Item 1. Business
General
We are the leading provider of integrated performance management solutions that enable businesses to test and monitor their Web-based applications. Our software products and hosted services help Global 2000 companies enhance the user experience by improving the performance, availability, reliability and scalability of their Web-based applications. Our hosted services provide our customers a cost-effective solution that quickly meets business needs without dedicating significant time and internal resources. By using our solutions to identify and assess performance problems, businesses can increase their ability to attract and retain customers, improve their competitive advantage and maximize overall performance with minimum investment.
Our customers represent a wide range of industries including global enterprises such as Anheuser-Busch, BMW, Charles Schwab, Citibank, DaimlerChrysler, DHL Airways, Ericsson, Ford Motor Company Hewlett-Packard, MCI WorldCom, Microsoft, Motorola, Nokia, Norwich Union, Qwest Communications, Siemens, Sony (US), Verizon and Walmart; and Internet infrastructure providers such as Akamai, BEA Systems, i2 Technologies and Oracle.
Our integrated performance management solutions enable customers to more quickly identify and correct problems before users experience them. Our products include load testing, functional testing and test management products that automate the testing of Internet and other applications, as well as Web performance monitoring products that monitor and measure Web site performance from the end-user's perspective, alert our customers to performance problems and quickly diagnose the root cause of these problems. Our hosted services provide outsourced load testing and Web performance monitoring services that complement our software products. Specifically, our performance management solutions include:
. Load testing products that stress applications under real-world conditions to predict systems' behavior, scalability and performance and to identify and isolate problems;
. Functional testing products that help ensure applications operate as expected;
. Test process management products that organize and manage the testing process to determine application readiness;
. Web performance monitoring products that monitor sites in real time and alert operations groups to performance problems before users experience them;
. Hosted Web performance monitoring services that proactively monitor Web sites in real time; and
. Hosted load testing services that identify bottlenecks and capacity constraints before a Web site goes live.
We collaborate with a number of enterprise software and Internet infrastructure companies, including Art Technology Group, Akamai, Allaire, Alteon Websystems, Ariba, BEA Systems, Bluestone Software (recently acquired by Hewlett-Packard), BroadVision, Cacheflow, Checkpoint, Cisco, IBM, iPlanet, i2 Technologies, Merant, Oracle, Peoplesoft, SAP, Siebel Systems and Vignette, to ensure that our performance management solutions are optimized for use with their product offerings. In addition, many of these collaborations allow us to conduct joint marketing programs and joint seminars and participate in their user conferences.
In February 2000, we formed a wholly-owned subsidiary to offer our hosted Web performance monitoring service, ActiveWatch, and our hosted Web load testing service, ActiveTest. We believe our Managed Service Provider (MSP) subsidiary complements our existing offerings by providing a cost-effective solution that allows customers to quickly meet their needs without dedicating significant time and internal resources. This subsidiary currently serves more than 400 customers.
Web Performance Testing and Monitoring Solutions
Our products and hosted solutions bring together two key aspects of application performance management ("APM"): Web performance testing and monitoring. Testing allows customers to check the scalability and reliability of applications prior to release. Customers then have the information they need to fix any problems and optimize performance before making an application available to users. After the application is released, customers can ensure continuous performance and availability through the use of Web performance monitoring products and services. Monitoring enables customers to detect, diagnose and isolate performance problems that can negatively impact the end- user experience. In particular, monitoring solutions alert customers to performance problems and provide the information needed to locate their exact source. Our software products and hosted services provide a comprehensive, integrated solution for Web performance testing and monitoring.
Our current Web performance testing and monitoring solutions include:
- -------- * List prices vary according to system configuration and country where purchased. In addition, actual prices may vary from list prices.
Testing Solutions
ActiveTest
ActiveTest(TM) is the hosted load testing service that can conduct full- scale testing of Web sites in as little as 24 hours. Based on LoadRunner technology, ActiveTest can emulate the behavior of millions of users interacting with a Web application to identify bottlenecks and capacity constraints before the site goes live. This hosted service enables customers with minimal hardware, personnel or technical expertise to achieve rapid results. ActiveTest was initially introduced in 2000.
Astra LoadTest
Astra(R) LoadTest is an easy-to-use load testing tool that tests the scalability and performance of Web applications. With Astra LoadTest, users can emulate the traffic of thousands of real users to identify and isolate bottlenecks and optimize the user experience. Astra LoadTest was initially released in 1996.
LoadRunner
LoadRunner(R) is a load testing tool that predicts system behavior and performance. It exercises an entire enterprise infrastructure by emulating thousands of users to identify and isolate problems. LoadRunner's integrated real-time monitors enable organizations to minimize test cycles, optimize performance and accelerate application deployment. LoadRunner is available for Windows, Windows 95, Windows NT, UNIX and Linux. LoadRunner was initially released in 1993.
Astra QuickTest
Astra QuickTest(TM) is an icon-based tool that allows expert and novice testers to test the functionality of dynamically changing Web applications. By mirroring end user behavior, Astra QuickTest creates interactive customizable tests that simplify and shorten the testing cycle for complex Web environments. Astra QuickTest was initially released in 1998.
WinRunner
WinRunner(R) is an enterprise functional testing tool that verifies that applications work as expected. By capturing, verifying and replaying user interactions automatically, WinRunner identifies defects and ensures that business processes work flawlessly and remain reliable throughout the lifecycle. WinRunner is available for Windows 2000, Windows Me and Windows NT platforms. WinRunner was initially released in 1993.
XRunner
XRunner(R) automates functional testing to ensure X-Window-based applications work as expected. It records business processes into test scripts, supports script enhancements as the application is developed or updated, executes scripts, reports results and enables script reusability throughout an application's lifecycle. XRunner was initially released in 1991.
Astra FastTrack
Astra FastTrack(TM) is a fast, simple Web-based defect-tracking tool. It supports the process for end-to-end defect management, helping companies deliver higher quality applications. Astra FastTrack was initially released in 2001.
Astra SiteManager
Astra SiteManager(TM) is a comprehensive visual Web site management tool that is designed to meet the challenges faced by Webmasters, Internet professionals and business managers of rapidly growing Web sites. Astra SiteManager automatically schedules and performs scans of an entire Web site-- highlighting functional areas with color-coded links and URLs--to create a complete visual map of a Web site. Astra SiteManager was initially released in 1996.
TestDirector
TestDirector(R) is a Web-based test management solution that globally coordinates testing across an organization. TestDirector integrates requirements management with test planning, test scheduling, test execution and defect tracking in a single application to accelerate the testing process. TestDirector was initially released in 1994.
Monitoring Solutions
ActiveWatch
ActiveWatch(TM) is a hosted service that monitors Web site performance around the clock to proactively identify and pinpoint problems within complex Web sites. Based on Topaz, ActiveWatch accurately measures the Web site user experience from various points across the globe to ensure peak performance 24x7. ActiveWatch was initially introduced in 1999.
Topaz and Topaz Prism
Topaz(TM) is a solution for monitoring, detecting and diagnosing Web application performance problems. It measures the end-user experience and correlates any performance issues with their root cause in the Web infrastructure. The Topaz family of application performance management solutions consists of Topaz ActiveAgent and Topaz Prism. These products alert customers to performance problems and provide the information needed to isolate their root cause and minimize the impact on users. By using Topaz, customers can optimize their Web site performance to ensure a positive end-user experience anytime, anywhere. Topaz was initially released in 1999.
Research and Development
Since our inception in 1989, we have made substantial investments in research and product development. We believe that our success will depend in large part on our ability to maintain and enhance our current product line, develop new products, maintain technological competitiveness and meet changing customer requirements.
In addition to the teams developing testing and performance monitoring products and services, we maintain an advanced research group that is responsible for exploring new directions and applications of core technologies, migrating new technologies into the existing product lines and maintaining research relationships outside Mercury both within industry and academia. The research and development group also maintains relationships with third-party software vendors and with all major hardware vendors on whose platforms our products operate. Key development engineers are rotated to assignments in customer support positions in our major markets for periods ranging from three months to two years. This improves feedback from current customers and strengthens ties between the Customer Support Organization and the research and development group.
Our primary research and development group is located near Tel Aviv, Israel. Performing research and development in Israel offers a number of strategic advantages. Our Israeli engineers typically hold advanced degrees in computer- related disciplines. Operation in Israel has allowed us to enjoy tax incentives from the government of Israel. Geographic proximity to Europe, a strategic market for Mercury, offers another key advantage.
As of December 31, 2000, our research and development group consisted of 316 employees. Our research and development expenses were $32.0 million in 2000, $23.5 million in 1999 and $16.9 million in 1998. We anticipate that we will continue to commit substantial resources to research and development.
Marketing, Sales and Support
We distribute our products and offer our services both directly, through our growing sales force, and indirectly, through our relationships with systems integrators and value-added resellers.
Direct Sales
We sell our products primarily through our direct sales organization. We employ technically proficient salespeople and highly skilled field application engineers capable of serving the sophisticated needs of prospective customers. Our direct sales organization includes our cybersales group which is focused on selling ActiveWatch and ActiveTest hosted services. As of December 31, 2000, our direct sales organization consisted of 561 employees.
We have 23 sales and support centers throughout the United States. Internationally, our subsidiaries operate 20 sales and support offices located in Canada, Brazil, Europe, Israel, South Africa and the Pacific Rim. We also market our products through international distributors in some markets.
International sales represented 32% of our total revenues in 2000, 34% in 1999 and 35% in 1998, respectively. We expect that in future periods, international sales will continue to account for a significant portion of our total revenue.
Indirect Distribution Channels
We derive a substantial portion of our revenue from sales of our products through indirect distribution channels such as systems integrators and value- added resellers, including Accenture, Computer Sciences Corporation, Ernst & Young, IBM Global Services, IXL, Inventa, Primix Solutions, Viant and ZEFER.
