ITEM 1. BUSINESS Microware Systems Corporation was organized under the laws of the state of Iowa in 1977. Its principal executive offices are located at 1500 N.W. 118th Street, Des Moines, Iowa 50325 (telephone number 515-223-8000; Internet: INFO@MICROWARE.COM or http://www.microware.com). References in this Annual Report on Form 10-K to "Microware" or "the Company" are to Microware Systems Corporation and its subsidiaries.
GENERAL DEVELOPMENT OF BUSINESS Microware develops, markets and supports sophisticated real-time operating system software and development tools for the traditional embedded systems, communications, and consumer products markets. Microware's product line is built around its OS-9 real-time operating system, which was first introduced in 1980 and has been continually refined to incorporate advances in technology. OS-9 is a real-time operating system targeted at "embedded systems" - computers dedicated to specialized tasks embedded within application-specific industrial or computer products. Microware markets its products primarily through its sales forces in North America, Europe and Japan.
Microware's business is focused on developing and marketing OS-9 for use in traditional embedded systems, including industrial automation, transportation, medical, and government/military systems; communications infrastructure products, including networking equipment, ATM, ISDN, digital subscriber loop, Ethernet and fast Ethernet, and custom connectivity applications; and higher volume embedded systems for consumer and business uses, such as digital television decoders, advanced wireless telephones and pagers, point-of-sale equipment, workforce automation devices, in-car navigation systems and Internet appliances. During the past fiscal year, Microware continued its emphasis on the traditional embedded systems and communications markets.
INDUSTRY BACKGROUND Real-time operating systems are significantly different from the operating systems that run general-purpose desktop computers. Many applications require a "real-time" capability that enables them to provide an immediate, predictable response to external events. For example, an embedded system that controls an anti-lock braking system in an automobile needs to react to external events such as pressure on the brake pedal, speed of the automobile and road conditions, all within a fraction of a second. Similarly, real-time systems are important to achieve "lip-sync" by simultaneously decompressing and synchronizing digital streams of audio and video information. Real-time systems are used to enhance performance, reduce manufacturing costs and enable product customization and differentiation.
Real-time operating systems may be loaded from external media, or may reside within a microprocessor as part of an embedded system. An embedded system is comprised of a microprocessor and related software that are dedicated to a specialized task or set of tasks, embedded within an application specific industrial or consumer product. Examples of typical products that have one or more microprocessors and embedded systems include automated teller machines, cellular telephones, pagers, copiers, facsimile machines and automobiles. Many of these products require real-time embedded systems that provide true multitasking, memory management and protection, input-output systems and networking/telecommunication capabilities. Fueled by declining costs and improving performance of 32/64 bit microprocessors, embedded systems are becoming increasingly sophisticated and used in or with a wider range of applications.
Demand for commercial real-time operating systems is driven by growth in real-time embedded systems. The Company anticipates that organizations that develop embedded systems will continue to migrate from internally developed systems to cost-effective third party products. Companies that internally develop application software for embedded systems are focused on maximizing productivity, minimizing costs and reducing time to market while maintaining flexibility. Thus, embedded systems applications developers seek to use a fully integrated and open modular suite of software development tools and real-time operating systems to allow software development to occur concurrently with product development. With increased product complexity and time to market pressures, organizations are relying more heavily on third party specialized consulting services for product and system design and development.
PRODUCTS AND SERVICES Microware offers a broad range of software products based on the OS-9 real-time operating system that can be configured to suit a range of applications in a variety of industries. These operating system products are complemented by the Company's development tools, technical support services, and custom software development services, which facilitate development of embedded OS-9 applications. Substantially all of the Company's revenues are derived from OS-9 and related tools.
Because the Company's current revenues and future growth are dependent upon the continued acceptance of OS-9 technology in its current markets and the successful application of OS-9 technology in new markets, impairment of the OS-9 software in any market for any reason could have a material adverse effect on the Company's current business or future revenues.
OPERATING SYSTEM PRODUCTS Microware's operating system products are based on a variety of packages of the OS-9 kernel, a range of I/O and file managers, various networking protocols, and device drivers. OS-9 is combined with more specialized software modules to create operating system products targeted at specific 32/64 bit processors and applications markets.
OS-9 products include those targeted at Original Equipment Manufacturers ("OEMs"), which include limited source code and enable OEMs to develop customized versions of OS-9 for their specific embedded system application. OEM packages are licensed on a processor-specific basis. Current OEM packages provide support for Motorola 68xxx (680x0, 683xx), Motorola/IBM Power PC (4xx, 6xx, 7xx, 8xx, 82xx), Intel Arm and StrongArm (SA 1100/SA 1110), Intel IXP 1200 network processor, Hitachi SuperH (SH3, SH4), Intel/AMD/ST Microelectronics/Cyrix x86/Pentium (386, 486, 586, Pentium, Pentium II), MIPS, over 30 manufacturers of ARM 7 and ARM 9 derivatives, and other processor families. Additionally, these OEM packages provide support for embedded, communications, and consumer applications.
Microware's DAVID (Digital Audio/Video Interactive Decoder) combines OS-9 with multimedia application programming interface (API) and support for various digital audio/video transmission and networking protocols to provide a full operating environment for the developers of digital TV, interactive television and set-top boxes.
Microware's operating system products are licensed to OEMs through OEM license agreements which generally provide licensees (i) the right to use a specific configuration of an OS-9 module for internal product development in consideration of payment of an initial license fee; and (ii) the right to distribute copies of OS-9 and related software embedded in the licensee's product in consideration of the licensee's payment of a per copy royalty for every copy of OS-9 distributed. OEM licenses are generally bundled with end-user licenses of related development tools on a password protected CD ROM providing a complete development solution in an easy to use package.
All of Microware's operating system products are also available as board-level products through end-user license agreements which grant licensees the right to embed copies of the software in a fixed number of single-board computers. Microware OS-9 board-level products are available for many popular single-board computers, including the Motorola MVME, Compact PCI (cPCI), and MBX platforms, single board computers (SBC), PC/AT-compatible computers, and all reference platforms for supported processors listed above.
Other OS-9 board-level products are also available through third party board-level vendors.
ADDITIONAL OPERATING SYSTEM PRODUCT COMPONENTS Microware also offers its customers a wide array of software product components providing additional functionality as needed for their specific embedded or consumer application. Certain of these products include technologies licensed from third parties. These additional product components include the following:
- Microware MAUI Graphical Environment, which provides a robust graphical environment for applications in a small memory footprint. MAUI supports numerous I/O devices including grayscale and color LCD panels, SVGA/VGA graphics terminals, touch screens, mouse, and keyboards. MAUI has a modular architecture designed to be easily scaled to meet specific system needs, and is interoperable across graphics and sound processor platforms.
- Microware SoftStax Communications Framework, which provides high performance integrated communications and control for communications devices. This unique technology allows developers to rapidly change underlying communications technologies without disturbing application software.
- Microware OS-9 USB - The Universal Serial Bus (USB) implementation uses the SoftStax(TM) universal framework to create a high performance, low footprint, low CPU utilization USB implementation for OS-9.
- Microware OS-9 IEEE1394 Software Developers' Kit (SDK) - Microware's IEEE1394 SDK for OS-9 provides an IEEE1394-1995 compliant turnkey solution for real-time, high performance applications.
- Microware OS-9 LAN Pak, which provides local area network connectivity support for Microware SoftStax.
- Microware OS-9 X.25 Pak, which enables networked embedded systems to communicate over X.25 packet topologies and custom networks.
- Microware OS-9 ISDN Pak, which enables networked embedded systems to communicate over Basic Rate ISDN network topologies.
- Microware OS-9 Power Management software, which provides configurable power policy software and integrated power manager software. This technology is necessary for battery-operated mobile devices.
- Third party middleware for Microware OS-9, including Serial Network Management Protocol (SNMP), PCMCIA support, True Flash File System (FFS) support, Infrared Data Association (IrDA), Asychronous Transfer Mode (ATM), web server and web browser support packages, GUI Builder, MP3 player.
- Microware's implementation of Sun's PersonalJava for OS-9, which enables PersonalJava-compatibility in OS-9 environments.
DEVELOPMENT TOOLS Development Tools are developed and sold by Microware to OS-9 licensees for developing OS-9 applications. Most development tools run on Microsoft Windows configurations, as well as on OS-9. The tools are designed to reduce the cost and increase the speed of the development of OS-9 applications. The Microware operating system and development tools are well integrated and are updated on a coordinated schedule. Customers therefore avoid potential incompatibility among competing vendors.
In July 1998, Microware released a new integrated development environment, Microware Hawk. Microware Hawk is designed as an all-in-one development suite to enable seamless editing, debugging and compilation of C and C++ code; management of complex software build scenarios; management of solo- or team-based changes to source code with version control and access to on-line support to provide immediate assistance for every function. Microware Hawk is an open development environment that can be interoperable with a wide variety of third party development tools. Microware continues to develop compiler, debugger, and utility program components for inclusion in the Microware Hawk integrated development. Through these core components, Microware can provide more substantial performance and operating system functionality than is available in competitive real-time operating systems.
Following the release of Hawk, the Company released HawkEye, a visualization tool for OS-9. HawkEye captures and analyzes a log of events such as forks and exits, context switches, system calls, and interrupts during the execution of a program. It stores all of this information and graphically displays it in an easy to understand format.
Microware's development tools are generally sold under end-user licenses that enable customers to install and use the tools at a fixed number of development seats. The development tools are typically packaged with the operating system product on a single CD-ROM.
CONSULTING SERVICES Consulting services cover a wide range of activities including custom engineering, technical support and training. A high level of customer service and support is essential because many of the Company's customers depend on the Company's products to support the development and operation of complex applications. Custom engineering revenues are typically generated from discrete software engineering projects adapting OS-9 to specific customer requirements. The Company also selectively engages in custom development in order to extend its product line. Professional services are generally provided on a rate per hour and/or per project basis.
SOFTWARE TECHNICAL SUPPORT AND UPGRADE SERVICES Licenses of Microware's operating system and tools products are typically sold together with maintenance support contracts that provide updates of the licensed software and routine technical support. The Company's technical support staff assists licensees with problems and questions in the installation and use of the Company's products. Technical support is provided by Microware's staff of support engineers in North America, Europe, and Japan. Distributors and OEMs generally offer first level customer support to their end-user customers and rely on the Company for higher level support.
