ITEM 2.
PROPERTIES
Our principal headquarters is located in approximately 105,000 square feet of space in Mountain View, California. This facility is leased through December 2009. Our principal research and development facility is located in approximately 96,000 square feet of space in Palo Alto, California. This facility is leased through August 2006. Our principal technical support facility is located in approximately 98,000 square feet of space in Burlington, Ontario. This facility is leased through September 2010. Through our acquisition of OTG, we have approximately 94,000 square feet of space in Rockville, Maryland, which will be used primarily as a research and development facility. This facility is leased through May 2011. We also currently lease other domestic offices throughout the United States, as well as international offices throughout the world.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
On or about July 26, 2001, a class action lawsuit was filed in the Southern District of New York naming OTG, officers of OTG who signed the registration statement in connection with OTG’s initial public offering, and the managing underwriters of the initial public offering as defendants. The complaint alleges that OTG’s initial public offering registration statement and final prospectus contained material misrepresentations and/or omissions, related in part to additional, excessive and undisclosed commissions allegedly received by the underwriters from investors to whom the underwriters allegedly improperly allocated shares of the public offering. The complaint seeks relief in the form of damages and/or rescission of the plaintiff’s purchase transaction. Since this initial complaint was filed, three other complaints making similar or identical allegations and seeking similar relief have been filed. All of the actions brought against OTG have been consolidated, and are being heard along with other similar actions brought against approximately 300 other issuers, issuers’ officers and underwriters in the Southern District of New York. On July 19, 2002, the defendants filed a motion to dismiss the complaint. We intend to defend the action vigorously and believe that it is not possible at the current time to estimate the amount of a probable loss, if any, that might result from this matter.
On July 1, 2002, we received notice that an action captioned Nickel v. Kay, et al. had been filed in the Circuit Court for Montgomery County, Maryland. The action, brought by a former OTG employee, asserts claims that Richard Kay, OTG and Legato are liable under various legal theories for the alleged breach of Mr. Nickel’s employment contract and breach of fiduciary duties allegedly owed to Mr. Nickel. The complaint alleges compensatory and punitive damages, to be proven at trial. The case is in its preliminary stages, and an investigation of the facts is not complete. We intend to defend this action vigorously; however the outcome is uncertain at this time. Although insurance may be available to cover some portion of any potential liability, an adverse judgment could be materially adverse to our operating results.
On or about November 20, 2002, we received an arbitration demand filed with the American Arbitration Association by Buro- und Datentechnik, an OTG European reseller. The reseller alleges that OTG misrepresented information concerning the capabilities of certain OTG products during 2001, and OTG’s intentions with respect to development plans for those products. On that basis, the reseller asserts that it is entitled to compensatory damages. Although insurance may be available to cover some portion of any potential liability, an adverse arbitration award could be materially adverse to our operating results.
On January 15, 2003, we received a notice of potential claim from the former shareholders of Intelliguard, Inc., a company purchased by Legato in April 1999. They allege that the Company and certain of its former officers made certain misrepresentations, upon which they relied when they agreed to sell Intelliguard to the Company. No formal legal action has been commenced, and the parties intend to pursue informal discussions in an effort to determine whether the former Intelliguard shareholders will proceed with their claims. We believe the Company has numerous meritorious defenses to any action brought by the Intelliguard shareholders, and if any action is brought, we intend to defend the action vigorously. At this time, we believe that it is not possible to estimate the amount of a probable loss, if any, that might result from this matter.
In addition to the foregoing matters, we are parties to various other lawsuits and disputes regarding commercial and employment matters arising in the ordinary course of operations. We believe that the amounts in dispute in these other matters are insubstantial, and the effect of these matters, individually and in the aggregate, would not be material to our operating results.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF STOCKHOLDERS
We did not submit any matters to a vote of stockholders during the fourth quarter of the fiscal year ended December 31, 2002.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
Our common stock is traded on the Nasdaq National Market under the symbol LGTO. As of January 31, 2003, there were 515 record holders of our common stock. We have never declared or paid a cash dividend on our common stock and do not intend to pay cash dividends on our common stock in the foreseeable future. The following table sets forth the high and low closing sales prices of our common stock for each quarter in the two-year period ended December 31, 2002.
ITEM 6.
ITEM 6.
SELECTED CONSOLIDATED FINANCIAL DATA
Five-Year Summary
(1)
Net loss for the year ended December 31, 2002 includes a provision for a valuation allowance against net deferred tax assets of $124.3 million, a litigation settlement charge of $67.0 million, restructuring charges of $11.7 million and in-process research and development of $32.2 million. Net loss for the year ended December 31, 2001 includes restructuring charges of $9.4 million and impairment of intangible of $48.9 million.
(2)
See Note 2 of Notes to Consolidated Financial Statements.
(3)
Selected financial data for the year-ended December 31, 1998 was derived by combining Legato’s selected financial data for the year ended December 31, 1998 with FullTime’s financial data for the twelve-months ended December 31, 1998.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The discussion in this report on Form 10-K contains forward-looking statements that involve risks and uncertainties. The statements contained in this Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements on our expectations, beliefs, intentions or strategies regarding the future, including without limitation, our financial outlook, successful introduction of new products and expansion of operation. In some cases, forward-looking statements can be identified by terminology such as “may,” “will,” “should,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negatives of these or other comparable terminology. All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those indicated in such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, fluctuations in quarterly operating results, uncertainty in future operating results, litigation, competition, product concentration, technological changes, reliance on enterprise license transactions, reliance on indirect sales channels, changes in marketing strategies, dependence on international revenue, management of our growth and expansion, the ability to attract and retain qualified personnel and other risks discussed in this item under the heading “Risk Factors” and the risks discussed in our other Securities and Exchange Commission filings.
Overview
We develop, market and support storage software products and services worldwide. Our solutions protect and manage information, assure the availability of applications and provide immediate access to business-critical information in distributed open systems environments. Our solutions provide enterprise level customers the business continuity and operational efficiency to maintain a constant state of access to, and availability of, business-critical information. Our solutions recognize the interdependence between data and applications. Information management within an enterprise includes the protection, recovery and archiving of data, the management of performance and operation of applications, the optimization of storage devices and media including disk and tape, and the capture, organization and immediate access to content and messages. Our heterogeneous software products are mostly found in distributed, open systems which are generally understood to include UNIX, Windows NT, Windows 2000 and Linux server and storage computer systems.
OTG Software, Inc. On May 14, 2002, we completed our acquisition of OTG for cash and stock at a value of $382.5 million. OTG, based in Rockville, Maryland, provides data management and collaboration solutions that virtualize storage for any type of data, including files, messages and databases, while providing easy and transparent access. OTG provides us with complementary channels, markets and technology, which will enable us to expand our opportunities by offering robust storage, content and email management solutions. We believe the combined company will have the scale, scope and worldwide channel access to leverage OTG’s strengths in data access and business applications such as email. Today, we market the OTG Software products under the XtenderSolutions® brand.
The OTG acquisition was accounted for under SFAS No. 141, “Business Combinations,” and certain specified provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” The results of the operations of OTG were included in our Consolidated Statement of Operations since May 15, 2002. OTG had approximately 400 employees at the time of the acquisition. Refer to Note 6 of our Consolidated Financial Statements.
Critical Accounting Policies
In preparing our financial statements, we must make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses during the reporting period. The areas that require significant judgment are as follows:
Revenue recognition and allowances for doubtful accounts and product returns. An assessment of our customers’ ability to pay is one of the considerations that affect revenue recognition. In some cases, we sell to undercapitalized resellers in emerging markets. As such, we defer revenue recognition until cash is received, the reseller has established a history of making timely payments or the reseller’s financial condition has improved. Furthermore, once we have recognized revenue, we must evaluate our accounts receivable at each period end for amounts that we believe are no longer collectible. This evaluation is largely done based on comments received from the customer and/or our sales personnel, a review of financial condition via credit agencies and our historical experience with the customer. The unexpected filing of a bankruptcy petition by a customer or reseller may impact our evaluation of accounts receivable in any given period. However, this risk is mitigated by the fact that our accounts receivable is dispersed among a large number of customers. As of December 31, 2002, no customer accounted for more than 10% of our accounts receivable. For each reporting period, we must also estimate the amount of product that will be returned for reasons, which include, among others, wrong product ordered, duplicate orders and excessive quantities. Our estimates are computed using our historical return experience. Product returns over the past several years have not deviated significantly from our historical experience.
Accounting for income taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing the temporary differences resulting from differing treatment of items, such as deferred revenue or deductibility of certain intangible assets, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income. To the extent we believe the recovery is not likely, we must establish a valuation allowance as we did in the third quarter of 2002. Going forward, we will assess the continued need for the valuation allowance. After we have determined that we will be able to begin utilizing a significant portion of the deferred tax assets, we may reverse the valuation allowance, resulting in a benefit to the statement of operations in some future period.
Valuation of long-lived and intangible assets and goodwill. We assess the impairment of long-lived assets, identifiable intangibles and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could trigger an impairment review include the following:
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Significant underperformance relative to historical or projected future operating results;
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Significant changes in the manner of our use of the acquired assets or the strategy for our overall business;
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Significant negative industry or economic trends; or
•
Significant decline in our market capitalization relative to net book value for a sustained period.
When we determine that the carrying value may not be recovered based upon the existence of one or more of the above indicators, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model.
