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
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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.