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QAD INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) FORWARD-LOOKING STATEMENTS In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995. Any statements contained herein that are not statements of historical fact should be construed as forward looking statements, including statements that are preceded or accompanied by such words as "may," "believe," "could," "anticipate," "would," "might," "plan," "expect," "intend" and words of similar meaning or the negative of these terms or other comparable terminology. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in Part I, Item 1A entitled "Risk Factors" within our Annual Report on Form 10-K for the year ended January 31, 2011. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's opinions only as of the date hereof and are subject to risks, uncertainties and assumptions about our business. We undertake no obligation to revise or update or publicly release the results of any revision or update to these forward-looking statements except as required by applicable securities laws. Readers should carefully review the risk factors and other information described in other documents we file from time to time with the Securities and Exchange Commission ("SEC"). INTRODUCTION The following discussion should be read in conjunction with the information included within our Annual Report on Form 10-K for the year ended January 31, 2011, and the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q. OVERVIEW QAD Inc. is a global provider of enterprise software applications, and related services and support. QAD provides enterprise software applications to global manufacturing companies primarily in the automotive, consumer products, food and beverage, high technology, industrial products and life sciences industries. QAD software is used by over 2,500 global manufacturing companies and we employ approximately 1,400 people worldwide. QAD was founded in 1979, incorporated in California in 1986 and reincorporated in Delaware in 1997. QAD's enterprise resource planning ("ERP") suite is called QAD Enterprise Applications and was formerly marketed as MFG/PRO. QAD Enterprise Applications supports our global manufacturing customers' core business needs and enables their most common business processes. QAD typically sells licenses to its software under a perpetual licensing model. Customers who purchase perpetual licenses typically deploy the application using an on premise model on their own servers. Customers under the perpetual licensing model may separately purchase contracts for maintenance and additional services. QAD also offers an on demand deployment option in which QAD hosts the application and provides support and management of the environment, and where the customers pay a subscription fee that grants them access to the environment. This "On Demand" product offering is part of our subscription revenue. Recent market and economic conditions have been challenging. Continued slow global economic growth and continued concerns about geopolitical issues have contributed to market volatility and diminished expectations for the global economy generally. However, toward the end of the last fiscal year and continuing into the current fiscal year we have seen some improvement in the industries in which we operate. Our revenues have grown in all business lines when compared to the same quarter and six months of last fiscal year. During this period, our overall headcount has increased by approximately 80 employees, or 6%, when comparing July 31, 2011 to July 31, 2010, which was primarily in professional services to support customer upgrades and new implementations, and also in subscription to support the growth of our On Demand offering. Our strategy remains focused on the development and delivery of best-in-class software applications for the manufacturing industry in our six key industry segments. 13-------------------------------------------------------------------------------- Index Total revenue increased to $62.0 million for the second quarter of fiscal 2012, up from $51.3 million in the second quarter of fiscal 2011. We experienced increases of 45% in license revenue, 13% in maintenance and other revenue, 23% in professional services revenue and 74% in subscription revenue over the same period last year. Total revenue for the first six months of fiscal 2012 was $121.4 million, a $19.2 million, or 19%, increase from the first six months of fiscal 2011. License revenue for the first six months of fiscal 2012 increased by 27%, maintenance and other revenue increased by 11%, professional services revenue increased by 28% and subscription revenue increased by 82% over the same period last year. Our increased revenue and our focus on managing costs have resulted in higher net income. Net income increased to $3.1 million for the second quarter of fiscal 2012, up from $0.3 million in the second quarter of fiscal 2011. Net income for the first six months of fiscal 2012 was $4.1 million compared to a net loss of $0.9 million for the first six months of fiscal 2011. In addition, our focus on maintaining financial strength by preserving a strong balance sheet and managing costs has resulted in a higher cash balance. We ended the quarter with $78.8 million in cash and cash equivalents, up from $67.3 million at January 31, 2011. Cash flows from operations were $13.3 million for the first six months of fiscal 2012 compared to $13.7 million for the first six months of fiscal 2011. CRITICAL ACCOUNTING POLICIES Our condensed consolidated financial statements are prepared applying certain critical accounting policies. Critical accounting policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or subject to variations and may significantly affect our reported results and financial position for the period or in future periods. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on our future financial condition and results of operations. Our financial statements are prepared in accordance with U.S. GAAP, and they conform to general practices in our industry. We apply critical accounting policies consistently from period to period and intend that any change in methodology will occur in an appropriate manner. Accounting policies currently deemed critical, including a) revenue recognition; b) accounts receivable allowances for doubtful accounts; c) impairment of long-lived assets and goodwill; d) capitalized software development costs; e) valuation of deferred tax assets and tax contingency reserves; and f) stock-based compensation are further discussed in the Annual Report on Form 10-K for the fiscal year ended January 31, 2011. Except as noted below there have been no significant changes to our accounting policies and estimates as discussed in our Annual Report on Form 10-K for the fiscal year ended January 31, 2011. Revenue Recognition We derive our revenues from the sale or the license of our software products and from support services, subscriptions, consulting, development, training, and other professional services. The majority of our software is sold or licensed in multiple-element arrangements that include support services and often consulting services or other elements. As a result, we exercise judgment and