UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ COMMISSION FILE NUMBER 000-20900 COMPUWARE CORPORATION --------------------- (Exact name of registrant as specified in its charter) MICHIGAN 38-2007430 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) ONE CAMPUS MARTIUS, DETROIT, MI 48226-5099 (Address of principal executive offices including zip code) Registrant's telephone number including area code: (313) 227-7300 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act): Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's class of common stock, as of the latest practicable date: As of November 2nd, 2004, there were outstanding 387,155,192 shares of Common Stock, par value $.01, of the registrant. Page 1 of 25 pages Page ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets as of September 30, 2004 and March 31, 2004 3 Condensed Consolidated Statements of Operations for the three and six months ended September 30, 2004 and 2003 4 Condensed Consolidated Statements of Cash Flows for the six months ended September 30, 2004 and 2003 5 Notes to Condensed Consolidated Financial Statements 6 Report of Independent Registered Public Accounting Firm 15 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 16 Item 3. Quantitative and Qualitative Disclosures about Market Risk 26 Item 4. Controls and Procedures 26 PART II. OTHER INFORMATION Item 1. Legal Proceedings 27 Item 4. Submission of Matters to a Vote of Security Holders 28 Item 6. Exhibits 29 SIGNATURES 30 2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS COMPUWARE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) SEPTEMBER 30, MARCH 31, 2004 2004 ---------- ---------- (UNAUDITED) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 376,281 $ 454,916 Investments 163,932 149,654 Accounts receivable, net 408,980 452,057 Deferred tax asset, net 31,440 32,460 Income taxes refundable, net 32,162 33,946 Prepaid expenses and other current assets 24,374 19,976 Building - held for sale 19,702 ---------- ---------- Total current assets 1,056,871 1,143,009 ---------- ---------- INVESTMENTS 154,439 162,484 ---------- ---------- PROPERTY AND EQUIPMENT, LESS ACCUMULATED DEPRECIATION AND AMORTIZATION 423,975 444,401 ---------- ---------- CAPITALIZED SOFTWARE, LESS ACCUMULATED AMORTIZATION 48,552 45,489 ---------- ---------- OTHER: Accounts receivable 214,449 198,742 Goodwill 289,539 213,359 Other 36,648 26,597 ---------- ---------- Total other assets 540,636 438,698 ---------- ---------- TOTAL ASSETS $2,224,473 $2,234,081 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 26,058 $ 35,298 Accrued expenses 132,282 154,962 Deferred revenue 307,143 302,804 ---------- ---------- Total current liabilities 465,483 493,064 DEFERRED REVENUE 293,445 300,664 ACCRUED EXPENSES 18,184 22,073 DEFERRED TAX LIABILITY, NET 12,797 4,689 ---------- ---------- Total liabilities 789,909 820,490 ---------- ---------- SHAREHOLDERS' EQUITY: Common stock 3,871 3,853 Additional paid-in capital 735,944 722,206 Retained earnings 689,169 681,115 Foreign currency translation adjustment 5,580 6,417 ---------- ---------- Total shareholders' equity 1,434,564 1,413,591 ---------- ---------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $2,224,473 $2,234,081 ========== ========== See notes to condensed consolidated financial statements. 3 COMPUWARE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------ ------------------------ 2004 2003 2004 2003 --------- --------- --------- --------- REVENUES: Software license fees $ 65,662 $ 59,358 $ 119,765 $ 114,683 Maintenance fees 104,771 99,397 208,272 200,973 Professional services fees 125,035 143,998 254,484 293,109 --------- --------- --------- --------- Total revenues 295,468 302,753 582,521 608,765 --------- --------- --------- --------- OPERATING EXPENSES: Cost of software license fees 8,077 7,657 15,886 15,043 Cost of professional services 112,934 136,567 231,784 276,047 Technology development and support 40,789 42,735 81,680 82,758 Sales and marketing 79,322 77,665 150,055 145,050 Administrative and general 48,396 54,597 100,414 107,829 --------- --------- --------- --------- Total operating expenses 289,518 319,221 579,819 626,727 --------- --------- --------- --------- INCOME (LOSS) FROM OPERATIONS 5,950 (16,468) 2,702 (17,962) OTHER INCOME 4,341 4,638 8,484 9,747 --------- --------- --------- --------- INCOME (LOSS) BEFORE INCOME TAXES 10,291 (11,830) 11,186 (8,215) INCOME TAX PROVISION (BENEFIT) 2,881 (3,312) 3,132 (2,300) --------- --------- --------- --------- NET INCOME (LOSS) $ 7,410 $ (8,518) $ 8,054 $ (5,915) ========= ========= ========= ========= Basic earnings (loss) per share $ 0.02 $ (0.02) $ 0.02 $ (0.02) ========= ========= ========= ========= Diluted earnings (loss) per share $ 0.02 $ (0.02) $ 0.02 $ (0.02) ========= ========= ========= ========= See notes to condensed consolidated financial statements. 4 COMPUWARE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) SIX MONTHS ENDED SEPTEMBER 30, ------------------------- 2004 2003 --------- --------- CASH FLOWS PROVIDED BY OPERATING ACTIVITIES: Net income (loss) $ 8,054 $ (5,915) Adjustments to reconcile net income (loss) to cash provided by operations: Depreciation and amortization 30,559 25,336 Tax benefit from exercise of stock options 249 152 Issuance of common stock to ESOP 4,872 Acquisition tax benefits 3,604 3,516 Deferred income taxes 8,802 (2,920) Other 1,250 4,447 Net change in assets and liabilities, net of effects from acquisitions: Accounts receivable 30,746 133,178 Prepaid expenses and other current assets (2,755) (1,248) Other assets 895 (2,719) Accounts payable and accrued expenses (36,768) (18,747) Deferred revenue (5,363) (29,727) Income taxes 1,755 (6,443) --------- --------- Net cash provided by operating activities 45,900 98,910 --------- --------- CASH FLOWS USED IN INVESTING ACTIVITIES: Purchase of: Business (96,993) Property and equipment: Headquarters facility (5,694) (40,314) Other (12,269) (4,166) Capitalized software (7,694) (5,440) Investments: Proceeds 127,335 216,648 Purchases (134,845) (212,180) --------- --------- Net cash used in investing activities (130,160) (45,452) --------- --------- CASH FLOWS PROVIDED BY FINANCING ACTIVITIES: Net proceeds from exercise of stock options 985 942 Contribution to stock purchase plans 4,064 4,544 Repurchase of common stock (996) --------- --------- Net cash provided by financing activities 5,049 4,490 --------- --------- EFFECT OF EXCHANGE RATE CHANGES ON CASH 576 4,921 --------- --------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (78,635) 62,869 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 454,916 319,466 --------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 376,281 $ 382,335 ========= ========= See notes to condensed consolidated financial statements. 5 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED STEPTEMBER 30, 2004 NOTE 1 - BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements include the accounts of Compuware Corporation and its wholly owned subsidiaries (collectively, the "Company"). All intercompany balances and transactions have been eliminated in consolidation. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. Generally accepted accounting principles require management to make estimates and assumptions that affect the reported amounts of assets, liabilities, contingencies and results of operations. While management has based their assumptions and estimates on the facts and circumstances existing at September 30, 2004, final amounts may differ from estimates. In the opinion of management of the Company, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, that are necessary for a fair presentation of the results for the interim periods presented. These financial statements should be read in conjunction with the Company's audited consolidated financial statements and notes thereto for the year ended March 31, 2004 included in the Company's Annual Report to Shareholders on Form 10-K filed with the Securities and Exchange Commission. The consolidated balance sheet at March 31, 2004 has been derived from the audited financial statements at that date but does not include all information and footnotes required by GAAP for complete financial statements. The results of operations for interim periods are not necessarily indicative of actual results achieved for full fiscal years. Certain amounts in the fiscal 2004 financial statements have been reclassified to conform to the fiscal 2005 presentation. Revenue Recognition - The Company earns revenue from licensing software products, providing maintenance and support for those products and rendering professional services. The Company's