-----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, S4isA/QrvdrNK9Jm6PTT981AJRSNMWkN0+lH2ZLtMUnqY2Abv9N9jZLZs7ViDYcj HXFYQTTH/RI25PGd44t/Sw== 0000859360-98-000018.txt : 19981113 0000859360-98-000018.hdr.sgml : 19981113 ACCESSION NUMBER: 0000859360-98-000018 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19980930 FILED AS OF DATE: 19981112 FILER: COMPANY DATA: COMPANY CONFORMED NAME: LEGATO SYSTEMS INC CENTRAL INDEX KEY: 0000859360 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 943077394 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-26130 FILM NUMBER: 98745006 BUSINESS ADDRESS: STREET 1: 3210 PORTER DR CITY: PALO ALTO STATE: CA ZIP: 94304 BUSINESS PHONE: 4158126000 MAIL ADDRESS: STREET 1: 3210 PORTER DRIVE CITY: PALO ALTO STATE: CA ZIP: 94304 10-Q 1 QUARTERLY REPORT ON FORM 10Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1998 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: 0-26130 LEGATO SYSTEMS, INC. (Exact name of registrant as specified in its charter) DELAWARE 94-3077394 (State of incorporation) (I.R.S. Employer Identification No.) 3210 Porter Drive Palo Alto, California 94304 (Address of principal executive offices) (650) 812-6000 (Registrant's telephone number, including area code) 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 The number of shares outstanding of the registrant's common stock as of October 30, 1998 was 37,428,905. LEGATO SYSTEMS, INC. INDEX
Page PART I: Condensed Financial Information Item 1. Financial Statements: Condensed Consolidated Balance Sheets as of September 30, 1998 and December 31, 1997 3 Condensed Consolidated Statements of Income for the three and nine month periods ended September 30, 1998 and 1997 4 Condensed Consolidated Statements of Cash Flows for the nine month periods ended September 30, 1998 and 1997 5 Notes to the Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 PART II: Other Information Item 6. Exhibits and Reports on Form 8-K 22 Signature 23
PART I: Condensed Financial Information Item 1: Financial Statements LEGATO SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands)
September 30, December 31, 1998 1997 (unaudited) ASSETS Current assets: Cash and cash equivalents $ 64,716 $ 34,891 Short-term investments 29,409 28,147 Accounts receivable, net 30,597 21,426 Other current assets 4,571 4,365 Deferred tax asset 4,099 2,702 ----------- ----------- Total current assets 133,392 91,531 Long-term investments 9,206 8,953 Property and equipment, net 15,164 10,515 Intangible assets, net 2,540 3,431 Other assets 515 362 ----------- ----------- Total assets $ 160,817 $ 114,792 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable and accrued liabilities $ 16,373 $ 8,224 Deferred revenues 16,885 12,491 ----------- ----------- Total current liabilities 33,258 20,715 Deferred tax liability 531 768 Stockholders' equity: Capital stock 81,919 66,326 Retained earnings 45,109 26,983 ----------- ----------- Total stockholders' equity 127,028 93,309 ----------- ----------- Total liabilities and stockholders' equity $ 160,817 $ 114,792 =========== ===========
The accompanying notes are an integral part of the Condensed Consolidated Financial Statements. LEGATO SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share amounts) (unaudited)
Three Months Ended Nine Months Ended September 30, September 30, ----------------------------- --------------------------- 1998 1997 1998 1997 -------------- ------------- ------------- ------------ REVENUES: Product $28,770 $17,415 $76,874 $45,573 Service and support 8,722 4,573 21,764 12,228 -------------- ------------- ------------- ------------ Total revenues 37,492 21,988 98,638 57,801 COST OF REVENUES: Product 1,155 773 2,917 1,938 Service and support 3,481 1,830 9,169 4,682 -------------- ------------- ------------- ------------ Total cost of revenues 4,636 2,603 12,086 6,620 -------------- ------------- ------------- ------------ GROSS PROFIT 32,856 19,385 86,552 51,181 OPERATING EXPENSES: Research and development 6,018 3,719 15,567 10,482 Sales and marketing 12,614 7,438 36,052 20,116 General and administrative 2,483 1,824 7,434 4,785 Amortization of intangibles 279 279 838 838 Merger related expenses 645 0 645 0 -------------- ------------- ------------- ------------ Total operating expenses 22,039 13,260 60,536 36,221 -------------- ------------- ------------- ------------ INCOME FROM OPERATIONS 10,817 6,125 26,016 14,960 Interest income, net 1,130 543 2,994 1,492 -------------- ------------- ------------- ------------ INCOME BEFORE PROVISION FOR INCOME TAXES 11,947 6,668 29,010 16,452 Provision for income taxes 4,420 2,395 10,883 6,254 -------------- ------------- ------------- ------------ NET INCOME $ 7,527 $ 4,273 $ 18,127 $ 10,198 ============== ============= ============= ============ Basic earnings per share $ 0.20 $ 0.12 $ 0.49 $ 0.29 ============== ============= ============= ============ Diluted earnings per share $ 0.19 $ 0.11 $ 0.46 $ 0.27 ============== ============= ============= ============ Shares used in the calculation of basic earnings per share 37,143 35,247 36,693 34,873 ============== ============= ============= ============ Shares used in the calculation of diluted earnings per share 40,348 37,961 39,813 37,710 ============== ============= ============= ============
The accompanying notes are an integral part of the Condensed Consolidated Financial Statements. LEGATO SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (in thousands)
Nine Months Ended September 30, 1998 1997 Cash flows from operating activities: Net income $ 18,127 $ 10,198 Adjustments to reconcile net income to net cash provided by operating activities: Net deferred tax asset (1,634) (224) Depreciation and amortization 4,144 2,572 Tax benefit from exercise of stock options 8,252 1,496 Changes in operating assets and liabilities: Accounts receivable (9,171) (6,005) Other current assets (206) (1,881) Deferred revenues 4,394 2,863 Accounts payable and current liabilities 8,148 4,083 ----------- ----------- Net cash provided by operating activities 32,054 13,102 ----------- ----------- Cash flows from investing activities: Purchase of available-for-sale securities (40,726) (24,964) Proceeds from maturity and sale of available- for-sale securities 39,353 23,967 Acquisition of property and equipment (7,955) (5,388) Other (101) (439) ----------- ----------- Net cash used in investing activities (9,429) (6,824) ----------- ----------- Cash flows from financing activities: Proceeds from issuance of common stock 7,185 2,832 Other 15 15 ----------- ----------- Net cash provided by financing activities 7,200 2,847 ----------- ----------- Net increase in cash and cash equivalents 29,825 9,125 Cash and cash equivalents at beginning of period 34,891 27,770 ----------- ----------- Cash and cash equivalents at end of period $ 64,716 $ 36,895
The accompanying notes are an integral part of the Condensed Consolidated Financial Statements. LEGATO SYSTEMS, INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) Note 1. Basis of Presentation In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all normal and recurring adjustments necessary to fairly present the financial position, results of operations and cash flows of Legato Systems, Inc. and its subsidiaries ("the Company"). The results of operations for the quarterly and nine month periods presented are not necessarily indicative of the results that may be expected for quarterly or annual periods in the future. The Notes to the Consolidated Financial Statements contained in the 1997 Report on Form 10-K should be read in conjunction with these Condensed Consolidated Financial Statements. The Company derived the balance sheet at December 31, 1997, from audited financial statements; however, it does not include all disclosures required by generally accepted accounting principles. Note 2. Computation of Earnings Per Share The Company adopted the provisions of Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128"), effective December 31, 1997. SFAS 128 requires the presentation of basic and diluted earnings per share. As required, the Company computes basic earnings per share by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period and computes diluted earnings per share by giving effect to all dilutive potential common shares outstanding during the period. Dilutive potential common equivalent shares consist of the incremental common shares issuable upon conversion of stock options. The Company restated prior period earnings per share amounts to comply with SFAS 128. As required by SFAS 128, the following table reconciles the numerator and denominator of basic and diluted earnings per (in thousands, except per share amounts):