We also target alternative distribution channels to complement our traditional direct and indirect channels. Our Astra family of products is now offered over the Internet. We also have private-labelling arrangements with application service providers (ASPs), Internet service providers (ISPs) and independent software vendors (ISVs) who incorporate our hosted services into their offerings.
Customer Support
We believe that strong customer support is crucial to both the initial marketing of our products and maintenance of customer satisfaction, which in turn enhances our reputation and generates repeat orders. In addition, we believe that the customer interaction and feedback involved in our ongoing support functions provide us with information on market trends and customer requirements that is critical to future product development efforts.
Pre-sales support is provided by sales personnel and post-sales support is provided by our Customer Support Organization through training and consulting engagements and renewable annual maintenance contracts. As of December 31, 2000, our Customer Support Organization consisted of 254 employees. The maintenance contracts provide for technical and emergency support as well as software upgrades, on an "if and when available" basis. When our local sales and support offices are unable to solve a problem, our engineers and product developers in Israel work with the support personnel. By taking advantage of time differences, we can provide support around the clock, ensuring prompt resolution of problems.
Pricing
We license our software to customers under non-exclusive license agreements that generally restrict use of the products to internal purposes at a specified site. We typically license software products to either allow up to a set number of users to access the software on a network at any one time, using any workstation attached to that network, or to allow use of the software on designated computers or workstations. In addition, our hosted services, our APM products and some of our testing products are priced based on usage, such as the number of transactions monitored, number of virtual users emulated per day, or period of usage.
Our products are priced to encourage customers to purchase multiple products and licenses because our cost to support a one-user configuration is almost the same as a multiple-user configuration. License fees depend on the product licensed, the number of users of the product licensed and the country in which such licenses are sold, as international prices tend to be higher than United States prices. Sales to our indirect sales channels, which are intended for resale to end users, are made at varying discounts off of our list prices, generally based on the sales volume of the indirect sales channels. Training and consulting revenues are generated on a time and expense basis.
Competition
The market for testing and performance monitoring products and services is extremely competitive, dynamic, and subject to frequent technological change. There are few substantial barriers of entry in our market. In addition, the use of the Internet for a growing range of Web applications is a recent and emerging phenomenon. The Internet has further reduced these barriers of entry, allowing other companies to compete with us in the testing and application performance management markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities.
In the market for solutions for testing of applications, our principal competitors include Compuware, Empirix, Radview, Rational Software and Segue Software. In the new and rapidly changing market for application performance management solutions, our competitors include providers of hosted services such as BMC Software, Keynote Systems and Service Metrics (a division of Exodus Communications), and emerging companies such as Freshwater Software. In addition, we face potential competition in this market from existing providers of testing solutions such as Segue. Finally, in both the market for testing solutions and the market for application performance management solutions, we face potential competition from established providers of systems and network management software such as Computer Associates.
We believe that the principal competitive factors affecting our market are:
. product functionality;
. product performance, including scalability and reliability;
. price and cost-effectiveness;
. quality of support and service; and
. company reputation.
Although we believe that our products currently compete favorably with respect to these factors, the market for Web performance management applications is new and rapidly evolving. We may not be able to maintain our competitive position, and competitive pressure could seriously harm our business.
Patents, Trademarks and Licenses
We rely on a combination of patents, copyrights, trademarks, service marks, and trade secret laws and contractual restrictions to establish and protect proprietary rights in our products and services. The source code for our products is protected both as a trade secret and as an unpublished copyrighted work. Despite our precautions, it may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization. In addition, the laws of various countries in which our products may be sold may not protect our products and intellectual property rights to the same extent as the laws of the United States. Our competitors may independently develop technologies that are substantially equivalent or superior to our technology.
We rely on software that we license from third parties for certain components of our products. For example, we use software that we license from RealNetworks and Microsoft to support the ability of our products to test and monitor the performance of streaming media Web applications. In the future, we may license other third party technologies to enhance our products and meet evolving customer needs. The failure to license any necessary technology, or to maintain our existing licenses, could result in reduced demand for our products.
Because the software industry is characterized by rapid technological change, we believe that factors such as the technological and creative skills of our personnel, new product developments, frequent product enhancements, name recognition and reliable product maintenance are more important to establishing and maintaining a technology leadership position than the various legal protections of our technology.
We hold seven patents for elements contained in some of our products, and we have filed several other U.S. and foreign patent applications on various elements of our products. Our patent applications may not result in issued patents and, if issued, such patents may not be upheld if challenged.
Although we believe that our products and other proprietary rights do not infringe upon the proprietary rights of third parties, third parties may assert intellectual property infringement claims against us in the future. Any such claims may result in costly, time-consuming litigation and may require us to enter into royalty or cross-license arrangements.
Personnel
As of December 31, 2000, we had a total of 1,418 employees, of which 634 were based in the Americas and 784 were based internationally. Of the total, 941 were engaged in marketing, sales and related customer support services, 316 were in research and development, and 161 were in general and administrative and operations support functions. Our success depends in significant part upon the performance of our senior management and certain key employees. Competition for highly skilled employees, including sales, technical and management personnel, is intense in the software and technology industry. We may not be able to recruit and retain key sales, technical and managerial employees. Our failure to attract, assimilate or retain highly qualified sales, technical and managerial personnel could seriously harm our business. None of our employees is represented by a labor union, and we have never experienced any work stoppages.
Our executive officers as of March 1, 2001 are as follows:
Mr. Amnon Landan has served as our President and Chief Executive Officer since February 1997, has served as Chairman of the Board of Directors since July 1999, and has been a director since February 1996. From October 1995 to January 1997, he served as President, and from March 1995 to September 1995, he served as President of North American Operations. He served as Chief Operating Officer from August 1993 until March 1995. From December 1992 to August 1993, he served as our Vice President of Operations and from June 1991 to December 1992, he served as Vice President of Research and Development. From November 1989 to June 1991, he served with us in various technical positions.
Mr. Kenneth Klein has served as our Chief Operating Officer since January 2000 and a member of the Board of Directors since July 2000. He served as President of North American Operations from July 1998 until December 1999. From April 1995 to July 1998, he served as Vice President of North American Sales. From May 1992 to March 1995, he served as our Western Area Sales Manager. From March 1990 to May 1992, he served as Regional Sales Manager for Interactive Development Environments, a CASE tool company. He has served as a director of Tumbleweed Communications Corporation since February 2000.
Ms. Sharlene Abrams has served as our Chief Financial Officer and Vice President of Finance and Administration since November 1993. From 1988 to November 1993, she was employed at Price Waterhouse LLP, most recently as a senior manager. Between 1978 and 1988, she held various finance and accounting positions in other public companies and in public accounting. She is a certified public accountant.
Mr. Moshe Egert has served as our President of European Operations since July 1999. From July 1996 to June 1999, he served as our Vice President of European Operations. From February 1994 to June 1996, he served as our Director of European Marketing. From October 1990 through January 1994, he served with us in several management and technical positions.
Mr. Douglas Smith has served as our Executive Vice President of Corporate Development since May 2000. From September 1996 to May 2000, he served in various positions with Chase H&Q, most recently as Managing Director and co- head of the Internet Group. From September 1994 to September 1996, he was the Chief Financial Officer and Executive Vice President of Strategy for ComputerVision Corporation.
Item 2.
Item 2. Properties
We are headquartered in Sunnyvale, California in two buildings that we own with a total square footage of 105,500. At the end of 2000, we purchased 26,000 and 24,000 square foot buildings in Sunnyvale, which will serve as additional headquarters, sales, and operations facilities.
Our research and development activities are conducted by our subsidiary in Israel in a 78,000 square foot building that we own. During 1999, we purchased an additional parcel of land in Israel, and have since begun construction of a second research and development facility.
Our field sales and support operations occupy leased facilities in 21 locations in the United States, one location in Canada, one location in Brazil, 15 locations in Europe, one location in Israel, one location in South Africa and five locations in the Pacific Rim.
We believe that our existing facilities are adequate for our current needs.
Item 3.
Item 3. Legal Proceedings
There are presently no legal proceedings pending, other than routine litigation incidental to our business, to which we are a party or to which any of our properties is subject.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted during the fourth quarter of 2000 to a vote of the holders of our common stock through the solicitation of proxies or otherwise.
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters
Market for Common Stock
Our common stock is traded publicly on the Nasdaq National Market under the trading symbol "MERQ." The following table presents, for the periods indicated, the high and low sales prices of our common stock as reported on the Nasdaq National Market.
The prices shown in the table above reflect the two-for-one splits of our common stock, each of which were distributed as stock dividends to our stockholders, on February 26, 1999 and February 11, 2000.
Holders of Record
On February 28, 2001, there were approximately 64,500 holders of record of our common stock. Because many of these shares are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.
Dividends
We have never declared or paid any cash dividends on our common stock. We currently intend to retain earnings for use in our business and do not anticipate paying any cash dividends in the foreseeable future.
Item 6.
Item 6. Selected Consolidated Financial Data
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as "believes," "anticipates," "expects," "intends," "plans," "will," "may" and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in "Management's Discussion and Analysis of Financial Condition and Results of Operations--Risk Factors." Our business may have changed since the date hereof, and we undertake no obligation to update these forward-looking statements.
Overview
We were incorporated in 1989, and began shipping automated software testing products in 1991. Since 1991, we have introduced a number of new products, and new versions of existing products, including products and versions designed for Web applications. We believe that a majority of customers that licensed our products in 2000 are using these products to test and monitor their Web applications. We also offer hosted load testing and monitoring services for Web applications.
Results of Operations
The following table sets forth, as a percentage of total revenue, certain consolidated statements of operations data for the periods indicated. These operating results are not necessarily indicative of the results for any future period.
Revenue
License revenue increased to $216.1 million in 2000 from $130.9 million in 1999 and $84.5 million in 1998. Our growth in license revenue is attributable primarily to growth in license fees from our LoadRunner, WinRunner and TestDirector products, as well as revenue from our new application performance management and MSP offerings.