use estimates in connection with the amount and timing of revenue recognition. For software license arrangements that do not require significant modification or customization of the underlying software, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. A majority of our license revenue is recognized in this manner. Revenue is presented net of sales, use and value-added taxes collected from our customers. Our typical payment terms vary by region. Occasionally, payment terms of up to one year may be granted for software license fees to customers with an established history of collections without concessions. Should we grant payment terms greater than one year or terms that are not in accordance with our established history for similar arrangements, we would recognize revenue as payments become due and payable assuming all other criteria for software revenue recognition requirements have been met. Provided all other revenue recognition criteria have been met, we recognize license revenue on delivery using the residual method when vendor-specific objective evidence of fair value ("VSOE") exists for all of the undelivered elements (for example, support services, consulting, or other services) in the arrangement. We allocate revenue to each undelivered element based on VSOE, which is the price charged when that element is sold separately or, for elements not yet sold separately, the price established by our management if it is probable that the price will not change before the element is sold separately. We allocate revenue to undelivered support services based on rates charged to renew the support services annually after an initial period. We allocate revenue to undelivered consulting services based on time and materials rates of stand-alone services engagements by role and by country. We review our VSOE at least annually. If we were to be unable to establish or maintain VSOE for one or more undelivered elements within a multiple-element arrangement, it could adversely impact our revenues, results of operations and financial position because we may have to defer all or a portion of the revenue or recognize revenue ratably from multiple-element arrangements. 14-------------------------------------------------------------------------------- Index Multiple element arrangements for which VSOE does not exist for all undelivered elements typically occur when we introduce a new product or product bundles for which we have not established VSOE for support services or consulting or other services under our VSOE policy. In these instances, revenue is deferred and recognized ratably over the longer of the support services (maintenance period) or consulting services engagement, assuming there are no specified future deliverables. In the instances in which it has been determined that revenue on these bundled arrangements will be recognized ratably due to lack of VSOE, at the time of recognition, we allocate revenue from these bundled arrangement fees to all of the non-license revenue categories based on VSOE of similar support services or consulting services. The remaining arrangement fees, if any, are then allocated to software license fee revenue. The associated costs primarily consist of payroll and related costs to perform both the consulting services and provide support services and royalty expense related to the license and maintenance revenue. These costs are expensed as incurred and included in the various cost of revenue categories. Revenue from support services and product updates, referred to as maintenance revenue, is recognized ratably over the term of the maintenance period, which in most instances is one year. Software license updates provide customers with rights to unspecified software product upgrades, maintenance releases and patches released during the term of the support period on a when-and-if available basis. Product support includes Internet access to technical content, as well as Internet and telephone access to technical support personnel. A majority of our customers purchase both product support and license updates when they acquire new software licenses. In addition, a majority of our customers renew their product support services contracts annually. Revenues from consulting services are typically comprised of implementation, development, training or other consulting services. Consulting services are generally sold on a time-and-materials basis and can include services ranging from software installation to data conversion and building non-complex interfaces to allow the software to operate in integrated environments. Consulting engagements can range anywhere from one day to several months and are based strictly on the customer's requirements and complexities and are independent of the functionality of our software. Our software, as delivered, can generally be used by the customer for the customer's purpose upon installation. Further, implementation and integration services provided are generally not essential to the functionality of the software, as delivered, and do not result in any material changes to the underlying software code. On occasion, we enter into fixed fee arrangements in which customer payments are tied to achievement of specific milestones. In fixed fee arrangements, revenue is recognized as services are performed as measured by hours incurred to date, as compared to total estimated hours to be incurred to complete the work. In milestone achievement arrangements, we recognize revenue as the respective milestones are achieved. Revenue from our subscription product offerings, including our On Demand products, is recognized ratably over the contract period when the customer does not have the right to take possession of the software. When our subscription product offerings are sold along with other elements as part of a multiple element arrangement, then the company allocates the total arrangement fee to each deliverable based on their relative selling prices. Amounts allocated to each deliverable are recognized as the revenue recognition criteria for each deliverable has been met. For subscription arrangements where the customer has the right and ability to take possession of the software, revenue is recognized using the residual method. Occasionally we resell third party systems as part of an end-to-end solution requested by our customers. Hardware revenue is recognized on a gross basis when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collection is considered probable. We consider delivery to occur when the product is shipped and title and risk of loss have passed to the customer. 