Microware also offers extended software support and maintenance services on a per-product basis for a fee. Licensees who purchase extended service are entitled to technical support services and software product updates during the service period.
MARKETS, APPLICATIONS AND CUSTOMERS Microware's strategy is to leverage its advanced technology, strategic customer relationships, commitment to quality, and expertise based on years of experience in the embedded systems market to establish and maintain OS-9 as a leading operating environment for embedded systems. To achieve this goal, Microware focuses its marketing and product development efforts on those sectors of the embedded systems market it believes have the greatest potential to increase Microware's future revenue: (i) traditional embedded systems such as industrial automation, transportation, medical, and government/military systems, (ii) communications infrastructure devices and equipment, and (iii) consumer products such as digital television decoders, wireless telephones, and Internet appliances. In product development, the Company endeavors to provide comprehensive solutions for these diverse markets by supporting market-leading embedded processors and developing new modules providing specialized functionality for those markets. For example, Microware provides specialized telecommunications protocol support for communications infrastructure products, motion picture file manager support for digital television products, power management software for hand-held, battery-operated wireless devices, and Java support for Internet access devices. In sales and marketing, this means developing strategic customer relationships with market leaders, such as Motorola , in the wireless products market or Zenith in the digital television market, and working closely with the providers of complementary technologies.
TRADITIONAL EMBEDDED SYSTEMS BUSINESS The traditional real-time embedded system software market is the core of Microware's business. Licenses to manufacturers of process control, scientific and medical instrumentation, and other relatively low-volume products are a significant source of revenue. Emerging markets for the
Company's traditional embedded systems business include intelligent transportation systems, private network computer systems, gaming devices, office automation and medical instrumentation. The Company believes that the market for its operating system software in the general embedded systems market is large and diversified, and continues to develop, market, support and license its products to and for customers in the traditional embedded systems market. Microware believes that it has a measurable share of the third party embedded operating system market.
In fiscal 2000, Microware continued its emphasis on the traditional embedded systems business by its support for board-level products, developing its relationships with leading embedded systems distributors and resellers, and hiring new sales personnel with substantial embedded systems experience. While the Company believes that its proven technology and long-standing presence in this rapidly growing market will enable it to substantially increase its revenues from this market, its ability to do so is subject to significant risks and uncertainties, particularly the Company's ability to rapidly develop effective internal and third party sales, distribution and marketing channels in the embedded systems marketplace.
COMMUNICATIONS INFRASTRUCTURE DEVICES MARKET The networked embedded systems marketplace is rapidly growing. Additionally, technological demands of networked embedded systems are evolving rapidly, as the bandwidth of digital networks expands simultaneously with the integration of greater multimedia functionality driven by applications such as telecommuting, Internet access, and video delivery. The Company believes this growth and the trend toward licensing of third party operating systems creates a substantial opportunity for targeted packages of OS-9 products.
Microware's solution for the communications infrastructure device market is to provide an embedded operating system platform which includes a simplified, integrated communications environment interoperable across telecommunications protocols and high performance with minimal memory and CPU utilization. The Microware OS-9 product line has integrated communications features based on the Microware SoftStax framework. Microware SoftStax is an open architecture designed to be interoperable with the leading communications protocols and third party communications infrastructure products.
Microware believes the technological sophistication and openness of its architecture will enable it to establish a revenue base in the communications infrastructure market. The communications infrastructure embedded systems software market is highly fragmented, very competitive, and technically demanding. As such, there can be no assurance that Microware will be able to successfully attain significant revenues from the communications infrastructure, or to recoup its investment in that market.
CONSUMER MARKETS Microware's efforts in the market for consumer and business embedded systems devices have focused on select categories which Microware believes represent significant market opportunities for the Company: the wireless and internet devices market and the digital television market.
WIRELESS AND INTERNET DEVICES Since 1996 Microware has marketed a configuration of OS-9 targeted at the manufacturers of wireless hand-held communications devices and Internet-based telephones. The current product configurations combine OS-9 with the MAUI graphics API and new software modules created for key wireless functions such as power management, Java-compatibility and Internet access.
Microware believes there is an emerging market for new categories of wireless communications devices combining the small size and low cost of
traditional pagers and mobile telephones with the more advanced interactivity, graphical user interface, and computing power of personal digital assistants such as new types of smart pagers and wireless telephones which include small screen displays and keyboards and use the Internet to enable transmission and receipt of electronic mail and in some cases World Wide Web browsing and in-car navigation syatems. The Company believes OS-9 is well suited to operate such devices and has developed strategic relationships with OEM manufacturers working toward their development and eventual deployment.
Microware's wireless and Internet strategy is to provide a wide variety of products and services for licensing to leading equipment manufacturers. The core of this strategy is the development of strategic customer relationships with leading manufacturers of wireless and Internet devices. Microware has developed such strategic licensing relationships with Motorola, among others, who have been developing next generation wireless and Internet communications devices using OS-9.
Under a July 1995 software development and license agreement, Microware is providing OS-9 as the operating system for various wireless devices under development by Motorola, Inc. Motorola's PageWriter two-way pager, currently being marketed through the SkyTel paging network, is based on a customized version of OS-9 jointly developed by Microware and Motorola. In July 1995, Motorola also purchased 1,526,232 shares of Microware Common Stock and was issued warrants to acquire additional shares. As of March 31, 2000, warrants to acquire 1,248,736 shares were outstanding, of which warrants to purchase 554,992 shares were exercisable. On August 1, 2000, warrants to acquire 693,744 shares will become exercisable. All outstanding warrants will expire on July 31, 2001. Pursuant to the Stock and Warrant Purchase Agreement, a designee of Motorola has the right to serve on Microware's Board of Directors. That seat is currently vacant.
During the past fiscal year, the Company's revenues from its wireless and Internet activities primarily consisted of license fees, non-refundable prepaid royalties and custom contract engineering fees received from wireless and Internet customers. The Company's future operating results will depend significantly on the development of its products and personal wireless and Internet communication devices. To date some of the wireless and Internet device projects for which OS-9 has been licensed and customized have been delayed due to factors beyond Microware's control. Such delays may continue in the future. As wireless and Internet communication markets develop, the Company's strategy depends on the incorporation of the Company's software into new products, such as two-way pagers, smart wireless telephones, and in-car navigation systems, for which demand is uncertain. There can be no assurance that such products will be successfully developed or commercialized or that the Company will derive significant revenues or earnings from such products. Moreover, the Company's wireless and Internet strategy is highly dependent on its ability to market Java-compatible versions of its products. There can be no assurance that Java will continue to develop as a popular platform for wireless and Internet communications devices of OEMs, that Microware will be able to maintain Java-compatibility on competitive terms under its license with Sun Microsystems, or that Microware will be able to keep pace with the rapid technological change in these markets.
DIGITAL TELEVISION MARKET Since 1993 Microware has offered an OS-9 operating system configuration targeted at the emerging digital television business. Microware OS-9 for Digital TV is designed to operate the digital decoders that turn standard televisions into smart clients on new digital television networks under development by telephone companies, cable companies, and direct broadcast satellite providers with interactive processing, graphics, video and audio functionality. Microware OS-9 for Digital TV has emerged as a leading
operating system for digital decoders, having been licensed by over 20 set-top box manufacturers and used in trial and commercial deployments around the world.
A streamlined configuration of Microware OS-9 for Digital TV is targeted at digital-video broadcast products for existing cable systems, new multichannel multipoint distribution systems ("MMDS") and DBS networks. Microware OS-9 for Digital TV-based digital decoders manufactured by Zenith Electronics Corporation have been contracted for procurement by Americast, a digital television technology consortium of Ameritech, SBC, Bell South, GTE, and Disney, and are currently deployed by Bell South in New Orleans.
To date, most of the Company's digital television revenues have been from Microware OS-9 for Digital TV license agreements and custom contract engineering with digital decoder OEMs and network operators. The Company's current activities relating to its new media markets remain focused upon licensing Microware OS-9 for Digital TV for digital television uses. The Company has increasingly focused its marketing efforts in the digital television business on the development of strategic marketing alliances which will enable the Company to leverage the market position of Microware OS-9 for Digital TV into additional OEM licenses.
While the Company has received significant revenues in the past from development licenses, non-refundable pre-paid royalties and custom contract engineering work sold to digital television decoder OEMs, only a small proportion of the Company's digital television licensees are actually manufacturing digital decoders. There can be no assurance that the Company will be able to achieve significant new digital decoder OEM design wins and development license revenues, that the Company will receive substantial run-time license revenues from any digital television industry participant, or that the Company will be able to establish and maintain DAVID as an industry standard.
Despite the announced intentions of many companies, and the Company's belief that Microware OS-9 for Digital TV is well positioned as a solution for the digital television market, the Company believes the digital television market remains at an early stage and is not well defined. Many prominent deployments have been delayed, and there can be no assurance that the digital television market will develop in any predictable or immediate way. These delays have eroded Microware OS-9 for Digital TV's early market advantage to the benefit of the Company's competitors. It is therefore difficult to make reliable estimates of the size of the digital television market or the Company's likely market share.
COMPETITION The embedded software industry is highly competitive, highly fragmented and is characterized by rapidly advancing technologies. To maintain or improve its position, the Company must continue to enhance its current product offerings and introduce new product features and extensions in a timely fashion.
All of the Company's products compete with proprietary software developed internally by embedded system product manufacturers, as well as with many third party vendors of development tools for embedded systems, including many privately held companies and several publicly held companies. Several microprocessor manufacturers, including Intel and Motorola, distribute software that at times competes with the Company's products. The Company expects that additional competitors, including other large software vendors, will emerge. Some of the Company's current competitors, and many of the Company's potential competitors, have substantially greater technical, sales, marketing and financial resources than the Company. Other than proprietary
software developed internally by embedded systems manufacturers, the Company's products compete primarily with products by Mentor Graphics Corp. (through its acquisition of Microtec Research, Inc.), Microsoft Corporation ("Microsoft"), QNX, LynuxWorks and Wind River Systems, Inc.(Wind River), who, in fiscal 2000, acquired another of the Company's primary competitors, Integrated Systems, Inc. (ISI).