Results of Operations
Revenue. Revenue is derived from primarily two sources: (i) license revenue, derived from the sale of software licenses to resellers and end users, including large-scale enterprises, and royalty revenue, derived from initial license fees and ongoing royalties from licenses of source code to OEMs; and (ii) service and support revenue, derived from providing software updates, technical support, training and consulting services to our customers.
License revenue is generally recognized when a signed contract or other persuasive evidence of an arrangement exists, the software has been shipped or electronically delivered, the license fee is fixed or determinable and collection of resulting receivables is reasonably assured. Estimated product returns are recorded upon recognition of revenue from customers having rights of return, including exchange rights for unsold products and product upgrades. Provisions for estimated warranty costs and anticipated retroactive price adjustments are recorded at the time products are shipped. For sales to international distributors, license revenue is generally recognized upon meeting the above criteria and identifying their customers. For sales to domestic distributors, license revenue is recognized upon sale by the distributor to its customer. License revenue from royalty payments is recognized upon receipt of royalty reports from OEMs related to their product sales. Revenue from subscription license agreements, which include software, rights to future products and maintenance, is recognized ratably over the term of the subscription period.
Service and support revenue consists primarily of revenue received for providing software updates, technical support for software products, on-site support, consulting and training. Revenue from updates and support is recognized ratably over the term of the agreements. Revenue allocated to training and consulting services, or derived from the separate sales of these services, is recognized as the related services are provided.
When contracts contain multiple obligations (e.g., products, updates, technical support and other services) wherein vendor specific objective evidence exists for all undelivered elements, we account for the delivered elements in accordance with the “Residual Method” prescribed by Statement of Position 98-9. Any revenue related to updates or technical support in these arrangements is recognized ratably over the term of the maintenance arrangement.
Sources of Revenue as a Percent of Total Revenue.
We sell our products with the first year of update service included, creating a multiple element arrangement. As discussed above, we account for these arrangements using the “Residual Method,” which means a portion, or potentially all, of the product sale is allocated to our update service with license fee being the remainder, or “residual.” Our best evidence for the value of the update service is the fees our customers are willing to pay for the update subscription when it sold separately in the second year. Therefore, as our update renewal fees increase as a percentage of product list price, the greater proportion of initial product sale is allocated to our update subscription, thereby reducing the residual amount of license fee. In 2002, license revenue decreased $15.0 million when compared to 2001. The decrease was primarily as a result of an increase in the average selling price of our update subscription service. We also saw a decrease in the amount of license revenue derived from our OEM channel. These decreases were partially offset by the revenue contribution from OTG since May 2002.
While license revenue increased in 2001 over the previous year, license revenue decreased as a percentage of total revenue in 2001, when compared to 2000, primarily as a result of the economic recession and the reduced spending by customers. In prior years, our customers were willing to forecast expected demand for the next couple of years and purchase that quantity of licenses upfront in exchange for a greater discount. In 2001, our customers were more conservative with their estimates or were unwilling to make these large purchases.
Service and support revenue increased $34.3 million in 2002, when compared to 2001, as a result of increased renewal rates and increased average selling price. As discussed above, the increase in average selling price resulted in incremental license revenue being allocated to our update subscription service. Service and support revenue increased for 2001, when compared to 2000, as a result of our improvement in the number of customers renewing their support contracts to over 90% and the increased rates we charge for such services. Our increase in staffing for software support helped to increase new sales and renewals of our software support contracts. Even though overall service and support revenue increased in 2001, our revenue from consulting and educational services decreased by $5.2 million. The decrease in consulting services revenue was due to productivity issues caused by the re-organization of our field sales force, which typically sells consulting engagements. The decrease in educational services revenue was a result of our outsourcing of this function to Global Knowledge Networks, Inc., an international information technology education integrator, in the second quarter of 2001. We expect that service and support revenue will increase in absolute dollars in 2003, but at a growth rate less than 2002.
Revenue by Geography.
Revenue by Geography as a Percent of Total Revenue.
Domestic revenue increased $30.1 million in 2002, when compared to 2001, primarily due to increased productivity of the U.S. sales team and the revenue contribution from our OTG acquisition. Historically, OTG had international revenue of 15% or less. International revenue decreased $10.8 million as we saw significant weakness in the Asia Pacific region only modestly offset by an increase in Europe.
Domestic revenue decreased for 2001, when compared to 2000, primarily due to the economic recession in the United States. Revenue from our OEM partners decreased significantly as their businesses suffered in the poor economic climate; and our customers in the United States reduced their information technology spending in order to better align their expenses with their deflated revenue trends. Further, a large part of our sales force in the United States was new to Legato, and they had not reached the level of productivity of which we believe they are capable. International revenue increased primarily as a result of the continued market acceptance of our products overseas.
Cost of Revenue.
Cost of Revenue as a Percent of the Related Revenue.
Cost of license revenue includes costs of production personnel, packaging and documentation, freight and royalties. Product gross margin decreased to 93% in 2002, compared to 96% in 2001 and 2000. The decrease in product gross margin related to an increase in sales of royalty-bearing products. In general, the XtenderSolutions® products have a greater portion of third-party code than the historical LEGATO products. We expect product margins to remain relatively constant for at least 2003.
Cost of service and support revenue includes costs associated with providing customers with services, such as consulting and education, telephonic and on-site support and product updates. Costs of service and support include primarily salaries, packaging, documentation and delivery of product updates and costs to maintain the infrastructure necessary to manage a services organization. Cost of service and support revenue decreased by $4.1 million in 2002, when compared to 2001, and was a result of decreases in use of external consultants of $2.0 million, incentive bonus of $0.9 million and travel related costs of $0.5 million. The combination of cost reductions with increase in service and support revenue resulted in the increase in service and support gross margin of 16% to 65% in 2002 from 49% in 2001. Cost of service and support revenue increased by $7.3 million in 2001, when compared to 2000, and was driven by increases in the support function as we delivered better support and increased our customer satisfaction as measured by periodic surveys. Service and support headcount increased to 322 in 2002 from 310 in 2001 and 298 in 2000. Service and support gross margin decreased slightly to 49% in 2001 from 52% in 2000.
Total gross profit was $207.6 million in 2002, $188.2 million in 2001 and $183.8 million in 2000, representing gross margin of 79% in 2002, 78% in 2001 and 79% in 2000. We expect gross margin to improve to approximately 80% to 82% in 2003.
Operating Expenses.
Operating Expenses as a Percent of Total Revenue.
Sales and Marketing Expenses. Sales and marketing expenses consist primarily of employee-related costs such as salaries, benefits, commissions and promotional and advertising expenses. The increase in sales and marketing expenses of $12.0 million for 2002, when compared to 2001, was a result of increase in salaries of $7.2 million, commissions of $3.8 million, fringe benefits of $2.9 million and information technology related costs of $2.2 million. These increases were offset by decreases in internal sales meetings of $1.8 million, recruiting related costs of $0.8 million and travel of $0.5 million. The increase in sales and marketing expenses of $16.6 million for 2001, when compared to 2000, was, for the most part, a result of an increase in salaries and other compensation. Our sales and marketing personnel increased to 583 in 2002 from 486 in 2001 and 454 in 2000. The increase in headcount in 2002 was largely due to the acquisition of OTG personnel. We believe that sales and marketing expenses will increase in absolute dollars in 2003, but decrease as a percentage of total revenue, as we focus our efforts on improving the efficiency and productivity of our current personnel.
Research and Development Expenses. Research and development expenses consist primarily of employee-related costs such as salaries, benefits and facilities and equipment costs. The increase in research and development expenses of $4.9 million for 2002, when compared to 2001, was attributable to increases in salaries of $5.0 million, information technology related expenses of $2.4 million and education of $1.7 million. These increases were offset by decreases in incentive bonuses of $1.7 million, depreciation expense of $1.3 million, product localization of $0.4 million and travel-related costs of $0.7 million. The increase in research and development expenses of $4.7 million for 2001, when compared to 2000, resulted from increased depreciation expense, facilities expenses and salaries and other compensation. Salary and other compensation increased even though overall headcount decreased as of December 31, 2001, because the majority of the headcount reductions associated with the development laboratory restructuring occurred in the fourth quarter of 2001. The number of research and development personnel increased to 450 in 2002 from 348 in 2001 and from 364 in 2000. The increase in headcount in 2002 was largely due to the acquisition of OTG personnel. We believe that research and development expenses will continue to increase slightly in absolute dollars in 2003, but decrease as a percentage of total revenue, as we invest in developing new products and integrating our existing technologies.
General and Administrative Expenses. General and administrative expenses primarily include employee-related costs of our finance, human resources and other administrative departments and an allocated amount of facilities, information technology and education costs. The increase in general and administrative costs of $2.4 million in 2002, when compared to 2001, related to increases in salaries of $4.9 million and facilities costs of $2.9 million. These increases were offset by decreases in incentive bonuses of $1.3 million, the use of consultants and outside services of $2.6 million, investor services of $0.9 million and recruiting-related costs of $0.8 million. The increase in general and administrative costs of $2.5 million in 2001, when compared to 2000, related to increases in salaries, other compensation, travel and entertainment, partially offset by a reduction in recruiting costs. General and administrative personnel increased to 222 in 2002 from 194 in 2001 and 154 in 2000. We expect that general and administrative expenses will increase in absolute dollars in 2002, but decrease as a percentage of revenue, as headcount will not fluctuate significantly from its current level.