15-------------------------------------------------------------------------------- Index Although infrequent, when an arrangement does not qualify for separate accounting of the software license and consulting transactions, the software license revenue is recognized together with the consulting services. Arrangements that do not qualify for separate accounting of the software license fee and consulting services typically occur when we are requested to customize software or where we view the installation of our software as high risk in the customer's environment. This requires us to make estimates about the total cost to complete the project and the stage of completion. The assumptions, estimates, and uncertainties inherent in determining the stage of completion affect the timing and amounts of revenues and expenses reported. Changes in estimates of progress toward completion and of contract revenues and contract costs are accounted for using the cumulative catch up approach. In these arrangements, we do not have a sufficient basis to estimate the costs of providing support services. As a result, revenue is typically recognized on a percent completion basis up to the amount of costs incurred (zero margin). Once the consulting services are complete and support services are the only undelivered item, the remaining revenue is recognized evenly over the remaining support period. If we do not have a sufficient basis to measure the progress of completion or to estimate the total contract revenues and costs, revenue is recognized when the project is complete and, if applicable, final acceptance is received from the customer. We allocate these bundled arrangement fees to support services and consulting services revenues based on VSOE. The remaining arrangement fees are then allocated to software license fee revenues. The associated costs primarily consist of payroll and related costs to perform the consulting and support services and royalty expense and are included in the various cost of revenues categories. We execute arrangements through indirect sales channels via sales agents and distributors in which the indirect sales channels are authorized to market our software products to end users. In arrangements with sales agents, revenue is recognized on a sell-through basis once an order is received from the end user, collectability from the end user is probable, a signed license agreement from the end user has been received by us, delivery has been made to the end user and all other revenue recognition criteria have been satisfied. Sales agents are compensated on a commission basis. Distributor arrangements are those in which the resellers are authorized to market and distribute our software products to end users in specified territories and the distributor bears the risk of collection from the end user customer. We recognize revenue from transactions with distributors when the distributor submits a written purchase commitment, collectability from the distributor is probable, a signed license agreement is received from the distributor and delivery has occurred to the distributor, provided that all other revenue recognition criteria have been satisfied. Revenue for distributor transactions is recorded on a net basis (the amount actually received by us from the distributor). We do not offer rights of return, product rotation or price protection to any of our distributors. RESULTS OF OPERATIONS We operate in several geographical regions as described in Note 12 "Business Segment Information" within Notes to Condensed Consolidated Financial Statements. In order to present our results of operations without the effects of changes in foreign currency, we provide certain financial information on a "constant currency basis", which is in addition to the actual financial information presented in the following tables. In order to calculate our constant currency results, we apply the foreign currency exchange rates that were in effect during the prior period to the current period results. Revenue Increase (Decrease) Increase (Decrease) Three Months Compared to Prior Three Months Six Months Compared to Prior Six Months Ended Period Ended Ended Period Ended July 31, 2011 $ % July 31, 2010 July 31, 2011 $ % July 31, 2010 (in thousands) Revenue License fees $ 8,550 $ 2,647 45 % $ 5,903 $ 14,894 $ 3,152 27 % $ 11,742 Percentage of total revenue 14 % 12 % 12 % 11 % Maintenance and other 35,393 4,089 13 % 31,304 69,731 6,916 11 % 62,815 Percentage of total revenue 57 % 61 % 57 % 62 % Subscription fees 2,322 985 74 % 1,337 4,530 2,045 82 % 2,485 Percentage of total revenue 4 % 2 % 4 % 2 % Professional services 15,692 2,931 23 % 12,761 32,205 7,101 28 % 25,104 Percentage of total revenue 25 % 25 % 27 % 25 % Total revenue $ 61,957 $ 10,652 21 % $ 51,305 $ 121,360 $ 19,214 19 % $ 102,146 16-------------------------------------------------------------------------------- Index Total Revenue. Total revenue was $62.0 million and $51.3 million for the second quarters of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, total revenue for the current quarter would have been approximately $58.9 million, representing a $7.6 million, or 15%, increase from the same period last year. When comparing categories within total revenue at constant rates, our current quarter results included increases across all revenue categories. Revenue outside the North America region as a percentage of total revenue was 59% for the second quarter of fiscal 2012, as compared to 57% in the second quarter of fiscal 2011. Total revenue increased across all geographic regions in which we operate during the second quarter of fiscal 2012 when compared to the same quarter last year. Our products are sold to manufacturing companies that operate mainly in the following six industries: automotive, consumer products, food and beverage, high technology, industrial products and life sciences. Given the similarities between food and beverage and consumer products as well as between high technology and industrial products, we aggregate them for management review. Revenue by industry for the second quarter of fiscal 2012 was approximately 31% in automotive, 23% in consumer products and food and beverage, 33% in high technology and industrial products and 13% in life sciences. In comparison, revenue by industry for the second quarter of fiscal 2011 was approximately 26% in automotive, 22% in consumer products and food and beverage, 35% in high technology and industrial products and 17% in life sciences. Revenue from each industry was higher in the second quarter of fiscal 2012 when compared to the second quarter of fiscal 2011; however, revenue from the automotive industry had the greatest increase. Total revenue was $121.4 million and $102.1 million for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, total revenue for the first six months of fiscal 2012 would have been approximately $116.7 million, representing a $14.6 million, or 14%, increase from the same period last year. When comparing categories within total revenue at constant rates, our first six months results included increases across all revenue categories. Revenue outside the North America region as a percentage of total revenue was 58% for the first six months of fiscal 2012, as compared to 57% in the same period of the prior fiscal year. Total revenue increased across all geographic regions in which we operate during the first six months of fiscal 2012 when compared to the same six months last year. Revenue by industry for the first six months of fiscal 2012 was approximately 30% in automotive, 23% in consumer products and food and beverage, 34% in high technology and industrial products and 13% in life sciences. In comparison, revenue by industry for the first six months of fiscal 2011 was approximately 26% in automotive, 22% in consumer products and food and beverage, 37% in high technology and industrial products and 15% in life sciences. Revenue from each industry was