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, 2005
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 by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's class of
common stock, as of the latest practicable date:
As of October 31, 2005, there were outstanding 387,448,499 shares of Common
Stock, par value $.01, of the registrant.
Page 1 of 31 pages
Page
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of
September 30, 2005 and March 31, 2005 3
Condensed Consolidated Statements of Operations
for the three and six months ended September 30, 2005 and 2004 4
Condensed Consolidated Statements of Cash Flows
for the six months ended September 30, 2005 and 2004 5
Notes to Condensed Consolidated Financial
Statements 6
Report of Independent Registered Public Accounting Firm 17
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 18
Item 3. Quantitative and Qualitative Disclosures about Market Risk 28
Item 4. Controls and Procedures 28
PART II. OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 29
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 6. Exhibits 30
SIGNATURES 31
2
COMPUWARE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30, MARCH 31,
ASSETS 2005 2005
------------ -----------
CURRENT ASSETS:
Cash and cash equivalents $ 550,903 $ 497,687
Investments 304,344 299,715
Accounts receivable, net 388,042 448,611
Deferred tax asset, net 32,783 35,726
Income taxes refundable, net 46,694 32,609
Prepaid expenses and other current assets 26,230 24,369
Building - held for sale 15,700 19,702
----------- -----------
Total current assets 1,364,696 1,358,419
----------- -----------
INVESTMENTS 27,274 69,169
----------- -----------
PROPERTY AND EQUIPMENT, LESS ACCUMULATED
DEPRECIATION AND AMORTIZATION 404,575 418,241
----------- -----------
CAPITALIZED SOFTWARE, LESS ACCUMULATED
AMORTIZATION 59,146 54,043
----------- -----------
OTHER:
Accounts receivable 226,141 248,686
Deferred tax asset, net 1,804
Goodwill 318,468 293,391
Other 34,570 34,465
----------- -----------
Total other assets 579,179 578,346
----------- -----------
TOTAL ASSETS $ 2,434,870 $ 2,478,218
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 17,532 $ 36,439
Accrued expenses 151,817 168,600
Deferred revenue 365,076 373,157
----------- -----------
Total current liabilities 534,425 578,196
DEFERRED REVENUE 326,123 364,270
ACCRUED EXPENSES 16,080 19,597
DEFERRED TAX LIABILITY, NET 6,569
----------- -----------
Total liabilities 883,197 962,063
----------- -----------
SHAREHOLDERS' EQUITY:
Common stock 3,874 3,884
Additional paid-in capital 756,971 744,747
Retained earnings 782,598 757,597
Unrealized loss on marketable securities (227)
Foreign currency translation adjustment 8,457 9,927
----------- -----------
Total shareholders' equity 1,551,673 1,516,155
----------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 2,434,870 $ 2,478,218
=========== ===========
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,
--------------------- ---------------------
2005 2004 2005 2004
-------- -------- -------- --------
REVENUES:
Software license fees $ 63,589 $ 65,662 $131,611 $119,765
Maintenance fees 110,901 104,771 218,275 208,272
Professional services fees 118,156 125,035 240,088 254,484
-------- -------- -------- --------
Total revenues 292,646 295,468 589,974 582,521
-------- -------- -------- --------
OPERATING EXPENSES:
Cost of software license fees 5,552 8,077 11,239 15,886
Cost of professional services 104,944 112,934 211,189 231,784
Technology development and support 34,400 40,789 70,053 81,680
Sales and marketing 68,198 79,322 140,235 150,055
Administrative and general 51,299 48,222 99,528 99,913
-------- -------- -------- --------
Total operating expenses 264,393 289,344 532,244 579,318
-------- -------- -------- --------
INCOME FROM OPERATIONS 28,253 6,124 57,730 3,203
OTHER INCOME, NET 7,852 4,167 14,585 7,983
-------- -------- -------- --------
INCOME BEFORE INCOME TAXES 36,105 10,291 72,315 11,186
INCOME TAX PROVISION 11,915 2,881 23,502 3,132
-------- -------- -------- --------
NET INCOME $ 24,190 $ 7,410 $ 48,813 $ 8,054
======== ======== ======== ========
Basic earnings per share $ 0.06 $ 0.02 $ 0.13 $ 0.02
======== ======== ======== ========
Diluted earnings per share $ 0.06 $ 0.02 $ 0.13 $ 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,
------------------------
2005 2004
--------- ---------
CASH FLOWS PROVIDED BY OPERATING ACTIVITIES:
Net income $ 48,813 $ 8,054
Adjustments to reconcile net income to cash provided
by operations:
Depreciation and amortization 25,394 30,559
Tax benefit from exercise of stock options 3,054 249
Issuance of common stock to ESOP 4,872
Acquisition tax benefits 3,502 3,604
Deferred income taxes 11,033 9,013
Other 8,910 1,250
Net change in assets and liabilities, net of
effects from acquisitions:
Accounts receivable 70,402 30,746
Prepaid expenses and other current assets (1,592) (2,755)
Other assets (506) 895
Accounts payable and accrued expenses (33,706) (36,979)
Deferred revenue (33,160) (5,363)
Income taxes (13,863) 1,755
--------- ---------
Net cash provided by operating activities 88,281 45,900
--------- ---------
CASH FLOWS USED IN INVESTING ACTIVITIES:
Purchase of:
Businesses, net of cash acquired (30,917) (96,993)
Property and equipment (6,321) (17,963)
Capitalized software (10,732) (7,694)
Investments:
Proceeds 209,798 127,335
Purchases (173,676) (134,845)
--------- ---------
Net cash used in investing activities (11,848) (130,160)
--------- ---------
CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:
Net proceeds from exercise of stock options 8,678 985
Contribution to stock purchase plans 4,447 4,064
Repurchase of common stock (31,354)
--------- ---------
Net cash provided by (used in) financing activities (18,229) 5,049
--------- ---------
EFFECT OF EXCHANGE RATE CHANGES ON CASH (4,988) 576
--------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 53,216 (78,635)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 497,687 454,916
--------- ---------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 550,903 $ 376,281
========= =========
See notes to condensed consolidated financial statements.
