-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Dy1mN1FOhA9eho9T5E39nQLf45XljswGixeX6Z9ScbXbRIkXcI57P1o0FZzNFlO4 ainI1nZh19Jg84TN3lnilg== 0000950134-98-002810.txt : 19980401 0000950134-98-002810.hdr.sgml : 19980401 ACCESSION NUMBER: 0000950134-98-002810 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: PEGASUS SYSTEMS INC CENTRAL INDEX KEY: 0001040261 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER PROCESSING & DATA PREPARATION [7374] IRS NUMBER: 752605174 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-22935 FILM NUMBER: 98583283 BUSINESS ADDRESS: STREET 1: 3811 TURTLE CREEK BLVD STREET 2: STE 1100 CITY: DALLAS STATE: TX ZIP: 75219 BUSINESS PHONE: 2145285656 MAIL ADDRESS: STREET 1: 3811 TURTLE CREEK BLVD STREET 2: STE 1100 CITY: DALLAS STATE: TX ZIP: 75219 10-K 1 FORM 10-K FOR YEAR ENDED DECEMBER 31, 1997 1 =============================================================================== SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to _________ Commission file number 000-22935 PEGASUS SYSTEMS, INC. (Exact name of registrant as specified in its charter) DELAWARE 75-2605174 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 3811 TURTLE CREEK BOULEVARD, SUITE 1100 75219 DALLAS, TEXAS (ZIP CODE) (Address of principal executive offices) Registrant's telephone number, including area code: (214) 528-5656 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, par value $0.01 per share (Title of class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ____. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value on March 26, 1998 of the registrant's voting securities held by non-affiliates was $246,113,033. ------------- Number of shares of registrant's Common Stock, par value $0.01 per share, outstanding as of March 26, 1998: 10,484,654. ------------- DOCUMENTS INCORPORATED BY REFERENCE (a) Selected portions of the Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1997.-Part II (b) Selected portions of the Registrant's definitive Proxy Statement for the 1998 Annual Meeting of Stockholders.-Part III =============================================================================== 2 PART I ITEM 1. BUSINESS. Unless the context otherwise requires, the term "Company" or "Pegasus" when used in this report refers to Pegasus Systems, Inc., a Delaware corporation, and its predecessors and consolidated subsidiaries. This report contains certain forward-looking statements within the meaning of the federal securities laws. Actual results and the timing of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including without limitation those listed herein under "Risk Factors". Pegasus is a provider of transaction processing services to the hotel industry worldwide. The Company's THISCO and its TravelWeb and other Internet-based hotel room reservation services improve the efficiency and effectiveness of the hotel reservation process by enabling travel agents and individual travelers to electronically access hotel room inventory information and conduct reservation transactions. The Company's HCC service improves the efficiency and effectiveness of the commission payment process for participating hotels and travel agencies by consolidating payments and providing comprehensive transaction reports. In addition, the Company is developing an information service to provide hotel industry participants with transaction specific information on industry trends and guest behavior. The Company's services benefit many of the participants in the hotel room distribution process, including hotels, hotel representation firms, Global Distribution Systems ("GDSs"), travel agencies, convention and other large meeting organizers, corporate travel departments and Web sites with travel-related features. For the fiscal year ending December 31, 1997, approximately 47.2% of the Company's consolidated revenues was derived from its electronic hotel reservation processing services, including approximately 41.0% from the THISCO service and approximately 6.2% from the TravelWeb and other Internet-based services, and approximately 52.8% of the Company's consolidated revenues was derived from its HCC service. SERVICES The Company's services generally fall into three categories: electronic hotel room reservations services, commission payment processing services and information services. HOTEL ROOM RESERVATION SERVICES THISCO. The Company's THISCO service is an electronic hotel room reservation processing service that interfaces communications concerning hotel reservation information between all major GDSs and hotel central reservation systems. THISCO enables a hotel to connect to all major GDSs without having to build and maintain a separate interface for each GDS. Without THISCO or a similar service, hotel chains that desire their room inventory to be accessible to travel agencies electronically on a GDS must develop protocols and message formats compatible with each GDS, a process that entails significant time and expense. Alternatively, hotels may rely more heavily on less-automated means, such as traditional toll-free telephone reservation centers with higher processing costs. THISCO enables the processing of hotel room reservations and also transmits daily millions of electronic status messages, which are used to update room rates, features and availability on GDS databases. Many participating hotels also have chosen to utilize the Company's UltraSelect service, which provides travel agencies using GDSs with direct access through THISCO to a hotel's central reservation system bypassing the GDS databases to obtain the most complete and up-to-date hotel room information available. 3 Internet-based Services. TravelWeb. Located at www.travelweb.com, TravelWeb provides individual travelers direct access to online hotel information and the ability to make reservations electronically over the Internet. Individual travelers traditionally obtain information or reserve a room by contacting a hotel directly by telephone or fax or indirectly through intermediaries, such as travel agencies, convention and other large meeting organizers and corporate travel departments. As a result, an individual traveler cannot easily obtain information from a wide range of hotel properties in a timely manner. TravelWeb provides travelers with detailed information regarding a wide array of hotel properties and, through its connection to the Company's THISCO service, allows travelers to reserve a hotel room and receive a confirmation in seconds. In addition to hotel room reservations, the TravelWeb service offers airline booking capability through Internet Travel Network, Inc. Additionally, TravelWeb offers "The Resources Center" which provides information and links for a variety of travel-related services, such as food, shopping, area attractions and business services. The Company also began to sell advertising space on TravelWeb during 1996, focusing on advertisers that target travelers. NetBooker. NetBooker is a service provided to other Web sites which combines TravelWeb's hotel information database and THISCO's electronic interface capability to make hotel room reservations. To conduct Internet-based electronic commerce successfully, Web site operators must offer a content set which is sufficiently broad, accurate, up-to-date, graphically appealing and useful to attract buyers to the Web site. Typically, the development of such a content set is expensive and time consuming. Furthermore, in addition to providing individual travelers with access to useful and graphically appealing information, the operator of a Web site must offer individual travelers the capability to effect a transaction in order to generate a transaction fee. The Company's NetBooker service provides Web sites with the same information contained on TravelWeb and simple and fast method of making a hotel room reservation online. The Company's NetBooker service utilizes advanced technology applications to customize the TravelWeb hotel database so that it appears to the user to be the database and booking capability of the third-party Web site. In connection with this service, there is an interface to the Company's THISCO service, which enables users of the Web site to shop and query room availability, electronically make a reservation and receive a confirmation in seconds. UltraRes. The Company's UltraRes service automates the processing of hotel room reservations for conventions and large meetings. The manual process traditionally used to reserve hotel rooms for these events is information- intensive and inefficient and frequently leads to inaccurate and delayed information and overbooking or underbooking. With the Company's UltraRes service, convention and other large meeting organizers are able to transfer reservation requests to the THISCO service, which electronically delivers the information to each hotel central reservation system. The UltraRes service eliminates the need to manually transmit and enter rooming lists and allows hotels to deliver reservations and confirmations electronically in a fast and reliable manner. UltraDirect. The Company's UltraDirect service provides the corporate travel management industry with a direct real-time link to the Company's THISCO service through corporate intranet travel management software. With the UltraDirect service, corporate travelers are able to check availability and make hotel reservations within seconds at hotel chains or properties with which the traveler's employer has negotiated rates. The UltraDirect service enables corporate travel departments of companies to have access to the customized information negotiated with hotel chains and properties to facilitate hotel room reservations. Furthermore, this information can be fully integrated into other components of the intranet site and facilitate the creation of passenger name records and detailed profile information. Corporate TravelWeb. The Company is developing its Corporate TravelWeb service to provide corporate travel departments with Web-based electronic hotel room and car reservation capabilities. This service is intended to benefit corporate travel departments by providing low-cost access to comprehensive travel information and on-line reservation functionality, reducing the time and effort required in making travel reservations, and improving travel information reporting, the enforcement of corporate travel policies and the use of negotiated or preferred rates. The Company has not received a material amount of revenues for certain of these electronic hotel room reservation services to date, and there can be no assurance that such services will produce material revenues to the Company in the future. See "Risk Factors -- Impact of Technological Advances; Delays in Introduction of New Services." -2- 4 COMMISSION PROCESSING SERVICES The Company's HCC service gathers commission payment information, processes that information and transmits to travel agencies one consolidated check in the travel agency's currency of choice, together with an information statement that enables the travel agency to reconcile its hotel commission activity. Typically, a hotel pays to the travel agency that made the hotel reservation a commission of approximately 10% of the room rate paid by a hotel guest. However, the payment process related to these commissions historically has been costly and inefficient, consisting of numerous checks in small amounts and little information regarding the basis from which the commission was calculated. The HCC service streamlines the commission payment process and consolidates into a single payment the aggregate commission owed by a participating hotel to all participating travel agencies. Additionally, the HCC service provides an incentive to travel agencies to make reservations at HCC-participating hotels in countries other than their own because the HCC service disburses checks denominated in each travel agency's currency of choice, saving costly exchange fees. Furthermore, the monthly and quarterly marketing reports and statistics prepared for the hotel by the HCC service allow the hotel to identify and market more effectively to those travel agencies that provide the hotel with the majority of its guests. The hotel also benefits from HCC's Customer Relations Center, which allows travel agency inquiries regarding commissions to be addressed by HCC rather than by the hotel itself. INFORMATION SERVICES The Company's Pegasus IQ service is being developed to provide hotel information to a wide variety of audiences in the travel and travel-related industries, from hotel chains to travel industry marketing groups to travel-related service companies. The service intends to compile data regarding hotel guests and their use of hotels in transaction-specific detail and to organize that data into meaningful information. The Pegasus IQ service intends to provide industry trend reports and guest behavior data in an automated, timely format for hotels and hotel marketing companies. The Pegasus IQ service also is intended to provide benchmark information services that compare a hotel's daily room and occupancy rates with that of its competition. Furthermore, Pegasus IQ intends to provide data in an electronic format to individual travelers, corporate travel departments or other travel service providers regarding a particular stay at a hotel, together with information provided by payment card companies, to facilitate automated expense reporting or to ensure travel policy adherence. INDUSTRY The room reservation and commission payment processes in the hotel industry are complex and information intensive. Making a hotel room reservation requires significant amounts of data, such as room rates, features and availability. This complexity is compounded by the need to confirm, revise or cancel room reservations, which generally requires multiple parties to have ongoing access to real-time reservation information. Similarly, the process of reconciling and paying hotel commissions to travel agencies is based on transaction-specific hotel data and consists of a number of relatively small payments to travel agencies, often including payments in multiple currencies. In addition, information regarding guest cancellations and "no-shows" needs to be accurately communicated between hotels and travel agencies in order to reconcile commission payments. Reservations for hotel rooms are made either directly by individual travelers or indirectly through intermediaries. Individual travelers typically make direct reservations by telephoning or faxing a hotel to ascertain room rates, features and availability and to make reservations. Increasingly, individual travelers can conduct all aspects of this transaction through hotel and travel-related Web sites. Intermediaries for hotel room reservations, including travel agencies, convention and other large meeting organizers and corporate travel departments, access hotel information either by telephone or fax or through a GDS. GDS's maintain databases of room rate, feature and availability information provided by hotels to which they are connected. Because each GDS has a unique electronic interface to hotel reservation systems, each GDS can obtain room information and book rooms only at hotels that have developed protocols and message formats compatible with that particular GDS. A number of current trends are affecting the hotel industry. First, the hotel industry has been shifting from manual to electronic means of making hotel room reservations. As more hotels become electronically bookable, the Company expects that electronic hotel room reservations will grow substantially in the United States and internationally over the -3- 5 next several years. Second, a small but growing number of individual travelers are making hotel room reservations electronically on the Internet. Third, smaller hotel chains and independent hotels increasingly have affiliated with large hotel chains through a process known in the industry as "branding" or "reflagging." This global consolidation process produces economies of scale and increases the global penetration of larger hotel chains, many of whom are the Company's stockholders and customers. Fourth, hotel commissions are becoming increasingly important to travel agencies as a source of revenue. Travel agencies are looking to increase their revenue by making more hotel room reservations to offset the effects of increased competition among travel agencies, new competition from emerging travel service distribution channels and caps on commissions for airline reservations, which historically have been the leading revenue source for travel agencies. COMPETITION The Company faces significant competition in connection with its THISCO hotel room reservation processing service. The principal competitor of the Company's THISCO service is WizCom International, Ltd. ("Wizcom"), which was a wholly owned indirect subsidiary of Avis, Inc. ("Avis"). As a result of the acquisition of Avis by HFS Incorporated ("HFS"), in September 1996, WizCom became a wholly owned indirect subsidiary of HFS. While HFS utilized the Company's THISCO service through 1997, HFS has moved its electronic hotel room reservation processing from THISCO to WizCom in 1998. There can be no assurance that any additional customers will not change their electronic reservation interface to WizCom or to another similar service. Also, hotels can choose to connect directly to one or more GDSs, thereby bypassing THISCO and eliminating the need to pay fees to the Company. In addition, one or more GDSs can choose to bypass the THISCO service and develop and operate a new common electronic interface to hotel central reservation systems. Such competitors or their affiliates may have greater financial and other resources than the Company. Factors affecting competitive success of the electronic hotel room reservation processing service include reliability, levels of fees, number of hotel properties on the system, ability to provide a neutral, comprehensive interface between hotels and other participants in the distribution of hotel rooms and ability to develop new technological solutions. There can be no assurance that another participant in the hotel room distribution process or a new competitor will not create services with features that would reduce the attractiveness of the Company's services. The Company's inability to compete effectively with respect to these services could have a material adverse effect on the Company's financial condition and results of operations. The market for the Company's TravelWeb, NetBooker and other Internet-based services is highly competitive. Current competition includes traditional telephone or travel agency reservation methods and other Internet-based travel reservation services. There are a large number of Internet-based travel-related services offered by the Company's competitors, and many of these competitors are larger and have significantly greater financial resources and name recognition than the Company. Several competitive Web sites such as Travelocity (a site operated by The SABRE Group Holdings, Inc.) and Expedia.com (a site operated by Microsoft Corporation) offer a more comprehensive range of travel services than those provided by the Company. The Company faces competition in the hotel room reservation business not only from its current competitors but also from possible new entrants including other Web sites. The costs of entry into the Internet-based hotel room reservation business is relatively low. There can be no assurance that the Company's Internet-based hotel room reservation services will compete successfully. The failure of these services to compete successfully could have a material adverse effect on the Company's financial condition and results of operations. The market for the Company's HCC service