higher in the first six months of fiscal 2012 when compared to the first six months of fiscal 2011; however, revenue from the automotive industry had the greatest increase. License Revenue. License revenue was $8.6 million and $5.9 million for the second quarters of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, license revenue for the current quarter would have been approximately $8.2 million, representing a $2.3 million, or 39%, increase from the same period last year. License revenue increased in our North America, Asia Pacific and Latin America regions, and decreased in our EMEA region during the second quarter of fiscal 2012 when compared to the same quarter last year. One of the metrics that management uses to measure license revenue performance is the number of customers that have placed sizable license orders in the period. During the second quarter of fiscal 2012, three customers placed license orders totaling more than $0.3 million and no orders exceeded $1.0 million. This compared to the second quarter of fiscal 2011 in which no customers placed a license order totaling more than $0.3 million. License revenue was $14.9 million and $11.7 million for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, license revenue for the first six months of fiscal 2012 would have been approximately $14.4 million, representing a $2.7 million, or 23%, increase from the same period last year. License revenue increased in our North America, Asia Pacific and Latin America regions, and decreased in our EMEA region during the first six months of fiscal 2012 compared to the same period last year. During the first six months of fiscal 2012, six customers placed license orders totaling more than $0.3 million and no orders exceeded $1.0 million. This compared to the first six months of fiscal 2011 in which one customer placed a license order totaling more than $0.3 million and no orders exceeded $1.0 million. 17-------------------------------------------------------------------------------- Index Maintenance and Other Revenue. Maintenance and other revenue was $35.4 million and $31.3 million for the second quarters of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, the second quarter of fiscal 2012 maintenance and other revenue would have been approximately $33.9 million, representing a $2.6 million, or 8%, increase from the same period last year. Maintenance and other revenue increased across all geographic regions in which the company operates during the second quarter of fiscal 2012 when compared to the same quarter last year. The increase in maintenance and other revenue was related to maintenance re-starts, price increases, new customers, new users and new modules in excess of cancellations. We track our rate of contract renewals by determining the number of customer sites with active contracts as of the end of the previous reporting period and compare this to the number of customers that renewed, or are in the process of renewing, their maintenance contracts as of the current period end. Our maintenance contract renewal rate has remained in excess of 90% for each of the second quarters of fiscal 2012 and 2011. Maintenance and other revenue was $69.7 million and $62.8 million for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, maintenance and other revenue for the first six months of fiscal 2012 would have been approximately $67.5 million, representing a $4.7 million, or 7%, increase from the same period last year. Maintenance and other revenue increased across all geographic regions in which the company operates during the first six months of fiscal 2012 when compared to the same period last year. The increase in maintenance and other revenue was related to maintenance re-starts, price increases, new customers, new users and new modules in excess of cancellations. In addition, we benefited from recognition of previously deferred revenue due to revenue recognition rules. Subscription Revenue. Subscription revenue was $2.3 million and $1.3 million for the second quarters of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, subscription revenue for the current quarter would have been unchanged at $2.3 million, representing a $1.0 million, or 77%, increase from the same period last year. Subscription revenue increased across all geographic regions during the second quarter of fiscal 2012 when compared to the same quarter last year. The increase in subscription revenue was due to additional revenue related to our On Demand product offering. We expect the growth rate of subscription revenue in the future to be primarily attributable to growth in our On Demand product offering and we expect subscription revenue growth will fluctuate in the short term. Subscription revenue was $4.5 million and $2.5 million for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, subscription revenue for the current period would have been unchanged at $4.5 million, representing a $2.0 million, or 80%, increase from the same period last year. Subscription revenue increased across all geographic regions during the first six months of fiscal 2012 when compared to the same period last year. The increase in subscription revenue was due to additional revenue related to our On Demand product offering. We expect the growth rate of subscription revenue in the future to be primarily attributable to growth in our On Demand product offering and we expect subscription revenue growth will fluctuate in the short term. Professional Services Revenue. Professional services revenue was $15.7 million and $12.8 million for the second quarters of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, professional services revenue for the second quarter of fiscal 2012 would have been approximately $14.5 million, representing a $1.7 million, or 13%, increase from the same period last year. Professional services revenue increased across all geographic regions in which the company operates during the second quarter of fiscal 2012 compared to the same quarter last year. The increase in professional services revenue quarter over quarter can be attributed to engagements in which we are recognizing a higher amount of professional services revenue per customer per quarter, which we believe is a result of higher license revenue over the recent quarters and decisions by customers to resume or accelerate previously delayed implementations, upgrades or other ongoing services projects. Professional services revenue was $32.2 million and $25.1 million for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, professional services revenue for the first six months of fiscal 2012 would have been approximately $30.3 million, representing a $5.2 million, or 21%, increase from the same period last year. Professional services revenue increased across all geographic regions in which the company operates during the first six months of fiscal 2012 compared to the same period last year. The increase in professional services revenue period over period can be attributed to engagements in which we are recognizing a higher amount of professional services revenue per customer per quarter, which we believe is a result of higher license revenue over the recent quarters and decisions by customers to resume or accelerate previously delayed implementations, upgrades or other ongoing services projects. 