 months; however, the Company may suspend or discontinue the repurchase program at any time. From August 6, 2003 through December 31, 2003, the Company repurchased 618,088 common shares at a purchase price of $2.9 million; the Company records treasury stock at cost. The Company repurchased 5,525 shares of common stock at a cost of $23,000 during the three month period ended December 31, 2004. As of December 31, 2004, the Company had repurchased a total of 2,777,032 common shares under this and previous repurchase programs. The Company intends to use the repurchased shares for its employee stock plans and for potential future acquisitions. 10. RESTRICTED COMMON STOCK AND STOCK PURCHASE RIGHTS During the three months ended December 31, 2004, the Company awarded net 68,477 restricted stock purchase units to certain senior executives and employees of the Company. As of December 31, 2004, there were 893,104 shares of restricted stock and 442,986 restricted stock units that were unvested and which may not be sold, transferred or assigned until such restrictions lapse. The holders of the restricted stock are entitled to participate in dividends and voting rights. The holders of restricted stock units are not entitled to dividends nor do they have voting rights. The restricted stock purchase units and shares of restricted stock vest no later than September 30, 2007, with opportunities for acceleration upon achievement of defined goals. Except as otherwise specified in the agreements, in the event that the executive or employees' employment with the Company terminates, any unvested shares shall be forfeited and revert to the Company. The purchase price of the restricted shares equaled the par value of the shares. The purchase price of the restricted stock purchase units, payable at time of issuance of shares, equaled the par value of the shares. The difference between the purchase price and the fair value of the Company's common stock on the date of issuance based on the listed exchange price, has been recorded as deferred compensation and additional paid-in-capital. The deferred compensation expense from the aforementioned awards is being recognized ratably over the vesting periods, resulting in $0.7 million and $0.2 million of stock compensation expense during the three months ended December 31, 2004 and 2003, respectively. 24 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) 11. SEGMENT AND GEOGRAPHIC INFORMATION AND SIGNIFICANT CUSTOMERS The Company operates in a single segment. The following table presents total revenue information by geographic area and principal product line (in thousands):
THREE MONTHS ENDED DECEMBER 31, ------------------- 2004 2003 -------- -------- United States of America.................................... $40,352 $32,429 Canada...................................................... 1,671 251 Other foreign countries..................................... 18,555 14,190 ------- ------- Total..................................................... $60,578 $46,870 ======= =======
No individual country within other foreign countries had revenues greater than 10% of total revenues. Revenue classification above is based on the country in which the sale originates. Revenue in other countries predominately relates to sales to customers in Europe and Asia. Inter-company sales are insignificant as products sold in other countries are sourced within Europe or the United States.
THREE MONTHS ENDED DECEMBER 31, ------------------- 2004 2003 -------- -------- Speech...................................................... $41,576 $28,093 Imaging..................................................... 19,002 18,777 ------- ------- Total..................................................... $60,578 $46,870 ======= =======
At December 31, 2004, two distribution and fulfillment partners, Ingram Micro and Digital River accounted for 10% and 11% of the Company's consolidated net revenues, respectively. At December 31, 2003, two distribution and fulfillment partners, Ingram Micro and Digital River accounted for 14% and 13% of the Company's consolidated net revenues, respectively. 12. PRO FORMA RESULTS The following table reflects unaudited pro forma results of operations of the Company assuming that the Telelogue, B&G and Rhetorical acquisitions had occurred on October 1, 2003 (in thousands, except per share data):
THREE MONTHS ENDED DECEMBER 31, ------------------- 2004 2003 -------- -------- Revenues.................................................... $60,978 $48,329 Net income (loss)........................................... $ 2,983 $ (767) Net income (loss) per diluted share......................... $ 0.03 $ (0.01)
The unaudited pro forma results of operations are not necessarily indicative of the actual results that would have occurred had the transactions actually taken place at the beginning of this period. 13. RELATED PARTIES On March 19, 2004, the Company announced that Warburg Pincus, a global private equity firm, had agreed to purchase all outstanding shares of the Company's stock held by Xerox Corporation for approximately $80 million. At December 31, 2003, Xerox owned approximately 15% of the Company's outstanding 25 SCANSOFT, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) common stock and all of the Company's outstanding Series B Preferred Stock. In addition, Xerox had the opportunity to acquire additional shares of common stock pursuant to a warrant (Note 9). As a result of the Xerox and Warburg Pincus transaction, Xerox is no longer a related party as of June 30, 2004. The Company does not engage in transactions in the normal course of its business with Warburg Pincus. At December 31, 2004, a member of the Company's Board of Directors, and a former member of the SpeechWorks Board of Directors, is a senior executive at Convergys Corporation. The Company and Convergys have entered into multiple non-exclusive agreements in which Convergys resells the Company's software. During the three months ended December 31, 2004, Convergys accounted for approximately $0.1 million in total net revenues. As of December 31, 2004 and September 30, 2004, Convergys owed the Company $0.1 million and $0.1 million, respectively, pursuant to these agreements, which are included in receivables from related parties. 14. SUBSEQUENT EVENTS On January 21, 2005, ScanSoft completed its acquisition of Advanced Recognition Technologies, Inc. ("ART") whose operations reside primarily in Israel. In connection with the ART acquisition, the Company paid approximately $10.0 million at closing and agreed to pay approximately $16.5 million in December 2005. With the acquisition of ART, the Company expands its portfolio of embedded speech solutions to include a deep set of resources, expertise and relationships with the world's leading mobile device manufacturers and service providers. On February 1, 2005, ScanSoft completed its acquisition of all of the outstanding capital stock of Phonetic Systems Ltd., an Israeli corporation ("Phonetic"). In connection with the Phonetic acquisition, the Company paid $17.5 million at closing, and agreed to pay $17.5 million 24 months after closing, make contingent payments of up to an additional $35.0 million in cash, in 2006 through 2008 if at all, upon the achievement of certain performance targets, and issue unvested warrants to purchase 750,000 shares of its' common stock that will vest, if at all, upon the achievement of certain performance targets. This acquisition furthers ScanSoft's global leadership in automated Directory Assistance and enterprise speech applications. In January 2005, ScanSoft, Inc. signed a 10 year lease for office space located in Burlington, Massachusetts. The Company will make approximately $22.3 million in operating lease payments over the term of the lease. This building will become the Company's new corporate headquarters and it intends to consolidate its 350 employees presently employed at its three existing Boston area offices into this location by June 2005. The Company will make all reasonable efforts to sublease its existing Boston area sites for the remainder of the existing lease terms. 26 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks described in "Risk Factors" starting on page 36 and elsewhere in this Quarterly Report. FORWARD-LOOKING STATEMENTS This quarterly report contains forward-looking statements. These forward-looking statements include predictions regarding: - - OUR FUTURE REVENUES, COST OF REVENUES, RESEARCH AND DEVELOPMENT EXPENSES, SELLING, GENERAL AND ADMINISTRATIVE EXPENSES, AMORTIZATION OF OTHER INTANGIBLE ASSETS AND GROSS MARGIN; - OUR STRATEGY RELATING TO SPEECH AND LANGUAGE TECHNOLOGIES; - THE POTENTIAL OF FUTURE PRODUCT RELEASES; - OUR PRODUCT DEVELOPMENT PLANS AND INVESTMENTS IN RESEARCH AND DEVELOPMENT; - FUTURE ACQUISITIONS; - INTERNATIONAL OPERATIONS AND LOCALIZED VERSIONS OF OUR PRODUCTS; AND - LEGAL PROCEEDINGS AND LITIGATION MATTERS. You can identify these and other forward-looking statements by the use of words such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "intends," "potential," "continue" or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in this quarterly report under the heading "Risk Factors" All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements. OVERVIEW OF THE BUSINESS We offer businesses and consumers market-leading speech and imaging solutions that facilitate the way people access, share, manage and use information in business and in daily life. We market and distribute our products indirectly through a global network of resellers, comprising system integrators, independent software vendors, value-added resellers, hardware vendors, telecommunications carriers and distributors; and directly to businesses and consumers through a dedicated direct sales force and our e-commerce website (www.scansoft.com). The value of our solutions is best realized in vertical markets that are information and process intensive, such as healthcare, telecommunications, financial services, legal and government. Our strategy is to deliver premier, comprehensive technologies and services as an independent application or as part of a larger integrated system in two areas -- speech and imaging. Our speech technologies enable voice-activated services over a telephone, transform speech into written word, and permit the control of devices and applications by simply speaking. Our imaging solutions eliminate the need to manually reproduce documents, automate the integration of documents into business systems, and enable the use of electronic documents and forms within XML, Internet, mobile and other business applications. Our software is delivered 27 as part of a larger integrated system, such as systems for customer service call centers, or as an independent application, such as dictation, document conversion or PDF, navigation systems in automobiles or digital copiers on a network. Our products and technologies deliver a measurable return on investment to our customers. Our extensive technology assets, intellectual property and industry expertise in speech and imaging capture create