is competitive. The Company's competitors in the commission processing business include National Processing Company ("NPC"), WizCom and Citicorp. NPC, a company that has traditionally provided car rental and cruise line commission processing services, recently began offering its services to hotels and travel agencies as well. WizCom recently announced that it is introducing a commissions payment service that may be competitive with the HCC service. Citicorp provides commission consolidation services to hotel chains. In addition, hotels that are current or prospective customers of the HCC service could decide to process commission payments without, or in competition with, the HCC service. Some of these current or potential competitors have substantially greater financial and other resources than the Company. Furthermore, while the Company has agreements with all of its hotel customers for the HCC service, many of the Company's travel agency customers are not obligated by any long-term agreement with the Company. If a significant percentage of these travel agencies were to cease using the HCC commission processing service, the Company's financial condition and results of operations could be materially adversely affected. -4- 6 INTELLECTUAL PROPERTY The Company is constantly developing new processing technology and enhancing existing proprietary technology. The Company has no patents. The Company primarily relies on a combination of copyright, trade secrets, confidentiality procedures and contractual provisions to protect its technology. Despite these protections, it may be possible for unauthorized parties to copy, obtain or use certain portions of the Company's proprietary technology. While any misappropriation of the Company's intellectual property could have a material adverse effect on the Company's competitive position, the Company believes that protection of proprietary rights is less significant to the Company's business than the continued pursuit of its operating strategies and other factors, such as the Company's relationship with industry participants and the experience and abilities of its key personnel. The Company has registered "UltraSwitch," "TravelWeb," "UltraAccess," "HCC Hotel Clearing Corporation," "HCC Link," "HCC Cash" and "Chain Link" as United States federal trademarks and applications to register "UltraRes," "Click-It" and "Pegasus" are pending with the United States Patent and Trademark Office. Trademark applications for "TravelWeb" also have been filed in Canada and Europe. RESEARCH AND DEVELOPMENT The Company's research and development activities primarily consist of software development, development of enhanced communication protocols and custom user interfaces and database design and enhancement. As of February 28, 1998, the Company employed 59 people in its Information Technology Group and from time to time, supplements their efforts with the use of independent consultants and contractors. This group is comprised of information technology, services development, technical services and product support personnel. The Company's total research and development expense was $2.1 million, $2.2 million and $2.5 million for 1995, 1996 and 1997, respectively. EMPLOYEES At February 28, 1998, the Company had 104 employees, 99 of which were located in the United States, with 59 persons in the Information Technology Group, 30 persons performing sales and marketing, customer relations and business development functions and the remainder performing corporate, finance and administrative functions. The Company has five employees in England performing international sales activities. The Company has no unionized employees. The Company believes that its employee relations are satisfactory. RISK FACTORS SUBSTANTIAL NET LOSSES. The Company has experienced substantial net losses, including a net loss of $3.5 million in 1996. The Company's HCC and THISCO services have accounted for the majority of the Company's revenues to date. Any decrease in the revenues from the HCC or THISCO services, or any increase in expenses related to any of the Company's services substantially above the amounts budgeted therefor, could have a material adverse effect on the Company's financial condition and results of operations. The Company anticipates that its budgeted operating expenses will increase in the foreseeable future as it continues to develop its services, increase its sales and marketing activities and expand its distribution channels. To achieve continued profitability, the Company must successfully implement its business strategy and increase its revenues while controlling expenses. COMPETITION. Electronic Hotel Room Reservation Processing Service. The Company faces significant competition in connection with its THISCO hotel room reservation processing service. The principal competitor of the Company's THISCO service is WizCom, which was a wholly owned indirect subsidiary of Avis. As a result of the acquisition of Avis by -5- 7 HFS, a stockholder and customer of the Company, in September 1996, WizCom became a wholly owned indirect subsidiary of HFS. While HFS utilized the Company's THISCO's service through 1997, HFS has moved its electronic hotel room reservation processing from THISCO to WizCom in 1998. There can be no assurance that any additional customers will not change their electronic reservation interface to WizCom or to another similar service. Also, hotels can choose to connect directly to one or more GDSs, thereby bypassing the THISCO service and eliminating the need to pay fees to the Company. Such competitors or their affiliates may have greater financial and other resources than the Company. Factors affecting the competitive success of an electronic hotel room reservation processing service include reliability, levels of fees, number of hotel properties on the system, ability to provide a neutral comprehensive interface between hotels and other participants in the distribution of hotel rooms and ability to develop new technological solutions. There can be no assurance that another participant in the hotel room distribution process or a new competitor will not create services with features that would reduce the attractiveness of the Company's services. The Company's inability to compete effectively with respect to these services could have a material adverse effect on the Company's financial condition and results of operations. Internet Hotel Room Reservation Service. The market for the Company's TravelWeb, NetBooker and other Internet-based services is highly competitive. Current competition includes traditional telephone or travel agency reservation methods and other Internet-based travel reservation services. There are a large number of Internet based travel-related services offered by the Company's competitors, and many of these competitors are larger and have significantly greater financial resources and name recognition than the Company. Several competitive Web sites such as Travelocity (a site operated by The SABRE Group Holdings, Inc.) and Expedia (a site operated by Microsoft Corporation) offer a more comprehensive range of travel services than TravelWeb or NetBooker. The Company faces competition in the online hotel room reservation business not only from its current competitors but also from possible new entrants, including other Web sites. The costs of entry into the Internet-based hotel room reservation business are relatively low. There can be no assurance that the Company's Internet-based hotel room reservation services will compete successfully. The failure of these services to compete successfully could have a material adverse effect on the Company's financial condition and results of operations. Commission Processing Service. The market for the Company's HCC service is competitive. The Company's competitors in the commission processing business include NPC, WizCom and Citicorp. NPC, a company that has traditionally provided car rental and cruise line commission processing services, recently began offering its services to hotels and travel agencies. WizCom has recently announced its intention to offer a service that may be competitive with the Company's HCC service. Citicorp provides commission consolidation services to hotel chains. In addition, hotels that are current or prospective customers of the HCC service can decide to process commission payments without, or in competition with, the HCC service. Some of these current or potential competitors have substantially greater financial and other resources than the Company. Furthermore, while the Company has agreements with all of its hotel customers for the HCC service, many of the Company's travel agency customers are not obligated by any long-term agreement with the Company. If a significant percentage of these travel agencies were to cease using the HCC commission processing service, the Company's financial condition and results of operations could be materially adversely affected. DEPENDENCE ON HOTEL INDUSTRY; CONSOLIDATION TRENDS. The Company derives substantially all of its revenues directly and indirectly from the hotel industry. The hotel industry is sensitive to changes in economic conditions that affect business and leisure travel and is highly susceptible to unforeseen events, such as political instability, regional hostilities, recession, gasoline price escalation, inflation or other adverse occurrences that result in a significant decline in the utilization of hotel rooms. Any event that results in decreased travel or increased competition among hotels may lower hotel room reservation volumes, the average daily rates for hotel rooms or both and could have a material adverse effect on the Company's financial condition and results of operations. The hotel industry recently has witnessed a period of consolidation in which hotel chains have acquired or merged with other chains. Such activities may reduce the Company's customer base. Similar consolidation trends have occurred in the GDS industry. After the recent merger between Amadeus and System One, the GDS industry has consolidated to four major GDSs. If further consolidation were to take place, the value provided by the Company to participants in the hotel room distribution process and the benefits to hotel operators of utilizing the THISCO service would be reduced. The Company typically offers volume-based discounting of its fees, which could result in a higher percentage of discounted fees if the consolidation trends in the hotel and GDS industries continue. There can be no assurance that any potential -6- 8 decrease in the Company's customer base or any potential increase in the percentage of discounted fees will not have a material adverse effect on the Company's financial condition and results of operations. FLUCTUATIONS IN QUARTERLY OPERATING RESULTS. The Company has experienced in the past and expects to experience in the future significant fluctuations in quarterly operating results. Such fluctuations may be caused by many factors, including but not limited to the introduction of new or enhanced services by the Company or its competitors, the degree of customer acceptance of new services, competitive conditions in the industry, seasonal factors, reduction in client base, changes in pricing, the extent of international expansion, the mix of international and domestic sales and general economic conditions. Because the Company's expense budget is set early in a fiscal year and a significant portion of the Company's operating expenses are relatively fixed in nature, fluctuations in revenues may cause substantial variation in the Company's results of operations from quarter to quarter. Due to the foregoing factors, many of which are beyond the Company's control, quarterly revenues and operating results are difficult to forecast, and the Company believes that period-to-period comparisons of its operating results will not necessarily be meaningful and should not be relied upon as any indication of future performance. It is likely that the Company's future quarterly operating results from time to time will not meet the expectations of securities analysts or investors, which could have a material adverse effect on the market price of the Company's Common Stock. POTENTIAL ADVERSE CHANGES IN HOTEL COMMISSION PAYMENTS. Absent any express arrangement in individual cases, hotels currently are under no contractual obligation to pay room reservation commissions to travel agencies. Hotels could elect to reduce the current industry customary commission rate of 10%, limit the maximum commission generally paid for a hotel room reservation or eliminate commissions entirely. In 1995, the airline industry placed a maximum limit on the amount of commissions payable to travel agencies for any domestic airline ticket issued. Recently, certain airlines have capped the dollar amount that they will pay to travel agencies for airline reservations made online. In addition, hotels increasingly are utilizing other direct distribution channels, such as the Internet, or offering negotiated rates to major corporate customers that are non-commissionable to travel agencies. Because a substantial portion of the Company's revenues are dependent on the dollar volume of travel agency commissions paid by hotels, any change in the hotel commission payment system that reduces the commissions payable to travel agencies and any acceleration of the trend towards direct distribution of rooms by hotels could have a material adverse effect on the Company's financial condition and results of operations. DEPENDENCE ON GROWTH OF INTERNET COMMERCE. The market for electronic hotel reservation services over the Internet is rapidly evolving and depends upon market acceptance of novel methods for distributing services and products, which involves a high degree of uncertainty. The success of the Company's TravelWeb, NetBooker and other Internet based services will depend upon the adoption of the Internet by consumers as a widely used medium for commerce. The Internet may not prove to be a viable commercial marketplace for any number of reasons, including inadequate development of the necessary infrastructure or the lack of complementary services and products, such as high speed modems and high speed communication lines. The Internet has experienced, and is expected to continue to experience, significant growth in the number of users and amount of traffic. There can be no assurance that the Internet infrastructure will continue to be able to support the demands placed on it by this continued growth. Moreover, critical issues concerning the commercial use of the Internet (including security, reliability, cost, ease of use, accessibility and quality of service) remain unresolved and may negatively affect the growth or attractiveness of commerce conducted on the Internet. If critical issues concerning the commercial use of the Internet are not favorably resolved, if the necessary infrastructure is not developed or if the Internet does not become a viable commercial marketplace, the Company's financial condition and results of operations could be materially adversely affected. SYSTEM INTERRUPTION AND SECURITY RISKS. The Company's operations are dependent on its ability to protect its computer systems and databases against damage or system interruptions from natural disasters, power loss, telecommunications failure, unauthorized entry or other events beyond the Company's control. A significant amount of the Company's computer equipment is located at a single site in Phoenix, Arizona. There can be no assurance that unanticipated problems will not cause a significant system outage or data loss. Despite the implementation of security measures, the Company's infrastructure may also be vulnerable to break-ins, computer viruses or other disruptions caused by its customers or others. Any damage to the Company's databases, failure of communication links or security breach or other loss that causes -7- 9 interruptions in the Company's operations could have a material adverse effect on the Company's financial condition and results of operations. IMPACT OF TECHNOLOGICAL ADVANCES; DELAYS IN INTRODUCTION OF NEW SERVICES. The Company's future success will depend, in part, on its ability to develop leading technology, enhance its existing services, develop and introduce new services that address the increasingly sophisticated and varied needs of its current and prospective customers and respond to technological advances and emerging industry standards and practices on a timely and cost effective basis. Although the Company strives to be a technological leader, there can be no assurance that future advances in technology will be beneficial to, or compatible with, the Company's business or that the Company will be able to economically incorporate such advances into its business. In addition, keeping abreast of technological advances in the Company's business may require substantial expenditures and lead time. There can be no assurance that the Company will be successful in effectively using new technologies, adapting its services to emerging industry standards or developing, introducing and marketing service enhancements or new services, or that it will not experience difficulties that could delay or prevent the successful development, introduction or marketing of these services. If the Company incurs increased costs or is unable, for technical or other reasons, to develop and introduce new services or enhancements of existing services in a timely manner in response to changing market conditions or customer requirements, or if new services do not achieve market acceptance, the Company's financial condition and results of operations could be materially adversely affected. DEPENDENCE ON KEY CUSTOMERS AND THIRD-PARTY SERVICE ARRANGEMENTS. The Company's business is dependent upon customer arrangements with its hotel stockholders or their affiliates, other hotel chains and hotel representation firms, travel agencies, travel agency consortia and GDSs. The Company has not entered into written agreements with certain travel agencies relating to the HCC service. There can be no assurance that the Company will be able to continue or renew these arrangements on equal or better terms or initiate new arrangements. Any cancellation or non-renewal of these arrangements that results in a significant reduction in the Company's customer base or revenue sources could materially adversely affect the Company's financial condition and results of operations. In addition, the Company relies on third parties to provide consolidation, remittance and worldwide currency exchange services for its HCC service and facility maintenance and disaster recovery services for computer and communications systems used in all of the Company's services. There can be no assurance that these service contracts will be successfully extended upon expiration or that Pegasus can enter into contracts with alternate service providers at the same or lower cost. Any failure by the Company to extend these contracts or to secure alternate service providers could have a material adverse effect on the Company's financial condition and results of operations. GOVERNMENT REGULATION. The Company's primary customers are hotel chains and hotel representation firms. The Company currently has as its stockholders many of the leading hotel chains in the world based on revenues. While the Company believes that it has been acting since its inception as an entity independent of its stockholders, and its stockholders have not engaged in any anti-competitive activities through or in connection with the Company, there can be no assurance that federal, state or foreign governmental authorities, the Company's competitors or its consumers will not raise anti-competitive concerns regarding the