December 15, 1997
SYSTEMSOFT CORP (SYSF)
Quarterly Report (SEC form 10-Q)
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is a discussion of the financial condition and results of operations of the Company for the three and nine months
ended October 31, 1997 and 1996. The Company designs, develops, markets, licenses and supports to the personal computer
industry call-avoidance software and system-level software designed to be the communication path between the personal
computer hardware and its operating system software. The principal markets for the Company's products are U.S. and Asia
Pacific based manufacturers of personal computers and related devices.
On December 19, 1996 the Company acquired Radish Communications Systems, Inc. ("Radish"), a developer of advanced
telecommunications software by means of a merger of a wholly-owned subsidiary of the Company with and into Radish with
Radish as the surviving corporation ("the Radish Merger"). The acquisition was accounted for as a purchase and accordingly
the results of Radish are included in the consolidated financial statements since the date of acquisition.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain financial data as a percentage of total revenues (except cost of
revenues items, which are set forth as a percentage of the corresponding revenue items):
Three Months Ended October 31, Nine Months Ended October 31,
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1997 1996 1997 1996
---- ---- ---- ----
Revenues:
Software license fees 90.3% 76.0% 85.5% 67.4%
Engineering services 8.1 15.6 11.4 25.3
Related party 0.8 8.4 2.4 7.3
Other 0.8 0.0 0.7 0.0
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Total revenues 100.0 100.0 100.0 100.0
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Cost of revenues:
Software license fees 13.4 11.0 11.8 9.9
Engineering services 136.9 57.3 84.3 37.5
Related party 572.6 36.1 140.2 36.6
Other 69.6 0.0 40.0 0.0
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Total cost of revenues 28.4 20.3 23.4 18.8
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Gross margin 71.6 79.7 76.6 81.2
Operating expenses:
Research and development 25.2 21.3 25.1 21.1
Sales and marketing 24.5 24.7 25.3 27.6
General and administrative 13.9 9.2 13.1 8.6
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Total operating expenses 63.6 55.2 63.5 57.3
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Income from operations 7.9 24.5 13.1 23.9
Other income 1.0 0.9 0.6 1.0
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Income before provision for income taxes 8.9 25.4 13.7 24.9
Provision for income taxes 1.8 8.9 4.1 8.7
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Net income 7.3% 16.5% 9.6% 16.2%
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Comparison of Three Months Ended October 31, 1997 and 1996
Revenues. Revenues were $13,233,000 and $10,308,000 in the three months ended October 31, 1997 and 1996,
respectively, an increase of approximately 28%. Software license fees increased to $11,944,000 from $7,839,000 or
approximately 52%. This increase was primarily due to growth in software license fees for the Company's call avoidance
product, SystemWizard, as well as growth in software license fees for the Company's system-level platform products. Certain
contracts include fixed royalty fees for various time periods in lieu of royalties on a per unit basis. Revenues attributable to such
fees, which are included in software license fees, were $2,635,000 and $1,100,000 in the three months ended October 31,
1997 and 1996, respectively. Although such contracts provide for fixed payments to be made at specified time periods, the
timing or amount of such payments may be renegotiated as a matter of business practice. In the three months ended October
31, 1997 and 1996 no revenue was recognized which resulted from renegotiated contract terms.
Revenues from engineering services decreased to $1,071,000 from $1,599,000 in the three months ended October 31, 1997
and 1996, respectively, or approximately 33% due primarily to the cancellation, in the fourth quarter of fiscal 1997, of the
SystemWizard development agreement with Digital Equipment Corporation. Related party revenues decreased to $108,000
from $870,000, or approximately 88%. Included in related party revenues were revenues generated under the Development
and License Agreement, as amended, with Intel Corporation (The "Intel Agreement"). Revenues under the Intel Agreement
were $0 and $750,000 for the three months ended October 31, 1997 and 1996, respectively. The Intel Agreement expired on
July 31, 1997 and no additional revenue will be recorded from this agreement.
Cost of Revenues. Cost of revenues was $3,762,000 and $2,095,000 in the three months ended October 31, 1997 and 1996,
respectively. These numbers represent a period over period increase of $1,667,000 or 80%. Cost of revenues consists
primarily of amortization of software development costs and purchased software, royalties due third parties and engineering
costs, principally direct engineering compensation expenses, associated with engineering services revenue. Cost of revenues as
a percentage of revenues increased to 28% from 20% in the three months ended October 31, 1997 and 1996, respectively.
