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COMPUWARE CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This "Management's Discussion and Analysis of Financial Condition and Results of Operations" ("MD&A") is intended to provide an understanding of our financial condition, changes in financial condition, cash flow, liquidity and results of operations. The MD&A should be read in conjunction with the unaudited condensed consolidated financial statements and notes included in item 1 of this report and our annual report on Form 10-K for the fiscal year ended March 31, 2014, particularly "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations". References to years are to fiscal years ended March 31 unless otherwise specified. In this section, we discuss our results of operations on a segment basis. We have two software segments, APM and Mainframe. We also have a platform-as-a-service ("PaaS") offering called Covisint or Application Services. Following the segment discussion, we then provide a separate discussion of the material period-to-period changes in our operating expenses, other income and income taxes as reflected on our statements of operations. Forward-Looking Statements The following discussion contains certain forward-looking statements within the meaning of the federal securities laws. When we use words such as "may", "might", "will", "should", "believe", "expect", "anticipate", "estimate", "continue", "predict", "forecast", "projected", "intend" or similar expressions, or make statements regarding our future plans, objectives or expectations, we are making forward-looking statements. Numerous important factors, risks and uncertainties affect our operating results 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. The material risks and uncertainties that we believe affect us are summarized below. These risks and uncertainties are not the only ones we face. Additional risks and uncertainties discussed elsewhere in this report and the other reports we file with the Securities and Exchange Commission (see for example Item 1A Risk Factors in our 2014 Form 10-K), as well as other risks and uncertainties that we are not aware of or focused on or that we currently deem immaterial, may also impair business operations. This report is qualified in its entirety by these risk factors and those listed below. If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and shareholders could lose all or part of their investment. 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. 29-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIESSummary of Risk Factors ? If we are not able to grow our APM revenue at anticipated levels, we may fail to achieve our forecasted financial results and we may fail to meet the expectations of analysts or investors which could cause our stock price to decline. ? A substantial portion of our Mainframe segment revenue is dependent on our customers' continued use of IBM and IBM-compatible products. ? Our product revenue is dependent on the acceptance of our pricing structure for our software solutions. ? Maintenance revenue could continue to decline. ? Our primary source of profitability is from our Mainframe segment. As revenues in this segment decline, our profitability will decline unless we are able to significantly increase margins in our APM segment. ? Changes in the financial services industry could have a negative impact on our revenue and margins. ? We may fail to achieve our forecasted financial results due to inaccurate sales forecasts or other unpredictable factors. If we fail to meet the expectations of analysts or investors, our stock price could decline substantially. ? Our business could be negatively affected as a result of actions of shareholders or others. ? Our planned distribution of all or a substantial part of our remaining shares of common stock in Covisint Corporation, which we refer to as the Tax-Free Distribution, could subject us and our shareholders to significant tax liability and could affect our ability to enter into certain transactions in the future. ? Our announced evaluation of a strategic separation of our APM and Mainframe businesses may take multiple forms, may not produce the intended benefits to shareholders or may not result in a separation of the businesses. ? Substantial changes in our operations, including business segregations and divestitures, may disrupt our business, divert the attention of our management or cause us to incur additional costs and may result in financial results that are worse than expected. ? The loss of certain key employees and technical personnel or our inability to hire additional qualified personnel could have a material adverse effect on our business. ? We may not achieve the results we expect from our expense reduction program, the timing could be delayed, or the restructuring charges necessary to achieve the targeted expense reductions could be higher than expected, any of which could materially and adversely affect our results of operations and financial condition. ? Defects or disruptions in our hosted software or application services networks or interruptions or delays in service would impair the delivery of our on-demand service and could diminish demand for our services and subject us to substantial liability. 30-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES? The market for application services is highly competitive with emerging competitors. As the market matures, competition may increase and could have a material negative impact on our results of operations. ? Economic uncertainties or slowdowns may reduce demand for our offerings, which may have a material adverse effect on our revenues and operating results. ? Future changes in the U.S. domestic automotive manufacturing business could reduce demand for our Covisint application services, which may have a material negative effect on our revenues and operating results. ? If the fair value of our long-lived assets deteriorated below the carrying value of these assets, recognition of an impairment loss would be required, which could materially and adversely affect our financial results. ? Our software technology may infringe the proprietary rights of others. ? Our results could be adversely affected by increased competition, pricing pressures and technological changes within the software products market. ? We must develop or acquire product enhancements and new products to succeed. ? Acquisitions may be difficult to integrate, disrupt our business or divert the attention of our management and may result in financial results that are different than expected. ? We are exposed to exchange rate risks on foreign currencies and