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 DECEMBER 31, 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 January 31, 2005, there were outstanding 387,333,606 shares of Common Stock, par value $.01, of the registrant. Page 1 of 31 pages Page ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets as of December 31, 2004 and March 31, 2004 3 Condensed Consolidated Statements of Operations for the three and nine months ended December 31, 2004 and 2003 4 Condensed Consolidated Statements of Cash Flows for the nine months ended December 31, 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 27 Item 4. Controls and Procedures 27 PART II. OTHER INFORMATION Item 1. Legal Proceedings 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) DECEMBER 31, MARCH 31, 2004 2004 ---------- ---------- (UNAUDITED) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 419,567 $ 454,916 Investments 194,719 149,654 Accounts receivable, net 431,701 452,057 Deferred tax asset, net 34,233 32,460 Income taxes refundable, net 23,578 33,946 Prepaid expenses and other current assets 24,756 19,976 Building - held for sale 19,702 ---------- ---------- Total current assets 1,148,256 1,143,009 ---------- ---------- INVESTMENTS 122,481 162,484 ---------- ---------- PROPERTY AND EQUIPMENT, LESS ACCUMULATED DEPRECIATION AND AMORTIZATION 424,524 444,401 ---------- ---------- CAPITALIZED SOFTWARE, LESS ACCUMULATED AMORTIZATION 55,715 45,489 ---------- ---------- OTHER: Accounts receivable 250,973 198,742 Deferred tax asset, net 15,676 28,628 Goodwill 297,108 213,359 Other 36,104 26,597 ---------- ---------- Total other assets 599,861 467,326 ---------- ---------- TOTAL ASSETS $2,350,837 $2,262,709 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 25,730 $ 35,298 Accrued expenses 188,631 188,279 Deferred revenue 293,176 302,804 ---------- ---------- Total current liabilities 507,537 526,381 DEFERRED REVENUE 339,140 300,664 ACCRUED EXPENSES 18,890 22,073 ---------- ---------- Total liabilities 865,567 849,118 ---------- ---------- SHAREHOLDERS' EQUITY: Common stock 3,873 3,853 Additional paid-in capital 738,165 722,206 Retained earnings 730,871 681,115 Foreign currency translation adjustment 12,361 6,417 ---------- ---------- Total shareholders' equity 1,485,270 1,413,591 ---------- ---------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $2,350,837 $2,262,709 ========== ========== 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 NINE MONTHS ENDED DECEMBER 31, DECEMBER 31, ------------------------------- ------------------------------- 2004 2003 2004 2003 -------------- -------------- --------------- -------------- REVENUES: Software license fees $ 98,996 $ 80,678 $ 218,761 $ 195,361 Maintenance fees 108,658 102,940 316,930 303,913 Professional services fees 122,881 134,567 377,365 427,676 -------------- -------------- --------------- -------------- Total revenues 330,535 318,185 913,056 926,950 -------------- -------------- --------------- -------------- OPERATING EXPENSES: Cost of software license fees 5,403 8,285 21,289 23,328 Cost of professional services 105,734 123,767 337,518 399,814 Technology development and support 33,907 41,640 115,587 124,398 Sales and marketing 84,441 82,117 234,496 227,167 Administrative and general 48,321 50,245 148,735 158,074 -------------- -------------- --------------- -------------- Total operating expenses 277,806 306,054 857,625 932,781 -------------- -------------- --------------- -------------- INCOME (LOSS) FROM OPERATIONS 52,729 12,131 55,431 (5,831) OTHER INCOME 5,191 4,988 13,675 14,735 -------------- -------------- --------------- -------------- INCOME BEFORE INCOME TAXES 57,920 17,119 69,106 8,904 INCOME TAX PROVISION (BENEFIT) 16,218 (4,706) 19,350 (7,006) -------------- -------------- --------------- -------------- NET INCOME $ 41,702 $ 21,825 $ 49,756 $ 15,910 ============== ============== =============== ============== Basic earnings per share $ 0.11 $ 0.06 $ 0.13 $ 0.04 ============== ============== =============== ============== Diluted earnings per share $ 0.11 $ 0.06 $ 0.13 $ 0.04 ============== ============== =============== ============== See notes to condensed consolidated financial statements. 4 COMPUWARE CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) NINE MONTHS ENDED DECEMBER 31, ------------------------- 2004 2003 --------- --------- CASH FLOWS PROVIDED BY OPERATING ACTIVITIES: Net income $ 49,756 $ 15,910 Adjustments to reconcile net income to cash provided by operations: Depreciation and amortization 43,654 39,994 Tax benefit from exercise of stock options 372 175 Issuance of common stock to ESOP 4,872 Acquisition tax benefits 5,406 5,275 Deferred income taxes 11,397 804 Other 2,015 3,012 Net change in assets and liabilities, net of effects from acquisitions: Accounts receivable (6,634) 144,406 Prepaid expenses and other current assets (2,341) 876 Other assets 1,968 5,204 Accounts payable and accrued expenses (24,936) (6,984) Deferred revenue 6,908 (72,429) Income taxes 10,362 (10,947) --------- --------- Net cash provided by operating activities 102,799 125,296 --------- --------- CASH FLOWS USED IN INVESTING ACTIVITIES: Purchase of: Businesses (104,993) Property and equipment: Headquarters facility (7,073) (50,497) Other (15,628) (5,500) Capitalized software (16,431) (9,165) Investments: Proceeds 157,927 275,344 Purchases (164,953) (302,353) --------- --------- Net cash used in investing activities (151,151) (92,171) --------- --------- CASH FLOWS PROVIDED BY FINANCING ACTIVITIES: Net proceeds from exercise of stock options 1,283 1,179 Contribution to stock purchase plans 6,111 6,468 Repurchase of common stock (996) --------- --------- Net cash provided by financing activities 7,394 6,651 --------- --------- EFFECT OF EXCHANGE RATE CHANGES ON CASH 5,609 7,957 --------- --------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (35,349) 47,733 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 454,916 319,466 --------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 419,567 $ 367,199 ========= ========= See notes to condensed consolidated financial statements. 5 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NINE MONTHS ENDED DECEMBER 31, 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 December 31, 2004, final amounts may differ from these estimates. In the opinion of management of the Company, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, that are necessary for a fair presentation of the results for the interim periods presented. These financial statements should be read in conjunction with the Company's audited consolidated financial statements and notes thereto for the year ended March 31, 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. In addition, income tax reserves totaling $33.3 million at March 31, 2004 have been reclassified from long-term deferred taxes to accrued expenses which thereby resulted in a corresponding increase in deferred tax assets. These reclassifications do not have any impact on the statement of operations and are immaterial to the financial statements overall. 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 6 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NINE MONTHS ENDED DECEMBER 31, 2004 sold separately and is consistent with vendor specific objective evidence (VSOE) as defined in SOP 97-2 (as amended). 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 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. Effective January 1, 2005, maintenance is included with all license agreements for up to one year. Maintenance is renewable thereafter for an annual fee. Maintenance fees are deferred and recognized as revenue on a ratable basis over the maintenance period. Professional services fees -- Professional services fees are generally based on hourly or daily rates; therefore, revenues from professional services are recognized in the period the services are performed, provided that collection of the related receivable is deemed probable. However, for development services rendered under fixed-price contracts, revenue is recognized using the percentage of completion method. Certain professional services contracts include a project and on-going support for the project. Revenue associated with these contracts is recognized over the support period as the customer derives value from the services, consistent with the proportional performance method. Capitalized Software -- Capitalized software includes the costs of purchased and internally developed software products and is stated at the lower of unamortized cost or net realizable value. 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 NINE MONTHS ENDED DECEMBER 31, 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 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 December 31, 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 nine months ended December 31, 2004 and 2003, consistent with the method prescribed by SFAS No. 123, the Company's net income and earnings per share would have been adjusted to the pro forma amounts indicated below (in thousands, except earnings per share data): Three Months Ended Nine Months Ended December 31, December 31, -------------------------- -------------------------- 2004 2003 2004 2003 ---------- ---------- ---------- ---------- Net income: As reported $ 41,702 $ 21,825 $ 49,756 $ 15,910 Compensation cost, net of tax (7,160) (8,501) (22,441) (25,490) ---------- ---------- ---------- ---------- Pro forma $ 34,542 $ 13,324 $ 27,315 $ (9,580) ========== ========== ========== ========== Earnings per share: As reported: Basic earnings per share $ 0.11 $ 0.06 $ 0.13 $ 0.04 Diluted earnings per share 0.11 0.06 0.13 0.04 Pro forma: Basic earnings (loss) per share 0.09 0.03 0.07 (0.03) Diluted earnings (loss) per share 0.09 0.03 0.07 (0.03) The pro forma amounts for compensation cost may not be indicative of the effects on net income and earnings per share for future years. Recently Issued Accounting Pronouncements -- In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (R), Share-Based Payment. This Statement requires companies to expense the value of employee stock options and other forms of stock-based compensation effective for interim and annual periods beginning after June 15, 2005. The Company will adopt the provisions of the Statement as of July 1, 2005 and use the modified prospective method to recognize compensation expense. Company management is currently evaluating whether the adoption of this Statement will change its compensation strategies. 