revenue recognition policies are consistent with GAAP including Statements of Position 97-2 "Software Revenue Recognition" and 98-9 "Modification of SOP 97-2, "Software Revenue Recognition," With Respect to Certain Transactions", Securities and Exchange Commission Staff Accounting Bulletin 104 and Emerging Issues Task Force Issue 00-21 "Revenue Arrangements with Multiple Deliverables". Accordingly, the Company recognizes revenue when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the fee is fixed or determinable, and collectibility is reasonably assured. Software license fees -- The Company's software license agreements provide its customers with a right to use the Company's software perpetually (perpetual licenses) or during a defined term (term licenses). Perpetual license fee revenue is recognized using the residual method, under which the fair value, based on Compuware-specific objective evidence (CSOE) of all undelivered elements of the agreement (e.g., maintenance and professional services) is deferred. CSOE is based on rates charged for maintenance and professional services when sold separately and is consistent with vendor specific objective evidence (VSOE) as defined in SOP 97-2. The remaining portion of the fee, net of discretionary discounts, (the residual) is recognized as license fee revenue upon shipment of the products, provided that no significant obligations remain and collection of the related receivable is deemed probable. For term licenses and for agreements in which the fair value of the undelivered elements cannot be 6 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED STEPTEMBER 30, 2004 determined using CSOE (e.g., transactions that include an option to exchange or select products in the future), the Company recognizes the license fee revenue on a ratable basis over the term of the license agreement. The Company offers flexibility to customers purchasing licenses for its products and related maintenance. Terms of these transactions range from standard perpetual license sales to large multi-year (generally one to five years), multi-product contracts. The Company allows deferred payment terms on multi-year contracts, with installments collectible over the term of the contract. Based on the Company's successful collection history for deferred payments, the license fee portion of the receivable is discounted to its net present value and recognized as discussed above. The discount is recognized as interest income over the term of the receivables. Maintenance fees - The Company's maintenance agreements provide for technical support and advice, including problem resolution services and assistance in product installation, error corrections and any product enhancements released during the maintenance period. Maintenance is included with all mainframe software license agreements for one year, and for most distributed product agreements for three months. Maintenance is renewable thereafter for an annual fee. Maintenance fees are deferred and recognized as revenue on a ratable basis over the maintenance period. Professional services fees -- Professional services fees are generally based on hourly or daily rates; therefore, revenues from professional services are recognized in the period the services are performed, provided that collection of the related receivable is deemed probable. However, for development services rendered under fixed-price contracts, revenue is recognized using the percentage of completion method. Certain professional services contracts include a project and on-going support for the project. Revenue associated with these contracts is recognized over the support period as the customer derives value from the services, consistent with the proportional performance method. Capitalized Software -- Capitalized software includes the costs of purchased and internally developed software products and is stated at the lower of unamortized cost or net realizable value. Capitalization of internally developed software products begins when technological feasibility of the product is established. Technology development and support includes primarily the costs of programming personnel associated with product development and support net of amounts capitalized. The amortization for both internally developed and purchased software products is computed on a product-by-product basis. The annual amortization is the greater of the amount computed using (a) the ratio of current gross revenues compared with the total of current and anticipated future revenues for that product or (b) the straight-line method over the remaining estimated economic life of the product, including the period being reported on. Amortization begins when the product is available for general release to customers. The amortization period for capitalized software is generally five years. 7 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED STEPTEMBER 30, 2004 Goodwill - Goodwill and those intangible assets with indefinite lives are tested for impairment annually and/or when events or circumstances indicate that their fair value has been reduced below carrying value. The Company evaluated its goodwill as of March 31, 2004 and 2003 and determined there was no impairment. Income Taxes - The Company accounts for income taxes using the asset and liability approach. Deferred income taxes are provided for the differences between the tax bases of assets or liabilities and their reported amounts in the financial statements. Stock-Based Compensation -- Through September 30, 2004, in accordance with SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure -- an amendment of FASB Statement No. 123" and SFAS No. 123, "Accounting for Stock-Based Compensation", the Company applied APB Opinion No. 25 and related Interpretations in accounting for its plans. Stock options are granted at current market prices at the date of grant. Therefore, no compensation cost has been recognized for the Company's fixed stock option plans or its stock purchase plans. If compensation cost for the Company's stock-based compensation plans had been determined based on the fair value at the grant dates for the three and six months ended September 30, 2004 and 2003, consistent with the method prescribed by SFAS No. 123, the Company's net income (loss) and earnings (loss) per share would have been adjusted to the pro forma amounts indicated below (in thousands, except earnings per share data): THREE MONTHS ENDED SIX MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------------- --------------------------- 2004 2003 2004 2003 ---------- ---------- ---------- ---------- Net income (loss): As reported $ 7,410 $ (8,518) $ 8,054 $ (5,915) Compensation cost, net of tax (8,101) (7,015) (15,334) (17,007) ---------- ---------- ---------- ---------- Pro forma $ (691) $ (15,533) $ (7,280) $ (22,922) ========== ========== ========== ========== Earnings per share: As reported: Basic earnings (loss) per share $ 0.02 $ (0.02) $ 0.02 $ (0.02) Diluted earnings (loss) per share 0.02 (0.02) 0.02 (0.02) Pro forma: Basic earnings (loss) per share 0.00 (0.04) (0.02) (0.06) Diluted earnings (loss) per share 0.00 (0.04) (0.02) (0.06) The pro forma amounts for compensation cost may not be indicative of the effects on net income and earnings per share for future years. 8 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED STEPTEMBER 30, 2004 NOTE 2 - COMPUTATION OF EARNINGS PER COMMON SHARE Earnings (loss) per common share data were computed as follows (in thousands, except for per share data): Three Months Ended Six Months Ended September 30, September 30, ------------------------ ------------------------ 2004 2003 2004 2003 --------- --------- --------- --------- BASIC EARNINGS (LOSS) PER SHARE: Numerator: Net income (loss) $ 7,410 $ (8,518) $ 8,054 $ (5,915) --------- --------- --------- --------- Denominator: Weighted-average common shares outstanding 386,200 382,591 385,574 382,556 --------- --------- --------- --------- Basic earnings (loss) per share $ 0.02 $ (0.02) $ 0.02 $ (0.02) ========= ========= ========= ========= DILUTED EARNINGS (LOSS) PER SHARE: Numerator: Net income (loss) $ 7,410 $ (8,518) $ 8,054 $ (5,915) --------- --------- --------- --------- Denominator: Weighted-average common shares outstanding 386,200 382,591 385,574 382,556 Dilutive effect of stock options 1,269 1,873 --------- --------- --------- --------- Total shares 387,469 382,591 387,447 382,556 --------- --------- --------- --------- Diluted earnings (loss) per share $ 0.02 $ (0.02) $ 0.02 $ (0.02) ========= ========= ========= ========= During the three months ended September 30, 2004 and 2003, stock options and a warrant to purchase a