to other international risks that may adversely affect our business and results of operations. ? Current laws may not adequately protect our proprietary rights. ? Unanticipated changes in our effective tax rates, or exposure to additional income tax liabilities, could affect our profitability. ? Our stock repurchase plan and future dividend payments may be suspended or terminated at any time, or our plans to distribute our Covisint shares to shareholders or to undertake a return of capital transaction may change, any of which may result in a decrease in our stock price. ? Acts of terrorism, acts of war, cyber-attacks and other unforeseen events may cause damage or disruption to us or our customers, which could materially and adversely affect our business, financial condition and operating results. ? Our articles of incorporation, bylaws and rights agreement as well as certain provisions of Michigan law may have an anti-takeover effect. OVERVIEW We deliver value to businesses by providing software solutions (both on-premises and SaaS models), software related services and application services that improve the performance of information technology organizations. 31-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES Our primary source of profitability and cash flow is the sale of our Mainframe productivity tools that are used within our customers' mainframe computing environments for fault diagnosis, file and data management, application performance monitoring and application debugging. We have generally experienced lower volumes of software license transactions for our Mainframe solutions in recent years causing an overall downward trend in our Mainframe product revenues which we expect to continue. Changes in our current customer IT computing environments and spending habits have impacted their need for additional mainframe computing capacity. In addition, increased competition and pricing pressures have had a negative impact on our revenues. Customers utilize our products to reduce operating costs, increase programmer productivity and create a smooth transition to the next generation of mainframe environment programmers. We will continue to make strategic enhancements to our Mainframe solutions through research and development investments with the goal of meeting customer needs and maintaining a high maintenance renewal rate. The cash flow generated from our Mainframe business helps to support our APM business segment. The APM market is a key source of future revenue growth. Web, mobile and cloud applications and the complex distributed applications delivery chain supporting them have become increasingly critical to a company's brand awareness, revenue growth and overall market share. Because of this development, the market for APM solutions is significant and growing rapidly. Our APM solutions provide our customers with on-premises software and SaaS platform based hosted software. These solutions are designed to ensure the optimal performance of each customer's enterprise, web, streaming, mobile and cloud applications. We are investing in our APM solutions with the goal of providing solutions that are best-in-class within the APM market. Specifically, our investments include: (1) enhancements to our global hosted software network with specific focus on ease of use, time-to-value and data analytics in mobile and cloud application performance capabilities and in video streaming performance; (2) enhancements to our solutions that are focused on optimizing application performance and accelerating time to market; and (3) enhancements which combine our on-premises software and SaaS solution into a single platform that provides performance metrics for mobile, web, non-web, streaming and cloud applications in a single solution. The secure collaboration services market is served by our Covisint application services. Technology has allowed business communities, organizations and systems to globally connect and share vital information, applications and processes across their internal and extended enterprises. Our Covisint services, which are provided on a PaaS basis to customers primarily in the automotive, healthcare and energy industries, create an environment that simplifies and secures this collaboration atmosphere. Our focus in the automotive and manufacturing industries is on enabling our customers to connect, engage and collaborate on mission critical business processes with their suppliers, customers and business partners. Our focus in the healthcare industry is on enabling hospitals, physicians and government entities to share electronic patient health and medical records. Quarterly Update The following occurred during the first quarter of 2015: ? Total revenue declined 3.7% from the first quarter of 2014. ? APM revenue increased 3.1% driven by increases in maintenance revenue. 32-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES ? Mainframe revenue decreased 8.5% with decreases in both license and maintenance revenue. ? Covisint revenue decreased 10.4% primarily due to declines in Covisint services revenue. ? Operating margin declined to (2.0%) during the first quarter of 2015 as compared to 1.7% during the first quarter of 2014 due primarily to the decline in the Covisint contribution margin, offset in part, by a decrease in corporate general and administrative costs. ? Realized $52,000 of net income compared to $4.3 million of income from continuing operations during the first quarter of last year. On a non-GAAP basis, excluding stock compensation expense, amortization of purchased software and other acquired intangibles, restructuring charges and certain advisory fees, net income decreased $5.2 million in the first quarter of 2015 as compared to the first quarter of 2014. See the "GAAP to non-GAAP Reconciliation" section below for a complete reconciliation of net income and earnings per share. ? Transitioned the APM for Mainframe product to the APM business segment. Prior period amounts have been reclassified to reflect the transition. ? Announced our intention to begin exploring the strategic separation of our APM and Mainframe business segments, which, if the separation were to occur, would likely have a material impact on our results of operations, financial position and cash flows. Our ability to execute our strategies and achieve our objectives is subject to a number of risks and uncertainties. See "Forward-Looking Statements". GAAP TO NON-GAAP RECONCILIATION In an effort to provide investors with additional information regarding the Company's results as determined by U.S. generally accepted accounting principles ("GAAP"), the Company has provided non-GAAP net income and non-GAAP