Item 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis is qualified by reference to, and should be read in conjunction with, the Consolidated Financial Statements of Datawatch and its subsidiaries which appear elsewhere in this Annual Report on Form 10-K.

GENERAL

Introduction

Datawatch is engaged in the design, development, manufacture, marketing, and support of business computer software primarily for the Business Intelligence and Enterprise Information Management markets which include business intelligence, enterprise content management and service management solutions to allow organizations to access and analyze information in a more meaningful fashion.

The Company’s principal products are Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch BI Server, Datawatch ES, Datawatch Dashboards, Datawatch Researcher, Visual Insight, iMergence and VorteXML), Content Management Solutions (including Datawatch BDS and Datawatch MailManager) and Service Management Solutions (including Visual QSM and Visual HD). Included in the above categories are: Monarch, a desktop report mining and business intelligence application that lets users extract and manipulate data from ASCII report files, PDF files or HTML files produced on any mainframe, midrange, client/server or PC system; Monarch Data Pump, a data replication and migration tool that offers a shortcut for populating and refreshing data marts and data warehouses, for migrating legacy data into new applications and for providing automated delivery of reports in a variety of formats via email; Monarch RMS, a web-based report

 

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mining and analysis solution that integrates with any existing Enterprise Report Management document or content management archiving solution; Monarch BI Server, an out-of-the-box web-based Business Intelligence solution developed specifically for small to mid-sized businesses and departments; Datawatch ES, an enterprise business intelligence system that provides web-enabled report management, mining and distribution as well as data analysis and MS Excel integration; Datawatch Dashboards, an interactive dashboard solution that provides a visual overview of operational performance as well as the ability to monitor specific business processes and events; Datawatch Researcher, a development platform for building performance management, content and data aggregation and workflow solutions; Visual Insight, a performance management solution that provides web-based knowledge management and Key Performance Indicator reporting; iMergence, an enterprise report mining system; VorteXML, a data transformation product for the emerging XML market that easily and quickly converts structured text output from any system into valid XML for web services and more using any DTD or XDR schema without programming; Datawatch BDS, a system for high-volume document capture, archiving, and online presentation; Datawatch MailManager, a highly scalable email management solution that provides complete lifecycle, compliance and storage management for Microsoft Exchange environments; Visual QSM, a fully internet-enabled IT service management solution that incorporates workflow and network management capabilities and provides web access to multiple databases via a standard browser; and Visual Help Desk or Visual HD, a web-based help desk and call center solution operating on the IBM Lotus Domino platform.

The Company offers its enterprise products through perpetual licenses and subscription pricing models. Subscriptions automatically renew unless terminated with 90 days notice following the first year of the subscription term. The subscription arrangement includes software, maintenance and unspecified future upgrades including major version upgrades. The subscription renewal rate is the same as the initial subscription rate. During fiscal years 2009, 2008 and 2007 subscription revenues were approximately $489,000, $600,000 and $649,000, respectively.

CRITICAL ACCOUNTING POLICIES

In the preparation of financial statements and other financial data, management applies certain accounting policies to transactions that, depending on choices made by management, can result in different outcomes. In order for a reader to understand the following information regarding the financial performance and condition of the Company, an understanding of those accounting policies is important. Certain of those policies are comparatively more important to the Company’s financial results and condition than others. The policies that the Company believes are most important for a reader’s understanding of the financial information provided in this report are described below.

Revenue Recognition, Allowance for Bad Debts and Returns Reserve

The Company has two types of software product offerings: Enterprise Software and Desktop and Server Software. Enterprise Software products are generally sold directly to end-users and through the use of value added resellers. The Company sells its Desktop and Server Software products directly to end-users and through distributors and resellers. Sales to distributors and resellers accounted for approximately 40%, 41% and 39%, of total sales for fiscal years 2009, 2008 and 2007, respectively. Revenue from the sale of all software products (when separately sold) is generally recognized at the time of shipment, provided there are no uncertainties surrounding product acceptance, the fee is fixed and determinable, collection is considered probable, persuasive evidence of the arrangement exists and there are no significant obligations remaining. Both types of the Company’s software product offerings are “off-the-shelf” as such term is customarily defined. The Company’s software products can be installed and used by customers on their own with little or no customization required. Multi-user licenses marketed by the Company are sold as a right to use the number of licenses and license fee revenue is recognized upon delivery of all software required to satisfy the number of licenses sold. Upon delivery, the licensing fee is payable without further delivery obligations of the Company.

Desktop and Server Software products are generally not sold in multiple element arrangements. Enterprise Software sales are generally multiple element arrangements which may include software licenses, professional services and post-contract customer support. In such multiple element arrangements, the Company applies the

 

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residual method in determining revenue to be allocated to the software license. In applying the residual method, the Company deducts from the sale proceeds the vendor specific objective evidence (“VSOE”) of fair value of the professional services and post-contract customer support in determining the residual fair value of the software license. The VSOE of fair value of the services and post-contract customer support is based on the amounts charged for these elements when sold separately. Professional services include implementation, integration, training and consulting services with revenue recognized as the services are performed. These services are generally delivered on a time and materials basis, are billed on a current basis as the work is performed, and do not involve modification or customization of the software or any other unusual acceptance clauses or terms. Post-contract customer support is typically provided under a maintenance agreement which provides technical support and rights to unspecified software maintenance updates and bug fixes on a when-and-if available basis. Revenue from post-contract customer support services is deferred and recognized ratably over the contract period (generally one year). Such deferred amounts are recorded as part of deferred revenue in the Company’s Consolidated Balance Sheets included herein.

The Company also licenses its Enterprise Software using a subscription model. At the time a customer enters into a binding agreement to purchase a subscription, the customer is invoiced for an initial 90 day service period and an account receivable and deferred revenue are recorded. Beginning on the date the software is installed at the customer site and available for use by the customer, and provided that all other criteria for revenue recognition are met, the deferred revenue amount is recognized ratably over the period the service is provided. The customer is then invoiced every 90 days and revenue is recognized ratably over the period of the subscription. The subscription arrangement includes software, maintenance and unspecified future upgrades including major version upgrades. The subscription renewal rate is the same as the initial subscription rate. Subscriptions can be cancelled by the customer at any time by providing 90 days written notice following the first year of the subscription term.