high barriers to entry in markets where we compete. Our technologies are based on complex mathematical formulas, which require extensive amounts of linguistic and image data, acoustic models and recognition techniques. A significant investment in capital and time would be necessary to replicate our current capabilities, and we continue to build upon our leadership position. Our speech technology has industry-leading recognition accuracy, provides recognition for 48 languages and natural sounding synthesized speech in 22 languages, and supports a broad range of hardware platforms and operating systems. Our digital capture technology is recognized as the most accurate in the industry, with rates as high as 99.8%, and supports more than 100 languages. Our technologies are covered by more than 650 patents or patent applications. Our strategy includes pursuing high growth markets in speech, expanding our PDF and imaging solutions, providing our partners and customers with a comprehensive portfolio of solutions, promoting the broad adoption of our technology, focusing and leverage our vertical expertise, building global sales and channel relationships and pursuing strategic acquisitions that complement our resources. ScanSoft was incorporated in 1992 as Visioneer. In 1999, we changed our name to ScanSoft, Inc. and ticker symbol to SSFT. From our founding until 2001, we focused exclusively on delivering imaging solutions that simplified converting and managing information as it moved from paper formats to electronic systems. On March 13, 2000, we merged with Caere Corporation, a California-based digital imaging software company, to expand our applications for document and electronic forms conversion. In December 2001, we entered the speech market through the acquisition of the Speech & Language Technology Business from Lernout & Hauspie. We believed speech solutions were a natural complement to our imaging solutions as both are developed, marketed and delivered through similar resources and channels. We continue to execute against our strategy of being the market leader in speech through the organic growth of our business as well as through strategic acquisitions. Since the beginning of 2003, we have completed a number of acquisitions, including: - On January 30, 2003, we acquired Royal Philips Electronics Speech Processing Telephony and Voice Control business units ("Philips") to expand our solutions for speech in call centers and within automobiles and mobile devices. - On August 11, 2003, we acquired SpeechWorks International, Inc. ("SpeechWorks") to broaden our speech applications for telecommunications, call centers and embedded environments as well as establish a professional services organization. - On December 19, 2003, we acquired LocusDialog, Inc. ("LocusDialog") to expand our speech application portfolio with automated attendant solutions for business. - On June 15, 2004, we acquired Telelogue, Inc. ("Telelogue") to enhance our automated directory assistance solutions. - On September 16, 2004, we acquired Brand & Groeber Communications GbR ("B&G") to enhance our embedded speech solutions, which will make mobile phones accessible to the visually impaired using ScanSoft's text-to-speech technology. - On December 6, 2004, we acquired Rhetorical Systems, Inc. ("Rhetorical") to complement our text-to-speech solutions and add capabilities for creating custom voices. - On January 21, 2005, we acquired ART Advanced Recognition Technologies, Inc. ("ART") to expand our portfolio of embedded speech solutions. - On February 1, 2005, we acquired Phonetic Systems Ltd. ("Phonetic") to complement our position in automated directory assistance and enterprise speech applications. 28 Our focus on providing solutions that enable the capture and conversion of information and the automation of systems requires a broad set of technologies and channel capabilities. We have made and expect to continue to make acquisitions of other companies, businesses and technologies to complement our internal investments in these areas. We have a team that focuses on evaluating market needs and potential acquisitions to fulfill them. In addition, we have a disciplined methodology for integrating acquired companies and businesses after the transaction is complete. OVERVIEW OF RESULTS OF OPERATIONS The following table presents, as a percentage of total revenue, certain selected financial data for each of the three month periods ended December 31:
2004 2003 ----- ----- Revenue: Product licenses.......................................... 77.3% 82.9% Professional services..................................... 23.4 17.1 ----- ----- Total revenue.......................................... 100.0% 100.0% Costs and expenses: Cost of product licenses.................................. 9.1 9.7 Cost of professional services............................. 15.8 12.6 Cost of revenue from amortization of intangible assets.... 4.7 6.5 ----- ----- Gross Margin................................................ 70.4 71.2 Research and development.................................. 15.0 18.9 Sales and marketing....................................... 30.6 37.3 General and administrative................................ 11.3 10.2 Amortization of other intangible assets(1)................ 1.1 1.8 Stock based compensation expense.......................... 1.2 0.5 Restructuring and other charges, net(2)................... 1.1 1.3 ----- ----- Total costs and expenses............................... 89.9 89.9 ----- ----- Income (loss) from operations............................... 10.1 1.2 Other income (expense), net................................. (1.5) 0.0 ----- ----- Income (loss) before income taxes........................... 8.6 1.2 Provision for (benefit from) income taxes................... 3.4 (1.6) ----- ----- Net income (loss)........................................... 5.2% 2.8% ===== =====
--------------- (1) See Note 5 of Notes to Consolidated Financial Statements. (2) See Note 7 of Notes to Consolidated Financial Statements. GENERAL We derive our revenue from licensing our software products to customers through distribution partners and value-added resellers, royalty revenues from OEM partners, license fees from sales of our products to customers and from professional services, which include, but are not limited to, custom software applications and other services considered essential to the functionality of the software, training, and maintenance associated with software license transactions. Our speech technologies enable voice-activated services over a telephone, transform speech into text and text into speech, and permit voice control of devices and applications by simply speaking. Our imaging solutions eliminate the need to manually reproduce documents, 29 automate the integration of documents into business systems, and enable the use of electronic documents and forms within XML, Internet, mobile and other business applications. TOTAL REVENUE Total revenue for the three months ended December 31, 2004 increased by $13.7 million, or 29.2%, from the comparable period in 2003. The overall growth in revenue is attributed to $8.0 million in growth from our product revenue and $5.7 million in growth from our professional services revenue. Geographic revenue classification is based on the country in which the sale is invoiced. Revenue for the three months ended December 31, 2004 was 69% North America and 31% international versus 70% and 30%, respectively for the comparable period in 2003. PRODUCT REVENUE Product revenue for the three months ended December 31, 2004 increased by $8.0 million, or 20.5%, from the comparable period in 2003. The increase in revenue from the comparable period in 2003 is attributed to an $8.0 million increase in speech revenue. The growth in speech revenue is accredited to growth and increased demand across all speech segments -- networked, embedded, and dictation. Our networked speech products grew $1.8 million, or 19%, from the comparable period 2003. This was largely driven by growth in our Text-to-Speech revenues, which contributed $1.3 million, or 57% growth. Our embedded speech products increased $1.3 million, or 58%, from the same period in 2003. Again, the largest contributor was our embedded Text-to-Speech revenues, which contributed $1.2 million, or 100% growth. In addition, our dictation productivity applications increased $4.9 million, or 57%, for the comparable period in 2003, due primarily to the launch of Dragon Naturally Speaking v.8 in November 2004. Our imaging revenue had modest growth, approximately $0.2 million, for the three months ended December 31, 2004 as compared to the comparable period in 2003. We experienced an increase of $3.3 million in our Paper Management products, due to the launch of PaperPort v10, in November 2004. Additionally, we experienced growth in our bundled imaging products and our PDF products. These increases were partially offset by a decrease of $4.6 million, from our OCR product line, primarily due to the launch of OmniPage v.14 in the comparable period of 2003. PROFESSIONAL SERVICE REVENUE Service revenue for the three months ended December 31, 2004 increased by $5.7 million from the comparable period in 2003. The substantial increase in service revenue from the comparable period in 2003 is attributed to the continued growth of our professional services organization which essentially was created in conjunction with the acquisition of SpeechWorks, in August 2003. Professional service revenue grew $3.9 million, or 61% from our networked services group, $1.3 million, or 94% from our embedded services, as well as a $0.5 million from our productivity services group, from the comparable period in 2003. COST OF PRODUCT LICENSE REVENUE Cost of revenue consists of material and fulfillment costs and third-party royalties. Cost of product license revenue for the three months ended December 31, 2004 was $5.5 million, or 11.8% of product license revenue, compared to $4.6 million, or 11.8%, for the comparable period in 2003. The increase in cost of product license revenue in absolute dollars for these periods ended December 31 was attributable to the overall increase in our product license revenue, as well as the absolute increase in our dictation products, which carry a higher manufacturing cost due to the inclusion of a headset. 