diluted earnings per share. These financial measures exclude the impact of certain items and, therefore, have not been calculated in accordance with GAAP. These non-GAAP financial measures exclude stock compensation expense; amortization of acquired software and intangible assets; restructuring charges; advisory fees associated with certain shareholder actions and business transformation; and the related tax impacts of these items. Each of the non-GAAP adjustments is described in more detail below. The table below provides a reconciliation of each of these non-GAAP measures to its most comparable GAAP financial measure. We believe that inclusion of these non-GAAP financial measures provides better comparability with our historical financial results and with the results of many of our competitors. In addition, we believe these non-GAAP financial measures are useful to investors because they allow investors to review supplemental information used internally by management to evaluate our financial results. These non-GAAP measures also represent the means by which we communicate our earnings guidance to investors. 33-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES While we believe that these non-GAAP financial measures provide useful supplemental information, there are limitations associated with the use of these non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with GAAP, are not audited, do not reflect a comprehensive system of accounting and may not be completely comparable to similarly titled measures of other companies due to potential differences in the exact method of calculation between companies. Items such as stock compensation expense; amortization of acquired software and intangible assets; restructuring charges; advisory fees associated with certain shareholder actions and business transformation; and the related tax impacts of these items that are excluded from our non-GAAP financial measures can have a material impact on net income. As a result, these non-GAAP financial measures have limitations and should not be considered in isolation from, or as a substitute for, net income or loss, cash flow from operations or other measures of performance prepared in accordance with GAAP. We compensate for these limitations by using these non-GAAP financial measures as supplements to GAAP financial measures and by reconciling the non-GAAP financial measures to their most comparable GAAP financial measure. We have procedures in place to ensure that these measures are calculated using the appropriate GAAP components in their entirety and to ensure that our performance is properly reflected to facilitate consistent period-to-period comparisons. Management reviews the non-GAAP adjustments on a net-of-tax basis when evaluating our performance. Therefore, we exclude the tax impact of these charges when presenting non-GAAP financial measures. The following discusses the reconciling items from our non-GAAP financial measures to the most comparable GAAP financial measures: · Stock compensation expense. Our non-GAAP financial measures exclude the compensation charges required to be recorded by GAAP for equity awards to employees and directors. Although this is a normal recurring expense for us, we believe it is useful in evaluating corporate performance during a particular time period to review the supplemental non-GAAP financial measures excluding this expense because these costs are generally fixed at the time an award is granted, are then expensed over several years and generally cannot be changed or influenced by management in the current period. · Amortization of purchased software and acquired intangibles. Our non-GAAP financial measures exclude costs associated with the amortization of acquired software and intangible assets. Although this is a normal recurring expense for us, we believe it is useful in evaluating corporate performance during a particular time period to review the supplemental non-GAAP financial measures excluding this expense because these costs are fixed at the time of acquisition, are then amortized over a period of several years after the acquisition and generally cannot be changed or influenced by management in the current period. · Restructuring charges. Our non-GAAP financial measures exclude restructuring charges, and any subsequent changes in estimates as they relate to our ongoing corporate restructuring activities. We believe it is useful in evaluating corporate performance during a particular time period to review the supplemental non-GAAP financial measures excluding restructuring charges in order to provide comparability and consistency with historical operating results. · Advisory fees associated with certain shareholder actions and our business transformation initiative. During the fourth quarter of fiscal 2013, in response to an unsolicited, nonbinding offer from a shareholder to purchase the outstanding shares of the Company, the Board of Directors announced its willingness to consider other viable offers. We continue to incur consultant fees to analyze the business, review additional requests for information from other interested parties and to investigate and implement business transformation plans. We believe it is useful in evaluating corporate performance during a particular time period to review the supplemental non-GAAP financial measures excluding such costs in order to provide comparability and consistency with historical operating results. 34-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES · Provision for income taxes on above pre-tax non-GAAP adjustments. Our non-GAAP financial measures exclude the tax impact of the above pre-tax non-GAAP adjustments. This amount is calculated using the tax rates of each country to which these pre-tax non-GAAP adjustments relate. Management excludes the non-GAAP adjustments on a net-of-tax basis in evaluating our performance. Therefore, we exclude the tax impact of these charges when presenting non-GAAP financial measures. Due to the January 2014 divestiture of our Changepoint, Professional Services and Uniface business segments, we have prepared the following reconciliation of GAAP to non-GAAP financial information based on net income from continuing operations (in thousands, except for per share data): Three Months Ended June 30, 2014 2013 NET INCOME FROM CONTINUING OPERATIONS ATTRIBUTABLE TO COMPUWARE CORPORATION $ 52 $ 4,262 ADJUSTMENTS EXCLUDING IMPACT OF NON-CONTROLLING INTEREST Stock compensation (excluding restructuring stock compensation) 8,304 8,574 Amortization of purchased software 1,696 2,370 Amortization of acquired intangibles 1,800 1,793 Restructuring expenses 2,975 4,803 Advisory fees 