Three Months Ended Nine Months Ended September 30, September 30, 1998 1997 1998 1997 Numerator - basic and diluted earnings per share Net income $ 7,527 $ 4,273 $ 18,127 $ 10,198 ========= ========= ========= ======== Denominator - basic earning per share Weighted average common shares outstanding 37,143 35,247 36,693 34,873 ========= ========= ========= ======== Basic earnings per share $ 0.20 $ 0.12 $ 0.49 $ 0.29 ========= ========= ========= ======== Denominator - diluted earnings per share Weighted average common shares outstanding 37,143 35,247 36,693 34,873 Effect of dilutive securities: Common stock options 3,205 2,714 3,120 2,837 --------- --------- --------- -------- Weighted average common and common equivalent shares 40,348 37,961 39,813 37,710 ========= ========= ========= ======== Diluted earnings per share $ 0.19 $ 0.11 $ 0.46 $ 0.27 ========= ========= ========= ======== Shares excluded from diluted earnings per shares calculation 28 47 52 1,106 - ------------------------------------------------------------ ========= ========= ========= ========
Certain shares of common stock options were excluded from the calculation of diluted earnings per share because the options' exercise prices were greater than the average market price of the common shares during these periods. Note 3. Stock Split The Company effected a two-for-one stock split (in the form of a stock dividend) on April 17, 1998. The accompanying Condensed Consolidated Financial Statements retroactively reflect the two-for-one stock split. Note 4. Software Moguls Acquisition In August 1998, the Company issued 249,999 shares of common stock in exchange for all the outstanding shares of Software Moguls, Inc., a developer of advanced backup-retrieval products for the Windows NT and UNIX environments. The Company accounted for the combination as a pooling of interests. Accordingly, the Company restated the accompanying financial statements and financial data to represent the combined financial results of the previously separate entities for all periods presented. The table below presents the separate results of operations for Software Moguls, Inc. for the periods prior to the combination. The Company's results of operations include Software Moguls since the transaction (in thousands):
Three Months Ended Nine Months Ended September 30, September 30, 1998 1997 1998 1997 Revenues: Legato Systems, Inc. $ 37,492 $ 21,436 $ 97,693 $ 56,207 Software Moguls, Inc. -- 552 945 1,594 --------- --------- --------- -------- Total $ 37,492 $ 21,988 $ 98,638 $ 57,801 ========= ========= ========= ======== Net Income (Loss): Legato Systems, Inc. $ 7,527 $ 4,352 $ 18,530 $ 10,648 Software Moguls, Inc. -- (79) (403) (450) --------- -------- --------- ------- Total $ 7,527 $ 4,273 $ 18,127 $ 10,198 ========= ========= ========= ========
Note 5. Other Matters Comprehensive Income The Company adopted the provisions of Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"), effective January 1, 1998. This statement requires the disclosure of comprehensive income and its components in a full set of general-purpose financial statements. SFAS 130 defines comprehensive income as net income plus revenues, expenses, gains and losses that, under generally accepted accounting principles, are excluded from net income. The components of the Company's comprehensive income excluded from net income are not significant, individually or in aggregate. Therefore, no separate statement of comprehensive income has been presented. Revenue Recognition The Company adopted the provisions of Statement of Position 97-2, Software Revenue Recognition ("SOP 97-2"), as amended by Statement of Position 98-4, Deferral of the Effective Date of Certain Provisions of SOP 97-2, effective January 1, 1998. SOP 97-2 supercedes Statement of Position 91-1 and delineates the accounting for software product and maintenance revenues. Under SOP 97-2, the Company recognizes product revenues upon shipment if a signed contract exists, the fee is fixed and determinable, collection of resulting receivables is probable and product returns are reasonably estimable, except for sales to distributors, which are recognized upon sale by the distributor to end-users. For contracts with multiple obligations (e.g. deliverable and undeliverable products, maintenance and other services), the Company allocates revenue to each component of the contract based on objective evidence of its fair value, which is specific to the Company, or for products not being sold separately, the price established by management. The Company recognizes revenue allocated to undelivered products when the criteria for product revenue set forth above are met. The Company recognizes revenue allocated to maintenance fees for ongoing customer support and product updates ratably over the period of the maintenance contract. Payments for maintenance fees are generally made in advance and are non-refundable. For revenue allocated to other services, the Company recognizes revenues as the related services are performed. Segment Reporting In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"), effective for fiscal years beginning after December 15, 1997. SFAS 131 supercedes Statement of Financial Accounting Standards, "Financial Reporting for Segments of a Business Enterprise" ("SFAS 14"). SFAS 131 changes current practice under SFAS 14 by establishing a new framework to base segment reporting and also requires interim reporting of segment information. The statement does not require interim reporting disclosures until the first quarter immediately subsequent to the fiscal year in which SFAS 131 is effective. Reclassifications The Company made certain reclassifications to prior period consolidated financial statements to conform to the current presentation. The reclassifications have no significant effect on previously reported financial position, results of operations or cash flows. Note 6. Subsequent Event On October 25, 1998, the Company entered into a definitive agreement to acquire Qualix Group, Inc. (dba FullTime Software, Inc.), a market leader and leading developer of distributed, enterprise-wide, cross-platform, adaptive computing solutions that enable customers to proactively manage application service level availability. The agreement provides for the issuance of 1,721,000 shares of the Company's common stock in exchange for all the common stock and options of Qualix Group, Inc. The transaction is expected to be completed by December 1998 or shortly thereafter, and is subject to the satisfaction of standard closing conditions, including regulatory approval and the approval of Qualix Group, Inc. stockholders. The transaction is expected to be accounted for as a pooling of interests. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The discussion in this report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements on the Company's expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this document are based on information available to the Company on the date hereof. The Company assumes no obligation to update any such forward-looking statements. The Company's actual results could differ materially from those indicated in such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to fluctuations in quarterly operating results, uncertainty in future operating results, product concentration, competition, and other risks discussed in this item under the heading "Risk Factors" and the risks discussed in the Company's other Securities and Exchange Commission filings. RESULTS OF OPERATIONS OVERVIEW The Company develops, licenses, markets and supports network storage management software products for heterogeneous client/server computing environments and large-scale enterprises. The Company's NetWorker family of software products, from which the Company derives a substantial majority of its revenues, and Global Enterprise Management Systems (G.E.M.S.) support many storage management server platforms and can accommodate a variety of servers, clients, applications, databases and storage devices. The Company licenses its products through resellers and directly to end users primarily located in North America, Europe and Asia Pacific. The Company also licenses its source code to original equipment manufacturers ("OEMs") in exchange for initial licensing fees and receives ongoing royalties from the OEMs' product sales. Substantially all of the OEMs are large computer system and software suppliers located in the United States, Europe and Asia Pacific. The following table shows selected elements of the Company's consolidated financial statements as a percentage of total revenues.