5
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
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, 2005, 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, 2005 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, 2005 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 2005 financial statements have been reclassified
to conform to the fiscal 2006 presentation. These reclassifications do not
affect net income 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 its 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 vendor
specific objective evidence ("VSOE"), of all undelivered elements of the
agreement (e.g., maintenance and professional services) is deferred. VSOE is
based on rates charged for maintenance and professional services when sold
separately. 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
6
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
agreements in which the fair value of the undelivered elements cannot be
determined using VSOE (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 two 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 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 software development
services rendered under fixed-price contracts, revenue is recognized using the
percentage of completion method. Certain professional services contracts include
up-front implementation services 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 SEPTEMBER 30, 2005
(UNAUDITED)
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, 2005 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, 2005, 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, 2005 and 2004, 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
(loss) per share data):
Three Months Ended Six Months Ended
September 30, September 30,
----------------------- -----------------------
2005 2004 2005 2004
---------- ---------- ---------- ----------
Net income:
As reported $ 24,190 $ 7,410 $ 48,813 $ 8,054
Compensation cost, net of tax (2,564) (8,101) (5,056) (15,334)
---------- ---------- ---------- ----------
Pro forma $ 21,626 $ (691) $ 43,757 $ (7,280)
========== ========== ========== ==========
Earnings (loss) per share:
As reported:
Basic earnings per share $ 0.06 $ 0.02 $ 0.13 $ 0.02
Diluted earnings per share 0.06 0.02 0.13 0.02
Pro forma:
Basic earnings (loss) per share 0.06 0.00 0.11 (0.02)
Diluted earnings (loss) per share 0.06 0.00 0.11 (0.02)
The pro forma amounts for compensation cost may not be indicative of the effects
on net income and earnings per share for future years.
Under SFAS No. 123, the fair value of each option grant is estimated on the date
of grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions for grants in the second quarter of fiscal 2006 and
2005, respectively: expected volatility of 72.96% and 43.45%; risk-free interest
rates of 4.10% and 3.45%; and expected lives at date of grant of 3.3 years and
5.0 years. Dividend yields were not a factor as the Company has never issued
cash dividends. The weighted-average fair value of the option rights granted
during the second quarter of fiscal 2006 and 2005 was $3.82 and $2.40,
respectively.
8
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
Under SFAS No. 123, the fair value of the employees' stock purchase rights
acquired by participation in the Employee Stock Purchase Plan were estimated
using the Black-Scholes model with assumptions comparable to the stock option
plans above. The weighted-average fair value of the purchase rights granted in
the second quarter of fiscal 2006 was $1.24.
In accordance with SFAS No. 123(R), the Company will begin recognizing expense
for stock options effective April 2006.
NOTE 2 - ACQUISITIONS
In May 2005, the Company acquired Adlex, Inc., a privately owned software
company that helps companies manage the quality of service that business
critical applications deliver to end users, for approximately $36.0 million in
cash. The acquisition has been accounted for using the purchase method in
accordance with SFAS No. 141, "Business Combinations" and, accordingly, the
assets and liabilities acquired have been recorded at preliminary fair value as
of the acquisition date. The purchase price exceeded the fair value of the
acquired assets and liabilities by $26.2 million and was recorded to goodwill.
Intangible assets subject to amortization totaled $5.4 million of which $3.5
million and $1.5 million, respectively, related to purchased software and
customer relationships each with a useful life of five years. The remaining
intangible assets subject to amortization have a useful life of two years.