8 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NINE MONTHS ENDED DECEMBER 31, 2004 NOTE 2 - ACQUISITIONS In May 2004, the Company 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, 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 was accounted for as a purchase, and accordingly, the assets and liabilities acquired were recorded at fair value as of the acquisition date. NOTE 3 - COMPUTATION OF EARNINGS PER COMMON SHARE Earnings per common share data were computed as follows (in thousands, except for per share data): Three Months Ended Nine Months Ended December 31, December 31, ------------------------- ------------------------- 2004 2003 2004 2003 -------- -------- -------- -------- BASIC EARNINGS PER SHARE: Numerator: Net income $ 41,702 $ 21,825 $ 49,756 $ 15,910 -------- -------- -------- -------- Denominator: Weighted-average common shares outstanding 387,211 384,090 386,475 382,550 -------- -------- -------- -------- Basic earnings per share $ 0.11 $ 0.06 $ 0.13 $ 0.04 ======== ======== ======== ======== DILUTED EARNINGS PER SHARE: Numerator: Net income $ 41,702 $ 21,825 $ 49,756 $ 15,910 -------- -------- -------- -------- Denominator: Weighted-average common shares outstanding 387,211 384,090 386,475 382,550 Dilutive effect of stock options 1,609 1,852 1,785 1,753 -------- -------- -------- -------- Total shares 388,820 385,942 388,260 384,303 -------- -------- -------- -------- Diluted earnings per share $ 0.11 $ 0.06 $ 0.13 $ 0.04 ======== ======== ======== ======== During the three months and nine months ended December 31, 2004, stock options to purchase a total of approximately 59,347,000 and 59,323,000 shares, respectively, were excluded from the diluted earnings per share calculation because they were anti-dilutive. During the three months and nine months ended December 31, 2003, stock options and a warrant to purchase a total of approximately 53,668,000 and 53,708,000 shares, respectively, were excluded from the diluted earnings per share calculation because they were anti-dilutive. 9 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NINE MONTHS ENDED DECEMBER 31, 2004 NOTE 4 - COMPREHENSIVE INCOME Other comprehensive income includes foreign currency translation gains and losses that have been excluded from net income and reflected in equity. Total comprehensive income is summarized as follows (in thousands): Three Months Ended Nine Months Ended December 31, December 31, ----------------------- ----------------------- 2004 2003 2004 2003 -------- -------- -------- -------- Net income $ 41,702 $ 21,825 $ 49,756 $ 15,910 Foreign currency translation adjustment, net of tax 6,781 7,038 5,944 14,770 -------- -------- -------- -------- Total comprehensive income $ 48,483 $ 28,863 $ 55,700 $ 30,680 ======== ======== ======== ======== 10 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NINE MONTHS ENDED DECEMBER 31, 2004 NOTE 5 - 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 Nine Months Ended December 31, December 31, ------------------------- ------------------------- 2004 2003 2004 2003 --------- --------- --------- --------- Revenues: Products: Mainframe $ 151,885 $ 135,943 $ 391,715 $ 376,195 Distributed systems 55,769 47,675 143,976 123,079 --------- --------- --------- --------- Total product revenue 207,654 183,618 535,691 499,274 Professional services 122,881 134,567 377,365 427,676 --------- --------- --------- --------- Total revenues $ 330,535 $ 318,185 $ 913,056 $ 926,950 ========= ========= ========= ========= Operating expenses: Products $ 123,751 $ 132,042 $ 371,372 $ 374,893 Professional services 105,734 123,767 337,518 399,814 Administrative and general 48,321 50,245 148,735 158,074 --------- --------- --------- --------- Total operating expenses $ 277,806 $ 306,054 $ 857,625 $ 932,781 ========= ========= ========= ========= Income (loss) from operations before other income: Products $ 83,903 $ 51,576 $ 164,319 $ 124,381 Professional services 17,147 10,800 39,847 27,862 Administrative and general (48,321) (50,245) (148,735) (158,074) --------- --------- --------- --------- Income (loss) from operations before other income 52,729 12,131 55,431 (5,831) Other income 5,191 4,988 13,675 14,735 --------- --------- --------- --------- Income before income taxes $ 57,920 $ 17,119 $ 69,106 $ 8,904 ========= ========= ========= ========= Financial information regarding geographic operations is presented in the table below (in thousands): Three Months Ended Nine Months Ended December 31, December 31, ---------------------------- ----------------------------- 2004 2003 2004 2003 --------- --------- --------- --------- Revenues: United States $ 220,385 $ 216,393 $ 629,365 $ 654,839 Europe and Africa 84,879 78,990 216,381 212,735 Other international operations 25,271 22,802 67,310 59,376 --------- --------- --------- --------- Total revenues $ 330,535 $ 318,185 $ 913,056 $ 926,950 ========= ========= ========= ========= 11 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NINE MONTHS ENDED DECEMBER 31, 2004 NOTE 6 - 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 nine months of fiscal 2005 (in thousands): Charges against Charges against Balance at the accrual during the accrual during Balance at March 31, the six months ended the quarter ended December 31, 2004 September 30, 2004 December 31, 2004 2004 ----------- -------------------- ------------------- ------------ Employee termination benefits $ 107 $ 38 $ 16 $ 53 Facilities costs (primarily lease abandonments) 13,488 1,455 644 11,389 Legal, consulting and outplacement costs 11 1 - 10 -------- ------- ------- -------- Total restructuring accrual $ 13,606 $ 1,494 $ 660 $ 11,452 ======== ======= ======= ======== 12 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NINE MONTHS ENDED DECEMBER 31, 2004 NOTE 7 - INVESTMENTS IN PARTIALLY OWNED COMPANIES At December 31, 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 December 31, 2004 and March 31, 2004, the Company's carrying value of its investments in and advances to CareTech was $23.0 million and $22.0 million, respectively. Included in the net investment at December 31, 2004 and March 31, 2004, are a note receivable with an adjusted basis of $14.0 million and $14.7 million, respectively, and accounts receivable due from CareTech of $9.0 million and $7.3 million, respectively. The note is payable in quarterly installments through January 2012 and bears interest at 5.25%. At December 31, 2004, CareTech was current with the terms of the note. 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 December 31, 2004 and March 31, 2004, CareTech's outstanding lease obligations were approximately $6.2 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 December 31, 2004 (and at March 31, 2004) and concluded that no impairment charge or valuation allowance related to our investment in 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 December 31, 2004 and March 31, 2004, the Company's carrying value of its investments in and advances to ForeSee was $3.1 million and $3.9 million, respectively. Included in the net investment at December 31, 2004 and March 31, 2004, are notes receivable from ForeSee with an adjusted basis of $2.9 million and $3.7 million, respectively. The ForeSee notes bear interest at the prime rate (5.25% at December 31, 2004) and are due between June 2007 and October 2009. The Company has agreed to provide $367,000 in additional loans to ForeSee, if needed, subject to approval by the ForeSee shareholders. During the second quarter of fiscal 2004, the carrying value of 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 December 31, 2004 (or at March 31, 2004). 13 COMPUWARE CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NINE MONTHS ENDED DECEMBER 31, 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 ("Case A"). In Case A, Compuware seeks injunctive relief and unspecified monetary damages, among other things, from IBM. IBM filed a counterclaim alleging Compuware infringed on IBM's copyrights and violated six IBM patents. The Court bifurcated the patent counterclaims ("Case B") from the copyright claims (Case A) and fact discovery in Case B is proceeding. In Case B, the Compuware products accused of infringement are File-AID CS, Abend-AID, and Xpediter. No trial date has been set for Case B. We believe we have valid defenses to the counterclaims, and we currently intend to continue to vigorously defend against those claims. In Case A, on January 7, 2005, the Court granted Compuware's motion for summary judgment, thereby dismissing the IBM counterclaim that Compuware infringed IBM's copyrights. Trial in Case A is set to begin on February 15, 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 currently 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. The Company strongly disagrees with the allegations and currently intends to continue to vigorously defend against the lawsuit. On August 27, 2004, plaintiff moved to certify a class. In January 2005, the Court ruled in Compuware's favor by denying plaintiff's motion for class certification. To date, the Company has not engaged in any meaningful discovery. 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. 