The Company’s software products are sold under warranty against certain defects in material and workmanship for a period of 30 days from the date of purchase. Certain software products, including desktop versions of Monarch, Monarch Data Pump, BI Server and VorteXML sold directly to end-users, include a guarantee under which such customers may return products within 30 days for a full refund. Additionally, the Company provides its distributors with stock-balancing rights. Revenue from the sale of software products to distributors and resellers is recognized at the time of shipment providing all other criteria for revenue recognition as stated above are met and (i) the distributor or reseller is unconditionally obligated to pay for the products, including no contingency as to product resale, (ii) the distributor or reseller has independent economic substance apart from the Company, (iii) the Company is not obligated for future performance to bring about product resale, and (iv) the amount of future returns can be reasonably estimated. The Company’s experience and history with its distributors and resellers allows for reasonable estimates of future returns. Among other things, estimates of potential future returns are made based on the inventory levels at the various distributors and resellers, which the Company monitors frequently. Once the estimates of potential future returns from all sources are made, the Company determines if it has adequate returns reserves to cover anticipated returns and the returns reserve is adjusted as required. Adjustments are recorded as increases or decreases in revenue in the period of adjustment. Actual returns have historically been within the range estimated by the Company. The Company’s returns reserves were $55,000 and $65,000 as of September 30, 2009 and 2008, respectively.

The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. The Company analyzes accounts receivable and the composition of the accounts receivable aging, historical bad debts, customer creditworthiness, current economic trends, foreign currency exchange rate fluctuations and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Based upon the analysis and estimates of the collectibility of its accounts receivable, the Company records an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Actual results could differ from the allowances for doubtful accounts recorded, and this difference may have a material effect on the Company’s financial position and results of operations. The Company’s allowance for doubtful accounts was $160,000 and $171,000 as of September 30, 2009 and 2008, respectively.

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Income Taxes

The Company has deferred tax assets primarily related to net operating loss carryforwards and tax credits that expire at different times through and until 2028. At September 30, 2009, the Company had U.S. federal tax loss carryforwards of approximately $6.5 million, expiring at various dates through 2028, including $366,000 resulting from the Mergence acquisition undertaken during 2004 which are subject to additional annual limitations as a result of the changes in Mergence’s ownership, and had approximately $867,000 in state tax loss carryforwards, which also expire at various dates through 2028. An alternative minimum tax credit of approximately $166,000 is available to offset future regular federal taxes. Research and development credits of approximately $525,000 expire beginning in 2011. In addition, the Company has the following foreign net operating loss carryforwards: United Kingdom losses of $8.5 million with no expiration date and Australian losses of $2.7 million with no expiration date.

Significant judgment is required in determining the Company’s provision for income taxes, the carrying value of deferred tax assets and liabilities and the valuation allowance recorded against net deferred tax assets.  Factors such as future reversals of deferred tax assets and liabilities, projected future taxable income, changes in enacted tax rates and the period over which the Company’s deferred tax assets will be recoverable are considered in making these determinations. Management does not believe the deferred tax assets are more likely than not to be realized and therefore a full valuation allowance has been provided against the deferred tax assets at September 30, 2009 and 2008. Management evaluates the realizability of the deferred tax assets quarterly and, if current economic conditions change or future results of operations are better than expected, future assessments may result in the Company concluding that it is more likely than not that all or a portion of the deferred tax assets are realizable. If this conclusion were reached, the valuation allowance against deferred tax assets would be reduced resulting in a tax benefit being recorded for financial reporting purposes. Total net deferred tax assets subject to the full valuation allowance were approximately $5.4 million as of September 30, 2009. In relation to the Company’s asset purchase of the IDARS business, the applicable goodwill associated with this purchase was determined to be fully impaired and written off for book purposes under generally accepted accounting principles during fiscal year 2009 but is deductible over a 15 year life for tax reporting purposes. Accordingly, upon impairment, the Company recorded a deferred tax asset, with a corresponding full valuation allowance, for the future tax benefit of the goodwill based on the Company’s effective tax rate for the period. Prior to the full impairment assessment and write off of this goodwill, the Company was recording, for each reporting period, deferred tax expense and an offsetting deferred tax liability on the difference in tax amortization of intangibles with indefinite lives for US GAAP purposes based on the Company’s effective tax rate for the period. Deferred tax benefit recorded for the fiscal year 2009 was approximately $266,000. Deferred tax expense recorded for the fiscal years ended September 30, 2008 and 2007 was approximately $115,000 and $111,000, respectively.

 The Company adopted the new accounting requirements for uncertain tax positions on October 1, 2007. The comprehensive model addresses the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. In accordance with these requirements, the Company first determines whether a tax authority would “more likely than not” sustain its tax position if it were to audit the position with full knowledge of all the relevant facts and other information. For those tax positions that meet this threshold, the Company measures the amount of tax benefit based on the largest amount of tax benefit that the Company has a greater than 50% chance of realizing in a final settlement with the relevant authority. Those tax positions failing to qualify for initial recognition are recognized in the first interim period in which they meet the more likely than not standard, or are resolved through negotiation or litigation with the taxing authority, or upon expiration of the statute of limitations. The Company maintains a cumulative risk portfolio relating to all of its uncertainties in income taxes in order to perform this analysis, but the evaluation of the Company’s tax positions requires significant judgment and estimation in part because, in certain cases, tax law is subject to varied interpretation, and whether a tax position will ultimately be sustained may be uncertain. The actual outcome of the Company’s tax positions, if significantly different from its estimates, could materially impact the financial statements.