9
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
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 Six Months Ended
September 30, September 30,
------------------- -------------------
2005 2004 2005 2004
-------- -------- -------- --------
BASIC EARNINGS PER SHARE:
Numerator: Net income $ 24,190 $ 7,410 $ 48,813 $ 8,054
-------- -------- -------- --------
Denominator:
Weighted-average common shares outstanding 387,327 386,200 387,775 385,574
-------- -------- -------- --------
Basic earnings per share $ 0.06 $ 0.02 $ 0.13 $ 0.02
======== ======== ======== ========
DILUTED EARNINGS PER SHARE:
Numerator: Net income $ 24,190 $ 7,410 $ 48,813 $ 8,054
-------- -------- -------- --------
Denominator:
Weighted-average common shares outstanding 387,327 386,200 387,775 385,574
Dilutive effect of stock options 3,837 1,269 2,183 1,873
-------- -------- -------- --------
Total shares 391,164 387,469 389,958 387,447
-------- -------- -------- --------
Diluted earnings per share $ 0.06 $ 0.02 $ 0.13 $ 0.02
======== ======== ======== ========
During the three and six months ended September 30, 2005, stock options to
purchase a total of approximately 40,095,000 and 49,091,000 shares,
respectively, were excluded from the diluted earnings per share calculation
because they were anti-dilutive. During the three and six months ended September
30, 2004, stock options and a warrant to purchase a total of approximately
61,391,000 and 61,310,000 shares, respectively were excluded from the diluted
earnings per share calculation because they were anti-dilutive.
10
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
NOTE 4 - COMPREHENSIVE INCOME
Other comprehensive income includes unrealized loss on marketable securities and
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 Six Months Ended
September 30, September 30,
---------------------- ----------------------
2005 2004 2005 2004
-------- -------- -------- --------
Net income $ 24,190 $ 7,410 $ 48,813 $ 8,054
Unrealized loss on
marketable securities (227) $ (227)
Foreign currency translation
adjustment, net of tax 746 2,316 (1,470) (837)
-------- -------- -------- --------
Total comprehensive income $ 24,709 $ 9,726 $ 47,116 $ 7,217
======== ======== ======== ========
NOTE 5 - PROPERTY AND EQUIPMENT
During fiscal 2005, the Company implemented a plan to market and sell the former
headquarters building in Farmington Hills, Michigan. Accordingly, the building
is classified in current assets as held for sale. During the second quarter of
fiscal 2006, the Company received viable offers to purchase the building which
were below its carrying value. As a result of this information, the Company
recorded a $4.0 million write-down of the building. This adjustment was included
in administrative and general expense.
11
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
NOTE 6 - GOODWILL AND INTANGIBLE ASSETS
The components of the Company's intangible assets were as follows (in
thousands):
September 30, 2005
-----------------------------------------------
Gross Carrying Accumulated Net Carrying
Amount Amortization Amount
-------------- ------------ ------------
Unamortized intangible assets:
Trademarks (1) $ 5,858 $ 5,858
============== ============ ============
Amortized intangible assets:
Capitalized software (2) $ 284,135 $ (224,989) $ 59,146
Customer relationship
agreements (3) 6,656 (1,561) 5,095
Non-compete agreements (3) 1,921 (816) 1,105
Other (4) 7,286 (5,417) 1,869
-------------- ------------ ------------
Total amortized intangible assets $ 299,998 $ (232,783) $ 67,215
============== ============ ============
March 31, 2005
-----------------------------------------------
Gross Carrying Accumulated Net Carrying
Amount Amortization Amount
-------------- ------------ ------------
Unamortized intangible assets:
Trademarks (1) $ 5,821 $ 5,821
============== ============= ============
Amortized intangible assets:
Capitalized software (2) $ 269,912 $ (215,869) $ 54,043
Customer relationship
agreements (3) 5,123 (939) 4,184
Non-compete agreements (3) 1,626 (497) 1,129
Other (4) 7,185 (5,071) 2,114
-------------- ------------ ------------
Total amortized intangible assets $ 283,846 $ (222,376) $ 61,470
============== ============= ============
(1) Certain trademarks were acquired as part of the Covisint, LLC and
Changepoint acquisitions in fiscal 2004 and 2005. These trademarks are
deemed to have an indefinite life and therefore are not being amortized.
(2) Amortization of capitalized software is primarily included in "cost of
software license fees" in the consolidated statements of operations.
Capitalized software is generally amortized over five years.
(3) Customer relationship agreements and non-compete agreements were acquired
as part of the Adlex acquisition in fiscal 2006 and Changepoint acquisition
in fiscal 2005. The customer relationship agreements are being amortized
over five years. The non-compete agreements are being amortized over three
years.
(4) Other amortized intangible assets include trademarks associated with past
product acquisitions with a useful life of ten years, trademarks associated
with the Adlex acquisition with a useful life of two years and Covisint
customer contracts that have a useful life of three years.