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 December 31, 2004, and the related condensed consolidated statements of operations for the three-month and nine-month periods ended December 31, 2004 and 2003 and of cash flows for the nine-month periods ended December 31, 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 February 3, 2005 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. The following occurred during the third quarter of 2005: - Released 4 mainframe and 9 distributed product updates designed to increase the productivity of the IT departments of our customers. - Acquired the technology assets of DevStream Corporation, based in Colorado Springs, Colorado. The privately owned software company developed an advanced J2EE performance analysis product, which we recently introduced as Vantage Analyzer for J2EE. - Achieved a products contribution margin of 40.4% in the third quarter of 2005 compared to 28.1% in the third quarter of 2004. The primary reason for the improved contribution margin was a $17.7 million increase in mainframe license revenue driven by our File-Aid and Abend-Aid product lines. - Achieved a 17% increase compared to the third quarter of 2004 in distributed product revenue. Approximately 40% 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 8.0% in the third quarter of 2004 to 14.0% in the third quarter of 2005 through improved utilization of professional services personnel and, to a lesser extent, a concerted effort to reduce low margin subcontractor arrangements. 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 Nine Months Ended December 31, Period- December 31, Period- -------------------- to-Period -------------------- to-Period 2004 2003 Change 2004 2003 Change ------ ------ ------ ----- ----- ------ REVENUE: Software license fees 30.0% 25.4% 22.7% 24.0% 21.1% 12.0% Maintenance fees 32.8 32.3 5.6 34.7 32.8 4.3 Professional services fees 37.2 42.3 (8.7) 41.3 46.1 (11.8) ------ ------ ------ ------ ------ ------- Total revenues 100.0 100.0 3.9 100.0 100.0 (1.5) ------ ------ ------ ------ ------ ------- OPERATING EXPENSES: Cost of software license fees 1.6 2.6 (34.8) 2.3 2.5 (8.7) Cost of professional services 32.0 38.9 (14.6) 37.0 43.1 (15.6) Technology development and support 10.3 13.1 (18.6) 12.7 13.4 (7.1) Sales and marketing 25.6 25.8 2.8 25.7 24.5 3.2 Administrative and general 14.6 15.8 (3.8) 16.3 17.1 (5.9) ------ ------ ------ ------ ------ ------- Total operating expenses 84.1 96.2 (9.2) 94.0 100.6 (8.1) ------ ------ ------ ------ ------ ------- Income (loss) from operations 15.9 3.8 334.7 6.0 (0.6) 1050.6 Other income 1.6 1.6 4.1 1.5 1.6 (7.2) ------ ------ ------ ------ ------ ------- Income before income taxes 17.5 5.4 238.3 7.5 1.0 676.1 Income tax provision (benefit) 4.9 (1.5) 444.6 2.1 (0.7) 376.2 ------ ------ ------ ------ ------ ------- Net income 12.6% 6.9% 91.1% 5.4% 1.7% 212.7% ====== ====== ====== ====== ====== ======= 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 62.8% and 57.7% of total revenue during the third quarter of 2005 and 2004, respectively, and 58.7% and 53.9% of total revenue during the first nine months of 2005 and 2004, respectively. Distributed software product revenue increased $8.1 million or 17.0% during the third quarter of 2005 to $55.8 million from $47.7 million during the third quarter of 2004 and increased $20.9 million or 17.0% during the first nine months of 2005 to $144.0 million from $123.1 million during the first nine months of 2004. The increased revenue during the third quarter and first nine months of 2005 was primarily due to an increase of $3.6 million and $9.2 million, respectively, in maintenance revenue related to our DevPartner and Vantage product lines and to the addition of $4.8 million and $10.4 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 $16 million or 11.7% during the third quarter of 2005 to $151.9 million from $135.9 million during the third quarter of 2004 and increased $15.5 million or 4.1% during the first nine months of 2005 to $391.7 million from $376.2 million during the first nine months of 2004. The increased revenue during the third quarter and first nine months of 2005 was primarily due to an increase of $15.6 million and $19.0 million, respectively, in license revenue primarily related to our File-Aid and Abend-Aid product lines. Part of this increase was related to a large MIPS capacity license for approximately $10 million that occurred in the third quarter of 2005. The increased license revenue for the first nine months of 2005 was partially offset by a $3.7 million decrease in mainframe maintenance revenue. License revenue increased $18.3 million or 22.7% during the third quarter of 2005 to $99.0 million from $80.7 million during the third quarter of 2004 and increased $23.4 million or 12.0% during the first nine months of 2005 to $218.8 million from $195.4 million during the first nine months of 2004. License revenue increased $3.4 million and $7.4 million, respectively, compared to the third quarter and first nine months of 2004 due to fluctuations in foreign currencies. Excluding the favorable effect of foreign currency fluctuations, license revenue increased 18.5% during the third quarter of 