10-Q 1 k07492e10vq.txt QUARTERLY REPORT FOR THE PERIOD ENDED JUNE 30, 2006 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006 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 000-20900 COMPUWARE CORPORATION --------------------- (Exact name of registrant as specified in its charter) MICHIGAN 38-2007430 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) ONE CAMPUS MARTIUS, DETROIT, MI 48226-5099 (Address of principal executive offices including zip code) Registrant's telephone number including area code: (313) 227-7300 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Indicate the number of shares outstanding of each of the issuer's class of common stock, as of the latest practicable date: As of July 31, 2006, there were outstanding 372,520,796 shares of Common Stock, par value $.01, of the registrant. Page 1 of 32 pages
Page ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets as of June 30, 2006 and March 31, 2006 3 Condensed Consolidated Statements of Operations for the three months ended June 30, 2006 and 2005 4 Condensed Consolidated Statements of Cash Flows for the three months ended June 30, 2006 and 2005 5 Notes to Condensed Consolidated Financial Statements 6 Report of Independent Registered Public Accounting Firm 18 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 19 Item 3. Quantitative and Qualitative Disclosures about Market Risk 29 Item 4. Controls and Procedures 29 PART II. OTHER INFORMATION Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 30 Item 6. Exhibits 31 SIGNATURES 32
2 COMPUWARE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
JUNE 30, MARCH 31, ASSETS 2006 2006 ---------- --------- (UNAUDITED) CURRENT ASSETS: Cash and cash equivalents $ 610,890 $ 612,062 Investments 285,699 265,131 Accounts receivable, net 391,016 418,745 Deferred tax asset, net 30,709 32,015 Income taxes refundable, net 72,923 77,956 Prepaid expenses and other current assets 27,606 24,455 Building - held for sale 13,000 14,816 ---------- ---------- Total current assets 1,431,843 1,445,180 ---------- ---------- INVESTMENTS 23,141 32,149 ---------- ---------- PROPERTY AND EQUIPMENT, LESS ACCUMULATED DEPRECIATION AND AMORTIZATION 391,730 395,653 ---------- ---------- CAPITALIZED SOFTWARE, LESS ACCUMULATED AMORTIZATION 66,983 61,918 ---------- ---------- OTHER: Accounts receivable 194,268 206,964 Deferred tax asset, net 13,781 13,983 Goodwill 334,594 320,082 Other 35,933 35,039 ---------- ---------- Total other assets 578,576 576,068 ---------- ---------- TOTAL ASSETS $2,492,273 $2,510,968 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 20,724 $ 24,468 Accrued expenses 148,223 170,590 Deferred revenue 374,930 350,349 ---------- ---------- Total current liabilities 543,877 545,407 DEFERRED REVENUE 319,612 343,246 ACCRUED EXPENSES 14,593 17,244 DEFERRED TAX LIABILITY, NET 28,380 25,572 ---------- ---------- Total liabilities 906,462 931,469 ---------- ---------- SHAREHOLDERS' EQUITY: Common stock 3,737 3,779 Additional paid-in capital 759,962 763,420 Retained earnings 811,504 805,781 Accumulated other comprehensive income 10,608 6,519 ---------- ---------- Total shareholders' equity 1,585,811 1,579,499 ---------- ---------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $2,492,273 $2,510,968 ========== ==========
See notes to condensed consolidated financial statements. 3 COMPUWARE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
THREE MONTHS ENDED JUNE 30, --------------------- 2006 2005 -------- -------- REVENUES: Software license fees $ 67,465 $ 68,022 Maintenance fees 110,317 107,374 Professional services fees 118,536 121,932 -------- -------- Total revenues 296,318 297,328 -------- -------- OPERATING EXPENSES: Cost of software license fees 6,585 5,687 Cost of professional services 107,615 106,245 Technology development and support 37,240 35,653 Sales and marketing 65,768 72,037 Administrative and general 46,228 48,229 -------- -------- Total operating expenses 263,436 267,851 -------- -------- INCOME FROM OPERATIONS 32,882 29,477 OTHER INCOME, NET 10,881 6,733 -------- -------- INCOME BEFORE INCOME TAXES 43,763 36,210 INCOME TAX PROVISION 14,442 11,587 -------- -------- NET INCOME $ 29,321 $ 24,623 ======== ======== Basic earnings per share $ 0.08 $ 0.06 ======== ======== Diluted earnings per share $ 0.08 $ 0.06 ======== ========
See notes to condensed consolidated financial statements. 4 COMPUWARE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
THREE MONTHS ENDED JUNE 30, ------------------------ 2006 2005 --------- --------- CASH FLOWS PROVIDED BY OPERATING ACTIVITIES: Net income $ 29,321 $ 24,623 Adjustments to reconcile net income to net cash provided by operations: Depreciation and amortization 13,393 12,842 Acquisition tax benefits 1,309 1,751 Stock option compensation 2,797 Deferred income taxes 4,700 7,280 Other (136) 4,469 Net change in assets and liabilities, net of effects from acquisitions: Accounts receivable 56,772 38,350 Prepaid expenses and other current assets (2,565) (2,705) Other assets 667 (680) Accounts payable and accrued expenses (32,393) (40,784) Deferred revenue (14,614) 6,461 Income taxes 4,626 (2,974) --------- --------- Net cash provided by operating activities 63,877 48,633 --------- --------- CASH FLOWS USED IN INVESTING ACTIVITIES: Purchase of: Businesses, net of cash acquired (20,484) (30,917) Property and equipment (2,663) (3,120) Capitalized software (5,486) (5,324) Proceeds from sale of property 2,016 Investments: Proceeds 125,816 100,904 Purchases (137,304) (79,077) --------- --------- Net cash used in investing activities (38,105) (17,534) --------- --------- CASH FLOWS USED IN FINANCING ACTIVITIES: Net proceeds from exercise of stock options 597 1,774 Contribution to stock purchase plans 1,504 2,405 Repurchase of common stock (32,839) (10,770) --------- --------- Net cash used in financing activities (30,738) (6,591) --------- --------- EFFECT OF EXCHANGE RATE CHANGES ON CASH 3,794 (4,912) --------- --------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (1,172) 19,596 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 612,062 497,687 --------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 610,890 $ 517,283 ========= =========
See notes to condensed consolidated financial statements. 5 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) NOTE 1 - BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements include the accounts of Compuware Corporation and its wholly owned subsidiaries (collectively, the "Company"). All intercompany balances and transactions have been eliminated in consolidation. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. Generally accepted accounting principles require management to make estimates and assumptions that affect the reported amounts of assets, liabilities, contingencies and results of operations. While management has based their assumptions and estimates on the facts and circumstances existing at June 30, 2006, final amounts may differ from these estimates. In the opinion of management of the Company, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, that are necessary for a fair presentation of the results for the interim periods presented. These financial statements should be read in conjunction with the Company's audited consolidated financial statements and notes thereto for the year ended March 31, 2006 included in the Company's Annual Report to Shareholders on Form 10-K filed with the Securities and Exchange Commission ("SEC"). The condensed consolidated balance sheet at March 31, 2006 has been derived from the audited financial statements at that date but does not include all information and footnotes required by GAAP for complete financial statements. The results of operations for interim periods are not necessarily indicative of actual results achieved for full fiscal years. Revenue Recognition - The Company earns revenue from licensing software products, providing maintenance and support for those products and rendering professional services. The Company's revenue recognition policies are consistent with GAAP including Statements of Position 97-2 "Software Revenue Recognition" and 98-9 "Modification of SOP 97-2, 'Software Revenue Recognition,' With Respect to Certain Transactions", Securities and Exchange Commission Staff Accounting Bulletin 104 and Emerging Issues Task Force Issue 00-21 "Revenue Arrangements with Multiple