12
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
Changes in the carrying amounts of goodwill for the six months ended September
30, 2005 were as follows (in thousands):
Goodwill: Products Services Total
--------- --------- ---------
Balance at March 31, 2005, net $ 152,044 $ 141,347 $ 293,391
Acquisition 26,244 26,244
Adjustments to previously recorded
purchase price 49 49
Effect of foreign currency
translation (2) (237) (239)
--------- --------- ---------
Balance at June 30, 2005, net 178,335 141,110 319,445
Adjustments to previously recorded
purchase price (1,112) (1,112)
Effect of foreign currency
translation 10 125 135
--------- --------- ---------
Balance at September 30, 2005, net $ 177,233 $ 141,235 $ 318,468
========= ========= =========
13
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
NOTE 7 - 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,
------------------------ ------------------------
2005 2004 2005 2004
--------- --------- --------- ---------
Revenues:
Products:
Mainframe $ 122,232 $ 126,096 $ 245,607 $ 239,841
Distributed systems 52,258 44,337 104,279 88,196
--------- --------- --------- ---------
Total product revenue 174,490 170,433 349,886 328,037
Professional services 118,156 125,035 240,088 254,484
--------- --------- --------- ---------
Total revenues $ 292,646 $ 295,468 $ 589,974 $ 582,521
========= ========= ========= =========
Operating expenses:
Products $ 108,150 $ 128,188 $ 221,527 $ 247,621
Professional services 104,944 112,934 211,189 231,784
Administrative and general 51,299 48,222 99,528 99,913
--------- --------- --------- ---------
Total operating expenses $ 264,393 $ 289,344 $ 532,244 $ 579,318
========= ========= ========= =========
Income (loss) from operations
before other income:
Products $ 66,340 $ 42,245 $ 128,359 $ 80,416
Professional services 13,212 12,101 28,899 22,700
Administrative and general (51,299) (48,222) (99,528) (99,913)
--------- --------- --------- ---------
Income from operations
before other income 28,253 6,124 57,730 3,203
Other income 7,852 4,167 14,585 7,983
--------- --------- --------- ---------
Income before income taxes $ 36,105 $ 10,291 $ 72,315 $ 11,186
========= ========= ========= =========
Financial information regarding geographic operations is presented in the table
below (in thousands):
Three Months Ended Six Months Ended
September 30, September 30,
--------------------- ---------------------
2005 2004 2005 2004
-------- -------- -------- --------
Revenues:
United States $196,826 $205,423 $396,305 $408,986
Europe and Africa 72,693 67,363 148,177 131,502
Other international operations 23,127 22,682 45,492 42,033
-------- -------- -------- --------
Total revenues $292,646 $295,468 $589,974 $582,521
======== ======== ======== ========
14
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
NOTE 8 - 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, 2005,
and charges against the accrual during the first six months of fiscal 2006 (in
thousands):
Charges and Charges and
adjustments against adjustments against
Balance at the accrual during the accrual during Balance at
March 31, the quarter ended the quarter ended September 30,
2005 June 30, 2005 September 30, 2005 2005
------------- ------------------- ------------------- -------------
Employee termination benefits $ 25 $ 15 $ 6 $ 4
Facilities costs (primarily lease
abandonments) 10,793 1,463 1,537 7,793
Legal, consulting and
outplacement costs 10 10 -- --
------------- ------------------- ------------------- -------------
Total restructuring accrual $ 10,828 $ 1,488 $ 1,543 $ 7,797
============= =================== =================== =============
During the first and second quarters of 2006, the Company recorded a reduction
of $846,000 and $807,000, respectively, in the restructuring accrual related to
subleases of abandoned lease space in excess of what was originally anticipated.
These adjustments were included in administrative and general expense.
15
COMPUWARE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SIX MONTHS ENDED SEPTEMBER 30, 2005
(UNAUDITED)
NOTE 9 - CONTINGENCIES
The Company and one of its employees are parties to a libel lawsuit filed in
April 2002 by two former employees titled Mary McCarthy O'Lee and Aidan O'Lee v.
Compuware Corp., et al., Case No. 406409, Superior Court of the State of
California, City and County of San Francisco. Plaintiffs alleged damages
totaling $1 million. The case was tried to a jury in late June and early July
2005. The jury rendered a verdict against the Company and awarded plaintiffs a
total of $1.15 million in compensatory and $10 million in punitive damages. On
post-trial motions, the Court affirmed the compensatory damages but reduced the
punitive damages award to $3.45 million. The Company has filed a notice of
appeal to seek a further reduction of the damages award. The Company believes
its accruals are adequate to provide for the final outcome of this matter.
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.
16
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Compuware Corporation:
We have reviewed the accompanying condensed consolidated balance sheet of
Compuware Corporation and subsidiaries (the "Company") as of September 30, 2005,
and the related condensed consolidated statements of operations for the
three-month and six-month periods ended September 30, 2005 and 2004 and of cash
flows for the six-month periods ended September 30, 2005 and 2004. 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, 2005, 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 June 7, 2005, 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, 2005 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 3, 2005
17
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 2005 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.
- 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 International Business Machines Corp. ("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.
- There can be no assurance that 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 and Mercury Interactive Corporation. Some of these
competitors have substantially greater financial, marketing, recruiting and
training resources than we do.
- 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., Infosys
Technologies 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 or acquire product
enhancements and 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.
18
COMPUWARE CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
(CONTINUED)
- We regard our software as proprietary and attempt to protect it with
copyrights, patents, 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 and to the varying
structure of customer arrangements and the associated revenue recognition
requirements.
- Changes in world economies could cause customers to 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.
19
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, 2005, particularly "Item 7 --
Management's Discussion and Analysis of Financial Condition and Results of
Operations".
We deliver value to businesses worldwide by providing software products and
professional services that increase the productivity of IT departments.
Originally founded as a professional services company, in the late 1970's we
began to offer mainframe productivity tools for fault management and diagnosis,
file and database management, and application debugging.