18-------------------------------------------------------------------------------- Index Total Cost of Revenue Increase (Decrease) Increase (Decrease) Three Months Compared Three Months Six Months Compared Six Months Ended to Prior Period Ended Ended to Prior Period Ended (in thousands) July 31, 2011 $ % July 31, 2010 July 31, 2011 $ % July 31, 2010 Cost of revenue Cost of license fees $ 1,004 $ (359 ) -26 % $ 1,363 $ 2,035 $ (758 ) -27 % $ 2,793 Cost of maintenance, subscription and other 9,067 1,035 13 % 8,032 17,842 1,162 7 % 16,680 Cost of professional services 16,741 4,648 38 % 12,093 33,029 8,362 34 % 24,667 Total cost revenue $ 26,812 $ 5,324 25 % $ 21,488 $ 52,906 $ 8,766 20 % $ 44,140 Percentage of revenue 43 % 42 % 44 % 43 % Cost of license fees includes license royalties, amortization of capitalized software costs and shipping. Cost of maintenance, subscription and other includes personnel costs of fulfilling maintenance and subscription contracts, stock-based compensation for those employees, travel expense, professional fees, hosting costs, royalties, direct material and an allocation of information technology and facilities costs. Direct material charges include the cost of fulfilling maintenance and subscription contracts, hardware, costs associated with transferring our software to electronic media, printing of user manuals and packaging materials. Cost of professional services includes personnel costs of fulfilling service contracts, stock-based compensation for those employees, third-party contractor expense, travel expense for services employees and an allocation of information technology and facilities costs. Total cost of revenue. Total cost of revenue (combined cost of license fees, cost of maintenance, subscription and other and cost of professional services) was $26.8 million for the second quarter of fiscal 2012 and $21.5 million for the second quarter of fiscal 2011, and as a percentage of total revenue was 43% and 42% for the second quarter of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, total cost of revenue for the second quarter of fiscal 2012 would have been approximately $25.3 million and as a percentage of total revenue would have been unchanged at 43%. The non-currency related increase in cost of revenue of $3.8 million in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011 was primarily due to higher cost of subcontractors, travel, and bonuses associated with higher professional services revenues. Total cost of revenue (combined cost of license fees, cost of maintenance, subscription and other and cost of professional services) was $52.9 million for the first six months of fiscal 2012 and $44.1 million for the first six months of fiscal 2011, and as a percentage of total revenue was 44% and 43% for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, total cost of revenue for the first six months of fiscal 2012 would have been approximately $50.8 million and as a percentage of total revenue would have been 43%. The non-currency related increase in cost of revenue was $6.7 million in the first six months of fiscal 2012 compared to the first six months of fiscal 2011 and was primarily due to higher salaries and related costs, subcontractors, travel, and bonuses associated with higher professional services revenues. Cost of License Fees. Cost of license fees was $1.0 million and $1.4 million for the second quarters of fiscal 2012 and fiscal 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, cost of license fees for the second quarter of fiscal 2012 would have been unchanged at $1.0 million, representing a decrease of $0.4 million, or 29%. The non-currency related decrease in cost of license fees of $0.4 million in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011 was due to lower amortization of capitalized software costs since the majority of our acquired software technology was fully amortized as of September 2010. 19-------------------------------------------------------------------------------- Index Cost of license fees was $2.0 million and $2.8 million for the first six months of fiscal 2012 and 2011. Holding foreign currency exchange rates constant to fiscal 2011, cost of license fees for the first six months of fiscal 2012 would have been unchanged at $2.0 million, representing a decrease of $0.8 million, or 29%. The non-currency related decrease in cost of license fees of $0.8 million in the first six months of fiscal 2012 compared to the first six months of fiscal 2011 was due to lower amortization of capitalized software costs since the majority of our acquired software technology was fully amortized as of September 2010. Cost of Maintenance, Subscription and Other. Cost of maintenance, subscription and other was $9.1 million and $8.0 million for the second quarters of fiscal 2012 and fiscal 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, cost of maintenance, subscription and other in the second quarter of fiscal 2012 would have been approximately $8.7 million, representing an increase of $0.7 million, or 9%. The non-currency increase in cost of maintenance, subscription and other of $0.7 million in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011 was primarily due to higher subscription costs, which included higher salaries and related costs of $0.3 million, higher hosting costs of $0.1 million and higher information technology and facilities allocated costs of $0.1 million. Cost of maintenance, subscription and other as a percentage of maintenance and other and subscription fees revenue were generally consistent at 24% and 25% in the second quarters of fiscal 2012 and fiscal 2011, respectively. Cost of maintenance, subscription and other was $17.8 million and $16.7 million for the first six months of fiscal 2012 and fiscal 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, cost of maintenance, subscription and other in the first six months of fiscal 2012 would have been approximately $17.4 million, representing an increase of $0.7 million, or 4%. The non-currency increase in cost of maintenance, subscription and other of $0.7 million for the first six months of fiscal 2012 compared to the first six months of fiscal 2011 was primarily due to higher subscription costs, which included higher salaries and related costs of $0.5 million, higher hosting costs of $0.3 million and higher information technology and facilities allocated costs of $0.2 million. These increases were partially offset by decreases in maintenance and other costs, which included lower salaries and related costs of $0.2 million, lower information technology and facilities allocated costs of $0.2 million and lower severance of $0.1 million. Cost of maintenance, subscription and other as a percentage of maintenance and other and subscription fees revenues were generally consistent at 24% and 26% in the first six months of fiscal 2012 and fiscal 2011, respectively. Cost of Professional Services. Cost of professional services was $16.7 million and $12.1 million for the second quarters of fiscal 2012 and fiscal 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, cost of professional services for the second quarter of fiscal 2012 would have been approximately $15.6 million, representing an increase