Amortization of Acquired Intangibles. The decrease in amortization of acquired intangibles of $24.8 million in 2002, when compared to 2001, related to the adoption of SFAS No. 142, “Goodwill and Other Intangible Assets” on January 1, 2002, whereby the amortization of goodwill was no longer required. (See Recent Accounting Pronouncements in Note 2 of the Consolidated Financial Statements for further details.) As of December 31, 2002, the weighted-average amortization period for patents and purchased technology, and customer relationships was 5.0 years and 3.2 years, respectively. Future intangible amortization expense is estimated to be $10.8 million in 2003, $7.9 million in 2004, $5.0 million in 2005 and 2006 and $1.9 million in 2007.
Litigation Settlement Charge. In April 2002, we settled the class action and derivative lawsuits filed in 2000 in the United States District Court for the Northern District of California and in San Mateo County Superior Court, respectively. The settlements in the federal and state litigation called for Legato to pay a total of $87.7 million, which included attorneys’ fees, in May 2002. Approximately $21.0 million of the settlement
amount was reimbursed by our insurance carriers. The settlement was recorded as a $67.0 million charge to the results of operations for the quarter ended March 31, 2002 and was paid during the quarter ended June 30, 2002.
Restructuring Charges. During 2002, we incurred a charge to our results of operations of $11.7 million primarily related to excess facilities located in Burlington, Ontario, Canada; Mountain View, California and Rockville, Maryland and to the closure of several smaller sales offices. Throughout 2002, we actively pursued sub-tenants for the excess space. However, given the current excess capacity in these metropolitan areas, we had limited success in finding sub-tenants. During 2001, we incurred $9.4 million in charges as we restructured our development operations to reduce our cost structure and to integrate and reduce selling and marketing activities. In connection with these activities, we reduced our workforce by approximately 215 employees and closed our development facilities in Sunnyvale, California; Eden Prairie, Minnesota; Orem, Utah and New Delhi, India. The following table summarizes the restructuring activity during 2001 and 2002 (in thousands):
We expect that the majority of the severance and benefits to be paid in the first quarter of 2003 while the majority of the excess facilities will be paid out over the next two years. When computing the restructuring charge for 2002, we assumed that we would find sub-tenants for the balance of the lease term and that we would derive sub-lease income of $11.8 million. If we are unsuccessful in finding quality sub-tenants or at the rate of rent estimated, we could have a further charge to the results of operations in a future period.
OTG Software, Inc. In the acquisition of OTG, all issued and outstanding shares were purchased for $382.5 million, consisting of cash of $87.3 million (OTG, in May 2002, had cash and investments of $85.7 million as of the closing date), the issuance of 23.8 million shares of Legato common stock valued at $262.7 million and the issuance of 3.4 million stock options valued at $22.8 million. We also incurred $9.7 million in merger-related costs. These costs primarily consist of investment banking, legal and other professional fees and severance and duplicate facility costs. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of the acquisition of OTG (in thousands):
The purchase price of $382.5 million has been allocated to the tangible and identifiable intangible assets acquired and liabilities assumed on the basis of their estimated fair values on the acquisition date. The valuation of identifiable intangible assets was performed by independent valuation experts. Deferred stock compensation is
the intrinsic value associated with the 1.2 million of unvested options that were assumed and is being amortized over the options’ remaining vesting period. Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired. The allocation of purchase price is as follows (in thousands):
In-process research and development, relating to development projects which had not reached technological feasibility and that had no future alternative uses, was expensed upon consummation of the merger in the current period. Other identifiable intangible assets are being amortized over their useful lives of five years for developed technology and the customer base. In accordance with SFAS No. 142, goodwill relating to the OTG acquisition is not being amortized and will be tested for impairment annually or whenever events indicate that impairment may have occurred. We do not expect any of the goodwill to be deductible for tax purposes.
Purchased technology, customer relationships and in-process research and development were identified and valued through interviews and analysis of data provided by management. For development projects that had reached technological feasibility, they were classified as purchased technology, and the value assigned to the purchased technology was capitalized. The income approach, which includes an analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing acquired intangible assets. Key assumptions included estimates of revenue growth, cost of sales, operating expenses and taxes. Discount rates used in the valuation of purchased technology, customer relationships and in-process research and development were 20%, 15% and 35%, respectively.
SCH. In the acquisition of SCH, all issued and outstanding shares of SCH were purchased for $10.3 million. We also paid $1.9 million to current and former employees as a transactional bonus, assumed net liabilities of $0.3 million and incurred $1.6 million in acquisition related expenses, which consisted primarily of professional fees, severance expenses and facility abandonment costs. Excluding SCH’s cash balance of $4.0 million, the aggregate purchase price was $10.1 million and was allocated as follows (in thousands):
The purchase price of SCH was allocated to the assets acquired, including tangible and intangible assets, and liabilities assumed based upon the fair value of such assets and liabilities on the date of acquisition and was based on our estimates of fair value with the excess purchase price over the net assets acquired allocated to goodwill. The tangible assets consisted primarily of accounts receivable, deferred tax assets and property and equipment. The liabilities assumed consisted primarily of accounts payable. Developed technology was identified and valued through analysis of data provided by SCH concerning development projects, their stage of development, the time and resources needed to complete them, if applicable, their expected income generating ability and the associated risks. The income approach, which includes an analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing the developed
technology. Since SCH had recently completed its latest product, AlphaStor, there were no research and development projects that were in-process as of the date of acquisition.
Impairment of Intangibles. In connection with the restructuring actions taken in the fourth quarter of 2001, we made certain decisions related to our various technologies, which resulted in the impairment of some of the acquired intangibles. With regard to the Intelliguard acquired intangibles, we chose to pursue an alternative technology, which resulted in writing-off all related intangibles of $20.3 million. With regards to the Vinca acquired intangibles, we chose to cease development of certain Vinca technology, impairing the related intangible assets by $28.5 million.
Interest and Other Income, Net. Interest and other income, net was $2.6 million in 2002, $7.7 million in 2001 and $6.6 million in 2000. The decrease in interest and other income, net in 2002 is attributable to the significant decrease in our investments, a reduction in our investment yield and some foreign currency losses. The increase in interest and other income, net in 2001 relates primarily to a $2.0 million gain on the sale of an equity investment during the second quarter of 2001. Excluding this gain, interest and other income, net decreased by $0.9 million, which reflects a decrease in interest rates during 2001 partially offset by higher yielding cash investments in taxable and longer duration instruments.
Provision for (Benefit from) Income Taxes. During 2002, we established a full valuation allowance against our deferred tax assets, because we determined that it is more likely than not that all deferred tax assets will not be realized in the foreseeable future. As a result, the provision for income taxes was $77.7 million in 2002 as compared to a benefit from income taxes of $35.5 million in 2001 and $9.5 million in 2000, with an effective tax rate of 51% (provision) in 2002, 30% (benefit) in 2001 and 21% (benefit) in 2000. The difference in the effective tax rate for 2001, when compared to 2000, is primarily related to a decrease in the amount of non-deductible goodwill amortization and a decrease in foreign tax expense related to foreign income.
Liquidity and Capital Resources
Our cash, cash equivalents and investments totaled $70.0 million as of December 31, 2002 as compared to $145.7 million as of December 31, 2001. To date, we have financed our operations primarily by cash from operations and sales of our common stock.
Net cash used by operating activities in 2002 was $80.4 million as compared to net cash provided by operating activities of $0.3 million in 2001. Net cash used by operating activities in 2002 was primarily attributable to our shareholder litigation settlement of $67.0 million (net of $21.0 million from our insurers). Cash used by our on-going operations was $13.4 million and consisted primarily of the net loss of $228.8 million, offset by the litigation settlement charge of $67.0 million, a decrease in the deferred tax assets of $78.0 million, the write-off of in-process research and development of $33.2 million, depreciation and amortization of $27.4 million and the net change in operating assets and liabilities of $5.5 million. Net cash provided by operating activities in 2001 consisted primarily of depreciation and amortization of $50.8 million, impairment of intangibles of $48.9 million and the tax benefit from stock option exercises of $4.1 million. This amount was partially offset by the net loss of $81.5 million, an increase in the deferred tax assets of $45.3 million and the net change in operating assets and liabilities of $16.6 million. Net cash provided by operating activities in 2000 consisted primarily of increases to accrued liabilities and deferred revenue of $14.9 million, depreciation and amortization of $52.8 million, the tax benefit from stock option exercises of $4.6 million and a provision for doubtful accounts and sales returns of $7.0 million partially, which were offset by the net loss of $35.2 million and increases in deferred tax assets of $19.9 million and other assets of $10.4 million.
Net cash provided by investing activities was $47.9 million compared to net cash used in investing activities of $61.7 million in 2001 and $25.1 million in 2000. In 2002, we had net redemptions of our investments of $66.2 million primarily to pay the settlement of our shareholder lawsuit. Purchases of property and equipment decreased to $13.4 million from $26.1 million in 2001 and $25.0 million in 2000. We spent $11.6 million in 2001
and $5.8 million in 2002 to replace and upgrade our core information technology infrastructure. Investing activities also consisted of net payments of $3.3 million for the purchase of technology and workforce and $1.6 million for OTG Software, Inc. in 2002 and $8.7 million related to the purchase of Software Clearing House in 2001. In 2003, we expect our total capital expenditures to be less than $10 million.