In the 1990's, the IT industry moved toward distributed and web-based platforms.
Our solutions portfolio grew in response, and we now market a comprehensive
portfolio of IT solutions for both distributed and mainframe systems that help
customers:
- Develop, test and deploy industrial-strength enterprise applications;
- Proactively manage the availability and performance of key applications and
resolve problems before they impact the business; and
- Govern, control and align the entire IT portfolio.
IT governance was added to our solution portfolio in May 2004 with the
acquisition of Changepoint Corporation ("Changepoint"). Changepoint offerings
help IT organizations by providing critical insight into IT spending, operations
and management, helping technology leaders align IT investments with business
priorities.
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 second quarter of 2006:
- Released 4 mainframe and 8 distributed product updates designed to increase
the productivity of the IT departments of our customers.
- Achieved a products contribution margin of 38.0% in the second quarter of
2006 compared to 24.8% in the second quarter of 2005. The primary reason
for the improved contribution margin was continued growth in our
distributed maintenance revenue and reductions in technology development
and support expense and sales and marketing expense.
- Achieved a 17.9% increase in distributed product revenue compared to the
second quarter of 2005. The increase was a reflection of our continued
focus on promoting our distributed products and an expanding maintenance
base for those products.
- Improved the professional services margin from 9.7% in the second quarter
of 2005 to 11.2% in the second quarter of 2006 through improved utilization
of professional services personnel and, to a lesser extent, a concerted
effort to reduce low margin subcontractor arrangements.
- Repurchased approximately 2.4 million shares of our common stock at an
average price of $8.64 per share.
These results were achieved without revenue or other income related to the IBM
agreement entered into in the fourth quarter of 2005. See Item 3 of our annual
report on Form 10-K for the fiscal year ended March 31, 2005 for a summary of
the agreement.
20
COMPUWARE CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
(CONTINUED)
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".
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
2005 2004 Change 2005 2004 Change
------ ------ --------- ------ ------ ---------
REVENUE:
Software license fees 21.7% 22.2% (3.2)% 22.3% 20.6% 9.9%
Maintenance fees 37.9 35.5 5.9 37.0 35.7 4.8
Professional services fees 40.4 42.3 (5.5) 40.7 43.7 (5.7)
------ ------ ------ ------
Total revenues 100.0 100.0 (1.0) 100.0 100.0 1.3
------ ------ ------ ------
OPERATING EXPENSES:
Cost of software license fees 1.9 2.7 (31.3) 1.9 2.7 (29.3)
Cost of professional services 35.9 38.2 (7.1) 35.8 39.8 (8.9)
Technology development and support 11.8 13.8 (15.7) 11.9 14.0 (14.2)
Sales and marketing 23.3 26.9 (14.0) 23.7 25.8 (6.5)
Administrative and general 17.5 16.3 6.4 16.9 17.2 (0.4)
------ ------ ------ ------
Total operating expenses 90.4 97.9 (8.6) 90.2 99.5 (8.1)
------ ------ ------ ------
Income from operations 9.6 2.1 361.3 9.8 0.5 1702.4
Other income 2.7 1.4 88.4 2.5 1.4 82.7
------ ------ ------ ------
Income before income taxes 12.3 3.5 250.8 12.3 1.9 546.5
Income tax provision 4.0 1.0 313.6 4.0 0.5 650.4
------ ------ ------ ------
Net income 8.3% 2.5% 226.5% 8.3% 1.4% 506.1%
====== ====== ====== ======
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 59.6% and 57.7% of total revenue during the
second quarter of 2006 and 2005, respectively, and 59.3% and 56.3% of total
revenue during the first six months of 2006 and 2005, respectively.
Distributed software product revenue increased $8.0 million or 17.9% during the
second quarter of 2006 to $52.3 million from $44.3 million during the second
quarter of 2005 and increased $16.1 million or 18.2% during the first six months
of 2006 to $104.3 million from $88.2 million during the first six months of
2005. The increased revenue during the second quarter and first six months of
2006 was primarily due to an increase of $4.5 million and $11.0 million,
21
COMPUWARE CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
(CONTINUED)
respectively, in maintenance revenue as the installed base of our distributed
products continues to expand. The remaining change is attributable to strong
license revenue growth within our Vantage product line.
Mainframe software product revenue decreased $3.9 million or 3.1% during the
second quarter of 2006 to $122.2 million from $126.1 million during the second
quarter of 2005 and increased $5.8 million or 2.4% during the first six months
of 2006 to $245.6 million from $239.8 million during the first six months of
2005. The decreased revenue during the second quarter of 2006 was primarily due
to our File-Aid product line. The increased revenue during the first six months
of 2006 was primarily due to our Strobe product line.
License revenue decreased $2.1 million or 3.2% during the second quarter of 2006
to $63.6 million from $65.7 million during the second quarter of 2005 and
increased $11.8 million or 9.9% during the first six months of 2006 to $131.6
million from $119.8 million during the first six months of 2005. The increased
revenue during the first six months of 2006 was primarily due to a $6.7 million
increase in mainframe license revenue primarily related to our File-Aid and
Strobe product lines and a $5.1 million increase in distributed license revenue
primarily related to our Vantage and Changepoint product lines.