2,744 1,156 Income tax effect of above adjustments (6,270 ) (6,493 ) Total adjustments 11,249 12,203 NON-GAAP NET INCOME FROM CONTINUING OPERATIONS $ 11,301 $ 16,465 DILUTED EARNINGS PER SHARE FROM CONTINUING OPERATIONS - GAAP $ 0.00 $ 0.02 ADJUSTMENTS EXCLUDING IMPACT OF NON-CONTROLLING INTEREST Stock compensation (excluding restructuring) 0.04 0.04 Amortization of purchased software 0.01 0.01 Amortization of acquired intangibles 0.01 0.01 Restructuring expenses 0.01 0.02 Advisory fees 0.01 0.01 Income tax effect of above adjustments (0.03 ) (0.03 ) Total adjustments 0.05 0.06 NON-GAAP EPS FROM CONTINUING OPERATIONS $ 0.05 $ 0.07 Diluted shares outstanding 223,347 219,694 35-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES BUSINESS SEGMENT ANALYSIS The following table sets forth, for the periods indicated, certain business segment operational data. We evaluate the performance of our segments based primarily on contribution margin which is operating profit before certain charges such as restructuring, internal information system support, finance, human resources, legal, administration and other corporate charges ("unallocated expenses"). Transactions between segments are eliminated. The allocation of income taxes is not evaluated at the segment level. Comparisons are to the comparable period of the prior year. Financial information for our business segments, including the portion allocated to non-controlling interest, was as follows (in thousands): Unallocated Total Expenses Three Months Ended: APM MF Software AS & Eliminations (1) Total June 30, 2014 Total revenues $ 77,376 $ 65,547 $ 142,923 $ 21,587 $ $ 164,510 Operating expenses 75,633 17,116 $ 92,749 33,392 41,655 167,796 Contribution / operating margin $ 1,743 $ 48,431 $ 50,174 $ (11,805 ) $ (41,655 ) $ (3,286 ) Margin % 2.3 % 73.9 % 35.1 % (54.7 %) N/ A (2.0 %) June 30, 2013 (2) Total revenues $ 75,065 $ 71,643 $ 146,708 $ 24,101 $ 170,809 Operating expenses 74,411 18,811 93,222 25,423 49,175 167,820 Contribution / operating margin $ 654 $ 52,832 $ 53,486 $ (1,322 ) $ (49,175 ) $ 2,989 Margin % 0.9 % 73.7 % 36.5 % (5.5 %) N/ A 1.7 % (1) Unallocated expenses for the three months ended June 30, 2014 and 2013 include $3.0 million and $4.8 million, respectively, in restructuring expenses. See note 9 for additional information. (2) June 30, 2013 amounts have been reclassified to reflect the transition of the APM for Mainframe product from our Mainframe business segment to our APM business segment. Software Segments Revenue associated with our software solutions consists of software license fees, maintenance fees, subscription fees and services fees (software related services). 36-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIESApplication Performance Management The financial results of operations for our APM segment were as follows (in thousands): Three Months Ended June 30, 2014 2013 % Change Revenue Software license fees $ 21,387 $ 23,530 (9.1 )% Maintenance fees 28,295 23,801 18.9 Subscription fees 19,362 20,132 (3.8 ) Services Fees 8,332 7,602 9.6 Total revenue 77,376 75,065 3.1 Operating expenses 75,633 74,411 1.6 Contribution margin $ 1,743 $ 654 166.5 % Contribution margin % 2.3 % 0.9 % APM segment revenue increased $2.3 million during the first quarter of 2015 due primarily to an increase in maintenance fees partially offset by a decline in license fees. The increase in maintenance fees was related to our growing customer base. The decline in license fees was a result of a greater percentage of customer license agreements during the quarter being term licenses. Term licenses are recognized ratably, therefore, a greater portion of license revenue associated with current customer agreements was deferred and will be recognized over the term of the agreement. Operating expenses increased during the first quarter of 2015 due to an increase in salary and benefits expense related to headcount increases and increased marketing expenses. The improvement in contribution margin resulted from the proportionately larger increase in revenue than expenses in the first quarter of 2015. The revenue increase was driven by the increase in maintenance fees during the first quarter of 2015. APM revenue by geographic location is presented in the table below (in thousands): Three Months Ended June 30, 2014 2013 United States $ 40,322 $ 41,065 Europe and Africa 22,536 19,837Other international operations 14,518 14,163 Total APM segment revenue $ 77,376 $ 75,065 37-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES Mainframe The financial results of operations for our Mainframe segment were as follows (in thousands): Three Months Ended June 30, 2014 2013 % Change Revenue Software license fees $ 5,300 $ 8,213 (35.5 )% Maintenance fees 60,165 63,361 (5.0 ) Services Fees 82 69 18.8 Total revenue 65,547 71,643 (8.5 ) Operating expenses 17,116 18,811 (9.0 ) Contribution margin $ 48,431 $ 52,832 (8.3 )% Contribution margin % 73.9 % 73.7 % Mainframe segment revenue declined $6.1 million for the first quarter of 2015 due to reductions in both license and maintenance fees, which was consistent with the general downward trend in our Mainframe product revenues we have experienced throughout the past several years and with the anticipated slowing of that trend. Changes in our current customers' IT computing environments and spending habits have reduced their demand for additional mainframe computing capacity. In addition, increased pricing pressures, competition and the effects of foreign exchange rate changes have had a negative impact on our revenues. We intend to continue to make strategic enhancements to our Mainframe solutions through research and development investments. The contribution margin percentage stayed relatively consistent as the percent decline in operating expenses was comparable to the percent decline in revenue for the first quarter of 2015. The decrease in contribution margin dollars resulted primarily from the proportionately larger decline in revenue during the first quarter of 2015. Mainframe revenue by geographic location is presented in the table below (in thousands): Three Months Ended June 30, 2014 2013 United States $ 35,664 $ 37,404 Europe and Africa 18,183 20,485Other international operations 11,700 13,754 Total Mainframe segment revenue $ 65,547 $ 71,643 Software Revenue Combined Software revenue includes both APM and Mainframe. 