Service revenue increased to $90.9 million in 2000 from $56.8 million in 1999 and $36.6 million in 1998. The increase in service revenue in 2000 compared to 1999 and 1998 is a result of new maintenance contracts accompanying the growth in license revenue as well as renewals of existing maintenance contracts. We expect that service revenue will continue to increase in absolute dollars as long as our customer base continues to grow.
Cost of revenue
License cost of revenue includes costs of materials, product packaging, equipment depreciation, production personnel, and costs associated with our MSP. License cost of revenue as a percentage of license revenue increased to 8% in 2000 from 6% in 1999 and 7% in 1998. The increase was primarily due to the investment in the headcount, capital equipment and Internet service fees for our MSP.
Service cost of revenue consists primarily of costs of providing customer technical support, training and consulting. Service cost of revenue increased to $24.7 million in 2000 from $17.0 million in 1999 and $10.5 million in 1998. As a percentage of service revenue, it decreased to 27% in 2000 from 30% in 1999 and 29% in 1998. The absolute dollar increase in service cost of revenue in 2000 as compared to 1999 was primarily due to an increase in personnel- related costs of $5.0 million reflecting growth in customer support and consulting headcount from 156 at December 31, 1999 to 254 at December 31, 2000 and a $2.1 million increase in training and consulting outsourcing expense.
Research and development, net
Research and development expense consists primarily of costs associated with the development of new products, enhancements of existing products, and quality assurance procedures, and comprised primarily of employee salaries and related costs, consulting costs, equipment depreciation and facilities expenses. For the year ended December 31, 2000, research and development, net was $32.0 million, or 10% of total revenue, an increase from $23.5 million, or 13% of total revenue in 1999, and $16.9 million, or 14% of total revenue in 1998. The increase in absolute dollars of research and development spending in 2000 as compared to 1999 reflected primarily increased research and development headcount from 226 at December 31, 1999 to 316 at December 31, 2000 and increased salaries of research and development engineers.
Research and development expense is reported net of research grants received from the government of Israel, and includes royalty expense for obligations to the government of Israel for sales of products developed under government- funded research. No grants were obtained from the Office of the Chief Scientist in the Israeli Ministry of Industry and Trade during 2000 and 1999. Research grants received amounted to $1.6 million in 1998. We were not obligated to repay these grants; however, we agreed to pay royalties at rates ranging from 2% to 5% of product sales resulting from the research, up to the amount of the grants obtained and for certain grants up to 150% of the grants obtained. There was no royalty expense under these agreements for the year ended December 31, 2000. Royalty expense amounted to approximately $2.7 million for each of the years ended December 31, 1999 and 1998. As of December 31, 2000, we had no outstanding royalty obligations. We have not applied for, nor do we anticipate applying for, any future grants from the Office of the Chief Scientist.
Marketing and selling
Marketing and selling expense consists primarily of employee salaries and related costs, commissions, facilities expenses and marketing programs. Marketing and selling expenses were $151.9 million, or 49% of
total revenue, in 2000, compared to $89.9 million in 1999 and $58.2 million in 1998, both 48% of total revenue. The increase in expenses in 2000 as compared to 1999 was primarily due to an increase in personnel-related costs of $26.7 million reflecting growth in headcount from 377 at December 31, 1999 to 632 at December 31, 2000, including the increase in sales head count related to our cybersales organization and APM business. The increase in expenses in 2000 as compared to 1999 was also due to an increase in sales commissions of $17.9 million attributable to higher revenue, an increase in facilities and related costs of $2.4 million and an increase in spending on marketing programs of $7.4 million. We expect marketing and selling expenses to increase in absolute dollars as total revenue increases, but these expenses may vary as a percentage of revenue.
General and administrative
General and administrative expense consists primarily of employee salaries and related costs related to executive and finance personnel. General and administrative expense increased to $17.8 million, or 6% of total revenue in 2000, from $11.7 million, or 6% of total revenue in 1999 and $8.8 million, or 7% of total revenue in 1998. The increase in the absolute dollars is primarily due to increased staffing and associated costs necessary to manage and support our growing operations.
Other income, net
Other income, net consists primarily of interest income and expense and foreign exchange gains and losses. The increase in other income, net to $17.5 million in 2000 from $6.0 million in 1999 primarily reflected increased interest income from the proceeds of the issuance in July 2000, of convertible subordinated notes, net of interest expense on the notes.
Provision for income taxes
We have structured our operations in a manner designed to maximize income in Israel where tax rate incentives have been extended to encourage foreign investments. The tax holidays and rate reductions, which we will be able to realize under programs currently in effect, expire at various dates through 2010. Future provisions for taxes will depend upon the mix of worldwide income and the tax rates in effect for various tax jurisdictions. See Note 4 of Notes to Consolidated Financial Statements and "--Risk Factors--We are subject to the risk of increased taxes."
Merger-related expenses
In connection with the acquisition of Conduct Ltd. in 1999, we incurred merger-related expenses of approximately $2.0 million, primarily relating to legal and accounting expenses, severance and the write-off of redundant facilities and equipment.
Liquidity and Capital Resources
At December 31, 2000, our principal source of liquidity consisted of $782.4 million of cash and investments compared to $186.9 million at December 31, 1999 and $130.7 million at December 31, 1998. The December 31, 2000 balance included $402.4 million of short-term and $153.6 million of long-term investments in high quality financial, government, and corporate securities. In July 2000, we raised $485.4 million from the issuance of convertible subordinated notes with an aggregate principal amount of $500.0 million. The notes mature on July 1, 2007 and bear interest at a rate of 4.75% per annum, payable semiannually on January 1 and July 1 of each year. The notes are subordinated in right of payment to all of our future senior debt. The notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. We may redeem our notes, in whole or in part, at any time on or after July 1, 2003. Accrued interest to the redemption date will be paid in each redemption.
During 2000, we generated $130.1 million cash from operating activities, compared to $61.1 million in 1999 and $39.5 million in 1998. The increase in 2000 compared to 1999 was due primarily to an increase in net income and increases in deferred revenue and accrued liabilities.
Our primary investing activities were net purchases of investments of $482.5 million in 2000 and $39.7 million in 1999 compared to net proceeds from investments of $1.3 million in 1998. We also purchased property and equipment, which totaled $45.6 million in 2000, $23.9 million in 1999 and $15.0 million in 1998. Purchases of property and equipment in 2000 included $19.2 million for the purchase of two additional headquarters buildings in Sunnyvale, California, as well as $5.7 million for the renovation of existing headquarters buildings. In addition, we spent $8.2 million in 1999 and $1.5 million in 1998 for the purchase and renovation of headquarters buildings in Sunnyvale, California. We expect to spend an additional $7.0 million to complete the renovation of our newly purchased buildings in Sunnyvale. We spent $3.5 million in 2000, $8.3 million in 1999, and $5.7 million in 1998, for the purchase and construction of research and development facilities in Israel. We expect to spend approximately $10.0 million to complete the construction in Israel.
Our primary financing activity consisted of issuance of the convertible subordinated notes and issuances of common stock under our stock option and stock purchase plans. Proceeds from issuance of stock under these plans, net of notes receivable issued and collected from issuance of stock, amounted to $26.2 million in 2000, $20.4 million in 1999 and $14.4 million in 1998.
Assuming there is no significant change in our business, we believe that our current cash and investment balances and cash flow from operations will be sufficient to fund our cash needs for at least the next twelve months. We also expect to satisfy our financing requirements through the incurrence of debt from time to time as we did in July 2000.
New Accounting Pronouncements
In June 1999, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 137, "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133--an amendment of FASB Statement No. 133" ("SFAS 137"). SFAS 137 defers for one year the application of Statement of Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), to all fiscal quarters of fiscal years beginning after June 15, 2000. In June 2000, the Financial Accounting Standards Board issued SFAS No. 138 "Accounting for Derivative Instruments and Hedging Activities-An Amendment of FASB No. 133" ("SFAS 138"). SFAS 138 amends the accounting and reporting standards for certain derivatives and hedging activities such as net settlement contracts, foreign currency translations and intercompany derivatives. We will adopt SFAS 138 in our year ended December 31, 2001. The adoption as of January 1, 2001 of SFAS 133, SFAS 137 and SFAS 138 did not have a material effect on our results of operations, financial position or cash flows.
In March 2000, the Financial Accounting Standards Board issued Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation--an interpretation of APB Opinion No. 25" ("FIN 44"). FIN 44 clarifies the application of Accounting Practice Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), regarding (a) the definition of employee for purposes of applying APB 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. FIN 44 was effective July 1, 2000, but certain conclusions in this Interpretation cover specific events that occurred after either December 15, 1998, or January 12, 2000. The Company's adoption of the provisions of FIN 44 has not had a material effect on our results of operations, financial position or cash flows.
Risk Factors
In addition to the other information included in this Annual Report on Form 10-K, the following risk factors should be considered carefully in evaluating us and our business.
Our future success depends on our ability to respond to rapid market and technological changes by introducing new products and services and continually improving the performance, features and reliability of our existing products and services and responding to competitive offerings. Our business will suffer if we do not successfully respond to rapid technological changes. The market for our software products is characterized by:
. rapidly changing technology;
. frequent introduction of new products and services and enhancements to existing products and services by our competitors;
. increasing complexity and interdependence of Web-related applications;
. changes in industry standards and practices; and
. changes in customer requirements and demands.
To maintain our competitive position, we must continue to enhance our existing software testing and application performance management products and services and to develop new products and services, functionality and technology that address the increasingly sophisticated and varied needs of our prospective customers. The development of new products and services, and enhancement of existing products and services, entail significant technical and business risks and require substantial lead-time and significant investments in product development. If we fail to anticipate new technology developments, customer requirements or industry standards, or if we are unable to develop new products and services that adequately address these new developments, requirements and standards in a timely manner, our products may become obsolete, our ability to compete may be impaired and our revenues could decline.