Maintenance fees increased $6.1 million or 5.9% to $110.9 million during the
second quarter of 2006 from $104.8 million during the second quarter of 2005 and
increased $10.0 million or 4.8% during the first six months of 2006 to $218.3
million from $208.3 million during the first six months of 2005. These increased
revenues were primarily due to increases of $4.5 million and $11.0 million,
respectively, in distributed maintenance revenue related to our DevPartner,
Vantage and Changepoint product lines.
Product revenue by geographic location is presented in the table below (in
thousands):
Three Months Ended Six Months Ended
September 30, September 30,
--------------------- ---------------------
2005 2004 2005 2004
-------- -------- -------- --------
United States $ 95,420 $ 95,644 $190,284 $184,571
Europe and Africa 57,644 53,893 116,924 104,243
Other international operations 21,426 20,896 42,678 39,223
-------- -------- -------- --------
Total product revenue $174,490 $170,433 $349,886 $328,037
======== ======== ======== ========
22
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,
--------------------- ---------------------
2005 2004 2005 2004
-------- -------- -------- --------
Revenue $174,490 $170,433 $349,886 $328,037
Expenses 108,150 128,188 221,527 247,621
-------- -------- -------- --------
Product contribution $ 66,340 $ 42,245 $128,359 $ 80,416
======== ======== ======== ========
The product segment generated contribution margins of 38.0% and 24.8% during the
second quarter of 2006 and 2005, respectively, and 36.7% and 24.5% during the
first six months of 2006 and 2005, 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 8.7% and 12.3% in the second quarter of 2006 and 2005,
respectively, and 8.5% and 13.3% in the first six months of 2006 and 2005,
respectively. The decrease in cost of software license fees for the second
quarter and first six months of 2006 was primarily attributable to a reduction
in amortization expense related to capitalized software acquired as a result of
the Programart 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
19.7% and 23.9% in the second quarter of 2006 and 2005, respectively, and 20.0%
and 24.9% during the first six months of 2006 and 2005, respectively.
The decreases in technology development and support expense for the second
quarter and first six months of 2006 were primarily attributable to lower
compensation and benefit costs of approximately $4.4 million and $8.1 million,
respectively, due to a reduction in employee headcount. The decreases were also
due to a reduction in outside service costs and 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 during the first six months
of 2006 compared to the first six months of 2005.
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 2006 decreased $5.8 million
or 12.8% to $39.7 million from $45.5 million in the second quarter of 2005 and
for the first six months of 2006 decreased $9.2 million or 10.3% to $80.2
million from $89.4 million in 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)
Sales and marketing costs consist primarily of personnel related costs
associated with product sales and sales support and marketing for all our
offerings. For the second quarter of 2006, sales and marketing costs decreased
$11.1 million or 14.0% to $68.2 million from $79.3 million in the second quarter
of 2005 and for the first six months of 2006 decreased $9.9 million or 6.5% to
$140.2 million from $150.1 million in the first six months of 2005. The
decreases in sales and marketing for the second quarter and first six months of
2006 were primarily attributable to lower compensation, benefit and commission
costs of approximately $7.4 million and $5.7 million, respectively, due to a
first quarter 2006 sales realignment that reduced headcount. The remaining
decreases primarily relate to reductions in marketing and advertising
expenditures through the first six months of 2006 with the timing of the OJX
conference having the biggest impact. In 2005, the conference was held during
our second quarter while in 2006, the OJX conference was held during our third
quarter resulting in lower expense for the first six months of 2006 compared to
2005. As a percentage of product revenue, sales and marketing costs were 39.1%
and 46.5% in the second quarter of 2006 and 2005, respectively, and 40.1% and
45.7% in the first six months of 2006 and 2005, 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 $6.8
million or 5.5% during the second quarter of 2006 to $118.2 million compared to
$125.0 million in the second quarter of 2005, and decreased $14.4 million or
5.7% during the first six months of 2006 to $240.1 million from $254.5 million
during the first six months of 2005. The decreases in revenue for 2006 were
primarily due to reduced spending from local and state government agencies and
the automotive sector.