In the digital television market, Microware OS-9 for Digital TV, also known as DAVID, competes with software developed internally by set-top box manufacturers, including Scientific-Atlanta's PowerTV and Thompson Consumer Electronics' Open TV and with products from Microsoft, Sony and Wind River. Many of the Company's digital television competitors have substantially greater technical, sales, marketing and financial resources than the Company.
The Company expects that as the embedded systems market continues to evolve, additional competitors will seek to enter these markets.
The Company believes that its ability to effectively compete in the embedded systems market depends on factors both within and outside its control, including the ability to establish effective sales and distribution channels, timing and success of new products developed and marketed by the Company and its competitors, product performance and price, the Company's ability to provide custom development and integration services, distribution and customer support, product reputation, customers' willingness to replace internally developed software solutions and customers' assessment of the Company's financial resources and its technical and service expertise. The Company believes that its products compete effectively in markets on the basis of product features, reliability, price and performance characteristics. However, there can be no assurance that the Company will be able to compete successfully with respect to these and other factors. In particular, competitive pressures, including pricing pressures for the Company's run-time licenses, the Company's past difficulties encountered in working to develop strong, effective sales and distribution channels and new product introductions from existing and new competitors could adversely affect the Company's future business and results from operations.
As a result of consolidation and other transactions involving competitors and other companies in the Company's markets, the Company occasionally reviews potential transactions relating to its business, products and technologies. Such transactions could include mergers, acquisitions, strategic alliances, joint ventures, licensing agreements, co-promotion agreements or other types of transactions. The Company may choose to enter into such transactions at any time, and such transactions could have a material effect on the Company its business or operations.
MARKETING, SALES AND DISTRIBUTION Microware markets and licenses its products principally through its direct sales force. Microware currently uses a direct sales force in North America, Europe and Japan. The Company has numerous sales offices in the U.S. International offices are located in the United Kingdom, Germany, France, The Netherlands and Japan. Distributors and sales representatives are used in certain countries. Direct sales representatives are supported by field application engineers who are experienced in the embedded market and the Company's products and technologies. International sales accounted for approximately 59%, 64% and 68% of total revenues in fiscal 1998, 1999, and 2000 respectively.
During the last three fiscal years, the Company has continued to experience significant turnover and attrition in its marketing and sales personnel. Additionally, the Japanese subsidiary's President and Representative Director, and the Managing Director of European Operations both
resigned and were replaced in calendar year 2000. The significant turnover experienced by the Company has had, and may continue to have, an adverse effect on the Company's operations, the extent of which cannot presently be determined.
The Company's future operating results will depend significantly on the Company's ability to develop its sales and distribution channels. In order to rapidly increase revenues and as the embedded market continues to mature, the Company continues to realign its efforts and resources towards strengthening its current sales and distribution channels, particularly in North America. Additionally, in fiscal 2001, the Company anticipates utilizing a focused network of Value Added Resellers (VARs) and distributors. While the Company believes the use of distributors will provide an effective channel to substantially increase its revenues, there can be no assurance that the Company will be able successfully engage distributors.
In fiscal 2000, the Company invested in the expansion and development of its sales channels and the upgrading of its infrastructure to increase marketing activity associated with the release of new products. In addition to hiring a Director of Corporate Communications, the Company has retained the services of a public relations firm. While the Company anticipates that these investments will lead to increased revenue generation, there can be no assurance that there will be that result.
The Company will continue to generate new business opportunities in its target markets through direct marketing, advertising, websites, press releases, trade shows, user group meetings, telemarketing, direct mailings and through its strategic alliances.
RESEARCH AND DEVELOPMENT The Company has made substantial investments in product development. The Company believes that its future success will depend in large part on its ability to enhance its existing products, to develop new products and to maintain its technological competitiveness. As of March 31, 2000, the Company employed 55 product development engineers. Of these, 47 engineers were based in Des Moines, Iowa and 8 were based in Tokyo, Japan.
During fiscal 1998, 1999, and 2000 research and development expenses amounted to $7.2 million, $6.8 million, and $5.8 million, respectively, excluding capitalized software development costs. For the above periods, research and development expenses represented 41%, 41%, and 43% of the Company's total revenues, respectively. For the same periods, software development costs capitalized totaled $215,000, $64,000,and $0 respectively. The Company believes that its current level of research and development expenses is adequate to meet its competitive needs. The Company anticipates that it will continue to commit substantial resources to product development in the future.
PRODUCTION The Company prepares master software media, user manuals and packaging for each product. The Company's media duplication, production of product packaging, and printing of user manuals and related materials is performed by the Company at its facilities and by third party sources throughout the world. The Company grants duplication rights to certain of its original equipment manufacturers. To date, the Company has not experienced any material difficulties or delays in production of its software products or documentation.
BACKLOG The Company generally ships its products within a few days after acceptance of a customer purchase order and, therefore, has insignificant
product backlog. The low product backlog makes it difficult to predict with accuracy quarterly revenues and quarterly earnings prior to the end of a quarterly reporting period.
EMPLOYEES As of March 31, 2000, the Company employed 127 people, including 57 in marketing, sales and support services, 55 in engineering and product development and 15 in operations, finance and administration. Of these employees, 82 are located in the United States, and 45 are employed by the Company's international operations. None of the Company's employees are represented by a labor union or is the subject of a collective bargaining agreement. The Company has never experienced a work stoppage and believes that its employee relations are good.
NOTICE REGARDING TRADEMARKS Microware, the Microware logo, OS-9, Hawk, HawkEye, DAVID, MAUI, UpLink, ITEM, FasTrak, Ultra C, Ultra C++ and SoftStax are registered trademarks of Microware Systems Corporation. Java, Java OS and PersonalJava are trademarks of Sun Microsystems, Inc. All other marks are trademarks or registered trademarks of their respective holders.
ADDITIONAL RISK FACTORS In addition to the other risk factors contained herein, the Company believes the following additional risk factors should be taken into consideration in evaluating its business:
HISTORY OF OPERATING LOSSES; VARIABILITY OF QUARTERLY OPERATING RESULTS. The Company has experienced significant operating losses for the past four fiscal years. While the Company has taken a number of measures to increase its revenues, decrease its operating expenses, and attain profitability, there can be no assurance that these measures will succeed or that the Company will become profitable. Furthermore, the Company's revenues and operating results have varied substantially from quarter to quarter, remain difficult to forecast due to the nature of the embedded systems market and the Company's business, and should not be relied upon as an indication of future performance.
MARKET RISKS. The Company has invested substantial resources in the development of emerging markets, in particular the digital television and wireless and Internet communications devices markets. While the Company has achieved a substantial number of OEM licenses in these markets and a number of the devices are currently in commercial deployment, these markets remain at an early stage and are increasingly competitive, and there can be no assurance that the Company will receive substantial revenues or earnings from products or services in these markets.
The Company has continued its focus on the traditional embedded systems business in an effort to lessen the variability of its quarterly operating results and attain profitability. The traditional embedded systems business is diverse and increasingly competitive, and there can be no assurance that the Company will be able to substantially increase its revenues from that market.
The communications infrastructure device market is highly fragmented, very competitive, and technically demanding. While Microware believes the technological sophistication and openness of its product architecture for the market will enable it to establish a substantial revenue base in the communications infrastructure market, there can be no assurance that the Company will be able to do so.
ABILITY TO KEEP PACE WITH COMPETITION AND RAPID TECHNOLOGY CHANGE. The embedded systems markets are highly diverse and devoid of established technology standards. A majority of embedded operating systems and applications are developed in-house by OEMs, and no single processor platform accounts for a majority or even a substantial minority of the embedded systems under development. Moreover, the market is increasingly competitive, with a number of industry-leading companies with substantially greater financial and technical resources than Microware devoting substantial resources to the development of significant market share in the embedded systems business. While the Company tries to support the industry-leading 32-bit microprocessors which it believes represent the best market opportunities, and to offer the best possible array of incremental software functionalities, there can be no assurance that the Company's current products will meet the demands of the market in an environment of increasing competition and rapid technology change.
RISKS ASSOCIATED WITH PRODUCT DEVELOPMENT AND TRANSITIONS. The Company has in the past experienced delays in software development, and there can be no assurance that the Company will not experience such delays in the future. Such delays, which can occur because of resource constraints, unforeseen technological obstacles within or outside the Company's control, and changes in market requirements, can have a material adverse effect on the Company's business.
COMPETITION. The Company has attracted substantial competition in its targeted markets. Many of the Company's traditional competitors have grown substantially as a result of successful exploitation of growth in the embedded systems market and through mergers and acquisitions, and in some cases have expanded their businesses in a manner which competes more directly with the Company. Microsoft has devoted substantial resources to the development of its Windows CE product, which is attempting to capture a significant market share in the handheld computer market and other segments of the embedded market. Sun Microsystems, Inc. offers an embedded operating system product called JavaOS, which it markets together with its Java technology. There can be no assurance the Company will be able to successfully attain new market share or even maintain its existing market share in this increasingly competitive market.
ATTRACTION AND RETENTION OF QUALIFIED PERSONNEL. The Company's future performance depends to a significant degree upon the continued contributions of its key management, product development, marketing and sales personnel, many of whom have joined the Company recently. The Company has continued to experience significant turnover in personnel during the past fiscal year. Additionally, the Japanese subsidiary's President and Representative Director, and the Managing Director of European Operations both resigned and were replaced in calendar year 2000. The Company's ability to execute its market strategy will depend to a large degree upon its ability to integrate new personnel into the Company. Competition for qualified personnel throughout the software industry is intense and there can be no assurance that the Company will be successful in attracting and retaining such personnel.
INTERNATIONAL OPERATIONS. In the past three fiscal years, the Company derived at least 50% of its total revenue from sales outside North America, and this trend is anticipated to continue in the future. This dependence on international operations subjects the Company to certain risks, including tariffs and other barriers, difficulty in staffing and managing foreign subsidiary operations, difficulty in managing distributors and resellers, difficulty in accounts receivable collection, foreign currency exposure and adverse tax consequences. The Company is also subject to the risks associated with the imposition of protective import or export legislation and regulations by the United States or other countries. The Company cannot predict whether
quotas, duties, taxes or other charges or restrictions will be implemented on the Company's products in the future. There can be no assurance that these factors or the adoption of restrictive policies will not have a material adverse effect on the Company's business, financial condition and results of operations.