Upon adoption of the accounting requirements for uncertain tax positions, the Company recorded a reduction of its deferred tax asset in the amount of $690,000 and a corresponding reduction to the tax asset valuation reserve

 

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of $690,000 for all identified uncertain tax positions, for any years open under the statute of limitations. At that time, the Company also recorded a $75,000 tax liability fully related to foreign tax exposure. During each of the fiscal years ended September 30, 2008 and 2009, the Company increased its tax liability by $25,000, resulting in a cumulative tax liability of $125,000 at September 30, 2009. These amounts have been recorded as an increase to other long-term liabilities on the Company’s Consolidated Balance Sheets.

Capitalized Software Development Costs

The Company capitalizes certain software development costs as well as purchased software upon achieving technological feasibility of the related products. Software development costs incurred and software purchased prior to achieving technological feasibility are charged to research and development expense as incurred.  Commencing upon initial product release, capitalized costs are amortized to the cost of software licenses using the straight-line method over the estimated life of the product (which approximates the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product) which is generally 18 to 36 months. The net amount of capitalized software development costs and purchased software was approximately $1,106,000 and $664,000 at September 30, 2009 and 2008, respectively. During fiscal 2009, the Company capitalized approximately $831,000 of software development costs related to new products in development.

Goodwill, Other Intangible Assets and Other Long-Lived Assets

The Company concluded based on an impairment analysis conducted at March 31, 2009 that its goodwill was fully impaired, as described below. The Company generally performs an evaluation of whether goodwill is impaired annually or when events occur or circumstances change that would more likely than not reduce the fair value of the applicable reporting unit below its carrying amount. To the extent goodwill exists, the annual impairment analysis is performed on May 31’st of each applicable fiscal year. Factors the Company considers important in determining whether to conduct an interim impairment review include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the Company’s overall business, significant negative industry or economic trends, a significant decline in the Company’s stock price for a sustained period, and decreases in our market capitalization below the recorded amount of our net assets for a sustained period.

Other intangible assets consist of internally developed software costs, acquired technology, patents, customer lists, trademarks, and non-compete agreements acquired through business combinations. The values allocated to these intangible assets are amortized using the straight-line method over the estimated useful life of the related asset. The Company reviews other intangible assets and other long-lived assets whenever an indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Should the fair value of the Company’s long-lived assets decline because of reduced operating performance, market declines, or other indicators of impairment, a charge to operations for impairment may be necessary. No impairment charges were taken for amortizing intangible assets during fiscal year 2009.

The Company performed interim tests of impairment for its goodwill and its indefinite lived trademark at September 30, 2008, December 31, 2008 and again at March 31, 2009 due to uncertainties surrounding the global economy and the volatility in the Company’s stock price. The Company tested goodwill for impairment using a two-step approach. The first step was to compare the fair value of the Company (which consists of one reporting unit) to its carrying amount, including goodwill. If the fair value of the reporting unit is greater than its carrying amount, goodwill is not considered impaired, but if the fair value of the reporting unit is less than its carrying amount, the amount of the impairment loss, if any, must be measured. An impairment loss is recognized to the extent that the carrying amount of the reporting unit exceeds the reporting unit’s fair value. The Company estimated its fair value using the best information available, including market information and discounted cash flow projections also referred to as the income approach. The income approach used future estimated operating results and cash flows that were discounted using a weighted-average cost of capital that reflected current market conditions. These projections utilized management’s best estimates of economic and market conditions over the projected period, including growth rates in revenues, costs, estimates of future expected changes in operating

 

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margins and cash expenditures. Other significant estimates and assumptions included terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. The Company validated its estimates of fair value under the income approach by comparing the values to fair value estimates using a market approach. The market approach estimated fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples were derived from comparable publicly traded companies with similar operating and investment characteristics of the reporting unit.

The results of the Company’s impairment analysis at March 31, 2009 indicated that the Company’s book value exceeded its estimated fair value. Further analysis indicated that the Company’s goodwill was fully impaired. Therefore, the Company recorded a non-cash impairment charge of approximately $6.1 million in the three months ended March 31, 2009.

The Company tested its indefinite lived intangible asset for impairment by comparing the fair value to the net book value of the asset. The Company estimated the fair value of its trademark using the relief-from-royalty method, which required assumptions related to projected revenues and assumed royalty rates that could be payable if it did not own the trademark, as well as an estimated discount rate. The results of the Company’s valuation analysis at March 31, 2009 indicated that the trademark was fully impaired at March 31, 2009. Therefore, the Company recorded a non-cash impairment charge of approximately $285,000 in the three months ended March 31, 2009.
 

Accounting for Stock-Based Compensation

The Company recognizes stock-based compensation expense in accordance with generally accepted accounting principles which require that all share-based awards, including grants of employee stock options, be recognized in the financial statements based on their fair value.

The Company recognizes the fair value of share-based awards over the requisite service period of the individual awards, which generally equals the vesting period. For the fiscal year ended September 30, 2009, the Company recorded stock-based compensation expense of approximately $213,000. In order to determine the fair value of stock options on the date of grant, the Company applies the Black-Scholes option-pricing model. Inherent in this model are assumptions related to expected stock-price volatility, option life, risk-free interest rate and dividend yield. While the risk-free interest rate and dividend yield are less subjective assumptions, typically based on factual data derived from public sources, the expected stock-price volatility and option life assumptions require a greater level of judgment which makes them critical accounting estimates.

The Company uses an expected stock-price volatility assumption that is based on historical volatilities of the underlying stock which are obtained from public data sources. The Company believes this approach results in a reasonable estimate of volatility. For stock option grants issued during the fiscal year ended September 30, 2009, the Company used an expected stock-price volatility of 73% based upon the historical volatility at the time of issuance.

With regard to the expected option life assumption, the Company considers the exercise behavior of past grants and models the pattern of aggregate exercises. Patterns are determined on specific criteria of the aggregate pool of optionees including the reaction to vesting, realizable value and short-time-to-maturity effect. For stock option grants issued during the year ended September 30, 2009, the Company used an expected option life assumption of 5 years.