2005 and 8.2% during the first nine months of 2005. These increases were primarily related to File-Aid and Abend-Aid license revenue and to the addition of IT Governance as discussed above. Maintenance fees increased $5.8 million or 5.6% to $108.7 million during the third quarter of 2005 from $102.9 million during the third quarter of 2004 and increased $13.0 million or 4.3% during the first nine months of 2005 to $316.9 million from $303.9 million during the first nine months of 2004. Maintenance fees increased $3.7 million and $10.1 million, respectively, compared to the third quarter and first nine months of 2004 due to fluctuations in foreign currencies. Excluding the favorable effect of foreign currency fluctuations, maintenance fees increased 2.0% during the third quarter of 2005 and 1.0% during the first nine months of 2005. These increases were primarily due to increases in distributed maintenance revenue and to the addition of IT Governance as discussed above. Product revenue by geographic location is presented in the table below (in thousands): Three Months Ended Nine Months Ended December 31, December 31, -------------------------- -------------------------- 2004 2003 2004 2003 --------- --------- --------- --------- United States $ 114,237 $ 97,003 $ 298,803 $ 271,398 Europe and Africa 69,367 64,961 173,610 171,078 Other international operations 24,050 21,654 63,278 56,798 ---------- ---------- ---------- --------- Total product revenue $ 207,654 $ 183,618 $ 535,691 $ 499,274 ========== ========== ========== ========= 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 Nine Months Ended December 31, December 31, ----------------------------- ------------------------------ 2004 2003 2004 2003 --------- --------- --------- --------- Revenue $ 207,654 $ 183,618 $ 535,691 $ 499,274 Expenses 123,751 132,042 371,372 374,893 --------- --------- --------- --------- Product contribution $ 83,903 $ 51,576 $ 164,319 $ 124,381 ========= ========= ========= ========= The product segment generated contribution margins of 40.4% and 28.1% during the third quarter of 2005 and 2004, respectively, and 30.7% and 24.9% during the first nine 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 5.5% and 10.3% in the third quarter of 2005 and 2004, respectively, and 9.7% and 11.9% in the first nine months of 2005 and 2004, respectively. The decreases in cost of software license fees for the third quarter and first nine months of 2005 were primarily attributable to a reduction in amortization expense related to capitalized software acquired as a result of the Programmart acquisition that became fully amortized in September 2004. 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 16.3% and 22.7% in the third quarter of 2005 and 2004, respectively, and 21.6% and 24.9% during the first nine months of 2005 and 2004, respectively. Capitalization of internally developed software products begins when the technological feasibility of the product is established. The decreases in technology development and support expense for the third quarter and first nine months of 2005 were primarily attributable to increased capitalization of development costs associated with new product releases that had reached technological feasibility ("capitalization phase"). Due to timing, a higher volume of projects were in the capitalization phase and a lower volume of projects were in the pre-capitalization phase during the third quarter of 2005 than historically experienced. As a result, we expect the capitalization rate to decline in the fourth quarter of 2005 as these products become generally available. Before the capitalization of internally developed software products, total research and development expenditures for the third quarter of 2005 decreased $2.8 million, or 6.0%, to $42.6 million from $45.4 million in the third quarter of 2004, and for the first nine months of 2005 decreased $1.6 million, or 1.2%, to $132.0 million from $133.6 million in the first nine months of 2004. 21 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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 third quarter of 2005, sales and marketing costs increased $2.3 million, or 2.8%, to $84.4 million from $82.1 million in the third quarter of 2004 and for the first nine months of 2005 increased $7.3 million, or 3.2% to $234.5 million from $227.2 million in the first nine months of 2004. The increase in sales and marketing costs for the third quarter and first nine months of 2005 were primarily attributable to increases in salary costs resulting from annual salary increases and the unfavorable effect of foreign currency fluctuations. The sales and marketing costs for the first nine months of 2005 were also affected by 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 40.7% and 44.7% in the third quarter of 2005 and 2004, respectively, and 43.8% and 45.5% in the first nine months of 2005 and 2004, respectively. PROFESSIONAL SERVICES REVENUE We offer a broad range