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VERINT SYSTEMS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following management's discussion and analysis is provided to assist readers in understanding our financial condition, results of operations, and cash flows. This discussion should be read in conjunction with our audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended January 31, 2014 and our unaudited condensed consolidated financial statements and notes thereto contained in this report. This discussion contains a number of forward-looking statements, all of which are based on our current expectations and all of which could be affected by uncertainties and risks. Our actual results may differ materially from the results contemplated in these forward-looking statements as a result of many factors including, but not limited to, those described under "Cautionary Note on Forward-Looking Statements". Our Business Verint is a global leader in Actionable Intelligence solutions. Actionable Intelligence is a necessity in a dynamic world of massive information growth because it empowers organizations with crucial insights and enables decision makers to anticipate, respond, and take action. With Verint solutions and value-added services, organizations of all sizes and across many industries can make more timely and effective decisions. Today, more than 10,000 organizations in over 180 countries, including over 80 percent of the Fortune 100, use Verint solutions to improve enterprise performance and make the world a safer place. Our Actionable Intelligence solutions help organizations address three important challenges: Customer Engagement Optimization; Security Intelligence; and Fraud, Risk, and Compliance. We help our customers capture large amounts of 37-------------------------------------------------------------------------------- Table of Contents information from numerous data types and sources, use analytics to glean insights from the information, and leverage the resulting Actionable Intelligence to help achieve their customer engagement, enhanced security, and risk mitigation goals. Headquartered in Melville, New York, we support our customers around the globe directly and with an extensive network of selling and support partners. We conduct our business through three operating segments-Enterprise Intelligence, Communications Intelligence, and Video Intelligence. Organizing our business through three operating segments allows us to align our resources and domain expertise to effectively address the Actionable Intelligence market. We address the Customer Engagement Optimization market opportunity through solutions from our Enterprise Intelligence segment. We address the Security Intelligence market opportunity through solutions from our Communications Intelligence segment and Video Intelligence segment, and we address the Fraud, Risk, and Compliance market opportunity through solutions from all three operating segments. Recent Developments On February 3, 2014, we completed the acquisition of KANA for net cash consideration of $516.6 million, through the merger of KANA Software, Inc.'s parent holding company, Kay Technology Holdings, Inc. with an indirect, wholly owned subsidiary of ours, with Kay Technology Holdings, Inc. continuing as the surviving company and as our wholly owned subsidiary. The acquisition was funded through a combination of cash on hand, $300.0 million of incremental term loans incurred in connection with an amendment to our Credit Agreement, and $125.0 million of borrowings under our revolving credit facility. KANA, based in Sunnyvale, California and with global operations, is a leading provider of on-premises and cloud-based solutions which create differentiated, personalized, and integrated customer experiences for large enterprises and mid-market organizations. KANA is being integrated into our Enterprise Intelligence operating segment. On March 31, 2014, we completed the acquisition of all of the outstanding shares of UTX, a provider of certain mobile device tracking solutions for security applications, from UTX Limited. UTX Limited was our supplier of these products to our Communications Intelligence operating segment prior to the transaction. The purchase price consisted of $82.9 million of cash paid at closing, subject to adjustment, and we agreed to make potential additional future cash payments to UTX Limited of up to $1.5 million, contingent upon the achievement of certain future performance targets. The cash paid at closing was funded with cash on hand. UTX is based in the EMEA region. On June 18, 2014, we completed concurrent public offerings of 5,750,000 shares of our common stock and $400.0 million in aggregate principal amount of 1.50% convertible senior notes due June 1, 2021 (the "Notes"). The aggregate net proceeds from the concurrent offerings were $657.5 million, after deducting underwriters' discounts and commissions, but excluding other offering expenses. We used $15.6 million of the net proceeds to pay the net costs of an arrangement consisting of the purchase of call options and the sale of warrants to purchase our common stock, the intent of which is to reduce the potential dilution to our common stock upon conversion of the Notes. We used the remainder of the net proceeds to repay a portion of the outstanding indebtedness under our Credit Agreement. Further details regarding our acquisitions and our long-term debt appear in Note 4, "Business Combinations" and Note 6, "Long-Term Debt", respectively, to our condensed consolidated financial statements included under Item 1 of this report. Critical Accounting Policies and Estimates Note 1, "Summary of Significant Accounting Policies" to the audited consolidated financial statements in our Annual Report on Form 10-K for the year ended January 31, 2014 describes the significant accounting policies and methods used in the preparation of the condensed consolidated financial statements appearing in this report. The accounting policies that reflect our more significant estimates, judgments and assumptions in the preparation of our consolidated financial statements are described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 of our Annual Report on Form 10-K for the year ended January 31, 2014, and include the following: • Revenue recognition; • Accounting for business combinations; • Impairment of goodwill and other intangible assets; • Accounting for income taxes; • Contingencies; • Accounting for stock-based compensation; 38-------------------------------------------------------------------------------- Table of Contents • Accounting for cost of revenue; and • Allowance for doubtful accounts We did not identify any significant changes to our critical accounting policies and estimates during the six months ended July 31, 2014. Results of Operations Seasonality and Cyclicality As is typical for many software and technology companies, our business is subject to seasonal and cyclical factors. On an organic basis, our revenue and operating income are typically highest in the fourth quarter and lowest in the first quarter. Moreover, revenue and operating income in the first quarter of a new year may be lower than in the fourth quarter of the preceding year, potentially by a significant margin on an organic basis. In addition, we generally receive a higher volume of orders in the last month of a quarter, with orders concentrated in the later part of that month. We believe that these seasonal and cyclical factors primarily reflect customer spending patterns and budget cycles, as well as the impact of incentive compensation plans for our sales personnel. While seasonal and cyclical factors such as these are common in the software and technology industry, this pattern should not be considered a reliable indicator of our future revenue or financial performance. Many other factors, including general economic conditions, may also have an impact on our business and financial results. Overview of Operating Results The following table sets forth a summary of certain key financial information for the three and six months ended July 31, 2014 and 2013: Three Months Ended Six Months Ended July 31, July 31, (in thousands, except per share data) 2014 2013 2014 2013 Revenue $ 276,816 $ 222,447 $ 534,209 $ 427,233 Operating income $ 11,470 $ 31,263 $ 12,466 $ 44,976 Net (loss) income attributable to Verint Systems Inc. common shares $ (12,278 ) $ 17,536 $ 15,678 $ 8,209 Net (loss) income per common share attributable to Verint Systems Inc.: Basic $ (0.21 ) $ 0.33 $ 0.28 $ 0.16 Diluted $ (0.21 ) $ 0.33 $ 0.28 $ 0.15 Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Our revenue increased approximately $54.4 million, or 24%, to $276.8 million in the three months ended July 31, 2014 from $222.4 million in the three months ended July 31, 2013. In our Enterprise Intelligence segment, revenue increased approximately $34.9 million, or 28%, to $160.8 million in the three months ended July 31, 2014 from $125.9 million in the three months ended July 31, 2013. The increase consisted of a $33.8 million increase in service and support revenue and a $1.1 million increase in product revenue. In our Communications Intelligence segment, revenue increased approximately $22.6 million, or 35%, from $64.4 million in the three months ended July 31, 2013 to $87.0 million in the three months ended July 31, 2014. The increase consisted of a $17.7 million increase in product revenue and a $4.9 million increase in service and support revenue. In our Video Intelligence segment, revenue decreased approximately $3.1 million, or 10%, from $32.1 million in the three months ended July 31, 2013 to $29.0 million in the three months ended July 31, 2014, primarily due to a decrease in product revenue. For additional details on our revenue by segment, see "-Revenue by Operating Segment". Revenue in the Americas, EMEA, and the Asia-Pacific region represented approximately 49%, 34%, and 17%, respectively, of our total revenue in the three months ended July 31, 2014, compared to approximately 53%, 21%, and 26%, respectively, in the three months ended July 31, 2013. Further details of changes in revenue are provided below. Operating income was $11.5 million in the three months ended July 31, 2014 compared to $31.3 million in the three months ended July 31, 2013. The decrease in operating income was primarily due to a $44.2 million increase in operating expenses, from $118.6 million to $162.8 million, partially offset by a $24.5 million increase in gross profit from $149.8 million to $174.3 million. The increase in operating