total of approximately 61,391,000 and 63,425,000 shares, respectively, were excluded from the diluted earnings (loss) per share calculation because they were anti-dilutive. During the six months ended September 30, 2004 and 2003, stock options and a warrant to purchase a total of approximately 61,310,000 and 63,425,000 shares, respectively, were excluded from the diluted earnings (loss) per share calculation because they were anti-dilutive. NOTE 3 - COMPREHENSIVE INCOME (LOSS) Other comprehensive income (loss) includes foreign currency translation gains and losses that have been excluded from net income (loss) and reflected in equity. Total comprehensive income (loss) is summarized as follows (in thousands): Three Months Ended Six Months Ended September 30, September 30, -------------------- --------------------- 2004 2003 2004 2003 ------- ------- ------- ------- Net income (loss) $ 7,410 $(8,518) $ 8,054 $(5,915) Foreign currency translation adjustment, net of tax 2,316 1,502 (837) 7,732 ------- ------- ------- ------- Total comprehensive income (loss) $ 9,726 $(7,016) $ 7,217 $ 1,817 ======= ======= ======= ======= 9 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED STEPTEMBER 30, 2004 NOTE 4 - SEGMENTS The Company operates in two business segments in the technology industry: products and professional services. The Company provides software products and professional services to IT organizations that help IT professionals efficiently develop, implement and support the applications that run their businesses. Financial information for the Company's business segments is as follows (in thousands): Three Months Ended Six Months Ended September 30, September 30, -------------------------- ------------------------- 2004 2003 2004 2003 --------- --------- --------- --------- Revenues: Products: Mainframe $ 126,096 $ 121,023 $ 239,841 $ 240,254 Distributed systems 44,337 37,732 88,196 75,402 --------- --------- --------- --------- Total product revenue 170,433 158,755 328,037 315,656 Professional services 125,035 143,998 254,484 293,109 --------- --------- --------- --------- Total revenues $ 295,468 $ 302,753 $ 582,521 $ 608,765 ========= ========= ========= ========= Operating expenses: Products $ 128,188 $ 128,057 $ 247,621 $ 242,851 Professional services 112,934 136,567 231,784 276,047 Administrative and general 48,396 54,597 100,414 107,829 --------- --------- --------- --------- Total operating expenses $ 289,518 $ 319,221 $ 579,819 $ 626,727 ========= ========= ========= ========= Income (loss) from operations before other income: Products $ 42,245 $ 30,698 $ 80,416 $ 72,805 Professional services 12,101 7,431 22,700 17,062 Administrative and general (48,396) (54,597) (100,414) (107,829) --------- --------- --------- --------- Income (loss) from operations before other income 5,950 (16,468) 2,702 (17,962) Other income 4,341 4,638 8,484 9,747 --------- --------- --------- --------- Income (loss) before income taxes $ 10,291 $ (11,830) $ 11,186 $ (8,215) ========= ========= ========= ========= Financial information regarding geographic operations is presented in the table below (in thousands): Three Months Ended Six Months Ended September 30, September 30, ------------------------ ------------------------ 2004 2003 2004 2003 -------- -------- -------- -------- Revenues: United States $205,423 $217,566 $408,986 $438,451 Europe and Africa 67,363 65,050 131,502 133,744 Other international operations 22,682 20,137 42,033 36,570 -------- -------- -------- -------- Total revenues $295,468 $302,753 $582,521 $608,765 ======== ======== ======== ======== 10 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED STEPTEMBER 30, 2004 NOTE 5 - RESTRUCTURING ACCRUAL In the fourth quarter of fiscal 2002, the Company adopted a restructuring plan to reorganize its operating divisions, primarily the professional services segment. These changes were designed to increase profitability by better aligning cost structures with current market conditions. The restructuring plan included a reduction of professional services staff at certain locations, the closing of entire professional services offices and a reduction of sales support personnel, lab technicians and related administrative and financial staff. Approximately 1,600 employees worldwide were terminated as a result of the reorganization. The following table summarizes the restructuring accrual as of March 31, 2004, and charges against the accrual during the first six months of fiscal 2005 (in thousands): Charges against Charges against Balance at the accrual during the accrual during Balance at March 31, the quarter ended the quarter ended Spetember 30, 2004 June 30, 2004 September 30, 2004 2004 ---------- ------------------ ------------------ ------------- Employee termination benefits $ 107 $ -- $ 38 $ 69 Facilities costs (primarily lease abandonments) 13,488 826 629 12,033 Legal, consulting and outplacement costs 11 1 -- 10 ------- ------- ------- ------- Total restructuring accrual $13,606 $ 827 $ 667 $12,112 ======= ======= ======= ======= NOTE 6 - INVESTMENTS IN PARTIALLY OWNED COMPANIES At September 30, 2004, the Company held a 33.3% interest in CareTech Solutions, Inc. (CareTech) and a 49% interest in ForeSee Results, Inc. (ForeSee). CareTech provides information technology outsourcing for healthcare organizations including data, voice, applications and data center operations. This investment is accounted for under the equity method including consideration of EITF 98-13, "Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of an Investee." At September 30, 2004 and March 31, 2004, the Company's carrying value of its investments in and advances to CareTech was $24.1 million and $22.0 million, respectively. Included in the net investment at September 30, 2004 and March 31, 2004, are a note receivable with an adjusted basis of $14.2 million and $14.7 million, respectively, and accounts receivable due from CareTech of $9.9 million and $7.3 million, respectively. The note is payable in quarterly installments through January 2012 and bears interest at 5.25%. At September 30, 2004, CareTech was current with the terms of the note. 11 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED SEPTEMBER 30, 2004 Since 1999, the Company has guaranteed lease obligations of CareTech up to $12.5 million. The Company has not recorded any liability related to these guarantees since it believes that CareTech will continue to meet its obligations. At September 30, 2004 and March 31, 2004, CareTech's outstanding lease obligations were approximately $1.9 million and $3.2 million, respectively. CareTech's most significant customer is the Detroit Medical Center and Subsidiaries (DMC). The DMC has requested, and CareTech has agreed, to provide the DMC with extended payment terms up to 90 days. The Company therefore agreed to extend 90 day payment terms to CareTech. The Company considered the relevant factors including the financial situation of the DMC at September 30, 2004 (and at March 31, 2004) and concluded that no impairment charge or valuation allowance related to our investment in and receivables due from CareTech was warranted. ForeSee was incorporated in October 2001 to provide online customer satisfaction management. This investment is also accounted for under the equity method including EITF 98-13. At September 30, 2004 and March 31, 2004, the Company's carrying value of its investments in and advances to ForeSee was $3.4 million and $3.9 million, respectively. Included in the net investment at September 30, 2004 and March 31, 2004, are notes receivable from ForeSee with an adjusted basis of $3.1 million and $3.7 million, respectively. The ForeSee notes bear interest at the prime rate (4.75% at September 30, 2004) and are due between June 2007 and July 2009. The Company has agreed to provide $567,000 in additional loans to ForeSee, if needed, subject to approval by the ForeSee shareholders. During the second quarter of fiscal 2004, the Company's equity investment in ForeSee was reduced to zero. At that point, the Company began recording 100 percent of the losses sustained by ForeSee as a reduction to the Company's outstanding advances to ForeSee since the Company is uncertain whether the other shareholders are willing or able to sustain their share of the losses. The Company continues to monitor the financial situation of ForeSee on a regular basis and has concluded that no impairment reserve was warranted at September 30, 2004 (or at March 31, 2004). NOTE 7 - BUILDING - HELD FOR SALE The Company plans to sell the former headquarters building in Farmington Hills, Michigan. Therefore, the building has been classified as held for sale as of September 30, 2004. 