Deliverables". Accordingly, the Company recognizes revenue when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee is fixed or determinable, and collectibility is reasonably assured. Software license fees - The Company's software license agreements provide its customers with a right to use its software perpetually (perpetual licenses) or during a defined term (term licenses). Perpetual license fee revenue is recognized using the residual method, under which the fair value, based on vendor specific objective evidence ("VSOE") of all undelivered elements of the agreement (e.g., maintenance and professional services) is deferred. VSOE is based on rates charged for maintenance and professional services when sold separately. The remaining portion of the fee, net of discretionary discounts (the residual), is recognized as license fee revenue upon delivery of the products, provided that no significant obligations remain and collection of the related receivable is deemed probable. For term licenses and for agreements in which the fair value of the undelivered elements cannot be determined using VSOE, the Company recognizes the license fee revenue on a ratable basis over the term of the license agreement or when all elements have been delivered depending on the nature of the undelivered elements. The Company offers flexibility to customers purchasing licenses for its products and related maintenance. Terms of these transactions range from standard perpetual license sales that 6 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) include one year of maintenance to large multi-year (generally two to five years), multi-product contracts. The Company allows deferred payment terms on multi-year contracts, with installments collectible over the term of the contract. Based on the Company's successful collection history for deferred payments, the license fee portion of the receivable is discounted to its net present value and recognized as discussed above. The discount is recognized as interest income over the term of the receivable. Maintenance fees - The Company's maintenance agreements provide for technical support and advice, including problem resolution services and assistance in product installation, error corrections and any product enhancements released during the maintenance period. Maintenance is included with all license agreements for up to one year. Maintenance is renewable thereafter for an annual fee. Maintenance fees are deferred and recognized as revenue on a ratable basis over the maintenance period. Professional services fees - Professional services fees are generally based on hourly or daily rates; therefore, revenues from professional services are recognized in the period the services are performed, provided that collection of the related receivable is deemed probable. However, for development services rendered under fixed-price contracts, revenue is recognized using the percentage of completion method. Certain professional services contracts include a project and on-going support for the project. Revenue associated with these contracts is recognized over the support period as the customer derives value from the services, consistent with the proportional performance method. Capitalized Software - Capitalized software includes the costs of purchased and internally developed software products and is stated at the lower of unamortized cost or net realizable value in accordance with Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed". Capitalization of internally developed software products begins when technological feasibility of the product is established. Technology development and support includes primarily the costs of programming personnel associated with product development and support net of amounts capitalized. The amortization for both internally developed and purchased software products is computed on a product-by-product basis. The annual amortization is the greater of the amount computed using (a) the ratio of current gross revenues compared with the total of current and anticipated future revenues for that product or (b) the straight-line method over the remaining estimated economic life of the product, including the period being reported on. Amortization begins when the product is available for general release to customers. The amortization period for capitalized software is generally five years. 7 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) Goodwill and Other Intangibles - Goodwill that is allocated to each operating segment and those intangible assets with indefinite lives are tested for impairment annually and/or when events or circumstances indicate that their fair value may have been reduced below carrying value. The Company evaluated its goodwill as of March 31, 2006 and determined there was no impairment. Income Taxes - The Company accounts for income taxes using the asset and liability approach. Deferred income taxes are provided for the differences between the tax bases of assets or liabilities and their reported amounts in the financial statements. Stock-Based Compensation - Effective April 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123(R)") using the modified prospective transition method and therefore has not restated results for prior periods. Under this transition method, stock-based compensation expense for the first quarter of fiscal 2007 includes compensation expense for all stock-based compensation awards ("awards") granted prior to, but not yet vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). Stock-based compensation expense for all awards granted after April 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). The Company recognizes these compensation costs net of an estimated forfeiture rate on a straight-line basis over the requisite service period of the award, which is generally the vesting term of five years. In March 2005, the Securities and Exchange Commission (the "SEC") issued Staff Accounting Bulletin No. 107 ("SAB 107") regarding the SEC's interpretation of SFAS 123(R) and the valuation of share-based payments for public companies. The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R). See Note 5 to the condensed consolidated financial statements for a further discussion on stock-based compensation including the impact on net income during the period. Prior to the adoption of SFAS No. 123(R), the Company measured compensation expense for its stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"). Awards were granted at current market prices at the date of grant. Therefore, no compensation cost was recognized for the Company's fixed stock option plans or its stock purchase plans. The Company applied the disclosure provisions of SFAS No. 123, as amended by SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure", as if the fair-value-based method had been applied in measuring compensation expense. Recently Issued Accounting Pronouncements - In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes--an interpretation of FASB Statement No. 109", which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that the Company recognize in its financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. This Interpretation is effective for fiscal years beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. Management is currently considering the impact this Interpretation will have on the Company's financial statements. 8 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) NOTE 2 - ACQUISITION In April 2006, the Company acquired SteelTrace Limited, a privately held provider of requirements management products that align application delivery to business needs through a structured, visual approach to the management of enterprise application requirements, for approximately $20.0 million in cash. The acquisition has been accounted for using the purchase method in accordance with SFAS No. 141, "Business Combinations" and, accordingly, the assets and liabilities acquired have been recorded at preliminary fair value as of the acquisition date. The purchase price exceeded the fair value of the acquired assets and liabilities by $14.2 million and was recorded to goodwill. Intangible assets subject to amortization totaled $6.5 million of which $4.7 million and $1.5 million related to purchased software and customer relationships with a useful life of five and three years, respectively. The remaining intangible assets subject to amortization have a useful life of one year. NOTE 3 - COMPUTATION OF EARNINGS PER COMMON SHARE Earnings per common share data were computed as follows (in thousands, except for per share data):