With regard to the forfeiture rate assumption, the Company reviews historical voluntary turnover rates. For stock option grants issued during the fiscal year ended September 30, 2009, the Company used an annual estimated forfeiture rate of 10%. Additional expense will be recorded if the actual forfeiture rate is lower than estimated, and a recovery of prior expense will be recorded if the actual forfeiture rate is higher than estimated.

 

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RESULTS OF OPERATIONS

The following table sets forth certain statements of operations data as a percentage of total revenues for the periods indicated. The data has been derived from the Company’s consolidated financial statements. The operating results for any period should not be considered indicative of the results expected for any future period.

 

		Year Ended September 30,
		2009				2008				2007
REVENUE:
Software licenses and subscriptions			55.7	%			54.0	%			58.8	%
Maintenance and services			44.3				46.0				41.2
Total revenue			100.0				100.0				100.0
COSTS AND EXPENSES:
Cost of software licenses and subscriptions			11.5				9.6				9.8
Cost of maintenance and services			16.0				18.5				15.6
Sales and marketing			32.7				35.4				36.8
Engineering and product development			12.4				12.9				11.7
General and administrative			21.8				21.4				19.3
Impairment of goodwill and other intangible assets			32.6				—				—
Total costs and expenses			127.0				97.8				93.2
INCOME (LOSS) FROM OPERATIONS			(27.0	)			2.2				6.8
Interest expense			—				—				(0.1	)
Interest income and other income (expense), net			1.0				1.6				0.4
INCOME (LOSS) BEFORE INCOME TAXES			(26.0	)			3.8				7.1
Benefit (provision) for income taxes			0.8				(0.7	)			(0.5	)
NET INCOME (LOSS)			(25.2	)			3.1				6.6

Fiscal Year Ended September 30, 2009 as Compared to

Fiscal Year Ended September 30, 2008

Total Revenues

The following table presents total revenue, total revenue decrease and percentage change in total revenue for the years ended September 30, 2009 and 2008:

 

		Year Ended September 30,								Increase				Percentage
		2009				2008				(Decrease)				Change
		(In thousands)
Software licenses and subscriptions		$	10,931			$	12,435			$	(1,504	)			-12.1	%
Maintenance and services			8,687				10,595				(1,908	)			-18.0	%
Total revenue		$	19,618			$	23,030			$	(3,412	)			-14.8	%

 

Revenue for the fiscal year ended September 30, 2009 was $19,618,000, which represents a decrease of $3,412,000 or approximately 15% from revenue of $23,030,000 for the fiscal year ended September 30, 2008. For fiscal 2009, Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch BI Server, Datawatch ES, Datawatch Dashboards, Visual Insight, iMergence and VorteXML), Content Management Solutions (including Datawatch BDS) and Service Management Solutions (including Visual QSM and Visual HD) revenue accounted for 71%, 17%, and 12% of total revenue, respectively, as compared to 67%, 16%, and 17%, respectively, for fiscal 2008.

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Software license and subscription revenue for the fiscal year ended September 30, 2009 was $10,931,000 or approximately 56% of total revenue, as compared to $12,435,000 or approximately 54% of total revenue for the fiscal year ended September 30, 2008. This represents a decrease of $1,504,000 or approximately 12% from fiscal 2008. The overall decrease in software license and subscription revenue consists of a $1,394,000 decrease in Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Datawatch BI Server, Datawatch ES, Datawatch Dashboards, Visual Insight, iMergence and VorteXML products), a $185,000 decrease in Service Management Solutions (including Visual QSM and Visual HD products) and a $75,000 increase in Content Management Solutions (including Datawatch BDS). The Company attributes the overall decrease in software licenses and subscription revenue to lower currency exchange rates in 2009 for the British Pound as compared to the U.S. dollar, softened demand for computer software due to the worldwide recession, and customers’ redistributing licenses of laid off employees internally. The decrease in Business Intelligence Solutions is primarily due to decreased Monarch license sales as a result of the global recession as compared to fiscal 2008.

Maintenance and services revenue for the fiscal year ended September 30, 2009 was $8,687,000 or approximately 44% of total revenue, as compared to $10,595,000 or approximately 46% of total revenue for the fiscal year ended September 30, 2008. This represents a decrease of $1,908,000 or approximately 18% from fiscal 2008. The decrease in maintenance and services revenue consists of a $1,309,000 decrease in Service Management Solutions (including Visual QSM and Visual HD products), a $467,000 decrease in Content Management Solutions (including Datawatch BDS) and a $132,000 decrease in Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch BI Server, Datawatch ES, Datawatch Dashboards, Visual Insight, iMergence and VorteXML products). The Company attributes the overall decreases in maintenance and services revenue to lower currency exchange rates in 2009 for the British Pound as compared to the U.S. Dollar, softened demand for computer software due to the worldwide recession, and lower renewal rates of annual maintenance contracts from existing customers. The decrease in Service Management Solutions revenue was also the result of less demand for professional services work related to this product line while customers waited for the release of the Company’s Visual QSM for the Web product which was introduced in the third quarter of fiscal 2009.

Costs and Operating Expenses

The following table presents costs and operating expenses, increase (decrease) in costs and operating expenses and percentage changes in costs and operating expenses for the years ended September 30, 2009 and 2008:

 

		Year Ended September 30,								Increase /				Percentage
		2009				2008				(Decrease)				Change
		(in thousands)
Cost of software licenses and subscriptions		$	2,248			$	2,218			$	30				1.4	%
Cost of maintenance and services			3,135				4,271				(1,136	)			-26.6	%
Sales and marketing			6,423				8,153				(1,730	)			-21.2	%
Engineering and product development			2,433				2,966				(533	)			-18.0	%
General and administrative			4,272				4,923				(651	)			-13.2	%
Impairment of goodwill and other intangible assets			6,401				—				6,401
Total costs and operating expenses		$	24,912			$	22,531			$	2,381				10.6	%

Cost of software licenses and subscriptions for the fiscal year ended September 30, 2009 was $2,248,000 or approximately 21% of software license and subscription revenues, as compared to $2,218,000 or approximately 18% of software license and subscription revenues for the fiscal year ended September 30, 2008. Cost of software licenses and subscriptions as a percent of software license and subscription revenue has remained relatively consistent year over year. The dollar increase in cost of software licenses and subscriptions is primarily due to higher software amortization costs associated with new products released during fiscal 2009.