DEPENDENCE ON PROPRIETARY TECHNOLOGY AND RISK OF TECHNOLOGY LITIGATION. Because substantially all of the Company's revenues are derived from OS-9 and related products, any impairment of OS-9 could have a material adverse impact on Microware's business. The Company's business is therefore dependent on the adequacy of the Company's intellectual property protection through patents, copyrights, trade secrets, and license agreements; the adequacy and continued availability of its licenses of integrated technology from third parties; and the absence of any material technology litigation related to the Company's products.
ISSUANCE OF PREFERRED STOCK, OPTIONS AND WARRANTS. In April 2000, the Company issued 3,500 shares of Series I Preferred Stock initially convertible into 1,473,684 shares of common stock, stock options to purchase 618,595 shares of common stock, and warrants to purchase 87,500 shares of common stock. Subsequently, 668,556 shares of common stock were issued pursuant to the conversion of 1,578 shares of Series I Preferred Stock. Additionally, the Company has previously issued warrants to acquire 1,803,728 shares of common stock to Motorola, of which warrants to acquire 554,992 shares of common stock have expired and warrants to acquire 554,992 shares of common stock are currently exercisable. In addition, the Company has issued and will continue to issue substantial stock options to employees. The holders of these preferred shares, options and warrants have the opportunity to profit from a rise in the market price of the Company's common stock, thus resulting in a possible dilution in the interest of other security holders. The Company's ability to obtain additional capital may be adversely affected as long as the convertible securities remain unexercised. Moreover, the holders of the convertible securities may exercise such securities at a time when the Company may be able to obtain capital by a new offering of securities on terms more favorable than those under which existing warrants or options are exercisable.
ITEM 2.
ITEM 2. PROPERTIES
The Company owns its main operating facility located in Des Moines, Iowa, subject to mortgage debt. This space is used for research and development, sales and marketing, operations and administration and consists of approximately 88,000 square feet. Annual mortgage payments for the Company's main operating facility total approximately $600,000. In December 1998, the Company began subletting excess capacity in its main operating facility in order to reduce its operating costs associated with the facility. As of January 1, 2000, the Company had sublet approximately 29,000 square feet of its main operating facility and will continue to sublet additional excess capacity in the future. The Company also leases numerous domestic and international sales and support offices for an aggregate annual rental payment of approximately $500,000. The Company believes that additional space will be available as needed.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On September 1, 1999, Microware filed suit in the United States District Court for the Southern District of Iowa ("Court") against Apple Computer, Inc. ("Apple"). The suit charges Apple with trademark infringement, false designation of origin, unfair competition, and trademark dilution. Microware believes that Apple's use of the trademark "MAC OS 9" to identify its operating system software has, and will continue to, cause confusion in the marketplace, and dilute the value and goodwill associated with Microware's registered trademark for the mark "OS-9". On March 16, 2000, the Company was notified that the Court had ruled in favor of Apple in this matter. The Company filed a notice of appeal to the decision on March 30, 2000.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of the Company are as follows:
Mr. Kaplan has served as President and Chief Executive Officer of the Company since he co-founded it in 1977. Mr. Kaplan was one of the principal designers of the OS-9 real-time operating system. Mr. Kaplan is a member of the boards of directors of the Interactive Multimedia Association and is a Trustee of Drake University and Buena Vista University. Mr. Kaplan attended Drake University.
Mr. Leonard joined the Company in August 1998 as Executive Vice President, Chief Financial Officer, Treasurer and Secretary. Mr. Leonard was appointed Chief Operating Officer and a director on May 16, 2000. Prior to joining the Company, from July 1996 to July 1998, Mr. Leonard was the Vice President and Chief Financial Officer and a director of Western Pacific Airlines, based in Colorado Springs, Colorado. Western Pacific Airlines filed for bankruptcy protection under Chapter 11 on October 4, 1997 and converted its filing to Chapter 7 in July 1998. Mr. Leonard also served as Chairman and Chief Executive Officer of Consumer Guaranty Corporation of Phoenix, Arizona, President and CEO of GEL Management Corporation, Chairman and Chief Executive Officer of AmBank Holding Company, and Executive Vice President, Chief Financial Officer, Chief Lending Officer and Chief Banking Officer and a Director of MeraBank from 1975 to 1996. Mr. Leonard holds as B.S. degree from the United States Naval Academy and an M.B.A from the University of Chicago
Mr. Boswell joined the Company in February 1999 as Vice President of Sales. From November 1995 until joining the Company, Mr. Boswell served with Paradigm Technology, Inc. of Milpitas, California, where he was successively Director of Marketing and Vice President of Sales and Marketing. From April 1994 to November 1995, Mr. Boswell was a Strategic Sales Manager with Sharp Microelectronics of San Jose, California. From 1989 to 1994 Mr. Boswell held various positions with Hitachi America, Ltd., including Regional Sales Manager. Mr. Boswell has held other electronics sales, marketing, and operations positions with LSI Logic, Advanced Micro Devices, and Hewlett Packard. Mr. Boswell holds a B.S. degree from the University of New Mexico and an M.B.A. from the University of Arizona.
Ms. Law has served as Chief Accounting Officer, Controller and Assistant Treasurer of the Company since February 2000. Prior to joining the Company, Ms. Law worked for Network Six, Inc., a systems integrator based in Warwick,
Rhode Island. Ms. Law is a Certified Public Accountant, and holds a B.S. degree from the University of Rhode Island.
On March 1, 2000 and May 10, 2000, respectively, Mr. Ishibashi, President, Microware Systems Kabushiki Kaisha (subsidiary) and Mr. Allen, Managing Director European Operations and a director, resigned their positions with the Company and were replaced later in the year. While not officers of the Company, the nature of their duties with respect to the Company's subsidiaries may mean they were deemed to be executive officers under applicable SEC rules.
The Company currently has an employment agreement with Mr. Leonard. The Company does not have employment agreements with any other executive officers, but has one-year agreements not to compete with certain of its executive officers and other key employees. The loss of service of one or more of the Company's other executive officers could adversely affect the Company's business.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's stock is listed on the Nasdaq National Market under the trading symbol "MWAR." The closing price of the Company's common stock, no par value (the "Common Stock"), as reported by the Nasdaq National Market as of May 31, 2000 was $3.00 per share. The following table sets forth the low and high closing sales prices per share for the Company's common stock on the Nasdaq National Market for the quarter indicated.
As of May 31, 2000, there were approximately 260 shareholders of record of the Company's Common Stock. Certain recordholders are brokers and other institutions holding on behalf of shareholders. The Company has estimated the total number of such shareholders to be 5,000.
The Company has never paid any cash dividends on its capital stock and does not expect to pay any cash dividends in the foreseeable future. Any future determinations to pay cash dividends will be at the discretion of the Board of Directors and will depend on the Company's earnings, capital requirements, financial condition, credit and loan agreements in effect at that time and any other factors deemed relevant by the Board of Directors.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table contains certain selected financial data. There were no cash dividends or distributions made by the Company during the periods presented.
(In thousands, except per share data)
(1) See Note 1 of Notes to Consolidated Financial Statements for information concerning the computation of net earnings (loss) per share. (2) Includes current installments of long-term debt and long-term portion of notes payable to banks. See Note 5 of Notes to Consolidated Financial Statements.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION PROVIDES AN ANALYSIS OF THE COMPANY'S FINANCIAL CONDITION AND RESULTS OF OPERATIONS, AND SHOULD BE READ IN CONJUNCTION WITH THE "SELECTED CONSOLIDATED FINANCIAL DATA" AND THE NOTES THERETO AND THE CONSOLIDATED FINANCIAL STATEMENTS AND THE NOTES THERETO OF THE COMPANY.
FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY This discussion and analysis of the Company's financial condition and results of operations includes forward-looking statements that involve risk and uncertainty, including management's expectations for fiscal 2001 and known trends and uncertainties in the business. Words such as "expects", "anticipates", "intends", "believes", "plans", "seeks", "estimates" and similar expressions or variations of these words are intended to identify forward-looking statements, but are not the only means of identifying forward-looking statements. Additionally, statements that refer to Microware's estimated or anticipated future results, sales or marketing strategies, new product development or performance or other non-historical facts are forward-looking and reflect Microware's current perspective of existing information. Forward-looking statements are inherently subject to risks and uncertainties that cannot be predicted or quantified, and actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements depending on a variety of factors including the volume and timing of orders received during the quarter, the Company's ability to successfully market its products, the Company's ability to keep pace with its competition and with rapid technological change, the Company's ability to manage turnover in its sales and marketing and other personnel and to attract and maintain personnel generally, as well as other risk factors mentioned throughout this Annual Report and in the Company's other filings with the Securities and Exchange Commission. Readers are urged not to place undue reliance on forward-looking statements and Microware disclaims any obligation to update any of the forward-looking statements contained in this Report to reflect any future events or developments. The Company's operating results have varied significantly from quarter to quarter in the past, and the future operating results of the Company may fluctuate as a result of the above and other risk factors detailed in this Annual Report and other documents filed by the Company with the Securities and Exchange Commission. Due to all of the foregoing factors, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as an indication of future performance. In prior years, the Company's actual financial performance has not always met market expectations and the Company has experienced significant quarterly losses. It is likely that, in some future quarter, the Company's financial performance will again fall below market expectations.
OVERVIEW Microware develops, markets and supports real-time operating system software and high-level language compilers used in consumer electronics, communications, process control and factory automation, scientific research, and government/defense applications. Microware's product line is built around the OS-9 family of real-time operating systems for advanced microprocessors. The Company's OS-9 product family includes options for programming languages, networking, graphical interfaces and productivity tools. Substantially all of the Company's revenues in the last and current fiscal years have been derived from licenses and related services from the OS-9 product family.
The Company has historically derived revenues from development licenses and run-time license royalty fees along with sales of related software productivity tools, maintenance support and custom contract engineering work. Custom contract engineering revenues are typically derived from discrete
software engineering projects porting the OS-9 operating system along with customized software products to a customer's product. Commonly, license royalty fees follow the completion of these contracts and the successful deployment of the customer's product. For financial reporting purposes, product revenues primarily consist of software licenses and software development tool products, along with license run-time royalty fees earned, including non-refundable prepaid royalties. Services revenues principally consist of revenues from custom contract engineering and maintenance support agreements, along with consulting and training activity.