Three Months Ended June 30, --------------------- 2006 2005 -------- -------- BASIC EARNINGS PER SHARE: Numerator: Net income $ 29,321 $ 24,623 -------- -------- Denominator: Weighted-average common shares outstanding 376,759 388,243 -------- -------- Basic earnings per share $ 0.08 $ 0.06 ======== ======== DILUTED EARNINGS PER SHARE: Numerator: Net income $ 29,321 $ 24,623 -------- -------- Denominator: Weighted-average common shares outstanding 376,759 388,243 Dilutive effect of stock options 768 1,680 -------- -------- Total shares 377,527 389,923 -------- -------- Diluted earnings per share $ 0.08 $ 0.06 ======== ========
During the three months ended June 30, 2006 and 2005, stock options to purchase a total of approximately 50,112,000 and 58,121,000 shares, respectively, were excluded from the diluted earnings per share calculation because they were anti-dilutive. 9 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) NOTE 4 - COMPREHENSIVE INCOME Other comprehensive income includes unrealized gains and losses on marketable securities and foreign currency translation gains and losses that have been excluded from net income and reflected in equity. Total comprehensive income is summarized as follows (in thousands):
Three Months Ended June 30, --------------------- 2006 2005 -------- -------- Net income $ 29,321 $ 24,623 Unrealized gain on marketable securities, net of tax 58 Foreign currency translation adjustment, net of tax 4,031 (2,216) -------- -------- Total comprehensive income $ 33,410 $ 22,407 ======== ========
NOTE 5 - STOCK BENEFIT PLANS AND STOCK-BASED COMPENSATION Employee Stock Purchase Plan - During fiscal 2002, the shareholders approved international and domestic employee stock purchase plans under which the Company was authorized to issue up to 15 million shares of common stock to eligible employees. Effective April 1, 2005, the offering periods were based on a three month period. Under the terms of the plan, employees can elect to have up to ten percent of their compensation withheld to purchase Company stock at the close of the offering period. The value of the stock purchased in any calendar year cannot exceed $25,000 per employee. Effective April 1, 2006, the purchase price is 95% of the last day's average high and low price for each offering period consistent with the non-compensatory requirements of SFAS 123(R). Employee Stock Option Plans - The Company adopted five employee stock option plans dating back to 1991. These plans provide for grants of options to purchase up to 91,000,000 shares of the Company's common stock to employees and directors of the Company. Under the terms of the plans, the Company may grant nonqualified options at the fair market value of the stock on the date of grant. Fifty percent of the option shares granted under these plans become exercisable on the third year anniversary of the date of grant, and 25 percent of the option shares vest on each of the fourth year and fifth year anniversaries of the date of grant. All options were granted at fair market value and expire ten years from the date of grant. In March 2001, the Company adopted the 2001 Broad Based Stock Option Plan. The plan was approved by the Board of Directors, but was not submitted to the shareholders for approval, as shareholder approval was not required at the time. The plan provides for grants of options to purchase up to 50,000,000 shares of the Company's common stock to employees or directors of the Company. Under the terms of the plan, the Company may grant nonqualified stock options at the fair market value of the stock on the date of grant. Option shares granted under the Broad Based Stock Option Plan either vest every six months over a four year period or fifty percent of the option shares become exercisable on the third year anniversary of the date of grant, and 25 percent of the option shares vest on each of the fourth year and fifth year anniversaries of the date of grant. All options were granted at fair market value and expire ten years from the date of grant. Non-Employee Director Stock Option Plan - In July 1992, the Company adopted the Stock Option Plan for Non-Employee Directors. Under this plan, 2,400,000 shares of common stock are reserved for issuance to non-employee directors of the Company who have not been employees of the Company, any subsidiary of the Company or any entity which controls more than 10% of the total combined voting power of the Company's capital stock for at least one year prior to becoming a director. 10 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) During fiscal 1999, the Company implemented a Replacement Stock Option Award program. The program allows selected participants to pay the option exercise price with shares of currently owned Company stock. The Company grants a new stock option award to replace the shares exchanged in the transaction. The following is a summary of the status of fixed stock option grants under Compuware's stock-based compensation plans as of June 30, 2006 and changes during the three months ended June 30, 2006 (intrinsic values and shares in thousands):
Three Months Ended June 30, 2006 ----------------------------------------------------- Weighted Weighted Average Average Remaining Aggregate Number of Exercise Contractual Intrinsic Options Price Term Value (1) --------- -------- ----------- --------- Options outstanding as of April 1, 2006 55,710 $ 11.66 Granted 611 7.58 Exercised (134) 3.68 $ 514 Forfeited (346) 6.67 Cancelled/expired (1,529) 10.78 --------- -------- Options outstanding as of June 30, 2006 54,312 $ 11.69 ========= ======== Options vested and expected to vest, net of estimated forfeitures, as of June 30, 2006 52,957 $ 11.80 3.79 $ 3,128 Options exercisable as of June 30, 2006 46,853 $ 12.41 3.25 $ 1,497
(1) For options exercised during the three months ended June 30, 2006, the aggregate intrinsic value represents the difference between the Company's closing stock price on the date the option was exercised and the exercise price, multiplied by the number of options exercised. For options vested and expected to vest, net of estimated forfeitures and options exercisable as of June 30, 2006, the aggregate intrinsic value represents the difference between the Company's closing stock price on the last trading day of the first quarter of fiscal 2007 and the exercise price, multiplied by the number of in-the-money options that would have been received by the option holders had the vested options been exercised on June 30, 2006. This amount changes based upon changes in the fair market value of the Company's stock. SFAS No. 123(R) requires the use of a valuation model to calculate the fair value of stock option awards. The Company has elected to use the Black-Scholes option pricing model, which incorporates various assumptions including volatility, expected term, and risk free interest rates. The volatility is based on historical volatility of the Company's common stock over the most recent period commensurate with the estimated expected term of the stock option granted. The Company uses historical volatility because management believes such volatility is representative of prospective trends. The expected term of an award is based on the "short-cut" method as described in SAB 107. The risk-free interest rate assumption is based upon observed interest rates appropriate for the expected term of our awards. The dividend yield assumption is based on the Company's history and expectation of dividend payouts. As of June 30, 2006, $17.4 million of total unrecognized compensation cost, net of estimated forfeitures, related to stock options is expected to be recognized over a weighted-average period of approximately 1.97 years. 11 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) The weighted-average fair value of stock options granted during the three months ending June 30, 2006 was determined utilizing the following assumptions:
Three Months Ended June 30, 2006 ------------------ Expected volatility 69.77% Risk-free interest rate 5.16% Expected lives at date of grant (in years) 6.9 Weighted-average fair value of the options granted $ 5.28