We expect our quarterly revenues and operating results to fluctuate, and it is difficult to predict our future revenues and operating results. Our revenues and operating results have varied in the past and are likely to vary significantly from quarter to quarter in the future. These fluctuations are due to a number of factors, many of which are outside of our control, including:
. fluctuations in demand for and sales of our products and services;
. our success in developing and introducing new products and services and the timing of new product and service introductions;
. our ability to introduce enhancements to our existing products and services in a timely manner;
. the introduction of new or enhanced products and services by our competitors and changes in the pricing policies of these competitors;
. the discretionary nature of our customers' purchase and budget cycles and changes in their budgets for software and Web-related purchases;
. changes in economic conditions affecting our customers or our industry;
. the amount and timing of operating costs and capital expenditures relating to the expansion of our business;
. deferrals by our customers of orders in anticipation of new products or services or product enhancements; and
. the mix of our domestic and international sales, together with fluctuations in foreign currency exchange rates.
In addition, the timing of our license revenues is difficult to predict because our sales cycles are typically short and can vary substantially from product to product and customer to customer. We base our operating expenses on our expectations regarding future revenue levels. As a result, if total revenues for a particular quarter are below our expectations, we could not proportionately reduce operating expenses for that quarter.
We have experienced seasonality in our revenues and earnings, with the fourth quarter of the year typically having the highest revenue and earnings for the year and higher revenue and earnings than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers and from the structure of our sales commission program. We expect this seasonality to continue in the future. In addition, our customers' decisions to purchase our products and services are discretionary and subject to their internal budgets and purchasing processes. A slowdown in the economy may cause customers to reassess their immediate technology needs and to defer purchasing decisions, and accordingly could reduce demand for our products and services.
Due to these and other factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. If our operating results are below the expectations of investors or securities analysts, the trading prices of our securities could decline.
We expect to face increasing competition in the future, which could cause reduced sales levels and result in price reductions, reduced gross margins or loss of market share. The market for our testing and application performance management products and services is extremely competitive, dynamic and subject to frequent technological changes. There are few substantial barriers of entry in our market. In addition, the use of the Internet for a growing range of Web applications is a recent and emerging phenomenon. The Internet lowers the barriers of entry, allowing other companies to compete with us in the testing and application performance management markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities.
In the market for solutions for testing of applications, our principal competitors include Compuware, Empirix, Radview, Rational Software and Segue Software. In the new and rapidly changing market for application performance management solutions, our competitors include providers of hosted services such as BMC Software, Keynote Systems and Service Metrics (a division of Exodus Communications), and emerging companies such as Freshwater Software. In addition, we face potential competition in this market from existing providers of testing solutions such as Segue. Finally, in both the market for testing solutions and the market for application performance management solutions, we face potential competition from established providers of systems and network management software such as Computer Associates.
The software industry is increasingly experiencing consolidation, and this could increase the resources available to our competitors and the scope of their product offerings. Our competitors and potential competitors may undertake more extensive marketing campaigns, adopt more aggressive pricing policies or make more attractive offers to distribution partners and to employees.
If we fail to maintain our existing distribution channels and develop additional channels in the future, our revenues will decline. We derive a substantial portion of our revenues from sales of our products through distribution channels such as systems integrators, value-added resellers, ASPs, ISPs or ISVs. We expect that sales of our products through these channels will continue to account for a substantial portion of our revenues for the foreseeable future. We have also entered into private labelling arrangements with ASPs and an enterprise software company who incorporate our products and services into theirs. We may not experience increased revenues from these new channels, which could harm our business.
The loss of one or more of our systems integrators, value-added resellers, ASPs, ISPs or ISVs, or any reduction or delay in their sales of our products and services could result in reductions in our revenue in future periods. In addition, our ability to increase our revenue in the future depends on our ability to expand our indirect distribution channels.
Our dependence on indirect distribution channels presents a number of risks, including:
. each of our systems integrators, value-added resellers, ASPs, ISPs or ISVs can cease marketing our products and services with limited or no notice and with little or no penalty;
. our existing systems integrators, value-added resellers, ASPs, ISPs or ISVs may not be able to effectively sell any new products and services that we may introduce;
. we may not be able to replace existing or recruit additional systems integrators, value-added resellers, ASPs, ISPs or ISVs if we lose any of our existing ones;
. our systems integrators, value-added resellers, ASPs, ISPs or ISVs may also offer competitive products and services from third parties;
. we may face conflicts between the activities of our indirect channels and our direct sales and marketing activities; and
. our systems integrators, value-added resellers, ASPs, ISPs or ISVs may not give priority to the marketing of our products and services as compared to our competitors' products.
In March 1999, we entered into an agreement with Tivoli Systems, a subsidiary of IBM, for the joint development and marketing of a family of products for enterprise application performance management, incorporating elements of our technology, which would be marketed and sold only by Tivoli. Under this agreement, we agreed that as long as Tivoli continued to pay minimum royalties, we would not license this technology to any other party for purposes of developing a product similar to any developed under this agreement. In addition, we agreed that we would not enter into technology relationships to create similar products with specified competitors of Tivoli as long as Tivoli continued to agree to pay minimum royalties. In October 2000, Tivoli elected not to continue paying their required minimum royalties and the exclusive provisions of this agreement terminated. Tivoli continues to have the rights to market and sell these elements of our technology on a non-exclusive basis.
We depend on strategic relationships and business alliances for continued growth of our business. Our development, marketing and distribution strategies rely increasingly on our ability to form strategic relationships with software and other technology companies. These business relationships often consist of cooperative marketing programs, joint customer seminars, lead referrals and cooperation in product development. Many of these relationships are not contractual and depend on the continued voluntary cooperation of each party with us. Divergence in strategy or change in focus by, or competitive product offerings by, any of these companies may interfere with our ability to develop, market, sell or support our products, which in turn could harm our business. Further, if these companies enter into strategic alliances with other companies or are acquired, they could reduce their support of our products. Our existing relationships may be jeopardized if we enter into alliances with competitors of our strategic partners. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products.
If we are unable to manage our growth, our business may be harmed. Since 1991, we have experienced significant annual increases in revenue, employees and number of product and service offerings. This growth has placed and, if it continues, will place a significant strain on our management and our financial, operational, marketing and sales systems. If we cannot manage our growth effectively, our business, competitive position, operating results and financial condition could suffer. Although we are implementing a variety of new or expanded business and financial systems, procedures and controls, including the improvement of our sales and
customer support systems, the implementation of these systems, procedures and controls may not be completed successfully, or may disrupt our operations. Any failure by us to properly manage these transitions could impair our ability to attract and service customers and could cause us to incur higher operating costs and experience delays in the execution of our business plan.
The success of our business depends on the efforts and abilities of our senior key personnel. We depend on the continued services and performance of our senior management and other key personnel. We do not have long term employment agreements with any of our key personnel. The loss of any of our executive officers or other key employees could hurt our business.
If we cannot hire qualified personnel, our ability to manage our business, develop new products and increase our revenues will suffer. We believe that our ability to attract and retain qualified personnel at all levels in our organization is essential to the successful management of our growth. In particular, our ability to achieve revenue growth in the future will depend in large part on our success in expanding our direct sales force and in maintaining a high level of technical consulting, training and customer support. There is substantial competition for experienced personnel in the software and technology industry. If we are unable to retain our existing key personnel or attract and retain additional qualified individuals, we may from time to time experience inadequate levels of staffing to perform services for our customers. As a result, our growth could be limited due to our lack of capacity to develop and market our products to our customers.
We depend on our international operations for a substantial portion of our revenues. Sales to customers located outside the United States have historically accounted for a significant percentage of our revenue and we anticipate that such sales will continue to be a significant percentage of our revenue. As a percentage of our total revenues, sales to customers outside the United States were approximately 32% in 2000, 34% in 1999 and 35% in 1998. In addition, we have substantial research and development operations in Israel. We face risks associated with our international operations, including:
. changes in taxes and regulatory requirements;
. difficulties in staffing and managing foreign operations;
. reduced protection for intellectual property rights in some countries;
. the need to localize products for sale in international markets;
. longer payment cycles to collect accounts receivable in some countries;
. seasonal reductions in business activity in other parts of the world in which we operate;
. political and economic instability; and
. economic downturns in international markets.
Any of these risks could harm our international operations and cause lower international sales. For example, some European countries already have laws and regulations related to technologies used on the Internet that are more strict than those currently in force in the United States. Any or all of these factors could cause our business to be harmed.
Because our research and development operations are primarily located in Israel, we may be affected by volatile economic, political and military conditions in that country and by restrictions imposed by that country on the transfer of technology. Our operations depend on the availability of highly skilled scientific and technical personnel in Israel. Our business also depends on trading relationships between Israel and other countries. In addition to the risks associated with international sales and operations generally, our operations could be adversely affected if major hostilities involving Israel should occur or if trade between Israel and its current trading partners were interrupted or curtailed.
These risks are compounded due to the restrictions on our ability to manufacture or transfer outside of Israel any technology developed under research and development grants from the government of Israel, without the prior written consent of the government of Israel. If we are unable to obtain the consent of the government of Israel, we may not be able to take advantage of strategic manufacturing and other opportunities outside of Israel. We have, in the past, obtained royalty-bearing grants from various Israeli government agencies. In addition, we participate in special Israeli government programs that provide significant tax advantages. The loss of, or any material decrease in these tax benefits, could negatively affect our financial results.
We are subject to the risk of increased taxes. We have structured our operations in a manner designed to maximize income in Israel where tax rate incentives have been extended to encourage foreign investment. Our taxes could increase if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased. Tax authorities could challenge the manner in which profits are allocated among us and our subsidiaries, and we may not prevail in any such challenge. If the profits recognized by our subsidiaries in jurisdictions where taxes are lower became subject to income taxes in other jurisdictions, our worldwide effective tax rate would increase.