of $3.5 million, or 29%. The non-currency increase in cost of professional services of $3.5 million in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011 was due primarily to higher services salaries and related costs of $1.9 million as a result of higher headcount, higher third-party contractor costs of $0.7 million, higher travel costs of $0.4 million and higher bonuses of $0.4 million. Cost of professional services as a percentage of revenues was 107% and 95% for the second quarters of fiscal 2012 and fiscal 2011, respectively. The increase in cost of professional fees as a percentage of professional services revenues was primarily due to lower utilizations in North America and Latin America as a result of training courses for our consultants and fixed price projects where work was performed but no corresponding revenue was recognized due to software revenue recognition rules. Cost of professional services was $33.0 million and $24.7 million for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, cost of professional services for the first six months of fiscal 2012 would have been approximately $31.4 million, representing an increase of $6.7 million, or 27%. The non-currency increase in cost of professional services of $6.7 million in the first six months of fiscal 2012 compared to the first six months of fiscal 2011 was due primarily to higher services salaries and related costs of $3.1 million as a result of higher headcount, higher third-party contractor costs of $1.6 million, higher travel costs of $0.9 million and higher bonuses of $0.5 million. Cost of professional services as a percentage of professional services revenues was 103% and 98% for the first six months of fiscal 2012 and fiscal 2011, respectively. 20-------------------------------------------------------------------------------- Index Sales and Marketing Increase Increase (Decrease) (Decrease) Three Months Compared Three Months Six Months Compared Six Months Ended to Prior Period Ended Ended to Prior Period Ended (in thousands) July 31, 2011 $ % July 31, 2010 July 31, 2011 $ % July 31, 2010 Sales and marketing $ 13,864 $ 1,681 14 % $ 12,183 $ 28,353 $ 2,664 10 % $ 25,689 Percentage of revenue 22 % 24 % 23 % 25 % Sales and marketing expense includes salaries, benefits, bonuses, stock-based compensation and travel expense for our sales and marketing employees in addition to costs of programs aimed at increasing revenue, such as trade shows, user group events, advertising and various sales and promotional programs. Sales and marketing expense also includes personnel costs of order processing, sales agent fees and an allocation of information technology and facilities costs. Sales and marketing expense was $13.9 million and $12.2 million for the second quarters of fiscal 2012 and fiscal 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, sales and marketing expense for the second quarter of fiscal 2012 would have been approximately $13.1 million, representing an increase of $0.9 million, or 7%. The non-currency related increase in sales and marketing expense of $0.9 million in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011 was primarily due to higher bonuses of $0.4 million and higher sales agent fees of $0.2 million. Sales and marketing expense was $28.4 million and $25.7 million for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, sales and marketing expense for the first six months of fiscal 2012 would have been approximately $27.2 million, representing an increase of $1.5 million, or 6%. The non-currency related increase in sales and marketing expense of $1.5 million in the first six months of fiscal 2012 compared to the first six months of fiscal 2011 was primarily due to higher salaries and related costs of $0.6 million, higher bonuses of $0.4 million, higher commissions of $0.2 million, higher travel costs of $0.2 million and higher professional fees of $0.2 million. Research and Development Increase Increase (Decrease) (Decrease) Three Months Compared Three Months Six Months Compared Six Months Ended to Prior Period Ended Ended to Prior Period Ended (in thousands) July 31, 2011 $ % July 31, 2010 July 31, 2011 $ % July 31, 2010 Research and development $ 9,237 $ 418 5 % $ 8,819 $ 17,720 $ (426 ) -2 % $ 18,146 Percentage of revenue 15 % 17 % 15 % 18 % Research and development expense is expensed as incurred and consists primarily of salaries, benefits, bonuses, stock-based compensation and travel expense for research and development employees, professional services, such as fees paid to software development firms and independent contractors, and training for such personnel. Research and development expense also includes an allocation of information technology and facilities costs, and is reduced by income from joint development projects. Research and development expense was $9.2 million and $8.8 million for the second quarters of fiscal 2012 and fiscal 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, research and development expense for the second quarter of fiscal 2012 would have been consistent with the prior year at $8.8 million. Research and development expense categories were generally consistent quarter over quarter. 21-------------------------------------------------------------------------------- Index Research and development expense was $17.7 million and $18.1 million for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, research and development expense for the first six months of fiscal 2012 would have been approximately $17.1 million, representing a decrease of $1.0 million, or 6%. The non-currency related decrease in research and development expense of $1.0 million in the first six months of fiscal 2012 compared to the first six months of fiscal 2011 was primarily due to higher research and development funding of $1.0 million from two projects, one of which concluded during the current quarter, lower professional fees of $0.3 million and lower information technology and facilities allocated costs of $0.3 million partially offset by higher bonuses of $0.4 million. We expect research and development expense in each of the third and fourth quarters of fiscal 2012 to approximate second quarter of fiscal 2012 research and development expense. General and Administrative Increase Increase (Decrease) (Decrease) Three Months Compared Three Months Six Months Compared Six Months Ended to Prior Period Ended Ended to Prior Period Ended (in thousands) July 31, 2011 $ % July 31, 2010 July 31, 2011 $ % July 31, 2010 General and administrative $ 7,397 $ (330 ) -4 % $ 7,727 $ 15,110 $ (58 ) 0 % $ 15,168 Percentage of revenue 12 % 15 % 12 % 15 % General and administrative expense includes salaries, benefits, bonuses, stock-based compensation and travel expense for our finance, human resources, legal and executive personnel, as well as professional fees for accounting and legal services, bad debt expense and an allocation of information technology and facilities costs. General and administrative expense was $7.4 million and $7.7 million for the second quarters of fiscal 2012 and fiscal 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, general and administrative expense for the second quarter of fiscal 2012 would have been approximately $7.1 million, representing a decrease of $0.6 