For the three months ending June 30, 2006 stock-based compensation expense was allocated as follows (in thousands):
Three Months Ended June 30, 2006 ------------------ Stock-based compensation classified as: Cost of professional services $ 419 Technology development and support 251 Sales and marketing 1,378 Administrative and general 749 ------------------ Total stock-based compensation expense before income taxes 2,797 Income tax benefit (923) ------------------ Total stock-based compensation expense after income taxes $ 1,874 ==================
12 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards using the intrinsic value method in accordance with APB 25. Under the intrinsic value method, no stock based compensation expense had been recognized in the results of operations for stock-based awards because the exercise price of the stock options granted equaled the fair market value of the underlying stock at the date of grant. By electing the modified prospective transition method allowed under SFAS 123(R), the Company's Consolidated Statements of Operations prior to fiscal 2007 have not been restated to reflect, and do not include, the impact of SFAS 123(R). If compensation cost for the Company's stock-based compensation plans had been determined based on the fair value at the grant dates for the three months ended June 30, 2005 consistent with the method prescribed by SFAS No. 123(R), the Company's net income and earnings per share would have been adjusted to the pro forma amounts indicated below (in thousands, except earnings per share data):
Three Months Ended June 30, 2005 ------------------ Net income: As reported $ 24,623 Compensation cost, net of tax (2,494) ------------------ Pro forma $ 22,129 ================== Earnings per share: As reported: Basic earnings per share $ 0.06 Diluted earnings per share 0.06 Pro forma: Basic earnings per share 0.06 Diluted earnings per share 0.06
The fair value of each option granted during the three months ended June 30, 2005 was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
Three Months Ended June 30, 2005 ------------------ Expected volatility 74.27% Risk-free interest rate 3.61% Expected lives at date of grant (in years) 5.0 Weighted average fair value of the options granted $ 4.32
Dividend yields were not a factor as the Company has never issued cash dividends and does not anticipate issuing cash dividends in the future. 13 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) NOTE 6 -- GOODWILL AND INTANGIBLE ASSETS The components of the Company's intangible assets were as follows (in thousands):
June 30, 2006 ------------------------------------------------- Gross Carrying Accumulated Net Carrying Amount Amortization Amount -------------- ------------ ------------ Unamortized intangible assets: Trademarks (1) $ 5,853 $ 5,853 ============== ============ ============ Amortized intangible assets: Capitalized software (2) $ 306,545 $ (239,562) $ 66,983 Customer relationship agreements (3) 9,799 (2,810) 6,989 Non-compete agreements (3) 2,280 (1,422) 858 Other (4) 7,747 (6,167) 1,580 -------------- ------------ ------------ Total amortized intangible assets $ 326,371 $ (249,961) $ 76,410 ============== ============ ============
March 31, 2006 ------------------------------------------------- Gross Carrying Accumulated Net Carrying Amount Amortization Amount -------------- ------------ ------------ Unamortized intangible assets: Trademarks (1) $ 5,853 $ 5,853 ============== ============ ============ Amortized intangible assets: Capitalized software (2) $ 295,996 $ (234,078) $ 61,918 Customer relationship agreements (3) 8,250 (2,251) 5,999 Non-compete agreements (3) 2,057 (1,164) 893 Other (4) 7,366 (5,775) 1,591 -------------- ------------ ------------ Total amortized intangible assets $ 313,669 $ (243,268) $ 70,401 ============== ============ ============
(1) Certain trademarks were acquired as part of the Covisint, LLC ("Covisint") and Changepoint Corporation ("Changepoint") acquisitions in fiscal 2004 and 2005. These trademarks are deemed to have an indefinite life and therefore are not being amortized. (2) Amortization of capitalized software is primarily included in "cost of software license fees" in the consolidated statements of operations. Capitalized software is generally amortized over five years. (3) Customer relationship agreements and non-compete agreements were acquired as part of recent acquisitions. The customer relationship agreements are being amortized over periods up to five years. The non-compete agreements are being amortized over periods up to three years. (4) Other amortized intangible assets include trademarks associated with product acquisitions and Covisint customer contracts. The trademarks are being amortized over periods up to ten years. The Covisint customer contracts are being amortized over three years. 14 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) Changes in the carrying amounts of goodwill are summarized as follows (in thousands):
Goodwill Products Services Total --------- --------- --------- Balance at March 31, 2006, net $ 178,910 $ 141,172 $ 320,082 Acquisition 14,175 14,175 Adjustments to previously recorded purchase price 2 2 Effect of foreign currency translation (57) 392 335 --------- --------- --------- Balance at June 30, 2006, net $ 193,030 $ 141,564 $ 334,594 ========= ========= =========
NOTE 7 -- PROPERTY AND EQUIPMENT During fiscal 2006, the Company implemented a plan to market and sell the former distribution center located in West Bloomfield, Michigan. The building was classified in current assets as held for sale with a carrying value of $1.8 million at March 31, 2006. This building was sold during the first quarter of fiscal 2007 for approximately $2.0 million. During fiscal 2005, the Company implemented a plan to market and sell the former headquarters building located in Farmington Hills, Michigan. The Company has been unable to reach an agreement with a buyer to dispose of the building. Nothing has come to the Company's attention that would warrant an adjustment to the carrying value at this time. The building is classified in current assets as held for sale with a carrying value of $13.0 million at June 30, 2006. 15 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) NOTE 8 - SEGMENTS The Company operates in two business segments in the technology industry: products and professional services. The Company provides software products and professional services to IT organizations that help IT professionals efficiently develop, implement and support the applications that run their businesses. Financial information for the Company's business segments is as follows (in thousands):
Three Months Ended June 30, ------------------------ 2006 2005 --------- --------- Revenues: Products: Mainframe $ 119,741 $ 123,376 Distributed systems 58,041 52,020 --------- --------- Total product revenue 177,782 175,396 Professional services 118,536 121,932 --------- --------- Total revenues $ 296,318 $ 297,328 ========= ========= Operating expenses: Products $ 109,593 $ 113,377 Professional services 107,615 106,245 Corporate expenses 46,228 48,229 --------- --------- Total operating expenses $ 263,436 $ 267,851 ========= ========= Income (loss) from operations before other income: Products $ 68,189 $ 62,019 Professional services 10,921 15,687 Corporate expenses (46,228) (48,229) --------- --------- Income from operations before other income 32,882 29,477 Other income 10,881 6,733 --------- --------- Income before income taxes $ 43,763 $ 36,210 ========= =========
Financial information regarding geographic operations is presented in the table below (in thousands):
Three Months Ended June 30, ----------------------- 2006 2005 --------- --------- Revenues: United States $ 202,632 $ 199,481 Europe and Africa 67,472 75,483 Other international operations 26,214 22,364 --------- --------- Total revenues $ 296,318 $ 297,328 ========= =========