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Cost of maintenance and services for the fiscal year ended September 30, 2009 was $3,135,000 or approximately 36% of maintenance and service revenue, as compared to $4,271,000 or approximately 40% of maintenance and service revenue for the fiscal year ended September 30, 2008. The decrease in the total cost of maintenance and services is primarily due to lower headcount and employee-related costs as well as lower use of external consultants in 2009 as compared to fiscal 2008.

Sales and marketing expenses for the fiscal year ended September 30, 2009 were $6,423,000, or 33% of total revenue as compared to $8,153,000, or approximately 35% of total revenue for fiscal 2008.  The decrease in sales and marketing expenses of $1,730,000, or approximately 21%, is primarily due to lower headcount and employee-related costs and commissions due to lower revenues. Additionally, the Company incurred fewer promotional and travel-related expenses during the fiscal year ended September 30, 2009 due to the worldwide recession.

Engineering and product development expenses were $2,433,000, or 12% of total revenue for the fiscal year ended September 30, 2009 as compared to $2,966,000, or 13% of total revenue in fiscal 2008. The decrease in engineering and product development expenses of $533,000, or approximately 18%, is primarily attributable to higher capitalized software costs from new product development as well as savings due to lower headcount and employee-related costs.

General and administrative expenses were $4,272,000, or 22% of total revenue for the fiscal year ended September 30, 2009 as compared to $4,923,000 or 21% of total revenue in fiscal 2008. The decrease in general and administrative expenses of $651,000, or approximately 13%, is primarily attributable to lower accounting and auditing fees, lower Sarbanes-Oxley compliance costs, and decreased use of outside consultants.

Impairment of goodwill and other intangible assets of $6,401,000 in fiscal 2009 is attributable to the full impairment of the Company’s goodwill totaling $6,116,000 and an indefinite lived trademark totaling $285,000 which were recorded in the second quarter of fiscal 2009. In conducting its interim impairment analysis at March 31, 2009, management took into account the effects of the global economic recession, including, among other factors, that Company revenues were lower than expected in the three months ended March 31, 2009. The results of the impairment analysis at March 31, 2009 indicated that the Company’s book value exceeded its estimated fair value and that the Company’s goodwill was fully impaired, resulting in a non-cash impairment charge of approximately $6,116,000. The results of the Company’s interim impairment analysis of its indefinite lived trademark indicated that the trademark was fully impaired at March 31, 2009 resulting in a non-cash impairment charge of approximately $285,000.

Interest income and other income (expense) for fiscal year 2009 includes primarily the following two components: interest income; and miscellaneous income. Interest income for the fiscal year ended September 30, 2009 was $29,000 as compared to $130,000 for fiscal 2008. Interest income was lower due to lower interest rates in 2009 due to the worldwide recession. Miscellaneous income for the fiscal year ended September 30, 2009 was $26,000 as compared to $15,000 for fiscal 2008. Interest income and other income (expense) for the fiscal year ended September 30, 2008 also included a $147,000 gain on the complete dissolution of the Company’s French and German subsidiaries (Datawatch France SARL and Datawatch GmbH). This amount represented the cumulative effect of translation adjustments related to the consolidation of these subsidiaries which were previously accumulated and reported in the shareholders’ equity section of the Company’s consolidated balance sheets.

Gain on foreign currency transactions for the fiscal year ended September 30, 2009 was $138,000 as compared to $79,000 for the fiscal year ended September 30, 2008.

Income tax benefit for the year ended September 30, 2009 was $161,000 as compared to income tax expense of $153,000 for the year ended September 30, 2008. The income tax benefit for 2009 was primarily attributable to the reversal of the Company’s deferred tax liability of $319,000 related to its goodwill from the IDARS acquisition which was determined to be fully impaired at March 31, 2009. The income tax provision for fiscal 2008 primarily represents deferred tax expense related to the tax-deductible goodwill generated by the Company’s

 

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acquisition of the business assets of IDARS. The goodwill resulting from this transaction was deductible for tax purposes and, prior to the 2009 impairment, a deferred tax expense was recognized for financial reporting purposes equal to the tax rate on the excess of tax amortization over the amortization for financial reporting purposes.

Net loss for the year ended September 30, 2009 was $4,940,000 as compared to net income of $717,000 for the year ended September 30, 2008. Net loss for fiscal 2009 includes the impairment of goodwill and an indefinite lived trademark of $6,401,000. Excluding the effects of the goodwill and trademark impairment charge, non-GAAP net income for the year ended September 30, 2009 would have been $1,142,000, or $0.19 per diluted share, as compared to $717,000, or $0.12 per diluted share, for the year ended September 30, 2008.

Fiscal Year Ended September 30, 2008 as Compared to

Fiscal Year Ended September 30, 2007

Total Revenues

The following table presents total revenue, total revenue increase (decrease) and percentage change in total revenue for the years ended September 30, 2008 and 2007:

 

		Year Ended September 30,								Increase				Percentage
		2008				2007				(Decrease)				Change
		(In thousands)
Software licenses and subscriptions		$	12,435			$	14,852			$	(2,417	)			-16.3	%
Maintenance and services			10,595				10,407				188				1.8	%
Total revenue		$	23,030			$	25,259			$	(2,229	)			-8.8	%

 

Revenue for the fiscal year ended September 30, 2008 was $23,030,000, which represents a decrease of $2,229,000 or approximately 9% from revenue of $25,259,000 for the fiscal year ended September 30, 2007. For fiscal 2008, Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Monarch BI Server, Datawatch ES, Visual Insight, iMergence and VorteXML), Content Management Solutions (including Datawatch BDS) and Service Management Solutions (including Visual QSM and Visual HD) revenue accounted for 67%, 16%, and 17% of total revenue, respectively, as compared to 67%, 14%, and 19%, respectively, for fiscal 2007.