Company's close relationship with its hotel stockholders. Any such action by federal, state or foreign governmental authorities or allegations by third parties could have a material adverse effect on the Company's financial condition and results of operations. While certain aspects of the travel industry are heavily regulated by the United States Government, the services currently offered by the Company, including electronic room reservation processing services, commission processing services and online reservation services, have not been subject to any material industry-specific government regulation. However, there can be no assurance that federal, state or foreign governmental authorities will not attempt to regulate one or more of the Company's current or future services. Due to the increasing popularity of the Internet, it is possible that laws and regulations may be adopted with respect to the Internet, covering issues such as privacy, pricing, content and quality of products and services. The adoption of laws or regulations affecting the Company's lines of business could reduce the rate of growth of the Company or could otherwise have a material adverse effect on the Company's financial condition and results of operations. RISKS ASSOCIATED WITH MANAGEMENT OF GROWTH. The Company has in recent years experienced significant growth and anticipates that significant expansion will continue to be required in order to address potential market opportunities. There -8- 10 can be no assurance that if the Company continues to expand, management will be effective in attracting and retaining additional qualified personnel, expanding the Company's physical facilities, integrating acquired businesses or otherwise managing growth. In addition, there can be no assurance that the Company's systems, procedures or controls will be adequate to support any expansion of the Company's operations. The Company's inability to manage growth effectively could have a material adverse effect on the Company's financial condition and results of operations. RISKS ASSOCIATED WITH INTERNATIONAL EXPANSION AND OPERATIONS. Pursuit of international growth opportunities may require significant investments for an extended period before returns on such investments, if any, are realized. There can be no assurance as to the extent, if at all, that the Company's plans to expand in international markets will be successful. The Company's current international activities and prospects may be adversely affected by factors such as policies of the United States and foreign governments affecting foreign trade, privacy issues, investment and taxation, exchange controls, political risks and currency risks. One or more of these factors could materially adversely affect the Company's financial condition and results of operations. DEPENDENCE ON KEY PERSONNEL. The Company believes that its success will continue to be dependent upon its ability to attract and retain skilled managers and other key personnel, including its President, John F. Davis, III, its Chief Information Officer, Joseph W. Nicholson, and its other present officers. The loss of the services of any of its present officers could have a material adverse effect on the Company's financial condition and results of operations. Although the Company currently has "key-man" insurance covering Messrs. Davis and Nicholson, there can be no assurance that the amount of such insurance would be adequate to compensate for the loss of the services of the insured officers. The Company believes that its future business results will also depend in significant part upon its ability to identify, attract, motivate and retain additional highly skilled technical personnel. Competition for such personnel in the information technology industry is intense. There can be no assurance that the Company will be successful in identifying, attracting, motivating and retaining such personnel, and the failure to do so could have a material adverse effect on the Company's financial condition and results of operations. DEPENDENCE ON PROPRIETARY TECHNOLOGY; RISK OF INFRINGEMENT. The Company's success depends upon its proprietary technology, consisting of both its software and its hardware designs. The Company relies upon a combination of copyright, trade secrets, confidentiality procedures and contractual provisions to protect its proprietary technology. There can be no assurance that the Company's present protective measures will be enforceable or adequate to prevent misappropriation of its technology or independent third-party development of the same or similar technology. Many foreign jurisdictions offer less protection of intellectual property rights than the United States, and there can be no assurance that the protection provided to the Company's proprietary technology by the laws of the United States or foreign jurisdictions will be sufficient to protect the Company's technology. In addition, litigation may be necessary in the future to enforce the Company's intellectual property rights, to protect the Company's trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation, whether successful or unsuccessful, could result in substantial cost and diversion of management resources, and a successful claim could effectively block the Company's ability to use or license its technology in the United States or abroad or otherwise have a material adverse effect on the Company's financial condition and results of operations. The Company has found and may in the future find it necessary or desirable to procure licenses from third parties relating to current or future services or technology, but there can be no assurance that the Company will continue to be able to obtain such licenses or other rights or, if it is able to obtain them, that it will be able to do so on commercially acceptable terms. The Company could be placed at a disadvantage if its competitors obtain licenses with lower royalty fee payments or other terms more favorable than those received by the Company. If the Company or its suppliers were unable to obtain licenses relating to current or future services or technology, the Company could be forced to market services without certain technological features. The Company's inability to obtain licenses necessary to use certain technology or its inability to obtain such licenses on competitive terms could have a material adverse effect on the Company's financial condition and results of operations. RISKS ASSOCIATED WITH POTENTIAL ACQUISITIONS. While the Company has no current agreements or negotiations underway with respect to any potential acquisitions, -9- 11 the Company regularly evaluates such opportunities and may make acquisitions of other companies or technologies in the future. Acquisitions involve numerous risks, including difficulties in assimilating acquired operations and products, diversion of management's attention from other business concerns, amortization of acquired intangible assets and potential loss of key employees of acquired companies. The Company has no experience in assimilating acquired nonaffiliated organizations into the Company's operations. There can be no assurance as to the ability of the Company to integrate successfully any operations, personnel or services that might be acquired in the future, and a failure by the Company to do so could have a material adverse effect on the Company's financial condition and results of operations. YEAR 2000 COMPLIANCE. The Company has implemented a program designed to ensure that all software used in connection with the Company's services will manage and manipulate data involving the transition of dates from 1999 to 2000 without functional or data abnormality and without inaccurate results related to such dates. However, other participants in the travel industry have announced that their software may experience such abnormalities unless significant resources are devoted to the problem. Any failure on the part of the Company, or its travel-related customers to ensure that any such software complies with year 2000 requirements, regardless of when such travel reservations occur, could have a material adverse effect on the financial condition and results of operations of the Company. ANTI-TAKEOVER MATTERS. The Company's Second Amended and Restated Certificate of Incorporation ("Certificate") and Second Amended and Restated By-laws ("By-laws") contain provisions that may have the effect of delaying, deterring or preventing a potential takeover of the Company that stockholders purchasing shares in this offering may consider to be in their best interests. The Certificate and By-laws provide for a classified Board of Directors serving staggered terms of three years, prevent stockholders from calling a special meeting of stockholders and prohibit stockholder action by written consent. The Certificate also authorizes only the Board of Directors to fill vacancies, including newly created directorships and states that directors of the Company may be removed only for cause and only by the affirmative vote of holders of at least two-thirds of the outstanding shares of the voting stock, voting together as a single class. In addition, the Certificate grants the Board of Directors the authority to issue up to 2,000,000 shares of preferred stock, having such rights, preferences and privileges as designated by the Board of Directors, without stockholder approval. Section 203 of the Delaware General Corporation Law, which is applicable to the Company, contains provisions that restrict certain business combinations with interested stockholders, which may have the effect of inhibiting a non-negotiated merger or other business combination involving the Company. POTENTIAL VOLATILITY OF STOCK PRICE. The market price for the Common Stock may be highly volatile. The Company believes that factors such as quarterly fluctuations in financial results or announcements by the Company or by its competitors, travel agencies, hotel operators or other hotel industry participants could cause the market price of the Common Stock to fluctuate substantially. In addition, the stock market may experience extreme price and volume fluctuations which often are unrelated to the operating performance of specific companies. Market fluctuations or perceptions regarding the hotel industry, as well as general economic or political conditions, may adversely affect the market price of the Common Stock. In the past, following periods of volatility in the market price for a company's securities, securities class action litigation has often been instituted. Such litigation could result in substantial costs and a diversion of management attention and resources, which could have a material adverse effect on the Company's financial condition and results of operations. ITEM 2. PROPERTIES. The Company's principal executive office is a leased facility with approximately 29,800 square feet of space in Dallas, Texas. The Company leases this space under a lease agreement that expires December 2002. The Company also maintains an administrative and sales office in a leased facility with approximately 3,300 square feet of space near London, England. The lease agreement for the current office in England expires in May 1998. The Company expects to move its England office during the second quarter of 1998 to another leased facility consisting of approximately 2,200 square feet. The Company has signed a lease agreement for the new office space in England, which extends through February 2006. Under an agreement with REZsolutions, Inc. certain of the equipment owned by the Company is housed at a site owned by REZsolutions, Inc. in Phoenix, Arizona. The Company believes that its existing facilities are well maintained and in good operating condition and are adequate for its present and anticipated levels of operations. -10- 12 ITEM 3. LEGAL PROCEEDINGS. The Company is a party from time to time to certain routine legal proceedings arising in the ordinary course of its business. Although the outcome of any such proceedings cannot be predicted accurately, the Company does not believe any liability that might result from such proceedings could have a material adverse effect on the Company's financial condition and results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted to a vote of the Company's stockholders during the fourth quarter of fiscal 1997. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock has traded on the Nasdaq National Market under the symbol "PEGS" since August 7, 1997. At February 28, 1998, there were approximately 26 record holders of the Company's Common Stock, although the Company believes that the number of beneficial owners of its Common Stock is substantially greater. The table below sets forth for the fiscal quarters indicated the high and low sale prices for the Common Stock.
HIGH LOW ---- --- Fiscal 1997 Fourth quarter................................... $20.75 $12.50 Third quarter (from August 7, 1997).............. $19.25 $15.50
The Company intends to retain any future earnings for use in its business and does not intend to pay cash dividends in the foreseeable future. The payment of future dividends, if any, will be at the discretion of the Company's Board of Directors and will depend, among other things, upon future earnings, operations, capital requirements, restrictions in future financing agreements, the general financial condition of the Company and general business conditions. The following information relates to all securities issued or sold by the Company within the past three years and not registered under the Securities Act. Effective in July 1995, the Company issued 4,934,667 shares of Common Stock in exchange for all of the outstanding capital stock of The Hotel Industry Switch Company ("THISCO") and 83.3% of the outstanding capital stock of The Hotel Clearing Corporation ("HCC") (the "Reorganization") in accordance with Section 4(2) of the Securities Act of 1933, as amended (the "Securities Act"). In connection with the Reorganization, the Company granted to Lodging Network, Inc. ("LNI") an option (the "LNI Option") to exchange the remaining 16.7% of capital stock of HCC, which was held by LNI, for 448,667 shares of the Company's Common Stock. In addition, certain members of HCC management agreed to forfeit their rights to participate in a special HCC bonus plan in return for a cash payment and the opportunity to purchase an aggregate of 283,333 shares of Common Stock for $570,874. These shares were issued in accordance with Section 4(2) of the Securities Act. In June 1996, the Company issued to Information Associates, L.P. and Information Associates, C.V. an aggregate of 1,538,462 shares of Series A Preferred Stock for $4.88 per share in accordance with Section 4(2) of the Securities Act. In June 1996, the Company issued in accordance with Section 4(2) of the Securities Act 89,733 shares of the Common Stock and paid $2.0 million to LNI for the remaining outstanding capital stock of HCC held by LNI, and in connection therewith, the LNI Option was cancelled. In May 1997, the Company issued in accordance with Section 4(2) of the Securities Act warrants to purchase 345,723 shares of the Common Stock to Holiday Inn in connection with the Distribution Services Agreement between the Company and Holiday Inn. In June 1996, the Company adopted its 1996 Stock Option Plan, and the Company has issued to participants in such plan under Section 4(2) of the Securities Act and Rule 701 of the Securities Act options to purchase an aggregate -11- 13 of 771,740 shares of Common Stock. A Registration Statement on Form S-8 covering the 1996 Stock Option Plan has been filed with the Securities and Exchange Commission (the "Commission"). In August 1997, the Company completed the initial public offering of its Common Stock (the "IPO"). The Commission declared the Registration Statement (File No. 333-28595) relating to the IPO effective on August 6, 1997. In the IPO, the Company issued and sold 3,450,000 shares for an aggregate price to the public of $44,850,000 and certain selling stockholders sold 659,000 shares of Common Stock for an aggregate offering price of $8,567,000. The IPO was a firm commitment underwriting, and the managing underwriters of the IPO were Hambrecht & Quist LLC, NationsBanc Montgomery Securities LLC and Volpe Brown Whelan & Company, LLC. The underwriting discount incurred by the Company relating to the IPO was $3,139,500, and as of December 31, 1997 other expenses incurred by the Company relating to the IPO were approximately $1.2 million. Net offering proceeds received by the Company from the IPO were approximately $40.5 million. Approximately $5.2 million of the proceeds received by the Company from the IPO were used to repay certain loans to stockholders and to repay certain lease obligations. Certain of the Company's current directors, including William C. Hammett, Jr., I. Malcolm Highet, Paul J. Travers, Mark C. Wells and Bruce Wolff, serve as officers or directors or both of certain of the stockholders whose loans were repaid. Pending final application, the Company has invested the proceeds received by it from the IPO (other than the proceeds used to repay the stockholder loans described above) in short term marketable securities. ITEM 6. SELECTED FINANCIAL DATA. This information is set forth under the caption "Selected Consolidated Financial Data" for each of the five years in the period ended December 31, 1997, of the Company's 1997 Annual Report to Stockholders, which portion of such Annual Report is filed herein as Exhibit 13.1 and incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This information is set forth under the caption "Management's Discussion and Analysis" of the Company's 1997 Annual Report to Stockholders, which portion of such Annual Report is filed herein as Exhibit 13.1 and incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not Applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The financial statements of the Company including the independent accountant's report thereon of the Company's 1997 Annual Report to Stockholders, which financial statements are filed herein as Exhibit 13.1, are incorporated herein by reference. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information set forth under the captions "Election of Directors" and "Executive Officers of the Company" of the Company's definitive Proxy Statement for the Company's 1998 Annual Meeting of Stockholders is incorporated herein by reference. -12- 14 ITEM 11. EXECUTIVE COMPENSATION. The information set forth under the caption "Executive Compensation and Other Matters" of the Company's definitive Proxy Statement for the Company's 1998 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information set forth under the caption "Outstanding Capital Stock and Stock Ownership of Directors, Certain Executive Officers and Principal Stockholders" of the Company's definitive Proxy Statement for the Company's 1998 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information set forth under the caption "Certain Transactions" of the Company's definitive Proxy Statement for the Company's 1998 Annual Meeting of Stockholders is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. The following financial statements are incorporated by reference from the Company's 1997 Annual Report to Stockholders, which financial statements are filed herein as Exhibit 13.1: Report of Independent Accountants. Consolidated Balance Sheets dated December 31, 1997 and 1996. Consolidated Statements of Operations for the three years ended December 31, 1997. Consolidated Statements of Changes in Shareholders' Equity (Deficit) for the three years ended December 31, 1997. Consolidated Statements of Cash Flows for the three years ended December 31, 1997. Notes to Consolidated Financial Statements.