Net cash provided by financing activities was $23.2 million in 2002, which consisted of proceeds from the issuance of our common stock of $12.6 million and a borrowing against a line of credit of $10.6 million. During 2002, we entered into a $20.0 million secured line of credit with Silicon Valley Bank. At December 31, 2002, $10.5 million was outstanding. The credit facility is due to expire in December 2003. Borrowings under the credit facility bear interest at the greater of 0.5% above the Prime Rate or 4.75% (4.75% at December 31, 2002), and are subject to our compliance with financial and other covenants. The credit agreement requires us to maintain specified financial covenants such as minimum quarterly revenue, minimum unrestricted cash balances and a minimum quick ratio; all of which we were in compliance with as of December 31, 2002. Net cash provided by financing activities was $14.4 million in 2001 and $8.3 million in 2000 and related primarily to proceeds received from the issuance of our common stock.
As of December 31, 2002, the only significant contractual obligations or commercial commitments consisted of our facility lease commitments totaling $94.8 million, of which $17.8 million will be paid in 2003, $15.9 million in 2004 and $61.1 million thereafter. (See Note 5 to the Notes to the Consolidated Financial Statements for further details.) We do not have any other off-balance sheet arrangement that could significantly reduce our liquidity.
During the fourth quarter of 2002, we generated $13.2 million in operating cash flows. Based on our current operating plan and limited capital spending, we expect to generate positive cash flow in 2003. We believe our existing cash and investment balances will provide us the liquidity and capital resources required to sustain our operations for at least through 2003.
Disclosures About Market Risk
Interest Rate Risk. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. While we are exposed to interest rate fluctuations in many countries, our interest income is most sensitive to fluctuations in the general level of U.S. interest rates. In this regard, changes in the U.S. interest rates affect the interest earned on our cash, cash equivalents and investments. We invest in high quality credit issuers and, by policy, limit the amount of our credit exposure to any one issuer. As stated in our policy, our first priority is to reduce the risk of principal loss. Consequently, we seek to preserve our invested funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in only high quality credit securities that we believe to be low risk and by positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer or guarantor. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity.
The table below presents the carrying value, which approximated fair value, and related weighted average interest rates for our investments in marketable securities as of December 31, 2002 (dollars in millions).
Foreign Currency Risk. As a global concern, we face exposure to adverse movements in foreign currency exchange rates. This exposure may change over time as business practices evolve and could seriously harm our financial results. Substantially all of our international sales are currently denominated in U.S. dollars and Euros. An increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and therefore, reduce the demand for our products. Reduced demand for our products could seriously harm our financial results. Currently, we do not hedge against any foreign currencies and, as a result, could incur unanticipated gains or losses.
Recent Accounting Pronouncements. In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock Based Compensation-Transition and Disclosure-as Amendment to FAS 123.” SFAS No. 148 provides two additional transition methods for entities that adopt the preferable method of accounting for stock based compensation. Further, the statement requires disclosure of comparable information for all companies regardless of whether, when or how an entity adopts the preferable, fair value based method of accounting. As we continued to disclose the fair value of stock option compensation only, SFAS No. 148 did not have any impact on our financial position or results of operations. The transition and annual disclosures of SFAS No. 148 have been disclosed in Note 7 to the Consolidated Financial Statements.
In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. We do not expect the adoption of FIN 45 will have a material impact on our financial position or results of operations.
In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We are evaluating the impact that the adoption of this standard will have on our consolidated financial statements.
In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The standard replaces EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” and requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. We will adopt SFAS No. 146 on January 1, 2003 and do not expect it will have a material impact on our financial position or results of operations.
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 supercedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of.” SFAS No. 144 applies to all long-lived assets, including discontinued operations, and consequently amends APB Opinion No. 30, “Reporting the Results of Operations, Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” SFAS No. 144 develops one accounting model for long-lived assets that are to be disposed of by sale. SFAS No. 144 requires that long-lived assets that are to be disposed of by sale be
measured at the lower of book value or fair value less cost to sell. Additionally SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that: (a) can be distinguished from the rest of the entity and (b) will be eliminated from the ongoing operations of the entity in a disposal transaction. The adoption of SFAS No. 144 did not impact our financial position or results of operations.
In April 2002, the Emerging Issues Task Force (“EITF”) issued EITF Issue No. 01-14, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred,” which requires that all out-of-pocket expenses billed to a customer be classified as revenue. EITF Issue No. 01-14 was effective for our fiscal quarter beginning on January 1, 2002, with comparative financial statements for prior periods reclassified to conform to this presentation. We had previously treated reimbursement for “out-of-pocket” expenses as a reduction to cost of revenue. Our adoption of EITF Issue No. 01-14 did not have a material impact on our revenue or any effect on our gross margins, operating margins, net loss and net loss per share.
In July 2001, the FASB issued SFAS No. 142, which addresses financial accounting and reporting for acquired goodwill and other intangible assets and supersedes Accounting Principles Board (“APB”) Opinion No. 17, “Intangible Assets.” Among other things, it requires that goodwill and certain other intangible assets no longer be amortized and be tested for impairment at least annually and written down only when impaired. Further, SFAS No. 142 required us to perform a transitional assessment of whether there is an indication that its goodwill is impaired as of the date of adoption (January 1, 2002). We are also required to review our other intangible assets for impairment and to reassess the useful lives of such assets and make any necessary adjustments.
Upon adoption of SFAS No. 142, we reclassified the remaining unamortized balance of acquired workforce, totaling $1.3 million, to goodwill. We ceased to amortize goodwill of $17.3 million as of January 1, 2002. We completed our initial impairment test and concluded that there was one reporting unit and no impairment charge was required.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by Item 7A is incorporated by reference from the section entitled “Disclosures About Market Risk” found in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
ITEM 8.
ITEM 8.
CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements required by Item 8 are submitted as a separate section of this Annual Report on Form 10-K. See Item 15.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 as to directors is incorporated by reference from the sections entitled “Election of Directors” and “Compliance with Reporting Requirements of Section 16(a)” in our definitive Proxy Statement for our annual stockholders’ meeting to be held in 2003.
The information required by Item 11
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by Item 12 is incorporated by reference from the section entitled “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” in our definitive Proxy Statement for our annual stockholders’ meeting to be held in 2003.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated by reference from the section entitled “Certain Relationships and Related Transactions” in our definitive Proxy Statement for our annual stockholders’ meeting to be held in 2003.
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), within 90 days of the filing date of this report. Based on their evaluation, our principal executive officer and principal accounting officer concluded that Legato’s disclosure controls and procedures are effective. There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1 Financial Statements
Index to Consolidated Financial Statements
(a) 2 Financial Statement Schedules
All schedules have been omitted because they are not required or the required information is shown in the financial statements or notes thereto.
(a) 3 Exhibits
The following exhibits are filed with this Annual Report on Form 10-K:
#
Compensatory plan or arrangements.
(1)
Incorporated by reference to the Registrant’s Registration Statement on Form S-1, filed May 9, 1995 (File No. 33-92072).
(2)
Incorporated by reference to the Registrant’s Registration Statement on Form S-8, filed March 14, 1996 (File No. 333-02378).
(3)
Incorporated by reference to the Registrant’s Form 14A, filed April 6, 1998.
(4)
Incorporated by reference to the Registrant’s Form 10-Q, filed August 13, 1996.
(5)
Incorporated by reference to the Registrant’s Current Report on Form 8-K, dated June 6, 1997.
(6)
Incorporated by reference to the Registrant’s Form 8-A, dated May 30, 1997.
(7)
Incorporated by reference to the Registrant’s Registration Statement on Form S-8, filed May 16, 2001 (File No. 333-61022).
(8)
Incorporated by reference to the Registrant’s Form 10-K, filed March 29, 2001.
(9)
Incorporated by reference to the Registrant’s Form 8-K, filed February 21, 2002.
(10)
Incorporated by reference to OTG Software, Inc.’s Form 10-Q for the Three Month Period Ended June 30, 2000.
(11)
Incorporated by reference to the Registrant’s Form 10-Q, filed November 14, 2002.
(12)
Incorporated by reference to the Registrant’s Form 10-K, filed March 14, 2002.
(b) Reports on Form 8-K
None.
(c) Exhibits
See (a) 3 above.
(d) Financial Statement Schedule
See (a) 2 above.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Legato Systems, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related statements of operations, of stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Legato Systems, Inc. and its subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 2 to the Consolidated Financial Statements, effective January 1, 2002, the Company changed its method of accounting for goodwill in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”
/s/ PRICEWATERHOUSECOOPERS LLP
San Jose, California
February 4, 2003
LEGATO SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amount)
The accompanying notes are an integral part of these consolidated financial statements.
LEGATO SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amount)
The accompanying notes are an integral part of these consolidated financial statements
LEGATO SYSTEMS, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
LEGATO SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. The Company
Legato Systems, Inc. was incorporated in Delaware in September 1988. We develop, market and support storage software products and services worldwide. Our solutions protect and manage information, assure the availability of applications and provide immediate access to business-critical information in distributed open systems environments. Our solutions provide enterprise level customers the business continuity and operational efficiency to maintain a constant state of access to, and availability of, business-critical information. Our solutions recognize the interdependence between data and applications. Information management within an enterprise includes the protection, recovery and archiving of data, the management of performance and operation of applications, the optimization of storage devices and media including disk and tape, and the capture, organization and immediate access to content and messages. Our heterogeneous software products are mostly found in distributed, open systems which are generally understood to include UNIX, Windows NT, Windows 2000 and Linux server and storage computer systems.