Three Months Ended Nine Months Ended September 30, September 30, 1998 1997 1998 1997 ----------- ----------- ----------- ------- Revenues: Product 76.7% 79.2% 77.9% 78.8% Service and support 23.3 20.8 22.1 21.2 ---------- ----------- ---------- ----------- Total revenues 100.0 100.0 100.0 100.0 Cost of revenues: Product 3.1 3.5 3.0 3.4 Service and support 9.3 8.3 9.3 8.1 ---------- ----------- ---------- ----------- Total cost of revenues 12.4 11.8 12.3 11.5 ---------- ----------- ---------- ----------- Gross profit 87.6 88.2 87.7 88.5 Operating expenses: Research and development 16.1 16.9 15.8 18.1 Sales and marketing 33.6 33.8 36.5 34.8 General and administrative 6.6 8.3 7.5 8.3 Merger related expenses 1.7 -- 0.7 -- Amortization of intangibles 0.7 1.3 0.8 1.4 ---------- ----------- ---------- ----------- Total operating expenses 58.7 60.3 61.3 62.6 ---------- ----------- ---------- ----------- Income from operations 28.9 27.9 26.4 25.9 Interest and other income, net 3.0 2.5 3.0 2.6 ---------- --------- ---------- ----------- Income before provision for income taxes 31.9 30.4 29.4 28.5 Provision for income taxes 11.8 10.9 11.0 10.8 ---------- ----------- ---------- ----------- Net income 20.1% 19.5% 18.4% 17.7% ========== =========== ========== ===========
REVENUES Revenues for the third quarter ended September 30, 1998, increased 70.5 percent to $37.5 million, from $22.0 million for the comparable period in 1997. Revenues for the first nine months ended September 30, 1998, grew 70.7 percent to $98.6 million, from $57.8 million from the comparable period in 1997. Revenues increased primarily as a result of the continued acceptance of the Company's Networker family of products and G.E.M.S. product and increased sales of service and support contracts. Product Revenues. Product revenues increased 65.2 percent to $28.8 million for the third quarter of 1998, from $17.4 million for the comparable period in 1997. Product revenues increased 68.7 percent to $76.9 million for the first nine months of 1998, from $45.6 million for the comparable period in 1997. Product revenue increased primarily as a result of the continued market acceptance of the Company's products. The Company recognizes product revenues upon shipment if a signed contract exists, the fee is fixed and determinable, collection of resulting receivables is probable and product returns are reasonably estimable, except for sales to distributors, which are recognized upon sale by the distributors to end-users. Product revenues also include royalty payments received from product sales by OEMs. The Company recognizes product revenues from royalty payments upon receipt of quarterly royalty reports from OEMs related to their product sales for the previous quarter. Prior growth rates of the Company's product revenues are not indicative of future product revenue growth rates and may not be sustainable in the future. Service and Support Revenues. Service and support revenues increased 90.7 percent to $8.7 million for the third quarter of 1998, from $4.6 million for the comparable period in 1997. For the first nine months of 1998, service and support revenues increased 78.0 percent to $21.8 million, from $12.2 million for the comparable period in 1997. Service and support revenues increased primarily as a result of an increase in sales of certain of the Company's products that include one-year of software support, an increase in the number of registered customers for the Company's products electing to subscribe to support contracts, an increase in the renewal of software support after the initial one-year term, an increase in internal staffing for software support sales and an increase in demand for the education and consulting services offered by the Company. The Company collects fees for ongoing customer support and product updates in advance and recognizes these support revenues ratably over the period of the contract. For education and consulting services, the Company recognizes revenues when such services are performed. Prior growth rates of the Company's software service and support revenues are not indicative of future software service and support revenue growth rates and may not be sustainable in the future. International product revenues increased 100.0 percent to $10.4 million for the third quarter of 1998, from $5.2 million for the comparable period in 1997. International product revenues accounted for 27.7 percent of total product revenues for the third quarter of 1998 and 23.6 percent of total product revenues for the comparable period in 1997. For the first nine months of 1998, international product revenues increased 90.0 percent to $27.7 million, from $14.6 million for the comparable period in 1997. International product revenues accounted for 28.1 percent of total product revenues for the first nine months of 1998 and 25.2 percent of total product revenues for the comparable period in 1997. International license revenues increased primarily as a result of the increase in the market acceptance of the Company's products overseas, the increase in the number of international sales offices, and the increase in the number of international distributors and resellers marketing the Company's products. Sales in Europe and Canada during these periods accounted for a majority of the Company's international sales. The Company continues to expand its international operations, which requires significant management attention and financial resources and could materially adversely affect the Company's operating results. To the extent that the Company is unable to successfully expand its international operations, the Company's growth, if any, in international sales will be limited, and the Company's business, operating results and financial condition could be materially adversely affected. GROSS PROFIT Gross profit increased 69.5 percent to $32.9 million, representing 87.6 percent of total revenues, for the third quarter of 1998, from $19.4 million, representing 88.2 percent of total revenues, for the comparable period in 1997. For the first nine months of 1998, gross profit increased 69.1 percent to $86.6 million, representing 87.7 percent of total revenues, from $51.2 million, representing 88.5 percent of total revenues, for the comparable period in 1997. Gross profit consists of product and service and support revenues less related costs. Gross profit from product revenues increased 65.9 percent to $27.6 million for the third quarter of 1998, from $16.6 million for the comparable period in 1997. For the first nine months of 1998, gross profit from product revenues increased 69.5 percent to $74.0 million, from $43.6 million for the comparable period in 1997. Gross profit as a percentage of product revenues increased to 96.0 percent for the third quarter of 1998, from 95.6 percent for the comparable period in 1997. Gross profit from product revenues as a percentage of product revenues increased to 96.2 percent for the first nine months of 1998, from 95.8 percent for the comparable period in 1997. Gross profit from product revenues consists of product revenues less the related costs. Related costs of revenues consist primarily of product media, documentation and packaging. Gross profit from product revenues as a percentage of product revenues increased primarily due to leveraging the costs of products over a larger revenue base. Gross profit from service and support revenues increased 91.1 percent to $5.2 million during the third quarter of 1998, from $2.7 million for the comparable period in 1997. Gross profit from service and support revenue increased 66.9 percent to $12.6 million during the first nine months of 1998, from $7.5 million for the comparable period in 1997. Gross profit from service and support revenues as a percentage of service and support revenues represented 60.0 percent for the third quarters of 1998 and 1997. Gross profit from service and support revenues as a percentage of service and support revenues decreased to 57.9 percent during the first nine months of 1998, from 61.7 percent for the comparable period in 1997. Gross profit from service and support revenues as a percentage of service and support revenues decreased primarily as a result of the Company's continued investment in developing new services and support offerings. The continued investment consists of additional costs associated with supporting a larger installed base of products, as well as additional costs to provide higher support levels to customers. Costs of service and support revenues consist primarily of personnel-related costs incurred in providing telephone support, consulting services, and training to customers, costs of providing software updates and costs of education and consulting materials. OPERATING EXPENSES Research and Development. Research and development expenses increased 61.8 percent to $6.0 million in the third quarter of 1998, from $3.7 million for the comparable period in 1997. Research and development expenses increased 48.5 percent to $15.6 million in the first nine months of 