38-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIESSoftware revenue consists of software license fees, maintenance fees, subscription fees and software related services. Software solutions revenues are presented in the table below (in thousands): Three Months Ended June 30, 2014 2013 % Change Software license fees $ 26,687 $ 31,743 (15.9 )% Maintenance fees 88,460 87,162 1.5 Subscription fees 19,362 20,132 (3.8 ) Services fees 8,414 7,671 9.7 Total software solutions revenue $ 142,923 $ 146,708 (2.6 )% Software revenue by geographic location is presented in the table below (in thousands): Three Months Ended June 30, 2014 2013 United States $ 75,986 $ 78,469 Europe and Africa 40,719 40,322Other international operations 26,218 27,917 Total software solutions revenue $ 142,923 $ 146,708 Changes in the various revenue line items are discussed previously in the "Application Performance Management" and "Mainframe" sections. Application Services The financial results of operations for our Covisint application services segment were as follows (in thousands): Three Months Ended June 30, 2014 2013 % Change Application services fees $ 21,587 $ 24,101 (10.4 )% Operating expenses 33,392 25,423 31.3 Contribution margin $ (11,805 ) $ (1,322 ) (793.0 )% Contribution margin % (54.7 %) (5.5 %) 39-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES Covisint application services are provided to customers primarily in the automotive and healthcare industries. Application services segment fees decreased $2.5 million for the first quarter of 2015 primarily due to declines in services performed for customers. The services revenue decline can be attributed to: 1) a natural reduction in the deferred revenue recognized in the current period versus last year due to a diminished balance remaining from the establishment of stand-alone value for many of our Covisint services, 2) a reduction in ad hoc services projects with major subscription customers, 3) an improvement in the ease of implementation of our Covisint platform that results in quicker/less costly installations, 4) improvements in our platform that allow customers to perform portions of the implementation themselves, and, to a lesser extent, 5) our relatively low subscription bookings in fiscal 2014. Operating expenses increased $8.0 million during the first quarter of 2015 due to higher salaries and benefits expense resulting from an increase in headcount during fiscal 2014 to support the expected growth and separation of the business, following the planned spin-off of Covisint. Costs further increased during the first quarter of 2015 due to additional stock compensation. During May 2014 we reduced the size of our Covisint workforce with reductions in our delivery, sales and marketing and research and development personnel. In addition, we transferred employees to our services delivery partners during the three months ended June 30, 2014. Application services segment revenue by geographic location is presented in the table below (in thousands): Three Months Ended June 30, 2014 2013 United States $ 20,135 $ 20,834 Europe and Africa 528 1,789 Other international operations 924 1,478 Total application services segment revenue $ 21,587 $ 24,101 Unallocated Expenses and Eliminations Unallocated expenses include costs associated with internal technology and the corporate executive, finance, human resources, administrative, legal, communications and investor relations departments. In addition, unallocated expenses include all facility-related costs, such as rent, building depreciation, maintenance and utilities associated with our worldwide offices. Significant changes in these areas are discussed in "Operating Expenses" under "Technology Development and Support" and "Administrative and General". Eliminations represented services performed by our former professional services segment on behalf of Covisint. All intercompany revenue, expenses and profit are eliminated in our condensed consolidated financial statements. 40-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES OPERATING EXPENSES Our operating expenses include costs from continuing operations for software license fees; cost of maintenance fees; cost of subscription fees; cost of services; cost of application services; technology development and support costs; sales and marketing expenses; administrative and general expenses; and restructuring. These expenses are described below without regard to the relevant segment(s) to which they are allocated. Cost of Software License Fees Cost of software license fees includes amortization of capitalized software related to our licensed software products, the cost of duplicating and disseminating products to customers, including associated hardware costs, and the cost of author royalties. Cost of software license fees is presented in the table below (in thousands): Three Months Ended June 30, % 2014 2013 ChangeCost of software license fees $ 4,995 $ 4,929 1.3 % Percentage of software license fees 18.7 % 15.5 % During the first quarter of 2015, cost of license fees remained consistent with the prior year. The increase in cost as a percentage of software license fees was a result of the decline in license fees discussed in the "Application Performance Management" and "Mainframe" sections of this report as the amortization of capitalized software and certain other costs are not directly proportional to license revenue during a given period. Cost of Maintenance Fees Cost of maintenance fees consists of the costs directly attributable to maintenance and product support such as helpdesk and technical support. Cost of maintenance fees is presented in the table below (in thousands): Three Months Ended June 30, % 2014 2013 Change Cost of maintenance fees $ 6,922 $ 7,339 (5.7 )% Percentage of maintenance fees 7.8 % 8.4 % Cost of maintenance fees declined slightly from the first quarter of 2014, primarily resulting from a reduction in customer support costs. 41-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIESCost of Subscription Fees Cost of subscription fees consists of the amortization of capitalized software related to our APM hosted software, depreciation and maintenance expense associated with our hosted software network related computer equipment; data center costs; and payments to individuals for tests conducted from their Internet-connected personal computers ("peer"). Cost of subscription fees is presented in the table below (in thousands): Three Months Ended June 30, % 2014 2013 Change Cost of subscription fees $ 8,202 $ 7,840 4.6 % Percentage of subscription fees 42.4 % 38.9 % Cost of subscription fees increased slightly during the first quarter of 2015 primarily due to increased amortization of capitalized research and development costs. We continued to invest in research and development throughout 2014 and the first quarter of 2015 which increased the amortizable base. Cost of Services Cost of services consists primarily of the personnel-related