16 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE MONTHS ENDED JUNE 30, 2006 (UNAUDITED) NOTE 9 - RESTRUCTURING ACCRUAL In the fourth quarter of fiscal 2002, the Company adopted a restructuring plan to reorganize its operating divisions, primarily the professional services segment. These changes were designed to increase profitability by better aligning cost structures with current market conditions. The restructuring plan included a reduction of professional services staff at certain locations, the closing of entire professional services offices and a reduction of sales support personnel, lab technicians and related administrative and financial staff. Approximately 1,600 employees worldwide were terminated as a result of the reorganization. The following table summarizes the restructuring accrual as of March 31, 2006, and charges against the accrual during the first three months of fiscal 2007 (in thousands):
Charges and adjustments against Balance at the accrual during Balance at March 31, the quarter ended June 30, 2006 June 30, 2006 2006 ---------- ------------------- ---------- Facilities costs (primarily lease abandonments) $ 5,950 $ 378 $ 5,572
NOTE 10 - DEBT The Company has no long term debt. As of June 30, 2006, the Company held a $100 million revolving credit facility maturing on July 27, 2006. If at any time the combined unencumbered liquid assets of the Company (as defined in the credit facility) are less than $200 million, the credit facility will be reduced to $50 million. Interest is payable at 1% over the Eurodollar rate or at the prime rate (8.25% at June 30, 2006), at the Company's option. The terms of the credit facility contain, among other provisions, a covenant to maintain a minimum $1 billion consolidated net worth, and specific limitations on additional indebtedness, liens and merger activity. No borrowings have occurred or are planned under this facility. On July 27, 2006, the Company amended the credit agreement extending the maturity to July 26, 2007. The amended credit agreement eliminated the liquidity and net worth covenants and no longer restricts merger and acquisition activity when the Company is the continuing or surviving entity. Interest is payable at 1% over the Eurodollar rate or at the prime rate. 17 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Compuware Corporation Detroit, Michigan We have reviewed the accompanying condensed consolidated balance sheet of Compuware Corporation and subsidiaries (the "Company"), as of June 30, 2006, and the related condensed consolidated statements of operations and cash flows for the three-month periods ended June 30, 2006 and 2005. These interim financial statements are the responsibility of the Company's management. We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 1 to the condensed consolidated financial statements, effective April 1, 2006, the Company changed its method of accounting for stock based compensation to conform to Statement of Financial Accounting Standards No. 123R, Share-Based Payment. We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Compuware Corporation and subsidiaries as of March 31, 2006, and the related consolidated statements of operations, shareholders' equity, and cash flows for the year then ended (not presented herein); and in our report dated May 15, 2006, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of March 31, 2006 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. DELOITTE & TOUCHE LLP Detroit, Michigan August 2, 2006 18 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) FORWARD-LOOKING STATEMENTS This discussion contains certain forward-looking statements within the meaning of the federal securities laws which are identified by the use of the words "believes," "expects," "anticipates," "will," "contemplates," "would" and similar expressions that contemplate future events. Numerous important factors, risks and uncertainties affect our operating results and could cause actual results to differ materially from the results implied by these or any other forward-looking statements made by us, or on our behalf. A summary of the material risks and uncertainties that we believe affect us are highlighted below and have not materially changed since the end of fiscal 2006 (see Item 1A Risk Factors in our 2006 10-K for a more detailed explanation of each risk). These risks and uncertainties are not the only ones we face. Additional risks and uncertainties that we are not aware of or focused on or currently deem immaterial may also impair business operations. This report is qualified in its entirety by these risk factors. If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and shareholders could lose all or part of their investment. There can be no assurance that future results will meet expectations. While we believe that our forward-looking statements are reasonable, you should not place undue reliance on any such forward-looking statements, which speak only as of the date made. Except as required by applicable law, we do not undertake any obligation to publicly release any revisions which may be made to any forward-looking statements to reflect events or circumstances occurring after the date of this report. - The majority of our software products revenue is dependent on our customers' continued use of International Business Machines Corp. ("IBM") and IBM-compatible products, and on the acceptance of our pricing structure for software licenses and maintenance. - Our software and technology may infringe the proprietary rights of others. - Our results could be adversely affected if our operating margins decline. - Our results could be adversely affected by increased competition, pricing pressures and technological changes. - The market for professional services is highly competitive, fragmented and characterized by low barriers to entry. - We must develop or acquire product enhancements and new products to succeed. - Acquisitions may be difficult to integrate, disrupt our business or divert the attention of our management and may result in financial results that are different than expected. - We are exposed to exchange rate risks on foreign currencies and to other international risks which may adversely affect our business and results of operations. - A further decline in the U.S. domestic automotive manufacturing business could adversely affect our professional services business. - Current laws may not adequately protect our proprietary rights. - The loss of certain key employees and technical personnel or our inability to hire additional qualified personnel could have a material adverse effect on our business. 19 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - Our quarterly financial results vary and may be adversely affected by a number of unpredictable factors. - Maintenance revenue could decline. - Unanticipated changes in our operating results or effective tax rates, or exposure to additional income tax liabilities, could affect our profitability. - Acts of terrorism, acts of war and other unforeseen events may cause damage or disruption to us or our customers which could adversely affect our business, financial condition and operating results. - Our articles of incorporation, bylaws and rights agreement as well as certain provisions of Michigan law may have an anti-takeover effect. OVERVIEW In this section, we discuss our results of operations on a segment basis for each of our financial reporting segments. We operate in two business segments in the technology industry: products and professional services. We evaluate segment performance based primarily on segment contribution before corporate expenses. References to years are to fiscal years ended March 31. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and notes included elsewhere in this report and our annual report on Form 10-K for the fiscal year ended March 31, 2006, particularly "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations". We deliver value to businesses worldwide by providing software products and professional services that increase the efficiency and effectiveness of the entire IT organization. Originally founded in 1973 as a professional services company, in the late 1970's we began to offer mainframe productivity tools for fault management and diagnosis, file and database management, and application debugging. In the 1990's, the IT industry moved toward distributed and web-based platforms. Our solutions portfolio grew in response, and we now market a comprehensive portfolio of IT solutions across the full range of enterprise computing platforms that help: - Develop and deliver high quality, high performance enterprise business applications in a timely and cost-effective manner. - Measure and manage application service using business-relevant metrics, and maintain consistent, high levels of service delivery. - Provide executive visibility, decision support and process automation across the entire IT organization to enable all available resources to be harnessed in alignment with business priorities. Additionally, to be competitive in today's global economy, enterprises must securely share applications, information and business processes. We address this market need through our Covisint offerings, which help manage the supply chain through the integration of vital business information and processes between partners, customers and suppliers. We focus on growing revenue and profit margins by enhancing and promoting our current product lines, expanding our product and service offerings through key acquisitions, developing strategic partnerships in order to provide clients with our product solutions and managing our costs. 