Software license and subscription revenue for the fiscal year ended September 30, 2008 was $12,435,000 or approximately 54% of total revenue, as compared to $14,852,000 or approximately 59% of total revenue for the fiscal year ended September 30, 2007. This represents a decrease of $2,417,000 or approximately 16% from fiscal 2007. The overall decrease in software license and subscription revenue consists of a $1,858,000 decrease in Business Intelligence Solutions (including Monarch, Monarch Data Pump, Monarch RMS, Datawatch BI Server, Datawatch ES, Visual Insight, iMergence and VorteXML products), a $144,000 decrease in Content Management Solutions (including Datawatch BDS) and a $415,000 decrease in Service Management Solutions (including Visual QSM and Visual HD products). The decrease in Business Intelligence Solutions is primarily due to decreased Monarch license sales as compared to fiscal 2007. Sales from the Company’s Monarch product were significantly higher during fiscal 2007 following the release of upgrade version 9.0 in February 2007.

Maintenance and services revenue for the fiscal year ended September 30, 2008 was $10,595,000 or approximately 46% of total revenue, as compared to $10,407,000 or approximately 41% of total revenue for the fiscal year ended September 30, 2007. This represents an increase of $188,000 or approximately 2% from fiscal 2007. The increase in maintenance and services revenue consists of a $554,000 increase in Business Intelligence Solutions

 

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(including Monarch, Monarch Data Pump, Monarch RMS, Monarch BI Server, Datawatch ES, Visual Insight, iMergence and VorteXML products) and a $191,000 increase in Content Management Solutions (including Datawatch BDS) which were partially offset by a $557,000 decrease in Service Management Solutions (including Visual QSM and Visual HD products). The Company attributes the overall increases in maintenance and services revenue to continued customer loyalty, which has resulted in high renewal rates for annual maintenance service contracts and an increased demand for professional services from existing customers, which also includes upgrades and additional training. The decrease in maintenance revenue for the Service Management Solutions product line was the result of lower renewal rates of annual maintenance contracts from existing customers. The decrease in Service Management Solutions revenue was also the result of less demand for professional services work related to this product line. No significant product upgrades were introduced within the Visual QSM or Visual Help Desk product lines during fiscal year 2008.

Costs and Operating Expenses

The following table presents costs and operating expenses, increase (decrease) in costs and operating expenses and percentage changes in costs and operating expenses for the years ended September 30, 2008 and 2007:

 

		Year Ended September 30,								Increase /				Percentage
		2008				2007				(Decrease)				Change
		(in thousands)
Cost of software licenses and subscriptions		$	2,218			$	2,468			$	(250	)			-10.1	%
Cost of maintenance and services			4,271				3,943				328				8.3	%
Sales and marketing expenses			8,153				9,290				(1,137	)			-12.2	%
Engineering and product development expenses			2,966				2,951				15				0.5	%
General and administrative expenses			4,923				4,872				51				1.0	%
Total costs and operating expenses		$	22,531			$	23,524			$	(993	)			-4.2	%

Cost of software licenses and subscriptions for the fiscal year ended September 30, 2008 was $2,218,000 or approximately 18% of software license and subscription revenues, as compared to $2,468,000 or approximately 17% of software license and subscription revenues for the fiscal year ended September 30, 2007. Cost of software licenses and subscriptions as a percentage of software licenses and subscription revenue have remained relatively consistent year over year. The dollar decrease in cost of software licenses and subscriptions is primarily due to lower royalty costs associated with lower sales of Monarch during fiscal 2008. As previously described, sales of the Company’s Monarch product were significantly higher during fiscal 2007 due to the release of version 9.0 in February 2007.

Cost of maintenance and services for the fiscal year ended September 30, 2008 was $4,271,000 or approximately 40% of maintenance and service revenue, as compared to $3,943,000 or approximately 38% of maintenance and service revenue for the fiscal year ended September 30, 2007. The increase in total cost of maintenance and services is primarily due to higher employee-related costs due to increased headcount and higher incentive compensation costs as compared to fiscal 2007.

Sales and marketing expenses for the fiscal year ended September 30, 2008 were $8,153,000, or 35% of total revenue as compared to $9,290,000, or approximately 37% of total revenue for fiscal 2007.  The decrease in sales and marketing expenses of $1,137,000, or approximately 12%, is primarily attributable to cost savings resulting from the Company’s restructuring plan which was initiated and completed during the first quarter of fiscal year 2007 and resulted in lower headcount. Additionally, the Company incurred fewer consulting and travel-related expenses during the fiscal year ended September 30, 2008 as compared to fiscal 2007.

Engineering and product development expenses were $2,966,000, or 13% of total revenue for the fiscal year ended September 30, 2008 as compared to $2,951,000, or 12% of total revenue in fiscal 2007. The slight increase in engineering and product development expenses of $15,000, or approximately 1%, is primarily attributable to the increased use of external development consultants and employee-related costs, net of capitalized software.

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General and administrative expenses were $4,923,000, or 21% of total revenue for the fiscal year ended September 30, 2008 as compared to $4,872,000, or 19% of total revenue in fiscal 2007. The increase in general and administrative expenses of $51,000, or approximately 1%, is primarily attributable to higher accounting and auditing fees and compliance costs associated with Section 404 of the Sarbanes-Oxley Act.

Interest expense for the fiscal year ended September 30, 2007 was $33,000 which resulted from the Company’s $1 million borrowing under its line of credit in the third quarter of fiscal 2006. There was no interest expense for the fiscal year ended September 30, 2008 as the Company elected to repay its outstanding balance under its line of credit in the second quarter of fiscal 2007.