Our financial results may be negatively impacted by foreign currency fluctuations. Our foreign operations are generally transacted through our international sales subsidiaries. As a result, these sales and related expenses are denominated in currencies other than the U.S. Dollar. Because our financial results are reported in U.S. Dollars, our results of operations may be harmed by fluctuations in the rates of exchange between the U.S. Dollar and other currencies, including:
. a decrease in the value of Pacific Rim or European currencies relative to the U.S. Dollar, which would decrease our reported U.S. Dollar revenue, as we generate revenues in these local currencies and report the related revenues in U.S. Dollars; and
. an increase in the value of Pacific Rim, European or Israeli currencies relative to the U.S. Dollar, which would increase our sales and marketing costs in these countries and would increase research and development costs in Israel.
We attempt to limit foreign exchange exposure through operational strategies and by using forward contracts to offset the effects of exchange rate changes on intercompany trade balances. This requires us to estimate the volume of transactions in various currencies. We may not be successful in making these estimates. If these estimates are overstated or understated during periods of currency volatility, we could experience material currency gains or losses.
Our ability to successfully implement our business strategy depends on the continued growth of the Internet. In order for our business to be successful, the Internet must continue to grow as a medium for conducting business. However, as the Internet continues to experience significant growth in the number of users and the complexity of Web-based applications, the Internet infrastructure may not be able to support the demands placed on it or the performance or reliability of the Internet might be adversely affected. Security and privacy concerns may also slow the growth of the Internet. Because our revenues ultimately depend upon the Internet generally, our business may suffer as a result of limited or reduced growth.
Acquisitions may be difficult to integrate, disrupt our business, dilute stockholder value or divert the attention of our management. We may acquire or make investments in other companies with similar products and technologies. In the event of any future acquisitions or investments, we could:
. issue stock that would dilute the ownership of our then-existing stockholders;
. incur debt;
. assume liabilities;
. incur expenses for the impairment of the value of investments or acquired assets;
. incur amortization expense related to intangible assets; or
. incur large write-offs.
If we fail to achieve the financial and strategic benefits of past and future acquisitions, our operating results will suffer. Acquisitions and investments involve numerous other risks, including:
. difficulties integrating the acquired operations, technologies or products with ours;
. failure to achieve targeted synergies;
. unanticipated costs and liabilities;
. diversion of management's attention from our core business;
. adverse effects on our existing business relationships with suppliers and customers or those of the acquired organization;
.difficulties entering markets in which we have no or limited prior experience; and
.potential loss of key employees, particularly those of the acquired organizations.
The price of our common stock may fluctuate significantly, which may result in losses for investors and possible lawsuits. The market price for our common stock has been and may continue to be volatile. For example, during the 52-week period ended March 2, 2001, the closing prices of our common stock as reported on the Nasdaq National Market ranged from a high of $156.75 to a low of $48.50. We expect our stock price to be subject to fluctuations as a result of a variety of factors, including factors beyond our control. These factors include:
. actual or anticipated variations in our quarterly operating results;
. announcements of technological innovations or new products or services by us or our competitors;
. announcements relating to strategic relationships or acquisitions;
. changes in financial estimates or other statements by securities analysts;
. changes in general economic conditions;
. conditions or trends affecting the software industry and the Internet; and
. changes in the economic performance and/or market valuations of other software and high-technology companies.
Because of this volatility, we may fail to meet the expectations of our stockholders or of securities analysts at some time in the future, and the trading prices of our securities could decline as a result.
In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many high-technology companies. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. Any negative change in the public's perception of software or Internet software companies could depress our stock price regardless of our operating results.
If we fail to adequately protect our proprietary rights and intellectual property, we may lose a valuable asset, experience reduced revenues and incur costly litigation to protect our rights. We rely on a combination of patents, copyrights, trademark, service mark and trade secret laws and contractual restrictions to establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our products and
use information that we regard as proprietary to create products that compete with ours. Some license provisions protecting against unauthorized use, copying, transfer and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the United States. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase.
In many cases, we enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products.
Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation like this, whether successful or unsuccessful, could result in substantial costs and diversions of our management resources, either of which could seriously harm our business.
Third parties could assert that our products and services infringe their intellectual property rights, which could expose us to litigation that, with or without merit, could be costly to defend. We may from time to time be subject to claims of infringement of other parties' proprietary rights. We could incur substantial costs in defending ourselves and our customers against these claims. Parties making these claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the United States and abroad and could result in an award of substantial damages against us. In the event of a claim of infringement, we may be required to obtain licenses from third parties, develop alternative technology or to alter our products or processes or cease activities that infringe the intellectual property rights of third parties. If we are required to obtain licenses, we cannot be sure that we will be able to do so at a commercially reasonable cost, or at all. Defense of any lawsuit or failure to obtain required licenses could delay shipment of our products and increase our costs. In addition, any such lawsuit could result in our incurring significant costs or the diversion of the attention of our management.
Defects in our products may subject us to product liability claims and make it more difficult for us to achieve market acceptance for these products, which could harm our operating results. Our products may contain errors or "bugs" that may be detected at any point in the life of the product. Any future product defects discovered after shipment of our products could result in loss of revenues and a delay in the market acceptance of these products that could adversely impact our future operating results.
In selling our products, we frequently rely on "shrink wrap" or "click wrap" licenses that are not signed by licensees. Under the laws of various jurisdictions, the provisions in these licenses limiting our exposure to potential product liability claims may be unenforceable. We currently carry errors and omissions insurance against such claims, however, we cannot assure you that this insurance will continue to be available on commercially reasonable terms, or at all, or that this insurance will provide us with adequate protection against product liability and other claims. In the event of a product liability claim, we may be found liable and required to pay damages which would seriously harm our business.
We have adopted anti-takeover defenses that could delay or prevent an acquisition of our company, including an acquisition that would be beneficial to our stockholders. Our Board of Directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present plans to
issue shares of preferred stock. Furthermore, certain provisions of our Certificate of Incorporation and of Delaware law may have the effect of delaying or preventing changes in our control or management, which could adversely affect the market price of our common stock.
Leverage and debt service obligations may adversely affect our cash flow. In July 2000, we completed an offering of convertible subordinated notes with a principal amount of $500.0 million. We now have a substantial amount of outstanding indebtedness, primarily the convertible subordinated notes. There is the possibility that we may be unable to generate cash sufficient to pay the principal of, interest on and other amounts due in respect of our indebtedness when due. Our leverage could have significant negative consequences, including:
. increasing our vulnerability to general adverse economic and industry conditions;
. requiring the dedication of a substantial portion of our expected cash flow from operations to service our indebtedness, thereby reducing the amount of our expected cash flow available for other purposes, including capital expenditures; and
. limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete.
Item 7a.
Item 7a. Quantitative and Qualitative Disclosures about Market Risk
Our exposure to market rate risk for changes in interest is limited to our investment portfolio. Derivative financial instruments are not a part of our investment policy. We place our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer or issue. In addition, we have classified all of our investments as "held to maturity." This classification does not expose the consolidated statement of income or balance sheet to fluctuation in interest rates. Information about our investment portfolio is presented in the table below, which states notional amounts and related weighted-average interest rates by year of maturity (in thousands):
Our long-term investments include $68.3 million of government agency instruments which have callable provisions and accordingly may be redeemed by the agencies should interest rates fall below the coupon rate of the investments.
The fair value of the our convertible subordinated debentures fluctuates based upon changes in the price of our common stock, changes in interest rates and changes in our creditworthiness. The fair market value of the convertible subordinated debentures as of December 31, 2000 was $522.6 million.
A portion of our business is conducted in currencies other than the U.S. Dollar. Our operating expenses in each of these countries are in the local currencies, which mitigates a significant portion of the exposure related to local currency revenues.
We have entered into forward foreign exchange contracts ("forward contracts") to hedge foreign currency denominated receivables due from certain European and Pacific Rim subsidiaries against fluctuations in exchange rates. We have not entered into forward contracts for speculative or trading purposes. Our accounting policies for these contracts are based on our designation of the contracts as hedging transactions. The criteria we use for designating a forward contract as a hedge considers it's effectiveness in reducing risk by matching hedging instruments to underlying transactions. Gains and losses on forward contracts are recognized in other income in the same period as gains and losses on the underlying transactions. The effect of an immediate 10% change in exchange rates would not have a material impact on our operating results or cash flows. We had outstanding forward contracts with notional amounts totaling approximately $13.0 million, $10.6 million and $3.4 million at December 31, 2000, 1999 and 1998, respectively. The open forward contracts at December 31, 2000 mature at various dates through December 2001 and are hedges of certain foreign currency transaction exposures in the Australian dollar, British pound, Danish Krone, French Franc, Euro, German Mark, Norwegian Kroner, Japanese Yen and Swedish Krona. The unrealized net gain on these forward contracts at December 31, 2000 totaled approximately $282,000.
Item 8.
Item 8. Financial Statements and Supplementary Data
Financial statements required pursuant to this Item are presented beginning on page of this report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
During the 24-month period preceding December 31, 2000 we neither changed accountants nor had disagreements with our accountants on any matter of accounting principles or practices, financial statement disclosure or auditing scope and procedures.
PART III
Certain information required by Part III is omitted from this Annual Report on Form 10-K because we will file a definitive proxy statement within 120 days after the end of our fiscal year pursuant to Regulation 14A for our annual meeting of stockholders, currently scheduled for May 15, 2001, and the information included in the proxy statement is incorporated herein by reference.
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information concerning our officers required by this Item is incorporated by reference to the section of Part I of this Annual Report on Form 10-K entitled "Item 1. Business--Personnel." The information concerning our directors required by this Item is incorporated by reference to the information under the heading "Election of Directors--Nominees" in our proxy statement.
Item 11.
Item 11. Executive Compensation
The information required by this Item is incorporated by reference to our proxy statement under the heading "Executive Compensation."
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this Item is incorporated by reference to our proxy statement under the heading "Security Ownership of Certain Beneficial Owners and Management."