PAGE ---- 2. Consolidated Financial Statement Schedule Report of Independent Accountants on Financial Statement Schedule. S-1 Consolidated Valuation and Qualifying Accounts. S-2 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. 3. The following documents are filed or incorporated by reference as exhibits to this Report: 2.1 Contribution and Restructuring Agreement dated effective as of July 21, 1995 by and among the Company and all of the stockholders of the Company 3.1 Second Amended and Restated Certificate of Incorporation 3.2 Second Amended and Restated Bylaws 4.1 Specimen of Common Stock Certificate 4.2 Second Amended and Restated Certificate of Incorporation and Second Amended and Restated Bylaws (see Exhibits 3.1 and 3.2) 4.3 Rights Agreement dated June 25, 1996 by and among the Company and certain holders of capital stock of the Company named therein 4.4 Common Stock Purchase Warrant issued to Holiday Hospitality Corporation
-13- 15 *10.1 Employment Agreement dated June 25, 1996 between the Company and John F. Davis, III *10.2 Employment Agreement dated June 25, 1996 between the Company and Joseph W. Nicholson *10.3 Employment Agreement dated August 29, 1996 between the Company and Jerome L. Galant *10.4 Employment Agreement dated May 18, 1997 between the Company and Michael R. Donahue *10.5 1996 Stock Option Plan, as amended (incorporated by reference to Exhibit 99.1 of Registration Statement on Form S-8 (File No. 333- 40039) filed with the Commission on November 12, 1997) *10.6 1997 Stock Option Plan, as amended (incorporated by reference to Exhibit 99.1 of Registration Statement on Form S-8 (File No. 333-40033) filed with the Commission on November 12, 1997) 10.7 Client Service Agreement, as amended, between the Company and Citibank, N.A. 10.8 Facilities Management Agreement dated January 1, 1996 between the Company and Anasazi, Inc., currently known as REZsolutions, Inc. 10.9 Service Agreement dated December 13, 1996 between the Company and Comdisco, Inc. 10.10 Service Agreement dated January 17, 1997 between the Company and Genuity, Inc. *10.11 1997 Employee Stock Purchase Plan (incorporated by reference to Exhibit 99.1 of Registration Statement on Form S-8 (File No. 333-40035) filed with the Commission on November 12, 1997) 10.13 Office Lease dated October 1, 1995 between the Company and the Utah State Retirement Investment fund relating to property located at 3811 Turtle Creek Blvd., Suite 1100, Dallas, Texas 75219 +13.1 Selected portions of the Company's Annual Report to Stockholders for fiscal year ended December 31, 1997 16.1 Letter regarding Change in Certifying Accountant 21.1 Subsidiaries of the Company (incorporated by reference to the Company's Registration Statement on Form S-1 (Registration No. 333-44927)) +23.1 Consent of Price Waterhouse LLP +23.2 Consent of Belew Averitt LLP +24.1 Power of Attorney (included on signature page) +27.1 Financial Data Schedule
- ---------------- Unless otherwise indicated, exhibits are incorporated by reference to the Company's Registration Statement (File No. 333-28595) on Form S-1 declared effective by the Commission on August 6, 1997. + Filed herewith. * Management contract or compensatory plan or arrangement. The Company will furnish a copy of any exhibit listed above to any shareholder without charge upon written request to Mr. Ric L. Floyd, Secretary, 3811 Turtle Creek Blvd., Suite 1100, Dallas, Texas 75219. (b) No reports on Form 8-K were filed during the last quarter of the period covered by this Report. -14- 16 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Dallas, State of Texas, on this 31st day of March, 1998. PEGASUS SYSTEMS, INC. By: /s/ JOHN F. DAVIS, III ----------------------------------------------- John F. Davis, III Chief Executive Officer, President and Director POWER OF ATTORNEY KNOW ALL MEN AND WOMEN BY THESE PRESENTS that each person whose signature appears below constitutes and appoints John F. Davis, III, Jerome L. Galant and Ric L. Floyd, and each of them, such individual's true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for such individual and in his or her name, place and stead, in any and all capacities, to sign any and all amendments to this Report, with all exhibits thereto, and to file the same with all exhibits thereto, and all documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises as fully and to intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
SIGNATURES TITLE DATE ---------- ----- ---- /s/ JOHN F. DAVIS, III Chief Executive Officer, March 31, 1998 ------------------------------- President and Director John F. Davis, III (Principal Executive Officer) /s/ JEROME L. GALANT Chief Financial Officer March 31, 1998 ------------------------------- (Principal Financial and Jerome L. Galant Accounting Officer) /s/ JOHN W. BIGGS Director March 31, 1998 ------------------------------- John W. Biggs /s/ DONALD R. DIXON Director March 31, 1998 ------------------------------- Donald R. Dixon /s/ WILLIAM C. HAMMETT, JR. Director March 31, 1998 ------------------------------- William C. Hammett, Jr. /s/ IAN MALCOLM HIGHET Director March 31, 1998 ------------------------------- Ian Malcolm Highet /s/ ROCKWELL A. SCHNABEL Director March 31, 1998 ------------------------------- Rockwell A. Schnabel /s/ PAUL J. TRAVERS Director March 31, 1998 ------------------------------- Paul J. Travers /s/ MARK C. WELLS Director March 31, 1998 ------------------------------- Mark C. Wells /s/ BRUCE WOLFF Director March 31, 1998 ------------------------------- Bruce Wolff
-15- 17 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE To the Board of Directors of Pegasus Systems, Inc. Our audits of the consolidated financial statements referred to in our report dated March 12, 1998 appearing in the 1997 Annual Report to Shareholders of Pegasus Systems, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedule, for the years ended December 31, 1996 and 1997, listed in Item 14(a) of this Form 10-K. In our opinion, this Financial Statement Schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE LLP Dallas, Texas March 12, 1998 To the Board of Directors of Pegasus Systems, Inc. Our audit of the consolidated financial statements referred to in our report dated March 2, 1996, except for Note 8, as to which the date is August 6, 1997 and Note 15, as to which the date is January 26, 1998 appearing in the 1997 Annual Report to Shareholders of Pegasus, Systems, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedule, for the year ended December 31, 1995, listed under Item 14(a) of this Form 10-K. In our opinion, this Financial Statement Schedule, when considered in relation to the consolidated financial statements taken as a whole, presents fairly, in all material respects, the information stated therein. BELEW AVERITT LLP Dallas, Texas March 2, 1996 S-1 18 SCHEDULE II PEGASUS SYSTEMS, INC. VALUATION AND QUALIFYING ACCOUNTS For the years ended December 31, 1995, 1996 and 1997 (In thousands)
Additions Additions Balance at Charged to from Balance Beginning Costs and Acquired at End Classification of Period Expenses Companies Deduction of Period -------------- ----------- ----------- --------- --------- --------- December 31, 1995 Allowance for doubtful accounts $ -- $ 20 $ -- $ -- $ 20 Income tax valuation allowances $ 2,532 $ 289 $ 707 $ -- $ 3,528 ------- ------- ----- ------ ------- Total reserves and allowances $ 2,532 $ 309 $ 707 $ -- $ 3,548 ======= ======= ===== ====== ======= December 31, 1996 Allowance for doubtful accounts $ 20 $ 25 $ -- $ -- $ 45 Income tax valuation allowances $ 3,528 $ 1,060 $ -- $ (39) $ 4,549 ------- ------- ----- ------ ------- Total reserves and allowances $ 3,548 $ 1,085 $ -- $ (39) $ 4,594 ======= ======= ===== ====== ======= December 31, 1997 Allowance for doubtful accounts $ 45 $ 81 $ -- $ (48) $ 78 Income tax valuation allowances $ 4,549 $ -- $ -- $ (237) $ 4,312 ------- ------- ----- ------ ------- Total reserves and allowances $ 4,594 $ 81 $ -- $ (285) $ 4,390 ======= ======= ===== ====== =======
- ---------------- (a) This schedule should be read in conjunction with the Company's audited consolidated financial statements and related notes thereto. S-2 19 EXHIBIT INDEX 2.1 Contribution and restructuring Agreement dated effective as of July 21, 1995 by and among the Company and all of the stockholders of the Company 3.1 Second Amended and Restated Certificate of Incorporation 3.2 Second Amended and Restated Bylaws 4.1 Specimen of Common Stock Certificate 4.2 Second Amended and Restated Certificate of Incorporation and Second Amended and Restated Bylaws (see Exhibits 3.1 and 3.2) 4.3 Rights Agreement dated June 25, 1996 by and among the Company and certain holders of capital stock of the Company named therein 4.4 Common Stock Purchase Warrant issued to Holiday Hospitality Corporation *10.1 Employment Agreement dated June 25, 1996 between the Company and John F. Davis, III *10.2 Employment Agreement dated June 25, 1996 between the Company and Joseph W. Nicholson *10.3 Employment Agreement dated August 29, 1996 between the Company and Jerome L. Galant *10.4 Employment Agreement dated May 18, 1997 between the Company and Michael R. Donahue *10.5 1996 Stock Option Plan, as amended (incorporated by reference to Exhibit 99.1 of Registration Statement on Form S-8 (File No. 333-40039) filed with the Commission on November 12, 1997) *10.6 1997 Stock Option Plan, as amended (incorporated by reference to Exhibit 99.1 of Registration Statement on Form S-8 (File No. 333-40033) filed with the Commission on November 12, 1997) 10.7 Client Service Agreement, as amended, between the Company and Citibank, N.A. 10.8 Facilities Management Agreement dated January 1, 1996 between the Company and Anasazi, Inc., currently known as REZsolutions, Inc. 10.9 Service Agreement dated December 13, 1996 between the Company and Comdisco, Inc. 10.10 Service Agreement dated January 17, 1997 between the Company and Genuity, Inc. *10.11 1997 Employee Stock Purchase Plan (incorporated by reference to Exhibit 99.1 of Registration Statement on Form S-8 (File No. 333-40035) filed with the Commission on November 12, 1997) 10.13 Office Lease dated October 1, 1995 between the Company and the Utah State Retirement Investment fund relating to property located at 3811 Turtle Creek Blvd., Suite 1100, Dallas, Texas 75219 +13.1 Selected portions of the Company's Annual Report to Stockholders for fiscal year ended December 31, 1997 16.1 Letter regarding Change in Certifying Accountant 21.1 Subsidiaries of the Company (incorporated by reference to the Company's Registration Statement on Form S-1 (Registration No. 333-44927)) +23.1 Consent of Price Waterhouse LLP +23.2 Consent of Belew Averitt LLP +24.1 Power of Attorney (included on signature page) +27.1 Financial Data Schedule
Unless otherwise indicated, exhibits are incorporated by reference to the Company's Registration Statement (File No. 333-28595) on Form S-1 declared effective by the Commission on August 6, 1997. + Filed herewith. * Management contract or compensatory plan or arrangement. The Company will furnish a copy of any exhibit listed above to any shareholder without charge upon written request to Mr. Ric L. Floyd, Secretary, 3811 Turtle Creek Blvd., Suite 1100, Dallas, Texas 75219. EX-13.1 2 ANNUAL REPORT TO SECURITY HOLDERS 1 EXHIBIT 13.1 Pegasus Systems Inc. Selected Consolidated Financial Data(1) The following selected consolidated financial data as of and for the years ended December 31, 1997 and 1996 are derived from the Consolidated Financial Statements of the Company that have been audited by Price Waterhouse LLP, independent accountants, and are included elsewhere in this Annual Report. The selected consolidated financial data for the year ended December 31, 1995 are derived from the financial statements of the Company that have been audited by Belew Averitt LLP, independent accountants, and are included elsewhere in this Annual Report. The selected consolidated financial data as of December 31, 1995 and as of and for the years ended December 31, 1994 and 1993 are derived from the Company's financial statements that have been audited by Belew Averitt LLP, but are not included herein. The data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and with the Company's Consolidated Financial Statements and Notes thereto.
(in thousands, except per share data) 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- Net revenues $20,903 $15,869 $ 9,296 $ 4,666 $ 3,938 Net income (loss) 589 (3,485) (3,571) (423) (398) Net income (loss) per share:(2) Basic 0.08 (0.66) (1.30) (0.56) (0.52) Diluted 0.07 (0.66) (1.30) (0.56) (0.52) Working capital (deficit) 38,397 2,068 (1,560) (844) (126) Total assets 49,923 13,892 10,316 4,150 4,872 Long-term obligations, net of current portion 661 6,353 6,994 4,718 6,224 Total stockholders' equity (deficit) $43,478 $ 1,954 $(2,380) $ (2,649) $(2,226)
2 (1) The Company's selected consolidated financial data for 1994 and 1993 consist of the accounts of THISCO. Selected consolidated financial data for periods thereafter reflect the operations of the Company, including the acquisition of 83.3% of the outstanding capital stock of HCC in July 1995 and the acquisition of the remaining 16.7% of the outstanding capital stock of HCC in June 1996, together with the depreciation and amortization applicable to such acquisitions. Amortization applicable to the acquisition of HCC totaled $1,534,044, $1,412,499 and $645,419 in 1997, 1996 and 1995 respectively. See Notes 1, 2 and 3 of Notes to Consolidated Financial Statements. (2) See Notes 1 and 15 of Notes to Consolidated Financial Statements for information concerning the calculation of basic and diluted net income (loss) per share. Such calculations reflect the adoption by the Company of Statement of Financial Accounting Standards No. 128, "Earnings per Share" (FAS 128) for the year ended December 31, 1997, which requires restatement of all periods presented in the Company's Consolidated Financial Statements included herein. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Recently Issued Accounting Standards." Management's Discussion and Analysis The following discussion and analysis should be read in conjunction with "Selected Consolidated Financial Data" and the Consolidated Financial Statements and Notes thereto included elsewhere in this Annual Report. This Annual Report contains certain forward-looking statements that involve risks and uncertainties. The Company's actual results and the timing of certain events could differ materially from those discussed in the forward-looking statements as a result of certain factors including those set forth in the Company's filings with the Securities and Exchange Commission, including its Form 10-K for the fiscal year ended December 31, 1997. Overview Pegasus is a leading provider of transaction processing services to the hotel industry worldwide. The Company's THISCO and TravelWeb hotel room reservation services improve the efficiency and effectiveness of the hotel reservation process by enabling travel agents and individual travelers to electronically access hotel room inventory information and conduct reservation transactions. The Company's HCC service, the global leader in hotel commission payment processing, improves the efficiency and effectiveness of the commission payment process for participating hotels and travel agencies by consolidating payments and providing comprehensive transaction reports. Historically, the 3 Company has derived a majority of its revenues from its THISCO and HCC services. For the year ended December 31, 1997, approximately 47.2% of the Company's consolidated revenues was derived from its electronic hotel reservation processing services, including 41.0% from the THISCO service and 6.2% from the TravelWeb and NetBooker services, and approximately 52.8% of the Company's consolidated revenues was derived from its HCC service. The Company has experienced substantial growth since its inception. Revenues increased at a compound annual rate of 49.6% to $20.9 million in 1997 from $2.8 million in 1992, excluding 1992 revenues from the HCC service which was acquired in 1995. However, there can be no assurance that the Company will experience the same rate of revenue growth in the future. Any significant decrease in the rate of revenue growth could have a material adverse effect on the Company's financial condition and results of operations. The Company's revenues are predominantly transaction-based. The Company derives its revenues from its THISCO service by charging its hotel participants a fee based on the number of reservations made, less the number canceled ("net reservations"), and a fee for "status messages" processed through the THISCO service. Status messages are electronic messages sent by hotels to GDSs to update room rates, features and availability information in GDS databases. As a hotel's cumulative volume of net reservations increases during the course of the calendar year, its fee per transaction decreases after predetermined transaction volume hurdles have been met. As a result, for higher volume customers, unit transaction fees are higher at the beginning of the year, when cumulative transactions are lower. The Company recognizes revenues based on the expected fee per transaction to be earned for services to be provided to the customer during the entire year. This process of recognizing revenues results in a deferred revenue balance being created during early periods of the year, which will be reflected in interim balance sheets and be fully utilized and eliminated by the end of each year. Additionally, Pegasus generally charges new participants in the THISCO service a onetime setup fee for work associated with the implementation of the interface with the THISCO service. The Company also charges certain GDSs a fee based on the number of net reservations to compensate for the management and consolidation of multiple interfaces. In the third quarter of 1997, the Company reduced certain of the fees that it charges hotels for transmitting status messages. Pegasus derives its revenues from its HCC service by charging a participating travel agency a fee based on a percentage of the dollar amount of commissions paid to that agency through the HCC service. The Company also generally charges a participating hotel a fee based on the number of commissionable transactions arising from that hotel. Revenues from HCC travel agency fees can vary substantially from period to period based on the fluctuations of the average 4 daily room rates. Pegasus recognizes revenues from its HCC service in the month in which the hotel stay occurs and collects and pays commissions to travel agencies by the 15th business day of the following month. If a hotel fails to deliver funds to the Company, the Company is not obligated to deliver commission payments on behalf of the hotel to travel agencies. HCC revenues also include amortization of a $2.0 million payment received by the Company in June 1993 in exchange for a five-year noncancelable data processing contract. This payment was initially recorded as unearned income and is being recognized as revenue over the life of the contract. The amounts recognized in 1997 and 1996 were approximately $471,000 and $431,000, respectively. See Note 11 of Notes to Consolidated Financial Statements. The Company offers two services, TravelWeb and NetBooker, that provide hotel reservation capability to individual travelers through the Internet. During 1996, Pegasus derived the substantial majority of its TravelWeb revenues from fees related to the creation of Web pages for hotels and for maintaining these pages on the TravelWeb site. During 1997, the Company transitioned its fee structure to begin charging participating hotels subscription fees based on the number of their properties included in the database and booking fees based on the number of net reservations made at their properties through the TravelWeb service. The Company is changing the