Interest income and other income (expense) includes primarily the following two components: interest income; and a gain on the dissolution of the Company’s French and German subsidiaries (Datawatch France SARL and Datawatch GmbH). Interest income for the fiscal year ended September 30, 2008 was $130,000 as compared to $40,000 for fiscal 2007. The increase in interest income was the result of higher cash balances held in interest-bearing accounts. Additionally, during fiscal 2008, there was a gain of $147,000 recorded upon the complete dissolution of two of the Company’s foreign subsidiaries: Datawatch France SARL and Datawatch GmbH. This amount represents the cumulative effect of translation adjustments related to the consolidation of these subsidiaries which were previously accumulated and reported in the shareholders’ equity section of the Company’s consolidated balance sheets.

Gain (loss) on foreign currency transactions for the fiscal year ended September 30, 2008 was a gain of $79,000 as compared to a loss of $7,000 for the fiscal year ended September 30, 2007.

Income tax expense for the year ended September 30, 2008 was $153,000 as compared to $133,000 for the year ended September 30, 2007. Income tax expense for both periods includes additional deferred tax expense related to the tax-deductible goodwill generated by the Company’s acquisition of the business assets of IDARS. The goodwill resulting from this transaction is deductible for tax purposes and a deferred tax expense is recognized for financial reporting purposes equal to the tax rate on the excess of tax amortization over the amortization for financial reporting purposes, which is zero unless there is an impairment. The increase in income taxes of $20,000 is a result of additional deferred tax expense related to the earn-out provisions of the IDARS acquisition and uncertain tax positions relative to foreign taxes.

Net income for the year ended September 30, 2008 was $717,000 as compared to net income of $1,669,000 for the year ended September 30, 2007.

OFF BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS

The Company leases various facilities and equipment in the U.S. and overseas under noncancelable operating leases that expire through 2011. The lease agreements generally provide for the payment of minimum annual rentals, pro rata share of taxes, and maintenance expenses. Rental expense for all operating leases was approximately $318,000, $440,000 and $511,000 for fiscal years 2009, 2008 and 2007, respectively.

As of September 30, 2009, contractual obligations include minimum rental commitments under non-cancelable operating leases and long-term liabilities related to uncertain tax positions as follows (in thousands):

 

						Less than 1												More than
Contractual Obligations:		Total				Year				1-3 Years				3-5 Years				5 Years
Operating Lease
Obligations		$	561			$	324			$	235			$	2			$	—
Other Liabilities		$	125			$	—			$	—			$	—			$	125

 

The Company is also obligated to pay royalties ranging from 7% to 50% on revenue generated by the sale of certain licensed software products. Royalty expense included in cost of software licenses was approximately

 

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$1,580,000, $1,779,000 and $1,865,000 respectively, for the years ended September 30, 2009, 2008 and 2007.  The Company is not obligated to pay any minimum amounts for royalties.

On August 11, 2004, the Company acquired 100% of the shares of Mergence Technologies Corporation. The purchase agreement includes a provision for quarterly cash payments to the former Mergence shareholders equal to 10% of revenue, as defined, of the Datawatch Researcher and Visual Insight products until September 30, 2010. The Company expensed approximately $5,000, $4,000 and $17,000 for the fiscal years ended September 30, 2009, 2008 and 2007, respectively, for royalty payments to Mergence.

The Company’s software products are sold under warranty against certain defects in material and workmanship for a period of 30 days from the date of purchase. If necessary, the Company would provide for the estimated cost of warranties based on specific warranty claims and claim history. However, the Company has never incurred significant expense under its product or service warranties. As a result, the Company believes the estimated fair value of these warranty agreements is minimal. Accordingly, there are no liabilities recorded for warranty claims as of September 30, 2009.

The Company is required by a sublease agreement related to its Chelmsford, Massachusetts facility to provide a letter of credit originally in the amount of $125,000 as a security deposit to the landlord of amounts due under the lease. In accordance with the terms of its sublease agreement, the Company was allowed to reduce its letter of credit to $107,000 following the completion of the first three years of its lease arrangement, which occurred during the first quarter of fiscal year 2009. Cash on deposit providing security in the amount of this letter of credit is classified as restricted cash in the Company’s consolidated balance sheets as of September 30, 2009 and 2008.

The Company enters into indemnification agreements in the ordinary course of business. Pursuant to these agreements, the Company generally agrees to indemnify, hold harmless, and reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its customers, in connection with any patent, copyright or other intellectual property infringement claim by any third party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these potential obligations is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of September 30, 2009.

Certain of the Company’s agreements also provide for the performance of services at customer sites. These agreements may contain indemnification clauses, whereby the Company will indemnify the customer from any and all damages, losses, judgments, costs and expenses for acts of its employees or subcontractors resulting in bodily injury or property damage. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has general and umbrella insurance policies that would enable it to recover a portion of any amounts paid. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these potential obligations is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of September 30, 2009.

As permitted under Delaware law, the Company has agreements with its directors whereby the Company will indemnify them for certain events or occurrences while the director is, or was, serving at the Company’s request in such capacity. The term of the director indemnification period is for the later of ten years after the date that the director ceases to serve in such capacity or the final termination of proceedings against the director as outlined in the indemnification agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company’s director and officer insurance policy would enable it to recover a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes the estimated fair value of these potential obligations is minimal. The Company has no liabilities recorded for these potential obligations as of September 30, 2009.

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LIQUIDITY AND CAPITAL RESOURCES

Management believes that its current cash balances and cash generated from operations will be sufficient to meet the Company’s cash needs for working capital and anticipated capital expenditures for at least the next twelve months. At September 30, 2009, the Company had $5,649,000 of cash and equivalents, an increase of $764,000 from September 30, 2008.