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by this Item is incorporated by reference to our proxy statement under the heading "Certain Transactions."
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) The following documents are filed as a part of this report:
1. Financial Statements.
The following financial statements of Mercury Interactive Corporation are filed as a part of this report:
2. Schedules
Financial statement schedules not listed above have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
3. Exhibits
- -------- (1) Exhibits 3.1, 3.3, 10.2, and 10.4 are incorporated by reference to Exhibits 3.3, 3.4, 10.2, and 10.12, respectively, filed in response to Item 16(a), "Exhibits," of Mercury Interactive Registration Statement on Form S-1, as amended (File No. 33-68554), which was declared effective on October 29, 1993. (2) Designates management contract or compensatory plan arrangements required to be filed as an exhibit of this Annual Report on Form 10-K. (3) Exhibit 3.3 is incorporated by reference to Exhibit 3.2 filed with the Form 10-Q for the three month period ended September June 30, 1999 (4) Exhibits 10.1 and 10.3 are incorporated by reference to Exhibits 4.1 and 4.3 filed with the Registration Statement on Form S- 8, No. 333-62125, filed with the Securities and Exchange Commission on August 24, 1998. (5) Exhibit 10.5 is incorporated by reference to Exhibit 10.1 filed with the Form 10-Q for the quarter ended September 30, 1994. (6) Exhibit 10.6 is incorporated by reference to Exhibit 10.26 filed with the Form 10-K for the year ended December 31, 1998. (7) Exhibits 10.7 and 10.8 are incorporated by reference to Exhibits 4.1 and 4.2 filed with the Registration Statement on Form S-8, No. 333-56316, filed with the Securities and Exchange Commission on February 28, 2001. (8) Exhibits 10.13, 10.14 and 10.15 are incorporated by reference to Exhibits 4.1, 4.2 and 4.3, respectively, filed with the Form 10-Q for the quarter ended June 30, 2000. (9) Exhibit 10.9 is incorporated by reference to Exhibit 1 to Form 8-A, filed with the Securities and Exchange Commission on July 9, 1996. (10) Exhibit 10.10 is incorporated by reference to Exhibit 1 to Form 8-A, Amendment No. 1, filed with the Securities and Exchange Commission on April 2, 1999. (11) Exhibit 10.11 is incorporated by reference to Exhibit 1 to Form 8-A, Amendment No. 2, filed with the Securities and Exchange Commission on May 22, 2000.
(b) Reports on Form 8-K
No report on Form 8-K was filed during the fourth quarter of the year ended December 31, 2000.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Mercury Interactive (s), Mercury Interactive Corporation, a corporation organized and existing under the laws of the State of Delaware, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: March 15, 2001 Mercury Interactive Corporation
/s/ Sharlene Abrams, By: _________________________________ Sharlene Abrams Chief Financial Officer, Vice President of Finance and Administration and Secretary
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints jointly and severally, Amnon Landan, Susan Skaer and/or Sharlene Abrams and each one of them, his or her attorneys- in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Mercury Interactive Corporation
In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) present fairly, in all material respects, the financial position of Mercury Interactive Corporation and its subsidiaries (the "Company") at December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
San Jose, California January 15, 2001
MERCURY INTERACTIVE CORPORATION
CONSOLIDATED BALANCE SHEETS (in thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
MERCURY INTERACTIVE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
MERCURY INTERACTIVE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
MERCURY INTERACTIVE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
MERCURY INTERACTIVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES
Mercury Interactive Corporation (the "Company") develops, markets and supports performance management solutions that enable businesses to test and monitor their Web site and other applications.
The Company acquired Conduct Ltd. on November 30, 1999, which was accounted for as a pooling of interests. The consolidated financial statements for each of the two years ended December 31, 1999 and 1998 and the accompanying notes reflect the results of operations as if the acquired entity was a wholly-owned subsidiary since its inception (see Note 8).
Basis of presentation
The Company has a wholly-owned research and development and sales subsidiary incorporated in Israel and sales subsidiaries in Brazil, Canada, Europe, South Africa and the Pacific Rim for marketing, distribution and support of products and services. In February 2000, the Company formed a wholly-owned subsidiary to offer its hosted Web site performance monitoring service, ActiveWatch, and its hosted Web site load testing service, ActiveTest. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Use of estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Foreign currency translation
The functional currency of the Company's subsidiary in Israel is the U.S. dollar. Assets and liabilities in Israel are translated at year-end exchange rates, except for property and equipment, which is translated at historical rates. Revenues and expenses are translated at average exchange rates in effect during the year, except for costs related to those balance sheet items, which are translated at historical rates. Foreign currency translation gains and losses, which have not been material to date for this subsidiary, are included in the consolidated statements of operations.
The functional currencies of all other subsidiaries are the local currencies. Accordingly, all assets and liabilities of these subsidiaries are translated at the current exchange rate at the end of the period and revenues and costs at average exchange rates in effect during the period. The gains and losses from translation of these subsidiaries' financial statements are recorded as other accumulated comprehensive income and included as a separate component of stockholders' equity. Net gains and losses resulting from foreign exchange transactions were not significant during any of the periods presented.
Derivative financial instruments
The Company enters into forward foreign exchange contracts ("forward contracts") to hedge foreign currency denominated intercompany receivables against fluctuations in exchange rates. The Company does not enter into forward contracts for speculative or trading purposes. The criteria used for designating a forward contract as a hedge considers its effectiveness in reducing risk by matching hedging instruments to underlying transactions. Gains and losses on forward contracts are recognized in other income in the same period as gains
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
and losses on the underlying transactions. The Company had outstanding forward contracts with notional amounts totaling approximately $13.0 million, $10.6 million and $3.4 million at December 31, 2000, 1999 and 1998, respectively. The open forward contracts at December 31, 2000 mature at various dates through December 2001 and are hedges of certain foreign currency transaction exposures in the Australian Dollar, British Pound, Danish Krone, French Franc, Euro, German Mark, Norwegian Kroner, Japanese Yen and Swedish Krona. The unrealized net gain on the Company's forward contracts at December 31, 2000 was approximately $282,000.
Cash and cash equivalents
The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.
Short-term and long-term investments
The Company considers all investments with remaining maturities of less than one year to be short-term investments and all investments with remaining maturities greater than one year to be long-term investments. In accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the Company has categorized its marketable securities as "held to maturity" securities.
The investments, which all have contractual maturities of less than two years, are carried at cost plus accrued interest. Realized gains or losses are determined based on the specific identification method and are reflected in other income.
The portfolio of short-term and long-term investments (including cash and cash equivalents) consisted of the following (in thousands):
Revenue recognition
Revenues are derived from product licensing fees, and from maintenance support services, training and consulting. Effective January 1, 1998, the Company adopted Statement of Position 97-2, "Software Revenue Recognition" ("SOP 97-2"), with the exception of the provisions deferred by Statement of Position 98-4, "Deferral of the Effective Date of a Provision of SOP 97-2" ("SOP 98-4"). Effective January 1, 1999 the Company adopted SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition" ("SOP 98-9"). In accordance with the adopted provisions of SOP 97-2 and SOP 98-9, the Company records revenues from software licenses when a license agreement is signed by both parties, the fee is fixed and determinable, collection of the fee is probable and delivery of the product has occurred. If an element of the arrangement had not been delivered, revenues for the element are deferred based on vendor-specific objective evidence of fair value. If vendor-specific objective evidence of fair value does not exist, all revenues are deferred until sufficient objective evidence exists or all elements have been delivered. Payments received in advance of revenue
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
recognition are recorded as deferred revenue. Revenues from hosted services and the Company's application performance management products are recognized ratably over the term of the related agreements. Service revenues from customer maintenance fees for ongoing customer support and product updates are recognized ratably over the period of the contract. Payments for maintenance fees are generally made in advance, are nonrefundable and are classified as deferred revenue. Revenues for training and consulting services are recognized as the services are provided.
In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"), which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. SAB 101 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosures related to revenue recognition policies. The Company applied the provisions of SAB 101 to all revenue transactions for fiscal 2000. SAB 101 has not had a material impact on the results of operations, financial position or cash flows of the Company.
In accordance with the provisions of Accounting Principles Board Opinion No. 29, "Accounting for Nonmonetary Transactions" ("APB 29"), the Company records barter transactions at the fair value of the goods or services provided or received, whichever is more readily determinable in the circumstances. To date, revenues from barter transactions have been insignificant and represent less than 1% of net revenues.
Property and equipment
Property and equipment are stated at cost. Depreciation and amortization are provided using the straight-line method over the estimated economic lives of assets, which are five to seven years for office furniture and equipment, two to five years for computers and related equipment, four to ten years for leasehold improvements, or the term of the lease, whichever is shorter, and thirty years for buildings.
Long-lived assets
The Company evaluates the recoverability of its long-lived assets in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" ("SFAS 121"). SFAS 121 requires recognition of impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to such assets. No such impairments have been identified to date. The Company assesses the impairment of long-lived assets when events or changes in circumstances indicate that the carrying value of an asset may not be recoverable.
Internal use software
The Company recognizes software development costs in accordance with Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." As such, the Company capitalizes substantially all external costs related to the purchase and implementation of software projects used for business operations. Capitalized software costs primarily include purchased software and external consulting fees. The Company expenses all costs incurred that relate to the planning and post-implementation phases of the software project. Capitalized costs are amortized over the estimated useful life of the product.
Research and development
In accordance with Statement of Financial Accounting Standards No. 86, "Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed," all costs incurred to establish the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
technological feasibility of a computer product to be sold, leased or otherwise marketed are expensed as research and development costs. Costs incurred subsequent to the establishment of technological feasibility, and prior to the general release of the product to the public are capitalized. Amortization of capitalized software development costs is provided on a product-by-product basis using the straight-line method over the estimated economic life of the products of two years. During 2000, 1999 and 1998, no software development costs were capitalized because the costs incurred subsequent to achieving technological feasibility and before the general release of our products were not significant. There were no amortization charges included in cost of license revenues in 2000, $585,000 in 1999 and $600,000 in 1998.