expenses consisted of a $25.8 million increase in selling, general and administrative expense, a $12.9 million increase in net research and development expenses, and a $5.5 million increase in amortization of 39-------------------------------------------------------------------------------- Table of Contents other acquired intangible assets. The increase in gross profit was primarily due to increased gross profit in our Enterprise Intelligence and Communication Intelligence segments. Further details of changes in operating income are provided below. Net loss attributable to Verint Systems Inc. common shares was $12.3 million, and diluted net loss per common share was $0.21, in the three months ended July 31, 2014 compared to net income attributable to Verint Systems Inc. common shares of $17.5 million, and diluted net income per common share of $0.33, in the three months ended July 31, 2013. The shift was primarily due to a $19.8 million decrease in operating income, as described above, a $5.3 million increase in losses upon early retirements of debt recorded during the three months ended July 31, 2014, a $2.0 million increase in interest expense, and a $2.7 million increase in our provision for income taxes, in each case, compared to the three months ended July 31, 2013. Further details of these changes are provided below. When comparing average exchange rates for the three months ended July 31, 2014 to average exchange rates for the three months ended July 31, 2013, while the U.S. dollar strengthened relative to the Brazilian real, and the Swiss franc, it weakened relative to the British pound sterling, euro, and Israeli shekel, resulting in an overall increase in our revenue, cost of revenue and operating expenses on a U.S. dollar-denominated basis. For the three months ended July 31, 2014, had foreign exchange rates remained unchanged from rates in effect for the three months ended July 31, 2013, our revenue would have been approximately $5.4 million lower and our cost of revenue and operating expenses would have been approximately $8.0 million lower, which would have resulted in a $2.6 million increase in operating income. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Our revenue increased approximately $107.0 million, or 25%, to $534.2 million in the six months ended July 31, 2014 from $427.2 million in the six months ended July 31, 2013. In our Enterprise Intelligence segment, revenue increased approximately $76.8 million, or 32%, to $315.6 million in the six months ended July 31, 2014 from $238.8 million in the six months ended July 31, 2013. The increase consisted of a $67.9 million increase in service and support revenue and a $8.9 million increase in product revenue. In our Communications Intelligence segment, revenue increased approximately $35.6 million, or 28%, from $127.5 million in the six months ended July 31, 2013 to $163.1 million in the six months ended July 31, 2014. The increase consisted of a $33.5 million increase in product revenue and a $2.1 million increase in service and support revenue. In our Video Intelligence segment, revenue decreased approximately $5.4 million, or 9%, from $60.9 million in the six months ended July 31, 2013 to $55.5 million in the six months ended July 31, 2014, primarily due to a decrease in product revenue. For additional details on our revenue by segment, see "-Revenue by Operating Segment". Revenue in the Americas, EMEA, and the Asia-Pacific region represented approximately 51%, 30%, and 19% of our total revenue, respectively, in the six months ended July 31, 2014, compared to approximately 54%, 21%, and 25%, respectively, in the six months ended July 31, 2013. The change in the percentage of revenue by geographical region in the six months ended July 31, 2014 compared to the six months ended July 31, 2013 primarily reflected the timing of revenue recognized in those regions under several large contracts, primarily in our Communications Intelligence segment. Further details of changes in revenue are provided below. Operating income was $12.5 million in the six months ended July 31, 2014 compared to $45.0 million in the six months ended July 31, 2013. The decrease in operating income was primarily due to a $80.1 million increase in operating expenses, from $236.3 million to $316.4 million, partially offset by a $47.5 million increase in gross profit from $281.3 million to $328.8 million. The increase in operating expenses consisted of a $45.1 million increase in selling, general and administrative expense, a $24.2 million increase in net research and development expenses, and a $10.7 million increase in amortization of other acquired intangible assets. The increase in gross profit was primarily due to increased gross profit in our Enterprise Intelligence and Communication Intelligence segments. Further details of changes in operating income are provided below. Net income attributable to Verint Systems Inc. common shares was $15.7 million, and diluted net income per common share was $0.28, in the six months ended July 31, 2014 compared to a net income attributable to Verint Systems Inc. common shares of $8.2 million, and diluted net income per common share of $0.15, in the six months ended July 31, 2013. The increase in net income attributable to Verint Systems Inc. common shares and diluted net income per common share in the six months ended July 31, 2014 was primarily due a $42.5 million decrease in our provision for income taxes (from a $5.9 million expense for the six months ended July 31, 2013 to a $36.6 million benefit for the six months ended July 31, 2014), and a $5.5 million increase in other income, net (from a $4.4 million expense during the six months ended July 31, 2013 to a $1.1 million benefit during the six months ended July 31, 2014) due primarily to a $4.1 million increase in foreign currency gains, net (from a loss of $3.2 million during the six months ended July 31, 2013 to a gain of $0.9 million during the six months ended July 31, 2014), partially offset by a $0.6 million decrease in gains on derivative financial instruments, net. These increases to net income attributable to Verint Systems Inc. common shares were partially offset by our decreased operating income, as described above, a $5.0 million increase in interest expense, and a $2.6 million increase in losses upon early retirement of debt recorded during the six months ended July 31, 2014 compared to the six months ended July 31, 2013. Further details of these changes are provided below. 40-------------------------------------------------------------------------------- Table of Contents When comparing average exchange rates for the six months ended July 31, 2014 to average exchange rates for the six months ended July 31, 2013, while the U.S. dollar strengthened relative to the Australian dollar, Brazilian real, Japanese yen, and Singapore dollar, it weakened relative to the Israeli shekel, British pound sterling and euro, resulting in an overall increase in our revenue, cost of revenue and operating expenses on a U.S. dollar-denominated basis. For the six months ended July 31, 2014, had foreign exchange rates remained unchanged from rates in effect for the six months ended July 31, 2013, our revenue would have been approximately $7.1 million lower and our cost of revenue and operating expenses would have been approximately $11.8 million lower, which would have resulted in a $4.7 million increase in operating income. As of July 31, 2014, we employed approximately 4,600 employees, including part-time employees and certain contractors, as compared to approximately 3,300 employees as of July 31, 2013. Revenue by Operating Segment The following table sets forth revenue for each of our three operating segments for the three and six months ended July 31, 2014 and 2013: Three Months Ended Six Months Ended July 31, % Change July 31, % Change (in thousands) 2014 2013 2014 - 2013 2014 2013 2014 - 2013 Enterprise Intelligence $ 160,775 $ 125,873 28% $ 315,593 $ 238,796 32% Communications Intelligence 86,990 64,438 35% 163,125 127,503 28% Video Intelligence 29,051 32,136 (10)% 55,491 60,934 (9)% Total revenue $ 276,816 $ 222,447 24% $ 534,209 $ 427,233 25% Enterprise Intelligence Segment Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Enterprise Intelligence revenue increased approximately $34.9 million, or 28%, from $125.9 million in the three months ended July 31, 2013 to $160.8 million in the three months ended July 31, 2014. The increase consisted of a $33.8 million increase in service and support revenue and a $1.1 million increase in product revenue. The $33.8 million increase in service and support revenue was primarily due to an increase in our customer install base, both organically and through business combinations, and the related support revenue generated from this customer base during the three months ended July 31, 2014, as well as increased revenue from new service offerings in the three months ended July 31, 2014. The $1.1 million increase in product revenue was due to an increase in product sales to new customers during the three months ended July 31, 2014. The continued growth of service revenue is attributable to various factors, including an increase in services associated with customer product upgrades, a higher component of service offerings in our standard arrangements, and our growing install base. The aggregate value of executed license arrangements, which comprises the majority of our product revenue, can fluctuate from quarter to quarter. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Enterprise Intelligence revenue increased approximately $76.8 million, or 32%, from $238.8 million in the six months ended July 31, 2013 to $315.6 million in the six months ended July 31, 2014. The increase consisted of a $67.9 million increase in service and support revenue, and an $8.9 million increase in product revenue. The $67.9 million increase in service and support revenue was primarily due to an increase in our customer install base, both organically and through business combinations, and the related support revenue generated from this customer base during the six months ended July 31, 2014, as well as increased revenue from new service offerings in the six months ended July 31, 2014. The $8.9 million increase in product revenue was due to an increase in product sales to new customers during the three months ended July 31, 2014. The continued growth of service revenue is attributable to various factors, including an increase in services associated with customer product upgrades, a higher component of service offerings in our standard arrangements, and our growing install base. The aggregate value of executed license arrangements, which comprises the majority of our product revenue, can fluctuate from quarter to quarter. Communications Intelligence Segment Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Communications Intelligence revenue increased approximately $22.6 million, or 35%, from $64.4 million in the three months ended July 31, 2013 to $87.0 million in the three months ended July 31, 2014. The increase consisted of a $17.7 million increase in product revenue and a $4.9 million increase in service and support revenue. The increase in product revenue was primarily due to an increase in product deliveries to customers and an increase in progress realized during the current year on projects recognized using the percentage of completion ("POC") method, some of which commenced in the previous fiscal year. The increase in service and support 41-------------------------------------------------------------------------------- Table of Contents revenue was primarily attributable to the timing of the annual renewal of a large product maintenance agreement that was finalized during the three months ended July 31, 2014 which also includes the service period that includes the three months ended April 30, 2014. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Communications Intelligence revenue increased approximately $35.6 million, or 28%, from $127.5 million in the six months ended July 31, 2013 to $163.1 million in the six months ended July 31, 2014. The increase consisted of a $33.5 million increase in product revenue and a $2.1 million increase in service and support revenue. The increase in product revenue was primarily due to an increase in product deliveries to customers and an increase in progress realized during the current year on projects recognized using the POC method, some of which commenced in the previous fiscal year. The increase in service and support revenue was primarily attributable to an increase in our Communications Intelligence software-as-a-service ("SaaS") offerings. Video Intelligence Segment Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Video Intelligence revenue decreased approximately $3.1 million, or 10%, from $32.1 million in the three months ended July 31, 2013 to $29.0 million in the three months ended July 31, 2014. The decrease was primarily attributable to a decrease in product deliveries to new and existing customers. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Video Intelligence revenue decreased approximately $5.4 million, or 9%, from $60.9 million in the six months ended July 31, 2013 to $55.5 million in the six months ended July 31, 2014. The decrease was primarily attributable to a $6.3 million decrease in product revenue, resulting from a reduction in sales of certain hardware products to a single customer during the six months ended July 31, 2014 as compared to the six months ended July 31, 2013. Volume and Price We sell products in multiple configurations, and the price of any particular product varies depending on the configuration of the product sold. Due to the variety of customized configurations for each product we sell, we are unable to quantify the amount of any revenue increases attributable to a change in the price of any particular product and/or a change in the number of products sold. Revenue by Product Revenue and Service and Support Revenue We derive and report our revenue in two categories: (a) product revenue, including licensing of software products and sale of hardware products (which include software that works together with the hardware to deliver the product's essential functionality), and (b) service and support revenue, including revenue from installation services, post-contract customer support, project management, hosting services, SaaS, product warranties, consulting services, and training services. For multiple-element arrangements for which we are unable to establish vendor-specific objective evidence of fair value for one or more elements, we use various available indicators of fair value and apply our best judgment to reasonably classify the arrangement's revenue into product revenue and service and support revenue. The following table sets forth product revenue and service and support revenue for the three and six months ended July 31, 2014 and 2013: Three Months Ended Six Months Ended July 31, % Change July 31, % Change (in thousands) 2014 2013 2014 - 2013 2014 2013 2014 - 2013 Product revenue $ 113,175 $ 97,865 16% $ 221,311 $ 185,215 19% Service and support revenue 163,641 124,582 31% 312,898 242,018 29% Total revenue $ 276,816 $ 222,447 24% $ 534,209 $ 427,233 25% Product Revenue Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Product revenue increased approximately $15.3 million, or 16%, from $97.9 million for the three months ended July 31, 2013 to $113.2 million for the three months ended July 31, 2014, resulting from a $17.7 million increase in our Communications Intelligence segment and a $1.1 million increase in our Enterprise Intelligence segment, partially offset by a $3.5 million decrease in our Video Intelligence segment. 42-------------------------------------------------------------------------------- Table of Contents Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Product revenue increased approximately $36.1 million, or 19%, from $185.2 million for the six months ended July 31, 2013 to $221.3 million for the six months ended July 31, 2014, resulting from a $33.5 million increase in our Communications Intelligence segment and a $8.9 million increase in our Enterprise Intelligence segment, partially offset by a $6.3 million decrease in our Video Intelligence segment. For additional information see "- Revenue by Operating Segment". Service and Support Revenue Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Service and support revenue increased approximately $39.0 million, or 31%, from $124.6 million for the three months ended July 31, 2013 to $163.6 million for the three months ended July 31, 2014. This increase was primarily attributable to an increase of $33.8 million in our Enterprise Intelligence segment and a $4.9 million increase in our Communications Intelligence segment. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Service and support revenue increased approximately $70.9 million, or 29%, from $242.0 million for the six months ended July 31, 2013 to $312.9 million for the six months ended July 31, 2014, resulting from a $67.9 million increase in our Enterprise Intelligence segment, a $2.1 million increase in our Communications Intelligence segment, and a $0.9 million increase in our Video Intelligence segment. For additional information see "- Revenue by Operating Segment". Cost of Revenue The following table sets forth cost of revenue by product and service and support, as well as amortization of acquired technology and backlog for the three and six months ended July 31, 2014 and 2013: Three Months Ended Six Months Ended July 31, % Change July 31, % Change (in thousands) 2014 2013 2014 - 2013 2014 2013 2014 - 2013Cost of product revenue $ 32,122 $ 30,090 7% $ 71,599 $ 61,262 17% Cost of service and support revenue 61,869 40,170 54% 118,857 78,668 51% Amortization of acquired technology and backlog 8,564 2,347 * 14,922 5,985 * Total cost of revenue $ 102,555 $ 72,607 41% $ 205,378 $ 145,915 41% * Percentage is not meaningful. We exclude certain costs of product revenue and certain costs of service and support revenue, including shared support costs, stock-based compensation, and asset impairment charges, among others, from the calculations of our operating segment gross margins. Cost of Product Revenue Cost of product revenue primarily consists of hardware material costs and royalties due to third parties for software components that are embedded in our software solutions. When revenue is deferred, we also defer hardware material costs and third-party software royalties and recognize those costs over the same period that the product revenue is recognized. Cost of product revenue also includes amortization of capitalized software development costs, employee compensation and related expenses associated with our global operations, facility costs, and other allocated overhead expenses. In our Communications Intelligence segment, cost of product revenue also includes employee compensation and related expenses, contractor and consulting expenses, and travel expenses, in each case for resources dedicated to project management and associated product delivery. Our product gross margins are impacted by the mix of products that we sell from period to period. As with many other technology companies, our software products tend to have higher gross margins than our hardware products. Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Cost of product revenue increased approximately 7% from $30.1 million in the three months ended July 31, 2013 to $32.1 million in the three months ended July 31, 2014. Our overall product gross margins increased to 72% in the three months ended July 31, 2014 from 69% in the 43-------------------------------------------------------------------------------- Table of Contents three months ended July 31, 2013. Product gross margins in our Enterprise Intelligence segment were 94% in each of the three months ended July 31, 2014 and 2013. Product gross margins in our Communications Intelligence segment increased from 54% in the three months ended July 31, 2013 to 63% in the three months ended July 31, 2014 primarily due to a change in product mix. Product gross margins in our Video Intelligence segment increased from 60% in the three months ended July 31, 2013 to 64% in the three months ended July 31, 2014 due to a change in product mix. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Cost of product revenue increased approximately 17% from $61.3 million in the six months ended July 31, 2013 to $71.6 million in the six months ended July 31, 2014. Our overall product gross margins increased to 68% in the six months ended July 31, 2014 from 67% in the six months ended July 31, 2013. Product gross margins in our Enterprise Intelligence segment were 93% in each of the six months ended July 31, 2014 and 2013. Product gross margins in our Communications Intelligence segment increased from 53% in the six months ended July 31, 2013 to 59% in the six months ended July 31, 2014 primarily due to a change in product mix. Product gross margins in our Video Intelligence segment increased from 59% in the six months ended July 31, 2013 to 61% in the six months ended July 31, 2014 due to a change in product mix. Cost of Service and Support Revenue Cost of service and support revenue primarily consists of employee compensation and related expenses, contractor costs, and travel expenses relating to installation, training, consulting, and maintenance services. Cost of service and support revenue also includes stock-based compensation expenses, facility costs, and other overhead expenses. In accordance with GAAP and our accounting policy, the cost of revenue associated with the services is generally expensed as incurred in the period in which the services are performed, with the exception of certain transactions accounted for under the POC method. Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Cost of service and support revenue increased approximately 54% from $40.2 million in the three months ended July 31, 2013 to $61.9 million in the three months ended July 31, 2014. Employee compensation and related expenses increased $13.4 million due primarily to increased headcount in connection with business combinations that closed subsequent to July 31, 2013. Contractor costs, travel expense, and materials expense incurred to provide services increased $2.8 million, $1.2 million, and $2.5 million, respectively, primarily due to business combinations that closed subsequent to July 31, 2013. Our overall service and support gross margins decreased from 68% in the three months ended July 31, 2013 to 62% in the three months ended July 31, 2014. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Cost of service and support revenue increased approximately 51% from $78.7 million in the six months ended July 31, 2013 to $118.9 million in the six months ended July 31, 2014. Employee compensation and related expenses increased $24.2 million due primarily to increased headcount in connection with business combinations that closed subsequent to July 31, 2013. Contractor costs, travel expense, and materials expense incurred to provide services increased $4.9 million, $2.6 million, and $5.1 million, respectively, primarily due to business combinations that closed subsequent to July 31, 2013. Our overall service and support gross margins decreased from 67% in the six months ended July 31, 2013 to 62% in the six months ended July 31, 2014. Amortization of Acquired Technology and Backlog Amortization of acquired technology and backlog consists of amortization of technology assets and customer backlog acquired in connection with business combinations. Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Amortization of acquired technology and backlog increased from $2.3 million in the three months ended July 31, 2013 to $8.6 million in the three months ended July 31, 2014, primarily due to an increase in amortization expense of acquired technology-based intangible assets associated with business combinations that closed subsequent to July 31, 2013. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Amortization of acquired technology and backlog increased from $6.0 million in the six months ended July 31, 2013 to $14.9 million in the six months ended July 31, 2014, primarily due to an increase in amortization expense of acquired technology-based intangible assets associated with business combinations that closed subsequent to July 31, 2013. Further discussion regarding our business combinations appears in Note 4, "Business Combinations" to our consolidated financial statements included under Item 1 of this report. Research and Development, Net 44-------------------------------------------------------------------------------- Table of Contents Research and development expenses consist primarily of personnel and subcontracting expenses, facility costs, and other allocated overhead, net of certain software development costs that are capitalized as well as reimbursements under government programs. Software development costs are capitalized upon the establishment of technological feasibility and continue to be capitalized through the general release of the related software product. The following table sets forth research and development, net for the three and six months ended July 31, 2014 and 2013: Three Months Ended Six Months Ended July 31, % Change July 31, % Change (in thousands) 2014 2013 2014 - 2013 2014 2013 2014 - 2013 Research and development, net $ 44,077 $ 31,203 41% $ 85,400 $ 61,231 39% Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Research and development, net increased approximately $12.9 million, or 41%, from $31.2 million in the three months ended July 31, 2013 to $44.1 million in the three months ended July 31, 2014. The increase was primarily attributable to a $10.6 million increase in employee compensation and related expenses due primarily to an increase in employee headcount in connection with business combinations that closed subsequent to July 31, 2013 in our Enterprise Intelligence and Communication Intelligence segments. Contractor expense increased approximately $0.6 million primarily due to increased use of contractors in our Communications Intelligence segment during the three months ended July 31, 2014 compared to the three months ended July 31, 2013. Stock-based compensation expense increased $0.5 million increase resulting from an increase in average amounts of outstanding restricted stock units, and continued increases in our stock price, which impacts the total stock-based compensation to be recognized over the vesting periods. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Research and development, net increased approximately $24.2 million, or 39%, from $61.2 million in the six months ended July 31, 2013 to $85.4 million in the six months ended July 31, 2014. The increase was primarily attributable to a $20.5 million increase in employee compensation and related expenses due primarily to an increase in employee headcount in connection with business combinations that closed subsequent to July 31, 2013 in our Enterprise Intelligence and Communication Intelligence segments. Contractor expense increased approximately $1.0 million primarily due to increased use of contractors in our Communications Intelligence segment during the six months ended July 31, 2014 compared to the six months ended July 31, 2013. Stock-based compensation expense increased $1.1 million resulting from an increase in average amounts of outstanding restricted stock units, and continued increases in our stock price, which impacts the total stock-based compensation to be recognized over the vesting periods. Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of personnel costs and related expenses, professional fees, sales and marketing expenses, including travel, sales commissions and sales referral fees, facility costs, communication expenses, and other administrative expenses. The following table sets forth selling, general and administrative expenses for the three and six months ended July 31, 2014 and 2013: Three Months Ended Six Months Ended July 31, % Change July 31, % Change (in thousands) 2014 2013 2014 - 2013 2014 2013 2014 - 2013 Selling, general and administrative $ 107,160 $ 81,364 32% $ 208,208 $ 163,068 28% Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Selling, general and administrative expenses increased approximately $25.8 million, or 32%, from $81.4 million in the three months ended July 31, 2013 to $107.2 million in the three months ended July 31, 2014. Employee compensation and related expenses increased $11.2 million primarily due to increased employee headcount in our Enterprise Intelligence and Communications Intelligence segments, as well as an increase in employee headcount for corporate support employees. Stock-based compensation expense increased $4.2 million due primarily to an increase in average amounts of outstanding restricted stock units, and continued increases in our stock price, which impacts the total stock-based compensation to be recognized over the vesting periods. Sales and marketing and travel expense increased $1.8 million and $1.5 million, respectively, due primarily to business combinations that closed subsequent to July 31, 2013. Also contributing to the increase in selling, general, and administrative expense was a $2.7 45-------------------------------------------------------------------------------- Table of Contents million increase in agent commissions expense in our Communication Intelligence segment, and a $0.9 million increase in contractor expense due primarily to increase use of contractors for corporate support activities. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Selling, general and administrative expenses increased approximately $45.1 million, or 28%, from $163.1 million in the six months ended July 31, 2013 to $208.2 million in the six months ended July 31, 2014. Employee compensation and related expenses increased $20.6 million due primarily to increased employee headcount in our Enterprise Intelligence and Communications Intelligence segments, as well as an increase in employee headcount for corporate support employees. Stock-based compensation expense increased $8.2 million due primarily to an increase in average amounts of outstanding restricted stock units, and continued increases in our stock price, which impacts the total stock-based compensation to be recognized over the vesting periods. Sales and marketing and travel expense increased $2.1 million and $2.7 million, respectively, due primarily to business combinations that closed subsequent to July 31, 2013. Also contributing to the increase in selling, general, and administrative expense was a $4.6 million increase in agent commissions expense in our Communication Intelligence segment, and a $1.7 million increase in contractor expense due primarily to increased use of contractors for corporate support activities. These increases were partially offset by a decrease of $3.5 million of expenses from special performance incentives associated with a prior period business combination included in selling, general, and administrative expenses during the six months ended July 31, 2013 with no equivalent expenses in the six months ended July 31, 2014. Amortization of Other Acquired Intangible Assets Amortization of other acquired intangible assets consists of amortization of certain intangible assets acquired in connection with business combinations, including customer relationships, distribution networks, trade names and non-compete agreements. The following table sets forth amortization of other acquired intangible assets for the three and six months ended July 31, 2014 and 2013: Three Months Ended Six Months Ended July 31, % Change July 31, % Change (in thousands) 2014 2013 2014 - 2013 2014 2013 2014 - 2013Amortization of other acquired intangible assets $ 11,554 $ 6,010 92% $ 22,757 $ 12,043 89% Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Amortization of other acquired intangible assets increased approximately $5.5 million, or 92%, from 6.0 million in the three months ended July 31, 2013 to $11.5 million in the three months ended July 31, 2014 primarily due to amortization associated with business combinations that closed subsequent to July 31, 2013. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Amortization of other acquired intangible assets increased approximately $10.7 million, or 89%, from $12.0 million in the six months ended July 31, 2013 to $22.7 million in the six months ended July 31, 2014 primarily due to amortization associated with business combinations that closed subsequent to July 31, 2013. Further discussion surrounding our business combinations appears in Note 4, "Business Combinations" to our consolidated financial statements included under Item 1 of this report. Other Income (Expense), Net The following table sets forth total other expense, net for the three and six months ended July 31, 2014 and 2013: 46-------------------------------------------------------------------------------- Table of Contents Three Months Ended Six Months Ended July 31, % Change July 31, % Change (in thousands) 2014 2013 2014 - 2013 2014 2013 2014 - 2013 Interest income $ 250 $ 166 51% $ 475 $ 321 48% Interest expense (9,383 ) (7,383 ) 27% (19,609 ) (14,571 ) 35% Losses on early retirements of debt (5,454 ) (173 ) * (12,546 ) (9,879 ) 27% Other (expense) income: Foreign currency (losses) gains (2,280 ) (1,487 ) 53% 915 (3,206 ) * Gains on derivative financial instruments, net 840 247 * 103 676 (85)% Other, net (289 ) (1,319 ) (78)% 81 (1,837 ) * Total other (expense) income (1,729 ) (2,559 ) (32)% 1,099 (4,367 ) * Total other expense, net $ (16,316 ) $ (9,949 ) 64% $ (30,581 ) $ (28,496 ) 7% * Percentage is not meaningful. Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Total other expense, net, increased by $6.4 million from $9.9 million in the three months ended July 31, 2013 to $16.3 million in the three months ended July 31, 2014. During the three months ended July 31, 2014, we recorded a $5.5 million loss upon early retirement of debt in connection with the retirement of $530.0 million of the February 2014 Term Loans and March 2014 Term Loans. Further discussion regarding our Term Loans appears in Note 6, "Long-term Debt" to our condensed consolidated financial statements included under Item 1 of this report. During the three months ended July 31, 2013, we recorded a $0.2 million loss upon early retirement of debt, which was recognized in connection with repayment of debt that was assumed in connection with a past business combination. Interest expense increased to $9.4 million in the three months ended July 31, 2014 from $7.4 million in the three months ended July 31, 2013 primarily due to incremental borrowings discussed in Note 6, "Long-term Debt" to our condensed consolidated financial statements included under Item 1 of this report. We recorded $2.3 million of net foreign currency losses in the three months ended July 31, 2014 compared to $1.5 million of net losses in the three months ended July 31, 2013. Foreign currency losses in the three months ended July 31, 2014 resulted primarily from the weakening of the U.S. dollar against the Israeli Shekel, resulting in foreign currency losses on Israeli Shekel-denominated net liabilities in certain entities which use a U.S. dollar functional currency, and the strengthening of the U.S. dollar against the euro, resulting in foreign currency losses on U.S. dollar-denominated net liabilities in certain entities which use a euro functional currency. Other, net expense decreased to $0.3 million in the three months ended July 31, 2014 from $1.3 million in the six months ended July 31, 2013. Other, net, during the three months ended July 31, 2013 included a $1.1 million write-off of an indemnification asset based upon our assessment of the collectibility of the indemnification from the former shareholders from a prior-year business combination in our Communications Intelligence segment. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Total other expense, net, increased by $2.1 million from $28.5 million in the six months ended July 31, 2013 to $30.6 million in the six months ended July 31, 2014. During the six months ended July 31, 2014, we recorded a $12.5 million loss upon early retirement of debt. Of this amount, $7.1 million was recorded in connection with the extinguishment of the March 2013 Term Loans, and $5.5 million was recorded in connection with the retirement of $530.0 million of the February 2014 Term Loans and March 2014 Term Loans. During the six months ended July 31, 2013, we recorded a $9.9 million loss upon early retirement of debt, which primarily related to the extinguishment of the April 2011 Term Loans. Further discussion regarding our Credit Agreement appears in Note 6, "Long-term Debt" to our condensed consolidated financial statements included under Item 1 of this report. Interest expense increased to $19.6 million in the six months ended July 31, 2014 from $14.6 million in the six months ended July 31, 2013 primarily due to incremental borrowings discussed in Note 6, "Long-term Debt" to our condensed consolidated financial statements included under Item 1 of this report. We recorded $0.9 million of net foreign currency gains in the six months ended July 31, 2014 compared to $3.2 million of net losses in the six months ended July 31, 2013. Foreign currency gains in the six months ended July 31, 2014 resulted primarily 47-------------------------------------------------------------------------------- Table of Contents from the weakening of the U.S. dollar against the British pound sterling, resulting in foreign currency gains on U.S. dollar-denominated net liabilities in certain entities which use a British pound sterling functional currency. Other, net was $0.1 million net benefit in the six months ended July 31, 2014 compared to $1.8 million net expense in the six months ended July 31, 2013. Other, net, during the six months ended July 31, 2013 included a $1.1 million write-off of an indemnification asset based upon our assessment of the collectibility of the indemnification from the former shareholders from a prior-year business combination in our Communications Intelligence segment. There were no equivalent expenses during the six months ended July 31, 2014. Provision for (Benefit from) Income Taxes The following table sets forth our provision for (benefit from) income taxes for the three and six months ended July 31, 2014 and 2013: Three Months Ended Six Months Ended July 31, % Change July 31, % Change (in thousands) 2014 2013 2014 - 2013 2014 2013 2014 - 2013 Provision for (benefit from) income taxes $ 5,534 $ 2,809 97% $ (36,554 ) $ 5,912 * * Percentage is not meaningful. Three Months Ended July 31, 2014 compared to Three Months Ended July 31, 2013. Our effective income tax rate was negative 114.2% for the three months ended July 31, 2014, compared to an effective income tax rate of 13.2% for the three months ended July 31, 2013. For the three months ended July 31, 2014, the effective income tax rate was significantly affected by the mix and levels of income and losses among taxing jurisdictions. Pre-tax income in our profitable jurisdictions, where we recorded tax provisions, was less than our domestic losses where we maintain valuation allowances and did not record the related tax benefits. The result was an income tax expense of $5.5 million on a pre-tax loss of $4.8 million, resulting in a negative effective tax rate of 114.2%. For the three months ended July 31, 2013, our effective income tax rate was significantly impacted by the level and mix of income and losses by jurisdiction. The effective tax rate was also reduced because CTI received a favorable ruling from the Internal Revenue Service which resulted in adjustments to deferred taxes and an indemnified tax liability. Pre-tax income in our profitable jurisdictions, where we recorded income tax provisions, was higher than our domestic losses where we maintain valuation allowances and did not record the related income tax benefits. The result was an income tax provision of $2.8 million on pre-tax income of $21.3 million, which resulted in an effective income tax rate of 13.2%. Six Months Ended July 31, 2014 compared to Six Months Ended July 31, 2013. Our effective income tax rate was 201.8% for the six months ended July 31, 2014, compared to an effective income tax rate of 35.9% for the six months ended July 31, 2013. For the six months ended July 31, 2014, we recorded an income tax benefit of $36.6 million on a pre-tax loss of $18.1 million. The effective income tax rate was significantly impacted by an income tax benefit recorded in the quarter ended April 30, 2014 attributable to the release of $45.2 million of Verint valuation allowances. We maintain valuation allowances on our net U.S. deferred income tax assets related to federal and certain state jurisdictions. In connection with the acquisition of KANA during the quarter ended April 30, 2014, we recorded deferred income tax liabilities primarily attributable to acquired intangible assets to the extent the amortization will not be deductible for income tax purposes. Under accounting guidelines, because the amortization of the intangible assets in future periods provides a source of taxable income, we expect to realize a portion of our existing deferred income tax assets. As such, in the quarter ended April 30, 2014, we reduced the valuation allowance recorded on our deferred income tax assets to the extent of the deferred income tax liabilities recorded. Because the valuation allowance related to existing Verint deferred income tax assets, the impact of the release was reflected as a discrete income tax benefit in the quarter ended April 30, 2014 and not as a component of the KANA acquisition accounting. The result was a $36.6 million benefit for income taxes on a pre-tax loss of $18.1 million, which represented an effective rate of 201.8%. The effective income tax rate was affected by the mix and levels of income and losses among taxing jurisdictions. Pre-tax income in our profitable jurisdictions, where we recorded tax provisions, was less than our domestic losses where we maintain valuation allowances and did not record the related tax benefits. Excluding the income tax benefit attributable to the valuation allowance release, the result for the six months ended July 31, 2014 was an income tax provision of $8.6 million on a pre-tax loss $18.1 million, resulting in a negative effective tax rate of 47.6%. 