A key element of the Company's long-term strategy is to develop products which can be embedded into successful, high volume customer products; thereby significantly increasing license run-time royalty fees. Any increase in the percentage of revenues attributable to license run-time royalties will depend on the Company's successful negotiation of license run-time royalties and on the successful commercialization by the Company's customer of the underlying product. In addition, there can be no assurances that the Company will be successful when the markets, for which the Company products are targeted, emerge.
RESULTS OF OPERATIONS
Amounts and percentage of revenues: The following table sets forth, for the periods indicated, the amount and related percentage of the Company's total revenues by each line item.
*Insignificant
FISCAL YEAR ENDED MARCH 31, 2000 COMPARED TO FISCAL YEAR ENDED MARCH 31, 1999
REVENUES. Total revenues decreased 19.2% or $3.2 million, from $16.6 million in fiscal 1999 to $13.4 million in fiscal 2000. During fiscal 2000, the Company experienced significant attrition and turnover in its North American sales and marketing personnel. The significant turnover experienced by the Company has had, and may continue to have, an adverse effect on the Company's operations, the extent of which cannot presently be determined. Product revenues decreased 15.7%, or $1.9 million, from $12.3 million in fiscal 1999 to $10.4 million in fiscal 2000. The decrease in product revenues from fiscal 1999 to fiscal 2000 resulted from fewer initial license fees. Additionally, fiscal 1999 product revenue included substantial prepaid royalties, which consequently decreased royalty revenue recognized in fiscal 2000. Product revenues from certain strategic customers and the Company's DAVID licensees, continued to fall below management expectations. Future growth in product revenues will continue to be substantially dependent on the Company's ability to develop cost effective sales channels in North America and abroad and the Company's customers' timely and successful development and distribution of new products using the Company's products. Each of these factors makes product revenues difficult to accurately forecast on a quarterly or annual basis. Services revenues decreased 29.5%, or $1.3 million, from $4.3 million in fiscal 1999 to $3.0 million in fiscal 2000. The decrease in service revenues resulted from a decline in custom engineering contracts.
International revenues represented 59%, 64% and 68% of total revenues in fiscal 1998, 1999 and 2000, respectively. The percentage increase in fiscal 2000 resulted from a continued decline in U.S. revenues, while overseas sales experienced a relatively smaller reduction. The Company expects international sales to continue to represent a significant portion of its revenues although the percentage may fluctuate from period to period. In Europe and Japan, revenues and expenses are primarily denominated in local currencies. The Company's operating and pricing strategies take into account changes in exchange rates over time. However, the Company's results of operations may be significantly affected in the short-term by fluctuations in foreign currency exchange rates.
COST OF REVENUES. Cost of product revenues includes direct and indirect costs for documentation, production quality, duplication of manuals and media for software products, as well as those costs related to the packaging, shipping and delivery of the product to the customer. Cost of product revenues also includes direct third party royalty expense and amortization expense of purchased and capitalized software. Cost of services revenues includes direct and indirect costs for technical phone support, training and education, and custom engineering.
Total cost of revenues decreased 29.4%, or $1.4 million, from $4.8 million in fiscal 1999 to $3.4 million in fiscal 2000. Overall cost of revenues decreased due to the reduction in total revenues. As a percentage of product revenues, cost of product revenues decreased from 21.2% in fiscal 1999 to 19.7% in fiscal 2000. Cost of product revenues decreased as a percentage of product revenues as a result of marginal efficiencies achieved in the direct costs of producing, packaging and shipping products to customers. As a percentage of services revenues, cost of services revenues decreased from 51.9% in fiscal 1999 to 45.5% in fiscal 2000. The percentage decrease between periods primarily resulted from an increase in higher margin support and maintenance contracts rather than custom engineering contracts which have greater costs associated.
RESEARCH AND DEVELOPMENT. Research and development expense includes expenses associated with the development of new products and the enhancements of existing products, and consists primarily of employee salaries and related expenses. Research and development expense decreased 14.9%, or $1.0 million, from $6.8 million in fiscal 1999 to $5.8 million in fiscal 2000. The reduction in research and development expense is a primary result of fewer engineers employed by the Company during fiscal 2000. While research and development costs have decreased from year to year, these same expenses have increased as a percentage of sales from 41% in fiscal 1999 to 43% in fiscal 2000. The Company has made substantial investments in product development. The Company believes that its future success will depend in large part on its ability to enhance its existing products, to develop new products and to maintain technological competitiveness. Consequently, the Company anticipates that it will continue to commit substantial resources to product development in the future.
SALES AND MARKETING. Sales and marketing expense consists primarily of sales and marketing personnel related costs, including sales commissions. Sales and marketing expense also includes costs of advertising, public relations and attendance at industry trade shows. Sales and marketing expense decreased 16.2%, or $1.9 million, from $11.5 million in fiscal 1999 to $9.6 million in fiscal 2000. The overall decrease was primarily attributable to reduction of the number of sales and marketing personnel through attrition and turnover. In fiscal 2001, the Company expects to increase its investment in the expansion and development of its sales channels and the upgrading of its infrastructure in addition to expanding marketing activities.
GENERAL AND ADMINISTRATIVE. General and administrative expenses consist primarily of personnel costs for administration, finance, human resources and facilities management, as well as legal, auditing and certain recruiting and relocation expenses. General and administrative expenses decreased 14.8%, or $529,000, from $3.6 million in fiscal 1999 to $3.0 million in fiscal 2000. The decrease in general administrative expenses primarily resulted from a reduction in administrative staff as well as decreased recruiting and relocation activities.
OTHER INCOME (EXPENSE). Other income (expense) decreased 123%, or $241,000, from $196,000 in fiscal 1999 to ($45,000) in fiscal 2000. The decrease between periods resulted from a reduction of interest income due to cash used in operations, and the inclusion in fiscal 1999 of the gain on the sale of the Company's former headquarters building.
FISCAL YEAR ENDED MARCH 31, 1999 COMPARED TO FISCAL YEAR ENDED MARCH 31, 1998
REVENUES. Total revenues decreased 6.3% or $1.1 million, from $17.7 million in fiscal 1998 to $16.6 million in fiscal 1999. During fiscal 1998, the Company experienced significant turnover in its sales personnel, particularly in North America and Japan. During fiscal 1999, the turnover in Japan was stabilized; however the Company experienced significant attrition in its marketing personnel and continued to experience significant turnover in its North American sales personnel. The significant turnover experienced by the Company has had, and may continue to have, an adverse effect on the Company's operations, the extent of which cannot presently be determined. Product revenues increased 2.2%, or $266,000, from $12.0 million in fiscal 1998 to $12.3 million in fiscal 1999. The increase in product revenues from fiscal 1998 to fiscal 1999 primarily stemmed from non-refundable prepaid royalties and license fees from Motorola for the Company's Digital TV and Java product offerings. The Company continues to be negatively impacted by the slower than anticipated emergence of various target markets, such as cellular phones, two-way paging, personal Internet devices and digital and interactive television. Product revenues from certain strategic customers including Motorola, Northern Telecom Ltd., Ericsson and the Company's DAVID licensees, continued to fall below management expectations. Future growth in product revenues will continue to be substantially dependent on the Company's ability to develop cost effective sales channels in North America and abroad and the Company's customers' timely and successful development and distribution of new products using the Company's products. Each of these factors makes product revenues difficult to accurately forecast on a quarterly or annual basis. Services revenues decreased 24.2%, or $1.4 million, from $5.7 million in fiscal 1998 to $4.3 million in fiscal 1999. The decrease in services revenues primarily resulted from a decrease in funded development of advanced processor ports along with, to a lesser extent, a reduction in DAVID custom services.
International revenues represented 50%, 59% and 64% of total revenues in fiscal 1997, 1998 and 1999, respectively. The percentage increase in fiscal 1999 resulted primarily from a reduction in U.S. revenue compounded by an overall increase in revenues from Europe. The Company expects international sales to continue to represent a significant portion of its revenues although the percentage may fluctuate from period to period. In Europe and Japan, revenues and expenses are primarily denominated in local currencies. The Company's operating and pricing strategies take into account changes in exchange rates over time. However, the Company's results of operations may be significantly affected in the short-term by fluctuations in foreign currency exchange rates.
COST OF REVENUES. Cost of product revenues includes direct and indirect costs for documentation, production quality, duplication of manuals and media for software products, as well as those costs related to the packaging, shipping and delivery of the product to the customer. Cost of product revenues also includes direct third party royalty expense and amortization expense of purchased and capitalized software. Cost of services revenues includes direct and indirect costs for technical phone support, training and education, and custom engineering.
Total cost of revenues decreased 18.5%, or $1.1 million, from $5.9 million in fiscal 1998 to $4.8 million in fiscal 1999. Overall cost of revenues decreased due to the reduction in total revenues. As a percentage of product revenues, cost of product revenues decreased from 22.8% in fiscal 1998 to 21.2% in fiscal 1999. Cost of product revenues decreased as a percentage of product revenues primarily as a result of marginal efficiencies achieved in the direct costs of producing, packaging and shipping products to customers. As a percentage of services revenues, cost of services revenues decreased from 56.4% in fiscal 1998 to 51.9% in fiscal 1999. The percentage decrease between
periods primarily resulted from higher margin custom contract engineering work being performed during fiscal 1999 as compared fiscal 1998.
RESEARCH AND DEVELOPMENT. Research and development expense includes expenses associated with the development of new products and the enhancements of existing products, and consists primarily of employee salaries and related expenses. Research and development expense decreased 6.2%, or $451,000, from $7.2 million in fiscal 1998 to $6.8 million in fiscal 1999. The reduction in research and development expense is a primary result of fewer engineers employed by the Company during fiscal 1999. The Company has made substantial investments in product development. The Company believes that its future success will depend in large part on its ability to enhance its existing products, to develop new products and to maintain technological competitiveness. Consequently, the Company anticipates that it will continue to commit substantial resources to product development in the future.