costs of providing our software related services. Cost of services is presented in the table below (in thousands): June 30, % 2014 2013 Change Cost of services $ 6,732 $ 6,642 1.4 % Percentage of services fees 80.0 % 86.6 % Cost of services remained consistent with the first quarter of 2014. The decrease in cost of services as a percentage of services fees is primarily a result of an increase in revenue from certain APM services. Cost of Application Services Cost of application services consists primarily of personnel-related costs of providing application services, including billable and technical staff, subcontractors and sales personnel net of the amounts capitalized for development of internal use software. As Covisint continues to prepare for their planned separation from us, additional administrative and general costs directly attributable to the Covisint business have been incurred and are included here. 42-------------------------------------------------------------------------------- Table of Contents Cost of application services is presented in the table below (in thousands): Three Months Ended June 30, % 2014 2013 Change Cost of application services $ 31,692 $ 26,211 20.9 % Capitalized internal software costs $ (790 ) $ (1,950 ) (59.5 ) Cost of application services expensed $ 30,902 $ 24,261 27.4 % Percentage of application services fees 143.2 % 100.7 % See "Application Services" for a discussion of the associated costs. Capitalization of internally developed software costs decreased $1.2 million during the first quarter of 2015 due to the timing and stage of our software development initiatives. During the first quarter of 2015, there was an increase of projects in the planning stage which therefore, were not capitalized. Technology Development and Support Technology development and support includes, primarily, the costs of programming personnel associated with software technology development and support of our products and our hosted software network less the amount of capitalized internal software costs during the reporting period. Also included are personnel costs associated with developing and maintaining internal systems and hardware/software costs required to support all technology initiatives. Technology development and support costs incurred internally and capitalized are presented in the table below (in thousands): Three Months Ended June 30, % 2014 2013 Change Technology development and support costs incurred $ 26,150 $ 27,442 (4.7 )% Capitalized software costs (6,198 ) (3,751 ) 65.2 Technology development and support costs expensed $ 19,952 $ 23,691 (15.8 )% Technology development and support costs expensed as a percentage of software revenue 14.8 % 17.0 % 43-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES Technology development and support before capitalized internal software costs declined $1.3 million for the first quarter of 2015. The decrease primarily related to a decline in salaries and benefits expense resulting from headcount reductions associated with our restructuring initiatives. Technology development and support as a percentage of software solutions revenues decreased for the first quarter of 2015 primarily due to the increase in capitalized software costs which reduced the net amount expensed as well as the overall decline in technology costs. The increase in capitalized internal software costs from the prior year relates primarily to the timing of projects that are in the capitalization phase of development. During the first quarter of 2015, several additional APM products were in the capitalization phase of development as compared to the first quarter of 2014, resulting in the increase in capitalization. Sales and Marketing Sales and marketing costs consist primarily of personnel related costs associated with product sales, sales support and marketing for our product offerings. Sales and marketing costs are presented in the table below (in thousands): Three Months Ended June 30, % 2014 2013 Change Sales and marketing costs $ 53,103 $ 52,267 1.6 % Percentage of software revenue 37.2 % 35.6 % Sales and marketing costs remained consistent with the first quarter of 2014. The decline in revenue caused the increase in costs as a percentage of revenue. Administrative and General Administrative and general expenses consist primarily of costs associated with the corporate executive, finance, human resources, administrative, legal, communications and investor relations departments. In addition, administrative and general expenses include all facility-related costs, such as rent, building depreciation, maintenance and utilities, associated with our worldwide offices. Administrative and general expenses are presented in the table below (in thousands): Three Months Ended June 30, % 2014 2013 ChangeAdministrative and general expenses $ 34,013 $ 36,048 (5.6 )% Administrative and general costs decreased $2.0 million during the first quarter of 2015 due primarily to a decrease in salaries and benefits expense related to headcount reductions associated with our restructuring initiatives. 44-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIESRESTRUCTURING CHARGE As part of our announced plan to increase shareholder value, we are implementing significant cost reduction actions with the intention to eliminate approximately $110 million to $120 million of administrative and general and non-core operational costs over two years. In February 2013, the Company approved the initial phase of the restructuring plan designed to achieve cost savings. In January 2014, the Company announced the final phase of this cost reduction plan which includes additional reductions in the global workforce across all general, administrative and shared services divisions of the Company, along with the early termination of certain operating leases and the closing or reductions in size of office facilities worldwide. These cost reduction efforts, which are expected to be substantially completed by the end of fiscal 2015, are expected to result in cumulative restructuring charges of $50 million to $60 million. Substantially all of the remaining estimated charges will result in future cash expenditures. As part of the final phase of these efforts, the Company recorded a restructuring charge in continuing operations of approximately $3.0 million and $4.8 million during the three months ended June 30, 2014 and 2013, respectively, for costs associated with these reductions. INCOME TAXES 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 and net operating loss and credit carryforwards. The income tax provision and effective tax rate are presented in the table below (in thousands): Three Months