Research and development expense is reported net of research grants received from the government of Israel, and includes royalty expense for obligations to the government of Israel for sales of products developed under government- funded research. No grants were obtained from the Office of the Chief Scientist in the Israeli Ministry of Industry and Trade ("the Chief Scientist") during 2000 and 1999. Research grants received amounted to $1.6 million in 1998. The Company was not obligated to repay these grants; however, the Company agreed to pay royalties at rates ranging from 2% to 5% of product sales resulting from the research, up to the amount of the grants obtained and for certain grants up to 150% of the grants obtained. There was no royalty expense under these agreements for the year ended December 31, 2000. Royalty expense amounted to approximately $2.7 million for each of the years ended December 31, 1999 and 1998. As of December 31, 2000, the Company had no outstanding royalty obligations. The Company has not applied for, nor does it anticipate applying for, any future Chief Scientist grants.
Stock-based compensation
The Company accounts for stock-based compensation using the intrinsic value method presented in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and related interpretations. The Company's policy is to grant options with an exercise price equal to the quoted market price of its stock on the grant date. Accordingly, no compensation cost has been recognized in the statements of operations. Additional pro forma disclosure is provided as required under Statement of Financial Accounting Standard No.123 ("SFAS 123"), "Accounting for Stock-based Compensation" (see Note 3). The Company has not issued stock options to non-employees.
Concentration of credit risks
Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash, cash equivalents, investments and accounts receivable. The Company invests primarily in money market accounts and marketable securities and places its investments with high quality financial, government or corporate institutions. Accounts receivables are derived from sales to customers located primarily in the United States, Brazil, Canada, Europe, Pacific Rim and Israel. The Company performs ongoing credit evaluations of its customers and to date has not experienced any material losses. No customer accounted for more than 10% of accounts receivable or revenue in 2000, 1999 or 1998.
Fair value of financial instruments
The carrying amount of the Company's financial instruments, including cash, cash equivalents, investments, accounts receivable and accounts payable approximates their respective fair values due to the short maturities of these financial instruments. Changes in the fair value of the Company's foreign currency forward contracts ("forward contracts") are generally offset by changes in the value of the underlying exposures being hedged.
The fair value of the Company's convertible subordinated debentures was $522.6 million at December 31, 2000, based on quoted market price.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Net income per share
Earnings per share are calculated in accordance with the provisions of Statement of Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"). SFAS 128 requires the reporting of both basic earnings per share, which is the weighted-average number of common shares outstanding, and diluted earnings per share, which includes the weighted-average number of common shares outstanding and all dilutive potential common shares outstanding, utilizing the treasury stock method. For the years ended December 31, 2000, 1999 and 1998, dilutive potential common shares outstanding reflects shares issuable under our stock option plans. Share and per share amounts reflect the effect of the two-for-one stock split distributed to stockholders on February 11, 2000. The following table summarizes the Company's earnings per share computations for the years ended December 31, 2000, 1999 and 1998 (in thousands, except per share amounts):
At December 31, 2000, 1999 and 1998, options to purchase a total of 314,250 shares of common stock with an exercise price of $107.37, 504,000 shares of common stock with an exercise price of $38.50, and 280,000 shares of common stock with an exercise price of $9.91, respectively, were not included in diluted earnings per share because the impact is considered anti-dilutive. The 4,494,000 shares of common stock reserved for issuance upon conversion of the outstanding convertible subordinated notes issued in 2000 were not included in diluted earnings per share because the assumed conversion would be antidilutive.
Reclassifications
Information technology expenses of $1.7 million in 1999 and $1.3 million in 1998 were reclassified from cost of revenues into selling and marketing and general and administrative expenses to reflect similar allocations made in the current year presentation.
Comprehensive income
Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 requires that all items recognized under accounting standards as components of comprehensive earnings be reported in an annual financial statement that is displayed with the same prominence as other annual financial statements. Comprehensive income has been included in the Consolidated Statements of Stockholders' Equity for all periods.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Segment reporting
Effective January 1998, the Company adopted Statement of Financial Accounting Standard No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131 establishes standards for the manner in which public companies report information about operating segments in annual and interim financial statements. During each of the three years ended December 31, 2000, 1999 and 1998, the Company's management considered its business activities to be focused on the license of its products and related services to end user customers. Since management's primary form of internal reporting is aligned with the offering of products and services, the Company believes it operates in one segment. Information related to geographic segments is included in Note 7.
New accounting pronouncements
In June 1999, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 137, "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133--an amendment of FASB Statement No. 133" ("SFAS 137"). SFAS 137 defers for one year the application of Statement of Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), to all fiscal quarters of fiscal years beginning after June 15, 2000. In June 2000, the Financial Accounting Standards Board issued SFAS No. 138 "Accounting for Derivative Instruments and Hedging Activities-An Amendment of FASB No. 133" ("SFAS 138"). SFAS 138 amends the accounting and reporting standards for certain derivatives and hedging activities such as net settlement contracts, foreign currency translations and intercompany derivatives. The Company will adopt SFAS 138 in its year ended December 31, 2001. The adoption as of January 1, 2001, of SFAS 133, SFAS 137 and SFAS 138 did not have a material effect on the Company's results of operations, financial position or cash flows.
In March 2000, the Financial Accounting Standards Board issued Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation--an Interpretation of APB Opinion No. 25" ("FIN 44"). FIN 44 clarifies the application of Accounting Practice Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), regarding (a) the definition of employee for purposes of applying APB 25, (b) the criteria for determining whether a plan qualifies as a noncompensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. FIN 44 was effective July 1, 2000, but certain conclusions in this Interpretation cover specific events that occured after either December 15, 1998, or January 12, 2000. The Company's adoption of the provisions of FIN 44 has not had a material effect on the Company's results of operations, financial position or cash flows.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
NOTE 2--FINANCIAL STATEMENT COMPONENTS
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
NOTE 3--COMMON STOCK
In August 1989, the Company adopted a stock option plan (the "1989 Plan"). Options granted under the 1989 Plan are for periods not to exceed ten years. For holders of 10% or more of the total combined voting power of all classes of the Company's stock, options may not be granted at less than 110% of the fair value of the common stock at the date of grant and the option term may not exceed 5 years. Incentive stock option grants under the 1989 Plan must be at exercise prices no less than 100% of the fair market value and non-statutory stock option grants under the 1989 Plan must be at exercise prices no less than 85% of the fair market value of the stock on the date of grant. Options are immediately exercisable but all shares purchased upon exercise of options are subject to repurchase by the Company until vested. Options generally vest over a period of four years. In August 1998, the stockholders reserved an additional 1,200,000 shares of common stock for issuance upon exercise of stock options to be granted under this plan. The term of the 1989 Plan expired in August 1999 and options are no longer granted under this plan.
In May 1996, the Company adopted a stock option plan solely for grants to employees of its subsidiaries located outside the United States (the "Supplemental Plan"). The Company reserved 2,000,000 shares of common stock for issuance upon exercise of stock options to be granted under this plan. The provisions of the Supplemental Plan regarding option term, grant price, exercise price, and vesting period is identical to those of the 1989 Plan.
In August 1998, the stockholders adopted the 1999 Stock Option Plan (the "1999 Plan") to replace the 1989 Plan, effective on the expiration of the term of such plan in August 1999. The Company reserved 900,000 shares of common stock for issuance upon exercise of stock options to be granted under this plan. The provisions of the 1999 Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1989 Plan except that all options granted under the 1999 Plan must be at exercise prices no less than 100% of the fair market value. In December 1999, the stockholders approved an automatic increase in the aggregate number of shares reserved for issuance under the 1999 Plan by 4% of the common stock and equivalents outstanding as of January 1 of each year starting in 2000 and ending in 2003.
In July 2000, the Company adopted the 2000 Supplemental Stock Option Plan (the "2000 Plan") which allows for options to be granted to any employee of the Company who is not a United States citizen or resident and who is not an executive officer or director of the Company. The Company reserved 2,000,000 shares of common stock for issuance upon exercise of stock options to be granted under the 2000 Plan. In November 2000, the Board amended and restated the 2000 Plan to better address tax issues of the Company and its employees in countries other than the United States. In February 2001, the Board approved the reservation of an additional 4,000,000 shares of common stock for issuance upon exercise of stock options to be granted under the 2000 Plan. The provisions of the 2000 Plan regarding option term, grant price and exercise price are identical to those of the 1999 Plan except that all the term of options granted in certain European countries may be different and the 2000 Plan provides for the grant of stock purchase rights.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following table presents the combined activity of the 1989 Plan, the 1999 Plan, the 2000 Plan and the Supplemental Plan for the years ended December 31, 1998, 1999 and 2000 (shares in thousands):
The following table presents weighted average price and remaining contractual life information about significant option groups outstanding under the above plans at December 31, 2000 (shares in thousands):
The Company holds notes receivable with balances totaling $7.5 million from its officers and certain employees in connection with the purchase of common stock. The notes bear interest at the market rate on the date of issuance and are secured by the shares purchased and require quarterly interest payments. The full amount of the notes and the final interest payment become due over the next five years until November, 2004.
Directors' Stock Option Plan
On August 3, 1994, the Board of Directors adopted the 1994 Directors' Stock Option Plan (the "Directors' Plan"). The Company reserved 2,000,000 shares of Common Stock for issuance upon exercise of stock options to be granted during the ten year term of the Directors' Plan. Only outside directors may be granted options under the Directors' Plan. The Plan provided for an initial option grant of 25,000 shares to the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Company's outside directors as of August 3, 1994 or upon initial election to the Board of Directors after August 3, 1994. In addition, the plan provided for automatic annual grants of 5,000 shares upon re-election of the individual to the Board of Directors. In August 1998, the stockholders agreed to amend the Directors' Plan to increase the number of shares granted to 50,000 shares as an initial grant to new non-employee directors, 10,000 shares as the annual grant to continuing non-employee directors of the Company, and to provide for a one- time grant of 25,000 shares to the non-employee directors of the Company who were serving as directors of the Company as of August 14, 1998. The option term is ten years, and options are exercisable while such person remains a director. The exercise price is no less than 100% of fair market value on the date of grant. The initial option grants and the one-time grants vest 20% annually for each director on the date of each Annual Meeting of Stockholders of the Company after the date of grant of such option. The annual option grants shall vest in full on the fifth anniversary following each individual's re-election to the Board of Directors.