30 COST OF PROFESSIONAL SERVICES REVENUE Cost of professional services revenue consists primarily of salaries for professional consulting staff, salaries for product support personnel, and engineering costs associated with certain contracts which were accounted for under the percentage-of-completion method of accounting. Cost of professional services revenue for the three months ended December 31, 2004 was $9.6 million, or 70%, of professional services revenue, compared to $5.9 million, or 73.5%, for the comparable period in 2003. The increase in cost of professional services revenue in absolute dollars for the three-month period ended December 31, 2004 was attributable to the increased services revenue. The improvement in cost as a percent of service revenue resulted from higher utilization of our services personnel. COST OF REVENUE FROM AMORTIZATION OF INTANGIBLE ASSETS Cost of revenue from amortization of intangible assets consists of the amortization of acquired patents and core and completed technology. Cost of revenue from amortization of intangible assets for the three months ended December 31, 2004 was $2.8 million, or 4.7% of total revenue, compared to $3.0 million, or 6.5%, for the comparable period in 2003. The decrease in cost of revenue from amortization of intangible assets for the three months ended December 31, 2004 in absolute dollars is attributable to an increase of $0.1 million related to the LocusDialog and Telelogue acquisitions which were completed on December 19, 2003 and June 15, 2004, offset by $0.3 million of intangible assets that became fully amortized during fiscal years 2003 and 2004. During fiscal 2005, we expect cost of revenue from amortization of intangible assets to be approximately $5.0 million based on our current level of intangible assets, but excluding, intangible assets associated with the ART and Phonetic acquisitions. GROSS MARGIN Gross margin was 70.4% of revenues for the three months ended December 31, 2004, as compared to 71.2% for the comparable period in 2003. The decrease is attributable to the increase in professional services revenue, which increased to 23.4% of total revenue for the three months ended December 31, 2004 from 17.1% for the comparable period in 2003, as services carry a lower margin than licenses. Research and Development Expense Research and development expense consists primarily of salary and benefits costs of engineers. We believe that the development of new products and the enhancement of existing products are essential to our success. Accordingly, we plan to continue to invest in research and development activities. To date, we have not capitalized any internal development costs as the cost incurred after technological feasibility but before release of product has not been significant. Research and development expense for the three months ended December 31, 2004 was $9.1 million, or 15.0%, of total revenue, compared to $8.9 million, or 18.9%, for the comparable period in 2003. In absolute dollars, research and development expenses increased marginally for the three months ended December 31, 2004, compared to the comparable period in 2003. The increase is primarily attributed to outsourced engineering labor which increased year over year. This was partially offset by decreased personnel costs associated with a decrease in research and development headcount by approximately 18 engineers from the comparable period in 2003. Sales and Marketing Expense Sales and marketing expenses include salaries, commissions, advertising, direct mail, public relations, trade shows, travel and other related sales and marketing expenses. Sales and marketing expense for the three months ended December 31, 2004 was $18.6 million, or 30.6% of total revenue, compared to $17.5 million, or 37.3%, for the comparable period in 2003. The increase in sales 31 and marketing expense for the three months ended December 31, 2004 was the result of increased compensation costs of approximately $1.0 million associated with the increased sales and marketing headcount of approximately 23 incremental sales and marketing staff. General and Administrative Expense General and administrative expenses include personnel costs for administration, finance, human resources, information systems and general management, in addition to legal and accounting expenses and other professional services. General and administrative expense for the three months ended December 31, 2004 was $6.9 million, or 11.3% of total revenue, compared to $4.8 million, or 10.2%, for the comparable period in 2003. The increase in general and administrative expenses in 2004 is due primarily to increased salaries of approximately $0.8 million, associated with increased headcount primarily in the finance and human resource departments and recruiting costs. Professional fees increased by approximately $0.6 million related to compliance with Sarbanes-Oxley regulatory requirements. Additionally, facility related costs increased by approximately $0.4 million, due to additional rental expense associated with the LocusDialog acquisition which closed on December 19, 2003. Amortization of Other Intangible Assets Amortization of other intangible assets includes amortization of acquired customer and contractual relationships, non-compete agreements and acquired trade names and trademarks. Amortization of other intangible assets for the three months ended December 31, 2004 was $0.7 million, or 1.1% of total revenue, compared to $0.9 million, or 1.8%, for the comparable period in 2003. The decrease in amortization of other intangible assets is attributable to $0.2 million of intangible assets that became fully amortized during fiscal year 2003. During 2005, we expect amortization of other intangible assets to be approximately $1.9 million based on our current level of intangible assets, but excluding, intangible assets associated with the ART and Phonetic acquisitions. Stock-Based Compensation Stock-based compensation expenses result from non-cash charges for common shares issued with exercise or purchase prices that are less than the fair market value of the common stock on the date of grant. Stock-based compensation expense was $0.7 million, or 1.2% of total revenue, for the three months ended December 31, 2004, as compared to $0.2 million, or 0.5%, for the comparable period in 2003, respectively. The absolute dollar increase of $0.5 million is directly attributed to increased non-cash compensation expense associated with the granting of approximately 1.0 million shares of restricted stock (or restricted stock purchase rights) subsequent to October 1, 2003. We expect stock-based compensation expense to increase significantly in fiscal 2005 due to the adoption of SFAS No. 123R, "Share-Based Payment" which will be effective for our fourth quarter beginning July 1, 2005. Restructuring and Other Charges, Net During the three months ended December 31, 2004, we recorded a charge of $0.7 million related to restructuring actions taken in our international subsidiaries in connection with our recently announced acquisitions. We expect these actions to continue for the remainder of fiscal 2005 as we integrate these acquisitions. During the three months ended December 31, 2003, we recorded a charge of $0.6 million related to restructuring actions taken during the nine months ended September 30, 2003. During the three months ended September 30, 2003, we assessed our history of employee termination plans under the guidance of Financial Accounting Standards No. 112 ("SFAS 112"), "Employers' Accounting for Postemployment Benefits." As a result of this review, we determined that we had an implied postemployment benefit plan and that future employee reduction actions would no longer meet the requirements of Financial Accounting Standards 32 No. 146 ("SFAS 146"), "Accounting for Costs Associated with Exit or Disposal Activities." As a result, any future employee reductions will not be recorded as a one-time charge, as allowed under SFAS 146, but will be recorded ratably over the period of the announcement of such reduction events to the date each employee ceases to provide services to the Company, as required under SFAS 112. Income (Loss) from Operations As a result of the above factors, income from operations was $6.1 million for the three months ended December 31, 2004, or 10.1% of total revenue, compared to income of $0.6 million, or 1.2%, for the comparable period in 2003. Other Income (Expense), Net Interest income was $0.1 million and $0.1 million for the three months ended December 31, 2004 and 2003, respectively. Interest expense was $0.1 million and $0.4 million for the three months ended December 31, 2004 and 2003, respectively. Other expense of $0.9 million for the three months ended December 31, 2004 consisted primarily of foreign currency losses of $1.0 million. These losses include $0.5 million generated from international operations that do business in foreign currencies other than their local currency and $0.5 million related to translation of intercompany balances. For the three months ended December 31, 2003, other income of $0.2 million consisted primarily of foreign currency gains. Income (Loss) Before Income Taxes Income before income taxes was $5.2 million for the three months ended December 31, 2004, or 8.6% of total revenue, compared with income of 0.6 million, or 1.2%, for the comparable period in 2003. Income Taxes The provision for income taxes for the three months ended December 31, 2004 was $2.1 million, or 3.4% of total revenue, compared to a tax benefit of $0.7 million, or 1.6%, in the comparable period for 2003. The provision for income taxes consists primarily of a foreign taxes relating to international operations and US alternative minimum taxes. Net Income (Loss) As a result of all of these factors, net income totaled $3.1 million, or 5.2% of total revenue for the three months ended December 31, 2004, compared with income of $1.3 million, or 2.8% of total revenue, for the comparable period in 2003. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2004, we had cash and cash equivalents of $41.3 million, marketable securities of $1.5 million, long term marketable securities of $3.8 million and net working capital of $41.3 million as compared to cash and cash equivalents of $23.0 million, marketable securities of $7.4 million, long term marketable securities of $17.4 million and net working capital of $27.9 million at September 30, 2004. Net cash provided by operating activities for the three months ended December 31, 2004 was $5.6 million, compared to $2.2 million for the comparable period in 2003. Cash provided by operations in the 2004 period came primarily from income from operations, after adjustments for non-cash amortization, depreciation and stock based compensation, which was offset by a significant increase in accounts receivable, offset by increases in accounts payables, accrued expenses and deferred revenue. Cash provided by operations in the 2003 period came primarily from income from operations, after adjustments for non-cash amortization and depreciation, which was offset by significant increases in accounts receivable, offset by increases in accounts payables, accrued expenses and deferred revenue. Net cash provided by investing activities for the three months ended December 31, 2004 was $11.9 million, compared to $0.3 million for the comparable period in 2003. Net cash provided by investing 33 activities during 2004 consisted of $19.5 million of gross sales and maturities of marketable securities, which was offset by $0.8 million in capital expenditures, and $6.7 million of payments associated with acquisitions. During the period, no short-term or long-term marketable securities were purchased. Net cash provided from investing activities during the 2003 period consisted of $1.2 million of cash received