SALES AND MARKETING. Sales and marketing expense consists primarily of sales and marketing personnel related costs, including sales commissions. Sales and marketing expense also includes costs of advertising, public relations and attendance at industry trade shows. Sales and marketing expense increased 13.1%, or $1.3 million, from $10.2 million in fiscal 1998 to $11.5 million in fiscal 1999. The overall increase was primarily attributable to the Company's continued investment in its domestic and international sales and distribution channels and support infrastructures. In fiscal 2000, the Company expects to continue investing in the expansion and development of its sales channels and the upgrading of its infrastructure in addition to increasing marketing activity associated with the release of new products.
GENERAL AND ADMINISTRATIVE. General and administrative expenses consist primarily of personnel costs for administration, finance, human resources and facilities management, as well as legal, auditing and certain recruiting and relocation expenses. General and administrative expenses decreased 20.2%, or $907,000, from $4.5 million in fiscal 1998 to $3.6 million in fiscal 1999. The decrease in general administrative expenses primarily resulted from a reduction in recruiting and relocation costs along with costs associated with the move to the Company's new headquarters facility.
SPECIAL CHARGES. No special charges were incurred during the 1999 fiscal year. During the fiscal year ended March 31, 1998, the Company determined that due to revised estimates of the marketability of certain products under development, a special charge of $940,000 was appropriate to more adequately reflect the residual value of certain intangible assets. Included in this charge was approximately $566,000 of deferred development costs in the form of prepaid royalties, approximately $202,000 relating to goodwill associated with MicroMall, Inc., a subsidiary of the Company, and approximately $172,000 relating to the write-off of previously capitalized purchased technology.
OTHER INCOME (EXPENSE). Other income decreased 84.7%, or $1.1 million, from $1.3 million in fiscal 1998 to $196,000 in fiscal 1999. The decrease between periods resulted from gains on the sale of the Company's interest in Unwired Planet Inc. and its former headquarters facility of $881,000 and $215,000, respectively, in fiscal 1998. In addition, other income decreased due to a reduction of interest income due to cash used in operations, and an increase in interest expense related to the Company's long-term debt on its new headquarters facility.
VARIABILITY OF QUARTERLY OPERATING RESULTS
The Company's revenues and operating results have varied substantially from quarter to quarter and should not be relied upon as an indication of future performance. The Company believes its revenues may fluctuate from quarter to quarter depending upon such factors as new product introductions by the Company or others, seasonality of customer buying patterns, the Company's sales commission plan, renewals of product licenses by customers, product development and marketing expenses, changes in Company and competitors' pricing policies, the timing of significant orders, the mix of products sold, the mix of international versus domestic revenues, currency fluctuations, the existence of product errors and the hiring and training of additional staff. Furthermore, delays in closing product licensing transactions or in completion of custom contract engineering work during any quarter could cause quarterly revenues and net earnings for that quarter to fall below anticipated levels. The Company derives a significant portion of its revenues from a relatively small number of large account customers, therefore any delay in the consummation of business with this small number of customers could significantly impact the Company's quarterly performance. The majority of the Company's revenues in a quarter has been historically derived from orders received in the last month of that quarter, which makes the Company's financial performance more susceptible to an unexpected downturn in business and makes quarterly results difficult to forecast. In addition, the Company's expense levels are based on present expectations of future revenue levels, and a shortfall in revenues could result in a disproportionate decrease in the Company's net earnings. As the markets in which the Company compete mature and as new and existing companies compete for customers, price competition is likely to intensify and such competition could adversely affect quarterly operating results. Variations in product mix may also affect gross profit margin percentages. Therefore, although the Company's revenues and gross profit in any period may increase in absolute terms, such an increase may result in lower gross profit margin percentages.
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically funded its operations primarily through cash flow from operations, the sale of common and preferred stock and, to a lesser extent, long-term debt. At March 31, 2000, the Company had approximately $1,509,000 in working capital and $1,967,000 in cash and short-term investments as compared to $7,908,000 in working capital and $7,527,000 in cash and short-term investments at March 31, 1999. The decrease in working capital and cash and short-term investments resulted principally from the use of cash during fiscal 2000 for operating activities.
Cash used in operating activities amounted to $8,859,000, $6,310,000 and $4,972,000 for fiscal years 1998, 1999 and 2000, respectively. The cash used in operations in fiscal 2000 primarily resulted from the net loss of $8,639,000. Additionally significant uses of cash resulted from a decrease in accounts payable of $171,000.
Cash provided by investing activities was $4,558,000, $6,799,000 and $3,464,000 for fiscal years 1998, 1999 and 2000, respectively. In fiscal 1999 and 2000, cash provided by investing activities resulted principally from net maturities of short-term investments of $6,924,000 and $3,904,000 respectively.
Cash (used in) provided by financing activities was ($508,000), $186,000, and $104,000 for fiscal years 1998, 1999 and 2000, respectively. In fiscal 1998, cash used in financing activities primarily resulted from the
payoff of the Company's construction note, partially offset by proceeds received on the Company's new long-term promissory note and the issuance of common stock resulting from stock options exercised. In fiscal 1999 and 2000, cash provided by financing activities primarily resulted from proceeds received from the issuance of common stock due to stock options exercised.
As of March 31, 2000, the Company had approximately $6,847,000 of long-term debt, including current portion, outstanding relating to its headquarters building. Monthly payments are $49,000, including interest at 7.46%, with the unpaid balance due January 1, 2008. In accordance with the loan agreement, the Company has provided the lender an irrevocable standby letter of credit in the amount of $786,000. In order to obtain the irrevocable standby letter of credit, the Company has pledged a $786,000 U.S. Treasury note as collateral. See Note 5 of Notes to Consolidated Financial Statements.
On April 19, 2000, subsequent to the fiscal year end, the Company completed a private placement of 3,500 shares of Series I 4% Cumulative Convertible Preferred Stock for gross proceeds of $3.5 million. The financing also includes warrants and options for purchase of additional shares of the Company's common stock, which if exercised, the Company estimates that it would receive gross cash proceeds of approximately $3.46 million in the aggregate. There can be no assurances that such warrants and options will be exercised, and therefore no certainty of future cash proceeds can be anticipated. On June 14, 2000, the holders of the Series I Preferred Stock converted 1,578 of those shares into 668,556 shares of common stock.
Management believes current working capital and its $1.0 million bank line of credit will be adequate to meet the Company's future working capital, new product development and capital expenditure requirements at least through the end of fiscal 2001.
Management does not believe that inflation has historically had a material effect on the Company's results of operations.
Many of the Company's international contracts are denominated in local currencies, and an increase in the relative value of the dollar against such currencies would lead to a reduction in Company revenues. The Company attempts to minimize its foreign currency exposure by attempting to keep intercompany balances current and minimizing assets in any one currency denomination. However, due to recent losses, intercompany balances have increased and are not specifically hedged and there can be no assurance that the Company's future results of operations will not be adversely affected by currency fluctuations.
The Company anticipates that international sales will continue to account for a significant portion of net sales in the foreseeable future. This dependence on international operations subjects the Company to certain risks, including tariffs and other barriers, difficulty in staffing and managing foreign subsidiary operations, difficulty in managing distributors and resellers, difficulty in accounts receivable collection, foreign currency exposure and adverse tax consequences. The Company is also subject to the risks associated with the imposition of protective import or export legislation and regulations by the United States or other countries. The Company cannot predict whether quotas, duties, taxes or other charges or restrictions will be implemented on the Company's products in the future. There can be no assurance that these factors or the adoption of restrictive policies will not have a material adverse effect on the Company's business, financial condition and results of operations.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 1998, the AICPA released SOP 98-9, "Modification of SOP 97-2, `Software Revenue Recognition with Respect to Certain Transactions." SOP 98-9 amends SOP 97-2 to require that an entity recognize revenue for multiple element arrangements by means of the "residual method" when (1) there is vendor-specific objective evidence of the fair values of all the undelivered elements that are not accounted for by means of long-term contract accounting (2) vendor-specific objective evidence of fair value does not exist for one or more of the delivered elements, and (3) all revenue recognition criteria of SOP 97-2 (other than the requirement for vendor-specific objective evidence of the fair value of each delivered element) are satisfied. The provisions of SOP 98-9 extend the deferral of certain paragraphs of SOP 97-2 and became effective for transactions that were entered into in fiscal years beginning after March 15, 1999. The adoption of this statement has not had a material impact on the Company's operating results, financial position or cash flows.
YEAR 2000 ISSUE
To date, the Company has not experienced, nor has been made aware of, any material Year 2000 compliance-related failures. Costs associated with assessment and implementation of a Year 2000 compliance plan have been expensed as incurred, and have not been material. The Company does not expect to incur significant additional costs related to year 2000 issues.
"EURO" ISSUES
On January 1, 1999, the European Union ("EU") introduced a new currency (the "Euro"). The Euro is intended to enable the EU to blend the economies of the EU's member states into one large market with unrestricted and unencumbered trade and commerce across borders. Eleven European countries are participating in the first membership wave, namely the Netherlands, Belgium, Luxembourg, Germany, France, Ireland, Finland, Austria, Italy, Spain and Portugal. Other member states are expected to join in the years to come. Legacy currencies will remain legal tender in the participating countries for a transition period between January 1999 and January 2002. During the transition period, non-cash payments can be made in the Euro, and parties can elect to pay for goods and services and transact business using either the Euro or a legacy currency. The Company does not presently expect that the introduction and use of the Euro will have a material adverse effect on the Company's financial position, results of operations or cash flows during the transition period. The significant requirement of companies during the transitionary period is the ability to invoice and accept payment in Euro denominated transactions if a customer makes this request. The Company will continue to evaluate issues involving the introduction of the Euro.
ITEM 7A.
ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE SENSITIVITY
Microware's exposure to market risk associated with changes in interest rates relates primarily to debt obligations as all financial assets are short term in nature. The Company is exposed to changes in fair values of its long-term debt that carries a fixed interest rate. As discussed in Note 5 of Notes to Consolidated Financial Statements, Microware had total long-term debt of $6,847,000 at March 31, 2000.
FOREIGN CURRENCY RISK
Microware transacts business in various foreign currencies, primarily Japanese yen and certain European currencies, as discussed in Item 1 and Note 10 of Notes to Consolidated Financial Statements, and accordingly is exposed to fluctuations in foreign currency markets. The Company does not enter into foreign currency hedging transactions.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item is contained in the financial statements set forth in Item 14(a) under the caption "Consolidated Financial Statements."