2. Summary of Significant Accounting Policies
Principles of Consolidation and Basis of Presentation. The consolidated financial statements include the Company’s accounts and the accounts of its wholly owned subsidiaries and branch offices. All significant intercompany balances and transactions have been eliminated. We have no investments which are accounted for under the equity method.
Foreign Currency Translation. Assets and liabilities of foreign subsidiaries, where the functional currency is the local currency, are translated using exchange rates in effect at the end of the period, and revenue and costs are translated using average exchange rates for the period. Gains and losses on the translation into U.S. dollars of amounts denominated in foreign currencies are included in the results of operations for those operations whose functional currency is the U.S. dollar, and as a separate component of stockholders’ equity for those operations whose functional currency is the local currency.
Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Concentration of Credit Risk. Financial instruments that potentially subject us to concentrations of credit risk consist principally of investments and accounts receivable. Our investment policy limits investments to shorter-term, low-risk instruments. Financial instruments are executed with financial institutions with strong credit ratings, which minimizes risk of loss due to non-payment. We have not experienced any losses due to credit impairment related to our financial instruments. Concentration of credit risk related to accounts receivable is limited as our customers are dispersed across geographies. As of December 31, 2002 and 2001, no single customer accounted for more than 10% of accounts receivable.
Cash, Cash Equivalents and Investments. Cash equivalents are highly liquid debt instruments with maturities of three months or less as of the date of purchase. Investments are equity securities or debt instruments with original maturities greater than three months. The appropriate classification of investments in marketable securities is determined at the time of purchase. Marketable securities classified as available-for-sale are carried at fair value, with the unrealized gains or losses (net of tax), reported as a separate component of stockholders’ equity until realized. Realized gains and losses are recognized based on the specific identification method and were not significant in 2000. However in 2002 and 2001, we realized gains of $1.0 million and $2.2 million, respectively. As of December 31, 2002 and 2001, all marketable securities were classified as available-for-sale.
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
A summary of our investments in marketable securities follows (in thousands):
As of December 31, 2002, investments with contractual maturities of one year or less and one year through three years were $6.6 million and $8.5 million, respectively. Our investments can be liquidated in short notice with no significant penalties.
Property and Equipment. Property and equipment are stated at cost. Depreciation for property and equipment is provided using the straight-line method over the estimated useful lives of the respective assets, which is generally two to five years for computer equipment and office furniture, three to seven years for computer software and three to ten years for furniture and fixtures. Depreciation for leasehold improvements is provided using the straight-line method over the shorter of the estimated useful lives of the respective assets or the remaining lease term.
Capitalized Software Development Costs. Capitalization of software development costs begins upon the establishment of technological feasibility of the product and ends when the product is available for general release to customers. Capitalized costs are then amortized on a straight-line basis over the estimated product life, or on the ratio of current revenue to the total projected product revenue, whichever is greater. To date, the period between achieving technological feasibility, which we have defined as the establishment of a working model and typically occurs when beta testing commences, and the general availability of such software has been short. As such, software development costs qualifying for capitalization have been insignificant.
Long-lived Assets. Long-lived assets, certain identifiable intangible assets and goodwill related to these assets are reviewed for impairment. For assets to be held and used, including acquired intangibles, we initiate a review whenever events or changes in circumstances indicate that the carrying value of a long-lived asset may not be recoverable. Recoverability of an asset is measured by comparison of its carrying value to the future undiscounted cash flows that the asset is expected to generate. Any impairment is measured by the amount by which the carrying value exceeds the projected discounted future operating cash flows. Assets to be disposed of and for which we have committed a plan to dispose of the assets, whether through sale or abandonment, are reported at the lower of carrying value or fair value less costs to sell.
Revenue Recognition. Revenue is derived from primarily two sources: (i) license revenue, derived from the sale of software licenses to resellers and end users, including large-scale enterprises, and royalty revenue,
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
derived from initial license fees and ongoing royalties from licenses of source code to OEMs; and (ii) service and support revenue, derived from providing software updates, technical support, training and consulting services to our customers.
License revenue is generally recognized when a signed contract or other persuasive evidence of an arrangement exists, the software has been shipped or electronically delivered, the license fee is fixed or determinable and collection of resulting receivables is reasonably assured. Estimated product returns are recorded upon recognition of revenue from customers having rights of return, including exchange rights for unsold products and product upgrades. Provisions for estimated warranty costs and anticipated retroactive price adjustments are recorded at the time products are shipped. For sales to international distributors, license revenue is generally recognized upon meeting the criteria above and identifying their customers. For sales to domestic distributors, license revenue is recognized upon sale by the distributor to its customer. License revenue from royalty payments is recognized upon receipt of royalty reports from OEMs related to their product sales. Revenue from subscription license agreements, which include software, rights to future products and maintenance, is recognized ratably over the term of the subscription period.
Service and support revenue consists primarily of revenue received for providing software updates, technical support for software products, on-site support, consulting and training. Revenue from updates and support is recognized ratably over the term of the agreements. Revenue allocated to training and consulting services, or derived from the separate sales of these services, is recognized as the related services are provided.
When contracts contain multiple obligations (e.g., products, updates, technical support and other services) wherein vendor specific objective evidence exists for all undelivered elements, we account for the delivered elements in accordance with the “Residual Method” prescribed by Statement of Position 98-9. Any revenue related to updates or technical support in these arrangements is recognized ratably over the term of the maintenance arrangement.
The following summarizes the activity related to the allowance for doubtful accounts and product returns (in thousands):
Advertising Expenses. Advertising costs are expensed as incurred and totaled $2.1 million in 2002, $2.0 million in 2001 and $2.0 million in 2000.
Comprehensive Income (Loss). Comprehensive income (loss) includes unrealized gains and losses on investments that are available for sale and on foreign currency translation adjustments, the impact of which have been excluded from net income (loss) and reflected as equity. The components of comprehensive income (loss) are reported on our consolidated statement of stockholders’ equity.
Net Income (Loss) Per Share. Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average shares of common stock outstanding during the year. Diluted net income per share is computed by dividing net income by the weighted average shares of common stock and potential common shares outstanding during the year. Potential common shares outstanding consist of dilutive shares issuable upon the exercise of outstanding options to purchase common stock as computed using the treasury stock method. For the
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
years in which we have a loss, potential common shares outstanding are excluded from the computation of diluted net loss per share as their effect is anti-dilutive. As of December 31, 2002, 2001 and 2000, there were potential common shares outstanding of 6.8 million, 11.7 million and 8.1 million with a weighted average price of $4.04 per share, $8.56 per share and $8.72 per share, respectively. These shares were not considered in calculating diluted net loss per share, because their effect was anti-dilutive.
Recent Accounting Pronouncements. In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock Based Compensation-Transition and Disclosure-as Amendment to FAS 123.” SFAS No. 148 provides two additional transition methods for entities that adopt the preferable method of accounting for stock based compensation. Further, the statement requires disclosure of comparable information for all companies regardless of whether, when or how an entity adopts the preferable, fair value based method of accounting. As we continue to disclose the fair value of stock option compensation only, SFAS No. 148 did not have any impact on our financial position or results of operations. The transition and annual disclosures of SFAS No. 148 have been disclosed in Note 7.
In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. We do not expect the adoption of FIN 45 will have a material impact on our financial position or results of operations.
In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We are evaluating the impact that the adoption of this standard will have on our consolidated financial statements.
In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The standard replaces EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” and requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. We will adopt SFAS No. 146 on January 1, 2003 and do not expect it will have a material impact on our financial position or results of operations.
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 supercedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of.” SFAS No. 144 applies to all long-lived assets, including discontinued operations, and consequently amends APB Opinion No. 30, “Reporting the Results of Operations, Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Occurring Events and Transactions.” SFAS No. 144 develops one accounting model for long-lived assets that are to be disposed of by sale. SFAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that: (a) can be distinguished from the rest of the entity and (b) will be eliminated from the ongoing operations of the entity in a disposal transaction. The adoption of SFAS No. 144 did not impact our financial position or results of operations.
In April 2002, the Emerging Issues Task Force (“EITF”) issued EITF Issue No. 01-14, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred,” which requires that all out-of-pocket expenses billed to a customer be classified as revenue. EITF Issue No. 01-14 was effective for our fiscal quarter beginning on January 1, 2002, with comparative financial statements for prior periods reclassified to conform to this presentation. We had previously treated reimbursement for “out-of-pocket” expenses as a reduction to cost of revenue. Our adoption of EITF Issue No. 01-14 did not have a material impact on our revenue or any effect on our gross margins, operating margins, net loss and net loss per share.
In July 2001, the FASB issued SFAS No. 142, which addresses financial accounting and reporting for acquired goodwill and other intangible assets and supersedes Accounting Principles Board (“APB”) Opinion No. 17, “Intangible Assets.” Among other things, it requires that goodwill and certain other intangible assets no longer be amortized and be tested for impairment at least annually and written down only when impaired. Further, SFAS No. 142 required us to perform a transitional assessment of whether there is an indication that its goodwill is impaired as of the date of adoption (January 1, 2002). We are also required to review our other intangible assets for impairment and to reassess the useful lives of such assets and make any necessary adjustments.