form the acquisition of LocusDialog and $0.6 million on maturities of marketable securities, which was offset by $1.5 million in capital expenditures. Net cash used by financing activities for the three months ended December 31, 2004 was $0.1 million, compared to $7.6 million for the comparable period in 2003. Net cash used by financing activities during 2004 consisted of $0.2 million of payments on outstanding equipment lines of credit, $0.1 million of purchases of treasury shares on net option exercises, which was offset by $0.2 million of cash received from the issuance of common stock in connection with employee stock compensation plans. Net cash used by financing activities during the three months ended December 31, 2003 consisted of the payment of $6.9 million of Philips related acquisition liabilities, $1.3 million of offering costs associated with the issuance of common stock in our underwritten public offering, $1.3 million for the purchase of treasury shares, $0.4 million in payment to the former Caere President and CEO in connection with the settlement of the non-competition and consulting agreement, and $0.3 million on outstanding equipment lines of credit. These disbursements were offset by proceeds of $2.4 million from the issuance of common stock in connection with employee stock compensation plans. Although we generated $5.6 million and $2.2 million of cash from operations during the three month period ended December 31, 2004 and 2003, respectively, and exited the period ended December 31, 2004 with a cash and cash equivalents balance of $41.3 million and marketable securities of $5.3 million, there can be no assurance that we will be able to continue to generate cash from operations or secure additional equity or debt financing if required. We sustained recurring losses from operations in each reporting period through December 31, 2001. While we report net income of $3.1 million for the three months ended December 31, 2004, we reported a net loss of $(9.4) million and $(5.5) million for the nine months ended September 30, 2004, and the fiscal year ended December 31, 2003, respectively. We had an accumulated deficit of $158.7 million at December 31, 2004. In connection with the Philips Speech Processing Telephony and Voice Control Business Unit acquisition we issued a $27.5 million, zero interest convertible debenture due January 2006. Additionally, in connection with the SpeechWorks acquisition we acquired certain long-term lease obligations that begin to come due in the next 12-24 months. In connection with the ART acquisition, we paid approximately $10.0 million at closing and agreed to pay $16.5 million in December 2005. In connection with the Phonetic acquisition, we paid $17.5 million at closing, and agreed to (i) pay $17.5 million 24 months after closing, (ii) make contingent payments of up to an additional $35.0 million in cash, in 2006 through 2008 if at all, upon the achievement of certain performance targets, and (iii) issue unvested warrants to purchase 750,000 shares of our common stock that will vest, if at all, upon the achievement of certain performance targets. The cash consideration for these acquisitions is expected to be provided by existing cash, marketable securities, cash generated from operations, or debt or equity offerings. In connection with the Rhetorical acquisition, we paid approximately $5.4 million in cash on December 6, 2004. We believe that cash flows from future operations in addition to cash and marketable securities on hand will be sufficient to meet our working capital, investing, financing and contractual obligations, including the debt obligation issued in connection with the Philips acquisition, lease obligations assumed in the SpeechWorks acquisition, and cash obligations related to acquisitions completed subsequent to the quarter end, as they become due for the foreseeable future. We also believe that in the event future operating results are not as planned, that we could take actions, including restructuring actions and other cost reduction initiatives, to reduce operating expenses to levels which, in combination with expected future revenues, will continue to generate sufficient operating cash flow. In the event that these actions are not effective in generating operating cash flows we may be required to issue equity or debt securities on less than favorable terms. 34 The following table outlines our contractual payment obligations as of December 31, 2004:
PAYMENTS DUE BY PERIOD -------------------------------------------------- LESS THAN 2-3 4-5 MORE THAN CONTRACTUAL OBLIGATIONS(1) TOTAL 1 YEAR YEARS YEARS 5 YEARS -------------------------- ------- --------- ------- ------ --------- (IN THOUSANDS) Philips Convertible debenture....... $27,524 -- $27,524 -- $ -- Deferred payments for technology license........................... 2,757 2,757 -- -- -- Operating leases.................... 38,220 7,427 8,392 5,813 16,588 Equipment line of credit............ 337 293 44 -- -- Standby letters of credit........... 1,610 494 46 46 1,024 Royalty commitments................. 770 560 120 90 Purchase commitments................ 1,124 1,124 -- -- -- Imputed interest.................... 43 43 -- -- -- ------- ------- ------- ------ ------- Total contractual cash obligations....................... $72,385 $12,698 $36,126 $5,949 $17,612 ======= ======= ======= ====== =======
--------------- (1) Excludes the impact of the Art Advanced Recognition Technologies, Inc. ("ART") and Phonetic Systems Ltd. ("Phonetic") acquisitions. In connection with the ART acquisition, we paid approximately $10.0 million at closing and agreed to pay $16.5 million in December 2005. In connection with the Phonetic acquisition, we paid $17.5 million at closing and agreed to (i) pay $17.5 million 24 months after closing, (ii) make a contingent payment of up to an additional $35.0 million, if at all, upon the achievement of certain performance targets, and (iii) issue unvested warrants to purchase 750,000 shares of our common stock that will vest, if at all, upon the achievement of certain performance targets. The cash consideration for these acquisitions is expected to be provided by existing cash, marketable securities, cash generated from operations, or debt or equity offerings. Excludes approximately $22.3 million in operating lease payments related to office space in Burlington, Massachusetts. Through December 31, 2004, we have not entered into any off balance sheet arrangements or transactions with unconsolidated entities or other persons. FOREIGN OPERATIONS Because we have international subsidiaries and distributors that operate and sell our products outside the United States, we are exposed to the risk of changes in foreign currency exchange rates or declining economic conditions in these countries. In certain circumstances, we have entered into forward exchange contracts to hedge against foreign currency fluctuations on intercompany balances with our foreign subsidiaries. We use these contracts to reduce our risk associated with exchange rate movements, as the gains or losses on these contracts are intended to offset any exchange rate losses or gains on the hedged transaction. We do not engage in foreign currency speculation. Hedges are designated and documented at the inception of the hedge and are evaluated for effectiveness monthly. Forward exchange contracts hedging firm commitments qualify for hedge accounting when they are designated as a hedge of the foreign currency exposure and they are effective in minimizing such exposure. On November 3, 2003, we entered into a forward exchange contract to hedge our foreign currency exposure related to 3.5 million euros of intercompany receivables from our Belgian subsidiary. The contract has a one year term that expired on November 1, 2004. On November 1, 2004 we renewed this forward hedge contract; the renewed contract has a one year term expiring on November 1, 2005; however it is cancelable at our discretion. On November 5, 2003, we entered into a forward exchange contract to hedge our foreign currency exposure related to 7.5 million Singapore dollars of intercompany receivables from our Singapore subsidiary. The original contract expired on January 30, 2004, but was extended six months to October 29, 2004. The contract was not extended and thereby terminated on October 29, 2004. We realized a loss of approximately $0.2 million. 35 As of December 31, 2004, we have a $0.8 million liability related to these contracts. With our increased international presence in a number of geographic locations and with international revenues projected to increase in 2005, we are exposed to changes in foreign currencies including the euro, Canadian dollar, Japanese yen and the Hungarian forint. Changes in the value of the euro or other foreign currencies relative to the value of the U.S. dollar could adversely affect future revenues and operating results. RECENT ACCOUNTING PRONOUNCEMENTS In May 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 was originally effective for financial instruments entered into or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning after June 15, 2003, however certain elements of SFAS No. 150 have been deferred. The adoption of the provisions of SFAS No. 150, not deferred, did not have a material impact on our financial position or results of operations and we do not expect the adoption of the deferred elements of SFAS No. 150 to have a material impact on our financial position or results of operations. On December 16, 2004, the FASB issued FASB SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. However, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The new standard will be effective, upon us, beginning July 1, 2005. We have not yet completed our evaluation but we expect the adoption to have a material effect on our consolidated financial statements. RISK FACTORS You should carefully consider the risks described below when evaluating our company and when deciding whether to invest in us. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations and financial situation. Our business, financial condition and results of operations could be seriously harmed if any of these risks actually occurs. As a result, the trading price of our common stock may decline and you can lose part or all of your investment in our common stock. RISKS RELATED TO OUR BUSINESS Our operating results may fluctuate significantly from period to period, and this may cause our stock price to decline. Our revenue and operating results have fluctuated in the past and, and we expect our revenue and operating results to continue to fluctuate in the future. Given this fluctuation, we believe that quarter to quarter comparisons of our revenue and operating results are not necessarily meaningful or an accurate indicator of our future performance. As a result, our results of operations may not meet the expectations of securities analysts or investors in the future. If this occurs, the price of our stock would likely decline. Factors that contribute to fluctuations in our operating results include the following: - slowing sales by our distribution and fulfillment partners to their customers, which may place pressure on these partners to reduce purchases of our products; - volume, timing and fulfillment of customer orders; - rapid shifts in demand for products given the highly cyclical nature of the retail software industry; - the loss of, or a significant curtailment of, purchases by any one or more of our principal customers; 36 - concentration of operations with one manufacturing partner and ability to control expenses related to the manufacture, packaging and shipping of our boxed software products; - customers delaying their purchasing decisions in anticipation of new versions of products; - customers delaying, canceling or limiting their purchases as a result of the threat or results of terrorism; - introduction of new products by us or our competitors; - seasonality in purchasing patterns of our customers, where purchases tend to slow in the fourth fiscal quarter; - reduction in the prices of our products in response to competition or market conditions; - returns and allowance charges in excess of recorded amounts; - timing of significant marketing and sales promotions; - write-offs of excess or obsolete inventory and accounts receivable that are not collectible; - increased expenditures incurred pursuing new product or market opportunities; - inability to adjust our operating expenses to compensate for shortfalls in revenue against forecast; and - general economic trends as they affect retail and corporate sales. Due to the foregoing factors, among others, our revenue and operating results are difficult to forecast. Our expense levels are based in significant part on our expectations of future revenue, and we may not be able to reduce our expenses quickly to respond to a shortfall in projected revenue. Therefore, our failure to meet revenue expectations would seriously harm our operating results, financial condition and cash flows. We have grown, and may continue to grow, through acquisitions, which could dilute our existing shareholders and could involve substantial integration risks. As part of our business strategy, we have in the past acquired, and expect to continue to acquire, other businesses and technologies. In connection with past acquisitions, we issued a substantial number of shares of our common stock as transaction consideration. We may continue to issue equity securities for future acquisitions that would dilute our existing stockholders, perhaps significantly depending on the terms of the acquisition. We may also incur debt in connection with future acquisitions, which, if available at all, may place additional restrictions on our ability to operate our business. Furthermore, our acquisition of the speech and language technology operations of Lernout & Hauspie Speech Products N.V. and certain of its affiliates, including L&H Holdings USA, Inc. (collectively, L&H), our acquisition of the Speech Processing Telephony and Voice Control business units from Philips, our acquisition of SpeechWorks International, Inc. and our acquisition of LocusDialog, Inc. required substantial integration and management efforts. Our recently completed acquisitions of Telelogue, Inc., Rhetorical Systems Ltd., ART Advanced Recognition Technologies, Inc. and Phonetic Systems, Ltd. will likely pose similar challenges. Acquisitions of this nature involve a number of risks, including: - difficulty in transitioning and integrating the operations and personnel of the acquired businesses, including different and complex accounting and financial reporting systems; - potential disruption of our ongoing business and distraction of management; - potential difficulty in successfully implementing, upgrading and deploying in a timely and effective manner new operational information systems and upgrades of our finance, accounting and product distribution systems; - difficulty in incorporating acquired technology and rights into our products and technology; - unanticipated expenses and delays in completing acquired development projects and technology integration; - management of geographically remote units both in the United States and internationally; - impairment of relationships with partners and customers; 37 - entering markets or types of businesses in which we have limited experience; and - potential loss of key employees of the acquired company. As a result of these and other risks, we may not realize anticipated benefits from our acquisitions. Any failure to achieve these benefits or failure to successfully integrate acquired businesses and technologies could seriously harm our business. We have a history of operating losses, and we may incur losses in the future, which may require us to raise additional capital on unfavorable terms. We sustained recurring losses from operations in each reporting period through December 31, 2001. We reported net income of $3.1 million for the three months ended December 31, 2004, and reported a net loss of $(9.4) million and $(5.5) million for the nine month period ended September 30, 2004 and the twelve months ended December 31, 2003, respectively. We had an accumulated deficit of $158.7 million at December 31, 2004. If we are unable to maintain profitability, the market price for our stock may decline, perhaps substantially. We cannot assure you that our revenues will grow or that we will maintain profitability in the future. If we do not maintain profitability, we may be required to raise additional capital to maintain or grow our operations. The terms of any additional capital, if available at all, may be highly dilutive to existing investors or contain other unfavorable terms, such as a high interest rate and restrictive covenants. Purchase accounting treatment of our acquisitions could decrease our net income in the foreseeable future, which could have a material and adverse effect on the market value of our common stock. Under accounting principles generally accepted in the United States of America, we have accounted for our acquisitions using the purchase method of accounting. Under purchase accounting, we record the market value of our common stock or other form of consideration issued in connection with the acquisition and the amount of direct transaction costs as the cost of acquiring the company or business. We have allocated that cost to the individual assets acquired and liabilities assumed, including various identifiable intangible assets such as acquired technology, acquired trade names and acquired customer relationships based on their respective fair values. Intangible assets generally will be amortized over a five to ten year period. Goodwill is not subject to amortization but is subject to at least an annual impairment analysis, which may result in an impairment charge if the carrying value exceeds its implied fair value. Sales of our dictation, document and PDF conversion products and our digital paper management products represented approximately 22%, 17% and 11%, of our revenue for the three months ended December 31, 2004 and 18%, 31% and 8%, for the three months ended December 31, 2003, respectively, and any reduction in revenue from these product areas could seriously harm our business. Historically, a small number of product areas have generated a substantial portion of our revenues. For the three months ended December 31, 2004, our dictation products represented 22% of our consolidated revenue, document and PDF conversion products represented approximately 17% of our consolidated revenue and our digital paper management products represented approximately 11% of our consolidated revenue. For the three months ended December 31, 2003, our dictation products represented 18% of consolidated revenues, document and PDF conversion products represented approximately 31% of our consolidated revenue and our digital paper management products represented approximately 8% of our consolidated revenue. A significant reduction in the revenue contribution in absolute dollars from these product areas could seriously harm our business, results of operations, financial condition, cash flows and stock price. We rely on a small number of distribution and fulfillment partners, including 1450, Digital River and, Ingram Micro, to distribute many of our products, and any adverse change in our relationship with such partners may adversely impact our ability to deliver products. Our products are sold through, and a substantial portion of our revenue is derived from, a network of over 2000 channel partners, including value-added resellers, computer superstores, consumer electronic stores, mail order houses, office superstores and eCommerce Web sites. We rely on a small number of distribution and fulfillment partners, including 1450, Digital River and Ingram Micro to serve this network of channel partners. For the three months ended December 31, 2004, two distribution and fulfillment partners, Ingram Micro and Digital River, accounted for 10% and 11% of our consolidated revenue, respectively. For the three months ended December 31, 2003, Ingram Micro and Digital River, accounted for 14% and 13% of our consolidated revenue, respectively. A 38 disruption in these distribution and fulfillment partner relationships could negatively affect our ability to deliver products, and hence our results of operations in the short term. Any prolonged disruption for which we are unable to arrange alternative fulfillment capabilities could have a more sustained adverse impact on our results of operations. A significant portion of our accounts receivable is concentrated among our largest customers, and non-payment by any of them would adversely affect our financial condition. Although we perform ongoing credit evaluations of our distribution and fulfillment partners' financial condition and maintain reserves for potential credit losses, we do not require collateral or other form of security from our major customers to secure payment. While, to date, losses due to non-payment from customers have been within our expectations, we cannot assure you that instances or extent of non-payment will not increase in the future. At December 31, 2004, Ingram Micro and Digital River represented 12% and 6%, of our net accounts receivable, respectively. At September 30, 2004, no one customer represented 10% of our net accounts receivable. If these or any of our other significant customers were unable to pay us in a timely fashion, or if we were to experience significant credit losses in excess of our reserves, our results of operations, cash flows and financial condition would be seriously harmed. Speech technologies may not achieve widespread acceptance by businesses, which could limit our ability to grow our speech business. We have invested and expect to continue to invest heavily in the acquisition, development and marketing of speech technologies. The market for speech technologies is relatively new and rapidly evolving. Our ability to increase revenue in the future depends in large measure on acceptance of speech technologies in general and our products in particular. The continued