12 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED SEPTEMBER 30, 2004 NOTE 8 - CONTINGENCIES On March 12, 2002, the Company filed suit in the United States District Court for the Eastern District of Michigan against International Business Machines Corporation ("IBM") alleging, among other things, infringement of our copyrights and misappropriation of our trade secrets with respect to our mainframe software tools, intentional interference with contractual relations with our employees and former employees, anti-trust law violations, tortious interference with our economic expectancy and various state law violations. The suit seeks injunctive relief and unspecified monetary damages, among other things, from IBM. In addition, IBM has filed a counterclaim against Compuware alleging violation of six IBM patents. The Compuware products accused of infringement are File-AID CS, Abend-AID, and Xpediter. The Court bifurcated the patent counterclaims from the other claims and fact discovery is proceeding. No trial date has been set for the counterclaims. We believe we have valid defenses to the counterclaims, and we will vigorously defend against those claims. In December 2003, the Court denied the Company's Motion for Preliminary Injunction on the trade secret and false advertising claims, ruling that there were fact issues that needed to be decided by a jury. The Company's Motion did not address IBM's antitrust violations or unfair competition. Trial of the case was previously set to begin November 8, 2004. The court recently reset the commencement date for the trial to February 2005. On January 15, 2004, IBM filed patent infringement claims against Compuware in the United States District Court for the Southern District of New York alleging infringement of seven IBM patents. The suit seeks injunctive relief and unspecified monetary damages. We believe we have valid defenses to the claims, and intend to vigorously defend against the lawsuit. The Company is a party to a consolidated class action proceeding filed in the United States District Court for the Eastern District of Michigan. The suit was brought on behalf of purchasers of the Company's common stock from January 1, 1999 to April 3, 2002. The plaintiffs allege that the Company failed to disclose under the securities laws its problems with the misappropriation of its software source code by IBM. The plaintiffs further allege that the Company omitted and/or disseminated materially false and misleading statements concerning its deteriorating relationship with IBM. The plaintiffs request that the court award them monetary damages and expenses of litigation, including reasonable attorneys fees. On August 27, 2004, plaintiffs moved to certify a class. The Company intends to oppose class certification. To date, the Company is not engaged in any meaningful discovery. The Company strongly disagrees with the allegations and intends to vigorously defend against the lawsuit. Due to the nature and status of this lawsuit and the uncertainties that exist, no estimate can be made of the possible impact of this lawsuit on the Company's results of operations at this time. The Company is subject to various other legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. The Company does not believe that the outcome of any of these legal matters, including those discussed above, will have a material adverse effect on the Company's consolidated financial position or results of operations. 13 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SIX MONTHS ENDED SEPTEMBER 30, 2004 NOTE 9 - SUBSEQUENT EVENTS In October 2004, the Company acquired certain assets and liabilities of DevStream Corporation ("DevStream"), a privately owned software company, for $8 million in cash and estimated future payments of $1.9 million. The additional payments will be calculated based on a percentage of the revenue associated with the DevStream products during the first 27 months after the acquisition date. The acquisition will be accounted for as a purchase during the third quarter of fiscal 2005, and accordingly, the assets and liabilities acquired will be recorded at fair value as of the acquisition date. 14 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Compuware Corporation: We have reviewed the accompanying condensed consolidated balance sheet of Compuware Corporation and subsidiaries (the "Company") as of September 30, 2004, and the related condensed consolidated statements of operations for the three-month and six-month periods ended September 30, 2004 and 2003 and of cash flows for the six-month periods ended September 30, 2004 and 2003. These consolidated interim financial statements are the responsibility of the Company's management. We conducted our reviews in accordance with standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company and subsidiaries as of March 31, 2004, and the related consolidated statements of operations, shareholders' equity, and cash flows for the year then ended (not presented herein); and in our report dated May 26, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of March 31, 2004 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. DELOITTE & TOUCHE LLP Detroit, Michigan November 4, 2004 15 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS This discussion contains certain forward-looking statements within the meaning of the federal securities laws which are identified by the use of the words "believes," "expects," "anticipates," "will," "contemplates," "would" and similar expressions that contemplate future events. Numerous important factors, risks and uncertainties affect our operating results, including, without limitation, those discussed below, contained elsewhere in this report, and in our 2004 Form 10-K filed with the Securities and Exchange Commission and could cause actual results to differ materially from the results implied by these or any other forward-looking statements made by us, or on our behalf. There can be no assurance that future results will meet expectations. While we believe that our forward-looking statements are reasonable, you should not place undue reliance on any such forward-looking statements, which speak only as of the date made. Except as required by applicable law, we do not undertake any obligation to publicly release any revisions which may be made to any forward-looking statements to reflect events or circumstances occurring after the date of this report. - In 2002, we filed a lawsuit against IBM alleging, among other things, copyright infringement, misappropriation of trade secrets, intentional interference with contractual relations and economic expectancy, false advertising and various violations of the Lanham Act, as well as various anti-trust law violations. We claim that IBM has misappropriated portions of our software tools, used our technology to develop competing products, used its monopoly power to engage in unlawful tying arrangements and subverted competition on the merits. IBM has filed a counterclaim against us alleging violation of six of their patents and in 2004 filed a separate complaint against us alleging violation of seven different IBM patents. Pursuing and defending these matters will be costly, time-consuming and may divert management's time and attention. Due to these matters, our legal expenses have increased substantially and our administrative and general expenses could further increase as a result of these factors. In addition, IBM may seek to influence our customers and potential customers to reduce or eliminate the amount of our products and services that they purchase, or our lawsuit against IBM and IBM's lawsuit against us may otherwise be viewed negatively by our customers and potential customers and cause them to refrain from buying our products and services. Any of the foregoing developments could adversely affect our position in the marketplace and the results of our operations. - While we are expanding our focus on distributed software products, a majority of our revenue from software products is dependent on our customers' continued use of IBM and IBM-compatible mainframe products and on the acceptance of our pricing structure for software licenses and maintenance. The pricing of our software licenses and maintenance is under constant pressure from customers and competitive vendors. - In addition to the IBM claims discussed above, there can be no assurance that other third parties will not assert infringement claims against us in the future with respect to current and future products or that any such assertion may not require us to enter into royalty arrangements or result