1998, from $10.5 million for the comparable period in 1997. The increases in research and development expenses in absolute dollars primarily reflect increased staffing and associated support for engineers necessary to expand and enhance the Company's product line. As a percentage of total revenues, research and development expenses decreased to 16.1 percent in the third quarter of 1998, from 16.9 percent in the third quarter of 1997. As a percentage of total revenues, research and development expenses decreased to 15.8 percent in the first nine months of 1998, from 18.1 percent for the comparable period in 1997. Research and development expenses as a percentage of total revenues decreased primarily as a result of research and development expenses increasing less than the rate of increase in total revenues. The Company believes that research and development expenses will continue to increase in absolute dollars as it continues to invest in developing new products, applications, and product enhancements. Sales and Marketing. Sales and marketing expenses increased 69.6 percent to $12.6 million in the third quarter of 1998, from $7.4 million in the third quarter of 1997. Sales and marketing expenses increased 79.2 percent to $36.1 million in the first nine months of 1998, from $20.1 million for the comparable period in 1997. As a percentage of total revenues, sales and marketing expenses decreased to 33.6 percent in the third quarter of 1998, from 33.8 percent in the comparable 1997. As a percentage of total revenues, sales and marketing expenses increased to 36.5 percent in the first nine months of 1998, from 34.8 percent for the comparable period in 1997 primarily as a result of the growth in the Company's sales force and increased marketing and promotional activities. The Company believes that sales and marketing expenses will increase in absolute dollars as the Company continues to expand its sales and marketing staff. General and Administrative. General and administrative expenses increased 36.1 percent to $2.5 million in the third quarter of 1998, from $1.8 million for the comparable period of 1997. General and administrative expenses increased 55.4 percent to $7.4 million for the first nine months of 1998, from $4.8 million for the comparable period of 1997. As a percentage of total revenues, general and administrative expenses decreased to 6.6 percent in the third quarter of 1998, from 8.3 percent in the comparable 1997 period, and decreased to 7.5 percent for the first nine months in 1998, from 8.3 percent in the comparable 1997 period. General and administrative expenses as a percentage of total revenues decreased primarily as a result of the Company leveraging general and administrative expenses over a larger revenue base. The Company expects that general and administrative expenses will increase in absolute dollars from the third quarter of 1998 level as the Company continues to expand its staffing and other support operations. Amortization of Intangibles. Amortization of intangibles was $279,000 for the third quarters of both 1998 and 1997. Amortization of intangibles was $838,000 for the first nine months of both 1998 and 1997. The Company recorded the related intangibles following an acquisition in the first quarter of 1996. The Company amortizes these intangibles on a straight-line basis over five years. Interest and Other Income, Net. Interest and other income, net, increased to $1.1 million in the third quarter of 1998, from $543,000 for the comparable period in 1997. Interest and other income, net, increased to $3.0 million for the first nine months of 1998, from $1.5 million for the comparable period in 1997. The increase in interest income relates primarily to interest earned from the increased cash provided by the Company's operations. Provision for Income Taxes. The provision for income taxes increased to $4.4 million in the third quarter of 1998, from $2.4 million for the comparable period in 1997. The provision for income taxes increased to $10.9 million for the first nine months of 1998, from $6.3 million for the comparable period in 1997. The effective tax rate increased to 37 percent for the third quarter of 1998, from 36 percent for the comparable period in 1997. The effective tax rates for the first nine months of 1998 and 1997 were both 38 percent. The increase in the effective tax rate from the third quarter of 1997 to 1998 primarily relates to the restatement of the Company's historical financial statement in connection with the acquisition of Software Moguls, Inc. during the third quarter of 1998. Merger-Related Expenses. In connection with the Company's acquisition of Software Moguls during the third quarter of 1998, the Company incurred merger-related expenses of $645,000 consisting primarily of investment bankers, attorneys and accountants fees. The Company did not incur any merger-related expenses for the three-month and nine-month periods ended September 30, 1997. LIQUIDITY AND CAPITAL RESOURCES The Company's cash, cash equivalents and investments totaled $103.3 million at September 30, 1998 and represented 64.3 percent of total assets. Cash equivalents consist of highly liquid financial instruments with original maturities of ninety days or less. Investments consist mainly of short-term and long-term municipal securities. At September 30, 1998, the Company had no long-term debt and stockholders' equity was $127.0 million. The Company has generated sufficient cash from operations and sales of common stock to finance the Company's operations to date. Cash and cash equivalents increased $29.8 million during the first nine months of 1998. The Company derived cash provided by operating activities of $32.1 million, primarily from net income of $18.1 million, tax benefit from the exercise of stock options of $8.3 million and changes in operating assets and liabilities of $3.2 million. Cash used in investing activities of $9.4 million primarily reflected the purchases of available-for-sale securities (net of maturities and sales of available-for-sale securities), of $1.4 million and the acquisition of property and equipment of $8.0 million. Cash from financing activities of $7.2 million reflected proceeds received from the issuance of common stock under the Company's stock plans. The Company believes its current cash balances and cash flow from operations, if any, will be sufficient to meet its working capital and capital expenditure requirements for at least the next twelve months. YEAR 2000 COMPLIANCE Many currently installed computer systems and software products include coding to accept only two digit entries in the date code field. These date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, in less than fifteen months, computer systems and/or software used by many companies will need to be upgraded to comply with such "Year 2000" requirements. Systems that do not properly recognize such information could generate erroneous data or cause a system to fail. Significant uncertainty exists in the software industry concerning the potential effects associated with such compliance. The Company has conducted Year 2000 compliance reviews for current versions of the Company's products. The review includes assessment, implementation, validation testing and contingency planning. The Company continues to respond to customer concerns about prior versions of the Company's products on a case-by-case basis. Although the Company believes its software products are Year 2000 compliant, the Company provides no assurance that its software products contain all the necessary software routines and programs for the accurate calculation, display, storage and manipulation of data involving dates. Failure of the Company's software products to contain all the necessary software routines and programs for the accurate calculation, display, storage and manipulation of data involving dates would have a material adverse effect on the Company's business, operating results and financial condition. The Company has tested software obtained from third parties that is incorporated into the Company's products, and seeks assurances from vendors that licensed software is Year 2000 compliant. Despite testing by the Company, current customers and potential customers, and assurances from developers of products incorporated into the Company's products, such products may contain undetected errors or defects associated with Year 2000 date functions. Known or unknown errors or defects in the Company's products may result in delay or loss of revenue, diversion of development resources, damage to the Company's reputation, or increased service and warranty costs. The occurrence of any of the foregoing could materially adversely affect the Company's business, operating results, or financial condition. The Company does not currently have any information concerning the Year 2000 compliance status of its customers. As is the case with other similarly situated software companies, if its current or future customers fail to achieve Year 2000 compliance