Cost of software license fees as a percentage of software license fees revenues increased to 13% from 11%, respectively,
primarily due to increases in royalties and amortization of purchased software and software development costs. The increase in
amortization expense in both absolute dollars and percentage of revenues was due to increases in purchased software and
capitalized development costs. The increase in royalties is due to the increased volume of SystemWizard revenue.
SystemWizard revenue is subject to varying royalties payable to certain vendors for licensed technology on different product
offerings within the SystemWizard family. These royalties may effect the total gross margin realized by the Company in any
particular reporting period depending upon the mix of the individual SystemWizard products sold as well as the percentage of
SystemWizard revenue when compared to the Company's total revenue.
Cost of engineering services increased as a percentage of engineering service revenues to 137% from 57% in the three months
ended October 31, 1997 and 1996, respectively primarily due to increased staffing levels in the engineering department as well
as the increased engineering effort required in the implementation of SystemWizard technology. Cost of related party revenues
as a percentage of related party revenues increased to 573% from 36%, due to the completion of revenue recognition
associated with the Intel Agreement while the royalties due the related party under the Intel Agreement on sales of the
Company's PC Card software and SystemWizard is continuing.
Research and Development. Research and development expenses, consisting primarily of payroll and related expenses, were
$3,333,000 and $2,192,000, net of capitalized development costs of $171,000 and $771,000 in the three months ended
October 31, 1997 and 1996, respectively. These results represent a period over period increase of $1,141,000 or 52%. As a
percent of revenue, research and development expenses increased to 25% from 21%. The increase in expenses resulted
primarily from payroll, benefits and related recruiting costs of staff additions from the purchase of Radish and to support the
Company's new product development efforts.
Sales and Marketing. Sales and marketing expenses, consisting primarily of payroll and related expenses, costs of marketing
programs and events, sales commissions to internal sales personnel and independent manufacturers' representatives and travel
costs, were $3,246,000 and $2,549,000 in the three months ended October 31, 1997 and 1996, respectively, an increase of
$697,000 or approximately 27%. The increase was primarily due to staff additions and related personnel expenses as well as
increased product marketing expenses. As a percent of revenue, sales and marketing expenses were 25% in the three months
ended October 31, 1997 and 1996.
General and Administrative. General and administrative expenses, consisting primarily of payroll and related expenses,
provision for doubtful accounts and professional fees, were $1,845,000 and $948,000 in the three months ended October 31,
1997 and 1996, respectively, an increase of approximately 95%. The increase was primarily due to increases in the provision
for doubtful accounts and additional staff hires. Also, the Company incurred moving costs associated with the September 1997
relocation of its corporate headquarters. As a percent of revenue general and administrative expenses increased to 14% from
9%.
Provision for Income Taxes. Provision for income taxes was $236,000 and $917,000 in the three months ended October 31,
1997 and 1996, respectively. The provision for the three months ended October 31, 1997 represents 20% of pre-tax income
as compared to 35% of pre-tax income for the three months ended October 31, 1996. In the quarter ended October 31, 1997
the Company reduced its annual effective tax rate to 30% from 33%. The Company had been providing for taxes at a 33%
rate in its previous two fiscal quarters and thus recorded the 20% rate in the quarter ended October 31, 1997 to reach an
annual provision of 30% of pre-tax income. This effective tax rate decrease is the result of the utilization of certain tax credits
including the credit for research and experimentation costs.
Comparison of Nine Months Ended October 31, 1997 and 1996
Revenues. Revenues were $38,615,000 and $27,649,000 in the nine months ended October 31, 1997 and 1996, respectively,
an increase of approximately 40%. Software license fees increased to $33,017,000 from $18,650,000 or approximately 77%.
This increase was primarily due to growth in software license fees for the Company's call avoidance product, SystemWizard, as
well as growth in the software license fees for the Company's system-level platform products. Certain contracts include fixed
royalty fees for various time periods in lieu of royalties on a per unit basis. Revenues attributable to such fees, which are
included in software license fees, were $5,932,000 and $2,150,000 in the nine months ended October 31, 1997 and 1996,
respectively. Although such contracts provide for fixed payments to be made at specified time periods, the timing or amount of
such payments may be renegotiated as a matter of business practice. The fixed royalties recognized from renegotiated contracts
were $260,000 and $452,000 in the nine months ended October 31, 1997 and 1996, respectively. Such revenue would have
otherwise been recorded in subsequent fiscal quarters.