20 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The following occurred during the first quarter of 2007: - Acquired SteelTrace Limited ("SteelTrace"), a privately held provider of requirements management products. - Announced authorization by the Board of Directors to repurchase an additional $125 million of common stock of which approximately 4.5 million shares of our common stock was repurchased at an average price of $7.24 per share. - Improved the products contribution margin to 38.4% in the first quarter of 2007 from 35.4% in the first quarter of 2006 due to continued distributed product revenue growth and reductions in sales and marketing expenditures. - Achieved an 11.6% increase in distributed product revenue compared to the first quarter of 2006. The increase was a reflection of our continued focus on promoting our distributed products and an expanding maintenance base for those products. - Incurred a 2.9% decrease in mainframe product revenue compared to the first quarter of 2006 primarily related to a decline in license revenue. - Released 3 mainframe and 12 distributed product updates designed to increase the productivity of the IT departments of our customers. - Hosted the Compuware Partner Summit, 2006, which highlighted collaboration between Compuware, its partners and their joint customers, focusing on innovations that drive business growth. - Experienced a decrease in professional services contribution margin to 9.2% in the first quarter of 2007 from 12.9% in the first quarter of 2006. The change is primarily due to reductions in professional services revenue and higher subcontract costs. Our ability to achieve our strategies and objectives is subject to a number of factors some of which we may not be able to control. See "Forward-Looking Statements". 21 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain operational data from the consolidated statements of operations as a percentage of total revenues and the percentage change in such items compared to the prior period:
Percentage of Total Revenues ------------------ Three Months Ended June 30, Period- ------------------ to-Period 2006 2005 Change ------ ------ --------- REVENUE: Software license fees 22.8% 22.9% (0.8)% Maintenance fees 37.2 36.1 2.7 Professional services fees 40.0 41.0 (2.8) ------ ------ Total revenues 100.0 100.0 (0.3) ------ ------ OPERATING EXPENSES: Cost of software license fees 2.2 1.9 15.8 Cost of professional services 36.3 35.8 1.3 Technology development and support 12.6 12.0 4.5 Sales and marketing 22.2 24.2 (8.7) Administrative and general 15.6 16.2 (4.1) ------ ------ Total operating expenses 88.9 90.1 (1.6) ------ ------ Income from operations 11.1 9.9 11.6 Other income 3.7 2.3 61.6 ------ ------ Income before income taxes 14.8 12.2 20.9 Income tax provision 4.9 3.9 24.6 ------ ------ Net income 9.9% 8.3% 19.1% ====== ======
SOFTWARE PRODUCTS REVENUE Our products are designed to enhance the effectiveness of key disciplines throughout the IT organization from application development and delivery to service management and IT portfolio management supporting all major enterprise computing platforms. Product revenue, which consists of software license fees and maintenance fees, comprised 60.0% and 59.0% of total revenue during the first quarter of 2007 and 2006, respectively. Distributed software product revenue increased $6.0 million or 11.6% during the first quarter of 2007 to $58.0 million from $52.0 million during the first quarter of 2006. The increase was primarily due to license revenue growth related to our Vantage product line resulting from increased customer demand for performance-related software and the enhancement of Vantage to include agentless monitoring through software acquired in the fiscal 2006 acquisition of Adlex, Incorporated. Mainframe software product revenue decreased $3.6 million or 2.9% during the first quarter of 2007 to $119.8 million from $123.4 million during the first quarter of 2006. The decline was primarily reflected in lower license revenue due to decreased demand for capacity in our European operations. 22 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) License revenue decreased $500,000 or 0.8% during the first quarter of 2007 to $67.5 million from $68.0 million during the first quarter of 2006. The decline was due to the reduction of $4.4 million in mainframe license revenue offset by the increase in distributed license revenue. Maintenance fees increased $2.9 million or 2.7% to $110.3 million during the first quarter of 2007 from $107.4 million during the first quarter of 2006. The increase was primarily due to an increase in distributed maintenance revenue related to our Vantage and QACenter product lines. Product revenue by geographic location is presented in the table below (in thousands):
Three Months Ended June 30, --------------------- 2006 2005 -------- -------- United States $100,426 $ 94,866 Europe and Africa 52,672 59,278 Other international operations 24,684 21,252 -------- -------- Total product revenue $177,782 $175,396 ======== ========
PRODUCT CONTRIBUTION AND EXPENSES Financial information for the products segment is as follows (in thousands):
Three Months Ended June 30, --------------------- 2006 2005 -------- -------- Revenue $177,782 $175,396 Expenses 109,593 113,377 -------- -------- Product contribution $ 68,189 $ 62,019 ======== ========
The product segment generated contribution margins of 38.4% and 35.4% during the first quarter of 2007 and 2006, respectively. Product expenses include cost of software license fees, technology development and support costs and sales and marketing expenses. These expenses are discussed below. Cost of software license fees includes amortization of capitalized software, the cost of duplicating and disseminating products to customers including associated hardware costs and the cost of author royalties. For the first quarter of 2007, cost of software license fees increased $900,000 or 15.8% to $6.6 million from $5.7 million in the first quarter of 2006. The change in cost of software license fees was primarily due to an increase in amortization expense related to internally developed software products and amortization expense associated with capitalized software purchased in recent acquisitions. As a percentage of software license fees, costs of software license fees were 9.8% and 8.4% in the first quarter of 2007 and 2006, respectively. 23 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Technology development and support includes, primarily, the costs of programming personnel associated with product development and support less the amount of software development costs capitalized during the period. Also included here are personnel costs associated with developing and maintaining internal systems and hardware/software costs required to support technology initiatives. As a percentage of product revenue, costs of technology development and support were 20.9% and 20.3% in the first quarter of 2007 and 2006, respectively. Capitalization of internally developed software products begins when technological feasibility of the product is established. Total technology development and support costs incurred internally and capitalized in the first quarter of 2007 and 2006 were as follows (in thousands):
Three Months Ended June 30, ---------------------- 2006 2005 -------- -------- Technology development and support costs incurred $ 42,722 $ 40,499 Capitalized technology development and support costs (5,482) (4,846) -------- -------- Technology development and support costs reported $ 37,240 $ 35,653 ======== ========