in costly litigation. - Our operating margins may decline. We are aware that operating expenses associated with our distributed systems products are higher than those associated with our traditional mainframe products. Since we believe the best opportunities for revenue growth are in the distributed systems market, product operating margins could experience more pressure. In addition, operating margins in the professional services business are significantly impacted by small fluctuations in revenue since most costs are fixed during any short term period. - Our results could be adversely affected by increased competition and pricing pressures. We consider over 40 firms to be directly competitive with one or more of our products. These competitors include but are not limited to BMC Software, Inc., Borland Software Corp., Computer Associates International, Inc., IBM, Mercury Interactive Corporation and Niku Corporation. Some of these competitors have substantially greater financial, marketing, recruiting and training resources than we do. 16 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - The market for professional services is highly competitive, fragmented and characterized by low barriers to entry. Our principal competitors in professional services include but are not limited to Accenture Ltd., Computer Sciences Corporation, Electronic Data Systems Corporation, IBM Global Services, Analysts International Corporation, Keane, Inc. and numerous other regional and local firms in the markets in which we have professional services offices. Several of these competitors have substantially greater financial, marketing, recruiting and training resources than we do. - Our success depends in part on our ability to develop product enhancements and to purchase or develop new products that keep pace with continuing changes in technology and customer preferences. - Approximately 30% of our total revenue is derived from foreign sources. This exposes us to exchange rate risks on foreign currencies and to other international risks such as the need to comply with foreign and U.S. export laws, and the uncertainty of certain foreign economies. - We regard our software as proprietary and attempt to protect it with copyrights, trademarks, trade secret laws and/or restrictions on disclosure, copying and transferring title. Despite these precautions, it may be possible for unauthorized third parties to copy certain portions of our products or to obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States. - We depend on key employees and technical personnel. The loss of certain key employees or our inability to attract and retain other qualified employees could have a material adverse effect on our business. - Our quarterly financial results vary and may be adversely affected by certain relatively fixed costs. Our product revenues vary from quarter to quarter. Net income may be disproportionately affected by a fluctuation in revenues because only a small portion of our expenses varies with revenues. - Historical seasonality in license revenue cannot be relied on as an indicator of future performance due to the current economic conditions affecting the Information Technology ("IT") industry. - Changes in world economies could cause customers to further delay or forego decisions to license new products or upgrades to their existing environments or to reduce their requirements for professional services, and this could adversely affect our operating results. - Acts of terrorism, acts of war and other unforeseen events may cause damage or disruption to our properties, employees, suppliers, distributors, resellers and customers which could adversely affect our business and operating results. 17 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) OVERVIEW In this section, we discuss our results of operations on a segment basis for each of our financial reporting segments. We operate in two business segments in the technology industry: products and professional services. We evaluate segment performance based primarily on segment contribution before corporate expenses. References to years are to fiscal years ended March 31. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and notes included elsewhere in this report and our annual report on Form 10-K for the fiscal year ended March 31, 2004, particularly "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations". We provide software products and professional services designed to increase the productivity of the IT departments of businesses worldwide. In the early years of our Company, we focused on offering professional services and mainframe products in the testing and implementation environment where we gained extensive experience and established long-term customer relationships. Over the past several years, we have expanded our presence into products and professional services in the IT governance, development, quality assurance, management and support areas of the application life cycle for all significant technology platforms. We focus on growing revenue and profit margins by enhancing and promoting our current product lines, expanding our product and service offerings through key acquisitions, developing strategic partnerships in order to provide clients with our product solutions and managing our costs. We achieved the following during the second quarter of 2005: - Released 2 mainframe and 6 distributed product updates designed to increase the productivity of the IT departments of our customers. - Achieved a 17% increase compared to the second quarter of 2004 in distributed product revenue. Approximately 59% of the increase was a reflection of our continued focus on promoting our distributed products with the remainder attributable to the addition of IT Governance in the first quarter of 2005. - Improved the professional services margin from 5.2% in the second quarter of 2004 to 9.7% in the second quarter of 2005 through improved utilization of professional services personnel and, to a lesser extent, a concerted effort to reduce low margin subcontractor arrangements. - Hosted OJX, an interactive Java development seminar at our Detroit, Michigan world headquarters. Java visionaries from Compuware, Sun and BEA presented at the event, which attracted more than 1,000 attendees. Our ability to achieve our strategies and objectives is subject to a number of factors some of which we may not be able to control. See "Forward-Looking Statements". 18 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain operational data from the consolidated statements of operations as a percentage of total revenues and the percentage change in such items compared to the prior period: Percentage of Percentage of Total Revenues Total Revenues ------------------ ----------------- Three Months Ended Six Months Ended September 30, Period- September 30, Period- ----------------- to-Period ----------------- to-Period 2004 2003 Change 2004 2003 Change ----- ----- ------ ----- ----- ------ REVENUE: Software license fees 22.2% 19.6% 10.6% 20.6% 18.8% 4.4% Maintenance fees 35.5 32.8 5.4 35.7 33.0 3.6 Professional services fees 42.3 47.6 (13.2) 43.7 48.2 (13.2) ----- ----- ----- ----- ----- ----- Total revenues 100.0 100.0 (2.4) 100.0 100.0 (4.3) ----- ----- ----- ----- ----- ----- OPERATING EXPENSES: Cost of software license fees 2.7 2.5 5.5 2.7 2.5 5.6 Cost of professional services 38.2 45.1 (17.3) 39.8 45.4 (16.0) Technology development and support 13.8 14.1 (4.6) 14.0 13.6 (1.3) Sales and marketing 26.9 25.7 2.1 25.8 23.8 3.5 Administrative and general 16.4 18.0 (11.4) 17.2 17.7 (6.9) ----- ----- ----- ----- ----- ----- Total operating expenses 98.0 105.4 (9.3) 99.5 103.0 (7.5) ----- ----- ----- ----- ----- ----- Income (loss) from operations 2.0 (5.4) 136.1 0.5 (3.0) 115.0 Other income 1.5 1.5 (6.4) 1.4 1.6 (13.0) ----- ----- ----- ----- ----- ----- Income (loss) before income taxes 3.5 (3.9) 187.0 1.9 (1.4) 236.2 Income tax provision (benefit) 1.0 (1.1) 187.0 0.5 (0.4) 236.2 ----- ----- ----- ----- ----- ----- Net income (loss) 2.5% (2.8)% 187.0% 1.4% (1.0)% 236.2% ===== ===== ===== ===== ===== ===== SOFTWARE PRODUCTS REVENUE Our products are designed to support the complete application lifecycle: development and integration, quality assurance, production readiness, performance management and IT governance of the application to optimize performance in production. Product revenue, which consists of software license fees and maintenance fees, comprised 57.7% and 52.4% of total revenue during the second quarter of 2005 and 2004, respectively, and 56.3% and 51.8% of total revenue during the first six months of 2005 and 2004, respectively. Distributed software product revenue increased $6.6 million or 17.5% during the second quarter of 2005 to $44.3 million from $37.7 million during the second quarter of 2004 and increased $12.8 million or 17.0% during the first six months of 2005 to $88.2 million from $75.4 million during the first six months of 2004. The increased revenue during the second quarter and first six months of 2005 was primarily due to an increase of $3.4 million and $5.6 million, respectively, in maintenance revenue related to our DevPartner and Vantage product lines and to the addition of $2.8 million and $5.6 million, respectively, related to IT Governance, which was acquired during the first quarter of 2005. 