Engineering services revenue decreased to $4,418,000 from $6,989,000 or approximately 37%. This decrease was due to a
drop in engineering services revenue for all products; however the largest decrease was in SystemWizard due to the
cancellation in fiscal 1997 of the development agreement with Digital Equipment Corporation. Related party revenues
decreased to $923,000 from $2,010,000 or approximately 54%. Revenues generated under the Intel Agreement were
$750,000 and $1,500,000 for the nine months ended October 31, 1997 and 1996, respectively. The Intel Agreement expired
on July 31, 1997 and no additional revenue will be recorded from this agreement.
Cost of Revenues. Cost of revenues was $9,025,000 and $5,202,000 in the nine months ended October 31, 1997 and 1996,
respectively. These numbers represent a period over period increase of $3,823,000 or 73%. Cost of revenues as a percentage
of revenues increased to 23% from 19% in the nine months ended October 31, 1997 and 1996, respectively. Cost of software
license fees as a percentage of software license fees revenues increased to 12% from 10% primarily due to increases in
amortization of purchased software and royalty expenses associated with SystemWizard revenue. The increase in amortization
expense in both absolute dollars and percentage of revenues was due to the increased asset balance in purchased software and
the commencement of amortization with new product releases. SystemWizard revenue is subject to varying royalties payable to
certain vendors for licensed technology on different product offerings within the SystemWizard family. These royalties may
effect the total gross margin realized by the Company in any particular reporting period depending upon the mix of the individual
SystemWizard products sold as well as the percentage of SystemWizard revenue when compared to the Company's total
revenue.
Cost of engineering services increased as a percentage of engineering service revenues to 84% from 38% in the nine months
ended October 31, 1997 and 1996, respectively. This increase was primarily the result of increased staffing levels and the
additional engineering costs associated with the delivery of SystemWizard. Cost of related party revenues as a percentage of
related party revenues increased to 140% from 37%, due to an overall decrease in the amount of revenue recognized
accompanied by an increase related party cost of sales. This increase in related party costs is due to increased royalties due
Intel for sales of SystemWizard.
Research and Development. Research and development expenses were $9,676,000 and $5,811,000, net of capitalized
development costs of $511,000 and $1,974,000 in the nine months ended October 31, 1997 and 1996, respectively, an
increase of approximately 67%. As a percent of revenue, research and development expenses increased to 25% from 21%.
The increase in expenses resulted primarily from staff additions as a result of the purchase of Radish and staff additions to
support the Company's new product development efforts.
Sales and Marketing. Sales and marketing expenses were $9,772,000 and $7,634,000 in the nine months ended October 31,
1997 and 1996, respectively, an increase of approximately 28%. The percentage increase was primarily due to staff additions,
increased costs of marketing programs and events, sales commissions resulting from the increased level of revenue and
increased travel expenses. Sales and marketing expenses as a percentage of revenues decreased to 25% from 28% due to the
substantial relative growth in revenues.
General and Administrative. General and administrative expenses were $5,070,000 and $2,382,000 in the nine months ended
October 31, 1997 and 1996, respectively, an increase of approximately 113%. The increase was primarily due to an increase
in the provision for doubtful accounts over the same period last year as well as increased professional fees and additional staff
hires. Due to these increases general and administrative expenses as a percentage of revenue increased to 13% from 9%.
Provision for Income Taxes. Provision for income taxes was $1,600,000 and $2,406,000 for the nine months ended October
31, 1997 and 1996, respectively. The provision for the nine months ended October 31, 1997 represents 30% of pre-tax
income as compared to 35% of pre-tax income for the nine months ended October 31, 1996. This effective tax rate decrease
is the result of the utilization of certain tax credits including the credit for research and experimentation costs.
LIQUIDITY AND CAPITAL RESOURCES
During the nine months ended October 31, 1997, the Company funded its operations primarily through its operating profits and
through a private sale of its common stock. As of October 31, 1997, the Company had cash and cash equivalents and
marketable securities of $12,376,000 and working capital of $34,576,000. The Company had a net increase of cash and cash
equivalents and marketable securities of $467,000 for the nine months ended October 31, 1997. The principal uses of cash for
the nine months ended October 31, 1997 were a $4,000,000 cash payment for a royalty agreement termination (see below),
purchases of property and equipment of $3,094,000 and purchases of software of $3,615,000.