or if they divert technology expenditures to address Year 2000 compliance problems, the Company's business, results of operations, or financial condition could be materially adversely affected. The Company has initiated an assessment of material internal systems. The Company believes the software and hardware it uses internally comply with Year 2000 requirements and is not aware of any material operational issues or costs associated with preparing its internally used software and hardware for the Year 2000. However, the Company provides no assurances that it will not experience serious, unanticipated negative consequences, including material costs caused by undetected errors or defects in the technology used in its internal systems. The occurrence of any of the foregoing could have a material adverse effect on the Company's business, operating results or financial condition. The Company has funded its Year 2000 compliance review from operating cash flows and has not separately accounted for these costs in the past. The Company will incur additional amounts related to the Year 2000 compliance review including administrative personnel to manage the review, outside contractors to provide technical advice and technical support for its products, product engineering and customer satisfaction. However, management does not anticipate that the Company will incur significant operating expenses or be required to invest heavily in computer systems improvements to be Year 2000 compliant. The Company is currently developing contingency plans to be implemented as part of its efforts to identify and correct Year 2000 problems affecting its internal systems. The Company expects to complete its contingency plans by the first quarter of 1999. Depending on the systems affected, these plans could include accelerated replacement of affected equipment or software, short to medium-term use of backup equipment and software, increased work hours for Company personnel or use of contract personnel to correct (on an accelerated schedule) any Year 2000 problems that arise or to provide manual workarounds for information systems, and similar approaches. If the Company is required to implement any of these contingency plans, it could have a material adverse effect on the Company's financial condition and results of operations. The discussion of the Company's efforts, and management's expectations, relating to Year 2000 compliance are forward-looking statements. The Company's ability to achieve Year 2000 compliance and the level of incremental costs associated therewith, could be adversely impacted by, among other things, the availability and cost of programming and testing resources, vendors' ability to modify proprietary software, and unanticipated problems identified in the ongoing compliance review. RISK FACTORS In addition to the other information in this Report, the following risk factors should be considered carefully in evaluating the Company and its business: Fluctuations in Quarterly Operating Results; Future Operating Results Uncertain The Company's quarterly operating results have in the past varied and may in the future vary significantly depending on a number of factors, including, but not limited to, the size and timing of significant orders; increased competition; market acceptance of new products, applications and product enhancements; changes in pricing policies by the Company and its competitors; the ability of the Company to timely develop, introduce and market new products, applications and product enhancements and to control costs; the Company's success in expanding its sales and marketing programs; technological changes in the network storage management market; the mix of sales among the Company's channels; deferrals of customer orders in anticipation of new products, applications or product enhancements; changes in Company strategy; personnel changes; and general economic factors. The Company's future revenues are difficult to predict. The Company operates with virtually no order backlog because its software products typically are shipped shortly after orders are received. In addition, the Company does not recognize revenues on sales to domestic distributors until the products are sold through to end-users. As a result, product license revenues in any quarter are substantially dependent on orders booked and shipped and on sell-through to end-users in that quarter. Revenues for any future quarter are not predictable with any significant degree of certainty. Product licenses and software services and support revenues are difficult to forecast because the network storage management market is rapidly evolving and the Company's sales cycle varies substantially from customer to customer. The Company has become increasingly dependent upon the larger enterprise license transactions to corporate customers, which often include product license, service and support components. The Company's operating results are sensitive to the timing of such orders and are subject to purchasing cycles and budgetary constraints of the customer, which are difficult to predict. Due to the lengthier sales cycle and the larger size of enterprise license transactions, if orders forecasted for a particular quarter are not realized in that quarter, the Company's operating results for that quarter may be adversely affected. Royalty revenues are substantially dependent upon product license sales by OEMs of their products that incorporate the Company's software. Accordingly, royalty revenues are subject to OEMs' product cycles, which are also difficult to predict. Royalty revenues are further impacted by fluctuations in licensing activity from quarter-to-quarter, because initial license fees generally are non-recurring and recognized upon the signing of the license agreement. The Company's expense levels are based, in part, on its expectations as to future revenues. If revenue levels are below expectations, operating results are likely to be adversely affected. Net income may be disproportionately affected by a reduction in revenues because a proportionately smaller amount of the Company's expenses varies with its revenues. As a result, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Due to all of the foregoing factors, it is possible that in some future quarters the Company's operating results may be below the expectations of public market analysts and investors. In such event, the price of the Company's common stock would likely be materially adversely affected. Product Concentration The Company currently derives a substantial majority of its revenues from its NetWorker software products and related services, and the Company expects that revenues from NetWorker will continue to account for a majority of the Company's revenues for the foreseeable future. Broad market acceptance of NetWorker is, therefore, critical to the Company's future success. As a result, a decline in unit prices of or demand for NetWorker, or failure to achieve broad market acceptance of NetWorker, as a result of competition, technological change or otherwise, would have a material adverse effect on the business, operating results and financial condition of the Company. The life cycle of NetWorker is difficult to estimate due in large measure to the recent emergence of the Company's market, the effect of new products, applications or product enhancements, technological changes in the network storage management environment in which NetWorker operates and future competition. The Company's future financial performance will depend in part on the successful development, introduction and market acceptance of new products, applications and product enhancements. There can be no assurance that the Company will continue to be successful in marketing and licensing NetWorker or any new products, applications, product enhancements and related services. Competition The network storage management market is intensely competitive, highly fragmented and characterized by rapidly changing technology and evolving standards. Competitors vary in size and in the scope and breadth of the products and services offered. The Company's major competitors on the Novell NetWare and Windows NT platforms include Computer Associates (Cheyenne Software) and Seagate (Palindrome and Arcada); on the Sun Solaris/SunOS platform include Computer Associates (Legent/Lachman), EMC2 (Epoch), Peripheral Devices (Delta Microsystems), Spectra Logic and Veritas; on the AIX platform include IBM; and on the HP-UX platform include Hewlett Packard. In the future, as the Company enters new markets, the Company expects that such markets will have additional, market-specific competitors. In addition, many of the Company's existing competitors are broadening their platform coverage. The Company also expects increased competition from systems and network management companies, especially those that have historically focused on the mainframe market and are broadening their focus to include the client/server market. In addition, because there are relatively low barriers to entry in the software market, the Company expects additional competition from other established and emerging companies. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any of which could materially adversely affect the Company's business, operating results and financial condition. Many of the Company's current and potential competitors have significantly greater financial, technical, marketing and other resources than the Company. As a result, they may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, promotion, sale and support of their products than the Company. The Company also expects that competition will increase as a result of future software industry consolidations, which have occurred in the network storage management market in the past and are expected to occur in the future. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. In addition, network operating system vendors could introduce new or upgrade existing operating systems or environments that include storage management functionality offered by the Company's products, which could render the Company's products obsolete and unmarketable. There can be no assurance that the Company will be able to compete successfully against current or future competitors or that competitive pressures faced by the Company will not materially adversely affect its business, operating results and financial condition. Dependence on New Software Products; Rapid Technological Change The network storage management market is characterized by rapid technological change, changing customer needs, frequent new software product introductions and evolving industry standards. The introduction of products embodying new technologies and the emergence of new industry standards could render the Company's existing products obsolete and unmarketable. The Company's future success will depend upon its ability to develop and introduce new software products (including new releases, applications and enhancements) on a timely basis that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated needs of its customers. There can be no assurance that the Company will be successful in developing and marketing new products that respond to technological changes or evolving industry standards, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products, or that its new products will adequately meet the requirements of the marketplace or achieve market acceptance. If the Company is unable, for technological or other reasons, to develop and introduce new products in a timely manner in response to changing market conditions or customer requirements, the Company's business, operating results and financial condition will be materially adversely affected. The Company currently has plans to introduce and market several potential new products in the next twelve months. Some of the Company's competitors currently offer certain of these potential new products. Due to the complexity of client/server software and the difficulty in gauging the engineering effort required to produce these potential new products, such potential new products are subject to significant technical risks. There can be no assurance that such potential new products will be introduced on a timely basis or at all. In the past, the Company has experienced delays in the commencement of commercial shipments of its new products, resulting in customer frustrations and delay or loss of product revenues. If potential new products are delayed or do not achieve market acceptance, the Company's business, operating results and financial condition will be materially adversely affected. The Company has also, in the past, experienced delays in purchases of its products by customers anticipating the launch of new products by the Company. There can be no assurance that material order deferrals in anticipation of new product introductions will not occur, which could have a material adverse effect upon the Company's business, operating results and financial condition. Software products as complex as those offered by the Company may contain undetected errors or failures when first introduced or as new versions are released. The Company has in the past discovered software errors in certain of its new products after their introduction and has experienced delays or lost revenues during the period required to correct these errors. Although the Company has not experienced material adverse effects resulting from any such errors to date, there can be no assurance that, despite testing by the Company and by current and potential customers, errors will not be found in new products after commencement of commercial shipments, resulting in loss of or delay in market acceptance, which could have a material adverse effect upon the Company's business, operating results and financial condition. Risks Associated with Reliance on Enterprise License Transactions; Resellers; Strategy of Expanding OEM Channel An integral part of the Company's strategy is to pursue larger enterprise license transactions with corporate customers. As there has been an increasing number of larger enterprise license transactions, which may often include product license, service and support components, the Company's operating results are sensitive to the timing of such orders. These transactions are typically difficult to manage and predict. The execution of such larger enterprise license transactions typically involves significant technical evaluation and commitment of capital and other resources, with the delays frequently associated with customers' internal procedures, including delays to approve large capital expenditures, to implement the deployment of new technologies within their networks, and to test and accept new technologies that affect key operations. For these and other reasons, the sales cycle associated with the completing an enterprise license transaction is typically lengthy, generally lasting three to six months, is subject to a number of significant risks, including customers' budgetary constraints and internal acceptance reviews, that are beyond the Company's control, and varies substantially from transaction to transaction. Due to the lengthy sales cycle and the large size of certain transactions, if orders forecasted for a specific transaction for a particular quarter are not realized in that quarter, the Company's operating results for that quarter may be adversely affected. There can be no assurance that the Company will continue to complete or increase the number of such larger enterprise license transactions, and the inability to do so could materially adversely affect the Company's business, operating results and financial condition. The Company relies significantly on its distributors, systems integrators and value added resellers (collectively, "resellers") for the marketing and distribution of its products. The Company's agreements with resellers are generally not exclusive and in many cases may be terminated by either party without cause. Many of the Company's resellers carry product lines that are competitive with those of the Company. There can be no assurance that these resellers will give a high priority to the marketing of the Company's products (they may, in fact, give a higher priority to other products, including the products of competitors) or that they will continue to carry the Company's products. Events or occurrences of this nature could materially adversely affect the Company's business, operating results and financial condition. The Company's results of operations could also be materially adversely affected by changes in reseller inventory strategies, which could occur rapidly, and in many cases, may not be related to end user demand. There can be no assurance that the Company will retain any of its current resellers, nor can there be any assurance that the Company will be successful in recruiting replacement or new organizations to represent it. Any such changes in the Company's distribution channels could materially adversely affect the Company's business, operating results and financial condition. The Company's strategy is also to increase the proportion of the Company's customers licensed through OEMs. The Company is currently investing, and intends to continue to invest, resources to develop this channel, which could materially adversely affect the Company's operating margins. There can be no assurance that the Company will be successful in its efforts to increase the revenues represented by this channel. The Company is dependent upon its OEMs' ability to develop new products, applications and product enhancements on a timely and cost-effective basis that will meet changing customer needs and respond to emerging industry standards and other technological changes. There is no assurance that the Company's OEMs will effectively meet these technological challenges. These OEMs are not within the control of the Company, may incorporate into their products the technologies of other companies in addition to those of the Company and are not obligated to