19 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Mainframe software product revenue increased $5.1 million or 4.2% during the second quarter of 2005 to $126.1 million from $121.0 million during the second quarter of 2004 and decreased $0.5 million or 0.2% during the first six months of 2005 to $239.8 million from $240.3 million during the first six months of 2004. The increased revenue during the second quarter was due to a $5.3 million increase in license revenue primarily related to our File-Aid, QACenter and Strobe product lines. License revenue increased $6.3 million or 10.6% during the second quarter of 2005 to $65.7 million from $59.4 million during the second quarter of 2004 and increased $5.1 million or 4.4% during the first six months of 2005 to $119.8 million from $114.7 million during the first six months of 2004. License revenue increased $2.3 million and $4.0 million, respectively, compared to the second quarter and first six months of 2004 due to fluctuations in foreign currencies. Excluding the favorable effect of foreign currency fluctuations, license revenue increased 6.8% during the second quarter of 2005 and 0.9% during the first six months of 2005. These increases were primarily due to increases of $5.3 million and $1.6 million, respectively, in mainframe license revenue primarily related to our File-Aid, QACenter and Strobe product lines and to the addition of $1.7 million and $3.6 million of revenues, respectively, related to IT Governance which was acquired during the first quarter of 2005. Maintenance fees increased $5.4 million or 5.4% to $104.8 million during the second quarter of 2005 from $99.4 million during the second quarter of 2004 and increased $7.3 million or 3.6% during the first six months of 2005 to $208.3 million from $201.0 million during the first six months of 2004. Maintenance fees increased $3.2 million and $6.4 million, respectively, compared to the second quarter and first six months of 2004 due to fluctuations in foreign currencies. Excluding the favorable effect of foreign currency fluctuations, maintenance fees increased 2.1% during the second quarter of 2005 and 0.5% during the first six months of 2005. These increases were primarily due to increases of $3.4 million and $5.6 million, respectively, in distributed maintenance revenue related to our DevPartner and Vantage product lines and to the addition of $1.2 million and $2.0 million of maintenance revenues, respectively, related to IT Governance. Product revenue by geographic location is presented in the table below (in thousands): Three Months Ended Six Months Ended September 30, September 30, --------------------------- --------------------------- 2004 2003 2004 2003 -------- -------- -------- -------- United States $ 95,644 $ 88,198 $184,571 $174,401 Europe and Africa 53,893 51,154 104,243 106,116 Other international operations 20,896 19,403 39,223 35,139 -------- -------- -------- -------- Total product revenue $170,433 $158,755 $328,037 $315,656 ======== ======== ======== ======== 20 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) PRODUCT CONTRIBUTION AND EXPENSES Financial information for the product segment is as follows (in thousands): Three Months Ended Six Months Ended September 30, September 30, -------------------------------- -------------------------------- 2004 2003 2004 2003 ---------- ---------- ---------- ---------- Revenue $ 170,433 $ 158,755 $ 328,037 $ 315,656 Expenses 128,188 128,057 247,621 242,851 ---------- ---------- ---------- ---------- Product contribution $ 42,245 $ 30,698 $ 80,416 $ 72,805 ========== ========== ========== ========== The product segment generated contribution margins of 24.8% and 19.3% during the second quarter of 2005 and 2004, respectively, and 24.5% and 23.1% during the first six months of 2005 and 2004, respectively. Product expenses include cost of software license fees, technology development and support costs and sales and marketing expenses. These expenses are discussed below. Cost of software license fees includes amortization of capitalized software, the cost of duplicating and disseminating products to customers and the cost of author royalties. As a percentage of software license fees, cost of software license fees were 12.3% and 12.9% in the second quarter of 2005 and 2004, respectively, and 13.3% and 13.1% in the first six months of 2005 and 2004, respectively. Technology development and support includes, primarily, the costs of programming personnel associated with product development and support less the amount of software development costs capitalized during the period. Also included here are personnel costs associated with developing and maintaining internal systems and hardware/software costs required to support technology initiatives. As a percentage of product revenue, costs of technology development and support were 23.9% and 26.9% in the second quarter of 2005 and 2004, respectively, and 24.9% and 26.2% during the first six months of 2005 and 2004, respectively. Capitalization of internally developed software products begins when the technological feasibility of the product is established. Before the capitalization of internally developed software products, total research and development expenditures for the second quarter of 2005 increased $0.5 million, or 1.0%, to $45.5 million from $45.0 million in the second quarter of 2004, and for the first six months of 2005 increased $1.2 million, or 1.3%, to $89.4 million from $88.2 million in the first six months of 2004. Sales and marketing costs consist primarily of personnel related costs associated with product direct sales and sales support, marketing for all our offerings, and personnel costs associated with new sales initiatives. For the second quarter of 2005, sales and marketing costs increased $1.6 million, or 2.1%, to $79.3 million from $77.7 million in the second quarter of 2004 and for the first six months of 2005 increased $5.0 million, or 3.5% to $150.1 million from $145.1 million in the first six months of 2004. The increase in sales and marketing costs for the second quarter and first six months of 2005 were primarily attributable to annual salary increases and an increase in marketing seminar costs related to the OJX seminar that was held at our Detroit world headquarters in September 2004. As a percentage of product revenue, sales and marketing costs were 46.5% and 48.9% in the second quarter of 2005 and 2004, respectively, and 45.7% and 46.0% in the first six months of 2005 and 2004, respectively. 21 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) PROFESSIONAL SERVICES REVENUE We offer a broad range of IT professional services, including business systems analysis, design and programming, software conversion and system planning and consulting. Revenue from professional services decreased $19.0 million or 13.2% during the second quarter of 2005 to $125.0 million compared to $144.0 million in the second quarter of 2004, and decreased $38.6 million or 13.2% during the first six months of 2005 to $254.5 million from $293.1 million during the first six months of 2004. The decrease in revenue for 2005 was primarily due to a reduction in subcontractor arrangements, along with a strategic move away from non-core professional services such as helpdesk, computer operations and non-technical project management. As we move forward, we are focusing on higher margin project development services and combined product and services solution arrangements. Professional services revenue by geographic location is presented in the table below (in thousands): Three Months Ended Six Months Ended September 30, September 30, ------------------------------ ------------------------------ 2004 2003 2004 2003 ---------- ---------- ---------- ---------- United States $ 109,779 $ 129,368 $ 224,415 $ 264,050 Europe and Africa 13,470 13,896 27,259 27,628 Other international operations 1,786 734 2,810 1,431 ---------- ---------- ---------- ---------- Total professional services revenue $ 125,035 $ 143,998 $ 254,484 $ 293,109 ========== ========== ========== ========== PROFESSIONAL SERVICES CONTRIBUTION AND EXPENSES Financial information for the professional services segment is as follows (in thousands): Three Months Ended Six Months Ended September 30, September 30, ------------------------------ ------------------------------ 2004 2003 2004 2003 ---------- ---------- ---------- ---------- Revenue $ 125,035 $ 143,998 $ 254,484 $ 293,109 Expenses 112,934 136,567 231,784 276,047 ---------- ---------- ---------- ---------- Professional services contribution $ 12,101 $ 7,431 $ 22,700 $ 17,062 ========== ========== ========== ========== During the second quarter of 2005, the professional services segment generated a contribution margin of 9.7%, compared to 5.2% during the second quarter of 2004. The professional services contribution margin was 8.9% and 5.8% for the first six months of 2005 and 2004, respectively. The increases are primarily due to improved utilization of professional services personnel and, to a lesser extent, a concerted effort to reduce low margin subcontractor projects. 