Professional services revenue by geographic location is presented in the table
below (in thousands):
Three Months Ended Six Months Ended
September 30, September 30,
--------------------- ---------------------
2005 2004 2005 2004
-------- -------- -------- --------
United States $101,406 $109,779 $206,021 $224,415
Europe and Africa 15,049 13,470 31,253 27,259
Other international operations 1,701 1,786 2,814 2,810
-------- -------- -------- --------
Total professional services revenue $118,156 $125,035 $240,088 $254,484
======== ======== ======== ========
24
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 Six Months Ended
September 30, September 30,
--------------------- ---------------------
2005 2004 2005 2004
-------- -------- -------- --------
Revenue $118,156 $125,035 $240,088 $254,484
Expenses 104,944 112,934 211,189 231,784
-------- -------- -------- --------
Professional services contribution $ 13,212 $ 12,101 $ 28,899 $ 22,700
======== ======== ======== ========
During the second quarter of 2006, the professional services segment generated a
contribution margin of 11.2%, compared to 9.7% during the second quarter of
2005. The professional services contribution margin was 12.0% and 8.9% for the
first six months of 2006 and 2005, respectively. The increase was primarily due
to improved utilization of professional services personnel and, to a lesser
extent, ongoing efforts 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 $8.0 million or 7.1% during
the second quarter of 2006 to $104.9 million compared to $112.9 million in the
second quarter of 2005 and decreased $20.6 million or 8.9% during the first six
months of 2006 to $211.2 million from $231.8 million during the first six months
of 2005. The decreases in costs for the second quarter and first six months of
2006 were primarily attributable to lower compensation, benefit, and bonus costs
of approximately $4.0 million and $12.1 million, respectively, due to a
reduction in employee headcount in this area from the first six months of 2005
to the first six months of 2006. The remaining decreases primarily relate to
reductions in subcontractor costs as a result of our ongoing efforts to reduce
low margin subcontractor projects.
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 increased
$3.1 million or 6.4% during the second quarter of 2006 to $51.3 million from
$48.2 million during the second quarter of 2005, and decreased $400,000 or 0.4%
during the first six months of 2006 to $99.5 million from $99.9 million in the
first six months of 2005. The increase in cost for the second quarter of 2006
and the decrease in cost for the first six months of 2006 were primarily
attributable to the effects of a second quarter 2006 write down of $4.0 million
related to our former headquarters building in Farmington Hills, Michigan (see
Note 5 to the Condensed Consolidated Financial Statements for more information)
offset by a decline in external legal fees and litigation costs of $1.4 million
and $7.8 million, respectively. The first six months of 2006 were further
impacted by a first quarter 2006 write down of $3.9 million related to a
purchased software application that management, at this time, does not have
plans to utilize. The decrease in external legal fees and litigation costs are
primarily due to reduced legal costs associated with the IBM litigation
partially offset by an unfavorable verdict against the Company. See Note 9
to the Condensed Consolidated Financial Statements for more information.
25
COMPUWARE CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
(CONTINUED)
Other income consists primarily of interest earnings on deferred customer
receivables, interest income realized from investments and income/losses
generated from our investments in partially owned companies. Other income
increased $3.7 million or 88.4% during the second quarter of 2006 to $7.9
million compared to $4.2 million in the second quarter of 2005 and increased
$6.6 million or 82.7% during the first six months of 2006 to $14.6 million from
$8.0 million during the first six months of 2005. The increases in income for
the second quarter and first six months of 2006 were primarily attributable to
an increase in investment interest income due to higher interest rates earned on
investments during the first six months of 2006 compared to 2005.
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 $11.9 million in the second quarter of 2006 and $23.5 million
for the first six months of 2006, which represents an effective tax rate of 33%
and 32.5%, respectively. This compares to an income tax provision of $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%. The increase in the
effective tax rate from 2005 to 2006 is primarily related to expected increases
in income before income taxes. We have reviewed the provisions of the American
Jobs Creation Act of 2004 and do not anticipate any changes to our effective tax
rate as a result of this Act.
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 8 to the Condensed Consolidated Financial
Statements for changes in the restructuring accrual for the first six months of
2006.
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, 2005. 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, 2005 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
2006.
26
COMPUWARE CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
(CONTINUED)
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 2005, cash and cash equivalents and investments totaled
approximately $882.5 million. During the first six months of 2006 and 2005, cash
flow from operations was $88.3 million and $45.9 million, respectively. The
increase was primarily due to a decrease in cash paid for salaries and benefits
due to lower headcount, primarily within the professional services, technology
development and support and sales and marketing segments, and higher collections
on customer receivables due to increased product revenue. During the first six
months of 2006 and 2005, capital expenditures including property and equipment
and capitalized research and software development totaled $17.1 million and
$25.7 million, respectively.
We hold a $100 million revolving credit facility that would have matured on July
28, 2005 (see Note 9 to the Consolidated Financial Statements included in our
Annual Report on Form 10-K for the year ended March 31, 2005 for a description
of the facility). During the second quarter of 2006, the credit facility was
extended through July 27, 2006 on the same terms. No borrowings have occurred
under this facility since inception.
During fiscal 2005, we implemented a plan to market and sell the former
headquarters building in Farmington Hills, Michigan. Accordingly, the building
is classified in current assets as held for sale. During the second quarter of
2006, we received viable offers to purchase the building which were below its
carrying value. As a result of this information, we recorded a $4.0 million
write-down of the building.
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. During the first six months of 2006, we repurchased approximately
3.9 million shares of our common stock under this program at an average price of
$7.98 per share. Approximately $92.6 million remains for future purchases under
this program.
In May 2005, we acquired Adlex, Incorporated, a privately owned software company
that helps companies manage the quality of service that business critical
applications deliver to end users, for approximately $36 million in cash. The
acquisition has been accounted for as a purchase and, accordingly, assets and
liabilities acquired have been recorded at preliminary 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, 2005. 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 2006.