purchase products from the Company. In addition, the Company's OEMs generally have exclusive rights to the Company's technology on their respective platforms, subject to certain minimum royalty obligations. There can be no assurance that any OEM will continue to carry the Company's products, and the inability to recruit, or the loss of, important OEMs could materially adversely affect the Company's business, operating results and financial condition. International Operations; Risks Associated with International Sales The Company believes that its continued growth and profitability will require further expansion of its international operations. In order to successfully expand international sales, the Company must establish additional foreign operations, hire additional personnel and recruit additional international resellers. This will require significant management attention and financial resources and could materially adversely affect the Company's operating margins. To the extent that the Company is unable to effect these additions in a timely manner, the Company's growth, if any, in international sales will be limited, and the Company's business, operating results and financial condition could be materially adversely affected. In addition, there can be no assurance that the Company will be able to maintain or increase international market demand for the Company's products. The Company's international sales are currently denominated in U.S. dollars. An increase in the value of the U.S. dollar relative to foreign currencies could make the Company's products more expensive and, therefore, potentially less competitive in those markets. In some markets, localization of the Company's products is essential to achieve market penetration. The Company may incur substantial costs and experience delays in localizing its products, and there can be no assurance that any localized product will ever generate significant revenues. In addition, the Company relies significantly on its distributors and other resellers in international sales efforts. Since these distributors and other resellers are not employees of the Company and typically do not offer the Company's products exclusively, there can be no assurance that they will continue to market the Company's products. Additional risks inherent in the Company's international business activities generally include unexpected changes in regulatory requirements, tariffs and other trade barriers, lack of acceptance of localized products, if any, in foreign countries, longer accounts receivable payment cycles, difficulties in managing international operations, potentially adverse tax consequences including restrictions on the repatriation of earnings, and the burdens of complying with a wide variety of foreign laws. There can be no assurance that such factors will not have a material adverse effect on the Company's future international sales and, consequently, the Company's business, operating results and financial condition. Management of Expanding Operations The Company has recently experienced a period of significant expansion of its operations that has placed a significant strain upon its management systems and resources. In addition, the Company has recently hired a significant number of employees, and plans to further increase its total headcount. The Company also plans to expand the geographic scope of its customer base and operations. This expansion has resulted and will continue to result in substantial demands on the Company's management resources. From time to time, the Company receives customer complaints about the timeliness and accuracy of customer support. Although the Company plans to add customer support personnel in order to address current customer support needs and intends to closely monitor progress in this area, there can be no assurance that these efforts will be successful. If the Company's efforts are not successful, the Company's business, operating results and financial condition could be materially adversely affected. The Company's ability to compete effectively and to manage future expansion of its operations, if any, will require the Company to continue to improve its financial and management controls, reporting systems and procedures on a timely basis and expand, train and manage its employee work force. There can be no assurance that the Company will be able to do so successfully. The Company's failure to do so could have a material adverse effect upon the Company's business, operating results and financial condition. Dependence Upon Key Personnel The Company's future performance also depends in significant part upon the continued service of its key technical and senior management personnel, none of whom is bound by an employment agreement. The loss of the services of one or more of the Company's officers or other key employees could have a material adverse effect on the Company's business, operating results and financial condition. The Company's future success also depends on its continuing ability to attract and retain highly qualified technical and managerial personnel. Competition for such personnel is intense, and there can be no assurance that the Company can retain its key technical and managerial employees or that it can attract, assimilate or retain other highly qualified technical and managerial personnel in the future. Dependence on Growth in the Network Storage Management Market; General Economic and Market Conditions All of the Company's business is in the network storage management market, which is still an emerging market. The Company's future financial performance will depend in large part on continued growth in the number of organizations adopting network storage management solutions for their client/server computing environments. There can be no assurance that the market for network storage management will continue to grow. If the network storage management market fails to grow or grows more slowly than the Company currently anticipates, the Company's business, operating results and financial condition would be materially adversely affected. During recent years, segments of the computer industry have experienced significant economic downturns characterized by decreased product demand, production overcapacity, price erosion, work slowdowns and layoffs. The Company's operations may in the future experience substantial fluctuations from period-to-period as a consequence of such industry patterns, general economic conditions affecting the timing of orders from major customers, and other factors affecting capital spending. There can be no assurance that such factors will not have a material adverse effect on the Company's business, operating results or financial condition. Dependence on Proprietary Technology; Risks of Infringement The Company depends significantly upon proprietary technology. The Company relies on a combination of patent, copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect its proprietary rights. The Company seeks to protect its software, documentation and other written materials under patent, trade secret and copyright laws, which afford only limited protection. There can be no assurance that the Company will develop proprietary products or technologies that are patentable, that any issued patent will provide the Company with any competitive advantages or will not be challenged by third parties, or that the patents of others will not have a material adverse effect on the Company's ability to do business. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or to obtain and use information that the Company regards as proprietary. Policing unauthorized use of the Company's products is difficult, and although the Company is unable to determine the extent to which piracy of its software products exists, software piracy can be expected to be a persistent problem. In licensing its products (other than in enterprise license transactions), the Company relies primarily on "shrink wrap" licenses that are not signed by licensees, and, therefore, such licenses may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that the Company's means of protecting its proprietary rights will be adequate or that the Company's competitors will not independently develop similar technology, duplicate the Company's products or design around patents issued to the Company or other intellectual property rights of the Company. There have also been substantial amounts of litigation in the software industry regarding intellectual property rights. The Company has from time to time received claims that it is infringing third parties' intellectual property rights, and there can be no assurance that third parties will not in the future claim infringement by the Company with respect to current or future products, trademarks or other proprietary rights. The Company expects that software product developers will increasingly be subject to infringement claims as the number of products and competitors in the Company's industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require