development of the market for our current and future speech solutions will also depend on the following factors: - consumer demand for speech-enabled applications; - development by third-party vendors of applications using speech technologies; and - continuous improvement in speech technology. Sales of our speech products would be harmed if the market for speech software does not continue to develop or develops more slowly than we expect, and, consequently, our business could be harmed and we may not recover the costs associated with our investment in our speech technologies. The markets in which we operate are highly competitive and rapidly changing, and we may be unable to compete successfully. There are a number of companies that develop or may develop products that compete in our targeted markets. The individual markets in which we compete are highly competitive, and are rapidly changing. Within imaging, we compete directly with ABBYY, Adobe, I.R.I.S. and NewSoft. Within speech, we compete with AT&T, Fonix, IBM, Microsoft, Nuance and Philips. In speech, some of our partners such as Avaya, Cisco, Edify, Genesys and Nortel develop and market products that can be considered substitutes for our solutions. In addition, a number of smaller companies in both speech and imaging produce technologies or products that are in some markets competitive with our solutions. Current and potential competitors have established, or may establish, cooperative relationships among themselves or with third parties to increase the ability of their technologies to address the needs of our prospective customers. The competition in these markets could adversely affect our operating results by reducing the volume of the products we license or the prices we can charge. Some of our current or potential competitors, such as Adobe, IBM and Microsoft, have significantly greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to new or emerging technologies or changes in customer requirements. They may also devote greater resources to the development, promotion and sale of their products than we do. Some of our customers, such as IBM and Microsoft, have developed or acquired products or technologies that compete with our products and technologies. These customers may give higher priority to the sale of these competitive products or technologies. To the extent they do so, market acceptance and penetration of our products, and therefore our revenue, may be adversely affected. 39 Our success will depend substantially upon our ability to enhance our products and technologies and to develop and introduce, on a timely and cost-effective basis, new products and features that meet changing customer requirements and incorporate technological advancements. If we are unable to develop new products and enhance functionalities or technologies to adapt to these changes, or if we are unable to realize synergies among our acquired products and technologies, our business will suffer. The failure to successfully implement, upgrade and deploy in a timely and effective manner new information systems and upgrades of our finance and accounting systems to address certain issues identified in connection with our fiscal 2004 year-end audit could harm our business. In connection with their audit of our 2004 consolidated financial statements, BDO Seidman, LLP, our independent registered public accounting firm advised management and our Audit Committee of the following significant deficiencies which do not individually or in the aggregate raise to the level of material weakness: The Company lacks the necessary corporate accounting resources to ensure consistently complete and accurate reporting of financial information which, when combined with the Company's need to realign and cross-train current finance and accounting personnel, has led to a dependence on key personnel in the organization, the loss of whom could impair the Company's ability to ensure consistently complete and accurate financial reporting. In certain circumstances the Company's accounting transactions, including related judgments and estimates, were not always supported in a timely manner by a sufficiently formal processes or sufficiently comprehensive documentation. In the third quarter of 2003, we commenced our Section 404 of the Sarbanes-Oxley Act compliance efforts. During 2004, we deployed Oracle 11i to process and report all of our general accounting functions in our three major locations (Peabody, Massachusetts, Belgium and Hungary). During 2005, we will implement additional modules to continue to enhance the functionality of our Oracle implementation. We are also currently in the process of augmenting current processes, repositioning current finance and accounting personnel and recruiting additional personnel to ensure consistently complete and accurate reporting of financial information and to reduce our dependence on key personnel in our finance and accounting organization. We currently expect these efforts to extend into the second half of fiscal 2005. While we believe that these actions will address the conditions raised by BDO, we have been and will continue to be required to devote substantial resources to these activities during 2005. Failure to successfully implement these systems or formalize and document these processes and controls in a timely, effective and efficient manner could result in the disruption of our operations, our inability to comply with our Sarbanes-Oxley obligations and the inability to report our financial results in a timely manner, particularly given the added requirements associated with the integration of our recently completed acquisitions of Telelogue, Inc., Rhetorical Systems Ltd., and ART Advanced Recognition Technologies, Inc. and Phonetic Systems Ltd., further accelerated filing deadlines mandated by the SEC and the requirements of Section 404 of the Sarbanes-Oxley Act. A significant portion of our revenue is derived from sales in Europe and Asia. Our results could be harmed by economic, political, regulatory and other risks associated with these and other international regions. Since we license our products worldwide, our business is subject to risks associated with doing business internationally. We anticipate that revenue from international operations will represent an increasing portion of our total revenue. Reported international revenue for the three months ended December 31, 2004 and 2003, represented 31% and 30% of our consolidated revenue for those periods, respectively. Most of these international revenues are generated by sales in Europe and Asia. In addition, some of our products are developed and manufactured outside the United States. A significant portion of the development and manufacturing of our speech products are completed in Belgium, and a significant portion of our imaging research and development is conducted in Hungary. In connection with the Philips acquisition, we added an additional research and development location in Germany, and in connection with the acquisition of Locus Dialog, we added an additional research and development location in Montreal, Canada. Accordingly, our future results could be harmed by a variety of factors associated with international sales and operations, including: - changes in a specific country's or region's economic conditions; - geopolitical turmoil, including terrorism and war; 40 - trade protection measures and import or export licensing requirements imposed by the United States or by other countries; - compliance with foreign and domestic laws and regulations; - negative consequences from changes in applicable tax laws; - difficulties in staffing and managing operations in multiple locations in many countries; - difficulties in collecting trade accounts receivable in other countries; and - less effective protection of intellectual property. We are exposed to fluctuations in foreign currency exchange rates. Because we have international subsidiaries and distributors that operate and sell our products outside the United States, we are exposed to the risk of changes in foreign currency exchange rates or declining economic conditions in these countries. In certain circumstances, we have entered into forward exchange contracts to hedge against foreign currency fluctuations on intercompany balances with our foreign subsidiaries. We use these contracts to reduce our risk associated with exchange rate movements, as the gains or losses on these contracts are intended to offset any exchange rate losses or gains on the hedged transaction. We do not engage in foreign currency speculation. Hedges are designated and documented at the inception of the hedge and are evaluated for effectiveness monthly. Forward exchange contracts hedging firm commitments qualify for hedge accounting when they are designated as a hedge of the foreign currency exposure and they are effective in minimizing such exposure. With our increased international presence in a number of geographic locations and with international revenues projected to increase in fiscal 2005, we are exposed to changes in foreign currencies including the euro, Canadian dollar, Japanese yen and the Hungarian forint. Changes in the value of the euro or other foreign currencies relative to the value of the U.S. dollar could adversely affect future revenues and operating results. If we are unable to attract and retain key personnel, our business could be harmed. If any of our key employees were to leave us, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any successor obtains the necessary training and experience. Our employment relationships are generally at-will and we have had key employees leave us in the past. We cannot assure you that one or more key employees will not leave us in the future. We intend to continue to hire additional highly qualified personnel, including software engineers and operational personnel, but we may not be able to attract, assimilate or retain qualified personnel in the future. Any failure to attract, integrate, motivate and retain these employees could harm our business. RISKS RELATED TO OUR INTELLECTUAL PROPERTY AND TECHNOLOGY Unauthorized use of our proprietary technology and intellectual property will adversely affect our business and results of operations. Our success and competitive position depend in large part on our ability to obtain and maintain intellectual property rights protecting our products and services. We rely on a combination of patents, copyrights, trademarks, service marks, trade secrets, confidentiality provisions and licensing arrangements to establish and protect our intellectual property and proprietary rights. Unauthorized parties may attempt to copy aspects of our products or to obtain, license, sell or otherwise use information that we regard as proprietary. Policing unauthorized use of our products is difficult and we may not be able to protect our technology from unauthorized use. Additionally, our competitors may independently develop technologies that are substantially the same or superior to ours and that do not infringe our rights. In these cases, we would be unable to prevent our competitors from selling or licensing these similar or superior technologies. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States. Although the source code for our proprietary software is protected both as a trade secret and as a copyrighted work, litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Litigation, regardless of the outcome, can be very expensive and can divert management efforts. 41 Third parties have claimed and may claim in the future that we are infringing their intellectual property, and we could be exposed to significant litigation or licensing expenses or be prevented from selling our products if such claims are successful. From time to time, we are subject to claims that we or our customers may be infringing or contributing to the infringement of the intellectual property rights of others. We may be unaware of intellectual property rights of others that may cover some of our technologies and products. If it appears necessary or desirable, we may seek licenses for these intellectual property rights. However, we may not be able to obtain licenses from some or all claimants, the terms of any offered licenses may not be acceptable to us, and we may not be able to resolve disputes without litigation. Any litigation regarding intellectual property could be costly and time-consuming and could divert the attention of our management and key personnel from our business operations. In the event of a claim of intellectual property infringement, we may be required to enter into costly royalty or license agreements. Third parties claiming intellectual property infringement may be able to obtain injunctive or other equitable relief that could effectively block our ability to develop and sell our products. On September 9, 2004, BIS Advanced Software Systems, Ltd. ("BIS") filed an action against us in the United States District Court for the District of Massachusetts claiming patent infringement. Damages are sought in an unspecified amount. In the lawsuit, BIS alleges that the Company is infringing United States Patent No. 6,401,239 entitled "System and Method for Quick Downloading of Electronic Files." We filed an Answer and Counterclaims on December 22, 2004. We believe this claim has no merit, and we intend to defend the action vigorously. On August 5, 2004, Compression Labs, Inc. filed an action against us in the United States District Court for the Eastern District of Texas claiming patent infringement. Damages are sought in an unspecified amount. In the lawsuit, Compression Labs alleges that we are infringing United States Patent No. 4,698,672 entitled "Coding System for Reducing Redundancy." We believe this claim has no merit, and we intend to defend the action vigorously. On April 23, 2004, Millennium L.P. filed an action against us in the United States District Court for the Southern District of New York claiming patent infringement. Damages are sought in an unspecified amount. In the lawsuit, Millennium alleges that we are infringing United States Patent No. 5,258,855 entitled "Information Processing Methodology"; No. 5,369,508 entitled "Information Processing Methodology"; No. 5,625,465 entitled "Information Processing Methodology"; No. 5,768,416 entitled "Information Processing Methodology"; and No. 6,094,505 entitled "Information Processing Methodology." We filed an Answer on June 17, 2004. We believe this claim has no merit, and we intend to defend the action vigorously. On July 15, 2003, Elliott Davis ("Davis") filed an action against SpeechWorks in the United States District Court for the Western District for New York (Buffalo) claiming patent infringement. Damages are sought in an unspecified amount. In addition, on November 26, 2003, Davis filed an action against ScanSoft in the United States District Court for the Western District for New York (Buffalo) also claiming patent infringement. Damages are sought in an unspecified amount. SpeechWorks filed an Answer and Counterclaim to Davis's Complaint in its case on August 25, 2003 and ScanSoft filed an Answer and Counterclaim to Davis's Complaint in its case on December 22, 2003. We believe these claims have no merit, and we intend to defend the actions vigorously. On November 27, 2002, AllVoice Computing plc filed an action against us in the United States District Court for the Southern District of Texas claiming patent infringement. In the lawsuit, AllVoice alleges that we are infringing United States Patent No. 5,799,273 entitled "Automated Proofreading Using Interface Linking Recognized Words to their Audio Data While Text is Being Changed" (the "273 Patent"). The "273 Patent generally discloses techniques for manipulating audio data associated with text generated by a speech recognition engine. Although we has several products in the speech recognition technology field, we believe that our products do not infringe the "273 Patent because, in addition to other defenses, they do not use the claimed techniques. Damages are sought in an unspecified amount. We filed an Answer on December 23, 2002. We believe this claim has no merit and we intend to defend the action vigorously. We believe that the final outcome of the current litigation matters described above will not have a significant adverse effect on our financial position and results of operations. However, even if our defense is 42 successful, the litigation could require significant management time and could be costly. Should we not prevail in these litigation matters, we may be unable to sell and/or license certain of our technologies we consider to be proprietary, and our operating results, financial position and cash flows could be adversely impacted. Our software products may have bugs, which could result in delayed or lost revenue, expensive correction, liability to our clients and claims against us. Complex software products such as ours may contain errors, defects or bugs. Defects in the solutions or products that we develop and sell to our customers could require expensive corrections and result in delayed or lost revenue, adverse client reaction and negative publicity about us or our products and services. Customers who are not satisfied with any of our products may also bring claims against us for damages, which, even if unsuccessful, would likely be time-consuming to defend, and could result in costly litigation and payment of damages. Such claims could harm our reputation, financial results and competitive position. RISKS RELATED TO OUR CORPORATE STRUCTURE, ORGANIZATION AND COMMON STOCK The holdings of our two largest stockholders may enable them to influence matters requiring stockholder approval. On March 19, 2004, Warburg Pincus, a global private equity firm agreed to purchase all outstanding shares of our stock held by Xerox Corporation for approximately $80 million. As of December 31, 2004, Warburg Pincus beneficially owned approximately 11.5% of our outstanding common stock, including warrants exercisable for up to 3,025,732 shares of our common stock and 3,562,238 shares of our outstanding Series B Preferred Stock, each of which is convertible into one share of our common stock. The State of Wisconsin Investment Board ("SWIB") is our second largest stockholder, owning approximately 8.5% of our common stock as of December 31, 2004. Because of their large holdings of our capital stock relative to other stockholders, Warburg Pincus and SWIB, acting individually or together, have a strong influence over matters requiring approval by our stockholders. The market price of our common stock has been and may continue to be subject to wide fluctuations. Our stock price historically has been and may continue to be volatile. Various factors contribute to the volatility of our stock price, including, for example, quarterly variations in our financial results, new product introductions by us or our competitors and general economic and market conditions. While we cannot predict the individual effect that these factors may have on the market price of our common stock, these factors, either individually or in the aggregate, could result in significant volatility in our stock price during any given period of time. Moreover, companies that have experienced volatility in the market price of their stock often are subject to securities class action litigation. If we were the subject of such litigation, it could result in substantial costs and divert management's attention and resources. Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new regulations promulgated by the Securities and Exchange Commission and Nasdaq National Market rules, are resulting in increased general and administrative expenses for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies, our business may be harmed. We have implemented anti-takeover provisions, which could discourage or prevent a takeover, even if an acquisition would be beneficial to our stockholders. Provisions of our certificate of incorporation, bylaws and 43 Delaware law, as well as other organizational documents could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include: - a preferred shares rights agreement; - authorized "blank check" preferred stock; - prohibiting cumulative voting in the election of directors; - limiting the ability of stockholders to call special meetings of stockholders; - requiring all stockholder actions to be taken at meetings of our stockholders; and - establishing advance notice requirements for nominations of directors and for stockholder proposals. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK EXCHANGE RATE SENSITIVITY We face exposure to adverse movements in foreign currency exchange rates, as a significant portion of our revenues, expenses, assets, and liabilities are denominated in currencies other than the U.S. Dollar, primarily the euro, the Canadian dollar, the Japanese yen and the Hungarian forint. These exposures may change over time as business practices evolve. We evaluate our foreign currency exposures on an ongoing basis and make adjustments to our foreign currency risk management program as circumstances change. In certain instances, we have entered into forward exchange contracts to hedge against foreign currency fluctuations. These contracts are used to reduce our risk associated with exchange rate movements, as the gains or losses on these contracts are intended to offset the exchange rate losses or gains on the underlying exposures. We do not engage in foreign currency speculation. The success of our foreign currency risk management program depends upon the ability of the forward exchange contracts to offset the foreign currency risk associated with the hedged transaction. To the extent that the amount or duration of the forward exchange contract and hedged transaction vary, we could experience unanticipated foreign currency gains or losses that could have a material impact on our results of operations. In addition, the failure to identify new exposures and hedge them in a timely manner may result in material foreign currency gains and losses. In connection with the Philips acquisition on January 30, 2003, we entered into a forward hedge in the amount of $5.3 million to cover our obligation to pay the 5.0 million euro promissory note (Philips Note) issued as part of the acquisition. On August 26, 2003, we entered into a forward exchange contract to hedge the foreign currency exposure of our 1.0 million euro note payable to Philips. As both the 5.0 million euro promissory note and 1.0 million euro note payable to Philips were paid prior to December 31, 2003, the related forward hedge and forward exchange contract were terminated. On November 3, 2003, we entered into a forward exchange contract to hedge our foreign currency exposure related to 3.5 million euros of inter-company receivables from our Belgian subsidiary to the United States. The contract had a one-year term that expired on November 1, 2004. On November 1, 2004, we renewed this forward hedge contract. The renewed contract has a one year term expiring on November 1, 2005; however it is cancelable at our discretion. On November 5, 2003, we entered into a forward exchange contract to hedge our foreign currency exposure related to 7.5 million Singapore dollars of intercompany receivables from our Singapore subsidiary. The original contract expired on January 30, 2004, but was extended six months to October 29, 2004. The contract was not extended and thereby terminated on October 29, 2004. We realized a loss of approximately $0.2 million. As of December 31, 2004, we have a $0.8 million liability related to these contracts. While the contract amounts of derivative instruments provide one measure of the volume of these transactions, they do not represent the amount of our exposure to changes in foreign currency exchange rates. Because the terms of the derivative instrument and underlying exposure are matched generally at inception, 44 changes in foreign currency exchange rates should not expose us to significant losses in earnings or net cash outflows when exposures are properly hedged, but could have an adverse impact on liquidity. INTEREST RATE SENSITIVITY We are exposed to interest rate risk as a result of our significant cash and cash equivalent and short and long-term marketable securities holdings. The rate of return that we may be able to obtain on investment securities will depend on market conditions at the time we make these investments and may differ from the rates we have secured in the past. At December 31, 2004, we held $41.3 million of cash and cash equivalents, $1.5 million of short-term marketable securities and $3.8 million of long-term marketable securities. Our cash and cash equivalents consist primarily of cash and money-market funds and our short-term and long-term marketable securities consist primarily of government agency and corporate securities. Due to the low current market yields and relatively short-term nature of our investments, a hypothetical increase in market rates is not expected to have a material effect on the fair value of our portfolio or results of operations. ITEM 4. CONTROLS AND PROCEDURES Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, our disclosure controls and procedures as of the end of the period covered by this report were effective in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. We believe that a control system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the control system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. On January 21, 2005, we closed our acquisition of ART Advanced Recognition Technologies, Inc. We reported the signing of the definitive agreement for this acquisition in November 2004 on a Form 8-K within four business days of the event and issued a press release announcing the closing of the transaction on January 24, 2005, the next business day following such closing. However, we inadvertently did not file a Form 8-K incorporating this previously announced information regarding the closing on a timely basis. We have taken steps intended to ensure that the closing of future acquisitions and dispositions that require the filing of a Form 8-K are so reported on a timely basis. There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting, except as discussed below. In connection with their audit of our 2004 consolidated financial statements, BDO Seidman, LLP, our independent registered public accounting firm, advised management and our Audit Committee of the following significant deficiencies which did not individually or in the aggregate raise to the level of material weakness: The Company lacks the necessary corporate accounting resources to ensure consistently complete and accurate reporting of financial information which, when combined with the Company's need to realign and cross-train current finance and accounting personnel, has led to a dependence on key personnel in the organization, the loss of whom could impair the Company's ability to ensure consistently complete and accurate financial reporting. In certain circumstances the Company's accounting transactions, including related judgments and estimates, were not always supported in a timely manner by a sufficiently formal processes or sufficiently comprehensive documentation. In the third quarter of 2003, we commenced our Section 404 compliance efforts. During 2004, we deployed Oracle 11i to process and report all of our general accounting functions in our three major locations (Peabody, Massachusetts, Belgium and Hungary). During 2005, we will implement additional modules to 45 continue to enhance the functionality of our Oracle implementation. We are also currently in the process of augmenting current processes, repositioning current finance and accounting personnel and recruiting additional personnel to ensure consistently complete and accurate reporting of financial information and to reduce our dependence on key personnel in our finance and accounting organization. We currently expect these efforts to extend into the second half of fiscal 2005. We believe that these efforts will address the conditions raised by BDO Seidman, LLP. To the knowledge of our Chief Executive Officer and Chief Financial Officer, our financial statements and other financial information included in this report fairly present in all material respects our financial condition as of the periods ended presented in this report and our results of operations and cash close for the periods presented in this report. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS This information included in Note 8 of the Notes to Consolidated Financial Statements is incorporated herein by reference from Item 1 of Part I hereof. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS During the three months ended December 31, 2004, we issued unregistered securities to a limited number of persons, as described below. None of these transactions involved any underwriters, underwriting discounts or commissions, or any public offering, and we believe that each transaction was exempt from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act") by virtue of Section 4(2) thereof and/or Regulation S promulgated thereunder. The recipients of securities in each such transaction represented their intention to acquire the securities for investment purposes only and not with a view to or for sale in connection with any distribution thereof, and appropriate legends were affixed to the share certificates and instruments issued in such transactions. All recipients had adequate access, through their relationships with us, to information about us. On December 6, 2004, in connection with the acquisition of Rhetorical Systems Ltd., certain shareholders of Rhetorical were issued 449,437 shares of ScanSoft common stock. We relied upon Section 4(2) of the Securities Act, and Regulation S promulgated thereunder, in connection with the issuance of these shares, and appropriate legends were affixed to the share certificates issued in the transaction. On November 15, 2004, in connection with the acquisition of Phonetics Systems, Ltd., we issued unvested warrants to purchase up to 750,000 shares of ScanSoft common stock at an exercise price of $4.46 per share that will vest, if at all, upon the achievement of certain performance targets. We relied upon Section 4(2) of the Securities Act, and Regulation S promulgated thereunder, in connection with the issuance of the warrants, and appropriate legends were affixed to the warrants issued in the transaction. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION The Annual Meeting of Stockholders will be held at the Company's corporate headquarters, 9 Centennial Drive, Peabody, Massachusetts 01960, on March 14, 2005 at 9:00 a.m., local time. Stockholders of record as of the close of business on January 14, 2005 will receive notice of the meeting. ITEM 6. EXHIBITS The exhibits listed on the Exhibit Index hereto are filed or incorporated by reference (as stated therein) as part of this report on Form 10-Q. 46 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Peabody, State of Massachusetts, on February 9, 2005. Scansoft, Inc. By: /s/ James R. Arnold, Jr. ------------------------------------ James R. Arnold, Jr. Chief Financial Officer 47 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION ------- ----------- 2.1(1) Agreement and Plan of Merger, dated as of November 14, 2004, by and among ScanSoft, Write Acquisition Corporation, ART Advanced Recognition Technologies, Inc., and with respect Article I, Article VII and Article IX only, Bessemer Venture Partners VI, LP, as stockholder representative. 2.2(1) Agreement and Plan of Merger, dated as of November 15, 2004, by and among Phonetic Systems, LTD., Phonetics Acquisition LTD., ScanSoft, and Magnum Communications Fund L.P., as stockholder representative. 3.1(2) Amended and Restated Certificate of Incorporation of the Registrant. 3.2(3) Certificate of Amendment of the Amended and Restated Certificate of Incorporation of the Registrant. 3.3(4) Amended and Restated Bylaws of the Registrant. 4.1(1) Common Stock Warrants, dated as of November 15, 2004, issued to Magnum Communications Fund L.P., as stockholder representative. 10.1(5)** Form of Restricted Stock Purchase Agreement. 10.2(5)** Form of Stock Option Agreement. 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) or 15d-14(a). 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) or 15d-14(a). 32.1 Certification Pursuant to 18 U.S.C. Section 1350.
--------------- ** Denotes Management compensatory plan or arrangement. (1) Incorporated by reference from the Registrant's Current Report on Form 8-K filed with the Commission on November 18, 2004. (2) Incorporated by reference from the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2001, filed with the Commission on May 11, 2001. (3) Incorporated by reference from the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2004, filed with the Commission on August 9, 2004. (4) Incorporated by reference from the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 2003, filed with the Commission on March 15, 2004. (5) Incorporated by reference from the Registrant's Current Report on Form 8-K filed with the Commission on November 2, 2004.