method it uses to calculate booking fees for the use of its TravelWeb service from a flat fee to a fee based on the rate of the hotel room reserved. There can be no assurance that the fees generated from the TravelWeb service will remain at the same or a higher level in the future. Any significant decrease in the amount of fees received for the TravelWeb service could have a material adverse effect on the Company's financial condition and results of operations. The Company also derives revenues through the sale of advertising space on the TravelWeb site. Pegasus realizes revenues from NetBooker, the Company's hotel room reservation service provided to third-party Web sites, by charging third-party Web sites an initial development and licensing fee and by charging hotels a fee based on the number of net reservations made through the NetBooker service. The Company has developed or is in the process of developing several new services, including UltraRes, UltraDirect and Pegasus IQ, to capitalize on its existing technology and customer base to provide additional electronic hotel reservation capabilities and information services to existing Pegasus customers and to other participants in the hotel room distribution process. The Company intends to derive revenues from UltraRes, a service that automates the processing of hotel bookings for large meetings and conventions, by charging participating hotels and meeting organizers transaction-based fees for net reservations made. The Company intends to derive revenues from UltraDirect, a service that automates the hotel room reservation process for corporate travelers, 5 by charging hotels transaction-based fees for net reservations. The Company has not received a material amount of revenues from these services and there can be no assurance that either of these services will produce a material amount of revenues in the future. The Company's future success will depend, in part, on its ability to develop leading technology, enhance its existing services, develop and introduce new services that address the increasingly sophisticated and varied needs of its current and prospective customers, and respond to technological advances and emerging industry standards and practices on a timely and cost-effective basis and there can be no assurances that any of these services will produce a material amount of revenues in the future. The Company's cost of services consists principally of: (i) personnel costs relating to information technology; (ii) facilities and equipment maintenance costs; and (iii) fees paid to Citicorp for the processing of travel agency commissions. Research and development costs consist principally of personnel costs, related overhead costs and fees paid to outside consultants. General and administrative expenses are primarily personnel, office, legal and accounting related. Marketing and promotion expenses consist primarily of personnel costs, advertising, public relations and participation in trade shows and other industry events. Depreciation and amortization expense includes: (i) computer equipment depreciation; (ii) office furniture, equipment and leasehold improvement depreciation; (iii) amortization of software, including software acquired as part of the acquisition of HCC; and (iv) goodwill amortization. Interest expense includes notes payable to certain stockholders of the Company and payments made under capital equipment leases. Minority interest represents certain former minority interests in subsidiaries that have been wholly owned by the Company since June 1996. See Notes 1, 2, 3 and 7 of Notes to Consolidated Financial Statements. All costs incurred in the internal development of computer software used in the delivery of the Company's services are expensed until a product design and a working model of the software have been tested and completed. Thereafter, any further development or production costs are capitalized. Maintenance and customer support costs are expensed as incurred. Prior to 1996, the capitalized development costs were being amortized over three to five years using the straight-line method. However, in 1996 the Company changed the estimated life of all internally and externally developed computer software to three years. The result of such change in estimated life was to increase the net income for 1997 by approximately $142,000 and to increase the net loss for 1996 by approximately $292,000. See Note 1 of Notes to Consolidated Financial Statements. Year 2000 Compliance. The Company has implemented a program designed to ensure that all software used in connection with the Company's services will 6 manage and manipulate data involving the transition of dates from 1999 to 2000 without functional or data abnormality and without inaccurate results related to such dates. However, other participants in the travel industry have announced that their software may experience such abnormalities unless significant resources are devoted to solving the problem. Any failure on the part of the Company or its travel-related customers to ensure that any such software complies with year 2000 requirements, regardless of when such travel reservations occur, could have a material adverse effect on the financial condition and results of operations of the Company. Years Ended December 31, 1997 and 1996 Net revenues. The Company's net revenues for 1997 increased to $20.9 million from $15.9 million in 1996, an increase of 31.7%. This increase in revenues was primarily driven by higher transactions levels for all of the Company's services including THISCO, HCC and TravelWeb. THISCO revenues increased as a result of a 25.7% increase in net reservations made in 1997 as compared to 1996. HCC revenues grew as a result of a 38.0% increase in hotel commission transactions processed during 1997 as compared to 1996, due in part, to the addition of hotel properties, including those of Marriott International, Inc., and travel agencies participating in the HCC service. The net revenues to the Company per commissionable transaction increased in 1997 because of an increase in overall hotel average daily rates. Revenues contributed by the TravelWeb service decreased by 7.7% in 1997 as compared to 1996. This decrease resulted primarily as a result of the transition from a reliance on Web page building and maintenance fees to revenues based on monthly subscription fees and booking fees per net reservation. Cost of Services. Cost of services increased by $1.2 million, or 20.1%, to $7.4 million in 1997 from $6.2 million in 1996. Cost of services increased due to additional staffing in support of the Thisco, TravelWeb and HCC services and the increased number of transactions processed through the HCC service. Research and Development; write-off of purchased in-process research and development. Research and development expenses increased $298,000, or 13.5%, to $2.5 million in 1997 from $2.2 million in 1996. After eliminating the effect of the one-time charge taken in 1996 for research and development expenses relating to the acquisition of HCC, research and development expenses increased $543,000, or 27.7%, to $2.5 million in 1997 from $2.0 million in 1996. This increase was primarily due to additional work on TravelWeb including the development of the hotel database. See Note 3 of Notes to Consolidated Financial Statements. General and administrative expenses. General and administrative expenses decreased $84,000, or 2.2%, to $3.7 million in 1997 from $3.8 million in 1996. This 7 decrease was primarily due to a number of non-recurring expenses incurred in 1996 associated with the closing of a financial transaction. Marketing and promotion expenses. Marketing and promotion expenses increased $1.2 million, or 41.5%, to $4.0 million in 1997 from $2.8 million in 1996. Marketing and promotion expenses grew primarily due to the addition of Sales and Marketing staff, the promotion of the TravelWeb service and, to a lesser degree, the promotion of the THISCO and HCC services. Depreciation and amortization. Depreciation and amortization expenses decreased $409,000, or 11.9%, to $3.0 million in 1997 from $3.4 million in 1996. This decrease was primarily due to the completion in 1996 of the amortization of a number of software development projects that had been previously capitalized. Interest expense. Interest expense decreased $293,000, or 32.8%, to $600,000 in 1997. The expense reflects interest accrued on promissory notes payable to certain stockholders of the Company and payments made under capital equipment leases. The Company repaid all of these promissory notes in August 1997 using proceeds from its initial public offering of common stock. Interest income. During 1997, the Company realized $994,000 in interest income as a result of short term investment of operating cash balances, including the net proceeds of its initial public offering. Income taxes. Income taxes reflect foreign income taxes payable with respect to the taxable earnings of the Company's United Kingdom subsidiary, which reports earnings on a cost-plus basis. Currently, the United Kingdom office reports taxable earnings equal to 10.0% of the total operating cost of the office. Years Ended December 31, 1996 and 1995 Net revenues. Net revenues increased by $6.6 million, or 70.7%, to $15.9 million in 1996 from $9.3 million in 1995. THISCO revenues increased as a result of a 27.0% increase in net reservations made in 1996 as compared to 1995. Additionally, the average fee paid by hotels using the THISCO service increased during 1996 as a result of an increase in total status messages processed. HCC revenues grew as a result of the acquisition by the Company of HCC in July 1995 and the subsequent growth in hotel commission transactions processed due, in part, to the addition of hotel properties and travel agencies participating in the HCC service. The net revenues to the Company per commissionable transaction increased in 1996 because of a change in the hotel customer mix and an increase in overall hotel average daily rates. Revenues contributed by the TravelWeb service increased 57.6% in 1996 as compared to 1995, which resulted primarily from amounts charged to hotels for Web page building and maintenance fees 8 and less significantly from advertising and promotions and from fees charged to hotels for net reservations processed through the TravelWeb service. In 1997, Pegasus transitioned its hotels participating in the TravelWeb service to a subscription fee arrangement, whereby, in addition to paying fees for net reservations made through this service, participating hotels will remit monthly fees per property listing in the TravelWeb service. See " Overview." Cost of services. Cost of services increased $2.3 million, or 59.7%, to $6.2 million in 1996 from $3.9 million in 1995. This increase was due to the acquisition by the Company of HCC in July 1995 and operating expenses for TravelWeb, including expenses for contract Web site page building, software development and the employment of additional technical personnel. Research and development. Research and development expenses increased $143,000, or 6.9%, to $2.2 million in 1996 from $2.1 million in 1995. After eliminating the effect of the onetime charges taken in 1995 and 1996 for research and development expenses relating to the acquisition of HCC, research and development expenses increased $1.2 million, or 133%, to $2.0 million in 1996 from $840,000 in 1995. This increase was due to increased development expenses primarily related to TravelWeb. See Note 3 of Notes to Consolidated Financial Statements. General and administrative expenses. General and administrative expenses increased $1.0 million, or 37.1%, to $3.8 million in 1996 from $2.8 million in 1995. This increase was due to greater office-related costs, personnel costs, legal and accounting fees and travel-related costs. Marketing and promotion expenses. Marketing and promotion expenses increased $1.9 million, or 209.6%, to $2.8 million in 1996 from $912,000 in 1995. As a percentage of net revenues, marketing and promotion expenses increased to 17.8% in 1996 from 9.8% in 1995. Marketing and promotion expenses grew primarily due to the promotion of the TravelWeb service and to a lesser degree the promotion of the THISCO and HCC services. Depreciation and amortization. Depreciation and amortization expenses increased $949,000, or 38.3%, to $3.4 million in 1996 from $2.5 million in 1995. In 1996, the Company changed the estimated life of certain capitalized software from five years to three years. The effect of this change was to increase amortization by $292,000 in 1996. Also, in 1996 the Company recognized a full year of amortization of software and goodwill relating to the Company's acquisition in July 1995 of 83.3% of the outstanding capital stock of HCC and began to amortize software and goodwill that resulted from the purchase by the 9 Company in June 1996 of the remaining 16.7% of the outstanding capital stock of HCC. Interest expense. Interest expense increased $77,000, or 9.5%, to $893,000 in 1996 from $816,000 in 1995. The expense includes interest accrued on promissory notes payable to certain stockholders of the Company and payments made under capital equipment leases. Interest income. During 1996, the Company realized $114,000 in interest income as a result of short term investments of operating cash balances on the proceeds from the sale of shares of the Company's Series A Preferred Stock in June 1996. Income taxes. Income taxes reflect foreign income taxes payable with respect to the taxable earnings of the Company's United Kingdom subsidiary, which reports earnings on a cost-plus basis. Currently, the United Kingdom office reports taxable earnings equal to 10.0% of the total operating cost of the office. Liquidity and Capital Resources The Company has financed its cash requirements for operations and investments in equipment primarily through the sale of capital stock, borrowings from stockholders and capital lease financing. Cash provided by operating activities was $2.8 million for the year ended December 31, 1997 compared to $410,000 in 1996 due to the Company's improved operating performance. The Company completed an initial public offering of its common stock in August 1997, raising proceeds, net of offering expenses, of $40.5 million. Approximately $5.2 million of these proceeds was used to repay notes payable to stockholders and to repay certain lease obligations. The remainder of these proceeds have been placed in short-term marketable securities. Net cash used in investing activities for the purchase of software, furniture and equipment amounted to $1.6 million in 1997 compared to $495,000 in 1996. In addition, in 1997 the Company acquired equipment under capital leases with a principal value of $79,000 compared with $1.0 million in 1996. The Company's principal sources of liquidity at December 31,1997 included cash and cash equivalents of $30.2 million, short-term investments of $9.4 million and restricted cash of $1.3 million, which represents funds for travel agency commission checks that have not cleared HCC's processing bank and are returned to HCC. See Note 1 of Notes to Consolidated Financial Statements. Any 10 of such amounts which are not remitted to travel agents will be escheated to the appropriate state, as required. The Company does not believe that inflation has materially impacted results of operations during the past three years. Substantial increases in costs and expenses could have a significant impact on the Company's results of operations to the extent such increases are not passed along to customers. Recently Issued Accounting Standards Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123), encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has elected to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), and related Interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair market value of the Company's stock at the date of the grant over the amount the employee must pay to acquire the stock. In February 1997, Statement of Financial Accounting Standards No. 128, "Earnings per Share" (FAS 128), was issued. FAS 128 specifies the computation, presentation and disclosure requirements for earnings per share ("EPS") for entities with publicly held common stock or potential common stock. FAS 128 simplifies the standards for computing EPS previously found in Accounting Principles Board Opinion No. 15, "Earnings per Share" (APB 15), and makes them comparable to international EPS standards. It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS on the face of the statement of operations for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. FAS 128 is effective for financial statements issued for periods ending after December 15, 1997, including interim periods; earlier application is not permitted. FAS 128 requires restatement of all prior-period EPS data presented. The Company adopted FAS 128 as of and for the year ended December 31, 1997. In June 1997, Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (FAS 130) was issued. FAS 130 establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains, and losses) in a full set of general-purpose financial statements. It requires all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. FAS 130 is effective for fiscal years beginning after December 15, 1997. The Company will adopt this Statement in the year ending December 31, 1998. Reclassification of financial statements for earlier periods provided for comparative purposes is required upon adoption. In June 1997, Statement of Financial Accounting Standards No. 131, "Disclosure About Segments of an Enterprise and Related Information" (FAS 131) was issued. FAS 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. FAS 131 is effective for periods beginning after December 15, 1997. The Company will adopt FAS 131 in the year ending December 31, 1998. 11 Consolidated Balance Sheets
December 31, 1997 and 1996 1997 1996 ---- ---- Assets Cash and cash equivalents $30,166,793 $ 1,796,311 Restricted cash 1,286,032 690,206 Short-term investments 9,380,050 2,705,076 Accounts receivable, net of allowance for doubtful accounts of $77,860 and $44,805, respectively 1,200,162 924,951 Accounts receivable from affiliates 771,973 754,405 Other current assets 1,232,874 190,976 Total current assets 44,037,884 7,061,925 Capitalized software, net 1,183,453 2,113,758 Property and equipment, net 2,712,091 3,001,012 Goodwill, net of accumulated amortization of $303,815 and $178,943, respectively 1,560,900 1,685,772 Other noncurrent assets 428,981 29,269 Total assets $49,923,309 $ 13,891,736 Liabilities and Shareholders' Equity Accounts payable and accrued liabilities $ 4,072,919 $ 2,574,186 Accounts payable to affiliates 42,118 115,049 Unearned income 477,688 470,588 Current portion of capital lease obligations 1,048,179 1,048,238 Current portion of notes payable to affiliates - 785,517 Total current liabilities 5,640,904 4,993,578 Capital lease obligations, net of current portion 661,049 1,749,899 Notes payable to affiliates, net of current portion - 4,603,568 Unearned income - 470,588 Other noncurrent liabilities 143,612 119,709 Commitments and contingencies (Note 11) - - Shareholders' equity: Preferred stock, $.01 par value; 2,000,000 shares authorized; Zero and 1,538,462 shares issued and outstanding, respectively - 15,385 Common stock, $.01 par value; 100,000,000 shares authorized, 10,297,529 and 5,307,733 shares issued, respectively 102,975 53,077 Additional paid-in capital 58,120,337 16,968,364 Unearned compensation (738,533) (485,937) Accumulated deficit (13,980,697) (14,570,157) Less treasury stock (116,484 shares, at cost) (26,338) (26,338) Total shareholders' equity 43,477,744 1,954,394 Total liabilities and shareholders' equity $49,923,309 $ 13,891,736
See accompanying notes to consolidated financial statements. 12 Consolidated Statements of Operations