48-------------------------------------------------------------------------------- Table of Contents For the six months ended July 31, 2013, the effective income tax rate was significantly impacted by the level and mix of earnings and losses by jurisdiction. The effective income tax rate was also reduced because CTI received a favorable ruling from the Internal Revenue Service which resulted in adjustments to deferred taxes and an indemnified tax liability. Pre-tax income in our profitable jurisdictions, where we recorded income tax provisions, was higher than our domestic losses where we maintain valuation allowances and did not record the related income tax benefits. The result was an income tax provision of $5.9 million on pre-tax income of $16.5 million, which resulted in an effective income tax rate of 35.9%. The comparison of our effective income tax rates between periods is significantly impacted by the level and mix of earnings and losses by tax jurisdiction, foreign income tax rate differentials, amount of permanent book to tax differences, the impact of unrecognized income tax income benefits, and the effects of valuation allowances on certain loss jurisdictions. Backlog The delivery cycles of most of our products are generally very short, ranging from days to several months, with the exception of certain projects with multiple deliverables over longer periods of time. Therefore, we do not view backlog as a meaningful indicator of future business activity and do not consider it a meaningful financial metric for evaluating our business. Liquidity and Capital Resources Overview Our primary source of cash is the collection of proceeds from the sale of products and services to our customers, including cash periodically collected in advance of delivery or performance. Our primary recurring use of cash is payment of our operating costs, which consist primarily of employee-related expenses, such as compensation and benefits, as well as general operating expenses for marketing, facilities and overhead costs, and capital expenditures. We also utilize cash for debt service under our Credit Agreement and our Notes, and periodically for business acquisitions. Cash generated from operations is our primary source of operating liquidity, and we believe that internally generated cash flows are sufficient to support our current business operations, including debt service and capital expenditure requirements. In February 2014, in connection with our acquisition of KANA, we borrowed $125.0 million under our 2013 Revolving Credit Facility and we also incurred $300.0 million of incremental term loans under our Credit Agreement, both for purposes of funding a portion of the purchase price for KANA. In June 2014, we completed concurrent public offerings of 5,750,000 shares of our common stock and $400.0 million in aggregate principal amount of 1.50% convertible senior notes due June 1, 2021. The aggregate net proceeds from the concurrent offerings were $657.5 million, after deducting underwriters' discounts and commissions, but excluding other offering expenses. We used $15.6 million of the net proceeds to pay the net costs of an arrangement consisting of the purchase of call options and the sale of warrants to purchase our common stock, the intent of which is to reduce the potential dilution to our common stock upon conversion of the Notes. We used the majority of the remainder of the net proceeds to repay a portion of the outstanding indebtedness under our Credit Agreement. Also in June 2014, we amended our Credit Agreement to increase the lending commitments under our March 2013 Revolving Credit Facility to $300.0 million and extended the facility's term by approximately six months to September 6, 2018. Further discussion of our Credit Agreement, Notes, call options and warrants appears below, under "Financing Arrangements". We have historically expanded our business in part by investing in strategic growth initiatives, including acquisitions of products, technologies, and businesses. We have used cash as consideration for substantially all of our historical business acquisitions, including approximately $517 million of net cash expended to acquire KANA in February 2014, funded through a combination of cash on hand, and as described above, incremental term loans and borrowings under our 2013 Revolving Credit Facility. We also expended approximately $83 million of cash on hand to acquire UTX in March 2014. We continually examine our options with respect to terms and sources of existing and future long and short-term capital resources to enhance our operating results and to ensure that we retain financial flexibility, and may from time to time elect to raise additional equity or debt capital in the capital markets. A considerable portion of our operating income is earned outside the United States. Cash, cash equivalents, short-term investments, and restricted cash and bank time deposits (including any long-term portions) held by our subsidiaries outside the United States were $251.9 million and $268.6 million as of July 31, 2014 and January 31, 2014, respectively, and are generally used to fund the subsidiaries' operating requirements and to invest in company growth initiatives, including business acquisitions. Cash on hand in the United States was utilized to fund a portion of the purchase price for KANA, and cash on 49-------------------------------------------------------------------------------- Table of Contents hand outside of the United States was utilized to fund the purchase price for UTX. We currently do not anticipate that we will need funds generated from foreign operations to fund our domestic operations for the next 12 months and for the foreseeable future. Should other circumstances arise whereby we require more capital in the United States than is generated by our domestic operations, or should we otherwise consider it in our best interests, we could repatriate future earnings from foreign jurisdictions, which could result in higher effective tax rates. We have not provided for deferred income taxes on the excess of the amount for financial reporting over the tax basis of investments in our foreign subsidiaries because we currently plan to indefinitely reinvest such earnings outside the United States. The following table sets forth our cash and cash equivalents, restricted cash and bank time deposits, short-term investments and long-term debt as of July 31, 2014 and January 31, 2014: July 31, January 31, (in thousands) 2014 2014 Cash and cash equivalents $ 186,669 $ 378,618 Restricted cash and bank time deposits $ 41,336 $ 6,423 Short-term investments $ 39,361 $ 32,049 Long-term debt: Gross long-term debt $ 811,207 $ 645,212 Unamortized debt discounts (79,255 ) (2,827 ) Net long-term debt $ 731,952 $ 642,385 At July 31, 2014, our cash and cash equivalents totaled $186.7 million, a decrease of $191.9 million from $378.6 million at January 31, 2014. During the six months ended July 31, 2014, we expended approximately $185 million of cash on hand for three business acquisitions, including associated financing fees. The increase in unamortized debt discounts at July 31, 2014, compared to January 31, 2014, resulted from a discount recorded on our 1.50% convertible senior notes, which were issued in June 2014, further details regarding which appear in Note 6, "Long-Term Debt" to our condensed consolidated financial statements included under Item 1 of this report. During the six months ended July 31, 2014, our operating activities generated $70.4 million of cash, our financing activities generated $396.6 million of net cash, and our investing activities used $659.2 million of net cash. Further discussion of these items appears below. Consolidated Cash Flow Activity The following table summarizes selected items from our condensed consolidated statements of cash flows for the six months ended July 31, 2014 and 2013: Six Months Ended July 31, (in thousands) 2014 2013 Net cash provided by operating activities $ 70,373 $ 72,658 Net cash used in investing activities (659,208 ) (106,353 ) Net cash provided by financing activities 396,601 54,379 Effect of exchange rate changes on cash and cash equivalents 285 (1,473 ) Net (decrease) increase in cash and cash equivalents $ (191,949 ) $ 19,211 Net Cash Provided by Operating Activities Net cash provided by operating activities is driven primarily by our net income or loss, adjusted for non-cash items, and working capital changes. Operating activities generated $70.4 million of net cash during the six months ended July 31, 2014, compared to $72.7 million generated during the six months ended July 31, 2013. Operating cash flow for the six months ended July 31, 2014, compared to the prior-year six-month period, was adversely impacted by $7.9 million of higher interest expense payments, as well as net income tax payments of $3.9 million, compared to net income tax refunds of $3.9 million in the prior-year six-month period. Excluding payments or refunds of interest and income taxes, net cash provided by operating activities was $93.3 million for the six months ended July 31, 2014, compared to $79.8 million for the six months ended July 31, 2013. 