22 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Cost of professional services consists primarily of personnel-related costs of providing services, including billable staff, subcontractors and sales personnel. Cost of professional services decreased $23.7 million or 17.3% during the second quarter of 2005 to $112.9 million compared to $136.6 million in the second quarter of 2004 and decreased $44.2 million or 16.0% during the first six months of 2005 to $231.8 million from $276.0 million during the first six months of 2004. The decreases in costs for the second quarter and first six months of 2005 were primarily attributable to lower compensation, benefit, bonus and travel costs of approximately $21.0 million and $40.2 million, respectively, and a decrease in subcontractor costs of approximately $3.2 million and $5.5 million, respectively. Compensation, benefit, bonus and travel costs were lower due to a reduction in average employee headcount in this area from the first six months of 2004 to the first six months of 2005. CORPORATE AND OTHER EXPENSES Administrative and general expenses primarily consist of costs associated with the corporate executive, finance, human resources, administrative, legal and corporate communications departments. In addition, administrative and general costs include all facility-related costs, such as rent, maintenance, depreciation expense, utilities, etc., associated with worldwide sales and professional services offices. Administrative and general expenses decreased $6.2 million, or 11.4% during the second quarter of 2005 to $48.4 million from $54.6 million during the second quarter of 2004, and decreased $7.4 million or 6.9% during the first six months of 2005 to $100.4 million from $107.8 million in the first six months of 2004. The decreases in costs for the second quarter and first six months of 2005 were primarily attributable to a decline in external legal fees of approximately $5.6 million and $8.9 million, respectively, due to reduced legal costs associated with the IBM litigation. The decrease in administrative and general expenses related to the first six months of 2005 were offset by an increase in depreciation expense of $2.2 million related to the Detroit headquarters building that was placed in service during the second quarter of 2004. Income taxes are accounted for using the asset and liability approach. Deferred income taxes are provided for the differences between the tax bases of assets or liabilities and their reported amounts in the financial statements. The income tax provision was $2.9 million in the second quarter of 2005 and $3.1 million for the first six months of 2005, which represents an effective tax rate of 28%. This compares to an income tax benefit of $3.3 million in the second quarter of 2004 and $2.3 million for the first six months of 2004, which represents an effective tax rate of 28%. The effective income tax rate is below the statutory rate due to the impact of certain tax benefits discussed in Note 12 of the Consolidated Financial Statements included in Item 8 of our Annual Report on Form 10-K for the year ended March 31, 2004. Changes in net income or in the domestic/foreign composition of revenue may change the relative effect of these tax benefits and could result in a change to the effective income tax rate. RESTRUCTURING ACCRUAL In the fourth quarter of 2002, we adopted a restructuring plan to reorganize our operating divisions, primarily the professional services segment. These changes were designed to increase profitability by better aligning cost structures with current market conditions. See Note 5 to the Condensed Consolidated Financial Statements for changes in the restructuring accrual for the first six months of 2005. 23 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) MANAGEMENT'S DISCUSSION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Assumptions and estimates were based on the facts and circumstances known at September 30, 2004. However, future events rarely develop exactly as forecast, and the best estimates routinely require adjustment. The accounting policies discussed in Item 7 of our Annual Report on Form 10-K for the year ended March 31, 2004 are considered by management to be the most important to an understanding of the financial statements, because their application places the most significant demands on management's judgment and estimates about the effect of matters that are inherently uncertain. These policies are also discussed in Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of that report. There have been no material changes to that information during the first six months of 2005. LIQUIDITY AND CAPITAL RESOURCES As of September 30, 2004, cash and investments totaled approximately $694.7 million. During the first six months of 2005 and 2004, cash flow from operations was $45.9 million and $98.9 million, respectively. The decrease was primarily due to lower collections on customer receivables due to the general decline in revenue during the past two years offset in 2005 by tax refunds of approximately $22.3 million. During the first six months of 2005 and 2004, capital expenditures including property and equipment and capitalized research and software development totaled $25.7 million and $49.9 million, respectively. On May 2, 2003, we entered into a $100 million revolving credit facility that matured on July 29, 2004 (see Note 9 to the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended March 31, 2004). During the second quarter of 2005, the credit facility was extended through July 28, 2005. No borrowings have occurred under this facility since inception. In July 2003, we entered into an option and purchase agreement for our vacated building in Farmington Hills, Michigan. The option agreement allowed the holder to commit to purchase the building for one year after the execution of this agreement. The option selling price of the building approximated the current net book value of $20 million for the building. This option expired in July 2004 and was not exercised by the holder. We have implemented a plan to market and sell the building, and the building has been classified as held for sale as of September 30, 2004. In the second quarter of 2005, we also evaluated whether the value of the building was impaired and we concluded that no impairment charge related to the building should be recorded at September 30, 2004. On May 6, 2003, the Board of Directors authorized the repurchase of up to $125 million of our common stock. Our purchases of stock may occur on the open market, through negotiated or block transactions based upon market and business conditions. We regularly evaluate market conditions for an opportunity to repurchase our stock. There were no purchases under this program during the second quarter of 2005. Approximately $124 million remains for future purchases under this program. 