Years Ended December 31, 1997, 1996 and 1995 1997 1996 1995 ----------- ----------- ----------- Net revenues (Notes 1 and 14): Shareholder $15,744,011 $11,961,445 $ 7,386,111 Nonshareholder 5,159,405 3,907,567 1,909,617 Total net revenues 20,903,416 15,869,012 9,295,728 Cost of services 7,445,271 6,199,058 3,882,496 Research and development 2,504,074 1,961,055 839,588 Write-off of purchased in-process research and development (Note 3) - 244,600 1,223,000 General and administrative expenses 3,715,547 3,799,199 2,770,474 Marketing and promotion expenses 3,998,054 2,824,633 912,230 Depreciation and amortization 3,016,619 3,425,678 2,476,812 Operating income (loss) 223,851 (2,585,211) (2,808,872) Other (income) expense: Interest expense 600,067 893,177 815,560 Interest income (993,592) (114,150) - Income (loss) before income taxes and minority interest 617,376 (3,364,238) (3,624,432) Income taxes 27,916 15,000 - Income (loss) before minority interest 589,460 (3,379,238) (3,624,432) Minority interest - (105,563) 53,528 Net income (loss) $ 589,460 $(3,484,801) $(3,570,904) Net income (loss) per share: Basic $ 0.08 $ (0.66) $ (1.30) Diluted $ 0.07 $ (0.66) $ (1.30) Weighted average shares outstanding: Basic 7,200,382 5,246,800 2,751,940 Diluted 8,676,052 5,246,800 2,751,940
See accompanying notes to consolidated financial statements. 13 Consolidated Statements of Changes in Shareholders' Equity (Deficit)
Additional Preferred Common Paid-in Unearned Years Ended December 31, 1997, 1996 and 1995 Stock Stock Capital Compensation Balance of THISCO at December 31, 1994 - $7,620 $4,857,478 - Conversion of shareholder loans - - 525,000 - Exchange of THISCO shares for Pegasus shares - (7,620) 7,620 - Formation of Pegasus - 26,919 (26,919) - Acquisition of HCC - 22,428 2,721,749 - Issuance of restricted shares to management - 2,833 568,041 - Net loss - - - - Balance at December 31, 1995 - 52,180 8,652,969 - Issuance of Pegasus preferred stock to Information Associates, L.P. and Information Associates, C.V. $ 15,385 - 7,484,620 - Issuance of Pegasus common stock for purchase of minority interest - 897 277,725 - Purchase of treasury stock - - - - Issuance of compensatory stock options - - 551,150 $(485,937) Proceeds from stock subscription - - 1,900 - Net loss - - - - Balance at December 31, 1996 15,385 53,077 16,968,364 (485,937) Conversion of preferred stock to common stock (15,385) 15,385 - - Initial public offering - 34,500 40,459,000 - Warrants issued for contract - - 238,000 - Issuance of compensatory stock options - - 450,847 (252,596) Exercise of stock options - 13 4,126 - Net income - - - - Balance at December 31, 1997 $ - $102,975 $58,120,337 $(738,533)
Treasury Accumulated Years Ended December 31, 1997, 1996 and 1995 Stock Deficit Total Balance of THISCO at December 31, 1994 - $(7,514,452) $(2,649,354) Conversion of shareholder loans - - 525,000 Exchange of THISCO shares for Pegasus shares - - - Formation of Pegasus - - - Acquisition of HCC - - 2,744,177 Issuance of restricted shares to management - - 570,874 Net loss - (3,570,904) (3,570,904) Balance at December 31, 1995 - (11,085,356) (2,380,207) Issuance of Pegasus preferred stock to Information Associates, L.P. and Information Associates, C.V. - - 7,500,005 Issuance of Pegasus common stock for purchase of minority interest - - 278,622 Purchase of treasury stock $(26,338) - (26,338) Issuance of compensatory stock options - - 65,213 Proceeds from stock subscription - - 1,900 Net loss - (3,484,801) (3,484,801) Balance at December 31, 1996 (26,338) (14,570,157) 1,954,394 Conversion of preferred stock to common stock - - - Initial public offering - - 40,493,500 Warrants issued for contract - - 238,000 Issuance of compensatory stock options - - 198,251 Exercise of stock options - - 4,139 Net income - 589,460 589,460 Balance at December 31, 1997 $(26,338) $(13,980,697) $43,477,744
See accompanying notes to consolidated financial statements. 14 Consolidated Statements of Cash Flows
Years Ended December 31, 1997, 1996 and 1995 1997 1996 1995 Cash flows from operating activities: Net income (loss) $ 589,460 $(3,484,801) $(3,570,904) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Minority interest - 105,563 (53,528) Accrued interest reclassified to notes payable 58,049 91,927 298,699 Loss on write-down of equipment - - 246,000 Write off of in-process research and development costs - 244,600 1,223,000 Adjustment for discontinued software projects - 316,698 - Loss (gain) on sale of equipment (53) 9,564 (14,553) Depreciation and amortization 3,016,619 3,425,678 2,476,812 Recognition of stock option compensation 198,251 65,213 - Amortization of premiums on short-term investments 3,359 - - Changes in assets and liabilities: Restricted cash (595,826) (360,029) (157,307) Accounts receivable (275,212) (185,455) (182,998) Accounts receivable from affiliates (17,567) (98,649) 80,785 Other current and noncurrent assets (1,203,609) (156,931) (24,032) Accounts payable and accrued liabilities 1,498,732 837,620 586,483 Accounts payable to affiliates (72,931) (89,139) (202,230) Unearned income (463,488) (431,373) (210,036) Other noncurrent liabilities 23,904 119,709 - Net cash provided by operating activities 2,759,688 410,195 496,191 Cash flows from investing activities: Purchase of software, property and equipment (1,594,401) (495,100) (639,461) Proceeds from sale of software, property and equipment 1,075 133,134 - Purchase of marketable securities (11,486,932) (2,705,076) - Proceeds from sale of marketable securities 4,808,599 - - Net cash used in investing activities (8,271,659) (3,067,042) (639,461) Cash flows from financing activities: Proceeds from issuance of stock 40,497,639 7,500,005 570,874 Purchase of minority interest - (2,000,000) - Repayments on notes payable to affiliates (5,447,133) (235,000) (103,337) Repayments of capital leases (1,171,966) (974,969) (578,271) Proceeds from capital leases 3,913 93,729 - Purchase of treasury stock - (26,338) - Proceeds from stock subscription - 1,900 - Proceeds from line of credit - 175,000 - Repayment of line of credit - (175,000) - Net cash provided (used) by financing activities 33,882,453 4,359,327 (110,734) Net increase (decrease) in cash and cash equivalents 28,370,482 1,702,480 (254,004) Cash and cash equivalents, beginning year 1,796,311 93,831 347,835 Cash and cash equivalents, end of year $ 30,166,793 $ 1,796,311 $93,831 Supplemental disclosure of cash flow information: Interest paid $ 601,787 $ 858,017 $ 706,842 Income taxes paid $ 17,916 $ - $ - Supplemental schedule of noncash investing and financing activities: Acquisition of equipment under capital leases $ 79,144 $ 1,045,988 $ 2,083,365 Conversion of notes payable to affiliates to additional paid-in capital (Note 7) $ - $ - $ 525,000 Issuance of common stock for acquisitions (Notes 2, 3 and 8) $ - $ 278,622 $ 2,744,177 Common stock warrants issued in exchange for customer contract asset $ 238,000 $ - $ -
See accompanying notes to consolidated financial statements. 15 Notes to Consolidated Financial Statements December 31, 1997, 1996 and 1995 1. Organization and Significant Accounting Policies Organization and background In July 1995, Pegasus Systems, Inc. (Pegasus or the Company) was formed as a Delaware holding company to combine the operations of two existing companies operating in the same industry, The Hotel Industry Switch Company (THISCO) and The Hotel Clearing Corporation (HCC), as discussed in Note 2. For accounting purposes, the combination was recorded as a purchase of HCC, as discussed in Note 3. Consolidation The consolidated financial statements for 1995 reflect the consolidated balance sheets of THISCO and HCC at December 31, 1995 and the consolidated operations of THISCO for the year ended 1995 and HCC from the date of acquisition to December 31, 1995. The 1996 consolidated financial 16 statements include the accounts of Pegasus and its wholly owned subsidiaries, THISCO and HCC. THISCO is consolidated with its wholly owned subsidiary, TravelWeb, Inc. (TravelWeb), and HCC is consolidated with its wholly owned subsidiary, Pegasus Systems Inc. (UK) Limited (Pegasus UK, formerly The Hotel Clearing Corporation (UK) Limited), (collectively, the Company or Pegasus). All significant intercompany balances have been eliminated in consolidation. THISCO was formed in September 1988 as a Delaware corporation. The Company's THISCO service provides an electronic interface from hotel central reservation systems to travel agencies through Global Distribution Systems (GDSs), which are electronic travel information and reservation systems such as SABRE. HCC, acquired by the Company in July 1995 (see Note 3), was formed in July 1991 as a Delaware corporation. The Company's HCC service consolidates commissions paid by participating hotels to a participating travel agency into a single monthly payment and provides participants with comprehensive transaction reports. Hotel properties and travel agencies worldwide utilize the HCC service to increase the efficiency and reduce costs associated with preparing, paying and reconciling hotel room reservation commissions. TravelWeb was formed in October 1995 as a Delaware corporation. The Company's TravelWeb service provides individual travelers direct access to online hotel information and the ability to make reservations electronically at hotel properties. In addition, through its recently introduced NetBooker service, the Company offers TravelWeb's comprehensive hotel database and Internet hotel reservation capabilities to third-party Web sites. Pegasus UK, a wholly-owned subsidiary of HCC, was formed in September 1993 in England to market and provide services for travel agents and hotel chains operating in Europe, Africa and Asia. Management estimates In preparing the consolidated financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses. Actual results may differ from those estimates. Cash and cash equivalents The Company considers all highly liquid investments with maturities of three months or less from the date of purchase to be cash equivalents. 17 Restricted cash Funds for travel agency commission checks which have not cleared HCC's processing bank after certain time periods are returned to HCC. Any amounts which are not remitted to travel agents will be escheated to the appropriate state, as required. Investments in debt and equity securities In 1996, the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (FAS 115). In accordance with this Statement, prior period financial statements have not been restated to reflect the change in accounting principle. The cumulative effect of the adoption of FAS 115 did not have a material effect on the Company's financial condition or results of operations. As of December 31, 1997 and 1996, the classification of the securities accounted for under FAS 115, was as follows:
Amortized cost ----------------------------- 1997 1996 ---------- ----------- Held to maturity: Corporate debt $9,380,050 $ 992,621 U.S. government agencies - $ 1,712,455 $9,380,050 $ 2,705,076
As of December 31, 1997 and 1996, the aggregate fair market value of the held-to-maturity securities was not materially different from their carrying values. The gross unrealized gains and losses by type of security were not material. The contract maturities of the held-to-maturity securities are less than one year. Capitalized software All costs incurred in the internal development of computer software used in delivery of the Company's services are expensed until a product design and a working model of the software have been tested and completed. Thereafter, any further development or production costs are capitalized until the software is placed into service. Maintenance and customer support costs are expensed when incurred. Capitalized software development costs are amortized on a product-by- product basis using the greater of the amount computed by the ratio of current year net revenue to estimated future net revenue, or the amount computed by the straight-line method over a period which approximates the estimated economic life of the products. The amount by which unamortized software costs exceed the net realizable value, if any, is recognized in the period the excess is determined. Additionally, capitalized software includes software purchased from third parties used in the operations of the Company. 18 Prior to 1996, capitalized software costs were being amortized over three to five years using the straight-line method. However, in 1996, the Company changed the estimated life of all capitalized software costs to three years. The effect of this change was to increase the net income during 1997 by approximately $142,000 or $0.02 basic and diluted income per share and increase the net loss during 1996 by approximately $292,000 or $0.06 basic and diluted loss per share. During 1996, the Company recorded a charge of $316,698 resulting from discontinued software development projects. During 1997, 1996 and 1995, the Company capitalized approximately $505,000, $470,000 and $3,840,000, respectively, of software costs. During 1997, 1996 and 1995, the Company amortized approximately $1,435,000, $2,125,000 and $1,532,000, respectively, of capitalized software costs. Accumulated amortization of capitalized software was $8,174,389 and $6,739,465 at December 31, 1997 and 1996, respectively. Property and equipment Property and equipment are recorded at cost and depreciated over their estimated useful lives, ranging from three to seven years. Leasehold improvements are amortized over the life of the lease using the straight-line method. Expenditures for maintenance and repairs, as well as minor renewals, are charged to operations as incurred; while, betterments and major renewals are capitalized. Upon retirement or sale of an asset, the cost of the asset and the related accumulated depreciation or amortization are removed from the accounts and any resulting gain or loss is credited or charged to operations. Long-lived assets held and used by the Company, or to be disposed of, are reviewed for impairment whenever events or changes in circumstances indicate that the net book value of the asset may not be recoverable. An impairment loss is recognized if the sum of the expected future cash flows (undiscounted and before interest) from the use of the asset is less than the net book value of the asset. The amount of the impairment loss will generally be measured as the difference between the net book value of the assets and the estimated fair value of the related assets. Based on its most recent analysis, the Company believes that no impairment of property and equipment existed at December 31, 1997 or 1996. Goodwill Goodwill represents the excess of the purchase price of acquisitions over the fair value of the net assets acquired. Such excess costs are being amortized on a straight-line basis over 15 years. Unamortized goodwill at December 31, 1997 and 1996, was $1,560,900 and $1,685,772, respectively. The carrying value of goodwill is evaluated periodically in relation to the operating performance and anticipated future undiscounted net cash flows of the related business. Based on its most recent analysis, the Company believes that no impairment of goodwill existed at December 31, 1997 or 1996. Amortization of goodwill was $124,872, $120,724 and $58,219 in 1997, 1996 and 1995, respectively. 19 Revenues The Company primarily derives its revenues from transaction fees and commissions charged to participating hotels and travel agencies. A substantial portion of the Company's revenue is derived from shareholders and shareholder-owned companies (see Note 14). The Company's revenues are predominantly transaction-based. The Company derives its revenues from its THISCO service by charging its hotel participants a fee based on the number of reservations made, less the number cancelled ("net reservations"), and a fee for "status messages" processed through the THISCO service. Status messages are electronic messages sent by hotels to GDSs to update room rates, features and availability information in GDS databases. Additionally, Pegasus generally charges new participants in the THISCO service a one-time set-up fee for work associated with the implementation of the interface with the THISCO service. Revenue for these one-time set-up fees is recognized on a percentage of completion basis as the services are performed over the set-up period, which generally ranges from two to six months. The Company also charges certain GDSs a fee based on the number of net reservations to compensate for the management and consolidation of multiple interfaces Pegasus derives its revenues from its HCC service by charging a participating travel agency a fee based on a percentage of the dollar amount of commissions paid to that agency through the HCC service. The Company also generally charges a participating hotel a fee based on the number of commissionable transactions arising from that hotel. Revenues from HCC travel agency fees can vary substantially from period to period based on the types of hotels at which reservations are made and overall room rates. Pegasus recognizes revenues from its HCC service in the month in which the hotel stay occurs. In the immediate following month, Pegasus collects commissions from the hotels by the 12th business day of such month and pays commissions to travel agencies by the 15th business day of such month. If a hotel fails to deliver funds to the Company, the Company is not obligated to deliver commission payments on behalf of the hotel to travel agencies. HCC revenues also include amortization of a $2.0 million payment received by the Company in June 1993 in exchange for a five-year non-cancelable data processing contract. This payment was initially recorded as unearned income and is being recognized as revenue over the life of the contract. The amount of revenue recognized in 1997 and 1996 was approximately $471,000 and $431,000, respectively (See Note 11). For the years ended December 31, 1997 and 1996 and the period from acquisition to December 31, 1995, HCC revenues from hotels are presented net of commission payments to travel agencies of approximately $165,000,000, $105,000,000, and $39,820,000 respectively. 20 The Company offers two services, TravelWeb and NetBooker, that provide hotel reservation capability to individual travelers through the Internet. During 1996, Pegasus derived the substantial majority of its TravelWeb revenues from fees related to the creation of Web site pages for hotels and for maintaining these pages on the TravelWeb site. During 1997, the Company transitioned its fee structure to begin charging participating hotels subscription fees based on the number of their properties included in the database and transaction fees based on the number of net reservations made at their properties through the TravelWeb service. TravelWeb revenues declined by approximately $108,000 from 1996 to 1997 after this change. The Company also derives revenues through the sale of advertising space on the TravelWeb site. Pegasus realizes revenues from NetBooker, the Company's hotel room reservation service provided to third-party Web sites, by charging third-party Web sites an initial development and licensing fee and by charging hotels a fee based on the number of net reservations made through the NetBooker service. Income taxes The Company presents income taxes pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109). FAS 109 uses an asset and liability approach to account for income taxes. In the event differences between the financial reporting basis and the tax basis of the Company's assets and liabilities result in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such assets is required. A valuation allowance is provided for a portion or all of the deferred tax assets when there is sufficient uncertainty regarding the Company's ability to recognize the benefits of the assets in future years. Advertising costs Advertising and promotion-related expenses are charged to operations when incurred. Advertising expense for 1997, 1996 and 1995 was approximately $609,000, $613,000 and $173,000, respectively. Financial instruments The carrying amounts of the Company's financial instruments reflected in the consolidated balance sheets at December 31, 1997 and 1996 approximate their respective fair values. Concentrations of credit risk The Company's financial instruments exposed to concentrations of credit risk consist primarily of cash and receivables. Cash balances, exceeding the federally insured limits, are maintained in financial institutions; however, management believes the institutions are of high credit quality. The majority of receivables are due from companies which are well- established entities in the travel industry. Therefore, management considers the exposure from concentrations of credit risks to be limited. 