At September 30, 2009, the Company had working capital of approximately $2,627,000 as compared to $1,130,000 as of September 30, 2008. The Company expects cash flows from operations to remain positive as it anticipates profitability in the future. However, if the Company’s cash flow from operations were to decline significantly, it may need to consider further reductions to its operating expenses. The Company does not anticipate additional cash requirements to fund significant growth or the acquisition of complementary technology or businesses. However, if in the future, such expenditures are anticipated or required, the Company may need to seek additional financing by issuing equity or obtaining credit facilities to fund such requirements. There can be no assurance that the Company will be able to issue additional equity or obtain a new credit facility at attractive prices or rates, or at all.

The Company had a net loss of approximately $4,940,000 for the year ended September 30, 2009 which was the result of a non-cash impairment charge of $6.4 million related to the impairment of goodwill and a trademark, as compared to net income of approximately $717,000 for the year ended September 30, 2008 and net income of approximately $1,669,000 for the year ended September 30, 2007. During the years ended September 30, 2009 and 2008, approximately $1,968,000 and $1,838,000, respectively, of cash was provided by the Company’s operations. During fiscal year 2009, the main source of cash from operations was net income adjusted for the impairment of goodwill and other intangible assets and adjusted for depreciation and amortization as well as a decrease in accounts receivable.

Net cash used in investing activities for the year ended September 30, 2009 of $909,000 is primarily related to capitalization of software development costs and the purchase of property and equipment.

Net cash provided by financing activities for the year ended September 30, 2009 of $1,000 is related to proceeds from the exercise of stock options.

The Mergence purchase agreement dated August 11, 2004 includes a provision for quarterly cash payments to the former Mergence shareholders equal to 10% of revenue, as defined, of the Datawatch Researcher and Visual Insight products for a period of six years. As the cash payments are based on recognized revenue and no minimum payments are required, they are not expected to have a significant impact on the Company’s liquidity or cash flows. See the section titled “Off Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments” included elsewhere herein for a more complete disclosure of the Company’s commitments and contingent liabilities.

An existing agreement between Datawatch and Math Strategies grants the Company exclusive worldwide rights to use and distribute through April 30, 2015 certain intellectual property owned by Math Strategies and incorporated by the Company in its Monarch, Monarch Data Pump, VorteXML and certain other products. The Company has also entered into an Option Purchase Agreement with Math Strategies giving the Company the option to purchase these intellectual property rights for a formula price based on a multiple of the aggregate royalties paid to Math Strategies by the Company for the four fiscal quarters preceding the exercise of the option. The option, if exercised, would provide the Company with increased flexibility to utilize the purchased technology in the future.

Management believes that the Company’s current operations have not been materially impacted by the effects of inflation.

 

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RECENT ACCOUNTING PRONOUNCEMENTS

In December 2007, the Financial Accounting Standards Board (“FASB”) issued guidance that established principles and requirements for determining how a company recognizes and measures in its financial statements the fair value of certain assets and liabilities acquired in a business combination, including non-controlling interests, contingent consideration, and certain acquired contingencies. The revised guidance on business combinations also requires acquisition-related transaction expenses and restructuring costs be expensed as incurred rather than capitalized. The guidance will be applied prospectively to business combinations beginning in the year ending September 30, 2010.

In February 2008, the FASB issued guidance that established principles and disclosure requirements for fair value measurements and disclosures, that delayed the effective date of fair value measurements accounting for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The adoption of this update to non-financial assets and liabilities became effective for the Company on October 1, 2009 and did not have any impact on the Company’s consolidated financial statements.

In May 2009, the FASB issued guidance that establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The guidance was effective for fiscal years and interim periods ending after June 15, 2009. The implementation of this standard did not have a material impact on the Company’s consolidated financial statements.

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Item 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The following consolidated financial statements and the related notes thereto of Datawatch Corporation and the Report of Independent Registered Public Accounting Firm thereon are filed as part of this Annual Report on Form 10-K.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM	32
CONSOLIDATED FINANCIAL STATEMENTS AS OF SEPTEMBER 30, 2009 AND 2008 AND FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED SEPTEMBER 30, 2009:
Consolidated Balance Sheets	33
Consolidated Statements of Operations	34
Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss)	35
Consolidated Statements of Cash Flows	36
Notes to Consolidated Financial Statements	37

 

 

 

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CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

		September 30,				September 30,
		2009				2008
ASSETS
CURRENT ASSETS:
Cash and equivalents		$	5,649			$	4,885
Accounts receivable, less allowance for doubtful accounts and sales returns of $215,000 in 2009 and $236,000 in 2008			2,968				3,287
Inventories			65				57
Prepaid expenses			340				361
Total current assets			9,022				8,590
Property and equipment:
Office furniture and equipment			1,136				1,157
Software			464				560
Leasehold improvements			509				509
			2,109				2,226
Less accumulated depreciation and amortization			(1,611	)			(1,489	)
Net property and equipment			498				737
Goodwill			—				6,116
Other intangible assets, net			2,397				2,577
Restricted cash			107				125
Other long-term assets			19				24
Total assets		$	12,043			$	18,169
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable		$	761			$	1,028
Accrued expenses			1,915				2,385
Deferred revenue			3,719				4,047
Total current liabilities			6,395				7,460
LONG-TERM LIABILITIES:
Deferred rent			55				120
Deferred revenue - long-term			302				145
Deferred tax liability			—				262
Other liabilities			125				100
Total long-term liabilities			482				627
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS’ EQUITY:
Common stock, par value $.01; 20,000,000 shares authorized; issued, 5,940,085 shares and 5,928,604 shares, respectively; outstanding, 5,925,839 shares and 5,914,358 shares, respectively			59				59
Additional paid-in capital			23,634				23,421
Accumulated deficit			(17,370	)			(12,430	)
Accumulated other comprehensive loss			(1,017	)			(828	)
			5,306				10,222
Less treasury stock, at cost, 14,246 shares			(140	)			(140	)
Total shareholders’ equity			5,166				10,082
Total liabilities and shareholders' equity		$	12,043			$	18,169

 

See notes to consolidated financial statements.

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DATAWATCH CORPORATION