50-------------------------------------------------------------------------------- Table of Contents Operating activity cash flow for the six months ended July 31, 2013 included the payment of a $7.2 million investment banking fee associated with the CTI Merger. The improved operating cash flow, excluding the impact of interest and income taxes, resulted primarily from our higher revenue for the six months ended July 31, 2014, which contributed to higher accounts receivable collections and customer deposits, compared to the six months ended July 31, 2013. Although our operating income decreased in the six months ended July 31, 2014 compared to the prior-year six-month period, our operating cash flow was not adversely impacted because the lower operating income included increases in non-cash depreciation, amortization, and stock-based compensation expenses, which increased from $41.0 million to $72.3 million. Net Cash Used in Investing Activities During the six months ended July 31, 2014, our investing activities used $659.2 million of net cash, the primary component of which was $602.9 million of net cash utilized for business acquisitions, including KANA in February 2014 and UTX in March 2014. We also had a $36.5 million increase in restricted cash and bank time deposits during this period. Restricted cash and bank time deposits are typically short-term deposits used to secure bank guarantees in connection with sales contracts, the amounts of which will fluctuate from period to period. The increase in restricted cash and bank time deposits during the six months ended July 31, 2014 reflected deposits associated with several large sales contracts. In addition, we made $12.3 million of payments for property, equipment, and capitalized software development costs, and made $7.4 million of net purchases of short-term investments, during the period. During the six months ended July 31, 2013, our investing activities used $106.4 million of net cash, primarily reflecting $105.0 million of net purchases of short-term investments. We expanded our short-term investing activity during the six months ended July 31, 2013 to increase returns on funds provided by the period's operating and financing activities. We also made $7.2 million of payments for property, equipment, and capitalized software development costs during this period. As of July 31, 2014, we had no significant capital expenditure commitments. Net Cash Provided by Financing Activities For the six months ended July 31, 2014, our financing activities provided $396.6 million of net cash. In connection with the February 3, 2014 acquisition of KANA, we incurred $300.0 million of incremental term loans and borrowed $125.0 million under our 2013 Revolving Credit Facility. Additionally, in March 2014, we incurred $643.5 million of new term loans, the proceeds of which were used to repay $643.5 million of prior term loans. In June 2014, we completed concurrent public offerings of 5,750,000 shares of our common stock, gross proceeds from which were $274.6 million, and $400.0 million in aggregate principal amount of 1.50% convertible senior notes due June 1, 2021. We used $15.6 million of the net proceeds from these offerings to pay the net costs of an arrangement consisting of the purchase of call options and the sale of warrants to purchase our common stock, the intent of which is to reduce the potential dilution to our common stock upon conversion of the Notes. We used the majority of the remainder of the net proceeds to retire $530.0 million of the February 2014 Term Loans and March 2014 Term Loans, and all $106.0 million of then-outstanding borrowings under the 2013 Revolving Credit Facility. In connection with these various financing activities, we paid $27.7 million of debt and equity issuance costs, including underwriting discounts and commissions associated with the public offerings. Other financing activities during the six months ended July 31, 2014 included payments of $6.0 million for the financing portion of payments under contingent consideration arrangements related to prior business combinations, the receipt of $8.6 million of proceeds from exercises of stock options, and payments of $2.2 million for purchases of treasury stock. For the six months ended July 31, 2013, our financing activities provided $54.4 million of net cash. During this period, we borrowed $646.7 million under our Credit Agreement (gross borrowings of $650.0 million, reduced by a $3.3 million original issuance discount), repaid $576.0 million of outstanding borrowings under a prior credit agreement, and paid $7.8 million of related debt issuance costs. We also received $10.4 million of cash in connection with the CTI Merger during this period. Other financing activities during the six months ended July 31, 2013 included payments of $15.4 million for the financing portion of payments under contingent consideration arrangements related to prior business combinations, and the receipt of $2.6 million of proceeds from exercises of stock options. Liquidity and Capital Resources Requirements Based on past performance and current expectations, we believe that our cash, cash equivalents, short-term investments and cash generated from operations will be sufficient to meet anticipated operating costs, required payments of principal and interest, working capital needs, ordinary course capital expenditures, research and development spending, and other 51-------------------------------------------------------------------------------- Table of Contents commitments for at least the next 12 months. Currently, we have no plans to pay any cash dividends on our common stock, which are not permitted under our Credit Agreement. Financing Arrangements 1.50% Convertible Senior Notes On June 18, 2014, we issued $400.0 million in aggregate principal amount of 1.50% convertible senior notes due June 1, 2021, unless earlier converted by the holders pursuant to their terms. The Notes pay interest in cash semiannually in arrears at a rate of 1.50% per annum. The Notes were issued concurrently with our issuance of 5,750,000 shares of common stock, the majority of the combined net proceeds of which were used to partially repay certain indebtedness under our Credit Agreement, as further described below. The Notes are unsecured and rank senior in right of payment to our indebtedness that is expressly subordinated in right of payment to the Notes; equal in right of payment to our indebtedness that is not so subordinated; effectively subordinated in right of payment to any of our secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally subordinated to indebtedness and other liabilities of our subsidiaries. The Notes are convertible into, at our election, cash, shares of common stock, or a combination of both, subject to satisfaction of specified conditions and during specified periods, as described below. If converted, we currently intend to pay cash in respect of the principal amount. The conversion price of the Notes at any time is equal to $1,000 divided by the then-applicable conversion rate. The Notes have an initial conversion rate of 15.5129 shares of common stock per $1,000 principal amount of Notes, which represents an initial effective conversion price of approximately $64.46 per share of common stock and would result in the issuance of approximately 6,205,000 shares if all of the Notes were converted. Throughout the term of the Notes, the conversion rate may be adjusted upon the occurrence of certain events. Holders may surrender their Notes for conversion at any time prior to the close of business on the business day immediately preceding December 1, 2020, only under the following circumstances: • during any calendar quarter commencing after the calendar quarter ending on September 30, 2014, if the closing sale price of our common stock, for at least 20 trading days (whether or not consecutive) in the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter, is more than 130% of the conversion price of the Notes in effect on each applicable trading day; • during the ten consecutive trading-day period following any five consecutive trading-day period in which the trading price for the Notes for each such trading day was less than 98% of the closing sale price of our common stock on such date multiplied by the then-current conversion rate; or • upon the occurrence of specified corporate events, as described in the indenture governing the Notes, such as a consolidation, merger, or binding share exchange. On or after December 1, 2020 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may surrender their Notes for conversion regardless of whether any of the foregoing conditions have been satisfied. If we satisfy our conversion obligation in solely cash or a combination of cash and shares of common stock, the amount of cash and shares of common stock, if any, due upon conversion will be based on a daily conversion value for each trading day in a 50 trading-day conversion period. Holders will not receive any additional cash payment or additional shares of common stock representing accrued and unpaid interest, if any, upon conversion of a Note, except in limited circumstances. Instead, interest will be deemed to be paid by the consideration delivered upon conversion of a Note. The conversion rate for the Notes is subject to adjustment as described in the indenture governing the Notes. An adjustment to the conversion rate will result in a corresponding (but inverse) adjustment to the conversion price. If specified "make-whole adjustment events" occur, the conversion rate for any Notes converted in connection with such make-whole adjustment event will, in specified circumstances, be increased by a number of additional shares of common stock. In 52-------------------------------------------------------------------------------- Table of Contents addition, holders may require us to purchase for cash all or any portion of their Notes upon the occurrence of a "fundamental change" at a price equal to 100% of the principal amount of the Notes being purchased, plus accrued and unpaid interest to, but excluding, the fundamental change purchase date. As of July 31, 2014, the Notes were not convertible. Note Hedges and Warrants Concurrently with the issuance of the Notes, we entered into convertible note hedge transactions (the "Note Hedges") and sold warrants (the "Warrants"). The combination of the Note Hedges and the Warrants serves to increase the effective initial conversion price for the Notes to $75.00 per share. The Note Hedges and Warrants are each separate instruments from the Notes. Note Hedges Pursuant to the Note Hedges, we purchased call options on our common stock, under which we have the right to acquire from the counterparties up to approximately 6,205,000 shares of our common stock, subject to customary anti-dilution adjustments, at a price of $64.46, which equals the initial conversion price of the Notes. Our exercise rights under the Note Hedges generally trigger upon conversion of the Notes and the Note Hedges terminate upon maturity of the Notes, or the first day the Notes are no longer outstanding. The Note Hedges may be settled in cash, shares of our common stock, or a combination thereof, at our option, and are intended to reduce our exposure to potential dilution upon conversion of the Notes. We paid $60.8 million for the Note Hedges, which was recorded as a reduction to additional paid-in capital. As of July 31, 2014, we had not purchased any shares under the Note Hedges. Warrants We sold the Warrants to several counterparties. The Warrants provide the counterparties rights to acquire from us up to approximately 6,205,000 shares of our common stock at a price of $75.00 per share. The Warrants expire incrementally on a series of