27
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, 2005, therefore the market risks remain substantially
unchanged since we filed the Annual Report on Form 10-K for the fiscal year
ending March 31, 2005.
ITEM 4. CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to ensure
material information required to be disclosed in our reports that we file or
submit under the Securities Exchange Act of 1934 is recorded, processed,
summarized, and reported within the time periods specified in the SEC's rules
and forms, and that such information is accumulated and communicated to our
management, including our Chief Executive Officer and Chief Financial Officer,
as appropriate, to allow timely decisions regarding required financial
disclosure. In designing and evaluating the disclosure controls and procedures,
management recognized that a control system, no matter how well designed and
operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Because of the inherent limitations in
all control systems, no evaluation of controls can provide absolute assurance
that all control issues and instances of fraud, if any, with a company have been
detected.
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 (the
"Exchange Act"). Based upon that evaluation, our Chief Executive Officer and
Chief Financial Officer concluded that our disclosure controls and procedures
are effective, at the reasonable assurance level, to cause the material
information required to be disclosed in the reports that we file or submit under
the Exchange Act to be recorded, processed, summarized and reported within the
time periods specified in the Commission's rules and forms.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
No changes in our internal control over financial reporting occurred during the
quarter ended September 30, 2005 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
28
COMPUWARE CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table sets forth, the repurchases of common stock for the quarter
ended September 30, 2005:
Total number of
shares Approximate
repurchased as dollar value of
part of publicly shares that may
Total number of Average price announced yet be purchased
shares paid per repurchase plan under the plan or
Period repurchased (a) share (a) or program (b) program (b)
------ ---------------- --------------- ---------------- -----------------
As of June 30, 2005 1,745,430 $ 113,236,000
July 1, 2005 - July 31, 2005 250,000 $ 8.34 1,995,430 111,150,000
Aug. 1, 2005 - Aug. 31, 2005 1,865,654 8.55 3,813,230 95,616,000
Sept. 1, 2005 - Sept. 30, 2005 326,366 9.39 4,129,337 92,650,000
---------------- ---------------
Total 2,442,020 $ 8.64
================ ===============
(a) Includes repurchases made pursuant to a publicly announced plan (see
footnote b below) and the surrender of 58,000 shares to the Company pursuant to
the exercise of options under the Replacement Stock Option Award program.
(b) On May 7, 2003, we announced that 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. Unless terminated earlier by resolution of our
Board of Directors, the share repurchase program will expire when we have
repurchased all shares authorized for repurchase thereunder.
29
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 23, 2005 at the Company's
headquarters. The first 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 2006 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 336,549,982 14,326,767
Gurminder S. Bedi 339,873,686 11,003,063
William O. Grabe 325,239,232 25,637,517
William R. Halling 301,906,882 48,969,867
Peter Karmanos, Jr. 341,557,091 9,319,658
Faye Alexander Nelson 327,931,494 22,945,255
Glenda D. Price 303,126,493 47,750,256
W. James Prowse 294,096,360 56,780,389
G. Scott Romney 333,901,574 16,975,175
Lowell P. Weicker, Jr. 267,280,720 83,596,029
The second matter voted upon ratified the appointment of Deloitte & Touche LLP,
our independent registered public accounting firm, to audit our consolidated
financial statements for the fiscal year ending March 31, 2006. Total votes for,
against and abstained were 280,184,522, 68,577,177 and 2,115,050, respectively.
The total number of the Company's common shares issued and outstanding and
entitled to be voted at the Annual Meeting was 387,660,688 shares. The total
number of shares voted at the Annual Meeting was 350,876,749 or 90.5% of the
shares outstanding and eligible to vote.
ITEM 6. EXHIBITS
Exhibit
Number Description of Document
4.5 Amendment No. 3 to Credit Agreement, dated July 28, 2005. (1)
15 Independent Registered Public Accounting Firm's Awareness
Letter (2)
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(a) of the Securities Exchange Act. (2)
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(a) of the Securities Exchange Act. (2)
32 Certification pursuant to 18 U.S.C. Section 1350 and Rule
13a-14(b) of the Securities Exchange Act. (2)
(1) Incorporated by reference to the registrant's Form 8-K filed on
August 2, 2005.
(2) Filed herewith.
30
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 7, 2005 By: /s/ Peter Karmanos, Jr.
----------------- -----------------------
Peter Karmanos, Jr.
Chief Executive Officer
(duly authorized officer)
Date: November 7, 2005 By: /s/ Laura L. Fournier
----------------- ----------------------
Laura L. Fournier
Senior Vice President
Chief Financial Officer
Treasurer
31
EXHIBIT INDEX
Exhibit Number Description of Document
4.5 Amendment No. 3 to Credit Agreement, dated July 28, 2005. (1)
15 Independent Registered Public Accounting Firm's Awareness Letter
(2)
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(a) of the Securities Exchange Act. (2)
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(a) of the Securities Exchange Act. (2)
32 Certification pursuant to 18 U.S.C. Section 1350 and Rule
13a-14(b) of the Securities Exchange Act. (2)
(1) Incorporated by reference to the registrant's Form 8-K filed on August 2,
2005
(2) Filed herewith
32