of IT services to help businesses make the most of their IT assets. Some of these services include outsourcing and co-sourcing, application management, product solutions, project management, enterprise resource planning and customer relationship management services, and our unique Compuware Application Reliability Solution, a comprehensive approach to application quality assurance. Revenue from professional services decreased $11.7 million or 8.7% during the third quarter of 2005 to $122.9 million compared to $134.6 million in the third quarter of 2004, and decreased $50.3 million or 11.8% during the first nine months of 2005 to $377.4 million from $427.7 million during the first nine 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 Nine Months Ended December 31, December 31, ----------------------------- ----------------------------- 2004 2003 2004 2003 --------- --------- --------- --------- United States $ 106,148 $ 119,390 $ 330,562 $ 383,441 Europe and Africa 15,512 14,029 42,771 41,657 Other international operations 1,221 1,148 4,032 2,578 --------- --------- --------- --------- Total professional services revenue $ 122,881 $ 134,567 $ 377,365 $ 427,676 ========= ========= ========= ========= 22 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) PROFESSIONAL SERVICES CONTRIBUTION AND EXPENSES Financial information for the professional services segment is as follows (in thousands): Three Months Ended Nine Months Ended December 31, December 31, ------------------------------ ------------------------------ 2004 2003 2004 2003 --------- --------- --------- --------- Revenue $ 122,881 $ 134,567 $ 377,365 $ 427,676 Expenses 105,734 123,767 337,518 399,814 --------- --------- --------- --------- Professional services contribution $ 17,147 $ 10,800 $ 39,847 $ 27,862 ========= ========= ========= ========= During the third quarter of 2005, the professional services segment generated a contribution margin of 14.0%, compared to 8.0% during the third quarter of 2004. The professional services contribution margin was 10.6% and 6.5% for the first nine 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. 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 $18.1 million or 14.6% during the third quarter of 2005 to $105.7 million compared to $123.8 million in the third quarter of 2004 and decreased $62.3 million or 15.6% during the first nine months of 2005 to $337.5 million from $399.8 million during the first nine months of 2004. The decreases in costs for the third quarter and first nine months of 2005 were primarily attributable to lower compensation, benefit, bonus and travel costs of approximately $14.9 million and $56.5 million, respectively, and a decrease in subcontractor costs of approximately $3.1 million and $7.9 million, respectively. Compensation, benefit, bonus and travel costs were lower due to a reduction in average employee headcount from the first nine months of 2004 to the first nine 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 $1.9 million, or 3.8% during the third quarter of 2005 to $48.3 million from $50.2 million during the third quarter of 2004, and decreased $9.4 million or 5.9% during the first nine months of 2005 to $148.7 million from $158.1 million in the first nine months of 2004. The decrease in costs for the first nine months of 2005 was primarily attributable to a decline in external legal fees of approximately $12.3 million due to reduced legal costs associated with the IBM litigation, a decrease in losses from our joint ventures of $1.4 million and a decrease in cost due to a one-time lease impairment charge of $2.2 million which was recorded in the first quarter of 2004 for two leased buildings that were vacated when we relocated to our new headquarters building in Detroit, Michigan. The decrease in administrative and general expenses was partially offset by an increase in salaries and benefits of $4.0 million and an increase in depreciation expense of 23 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) $2.3 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 $16.2 million in the third quarter of 2005 and $19.4 million for the first nine months of 2005, which represents an effective tax rate of 28%. This compares to an income tax benefit of $4.7 million in the third quarter of 2004 and $7.0 million for the first nine months of 2004. During the quarter ended December 31, 2003, we adjusted our reserves related to various tax matters. This adjustment resulted in an income tax benefit of $9.5 million relating primarily to favorable tax settlements with the U.S. Internal Revenue Service (IRS) and developments in other tax matters both in the US and other taxing jurisdictions. We recorded a net benefit of $4.7 million related to the completion of an IRS exam which challenged the deductibility of interest paid on Corporate Owned Life Insurance (COLI) policies. We entered into a Closing Agreement with the IRS on this matter in October 2003. All COLI policies have been cancelled. The balance of the adjustment related to revisions in estimates for reserves related to the U.S. Research and Experimentation tax credit, an audit of our Australian operations for fiscal years 1996 through 2001, and other reserves no longer deemed necessary. Excluding the $9.5 million tax benefit, the effective tax rate for the quarter and for the nine months ended December 31, 2003 was 28%. The effective income tax rates for the quarter and for the nine months ended December 31, 2004 and 2003 are 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 6 to the Condensed Consolidated Financial Statements for changes in the restructuring accrual for the first nine months of 2005. 