Upon adoption of SFAS No. 142, we reclassified the remaining unamortized balance of acquired workforce, totaling $1.3 million, to goodwill. We ceased to amortize goodwill of $17.3 million as of January 1, 2002. We completed our initial impairment test and concluded that there was one reporting unit and no impairment charge was required. The following table presents the effects on net loss and net loss per share, basic and diluted, as if the goodwill had not been amortized during the periods presented (in thousands, except for per share amounts):
The components of other intangibles are as follows (in thousands):
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The changes in the carrying amount of goodwill are as follows (in thousands):
As of December 31, 2002, the following is the gross carrying amount and accumulated amortization for the acquired intangible assets (in thousands):
As of December 31, 2002, the weighted-average amortization period for patents and purchased technology, and customer relationships was 5.0 years and 3.2 years, respectively. Future intangible amortization expense is estimated to be $10.8 million in 2003, $7.9 million in 2004, $5.0 million in 2005 and 2006 and $1.9 million in 2007.
3. Consolidated Balance Sheet Detail
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
4. Line of Credit
During 2002, we entered into a $20.0 million secured line of credit with Silicon Valley Bank. At December 31, 2002, $10.5 million was outstanding. The credit facility is due to expire in December 2003. Borrowings under the credit facility bear interest at the greater of 0.5% above the Prime Rate (4.75% at December 31, 2002), and are subject to our compliance with financial and other covenants. The credit agreement requires us to maintain specified financial covenants such as minimum quarterly revenue, minimum unrestricted cash balances and a minimum quick ratio; all of which we were in compliance with as of December 31, 2002.
5. Commitments and Contingencies
Operating Leases. We lease our operating facilities under non-cancelable operating leases that expire at various dates through 2011. Certain of these leases contain renewal options. Rent expense was $16.4 million in 2002, $13.6 million in 2001 and $12.1 million in 2000. We also entered into non-cancelable sub-leases that expire at various dates through 2011 and recognized sub-lease income of $1.8 million in 2002, $2.9 million in 2001 and $1.7 million in 2000, which was offset against rent expense. As of December 31, 2002, future minimum lease commitments and sub-lease income were as follows (in thousands):
Restructuring Charges. During 2002, we incurred a charge to our results of operations of $11.7 million primarily related to excess facilities located in Burlington, Ontario, Canada; Mountain View, California and Rockville, Maryland and to the closure of several smaller sales offices. Throughout 2002, we actively pursued sub-tenants for the excess space. However, given the current excess capacity in these metropolitan areas, we had limited success in finding sub-tenants. During 2001, we incurred $9.4 million in charges as we restructured our development operations to reduce our cost structure and to integrate and reduce selling and marketing activities. In connection with these activities, we reduced our workforce by approximately 215 employees and closed our development facilities in Sunnyvale, California, Eden Prairie, Minnesota, Orem, Utah and New Delhi, India. The following table summarizes the restructuring activity during 2001 and 2002 (in thousands):
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Litigation. In April 2002, we settled the class action and derivative lawsuits filed in 2000 in the United States District Court for the Northern District of California and in San Mateo County Superior Court, respectively. The settlements in the federal and state litigation called for Legato to pay a total of $87.7 million, which included attorneys’ fees, in May 2002. Approximately $21.0 million of the settlement amount was reimbursed by our corporate insurance. The settlement was recorded as a $67.0 million charge to the results of operations for the quarter ended March 31, 2002 and was paid during the quarter ended June 30, 2002.
On or about July 26, 2001, a class action lawsuit was filed in the Southern District of New York naming OTG, officers of OTG who signed the registration statement in connection with OTG’s initial public offering, and the managing underwriters of the initial public offering as defendants. The complaint alleges that OTG’s initial public offering registration statement and final prospectus contained material misrepresentations and/or omissions, related in part to additional, excessive and undisclosed commissions allegedly received by the underwriters from investors to whom the underwriters allegedly improperly allocated shares of the public offering. The complaint seeks relief in the form of damages and/or rescission of the plaintiff’s purchase transaction. Since this initial complaint was filed, three other complaints making similar or identical allegations and seeking similar relief have been filed. All of the actions brought against OTG have been consolidated, and are being heard along with other similar actions brought against approximately 300 other issuers, issuers’ officers and underwriters in the Southern District of New York. On July 19, 2002, the defendants filed a motion to dismiss the complaint. We intend to defend the action vigorously and believe that it is not possible at the current time to estimate the amount of a probable loss, if any, that might result from this matter.
On July 1, 2002, we received notice that an action captioned Nickel v. Kay, et al. had been filed in the Circuit Court for Montgomery County, Maryland. The action, brought by a former OTG employee, asserts claims that Richard Kay, OTG and Legato are liable under various legal theories for the alleged breach of Mr. Nickel’s employment contract and breach of fiduciary duties allegedly owed to Mr. Nickel. The complaint alleges compensatory and punitive damages, to be proven at trial. The case is in its preliminary stages, and an investigation of the facts is not complete. We intend to defend this action vigorously; however the outcome is uncertain at this time. Although insurance may be available to cover some portion of any potential liability, an adverse judgment could be materially adverse to our operating results.
On or about November 20, 2002, we received an arbitration demand filed with the American Arbitration Association by Buro- und Datentechnik, an OTG European reseller. The reseller alleges that OTG misrepresented information concerning the capabilities of certain OTG products during 2001, and OTG’s intentions with respect to development plans for those products. On that basis, the reseller asserts that it is entitled to compensatory damages. Although insurance may be available to cover some portion of any potential liability, an adverse arbitration award could be materially adverse to our operating results.
On January 15, 2003, we received a notice of potential claim from the former shareholders of Intelliguard, Inc., a company purchased by Legato in April 1999. They allege that the Company and certain of its former officers made certain misrepresentations, upon which they relied when they agreed to sell Intelliguard to the Company. No formal legal action has been commenced, and the parties intend to pursue informal discussions in an effort to determine whether the former Intelliguard shareholders will proceed with their claims. We believe the Company has numerous meritorious defenses to any action brought by the Intelliguard shareholders, and if any action is brought, we intend to defend the action vigorously. At this time, we believe that it is not possible to estimate the amount of a probable loss, if any, that might result from this matter.
In addition to the foregoing matters, we are parties to various other lawsuits and disputes regarding commercial and employment matters arising in the ordinary course of operations. We believe that the amounts in dispute in these other matters are insubstantial, and the effect of these matters, individually and in the aggregate, would not be material to our operating results.
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
6. Acquisitions
OTG Software, Inc. On May 14, 2002, we completed our acquisition of OTG for cash and stock at a value of $382.5 million. OTG, based in Rockville, Maryland, provides data management and collaboration solutions that virtualize storage for any type of data, including files, messages and databases, while providing easy and transparent access. Each share of OTG common stock was exchanged for 0.6876 of a share of Legato common stock and $2.50 per share in cash. We also assumed all outstanding options to purchase OTG common shares. OTG provides us with complementary channels, markets and technology, which will enable us to expand our opportunities by offering robust storage, content and email management solutions. The combined company will have the scale, scope and worldwide channel access to leverage OTG’s strengths in data access and business applications such as email.
The total purchase price of $382.5 million consisted of cash of $87.3 million (OTG had cash and investments of $85.7 million as of the closing date), the issuance of 23.8 million shares of Legato common stock valued at $262.7 million and the issuance of 3.4 million stock options valued at $22.8 million. We also incurred $9.7 million in merger-related costs. These costs primarily consist of investment banking, legal and other professional fees of $4.8 million and severance and duplicate facility costs of $4.4 million. As of December 31, 2002, accrued severance and excess facility costs were $2.3 million.
The shares issued in the acquisition have been valued in accordance with EITF 99-12, “Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination.” In accordance with EITF 99-12, we established that the first date on which the number of our shares and the amount of other consideration became fixed was February 21, 2002, the date we announced the acquisition. Accordingly, we have valued the common stock at $10.94 per share, which represents the average closing price for the period from February 19, 2002 to February 25, 2002. The assumed stock options were valued using the Black Scholes valuation model with a volatility factor of 100%, an average risk free interest rate of 3% and estimated lives of three to 24 months.
The OTG acquisition was accounted for under Statements of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” and certain specified provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” The results of the operations of OTG were included in our Consolidated Statement of Operations since May 15, 2002.
The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of the acquisition of OTG (in thousands):
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The purchase price of $382.5 million has been allocated to the tangible and identifiable intangible assets acquired and liabilities assumed on the basis of their estimated fair values on the acquisition date. The valuation of identifiable intangible assets was performed by independent valuation experts. Deferred stock compensation is the intrinsic value associated with the 0.8 million of unvested options that were assumed (net of 0.4 million of forfeitures) and is being amortized over the options’ remaining vesting period. Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired. The allocation of purchase price is as follows (in thousands):
In-process research and development, relating to development projects which had not reached technological feasibility and that had no future alternative uses, was expensed upon consummation of the merger in the current period. Other identifiable intangible assets are being amortized over their useful lives of five years for developed technology and the customer base. In accordance with SFAS No. 142, goodwill relating to the OTG acquisition is not being amortized and will be tested for impairment annually or whenever events indicate that impairment may have occurred. We do not expect any of the goodwill to be deductible for tax purposes.