expiration dates beginning in August 2021. At expiration, if the market price per share of our common stock exceeds the strike price of the Warrants, we will be obligated to issue shares of our common stock having a value equal to such excess. The proceeds from the sale of the Warrants were $45.2 million and were recorded as additional paid-in capital. As of July 31, 2014, no Warrants had been exercised and all Warrants remained outstanding. Credit Agreement As of January 31, 2014, our Credit Agreement provided for $850.0 million of senior secured credit facilities, including $650.0 million of term loans maturing in September 2019, of which $645.1 million was outstanding at January 31, 2014, and a $200.0 million 2013 Revolving Credit Facility maturing in March 2018, under which there were no borrowings at January 31, 2014. The credit facility was subject to a maximum increase of $300.0 million and reduction from time to time. As noted above, in February 2014, in connection with our acquisition of KANA, we borrowed $125.0 million under the 2013 Revolving Credit Facility and we also incurred $300.0 million under the February 2014 Term Loans, which are incremental term loans under an amendment to our Credit Agreement, both for purposes of funding a portion of the purchase price for KANA. In March 2014, we refinanced the $643.5 million of outstanding March 2013 Term Loans with the proceeds of the March 2014 Term Loans, primarily for purposes of reducing the interest rate on such loans. We also amended our Credit Agreement in February and March 2014 to, among other things, (i) change the basis for determining the interest rate on borrowings under the 2013 Revolving Credit Facility, (ii) increase the permitted amount of incremental term loans and revolving credit commitments (beyond the incremental term loans borrowed in February 2014) by up to an aggregate of $200.0 million plus an additional amount such that our leverage ratio (as defined in the Credit Agreement) would not exceed a specified maximum ratio, (iii) permit us to issue convertible indebtedness (as defined in the Credit Agreement), (iv) permit us to refinance all or a portion of any existing term loans with replacement term loans, and (v) extend by one year, to January 31, 2016, the step-down date of the leverage ratio covenant applicable to the 2013 Revolving Credit Facility. On June 18, 2014, we utilized the majority of the combined net proceeds from the issuance of the Notes and the concurrent issuance of 5,750,000 shares of common stock to retire $530.0 million of the February 2014 Term Loans and March 2014 Term Loans, and to repay all $106.0 million of then-outstanding borrowings under the 2013 Revolving Credit Facility. 53-------------------------------------------------------------------------------- Table of Contents Also in June 2014, we further amended our Credit Agreement to increase the lending commitments under our March 2013 Revolving Credit Facility to $300.0 million and extended the facility's term by approximately six months to September 6, 2018. As of July 31, 2014, we had an aggregate $411.1 million of February 2014 Term Loans and March 2014 Term Loans outstanding, bearing interest at an annual rate of 3.50%. Following the partial retirements of the term loans in June 2014, there are no scheduled principal payments on the term loans until August 2016. The vast majority of the term loans are due upon maturity in September 2019. There were no outstanding borrowings under the 2013 Revolving Credit Facility at July 31, 2014. The 2013 Revolving Credit Facility contains a financial covenant that requires us to maintain a ratio of Consolidated Total Debt to Consolidated EBITDA (each as defined in the Credit Agreement) of no greater than 5.00 to 1 until January 31, 2016 and no greater than 4.50 to 1 thereafter (the "Leverage Ratio Covenant"). At July 31, 2014, our consolidated leverage ratio was approximately 2.4 to 1 compared to a permitted consolidated leverage ratio of 5.00 to 1, and our EBITDA for the twelve-month period then ended exceeded by at least $139.0 million the minimum EBITDA required to satisfy the Leverage Ratio Covenant given our outstanding debt as of such date. Contractual Obligations Our Annual Report on Form 10-K for the year ended January 31, 2014 includes a table summarizing our contractual obligations of approximately $909 million as of January 31, 2014, including approximately $788 million for long-term debt obligations, including projected future interest. This table appears under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in that report. As described above under "Financing Arrangements", during the six months ended July 31, 2014, we incurred additional long-term debt in connection with our acquisition of KANA, executed several amendments to our Credit Agreement, issued the Notes, issued common stock, and repaid a portion of our outstanding indebtedness. As a result, our long-term debt obligations, including projected future interest, have increased from approximately $788 million at January 31, 2014 to approximately $930 million at July 31, 2014. Details regarding our long-term debt obligations are provided in Note 6, "Long-Term Debt" to our condensed consolidated financial statements included under Item 1 of this report. Additional operating lease obligations that we assumed upon the February 3, 2014 acquisition of KANA and March 31, 2014 acquisition of UTX were less than $10.0 million and are not included in the contractual obligations table in our Annual Report on Form 10-K for the year ended January 31, 2014. Other than the impact of the transactions described above, we believe that our contractual obligations and commercial commitments did not materially change during the six months ended July 31, 2014. Contingent Payments Associated with Business Combinations In connection with certain of our business combinations, we have agreed to make contingent cash payments to the former owners of the acquired companies based upon achievement of performance targets following the acquisition dates. For the six months ended July 31, 2014, we made $7.0 million of payments under contingent consideration arrangements. As of July 31, 2014, potential future cash payments and earned consideration expected to be paid subsequent to July 31, 2014 under contingent consideration arrangements total $38.1 million, the estimated fair value of which was $15.7 million, including $7.4 million reported in accrued expenses and other current liabilities, and $8.3 million reported in other liabilities. The performance periods associated with these potential payments extend through January 2019. Off-Balance Sheet Arrangements As of July 31, 2014, we did not have any off-balance sheet arrangements that we believe have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Recent Accounting Pronouncements New Accounting Pronouncements Implemented In March 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2013-05, Foreign Currency Matters (Topic 830): Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity. This 54 -------------------------------------------------------------------------------- new standard is intended to resolve diversity in practice regarding the release into net income of a cumulative translation adjustment upon derecognition of a subsidiary or group of assets within a foreign entity. ASU No. 2013-05 was effective prospectively for us on February 1, 2014. The adoption of this standard did not impact our condensed consolidated financial statements. New Accounting Pronouncements To Be Implemented In April 2014, the FASB issued ASU No. 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. ASU No. 2014-08 raises the threshold for a disposal to qualify as a discontinued operation and requires new disclosures of both discontinued operations and certain other disposals that do not meet the definition of a discontinued operation. It is effective for annual reporting periods beginning on or after December 15, 2014. Early adoption is permitted but only for disposals that have not been reported in previously issued financial statements. We are currently reviewing this standard, but we do not expect its adoption to materially impact our condensed consolidated financial statements, absent any disposals of components or groups of components that have a material effect on our financial results in future periods. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). ASU No. 2014-09 supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific revenue recognition guidance throughout the Industry Topics of the Accounting Standards Codification. Additionally, this update supersedes some cost guidance included in Subtopic 605-35, Revenue Recognition-Construction-Type and Production-Type Contracts. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. It is effective for the first interim period within annual reporting periods beginning after December 15, 2016, and early adoption is not permitted. Entities may choose from two adoption methods, with certain practical expedients. We are currently reviewing this standard to assess the impact on our future condensed consolidated financial statements and evaluating the available adoption methods. In June 2014, the FASB issued ASU No. 2014-10, Development Stage Entities (Topic 915): Elimination of Certain Financial Reporting Requirements, Including an Amendment to Variable Interest Entities Guidance in Topic 810, Consolidation. ASU No. 2014-10 removes the financial reporting distinction between development stage entities and other reporting entities from GAAP and it eliminates an exception provided in the consolidation guidance for development stage enterprises. It is effective for fiscal years, and interim periods within those years, beginning after December 15, 2015, although early adoption is permitted. We are currently reviewing this standard to assess the impact on our future condensed consolidated financial statements. In June 2014, the FASB issued ASU No. 2014-12, Compensation-Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period, which requires that a performance target that affects vesting, and that could be achieved after the requisite service period, be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant date fair value of the award. ASU No. 2014-12 is effective for annual reporting periods beginning after December 15, 2015, including interim periods within that reporting period, although early adoption is permitted. We are currently reviewing this standard to assess the impact on our future condensed consolidated financial statements. |