24 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 December 31, 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 nine months of 2005. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2004, cash and investments totaled approximately $736.8 million. During the first nine months of 2005 and 2004, cash flow from operations was $102.8 million and $125.3 million, respectively. The decrease was primarily due to lower collections on customer receivables resulting from the general decline in revenue and installment receivables during the past two years, partially offset in 2005 by tax refunds of approximately $22.3 million, a decrease in cash paid for salaries and benefits due to lower headcount, primarily within the professional services segment, and a decrease in cash paid to professional services subcontract vendors consistent with our move away from subcontract arrangements. During the first nine months of 2005 and 2004, capital expenditures including property and equipment and capitalized research and software development totaled $39.1 million and $65.2 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 for a description of the facility). During the second quarter of 2005, the credit facility was extended through July 28, 2005 on the same terms. 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. As of September 30, 2004, we implemented a plan to market and sell the building, and the building was classified as held for sale. We have also evaluated whether the value of the building was impaired and concluded that no impairment charge related to the building should be recorded at December 31, 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. There were no purchases under this program during the third quarter of 2005. Approximately $124 million remains for future purchases under this program. 25 COMPUWARE CORPORATION AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) As discussed in Note 7 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 CareTech should be recorded at December 31, 2004. At December 31, 2004, the carrying value of investments in and advances to Caretech was $23.0 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 was accounted for as a purchase, and accordingly, the assets and liabilities acquired were 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 nine months of 2005. 26 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 December 31, 2004 that materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting. 27 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 Reports on Form 10-Q for the quarters ended June 30, 2004 and September 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 ("Case A"). IBM filed a counterclaim alleging Compuware infringed on IBM's copyrights and violated six IBM patents. The Court bifurcated the patent counterclaims ("Case B") from the copyright claims (Case A) and fact discovery in Case B is proceeding. In Case B, the Compuware products accused of infringement are File-AID CS, Abend-AID, and Xpediter. No trial date has been set for Case B. We believe we have valid defenses to the counterclaims, and we currently intend to continue to vigorously defend against those claims. In Case A, on January 7, 2005, the Court granted Compuware's motion for summary judgment, thereby dismissing the IBM counterclaim that Compuware infringed IBM's copyrights. Trial in Case A is set to commence on February 15, 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. In January 2005, the Court ruled in Compuware's favor by denying plaintiff's motion for class certification. To date, the Company has 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. 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 (filed as an exhibit to the Company's Form 10-Q for the period ended September 30, 2004 and incorporated herein by reference) 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: February 3, 2005 By: /s/ Peter Karmanos, Jr. ----------------------- Peter Karmanos, Jr. Chief Executive Officer (duly authorized officer) Date: February 3, 2005 By: /s/ Laura L. Fournier ---------------------- Laura L. Fournier Senior Vice President Chief Financial Officer Treasurer 30 EXHIBIT INDEX Exhibit Number Description of Document 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.