Ended June 30, % 2014 2013 ChangeIncome tax provision (benefit) $ (1,707 ) $ (1,071 ) 59.4 % Effective tax rate 55.7 % (33.6 %) The Company's effective tax rate for the first quarter of fiscal year 2015 was 55.7% compared to (33.6%) for the first quarter of fiscal year 2014. The effective rate for the three months ended June 30, 2014, reflects a benefit due to the loss incurred and the recording of interest income resulting from a refund claim approved by the IRS during the quarter. The effective rate for the three months ended June 30, 2013, reflects the recording of a benefit related to stock compensation that was previously expected to not result in a tax deduction. This benefit resulted due to a change in our expectation regarding the tax deductibility of compensation for certain officers during the first quarter of fiscal year 2014. MANAGEMENT'S DISCUSSION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our condensed consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities and shareholders' equity and the disclosure of contingencies 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 June 30, 2014. 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, 2014 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 condensed consolidated financial statements included in Item 8 of that report. There have been no material changes to that information since the end of 2014. Long-lived assets We follow the guidance of ASC 360-10, "Property, Plant and Equipment" to assess potential impairment losses on long-lived assets used in operations. A long-lived asset, or group of assets, to be held and used in the business are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset group may not be recoverable. A long-lived asset group that is not held for sale is considered to be impaired when the asset group is not recoverable, that is when the undiscounted net cash flows expected to be generated by the asset group is less than its carrying amount and the carrying amount of the asset group exceeds its fair value. We review long-lived assets for impairment at the lowest level for which identifiable cash flows are largely independent of the cash flows of the other assets and liabilities. Certain long-lived assets do not have identifiable cash flows that are largely independent, and in those circumstances, the asset group for that long-lived asset includes all assets and liabilities of the company. As part of our announced transformation plan, during the fourth quarter of 2014, we began to consider various strategic alternatives for certain long-lived assets, which indicated their carrying amount may not be recoverable. We, therefore, performed a recoverability test for certain long-lived asset groups currently held and used as of March 31, 2014. The recoverability test indicated that the associated long-lived asset group was not impaired. While we believe our judgments and assumptions are reasonable, a change in facts or assumptions underlying certain estimates and judgments made as part of our recoverability test, including the decision to sell certain assets within the asset group, could result in a substantial impairment and would have a negative effect on our results of operations. Since March 31, 2014, there have been no events or changes in circumstances that would require the completion of an interim impairment analysis. Goodwill Impairment Evaluation The goodwill balance by reporting unit as of June 30, 2014 is presented as follows (in thousands): APM MF AS Total Goodwill as of March 31, 2014 $ 482,857 $ 140,304 $ 25,385 $ 648,546 Effect of foreign currency translation (1,101 ) - - (1,101 ) Goodwill as of June 30, 2014 $ 481,756 $ 140,304 $ 25,385 $ 647,445 We are required to assess the impairment of goodwill and other intangible assets annually, or more frequently if events or changes in circumstances indicate that the carrying value may exceed the fair value. The performance test involves a two-step process. Step 1 of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. We measure the fair value of our APM and Mainframe reporting units and other intangible assets using an estimate of the related discounted cash flow and market comparable valuations, where appropriate. We measure the fair value of our Covisint reporting unit based on the market value for the Covisint shares as of March 31, 2014. The discounted cash flow model uses significant assumptions, including projected future cash flows, the discount rate reflecting the risk inherent in future cash flows, and a terminal growth rate. The key assumptions in the market comparable value analysis are peer group and comparable transaction selection and application of this information to the respective reporting unit. If the carrying amount of a reporting unit exceeds the reporting unit's fair value, we perform Step 2 of the goodwill impairment test to determine the amount of impairment loss by comparing the implied fair value of the respective reporting unit's goodwill with the carrying amount of that goodwill. Under such evaluation, if the carrying amount of the reporting unit's goodwill exceeds the implied fair value of the goodwill, the impairment loss is recognized as an operating expense in an amount equal to that excess. There is a high degree of judgment regarding management's forecast for the reporting units as market developments for both customers and competitors can affect actual results. There can also be uncertainty regarding management's selection of peer companies and comparable transactions as an exact match is unlikely to exist. Application of the goodwill and other intangibles impairment test requires judgment, including the assignment of assets and liabilities to reporting units and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow model in combination with a market approach. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, estimation of market interest rates, determination of our weighted average cost of capital and selection and application of peer group information. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions and estimated future cash flows. While we believe that the assumptions and estimates used to determine the estimated fair values of each of our reporting units are reasonable, a change in assumptions underlying these estimates could materially affect the determination of fair value and goodwill impairment for each reporting unit. The events and circumstances that could affect our key assumptions in the analysis of fair value in the future include the following: · Our ability to achieve sales productivity at a level to achieve the profitability in the forecast period. · Our ability to hire and retain sales, technology and management personnel. · Future negative changes in the global economy. · Increased competition and pricing pressures. We evaluated our goodwill for impairment on a reporting unit basis at March 31, 2014, and the fair value of our APM, Mainframe and Covisint reporting units were substantially in excess of each unit's respective carrying value as of March 31, 2014. Since March 31, 2014, there have been no events or changes in circumstances that would require the completion of an interim impairment analysis. 