Purchased technology, customer relationships and in-process research and development were identified and valued through interviews and analysis of data provided by management. For development projects that had reached technological feasibility, they were classified as purchased technology, and the value assigned to the purchased technology was capitalized. The income approach, which includes an analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing acquired intangible assets. Key assumptions included estimates of revenue growth, cost of sales, operating expenses and taxes. Discount rates used in the valuation of purchased technology, customer relationships and in-process research and development were 20%, 15% and 35%, respectively.
The following unaudited pro forma financial information was prepared as if the acquisition of OTG occurred as of the beginning of each period presented. This information represents an estimate of the ongoing operations of the combined entities as if OTG was acquired at the beginning of each period presented and excludes the write-off of in-process research and development discussed above. In our opinion, all adjustments necessary to present fairly such information have been made based on the terms and structure of the transaction. The following table is presented for illustrative purposes only and does not necessarily represent the financial results that would have resulted had the acquisition actually occurred on the date indicated nor are the results indicative of the future results of operations or financial condition of the Company on a consolidated basis (in thousands, except per share data).
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
SCH. On July 17, 2001, we acquired Software Clearing House, Inc. (d/b/a SCH Technologies), a developer of media management for the open systems market. All issued and outstanding shares of SCH were purchased for $10.3 million. We also paid $1.9 million to current and former employees as a transactional bonus, assumed net liabilities of $0.3 million and incurred $1.6 million in acquisition related expenses, which consisted primarily of professional fees, severance expense and facility abandonment costs. Excluding SCH’s cash balance of $4.0 million, the aggregate purchase price was $10.1 million and was allocated as follows (in thousands):
The purchase price was allocated to the assets acquired, including tangible and intangible assets, and liabilities assumed based upon the fair value of such assets and liabilities on the date of acquisition and was based on our estimates of fair value with the excess purchase price over the net assets acquired allocated to goodwill. The tangible assets consist primarily of accounts receivable, deferred tax assets and property and equipment. The liabilities assumed consist primarily of accounts payable. Developed technology was identified and valued through analysis of data provided by SCH concerning development projects, their stage of development, the time and resources needed to complete them, if applicable, their expected income generating ability and the associated risks. The income approach, which includes an analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing the developed technology. Since SCH had recently completed its latest product, AlphaStor, there were no research and development projects that were in-process as of the date of acquisition.
The pro forma financial information presented below is not necessarily indicative of either the results of operations that would have occurred had the acquisitions taken place at the beginning of the periods presented or of future results of operations of the combined companies. The following unaudited pro forma information combines the results of operations as if the acquisition of SCH was consummated at the beginning of the periods presented (in thousands, except for per share data):
Impairment of intangibles. In connection with the restructuring actions taken in the fourth quarter of 2001, we made certain decisions related to our various technologies, which resulted in the impairment of some of the acquired intangibles. With regard to the Intelliguard acquired intangibles, we chose to pursue an alternative technology, which resulted in writing-off all related intangibles of $20.3 million. With regards to the Vinca acquired intangibles, we chose to cease development of certain Vinca technology, impairing the related intangible assets by $28.5 million.
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
7. Stockholders’ Equity
Preferred Stock. We are authorized to issue 5.0 million shares of preferred stock, none of which are issued or outstanding. The Board of Directors has the authority to issue the preferred stock in one or more series and to fix rights, preferences, privileges and restrictions, and the number of shares constituting any series and the designation of such series, without any further vote or action by the stockholders.
Option Program Description. Our stock option program is a broad-based, long-term retention program that is intended to attract and retain talented employees and align stockholder and employee interests. We consider our option program critical to our operation and productivity; essentially all of our employees participate. Of the options we granted in 2002, eighty-eight percent went to employees other than the five most highly compensated officers. The program consists of one plan (the “1995 Plan”), which was approved by our shareholders, and is divided into three separate components:
•
Discretionary Option Grant Program, under which employees, non-employee Board members who are not serving on our Compensation Committee and consultants may, at the discretion of the Compensation Committee, be granted options to purchase shares of common stock;
•
Stock Issuance Program, under which such persons may, at the Compensation Committee’s discretion, be issued shares of common stock directly, through the purchase of such shares or in consideration of the past performance of services; and
•
Automatic Option Grant Program, under which option grants will automatically be made at periodic intervals to eligible non-employee Board members to purchase shares of common stock at an exercise price equal to 100% of their fair market value on the grant date. Each individual who first becomes a non-employee Board member will receive a 96,000 share option grant on the date such individual joins the Board, provided such individual has not been previously employed by us. In addition, at each Annual Stockholders Meeting, each individual who has served as a non-employee Board member for at least six months prior to such Annual Meeting and who is to continue to serve as a non-employee Board member after the meeting will receive an additional option grant to purchase 24,000 shares of common stock, whether or not such individual has been in our prior employment.
All stock option grants are made after a review by the Chief Executive Officer, and, for option grants in excess of 30,000 shares, with the approval of, the Compensation Committee of the Board of Directors. All members of the Compensation Committee are independent directors, as defined in the applicable rules for issuers traded on The Nasdaq Stock Market. See the “Report of the Compensation Committee on Executive Compensation” appearing in the Company’s proxy statement dated April 12, 2002 for further information concerning the policies and procedures of the Company and the Compensation Committee regarding the use of stock options.
As of December 31, 2002, 35.5 million shares of common stock have been authorized for issuance under the 1995 Plan, of which 5.1 million were available for future grant. Options to purchase shares may be granted and shares may be issued directly under the 1995 Plan. Options must have an exercise price not less than 100% and 85% of fair market value of the common stock on the date of grant for incentive stock options and non-statutory stock options, respectively. The purchase price for shares issued directly may not be less than 85% of fair market value on the date of grant. Options generally vest over four years, whereby 25% of the shares become exercisable one year after the grant date and monthly thereafter over 36 months, and terminate ten years after their original grant date.
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
During 2002, we assumed 3.4 million options in connection with our acquisition of OTG. A summary of option activity follows (in thousands, except per share amounts):
As of December 31, 2002, the options outstanding and exercisable by exercise price are as follows (in thousands, except per share amounts):
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Distribution and Dilutive Effect of Options. We have a goal to keep the dilution related to our option program to an average of less than three percent annually. Accordingly, the shares reserved under this program automatically increases on the first trading day in each calendar year by the lesser of (i) the number of shares equal to 3% of the total number of shares of our common stock outstanding on December 31 of the immediately preceding calendar year or (ii) 3.0 million shares. The dilution percentage is calculated as the new option grants for the year, net of options forfeited by employees leaving the Company, divided by the total outstanding shares at the beginning of the year. Employee and executive option grants are as follows:
*
See below for the listed officers; they are defined by the SEC for the proxy as the CEO and each of the four other most highly compensated executive officers.
During 2002, we granted options to purchase 6.6 million shares of our stock to our employees, which was a net grant of options for 3.1 million shares after deducting 3.5 million shares for options forfeited. The net options granted after forfeitures represented approximately 4.2% of our total outstanding shares of 89.6 million as of the beginning of this year.
Options granted to the five most highly compensated officers as a percentage of the total options granted to all employees vary from year to year. During 2002, options granted to the five most highly compensated executive officers amounted to 11.8% of the grants made to all employees, which is lower than 2001 and 2000. This decrease is a result of the fact that two of the listed executive officers were hired in 2000, and one was hired 2001. In order to attract and retain these executive officers, significant initial stock grants were made. Subsequent grants are substantially less than the initial grant.
As of December 31, 2002, the “In-the-Money” and “Out-of-the Money” option information is as follows (in thousands, except per share amounts):
*
“Out-of-the-money” options are those options with an exercise price equal to or above the closing price of $5.03 at the end of the year. Our stock price is volatile. The high, average and low closing stock price for the year ended December 31, 2002 was $17.43, $6.55 and $1.88, respectively.
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Executive Officer Options. A “Listed Officer” is defined as the CEO and each of the four other most highly compensated executive officers. This is the same definition used by the SEC for proxy statements. For the year ended December 31, 2002, options granted to Listed Officers were as follows:
All of these grants have standard vesting periods as defined above in “Option Program Description.”
With the closing stock price of $5.03 on December 31, 2002, the majority of the Listed Officers’ options were “under water” or “out-of-the-money.” As of and for the year ended December 31, 2002, options exercised and total holdings of the Listed Officers were as follows:
Employee Stock Purchase Plan. The 1995 ESP Plan was concluded in July 2002. The 2001 Employee Stock Purchase Plan and the 2001 International Employee Stock Purchase Plan (collectively, the “2001 ESP Plan”) were approved by the stockholders and replaced the 1995 ESP Plan. The 2001 ESP Plan has reserved for issuance 4.8 million shares of common stock and is administered over offering periods of 24 months each, with each offering period divided into four consecutive six-month purchase periods beginning May 1 and November 1 of each year. Eligible employees may designate not more than 10% of their cash compensation (up to $25,000 per employee per annum) to be deducted each pay period for the purchase of common stock under the 2001 ESP Plan, and participants may not purchase more than 4,000 shares of stock in any one six-month purchase period. On the last business day of each purchase period, shares of common stock are purchased with the employee’s payroll deductions accumulated during the six months, generally at a price per share of 85% of the market price of the common stock on the employee’s entry date into the applicable offering period or the last day of the applicable purchase period, whichever is lower. As of December 31, 2002, there were 3.6 million shares of common stock reserved for future issuance under the 2001 ESP Plan.