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
PART III
ITEMS 10-13
The response to Items 10, 11, 12, and 13 are incorporated by reference to the information concerning the applicable subjects in the Company's Proxy Statement for the 2000 Annual Meeting of Shareholders, expected to be filed pursuant to Regulation 14A no later than 120 days following March 31, 2000.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
1. Consolidated Financial Statements
The following are included herein:
Independent Auditors' Report Consolidated Balance Sheets as of March 31, 1999 and 2000 Consolidated Statements of Operations for the three years ended March 31, 2000 Consolidated Statements of Shareholders' Equity for the three years ended March 31, 2000 Consolidated Statements of Cash Flows for the three years ended March 31, 2000 Notes to Consolidated Financial Statements
2. Exhibits. The following are filed herewith or are incorporated by reference to exhibits previously filed with the Commission:
+ Compensation Plan or Agreement * Filed Herewith
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 authorized, on the 28th day of June, 2000.
MICROWARE SYSTEMS CORPORATION, AN IOWA CORPORATION
By: /s/ KENNETH B. KAPLAN Kenneth B. Kaplan, President and Chief Executive Officer
KNOW ALL PERSONS BY THESE PRESENTS, that the undersigned directors and officers of Microware Systems Corporation, an Iowa corporation, which is filing an Annual Report on Form 10-K with the Securities and Exchange Commission under the provisions of the Securities Exchange Act of 1934 as amended, hereby constitute and appoint Kenneth B. Kaplan, George E. Leonard, Beth E. Law, and Arthur Don and each of them, each of their 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 or all amendments to the report to be filed 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 and about the premises, as fully to all interests and purposes as each of them might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
INDEPENDENT AUDITORS' REPORT
Board of Directors Microware Systems Corporation:
We have audited the accompanying consolidated balance sheets of Microware Systems Corporation and subsidiaries as of March 31, 1999 and 2000 and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended March 31, 2000. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Microware Systems Corporation and subsidiaries at March 31, 1999 and 2000 and the results of their operations and their cash flows for each of the years in the three-year period ended March 31, 2000, in conformity with generally accepted accounting principles.
KPMG LLP
Des Moines, Iowa April 28, 2000
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
($ in thousands, except share and per share amounts)
See accompanying notes to consolidated financial statements.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
($ in thousands, except share and per share amounts)
See accompanying notes to consolidated financial statements.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
($ in thousands, except per share amounts)
See accompanying notes to consolidated financial statements.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
($ in thousands)
See accompanying notes to consolidated financial statements.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
($ in thousands)
See accompanying notes to consolidated financial statements.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
($ in thousands, except share and per share amounts)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND RELATED MATTERS
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the financial statements of Microware Systems Corporation (Microware) and its subsidiaries (the Company): Microware Systems (U.K.) Limited; Microware Systems K.K.; MSC Toolco, Inc.; Microware Systems France S.A.R.L.; Microware Systems Corporate Park, Inc.; and MicroMall, Inc. All significant intercompany balances and transactions have been eliminated in consolidation.
NATURE OF BUSINESS
The Company develops and markets operating system software and high-level language compilers used in industrial automation, communications, scientific research, and consumer electronics applications. The Company's operations are primarily conducted in North America, Japan and Europe.
TRANSLATION OF FOREIGN FINANCIAL STATEMENTS
All assets and liabilities in the balance sheets of foreign subsidiaries whose functional currency is other than the U.S. dollar are translated at year-end exchange rates. Income and expense items are translated at the average exchange rate for the year. Translation gains and losses are not included in determining net earnings but are accumulated as a separate component of shareholders' equity. Foreign currency transaction gains and losses are included in determining net earnings (loss).
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of 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.
CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
Cash equivalents consist of money market funds, a United States treasury fund and United States treasury bills with stated effective maturities of three months or less at time of purchase. Short-term investments consist of United States treasury bills with stated effective maturities greater than three months at time of purchase. Cash equivalents and all of the Company's short-term investments are classified as "held-to-maturity" under the Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and are stated at amortized cost, which approximates fair value.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND RELATED MATTERS, CONTINUED
INVENTORIES
Inventories are composed primarily of user manuals and software media production materials and are stated at the lower of cost or market on a first-in, first-out basis. Additionally, inventories include costs incurred to develop customized software under certain consulting agreements in progress.
INVESTMENTS
In October of 1996, Microware purchased a preferred stock interest in another company for $5,004. On February 20, 1998, the Company received net proceeds of $5,885 from the sale of the preferred stock.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost and are depreciated on straight-line methods with estimated useful lives of 5 to 30 years for building and improvements and 3 to 5 years for furniture, fixtures, and equipment and research and development equipment.
INTANGIBLE ASSETS
The balance of intangible assets as of March 31, 1999 and 2000 consisted of the following:
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND RELATED MATTERS, CONTINUED
INTANGIBLE ASSETS, CONTINUED
The Company historically has capitalized software development costs incurred in the production of computer software. Software development costs incurred prior to technological feasibility were expensed as research and development costs. Capitalization of these costs ceased when the product was considered available for general release to customers. The Company no longer capitalizes these costs, but expenses them as research and development costs. Amortization of previously capitalized software development costs is calculated using the straight-line method over the expected product life cycle of three years. Amortization of capitalized software development costs amounted to $151, $150 and $105 for the years ended March 31, 1998, 1999, and 2000, respectively.
Purchased software represents the cost of acquiring computer software used in the Company's products. Amortization of purchased software is calculated as the greater of the ratio that current revenues bear to estimated future revenues or the straight-line method not to exceed three years.
Patents, copyrights, and other are being amortized over 5 to 15 year periods on the straight-line method.
In April 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". SOP 98-1 provides guidance for determining whether computer software is internal-use software and on accounting for the proceeds of computer software originally developed or obtained for internal use and then subsequently sold to the public. It also provides guidance on capitalization of the losses incurred for computer software developed or obtained for internal use. The adoption of SOP 98-1 has not had a material impact on the Company's operating results, financial position or cash flows.
ADVERTISING
Advertising costs incurred for the years ended March 31, 1998, 1999, and 2000 were $687, $810, and $982, respectively.
REVENUE RECOGNITION
The Company adopted the provisions of the American Institute of Certified Public Accountants' (AICPA) Statement of Position (SOP) 97-2, "Software Revenue Recognition," as amended by SOP 98-4, "Deferral of the Effective Date of a Provision of SOP 97-2, "Software Revenue Recognition," effective April 1, 1998. SOP 97-2 and SOP 98-4 provide guidance on recognizing revenue on software transactions and supersede SOP 91-1. The adoption of SOP 97-2 and SOP 98-4 did not have a material impact on the Company's current licensing or revenue recognition practices. Product revenues primarily consist of software licenses and development tool products sold and royalties earned from equipment distributors. Software license fees are recognized as revenues upon contract signing and shipment of the software master copy. Sales of development tool products are recognized as revenues upon shipment. Royalties earned from equipment distributors are recognized as revenues when reported by the equipment distributors or upon written agreement for non-refundable prepaid royalties.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND RELATED MATTERS, CONTINUED
REVENUE RECOGNITION, CONTINUED
Service revenues are derived primarily from custom contract engineering work, customer support (maintenance) agreements, and training and consulting services. Revenues from custom contract engineering work are recognized using the percentage of completion method. Maintenance revenues, including maintenance bundled with software license fees, are recognized ratably over the term of the related agreements. Revenues from training and consulting services are recognized as the services are rendered.
In December 1998, the AICPA released SOP 98-9, "Modification of SOP 97-2, `Software Revenue Recognition with Respect to Certain Transactions." SOP 98-9 amends SOP 97-2 to require that an entity recognize revenue for multiple element arrangements by means of the "residual method" when (1) there is vendor-specific objective evidence of the fair values of all the undelivered elements that are not accounted for by means of long-term contract accounting (2) vendor-specific objective evidence of fair value does not exist for one or more of the delivered elements, and (3) all revenue recognition criteria of SOP 97-2 (other than the requirement for vendor-specific objective evidence of the fair value of each delivered element) are satisfied. The provisions of SOP 98-9 extend the deferral of certain paragraphs of SOP 97-2 and became effective for transactions that were entered into in fiscal years beginning after March 15, 1999. The adoption of this statement has not had a material impact on the Company's operating results, financial position or cash flows.
COMPUTATION OF NET EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share (EPS) has been computed by dividing net earnings (loss) by the weighted average number of common shares outstanding during the periods presented. Diluted EPS has been computed by dividing net earnings (loss) by the weighted average and, when dilutive, common equivalent shares outstanding during the periods presented. Dilutive common equivalent shares are calculated using the treasury stock method and consist of common stock issuable upon the exercise of options and warrants.
COMPREHENSIVE INCOME (LOSS)
On April 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income". Comprehensive income is defined as the change in equity of a company during a period from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. For the Company, the primary difference between net income and comprehensive income results from foreign currency translation adjustments. The adoption of SFAS No. 130 had no impact on the Company's results of operations.
The Company's comprehensive income has been presented in the Consolidated Statements of Shareholders' Equity. As of March 31, 2000, accumulated other comprehensive loss consisted of foreign currency translation adjustments of $802.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND RELATED MATTERS, CONTINUED
FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," requires the Company to disclose the estimated fair values for its financial instruments. Fair value estimates, methods, and assumptions are set forth below:
CASH AND CASH EQUIVALENTS, SHORT-TERM INVESTMENTS, TRADE RECEIVABLES, NOTES PAYABLE TO BANKS, ACCOUNTS PAYABLE AND ACCRUED EXPENSES
The carrying amount approximates the estimated fair value due to the short-term nature of those instruments.
LONG-TERM DEBT
Rates currently available to the Company for such borrowings with similar terms and remaining maturities are used to discount the future cash flows to estimate the fair value for long-term debt.