45-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIESLIQUIDITY AND CAPITAL RESOURCES As of June 30, 2014, cash and cash equivalents totaled $275.5 million, compared to $300.1 million at March 31, 2014. Net cash provided by operating activities Net cash provided by operating activities during the first three months of 2015 was $22.1 million, which represents a $6.6 million decrease from the first three months of 2014. The condensed consolidated statements of cash flows compute net cash from operating activities using the indirect cash flow method. Therefore non-cash adjustments and net changes in assets and liabilities (net of effects from currency fluctuations) are adjusted from net income to derive net cash from operating activities. Changes in accounts receivable and deferred revenue have typically represented the most significant adjustments to net income to arrive at operating cash flow as we allow for deferred payment terms on multi-year products contracts. The impact of the net decrease in accounts receivable as compared to the prior year was $41.5 million and was primarily related to the cyclical nature of our Mainframe business which has higher sales and maintenance renewals during our third and fourth quarters of our fiscal year. The impact of the net decrease in deferred revenue was $16.2 million and was primarily related to our normal cycle of maintenance renewals which is cyclically higher in our third and fourth quarters. Operating cash flows for the first quarter of fiscal 2015 were negatively impacted by cash paid for income taxes during the quarter. This cash payment related to the fourth quarter fiscal 2014 gain on divestiture of our Changepoint, Professional Services and Uniface business segments. We believe our existing cash resources, including our line of credit and its expansion provision, and cash flow from operations will be sufficient to meet our short-term and long-term liquidity requirements, including the additional liquidity needed to fund the anticipated restructuring, business transformation and quarterly dividends. Net cash used in investing activities Net cash used in investing activities during the first three months of 2015 was $17.2 million, which represented a $9.5 million increase in cash used as compared to the first three months of 2014 due primarily to the payment of a purchase price adjustment to Marlin of $8.0 million. The adjustment relates to accounts receivable which we retained in excess of a contractually specified amount. We will continue to evaluate business acquisition opportunities that fit our strategic plans. If the cash consideration for a future acquisition or combination of acquisitions were to exceed our operating cash balance resources, we would probably further utilize our credit facility and may need to seek additional financing. 46-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIESNet cash used in financing activities Net cash used in financing activities during the first three months of 2015 was $30.1 million compared to $27.2 million during the first three months of 2014. Cash flows from financing activities consist primarily of cash dividends paid. Additionally, during the first quarter of 2015, we purchased approximately 1.4 million Covisint shares in the market and in private transactions for $5.6 million. These purchases were made to maintain our 80% or greater ownership of Covisint common stock, a condition to the tax-free status of the anticipated spin-off, in anticipation of the expiration of lock-up agreements applicable to holders of non-qualified stock options to acquire Covisint common stock and the subsequent exercise of those options. The increase in net cash used in financing activities was primarily due to the Covisint share repurchases and a decrease in net proceeds from the exercise of stock awards of $3.7 million, partially offset by a decline in repurchases of Compuware shares. Since May 2003, the Board of Directors has authorized the Company to repurchase a total of $1.7 billion of our common stock under a discretionary stock repurchase plan ("Discretionary Plan"). Purchases of common stock under the Discretionary Plan may occur on the open market, or through negotiated or block transactions based upon market and business conditions, subject to applicable legal limitations. Our credit facility limits stock repurchases from August 8, 2013 through the end of the agreement to a total of $50 million without approval of the lenders. Typically, the maximum amount of repurchase activity under the repurchase plan is limited on a daily basis to 25% of the average trading volume of our common stock for the previous four week period. In addition, no purchases are made during our self-imposed trading black-out periods in which the Company and our insiders are prohibited from trading in our common shares. Our standard quarterly black-out period commences 10 business days prior to the end of each quarter and terminates one full market day following the public release of our operating results for the period. We reserve the right to change the timing and volume of our repurchases at any time without notice. As of June 30, 2014, approximately $139.5 million remains authorized for future purchases under the Discretionary Plan. The authorization will remain in effect until exhausted absent further action of the Board. The Company has an unsecured revolving credit agreement (the "credit facility") with Comerica Bank and other lenders to provide leverage for the Company if needed. As of June 30, 2014, there were no outstanding borrowings under the credit facility and we were in compliance with all covenants in the agreement. Recently Issued Accounting Pronouncements See note 1 of the condensed consolidated financial statements included in this report for recently issued accounting pronouncements that may affect the Company. 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, 2014. 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 since the end of 2014. 47-------------------------------------------------------------------------------- Table of Contents COMPUWARE CORPORATION AND SUBSIDIARIES |