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Fair Value Disclosures. Had compensation expense for our fixed stock option and employee stock purchase plans been based on the fair value at the date of grant for the awards under a method prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” compensation expense would have increased by $45.3 million in 2002, $69.6 million in 2001 and $44.4 million in 2000. Our net loss and net loss per share would have been adjusted to the following pro forma amounts (in thousands, except per share amounts):
The fair value of options granted and shares purchased under our various option plans was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions assuming a dividend yield of zero for all periods:
These pro forma amounts may not be representative of the effects on reported net loss for future years as options vest over several years and additional awards are generally made each year.
Stockholder Rights Plan. In May 1997, we adopted a stockholder rights plan (the “Rights Plan”), in which preferred stock rights were distributed as a rights dividend at a rate of one right for each share of common stock held as of the close of business on June 23, 1997. The Rights Plan is designed to deter coercive or unfair takeover tactics and to prevent an acquirer from gaining control of Legato without offering a fair price in the event we are confronted in the future with coercive or unfair takeover tactics. The rights expire on May 23, 2007.
Profit Sharing Plan. We have a 401(k) Profit Sharing Plan (the “Plan”) covering all of our employees. Under the Plan, participating employees may elect to contribute up to 15% of their eligible compensation, subject to certain limitations. We may make contributions to the Plan at the discretion of the Board of Directors and have contributed $0.8 million in 2002, 2001 and 2000.
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
8. Income Taxes
The provision for (benefit from) income taxes consists of the following (in thousands):
In 2002, loss before provision for income taxes consisted of a loss from U.S. operations of $143.3 million and loss from foreign operations of $7.7 million. In 2001, loss before benefit from income taxes consisted of a loss from U.S. operations of $119.3 million and income from foreign operations of $2.3 million. In 2000, loss before benefit from income taxes consisted of a loss from U.S. operations of $47.6 million and income from foreign operations of $2.8 million. The tax benefit (expense) associated with dispositions from employee stock plans for 2002, 2001 and 2000 was $(0.8) million, $4.1 million and $4.6, respectively. Such benefit (expense) was recorded to common stock and capital in excess of par and a reduction to taxes payable or an increase to deferred tax assets. The effective tax rate differs from the statutory federal income tax rate as follows:
As of December 31, 2002, we have federal and California net operating loss carryforwards of $186.2 million and $23.0 million available to reduce future federal and California taxable income, respectively. These federal and California carryforwards begin to expire in 2010 and 2003, respectively. In addition to these carryforwards, as a result of our acquisition of OTG in 2002, we also have federal and state net operating loss carryforwards of
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
$5.7 million and $5.7 million available to offset future federal and state taxable income, respectively. These federal and state carryforwards begin to expire in 2020 and 2005, respectively. The extent to which the OTG loss carryforwards can be used to offset future taxable income are limited under Section 382 of the Internal Revenue Code and applicable state tax law.
As of December 31, 2002, we have federal and California research and experimentation tax credit carryforwards of $10.0 million and $4.5 million, respectively. These federal tax credit carryforwards begin to expire in 2012, and the California tax credit carryforwards do not expire. In addition to these tax credit carryforwards, as a result of our acquisition of OTG in 2002, we have federal research and experimentation tax credit carryforwards of $1.6 million, which begin to expire in 2019. The extent to which the OTG tax credit carryforwards can be used to offset future taxes are limited under Section 383 of the Internal Revenue Code.
As of December 31, 2002, we have foreign tax credit carryforwards of $3.7 million, which begin to expire in 2003.
As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us determining our income tax expense (benefit) together with calculating our deferred income tax expense (benefit) related to temporary differences resulting from differing treatment of items, such as deferred revenue or deductibility of certain intangible assets, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered through the generation of future taxable income. During 2002, due primarily to our historical operating losses, we established a full valuation allowance against our deferred tax assets, because we determined that it is more likely than not that all deferred tax assets will not be realized in the foreseeable future.
Significant components of our deferred tax assets and liabilities are as follows (in thousands):
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
9. Industry and Geographic Segment Information
We use one measurement of profitability for our business. Our software products and related services are developed and marketed to support heterogeneous client/server computing environments and mid- to large-scale enterprises. Revenue information on a product basis is as follows (in thousands):
We market our products and related services to customers in the United States, Canada, Europe and Asia Pacific. Product revenue and long-lived-asset information by geographic areas are as follows (in thousands):
The revenue information by geographical area is based on the country of destination. Other than the United States, no country accounted for more than 10% of our total revenue for 2002, 2001 and 2000, except for Germany accounted for 12% of total revenue for 2001. No single customer accounted for more than 10% of our total revenue for 2002, 2001 and 2000.
10. Related Party Transactions
In December 2000, we loaned $0.5 million to Mr. Wright, Chairman of the Board, President and Chief Executive Officer in connection with his initial employment agreement with the Company. The note is secured by a deed of trust conveying a security interest in Mr. Wright’s principal residence. The note bears interest at 6.5%, compounded annually, with principal and interest due on December 6, 2003, subject to acceleration upon borrower’s cessation of employment and certain other events. In addition, the note provides that 50% of the principal and all accrued interest to date shall be forgiven on December 6, 2002 and 50% on December 6, 2003 provided Mr. Wright is employed on each of those dates and not in default under the note. Accordingly, half of the loan and related accrued interest was forgiven in December 2002. The largest aggregate amount of indebtedness outstanding during 2002 was $0.6 million, and the balance outstanding, including accrued interest, as of December 31, 2001 was $0.3 million.
LEGATO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
In December 2001, we loaned $0.3 million to Mr. Chappell, Senior Vice President, Business Process and Development, which was repaid with interest in December 2002. The note bore interest at 4.55% and was secured by a deed of trust conveying a security interest in Mr. Chappell’s principal residence.
Eric A. Benhamou had been a director of Legato since March 1993 and is the Chairman of the Board of 3Com Corporation (“3Com”). Legato and 3Com entered into an Enterprise Software License Agreement in June 1999. In exchange for a $0.9 million payment from 3Com, Legato granted 3Com a perpetual license to use certain Legato software. 3Com also made update and support payments of $0.2 million in each of 1999, 2000 and 2001. Subsequently, we performed an audit of 3Com’s use of our software and determined that 3Com deployed software for which 3Com did not have a license to use. Accordingly, in 2002, we have invoiced 3Com in the amount of $0.4 million for the software it deployed without a license.
We paid Brendan J. Dawson, a Director of Legato since March 2001, $0.1 million in 2001 and less than $0.1 million in 2002 for consulting services and the reimbursement of travel expenses. Also, in March 2002, we engaged Mr. Dawson to provide integration support in connection with our acquisition of OTG. Mr. Dawson received 10,000 shares of common stock, valued at $0.1 million, in connection with this work.
Richard A. Kay has been a Director of Legato since May 2002. Mr. Kay has ownership interests in the Washington Capitals, a professional hockey team, the Washington Wizards, a professional basketball team, KJets LLC and National Operator Service, Inc. (dba Sonet Solutions):
•
In February 2002, OTG entered into a two-year marketing commitment with the Washington Capitals for $0.3 million, which was amended to one year for $0.2 million in January 2003. In addition, OTG purchased 2002-2003 season tickets from the Washington Capitals for less than $0.1 million.
•
In April 2002, OTG purchased 2002-2003 season tickets from the Washington Wizards for $0.1 million.
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Legato agreed to reimburse Mr. Kay for use of a corporate jet for business purposes through December 31, 2002. We incurred $0.2 million of costs in connection with this agreement, and payments were made to KJets LLC.
•
Sonet Solutions currently subleases space in our Rockville facility. Legato received sublease income of less than $0.1 million in 2002.
11. Selected Quarterly Financial Data-(Unaudited)
(1)
In 2002, we incurred restructuring charges of $11.7 million in the fourth quarter, provided for an income tax valuation of $119.2 million in the third quarter, wrote-off in-process research and development of $33.2 million in the second quarter and accrued for a litigation settlement of $67.0 million in the first quarter. In the fourth quarter of 2001, we expensed $48.9 million related to the impairment of intangibles.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints David B. Wright and Andrew J. Brown, and each of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitutes, may lawfully do or cause to be done by virtue thereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of the Registrant and in the capacities and on the dates indicated have signed this report below.
CHIEF EXECUTIVE OFFICER CERTIFICATION
I, David B. Wright, certify that:
1.
I have reviewed this report on Form 10-K of Legato Systems, Inc.;
2.
Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements and other financial information included in this report fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13c-14 and 15d-4) for the registrant and have:
a)
designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b)
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this report (the “Evaluation Date”); and
c)
presented in this report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5.
The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
a)
all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize, and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b)
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6.
The registrant’s other certifying officers and I have indicated in this report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date:
February 28, 2003
By:
/s/ DAVID B. WRIGHT
David B. Wright
Chairman and Chief Executive Officer
CHIEF FINANCIAL OFFICER CERTIFICATION
I, Andrew J. Brown, certify that:
1.
I have reviewed this report on Form 10-K of Legato Systems, Inc.;
2.
Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements and other financial information included in this report fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13c-14 and 15d-4) for the registrant and have:
a)
designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b)
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this report (the “Evaluation Date”); and
c)
presented in this report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5.
The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
a)
all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize, and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b)
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
6.
The registrant’s other certifying officers and I have indicated in this report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date:
February 28, 2003
By:
/s/ ANDREW J. BROWN
Andrew J. Brown
Executive Vice President and
Chief Financial Officer