the Company to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to the Company or at all, which could have a material adverse effect upon the Company's business, operating results and financial condition. Product Liability The Company's license agreements with its customers typically contain provisions designed to limit the Company's exposure to potential product liability claims. In licensing its products (other than in enterprise license transactions), the Company relies primarily on "shrink wrap" licenses that are not signed by licensees, and, therefore, such licenses may be unenforceable under the laws of certain jurisdictions. As a result of these and other factors, the limitation of liability provisions contained in the Company's license agreements may not be effective. The Company's products can be used to manage data critical to organizations, and, as a result, the sale and support of products by the Company may entail the risk of product liability claims. A successful product liability claim brought against the Company could have a material adverse effect upon the Company's business, operating results and financial condition. Year 2000 Compliance Many currently installed computer systems and software products include coding to accept only two digit entries in the date code field. These date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, in less than fifteen months, computer systems and/or software used by many companies will need to be upgraded to comply with such "Year 2000" requirements. Systems that do not properly recognize such information could generate erroneous data or cause a system to fail. Significant uncertainty exists in the software industry concerning the potential effects associated with such compliance. The Company has conducted Year 2000 compliance reviews for current versions of the Company's products. The review includes assessment, implementation, validation testing and contingency planning. The Company continues to respond to customer concerns about prior versions of the Company's products on a case-by-case basis. Although the Company believes its software products are Year 2000 compliant, the Company provides no assurance that its software products contain all the necessary software routines and programs for the accurate calculation, display, storage and manipulation of data involving dates. Failure of the Company's software products to contain all the necessary software routines and programs for the accurate calculation, display, storage and manipulation of data involving dates would have a material adverse effect on the Company's business, operating results and financial condition. The Company has tested software obtained from third parties that is incorporated into the Company's products, and seeks assurances from vendors that licensed software is Year 2000 compliant. Despite testing by the Company, current customers and potential customers, and assurances from developers of products incorporated into the Company's products, such products may contain undetected errors or defects associated with Year 2000 date functions. Known or unknown errors or defects in the Company's products may result in delay or loss of revenue, diversion of development resources, damage to the Company's reputation, or increased service and warranty costs. The occurrence of any of the foregoing could materially adversely affect the Company's business, operating results, or financial condition. The Company does not currently have any information concerning the Year 2000 compliance status of its customers. As is the case with other similarly situated software companies, if its current or future customers fail to achieve Year 2000 compliance or if they divert technology expenditures to address Year 2000 compliance problems, the Company's business, results of operations, or financial condition could be materially adversely affected. The Company has initiated an assessment of material internal systems. The Company believes the software and hardware it uses internally comply with Year 2000 requirements and is not aware of any material operational issues or costs associated with preparing its internally used software and hardware for the Year 2000. However, the Company provides no assurances that it will not experience serious, unanticipated negative consequences, including material costs caused by undetected errors or defects in the technology used in its internal systems. The occurrence of any of the foregoing could have a material adverse effect on the Company's business, operating results or financial condition. The Company has funded its Year 2000 compliance review from operating cash flows and has not separately accounted for these costs in the past. The Company will incur additional amounts related to the Year 2000 compliance review including administrative personnel to manage the review, outside contractors to provide technical advice and technical support for its products, product engineering and customer satisfaction. However, management does not anticipate that the Company will incur significant operating expenses or be required to invest heavily in computer systems improvements to be Year 2000 compliant. The Company is currently developing contingency plans to be implemented as part of its efforts to identify and correct Year 2000 problems affecting its internal systems. The Company expects to complete its contingency plans by the first quarter of 1999. Depending on the systems affected, these plans could include accelerated replacement of affected equipment or software, short to medium-term use of backup equipment and software, increased work hours for Company personnel or use of contract personnel to correct (on an accelerated schedule) any Year 2000 problems that arise or to provide manual workarounds for information systems, and similar approaches. If the Company is required to implement any of these contingency plans, it could have a material adverse effect on the Company's financial condition and results of operations. The discussion of the Company's efforts, and management's expectations, relating to Year 2000 compliance are forward-looking statements. The Company's ability to achieve Year 2000 compliance and the level of incremental costs associated therewith, could be adversely impacted by, among other things, the availability and cost of programming and testing resources, vendors' ability to modify proprietary software, and unanticipated problems identified in the ongoing compliance review. Possible Volatility of Stock Price The trading price of the Company's common stock has been subject to wide fluctuations. The trading price of the Company's common stock could be subject to wide fluctuations in the future in response to quarterly variations in operating results, announcements of technological innovations or new products, applications or product enhancements by the Company or its competitors, changes in financial estimates by securities analysts and other events or factors. In addition, the stock market has experienced volatility that has particularly affected the market prices of equity securities of many high technology companies. The volatility of the market has often been unrelated to the operating performance of such companies. These broad market fluctuations may adversely affect the market price of the Company's common stock. PART II: Other Information Item 5. Other Information Stockholder Proposals Pursuant to new amendments to Rule 14a-4(c) of the Securities Exchange Act of 1934, as amended, if a stockholder who intends to present a proposal at the 1999 annual meeting of stockholders does not notify the Company of such proposal on or prior to March 15, then management proxies would be allowed to use their discretionary voting authority to vote on the proposal when the proposal is raised at the annual meeting, even though there is no discussion of the proposal in the 1999 proxy statement. The Company currently believes that the 1999 annual meeting of stockholders will be held during the first two weeks of May, 1999. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 27.1 Financial Data Schedule (b) Reports on Form 8-K No reports of Form 8-K were filed during the quarter ended September 30, 1998. SIGNATURE 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. LEGATO SYSTEMS, INC. Date: November 12, 1998 /s/ Stephen C. Wise ------------------- Stephen C. Wise Senior Vice President of Finance and Chief Financial Officer (Duly authorized officer and principal financial and accounting officer) EX-27.1 2 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CONDENSED CONSOLIDATED BALANCE SHEET - UNAUDITED AND CONDENSED CONSOLIDATED STATEMENT OF INCOME AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 0000859360 LEGATO SYSTEMS, INC. 1000 9-MOS DEC-31-1998 JAN-01-1998 SEP-30-1998 64,716 38,615 30,597 0 0 133,392 15,164 0 160,817 33,258 0 0 0 0 127,028 160,817 0 98,638 12,086 72,622 0 0 0 29,010 10,883 0 0 0 0 18,127 0.49 0.46
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