In February 1997, the Company terminated its Software Development and License Agreement (the "Original Agreement") with
Digital Equipment Corporation ("DEC") whereby the Company agreed to provide DEC certain license privileges and guarantee
payments of $6,750,000 in lieu of future royalties which would have been paid over the life of the
System Wizard software products. The guaranteed payments include cash payments of $5,500,000 of which $4,000,000 has
heretofore been made by the Company. In addition a $1,250,000 receivable due the Company from DEC was offset in the
first quarter. The Company has begun expensing these amounts based upon the royalty rates negotiated in the Original
Agreement and expects the amounts to be substantially expensed by the end of fiscal 1999.
During the nine months ended October 31, 1997, the Company's financing activities have provided cash of $1,541,000 due to
the exercise of stock options. In May 1997, the Company completed a private placement of its common stock whereby the
Company sold 1,066,666 shares of stock and the Company received gross proceeds of $8,000,000. Additionally, in
September 1997, the Company finalized a revolving line of credit with a bank under which the Company may borrow up to the
lesser of $7,000,000 or 85% of eligible accounts receivable, conditioned upon maintaining certain financial covenants, including
specified levels of quarterly earnings, tangible net worth, working capital and liquidity. At October 31, 1997 the Company had
no borrowings outstanding under the line of credit. The line of credit also limits the Company's ability to pay dividends. The
Company believes that its current cash balances and cash flow from operations will be sufficient to meet its working capital and
capital expenditure requirements through the next twelve months. To date, inflation has not had a material impact on the
Company's financial results.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
Information provided by the Company or statements made by its employees may contain "forward-looking" information which
involves risk and uncertainties. In particular, statements contained in the Management's Discussion and Analysis of Financial
Condition and Results of Operations which are not historical facts (including, but not limited to, statements concerning
sufficiency of funds for the Company's working capital and capital expenditures) are "forward-looking statements." The
Company's actual future results may differ significantly from those stated in any forward-looking statements. Factors that may
cause such differences include, but are not limited to, the factors discussed below as well as the accuracy of the Company's
internal estimates of revenue and operating expense levels. Each of these factors, and others, are discussed from time to time in
the Company's Securities and Exchange Commission filings including its annual report on Form 10-K for the period ended
January 31, 1997 filed on May 1, 1997.
The Company's future operating results are subject to substantial risks and uncertainties. Revenue growth rates experienced by
the Company to date may not be indicative of future growth rates and there can be no assurance that the Company will remain
profitable in the future. The market for the Company's system-level and call-avoidance software is characterized by rapidly
changing technology, evolving industry standards and frequent new product introductions. The Company's future success will
depend upon its ability to enhance its current software and to develop and introduce new software which keeps pace with
technological developments and evolving industry standards as well as to respond to changes in customer requirements. The
Company may confront new competitors as it introduces new products and expands into new markets. Certain current and
potential competitors of the Company are more established, benefit
from greater market recognition and have substantially greater financial, development and marketing resources than the
Company. Competitive pressures or other factors, including entry into new markets, may result in unit royalty erosion that could
have a material adverse effect on the Company's results of operations. The Company believes that its success to date has been
largely dependent on the adoption of its software by key participants in the PC industry the loss of which could adversely affect
the Company's product development efforts. In addition, the inability of the Company to replace revenues provided by a key
customer could have a material adverse effect on the Company's business and financial condition. The Company's success to
date has depended to a significant extent upon a number of key management and technical employees. The loss of services of
one or more of these key employees could have a material adverse effect on the Company's business and financial condition.
The Company believes that future results of operations may fluctuate significantly based upon several factors including the timing
of new product introductions, product mix, utilization of pilot programs of SystemWizard, changes in level of operating
expenses, gain or loss of significant customers, personnel changes, activities of competitors, the ability of the Company to
penetrate new markets and changes in general economic conditions in general and in the Company's industry. SystemWizard
revenue is subject to varying royalties payable to certain vendors for licensed technology on different product offerings within
the SystemWizard family. These royalties may effect the total gross margin realized by the Company in any particular reporting
period depending upon the mix of the individual SystemWizard products sold as well as the percentage of SystemWizard
revenue when compared to the Company's total revenue. The volume, timing and nature of new contracts could have a
significant impact on operating results for a particular quarter and may result in unanticipated quarterly earnings, shortfalls or
losses. In such an event, the price of the Company's Common Stock would likely be materially adversely affected. |