STOCK-BASED COMPENSATION
The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," (ABP No. 25) and related interpretations. Under APB No. 25, compensation cost is measured as the excess, if any, of the quoted market price of the Company's stock at the date of grant over the exercise price of the option granted. Compensation cost for stock options, if any, is recognized ratably over the vesting period. The Company's policy is to grant options with an exercise price equal to the quoted market price of the Company's stock on the grant date. Accordingly, no compensation cost has been recognized for the Company's stock option plan. The Company provides additional pro forma disclosures as required under SFAS No. 123, "Accounting for Stock-Based Compensation" (see note 8).
(2) TRADE RECEIVABLES
At March 31, 1999 and 2000 the Company had no customer whose trade receivable balance exceeded 10 percent of consolidated trade receivables.
The activity in the Company's allowance for doubtful accounts for the years ended March 31, 1998, 1999, and 2000 consisted of the following:
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(3) PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
(4) NOTES PAYABLE TO BANKS
Microware has a $1,000 line of credit with a bank bearing interest at the bank's base rate. The line of credit matures on October 31, 2000 and is renewable annually. Funds advanced are secured by Microware's trade receivables, inventories, and intangible assets. There were no borrowings outstanding at March 31, 1999 or 2000.
Microware Systems K.K. has credit agreements with various maturities. Outstanding balances at March 31, 1999 and 2000 totaled $253 and $0, respectively. The credit agreements were fully secured by Microware Systems K.K.'s deposit placed on its Tokyo office space.
(5) LONG-TERM DEBT
Long-term debt at March 31, 1999 and 2000 consisted of the following:
On December 30, 1997, the Company, through its wholly owned subsidiary Microware Systems Corporate Park, Inc. executed a promissory note with GMAC Commercial Mortgage Corporation in the amount of $7,000. The note is secured by the Company's headquarters facility and associated real estate. In accordance with the agreement, the Company has provided GMAC an irrevocable standby letter of credit in the amount of $786 In order to obtain the irrevocable standby letter of credit, the Company has pledged a $786 U.S. Treasury note as collateral. Monthly payments are $49, including interest at 7.46 percent, with the unpaid balance due January 1, 2008.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(5) LONG-TERM DEBT, CONTINUED
The aggregate maturities of long-term debt for each of the five years ending March 31, 2005 and thereafter are as follows:
The carrying amount of the Company's long-term debt approximates the fair value as of March 31, 2000.
(6) INCOME TAXES
The provision for income taxes is based on losses before income tax expense (benefit) as follows:
Components of income tax expense (benefit) for the years ended March 31, 1998, 1999, and 2000 consist of the following:
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(6) INCOME TAXES, CONTINUED
Income tax expense (benefit) for the years ended March 31, 1998, 1999, and 2000 differs from the "expected" income tax expense (benefit) computed by applying the United States expected federal income tax rate of 34 percent to pretax income (loss) due to the following:
The tax effects of temporary differences that give rise to deferred tax assets and liabilities at March 31, 1999 and 2000 are presented below:
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(6) INCOME TAXES, CONTINUED
The net deferred tax assets at March 31, 1999 and 2000, are composed of current deferred tax assets of $473 and $381 respectively, and noncurrent deferred tax liabilities of $428 and $381, respectively.
The net change in the total valuation allowance for the years ended March 31, 1999 and 2000 was an increase of $3,422 and $2,736 respectively, and relates primarily to increases in net operating loss carryforwards. Utilization of the U.S. and foreign net operating losses is dependent upon future taxable income generated in the respective U.S. and foreign subsidiaries. The Company recorded the valuation allowance due to its lack of history of consistent earnings in the U.S. and in a foreign subsidiary generating the net operating loss carryforwards. At March 31, 2000, the Company has U.S. net operating loss carryforwards for federal income tax purposes of approximately $36,000 (including approximately $3,600 from tax benefits related to employee stock options) which are available to offset future federal taxable income, if any, expiring as follows: $8,500 in 2012, $10,700 in 2013, $9,400 in 2019, and $7,400 in 2020. The foreign net operating loss carryforwards expire as follows: $1,860 in 2003 and $1,500 in 2004.
(7) PROFIT SHARING PLAN
Microware has a contributory profit sharing plan for substantially all full-time employees. Under the contributory plan, Microware provides matching cash contributions based on qualified employee contributions, as well as certain other contributions. Microware's contributions to the contributory plan for the years ended March 31, 1998, 1999, and 2000 amounted to $175, $114, and $99, respectively.
(8) STOCK OPTIONS
The Company has established 1989, 1991, 1992 and 1995 Stock Option Plans (the Plans) and granted options to certain officers, directors, and employees to purchase shares of common stock. The options granted under the Plans expire 10 years from the date such option is granted. Options vest over a two to five year period and are exercisable under conditions specified in the Plans' agreements.
The 1989, 1991, 1992 and 1995 Plans had available 1,200,000, 512,000, 496,000 and 2,070,000 total shares of common stock subject to option, respectively.
Activity for the Company's Plans is as follows:
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(8) STOCK OPTIONS, CONTINUED
SFAS No. 123 requires proforma information regarding net earnings (loss) and net earnings (loss) per share be determined as if the Company has accounted for its stock options granted subsequent to December 15, 1994 under the "fair value" method. Under SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model with the following assumptions used for grants during fiscal 1998, 1999 and 2000: risk free interest rates of 6.0%, 5.0% and 6.0% respectively; expected volatility of 88.40%, 90.0% and 120.0%, respectively; an expected option life of 6.0 years, 6.0 years, and 5.0 years, respectively; and no expected dividends for any year. As the Company was a nonpublic entity until April 2, 1996, it is permitted under SFAS No. 123 to use the "minimum value" method to value stock options granted prior to April 2, 1996. Under the "minimum value" method expected volatility is effectively zero. The weighted average fair value of stock options granted under the Plans for the years ended March 31, 1998, 1999, and 2000 were $4.90, $2.03 and $1.86, respectively.
The Black-Scholes option valuation model was developed for use in estimating the fair-value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing option valuation models do not necessarily provide a reliable single measure of the fair value of its stock options.
The Company applies the provisions of APB No. 25 and related interpretations in accounting for compensation expense under the Plans. Had compensation expense under the Plans been determined pursuant to SFAS No. 123, the Company's proforma net loss and net loss per share for the years ended March 31, 1998, 1999 and 2000 would have been as follows:
The above proforma disclosures are not necessarily representative of the effects on reported net earnings (loss) for future years. Diluted loss per share does not include stock options exercisable (see below) as the exercise would have an antidilutive effect on the computation.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(8) STOCK OPTIONS, CONTINUED
The following table summarizes information about fixed stock options outstanding under the Plans at March 31, 2000:
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(9) FOREIGN OPERATIONS
A summary of the Company's domestic and foreign operations as of and for the years ended March 31, 1998, 1999, and 2000 is presented below:
Included in U.S. revenues are foreign export sales, of approximately $690, $553, and $422 during the years ended March 31, 1998, 1999, and 2000, respectively. Revenue eliminations represent primarily intercompany sales between the U.S. and foreign operations and royalties paid to the U.S. by foreign subsidiaries.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(10) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
During the years ended March 31, 1998, 1999, and 2000, the Company paid interest of approximately $701, $519, and $568, respectively.
Income taxes paid during the years ended March 31, 1998, 1999, and 2000 amounted to approximately $95, $13, and $25 respectively.
(11) SPECIAL CHARGES
During the year ended March 31, 1998, the Company determined that due to revised estimates of the marketability of certain products under development, a special charge of $940 was appropriate to more adequately reflect the residual value of certain intangible assets. Included in this charge was approximately $566 of deferred development costs in the form of prepaid royalties, approximately $202 relating to goodwill associated with MicroMall, Inc., a subsidiary of the Company, and $172 relating to the write-off of previously capitalized purchased technology.
(12) MOTOROLA STOCK AND WARRANT PURCHASE AGREEMENT
On July 31, 1995, the Company entered into a Stock and Warrant Purchase Agreement (the Agreement) with Motorola, Inc. (Motorola) pursuant to which Motorola purchased 1,526,232 common shares of stock of the Company for $12,100 ($7.93 per share). In addition, pursuant to the Agreement, Motorola currently holds three separate warrants to purchase an additional 1,248,736 common shares of stock of the Company at an exercise price of $10.81 per share. These warrants are exercisable and expire at certain periods through July 31, 2001. The Agreement contains certain anti-dilution protection in the event of certain dividends, stock splits, reclassifications, or issuances of common shares of stock of the Company or rights thereto. Revenues from Motorola for the years ended March 31, 1998, 1999, and 2000 were $1,428, $2,227, and $592, respectively.
(13) COMMITMENTS
The Company leases certain domestic and foreign facilities under noncancelable operating leases. Minimum annual rental commitments at March 31, 2000 under all noncancelable operating leases are as follows:
2001 $ 484 2002 $ 125 2003 $ 54 2004 $ 54 2005 $ 31 Thereafter $ -
Rental expense under cancelable and non-cancelable operating leases was $785, $832, and $573 during the years ended March 31, 1998, 1999, and 2000, respectively.
MICROWARE SYSTEMS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
($ in thousands, except share and per share amounts)
(14) SALE OF SERIES I PREFERRED STOCK
On April 19, 2000 the Company entered into a Securities Purchase Agreement (the Agreement) with Elliott Associates, L.P. and Westgate International, L.P. pursuant to which Elliott and Westgate purchased a total of 3,500 shares of Series I Cumulative Convertible Preferred Stock of the Company for $3,500,000. In addition, pursuant to the Agreement, Elliott and Westgate currently hold two separate warrants to purchase an additional 87,500 common shares in aggregate of stock of the Company at an exercise price of $5.3116 per share, and options to purchase an additional 618,595 shares in aggregate of common stock at an exercise price of $4.8497 per share. The Series I Preferred Stock is convertible into common stock at a conversion price of the lower of (a) $4.8497 or (b) the average of the two lowest closing bid prices of the common stock, as recorded on Nasdaq, during the fifteen trading days prior to the conversion date. The warrants are exercisable at any time, and expire on April 19, 2005. The options are exercisable at any time, and expire one year from the date the Registration Statement registering such common shares is declared effective by the SEC.
(15) CONVERSION OF SERIES I PREFERRED STOCK (UNAUDITED)
On June 14, 2000 Elliott Associates, L.P. and Westgate International, L.P. converted a total of 1,578 shares of Series I Preferred Stock to 668,556 common shares in aggregate, at a conversion price of $2.375 per common share.