21 Accounting for stock-based compensation Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123), encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has elected to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), and related Interpretations. Accordingly, compensation cost for stock options issued to employees is measured as the excess, if any, of the fair market value of the Company's stock at the date of grant over the amount the employee must pay to acquire the stock. Pro forma disclosure of net income (loss) based on the provisions of FAS 123 is discussed at Note 9. Stock splits A one hundred-for-one stock split was effected in June 1996. All references in the consolidated financial statements to shares, share prices, per share amounts and stock plans have been adjusted retroactively for the one hundred-for-one stock split. Additional information is presented in Note 8. In May 1997, the board of directors approved the declaration of a four-for-three stock split of the outstanding common and preferred stock effected in the form of a dividend to shareholders of record on the effective date of the Registration Statement on Form S-1 with respect to the Company's initial public offering (IPO) (see Note 8). Concurrent with the IPO, the number of authorized shares of common stock of the Company increased from 20 million to 100 million while the number of authorized shares of preferred stock remained two million. All references in the consolidated financial statements to shares, share prices, per share amounts and stock plans have been adjusted retroactively for the four-for-three stock split. Foreign Currency Translation The U.S. dollar is the functional currency for the Company's foreign operations. Gains and losses on the translation into U.S. dollars of amounts denominated in foreign currencies are included in net income. Net income (loss) per share The Company has adopted Statement of Financial Accounting Standards No. 128, "Earnings per Share" (FAS 128). FAS 128 simplifies the standards for computing EPS previously found in Accounting Principles Board No. 15, "Earnings per Share" (APB 15), and makes them comparable to international EPS standards by replacing the presentation of primary EPS with a presentation of basic EPS. The provisions and disclosure requirements for FAS 128 were required to be adopted for interim and annual periods ending after December 15, 1997, with restatement of EPS for prior 22 periods. Accordingly, EPS data for all periods presented has been restated to reflect the computation of EPS in accordance with the provisions of FAS 128. 2. Reorganization Effective in July 1995, the Company issued 4,934,667 shares of its common stock in exchange for all of the outstanding capital stock of THISCO and 83.3% of the outstanding capital stock of HCC (the Reorganization). Lodging Network, Inc. (LNI) retained 210 shares of HCC preferred stock, representing a 16.7% minority ownership interest in HCC. In conjunction with the Reorganization, LNI was granted an option (LNI Option), expiring in July 1998, to exchange its 16.7% ownership interest in HCC for 448,667 shares of the Company's common stock. The LNI Option was subsequently canceled in June 1996, as part of the purchase of all of LNI's minority interest ownership in HCC by the Company (see Note 3). The Company incurred expenses of approximately $194,000 related to the Reorganization. Such expenses have been included in the general and administrative expenses in the Company's statement of operations for the year ended December 31, 1995. The Reorganization brought THISCO and HCC together under the control of Pegasus and was initiated to integrate and expand the existing businesses of THISCO and HCC. Pegasus was formed immediately prior to the transaction for the purpose of combining the two operations into a single operating entity. Prior to the Reorganization, THISCO and HCC were primarily controlled by a common (though not identical) group of shareholders and a common management group. For accounting purposes, the Reorganization was treated as an acquisition of HCC and accounted for as a purchase business combination. Accordingly, the HCC assets acquired and liabilities assumed have been recorded at their fair values at the date of acquisition. The amount of the purchase price ($2.7 million) in excess of the fair value of net assets acquired has been recorded as goodwill and will be amortized on a straight-line basis over 15 years (see Note 3). The Company's consolidated financial statements include the consolidated accounts and operations of THISCO and HCC for all periods subsequent to the July 1995 acquisition date. Prior to the Reorganization, HCC had a special bonus plan for the management of HCC. As part of the Reorganization, management of HCC agreed to forfeit its rights to participate in the bonus plan to HCC in return for a cash payment and the opportunity to purchase an aggregate of 283,333 shares of the Company's common stock for $570,874. Compensation expense in the amount of $570,874 related to this transaction has been included in the net loss for the year ended December 31, 1995. These shares are restricted and are subject to repurchase upon termination of employment (see Note 8). 23 3. Acquisition In July 1995, the Company acquired 83.3% of HCC (the Acquisition) in exchange for 2,242,800 shares of the Company's common stock. HCC markets and operates an automated commission payment service which settles electronic bookings for travel agencies and hotel chains. HCC acts as a clearinghouse to consolidate, collect and pay member travel agent commissions for participating hotels. The Acquisition was recorded under the purchase method of accounting, and accordingly, the results of operations of HCC for all periods subsequent to the Acquisition date are included in the accompanying consolidated financial statements. The fair value of HCC was determined based on certain arm's length equity transactions occurring shortly before the Reorganization. The purchase price of approximately $2,744,000 has been allocated to assets acquired and liabilities assumed based on estimated fair value at the date of the Acquisition. The approximate fair value of assets acquired and liabilities assumed at the date of acquisition, after giving effect to the write off of certain purchased research and development, is summarized as follows: Current assets $ 505,000 Software $ 3,523,000 Property and equipment $ 245,000 Goodwill $ 1,746,000 Other noncurrent assets $ 18,000 Current liabilities $ (1,034,000) Long-term liabilities $ (2,089,000) Minority interest $ (1,393,000)
Approximately $1,223,000 was allocated to in-process research and development projects that at the time of the Acquisition had not reached technological feasibility and had no probable alternative future use. Such amount of in- process research and development was charged to expense at the date of acquisition. In addition, as indicated above, $3,523,000 was allocated to software and is being amortized over a three year period ending June 1998. The balance of the purchase price paid, approximately $1,746,000, was recorded as the excess of cost over the fair value of net assets acquired (goodwill) and is being amortized on a straight-line basis over a 15 year period ending June 2010. Results of operations of HCC after the date of the Acquisition are included in the 1995 Consolidated Statement of Operations. Assuming the Acquisition took place at January 1, 1995, the pro forma net revenues would have been approximately $11,455,000, and the pro forma net loss would have been approximately $4,071,000. The pro forma information for 1995 includes adjustments for additional amortization based on the fair market value of the 24 acquired software and the goodwill arising from the transaction. The pro forma financial information is not necessarily indicative of the operations as they would have been had the transaction been effected on the assumed date. In June 1996, the Company purchased 210 shares of HCC preferred stock from LNI for $2,000,000 cash and 89,733 shares of Pegasus common stock. The 210 HCC preferred shares purchased represented a 16.7% minority ownership of HCC. After the purchase, Pegasus owned 100% of the outstanding shares of HCC. The transaction was accounted for as a purchase. The price paid in excess of the minority interest value of $1,445,245 on the date of purchase was approximately $833,000 and was accounted for as $119,000 of goodwill to be amortized ratably over a 15 year period, with the remaining excess allocated to $245,000 of in-process research and development costs and $469,000 of step-up in the fair value of capitalized software costs. Such amount of in-process research and development was charged to expense at the date of acquisition. The fair value of the Company's common stock given as consideration was determined using an independent valuation. 4. Accounts Receivable HCC collects travel agents' commissions from hotel chains and, after retaining a portion of these commissions as a fee for services, remits the net commissions to the travel agents. At December 31, 1997 and 1996, trade accounts receivable were stated net of commissions of $14,309,063 and $8,149,815, respectively. Net accounts receivable from affiliates included in the accompanying consolidated balance sheets were as follows at December 31:
1997 1996 ------ ------ Amounts due to THISCO from hotel chains $551,685 $702,612 Amounts due to TravelWeb from hotel chains 173,591 11,152 Amounts due to HCC from hotel chains 37,744 34,606 Employee travel advances 8,953 6,035 Accounts receivable from affiliates $771,973 $754,405
5. Property and Equipment Property and equipment at December 31 consisted of the following:
1997 1996 ------ ------ Computer equipment $ 4,985,455 $ 4,261,482 Furniture and equipment 677,183 640,507 Office equipment 974,851 712,245 Leasehold improvements 97,379 93,777 6,734,868 5,708,011 Less: accumulated depreciation (4,022,777) (2,706,999) Property and equipment, net $ 2,712,091 $ 3,001,012
25 In 1995, the Company purchased assets previously recorded as capital leases. These capitalized assets were being amortized over the life of the lease, which was due to expire in the first quarter of 1996. The Company financed the purchase of the assets and extended the assets' estimated lives by one year. The effect of these changes was to decrease net income during 1997 by $36,000, increase the net loss during 1996 by $72,000 and to decrease the net loss during 1995 by approximately $108,000. 6. Capital Leases Assets recorded under capital leases, primarily consisting of computer equipment, are recorded at the lower of the present value of future minimum lease payments or the fair value of the asset. In 1995, the Company charged off $246,000 related to switch equipment which was considered obsolete. The assets were written down to the estimated salvage value of approximately $20,000. Total assets recorded under capital leases in 1997 and 1996 were approximately $3,747,000 and $3,829,000, respectively, net of accumulated amortization of $2,531,000 and $1,591,000, respectively. Amortization of assets under capital leases is included in depreciation and amortization expense. Future minimum lease payments and related interest are as follows: Year Ending December 31, 1998 $ 1,193,469 1999 635,214 2000 58,631 Aggregate minimum lease payments 1,887,314 Less: amount representing interest (178,086) 1,709,228 Less current portion (1,048,179) $ 661,049
Interest rates on capital leases range from approximately 7% to 15%. Interest expense on capital leases for the years ended December 31, 1997, 1996 and 1995 was approximately $277,000, $351,000 and $238,000, respectively. 26 7. Notes Payable to Affiliates Notes payable to affiliates at December 31, 1996 consisted of the following:
1996 ---- Note payable to shareholder, bearing interest at prime plus 2.0% on the last day of the previous quarter (the prime rate at September 30, 1995 and 1996 was 8.75% and 8.25%, respectively); principal and accrued interest due in full June 30, 2001 $4,261,482 Notes and accrued interest payable to shareholders, bearing interest at prime plus 1.0%; principal and accrued interest due in full July 21, 2000, (the prime rate at December 31, 1995 and 1996 was 8.5% and 8.25%, respectively) 554,474 Notes and accrued interest payable to shareholders, bearing interest at prime plus 1.0%; principal and accrued interest due in full July 21, 2000 (the prime rate at December 31, 1995 and 1996 was 8.5% and 8.25%, respectively) 573,129 5,389,085 Less current portion (785,517) $4,603,568
In August 1997, the Company repaid all outstanding principal and accrued interest of the notes payable from the proceeds of the Company's initial public offering (see Note 8). Total principal and interest paid during 1997 was $5,253,662 and $456,932, respectively. During 1996, the Company paid interest totaling $478,000. Interest expense related to these notes was approximately $322,000, $539,000 and $578,000 during the years ended December 31, 1997, 1996 and 1995, respectively. In July 1995, simultaneous with the acquisition of HCC, the Company negotiated new note agreements with all but one shareholder. The new note agreements, representing obligations of subsidiaries guaranteed by Pegasus, converted $450,000 in principal to additional paid-in capital, financed $255,203 of unpaid interest, reduced the interest rate from prime plus two percent to prime plus one percent and extended the due dates from December 31, 1995 to July 21, 2000. The note agreement related to the one shareholder which was not renegotiated was reduced in principal by $75,000 in exchange for Pegasus agreeing to guarantee the remaining THISCO debt. The reduction of principal was recorded as a capital contribution. 8. Shareholders' Equity During 1995, the Company issued 283,333 shares of restricted common stock to certain members of management in connection with the termination of the HCC special bonus plan (see Note 2). A compensation charge was recorded in 1995 for the fair value of the shares issued. For a period of three years from date of issuance, these shares cannot be sold. If an employee leaves the Company, the Company has the right to repurchase the shares at the lesser of fifty percent of 27 the original purchase price or the current market value. During 1996, the Company repurchased 25,467 shares from a terminated employee. As a result of the Reorganization, effective July 1995, certain shareholders exchanged shares of THISCO for shares of Pegasus. Additionally, in order to effect the purchase of HCC, the Company issued Pegasus shares to HCC shareholders in exchange for 83.3% of the outstanding capital stock of HCC. Some of the Pegasus shares exchanged for HCC shares were subject to repurchase. The repurchase was based upon an agreement by the HCC shareholders that some value for the HCC shares exchanged should be assigned based upon the number of transactions that an HCC shareholder committed to process through HCC in 1996. If a shareholder did not fulfill its commitment by processing the agreed number of transactions through HCC in 1996, the Company had the option to repurchase such shares for $0.01 per share. The total number of shares repurchased from each shareholder is based upon the percentage of their transaction commitment actually processed by HCC during 1996. Effective December 31, 1996, the Company repurchased 91,017 shares of the 477,733 shares subject to repurchase. In conjunction with the Reorganization described in Note 2, LNI was granted an option, expiring in July 1998, to exchange its 210 shares of HCC preferred stock for 448,667 shares of the Company's common stock. The option was canceled in June 1996 in conjunction with the Company's purchase of LNI's minority interest in HCC. In June 1996, the Company declared a one hundred-for-one stock split effected in the form of a stock dividend to stockholders of record on that date (See Note 1). The number of common shares the Company is authorized to issue was also increased from 100,000 to 20 million and the number of authorized preferred shares was increased from 10,000 to 2 million. In June 1996, Information Associates, L.P. and Information Associates, C.V. purchased 1,538,462 shares of the Company's Series A preferred stock (par value $0.01) for $4.88 per share or $7,500,005. Total shares outstanding increased from 5,191,249 (including the 89,733 issued to LNI as part of the purchase of minority interest in HCC) to 6,729,712 shares, with the Information Associates, L.P. and Information Associates, C.V. ownership. The Series A preferred shares carry special provisions which include: conversion rights to exchange one share of Series A preferred stock for one share of Pegasus common stock; the right to elect two of nine persons to the board of directors; preferred status as to the payment of any dividends that are declared by the board of directors; and preferred status in the event of any liquidation, dissolution or winding up of the corporation. 28 The Company completed an initial public offering (IPO) in August 1997. The Company's Registration Statement on Form S-1 (File No. 333-28595) with respect to the IPO was declared effective on August 6, 1997, and the Company's stock began trading on the Nasdaq National Market under the symbol PEGS on August 7, 1997. The Company sold 3,450,000 shares of common stock at a per share price of $13.00. Net proceeds to the Company, after deduction of the underwriting discount and estimated IPO expenses, were approximately $40.5 million. Selling shareholders also sold 659,000 shares at a per share price of $13.00. Net proceeds to the shareholders after deduction of the underwriting discount were approximately $8.0 million. The Company did not receive any proceeds from the sale of shares by the selling shareholders. Concurrent with the completion of the Company's IPO, a 4-for-3 split of the Company's outstanding common and Series A preferred stock was effected (See Note 1) and all outstanding shares of Series A preferred stock were converted into shares of common stock. 9. Stock-Based Compensation The Company's 1996 stock option plan, as amended and restated, was approved by the board of directors and the shareholders in March 1997 and authorizes the grant of up to 866,667 shares of the Company's common stock in the form of incentive stock options (ISOs) and nonqualified stock options. The plan is administered and grant prices are determined by the Stock Option Committee of the board of directors (Committee). Options normally extend for a period of 10 years and under Committee policy become exercisable in installments of 25% per year commencing one year from the date of grant, or over a vesting period determined by the Committee. Shares granted come from the Company's authorized but unissued or reacquired common stock. In 1996, the Company issued to executives and employees options to purchase an aggregate of 771,740 shares of common stock. These options will become exercisable over a period of four years. In September 1997, options to purchase 44,000 shares of common stock at an exercise price of $15.30 were issued under the 1996 plan to executives and employees. The options will become exercisable over a period of four years. The Company's 1997 stock option plan was approved by the board of directors and shareholders in March 1997 and authorizes the issuance of up to 333,333 shares of the Company's common stock in the form of ISO's and nonqualified stock options to employees of the Company. The board of directors amended the 1997 stock option plan in September 1997, subject to shareholder approval which is expected to occur at the 1998 annual shareholders meeting, to provide for the annual grant to the Company's non-employee directors of options to purchase the Company's common stock. In September 1997, options to purchase an aggregate of 203,000 shares of common stock at an exercise price of $15.30 were issued under the 1997 plan to executives and employees. Also, options to 29 purchase an aggregate of 16,000 shares of common stock at the same exercise price of $15.30 were issued under the 1997 plan to non-employee directors. The executive and employee options will become exercisable over a period of four years. The non-employee director options will become exercisable at the 1998 annual shareholders meeting, which is a period of approximately eight months from the date of grant. The Company has accounted for options issued in 1997 and 1996 under the 1997 and 1996 plans, using the intrinsic value method prescribed in APB 25. Accordingly, unearned compensation related to the options is being recognized ratably over the related vesting periods The Company has adopted the disclosure-only provisions of FAS 123. As discussed in Note 1, the Company has elected to continue to account for stock-based compensation using the intrinsic value method prescribed in APB 25. Accordingly, in 1997 and 1996 unearned compensation of $450,847 and $551,150, respectively, related to options is being recognized ratably over the vesting period for stock option grants with exercise prices which are less than fair market value of the stock at the date of grant. Compensation expense of $198,251 and $65,213 was charged to operations in 1997 and 1996, respectively. There were no stock option awards granted prior to 1996; however, had compensation cost for the Company's stock option plan been determined based on the fair value at the grant date for awards issued in 1997 and 1996 consistent with the provisions of FAS 123, the Company's net income (loss) and net income (loss) per share would have been increased to the pro forma amounts indicated below:
1997 1996 ---- ---- Net income (loss) - as reported $589,460 $(3,484,801) Net income (loss) - pro forma $334,589 $(3,511,531) Net income (loss) per share - as reported: Basic $0.08 $(0.66) Diluted $0.07 $(0.66) Net income (loss) per share - as adjusted for pro forma impact of FAS 123: Basic $0.05 $(0.67) Diluted $0.04 $(0.67)
The weighted average fair value at date of grant for options granted during 1997 and 1996 was $8.51 and $1.22 per option. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used: 30
1997 1996 ---- ---- Dividend yield -- -- Expected volatility: Pre-IPO grants 0.0% 0.0% Post-IPO grants 65.0% -- Risk-free rate of return 6.1% 6.5% Expected life 4.9 years 4.0 years
The following table summarizes activity under the Company's stock option plans during the years ended December 31, 1997 and 1996:
Weighted Average Price Options Exercise Price Per Share ------- -------------- --------- Outstanding at December 31, 1995 -- -- -- Granted 771,740 $2.01 - $3.11 $2.39 Canceled -- -- -- Outstanding at December 31, 1996 771,740 $2.01 - $3.11 $2.39 Granted 331,666 $5.25 - $15.30 $13.49 Exercised 1,333 $3.11 $3.11 Canceled 19,795 $3.11 - $15.30 $4.34 Outstanding at December 31, 1997 1,082,278 $2.01 - $15.30 $5.75 Options exercisable at December 31, 1997 263,434 $2.01 - $3.11 $2.33
Options Outstanding at Remaining Exercise Prices December 31, 1997 Contractual Life - --------------- ----------------- ---------------- $ 2.01 503,333 8.0 years $ 3.11 249,279 8.0 years $ 5.25 53,333 8.0 years $11.05 - $15.30 276,333 8.8 years
31 10. Income Taxes Pretax income (loss) from continuing operations for the years ended December 31 was taxed under the following jurisdictions:
1997 1996 1995 ---- ---- ---- Domestic $ 519,459 $(3,528,503) $(3,527,122) Foreign 97,917 58,702 (43,782) ----------- ----------- ----------- $ 617,376 $(3,469,801) $(3,570,904)
Deferred taxes consisted of the following at December 31:
1997 1996 ---- ---- Deferred tax assets: Net operating loss carryforward $ 4,214,785 $ 4,975,949 Bad debt reserves 26,473 15,234 Depreciation and amortization -- 1,896 Stock option compensation expense 81,873 22,172 Rent expense 82,552 37,213 Various expense accruals 42,160 53,793 Other 10,801 2,164 Total gross deferred tax assets 4,458,644 5,108,421 Valuation allowance (4,312,266) (4,549,452) Deferred tax liabilities: Software amortization (79,850) (558,969) Depreciation and amortization (66,528) -- Net deferred tax asset $ -- $ --
The net deferred tax asset is fully reserved because of uncertainty regarding the Company's ability to recognize the benefit of the asset in future years. At December 31, 1997, 1996 and 1995, the Company had net operating loss carryforwards of approximately $12,396,000, $14,635,000, and $13,162,000, respectively, which begin to expire in 2003, if not previously utilized. Utilization of the net operating loss carryforwards may be limited by the separate return loss year rules and could be affected by ownership changes which have occurred or could occur in the future. The components of the income tax provision for the years ended December 31 were as follows:
1997 1996 1995 ---- ---- ---- Current provision: Federal $ 51,525 $ -- $ -- Foreign 27,916 15,000 -- 79,441 15,000 -- Deferred provision (benefit): Federal (51,525) -- -- Provision for income taxes $ 27,916 $15,000 $ --
32 A reconciliation of taxes based on the federal statutory rate of 34.0% and the Company's effective rate for income taxes is summarized as follows for the years ended December 31:
1997 1996 1995 ---- ---- ---- Income taxes (benefit) at the federal statutory rate 34.0% (34.0%) (34.0%) Valuation allowance (38.4%) 29.4% 19.8% Permanent differences 9.8% 5.1% 14.3% Other, net (0.9%) (0.5%) (0.1%) Provision for income taxes 4.5% 0.0% 0.0%
11. Commitments and Contingencies The Company leases its corporate office space and certain office equipment under non-cancelable operating leases. The Company incurred rent expense of approximately $720,000, $697,000 and $318,000 in 1997, 1996 and 1995, respectively. Approximate future minimum lease payments at December 31, 1997, under non-cancelable operating leases with original terms exceeding one year, including the Pegasus UK operating lease translated at the rate in effect at December 31, 1997, were as follows: Year Ending December 31, 1998 $ 612,000 1999 579,000 2000 557,000 2001 557,000 2002 552,000 Thereafter -- $2,857,000
In June 1993, HCC received $2,000,000 from Citicorp in exchange for a five-year non-cancelable data processing contract and recorded the amount as deferred income. The non-cancelable contract requires Citicorp to process transactions and generate various reports in exchange for a processing fee. The contract requires HCC to maintain an annual minimum volume of transactions. If the annual minimum volume is not attained, HCC is required to pay Citicorp an additional processing fee for each transaction under the minimum volume. At the date of the Acquisition, there was approximately $1,583,000 of deferred income to be amortized over the remaining life of the contract according to the volume of guaranteed transactions, as defined by the contract. During 1997, 1996 and 1995, the Company recognized approximately $471,000, $431,000 and $210,000, respectively, of the deferred income. However, because the Company did not meet its annual minimum volume of transactions during 1995, it also recorded an additional processing fee of approximately $44,700 for the year ended December 31, 1995. In 1997 and 1996, the Company exceeded the annual minimum volume requirement. 33 In May 1997, the Company issued a warrant to a customer for the purchase of 345,723 shares of the Company's common stock as part of a five year contract involving a wide range of the Company's services. The warrant is exercisable during the two year period ended May 12, 1999 at an exercise price of $7.20 per share. The Company used the Black-Scholes option pricing model to value the warrant. A contract asset of $238,000 was recorded in May 1997, which is amortized ratably over the associated five year contract period. 12. Employee Benefit Plan The Company sponsors a 401(k) defined contribution retirement plan (401(k) Plan) covering full-time employees who have attained the age of twenty-one. Employees may elect to participate at the beginning of any calendar quarter after their hire date. Effective January 1, 1995, the 401(k) Plan was amended to change the pro rata vesting schedule from two to five years. The sponsor can make discretionary matching contributions up to five percent of employees' annual contributions. During 1997, 1996 and 1995, the Company contributed approximately $217,000, $160,000 and $101,000, respectively, to the 401(k) Plan. Prior to the Acquisition of HCC by THISCO, both companies participated in the 401(k) Plan. Accordingly, prior to the Acquisition, HCC contributed $18,000 in 1995. 13. Employee Stock Purchase Plan In September 1997, the Company's Board of Directors adopted the Pegasus Systems, Inc. 1997 Employee Stock Purchase Plan subject to shareholder approval, which is expected to occur at the 1998 annual meeting of the Company's shareholders. The Company has reserved 500,000 shares of its common stock for purchase by its employees pursuant to the terms of this plan. Eligible participating employees of the Company may elect to have an amount up to, but not in excess of, 10% of their regular salary or wages withheld for the purpose of purchasing the Company's common stock. Under the 1997 Employee Stock Purchase Plan, an eligible employee who participates in the Plan will be granted an option at the beginning of each year of the Plan (the "Offering Commencement Date") to purchase at the end of that year (the "Offering Termination Date") shares of common stock using the amounts that have accumulated from the employee's payroll deductions made during that year at a price that is 85% of the closing price of the common stock on the Nasdaq National Market (or any other national securities exchange) on the Offering Commencement Date or the Offering Termination Date, whichever is lower. 34 14. Related Parties As explained in Note 1, the Company derives a substantial portion of its revenue from shareholders and shareholder-owned companies through the operation of its international automated interface called Ultraswitch. Also, as a result of the Acquisition of HCC in July 1995, a significant portion of the Company's revenue is generated indirectly by shareholders as a function of the Company's role as the consolidator and payor of commissions to travel agencies. The Company receives a fee from hotels for consolidating and remitting commission payments to travel agencies on behalf of the hotel properties and receives a fee from travel agencies through the retention of a percentage of commission payments remitted to travel agencies. A summary of revenues is as follows:
1997 1996 1995 ----------------------- ----------------------- ---------------------- Source of Revenue Amount % Amount % Amount % ----------- ----- ----------- ----- ---------- ----- Shareholders - direct $7,428,143 35.5% $6,458,380 40.7% $4,935,785 53.1% Shareholders - indirect 8,315,868 39.8% 5,503,065 34.7% 2,450,326 26.4% Total generated by shareholders directly and indirectly 15,744,011 75.3% 11,961,445 75.4% 7,386,111 79.5% All other revenue 5,159,405 24.7% 3,907,567 24.6% 1,909,617 20.5% Total $20,903,416 100.0% $15,869,012 100.0% $9,295,728 100.0%
A shareholder provides services to the Company, including facility management, consulting and software development. During 1997, 1996 and 1995, the Company recognized expense in the amount of approximately $488,000, $774,000 and $495,000, respectively, for those services. Persons related to an officer of the Company have provided printing, design and procurement services to the Company. During 1997, 1996 and 1995, the Company paid approximately $6,000, $143,000 and $48,000, respectively, relating to these services, the majority of which related to capitalized furniture purchases. 15. Net Income (Loss) Per Share In February 1997, Statement of Financial Accounting Standards No. 128, "Earnings per Share" (FAS 128), was issued. FAS 128 specifies the computation, presentation and disclosure requirements for earnings per share (EPS) for entities with publicly held common stock or potential common stock. FAS 128 is effective for financial statements issued for periods ending after December 15, 1997, including interim periods; earlier application was not permitted. Once adopted, FAS 128 requires restatement of all prior-period EPS data presented. Basic net 35 income (loss) per share for the years ended December 31, 1997, 1996 and 1995 has been computed in accordance with FAS 128 using the weighted average number of common shares outstanding after giving retroactive effect to the stock splits effected in August 1997 and June 1996. Diluted net income per share for the year ended December 31, 1997 and diluted net loss per share for the years ended December 31, 1996 and 1995 give effect to all dilutive potential common shares that were outstanding during the periods. The Company has a net income for the year ended December 31, 1997; therefore, all options or warrants outstanding throughout the year were included in the diluted net income per share calculations when they were dilutive. The Company had a net loss for the years ended December 31, 1996 and 1995; therefore, none of the options outstanding at period ends were included in the diluted net loss per share calculations for years ended December 31, 1996 and 1995, since they were anti-dilutive. The following table sets forth the basic and diluted net income (loss) per share computation for the year ended December 31:
1997 1996 1995 ---- ---- ---- Net income (loss) $ 589,640 $(3,484,801) $(3,570,904) Basic: Weighted average number of shares outstanding 7,200,382 5,246,800 2,751,940 Net income (loss) per share $ 0.08 $ (0.66) $ (1.30) Diluted: Weighted average number of shares outstanding 7,200,382 5,246,800 2,751,940 Additional weighted average shares from assumed conversion of dilutive convertible preferred stock to common stock, net of shares to be repurchased with exercise proceeds 921,355 -- -- Additional weighted average shares from assumed exercise of dilutive stock options and warrants, net of shares to be repurchased with exercise proceeds 554,315 -- -- Weighted average number of shares outstanding used in the diluted net income (loss) per share calculation 8,676,052 5,246,800 2,751,940 Net income (loss) per share $ 0.07 $ (0.66) $ (1.30)
There were no options or warrants outstanding at December 31, 1995. There were 1,538,462 shares of Series A preferred stock outstanding at December 31, 1996 which were not included in the computation of diluted EPS. None of the options 36 granted during 1997 or 1996 were excluded from the diluted EPS calculation for the year ended December 31, 1997, as the average fair market value used in the period calculations was higher than the strike price of the underlying options or warrants. Options granted during 1996, which were not included in the computation of diluted EPS for the year ended December 31, 1996, were as follows:
Exercise Price Number of Options Per Share Date of Grant Expiration Date - ----------------- --------- ------------- --------------- 450,000 $2.01 June 1996 December 2005 53,333 $2.01 December 1996 December 2005 268,400 $3.11 December 1996 December 2005
16. Subsequent Events The Company completed a secondary offering ("Secondary") in February 1998. The Company's Registration Statement on Form S-1 with respect to the Secondary was declared effective February 11, 1998. The Company sold 280,321 shares of common stock at a per share price of $17.50. Net proceeds to the Company, after deduction of the underwriting discount and estimated Secondary expenses, were approximately $4.2 million. Selling shareholders also sold 2,134,679 shares at a per share price of $17.50. Net proceeds to the shareholders, after deduction of the underwriting discount, were approximately $35.2 million. The Company did not receive any proceeds from the sale of shares by the selling shareholders. 37 Reports of Independent Accountants To the Board of Directors and Shareholders of Pegasus Systems, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and changes in shareholders' equity (deficit) and of cash flows present fairly, in all material respects, the financial position of Pegasus Systems, Inc. and its subsidiaries at December 31, 1997 and 1996, and the results of their operations and their cash flows for the two years ended December 31, 1997, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE LLP Dallas, Texas March 12, 1998 38 To the Board of Directors and Shareholders of Pegasus Systems, Inc. We have audited the accompanying consolidated statements of operations, changes in shareholders' equity (deficit) and cash flows of Pegasus Systems, Inc. and its subsidiaries (the Company) for the year ended December 31, 1995. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the Company's results of operations and cash flows for the year ended December 31, 1995 in conformity with generally accepted accounting principles. BELEW AVERITT LLP Dallas, Texas March 2, 1996, except for Note 8, as to which the date is August 6, 1997 and Note 15, as to which the date is January 26, 1998 39 EX-23.1 3 CONSENT OF PRICE WATERHOUSE LLP 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in this Annual Report on Form 10-K of our report dated March 12, 1998, which appears in the 1997 Annual Report to Shareholders of Pegasus Systems, Inc., which is incorporated by reference in Pegasus Systems, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1997. We also consent to the incorporation by reference in the Registration Statements on Form S-8 (Nos. 333-40039, 333-40033 and 333-40035) of Pegasus Systems, Inc. of our report dated March 12, 1998 appearing in Pegasus System's Inc.'s 1997 Annual Report to Shareholders which is incorporated by reference into Pegasus Systems, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1997. We also consent to the incorporation by reference of our report on the Financial Statement Schedule, which appears on page S-1 of such Annual Report on Form 10-K. PRICE WATERHOUSE LLP Dallas, Texas March 31, 1998 EX-23.2 4 CONSENT OF BELEW AVERITT LLP 1 EXHIBIT 23.2 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in this Annual Report (Form 10-K) of Pegasus Systems, Inc. of our report dated March 2, 1996, except for Note 8, as to which the date is August 6, 1997 and Note 15, as to which the date is January 26, 1998, included in the 1997 Annual Report to Shareholders of Pegasus Systems, Inc. We also consent to the incorporation by reference of our report on the Financial Statement Schedule, which appears on page S-1 of such Annual Report on Form 10-K. Belew Averitt LLP Dallas, Texas March 31, 1998 EX-27.1 5 FINANCIAL DATA SCHEDULE
5 This schedule contains summary financial information extracted from Company's form 10K for the year ended December 31, 1997 filed March 31, 1998 with Securities and Exchange Commission and is qualified in its entirety by reference to such 10K. 1,000 YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 31,453 9,380 2,050 78 0 44,038 16,093 12,197 49,923 5,641 661 0 0 103 43,375 49,923 0 20,903 0 7,445 2,504 81 600 617 28 589 0 0 0 589 0.08 0.07
-----END PRIVACY-ENHANCED MESSAGE-----