24 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) As discussed in Note 6 to the Condensed Consolidated Financial Statements, we regularly review the financial condition of our partially owned companies, inclusive of considering the companies' relationships with their major customers, to determine that the recorded amounts in our financial statements are appropriate and the investments (inclusive of the debt obligations) are not impaired. CareTech Solutions, Inc.'s (Caretech) most significant customer is the Detroit Medical Center and Subsidiaries (DMC). The DMC has requested, and CareTech has agreed, to provide the DMC with extended payment terms up to 90 days. In turn, we have also agreed to extend 90 day payment terms to CareTech. After consideration of all relevant factors, we concluded that no impairment charge or valuation allowance related to our investment in and receivables due from CareTech should be recorded at September 30, 2004. At September 30, 2004, the carrying value of investments in and advances to Caretech was $24.1 million. In May 2004, we acquired privately held Changepoint Corporation, a market-leading provider of IT Governance application software for approximately $100 million in cash. The acquisition has been accounted for as a purchase and, accordingly, assets and liabilities acquired have been recorded at fair value as of the acquisition date. In October 2004, we acquired certain assets and liabilities of DevStream Corporation ("DevStream"), a privately owned software company, for $8 million in cash and estimated future payments of $1.9 million. The additional payments will be calculated based on a percentage of the revenue associated with the DevStream products during the first 27 months after the acquisition date. The acquisition will be accounted for as a purchase during the third quarter of fiscal 2005, and accordingly, the assets and liabilities acquired will be recorded at fair value as of the acquisition date. We continue to evaluate business acquisition opportunities that fit our strategic plans. We believe available cash resources, together with cash flow from operations, will be sufficient to meet cash needs for the foreseeable future. CONTRACTUAL OBLIGATIONS Our contractual obligations are described in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in our Annual Report on Form 10-K for the year ended March 31, 2004. Except as described elsewhere in this report on Form 10-Q, there have been no material changes to those obligations or arrangements outside of the ordinary course of business during the first six months of 2005. 25 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed primarily to market risks associated with movements in interest rates and foreign currency exchange rates. There have been no material changes to our foreign exchange risk management strategy or our investment standards subsequent to March 31, 2004, therefore the market risks remain substantially unchanged since we filed the Annual Report on Form 10-K for the fiscal year ending March 31, 2004. ITEM 4. CONTROLS AND PROCEDURES As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to cause the material information we are required to disclose in the reports that we file or submit under the Securities Exchange Act of 1934 to be recorded, processed, summarized and reported within the time periods specified in the Commission's rules and forms. There was no change in our internal controls over financial reporting during the quarter ended September 30, 2004 that materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting. 26 COMPUWARE CORPORATION AND SUBSIDIARIES PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. As disclosed in our Annual Report on Form 10-K for the fiscal year ending March 31, 2004 and in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, on March 12, 2002, we filed suit in the United States District Court for the Eastern District of Michigan against International Business Machines Corporation ("IBM") alleging, among other things, infringement of our copyrights and misappropriation of our trade secrets with respect to our mainframe software tools, intentional interference with contractual relations with our employees and former employees, anti-trust law violations, tortious interference with our economic expectancy and various state law violations. The Court adjourned the previous trial date of November 8, 2004. Trial of the case is now set to commence in February 2005. While we currently believe we ultimately will benefit from this litigation, the impact of this action on the Company's liquidity, financial position and results of operations are not determinable at the present time. As disclosed in our Annual Report on Form 10-K for the fiscal year ending March 31, 2004, the Company is a party to a consolidated class action proceeding filed in the United States District Court for the Eastern District of Michigan titled In re Compuware Securities Litigation. The suit was brought on behalf of purchasers of the Company's common stock from January 1, 1999 to April 3, 2002. The defendants are the Company and Peter Karmanos, Jr. The plaintiffs allege that the Company omitted and/or disseminated materially false and misleading statements concerning its alleged deteriorating relationship with IBM. The plaintiffs request that the court award them monetary damages and expenses of litigation, including reasonable attorneys fees. The Company strongly disagrees with the allegations and is vigorously defending against the lawsuit. On August 27, 2004, plaintiffs moved to certify a class. The Company intends to oppose class certification. To date, the Company is not engaged in any meaningful discovery. Due to the nature and status of this lawsuit and the uncertainties that exist, the impact of this action, if any, on the Company's liquidity, financial position and results of operations are not determinable at the present time. 27 COMPUWARE CORPORATION AND SUBSIDIARIES PART II - OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Annual Meeting of Shareholders was held on August 24, 2004 at the Company's headquarters. The only matter voted upon at the meeting was the election of directors. Each of the nominees was elected to hold office for one year until the 2005 Annual Meeting of Shareholders or until their successors are elected and qualified. The results of the voting at the meeting are as follows: Nominee for Director Total Votes For Total Votes Withheld --------------------------- --------------- -------------------- Dennis W. Archer 256,370,976 71,609,563 Gurminder S. Bedi 317,540,432 10,440,107 Elaine K. Didier 316,235,095 11,745,444 William O. Grabe 317,885,340 10,095,199 William R. Halling 313,940,988 14,039,551 Peter Karmanos, Jr. 317,407,142 10,573,397 Faye Alexander Nelson 317,445,685 10,534,854 Glenda D. Price 316,196,808 11,783,731 W. James Prowse 250,312,311 77,668,228 G. Scott Romney 316,135,994 11,844,545 Lowell P. Weicker, Jr. 304,185,956 23,794,583 The total number of the Company's common shares issued and outstanding and entitled to be voted at the Annual Meeting was 386,183,070 shares. The total number of shares voted at the Annual Meeting was 327,980,539 or 84.9% of the shares outstanding and eligible to vote. 28 COMPUWARE CORPORATION AND SUBSIDIARIES PART II - OTHER INFORMATION ITEM 6. EXHIBITS Exhibit Number Description of Document 2.5 Asset Purchase Agreement among Compuware Corporation, DevStream Corporation, Mario Ciabarro, Jaimie Ciabarro and Thomas Cross, dated as of October 1, 2004. 4.4 Amendment No. 2, dated as of July 29, 2004, Revolving Credit Agreement dated as of May 2, 2003, between Compuware Corporation and Comerica Bank. 10.91 Nonqualified Stock Option Agreement for Executive Officers 10.92 Nonqualified Stock Option Agreement for Outside Directors 10.93 Phantom Share Award Agreement 10.94 Executive Incentive Plan - Corporate 15 Independent Registered Public Accounting Firm's Awareness Letter 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. 32 Certification pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) of the Securities Exchange Act. 29 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. COMPUWARE CORPORATION Date: November 4, 2004 By: /s/ Peter Karmanos, Jr. ----------------------------- Peter Karmanos, Jr. Chief Executive Officer (duly authorized officer) Date: November 4, 2004 By: /s/ Laura L. Fournier ------------------------------ Laura L. Fournier Senior Vice President Chief Financial Officer Treasurer 30 EXHIBIT INDEX Exhibit Number Description 2.5 Asset Purchase Agreement among Compuware Corporation, DevStream Corporation, Mario Ciabarro, Jaimie Ciabarro and Thomas Cross, dated as of October 1, 2004. 4.4 Amendment No. 2, dated as of July 29, 2004, Revolving Credit Agreement dated as of May 2, 2003, between Compuware Corporation and Comerica Bank. 10.91 Nonqualified Stock Option Agreement for Executive Officers 10.92 Nonqualified Stock Option Agreement for Outside Directors 10.93 Phantom Share Award Agreement 10.94 Executive Incentive Plan - Corporate 15 Independent Registered Public Accounting Firm's Awareness Letter 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act. 32 Certification pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) of the Securities Exchange Act.