The following table presents the activity for the Directors' Plan for the years ended December 31, 1998, 1999 and 2000 (shares in thousands):
The following table presents weighted average price and remaining contractual life information about significant option groups outstanding under the Directors' Plan at December 31, 2000 (shares in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Employee Stock Purchase Plans
In October 1993, the Board of Directors and stockholders adopted the Employee Stock Purchase Plan (the "1993 ESPP") and reserved 2,000,000 shares for issuance. Under the plan, employees were granted the right to purchase shares of common stock at a price per share that was the lesser of: (i) 85% of the fair market value of the shares at the participant's entry date into the two-year offering period, or (ii) the fair market value at the end of each six- month segment within such offering period. The 1993 ESPP was terminated in February 1998. In August 1998, the stockholders adopted the 1998 Employee Stock Purchase Plan (the "1998 ESPP") to replace the 1993 ESPP and the reservation of 1,300,000 shares for issuance thereunder. Under the 1998 ESPP, employees are granted the right to purchase shares of common stock at a price per share that is the lesser of (i) 85% of the fair market value of the shares at the participant's entry date into the six month offering period, or (ii) 85% of the fair market value of the shares at the end of the six month offering period. In May 2000, the stockholders approved the reservation of an additional 500,000 shares of common stock for issuance under the 1998 ESPP. During 2000, 1999 and 1998, approximately 189,000, 345,000 and 84,000 shares, respectively, were purchased under our Employee Stock Purchase Plans (the "ESPPs").
Pro Forma Disclosure
The Company has adopted the disclosure provisions only of SFAS 123 and will continue to account for its stock option plans in accordance with the provisions of APB 25. Accordingly, no compensation cost has been recognized for the option plans or the ESPPs.
Pursuant to the requirements of SFAS 123, the following are pro forma net income (loss) and net income (loss) per share for 2000, 1999, and 1998, as if the compensation costs for the option plans and the ESPPs had been determined based on the fair value at the grant date for grants in 2000, 1999, and 1998, consistent with the provisions of SFAS 123:
The fair value of options and shares issued pursuant to the option plans and the ESPPs at the grant date were estimated using the Black-Scholes model with the following weighted average assumptions:
The weighted fair value per share of options granted under the 1989 Plan, the 1999 Plan, the 2000 Plan and Supplemental Plan during the years ended December 31, 2000, 1999 and 1998 were $37.02, $10.12 and $4.13, respectively. The weighted fair value per share of options granted under the Directors' Plan during the years ended December 31, 2000, 1999 and 1998 were $45.51, $9.84, and $6.13, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
NOTE 4--INCOME TAXES
Income before provision for income taxes consists of the following (in thousands):
The provision for income taxes consists of the following (in thousands):
Deferred income taxes consists of the following (in thousands):
The Company has provided a valuation allowance of $1.7 million and $1.9 million for the years ended December 31, 2000 and 1999, respectively. The valuation allowance is for deferred income taxes due to foreign net operating losses for which realization of future benefit is uncertain.
As of December 31, 2000, the Company had net operating loss carryforwards for federal and state purposes of approximately $119.2 million and $24.6 million, respectively. The federal and state carryforwards will expire in various years through 2020 for the federal, and through 2005, for the state carryforwards. The net operating losses are attributable to stock option compensation deductions. Accordingly, the tax benefit realized upon utilization of the net operating loss carryforwards will be credited directly to equity.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The provision for income taxes differs from the amount obtained by applying the statutory federal income tax rate to income before taxes as follows (in thousands):
Income taxes are not provided for the undistributed earnings of the Company's foreign subsidiaries because it is management's intention to reinvest such earnings in its foreign operations.
The Company's Israeli operation has been granted the status of an "Approved Enterprise" under the Israeli law for the Encouragement of Capital Investments, 1959, as amended.
An Approved Enterprise is eligible for significant tax benefits for 10 years starting the first year in which the Company has Israeli taxable income (after consideration of tax losses carried forward). The benefits include a corporate tax rate of 10% on income from certain approved enterprises and a tax exemption on income from approved enterprises in respect of which the Company has elected the "alternative benefits". The exemption period is 2 years, after which the income from these enterprises is taxable at the rate of 10% for 8 years, and the regular rate thereafter. While the Company will continue to apply for "Approved Enterprise" status in future years, there is no assurance that the benefits available under the current law will remain unchanged.
The Company's Israeli operation has six overlapping Approved Enterprises plans. The Company expects to be able to realize the tax holidays and rate of the current plans through the year 2010. The entitlement to the "Approved Enterprise" benefits is conditional upon the Company fulfilling the conditions stipulated by the law, regulations published thereunder and the instruments of approval for the specific investments in approved enterprises or approved assets. In the event of failure to comply with these conditions, the benefits may be cancelled and the Company may be required to refund the amount of the benefits, in whole or in part, with the addition of interest.
The 1999 tax provision was calculated without the benefit of Conduct's pre- acquisition losses because the realization of any future tax benefit is uncertain.
NOTE 5--COMMITMENTS
Royalty Commitments
Research and development expense is reported net of research grants received from the government of Israel, and includes royalty expense for obligations to the government of Israel for sales of products developed under government- funded research. No grants were obtained from the Office of the Chief Scientist in the Israeli Ministry of Industry and Trade ("the Chief Scientist") during 2000 and 1999. Research grants received amounted to $1.6 million in 1998. The Company was not obligated to repay these grants; however, the Company agreed to pay royalties at rates ranging from 2% to 5% of product sales resulting from the research, up to the amount of the grants obtained and for certain grants up to 150% of the grants obtained. There was no
MERCURY INTERACTIVE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
royalty expense under these agreements for the year ended December 31, 2000. Royalty expense amounted to approximately $2.7 million for each of the years ended December 31, 1999 and 1998. As of December 31, 2000, the Company had no outstanding royalty obligations. The Company has not applied for, nor does it anticipate applying for, any future Chief Scientist grants.
Lease commitments
The Company leases facilities for sales offices in the U.S. and foreign locations under non-cancelable operating leases that expire from 2001 through 2005. Certain of these leases contain renewal options. The Company leases certain equipment under various leases with lease terms ranging from month-to- month up to one year. Future minimum payments under the facilities and equipment leases with non-cancelable terms in excess of one year are as follows as of December 31, 2000 (in thousands):
Total rent expense under operating leases amounted to $4.1 million, $2.8 million and $2.0 million for the years ended December 31, 2000, 1999 and 1998, respectively.
NOTE 6--RELATED PARTIES
At December 31, 2000, the Company held notes receivable with balances totaling $7.5 million from its officers and certain employees. These notes were issued over the last 3 years to purchase shares of the Company's common stock at the then fair market value. The remaining notes, which bear interest at the market rate on the date of issuance, mature over the next five years until November, 2004. Interest on the notes is due quarterly, with the principal amount and final interest payment being payable in full no later than the maturity date. If the officer or key employee's employment is terminated prior to the respective notes maturity date, the unpaid portion of the note would become payable in full. These notes are full recourse loans collateralized by the shares purchased. The receivable is shown on the balance sheets as a reduction in equity.
NOTE 7--GEOGRAPHIC REPORTING
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The subsidiary located in the United Kingdom accounted for 10%, 12% and 11% of the consolidated net revenue to unaffiliated customers for the years ended December 31, 2000, 1999 and 1998 respectively. Operations located in Israel accounted for 13%, 23% and 19% of the consolidated identifiable assets at December 31, 2000, 1999 and 1998 respectively.
NOTE 8--ACQUISITIONS
On November 30, 1999, the Company acquired Conduct Ltd. Under terms of the agreement, approximately 408,000 shares of the Company's common stock were issued in exchange for all issued and outstanding convertible preferred and common shares of Conduct, and assumption of all outstanding Conduct stock options, warrants and other securities. The transaction was accounted for as a pooling of interests in the year ended December 31, 1999; therefore, all prior periods presented have been restated to include Conduct in operations since its inception.
Since its inception, Conduct Ltd. has not recorded any revenues. The net income for the separate companies and the combined amounts presented in the consolidated financial statements follow (in thousands).
NOTE 9--LONG-TERM DEBT
In July 2000, the Company issued $500.0 million in convertible subordinated notes. The notes mature on July 1, 2007 and bear interest at a rate of 4.75% per annum, payable semiannually on January 1 and July 1 of each year. The notes are subordinated in right of payment to all of Mercury's future senior debt. The notes are convertible into shares of the Company's common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. The notes may be redeemed, in whole or in part, by the Company at any time on or after July 1, 2003. Accrued interest to the redemption date will be paid by the Company in each redemption.
In connection with the issuance of convertible subordinated notes, the Company incurred $14.6 million of issuance costs, which primarily consisted of investment banker fees, legal, and other professional fees. The costs are being amortized using a straight-line method over the seven-year term of the notes. Amortization expense related to the issuance costs was $1.0 million in 2000.
NOTE 10--EMPLOYEE BENEFIT PLAN
The Company has a qualified 401(k) plan available to eligible employees. Participants may contribute up to 15% of their annual compensation to the plan, limited to a maximum annual amount set by the Internal Revenue Service. The Company matches employee contributions dollar for dollar up to a maximum of $1,000 per year per person. Matching contributions vest according to the number of years of employee service. The Company contributed approximately $415,000 to the 401(k) plan during 2000.
UNAUDITED QUARTERLY FINANCIAL DATA