Before the capitalization of internally developed software products, total technology development and support expenditures for the first quarter of 2007 increased $2.2 million or 5.5%, to $42.7 million from $40.5 million in the first quarter of 2006. The change in expense is primarily due to higher compensation and benefit costs resulting from increased employee headcount, primarily programming personnel, in order to meet new product initiatives. Sales and marketing costs consists primarily of personnel related costs associated with product sales and sales support and marketing for all our offerings. For the first quarter of 2007, sales and marketing costs decreased $6.2 million or 8.7% to $65.8 million from $72.0 million in the first quarter of 2006. The change in sales and marketing costs was primarily attributable to higher severance expense being incurred during the first quarter of 2006 in our European operations due to a worldwide sales realignment that occurred during the quarter. There was no such initiative in the first quarter of 2007. In addition, compensation and bonus costs were lower during the first quarter of 2007 due to the decrease in headcount that resulted from the realignment. As a percentage of product revenue, sales and marketing costs were 37.0% and 41.1% in the first quarter of 2007 and 2006, respectively. PROFESSIONAL SERVICES REVENUE We offer a broad range of IT services to help businesses make the most of their IT assets. Some of these services include outsourcing and co-sourcing, application management, product solutions, project management, enterprise resource planning and customer relationship management services. Revenue from professional services decreased $3.4 million or 2.8% during the first quarter of 2007 to $118.5 million compared to $121.9 million in the first quarter of 24 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 2006. The decrease in revenue was primarily due to cost cutting initiatives adopted by certain domestic customers within the automotive sector reducing the spending on certain IT programs. Professional services revenue by geographic location is presented in the table below (in thousands):
Three Months Ended June 30, --------------------- 2006 2005 -------- -------- United States $102,206 $104,615 Europe and Africa 14,800 16,205 Other international operations 1,530 1,112 -------- -------- Total professional services revenue $118,536 $121,932 ======== ========
PROFESSIONAL SERVICES CONTRIBUTION AND EXPENSES Financial information for the professional services segment is as follows (in thousands):
Three Months Ended June 30, --------------------- 2006 2005 -------- -------- Revenue $118,536 $121,932 Expenses 107,615 106,245 -------- -------- Professional services contribution $ 10,921 $ 15,687 ======== ========
During the first quarter of 2007, the professional services segment generated a contribution margin of 9.2%, compared to 12.9% during the first quarter of 2006. Cost of professional services consists primarily of personnel-related costs of providing services, including billable staff, subcontractors and sales personnel. Cost of professional services increased $1.4 million or 1.3% during the first quarter of 2007 to $107.6 million compared to $106.2 million in the first quarter of 2006. The change was primarily attributable to higher subcontractor costs to meet a European customer's increased demand for our services. CORPORATE AND OTHER EXPENSES Administrative and general expenses primarily consist of costs associated with the corporate executive, finance, human resources, administrative, legal, communications and investor relations departments. In addition, administrative and general expenses include all facility-related costs, such as rent, building depreciation, maintenance, utilities, etc., associated with worldwide sales and professional services offices. Administrative and general expenses decreased $2.0 million or 4.1% during the first quarter of 2007 to $46.2 million from $48.2 million during the first quarter of 2006. The decrease in cost was primarily attributable to an impairment charge of $3.9 million in the first quarter of 2006 related to a purchased software application that management, at that time, did not have plans to utilize. There was no significant impairment charge incurred during the first quarter of 2007. This was offset by approximately 25 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) $2.2 million in foreign currency losses incurred in the first quarter of 2007 related to inter-company balances with our wholly owned subsidiaries. Other income, net ("other income") consists primarily of interest income realized from investments, interest earnings on deferred customer receivables and income/losses generated from our investments in partially owned companies. Other income increased $4.2 million or 61.6% during the first quarter of 2007 to $10.9 million compared to $6.7 million in the first quarter of 2006. The change in income was primarily attributable to an increase in investment interest income due to higher interest rates earned on investments during the respective periods of 2007 compared to 2006. Income taxes are accounted for using the asset and liability approach. Deferred income taxes are provided for the differences between the tax bases of assets or liabilities and their reported amounts in the financial statements. The income tax provision was $14.4 million in the first quarter of 2007 and $11.6 million for the first quarter of 2006, which represents an effective tax rate of 33% and 32%, respectively. The increase in the effective tax rate from 2006 to 2007 is primarily due to expected increases in income before income taxes reducing the effect of certain tax benefits compared to the prior year and in the domestic/foreign composition of revenue. RESTRUCTURING ACCRUAL In the fourth quarter of 2002, we adopted a restructuring plan to reorganize our operating divisions, primarily the professional services segment. These changes were designed to increase profitability by better aligning cost structures with current market conditions. See Note 9 to the Condensed Consolidated Financial Statements for changes in the restructuring accrual for the first three months of 2007. MANAGEMENT'S DISCUSSION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Assumptions and estimates were based on the facts and circumstances known at June 30, 2006. However, future events rarely develop exactly as forecast, and the best estimates routinely require adjustment. The accounting policies discussed in Item 7 of our Annual Report on Form 10-K for the year ended March 31, 2006 are considered by management to be the most important to an understanding of the financial statements, because their application places the most significant demands on management's judgment and estimates about the effect of matters that are inherently uncertain. These policies are also discussed in Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of that report. There have been no material changes to that information since the end of fiscal 2006. 