million, or 8%. The non-currency related decrease in general and administrative expense of $0.6 million in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011 was primarily due to lower professional fees of $0.7 million as a result of our recapitalization implemented in the prior fiscal year. General and administrative expense was $15.1 million and $15.2 million for the first six months of fiscal 2012 and 2011, respectively. Holding foreign currency exchange rates constant to fiscal 2011, general and administrative expense for the first six months of fiscal 2012 would have been approximately $14.6 million, representing a decrease of $0.6 million, or 4%. The non-currency related decrease in general and administrative expense of $0.6 million in the first six months of fiscal 2012 compared to the first six months of fiscal 2011 was due to lower professional fees of $0.8 million as a result of our recapitalization implemented in the prior fiscal year, partially offset by higher bonuses of $0.3 million. Other (Income) Expense Increase (Decrease) Six Increase (Decrease) Six Three Months Compared Three Months Months Compared Months Ended to Prior Period Ended Ended to Prior Period Ended July 31, July 31, (in thousands) July 31, 2011 $ % July 31, 2010 2011 $ % 2010 Other (income) expense Interest income $ (146 ) $ (35 ) -32 % $ (111 ) $ (282 ) $ (38 ) -16 % $ (244 ) Interest expense 287 (22 ) -7 % 309 557 (50 ) -8 % 607 Other (income) expense, net (356 ) (257 ) -260 % (99 ) 462 584 479 % (122 ) Total other (income) expense $ (215 ) $ (314 ) -317 % $ 99 $ 737 $ 496 206 % $ 241 Percentage of revenue 0 % 0 % 1 % 0 % Net other (income) expense was $(0.2) million and $0.1 million for the second quarters of fiscal 2012 and fiscal 2011, respectively. The favorable change primarily related to higher foreign exchange gains in the current quarter. 22-------------------------------------------------------------------------------- Index Net other expense was $0.7 million and $0.2 million for the first six months of fiscal 2012 and 2011, respectively. The unfavorable change is primarily related to higher foreign exchange losses in the current period. Income Tax Expense (Benefit) Three Increase (Decrease) Three Six Increase (Decrease) Six Months Compared Months Months Compared Months Ended to Prior Period Ended Ended to Prior Period Ended July 31, July 31, July 31, July 31, 2011 $ % 2010 2011 $ % 2010 (in thousands) Income tax expense (benefit) $ 1,792 $ 1,118 166 % $ 674 $ 2,444 $ 2,777 834 % $ (333 ) Percentage of revenue 3 % 1 % 2 % 0 % Effective tax rate 37 % 68 % 37 % 27 % We recorded income tax expense of $1.8 million and $0.7 million for the second quarters of fiscal 2012 and 2011, respectively. Our effective tax rate decreased to 37% during the second quarter of fiscal 2012 compared to 68% for the same quarter in the prior year. The lower effective tax rate for the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011 was primarily due to significantly higher income before taxes in the second quarter of fiscal 2012. In addition, in fiscal 2011 our effective tax rate was increased by non-deductible professional fees related to the stock recapitalization. We will not incur these professional fees in fiscal 2012. We recorded income tax expense (benefit) of $2.4 million and $(0.3) million for the first six months of fiscal 2012 and 2011, respectively. Our effective tax rate increased to 37% from 27% for the same period in the prior year. The higher effective tax rate for the first six months of fiscal 2012 compared to the first six months of fiscal 2011 was primarily due to the fact that the Company had income before taxes in the current period as opposed to a loss before taxes during the same period in the prior year. We benefit from operating in foreign locations, such as Ireland, due to the lower statutory income tax rate relative to the U.S. Federal and state tax rate. This benefit is significantly reduced by withholding taxes and foreign base company sales and services income that is taxed both in the U.S. and in the foreign jurisdiction. LIQUIDITY AND CAPITAL RESOURCES Our primary source of cash is from the sale of licenses, maintenance, subscription and professional services to our customers. Our primary use of cash is payment of our operating expenses which mainly consist of employee-related expenses, such as compensation and benefits, as well as general operating expenses for facilities and overhead costs. In addition to operating expenses, we also use cash for capital expenditures and to invest in our growth initiatives, which could include acquisitions of products, technology and businesses, as well as payments of dividends or stock repurchases. Toward the end of the last fiscal year and continuing into the current fiscal year we have seen some improvement in the industries in which we operate, although current global economic circumstances remain volatile and unclear. We are monitoring economic conditions since our performance is heavily influenced by our customers' outlook and production. We have remained focused on conserving cash and as a result our cash balance increased from $67.3 million at January 31, 2011, to $78.8 million at July 31, 2011. At July 31, 2011, our principal sources of liquidity were cash and equivalents totaling $78.8 million and net accounts receivable of $41.7 million. At July 31, 2011, our cash and equivalents consisted of current bank accounts, registered money market funds and time delineated deposits. Approximately 80% of our cash and equivalents were held in U.S. dollar denominated accounts as of July 31, 2011 and as of January 31, 2011. We have a U.S. line of credit facility that permits unsecured short-term borrowings of up to $20 million. Our line of credit agreement contains customary covenants that could restrict our ability to incur additional indebtedness. Our line of credit is available for working capital or other business needs. We have not drawn down on the line of credit during any of the last three fiscal years nor do we expect to draw down on the line of credit during fiscal 2012. 23-------------------------------------------------------------------------------- Index Our primary commercial banking relationship is with Bank of America and its global affiliates. Our cash and equivalents are held by diversified financial institutions globally, and as of July 31, 2011 the portion of our cash and equivalents held by Bank of America was approximately 75%. The amount of cash and equivalents held by foreign subsidiaries was $52.0 million and $46.8 million as of July 31, 2011 and January 31, 2011, respectively. If these funds are needed for our operations in the U.S., and if U.S. tax has not been previously provided, we would be required to accrue and pay taxes in the U.S. to repatriate these funds. However, our intent is to permanently reinvest these funds outside the U.S. and our current plans do not demonstrate a need to repatriate them to fund our operations in the U.S. The following table summarizes our cash flows for the six months ended July 31, 2011 and 2010, respectively. Six Months Six Months Ended Ended July 31, (in thousands) July 31, 2011 2010 Net cash provided by operating activities $ 13,307 $ 13,693 Net cash used in investing activities (2,073 ) (926 ) Net cash used in financing activities (1,162 ) (1,590 ) Effect of foreign exchange rates on cash and equivalents 1,490 (92 ) Net increase in cash and equivalents $ 11,562 $ 11,085 Net cash flows provided by operating activities was $13.3 million for the first six months of fiscal 2012 compared to $13.7 million for the first six months of fiscal 2011. The $0.4 million decrease in net cash flows provided by operating activities was due primarily to the negative cashflow effect of changes in accounts payable, deferred revenue and other liabilities of $13.8 million and noncash charges (including depreciation and amortization, stock-based compensation and provisions for doubtful accounts/sales adjustments) of $2.3 million partially offset by the positive cashflow effect of changes in net income of $5.0 million and in accounts receivable of $7.3 million. Capital expenditures were $2.0 million for the first six months of fiscal 2012, primarily relating to purchases of computer equipment and leasehold improvements, compared to $0.7 million for the first six months of fiscal 2011. We expect capital expenditures in the second half of fiscal 2012 to remain fairly consistent with the first half of fiscal 2012. We continue to monitor our capital spending and do not believe we are delaying critical capital expenditures required to run our business. Dividend-related payments for the first six months of fiscal 2012 totaled $0.6 million compared to $1.3 million in the same period of fiscal 2011. In fiscal 2010, we modified our dividend program to allow shareholders the choice of stock or cash, which has enabled us to conserve cash. The number of shares issued to the holders of record as a stock dividend is calculated based on the average closing price of QAD's Class A common stock for the three trading days immediately following the election deadline. The Board of Directors evaluates our ability to continue to pay dividends and the structure of any dividends on a quarterly basis. There were no stock repurchase-related payments during the first six months of fiscal 2012. We do not currently have a stock repurchase program in place; however, the Board of Directors evaluates our position relating to future potential repurchases on a regular basis. We have historically calculated accounts receivable days' sales outstanding ("DSO"), using the countback, or last-in first-out, method. This method calculates the number of days of billed revenue represented by the accounts receivable balance as of period end. When reviewing the performance of our entities, DSO under the countback method is used by management. It is management's belief that the countback method best reflects the relative health of our accounts receivable as of a given quarter-end or year-end because of the cyclical nature of our billings. Our billing cycle includes high annual maintenance renewal billings at year-end that will not be recognized as earned revenue until future periods. 24-------------------------------------------------------------------------------- Index DSO under the countback method was 57 days at July 31, 2011, compared to 52 days at January 31, 2011 and 66 days at July 31, 2010. The increase in DSO under the countback method as of July 31, 2011 when compared to January 31, 2011, was primarily related to less billings in the second quarter of fiscal 2012 compared to the fourth quarter of fiscal 2011. This result is generally consistent with management expectations as our fourth quarters include a higher volume of annual maintenance renewals than the other quarters. The decrease in DSO under the count-back method as of July 31, 2011, when compared to July 31, 2010, was related to improved cash collections as a percent of our available accounts receivable balance and higher billings in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011. DSO using the average method, which is calculated utilizing the accounts receivable balance and earned revenue for the most recent quarter, was 61 days at July 31, 2011, compared to 95 days at January 31, 2011 and 75 days at July 31, 2010. We believe our reserve methodology is adequate and our reserves are properly stated as of July 31, 2011. We will continue to monitor our receivables. Cash requirements for items other than normal operating expenses are anticipated for capital expenditures and dividend payments. We may require cash for acquisitions of new businesses, software products or technologies complementary to our business. We believe that the cash on hand, net cash provided by operating activities and the available borrowings under our existing credit facility will provide us with sufficient resources to meet our current and long-term working capital requirements, debt service, dividend payments and other cash needs for at least the next twelve months. CONTRACTUAL OBLIGATIONS A summary of future obligations under our various contractual obligations and commitments as of January 31, 2011 was disclosed in our fiscal 2011 10-K. During the six months ended July 31, 2011 there have been no material changes in our contractual obligations or commercial commitments outside the ordinary course of business. Credit Facility On July 8, 2011, we entered into an unsecured credit agreement with Rabobank, N.A. (the "Facility"). The Facility replaced our $20 million unsecured credit line with Bank of America N.A. which expired on July 9, 2011. The Facility provides a one-year commitment for a $20 million line of credit for working capital or other business needs. We will pay a commitment fee of 0.25% per annum of the daily average of the unused portion of the $20 million Facility. Borrowings under the Facility bear interest at a rate equal to LIBOR plus 0.75%. The Facility provides that we maintain certain financial and operating ratios which include, among other provisions, minimum liquidity on a consolidated basis of $25 million in cash and cash equivalents at all times, a current ratio (calculated using current liabilities excluding deferred revenue) of not less than 1.3 to 1.0 determined at the end of each fiscal quarter, a leverage ratio of not more than 1.5 to 1.0 determined at the end of each fiscal quarter, and a debt service coverage ratio of not less than 1.5 to 1.0 determined at the end of each fiscal year. The Facility also contains customary covenants that could restrict our ability to incur additional indebtedness. At July 31, 2011, the effective borrowing rate would have been 0.94%. As of July 31, 2011, there were no borrowings under the Facility and we were in compliance with the financial covenants. Notes Payable In July 2004, we entered into a loan agreement with Mid-State Bank & Trust, a bank which was subsequently purchased by Rabobank, N.A. The loan had an original principal amount of $18.0 million and bears interest at a fixed rate of 6.5%. This loan is secured by our headquarters located in Santa Barbara, California. The terms of the loan provide that we will make 119 monthly payments of $115,000 consisting of principal and interest and one final principal payment of $15.4 million. The loan matures in July 2014. The balance of the note payable at July 31, 2011 was $16.3 million. 25-------------------------------------------------------------------------------- Index |