26 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) LIQUIDITY AND CAPITAL RESOURCES As of June 30, 2006, cash and cash equivalents and investments totaled approximately $919.7 million. During the first three months of 2007 and 2006, cash flow from operations was $63.9 million and $48.6 million, respectively. The increase was due to a decrease in cash paid to vendors, primarily legal services, and to a decrease in cash paid for salaries and benefits due to lower headcount, primarily within the professional services and sales and marketing segments. During the first three months of 2007 and 2006, capital expenditures including property and equipment and capitalized research and software development totaled $8.1 million and $8.4 million, respectively. We hold a $100 million revolving credit facility that would have matured on July 27, 2006 (see Note 9 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended March 31, 2006 for a description of the facility). On July 27, 2006, we amended the credit agreement extending the maturity to July 26, 2007 (see Note 10 to the Condensed Consolidated Financial Statements for more details regarding amendments to the terms of the facility). No borrowings have occurred under this facility since inception. During fiscal 2005, we implemented a plan to market and sell the former headquarters building located in Farmington Hills, Michigan. We have been unable to reach an agreement with a buyer to dispose of the building. Nothing has come to our attention that would warrant an adjustment to the carrying value at this time. The building is classified in current assets as held for sale with a carrying value of $13.0 million at June 30, 2006. During fiscal 2006, we implemented a plan to market and sell the former distribution center located in West Bloomfield, Michigan. This building was sold during the first quarter of fiscal 2007 for approximately $2.0 million. On April 13, 2006, we announced that the Board of Directors authorized the repurchase of up to $125 million of our common stock. Our purchases of stock may occur on the open market, through negotiated or block transactions based upon market and business conditions. During the first three months of 2007, we repurchased approximately 4.5 million shares of our common stock under this program at an average price of $7.24 per share and a total cost of $32.8 million. Approximately $92.2 million remains for future purchases under this program. In April 2006, we acquired SteelTrace Limited, a privately held provider of requirements management products that align application delivery to business needs through a structured, visual approach to the management of enterprise application requirements, for approximately $20.0 million in cash. The acquisition has been accounted for using the purchase method in accordance with SFAS No. 141, "Business Combinations" and, accordingly, the assets and liabilities acquired have been recorded at preliminary fair value as of the acquisition date. We continue to evaluate business acquisition opportunities that fit our strategic plans. We believe available cash resources, together with cash flow from operations, will be sufficient to meet cash needs for the foreseeable future. 27 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Recently Issued Accounting Pronouncements In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes--an interpretation of FASB Statement No. 109", which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. This Interpretation is effective for fiscal years beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. Management is currently considering the impact this Interpretation will have on the financial statements. CONTRACTUAL OBLIGATIONS Our contractual obligations are described in "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in our Annual Report on Form 10-K for the year ended March 31, 2006. Except as described elsewhere in this report on Form 10-Q, there have been no material changes to those obligations or arrangements outside of the ordinary course of business since the end of fiscal 2006. 28 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed primarily to market risks associated with movements in interest rates and foreign currency exchange rates. There have been no material changes to our foreign exchange risk management strategy or our investment standards subsequent to March 31, 2006, therefore the market risks remain substantially unchanged since we filed the Annual Report on Form 10-K for the fiscal year ending March 31, 2006. ITEM 4. CONTROLS AND PROCEDURES DISCLOSURE CONTROLS AND PROCEDURES We maintain disclosure controls and procedures that are designed to ensure material information required to be disclosed in our reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required financial disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, with a company have been detected. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934 (the "Exchange Act"). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective, at the reasonable assurance level, to cause the material information required to be disclosed in the reports that we file or submit under the Exchange Act to be recorded, processed, summarized and reported within the time periods specified in the Commission's rules and forms. CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING No changes in our internal control over financial reporting occurred during the quarter ended June 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 29 COMPUWARE CORPORATION AND SUBSIDIARIES PART II - OTHER INFORMATION ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS The following table sets forth, the repurchases of common stock for the quarter ended June 30, 2006:
Total number of shares Approximate repurchased as dollar value of part of publicly shares that may Total number of Average price announced yet be purchased shares paid per repurchase plans under the plan or Period repurchased (a) share (a) or program (a) program (a) ------ --------------- ------------- ---------------- ----------------- As of March 31, 2006 $ 125,000,000 April 1, 2006 - April 30, 2006 125,000,000 May 1, 2006 - May 31, 2006 1,326,141 $ 7.38 1,326,141 115,210,000 June 1, 2006 - June 30, 2006 3,207,406 7.19 4,533,547 92,161,000 --------------- ------------- Total 4,533,547 $ 7.24 =============== =============
(a) On April 13, 2006, we announced that the Board of Directors has authorized the repurchase of $125 million of the Company's common stock. Our purchases of stock may occur on the open market or in negotiated or block transactions based upon market and business conditions. Unless terminated earlier by resolution of our Board of Directors, the share repurchase program will expire when we have repurchased all shares authorized for repurchase thereunder. 30 COMPUWARE CORPORATION AND SUBSIDIARIES PART II - OTHER INFORMATION ITEM 6. EXHIBITS Exhibit Number Description of Document 4.7 Amendment No. 2, dated as of May 9, 2006, To Rights Agreement, dated as of October 25, 2000, between Compuware Corporation and Equiserve Trust Company, N.A. (now known as Computershare Trust Company, N.A.) (1) 4.8 Amended and Restated Credit Agreement Dated May 2, 2003 as of July 27, 2006 (4) 10.98 2005 Non-Employee Directors' Deferred Compensation Plan (2) 10.99 Executive Incentive Plan -- Corporate, as of May 31, 2006 (3) 10.101 Fifth Amendment to the Compuware Corporation ESOP/401(k) Plan (4) 15 Independent Registered Public Accounting Firm's Awareness Letter (4) 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. (4) 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. (4) 32 Certification pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) of the Securities Exchange Act. (4) (1) Incorporated by reference to the first Form 8-K filed by the Company on May 11, 2006. (2) Incorporated by reference to the second Form 8-K filed by the Company on May 11, 2006. (3) Incorporated by reference to the Form 8-K filed by the Company on June 6, 2006. (4) Filed herewith. 31 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. COMPUWARE CORPORATION Date: August 2, 2006 By: /s/ Peter Karmanos, Jr. --------------- ----------------------- Peter Karmanos, Jr. Chief Executive Officer (duly authorized officer) Date: August 2, 2006 By: /s/ Laura L. Fournier --------------- ----------------------- Laura L. Fournier Senior Vice President Chief Financial Officer Treasurer 32 Exhibit Index Exhibit Number Description of Document 4.7 Amendment No. 2, dated as of May 9, 2006, To Rights Agreement, dated as of October 25, 2000, between Compuware Corporation and Equiserve Trust Company, N.A. (now know as Computershare Trust Company, N.A.) (1) 4.8 Amended and Restated Credit Agreement Dated May 2, 2003 as of July 27, 2006 (4) 10.98 2005 Non-Employee Directors' Deferred Compensation Plan (2) 10.99 Executive Incentive Plan -- Corporate, as of May 31, 2006 (3) 10.101 Fifth Amendment to the Compuware Corporation ESOP/401(k) Plan (4) 15 Independent Registered Public Accounting Firm's Awareness Letter (4) 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. (4) 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. (4) 32 Certification pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) of the Securities Exchange Act. (4) (1) Incorporated by reference to the first Form 8-K filed by the Company on May 11, 2006. (2) Incorporated by reference to the second Form 8-K filed by the Company on May 11, 2006. (3) Incorporated by reference to the Form 8-K filed by the Company on June 6, 2006. (4) Filed herewith.